ECONOMIC GROWTH

DEBRAJ RAY
OVERVIEW ON GROWTH THEORY
How to study growth?
Observations on growth.
Questions asked in growth theories.
Short history of modern growth theory.
Basic concepts in growth models.
Harrod- Domar model.
Solow model.
OBSERVATIONS ON GROWTH
1. GDP/capita varies a lot from country to
country.
About 50% of the world population live in
countries with GDP/capita less than 10% of
that of the richest countries.
Growth rates vary a lot, but there is no huge
difference between the average growth rates
of developing and developed countries
Average per capita growth rate in 16 today's developed countries
(Europe, USA, Canada, Australia)
period growth rate, % per year
1870-1890 - 1.2
1890-1910 - 1.5
1910-1930 - 1.3
1930-1950 - 1.4
1950-1970 - 3.7
1970-1990 - 2.2
Average per capita growth rate in 15 developing countries in Asia
and
South America.
1900-1913 - 1.2
1913-1950 - 0.4
1950-1973 - 2.6
1973-1987- 2.4
Growth rates are not necessarily constant
over time
Ex. India: 1960-97 average growth rate was
2.3%, but
1960-80: 1.3%
1980-1997: 3.5%
China:
1960-1978: 1.9%
1978- 1997: 5%

Countrys relative position in the world
distribution of per capita incomes can change.
Countries can move from being poor to being
rich:
Korea, Taiwan, Singapore, Japan, Hong Kong.
Ex. Korean GDP/capita 7.4 times higher in 1990
than in 1960 (880 -> 6580 USD, 1985 prices).
Or from being rich to being poor:
Ex. Iraq GDP/capita fell from 3300 to 1780 USD
from 1960 to 1990 in 1985 prices).
Growth in output and growth in the volume of
international trade are closely related.
Both skilled and unskilled workers tend to
migrate from poor to rich countries or regions.
QUESTIONS ASKED
Why are some countries poor and others rich?

Why are some countries growing and others
not?

Where does growth come from?
Neoclassical growth
The neoclassical growth model, also known as
the SolowSwan growth model or exogenous
growth model, is a class of economic models
of long-run economic growth set within the
framework of neo classical economics.
Neoclassical growth models attempt to
explain long run economic growth by looking
at productivity, capital accumulation,
population growth and technology.
The neo-classical model was an extension to
the 1946 Harrod - Domar model that included
a new term: productivity growth.
Important contributions to the model came
from the work done by Robert Solow and T. W.
Swan who independently developed relatively
simple growth models.
SHORT HISTORY OF MODERN
GROWTH THEORY
Modern growth theory originates from 1950s
(by Robert Solow)
role of physical capital and technological
progress central.
perfect competition as a starting point.
technology assumed to grow exogenously in
time as manna from heaven
Harrod- Domar Model
Developed by Sir Roy Harrod and Evsey Domar
in the 40s .
The HarrodDomar model is used in
development economics to explain an
economy's growth rate in terms of the level of
saving and productivity of capital.

The Harrod-Domar Model
R. F. Harrod, The
Economic Journal,
Vol. 49, No. 193.
(Mar., 1939), pp. 14-
33.

Econometrica
, Vol. 14, No.
2. (Apr.,
1946), pp.
137-147
Economic Growth is the result of abstention
from current consumption.
Two type of commodities:
1. Consumption Goods: produced to satisfy
human wants and preferences.
2. Capital Goods: Commodities that are
produced to produce other commodities.
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The Harrod-Domar Growth Model
(continued)

Firms
Households
Wages, Profits,
Rents
Consumption
Expenditure
Outflow
Inflow
Inflow
Outflow
Investment
Savings
BASIC CONCEPTS
Capital (K) and Labor (L) used as inputs to
produce the output (Y).
Fixed factor proportions assumed.
The state of technology is given and requires
that inputs to be used in fixed proportion.

