# ENDOGENOUS GROWTH THEORY

 SOLOW MODEL:
 SUSTAINED GROWTH IN LIVING STANDARDS IS DUE
TO TECHNICAL PROGRESS.
 THE RATE OF TECHNICAL PROGRESS IS
EXOGENOUS.
 ENDOGENOUS GROWTH THEORY:
 A SET OF MODELS IN WHICH THE GROWTH RATE OF
PRODUCTIVITY AND LIVING STANDARDS IS
ENDOGENOUS.
A BASIC MODEL
 Production function: Y = A K
where A is the amount of output for each unit of
capital (A is exogenous & constant)
 Key difference between this model & Solow: MPK is
constant here, diminishes in Solow
 Investment: s Y
 Depreciation: o K
 Equation of motion for total capital:
AK = s Y ÷ o K
A BASIC MODEL
AK = s Y ÷ o K
Y K
sA
Y K
= = ÷ o
A A
• If s A > o, then income will grow forever, and
investment is the “engine of growth.”
• Here, the permanent growth rate depends on s. In
Solow model, it does not.
• Divide through by K and use Y = A K
to get:
DOES CAPITAL HAVE DIMINISHING
RETURNS OR NOT?
 DEPENDS ON DEFINITION OF “CAPITAL.”
 IF “CAPITAL” IS NARROWLY DEFINED (ONLY PLANT &
EQUIPMENT), THEN YES.
 ADVOCATES OF ENDOGENOUS GROWTH THEORY
ARGUE THAT KNOWLEDGE IS A TYPE OF CAPITAL.
 IF SO, THEN CONSTANT RETURNS TO CAPITAL IS MORE
PLAUSIBLE, AND THIS MODEL MAY BE A GOOD
DESCRIPTION OF ECONOMIC GROWTH.
A TWO-SECTOR MODEL
 Two sectors:
 manufacturing firms produce goods.
 research universities produce knowledge that increases
labor efficiency in manufacturing.
 u = fraction of labor in research
(u is exogenous)
 Manufacturing production function:
 Y = F [K, (1-u )E L]
 Research production function: AE = g (u )E
 Capital accumulation: AK = s Y ÷ o K
A TWO-SECTOR MODEL

 In the steady state, manufacturing output per worker and
the standard of living grow at rate
AE/E = g (u ).
 Key variables:
s: affects the level of income, but not its growth rate
(same as in Solow model)
u: affects level and growth rate of income

