CHAPTER SIX:

MODELS OF MACROECONOMIC GROWTH

 Introduction: Modeling Economic Growth

 To explain theories of Economic Growth

 To explain the Harrod-Domar Growth Model

 To explain the Neo-classical Growth model

 To explain Endogenous Growth Theory

 Modeling Economic Growth

Introduction
Basic Questions:
 Why some countries are richer than other
countries?
 What exactly is the engine of growth?
 Why some countries do exhibit sustained
growth while others not?
 How can we explain the recent growth miracle?
 Con…

 Conceiving of the growth-development relationship only in

terms of the effects on the average citizens obscures a great
deal of what may be happening in a society.

 Two societies may have the same per capita growth in

average well-being, but if the fruits of this growth are shared
uniformly in one and unequally in the second.

 It is important to be aware of that economic growth may

improve the cost of the average citizen in the developed
world.
 Con…

 To determine whether the poorest citizens also benefit

from growth, we must dig deeper in to the nature of the
growth process.

 The failure of economic growth does not reduce

economic inequality as it might appear, it imply that
growth has not benefited the poor.

 Economic growth can be a vehicle for development and

the form of development can benefit the poor as well as
the rich.
 Con…

Facts and patterns of growth

 Fact 1: There is enormous variation in per capita
income across economies.
 The poorest countries have per capita incomes that are
less than 5% per capita incomes in the richest
countries.
 A Per capita income in the United State is more than 40
times higher than income in Ethiopia.
 A typical worker in Ethiopia must work a month and a
half to earn what a typical worker in the United State
earns in a day.
 In Ethiopia, about 40% of GDP is spent on food as
compared to about 7% in the USA.
 Con…

 Fact 2: Rates of economic growth vary substantially

across countries.
 Fact 3: Growth rates are not generally constant over time.
 For the world as a whole, growth rates were close to zero
over most of history but have increased sharply in the
twentieth century.
 For individual countries, growth rates also change over
time.
 Fact 4: A country's relative position in the world
distribution of per capita incomes is not immutable
(unchallengeable).
 Countries can move from being "poor" to being "rich",
and vice versa.
 Con…

 The East Asian countries have demonstrated the

earlier case while Argentina is a classic example of
the latter fact.
 At the end of the nineteenth century, Argentina was
one of the richest countries in the world.
 With a tremendous/ wonderful natural resource
base and a rapidly developing infrastructure, it
attracted foreign investment and immigration on a
large scale.
 By 1990, however, Argentina's per capita income
was only about one-third of per capita income in
the US.
 Theories of Economic Growth

Basic Assumptions of Growth Models

 Growth Models are generally based on a combination
of three assumptions or assumed relationships.
 The first is usually an exogenously determined labour
supply, which grows at some given rate
n= dL/dt.
 The second is a production function, which converts
labour and capital inputs at any given time into
outputs. Yt = F(Kt , Lt)
 Both marginal products and are assumed to be
positive and decreasing as the relevant input
increases.
 Con…

 In general, we will assume that the production

function is homogenous of degree one in K and
L.
 This means that we assume constant returns to
scale so that output per person y t depends only on
capital per person, kt.
 Formally, a function is homogenous of degree h
if, for any arbitrary positive number a, we have
ahY= F(aK, aL).
 First degree homogeneity means that
aY= F(aK, aL).
 Con…

 If this is the case, we can set a equal to 1/L to

obtain the labour-intensive (or output per worker)
production function;
 Con…

 The third basic building block in growth model

construction is the saving-investment relationship.
 Since we are dealing with full-employment
growth paths, the static equilibrium equation of S
and I holds.
 From the point of view of the growth process, this
equilibrium condition gives us the link between
current social saving S+T- the amount of income
not spent on consumption and total investment,
which is just the rate of increase of the capital
stock.
 Con…

 If we view I+G as total social investment I, which

is the time rate of change of capital, dK/dt, then
we have

 as the equation relating saving S to capital

formation dK/dt.
 The simplest saving function is obtained by
assuming that a constant fraction s of output is
saved and invested.
 In this case the capital formation relationship
would be:
 Harrod-Domar Growth Model

What is the Harrod-Domar Model?

