Question

Michael Pettis from Peking University wrote in May 2011:“In most countries households typically consume around 60-70 percent of GDP, and even the countries of East Asia that have followed a growth model similar to that of the Chinese, household consumption typically represents 50-55 percent of GDP. In China, a decade ago household consumption represented about 45 percent of GDP.But the story doesn’t end there. Five years ago household consumption in China declined to around 40 percent of GDP. ... Policymakers pledged to take every step necessary to raise household consumption growth and to help re-balance the economy. A few economists remained skeptical. They argued that Beijing would not be able to raise the consumption level because doing so would require fundamental change to the growth model. .... Even the skeptics were wrong. For the next five years GDP growth continued to surge ahead of household consumption growth until by last year household consumption represented an astonishing 36% of GDP.”

a. Using tools from the Solow model of growth, explain how a decrease in the share of consumption (and a corresponding increase in the share of investment) in GDP affects Chinese growth in the short term. How does it affect the long-run steady-state capital stock per worker and the marginal productivity of capital in this eventual steady state? What might be the implications for consumer welfare (as opposed to the size of the capital stock and the size of the GDP)?

b. What is the logic behind the statement that China can keep investing in new capital “without running into diminishing returns, because it can keep drawing new labor from the countryside?” [Hint: recall the concepts of constant returns to scale in the production function versus diminishing returns to a given factor of production.]

Answer 1