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THE ECONOMIC AND SOCIAL REVIEW
This schedule is upward sloping in K-L space, but cuts the 45-degree line
from above. A rise in total factor productivity A or a fall in r* (capturing a fall
in the external risk premium) will shift the KK schedule up and to the left.
The LL schedule describes labour market equilibrium and is given by:
— —
AFL(K , L) = w1
where the right hand side comes from inverting the labour supply function (8).
The implicit assumption here is that an improvement in labour market
institutions leads to an increase in total labour supply at a given real wage,
but does not alter the elasticity of labour supply to changes in the home real
wage. The LL curve is also upward sloping, but intersects the 45-degree line
from below. A rise in Θ or a rise in A shifts the LL curve to the right.
Our model thus captures three sources of growth - a reduction in the cost
of borrowing, changes in labour market institutions, or changes in total factor
productivity. In the first case, a fall in the external risk premium will shift the
KK curve up, and increase the capital labour ratio. This implies that long-run
output rises more than employment. An improvement in labour market
institutions however will have the opposite effect, reducing the capital labour
ratio, so long-run GDP rises by less than employment. Finally, a rise in total
factor productivity may increase or reduce the capital labour ratio, depending
on the elasticity of labour supply and the importance of the endogenous
external risk premium in foreign borrowing.
IV GROWTH DYNAMICS
The critical features of the model are the openness of the labour and
capital markets. To illustrate this we simulate the quantitative response of the
model in a series of cases. We solve and simulate the model by linear
approximation around an initial steady state. In order to do this we are
required to choose numerical values for a number of key parameters. We
assume that the production function is Cobb-Douglas, and assume a capital
share equal to 0.36. The rate of capital depreciation is set at 10 per cent, so
that δ= 0.1. We assume that the implicit labour supply function (3) has a wage
elasticity equal to unity (see below for discussion). A critical factor in the
calibration is the magnitude of adjustment costs in investment. A low
elasticity of investment with respect to the price of capital implies higher
adjustment costs and slower convergence. We follow previous literature (see
Bernanke, Gertler and Gilchrist, 1999) in assuming an elasticity of the price