Macro inovation dynamics and the golden age

Paul J. J. Welfens

Macro Innovation
Dynamics and
the Golden Age
New Insights into Schumpeterian
Dynamics, Inequality and Economic
Growth


Macro Innovation Dynamics and the
Golden Age


Paul J. J. Welfens

Macro Innovation
Dynamics and the
Golden Age
New Insights into Schumpeterian
Dynamics, Inequality and
Economic Growth


Paul J. J. Welfens
Jean Monnet Chair for European Economic Integration and Chair for Macroeconomics
President of European Institute for International Economic Relations (EIIW) at the
University of Wuppertal
Wuppertal, Germany
Non-resident Senior Research Fellow
AICGS/Johns Hopkins University

Washington, DC
USA
Research Fellow
IZA
Bonn, Germany

ISBN 978-3-319-50366-0
ISBN 978-3-319-50367-7
DOI 10.1007/978-3-319-50367-7

(eBook)

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Preface

Innovations were responsible for driving the Industrial Revolution in the eighteenth
and nineteenth centuries. The twentieth century has witnessed the combination of
multinational companies’ foreign direct investment dynamics and product as well
as process innovations; and the early twenty-first century is shaped largely by
digital innovation dynamics. While innovations have been analyzed by many
economists—beginning, in particular, with Schumpeter—there is surprisingly limited research carried out on the role of innovations in Macroeconomics (as a
textbook, Aghion/Howitt’s Endogenous Growth Theory summarizes many
approaches). With my book, “Innovations in Macroeconomics”, I have tried to
contribute to closing some of the knowledge gaps and emphasis has been given to
the role of foreign direct investment (FDI), innovations and trade. The role of FDI is
growing in the context of economic globalization and it requires the making of a
distinction between GDP and gross national product—typically neglected in open
economy macroeconomics so far. This point has already been emphasized in
Innovations in Macroeconomics. Consumption in an economy with trade and FDI
is proportionate to GNP, not to GDP; and imports are also proportionate to domestic
GNP. The export volume is proportionate to foreign GNP—not to GDP. For many
countries there is a considerable difference between GNP and GDP.
In this complementary book, I present my papers for the Brisbane conference of
the Schumpeter Society, the paper for the Jena conference of the Schumpeter
Society as well as my paper on innovation and growth for a Sino-German project—here funding from the German National Science Foundation is gratefully
acknowledged—plus a new approach to the golden age in the presence of a research
sector. Moreover, the last chapter—my paper for the Montreal conference of the
International Joseph A. Schumpeter Society—suggests an innovative approach that
uses a knowledge production function that can be plugged directly into a macroeconomic production function and hence enables a straightforward way for new
endogenous growth approaches from both a theoretical and empirical perspective.

The main ideas in this book are to include innovations into the Mundell-Fleming
model and to take a broad, fresh look at the golden age in neoclassical growth
theory. In a broader view that includes environmental aspects, the question of a
golden rule that maximizes per capita consumption is even more important than the
classical contributions in this field: An economy that has a capital intensity
v


vi

Preface

exceeding that which is required by the golden rule is not achieving the maximum
per capita consumption on the one hand, on the other hand, in the case of a closed
economy, one may emphasize that the amount of physical capital produced and
employed—this is associated with the use of resources and energy (leading to
higher CO2 emissions)—is too high: the environmental quality is thus worse than
a situation in which the golden rule was observed would imply.
The golden age, characterized by maximum per capita consumption in the steady
state, has, in the original contribution of Edmund Phelps (1961), been dubbed “a
fable for growthmen” and indeed the golden rule has not been considered as a
serious element of economic policy—it was rather discussed as a very theoretical
point of neoclassical growth analysis; with the adoption of endogenous growth
theory the golden rule seemed to become a remote corner of analysis. The contribution of Phelps had emphasized, in its application to a setup with a Cobb-Douglas
production function, that the golden rule requires that the savings rate is equal to the
income share of capital and the output elasticity of capital. This interpretation is not
fully consistent to the extent that it is understood to imply that all profits must be
invested if per capita consumption is to be maximized; rather a certain combination
of the savings rate of capital owners and of workers is also compatible with the
golden age. An alternative condition for the golden rule is to require that the growth

rate of output should be equal to the real interest rate and one may argue that profit
maximization and competition will bring about this equality. Hence the only task of
government then is to implement competition and to encourage profit maximization. There are, however, three difficult problems for competition policy: (1) Competition policy in small open economies is not easy to implement effectively in a
world economy with multinational companies playing an increasing role; while in
the tradables sector free trade policy effectively is competition policy, the problem
in the non-tradables sector is much more difficult—often the presence of just one
multinational company already covers the entire domestic market so that there is
little room for actual or potential competition (the non-tradables sector could
represent between 20% and 40% of output in OECD countries and Newly
Industrialized Countries; and even more in developing countries). (2) Profit maximization is not always the natural behavior of relevant economic actors; the
government sector itself and government-owned firms should be considered as a
potential problem or to put it differently: here, looking at the sectoral implication of
the golden rule would be particularly useful, but no minister of finance and no
council of economic advisers has so far seriously emphasized the golden rule as a
policy element. This point will be rather neglected in the subsequent analysis: There
is (3) the question of negative external effects from production. How can negative
external environmental effects—related to production—be integrated in a simple
growth model? Finally, there is the problem that the more innovative the economy
is, the less likely one should expect full competition to characterize the economy:
Whenever there are product innovations or patents—the latter giving an effective
monopoly over several years to the innovator—one may face the problem that
production factors are not simply rewarded in line with marginal productivity:
Market power could play a crucial role in factor markets, possibly less so in
small open economies than in big economies.


