Introduction to Economics –ECO401 VU

Lesson 39

THE FOUR BIG MACROECONOMIC ISSUES AND THEIR INTER-RELATIONSHIPS

(CONTINUED)

EXOGENOUS GROWTH THEORY

The Exogenous growth model, also known as the Neo-classical growth model or Solow growth
model is a term used to sum up the contributions of various authors to a model of long-run
economic growth within the framework of neoclassical economics. The most important
contribution was probably the work done by Robert Solow; Solow received the 1987 Nobel
Prize in Economics for his work on the model. The key assumption of the neoclassical growth
model is that capital is subject to diminishing returns. 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, the economy ceases to grow.

MATHEMATICAL FORM OF THE MODEL

Cobb Douglas production function (constant returns to scale)
Before we move to neo-classical and endogenous growth theories, let us gain a better
understanding of the link between growth and the various factors of production. We begin by
recalling the familiar Cobb-Douglas constant returns to scale production function:
Y = KαL1-α for a hypothetical economy. Here Y denotes output, K denotes capital (machines,
buildings etc.), L denotes labour, and α is a parameter that lies between 0 and 1. Dividing both
sides by L and substituting Y/L = y (per capita output), and K/L = k (per capita capital),
We have the per capita production function y = kα
Y = A Kα L1 – α (0< α <1)
A = Level of technical knowledge (fixed)
K = Stock of capital
L = Size of the labor force
Y = Aggregate real output
Diminishing returns to factors: Differentiate Y w.r.to K
dY / dK = A α Kα – 1 L1 – α
R.H.S is falling in K as (α – 1) < 0
Differentiate Y w.r.to L
dY / dL = AKα (1 – α)L – α
R.H.S is falling in L as (– α) < 0
To get per capita functions, divide Y by L
• Y = AKα x L1 – α
L L
Let, L = Lα x L1 – α
• Y = AKα x L1 – α
L Lα L1 – α
• y=Ak α

Where,
y = Per capita output
k = Capital per person (K/L)
Total capital accumulation = sY
As Y = Akα
So,
Total Capital accumulation = sAkα
Capital widening = nk
(Maintaining K/L ratio)

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Let k▪ = dk / dt
k▪ = sAkα – nk
As k increases k falls
k▪ = o when sAkα = nk
This is the point of Steady State level of capital. Or Constant per capita capital
Solving the equation of k▪
k▪ = [ sA ] 1 / (1 – α)
n
When k▪ = 0 It means d(K/L) = 0
dt
i.e. K & L are growing at the same rate
Now gk = n
gk = (dK / dt) & n = (dL / dt) = gL
K L
Rate of growth for Y:
Y = A Kα L1 – α
Take log of both sides
ln Y = ln A + ln Kα + ln L1 – α
Take derivatives of this w.r.to time
We get,
dY / dt = 0 + αgK + (1 – α)gL
L
• gY = αn + (1 – α)n = αn + n – αn = n
Therefore Y is growing at n (exogenously given).

Thus the growth rate of output is determined by the growth rate of population which is
exogenously given and Govt can not do anything about it.

INFERENCES FROM THIS THEORY

We can draw following inferences from this theory:
• Saving has no effect on the steady state growth rate.
• Determinants of growth are beyond the control of the policy makers.
• Convergence theory: Countries with higher level of ‘k’ would converge to the level of
output of those countries which has lower level of ‘k’.
Based on the principle of diminishing returns to capital, the main theses of the neo-classical
exogenous growth theory were:
• The steady-state growth rate of real GDP depends on n and t, the exogenous rates of
growth of population and technology. By exogenous, we mean determined outside the
model. Thus, there were no policy insights for how governments could affect the steady
state growth rates of countries. In particular, the model suggested that higher savings
could only have a level effect on income, not a long-term growth effect as had been
earlier thought. The reason was that savings-enabled investment and capital
accumulation eventually banged into diminishing returns.
• If one country started with lower income and capital than another country, then the
poorer country would grow faster in order to catch up with the richer country.
Eventually, both would grow at the same rate.

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y nk
Convergence theory

y = sAkα

Convergence to steady
state

O k0 k1 k2 k
k
This convergence theory states that if we are to the right of k2, k▪ is negative. So k▪ will
decrease and move towards k2. On the other hand, If we are to the left of k2, k▪ is positive. So
k▪ will increase and move towards k2.

CRITICISM / MAJOR WEAKNESSES OF EXOGENOUS GROWTH MODEL

Empirical evidence offers mixed support for the model. Limitations of the model include its
failure to take account of entrepreneurship (which may be catalyst behind economic growth)
and strength of institutions (which facilitate economic growth). In addition, it does not explain
how or why technological progress occurs. This failing has led to the development of
endogenous growth theory, which endogenizes technological progress and/or knowledge
accumulation.
Exogenous growth theory suffered from three major weaknesses:
i. It could not explain why the gap between the poor and rich countries had widened
(anti-catch up),
ii. It could not explain why some countries in East Asia had apparently grown
consistently on the back of higher saving rates, and
iii. It modeled technology as exogenous, and beyond the influence of policy.
The first weakness was answerable within the neo-classical framework: the key insight was
that convergence would only be witnessed among countries with similar capital and income
levels to start with; countries with very low capital to start with might actually never grow out of
their poverty and could see their capital stock falling over time.
The second weakness was addressed by endogenous growth theory (endogenous because
the steady state growth rate was determined inside the model, not determined by factors
exogenous to it) which set up the model in a way that the steady state growth rate now
depended directly on the saving rate and level of technology. A permanent increase in the
saving rate, therefore, meant a permanent increase in the growth rate.
The third weakness was also addressed by endogenous growth theory, which by using
different industry structures and technology functions specifications could link technological
progress to conscious R&D effort by firms and government. Non-diminishing returns to
technical progress would then generate endogenous growth.

