Chapter 4
Growth and Policy
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-1
Objectives
• Use Endogenous Growth theory to explain the
influence of society’s choices on patterns of
economic growth
• Examine the process by which some countries
move from underdeveloped to developed
economies
• Consider the problems of population growth
• Analyse the lessons of countries that have
experienced rapid economic growth
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-2
Chapter Organisation
4.1
Endogenous Growth Theory
4.2
Growth Policy
4.3
Lessons from Asia and Africa
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-3
4.1 Endogenous Growth Theory
• GDP and GDP growth are determined by
the rates of:
– Savings
– Population growth
– Technical progress.
• How do society’s choices affect these parameters?
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-4
Endogenous Growth
• Neoclassical growth theory:
– Attributes long-run growth to technical progress
– Does not explain the economic determinants of
technical progress
– also suggests that economic policy cannot affect
long-run rates of growth.
• Dissatisfaction with the neoclassical growth
model led to other growth theories being
formulated.
• Consider Endogenous Growth theory.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-5
The Mechanics of Endogenous Growth
• The development of other growth models either:
– Explicitly include technological change in the model, or
– Exhibit non-diminishing returns to capital.
• These models explain continuous growth without
the need to assume an exogenous change in
technological development.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-6
The Mechanics of Endogenous Growth
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-7
The Mechanics of Endogenous Growth
• Consider the basic Solow growth model in
Figure 4.1(a).
• The model predicts that:
–
–
–
–
–
Savings grow at a diminishing rate (sy)
Investment grows at the constant rate, ((n + d)k)
The economy will reach the steady state (C)
Where savings equals investment
Savings greater than investment implies growth.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-8
The Mechanics of Endogenous Growth
• Because of diminishing marginal product of capital:
– Production (y = f(k)) and savings (sy) must eventually
flatten out.
– Investment grows constantly.
– Until savings is equal to investment in steady-state
equilibrium.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-9
The Mechanics of Endogenous Growth
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-10
The Mechanics of Endogenous Growth
• In Figure 4.1(b) the shape of the production
function is altered to assume constant
marginal product of capital.
• For constant marginal product of capital:
– savings are always equal to investment
– savings therefore cause economic growth.
• The growth rate of output is therefore:
– dependent upon the savings rate
– the constant marginal product of capital.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-11
The Mechanics of Endogenous Growth
• The production function is now expressed as:
Y = aK
(4.1)
• Assuming that the rate of savings is constant and
there is no population growth or depreciation of
capital:
K = sY = saK or
K/K = sa
(4.2)
• Following from this:
Y/Y= sa
(4.3)
• This implies that the higher the savings rate, the higher
the rate of growth in output.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-12
Deeper Economics of Endogenous Growth
• Constant returns to capital implies that doubling
capital doubles output.
• Hence, the doubling of all factors of production:
– Will more than double output, or
– There will be increasing returns to scales if all factors
of production are included.
• This suggests larger firms are more efficient.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-13
Deeper Economics of Endogenous Growth
• An implication of the assumption of constant
returns to scale for capital is that it will encourage
industry concentration.
• Monopolisation has not occurred across the
economy because:
– Private returns differ from social returns.
– The firm is not able to ‘capture’ all the benefits of
its capital stock.
– There are positive externalities to increases in
capital stock.
– A firm’s increasing capital causes other firms’
productivity to increase.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-14
Convergence
• Classical growth theory predicts conditional
convergence, that is:
– Countries which invest more grow faster.
– This faster growth is transitory.
– Higher savings and investment will end with higher
per capita income in steady state.
– The growth rate will not be higher.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-15
Convergence
• In contrast, Endogenous Growth theory
suggests that:
– A high savings rate leads to a higher growth rate.
– Countries do not converge conditionally.
– We are more likely to observe countries diverging.
•
Empirical evidence tends to support the
argument that conditional convergence occurs.
•
This suggests that endogenous growth theory
might not be important in explaining the
differences in growth rates between countries.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-16
Chapter Organisation
• 4.1 Endogenous Growth Theory
• 4.2 Growth Policy
• 4.3 Lessons from Asia and Africa
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-17
Growth Policy
• Neither the neoclassical growth model or the
Endogenous Growth model explain why some
countries experience no growth and others very
high growth.
• One method of doing this is to combine the two
models to form a two-sector model.
• Figure 4.2 illustrates the two-sector model.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-18
Growth Policy
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-19
Growth Policy
• In Figure 4.2 the neoclassical steady-state
model can be seen at point A.
• At low income and capital point A represents
a no-growth steady state.
• The economy at this point is caught in a
growth trap.
• At high income and capital beyond point B the
savings line is above the capital requirement
line, leading to continuing increases in the rate
of growth.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-20
Population Growth and Growth Traps
• Growth theories suggest that living standards
decrease when population growth increases.
• The Solow growth model predicts that:
– High population growth reduces the steady-state income.
– Each worker will have less capital to work with.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-21
Population Growth and Growth Traps
• The Solow model predicts that high population
growth leads to a lower steady-state income.
• Adapting the Solow model to indicate endogenous
population growth points to the existence of
a poverty trap.
• The slope of the investment requirement line
changes as population growth is not longer
assumed to be constant.
• Figure 4.3 illustrates this adjustment and
the poverty trap.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-22
Population Growth and Growth Traps
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-23
Population Growth and Growth Traps
• The investment requirement line with variable
population growth now:
– Rises slowly (due to the moderate population growth
when income is very low)
– Then increases sharply (due to the increase in population
growth when income rises)
– Before eventually flattening out (as population growth
drops again due to high incomes)
– Point A on the diagram represents the poverty trap. At this
point, population growth is high and income low.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-24
Natural Resources: Limits to Growth?
• Will exponential growth in the economy eventually
lead to the complete depletion of the fixed stock
of resources?
• No. Why?
• The economy is protected from resource
depletion disasters by two factors:
– Technical progress permits us to produce more
using fewer resources.
– As resource supply lessens, prices rise, leading
producers to shift towards substitutes.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-25
Social Infrastructure
• Why do some countries have more capital
than others?
• Why do some countries save and invest more
than others?
• The answers to these questions lie partly in
the provision of social infrastructure.
• Social infrastructure is the institutions and
policies that encourage and protect the
individual and provide the framework in
which economic decisions are made.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-26
Chapter Organisation
4.1
Endogenous Growth Theory
4.2
Growth Policy
4.3
Lessons from Asia and Africa
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-27
4.3 Lessons from the Asian Tigers
• Hong Kong, Singapore, South Korea and
Taiwan have grown rapidly for two decades.
• What were the reasons for this?
• Studies indicate that high growth rates
were explained by increased input not
higher productivity.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-28
Lessons from the Asian Tigers
•
Characteristics of the growth experience in
these countries have been:
– Increased human capital
– Encouraged labour force participation, and
– Concentrated on education.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-29
Lessons from Africa
• In contrast to the Asian Tigers, sub Saharan Africa
has experienced ‘growth disasters’. Why?
• Low savings rates and high population growth partly
explain why sub Saharan countries have failed to grow.
• ‘Destiny factors’ determined by geographic and climatic
conditions have also contributed to low growth rates.
• Socio-political factors such as unstable political
conditions and lack of social infrastructure are also
important considerations.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-30
Lessons from Africa
• Models of savings and population growth can
partly explain why sub Saharan African countries
have failed to grow.
• The experiences of these countries point to the
need to consider the policy environments which
are conducive to economic growth.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 2e by Dornbusch, Bodman, Crosby, Fischer, Startz
Slides prepared by Dr Monica Keneley.
4-31