Download Textbook Solutions Ch.15

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CHAPTER 15
Advanced Topics in Growth Theory
This chapter explores two topics related to growth. The first one of these is endogenous technical change. This
is defined as the technical change that results from decisions made by economic agents to change knowledge
on the production technology. Examples of such decisions are those on the acquisition of new skills, research
and development (R&D) and investment in new or improved equipment.
This chapter also explores the relationships between inflation and growth, between the growth of the
money supply and the growth of output and the development of the financial sector and output growth.
15.1 Answers to Book Questions
15.1.1 Review and discussion questions
1. What is meant by ‘endogenous growth’?
‘Endogenous growth’ refers mainly to the modelling of endogenous technical change in growth theory.
Contrary to the Solow model in which growth in technological change is postulated as occurring exogenously without cost, endogenous growth models try to model the economic decisions that bring about
a change in the technology of production. In some cases, endogenous growth theory models technical change in a way that, at the macroeconomic level, the (social) MPK increases or becomes constant
(although private MPK is decreasing). Such modelling implies that the economy does not reach a steady
state.
2. Which is more significant for (a) steady-state (SS) growth and (b) pre-steady-state (pre-SS) growth:
investment (without technical change) or innovation? Discuss.
For pre-SS growth, both investment and innovations are important since they lead to an increase in
physical capital per worker and technical change, and therefore in output per worker. An increase in the
saving rate (and therefore investment) would increase the SS capital per worker level, and lead to higher
pre-SS growth. In the SS, however, the Solow model shows that growth is equal to zero if there is no
technical change. Therefore, for SS growth, innovation is clearly more important.
Various studies, including that by Solow, show that technical change (which includes inventions and
innovations) accounts for a larger part of the growth of per capita output than increases in capital per
capita, which occur through investment.
However, innovation normally requires new investment, and so growth-accounting measures of the
contributions of innovation and investment tend to underestimate the contribution of investment to both
pre-SS and SS growth.
3. What is meant by ‘human capital’? Is it schooling or new knowledge or does it include both? What
is the role of each one in growth? Discuss.
Human capital is the knowledge embodied in workers. It is acquired through schooling, on-the-job
training and other modes of learning.
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Schooling in schools and universities mostly means maintaining the existing level of human capital by
educating the young up to this level. An increase in the average level of education represents an increase
in the average amount of human capital.
New knowledge requires a change in the knowledge that is imparted and initially occurs through
research. A change in the quality of education usually produces a shift in the efficiency of human capital
and can have similar effects on growth as those of new knowledge.
While educating the population at the existing level of knowledge will sustain the SS level of output
per worker, only generating new knowledge will increase the SS growth rates of output per worker.
4. Discuss the relevance of capitalism versus totalitarianism (with a centralised economy) to growth.
Planned economies seem to do worse than capitalist, free enterprise economies in invention, innovation
and dissemination of information. Taking the Soviet Union as an example, industry was governmentcontrolled and planned, and provided little incentive to innovate — in fact, there were many disincentives
to change. Innovations were not given protection by patents and copyright, and did not provide higher
income or royalties to the producers, which limited the incentive to invent and innovate. Further, due
to restriction on travels and exchanges with capitalist economist economies, even when new technologies
arose in the latter, these technological changes were not adopted or there were lengthy delays in adoption.
The relative failure of communist countries contributed to the slower growth of the standards of living in
them and, according to many economists, was a major contributor to the downfall of the Soviet system.
Capitalism, on the other hand, encourages firms and workers to innovate in order to make higher
profits and incomes. It also favours the adoption of the most advanced technology available in order to
survive in a competitive environment. In such an environment, firms need to develop and/or adopt new
products and new techniques of production in order to gain some advantage over other firms and prosper,
sometimes even survive.
5. What types of fiscal policies can promote growth? What types can hinder it? Give examples.
The Solow model of growth assumes that labour growth rates and technical change are both taken to be
exogenous. This implies limited scope for fiscal policy to create growth.
