ECONOMIC GROWTH THEORIES AND MODELS

Classical

growth by Adam Smith (1776) and David Ricardo(1817) H-D model by Harrod(1939) and Domar(1947) Neoclassical model Slow(1956). Modification to include inter-temporal optimization does not alter the basic conclusion-Cass-KoopmansRamsey(1965), Romer (1986), Blanchard and Fisher (1989) Endogenous growth model pioneered by Robert Lucas (1988) and Paul Romer (1986, 1990) Issue of Convergence

The classical economists were the economists of the late 18th and early 19th centuries who were very much concerned with the conditions of economic progress. This was the period of the Industrial Revolution in Europe. The classical economists lived through the period of take-off into sustained growth. For the classical economists, the development of capitalist economies was a race b/n technological progress and population growth.

His idea of development is very much tied up to the wealth of nations. i.e. If a nation is able to increase it wealth, then it is developing.

His Ideas on Growth He attempted to determine the factors that were responsible for economic progress. His main concern was an investigation into: 1. Capital accumulation 2. Population growth 3. Labour productivity

His production was a function expressed as Q=f(L, N, K, T) His production function is not subject to diminishing returns but it is influenced by increasing returns to scale. He postulated that the real cost of production will tend to diminish with passage of time as a result of the existence of internal and external economies arising from increases in market size

He related the labour force to population. The wage rate therefore plays a critical role in determining population size. The rate of growth of population depended on how much money was available to pay wages. This was the sufficient wage that gave birth to the Wage Fund Theory of the classical economists. Labour force growth was related to the growth of income and capital. This relation was also direct and positive. Increase in income will lead to increase in capital accumulation - increase in output - increase in higher wages - increase in labour force.

To Smith, a fixed proportion of labour and capital was required for production and we cannot substitute one factor for the other. The improvement in the productive power of labour depended on improve skills and greater use of machinery.

Adams Smiths idea of capital was that, he assumed that investment equals savings i.e. the portion which a rich man annually saves from profit will immediately be employed as capital. He observed that in the course of economic progress, as the economys capital stock grows the rate of profit falls. Therefore, economic progress is an accumulative progress because you have to build more and more capital. It will be at a faster rate until the capital stock is so large and the rate of profit drops to a constant rate and we will get to stationary state.

Per capita output is constant Wages are at the subsistence level Profits are at the minimum No net investment takes place Population remains the same Total income is constant Total output will also be constant Growth will also cease

To Smith, the most important determinant of growth is capital accumulation or the rate of capital formation. The rate of progress of an economy is therefore appropriate to its rate of investment.

Classical economists clearly illustrates the dynamics and aggregative aspects of development. It analyses the process whereby a portion of economic surplus available to the community is employed for the purpose of capital accumulation. In the long-run, certain factors can affect the rate of capital accumulation negatively according to the classical. These are; 1 Historical Diminishing Returns 2 The Malthusian Principle of Population

Modern growth theory started with the classical article by the British economist Roy Harrod, An Essay in Dynamic Theory (1939), Economic Journal, March 1939. Harrods original model is a dynamic extension of Keynes static equilibrium analysis. In Keynes General Theory, the condition for income and output to be in equilibrium (in the closed economy) states that plans to invest must be equal to plans to save or injections should equal leakages.

The Harrod model is seen to have a knife-edge problem or the instability problem because any departure from equilibrium, in stead of being self-righting will be self-aggravating. That is if actual growth exceeds the warranted growth rate, plans to invest will exceed plans to save; and the actual growth rate is pushed even further above the warranted rate. On the other hand, if actual growth is less than the warranted rate, plans to invest will be less than plans to save and growth will fall further below the warranted rate.

The American economist, Evesey Domar (Expansion and Employment, American Economic Review, March 1947), working independently of Harrod also arrived at Harrods central conclusion, although by a slightly different route. Domar recognized that investment is a double-edged sword: it both increases demand via the multiplier and increase supply via its effect on expanding capacity.

Closed economy [ S(t) = I(t)] s, , ,are exogenously given (determined outside the model) s (saving rate) =S(t)/Y(t) ; where S = savings and Y = income or GDP (capital-output ratio) = K(t)/Y(t) ; where K = capital stock : capital depreciation rate.

