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A Contribution to the Empirics of Economic Growth Author(s): N. Gregory Mankiw, David Romer and David N. Weil Source: The Quarterly Journal of Economics, Vol. 107, No. 2 (May, 1992), pp. 407-437 Published by: Oxford University Press Stable URL: http://www.jstor.org/stable/2118477 . Accessed: 22/02/2015 13:38

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A CONTRIBUTION TO THE EMPIRICS OF ECONOMIC GROWTH*

N. GREGORY MANKIW

DAVID ROMER

DAVID N. WEIL

This paper examines whether the Solow growth model is consistent with the international variation in the standard of living. It shows that an augmented Solow model that includes accumulation of human as well as physical capital provides an excellent description of the cross-country data. The paper also examines the implications of the Solow model for convergence in standards of living, that is, for whether poor countries tend to grow faster than rich countries. The evidence indicates that, holding population growth and capital accumulation constant, countries converge at about the rate the augmented Solow model predicts.

INTRODUCTION

This paper takes Robert Solow seriously. In his classic 1956 article Solow proposed that we begin the study of economic growth by assuming a standard neoclassical production function with decreasing returns to capital. Taking the rates of saving and population growth as exogenous, he showed that these two vari- ables determine the steady-state level of income per capita. Be- cause saving and population growth rates vary across countries, different countries reach different steady states. Solow's model gives simple testable predictions about how these variables influ- ence the steady-state level of income. The higher the rate of saving, the richer the country. The higher the rate of population growth, the poorer the country.

This paper argues that the predictions of the Solow model are, to a first approximation, consistent with the evidence. Examining recently available data for a large set of countries, we find that saving and population growth affect income in the directions that Solow predicted. Moreover, more than half of the cross-country variation in income per capita can be explained by these two variables alone.

Yet all is not right for the Solow model. Although the model correctly predicts the directions of the effects of saving and

*We are grateful to Karen Dynan for research assistance, to Laurence Ball, Olivier Blanchard, Anne Case, Lawrence Katz, Robert King, Paul Romer, Xavier Sala-i-Martin, Amy Salsbury, Robert Solow, Lawrence Summers, Peter Temin, and the referees for helpful comments, and to the National Science Foundation for financial support.

? 1992 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology. The Quarterly Journal of Economics, May 1992

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population growth, it does not correctly predict the magnitudes. In the data the effects of saving and population growth on income are too large. To understand the relation between saving, population growth, and income, one must go beyond the textbook Solow model.

We therefore augment the Solow model by including accumu- lation of human as well as physical capital. The exclusion of human capital from the textbook Solow model can potentially explain why the estimated influences of saving and population growth appear too large, for two reasons. First, for any given rate of human- capital accumulation, higher saving or lower population growth leads to a higher level of income and thus a higher level of human capital; hence, accumulation of physical capital and population growth have greater impacts on income when accumulation of human capital is taken into account. Second, human-capital accu- mulation may be correlated with saving rates and population growth rates; this would imply that omitting human-capital accu- mulation biases the estimated coefficients on saving and population growth.

To test the augmented Solow model, we include a proxy for human-capital accumulation as an additional explanatory variable in our cross-country regressions. We find that accumulation of human capital is in fact correlated with saving and population growth. Including human-capital accumulation lowers the esti- mated effects of saving and population growth to roughly the values predicted by the augmented Solow model. Moreover, the augmented model accounts for about 80 percent of the cross- country variation in income. Given the inevitable imperfections in this sort of cross-country data, we consider the fit of this simple model to be remarkable. It appears that the augmented Solow model provides an almost complete explanation of why some countries are rich and other countries are poor.

After developing and testing the augmented Solow model, we examine an issue that has received much attention in recent years: the failure of countries to converge in per capita income. We argue that one should not expect convergence. Rather, the Solow model predicts that countries generally reach different steady states. We examine empirically the set of countries for which nonconvergence has been widely documented in past work. We find that once differences in saving and population growth rates are accounted for, there is convergence at roughly the rate that the model predicts.

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THE EMPIRICS OF ECONOMIC GROWTH 409

Finally, we discuss the predictions of the Solow model for international variation in rates of return and for capital move- ments. The model predicts that poor countries should tend to have higher rates of return to physical and human capital. We discuss various evidence that one might use to evaluate this prediction. In contrast to many recent authors, we interpret the available evidence on rates of return as generally consistent with the Solow model.

