Deadline: 24-May-2019

On growth theory?

1. Comparison between growth theories of 1940-50 with theories of 1960-70

Homer Domar 1946: The Harrod–Domar model is a classical Keynesian model of economic
growth. It is used in development economics to explain an economy's growth rate in terms of the
level of saving and productivity of capital. It suggests that there is no natural reason for an
economy to have balanced growth. The model was developed independently by Roy F. Harrod in
1939 and Evsey Domar in 1946, although a similar model had been proposed by Gustav
Cassel in 1924. The Harrod–Domar model was the precursor to the exogenous growth model.

Neoclassical economists claimed shortcomings in the Harrod–Domar model—in particular

the instability of its solution and, by the late 1950s, started an academic dialogue that led to the
development of the Solow–Swan model.

According to the Harrod–Domar model there are three kinds of growth: warranted growth, actual
growth and natural rate of growth. Warranted growth rate is the rate of growth at which the
economy does not expand indefinitely or go into recession. Actual growth is the real rate
increase in a country's GDP per year. Natural growth is the growth an economy requires to
maintain full employment. For example, If the labor force grows at 3 percent per year, then to
maintain full employment, the economy’s annual growth rate must be 3 percent.

Slow Swan model 1956: The Solow–Swan model is an economic model of long-run economic
growth set within the framework of neoclassical economics. It attempts to explain long-run
economic growth by looking at capital accumulation, labor or population growth, and increases
in productivity, commonly referred to as technological progress. At its core is a neoclassical
(aggregate) production function, often specified to be of Cobb–Douglas type, which enables the
model "to make contact with microeconomics." The model was developed independently
by Robert Solow and Trevor Swan in 1956, and superseded the Keynesian Harrod–Domar
model.
Mathematically, the Solow–Swan model is a nonlinear system consisting of a single ordinary
differential equation that models the evolution of the per capita stock of capital. Due to its
particularly attractive mathematical characteristics, Solow–Swan proved to be a convenient
starting point for various extensions. For instance, in 1965, David Cass and Tjalling
Koopmans integrated Frank Ramsey's analysis of consumer optimization, thereby endogenizing
the saving rate, to create what is now known as the Ramsey–Cass–Koopmans model.

Endogenous growth theory: holds that economic growth is primarily the result
of endogenous and not external forces. Endogenous growth theory holds that investment
in human capital, innovation, and knowledge are significant contributors to economic growth.
The theory also focuses on positive externalities and spillover effects of a knowledge-based
economy which will lead to economic development. The endogenous growth theory primarily
holds that the long run growth rate of an economy depends on policy measures. For
example, subsidies for research and development or education increase the growth rate in some
endogenous growth models by increasing the incentive for innovation.

2. Compare Homer-Domar theory with Solow growth model

The main difference between the Harrod-Domar (HD) model and the Solow model is that HD
assumes constant marginal returns to capital, while Solow assumes decreasing marginal returns
to capital. The reason that a change in the savings rate has a permanent effect in HD, while only
a temporary effect in Solow, is exactly due to the differences in assumptions on the marginal
returns to capital.

To see why, assume that we initially are in the steady state in the Solow model, where
investments exactly are equal to break-even investments (i.e. the amount of investments are
equal to (n + δ)kt , the amount of investment that needs to be undertaken in order for the capital
stock per capita next period to be the same size as today). If we increase the savings rate in the
Solow model from s to s0 , we will in the next period have more capital per capita than before, as
depreciation (δ), population growth (n) and capital today (kt) are the same, i.e. break-even
investments today do not change. This additional capital will generate more output next period (a
fraction s0 of which is saved), but we will also need to invest more next period if we were to
keep capital constant at this new level since the new break-even investment level (n + δ) kt+1 >
(n + δ)kt since kt+1 > kt .

