3. Growth Models … 3.3.2.
Endogenous Growth Model
• Recall: The neoclassical (Solow) model, in the absence of external
“shocks” or technological change, which is not explained in the model, all
economies will converge to zero growth.
• A sustained increase in per capita income arises purely from
technological change, commonly referred to as the Solow residual, not
attributed to changes in labor or capital.
• Thus, the Solow model suggests that low capital-labour ratio in
developing countries allows investment injection to have higher labour
productivity.
• The Solow model prescribes a policy that creates an enabling
environment to attract additional investment; nonetheless, no significant
achievement was observed among countries.
• Because of this, capital rather tends to flow from poor to rich countries
seeking for higher returns.
• Why?
41
3. Growth Models … 3.3.2. Endogenous Growth Model
• Two major draw backs of the Solow Model:
– (a) It does not analyze the determinants of technological advance because
technology is assumed to be completely independent of the decisions of
economic agents (or the model).
– (b) It fails to explain large differences in residuals across countries with similar
technologies
• New Endogenous growth theory explains:
– (a) growth rate differentials across countries and
– (b) factors that determine the rate of growth of GDP that is left
unexplained/exogenously determined in the Solow model (A or also called the
Solow residual).
• Endogenous growth model assumes increasing returns to scale.
• It explains the role of externalities.
• Public and private investments in human capital generate external
economies and productivity improvements that offset the natural
tendency for diminishing returns.
• According to the model, exacerbated wealth disparities between
developed and developing countries arises because high rates of return
on investment offered by developing economies with low capital-labor
ratios are eroded by lower levels of complementary investments in
human capital (education), infrastructure, or (R&D). 42
3. Growth Models … 3.3.2. Endogenous Growth Model
• Thus, an active role for public policy in promoting economic development
through direct and indirect investments in human capital formation and the
encouragement of FDI in knowledge-intensive industries.
A Simplified Version of the Romer Endogenous Model
• The model addresses technological spillovers (in which one firm or
industry’s productivity gains lead to productivity gains in other firms or
industries) during the process of industrialization.
• Each industry individually produces with constant returns to scale, so the
model is consistent with perfect competition; and matches assumptions of
the Solow model.
• Economy-wide capital stock, K, positively affects output at the industry
level so that there may be increasing returns to scale at the economy-wide
level.
• Each firm’s capital stock includes knowledge and knowledge is a public
good, spilling over instantly to the other firms in the economy.
43
3. Growth Models … 3.3.2. Endogenous Growth Model
• Assuming production function of each firm is given by:
𝑌𝑖 = 𝐴𝐾𝑖𝛼 𝐿1−𝛼
𝑖
ഥ𝛽 … (1)
𝐾
• Assuming symmetry among firms, industry level production function
becomes:
𝑌 = 𝐴𝐾 𝛼+𝛽 𝐿1−𝛼 … (2)
• Assume, no technical progress (A is constant) for the time being, using
chain rule we have:
𝑑𝑌 𝜕𝑌 𝜕𝐾 𝜕𝑌 𝜕𝐿
= +
𝑑𝑡 𝜕𝐾 𝑑𝑡 𝜕𝐿 𝜕𝑡
𝛿𝐾 𝛿𝐿
= [𝐴(𝛼 + 𝛽)𝐾 𝛼+𝛽−1 𝐿1−𝛼 ] +[𝐴 1 − 𝛼 𝐾 𝛼+𝛽 𝐿1−𝛼−1 ]
𝛿𝑡 𝛿𝑡
𝐾ሶ 𝐿ሶ
=[𝐴𝐾 𝛼+𝛽 𝐿1−𝛼 ][ α+𝛽 . + 1−𝛼 . ] or
𝐾 𝐿
ሶ 𝐾ሶ 𝐿ሶ
𝑌 = 𝑌[ 𝛼 + 𝛽 +(1-𝛼) ]….(3)
𝐾 𝐿
𝑌ሶ 𝐾ሶ 𝐿ሶ
Assuming steady state: , and are constant as in the Solow model, and
𝑌 𝐾 𝐿
𝐾ሶ 𝑠𝑌 𝑌ሶ
ሶ I − δ𝐾 = sY − δ𝐾, then
𝐾= = − 𝛿= = 𝑔 …(4)
𝐾 𝐾 𝑌 44
3. Growth Models … 3.3.2. Endogenous Growth Model
Using (3&4):
𝑌ሶ 𝐾ሶ 𝐿ሶ
+=(𝛼+ (1 −𝛽) 𝛼) =
𝑌 𝐾 𝐿
𝑔 = 𝛼+𝛽 𝑔+ 1−α 𝑛
𝑛 1−𝛼
𝑔(1 − 𝛼 + 𝛽) = 1 − 𝛼 𝑛 or 𝑔 = = sc − 𝛿 where 𝑐 = 𝑌/𝐾
(1−𝛼−𝛽)
𝑛 1−𝛼 −𝑛(1−𝛼−𝛽) 𝛽𝑛
Growth rate of per capita income: 𝑔 − 𝑛 = = = [𝑠𝑐 − δ]-n
(1−𝛼−𝛽) (1−𝛼−𝛽)
If “A” is not constant:
𝑑𝑌 𝜕𝑌 𝜕𝐴 𝜕𝑌 𝜕𝐾 𝜕𝑌 𝜕𝐿
= + +
𝑑𝑡 𝜕𝐴 𝑑𝑡 𝜕𝐿 𝜕𝐾 𝜕𝐿 𝑑𝑡
𝜕𝐴 𝛿𝐾 𝛿𝐿
=𝐾 𝛼+𝛽 𝐿1−𝛼 + [𝐴(𝛼 + 𝛽)𝐾 𝛼+𝛽−1 𝐿1−𝛼 ] +[𝐴 1 − 𝛼 𝐾 𝛼+𝛽 𝐿1−𝛼−1 ]
𝜕𝑡 𝛿𝑡 𝛿𝑡
𝐴ሶ 𝐾ሶ 𝐿ሶ
= [𝐴𝐾 𝛼+𝛽 𝐿1−𝛼 ] + [𝐴(𝛼 + 𝛽)𝐾 𝛼+𝛽 𝐿1−𝛼 ] + 𝐴 1 − 𝛼 𝐾 𝛼+𝛽 𝐿1−𝛼
𝐴 𝐾 𝐿
𝑑𝑌
= 𝑌[𝜔 + 𝜂(𝛼 + 𝛽) + 𝑛(1 − 𝛼)]
𝑑𝑡
𝑌ሶ
= g = 𝜔 + 𝜂(𝛼 + 𝛽) + 𝑛(1 − 𝛼)
𝑌
Growth rate of per capita:
𝑔 − 𝑛 = 𝜔 + 𝜂 𝛼 + 𝛽 + 𝑛(1- 𝛼 )-n= 𝝎 + 𝜼 𝜶 + 𝜷 − 𝜶n
𝑌ሶ 𝐾ሶ 𝐿ሶ 𝐴ሖ 45
Where g= ; η = = = n; = 𝜔
𝑌 𝐾 𝐿 𝐴
3. Growth Models … 3.3.2. Endogenous Growth Model
• Savings and human capital are important for achieving
rapid growth. Two outcomes of the model:
• (a) No long-run equilibration of growth rates across closed
economies. Growth rates differ across countries,
depending on savings rates and technology levels.
• (b) No tendency for per capita income levels in capital-
poor countries to catch up with those in rich countries
even if they have similar savings and population growth
rates.
• Thus, a temporary or prolonged recession in one country
can lead to a permanent increase in the income gap
between itself and wealthier countries.
46
