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DEBRAJ RAY
OVERVIEW ON GROWTH THEORY
How to study growth?
Observations on growth.
Questions asked in growth theories.
Short history of modern growth theory.
Basic concepts in growth models.
Harrod- Domar model.
Solow model.
OBSERVATIONS ON GROWTH
1. GDP/capita varies a lot from country to
country.
About 50% of the world population live in
countries with GDP/capita less than 10% of
that of the richest countries.
Growth rates vary a lot, but there is no huge
difference between the average growth rates
of developing and developed countries
Average per capita growth rate in 16 today's developed countries
(Europe, USA, Canada, Australia)
period growth rate, % per year
1870-1890 - 1.2
1890-1910 - 1.5
1910-1930 - 1.3
1930-1950 - 1.4
1950-1970 - 3.7
1970-1990 - 2.2
Average per capita growth rate in 15 developing countries in Asia
and
South America.
1900-1913 - 1.2
1913-1950 - 0.4
1950-1973 - 2.6
1973-1987- 2.4
Growth rates are not necessarily constant
over time
Ex. India: 1960-97 average growth rate was
2.3%, but
1960-80: 1.3%
1980-1997: 3.5%
China:
1960-1978: 1.9%
1978- 1997: 5%
Countrys relative position in the world
distribution of per capita incomes can change.
Countries can move from being poor to being
rich:
Korea, Taiwan, Singapore, Japan, Hong Kong.
Ex. Korean GDP/capita 7.4 times higher in 1990
than in 1960 (880 -> 6580 USD, 1985 prices).
Or from being rich to being poor:
Ex. Iraq GDP/capita fell from 3300 to 1780 USD
from 1960 to 1990 in 1985 prices).
Growth in output and growth in the volume of
international trade are closely related.
Both skilled and unskilled workers tend to
migrate from poor to rich countries or regions.
QUESTIONS ASKED
Why are some countries poor and others rich?
Why are some countries growing and others
not?
Where does growth come from?
Neoclassical growth
The neoclassical growth model, also known as
the SolowSwan growth model or exogenous
growth model, is a class of economic models
of long-run economic growth set within the
framework of neo classical economics.
Neoclassical growth models attempt to
explain long run economic growth by looking
at productivity, capital accumulation,
population growth and technology.
The neo-classical model was an extension to
the 1946 Harrod - Domar model that included
a new term: productivity growth.
Important contributions to the model came
from the work done by Robert Solow and T. W.
Swan who independently developed relatively
simple growth models.
SHORT HISTORY OF MODERN
GROWTH THEORY
Modern growth theory originates from 1950s
(by Robert Solow)
role of physical capital and technological
progress central.
perfect competition as a starting point.
technology assumed to grow exogenously in
time as manna from heaven
Harrod- Domar Model
Developed by Sir Roy Harrod and Evsey Domar
in the 40s .
The HarrodDomar model is used in
development economics to explain an
economy's growth rate in terms of the level of
saving and productivity of capital.
The Harrod-Domar Model
R. F. Harrod, The
Economic Journal,
Vol. 49, No. 193.
(Mar., 1939), pp. 14-
33.
Econometrica
, Vol. 14, No.
2. (Apr.,
1946), pp.
137-147
Economic Growth is the result of abstention
from current consumption.
Two type of commodities:
1. Consumption Goods: produced to satisfy
human wants and preferences.
2. Capital Goods: Commodities that are
produced to produce other commodities.
16
The Harrod-Domar Growth Model
(continued)
Firms
Households
Wages, Profits,
Rents
Consumption
Expenditure
Outflow
Inflow
Inflow
Outflow
Investment
Savings
BASIC CONCEPTS
Capital (K) and Labor (L) used as inputs to
produce the output (Y).
Fixed factor proportions assumed.
The state of technology is given and requires
that inputs to be used in fixed proportion.
The state of technology is given and requires
that inputs to be used in fixed proportion.