 The Harrod-Domar economic growth model
stresses the importance of savings and
investment as key determinants of growth
General Assumptions:
 The main assumptions of the Harrod-Domar
models are as follows:
1. A full-employment level of income already
exists.
2. There is no government interference in the
functioning of the economy
 Con…

3. The model is based on the assumption of “closed

economy.” In other words, government restrictions
on trade and the complications caused by
international trade are ruled out.
4. There are no lags in adjustment of variables i.e.,
the economic variables such as savings,
investment, income, expenditure adjust themselves
completely within the same period of time.
5. The average propensity to save (APS) and
marginal propensity to save (MPS) are equal to
each other. APS = MPS or written in symbols,
S/Y= ∆S/∆Y
 Con…

6. Both propensity to save and “capital coefficient” (i.e.,

capital-output ratio) are given constant. This amounts to
assuming that the law of constant returns operates in the
economy because of fixity of the capita-output ratio.
7. Income, investment, savings are all defined in the net
sense, i.e., they are considered over and above the
depreciation. Thus, depreciation rates are not included
in these variables.
8. Saving and investment are equal in ex-ante as well as in
ex-post sense i.e., there is accounting as well as
functional equality between saving and investment.
 These assumptions were meant to simplify the task of
growth analysis; these could be relaxed later.
 Con…

 The Harrod Domar Growth model is a

growth model and not a growth strategy!
 A model helps to explain how growth has occurred
and how it may occur again in the future.
 Growth strategies are the things a government might
introduce to replicate the outcome suggested by the
model.
 Basically, the model suggests that the economy's rate
of growth depends on:
 The level of national saving (S)
 The productivity of capital investment (this is
known as the capital-output ratio)
 Con…

Basic Harrod-Domar model says:

 Rate of growth of GDP = Savings ratio / capital
output ratio
1. Net saving (S) is some proportion, s, of national
income (Y), such that we have the simple
equation
S = sY
2. Net investment (I ) is defined as the change in
the capital stock, K, and can be represented by K
such that
I=K
 Con…

 Total capital stock, K, a direct relationship to

total national income or output, Y, as expressed by
the capital-output ratio, c,
it follows that
=c
Or
=c
finally,
K = cY
 Con…

3. Finally, because net national savings, S, must

equal net investment, I, we can write this
equality as
S=I
 from Equation know that S = sY, and from I = K
and we know that
I = K=cY
 therefore follows that we can write the “identity”
of saving equaling investment shown by Equation
S = sY=K=cY=I
 Con…

 or simply as
sY=cY
 Dividing both sides of above equation first by Y
and then by c, we obtain the following expression:

 Note that the left-hand side of above equation, Y/Y,

represents the rate of change or rate of growth of
GDP.
Therefore, g=
 Con…

Harrod’s growth model raised three issues:

1. How can steady growth be achieved for an
economy with a fixed (capital- output ratio)
(capital-coefficient) and a fixed saving-income
ratio?
2. How can the steady growth rate be maintained?
Or what are the conditions for maintaining
steady uninterrupted growth?
3. How do the natural factors put a ceiling on the
growth rate of the economy?
 Con…

In order to discuss these issues, Harrod had adopted three

different concepts of growth rates:
i. The actual growth rate, G,
ii. The warranted growth rate, Gw
iii. The natural growth rate, Gn.
1. The Actual Growth Rate is the growth rate determined
by the actual rate of savings and investment in the
country.
 In other words, it can be defined as the ratio of change
in income (AT) to the total income (Y) in the given
period.
 If actual growth rate is denoted by G, then
G = ∆Y/Y
 Con…

 The actual growth rate (G) is determined by saving-

income ratio and capital- output ratio.
 Both the factors have been taken as fixed in the
given period.
 The relationship between the actual growth rate and
its determinants was expressed as:
GC = s …(1)
 where G is the actual rate of growth, C represents
the capital-output ratio ∆K/∆Y and s refers to the
saving-income ratio ∆S/∆Y.
 This relation state that saving and investment are
equal in equilibrium.
 Con…

 This is clear from the following derivation.

