Theory of Economic Growth

The videos on Study. Students in online learning conditions performed better than those receiving face-to-face instruction. Explore over 4, video courses. Find a degree that fits your goals. What is Economic Growth? This lesson will go through the various theories of economic growth which all try to explain how a country continues to increase production.

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Ability-to-Pay Principle of Taxation: Price Stability in Monetary Policy: How to Raise a Nation's Potential Output. What is an Investment? Rational Expectations in the Economy and Unemployment. LM Curve in Macroeconomics: Five Stages of Economic Development. Growth Policy and Economic Productivity. What is Monetary Policy? What is Sustainable Economic Growth? Intro to Public Relations. How do we measure and explain economic growth? Definition Economic growth is the increase in the goods and services produced by an economy, typically a nation, over a long period of time. Classical Theory The classical theory of economic growth was a combination of economic work done by Adam Smith, David Ricardo, and Robert Malthus in the eighteenth and nineteenth centuries.

Try it risk-free No obligation, cancel anytime. Want to learn more? Select a subject to preview related courses: New Growth Theory While the Neo-Classical model concluded that if all nations had access to the same technology, the standard of living between the nations would be the same. Lesson Summary Economic growth is the increase in the goods and services produced by an economy, typically a nation, over a long period of time.

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To learn more, visit our Earning Credit Page Transferring credit to the school of your choice Not sure what college you want to attend yet? Browse Articles By Category Browse an area of study or degree level. You are viewing lesson Lesson 6 in chapter 8 of the course:. Homework Help Resource 15 chapters lessons. They favored a model that replaced the exogenous growth variable unexplained technical progress with a model in which the key determinants of growth were explicit in the model.

The AK model , which is the simplest endogenous model, gives a constant-savings rate of endogenous growth and assumes a constant, exogenous, saving rate. It models technological progress with a single parameter usually A. It uses the assumption that the production function does not exhibit diminishing returns to scale to lead to endogenous growth. Various rationales for this assumption have been given, such as positive spillovers from capital investment to the economy as a whole or improvements in technology leading to further improvements learning by doing. However, the endogenous growth theory is further supported with models in which agents optimally determined the consumption and saving, optimizing the resources allocation to research and development leading to technological progress.

The AK model production function is a special case of a Cobb—Douglas production function:. This equation shows a Cobb—Douglas function where Y represents the total production in an economy. In neo-classical growth models, the long-run rate of growth is exogenously determined by either the savings rate the Harrod—Domar model or the rate of technical progress Solow model.

However, the savings rate and rate of technological progress remain unexplained. Endogenous growth theory tries to overcome this shortcoming by building macroeconomic models out of microeconomic foundations. Households are assumed to maximize utility subject to budget constraints while firms maximize profits. Crucial importance is usually given to the production of new technologies and human capital. The engine for growth can be as simple as a constant return to scale production function the AK model or more complicated set ups with spillover effects spillovers are positive externalities, benefits that are attributed to costs from other firms , increasing numbers of goods, increasing qualities, etc.

Often endogenous growth theory assumes constant marginal product of capital at the aggregate level, or at least that the limit of the marginal product of capital does not tend towards zero. This does not imply that larger firms will be more productive than small ones, because at the firm level the marginal product of capital is still diminishing. Therefore, it is possible to construct endogenous growth models with perfect competition. Another major cause of economic growth is the introduction of new products and services and the improvement of existing products.

New products create demand, which is necessary to offset the decline in employment that occurs through labor-saving technology and to a lesser extent employment declines due to savings in energy and materials. Also, the creation of new services has been more important than invention of new goods. Economic growth in the U. The transition from an agricultural economy to manufacturing increased the size of the sector with high output per hour the high-productivity manufacturing sector , while reducing the size of the sector with lower output per hour the lower productivity agricultural sector.

Eventually high productivity growth in manufacturing reduced the sector size, as prices fell and employment shrank relative to other sectors. In classical Ricardian economics, the theory of production and the theory of growth are based on the theory or law of variable proportions, whereby increasing either of the factors of production labor or capital , while holding the other constant and assuming no technological change, will increase output, but at a diminishing rate that eventually will approach zero.

Malthus's examples included the number of seeds harvested relative to the number of seeds planted capital on a plot of land and the size of the harvest from a plot of land versus the number of workers employed. Criticisms of classical growth theory are that technology, an important factor in economic growth, is held constant and that economies of scale are ignored. The Malthusian theory proposes that over most of human history technological progress caused larger population growth but had no impact on income per capita in the long run.

According to the theory, while technologically advanced economies over this epoch were characterized by higher population density, their level of income per capita was not different than those among technologically regressed society. The conceptual foundations of the Malthusian theory were formed by Thomas Malthus, [67] and a modern representation of these approach is provided by Ashraf and Galor. Robert Solow and Trevor Swan developed what eventually became the main model used in growth economics in the s.

