Neo-classical thinking on growth, Macroeconomics

Neo-classical thinking on growth:

Neo-classical  thinking  on  growth  is  owed  to  the Robert  Solow  whose  exogenous  growth models in the of the mid-20th century remained the much influential work in the area till the late 1980s when endogenous growth theories revolutionized thinking in this area.

Based on the principle of the diminishing returns to capital, the main theses of the neo-classical exogenous growth theory were as follows:

a.  The steady-state growth rate of the real GDP depends upon n and t, the exogenous rates of growth/development of population and technology. By exogenous, we mean determined outside the model. Hence, there were no policy insights for how governments could affect the steady state growth rates of countries. In particular, the model suggested that higher savings could only have the level effect on the income, not the long-term growth/development effect as had been prior thought.  The reason  was  that  the savings-enabled  investment  and  capital accumulation eventually banged into the diminishing returns.

b.  If one of the country begun with lower income and capital than the other country, then the poorer  country  would  grow/develop  faster  in  order  to  catch  up  with  \richer  country. Ultimately, both would grow at same rate.

The Major Weaknesses of Exogenous Growth Model:

Exogenous growth theory suffered from the three main weaknesses:

i. It could not explain why there is gap between the poor and rich countries had widened

(anti-catch up),

ii. It  could not explain why some countries in East Asia had appeared that grown consistently on the back of the higher saving rates, and

iii.  It modelled technology as exogenous, and beyond the influence of the policy.

The first weakness was answered within the neo-classical framework: the key insight was that convergence would only be witnessed between countries with similar capital and income levels to begin with; countries with very low capital to begin with might actually never come out of their poverty and could see their capital stock falling over the period of time.

The second weakness was addressed by the endogenous growth theory (endogenous because steady state growth/development rate was determined inside the model, not determined by factors exogenous to it) which set up model in a way that steady state growth/development rate now depended directly on the saving rate and the level of technology. The permanent increase in the saving rate, thus, meant a permanent rise in the growth rate.

The third weakness was also addressed by endogenous growth theory only, which by using the different industry structures and technology functions specifications could link technological development to conscious R&D  effort  by  the firms  and  government.  Non-diminishing returns to the technical progress would then generate endogenous growth/development.

Posted Date: 7/19/2012 3:08:48 AM | Location : United States







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