Since
G = ∆Y/Y
C== when I=∆K
Because S=
 Substituting the value of G,C, and s in equation,
we get

Or or I=S
 Con…

 This relation explains that the condition for

achieving the steady state growth is that savings
must be equal to investment.
2. Warranted growth refers to that growth rate of
the economy when it is working at full capacity.
It is also known as Full-capacity growth rate.
 This growth rate denoted by G w is interpreted as
the rate of income growth required for full
utilization of a growing stock of capital, so that
entrepreneurs would be satisfied with the amount
of investment actually made.
 Con…

 Warranted growth rate (Gw) is determined by capital-

output ratio and saving- income ratio.
 The relationship between the warranted growth rate
and its determinants can be expressed as
Gw Cr = s
 where Cr shows the needed C to maintain the
warranted growth rate and s is the saving-income
ratio.
 Let us now discuss the issue: how to achieve steady
growth? According to Harrod, the economy can
achieve steady growth when
G = Gw and C = Cr
 Con…

 This condition states, firstly, that actual growth

rate must be equal to the warranted growth rate.
 Secondly, the capital-output ratio needed to
achieve G must be equal to the required capital-
output ratio in order to maintain G w, given the
saving co-efficient (s).
 This amounts to saying that actual investment
must be equal to the expected investment at the
given saving rate.
 Con…

Instability of Growth:
 We have stated above that the steady-state growth
of the economy requires an equality between G and
Gw on the one hand and C and Cr on the other.

 In a free-enterprise economy, these equilibrium

conditions would be satisfied only rarely, if at all.
 Therefore, Harrod analysed the situations when
these conditions are not satisfied.
 Con…
i. If G >Gw then C < Cr
ii. If G <Gw then C <>Cr
 We analyse the situation where G is greater than Gw.
 Under this situation, the growth rate of income being
greater than the growth rate of output, the demand
for output (because of the higher level of income)
would exceed the supply of output (because of the
lower level of output) and the economy would
experience inflation.
 This can be explained in another way too when C <
Cr Under this situation, the actual amount of capital
falls short of the required amount of capital.
 Con…

 This would lead to deficiency of capital, which

would, in turn, adversely affect the volume of
goods to be produced.
 Fall in the level of output would result in scarcity
of goods and hence inflation.
 This, under this situation the economy will find
itself in the quagmire of inflation.
 On the other hand, when G is less than G w, the
growth rate of income would be less than the
growth rate of output.
 Con…

 In this situation, there would be excessive goods

for sale, but the income would not be sufficient to
purchase those goods.
 In Keynesian terminology, there would be
deficiency of demand and consequently the
economy would face the problem of deflation.
 This situation can also be explained when C is
greater than Cr.
 Here the actual amount of capital would be larger
than the required amount of capital for
investment.
 Con…

 The larger amount of capital available for

investment would dampen the marginal efficiency
of capital in the long period.
 Secular decline in the marginal efficiency of
capital would lead to chronic depression and
unemployment. This is the state of secular
stagnation.
• From the above analysis, it can be concluded that
steady growth implies a balance between G and
Gw. In a free-enterprise economy, it is difficult to
strike a balance between G and G w as the two are
determined by altogether different sets of factors.
 Con…

 Since a slight deviation of G from G w leads the

economy away and further away from the steady-
state growth path, it is called ‘knife-edge’
equilibrium.
 Gn the Natural growth rate is determined by
natural conditions such as labour force, natural
resources, capital equipment, technical
knowledge etc.
 These factors place a limit beyond which
expansion of output is not feasible.
 This limit is called Full-Employment Ceiling.
 Con…

 This upper limit may change as the production

factors grow, or as technological progress takes
place.
 Thus, the natural growth rate is the maximum
growth rate which an economy can achieve with
its available natural resources. The third
fundamental relation in Harrod’s model showing
the determinants of natural growth rate is
• GnCr is either = or ≠s
 Con…