The state of technology is given and requires
that inputs to be used in fixed proportion.
Thus production function is of fixed coefficient
type:

= labour output ratio;
= capital output ratio
}
) (
,
) (
min{ ) (
| o
t K t L
t Y =
It is also assumed that the economy is closed and
is producing a single commodity, which is partly
consumed and partly invested.
Labor forces grows at an exogenous determined
constant exponential rate.
Investment is proportional to change in output. It
is also assumed that the capital stock does not
depreciate and there is no technical progress.
The society is inclined to save a constant
proportion of its output all the time.
Entrepreneurs are profit maximizers.
Use of aggregate production

Y(t)= C(t)+ I(t)..1
Y(t)= real GDP in year t.

C(t)= Consumption in period t.

I(t)= Investment in period t.
Use of aggregate income
Y(t)= C(t)+ S(t).2

C(t)= Purchase of consumption in period t.

S(t)= Household saving in period t.
Using the above equations==
S(t)=I(t).savings =investment.
How are capital stock (K) and investment flow (I)
related?
Investment augments the national capital stock K and
replaces that part of it which is wearing out.
I(t)= K(t+1)-K(t) + K(t)

Or, K(t+1) = (1-) K(t) + I(t)

This tells us how capital stock must change over time.

= rate of depreciation of the capital stock
t = index for time
In equilibrium

C +S = C+ I ( from 1 and 2)
<=> S = I..(3)
=> S(t) = K(t+1) (1- ) K(t)
Investment augments the national capital
stock K and replaces that part of it which is
wearing out.
Let Savings rate:

..(4)

Share of income that can be allocated to
investment to increase the growth rate.
) (
) (
) (
t Y
t S
t s =
Define Capital Output ratio=
The amount of capital required to produce a
single unit of output in the economy.
= .(5)
is assumed to be a technologically given
constant.
Combining equation 4 and 5, we get
= g+
H-D Equations
K(t+1) = (1-) K(t) + I(t)
S(t)=I(t)
K(t+1) = (1-) K(t) +S(t)
S(t)=s Y(t)
K(t)= Y(t)
Y(t+1)= (1-) Y(t)+ s Y(t)
Or, [ Y(t+1)- Y(t)]= Y(t) (s-)
or,
o
u
=
+ s
t Y
t Y t Y
) (
) ( ) 1 (
g= overall rate of growth
g=[Y(t+1)-Y(t)]/ Y(t) .




This is the Harrod Domar Equation.



o
u
=
s
g
u
o
s
g = +
is called the warranted rate of growth.
Under the assumption of constant , g
increases proportionally with s.
Because s is considered to increase
proportionally with income per capita, s is
bound to be low.
Hence, g will be low in low-income economies
if savings and investment are left to private
decision in the free market.

The model implies, that promotion of
investment is needed to accelerate economic
growth in low-income economies.

Infact, the Harrod - Domar model provided a
framework for economic planning in
developing economies, such as India's Five
Year Plan.
Suppose = 4 and s = .02 (20%).
The growth rate would then be 20/5 = 5%.
These numbers in fact roughly describes the
Indian economy in the 1980s. Policy makers in
India argued how India needed to increase its
savings rate or make capital more productive
(i.e. lower )
H-D model links growth rate of the economy
to two fundamental variables:
Ability of the economy to save.
Capital output ratio.
Higher saving rate would push up the
economy.
Increasing the rate at which capital produces
output (a lower ), growth would be
enhanced.
What causes growth in this model?

How does the Harrod-Domar model
conceive of growth?
Expanding yields the approximate equation:


Ability to save and invest (s)
Ability to convert capital into output ()
Rate of capital depreciation ()
Rate of population growth (n)

o u + + ~ n g s * /
For developing countries, the key to successful
development is increasing the rate of savings.
Capital created by investment is the main
determinant of growth.
Saving makes investment possible.
The tricks of economic growth, according to this
model, are simply a matter of increasing savings
and investment.
The main obstacle to or constraint on
development then is the relatively low level of
new capital formation or investment in most
LDCs.