It will now (in period t+ 1) also be the case that investments are higher than the new break-even
investment level, but less so than last period because the marginal product of capital is lower at
the new and higher level of k. As the marginal product of capital decreases as k gets larger, while
the ‘cost’ of higher k in terms of higher break-even investments increases linearly with k, the
temporary effect on growth of the change in s will gradually level off until we reach the new
steady state, where growth again is 0.

Note that the last argument does not hold for the HD model. In the HD model the marginal
product of capital per capita is constant, and hence a permanent change in s will have a
permanent effect on the growth rate of the economy.

Q.3 Explain the growth theories in historical perspective with their assumptions

1. Solow–Swan model:

The Solow–Swan model is an economic model of long-run economic growth set within the
framework of neoclassical economics. It attempts to explain long-run economic growth by
looking at capital accumulation, labor or population growth, and increases in productivity,
commonly referred to as technological progress. At its core is a neoclassical
(aggregate) production function, often specified to be of Cobb–Douglas type, which enables
the model "to make contact with microeconomics". The model was developed independently
by Robert Solow and Trevor Swan in 1956, and superseded the Keynesian Harrod–Domar
model.

Assumptions:

The key assumption of the neoclassical growth model is that capital is subject to diminishing
returns in a closed economy.

→Given a fixed stock of labor, the impact on output of the last unit of capital accumulated
will always be less than the one before.

→Assuming for simplicity no technological progress or labor force growth, diminishing

returns implies that at some point the amount of new capital produced is only just enough to
make up for the amount of existing capital lost due to depreciation. At this point, because of
the assumptions of no technological progress or labor force growth, we can see the economy
ceases to grow.

→Assuming non-zero rates of labor growth complicate matters somewhat, but the basic logic
still applies– in the short-run, the rate of growth slows as diminishing returns take effect and
the economy converges to a constant "steady-state" rate of growth (that is, no economic
growth per-capita).

→Including non-zero technological progress is very similar to the assumption of non-zero

workforce growth, in terms of "effective labor": a new steady state is reached with constant
output per worker-hour required for a unit of output. However, in this case, per-capita
output grows at the rate of technological progress in the "steady-state" (that is, the rate
of productivity growth).

2. Endogenous growth theory holds that economic growth is primarily the result of
endogenous and not external forces. Endogenous growth theory holds that investment in
human capital, innovation, and knowledge are significant contributors to economic
growth. The theory also focuses on positive externalities and spillover effects of a
knowledge-based economy which will lead to economic development. The endogenous
growth theory primarily holds that the long run growth rate of an economy depends on
policy measures. For example, subsidies for research and development or education
increase the growth rate in some endogenous growth models by increasing the incentive
for innovation

3. Exogenous growth theory: In neo-classical growth models, the long-run rate of growth
is exogenously determined by either the savings rate (the Harrod–Domar model) or the
rate of technical progress (Solow model). However, the savings rate and rate of
technological progress remain unexplained. Endogenous growth theory tries to overcome
this shortcoming by building macroeconomic models out of microeconomic foundations.
Households are assumed to maximize utility subject to budget constraints while firms
maximize profits. Crucial importance is usually given to the production of new
technologies and human capital. The engine for growth can be as simple as a constant
return to scale production function (the AK model) or more complicated set ups with
spillover effects (spillovers are positive externalities, benefits that are attributed to costs
from other firms), increasing numbers of goods, increasing qualities, etc.

Often endogenous growth theory assumes constant marginal product of capital at the
aggregate level, or at least that the limit of the marginal product of capital does not tend
towards zero. This does not imply that larger firms will be more productive than small
ones, because at the firm level the marginal product of capital is still diminishing.
Therefore, it is possible to construct endogenous growth models with perfect competition.
However, in many endogenous growth models the assumption of perfect competition is
relaxed, and some degree of monopoly power is thought to exist. Generally monopoly
power in these models comes from the holding of patents. These are models with two
sectors, producers of final output and an R&D sector. The R&D sector develops ideas
that they are granted a monopoly power. R&D firms are assumed to be able to make
monopoly profits selling ideas to production firms, but the free entry condition means
that these profits are dissipated on R&D spending.