INTER-TEMPORAL CHOICE
KEYNES’S CONJECTURES ON CONSUMPTION
0 < MPC < 1
AVERAGE PROPENSITY TO CONSUME (APC )
FALLS AS INCOME RISES.
(APC = C/Y )
INCOME IS THE MAIN DETERMINANT OF
CONSUMPTION.
THE KEYNESIAN CONSUMPTION
FUNCTION
C
Y
1
c
C C cY = +
C
c = MPC
= slope of the
consumption
function
THE KEYNESIAN CONSUMPTION
FUNCTION
C
Y
C C cY = +
slope = APC
As income rises, consumers save a bigger fraction
of their income, so APC falls.
C C
c
Y Y
= = + APC
EARLY EMPIRICAL SUCCESSES:
RESULTS FROM EARLY STUDIES
 HOUSEHOLDS WITH HIGHER INCOMES:
 CONSUME MORE, ¬ MPC > 0
 SAVE MORE, ¬ MPC < 1
 SAVE A LARGER FRACTION OF THEIR INCOME,
¬ APC + AS Y |
 VERY STRONG CORRELATION BETWEEN
INCOME AND CONSUMPTION:
¬ INCOME SEEMED TO BE THE MAIN
DETERMINANT OF CONSUMPTION
PROBLEMS FOR THE
KEYNESIAN CONSUMPTION FUNCTION
 BASED ON THE KEYNESIAN CONSUMPTION
FUNCTION, ECONOMISTS PREDICTED THAT C
WOULD GROW MORE SLOWLY THAN Y OVER TIME.
 THIS PREDICTION DID NOT COME TRUE:
 AS INCOMES GREW, APC DID NOT FALL,
AND C GREW AT THE SAME RATE AS INCOME.
 SIMON KUZNETS SHOWED THAT C/Y WAS
VERY STABLE IN LONG TIME SERIES DATA.
THE CONSUMPTION PUZZLE
C
Y
Consumption
function from long
time series data
(constant APC )
Consumption
function from cross-
sectional household
data
(falling APC )
IRVING FISHER AND INTERTEMPORAL
CHOICE
 THE BASIS FOR MUCH SUBSEQUENT WORK ON
CONSUMPTION.
 ASSUMES CONSUMER IS FORWARD-LOOKING AND
CHOOSES CONSUMPTION FOR THE PRESENT AND
 CONSUMER’S CHOICES ARE SUBJECT TO AN
INTERTEMPORAL BUDGET CONSTRAINT, A
MEASURE OF THE TOTAL RESOURCES AVAILABLE
FOR PRESENT AND FUTURE CONSUMPTION.
THE BASIC TWO-PERIOD MODEL
 Period 1: the present
 Period 2: the future
 Notation
Y
1
, Y
2
= income in period 1, 2
C
1
, C
2
= consumption in period 1, 2
S = Y
1
÷ C
1
= saving in period 1
(S < 0 if the consumer borrows in period 1)
DERIVING THE INTERTEMPORAL
BUDGET CONSTRAINT
 Period 2 budget constraint:
2 2
(1 ) C Y r S = + +
2 1 1
(1 ) ( ) Y r Y C = + + ÷
• Rearrange terms:
1 2 2 1
(1 ) (1 ) r C C Y r Y + + = + +
• Divide through by (1+r )
to get…
THE INTERTEMPORAL BUDGET CONSTRAINT
2 2
1 1
1 1
C Y
C Y
r r
+ = +
+ +
present value of
consumption
present value of
THE INTERTEMPORAL BUDGET CONSTRAINT
The budget constraint
shows all
combinations
of C
1
and C
2
that just
exhaust the
consumer’s resources.
C
1
C
2
1 2
(1 ) Y Y r + +
1 2
(1 ) r Y Y + +
Y
1
Y
2
Borrowing
Saving
Consumption
= income in
both periods
2 2
1 1
1 1
C Y
C Y
r r
+ = +
+ +
THE INTERTEMPORAL BUDGET
CONSTRAINT
The slope of
the budget
line equals
÷(1+r )
C
1
C
2
Y
1
Y
2
1
(1+r )
2 2
1 1
1 1
C Y
C Y
r r
+ = +
+ +
CONSUMER PREFERENCES
An indifference curve
shows
all combinations of C
1

and C
2

that make the
consumer
equally happy.
C
1
C
2
IC
1
IC
2
Higher
indifference
curves
represent
higher levels
of happiness.
CONSUMER PREFERENCES
Marginal rate of substitution
(MRS ): the amount of C
2

the consumer
would be willing to substitute
for
one unit of C
1
.

C
1
C
2
IC
1
The slope of an
indifference
curve at any
point equals
the MRS
at that point.
1
MRS
OPTIMIZATION
The optimal (C
1
,C
2
)
is where the
budget line
just touches
the highest
indifference curve.
C
1
C
2
O

At the optimal point,
MRS = 1+r
HOW C RESPONDS TO CHANGES IN Y
An increase
in Y
1
or Y
2

shifts the
budget line
outward.
C
1
C
2
Results:
Provided they are both
normal goods, C
1
and C
2

both increase,
…regardless of
whether the
income increase
occurs in period
1 or period 2.
KEYNES VERSUS FISHER
 KEYNES:
CURRENT CONSUMPTION DEPENDS ONLY
ON CURRENT INCOME.
 FISHER:
CURRENT CONSUMPTION DEPENDS ONLY
ON THE PRESENT VALUE OF LIFETIME
INCOME. THE TIMING OF INCOME IS
IRRELEVANT BECAUSE THE CONSUMER CAN
BORROW OR LEND BETWEEN PERIODS.
A

HOW C RESPONDS TO CHANGES
IN r
An increase in r
pivots the budget
line around the
point (Y
1
,Y
2
).
C
1
C
2
Y
1
Y
2
A