The Harrod-Domar Model
Consequences
Saving as crucial for growth
The preceding result is valid as long as there
is no labor shortage. If n = s/c population,
capital and income will grow at the same
rate.
Knife-edge dynamics
If n>g , then chronic unemployment
If n<g , then chronic labor shortages, capital
becomes idle.
No endogenous process to bring the
economy to equilibrium
What are the problems with the
Harrod-Domar model?
Model assumes economy grows forever.
Saving as sufficient.
No diminishing returns; no factor substitution.
No technological change.
All three factors (s, n and ) are given facts of
nature .
Constancy of capital output ratio .
Thus, only capital and not labour contributes
to production.
Labour and capital are not substitutable in
Production.
Output does not increase by applying more
labour for a given stock of capital.
Harrod Domar Model is a neutral theory of
economic growth.
39
Beyond Harrod- Domar model
Endogeneity of savings
Savings are influenced by per capita incomes and
distribution of income in an economy
Both of these are influenced by economic growth
Economic growth mirrors the movement of savings
with income
Endogeneity of population growth
Relationship between demographic transition and
per capita income
External policy can prevent an economy from sliding
in to a trap (process of demographic transition)
Endogeneity of capital-output ratio
Captured in Solows model

Solow Model
Solow altered the Harrod - Domar story by
making the capital-output ratio endogenous.
Solows model is based on the diminishing
returns to individual factors of production.
Capital and Labor (L) are both needed to
produce output.
K/Y ratio is no longer fixed but depends e.g.
on the economy with relative endowments of
capital and labor.
Assumptions:
Savings rate (ratio of savings to income), s, is
constant. Savings will be channelled into
investment as previously.
Population growth rate is constant:L/L = n,
where L denotes population or labor.
There is perfect competition: the firm takes
the market wages on labor and rents on
capital as given.
Constant returns to scale. If labor and capital
inputs are doubled, the output gets doubled
as well.
The Solow model is built around two
equations, a production function and a capital
accumulation equation.
The production function is assumed to have
the Cobb-Douglas form and is given by
Y=F(K,L)= K

L
1-
where a is some number between 0 and 1
Production function exhibits constant returns
to scale: if all of the inputs are doubled,
output will exactly double.

Perfect competition prevails and the firms are
price-takers.
w=workers wage
r= rent payment to capital.
Profit maximizing condition implies:
max F(K, L) - rK - wL.
First-order conditions implies:
Firms will hire labor until the marginal product
of labor is equal to the wage and will rent
capital until the marginal product of capital is
equal to the rental price:
w = = (1-)
r= =
wL + rK = Y; payments to the inputs ("factor
payments") completely exhaust the value of
output produced so that there are no
economic profits to be earned.
share of output paid to labor is:
wL/Y = 1 -
the share paid to capital is:
rK/Y =
These factor shares are constant over time.

Rewrite the production function as


output per worker, y = Y/L,
capital per worker, k = K/L:
k
y
o
=
Equation on Capital Accumulation:



=K
t+l
K
t



=


sY = gross investment; dK = depreciation.



dK sY K =
.
we assume that workers/consumers save a
constant fraction, s, of their combined wage
and rental income, Y = wL + rK.
a constant fraction, d, of the capital stock
depreciates every period (regardless of how
much output is produced).