• Interaction of G, Gw and Gn:

 Con…

 Comparing the second and the third relations about the

warranted growth rate and the natural growth rate
which have been given above, we may conclude that
Gn may or may not be equal to Gw.
 In case G„ happens to be equal to Gw, the conditions of
steady growth with full employment would be satisfied.
 But such a possibility is remote because of the variety
of hindrances are likely to intervene and make the
balance among all these factors difficult.
 As such there is a definite possibility of inequality
between Gn and Gw.
 Con…

 If G„ exceeds Gw, G would also exceed Gw for most of

the time as is shown in Figure, and there would be a
tendency in the economy for cumulative boom and
full employment.
 Such a situation will create an inflationary trend.
 To check this trend, savings become desirable because
these would enable the economy to have a high level
of employment without inflationary pressures.
 If on the other hand Gw exceeds G„, G must be below
G„ for most of the time and there would be a tendency
for cumulative recession resulting in unemployment
Figure .
 The Neo-classical Growth model

The Solow-Swan Model of Economic Growth!

 The Solow-Swan model of economic growth
postulates a continuous production function
linking output to the inputs of capital and labor
which leads to the steady state equilibrium of the
economy.
It’s Assumptions:
It is based on the following assumptions:
1. One composite commodity is produced.
2. Output is regarded net output after making
allowance for the depreciation of capital.
 Con…

3. There are constant returns to scale.

4. There are diminishing returns to an individual
input.
5. The two factors of production, labor and capital,
are paid according to their marginal physical
productivities.
6. Prices and wages are flexible.
7. There is perpetual full employment of labor.
8. There is also full employment of the available
stock of capital.
 Con…

9. Labor and capital are substitutable for each

other.

10.There is no technical progress.

11.The saving ratio is constant.

12.Saving equals investment.

13.Capital depreciates at the constant rate, d.

14.Population grows at a constant rate, n.

 Con…

 The Solow-Swan model is built around two

equations, a production function and a capital
accumulation equation.
 The production function describes how inputs are
combined to produce output.
 To simplify the model, inputs categories into
two , capital, K, and labour, L, and denote output
as Y.
 The production function is assumed to have the
Cobb-Douglas form and is given by
Y = F(K, L) = KαL1-α,
 Con…

 Where Y is income or output, K is capital and L is

labor, α is some number between 0 and 1
 The condition of constant returns to scale implies
that if we divide by L, the production function can
be written as
Y/L = F (K/L, 1) = L.f(k)
 Where Y = Y/L is output or income per worker, k
= K/L is the capital-labor ratio, and the function
f(k) = F(k, 1).
 Thus the production function can be expressed as
• y= f (k) …(2)
 Con…

 In the Solow-Swan model, saving is a constant

fraction, s, of income.
 So saving per worker is sy.
 Since income equals output,
sy = sf(k) …(3)
 The investment required to maintain capital per
worker k, depends on population growth, and the
depreciation rate, d.
 Since it is assumed that population grows at a
constant rate n, the capital stock grows at the rate
n.k to provide capital to the growing population.
 Con…

 Since depreciation is a constant, d, per cent of the

capital stock, d.k is the investment needed to replace
worn-out capital.
 This depreciation investment per worker d.k is added
to nk, the investment per worker to maintain capital-
labor ratio for the growing population,
(nk + dk) = (n + d) k …(4)
 Which is the investment required to maintain capital
per worker.
 The net change in capital per worker (capita-labor
ratio) k over time is the excess of saving per worker
over the required investment to maintain capital per
worker,
 Con…

K= sf(k) — (n + d)k …(5)

 This is the fundamental equation for the Solow-Swan
model, where the steady state corresponds to k = 0.
 The economy reaches a steady state when
sf(k) = (n + d)k …(6)
 The Solow-Swan model is explained in Fig. 1.
 Con…