B

As depicted here,
C
1
falls and C
2
rises.
However, it could turn
out differently…
HOW C RESPONDS TO CHANGES
IN r
 INCOME EFFECT: IF CONSUMER IS A SAVER,
THE RISE IN r MAKES HIM BETTER OFF, WHICH TENDS TO INCREASE
CONSUMPTION IN BOTH PERIODS.
 SUBSTITUTION EFFECT: THE RISE IN r INCREASES
THE OPPORTUNITY COST OF CURRENT CONSUMPTION, WHICH
TENDS TO REDUCE C
1
AND INCREASE C
2
.
 BOTH EFFECTS ¬ |C
2
.
WHETHER C
1
RISES OR FALLS DEPENDS ON THE RELATIVE SIZE OF
THE INCOME & SUBSTITUTION EFFECTS.
CONSTRAINTS ON BORROWING
 IN FISHER’S THEORY, THE TIMING OF INCOME IS
IRRELEVANT: CONSUMER CAN BORROW AND
LEND ACROSS PERIODS.
 EXAMPLE: IF CONSUMER LEARNS THAT HER
FUTURE INCOME WILL INCREASE, SHE CAN
SPREAD THE EXTRA CONSUMPTION OVER BOTH
PERIODS BY BORROWING IN THE CURRENT
PERIOD.
 HOWEVER, IF CONSUMER FACES BORROWING
CONSTRAINTS (AKA “LIQUIDITY
CONSTRAINTS”), THEN SHE MAY NOT BE ABLE
TO INCREASE CURRENT CONSUMPTION
…AND HER CONSUMPTION MAY BEHAVE AS
IN THE KEYNESIAN THEORY EVEN THOUGH
SHE IS RATIONAL & FORWARD-LOOKING.

CONSTRAINTS ON BORROWING
The budget line
with no
borrowing
constraints
C
1
C
2
Y
1
Y
2
CONSTRAINTS ON BORROWING
The borrowing
constraint
takes the
form:
C
1
s Y
1

C
1
C
2
Y
1
Y
2
The budget
line with a
borrowing
constraint
CONSUMER OPTIMIZATION WHEN THE BORROWING
CONSTRAINT IS
NOT BINDING
The borrowing
constraint is not
binding if the
consumer’s
optimal C
1

is less than Y
1
.
C
1
C
2
Y
1
CONSUMER OPTIMIZATION WHEN THE BORROWING
CONSTRAINT
IS BINDING
The optimal choice
is at point D.
But since the
consumer cannot
borrow, the best he
can do is point E.
C
1
C
2
Y
1
D

E

IS THE GOVT DEBT REALLY A
PROBLEM?
CONSIDER A TAX CUT WITH CORRESPONDING
INCREASE IN THE GOVERNMENT DEBT.
TWO VIEWPOINTS:
2. RICARDIAN VIEW

 SHORT RUN: |Y, +u
 LONG RUN:
 Y and u BACK AT THEIR NATURAL RATES
 CLOSED ECONOMY: |r, +I
 OPEN ECONOMY: |c, +NX

THE RICARDIAN VIEW
 DUE TO DAVID RICARDO (1820),
MORE RECENTLY ADVANCED BY ROBERT BARRO
 ACCORDING TO RICARDIAN EQUIVALENCE,
A DEBT-FINANCED TAX CUT HAS NO EFFECT ON
CONSUMPTION, NATIONAL SAVING, THE REAL
INTEREST RATE, INVESTMENT, NET EXPORTS, OR
REAL GDP,
EVEN IN THE SHORT RUN.
THE LOGIC OF RICARDIAN
EQUIVALENCE
 CONSUMERS ARE FORWARD-LOOKING,
KNOW THAT A DEBT-FINANCED TAX CUT TODAY
IMPLIES AN INCREASE IN FUTURE TAXES
THAT IS EQUAL – IN PRESENT VALUE – TO THE
TAX CUT.
 THE TAX CUT DOES NOT MAKE CONSUMERS
BETTER OFF,
SO THEY DO NOT INCREASE CONSUMPTION
SPENDING.

INSTEAD, THEY SAVE THE FULL TAX CUT IN
ORDER TO REPAY THE FUTURE TAX
LIABILITY.
 RESULT: PRIVATE SAVING RISES BY THE
AMOUNT PUBLIC SAVING FALLS, LEAVING
NATIONAL SAVING UNCHANGED.

