NEWS 2020-08-10

Fuel for economic growth?

The transition to sustained growth, which began with the Industrial Revolution, has not been universal. Many countries around the world have remained stagnant or experienced only limited growth throughout history and there are currently large and growing differences in income per capita across countries, referred to as the Great Divergence. Uusing a macroeconomic model, a study published in the Journal of Economic Theory demonstrates that international competition for fossil fuel can help explain this divergence.

The starting point of the study is the empirical observation that GDP and growth in GDP are larger in countries and times where a relatively large share of the energy supply is derived from fossil fuel. While more fossil fuel use can generally be expected in richer countries, it is not self-evident that the share of fossil fuels should be larger.

“The work on this paper started from the notion that the role of energy had received surprisingly little attention in macroeconomic research on growth, especially given the centrality of the energy sector for climate change”, explains Beijer Institute researcher Johan Gars, co-author of the study together with Conny Olovsson at Sveriges Riksbank. “We therefore wanted to study how energy availability may have contributed to the most important international patterns of growth.”

Modelling the role of energy in the global economy
The study goes on to build a multi-country macroeconomic model with endogenous and directed technological progressTwo important empirically grounded assumptions in the model are that energy is complementary to other inputs in production, implying that significant long-term growth requires increased energy use, and that it is easier to improve the productivity of fossil energy use than use of other energy sources. With these assumptions, the model gives rise to two interesting results: First, the discovery of fossil fuels was an important factor behind the Industrial Revolution. Second, international competition for fossil fuel can help explain the Great Divergence.

The implication behind the second result is that in order to benefit from the increased knowledge about energy technology, investments into domestic research must still be made. If international fossil fuel prices are determined by more advanced countries, such investments may not be profitable, since fossil fuels are too expensive. Hence, countries may be forced to use less efficient energy sources.

Looking ahead
Looking forward, it seems likely that the assumption that energy is important for growth will continue to hold. However, recent rapid improvements in alternative, and less polluting, energy sources mean that fossil fuels may not be necessary in the future. Hence growth, not least in currently poor countries, could become feasible even while achieving the significant global reductions in fossil fuel use required to limit climate change.

Johan Gars believes the model can serve many other purposes: “The model we develop in this work strikes a good balance between on the one hand including several important components, such as multiple energy sources, multiple countries and endogenous directed technological progress, and on the other hand being compact and tractable. We believe that these properties make the model well suited for studying many other questions about the role of energy in the global economy.”

Go to article

Gars. J. and C. Olovsson. 2019. Fuel for economic growth?. Journal of Economic Theory 184:104941