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| The '''Solow residual''' is a [[number]] describing empirical [[productivity]] growth in an [[economy]] from year to year and decade to decade. [[Robert Solow]] defined rising productivity as rising [[Output (economics)|output]] with constant [[capital (economics)|capital]] and [[labour (economics)|labor]] input. It is a "[[errors and residuals in statistics|residual]]" because it is the part of growth that cannot be explained through [[capital accumulation]] or the accumulation of other traditional factors, such as land or labor. The Solow Residual is [[procyclical]] and is sometimes called the rate of growth of [[total factor productivity]].
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| == History ==
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| In the 1950s, many economists undertook comparative studies of economic growth following [[World War II]] reconstruction. Some said that the path to long-term growth was achieved through investment in industry and infrastructure and in moving further and further into [[capital intensive]] automated production. Although there was always a concern about [[Law of diminishing returns|diminishing returns]] to this approach because of equipment [[depreciation]], it was a widespread view of the correct industrial policy to adopt. Many economists pointed to the [[Soviet Union|Soviet]] [[command economy]] as a model of high-growth through tireless re-investment of output in further industrial construction.
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| However, some economists took a different view: they said that greater capital concentrations would yield diminishing returns once the marginal return to capital had equalized with that of labour—and that the apparently rapid growth of economies with high [[savings]] rates would be a short-term phenomenon. This analysis suggested that improved labour productivity or total factor technology was the long-run determinant of national growth, and that only under-capitalized countries could grow per-capita income substantially by investing in infrastructure—some of these undercapitalized countries were still recovering from the war and were expected to rapidly develop in this way on a path of convergence with developed nations.
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| The Solow residual is defined as per-capita economic growth above the rate of per-capita capital stock growth, so its detection indicates that there must be some contribution to output other than advances in industrializing the economy. The fact that the measured growth in the standard of living, also known as the ratio of output to labour input, could not be explained entirely by the growth in the capital/labour ratio was a significant finding, and pointed to innovation rather than capital accumulation as a potential path to growth.
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| The '[[Exogenous growth model|Solow growth model]]' is not intended to explain or derive the empirical residual, but rather to demonstrate how it will affect the economy in the long run when imposed on an aggregate model of the macroeconomy exogenously. This model was really a tool for demonstrating the impact of “technology” growth as against “industrial” growth rather than an attempt to understand where either type of growth was coming from. The Solow residual is primarily an observation to explain, rather than predict the outcome of a theoretical analysis. It is a question rather than an answer, and the following equations should not obscure that fact.
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| == As a residual term in the Solow model ==
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| Solow assumed a very basic model of annual aggregate output over a year (''t''). He said that the output quantity would be governed by the amount of capital (the infrastructure), the amount of labour (the number of people in the workforce), and the productivity of that labour. He thought that the productivity of labour was the factor driving long-run [[GDP]] increases. An example economic model of this form is given below:<ref>This equation is a "[[Cobb-Douglas|Cobb-Douglas function]]", which is used more often than any other output relationship because of its analytical tractability, and because in the long-run, the precise relationship of capital to labour in the production function is not important. The same results can be derived with greater hardship using any production function having constant [[returns to scale]] (and satisfying the technical [[Inada conditions]].)</ref>
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| :<math>Y(t) = [K(t)]^{\alpha} [A(t)L(t)]^{1-\alpha} \,</math>
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| where:
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| * ''Y''(''t'') represents the total production in an economy (the [[GDP]]) in some year, ''t''.
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| * ''K''(''t'') is [[capital (economics)|capital]] in the productive economy - which might be measured through the combined value of all companies in a [[capitalism|capitalist]] economy.
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| * ''L''(''t'') is labour; this is simply the number of people in work, and since growth models are long run models they tend to ignore cyclical [[unemployment]] effects, assuming instead that the labour force is a constant fraction of an expanding population.