Overall, the findings reported in this paper cast doubt on the recent trend among economists to dismiss the Solow growth model in favor of endogenous-growth models that assume constant or increasing returns to scale in capital. One can explain much of the cross-country variation in income while maintaining the assump- tion of decreasing returns. This conclusion does not imply, how- ever, that the Solow model is a complete theory of growth: one would like also to understand the determinants of saving, popula- tion growth, and worldwide technological change, all of which the Solow model treats as exogenous. Nor does it imply that endogenous- growth models are not important, for they may provide the right explanation of worldwide technological change. Our conclusion does imply, however, that the Solow model gives the right answers to the questions it is designed to address.

I. THE TEXTBOOK SOLOW MODEL

We begin by briefly reviewing the Solow growth model. We focus on the model's implications for cross-country data.

A. The Model

Solow's model takes the rates of saving, population growth, and technological progress as exogenous. There are two inputs, capital and labor, which are paid their marginal products. We assume a Cobb-Douglas production function, so production at time t is given by

(1) Y(t) = K(t)a(A(t)L(t))l- 0 < a. < 1.

The notation is standard: Y is output, K capital, L labor, and A the level of technology. L and A are assumed to grow exogenously at rates n and g:

(2) L (t) = L ()ent

(3) A (t) = A (r)ent.

The number of effective units of labor, A (t)L (t), grows at rate n + g.

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The model assumes that a constant fraction of output, s, is invested. Defining k as the stock of capital per effective unit of labor, k = KIAL, and y as the level of output per effective unit of labor, y = Y/AL, the evolution of k is governed by

(4) k(t) = sy(t) - (n + g + 8)k (t)

= sk(t)0 - (n + g + 8)k(t),

where 8 is the rate of depreciation. Equation (4) implies that k converges to a steady-state value k* defined by sk *a = (n + g + 8)k *, or

(5) k* = [s/(n + g + 5)]1I(1-a)

The steady-state capital-labor ratio is related positively to the rate of saving and negatively to the rate of population growth.

The central predictions of the Solow model concern the impact of saving and population growth on real income. Substituting (5) into the production function and taking logs, we find that steady- state income per capita is

(6)tl [Ot]ln()gt (6) In = In A (0) + gt + 1 In(s) - 1 ln(n + g + 8).

Because the model assumes that factors are paid their marginal products, it predicts not only the signs but also the magnitudes of the coefficients on saving and population growth. Specifically, because capital's share in income (a) is roughly one third, the model implies an elasticity of income per capita with respect to the saving rate of approximately 0.5 and an elasticity with respect to n + g + 8 of approximately -0.5.

B. Specification The natural question to consider is whether the data support

the Solow model's predictions concerning the determinants of standards of living. In other words, we want to investigate whether real income is higher in countries with higher saving rates and lower in countries with higher values of n + g + 5.

We assume that g and 8 are constant across countries. g reflects primarily the advancement of knowledge, which is not country-specific. And there is neither any strong reason to expect depreciation rates to vary greatly across countries, nor are there any data that would allow us to estimate country-specific deprecia- tion rates. In contrast, the A(0) term reflects not just technology

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THE EMPIRICS OF ECONOMIC GROWTH 411

but resource endowments, climate, institutions, and so on; it may therefore differ across countries. We assume that

lnA(O) = a + E,

where a is a constant and E is a country-specific shock. Thus, log income per capita at a given time-time 0 for simplicity-is

(7) In a+ In(s)- In(n+g+8)+E.

Equation (7) is our basic empirical specification in this section. We assume that the rates of saving and population growth are

independent of country-specific factors shifting the production function. That is, we assume that s and n are independent of e. This assumption implies that we can estimate equation (7) with ordi- nary least squares (OLS).1

There are three reasons for making this assumption of indepen- dence. First, this assumption is made not only in the Solow model, but also in many standard models of economic growth. In any model in which saving and population growth are endogenous but preferences are isoelastic, s and n are unaffected by E. In other words, under isoelastic utility, permanent differences in the level of technology do not affect saving rates or population growth rates.