Preface

vii

Moreover, deviations from the golden age are not in practice an irrelevant
problem of reality and economic policy, respectively. It should be rather obvious
that in rather poor countries a lack of growth-enhancing economic policy will bring
about starvation, so that pushing governments to consider the implications of the
golden rule should be a natural element of modern development policy and UN or
World Bank projects for stimulating economic development in the South of the
world economy.
This book has been completed in 2015 and 2016 in Beijing and Washington DC,
respectively. In China another project financed by the German National Foundation
has commenced. Again, we are grateful to Mu Rongping and Reinhard Meckl who
have initiated the projects that have a broad focus on innovation dynamics, including green innovation dynamics (the first book edited by Rongping/Meckl was
Innovation for Green Growth; Beijing: Science Press: 2014). In Washington DC I
presented at both the Congressional Research Service and at the IMF (on June
27 and 28, 2016, respectively) a theoretical and empirical paper on the knowledge
production function—a joint paper with Andre Jungmittag in which we have
conducted an empirical analysis covering 20 EU countries between 2002 and
2014 and also suggested ways of plugging the empirical results into a macroeconomic production function. This paper, which looks at the creation of new knowledge, is not included here, however, part of the theoretical basis is shown in the last
chapter of this book (those interested can find the EIIW paper No. 212 on the website
of the European Institute for International Economic Relations: www.eiiw.eu).
I am grateful for the research support of Jens Perret and Tony Irawan (EIIW and
the Schumpeter School of Business and Economics, respectively). I am also
grateful for the editorial support of David Hanrahan, Samir Kadiric and Evgeniya
Yushkova (EIIW). As regards our China research projects, I would also like to
thank Mu Rongping (Chinese Academy of Sciences), Rainer Walz (Fraunhofer
Institut ISI, Karlsruhe), Klaus Rennings (ZEW) and Reinhard Meckl (Universita¨t
Bayreuth) for discussions on the subject matter, as well Raimund Bleischwitz
(University College, London) and, in the field of innovation and growth, colleagues
at the International Joseph A. Schumpeter Society—the bi-annual meeting in
Denmark was particularly stimulating (unfortunately I was unable to attend the
Brisbane meeting but Tony Irawan has presented my paper). Special thanks go to

Andre Jungmittag from the Frankfurt Applied University; discussions about trade,
innovation and economic stability with IMF colleagues are also acknowledged, as
is the hospitality of AICGS/The Johns Hopkins University, Washington, DC, over
many years. The responsibility lies, however, with the author only.
Wuppertal, Washington and Beijing
Summer 2016

Paul J. J. Welfens 保罗. 威尔芬斯

Reference
Phelps ES (1961) The golden rule of capital accumulation. Am Econ Rev 51:638–643


About the Book

This book is organized in five chapters: Following a short introduction, Chap. 1
suggests some new ideas on innovation, growth and income inequality. The innovative approach presented introduces a modified neoclassical growth model which
includes a new bias of technological progress in a quasi-endogenous growth model
in which part of labor is used in the research & development sector. The combination of a macroeconomic production function and a new progress function, plus the
assumption that the output elasticity of capital is positively influenced by the size of
the R&D sector, sheds new light on innovation and growth as well as on income
inequality: Thus there is a new approach for explaining Piketty’s historical findings
of a medium term rise of the capital income share in industrialized countries—both
in the earlier and later part of the nineteenth century and in 1990–2010 (this
contribution has been published originally in the Journal International Economics
and Economic Policy). A rising share of capital income can be explained within this
approach by the increase in the output elasticity of capital, which has been developed in a new way, namely in the context of R&D. In the approach presented
herein, the golden rule issues are also highlighted and it is shown that choosing the
right size of the R&D sector will bring about maximum sustainable per capita
consumption. While the basic new model is presented for the case of a closed

economy, one could easily accommodate both trade and foreign direct investment
and thereby get a better understanding of complex international investment, trade
and FDI dynamics—including with respect to the envisaged Transatlantic Trade
and Investment Partnership between the US and the EU.
The second chapter is my revised contribution from the first Sino-German
project. The analysis links R&D, foreign direct investment, output and CO2
emissions in a simple growth model. Based on the modified neoclassical growth
model, key issues can be raised with respect to sustainable growth and several
conclusions can be drawn with respect to economic welfare and optimum consumption per capita, respectively. It may be argued that in several industrialized
countries—and China—investment-GDP ratios in certain periods are above the
level that is consistent with optimum per capita consumption; the capital intensity
exceeds the ratio of capital to workers (in efficiency units) that is consistent with a
maximum long-run per capita consumption. CO2 emission levels could be reduced
in an efficient manner on the basis of a broad approach that emphasizes
ix


x

About the Book

Schumpeterian dynamics: Taxing emissions and giving subsidies for innovations
could be useful elements of innovation-enhancing policy. Promoting green
innovations—including the sustainability design of products-, renewable energy
and realizing adequate genuine savings could be key policy elements for a consistent strategy to achieve sustainable growth. Moreover, green ratings for companies
listed on the stock market could be crucial options for combining sustained growth,
modernization and innovation. Part of the analysis is based on the EIIW-vita global
sustainability indicator.
A further analytical contribution is presented in Chap. 3. Economic growth is, in
reality, not a smooth process and it is not clear why economic growth is rather

