Saving ,Capital Accumulation and Output

Saving, Capital Accumulation, and Output

The effects of the saving rate - the ratio of saving to GDP – on capital
and output per capita are the topics of this chapter.

An increase in the saving rate would lead to higher growth for some
time, and eventually to a higher standard of living in the United States
 Interactions between Output and Capital

At the center of the determination of output in the long run are two
relations between output and capital:

 The amount of capital determines the amount of output being

produced.

 The amount of output determines the amount of saving and, in

turn, the amount of capital accumulated over time.
 Interactions between Output and Capital

Capital, Output, and Saving/Investment

 Interactions between Output and Capital

The Effects of Capital on Output

Under constant returns to scale, we can write the relation between

output and capital per worker as follows:
 Interactions between Output and Capital

The Effects of Capital on Output

Since the focus here is on the role of capital accumulation, we make

the following assumptions:

 The size of the population, the participation rate,

and the unemployment rate are all constant.

 There is no technological progress

 Interactions between Output and Capital

The Effects of Capital on Output

With these two assumptions, our first relation between output and
capital per worker, from the production side, can be written as

In words, higher capital per worker leads to higher

output per worker
 Interactions between Output and Capital

The Effects of Output on Capital Accumulation

To derive the second relation, between output and capital

accumulation, we proceed in two steps:

1. We derive the relation between output and investment.

2. We derive the relation between investment

and capital accumulation.
 Interactions between Output and Capital

The Effects of Output on Capital Accumulation

Output and Investment
We make three assumptions to derive the relation between output and
investment:

 We assume the economy is closed

 We assume public saving, T – G, is equal to zero.

 We assume that private saving is proportional to income, so

 Interactions between Output and Capital

The Effects of Output on Capital Accumulation

Investment and Capital Accumulation
• The evolution of the capital stock is given by

 denotes the rate of depreciation

Combining the relation from output to investment,

I , and the relation from investment to capital

accumulation, we obtain the second important relation
we want to express, from output to capital accumulation
 Interactions between Output and Capital

The Effects of Output on Capital Accumulation

Investment and Capital Accumulation
Output and Capital per Worker:

Rearranging terms in the equation above, we can

articulate the change in capital per worker over time

In words, the change in the capital stock per worker (left side) is
equal to saving per worker minus depreciation (right side).
 The Implications of Alternative
Saving Rates

Our two main relations are:

First relation: Second relation:

Capital determines output Output determines capital
accumulation

Combining the two relations, we can study the behavior of output

and capital over time
 The Implications of Alternative
Saving Rates

From our main relations above, we express output per worker

(Yt/N) in terms of capital per worker to derive the equation below

= _

Change in capital =
Investment Depreciation
from year t to year t + 1 during year t
_ during year t
 The Implications of Alternative
Saving Rates

Dynamics of Capital and Output

Investment
during year t

This relation describes what happens to capital per worker. The change in
capital per worker from this year to next year depends on the difference between
two terms:

If investment per worker exceeds depreciation per worker, the change in

capital per worker is positive: Capital per worker increases.

If investment per worker is less than depreciation per worker, the change in
capital per worker is negative: Capital per worker decreases.
 The Implications of Alternative
Saving Rates Dynamics of Capital and Output

• At K0/N, capital per

worker is low,
investment
exceeds
depreciation, thus,
capital per worker
and output per
worker tend to
increase over time
 The Implications of Alternative
Saving Rates Dynamics of Capital and Output

At K*/N, output per worker

and capital per worker
remain constant at their
long-run equilibrium
levels.

Investment per worker increases with capital per worker, but by less and less as
capital per worker increases.
Depreciation per worker increases in proportion to capital per worker.
 The Implications of Alternative
Saving Rates Dynamics of Capital and Output

Capital and Output

Dynamics
When capital and output are low,
investment exceeds depreciation,
and capital increases. When
capital and output are high,
investment is less than
depreciation, and capital
decreases.
 The Implications of Alternative
Saving Rates

Steady-State Capital and Output

The state in which output per worker and capital per worker are no
longer changing is called the steady state of the economy. In
steady state, the left side of the equation above equals zero, then

Given the steady state of capital per worker (K*/N), the

steady-state value of output per worker (Y*/N), is given by the
production function
 The Implications of Alternative
Saving Rates

The Saving Rate and Output

Three observations about the effects of the saving rate on the growth rate
of output per worker are:

1. The saving rate has no effect on the long run growth rate of output per
worker, which is equal to zero.

2. Nonetheless, the saving rate determines the level of output per

worker in the long run. Other things equal, countries with a higher
saving rate will achieve higher output per worker in the long run.