Thus production function is of fixed coefficient
type:
= labour output ratio;
= capital output ratio
}
) (
,
) (
min{ ) (
| o
t K t L
t Y =
It is also assumed that the economy is closed and
is producing a single commodity, which is partly
consumed and partly invested.
Labor forces grows at an exogenous determined
constant exponential rate.
Investment is proportional to change in output. It
is also assumed that the capital stock does not
depreciate and there is no technical progress.
The society is inclined to save a constant
proportion of its output all the time.
Entrepreneurs are profit maximizers.
Use of aggregate production
Y(t)= C(t)+ I(t)..1
Y(t)= real GDP in year t.
C(t)= Consumption in period t.
I(t)= Investment in period t.
Use of aggregate income
Y(t)= C(t)+ S(t).2
C(t)= Purchase of consumption in period t.
S(t)= Household saving in period t.
Using the above equations==
S(t)=I(t).savings =investment.
How are capital stock (K) and investment flow (I)
related?
Investment augments the national capital stock K and
replaces that part of it which is wearing out.
I(t)= K(t+1)-K(t) + K(t)
Or, K(t+1) = (1-) K(t) + I(t)
This tells us how capital stock must change over time.
= rate of depreciation of the capital stock
t = index for time
In equilibrium
C +S = C+ I ( from 1 and 2)
<=> S = I..(3)
=> S(t) = K(t+1) (1- ) K(t)
Investment augments the national capital
stock K and replaces that part of it which is
wearing out.
Let Savings rate:
..(4)
Share of income that can be allocated to
investment to increase the growth rate.
) (
) (
) (
t Y
t S
t s =
Define Capital Output ratio=
The amount of capital required to produce a
single unit of output in the economy.
= .(5)
is assumed to be a technologically given
constant.
Combining equation 4 and 5, we get
= g+
H-D Equations
K(t+1) = (1-) K(t) + I(t)
S(t)=I(t)
K(t+1) = (1-) K(t) +S(t)
S(t)=s Y(t)
K(t)= Y(t)
Y(t+1)= (1-) Y(t)+ s Y(t)
Or, [ Y(t+1)- Y(t)]= Y(t) (s-)
or,
o
u
=
+ s
t Y
t Y t Y
) (
) ( ) 1 (
g= overall rate of growth
g=[Y(t+1)-Y(t)]/ Y(t) .
This is the Harrod Domar Equation.
o
u
=
s
g
u
o
s
g = +
is called the warranted rate of growth.
Under the assumption of constant , g
increases proportionally with s.
Because s is considered to increase
proportionally with income per capita, s is
bound to be low.
Hence, g will be low in low-income economies
if savings and investment are left to private
decision in the free market.
The model implies, that promotion of
investment is needed to accelerate economic
growth in low-income economies.
Infact, the Harrod - Domar model provided a
framework for economic planning in
developing economies, such as India's Five
Year Plan.
Suppose = 4 and s = .02 (20%).
The growth rate would then be 20/5 = 5%.
These numbers in fact roughly describes the
Indian economy in the 1980s. Policy makers in
India argued how India needed to increase its
savings rate or make capital more productive
(i.e. lower )
H-D model links growth rate of the economy
to two fundamental variables:
Ability of the economy to save.
Capital output ratio.
Higher saving rate would push up the
economy.
Increasing the rate at which capital produces
output (a lower ), growth would be
enhanced.
What causes growth in this model?
How does the Harrod-Domar model
conceive of growth?
Expanding yields the approximate equation:
Ability to save and invest (s)
Ability to convert capital into output ()
Rate of capital depreciation ()
Rate of population growth (n)
o u + + ~ n g s * /
For developing countries, the key to successful
development is increasing the rate of savings.
Capital created by investment is the main
determinant of growth.
Saving makes investment possible.
The tricks of economic growth, according to this
model, are simply a matter of increasing savings
and investment.
