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##### Subject 5. Theories of Growth
Classical Model

Classical growth theory is the view that real GDP growth is temporary. When real GDP per person rises above the subsistence level, a population explosion will bring real GDP per person back to the subsistence level.

The basic classical idea:

• There is a subsistence real wage rate, which is the minimum real wage rate needed to maintain life.
• Labor productivity increases and the real wage rate rises above the subsistence level.
• When the real wage rate is above the subsistence level, the population grows.
• Population growth increases the supply of labor, which lowers the real wage rate.
• The population continues to increase until the real wage rate has been driven back to the subsistence real wage rate.
• At this real wage rate, both population growth and economic growth stop.

Contrary to the assumption of the classical theory, the historical evidence is that population growth rate is not tightly linked to income per person, and population growth does not drive incomes back down to subsistence levels.

Neoclassical Model

In the steady state, the growth of potential GDP depends on three factors: the growth rate of TFP, the labor share of output, and the growth rate of labor force.

where θ is the growth rate of TFP (i.e., ΔA/A), α is the capital share of output, and n is the labor force growth (ΔL/L).

In the steady state, the output-capital ratio is constant:

Both the capital-to-labor ratio (k) and output per worker (y) grow at the same rate: [θ/(1 - α)]

When an economy is in the steady state, the following parameters can affect its per capita income:

• Saving rate(s). A higher saving rate will cause a higher per capital income.
• Labor force growth. An increase in the labor force growth rate will lower output per worker.
• Depreciation rate. A higher depreciation rate will lower output per worker.
• Growth rate of TFP. An increase in the growth rate of TFP will lower output per worker for a given supply of labor.

Implications:

• Capital accumulation affects the level of output but not the long-run growth rate, which depends on labor force growth, TCP growth scaled by labor's share of income.
• Long-term sustainable growth cannot rely solely on capital deepening investment. The key driver is technological progress.
• Convergence is the process of one economy's catching up with another economy. Countries with a low level of capital would have a higher marginal product of capital because of diminishing returns, and hence attract more investment and grow faster.
• Higher saving rate can increase the level of per capita output and labor productivity, but it CAN NOT deliver sustainable growth.

The main criticism is that the long-run rate of growth is exogenously determined - that is, it is determined outside the model. The model provides no quantifiable prediction of the rate or form of TFP change.

Endogenous Growth Theory

The neoclassical model does not explain how or why technological progress occurs, as TFP progress is regarded as exogenous to the model. This failing has led to the development of endogenous growth theory, which endogenizes technological progress and/or knowledge accumulation.

The basic idea:

• There are no diminishing marginal returns to capital for the economy as a whole. Instead, there can be constant or even increasing returns to capital in the aggregate economy.
• Knowledge or human capital, and R&D spending are factors of production. Expenditures made on R&D and for human capital may have large positive externalities or spillover effects.
• Savings and investment decisions can generate self-sustaining growth at a permanently higher rate. A higher saving rate implies a permanently higher growth rate.
• There is no reason why the incomes of developed and developing countries should converge.

Summary:

• In classical model, when technological advances increase real GDP per person above the subsistence level, a population explosion brings diminishing returns to labor and real GDP per person returns to the subsistence level.
• In neoclassical model, when technological advances increase saving and investment, an increase in the capital stock brings diminishing returns to capital and eventually, without further technological change, the capital stock and real GDP per person stop growing.
• In endogenous growth theory, when technological advances increase saving and investment, an increase in the capital stock does not bring diminishing returns to capital and growth persists indefinitely.

Convergence Hypotheses

The convergence hypothesis predicts that the rates of growth of productivity and GDP should be higher in the developing countries. Those higher growth rates imply that the per capita GDP gap between developing and developed countries should narrow over time.

There are absolute convergence and conditional convergence.

The evidence on convergence is mixed. Convergence only seems to hold within industrialized economies. If we look at a larger sample of countries, then poor countries do not seem to grow faster than rich ones.

Countries fail to converge because of low rates of investment and savings, lack of property rights, political instability, poor education and health, restrictions on trade, and tax and regulatory policies that discourage work and investing.

Learning Outcome Statements

compare classical growth theory, neoclassical growth theory, and endogenous growth theory;

explain and evaluate convergence hypotheses;

describe the economic rationale for governments to provide incentives to private investment in technology and knowledge;

CFA® 2023 Level II Curriculum, Volume 1, Module 9

User Comment
Oksanata why the increase in growth rate of TFP and labor force will lower the output per worker as they say in neoclassical model??
wdorriety I saw the same thing. I think they made a typo growth in technology increases the output of labor. The curve shifts up.
charliedba According to the textbook (Page 645): Raising the growth rate of TFP means that output per worker will grow faster in the future, but at a given point in time, a given supply of labor, and a given level of TFP, output per worker is lower than it would be with a slower TFP growth rate. In effect, the economy is on a steeper trajectory off a lower base of output per worker.

So it is correct.