LONG-RUN ECONOMIC

GROWTH
 TOPICS
 Sources of Economic Growth – Solow Model
Growth
 Drivers of Growth – Technology, policy,
institutions, and Romer Model
 SESSION PLAN
 What is the Solow Model of Economic Growth?
 Assumptions of the Model
 Building Blocks of the Model
 Parameters of the Model
 SOLOW MODEL OF
ECONOMIC GROWTH
Central Questions of the Model
1. How do countries grow over time?
2. Why are some countries richer than
others?
 ASSUMPTIONS OF THE
MODEL
 Closed Economy
 Absence of government intervention
 Diminishing marginal returns to factors of production (labor and capital)
 Constant returns to scale
 Fixed savings rate
 Steady growth of the labor force
 Constant rate of technological progress
 Constant rate of capital depreciation
 BUILDING BLOCKS OF THE MODEL

 Core components or foundational elements of the model

 Describe how the economy functions in this model
 Determines the outcomes of the model
The building blocks are as follows:-
 Production Function
 Investment Function
 Capital accumulation
 Steady-state equilibrium
 KEY PARAMETERS OF THE MODEL
 Values that influence the relationship between the key components
 Determine how the components will interact with each other
 Determines how fast or slow the outcomes occur
The following are the key components
 Savings rate
 Depreciation rate
 PRODUCTION FUNCTION
Cobb-Douglas Constant Returns to Scale Production Function

Yt=F(Kt, Lt)=A⋅Ktα⋅Ltβ
Yt- Output at time t
Kt- Capital stock at time t
Lt- Labor stock at time t
A – Technology (measured by total factor productivity)– How effectively the factors of production
(labor and capital) are utilized
α - output elasticity of capital (how much output changes in response to one unit change in capital)
β -output elasticity of labor (how much output changes in response to one unit change in labor)
Constant returns to scale: α+ β=1
This condition ensures that if all inputs (capital and labor) are increased by the same proportion, the
output increases by exactly the same proportion.
Solow model represents the economy is per worker terms
1. Output per worker
yt= Yt/Lt
2. Capital per worker (Capital Labor ratio) (plays a prominent role in the Solow
Model)
kt= Kt/Lt
Representing the production function in per-worker terms :
(Dividing by Lt on both sides)

Yt=A⋅Ktα⋅Ltβ

yt=
=Aktα
Output per worker depends on the productivity of capital per worker
/capital/workeroutput porkers
 INVESTMENT FUNCTION
 How much of the income is re-invested in the economy to create additional capital

Investment Function Basics

Assumptions
1. Closed economy
2. No government intervention
3. Consumers save a fixed portion of their income (s)
 CAPITAL ACCUMULATION
 Two forces determine the change in capital accumulation – investment and
depreciation
 Depreciation – loss of capita due to wear and tear
 Solow model assumes that a constant fraction of capital (δ)– depreciation rate
wears out each year
 As depreciation is a constant value– depreciation per worker equals δkt
 Depreciation is a 45-degree line
STEADY STATE EQUILIBRIUM
 The amount of capital per worker comes to rest and stops changing
 This is the state where the new capital added is just enough to cover
the depreciation .
 The economy will not experience any growth in this state by
increasing the capital per worker
 Convergence – Economies below this will reach this point, and those
above will slide back to the steady state
 TAKEAWAY OF THE SOLOW
MODEL
Capital (machines, factories) boosts growth, but there’s a limit to how much it can achieve
alone.
•Labour (workers) also drives growth, but it has limits without sufficient capital to support
productivity.
•Technology is the key to long-term growth, as better technology increases productivity and
enables sustained economic expansion.
•Countries investing in technology and innovation are likely to experience continuous growth,
while those that don’t invest will eventually see growth slow down
 ROMER MODEL OF
ECONOMIC GROWTH
 This is a type of endogenous growth model.

What are endogenous growth models?

1. State that economic growth is driven by factors within the economy rather than from
external sources
Romer Model of Economic Growth
 Sustained economic growth is driven by technological progress.
 Companies and individuals invest in R&D to develop new ideas and innovation which
drives technological progress
 Technological progress is endogenous to the economic system (occurs from within the
economic system).
 CORE CONCEPTS OF THE ROMER MODEL
1. Ideas are non-rival resources:
 Unlike physical resources, ideas can be used by many people simultaneously without being depleted
 Non-rival nature of ideas contributes to economic growth
 Example: A new method of production can be used by many people simultaneously.

2. Increasing returns to scale:

 Ideas do not dimmish with use.
 As more ideas are created and used across the economy, productivity can grow at an increasing rate,
thereby contributing to sustained economic growth.
3. Endogenous Technological Progress:
 Technological progress is generated within the economy by investing in research and development
(R&D) and human capital.
 This contrasts with the Solow Model, which assumes that technological progress is exogenous (external
to the economic system).
4. Growth rate of technology (gA)
Depends on the following:-
 Productivity of research and development (µ)
 Fraction of population devoted to R & D (α)
 Total population of the country (N)

gA= µαN
 STEADY STATE OF THE ROMER MODEL

 There is no steady state in the Romer Model (unlike the Solow Model).
 Instead of economic growth remaining constant after a certain point, the
Romer model suggests that economic growth can continue perpetually due
to the continuous generation of new ideas which drives technological
advancements.
 HOW DOES THE ROMER MODEL WORK

 No Convergence to Zero Growth:

1. The growth does not converge to zero.
2. The growth rate remains positive and can even increase over time, depending on the
level of investment in R&D.
 Balanced Growth Path:
1. Instead of a steady state, the Romer Model describes a balanced growth path where the
economy grows at a constant rate due to continuous technological progress.
 BALANCED GROWTH PATH
•Continuous Growth through Ideas: The balanced growth path occurs when the economy
maintains a stable, positive growth rate driven by continuous technological progress.

•Increasing Returns to Knowledge and ideas: Unlike physical capital, ideas and knowledge
do not face diminishing returns. The accumulation of ideas leads to increasing returns,
enabling productivity improvements across the economy

•Positive Growth in Output Per Capita: The balanced growth path results in positive,
consistent growth in output per capita, as technological advancements improve productivity
per worker over time
 FACTORS THAT AFFECT ENDOGENOUS GROWTH
Three factors can change the economic growth rate:
 Productivity of research and development (µ)
 Fraction of population devoted to R & D (α)
 Total population of the country (N)

These factors will cause and upward shift of the Balanced growth path.
 KEY TAKEAWAYS OF THE
ROMER MODEL
 The Romer Model shows that while capital and labor are important, ideas and technological
innovation are essential for long-term economic growth.
 The Romer Model highlights that economic growth can be driven from within the economy
through investments in ideas and innovation that drive technological progress.
 SOLOW MODEL VS ROMER MODEL
Aspect Solow Model Romer Model
Source of Economic Growth Capital accumulation, labour force Endogenous technological progress
growth and exogenous driven by ideas and innovation
technological progress
Exogenous (technology grows Endogenous (technology evolves
Role of Technology independently of the economy) within the economy)

Steady State Reaches a steady state where per No traditional steady state;
capita growth stops unless driven continuous growth along a
by external technology. balanced growth path
Returns to Capital Diminishing returns to capital Increasing returns to ideas and
knowledge
Role of Ideas Ideas are not explicitly considered Ideas and knowledge are central,
in the model driving sustained growth

Policy Implications Limited policy role, mainly around Strong policy role in promoting
savings and investment rates R&D, and technological
advancements