Capital accumulates through investment, but its level or stock continually decreases due to depreciation. This condition is called the 'steady state'. As a consequence, growth in the model can occur either by increasing the share of GDP invested or through technological progress. As a consequence, with world technology available to all and progressing at a constant rate, all countries have the same steady state rate of growth.

Implicitly in this model rich countries are those that have invested a high share of GDP for a long time. Poor countries can become rich by increasing the share of GDP they invest. One important prediction of the model, mostly borne out by the data, is that of conditional convergence ; the idea that poor countries will grow faster and catch up with rich countries as long as they have similar investment and saving rates and access to the same technology.

The Solow—Swan model is considered an "exogenous" growth model because it does not explain why countries invest different shares of GDP in capital nor why technology improves over time. Instead the rate of investment and the rate of technological progress are exogenous. The value of the model is that it predicts the pattern of economic growth once these two rates are specified. Its failure to explain the determinants of these rates is one of its limitations. Although the rate of investment in the model is exogenous, under certain conditions the model implicitly predicts convergence in the rates of investment across countries.

In a global economy with a global financial capital market, financial capital flows to the countries with the highest return on investment. According to Harrod, the natural growth rate is the maximum rate of growth allowed by the increase of variables like population growth, technological improvement and growth in natural resources. In fact, the natural growth rate is the highest attainable growth rate which would bring about the fullest possible employment of the resources existing in the economy.

Unsatisfied with the assumption of exogenous technological progress in the Solow—Swan model, economists worked to " endogenize " i. Unlike physical capital , human capital has increasing rates of return. Research done in this area has focused on what increases human capital e.

Unified growth theory was developed by Oded Galor and his co-authors to address the inability of endogenous growth theory to explain key empirical regularities in the growth processes of individual economies and the world economy as a whole. The theory suggests that during most of human existence, technological progress was offset by population growth, and living standards were near subsistence across time and space. However, the reinforcing interaction between the rate of technological progress and the size and composition of the population has gradually increased the pace of technological progress, enhancing the importance of education in the ability of individuals to adapt to the changing technological environment.

The rise in the allocation of resources towards education triggered a fertility decline enabling economies to allocate a larger share of the fruits of technological progress to a steady increase in income per capita, rather than towards the growth of population, paving the way for the emergence of sustained economic growth. The theory further suggests that variations in biogeographical characteristics, as well as cultural and institutional characteristics, have generated a differential pace of transition from stagnation to growth across countries and consequently divergence in their income per capita over the past two centuries.

One popular theory in the s was the big push model , which suggested that countries needed to jump from one stage of development to another through a virtuous cycle , in which large investments in infrastructure and education coupled with private investments would move the economy to a more productive stage, breaking free from economic paradigms appropriate to a lower productivity stage.

Schumpeterian growth is an economic theory named after the 20th-century Austrian economist Joseph Schumpeter. In doing so, they make old technologies or products obsolete.

This can be seen as an annulment of previous technologies, which makes them obsolete, and "destroys the rents generated by previous innovations. Some theories developed in the s suggested possible avenues through which inequality may have a positive effect on economic development. In contrast to the Neoclassical paradigm and the representative agent approach that denied the role of inequality in the growth process, novel theories that emerged in the late s and empirical studies of these theories have established that income distribution has a significant impact on the process of development.

The modern perspective, originated by Galor and Zeira , , [85] has underscored the role of heterogeneity in the determination of macroeconomic activity, and has demonstrated that income distribution is an important determinants of the growth process and the evolution of income per capita.

Later analysis, such as the political economy approach, developed by Alesina and Rodrik and Persson and Tabellini , stressed the negative impacts of inequality on economic development; inequality generates a pressure to adopt redistributive policies that have an adverse effect on investment and economic growth. A study by Perotti showed that in accordance with the credit market imperfection approach, inequality is associated with lower level of human capital formation education, experience, apprenticeship and higher level of fertility, while lower level of human capital is associated with lower growth and lower levels of economic growth.

In contrast, his examination of the political economy channel found no support for the political economy mechanism.

A review stated that high inequality lowers growth, perhaps because it increases social and political instability; however, changes in the degree of inequality have a relatively minor effect on growth. Research by Robert Barro , found that there is "little overall relation between income inequality and rates of growth and investment". According to Barro, high levels of inequality reduce growth in relatively poor countries but encourage growth in richer countries.

According to Andrew Berg and Jonathan Ostry of the International Monetary Fund , inequality in wealth and income is negatively correlated with subsequent economic growth. In , French economist Thomas Piketty postulated that in periods when the average annual rate on return on investment in capital r exceeds the average annual growth in economic output g , the rate of inequality will increase. An advocate of reducing inequality levels, Piketty suggests levying a global wealth tax in order to reduce the divergence in wealth caused by inequality.