unstable across OECD countries and the global economy. Economic growth is
certainly influenced by many factors, including innovation dynamics and technology, respectively. Technological progress can have domestic sources and is, then,
largely related to the innovation system, but in open economies the subsidiaries of
foreign MNCs can also play a role in the host country. Moreover, there could be
international technology spillovers, part of which are related to international trade
and FDI dynamics. Foreign direct investment has rarely been included in the
analysis of economic growth, despite the fact that economic globalization has
clearly reinforced the role of multinational companies in world investment. From
a macroeconomic perspective, the presence of MNCs’ subsidiaries should not only
bring effects on capital accumulation and technology transfer; rather it is important
to consider that a distinction has to be made between GDP and GNP. This
distinction, which concerns the specification of the savings function as well as
other functions, has been much neglected in the literature; it is relevant both in
medium term macro models and in long run growth models. In the standard
neoclassical growth model with exogenous technological progress a rise of the
progress rate leads to a fall of the level of the growth path and a higher permanent
growth rate of output. This suggests that a technology shock should bring about a
quasi-growth cycle and such a phenomenon—with a temporary fall of output—is,
however, not observed in newly industrialized countries. The empirical patterns of
growth and innovation dynamics do not show such a paradoxical temporary fall of
income and income per capita, respectively. The paradoxical result of the standard
growth model is avoided in a model in which the output elasticity of capital depends
on the progress rate; certain parameter restrictions apply which are highlighted in
the analysis; furthermore, we get additional insights into the issue of the golden rule
and maximization of per capita consumption, respectively. Moreover, it is interesting to consider the role of foreign direct investment for the growth model of an open
economy and technological progress, respectively. In this semi-endogenous set-up,
the focus is mainly on asymmetrical foreign investment, namely inward FDI
inflows. Foreign direct investment inflows have a direct impact on the steady
state solution, namely both on the level of the growth path and the permanent
growth rate—the latter to the extent that we consider a technological progress

function in which both the foreign progress rate and the share of the capital stock
owned by foreign investors are considered. The relative impact of domestic


About the Book

xi

progress and internationally induced progress is discussed. Finally, the issue of a
consistent investment function which takes into account both the short term and the
long run consistency is considered and the impact of changes in the progress rate are
pointed out—along with broader policy conclusions of the analysis presented. At
the bottom line it is shown that a positive impact of the progress rate on the output
elasticity of the capital stock can bring a smooth transition to both a higher level of
the growth path and a higher permanent growth rate. The perspectives on the role of
FDI inflows in a two-country model with symmetrical flows have to be explored in
further analysis. Key policy conclusions concern the question of to what extent
government should try to achieve a golden state while adequately taking into
account the role of foreign direct investment inflows. Within a broader group of
countries it would also be useful to consider options for cooperation in growth
policies—certainly to the extent that there are symmetrical or asymmetric international technology spillover effects.
Chapter 4 presents a new multiplier analysis for a Schumpeterian MundellFleming model. Traditional open economy macro models have focused on the
mix of fiscal and monetary policy while completely neglecting innovation policy.
The new model presented is the first macro model that explicitly considers product
innovations in an open economy model. Product innovations are considered in the
consumption function, the investment function, the export function, the import
function as well as the money demand function; plus the net capital inflow function.
The policy multipliers are derived for fiscal policy, monetary policy and innovation
policy. In an extended version of the model, the role of foreign direct investment is
considered, in an approach for a small open economy. Domestic and foreign

product innovations are considered and their impact on policy multipliers is
analyzed. Finally, the role of supply-oriented, innovation-enhancing fiscal policy
is discussed. Moreover, the empirical evidence for product innovation dynamics is
considered.
Chapter 5 can be summarized as follows: The macroeconomic production
function is a traditional key element of modern macroeconomics, as is the more
recent knowledge production function which explains knowledge/patents by certain
input factors such as research, foreign direct investment or international technology
spillovers. This study is a major contribution to innovation, trade, FDI and growth
analysis, namely in the form of a combination of an empirically relevant knowledge
production function for open economies—with both trade and inward FDI as well
as outward foreign direct investment plus research input—with a macro production
function. Plugging the open economy knowledge production function into a standard macroeconomic production function yields important new insights for many
fields: The estimation of the production potential in an open economy, growth
decomposition analysis in the context of economic globalization and the demand
for labor as well as long run international output interdependency of big countries;
and this includes a view at the asymmetric case of a simple two country world in
which one country is at full employment while the other is facing underutilized
capacities. Finally, there are crucial implications for the analysis of broad regional
integration schemes such as TTIP or TPP and a more realistic and comprehensive
empirical analysis.


xii

About the Book

At the bottom line, there are many good arguments for integrating
Schumpeterian aspects into open economy macroeconomics. The technology factor
in International Economics—with people concerned about the environment—is

increasingly important (here Lucas Bretschger’s research at ETH Zürich has
made crucial contributions over many years). The modified neoclassical growth
models are rather simple in the basic setting, however, this type of modeling is still
very useful for considering key issues and topics.


Contents

1

2

Green Innovations and CO2 in a Growth Perspective:
A Neoclassical Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.1 A Rational Approach to Promotion of Green Innovation . . . . . . .
1.1.1 Taxation and Subsidies as a Means to Internalize
External Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.1.2 Economic Growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.1.3 Traditional Neoclassical Growth Modeling . . . . . . . . . . .
1.2 Technological Progress and R&D . . . . . . . . . . . . . . . . . . . . . . .
1.2.1 Golden Rule Aspects in an Economy with Technological
Progress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.2.2 Extensions of the Neoclassical Growth Model . . . . . . . . .
1.2.3 Growth Model with R&D and Emissions . . . . . . . . . . . .
1.2.4 Growth in a World with Negative External Effects:
CO2 Emissions and Hybrid Welfare . . . . . . . . . . . . . . . .
1.3 Policy Perspectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.3.1 Taxation, Risk, and Innovation . . . . . . . . . . . . . . . . . . . .
1.3.2 Liability Rules and Insurance Costs . . . . . . . . . . . . . . . .
1.3.3 Green Rating and Capital Markets . . . . . . . . . . . . . . . . .

