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Chapter 4

Chapter 4

Theories ofEconomic

Growth

Norton Media Library

Dwight H. PerkinsSteven Radelet

David L. Lindauer

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Lucas (1985): “The diversity across countries in measured per-capita income levels, is literally too great to be believed”

Recall: growth depends on:

1. Accumulation of assets (K, L, land)

2. Increasing productivity of these assets

3. S and I

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other factors influencing growth:

Government policy, institutions, political and economic stability, geography, natural resource endowment, health and education services quality

This chapter: models of economic growth

In general: relating quantity of L and K, their productivity, and the resulting aggregate output

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The Basic Growth ModelThe Basic Growth ModelAggregate Production functionAggregate Production function

Is based on five equations

1. Aggregate production function Y=f (K,L)

2. Saving(S)= sY (s=.20 and Y=10bill, S=2B)

3. S= I (Saving=Investment)

4. ΔK=(I- dK) where d=depreciation and K= capital

5. Δ L= nxL n=population growth and L=Labor force, (If L=1mill. & n=.02)

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Combining 2,3,4, leads to

ΔK =sY-dK

5 equations and 5 variables can be solved

ΔK can be substituted into Production function Y=f(K,L)

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The Harrod-Domar Growth The Harrod-Domar Growth ModelModel

HD Growth model is a particular model with basic feature of fixed coefficient production function.

It assumes no substitution between labor and capital Q= min F(L,K): the production Isoquant is L shaped

It also shows constant returns to scale (CRS) i.e. doubling inputs will double output

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Production function

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Harrod-Domar Prod. Harrod-Domar Prod. functionfunction

The production function Y= (1/v).K or Y=K/v, where v= constant or v=K/Y

v= capital output ratio or measure of the productivity of capital or investment. (indication of K intensity)

For example if v=4, then how 20 million investment will be needed produce 5 million output or 20/4 =5 based on Y=K/v

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ΔY=ΔK/v and g= ΔY/Y=ΔK/Yv ... growth rate of output

since ΔK =sY-dK:

g= (s/v)-d ... thus:

1. K created by I is the main determinant of growth in output

2. S makes I possible

The Basic HD Model Point: S more and make productive I and the economy will grow. This makes sense!

Example: if s=.24, v=3, and d=.05, then the economy will grow at 3% (why? s/v-d – 0.24/3-0.05= 0.03=3%)

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Case Study: Economic Growth Case Study: Economic Growth in Thailandin Thailand

Thailand in 1960 was an agrarian economy with 75% of population in agriculture, GDP was about $1000, Life expectancy was 53, infant mortality was 103 per 1000

Beginning 1970 Thailand began to save averaging 20% and reaching 35% in 1990

This combined with good governance and prudent policies led to rapid economic growth

Average income is more than 6 times it was in 1960,Life expectancy is 69, infant mortality 24 per 1000, adult literacy is 93%, Labor intensive manufacturing is 80% of exports and ICOR rose from 2.6 to 4.1 by 1990.

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The Solow ModelThe Solow Model

The Solow model is an improvement over Harrod-Domar Model

It drops fixed coefficient or no substitution and allows for substitution between factors

Y= f(K,L) Labor and capital are substitutable

The production function or Isoquant is u-shaped showing substitution as in figure 4.2

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a to b: same as FPM

K-intensive

L-intensive

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if the production function facing a country i a neoclassical, then capital output ratio becomes a variable that influenced by relative prices, policies,...

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Basic Equations:Basic Equations:

Divide Y=f (K,L) by L to express all variables in per-worker terms

Y/L=F(K/L,1)

y=f(k)

Thus we have diminishing returns to capital as in (4.3)

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Since ΔK =sY-dK:

Δk=sy-(n+d)k

Δk is determined by:

s, -nk, and -dk

Thus: S (and I) adds to K-per-worker, while L growth and dep reduce K-per-worker

When sy>(n+d)k then Δk is increasing

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at the intersection: point A:

k=k0 and y=f(k)=y0

at A: sy=(n+d)k

if k=k1 and y=y1: sy>(n+d)k, so k grows

if k=k2 and y=y2: sy<(n+d)k, so k falls

all move towards A!

