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Growth accounting relations is a quantitative model Robert Solow developed in 1957. It is used to measure the effect of different factors of economic growth. In addition, it indirectly estimates the technological progress in an economy. In other words, it is a production function regarding growth rates.
This equation is based on the Cobb-Douglas production function, broken down into percentage changes in output factors associated with labor, capital, and technology. It is given by:
$$ \frac{\Delta Y}{Y}=\frac{\Delta A}{A}+\alpha\frac{\Delta K}{K}+\left(1-\alpha\right)\frac{\Delta L}{L} \ldots\ldots\ldots (i) $$
From the equation above, the growth accounting equation mentions that:
$$ \begin{align*} \text{The growth rate of output} &=\text{Technological change} \\ & + \alpha(\text{growth rate of capital}) \\ & +(1- \alpha)(\text{Growth rate of labor}) \end{align*} $$
\(\alpha\) is the elasticity of our output relative to the capital since a 1% rise in capital causes an \(\alpha\)% rise in output. Similarly, \((1-\alpha)\) is the elasticity of output concerning labor. Recall also that \(\alpha\) and \((1-\alpha)\) are the proportion of income paid to each factor. Any other unspecified factor is taken care of by the TFP factor.
Economic data of a developed country reveals that shares of capital (\(\alpha\)) and labor \((1-\alpha)\) are roughly 0.2 and 0.8, respectively. What can be deduced from these results?
This implies that a rise in the labor growth rate will significantly impact potential GDP growth more than the capital growth rate while keeping other factors constant. A 1% increase in capital for each worker raises the output by 0.2%, and an equivalent rise in labor increases production by 0.8%.
Estimation of the Contribution of Technological Progress to Economic Growth
Solow approximated TFP from equation (1) by making \(\frac{ {\Delta A}}{A}\) the subject of the formula, then substituting in the values of \(\frac{{\Delta K}}{K},\frac{{\Delta L}}{L}\) and \(\alpha\). TFP represents the quantity of output that growth in capital or labor does not explain.
Measurement of Sources of Growth in the Economy
The growth accounting equation is used to measure the impact of each production factor on the economy’s long-term growth.
Measurement of Potential GDP
The potential GDP is approximated using equation (1) as a function of growth rates of capital, labor, the TFP (this is residual in the growth accounting equation), and the factor \(\alpha\).
The labor productivity growth accounting equation is a substitute for measuring potential GDP. It possesses the same characteristics as Solow’s approach. However, it is easy and represented as the function of labor input and labor input productivity. Therefore, there is no need to approximate the capital input and total factor productivity (TFP).
However, the major shortcoming involves both capital deepening and TFP progress in the productivity period, making it hard to analyze and anticipate over a long period.
The labor productivity growth accounting equation is given by:
$$ \begin{align*} & \text{The growth rate in Potential GDP} \\ & = \text{Growth rate of the labor force over a long-term period} \\ & + \text{Growth rate of labor productivity over a long-term period.} \end{align*} $$
Question
The labor force of country X grows by 2% per year and labor productivity by 4%; the growth rate of the potential GDP per year is closest to:
- 2%.
- 4%.
- 6%.
Solution
The correct answer is C.
According to the labor productivity growth accounting equation,
$$ \begin{align*} & \text{The growth rate in Potential GDP} \\ & = \text{Growth rate of the labor force over a long-term period} \\ & + \text{Growth rate of labor productivity over a long-term period.} \\ & = 2\% + 4\% = 6\% \text{ per year} \end{align*} $$
Reading 9: Economic Growth
LOS 9 (e) Demonstrate forecasting potential GDP based on growth accounting relations.