Classical Growth Theory

– Classical growth theory came to the conclusion that real GDP growth was temporary; when real GDP
per person rises above the subsistence level, a population explosion brings real GDP per person back to
the subsistence level.

Example:

Suppose, number of people in a country is 10 and the real GDP is 100tk. So Income per person = 100/10
= 10tk. Now, if the real GDP rises at 150tk, Income per person should be = 150/10 = 15tk but according
to Classical Growth Theory, if there is a rise in GDP, there will be a rise in population growth at the same
time. So if the GDP rises to 150, the population will rise to 15 from 10 and Income per person would be =
150/15 = 10tk. Which means there will be no change in income per person. This income is called
subsistence level of income. Subsistence level of income is the minimum income needed to maintain life
and match births to deaths.

Explanation:

Suppose we have output/income per worker (y) in the vertical axis and capital per worker (k) at
horizontal axis. Also the output line is y1. Now at fixed income y bar, capital per worker is k1 and
equilibrium point is A. Now if there is a economic growth, new output line will be y2 which intersects
capital per worker k1 at point B and new income per worker becomes y*. But according to Classical
growth theory, Income must be same. As a result the capital per worker declines at k2 and new
equilibrium point becomes C while income remain fixed. Capital per worker declines as there is a
positive growth in the economy.

New Growth theory

At any moment, the capital stock is a key determinant of the economy’s output, but the capital stock
can change over time, and those changes can lead to economic growth. In particular, two forces
influence the capital stock: investment and depreciation. We can express the impact of investment and
depreciation on the capital stock with this equation:

Change in Capital Stock = Investment – Depreciation

The higher the capital stock, the greater the amounts of output and investment. Yet the higher the
capital stock, the greater also the amount of depreciation. In New growth theory, each time a surplus is
generated which is invested again to increase the capital per worker.

Explanation:

Suppose we have output per worker (y) in the vertical axis and capital per worker (k) in the horizontal
axis. Also the up word sloping depreciation line from the origin is delta k and the output line is y1. Now
when the capital per worker is k1, it intersects delta k at point B and the output line at point A. So, AB is
the surplus generated from capital per worker k1. This amount of surplus can be invested again and the
new capital per worker will be k2. If k2 intersects delta k at point C and the output line at point D, the
new generated surplus will be CD and it can be invested again. This process continues until the
generated surplus becomes 0 and after that, economy stops growing temporarily.
If there is an increase in depreciation in the economy, the surplus will decline. As a result capital per
worker will decline and also output per worker will decline. This will create a negative economic growth.

Law of diminishing return:

From the production function we know that,

Y = f (L, K)

 Y/L = f(L/L, K/L) [Dividing both sides by L]

 y = f (1, k) [y = output per worker, k = capital per worker]

Now, we can draw our output line taking y in the vertical axis and k in the horizontal axis. The shape of
this output line is called increasing at a decreasing rate. That means total output is increasing but at a
decreasing rate with time.

Example:

Suppose a person works 4 hour daily. In the 1 st hour he can complete 10 units of work. In the 2 nd hour 8
units, 3rd hour 7 units and in final hour he can complete 6 units of work. So the unit of work the person
can perform is decreasing over time but the total output is increasing like in hour 1, work completed was
10 units. In first 2 hours, it was (10+8) = 18 unit. In first 3 hours, it was (18+7) = 25 unit. In first 4 hours, it
was (25+6) = 31 unit which is an increasing rate... This is known as Law of diminishing return.

1. Describe the effects of transmission mechanism in a Keynesian economy when the central bank sells
bonds to the market. Discuss.

2. How economic growth is accounted in New Growth Theories? Explain

3. What is money multiplier? How the determinants of money multiplier can affect money supply in the
economy?

4. Use the following infromation to compute inflation by using deflator and CPI method. Consider 2006
as the base year wherever applicable. For 2016, prices of Good A and B are 30 and 100 TK respectively.
In that year the production of Good A and B are 900 and 192 units respectively. For 2017, prices of Good
A and B are 31 and 102 TK respectively. In that year the production of Good A and B are 1000 and 200
units respectively. For 2018, prices of Good A and B are 36 and 100 TK respectively. In that year the
production of Good A and B are 1050 and 205 units respectively. (5 marks)
5. How nominal and real GDP calculations are different. Why real GDP method is more meaningful. Use
example to justify your answer. Do you think chain weighted method is more trustworthy? (4 marks)

6. What is Tax multiplier. How the tax multiplier impacts the change in national income? Explain.

Bonus Question (3 marks) : How classical and neo classical growth theories are different from each
other? Which one do you think is more practical? Discuss.