1.3.4 Double Sustainability . . . . . . . . . . . . . . . . . . . . . . . . . .
Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Innovation, Inequality, and a Golden Rule for Growth
in an Economy with R&D . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.1 New Quasi-endogenous Growth Model with Biased
Technological Progress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.2 Policy Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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5

Contents

Technological Progress, Output Elasticity, FDI, and Growth
Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.1 A Growth Model with Foreign Direct Investment . . . . . . . . . . . .
3.2 Technology, the Production Function, and the Impact
of a Shift in the Progress Rate . . . . . . . . . . . . . . . . . . . . . . . . . .

3.3 Asymmetric FDI Inflows and the Role of Induced International
Technology Transfer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.4 Policy Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Product Innovations in a Schumpeterian Mundell–Fleming Model . . .
4.1 Theoretical Approach: Schumpeterian Open Economy
Macro-model with Product Innovations . . . . . . . . . . . . . . . . . . . .
4.1.1 Basic Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4.1.2 New Analytical Approach: A Schumpeterian
Mundell–Fleming Model Without and with FDI . . . . . . . .
4.2 Empirical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.3 Policy Implications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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Schumpeterian Macroeconomic Production Function
for Open Economies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.1 Knowledge Production Function and Macroeconomic Production
Function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.2 The Schumpeterian Macroeconomic Production Function . . . . . .
5.2.1 Output Elasticity with Respect to Foreign Knowledge . . .
5.2.2 Endogenous Growth Model . . . . . . . . . . . . . . . . . . . . . .
5.2.3 Golden Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.3 Labor Market Demand and Other Macro Aspects . . . . . . . . . . . .
5.4 Hybrid Medium-Term Macro-model . . . . . . . . . . . . . . . . . . . . .
5.5 Further Extensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.6 Policy Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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List of Figures

Fig. 1.1
Fig. 1.2

Fig. 1.3

Fig. 1.4
Fig. 1.5

Fig. 1.6

Fig. 1.7

Fig. 1.8

Fig. 1.9
Fig. 1.10
Fig. 1.11

Subsidizing the innovation sector and imposing a Pigou tax on
the sector with emissions .. . . .. . . .. . .. . . .. . . .. . . .. . .. . . .. . . .. . .. . . .. . .
Gross investment-GDP ratios in selected countries. Data Source:
International Monetary Fund (2010), World Economic
Outlook Database . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Investment-GDP ratio and net savings ratio in selected
countries. Data Source: World Bank, World Development
Indicators & Global Development Finance; International
Monetary Fund (2010), World Economic Outlook Database . . . . .
Golden rule in a standard neoclassical growth model
(E1F ¼ C/L ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(a) Shares of renewables, (b) genuine savings rate/World Bank,
(c) volume-based RCAs for “green exports.” Data Source:
WDI Online, own calculations (RCA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Impact of a rise of the growth rate of knowledge on the level of
per capita income ( y) and the growth rate of per capita income
(tg α ¼ a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Real interest rate and growth rate of real GDP in selected
countries. Data Source: European Commission Ameco Database,
OCED (2008), [Real long-term interest rate based on GDP
deflator (%)]; World Bank, World Development Indicators &
Global Development Finance [Real interest rate
(real lending rate) (%), GDP growth (annual %)] . . . . . . . . . . . . . . . . .
Genuine savings rate for selected countries. Note: Adjusted
net savings are equal to net national savings plus education
expenditure, minus energy, mineral and net forest depletion,
and carbon dioxide and particulate emissions damage.
Data Source: World Bank, World Development
Indicators & Global Development Finance . . .. .. . .. .. . .. .. . .. .. . .. .
Golden rule with real money balances and R&D sector
employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Double sustainability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Global sustainability indicator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

8

11

12
13

16

18

20

22
26
34
35
xv


xvi

List of Figures

Fig. 2.1

Rise of the R&D sector in the quasi-neoclassical growth model . . .

66

Fig. 3.1

Traditional and Schumpeterian growth models . . . . . . . . . . . . . . . . . . . .

82

Fig. 4.1

Product innovations in a Schumpeterian MundellÀFleming
model . .. . .. . .. . .. . .. .. . .. . .. . .. . .. .. . .. . .. . .. . .. . .. .. . .. . .. . .. . .. .. . .. . . 99
Basic regression model for product innovations in 25 EU
countries: 2006–2012: panel correct standard error (PCSE)
regression and feasible generalized least square (FGLS)
regression results; data for product innovations from EU
surveys . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

Fig. 4.2


List of Tables

Table 2.1
Table 2.2
Table 2.3
Table 2.4
Table 2.5
Table 2.6
Table 2.7
Table 4.1
Table 4.2
Table 4.3
Table 5.1

Capital income share as a % of GDP . . . . . . .. . . . . . .. . . . . .. . . . . . .. . . .
Gini coefficient . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Imported R&D services from abroad which is used as
intermediate input (as a % of GDP/total value added) . . . . . . . . . . .

Total R&D services which is used as intermediate input
(as a % of GDP/total value added) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total domestic R&D services which is used as intermediate
input (as a % of GDP/total value added) . . . . . . . . .. . . . . . . . . . . .. . . . . .
Total intramural R&D expenditure (GERD) (as a % of GDP) . . . .
Total factor productivity (2010 ¼ 100) . . . . . . . . . . . . . . . . . . . . . . . . . . . .

