Michael Parkin, Economics, 7th edition 2005 Chapter 9/25

Growth Theories

A.    Classical Growth Theory

1.     Classical economists lived in a time and place where population growth was rapid (it has been faster since) and income per person had started to rise.

2.     Classical growth theory is the view that real GDP growth is temporary and that when real GDP per person rises above the subsistence level, a population explosion eventually brings real GDP per person back to the subsistence level.

3.     The classical model unfolds as:

a)    Advances in technology increase labor productivity and the demand for labor increases.

b)    The increase in the demand for labor raises the real wage rate.

c)     The rise in the real wage rate boosts the population growth rate, which then increases the supply of labor.

d)    The increase in the supply of labor lowers the real wage rate.

e)     The supply of labor continues to increase until the real wage rate has been driven back to the subsistence real wage rate, which is the minimum real wage rate necessary to maintain life. At this real wage rate, both population growth and economic growth stop. Figure 9.7 illustrates this process using a productivity curve.

4.     Contrary to the assumption of the classical theory, the historical evidence shows that population growth rate is not a simple function of income, and population does not always grow sufficiently to drive average incomes back down to subsistence levels.

B.    Neoclassical Growth Theory

1.     Neoclassical growth theory was developed in the 1950s, when technology was advancing and economic growth occurring.

2.     Neoclassical growth theory is the proposition that that real GDP per person grows because technological change induces a level of saving and investment that makes capital per hour grow.

3.     The precursor to neoclassical growth theory was better understanding of the economic influences on birth and death rates.

a)    A key determinant of birth rates is the opportunity cost of women’s time; higher incomes and modern living conditions raise the cost of having children.

b)    Higher incomes also greatly lower infant and child mortality.

c)     These two forces tend to offset each other, and neoclassical growth theory assumes that the population growth rate is independent of the economic growth rate.

4.     The neoclassical model unfolds as:

a)    Technological change occurs as the result of chance or luck.

b)    An increase in technology raises the profit from investment, so investment increases. The increase in investment demand raises the real interest rate and also increases the equilibrium quantity of investment.

c)     The increase in investment increases the capital stock. The faster the capital stock grows, the more rapid is economic growth per person.

d)    As long as the real interest rate exceeds people’s target interest rate, saving is sufficient to increase capital per hour of labor.

e)     As the capital stock increases, the real interest rate falls.

f)     Growth continues as long as technological change keeps the real interest rate above the target rate of return.

g)     Eventually technological change stops and the capital stock increases sufficiently to drive the interest rate back to its target level. At this point, economic growth stops and only enough investment is made to replace depreciated capital. Figure 9.8 illustrates the neoclassical growth model using a productivity curve.

5.     A drawback to the neoclassical growth theory is that it predicts that all countries converge to the same level of GDP per person.

C.    New Growth Theory

1.     The new growth theory holds that real GDP per person grows because of the choices that people make in the pursuit of profit and that growth can persist indefinitely.

2.     Two facts about market economies are important:

a)    Discoveries result from people’s choices.

b)    Discoveries give the discoverer the opportunity to temporarily earn large economic profits, but competition destroys those profits.

3.     Two further facts play a key role:

a)    Discoveries of new technology can be used by many people at the same time, that is they are a public capital good.

b)    Knowledge itself is not subject to diminishing returns, and physical activities (firms) can be replicated throughout the economy.

4.     The fact that physical activities can be replicated is crucial. It means that for the economy as a whole, the return from capital does not diminish as more capital is acquired, so long as knowledge and human capital continue to advance and add to productivity. So once the real interest exceeds the target rate of return, there is no force to drive it back down to the target rate of return.

5.     As long as the return from capital exceeds the target rate of return, more capital is acquired and economic growth persists. Capital constantly increases and economic growth is perpetual.

6.     Figure 9.9 illustrates the new growth theory in terms of the productivity curve. Figure 9.10 shows the implied perpetual motion as a circular flow chart.

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