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production function

saving function

the amount of K needed b/c of n and d just to keep k constant

sy>(n+d)k

sy<(n+d)k

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The Solow Growth Model (see The Solow Growth Model (see 4.4)4.4)

Point A is where new savings Sy = amount of new capital needed for growth in the labor force and depreciation (n+d).

Point A is steady state level of capital per worker where stable equilibrium occurs

At steady state total output continues to grow at the rate of population (n) or labor force, but GDP per capital (y) is constant.

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The Effect of Changes in Saving Rate The Effect of Changes in Saving Rate and Population Growth in the Solow and Population Growth in the Solow

ModelModel

An increase in the S in the Solow Model from s to s’, k increases from k1 to k2 or A to B

An increase in the n to n‘ will drop k from k0 to k1 or A to C

2121

2222

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Evaluating the Solow Model: Evaluating the Solow Model: Strengths and WeaknessesStrengths and Weaknesses

It is an improvement over H-D Fixed coefficient model

With neoclassical production function it allows for substitution between inputs

Provides good insights about the relationship between role of technology and innovation on growth

Limitations: One sector approach, factors that drive steady state, and assumes saving rate, population growth , and technical change as given. It does not explain how these parameters change over time

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Read: What Explains Differences in Read: What Explains Differences in Growth Rates among countries( see Growth Rates among countries( see

Box 4.3)Box 4.3)

Key factors from a recent study: initial level of income, openness to trade, healthy population, effective governance, high saving rate and geography

The above policy variables explain the differences between 3 groups of countries from 1965-90

10 East Asian countries (4.6%)

17 African Countries (0.6%)

21 Latin American countries (0.7%)

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Beyond the Solow Model: New Beyond the Solow Model: New Approaches to GrowthApproaches to Growth

The Solow model assumes fixed or exogenous saving rate, growth rate of savings and labor force.

Recent works provides models where these variables are determined within or endogenously in the model.

These new models allow for increasing returns to scale and positive and negative externalities

They are called endogenous models but their estimation suffers from lack of good data.

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Chapter 4: Summary of Theories of Economic Chapter 4: Summary of Theories of Economic

GrowthGrowth I. Building blocks common to modern theories of growth: the production function (technology), saving and investment behavior, the relationship between existing stock of capital and new investment, and labor force growth.

II. Three models of growth have informed much of the empirical work and policy analysis on developing economies. They are the HD growth model, which is short term in orientation and Keynesian in spirit; the Solow growth model, which is long term in orientation and neoclassical in spirit; and the Lewis two-sector model, which is also long term but is classical in spirit.

The basic HD growth model suggests that the steady-state rate of growth is determined by the saving rate, the fixed incremental capital-output ratio (ICOR), and the rate of depreciation of fixed capital. Full employment is assured if this growth rate is equal to the rate of growth of the labor force. In terms of the realism of its (highly restrictive) assumptions and its widespread use by development institutions in formulating policy advice.

III. The basic Solow model suggests that the steady-state rate of growth is determined by the saving rate, the flexible ICOR, and the rate of depreciation of fixed capital. Furthermore, factor substitution ensures that steady-state output, net capital, and the labor force grow at the same rate. This implies that all per capita variables remain unchanged in the long run following any changes in such parameters as the saving rate or the population growth rate. The basic model is extended to accommodate exogenously given, labor-augmenting technological change, which ensures that total output will grow at the rate of labor force growth plus technological progress.

IV. A brief discussion of recent research that attempts to explain technological progress within the model (endogenize it) rather than taking it as determined outside the model. Endogenous growth models seek to understand how the interplay between technological knowledge (produced by such efforts as investment in human capital, R&D, and the diffusion of ideas to latecomers) and a country’s institutions affect the prospects for sustained economic growth.

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End Chapter 1End Chapter 1

This concludes the Norton Media LibrarySlide Set for Chapter 4

W. W. Norton & CompanyIndependent and Employee-Owned

Economics ofDevelopment

SIXTH EDITION

ByDwight H. Perkins Steven Radelet

David L. Lindauer