55
56
57
58
59
60
61

Multiplier for Schumpeterian MundellÀFleming model . . . . . . . . . 105
Multiplier for innovation dynamics and FDI inflows in a
Schumpeterian MundellÀFleming model . . . . . . . . . . . . . . . . . . . . . . . . . . 106
α* multiplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
Knowledge production function: patent applications at the
European Patent Office explained by researchers (full time
equivalent), per capita GDP (PPP, constant dollars), inward
FDI–GDP ratio: panel data analysis for 20 EU countries,
2002–2012; all variables in logs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

xvii


1

Green Innovations and CO2 in a Growth
Perspective: A Neoclassical Model

Economic growth is a key field of modern Economics and indeed since the
Industrial Revolution sustained economic growth of per capita income has been
observed in the world economy. In the USA, the twentieth century stands for a longrun per capita growth rate of about 2%, the 1990s even 3% per year was achieved.
Japan and several Asian Newly Industrialized Countries have recorded 5–8% over
more than a decade in the 1960s, 1970s, and 1980s, China even achieved 8–10% in
the first decade of the twenty-first century, but there is, of course, not much doubt
that the growth rate of China will reduce to 2–3% over time, as its per capita income
is converging towards that of the US or leading EU countries. Economic growth is
welcomed by both ordinary citizens and politicians; however, the rise of per capita
income typically also means that there is an increasing use of natural resources and
fossil energy sources—the exploitation of natural, nonrenewable resources is effectively reducing the effective (adjusted) savings rate as is emphasized by the World
Bank, which adds education expenditures to the traditional definition of savings and
thus gets rather different savings rates than the traditional view on gross savings
suggests. Moreover, the use of fossil fuels implies that the growth of output in the
world economy goes along with CO2 and other emissions (particulate matter) that
imply risks for physical assets and human life in the long run. The question as to
how CO2 emissions, as a negative externality of production, could be included in a
growth model is considered subsequently; in this context, one may also point to the
new sustainability book with the EIIW-vita global sustainability indicator (Welfens
et al. 2015).
The basic neoclassical closed economy growth model, with a savings rate (s), a
growth rate of population (n), and a growth rate of knowledge (a), results in the
steady state solution for the ratio of real GDP (Y ) to labor in efficiency units y # : ¼
(Y/(AL) ¼ (s(1 À τ)/(a + n))β/(1 À β), where β is the output elasticity of capital K, and
the production function is Y ¼ Kβ(AL)1 À β (A is the stock of knowledge, L is labor, τ
is the income tax rate, # indicates the steady state; 0 < β < 1). Note that the only
fiscal variable that can be considered here is the income tax rate; the growth rate of

Y in the steady state is a + n. Under certain conditions, the neoclassical model is
# Springer International Publishing AG 2017
P. J. J. Welfens, Macro Innovation Dynamics and the Golden Age,
DOI 10.1007/978-3-319-50367-7_1

1


2

1

Green Innovations and CO2 in a Growth Perspective: A Neoclassical Model

equivalent to the modern growth model as presented in Aghion and Howitt (1998):
The modeling is more complex, the ingredients are Utility-maximizing households
(infinite time horizon), and the utility function is U(C) ¼ (C(1 À ε) – 1)/(1 À ε); the
intertemporal elasticity of substitution η ¼ 1/ε. The relevant Euler equation is here
given by –ε(dC/dt)/C ¼ ρ – r, (where r is the real interest rate; note (1/(1 + ρ) is the
0
discount factor; ρ > 0. This gives the fundamental equation for the growth rate g
¼ (ρ – r)η.
According to the above equation, in the decade after the Transatlantic Banking
Crisis, the growth rate should have increased strongly since the real interest rate has
fallen massively in the USA, Europe, and Asia. This is not what we see however.
The frictions observed in the new post-Lehman Brothers reality are particular, and
the new world with almost zero real interest rates implies many distortions.
This book is really about the normal world and complementary aspects of
economic growth (e.g., environmental aspects in the subsequent analysis)—and
one may hope that the OECD countries will have returned to a normal economy

setting by the end of 2025 (BREXIT is, however, another destabilizing impulse for
the EU and the OECD, respectively). A modified neoclassical growth model is still
quite useful. Additionally, the implications of some modern endogenous growth
models are not fully convincing; e.g., in the context of a simple Romer model—
with λ denoting a productivity parameter in the research sector where product
varieties are produced that feed into output (output parameter α00 > 0)—one gets
0
00
00
for the growth rate g0 in steady state: g ¼ (α λL – ρ)/(α + ε); it is a bit strange that
the size of the economy (L) affects g0 , although in a digital world the number of
people L could play a positive role for economic growth—namely in the context of
digital network effects. The digital economy itself raises, however, certain critical
issues which have been largely neglected (see, however, my book
Interneteconomics.net). Again, the neoclassical growth model is useful for many
key issues and topics, including certain environmental aspects of growth.
People have a natural interest in achieving high living standards, which thus
generates analytical interest in the topic of economic growth. At the beginning of
the twenty-first century, the dynamics of global warming have added one important
element, namely to consider the role of CO2 emissions and other greenhouse gas
emissions, respectively. Innovation dynamics—including green innovations—can
be considered in various ways in growth models (e.g., Bretschger 1999, 2008,
2011); some economists have argued that green innovations and the diffusion of
environmentally friendly new products could contribute to climate change mitigation in an efficient manner and create new opportunities for economic growth (e.g.,
Aghion et al. 2009; Popp et al. 2009). Environmental issues and growth dynamics
can also be considered in the broader context of trade (e.g., WTO 1999) and foreign
direct investment (Welfens 2011; Erdem 2010, 2015). In a broader perspective,
issues may also be raised related to capital markets and investment incentives—
subsequently, part of the analytical focus will be on the role of green ratings:
Companies are rated on the basis of the sustainability of production processes and

products sold.