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| * ''A''(''t'') represents [[multifactor productivity]] (often generalized as "[[technology]]"). The change in this figure from ''A''(1960) to ''A''(1980) is the key to estimating the growth in labour 'efficiency' and the Solow residual between 1960 and 1980, for instance.
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| To measure or predict the change in output within this model, the equation above is [[derivative|differentiated]] in time (''t''), giving a formula in [[partial derivative]]s of the relationships: labour-to-output, capital-to-output, and productivity-to-output, as shown:
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| :<math>\frac{ \partial Y}{ \partial t} = \frac{ \partial Y}{ \partial K} \frac{ \partial K}{ \partial t} + \frac{ \partial Y}{ \partial L} \frac{ \partial L}{ \partial t} + \frac{ \partial Y}{ \partial A} \frac{ \partial A}{ \partial t} </math>
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| Observe:
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| :<math>\frac{ \partial Y}{ \partial K} = {\alpha}[K(t)]^{\alpha-1}\cdot [A(t) L(t)]^{1-\alpha} = \frac{ {\alpha}Y }{[K(t)]} </math>
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| Similarly:
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| :<math>\frac{ \partial Y}{ \partial L} = \frac{ (1 - {\alpha})Y }{[L(t)]} \text{ and } \frac{ \partial Y}{ \partial A} = \frac{ (1 - {\alpha})Y }{[A(t)]} </math>
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| Therefore:
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| :<math>\frac{ \partial Y}{ \partial t} = \frac{ {\alpha}Y }{[K(t)]} \frac{ \partial K}{ \partial t} + \frac{ (1 - {\alpha})Y }{[L(t)]} \frac{ \partial L}{ \partial t} + \frac{ (1 - {\alpha})Y }{[A(t)]} \frac{ \partial A}{ \partial t} </math>
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| The growth factor in the economy is a proportion of the output last year, which is given (assuming small changes year-on-year) by dividing both sides of this equation by the output, ''Y'':
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| :<math>\frac {\frac{ \partial Y}{ \partial t}}{Y} = \alpha \frac{ \frac{ \partial K}{ \partial t} }{K(t)} + (1 - {\alpha})\frac{ \frac{ \partial L}{ \partial t} } {L(t)} + (1 - {\alpha})\frac{ \frac{ \partial A}{ \partial t} } {A(t)} </math>
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| The first two terms on the right hand side of this equation are the proportional changes in labour and capital year-on-year, and the left hand side is the proportional output change. The remaining term on the right, giving the effect of productivity improvements on [[GDP]] is defined as the Solow residual:
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| :<math> SR(t) = \frac {\frac{ \partial Y}{ \partial t}}{Y} - \left( \alpha \frac{ \frac{ \partial K}{ \partial t} }{K(t)} + (1 - {\alpha})\frac{ \frac{ \partial L}{ \partial t} } {L(t)} \right) </math> | |
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| The residual, ''SR''(''t'') is that part of growth not explicable by measurable changes in the amount of capital, ''K'', and the number of workers, ''L''. If output, capital, and labour all double every twenty years the residual will be zero, but in general it is higher than this: output goes up faster than growth in the input factors. The residual varies between periods and countries, but is almost always positive in peace-time capitalist countries. Some estimates of the post-war [[U.S.]] residual credited the country with a 3% productivity increase per-annum until the early 1970s when [[productivity growth]] appeared to stagnate.
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| == Regression analysis and the Solow residual ==
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| The above relation gives a very simplified picture of the economy in a single year; what growth theory [[econometric]]s does is to look at a [[time series|sequence of years]] to find a [[statistically significant]] pattern in the changes of the variables, and perhaps identify the existence and value of the "Solow residual". The most basic technique for doing this is to assume '''constant rates of change''' in all the variables (obscured by noise), and [[regression analysis|regress]] on the data to find the best estimate of these rates in the historical data available (using an [[Ordinary least squares regression]]). Economists always do this by first taking the [[natural log]] of their equation (to separate out the variables on the right-hand-side of the equation); logging both sides of this production function produces a [[simple linear regression]] with an error term, <math>\varepsilon</math>:
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| :<math>\ln(Y(t))= \alpha \ln(K(t)) + (1-\alpha)[\ln(L(t))] + [\ln(A(t))] + \varepsilon. \, </math>
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| A constant growth factor implies exponential growth in the above variables, so differentiating gives a linear relationship between the growth factors which can be deduced in a simple regression.