Derivation of H-D Growth Equation

Kt + 1 = (1 )Kt + It Yt +1 = (1 ) Yt + St Yt +1 = (1 ) Yt + sYt [Yt + 1 Yt] = Yt + sYt = Yt + 1 Yt/ Yt = + s g = + s Therefore, g = s/ [H-D Growth equation] When s increases, g also increases; increases, g decreases; and if increases, g decreases.

s, , , and n are exogenously determined. Issue of population growth- relationship b/n level of economic development and death and birth rates. also the one child policy in china reduces n delibrately Constant return to capital when labour is fixed.

The Solow-Swan growth model (Solow 1956, Swan 1956) is often seen as the benchmark for this growth model. This model expanded on the Harrod-Domar formulation by adding a second factor, Labor and introducing a third independent variable, Technology, to the growth equation Aggregate output (Y) depends on capital (K) and labor (L) according to constant returns to scale production function. Technological progress is introduced in terms of of an aggregate parameter (A) reflecting the current state of laboraugmenting technological knowledge.

. Taking a Cobb-Douglas production function we have: Y= (AL)1-K 0<<1. The growth rate of the labor force (n) as well as the saving rate (s) is assumed to be constant and exogenous. Given these axioms, an economy regardless of its starting point converges to a balanced growth path where long-run growth of output and capital are determined solely by the rate of labor-augmenting technological progress and the rate of population growth.

A steady state is defined as the situation in which output and capital growth at the same proportional rate as the effective population (AL) resulting in a constant capital intensity (k). This implies that output and capital per capita will grow at the exogenous rate of technological progress (g). In other words, the economy converges to a steady state in which diminishing returns are exactly offset by exogenous technological progress.

The main shortcoming of this model is that it takes as given the behavior of the variables that are identified as the driving force of growth. Solow (1957) used the model for growth accounting and it turned out that it was unable to explain growth rates of output on the basis of accumulation of physical inputs (capital and labor) alone. A large and persistently positive residual remained, which has become known as the Solow-residual.

This model goes beyond the Solow-Swan model by endogenizing technological change and relaxing the assumption of diminishing returns to capital. The endogenous growth model pioneered by Robert Lucas (1988) and Paul Romer (1986, 1990), assumed that there is positive externality associated with human capital formulation ( for example education and training) and Research and Development that prevent the marginal product of capital from falling and the capitaloutput ratio from rising.

The basic idea of this approach is that technology grows in proportion to the macroeconomic capital stock, potentially offsetting the effects of diminishing returns. Capital in such setting should be seen as a broad concept, including human and intangible capital. This approach is known as the AK approach because it results in a production function in the form: Y=AK

The main shortcoming of this model is that it has a knife-edge character due to the assumption of constant returns to scale with respect to reproducible factors. Any deviations from this will significant effects in the (very) long run. With slightly decreasing returns, growth will vanish in the very long run, whereas with slightly increasing returns growth will accelerate indefinitely (as in Romer 1986). As a consequence, the explanatory power of endogenous growth models with respect to changing technology variables for the very long run cannot be taken too literally. One cannot preclude that reality is characterized by slightly increasing or decreasing returns to scale.

Convergence has its roots in the traditional neoclassical growth theory. According to neoclassical growth models for closed economies [Ramsey [1928], Solow [1956]], Cass [1965], and Koopmans [1965]], the per capita growth rate of a country tends to be inversely related to its starting level of income per person.

In other words, given similar preferences and technology, the assumption of diminishing marginal product of capital means that poor countries grow faster to catch up with rich countries [since the former has a lower capital to labor ratio and consequently higher marginal product of capital], and hence this results in absolute convergence among countries.

The endogenous growth theory (Lucas 1988; Romer 1986, 1990) views economic growth as driven by accumulation of knowledge or human capital which is (partially) a public good. Therefore cross-country convergence depends on the extent of international knowledge spillovers, allowing less productive countries to catch up with developed economies. As such endogenous growth theory supports the old hypothesis of the existence of an advantage of backwardness (Gerschenkron 1952), suggesting that being relatively backward in productivity carries a potential for rapid advancement (Abramovitz 1986).

A tendency of countries with relatively low initial productivity levels to grow relatively fast, building upon the proposition that growth rates tend to decline as countries approach their steady state. Betaconvergence is a necessary but not a sufficient condition for alpha-convergence.

Barro and Sala-i-Martin [1995] refers to another type of convergence, s convergence, which is based on cross-sectional dispersion of per capita incomes among countries. According to the latter, convergence occurs if the dispersion [measured as the standard deviation of the logarithm of per capita incomes] among a group of countries declines over time. It is explained that the first type of convergence, dubbed convergence [where poor countries grow faster than rich ones] tends to generate convergence [reduced dispersion of per capita incomes]