1

Green Innovations and CO2 in a Growth Perspective: A Neoclassical Model

3

Green innovations are not easy to launch since innovation risks and costs are
often high, while established, less environmentally friendly technologies and
products dominate many markets. However, once green innovations have successfully been launched, there are good prospects that competition in markets will lead
to rapid diffusion of more environmentally friendly products (Acemoglu et al.
2009; Aghion et al. 2009). If companies with a green innovation project are afraid
that they cannot fully capture the Schumpeterian innovation rents, because
policymakers will effectively push for accelerated diffusion, there is risk of underinvestment in green innovations (Jaffe et al. 2005; Newell 2009). The role of
innovations for sustainable growth—sustainable consumption and production—
has been emphasized by many authors (e.g., Iges 2010; Erdem 2010). The role of
information and communication technology, including concepts of green IT, has
also been emphasized (e.g., Welfens 2010b).
With some degree of uncertainty, green innovations (Walz 2010) can be
measured and also countries can be identified on the basis of their innovation
dynamics. International patent applications are highly correlated with per capita
income, except for most OPEC countries. It is well known that resource rich
countries face Dutch Disease problems, which is to say that the high share of
value added in the capital-intensive resource extraction sector only gives weak
impulses for the modernization of the industry—and only with a relatively high
share of modern manufacturing industries and a modern innovation system will a
country generate significant contributions to green innovations. The market power
of OPEC countries has ambiguous effects on CO2 emissions and global innovation

dynamics, respectively:
• As regards impulses for reducing CO2 emissions it might be argued that OPEC
countries’ market power indirectly stimulates CO2-emission-saving technologies
in OECD countries and some Newly Industrialized Countries.
• While the above argument may be valid to some extent, it should not be
overlooked that the industrial modernization of OPEC countries in a world
economy with lower prices of nonrenewable energy sources is likely to have
advanced faster than it currently is and this would mean that global innovation
dynamics might be stronger without OPEC market power; whether a general
increase in innovation dynamics also implies more green innovation dynamics
has to be clarified on the basis of empirical analysis.
The broad international consensus to limit greenhouse gas emissions in the
medium term and to cut emissions in the very long run has contributed to a broad
policy debate in OECD countries on how energy efficiency and resource productivity could be raised. The broad need to implement eco-efficiency principles in
production implies certain adjustment requirements and the need to adopt new
initiatives for green innovation dynamics. The OECD (2009, p. 28), with respect to
the EU and the USA notes: “Such tasks are not trivial for manufacturing companies
and places great demands on their organizational management capability. The
development of environmental management systems (EMSs) has tied many of the


4

1

Green Innovations and CO2 in a Growth Perspective: A Neoclassical Model

environmental monitoring and management principles together, providing a framework to move towards eco-efficient production. [. . .] An EMS is meant to provide
companies with a comprehensive and systematic management system for continuous improvement of its environmental performance. Once implemented, the system
relies on a structure that is typically characterized by four cyclical, action-oriented

steps: i) plan; ii) implement; iii) monitor and check; and iv) review and improve
[. . .]”; and with respect to the European Union, the OECD analysis states (p. 38):
“In the last few years, many companies and consulting firms have started using
eco-innovation or similar terms to present positive contributions by business to
sustainable development through innovation and improvements in production processes and products/services. A few governments and the European Union (EU) are
now promoting the concept as a way to meet sustainable development targets that
keep the industry and the economy competitive. In the EU, eco-innovation has been
considered to support the wider objectives of its Lisbon Strategy for competitiveness and economic growth. In 2004, the Environmental Technology Action Plan
(ETAP) was introduced to promote the development and implementation of
eco-innovation. The ETAP defines eco-innovation as ‘the production, assimilation
or exploitation of a novelty in products, production processes, services or in
management and business methods, which aims, throughout its life cycle, to prevent
or substantially reduce environmental risk, pollution and other negative impacts of
resource use (including energy)’. The action plan provides a general road map for
promoting environmental technologies and business competitiveness by focusing on
bridging the gap between research and markets, improving market conditions for
environmental technologies, and acting globally. Eco-innovation now forms part of
the EU’s Competitiveness and Innovation Framework Program 2007-13, which
offered EUR 28 million in funding in 2008 to stimulate the uptake of environmental
products, processes and services especially among SMEs. In the United States,
environmental technologies are also seen as a promising means of improving
environmental conditions without impeding economic growth, and are being promoted through various public private partnership programs and tax credits. [. . .] In
2002, the Environmental Protection Agency laid out a strategy for achieving better
environmental results through innovation. [. . .] Based on this strategy, it set up the
National Center for Environmental Innovation and is promoting the research,
development and demonstration of technologies. [. . .] In Japan, the government’s
Industrial Science Technology Policy Committee introduced the term ‘ecoinnovation’ in 2007 as an overarching concept which provides direction and a
vision for the societal and technological changes needed to achieve sustainable
development.”
A study by the European Commission (Conte et al. 2010) has presented a modelbased approach of cost-efficiency of alternative EU climate policy options through

which innovation dynamics could be encouraged to contribute to an environmentally sustainable growth path. The innovative model, which is based on the
Commission’s QUEST Dynamic Stochastic General Equilibrium Model, assesses
different policy options in order to identify the best policy mix of environmental
and innovation market instruments in terms of their cost-effectiveness. The key


1

Green Innovations and CO2 in a Growth Perspective: A Neoclassical Model

5

finding of the authors is that an adequate policy mix should strongly stimulate
research and development in the short-term and phase it out by spreading the
innovation support to all sectors in the economy in the medium run. Moreover,
the authors emphasize the role of the supply chain (Conte et al. 2010, p. 1): “The
essential contribution of our approach is to consider that green innovation occurs
along the supply chain and is not necessarily bounded within a single sector. The
introduction of an exhaustive sectoral input-output matrix allows us to capture the
development and use of environmentally friendly products substituting dirty
products across different sectors of the economy. Such a “green” multi-sectoral
version of the model allows us to evaluate the marginal economic effects of sectorwide measures compared to economy-wide policy intervention in the environmental
and innovation markets. In applied terms, this model is calibrated on our newly
constructed dataset that includes green R&D and CO2 emissions for five sectors
with a distinctive potential for nesting green activities.”
Sustainable growth is a key challenge for Europe, Asia, and other regions of the
globe in the twenty-first century. The concept of double sustainability will be
emphasized here; sustainability in the traditional sense of environmental economics
means that future generations should have the opportunity to enjoy at least the same
level of well-being as current generations (a notion of sustainability developed in