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| In regression analysis, the equation one would estimate is
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| :<math>y= C + \beta k + \gamma \ell + \varepsilon. \, </math>
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| where:
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| ''y'' is (log) output, ln(Y)
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| ''k'' is capital, ln(K)
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| ''ℓ'' is labour, ln(L)
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| ''C'' can be interpreted as the co-efficient on log(''A'') – the rate of technological change – (1 − ''α'').
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| Given the form of the regression equation, we can interpret the coefficients as elasticities.
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| == Why the productivity growth is attached to labor ==
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| The Solow residual measures [[total factor productivity]], but is normally attached to the labour variable in the macroeconomy because [[return on investment]] doesn't seem to change very much in time or between [[developing nation]]s, and [[developed nation]]s—not nearly as much as human productivity seems to change, anyway.
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| == Critique of the measurement in rapidly developing economies ==
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| Rapidly expanding countries (catching up after a crisis or [[trade liberalization]]) tend to have a rapid turn-over in technologies as they accumulate capital. It has been suggested that this will tend to make it harder to gain experience with the available technologies and that a zero Solow residual in these cases actually indicates rising labour productivity. In this theory, the fact that ''A'' (labour output productivity) is not falling as new skills become essential indicates that the labour force is capable of adapting, and is likely to have its productivity growth underestimated by the residual—This idea is linked to "[[learning]] by doing".
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| == See also ==
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| * [[Solow computer paradox]] is based on finding a zero residual in many countries even as [[information technology]] was becoming more widely available.
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| * [[Capital controversy]] over whether the level of capital in an economy can be measured even in theory; if not, neither can the Solow residual.
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| * The [[Solow growth model]] is a model of economic development into which the Solow residual can be added [[exogenous]]ly to allow predictions of [[GDP]] growth at differing levels of productivity growth.
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| * The [[Balassa–Samuelson effect]] describes the effect of ''variable'' Solow residuals: it assumes that mass-produced [[traded goods]] have a higher residual than does the service sector. This assumption has been used to explain the [[Penn effect|PPP-deviations]], and may create a 'drag' on the overall-residual as more effort is moved into services industries ''precisely because'' they have low productivity growth (being harder to automate.)
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| * [[Multifactor productivity]]
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| == References ==
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| {{Reflist}}
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| == Further reading ==
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| *{{cite book |authorlink=David Romer |first=David |last=Romer |title=Advanced Macroeconomics |location=Boston |edition=2nd |publisher=McGraw-Hill/Irwin |year=2000 |isbn=0-07-231855-4 }} Gives a clear introduction to the model above in its first chapter. Later chapters extend this into the modern analysis of [[Endogenous growth theory|endogenous growth]]. The book also discusses the residual's significance in [[growth accounting]].
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| == External links ==
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| * [http://ideas.repec.org/p/ecm/feam04/777.html ''Does the Solow Residual for Korea Reflect Pure Technology Shocks?''] - a paper showing how modern econometric techniques such as [[cointegration]] are being used to draw a more reliable inference on the Solow residual, because the real world is not like the smoothly evolving model described in the simple regression here.
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| [[Category:Macroeconomics]]
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| [[de:Totale Faktorproduktivität]]
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I'm a 49 years old, married and working at the university (Creative Writing).
In my free time I learn Arabic. I've been there and look forward to go there sometime near future. I love to read, preferably on my kindle. I like to watch The Big Bang Theory and Two and a Half Men as well as documentaries about nature. I enjoy Basketball.
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