Rewrite the capital accumulation equation in
terms of capital per person.
The production function in equation will tell
us the amount of output per person produced
for whatever capital stock per person is
present in the economy.

k= K/L= log k= log K-log L


Also, , so that


Or,
Capital accumulation equation in per worker
terms:


This equation says that the change in capital
per worker each period is determined by three
terms:
Investment per worker, sy.
depreciation per worker, dk.
population growth n.
SOLVING THE BASIC SOLOW MODEL
1 ... .......... ..........
k
y
o
=
2 ......... .......... ) (
.
k d n sy k + =
The first equation shows how output is
produced from capital and labour.
The 2
nd
equation shows how capital is
accumulated over time.
Y and K are endogenous variables, so is y and
k .
Solving a model means obtaining the values of
each endogenous variable when given values
for the exogenous variables and parameters.
The Solow Diagram:



(n+d)k
Investment: sy
Investment, depreciation
Capital, k k*
Net investment
k0
Steady state.
The first curve is the amount of investment
per person, sy = sk

. This curve has the same

shape as the production function.
The second curve is the line (n + d)k, which
represents the amount of new investment per
person required to keep the amount of capital
per worker constant .
The difference between these two curves is the
change in the amount of capital per worker.
When this change is positive and the economy is
increasing its capital per worker, we say that
capital deepening is occurring.
When this per worker change is zero but the
actual capital stock K is growing (because of
population growth), we say that only capital
widening is occurring.
At k
o
, the amount of investment per worker
exceeds the amount needed to keep capital
per worker constant, so that capital deepening
occurs-that is, k increases over time.
This capital deepening will continue until k =
k*, at which point sy = (n + d)k, so that = 0.
At this point, the amount of capital per worker
remains constant, and we call such a point a
steady state.
k

At points to the right of k* the amount of

investment per worker provided by the
economy is less than the amount needed to
keep the capital-labor ratio constant.
The term k is negative, and therefore the
amount of capital per worker begins to decline
in this economy.
This decline occurs until the amount of capital
per worker falls to k*.
The Solow diagram determines the steady-
state value of capital per worker.
The production function of equation then
determines the steady-state value of output
per worker, y*, as a function of k*.
The Solow Diagram and the Production Function

Investment, depreciation,
and output
Capital, k
Y0
k0
y*
k*
Consumption
sy
Output: Y
(n+d)k
Long run capital output ratio must be
constant.
Per capita capital stock settles to some steady
state.
Per capita income also settles to some steady
state.
Thus, no long run growth of per capita output.
Total output grows at the rate of growth of
population.
Savings do no have any long run effect on the
rate of growth rate of per capita income. But
affects the L-R level of income.
Diminishing returns to capital creates
endogenous changes in capital output ratio.
This chokes off growth.
How Parameters affect the steady
state

What happens to per capita income in an
economy that begins in steady state but then
experiences a "shock."
Increase in the saving rate, s.
Increase in the population growth rate, n.
Investment, depreciation
Capital, k
New investment
exceeds depreciation
Depreciation: d K
k
**
k
*
Old investment: sy
An Increase in the Saving Rate
sy
A Rise in the Population Growth Rate
Investment, depreciation
Capital, k
k
**
k
*
sy
(n+d)k
(n+d)k
PROPERTIES OF THE STEADY STATE
o
o

+
=
=
+ =
1
1
*
.
.
) (
0
) (
d n
s
k
k
k d n sk k
In steady state =0
k

Substituting the above in the production

function:



Thus, we have a solution for the model at
steady state.
o
o

+
=
1
*
) (
d n
s
y
This equation reveals the Solow model's answer :
"Why are we so rich and they so poor?"
Countries that have high investment rates will
tend to be richer, ceteris paribus.
Countries that have population growth rates, in
contrast, will tend to be poorer.
A higher fraction of savings in these economies
must go simply to keep the capital-labor ratio
constant in the face of a growing population
This capital-widening requirement makes
capital deepening more difficult, and these
economies tend to accumulate less capital per
worker.
Empirically, countries with higher investment rates have higher
capital to output ratios:

ECONOMIC GROWTH IN THE SIMPLE
MODEL
k/k
1
=
o
sk
k
sy
n+d
k*
k
What does economic growth look like in the
steady state of this simple version of the
Solow model?
There is no per capita growth in this version of
the model!
Output per worker is constant in the steady
state.
Output itself, Y, is growing, of course, but only
at the rate of population growth.
there is no long-run economic growth in the
Solow model.
in the steady state: output, capital, output per
person, and consumption per person are all
constant and growth stops.
An economy that begins with a stock of capital
per worker below its steady-state value will
experience growth in k and y along the
transition path to the steady state.