 Output per worker y is measured along the vertical

axis and capital per worker (capital-labor ratio), k,
is measured along the horizontal axis.
 The y =f(k) curve is the production function which
shows that output per worker increases at a
diminishing rate as k increases due to the law of
diminishing returns.
 The sf (k) curve represents saving per worker. The
(n + d) k is the investment requirement line from
the origin with a positive slope equal to (n+d).
 Con…

 The steady state level of capital, is determined

where the sf (k) curve intersects the (n+d)k line at
point E.
 The steady state income is y with output per
worker k P, as measured by point P on the
production function y = f (k).
 In order to understand why k is a steady state
situation, suppose the economy starts at the
capital- labor ratio k1.
 Here saving per worker k1B exceeds the
investment required to keep the capital-labor ratio
 Con…

 Thus, k and y increase until k is reached when the

economy is in the steady state at point E.
 Alternatively, if the capital-labor ratio is k 2, the saving
per worker, k2C, will be less than the investment
required to keep the capital-labor ratios constant, k 2D,
(k2C < k2D).
 Thus y will fall as k falls to k and the economy
reaches the steady state E.
 The Solow-Swan model shows that the growth process
is stable.
 No matter where the economy starts, forces exist that
will push the economy over time to a steady state.
 Con…

Growth with Saving:

 An important conclusion of the Solow-Swan
model is that the growth rate does not depend
upon the saving rate.
 In the steady state, both k and y being constant,
the growth rate is not affected by the saving rate.
 This is explained in Fig. 2 where K, is the steady
state capital per worker and y is output per worker
when the sf(k) curve intersects the (n+d)k, curve
at point E.
 Con…

 An increase in the saving rate from s to s1 shifts the

saving curve sf(k) upward to s1f(k). The new steady state
point is E1.
 Con…

 When the saving rate increases forms s to s 1 with no

change in the growth rate of labor force (n), the capital per
worker will continue to rise to k 1, which will raise output
per worker to y1 and so will the growth rate of output
increase.
 But this process continues at a diminishing rate in the
transition period.
 As a result, the initial growth rate of output is restored
over the long run at the new steady state equilibrium point
E1 where (n +d) k = s1f(k).
 After this point, there will be no further increase in output
per worker because the growth rate of labor force (n) does
not change and the long-run growth rate of output also
 Con…

 Figure 3 depicts the effect on the growth rate of

output when there is increase in the saving rate.
 The saving rate increases at time t 0.
 Initially, the growth rate of output rises from g to
g1.
 This is the transition period in which output per
worker is increasing from y to y 1 and capital per
worker from k to k1, as shown
 in Fig. 2 But at time t1 the initial equilibrium
growth rate is restored with the fall in the growth
rate of output from points to B.
 Con…

Implications of the Model:

There are some important implications or predictions
of the Solow-Swan model of growth:
1. The growth rate of output in steady state is exogenous
and is independent of the saving rate and technical
progress.
2. If the saving rate increases, it increases the output per
worker by increasing the capital per worker, but the
growth rate of output is not affected.
3. Another implication of the model is that growth in per
capita income can either be achieved by increased
saving or reduced rate of population growth. This will
hold if depreciation is allowed in the model.
 Con…

4. Another prediction of the model is that in the

absence of continuing improvements in technology,
growth per worker must ultimately cease. This
prediction follows from the assumption of
diminishing returns to capital.
5. This model predicts conditional convergence. All
countries having similar characteristics like saving
rate, population growth rate, technology, etc. that
affect growth will converge to the same steady state
level. It means that poor countries having the same
saving rate and level of technology of the rich
countries will reach the same steady state growth
rates in the long run.
 Endogenous Growth Theory

 Endogenous growth theory holds that economic

growth is primarily the result of Endogenous
and not external forces.
 Endogenous growth theory holds that investment
in human capital, innovation, and knowledge are
significant contributors to economic growth.
 The theory also focuses on positive externalities
and spillover effects of a knowledge-based
economy which will lead to economic
development.
 Con…

 The endogenous growth theory primarily holds

that the long run growth rate of an economy
depends on policy measures.

 For example, subsidies for research and

development or education crease the growth rate
in some endogenous growth models by increasing
the incentive for innovation