The main obstacle to or constraint on
development then is the relatively low level of
new capital formation or investment in most
LDCs.
The Harrod-Domar Model
Consequences
Saving as crucial for growth
The preceding result is valid as long as there
is no labor shortage. If n = s/c population,
capital and income will grow at the same
rate.
Knife-edge dynamics
If n>g , then chronic unemployment
If n<g , then chronic labor shortages, capital
becomes idle.
No endogenous process to bring the
economy to equilibrium
What are the problems with the
Harrod-Domar model?
Model assumes economy grows forever.
Saving as sufficient.
No diminishing returns; no factor substitution.
No technological change.
All three factors (s, n and ) are given facts of
nature .
Constancy of capital output ratio .
Thus, only capital and not labour contributes
to production.
Labour and capital are not substitutable in
Production.
Output does not increase by applying more
labour for a given stock of capital.
Harrod Domar Model is a neutral theory of
economic growth.
39
Beyond Harrod- Domar model
Endogeneity of savings
Savings are influenced by per capita incomes and
distribution of income in an economy
Both of these are influenced by economic growth
Economic growth mirrors the movement of savings
with income
Endogeneity of population growth
Relationship between demographic transition and
per capita income
External policy can prevent an economy from sliding
in to a trap (process of demographic transition)
Endogeneity of capital-output ratio
Captured in Solows model
Solow Model
Solow altered the Harrod - Domar story by
making the capital-output ratio endogenous.
Solows model is based on the diminishing
returns to individual factors of production.
Capital and Labor (L) are both needed to
produce output.
K/Y ratio is no longer fixed but depends e.g.
on the economy with relative endowments of
capital and labor.
Assumptions:
Savings rate (ratio of savings to income), s, is
constant. Savings will be channelled into
investment as previously.
Population growth rate is constant:L/L = n,
where L denotes population or labor.
There is perfect competition: the firm takes
the market wages on labor and rents on
capital as given.
Constant returns to scale. If labor and capital
inputs are doubled, the output gets doubled
as well.
The Solow model is built around two
equations, a production function and a capital
accumulation equation.
The production function is assumed to have
the Cobb-Douglas form and is given by
Y=F(K,L)= K
L
1-
where a is some number between 0 and 1
Production function exhibits constant returns
to scale: if all of the inputs are doubled,
output will exactly double.
Perfect competition prevails and the firms are
price-takers.
w=workers wage
r= rent payment to capital.
Profit maximizing condition implies:
max F(K, L) - rK - wL.
First-order conditions implies:
Firms will hire labor until the marginal product
of labor is equal to the wage and will rent
capital until the marginal product of capital is
equal to the rental price:
w = = (1-)
r= =
wL + rK = Y; payments to the inputs ("factor
payments") completely exhaust the value of
output produced so that there are no
economic profits to be earned.
share of output paid to labor is:
wL/Y = 1 -
the share paid to capital is:
rK/Y =
These factor shares are constant over time.
Rewrite the production function as
output per worker, y = Y/L,
capital per worker, k = K/L:
k
y
o
=
Equation on Capital Accumulation:
=K
t+l
K
t
=
sY = gross investment; dK = depreciation.
dK sY K =
.
we assume that workers/consumers save a
constant fraction, s, of their combined wage
and rental income, Y = wL + rK.
a constant fraction, d, of the capital stock
depreciates every period (regardless of how
much output is produced).
Rewrite the capital accumulation equation in
terms of capital per person.
The production function in equation will tell
us the amount of output per person produced
for whatever capital stock per person is
present in the economy.
k= K/L= log k= log K-log L
Also, , so that
Or,
Capital accumulation equation in per worker
terms:
This equation says that the change in capital
per worker each period is determined by three
terms:
Investment per worker, sy.
depreciation per worker, dk.
population growth n.