the Brundtland Report that largely shows the perspective of industrialized countries
and does not emphasize the obvious desire and need of developing countries to
catch up with OECD countries). The second notion of sustainability emphasized
here is related to financial markets—sustainability means that banks, investment
funds, and insurance companies, as well as other investors, have a long-run
perspective. This second notion suggests emphasizing a stronger role for the
green rating of companies listed on the stock market, and such a rating should be
a signal for investors interested in thoughtful long-run decision-making. Sustainable development has a natural connotation with growth analysis, namely in the
sense that the growth modeling typically looks into the conditions of long-run
growth and a stable steady state solution.
Besides the long-run growth analysis, medium-term adjustment and growth
dynamics can also be looked into. (Barbier 2009) has argued that governments’
spending programs aiming to overcome the Transatlantic Banking Crisis should be
more focused on the promotion of environmentally friendly growth, so that the
global economy could be stimulated and new employment would be created, at the
same time, carbon dependency could be reduced, the degradation of the ecosystem
could be reduced, and the problem of water scarcity could be tackled more
effectively. Moreover, the Millennium Development Goal of overcoming extreme
poverty by 2015 could be achieved. The approach of Barbier is comprehensive but
leaves many questions open, including whether or not the chosen analytical basis is
consistent. Many policymakers prefer to rely on DSGE models that stand for a
complex approach while neglecting key elements of globalization, which in turn are
relevant for greenhouse gas emissions; e.g., the role of foreign direct investment
(FDI) is ignored, although FDI is quite important for international technology
transfer and green growth in many countries. In a rather simple neoclassical growth


6

1

Green Innovations and CO2 in a Growth Perspective: A Neoclassical Model

framework, many key analytical challenges of green innovation and green growth
can easily be incorporated.
While a DSGE model is certainly useful for certain analytical perspectives, the
following analysis will largely be confined to a simple modified neoclassical
growth model. The analysis presented first looks at the basics of green innovation
dynamics (Sect. 1.1). In Sect. 1.2, aspects of modified neoclassical growth
modeling—including the role of the golden rule—are discussed. Section 1.3
presents some policy conclusions.
At the bottom line, analytical progress is developed subsequently and some
rough calculations on the impact of CO2 emissions on true gross domestic product
are also presented; for many OECD countries the corrected gross domestic product
figures—taking into account the quasi-negative value-added of CO2 emissions—
are rather small relative to official figures from the System of National Accounts.
However, there are also industrialized countries in which imputed negative valueadded from CO2 emissions are rather big: China, a country where CO2 emissions
have so far not been internalized through policy intervention, is an interesting case
where the negative value-added from CO2 emission is in the range of 2–3% of
official gross domestic product (the range is a function of the opportunity costs of
CO2 emission reduction). The analysis presented argues that green innovation
dynamics could play a crucial role in sustainability and long-run growth. Information and communication technology is a sector that is highly innovative and could
particularly contribute to green growth—despite some rebound effects in the field
of green ICT. One of the most important green potentials that could be exploited by
ICT is a much more efficient use of machinery and equipment: By introducing
virtual markets and creating virtual machines, individual demand curves at any
point of time can be aggregated rather effectively, namely in a way that raises the
capacity utilization of real machinery and equipment: The demand collected via
computer systems and assigned to virtual machines can be assigned in a second step
to real machines and this two-stage system will allow to operate the existing capital

stock in many sectors in a much more efficient way than prior to the expansion of
ICT. This special aspect will subsequently be neglected. However, many other key
aspects of green innovation and green growth will be discussed. It will be argued
that rather simple growth models allow to gain important new insights in the field of
green growth analysis.

1.1

A Rational Approach to Promotion of Green Innovation

1.1.1

Taxation and Subsidies as a Means to Internalize External
Effects

A government in a market economy has several tasks: creating institutions necessary for transactions in markets, stabilization of the economy, and internalizing
negative as well as positive external effects. Promoting innovations is a standard


1.1

A Rational Approach to Promotion of Green Innovation

7

task of government, however, before paying subsidies for research and development; the economy should be opened up for trade and competition in goods and
factor markets introduced; China has been among the countries that have made
enormous progress in this field since 1990, and membership of the WTO in 2001
has been an important signal. The EU’s eastern enlargement also stands for a
remarkable experience in the field of trade liberalization, privatization, and competition. With the ongoing discussion about greenhouse warming and other environmental problems—including nuclear risks—there is a special need to emphasize

green innovation dynamics. Innovation dynamics will be high if there are five key
elements present:
• Strong competition
• Sufficient emphasis on human capital formation and the expansion of digital
networks which are important for both fast diffusion of technologies and for
creating internet-based innovation networks (with more emphasis on
technology-intensive production, there will be a growing demand for human
capital so that there is some trade-off between rising government expenditures
on education and rising promotion of innovation)
• Efficient innovation system
• International technology flows—typically partly related to trade and foreign
direct investment inflows
• Adequate incentives: such incentives should tax emissions and provide R&D
subsidies
As regards innovations, there are often positive external effects from innovations
in a certain sector (or from certain innovative firms in this sector) so that subsidies
for innovators and research & development are justified. In the market for R&D
services, the social benefits are higher than the private benefits (DD1 is above DD0;
DD1 indicates private benefits from R&D; q is the quantity) so that the optimum
allocation of resources—the optimum quantity of R&D (q1)—is only obtained if the
marginal costs curve in the innovation sector (k0i) is shifted downwards in a way that
we get an output that internalizes the positive external effect. In the left-hand panel
b, we consider an industry j with emissions, that is, a sector j with negative external
0
effects is shown so that the social marginal benefits (DD 1) are below the private
0
social benefits (DD 0); Q stands for the quantity of the good with emissions. By
imposing an adequate Pigou taxon producers, the supply curve—the marginal cost
curve—can be shifted upwards k0j1 ¼ k0j0 ð1 þ t0 Þ where t0 is the Pigou tax rate (see

Fig. 1.1): Thus, the optimal output Q1 is obtained and not the output Q0, which
would result in an economy without government intervention. The Pigou tax—or
tradable emission permits—helps to correct a partial market failure, which would
normally characterize the market for goods with emissions. If there were no sector
with Pigou tax, the income tax would have to be raised in order to finance the
subsidies for innovative firms.


