Professional Documents
Culture Documents
ClassicalandNeoclassical Growth Theories
ClassicalandNeoclassical Growth Theories
Division of labour
Increasing returns
More output
Larger market
profit
Larger savings
• Savings are invested in full in machines and
land
• Only capitalist and landlords are capable to
save and invest
• Labour gets wage funds
– Amount necessary for subsistence
• Reciprocal Model
– Balanced growth between agriculture and
manufacturing is essential
Banancing
• Supply side
– Agricultural surplus required to sustain industrial
population
– increase in productivity of agriculture supplies
labour to industry
• Demand side
– Agricultural surplus gives rise to demand of
industrial products
Limits to growth
• Desire for investment falls if profit falls
• Profits falls as
– competition between capitalists increases
– wage rise
• Profits rise as
– New investment opportunities
Policy Implications
• Invisible hands
– Each individual is guided by invisible hands which
guided market mechanism
– If individuals are set free, will seek to maximize
own wealth, therefore all individuals , if left free,
will maximize aggregate wealth
• Free trade
• Laissez-faire
• No government intervention
Underdeveloped Countries
• Small size of markets
• Capacity to save and investment low
• Low growth rate
Income elasticity of global trade
The ghost of Malthus
• Thomas Malthus (1766-1834)
• English
• Essay of the Principal of Population (1798)
– Constant tendency in all animal life to increase
beyond the nourishment prepared for it
– Population increases in geometrical ratio but
subsistence increase in arithmetical ratio
Growth of subsistence 1, 2, 3, 4, 5, 6, 7
Pessimism
• Identified problem of effective demand
• Effective demand must grow in line with
production potential
• Per capita income around subsistence
• Increase in per capita income through
technological progress
– More births
– Reduces per capita income
• Imbalance between savings and investment
– Savings of landlords may exceed demand for fund by
the capitalist for planned investment
• Low demand for product due to low per capita income
Other Pessimists
• Low level equilibrium trap in 1956
– Richard R. Nelson
• Big push Model in 1943
– Paul Rosenstein-Rodan
• Dismal Science????
Implications
• Preventive checks
– Sexual abstinence or use of contraception
• Positive (natural) checks
– Pestilence (epidemic), disease and famine
• Population growth was resisted in many parts
of the world and agricultural production
increased more than arithmetic progression
David Ricardo (1772-1823)
Wages
Rent Profit
A B
B is relatively unproductive as
compared to A
Total Output
wage
L* Labour
L
Higher wage
fund
Growth of
population
and labour
Technological
improvement
Decreasing returns
Higher and lower profit
Higher lower
output investment
investment
Lower
output
Higherlower
profitprofit
expectation
expectation
Missing Demand Side
Say’s Law
• Jean-Baptiste Say (1767-1832)
• French Economist
• Idea of Say’s Law in 1803
– Treatise on Political Economy
• Supply creates its own demand
– ”A product is no sooner created, than it, from that
instant, affords a market for other products to the full
extent of its own value”
– “As each of us can only purchase the productions of
others with his own productions – as the value we can
buy is equal to the value we can produce, the more men
can produce, the more they will purchase”
– No general glut of product
Keynesian Ideas
• Say’s Law was challenges during
Great Depression
– 25% unemployment in Unites States
• John Maynard Keynes argued in
1936 that Say's law is not true Great Depression
– Demand determines overall economic
• severe worldwide economic
activity depression that took place
• Keynes (1883-1946) - British during the 1930s
• Keynesian economics explains how• longest, deepest, and most
in the short run, and especially widespread depression of the
during recessions, economic 20th century
output is strongly influenced • US Stock market crash on
by aggregate demand October 29, 1929 (known as
– Keynesian Multiplier Black Tuesday)
• Lasted till World War II
Idea of “Creative Destruction”
Joseph Schumpeter (1883-1950)
• Austrian American - professor at Harvard University in 1932
• When innovations or changes (economic, social, political and technical)
take place in the economy, the stationary equilibrium or circular flow is
displaced and the process of development starts
• Schumpeter’s model starts with the breaking of circular flow with an
innovation in the form of a new product.
• Entrepreneur is the key figure in Schumpeter’s analysis of the process
of development/ breaking of circular flow
• Entrepreneurs is to
– Appreciate the possibilities of innovation
– Overcome the socio-psychological barriers against the introduction of
new things,
– Direct the means of production into new channels
– Persuade the banker to provide him with necessary finance for
innovations.