SOLVING THE BASIC SOLOW MODEL
1 ... .......... ..........
k
y
o
=
2 ......... .......... ) (
.
k d n sy k + =
The first equation shows how output is
produced from capital and labour.
The 2
nd
equation shows how capital is
accumulated over time.
Y and K are endogenous variables, so is y and
k .
Solving a model means obtaining the values of
each endogenous variable when given values
for the exogenous variables and parameters.
The Solow Diagram:
(n+d)k
Investment: sy
Investment, depreciation
Capital, k k*
Net investment
k0
Steady state.
The first curve is the amount of investment
per person, sy = sk
+
=
=
+ =
1
1
*
.
.
) (
0
) (
d n
s
k
k
k d n sk k
In steady state =0
k
+
=
1
*
) (
d n
s
y
This equation reveals the Solow model's answer :
"Why are we so rich and they so poor?"
Countries that have high investment rates will
tend to be richer, ceteris paribus.
Countries that have population growth rates, in
contrast, will tend to be poorer.
A higher fraction of savings in these economies
must go simply to keep the capital-labor ratio
constant in the face of a growing population
This capital-widening requirement makes
capital deepening more difficult, and these
economies tend to accumulate less capital per
worker.
Empirically, countries with higher investment rates have higher
capital to output ratios:
ECONOMIC GROWTH IN THE SIMPLE
MODEL
k/k
1
=
o
sk
k
sy
n+d
k*
k
What does economic growth look like in the
steady state of this simple version of the
Solow model?
There is no per capita growth in this version of
the model!
Output per worker is constant in the steady
state.
Output itself, Y, is growing, of course, but only
at the rate of population growth.
there is no long-run economic growth in the
Solow model.
in the steady state: output, capital, output per
person, and consumption per person are all
constant and growth stops.
An economy that begins with a stock of capital
per worker below its steady-state value will
experience growth in k and y along the
transition path to the steady state.
Over time, however, growth slows down as
the economy approaches its steady state, and
eventually growth stops altogether.
The further an economy is below its steady-
state value of k, the faster the economy grows.
Also, the further an economy is above its
steady-state value of k, the faster k declines.
empirically, economies appear to continue to
grow over time
thus capital accumulation is not the engine of
long-run economic growth
saving and investment are beneficial in the short-
run, but diminishing returns to capital do not
sustain long-run growth
in other words, after we reach the steady state,
there is no long-run growth in Y
t
(unless L
t
or A
increases)
Level effects and Growth effects.
C
D
F
B
A
E
Time
(
L
o
g
)
p
e
r
c
a
p
i
t
a
i
n
c
o
m
e
A growth effect : Changes the rate of growth
of a variable.
A level effect leaves the rate of growth
unchanged.
Savings rate has a level effect only in the
Solow model.
Savings rate, s, and population growth ,n,
only has level effects.
Solow Model with Technology
To generate sustained growth in per capita
income , we must introduce technological
progress to the model.
Y = F(K, AL) = K
(AL)
1-
Technology variable: A
The technology variable A is said to be "labor
augmenting. Technological progress occurs when
A increases over time - a unit of labor, for
example, is more productive when the level of
technology is higher.
exogenous technical progress
Consider the labour-augmenting production
function:
Technical progress occurs when A rises over
time, with labour becoming more productive
when the level of technology is higher.
Let,
Y F(K, AL) =
g
A
A
=
A
1-
A
A
k
k
y
y
) 1 ( o o + =
From the capital accumulation equation we
can see that the growth rate of K will be
constant if and only if Y / K is constant.
If Y / K is constant, y/k is also constant.
y and k will be growing at the same rate.
A situation in which capital, output,
consumption, and population are growing at
constant rates is called a balanced growth
path.
Let, g, to denote the growth rate of some
variable x along a balanced growth path.
Then, along a balanced growth path, g
y
= g
k
Recalling that,
g
y
=g
k
=g
g
A
A
=
=
~
~
k d g n y s k
~
) (
~
~
+ + =