Second, much recent theoretical work on growth has been motivated by informal examinations of the relationships between saving, population growth, and income. Many economists have asserted that the Solow model cannot account for the international differences in income, and this alleged failure of the Solow model has stimulated work on endogenous-growth theory. For example, Romer [1987, 1989a] suggests that saving has too large an influence on growth and takes this to be evidence for positive externalities from capital accumulation. Similarly, Lucas [1988] asserts that variation in population growth cannot account for any substantial variation in real incomes along the lines predicted by the Solow model. By maintaining the identifying assumption that s and n are independent of E, we are able to determine whether systematic examination of the data confirms these informal judg- ments.

1. If s and n are endogenous and influenced by the level of income, then estimates of equation (7) using ordinary least squares are potentially inconsistent. In this case, to obtain consistent estimates, one needs to find instrumental variables that are correlated with s and n, but uncorrelated with the country-specific shift in the production function e. Finding such instrumental variables is a formidable task, however.

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Third, because the model predicts not just the signs but also the magnitudes of the coefficients on saving and population growth, we can gauge whether there are important biases in the estimates obtained with OLS. As described above, data on factor shares imply that, if the model is correct, the elasticities of Y/L with respect to s and n + g + 8 are approximately 0.5 and -0.5. If OLS yields coefficients that are substantially different from these values, then we can reject the joint hypothesis that the Solow model and our identifying assumption are correct.

Another way to evaluate the Solow model would be to impose on equation (7) a value of ao derived from data on factor shares and then to ask how much of the cross-country variation in income the model can account for. That is, using an approach analogous to "growth accounting," we could compute the fraction of the vari- ance in living standards that is explained by the mechanism identified by the Solow model.2 In practice, because we do not have exact estimates of factor shares, we do not emphasize this growth- accounting approach. Rather, we estimate equation (7) by OLS and examine the plausibility of the implied factor shares. The fit of this regression shows the result of a growth-accounting exercise per- formed with the estimated value of a. If the estimated a differs from the value obtained a priori from factor shares, we can compare the fit of the estimated regression with the fit obtained by imposing the a priori value.

C. Data and Samples

The data are from the Real National Accounts recently constructed by Summers and Heston [1988]. The data set includes real income, government and private consumption, investment, and population for almost all of the world other than the centrally planned economies. The data are annual and cover the period 1960-1985. We measure n as the average rate of growth of the working-age population, where working age is defined as 15 to 64.3 We measure s as the average share of real investment (including

2. In standard growth accounting, factor shares are used to decompose growth over time in a single country into a part explained by growth in factor inputs and an unexplained part-the Solow residual-which is usually attributed to technological change. In this cross-country analogue, factor shares are used to decompose variation in income across countries into a part explained by variation in saving and population growth rates and an unexplained part, which could be attributed to international differences in the level of technology.

3. Data on the fraction of the population of working age are from the World Bank's World Tables and the 1988 World Development Report.

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THE EMPIRICS OF ECONOMIC GROWTH 413

government investment) in real GDP, and Y/L as real GDP in 1985 divided by the working-age population in that year.

We consider three samples of countries. The most comprehen- sive consists of all countries for which data are available other than those for which oil production is the dominant industry.4 This sample consists of 98 countries. We exclude the oil producers because the bulk of recorded GDP for these countries represents the extraction of existing resources, not value added; one should not expect standard growth models to account for measured GDP in these countries.5

Our second sample excludes countries whose data receive a grade of "D" from Summers and Heston or whose populations in 1960 were less than one million. Summers and Heston use the "D" grade to identify countries whose real income figures are based on extremely little primary data; measurement error is likely to be a greater problem for these countries. We omit the small countries because the determination of their real income may be dominated by idiosyncratic factors. This sample consists of 75 countries.

The third sample consists of the 22 OECD countries with populations greater than one million. This sample has the advan- tages that the data appear to be uniformly of high quality and that the variation in omitted country-specific factors is likely to be small. But it has the disadvantages that it is small in size and that it discards much of the variation in the variables of interest.

See the Appendix for the countries in each of the samples and the data.