However, the endogenous growth models maintain that fiscal policy can be used to create growth by
encouraging inventions and innovations through investment in human and physical capital. Examples of
such policies are tax cuts on profits and earnings, funding of universities and research, etc.
Policies that can hinder growth include excessive taxation, corruption, excessive regulation, failure to
effectively offer protection of patents and copyright, etc.
6. How do wars (a) reduce growth and (b) promote growth. Use diagrams to support your answer
and give some examples.
Wars reduce output if they lead to lower levels of capital because of its destruction, e.g., by enemy action.
This reduction in growth can have serious consequences for growth, especially if the production function
has the shape shown in Figure 15.6, where k is a proxy for technology as well. The production function
shown in this diagram has increasing returns, followed by diminishing ones, to k.
In Figure 15.6, for an economy with initial capital per worker of k4 , if a war reduces k to k3 , the economy
will move below the take-off point k1∗ , and so it will not move along the growth path leading to k2∗ .
On the other hand, a destruction of capital that leaves the level of k above k1∗ will lead to an increase in
the pre-SS growth rate (assuming the saving rate to be constant).
Wars can promote both pre-SS and SS economic growth if they cause sufficient increases in knowledge.
During wartime, there are often significant increases in expenditures on research, which lead to inventions
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Advanced Topics in Growth Theory
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nk
output units
σ f(k)
k*0
k3
k*1
k4
k*2
k
Figure 15.6
and innovations. The new knowledge thus generated may be applied to civilian production after the war,
and can lead to higher output per capita for a long period after the war.
7. What is meant by the globalisation of international trade? Discuss its advantages and disadvantages
for the less developed economies with agriculture as the dominant economic sector.
Globalisation of international trade means that countries become progressively more and more open to
trade in commodities, capital and knowledge flows. The benefits of globalisation occur from the expansion
of markets and from the flows of new knowledge.
The expansion of markets for the products of a country allows it to specialise on the basis of comparative
advantage and to increase its productivity. The current pattern of ‘truncated globalisation’ in which
there is greater liberalisation in industrial products than in agricultural products limits the benefits from
comparative advantage for agricultural economies.
International flows, whether of products, capital or people, carry externalities in the form of knowledge
flows. These knowledge flows can benefit less developed economies. However, to significantly benefit from
the international flows of new knowledge, they need openness, absorptive capacity, new investment and
the appropriate environment — consisting of the political, social and economic systems — to acquire and
effectively utilise the new knowledge. Some developing countries do not possess these to the same extent
as others.
Further, if the expansion of knowledge occurs mainly abroad while the destruction of productive
capacity through the inability or unwillingness of domestic firms to innovate at the rate attained by firms
abroad occurs at home, the domestic economy can end up with lower output. This is especially likely to
be the case in poorer countries with more limited resources for investments in R&D and in education.
Therefore, the endogenous growth theory does not imply that the liberalisation of foreign trade will
necessarily benefit all countries equally; in fact, some countries can be net losers — at least in the short
term.
8. What is a patent? In what ways do patents encourage and in what ways do they discourage the
growth and spread of new knowledge?
A patent confers on the inventor or innovator the exclusive ownership for a specified period of the item
that he or she has created. Patents are usually limited to physical products and processes. They allow the
inventor to make higher profits, thereby creating incentives to innovate.
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However, patents also create monopoly power for the specified duration. The period for which the
patent is granted is relevant for endogenous growth. Lengthening the period increases the returns and
incentives for the owner of the patent, but it also restricts production by others within the country and
in other countries. Further, stronger patents discourage sequential research and follow-on inventions.
These constitute the opposing effects of patents on the creation and use of new knowledge and imply that
while some patent length is likely to be desirable, extremely long patent protection can stifle the growth
of knowledge.
9. ‘It is vital for understanding the contribution of money to growth that we distinguish between
the quantity of money and the size and the efficiency of the financial sector.’ Discuss.