Over time, however, growth slows down as
the economy approaches its steady state, and
eventually growth stops altogether.
The further an economy is below its steady-
state value of k, the faster the economy grows.


Also, the further an economy is above its
steady-state value of k, the faster k declines.
empirically, economies appear to continue to
grow over time
thus capital accumulation is not the engine of
long-run economic growth
saving and investment are beneficial in the short-
run, but diminishing returns to capital do not
sustain long-run growth
in other words, after we reach the steady state,
there is no long-run growth in Y
t
(unless L
t
or A
increases)

Level effects and Growth effects.
C
D

F
B
A
E
Time
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A growth effect : Changes the rate of growth
of a variable.
A level effect leaves the rate of growth
unchanged.
Savings rate has a level effect only in the
Solow model.
Savings rate, s, and population growth ,n,
only has level effects.
Solow Model with Technology
To generate sustained growth in per capita
income , we must introduce technological
progress to the model.
Y = F(K, AL) = K

(AL)
1-
Technology variable: A
The technology variable A is said to be "labor
augmenting. Technological progress occurs when
A increases over time - a unit of labor, for
example, is more productive when the level of
technology is higher.

exogenous technical progress
Consider the labour-augmenting production
function:

Technical progress occurs when A rises over
time, with labour becoming more productive
when the level of technology is higher.
Let,


Y F(K, AL) =
g
A
A
=

Capital accumulation equation:

Production function in terms of output per
worker:
y= k

A
1-

Taking log and differentiating:

d
K
Y
s
K
K
=

A
A
k
k
y
y

) 1 ( o o + =
From the capital accumulation equation we
can see that the growth rate of K will be
constant if and only if Y / K is constant.
If Y / K is constant, y/k is also constant.
y and k will be growing at the same rate.
A situation in which capital, output,
consumption, and population are growing at
constant rates is called a balanced growth
path.
Let, g, to denote the growth rate of some
variable x along a balanced growth path.

Then, along a balanced growth path, g
y
= g
k


Recalling that,


g
y
=g
k
=g
g
A
A
=

Along a balanced growth path , output per

worker and capital per worker both grow at
the rate of exogenous technological change.

No technological progress, and therefore
there was no long-run growth in output per
worker or capital per worker; g
y
= g
k
= g = 0.

Technological progress is the source of
sustained per capita growth.
THE SOLOW DIAGRAM WITH
TECHNOLOGY
k is no longer constant in the long run.
The new state variable will be:

= ratio of capital per worker to technology
or capital technology ratio and is equal to k/A
and constant along the balanced growth path.


o
k y
~
~
=
k
~
AL
K
k
~
A
y
AL
Y
y =
~
= y
~
Output technology
ratio
Rewriting the capital accumulation equations
in terms of


Combining it with capital accumulation
equation:


k
~
L
L
A
A
K
K
k
k

=
~
~
k d g n y s k
~
) (
~
~
+ + =

the Solow diagram with technical progress

f (k)
k
(d n g)k + +
y s
~
0
~
k
*
~
k


Capital techology ratio converges to a
stationary steady state.


Long run increase in per capita income takes
place at the rate of technical progress.