– Induce other producers in his branch of activity for taking risk.
– Create an environment conducive to the satisfaction of wants as the
normal motive.
– Provide leadership and
– Take high degree of risk in the economic world.
Creative destruction
• New production units replace outdated ones
Post-Keynesian Model of Economic Growth:
Harrod-Domar Models
• help analyse the business cycle
• explain economic growth
Demand
Income
Investment Balance
steady growth
Increase through
productive adjustment of
Supply
capacity supply of
demand for
Increase capital
Savings
investment
in long Neutral
term technology
Bank credit
• goods market equilibrium:
• sY = I s = I/Y
• is income, I investment, s the marginal propensity to save
• I/Y = (I/K)(K/Y), K is capital stock
• (I/K) = g, rate of capacity growth, rate of capital
accumulation
• (K/Y) = v, capital output ratio
• g = s/v, s/v is the "warranted growth rate" of output
• Harrodian "knife-edge“
– actual growth is slower than the warranted rate, invest less, low
demand, further lesser actual growth
– Actual growth higher than the warranted rate, invest more, high
demand, shortage of capital more acute
– unless we have demand growth and output growth at exactly the
same rate, i.e., demand is growing at the warranted rate, then the
economy will either grow or collapse indefinitely.
Aggregate demand must grow at the same rate as the economy's output capacity grows
for "steady state" growt
• Low savings is the reason for low economic growth in
underdeveloped countries
• Harrod-Domar followed in First Five Year Plan (1951–1956)
– One sector: aggregates all types of production into a single total
• Mahalanabis model
– Two sector: consumption good and capital good
– emphasis on the possibility that the overall rate of real
investment in the economy might be constrained by the
level of output in the capital goods industry within the
economy.
– overall rate of growth over a given period of time tended
to vary directly with the overall rate of investment in the
economy
– Government expenditure
Solow Model
• due to Robert Solow
• Criticism of Harrod-Domar
– Production under fixed proportion: no possibility
of substituting labour for capital in production
– Unstable balance of growth
Solow Model
• K is no longer fixed:
investment causes it to grow,
depreciation causes it to shrink
• L is no longer fixed:
population growth causes it to grow
• no G or T
The production function
In aggregate terms: Y = F (K, L)
Constant Returns to Scale
Define: y = Y/L = output per worker
k = K/L = capital per worker
y = f(k)
The production function
Output per
worker, y
f(k)
Capital per
worker, k
The consumption function
s = the saving rate,
the fraction of income that is saved
(s is an exogenous parameter)
Note: s is the only lowercase variable
that is not equal to
its uppercase version divided by L
c1
y1 sf(k)
i1
k1 Capital per
worker, k
Capital accumulation
The basic idea: Investment increases the capital stock,
depreciation reduces it.
k = s f(k) – k
The equation of motion for k
k = s f(k) – k
• The Solow model’s central equation
• Determines behavior of capital over time…
• …which, in turn, determines behavior of
all of the other endogenous variables
because they all depend on k. E.g.,
income per person: y = f(k)
consumption per person: c = (1–s) f(k)
The steady state
k = s f(k) – k
If investment is just enough to cover depreciation
[sf(k) = k ],
then capital per worker will remain constant:
k = 0.
CHAPTER 7
Economic
The steady state
Investment
and k
depreciation
sf(k)
k* Capital per
worker, k
Moving toward the steady state
Investment
k = sf(k) k
and k
depreciation
sf(k)
k
investment
depreciation
k1 k* Capital per
worker, k
Moving toward the steady state
Investment
k = sf(k) k
and k
depreciation
sf(k)
k
k1 k2 k* Capital per
worker, k
Moving toward the steady state
Investment
k = sf(k) k
and k
depreciation
sf(k)
k
k2 k3 k* Capital per
worker, k
An increase in the saving rate
An increase in the saving rate raises investment…
…causing k to grow toward a new steady state:
Investment
and k
depreciation s2 f(k)
s1 f(k)
k
k 1* k 2*
Prediction:
actual
break-even
investment
investment
The Solow model diagram
Investment,
k = s f(k) ( +n)k
break-even
investment
( + n ) k
sf(k)
k* Capital per
worker, k
The impact of population growth
Investment,
break-even ( +n2) k
investment
( +n1) k
An increase in n
causes an increase sf(k)
in break-even
investment,
leading to a lower
steady-state level of
k.