D. Results

We estimate equation (7) both with and without imposing the constraint that the coefficients on ln(s) and ln(n + g + 8) are equal in magnitude and opposite in sign. We assume that g + 8 is 0.05; reasonable changes in this assumption have little effect on the estimates.6 Table I reports the results.

4. For purposes of comparability, we restrict the sample to countries that have not only the data used in this section, but also the data on human capital described in Section II.

5. The countries that are excluded on this basis are Bahrain, Gabon, Iran, Iraq, Kuwait, Oman, Saudi Arabia, and the United Arab Emirates. In addition, Lesotho is excluded because the sum of private and government consumption far exceeds GDP in every year of the sample, indicating that labor income from abroad constitutes an extremely large fraction of GNP.

6. We chose this value of g + 8 to match the available data. In U. S. data the capital consumption allowance is about 10 percent of GNP, and the capital-output ratio is about three, which implies that 8 is about 0.03; Romer [1989a, p. 60] presents a calculation for a broader sample of countries and concludes that 8 is

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TABLE I ESTIMATION OF THE TEXTBOOK SOLOW MODEL

Dependent variable: log GDP per working-age person in 1985

Sample: Non-oil Intermediate OECD Observations: 98 75 22 CONSTANT 5.48 5.36 7.97

(1.59) (1.55) (2.48) ln(I/GDP) 1.42 1.31 0.50

(0.14) (0.17) (0.43) ln(n + g + 8) -1.97 -2.01 -0.76

(0.56) (0.53) (0.84) H2 0.59 0.59 0.01 s.e.e. 0.69 0.61 0.38 Restricted regression: CONSTANT 6.87 7.10 8.62

(0.12) (0.15) (0.53) ln(I/GDP) - ln(n + g + 8) 1.48 1.43 0.56

(0.12) (0.14) (0.36) 1?2 0.59 0.59 0.06 s.e.e. 0.69 0.61 0.37 Test of restriction:

p-value 0.38 0.26 0.79 Implied a 0.60 0.59 0.36

(0.02) (0.02) (0.15)

Note. Standard errors are in parentheses. The investment and population growth rates are averages for the period 1960-1985. (g + 8) is assumed to be 0.05.

Three aspects of the results support the Solow model. First, the coefficients on saving and population growth have the predicted signs and, for two of the three samples, are highly significant. Second, the restriction that the coefficients on ln(s) and ln(n + g + 8) are equal in magnitude and opposite in sign is not rejected in any of the samples. Third, and perhaps most important, differences in saving and population growth account for a large fraction of the cross-country variation in income per capita. In the regression for the intermediate sample, for example, the adjusted R2 is 0.59. In contrast to the common claim that the Solow model "explains" cross-country variation in labor productivity largely by appealing to variations in technologies, the two readily observable

about 0.03 or 0.04. In addition, growth in income per capita has averaged 1.7 percent per year in the United States and 2.2 percent per year in our intermediate sample; this suggests that g is about 0.02.

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THE EMPIRICS OF ECONOMIC GROWTH 415

variables on which the Solow model focuses in fact account for most of the variation in income per capita.

Nonetheless, the model is not completely successful. In par- ticular, the estimated impacts of saving and labor force growth are much larger than the model predicts. The value of a. implied by the coefficients should equal capital's share in income, which is roughly one third. The estimates, however, imply an a that is much higher. For example, the a implied by the coefficient in the constrained regression for the intermediate sample is 0.59 (with a standard error of 0.02). Thus, the data strongly contradict the prediction that a = 1/3.

Because the estimates imply such a high capital share, it is inappropriate to conclude that the Solow model is successful just because the regressions in Table I can explain a high fraction of the variation in income. For the intermediate sample, for instance, when we employ the "growth-accounting" approach described above and constrain the coefficients to be consistent with an a of one third, the adjusted R2 falls from 0.59 to 0.28. Although the excellent fit of the simple regressions in Table I is promising for the theory of growth in general-it implies that theories based on easily observable variables may be able to account for most of the cross-country variation in real income it is not supportive of the textbook Solow model in particular.

II. ADDING HUMAN-CAPITAL ACCUMULATION TO THE SOLOW MODEL

Economists have long stressed the importance of human capital to the process of growth. One might expect that ignoring human capital would lead to incorrect conclusions: Kendrick [1976] estimates that over half of the total U. S. capital stock in 1969 was human capital. In this section we explore the effect of adding human-capital accumulation to the Solow growth model.

