Endogenous Growth theory

Tadele Ferede (PhD)

Addis Ababa University
School of Economics
2011-2012
 Dissatisfaction with neoclassical growth model
• In the mid-1980s it became increasingly clear that the
standard neoclassical growth model was theoretically
unsatisfactory as a tool to explore the determinants of long-
run growth.
• The model without technological change predicts that the
economy will eventually converge to a steady state with zero
per capita growth.
• The fundamental reason is the diminishing returns to capital.
• One way out of this problem was to broaden the concept of
capital
• Notably to include human components, and then assume
that diminishing returns did not apply to this broader class of
capital.
 1. First-Generation Models of Endogenous Growth
• The AK Model
• The key property of this class of endogenous-
growth models is the absence of diminishing
returns to capital.
• The simplest version of a production function
without diminishing returns is the AK function:

• Where A is a positive constant that reflects the level

of the technology.
• Output per capita is:
 First…
• Recall the accumulation equation:

• Upon substitution, we have:

• Where we make use of the fact that

• Two constants: sA and (n+δ).
• The growth rate of k is the vertical distance
between these constants.
• Assume that sA>(n+δ)
– Perpetual growth of k occurs, even without technological
progress.
 First…
• Then we have:

• Since y=Ak, and , the model has no transitional

dynamics.
• All the per capita variables in the model always grow at the
same rate.
 First…
• Key predictions of the model
– Unlike the neoclassical model, a higher saving rate, s, leads to a
higher rate of long-run per capita growth.
– Changes in the rates of depreciation, δ, and population growth, n,
also have permanent effects on the per capita growth rate.
– Unlike the neoclassical model, the AK formulation does not predict
absolute or conditional convergence
• The speed of convergence is zero.
• The AK model delivers endogenous growth by avoiding
diminishing returns to capital in the long run.
• This particular production function also implies, that the
marginal and average products of capital are always constant
and, hence, that growth rates do not exhibit the convergence
property.
 AK with physical and human capital
• Another major shortcoming of the baseline AK model is
that the share of capital accruing to national income is
equal to 1.
• One way of enriching the AK model and avoiding these
problems is to include both physical and human capital.
• Output is a Cobb-Douglas combination of capital
types

• There is a representative agent who wishes to

maximize the standard functional subject to the
adding up restriction:
 AK…
• Suppose that physical and human capital obey the
following laws of motion:

• where the shares of income going to gross

investment in each type of capital are denoted by sk
and sh, respectively.
• The Hamiltonian in current value for this problem is:
 A note on Hamiltonian
• The Finite Horizon Problem
• Optimal control theory is useful to solve continuous
time optimization problems.

• Subject to:
A note…
 A note…
• The different constraints are:
• Equation (1) defines the transition equations for
each state variables. It describes how the state
variables evolve over time.
• Equation (2) show the initial conditions for each
state variable. In this, xi0 are constants.
• Equation (3) show the terminal conditions for each
state variable.
• Equation (4) defines the feasible set for control
variables.
 A note…
• This can be solved using the Pontryagin maximum
principle which is a powerful method for the
computation of optimal controls.
• This principle says that we can solve the
optimization problem P using a Hamiltonian
function H over one period.
• Hamiltonian function H is defined by:

• Then we have:
 A note…
• Note also that:

• The Present Value Hamiltonian

• One can solve problem P by simply setting up the
following present value Hamiltonian:
 A note…
• In the above, we call¸  i(t) co-state variables. They
are analogous to Lagrange multipliers.
• The necessary conditions for a maximum are:
 A note…
• Summary:
• Assume that you face the following problem:

• There are two ways to proceed:

• Present Value Hamiltonian
• Step 1: Write the present value Hamiltonian:
 A note…
• Step 2: Find the first-order conditions:

• 2. Current Value Hamiltonian

• Step 1: Write the current value Hamiltonian:
 A note…
• Step 2: Find the first-order conditions:
 Examples
• Consider the following problem:
 A note…

• The first-order conditions are:

 A note…

• Note that

• Then, totally differentiating the first -order

condition yields:
 Examples…
• The current value Hamiltonian is:

• First-order conditions are:

 Examples…
• The interpretation of these first-order conditions
relates consumption growth to the elasticity of
intertemporal substitution, the market discount
rate, and the subjective discount rate.
• To show this, first note that:

• Then, totally differentiating the first-order condition

yields:
 Examples…
• Hence, we have:

• Or

• Thus, consumption grows whenever the market

discount rate is larger than the subjective discount
factor. In that case, the consumer is less impatient
than the market.
 A note…
• We have:

• Thus, consumption grows whenever the market

discount rate is larger than the subjective discount
rate. In that case, the consumer is less impatient
than the market.
 AK…
• FOCs:

• The shadow prices of each type of capital are

identical, and equal to the marginal utility of
consumption.
• The first order conditions with respect to physical
capital gives:
 AK…
• Upon substitution into the shadow prices to obtain:

• Similarly, the Euler equation for human capital:

• Returns on the two types of asset must be equal.

• Bringing the two equations, we have:

• One implication of this is that the expenditure

shares must be related by:
 AK…
• The Euler equation tells us the growth rate of
consumption is constant:

• Notice that this holds at all points on the optimal path

• The production technology can now be expressed as:

• The growth rate of output is thus:

• Implication: changes in the share of income going to

investment affect the growth rate.
• By continuously investing in human capital, growth can be
sustained.
 Beyond AK model: additional illustration
• Assumptions
• Production function

• Where H refers to the stock of human capital

• CRS in K,H and L together

• Dynamics of K, H and L

• that sk and sh denote fraction of output devoted to physical and human capital, respectively.

• Assume a technological progress of the form:

 Beyond…
• System dynamics
• Production function in per capita terms:

• Consider the evolution of k in the (h,k) space:

 Beyond…
• Notice that is zero when

• Solving for k, we have:

• Consider the relationship between k and h:

• The first derivative of k wrt h is positive (graph).
– increases in h
• But the second derivative of k wrt h is negative
since
 Beyond…
• Consider the evolution of k in the (h,k) space:
 Beyond…

• Similarly, consider h

• Note is zero when

• Or
• The first derivative of k wrt h is positive.
•
 Beyond…
• System dynamics
• Point E is globally stable (assume positive initial k and h).
• Whatever the economy’s initial position, it tends to E.
 Beyond…
• Implications:
• Once the economy reaches point E, it is on BGP.
• On BGP, k, h and y are all constant and growing at a
constant rate of g.
• Similar to the Solow-Swan model
• What about H, K and Y?
• What happens to the economy if sk increase?
• This change affects locus and it shifts up.
• On the old BGP, point E is on the locus which lies
below the new locus.
• Both k and h increase. How does h rise?
 Beyond…

• Effects of rising sk on the economy

 Beyond…

• Quantifying the impacts

• Making use of the steady state conditions, we have:

• Star variables indicate steady state values.

• Solving for k and h and t taking logs, we have:
 Beyond…

• Upon substitution into the production function:

• Compare it with the Solow-Swan model:

• There is no human capital.

• Overall: due to the assumption of diminishing marginal
return, rates of return are lower in rich than poor countries
• Howe the model does not answer why capital does not
flow to poor countries.