Module 12.3 LOS 12.i: Classical growth theory, neoclassical growth theory and endogenous growth theory

Classical Growth Theory

Based on the concept of a mean-reverting subsistence level, this theory from Malthusian economics contends that there is no such thing as permanent growth in real GDP. When GDP per capita rises about subsistence levels, an ensuing population explosion will create lead to diminishing returns on labor and productivity until GDP falls back to subsistence levels.

Neoclassical Growth Theory

Neoclassical growth theory is based on the concept of a long-term steady state growth rate.

The sustainable growth rate of output in the neoclassical model is:

The sustainable growth rate of output per capita in the neoclassical model is:

Under Neoclassical theory:

  • Capital deepening affects the level of output but not the growth rate in the long run. Capital deepening may temporarily increase the growth rate, but the growth rate will revert back to the sustainable level if there is no technological progress. (Not part of Cobb-Douglas function above)
  • An economy’s growth rate will move towards its steady state regardless of the initial capital to labor ratio or level of technology.
  • In the steady state, the growth rate in productivity (i.e., output per worker) is a function only of the growth rate of technology (θ) and labor’s share of total output (1 − α).
  • In the steady state, marginal product of capital (MPK) = αY/K is constant, but marginal productivity is diminishing.
  • An increase in savings will only temporarily raise economic growth. However, countries with higher savings rates will enjoy higher capital to labor ratio and higher productivity.
  • Developing countries (with a lower level of capital per worker) will be impacted less by diminishing marginal productivity of capital, and hence have higher growth rates as compared to developed countries; there will be eventual convergence of per capita incomes.

Endogenous Growth Theory

In contrast to Neoclassical Growth theory, endogenous growth theory centers on the role of technological progress leading to permanent increases rates of growth. Investments in both physical and human capital lead to technological progress, which in turns enhances productivity of factors.

The endogenous growth model theorizes that returns to capital are constant. The key implication of constant returns to capital is the effect of an increase in savings: unlike the neoclassical model, the endogenous growth model implies that an increase in savings will permanently increase the growth rate.

The difference between neoclassical and endogenous growth theory relates to total factor productivity. Neoclassical theory assumes that capital investment will expand as technology improves (i.e., growth comes from increases in TFP not related to the investment in capital within the model). Endogenous growth theory, on the other hand, assumes that capital investment (R&D expenditures) may actually improve total factor productivity.

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