3. An increase in the saving rate will lead to higher growth of output per
worker for some time, but not forever.
 The Implications of Alternative
Saving Rates The Saving Rate and Output

The Effects of Different Saving

Rates
• A country with a higher saving rate
achieves a higher steady- state
level of output per worker
 The Implications of Alternative
Saving Rates The Saving Rate and Output

The Effects of an
Increase in the
Saving Rate on
Output per Worker
• An increase in the
saving rate leads to a
period of higher growth
until output reaches its
new, higher steady-
state level
 The Implications of Alternative
Saving Rates The Saving Rate and Output

The Effects of an Increase

in the Saving Rate on
Output per Worker in an
Economy with
Technological Progress
• An increase in the saving rate
leads to a period of higher
growth until output reaches a
new, higher path
 The Implications of Alternative
Saving Rates

The Saving Rate and Consumption

An increase in the saving rate always leads to an increase in the level
of output per worker. But output is not the same as consumption. To see
why, consider what happens for two extreme values of the saving rate:
An economy in which the saving rate is (and has always been) 0 is
an economy in which capital is equal to zero. In this case, output is
also equal to zero, and so is consumption. A saving rate equal to
zero implies zero consumption in the long run.
Now consider an economy in which the saving rate is equal to one:
People save all their income. The level of capital, and thus output,
in this economy will be very high. But because people save all their
income, consumption is equal to zero. A saving rate equal to one
also implies zero consumption in the long run.
 The Implications of Alternative
Saving Rates

The Saving Rate and Consumption

The level of capital associated with the value of the saving rate that
yields the highest level of consumption in steady state is known as the
golden-rule level
of capital.
 The Implications of Alternative
Saving Rates The Saving Rate and Consumption

The Effects of the

Saving Rate on Steady-
State Consumption per
Worker
• An increase in the saving
rate leads to an increase
and then to a decrease in
steady-state consumption
per worker
 Social Security, saving and Capital Accumulation

One way to run a social security system is the fully-funded

system, where workers are taxed, their contributions invested in
financial assets, and when workers retire, they receive the principal
plus the interest payments on their investments.

Another way to run a social security system is the pay-as-you-go

system, where the taxes that workers pay are the benefits that
current retirees receive.

In anticipation of demographic changes, the Social Security tax rate

has seen increases, and contributions are now larger than benefits,
leading to the accumulation of a Social Security trust fund.
 Getting a Sense of Magnitudes

• Assume the production function is

Output per worker is

Output per worker, as it relates to capital per worker is

Given our second relation

Then,
 Getting a Sense of Magnitudes

The Effects of the Saving Rate on Steady-State Output

Steady-state output per worker is equal to the ratio of the saving rate
to the depreciation rate.

A higher saving rate and a lower depreciation rate both lead to

higher steady-state capital per worker and higher steady-state
output per worker.
 Getting a Sense of Magnitudes

The U.S. Saving Rate and the Golden Rule

• In steady state, consumption per worker is equal to output per
worker minus depreciation per worker

Knowing that and

then

These equations are used to derive Table below in

the next slide
 Getting a Sense of Magnitudes

The U.S. Saving Rate and the Golden Rule

The Saving Rate and the Steady-state Levels of

Capital, Output, and Consumption per Worker
Capital per Output per Consumption per
Saving Rate, s Worker, (K/N) Worker, (Y/N) Worker, (C/N)
0.0 0.0 0.0 0.0
0.1 1.0 1.0 0.9
0.2 4.0 2.0 1.6
0.3 9.0 3.0 2.1
0.4 16.0 4.0 2.4
0.5 25.0 5.0 2.5
0.6 36.0 6.0 2.4
– – – –
1.0 100.0 10.0 0.0
 Physical versus Human Capital

The set of skills of the workers in the economy is called human

capital.

An economy with many highly skilled workers is likely to be much more

productive than an economy in which most workers cannot read or
write.

The conclusions drawn about physical capital accumulation remain

valid after the introduction of human capital in the analysis.
 Physical versus Human Capital

Extending the Production Function

• When the level of output per workers depends on both the level of
physical capital per worker, K/N, and the level of human capital per
worker, H/N, the production function may be written as

An increase in capital per worker or the average skill of

workers leads to an increase in output per worker
 Physical versus Human Capital

Extending the Production Function

A measure of human capital may be constructed as follows:

Suppose an economy has 100 workers, half of them unskilled and half
of them skilled. The relative wage of skilled workers is twice that of
unskilled workers.

Then:
 Physical versus Human Capital

Human Capital, Physical Capital, and Output

An increase in how much society “saves” in the form of human capital
—through education and on-the-job-training—increases steady-state
human capital per worker, which leads to an increase in output per
worker.

In the long run, output per worker depends not only on how much
society saves but also how much it spends on education.
 Physical versus Human Capital

Human Capital, Physical Capital, and Output

In the United States, spending on education comprises about 6.5% of GDP,
compared to 16% investment in physical capital. This comparison:

 Accounts for the fact that education is partly consumption.

 Does not account for the opportunity cost of education.

 Does not account for the opportunity cost of on-the-

job-training.

 Considers gross, not net investment. Depreciation of human capital is

slower than that of physical capital
 Physical versus Human Capital
Endogenous Growth
• A recent study has concluded that output per worker depends roughly equally on
the amount of physical capital and the amount of human capital in the economy.

• Models that generate steady growth even without technological progress are
called models of endogenous growth, where growth depends on variables such as
the saving rate and the rate of spending on education.

• Output per worker depends on the level of both physical capital per worker and
human capital per worker.

• Is technological progress unrelated to the level of human capital in the economy?

Can’t a better-educated labor force lead to a higher rate of technological
progress? These questions take us to the topic of the next chapter: the sources
and the effects of technological progress
 Key Terms
 saving rate pay-as-you-go system
 steady state trust fund
 golden-rule level of capital human capital
 fully funded system models of endogenous growth