8

1

Green Innovations and CO2 in a Growth Perspective: A Neoclassical Model
a) R&D Sector

b) Sector with Emission

p‘

p

k‘j0 (1+t‘)

k‘i0

k‘j0
k‘i0 (1-subsidy rate)
E‘1

E1

p‘2 p1
E0

E‘0

B

p‘1

p0

F
p2

DD‘0

DD1
DD‘1

Q

DD0
Q0

Q1

0

q0

q1

q

Fig. 1.1 Subsidizing the innovation sector and imposing a Pigou tax on the sector with emissions

As regards the economy in the real world, in a framework of Schumpeterian
innovation dynamics and emissions, it may be emphasized that there are two types
of market failures at the same time that can, however, be solved through a combined
policy: Subsidies are given to innovative firms in order to internalize the positive
external effects from innovation; these subsidies can be financed partly or fully
from revenues arising from a Pigou tax on emissions (or from government selling
tradable CO2 emission permits to firms). For the sake of simplicity, focus will be
placed on a Pigou tax where the tax rate is τ0 , so that the government budget
00 00
0 0
constraint reads: G + τ η Y ¼ τY + τ η Y.
G denotes real government consumption, τ00 is the subsidy rate for the share η00 of
production activities that are subsidized; τ is the income tax rate, η0 is the share of
output, which is subject to the Pigou tax (seigniorage from “producing money” is
ignored here). This problem of an adequate tax and subsidization system is considered here in a principal way. Paradoxically, the emissions are welcome to some
extent because this allows government to finance subsidies for innovations and
research & development, respectively—without any deadweight loss; in the
absence of emissions and an emission tax, respectively, the subsidization of
innovations would require to raise the income tax rate, which in turn would reduce
the level of the long-run growth path in a growth model; and under certain
assumptions could even reduce the long-run growth rate of output, namely if the
income tax rate would negatively affect the technological progress rate. It may also
be noted—taking due account of well-known results from endogenous growth

models in the context of the Lucas–Uzawa approach (see Appendix A.4 for a
simple model without tax considerations)—that a progressive income tax rate


1.1

A Rational Approach to Promotion of Green Innovation

9

system might to some extent undermine the incentive to invest in human capital and
could thereby reduce the long-run growth rate.
A few formal aspects of the link between R&D subsidies and emission taxation
should also be highlighted. Let us rewrite the government budget constraint as
follows:
h
 00 i
00 00
τ ¼ γ À τ0 η0 ðτ0 Þ À τ η τ

ð1:1Þ
0

0

0

0

0

Here, γ : ¼ G/Y; it has been taken into account that η ¼ η (τ )—with ∂η /∂τ
00
00
00
00
00
< 0—and that η ¼ η (τ )—with ∂η /∂τ > 0. This implies that the income tax
0 0
0
00 00
00
rate can be reduced if τ η (τ ) > τ η (τ ), and a lower income tax rate will raise the
level of the growth path. An interesting case is an economy without any income tax;
00
0
0 0
0
therefore, the government budget constraint will read (with η ¼ (1 À η ) ): γ ¼ τ η (τ ) À
00
0
00
τ [1 À η ](τ ). Taking the total differential, we can write:
00

00

dγ ¼ η0 dτ0 þ τ0 η0 τ0 dτ0 þ τ dη0 À ητ00 dτ

00

ð1:2Þ

À
Á
00
00
00
Since dη0 ¼ η0τ0 dτ0 , we finally get dγ ¼ η0 þ τ0 η0 τ0 þ τ η0 τ0 dτ0 À ητ00 dτ and can
thus derive a condition under which the ratio of government consumption to GDP is
unchanged: It must hold that:
00

dτ ¼

h
 00 i
00
η0 þ τ0 η0 τ0 þ τ η0 τ0 =ητ00 dτ0

ð1:3Þ

There is a problem here, since if γ 0 is optimal (however defined), it would be
pure coincidence if a necessary change in one of the tax rates—the subsidy rate is a
negative tax rate—would leave γ unchanged. In any case, sustainable development,
broadly defined, not only requires that environmental constraints are taken into
account, but that the government budget constraint and the balance of payments
constraints are considered as well.
As regards externalities, it is quite important to make a distinction between
consumption and investment goods. It has been assumed that negative externalities

from emissions are from both sectors and that there is no difference between the two
types of goods. Unfortunately, the OECD/IEA does not offer adequate data on
sector differences in CO2 emissions—some of the relevant data for the BRICS are
given in Appendix A.3.
Different sectoral externalities can broadly be analyzed within a two-sector
approach. If there are only positive externalities in the capital goods sector—and
if these are internalized through a subsidy—and if all negative externalities
(emissions) are in the consumption goods sector, key issues can be analyzed within
a one sector model: The positive externality shows up in the equation for profit
maximization, namely that the real interest rate should be equal to the net marginal
00
product of capital, which is βkβ À 1 – δ + τ (assuming that per capita output y ¼ kβ,
00
where k is the capital intensity K/L; K is capital and L is labor). Moreover, τ ¼ γ + τ
will have to be taken into account, which is relevant for the savings function—since