According to Daron Acemoglu , Simon Johnson and James Robinson , the positive correlation between high income and cold climate is a by-product of history. Europeans adopted very different colonization policies in different colonies, with different associated institutions. In places where these colonizers faced high mortality rates e. In these 'neo-Europes' better institutions in turn produced better development outcomes.

Thus, although other economists focus on the identity or type of legal system of the colonizers to explain institutions, these authors look at the environmental conditions in the colonies to explain institutions. For instance, former colonies have inherited corrupt governments and geopolitical boundaries set by the colonizers that are not properly placed regarding the geographical locations of different ethnic groups, creating internal disputes and conflicts that hinder development. In another example, societies that emerged in colonies without solid native populations established better property rights and incentives for long-term investment than those where native populations were large.

Many theoretical and empirical analyses of economic growth attribute a major role to a country's level of human capital , defined as the skills of the population or the work force. Human capital has been included in both neoclassical and endogenous growth models. A country's level of human capital is difficult to measure, since it is created at home, at school, and on the job.

The most commonly-used measure of human capital is the level average years of school attainment in a country, building upon the data development of Robert Barro and Jong-Wha Lee. One problem with the schooling attainment measure is that the amount of human capital acquired in a year of schooling is not the same at all levels of schooling and is not the same in all countries.

This measure also presumes that human capital is only developed in formal schooling, contrary to the extensive evidence that families, neighborhoods, peers, and health also contribute to the development of human capital. Eric Hanushek and Dennis Kimko introduced measures of students' mathematics and science skills from international assessments into growth analysis.

He shows that economic growth is not correlated with average scores in more educated countries. They show that the level of students' cognitive skills can explain the slow growth in Latin America and the rapid growth in East Asia. Energy economic theories hold that rates of energy consumption and energy efficiency are linked causally to economic growth.

A fixed relationship between historical rates of global energy consumption and the historical accumulation of global economic wealth has been observed. These include the great improvements in efficiency of conversion of heat to work, the reuse of heat, the reduction in friction and the transmission of power, especially through electrification.

For example, the United Kingdom experienced a 1. It grew to 1,, million pounds by A growth rate that averaged 1. The large impact of a relatively small growth rate over a long period of time is due to the power of exponential growth. For example, a growth rate of 2. Thus, a small difference in economic growth rates between countries can result in very different standards of living for their populations if this small difference continues for many years.

One theory that relates economic growth with quality of life is the "Threshold Hypothesis", which states that economic growth up to a point brings with it an increase in quality of life. But at that point — called the threshold point — further economic growth can bring with it a deterioration in quality of life.

Economic growth has the indirect potential to alleviate poverty , as a result of a simultaneous increase in employment opportunities and increased labor productivity. In some instances, quality of life factors such as healthcare outcomes and educational attainment, as well as social and political liberties, do not improve as economic growth occurs.

Productivity increases do not always lead to increased wages, as can be seen in the United States , where the gap between productivity and wages has been rising since the s. Economists distinguish between short-run economic changes in production and long-run economic growth. Short-run variation in economic growth is termed the business cycle. Generally, economists attribute the ups and downs in the business cycle to fluctuations in aggregate demand.

In contrast, economic growth is concerned with the long-run trend in production due to structural causes such as technological growth and factor accumulation. While acknowledging the central role economic growth can potentially play in human development , poverty reduction and the achievement of the Millennium Development Goals , it is becoming widely understood amongst the development community that special efforts must be made to ensure poorer sections of society are able to participate in economic growth.

Critics such as the Club of Rome argue that a narrow view of economic growth, combined with globalization, is creating a scenario where we could see a systemic collapse of our planet's natural resources. Concerns about negative environmental effects of growth have prompted some people to advocate lower levels of growth, or the abandoning of growth altogether. In academia, concepts like uneconomic growth , steady-state economy and degrowth have been developed in order to achieve this. In politics, green parties embrace the Global Greens Charter , recognising that " Those more optimistic about the environmental impacts of growth believe that, though localized environmental effects may occur, large-scale ecological effects are minor.

The argument, as stated by commentator Julian Lincoln Simon , states that if these global-scale ecological effects exist, human ingenuity will find ways to adapt to them. Up to the present, there is a close correlation between economic growth and the rate of carbon dioxide emissions across nations, although there is also a considerable divergence in carbon intensity carbon emissions per GDP.

As a consequence, growth-oriented environmental economists propose government intervention into switching sources of energy production, favouring wind , solar , hydroelectric , and nuclear. This would largely confine use of fossil fuels to either domestic cooking needs such as for kerosene burners or where carbon capture and storage technology can be cost-effective and reliable. Because carbon capture and storage are as yet widely unproven, and its long term effectiveness such as in containing carbon dioxide 'leaks' unknown, and because of current costs of alternative fuels, these policy responses largely rest on faith of technological change.

British conservative politician and journalist Nigel Lawson has deemed carbon emission trading an 'inefficient system of rationing '. Instead, he favours carbon taxes to make full use of the efficiency of the market.