ENDOGENOUS GROWTH THEORY

In economics, endogenous growth theory or new growth theory was developed in the
1980s as a response to criticism of the neo-classical growth model.
In neoclassical growth models, the long-run rate of growth is exogenously determined by
assuming a savings rate (the Solow model) or a rate of technical progress. This does not
explain the origin of growth, which makes the neo-classical model appear very unrealistic.
Endogenous growth theorists see this as an over-simplification.
Endogenous growth theory tries to overcome this shortcoming by building macroeconomic
models out of microeconomic foundations. Households are assumed to maximize utility

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Introduction to Economics –ECO401 VU

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, increasing numbers of goods, increasing qualities, etc.
Endogenous growth theory demonstrates that policy measures can have an impact on the
long-run growth rate of an economy. In contrast, with the Solow model only a change in the
savings rate could generate growth. Subsidies on research and development or education
increase the growth rate in some endogenous growth theory models by increasing the
incentive to innovate.

MATHEMATICAL FORM OF THE MODEL

y = Ak
There is no α because of non diminishing returns to factors.
• Total capital accumulation: sy = sAk
• Capital widening = nk
• k▪ or capital deepening = sAk – nk or (sA – n)k
• (k▪ / k) = sA – n
Since, y = Ak
Take log of both sides
lny = lnA + lnk
• y▪ = k▪
y k
• y=Y/L
• gy = gY – gL
• gY = gy + gL

• gy = y▪ = sA – n
y
Putting in gY = gy + gL

• gY = sA – n + n

• gY = sA
Thus growth arte of output depends on the saving rate and technological progress.
Labor and Capital:
Now for a given L and no depreciation, an increase in K should translate into an increase in k
and through it an increase in y. This is an example of capital deepening induced growth.
However, when there is depreciation (say at a rate d% p.a.) of the capital stock and the labour
supply is growing at n% p.a., capital must grow at least by (d+n)% p.a. in order keep K/L, or k,
constant. This is called capital widening, i.e. more capital being created but spread over a
larger population so as to deliver the same K/L. The per capita output impact of capital
widening is zero, because k remains the same.
Now taking capital as fixed, let’s analyze the ways in which labour can serve as the engine of
growth. It is obvious that an increase in the no. of labour hours worked would expand output.
However, historically, the working week has been shortened from 6 to 5 days so it would be
incorrect to cite this as the major source of world economic growth over the last century. What
else could therefore have driven the rapid expansion of production in the 20 th century. It might
be the case that there are now more people on the labour force, due to perhaps a larger
proportion of women doing marketable jobs (which is historically accurate). Then it might be
that the quality of human capital has gone up. The same workers, because they are better
educated and have better skills, can produce more output using the same amount of capital.
Japan and Germany are prime examples of this – i.e. of countries which achieved very high
growth rates despite having very low levels of physical capital left after World War II. It was the
quality of these countries’ human capital which made the difference.

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Land:
Let’s now concentrate on land. The earliest thinking on this was all doom and gloom. Malthus
(1798), for instance, noted that the supply of land, esp. agricultural land, was fixed, whereas
world population was rising fast. Given diminishing returns (in terms of marginal food product)
to labour, the implication was obvious: world hunger. While the starvation hypothesis did come
true for come countries, it did not happen for the whole world. Why? Predominantly because
of unanticipated productivity improvements in agricultural production. Technological
breakthroughs, like tractors, fertilizers, etc. increased yields per acre by many 100s of
percents permitting a food output that far exceeded world food requirements even with a larger
population. Today, land does not feature centrally in growth theory, as many countries (e.g.
European countries, Japan, Singapore, Hong Kong, etc.) were seen to achieve very high
growth rates while geographically much larger South Asian, Latin American and African
countries lagged behind.
Land is one type of natural resource that goes into production. The other type is raw materials
like mineral wealth or timber. The important point about these resources is that some of them
they are not renewable (like oil, coal, gas and other minerals), while others are: timer, fish etc.
It is important to take these concerns into consideration when talking about the ability of a
particular type of natural resource to act as the engine of growth.
The above is not true for technical progress, however, which neither depletes nor requires
renewing. An essential and important ingredient in the production process, the technical
knowledge/stock of a country is additive and cumulative and depends on the pace of invention,
innovation and learning by doing that is happening in the economy. In order to protect the
incentive to invent and innovate, governments introduce patent and copyright laws which grant
the inventor monopoly production rights for a certain period. Also governments directly or
indirectly fund research and development activities which are the engine for invention and
innovation.

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