Modern economic theory holds that long-run growth rates of the output of economies are independent
of the growth rates of the quantity of money and the rates of inflation. Some empirical studies show that
output growth rates are independent of the growth rates of the quantity of money in the economy, except
possibly in low-inflation countries.
However, the efficiency of the financial sector is very important to long-run growth. If the banks and
other financial institutions and financial market become more efficient, it becomes easier and less costly for
firms generally to obtain external financing for investment and working capital for day-to-day operations.
This enables firms to set up, expand and refine their technologies, to invent and innovate and to have
breakthroughs.
Schumpeter’s idea of ‘creative destruction’ hinges on the financial sector. If small, new firms were
unable to secure external funding, change and growth in the economy would be reduced. To connect
this idea to endogenous growth, the nature and efficiency of the financial market is very important in
channelling funds to innovators. This facilitates endogenous technical change, thereby contributing to
output growth.
10. LDCs have sometimes resorted to high money growth rates to finance their development efforts
in an attempt to push up their own growth rates. Why? Was it misguided in retrospect and, if
so, why?
Empirical evidence and economic theory suggest that high money growth rates lead to high inflation
rates and sometimes hyperinflation, which do not benefit long-term growth. Many LDC governments
undertake large fiscal deficits, financed by increasing the money supply. While some benefit of large moneyfinanced deficits may be achieved in the short term, the long-run effects include high nominal interest
rates (because of the Fisher equation on interest rates), lack of investor and consumer confidence, waste
of resources, etc., which reduce investment and growth. For these reasons, development financed by high
money growth rates is misguided and unsustainable.
11. ‘Banking inefficiency and the excessive regulation of the banking sector and interest rates in some
of the LDCs have proved to be highly detrimental to their growth rates.’ Discuss.
Banking inefficiency and excessive regulation of banking reduce the amounts of loans by banks and increase
the interest rates to the borrowers. They also usually cause banks to lend to less productive borrowers, as
well as sometimes leading to corruption in the loan process.
The financial sector, which includes banks, promotes growth by channelling funds to small firms and
entrepreneurs who invent and innovate. Without a developed financial sector, firms cannot obtain adequate funds to translate their ideas into production.
Banking is a subset of the financial sector and provides services that are distinct from those offered
by stock markets. Banks directly extend loans that are crucial to small firms. Such firms can often obtain
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funding through banks (and venture capital financial firms) rather than via the stock market, listing
for which requires the firm to meet strict criteria on size and convincing evidence of positive profits.
Overregulation of the banking systems, perhaps by specifying who may or may not obtain a loan etc.,
does not allow funds to be channelled to their most productive uses, and limits growth. Empirical evidence
shows that funds find their most productive use when the market forces are left to direct them.
Note that while excessive regulation of financial institutions is detrimental, some regulation is needed in
order to prevent fraud, accounting standards to ensure the accuracy of financial reports, adequate capital
and solvency, restraint on risk taking, etc.
12. Define ‘hyperinflation’. How might it hinder growth?
Hyperinflation occurs when the price level rises rapidly and continuously, and the currency loses its value
very rapidly. It is usually caused by excessive and sustained money growth. Hyperinflation creates a high
degree of uncertainty about the future profitability of investments. It also increases nominal interest rates
since the market interest rates incorporate the expected inflation rate. Therefore, it reduces both domestic
investment and direct foreign investment.
Further, the magnitudes of inflation and interest rates under hyperinflation become unpredictable.
Buyers and sellers of commodities and capital cannot confidently sign contracts, since the future value of
the currency is unpredictable. In addition, the citizens of the country undergoing hyperinflation spend
valuable time and energy in avoiding the costs of holding a depreciating currency, which is a waste of
otherwise productive resources. Therefore, hyperinflation is highly undesirable for growth.
13. In explaining the growth rate of output per capita during the past fifty years for the USA, what
factors explain its decrease from the mid-1970s to the mid-1990s, followed by its increase?
