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Chapter 4
Theories of
Economic
Growth
Dwight H. Perkins
Steven Radelet
David L. Lindauer
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Lucas (1985): “The diversity across countries in
measured per-capita income levels, is literally too great
to be believed”
Recall: growth depends on:
1. Accumulation of assets (K, L, land)
2. Increasing productivity of these assets
3. S and I
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other factors influencing growth:
Government policy, institutions, political and economic
stability, geography, natural resource endowment,
health and education services quality
This chapter: models of economic growth
In general: relating quantity of L and K, their
productivity, and the resulting aggregate output
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The Basic Growth Model
Aggregate Production function
Is based on five equations
1. Aggregate production function Y=f (K,L)
2. Saving(S)= sY
(s=.20 and Y=10bill, S=2B)
3. S= I (Saving=Investment)
4. ΔK=(I- dK) where d=depreciation and K= capital
5. Δ L= nxL n=population growth and L=Labor force,
(If L=1mill. & n=.02)
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Combining 2,3,4, leads to
ΔK =sY-dK
5 equations and 5 variables can be solved
ΔK can be substituted into Production function Y=f(K,L)
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The Harrod-Domar Growth
Model
HD Growth model is a particular model with
basic feature of fixed coefficient production
function.
It assumes no substitution between labor and
capital Q= min F(L,K): the production Isoquant
is L shaped
It also shows constant returns to scale (CRS)
i.e. doubling inputs will double output
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Production function
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Harrod-Domar Prod.
function
The production function Y= (1/v).K or Y=K/v, where
v= constant or v=K/Y
v= capital output ratio or measure of the productivity of
capital or investment. (indication of K intensity)
For example if v=4, then how 20 million investment will
be needed produce 5 million output or 20/4 =5 based
on
Y=K/v
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ΔY=ΔK/v and g= ΔY/Y=ΔK/Yv ... growth rate of output
since ΔK =sY-dK:
g= (s/v)-d ... thus:
1. K created by I is the main determinant of growth in output
2. S makes I possible
The Basic HD Model Point: S more and make productive I and the economy
will grow. This makes sense!
Example: if s=.24, v=3, and d=.05, then the economy will grow at 3% (why?
s/v-d – 0.24/3-0.05= 0.03=3%)
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Case Study: Economic Growth in
Thailand
Thailand in 1960 was an agrarian economy with 75% of
population in agriculture, GDP was about $1000, Life
expectancy was 53, infant mortality was 103 per 1000
Beginning 1970 Thailand began to save averaging 20%
and reaching 35% in 1990
This combined with good governance and prudent
policies led to rapid economic growth
Average income is more than 6 times it was in
1960,Life expectancy is 69, infant mortality 24 per
1000, adult literacy is 93%, Labor intensive
manufacturing is 80% of exports and ICOR rose from
2.6 to 4.1 by 1990.
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The Solow Model
The Solow model is an improvement over HarrodDomar Model
It drops fixed coefficient or no substitution and allows
for substitution between factors
Y= f(K,L) Labor and capital are substitutable
The production function or Isoquant is u-shaped
showing substitution as in figure 4.2
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a to b: same as FPM
K-intensive
L-intensive
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if the production function facing a country i a
neoclassical, then capital output ratio becomes a
variable that influenced by relative prices, policies,...
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Basic Equations:
Divide Y=f (K,L) by L to express all variables in per-worker
terms
Y/L=F(K/L,1)
y=f(k)
Thus we have diminishing returns to capital as in (4.3)
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Since ΔK =sY-dK:
Δk=sy-(n+d)k
Δk is determined by:
s, -nk, and -dk
Thus: S (and I) adds to K-per-worker, while L growth
and dep reduce K-per-worker
When sy>(n+d)k then Δk is increasing
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at the intersection: point A:
k=k0 and y=f(k)=y0
at A: sy=(n+d)k
if k=k1 and y=y1: sy>(n+d)k, so k grows
if k=k2 and y=y2: sy<(n+d)k, so k falls
all move towards A!
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the amount of K needed b/c of n and d just to keep k
constant
sy>(n+d)k
production function
saving function
sy<(n+d)k
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The Solow Growth Model (see 4.4)
Point A is where new savings Sy = amount of new
capital needed for growth in the labor force and
depreciation (n+d).
Point A is steady state level of capital per worker where
stable equilibrium occurs
At steady state total output continues to grow at the rate
of population (n) or labor force, but GDP per capital (y)
is constant.
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The Effect of Changes in Saving Rate and
Population Growth in the Solow Model
An increase in the S in the Solow Model from s to s’, k
increases from k1 to k2 or A to B
An increase in the n to n‘ will drop k from k0 to k1 or A
to C
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Evaluating the Solow Model:
Strengths and Weaknesses
It is an improvement over H-D Fixed coefficient model
With neoclassical production function it allows for
substitution between inputs
Provides good insights about the relationship between
role of technology and innovation on growth
Limitations: One sector approach, factors that drive
steady state, and assumes saving rate, population
growth , and technical change as given. It does not
explain how these parameters change over time
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Read: What Explains Differences in Growth
Rates among countries( see Box 4.3)
Key factors from a recent study: initial level of
income, openness to trade, healthy population,
effective governance, high saving rate and
geography
The above policy variables explain the
differences between 3 groups of countries from
1965-90
10 East Asian countries (4.6%)
17 African Countries (0.6%)
21 Latin American countries (0.7%)
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Beyond the Solow Model: New
Approaches to Growth
The Solow model assumes fixed or exogenous
saving rate, growth rate of savings and labor
force.
Recent works provides models where these
variables are determined within or
endogenously in the model.
These new models allow for increasing returns
to scale and positive and negative externalities
They are called endogenous models but their
estimation suffers from lack of good data.
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Chapter 4: Summary of Theories of Economic Growth
I. Building blocks common to modern theories of growth: the production function (technology),
saving and investment behavior, the relationship between existing stock of capital and new
investment, and labor force growth.
II. Three models of growth have informed much of the empirical work and policy analysis on
developing economies. They are the HD growth model, which is short term in orientation and
Keynesian in spirit; the Solow growth model, which is long term in orientation and neoclassical
in spirit; and the Lewis two-sector model, which is also long term but is classical in spirit.
The basic HD growth model suggests that the steady-state rate of growth is determined by the
saving rate, the fixed incremental capital-output ratio (ICOR), and the rate of depreciation of
fixed capital. Full employment is assured if this growth rate is equal to the rate of growth of the
labor force. In terms of the realism of its (highly restrictive) assumptions and its widespread use
by development institutions in formulating policy advice.
III. The basic Solow model suggests that the steady-state rate of growth is determined by the
saving rate, the flexible ICOR, and the rate of depreciation of fixed capital. Furthermore, factor
substitution ensures that steady-state output, net capital, and the labor force grow at the same
rate. This implies that all per capita variables remain unchanged in the long run following any
changes in such parameters as the saving rate or the population growth rate. The basic model is
extended to accommodate exogenously given, labor-augmenting technological change, which
ensures that total output will grow at the rate of labor force growth plus technological progress.
IV. A brief discussion of recent research that attempts to explain technological progress within
the model (endogenize it) rather than taking it as determined outside the model. Endogenous
growth models seek to understand how the interplay between technological knowledge
(produced by such efforts as investment in human capital, R&D, and the diffusion of ideas to
latecomers) and a country’s institutions affect the prospects for sustained economic growth.
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This concludes the Norton Media Library
Slide Set for Chapter 4
Economics of
Development
SIXTH EDITION
By
Dwight H. Perkins
Steven Radelet
David L. Lindauer
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