THE TAXPAYER’S BUDGET
CONSTRAINT
 THE BUDGET CONSTRAINT OF THE
CONSUMER (TAXPAYER) IS REPRESENTED
BY THE CONDITION THAT HER PRESENT
VALUE OF CONSUMPTION MUST BE EQUAL
TO THE PRESENT VALUE OF INCOME LESS
THE PRESENT VALUE OF ALL TAX
LIABILITIES: WHICH TURNS OUT TO BE THE
PRESENT VALUE OF DISPOSABLE INCOME
C
1
+ [C
2
/(1+r)] = [Y
1
– T
1
] + [(Y
2
– T
2
)/(1+r)]
 THE CONSUMER KNOWS HER INCOME
STREAM AND r. SHE HAS TO MAKE AN
ESTIMATE OF FUTURE TAX LIABILITIES
 THE RATIONAL WAY TO DO THIS IS TO
REALIZE THAT THE GOVERNMENT HAS A
BUDGET CONSTRAINT THAT HAS TO BE
SATISFIED, AND USES THAT INFORMATION
IN HER ESTIMATE OF PRESENT VALUE OF
TAXES
INTER-TEMPORAL BUDGET CONSTRAINT OF
GOVERNMENT
 G
1
= T
1
+ B WHERE B IS BORROWING IN PERIOD 1
 IN PERIOD 2 THE GOVERNMENT HAS TO SPEND SOME G
2

AND REPAY THE DEBT WITH INTEREST
 SO G
2
+ (1+r)B = T
2
 SO GOVERNMENT’S BUDGET CONSTRAINT IS
 G
2
+ (1+r)G
1
= (1+r)T
1
+ T
2
 OR DIVIDING BY (1+r)
 G
2
/(1+r)

+ G
1
= T
1
+ T
2
/(1+r)

WHICH IS PVG =PVT

 G
2
+ (1+r)G
1
= (1+r)T
1
+ T
2
 IF PVG = PVT AND PVG IS CONSTANT, THEN PVT IS
CONSTANT TOO
 THIS IMPLIES (1+r) T
1
+ T
2
= CONSTANT
 GIVEN G FOR THE TWO PERIODS
 A TAX CUT IN PERIOD 1 OF ∆T
1
IMPLIES ∆T
2
= -
(1+r)∆T
1

 THIS LEADS TO THE RICARDIAN EQUIVALENCE
PROPOSITION

 THE CONSUMER’S BUDGET CONSTRAINT IS
 PVC + PVT = PVY
 ∆PVC + ∆PVT = ∆PVY
 PVT IS CONSTANT AS LONG AS THE G
VALUES DO NOT CHANGE
 SO EVEN IF T
1
AND T
2
CHANGE, C
1
AND C
2
ARE
UNAFFECTED
 HENCE FULL AMOUNT OF THE TAX CUT IS
SAVED TO PAY FOR FUTURE TAX INCREASE
PROBLEMS WITH RICARDIAN
EQUIVALENCE
 MYOPIA: NOT ALL CONSUMERS THINK SO FAR AHEAD,
SOME SEE THE TAX CUT AS A WINDFALL.
 BORROWING CONSTRAINTS: SOME CONSUMERS CANNOT
BORROW ENOUGH TO ACHIEVE THEIR OPTIMAL
CONSUMPTION, SO THEY SPEND A TAX CUT.
 FUTURE GENERATIONS: IF CONSUMERS EXPECT THAT
THE BURDEN OF REPAYING A TAX CUT WILL FALL ON
FUTURE GENERATIONS, THEN A TAX CUT NOW MAKES
THEM FEEL BETTER OFF, SO THEY INCREASE SPENDING.
EVIDENCE AGAINST RICARDIAN
EQUIVALENCE?
EARLY 1980S:
REAGAN TAX CUTS INCREASED DEFICIT.
NATIONAL SAVING FELL, REAL INTEREST RATE ROSE,
EXCHANGE RATE APPRECIATED, AND NX FELL.
1992:
INCOME TAX WITHHOLDING REDUCED TO STIMULATE
ECONOMY.
 THIS DELAYED TAXES BUT DIDN’T MAKE CONSUMERS
BETTER OFF.
 ALMOST HALF OF CONSUMERS INCREASED
CONSUMPTION.