Question

Critically access the theoretical propositions of the Solow neo-classical model of growth. How does endogenous growth model help to address some of the weaknesses of the Solow model? Illustrate the implications of technical advances and saving rates increase on growth according to both of these approaches.50 marks

Answer 1

NEOCLASSICAL GROWTH THEORY

The theory explains that the different amounts of labor and capital are used in the production in the short run. It also explains that the economy cannot grow without technological change. There are three factors associated with this theory, namely,

• labor
• capital
• technology

The endogenous growth model explains that factors determining economic growth are endogenously determined.

According to the Solow model, long-run economic growth is sustained by exogenously determined technological progress. In addition, it is based on diminishing returns to capital. Therefore, it argued that growth will stop after attaining a steady state. In this model, savings lead to growth but only temporary and diminishing returns to capital eventually force the economy to approach steady-state. This is the weakness of the Solow model.

Endogeneous growth model assumes that the production function is

Y = AK

where, A is the constant, measuring the amount of output produced for each unit of capital.

We must note that this production function does not represent diminishing returns to capital. It is an important difference between the Solow model and the endogenous growth model.

However, both models argue that capital accumulation will cause economic growth, and change in capital accumulation is the difference between investment and depreciation.

Y = AK

K = investment - depreciation

= sY - K

=sAK - K

K = K(sA - )

K/K = (sA - ) ------ steady state condition

So long as sA>, there will be continuous growth of output without the assumption of exogeneously determined technological progress. This is because capital is interpreted broadly to include physical as well as human capital. Although it is natural to assume diminishing returns to physical capital but human capital in the form of knowledge has shown increasing return. Therefore, returns to capital may remain constant.

There are 2 key decisions variables in this model:

1. The value of 's' = saving rate (this was the case in solow model)

2. The value of 'u' which determines the growth in the state of knowledge.

Both s and u affect the level of income , although only u affects the steady state growth rate of income. Basically, growth in output is equal to growth in technological progress plus contibution of capital to output plus contribution of labor to output.