1 Growth and Development ECON 205W Summer 2006 Prof. Cunningham

2 What is growth? Economic growth is the increase of a nation’s real output (GDP). Results from: Greater quantities of natural resources, human resources, and capital, Improvements in the quality of resources, and Technological advances that boost productivity.

3 Development Economic development is the process by which a nation enhances its standard of living over time. The economic standard of living is often defined as GDP per capita.

4 Growth and Development Models Harrod and Doman—Keynesian Growth Solow—Neoclassical growth Schumpeter—economic development and institutional change Nurkse, Lewis, Schultz—theories of economic development

5 Sir Roy Harrod and Evsey Domar Sir Roy F. Harrod ( ), University of London Evsey Domar (1914- ), Johns Hopkins and MIT Harrod viewed himself as more of a specialist on the int’l monetary system. “An Essay in Dynamic Theory” (1939), Economic Journal.

6 Harrod’s Ideas Based on two hypotheses: Capital and labor have to combine in a fixed proportion dictated by current technology to produce product. The saving rate is fixed. The rate of growth of the capital stock (“the warranted rate of growth”) is defined as the ratio of two constants: Saving and investment per unit of desired output Stock of capital per unit of output dictated by technology. The rate of growth of labor is called the “natural rate of growth” Society is fully utilizing the capital and labor only if the “warranted” and the “natural” rates of growth happen to be equal. This is the “knife edge” problem. If investment is above the warranted rate, recession follows. If investment is below, inflation follows.

7 Domar’s Ideas “Essay’s in the Theory of Economic Growth” (1957). Assumes: Fixed saving rate. Change in AD is proportional to the change in investment. The productivity of investment is constant. Net investment adds to the capital stock, increasing potential GDP. Investment spending also adds to aggregate demand, but investment spending must increase from period to period if the potential income arising from increased capital is to be realized. “Balanced growth” is a rate of income growth which maintains full employment of all resources. To achieve balanced growth, investment must increase at a rate equal to the product of the potential average productivity of investment and the propensity to save.

8 Robert M. Solow (1924- ) PhD, Harvard. Career at MIT. Contributions across the breadth of economics. Nobel prize in Solow’s theory on growth supports the neoclassical view that the economy naturally adjusts to achieve stable equilibrium growth.

9 Joseph Schumpeter ( ) Background 1908, The Nature and Essence of Theoretical Economics 1911, The Theory of Economic Development 1914, Economic Doctrine and Method 1939, Business Cycles 1942, Capitalism, Socialism, and Democracy 1954, History of Economic Analysis (published posthumously)

10 Schumpeter (2) Starts with neoclassical model. Introduces entrepreneurship and innovation— change. The balanced, circular flow is disrupted. Innovations drive business cycles and development. Innovations occur in clusters. Innovation is followed by recession and depression, then recovery. Breaks down economic development three cycles: Kitchin Cycles (40 months) Kuznet’s Cycles (10 years) Kondratieff Waves (35-55 years)

11 Schumpeter (3) Argues that capitalism will not survive. Rejects Ricardian and Socialist arguments for the decline of capitalism. Obsolescence of entrepreneurial function Collapse of Political Strata Institutions crumble The cold, rational mindset of capitalism is destructive of moral authority Economic issues move to political sphere Welfare state expands and takes over—guided capitalism to state capitalism, etc.

12 Theodore Schultz ( ) Background and accomplishments. Nobel Prize, Cited his work in growth and development, as well as agricultural economics. Initiated the “human capital” revolution in economic thought. Knowledge and skill are the result of investment, and help to explain the productivity advantages of developed nations.

13 Schultz (2) Human capital helps to explain three things: We thought that K/L ratios should rise with growth, but in fact they fall. The problem is that we are not including the entire stock of capital. Income has risen faster than the combined amount of factors. That is, there appears to be increasing returns to scale. How? Ans: better quality of factors. To develop economies, we should not focus solely on physical capital formation, but rather include human capital formation.