Steady-state income and growth
Setting




Substituting this into the production function
gives


1/(1 )
*
s
k
n d g
o
| |
=
|
+ +
\ .
/(1 )
*
s
y
n d g
o o
| |
=
|
+ +
\ .
0
~
= k

Recall the capital accumulation equation :

This can be re-written as
k sy (n g d)k = + +
k y
s (n g d)
k k
= + +
An Increase in Investment
y s
~
y s
~
'
k d g n
~
) ( + +
* *
~
k
*
~
k
k
~
a rise in the saving rate
k
n+g+d
1
s' k
o
*
k
**
k
1
sk
o
k / k
THE EFFECT OF AN INCREASE IN
INVESTMENT ON GROWTH
y
y
Time
g
*
t
THE EFFECT OF AN INCREASE IN
INVESTMENT ON y
Level Effect
*
t
Time
Log y
EVALUATING THE SOLOW MODEL
How does the Solow model answer the key
questions of growth and development?
First, the Solow model appeals to differences
in investment rates and population growth
rates and (perhaps) to exogenous differences
in technology to explain differences in per
capita incomes.
Why are we so rich and they so poor?

Invest more and have lower population growth
rates, both of which allow us to accumulate more
capital per worker and thus increase labor
productivity.

Second, why do economies exhibit sustained
growth in the Solow model?

Technological progress.

Without technological progress, per capita
growth will eventually cease as diminishing
returns to capital set in.

Technological progress, can offset the
tendency for the marginal product of capital
to fall.

In the long run, countries exhibit per capita
growth at the rate of technological progress.
How, then, does the Solow model account for
differences in growth rates across countries?
Transition dynamics can allow countries to
grow at rates different from their long-run
growth rates.
An economy with a capital-technology ratio
below its long-run level will grow rapidly until
the capital-technology ratio reaches its
steady-state level.
The principle of transition dynamics says that
the farther below its steady state an economy
is, in percentage terms, the faster the
economy will grow
Similarly, the farther above its steady state, in
percentage terms, the slower the economy
will grow
This principle allows us to understand why
economies may grow at different rates at the
same time

How do we understand the discrepancy between
Harrod-
Domar and Solow models?
In the former the savings rate, for example,
affected the long run growth rate, while in the
Solow model savings rate does not affect the
growth rate.
There is no sustained growth to begin with in
this version of the Solow model!
This is because there are diminishing returns
to capital, which create endogenous changes
in capital-output ratio.
This chokes off growth in the Solow model. If
capital were to grow faster than labor, each
unit of capital had less labor to work with it,
and the output per unit of capital would be
reduced.
There can be no steady state growth.
Unconditional Convergence
(
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)

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Time
B
A
AB plots the time path of per capita income at the steady state.
If Countries in the long run have the same rates
of technical progress, savings, population growth
and capital depreciation .
Solow model predicts that all countries , capital
per efficiency unit of labour converges to the
common vales of k*.
If a country starts below the steady state level
per efficiency unit , the country will initially
display a rate of growth that exceeds the steady
state level and over time growth will decelerate
to steady state level. Vice versa.
Convergence shows a strong relationship
between growth rate of per capita income and
the initial value of per capita income.

Poor countries grow faster than the rich ones.

A country which is poor initially (with low per
capita income and capital stock) will then grow
faster than the rich country.

Relative income differences between countries
must die away in the LR.


Evidence

Option 1. Small number of countries, long
horizon.
Option 2. Large number of countries, short
horizon.
Empirical evidence
The growth rates of homogenous countries do
converge more clearly than the growth rates
of non-homogenous countries (the US states,
OECD vs. the world).
Homogenous countries are more likely to have
the same steady state.
Conditional convergence:
Unconditional convergence assumes all
parameters are the same.
Parameters, population, capital depreciation,
savings differ.
The steady state could be different from
country to country.
Countries need not converge to other.
Weaker hypothesis called conditional
convergence.

Assume that knowledge flows freely across
countries.
Technical progress determines the growth rate
of per capita income in the long run.
This leads to the prediction of convergence in
growth rates.
Long run per capita incomes vary from
country to country.
Long run per capita growth rates off all
countries are predicted to be the same.
(
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)

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Time
Conditional convergence implies convergence
in growth rates.
Growth rate convergence implies that a
country that is below its own steady state
grows faster than its steady state growth rate.