According to one study, the annual rate of growth of output per hour in the USA was 2.9% during
1948–1973, 1.4% during 1973–1995 and 2.79% during 1995–2000. The slowdown in growth during
1973–1995 relative to that during 1948–1973 was mainly due to the rate of decrease of multifactor
productivity (MFP) growth, which decreased from 1.9% annually to 0.4%. The resurgence of growth
after 1995 was also largely due to the recovery in the MFP growth, which was in turn mainly attributable
to the development of the Information Technology (IT) sector (including the computer one). This sector
contributed to growth through contributions to capital’s share and to MFP growth. It accounted for 0.4%
of capital’s contribution during 1973–1995, followed by an increase by 0.59% (to 0.99%) during 1995–
2000. It also increased the rate of growth of MFP by 0.18%, and so the increase (as between 1973–1995
and 1995–2000) in annual output growth due to IT developments was 0.79%. This difference compares
with labour’s total contribution of 0.02% during 1973–1995 and 0.06% during 1995–2000. Therefore,
the IT and computer revolution has been the largest contributor to the growth of output per hour and
hence to the growth of living standards during the period since the mid-1990s.
15.2 Advanced and Technical Questions
T1. If the marginal product of physical capital is increasing for a given firm, it can indefinitely increase
its profits by increasing its physical capital stock, and so (a) profit maximisation under perfect
competition implies that the firm would use increasingly large amounts of capital and (b) the firm
would grow to meet the industry’s total demand. This is clearly unrealistic. How does endogenous
growth theory accommodate the increasing marginal productivity of capital for the economy while
maintaining the assumption of competition among firms?
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Endogenous growth theory maintains diminishing MPK at the micro level of firms. Since each firm experiences decreasing marginal productivity of capital in the production of commodities (and new knowledge),
it reaches profit maximisation at a limited level of output. This means that one firm does not eventually
satisfy all the market’s demand, and that competition can still exist.
Endogenous growth theory proposes that the externalities of new knowledge are the link between the
different behaviours of the marginal productivity of capital per worker at the micro and macro levels —
not only do the firms involved in the invention and innovation benefit from them, but other firms in
the economy also benefit from knowledge spillovers and imitations. These externalities can convert the
diminishing MPK at the level of a given firm to an increasing one in the aggregate over all firms.
Endogenous growth theory suggests that if inventions and innovations and their externalities are
sufficiently large, the marginal productivity of capital per worker for the economy as a whole can increase
or at least become constant. If this happens, the economy can maintain positive growth rates of output
per capita indefinitely.
T2. Is there a link between rapid growth through invention and innovation and financial crises? Why?
Discuss.
There is a strong link between rapid growth based on invention and innovation and financial crises.
Economies undergoing extensive invention and innovation generate considerable speculation and uncertain loans, which makes their performance unstable and vulnerable to crises. While some of these loans
go to funding breakthroughs that prove very lucrative, some go to ventures that fail. Further, the public
gets carried away and bids the prices of the stocks of corporations, especially the ones with the inventions
and innovations, to unsustainable levels. These eventually crash. Banks that had lent to speculators suffer
bad loans and make losses.
These factors cause economies undergoing rapid innovations and inventions to periodically run into
financial crises.
T3. ‘Given that saving is positively related to the rate of interest and that an increase in the rate of
inflation will increase the rate of interest, both the saving rate and the growth of the economy
will be positively related to the inflation rate and money growth rate.’ Discuss. [Hint: Modern
classical economists believe that saving depends on the real interest rate.]
The nominal interest rate has two components: one represents the return on capital, and the second
represents the inflation premium. When high money growth and the subsequent inflation occur, nominal
interest rates rise because the premium for inflation rises. However, savers react to the real return to their
savings. If inflation increases, the real return to savings mainly remains unchanged, so that saving remains
unchanged and the economy does not grow faster. In other words, it is the interest rate adjusted for
inflation, i.e., the real interest rate, on which savers base their decisions. In fact, high inflation rates actually
increase uncertainty about the future real return on saving and investment. The increased uncertainty
reduces investment and the growth of the capital stock.