Including human capital can potentially alter either the theoretical modeling or the empirical analysis of economic growth. At the theoretical level, properly accounting for human capital may change one's view of the nature of the growth process. Lucas [1988], for example, assumes that although there are decreasing returns to physical-capital accumulation when human capital is held constant, the returns to all reproducible capital (human plus physical) are constant. We discuss this possibility in Section III.

At the empirical level, the existence of human capital can alter the analysis of cross-country differences; in the regressions in

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Table I human capital is an omitted variable. It is this empirical problem that we pursue in this section. We first expand the Solow model of Section I to include human capital. We show how leaving out human capital affects the coefficients on physical capital investment and population growth. We then run regressions analogous to those in Table I to see whether proxies for human capital can resolve the anomalies found in the first section.7

A. The Model

Let the production function be

(8) Y(t) = K(t)H(t)P(A(t)L(t))1-a-,

where H is the stock of human capital, and all other variables are defined as before. Let Sk be the fraction of income invested in physical capital and Sh the fraction invested in human capital. The evolution of the economy is determined by

(9a) k(t) = sky(t) - (n + g + 8)k(t), (9b) h(t) = Shy(t) - (n + g + 8)h(t),

where y = Y/AL, k = K/AL, and h = H/AL are quantities per effective unit of labor. We are assuming that the same production function applies to human capital, physical capital, and consump- tion. In other words, one unit of consumption can be transformed costlessly into either one unit of physical capital or one unit of human capital. In addition, we are assuming that human capital depreciates at the same rate as physical capital. Lucas [1988] models the production function for human capital as fundamen- tally different from that for other goods. We believe that, at least for an initial examination, it is natural to assume that the two types of production functions are similar.

We assume that a + ,B < 1, which implies that there are decreasing returns to all capital. (If a + ,B = 1, then there are constant returns to scale in the reproducible factors. In this case,

7. Previous authors have provided evidence of the importance of human capital for growth in income. Azariadis and Drazen [1990] find that no country was able to grow quickly during the postwar period without a highly literate labor force. They interpret this as evidence that there is a threshold externality associated with human capital accumulation. Similarly, Rauch [1988] finds that among countries that had achieved 95 percent adult literacy in 1960, there was a strong tendency for income per capita to converge over the period 1950-1985. Romer [1989b] finds that literacy in 1960 helps explain subsequent investment and that, if one corrects for measurement error, literacy has no impact on growth beyond its effect on investment. There is also older work stressing the role of human capital in development; for example, see Krueger [1968] and Easterlin [1981].

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there is no steady state for this model. We discuss this possibility in Section III.) Equations (9a) and (9b) imply that the economy converges to a steady state defined by

\n + g + (10)

(* a k -S a 1/(1-a-)

, n +g+ / Substituting (10) into the production function and taking logs gives an equation for income per capita similar to equation (6) above:

(1 1) In [L(t)| In A(O) + gt - +

(I ln(n + g + a Y (t)]_

+ Iln(Sk) + In(Sh)

This equation shows how income per capita depends on population growth and accumulation of physical and human capital.

Like the textbook Solow model, the augmented model predicts coefficients in equation (11) that are functions of the factor shares. As before, a is physical capital's share of income, so we expect a value of a of about one third. Gauging a reasonable value of P, human capital's share, is more difficult. In the United States the minimum wage-roughly the return to labor without human capital-has averaged about 30 to 50 percent of the average wage in manufacturing. This fact suggests that 50 to 70 percent of total labor income represents the return to human capital, or that ,B is between one third and one half.

Equation (11) makes two predictions about the regressions run in Section I, in which human capital was ignored. First, even if In (Sh) is independent of the other right-hand side variables, the coefficient on ln(sk) is greater than a/(1 - a). For example, if a = P = 1/3, then the coefficient on ln(sk) would be 1. Because higher saving leads to higher income, it leads to a higher steady-state level of human capital, even if the percentage of income devoted to human-capital accumulation is unchanged. Hence, the presence of human-capital accumulation increases the impact of physical- capital accumulation on income.

Second, the coefficient on ln(n + g + 8) is larger in absolute

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