Beyond the Solow Growth Model

Three Reasons to Go Beyond the Solow Growth Model (SGM) The SGM doesn’t fit facts too well Saving and Investment Don’t Seem to Always Foster Growth Technology is only a residual in the SGM (technological change is not explained but taken as a fact-of-life).

The SGM Doesn’t Fit the Facts The SGM predicts: that growth rates would decline as economies approached their steady states convergence - income per person of poor countries will catch up to that of rich countries Facts World growth rates have not declined Convergence hasn’t happened

SGM Predicts Rich Countries Grow More Slowly than Poor Countries

Growth in the United States PeriodAnnual Percent Change in Real GDP per Person % % % % %

Comparisons of Income per Capita

Saving and Investment Don’t Always Foster Growth! The SGM suggests that saving and investing cause economies to grow The Soviet Union is an exception to the rule The Soviet Union saved and invested a tremendous amount of capital in its 80-year history Most of the countries in the former Soviet Union have income levels comparable to developing countries

Explanations for Non-convergence (or conditional convergence) Differences in the Quality of the Labor Force Education Health Sociological Aspects of Labor (Social capital) Differences in Institutions Increasing Returns to scale

Differing Quality of Labor The adjustment for quality of labor makes capital per quality adjusted person smaller in developed countries with more productive labor the marginal product of capital in developed countries higher The expanded SGM predicts that a developed country will grow faster.

Higher Education

Education and Growth

Differing Institutions Social capital is the set of institutions of a society, such as degree of trust, customs, laws, and civic and government organizations that positively affect growth. Social capital provides incentives to produce, invest, and innovate. Countries with more social capital generally have higher income (growth) levels.

Institutions

Corruption

Rule of Law

Foreign Aid and Social Capital

Increasing Returns A production function shows increasing returns to scale when an increase in all inputs leads to a proportionately greater increase in output. Increasing returns production allows continual increases in income per person creates the possibility of a virtuous cycle in which growth creates more growth

Production Function - Increasing Returns Production function with increasing returns B: Constant Returns Inputs Output Income per person Time A: Increasing returns

Why Increasing Returns Makes Sense Geographical effects of technology Areas where technology initially develops may have increasing returns Hollywood, the Tropics Learning by doing The more one does something, the more productive one becomes Textiles in Bangladesh, toys in China Agglomeration effects Concentration of similar firms increases the productivity for all area firms Silicon Valley, Liverpool

New (Endogenous) Growth Theory New growth theory focuses on the role of technology in economic growth. In the Solow growth model, technology is a residual (exogenous parameter). In new growth theory technology is endogenous, explained by the model.

Capital, Labor and R&D Capital and labor in the technology production function are the amounts of capital and labor used in research and development. The more a society invests in research and development, the faster its economy will grow.

Not-So-New Growth Theory Not-So-New Growth Theory Joseph Schumpeter ( early 20th century) Entrepreneurs Developed From Adam Smith (18th century) Specialization and Markets

Adam Smith

Specialization and the Market Specialization of labor was the key to growth. Trade expands markets and encourages further specialization. Specialization increases output, which increases the market, and leads to more specialization.

Joseph Schumpeter

The Entrepreneur Entrepreneurs are individuals who see opportunities to produce and coordinate, manage, and assume the risk of production. Entrepreneurs create major technological changes and growth. The entrepreneurs’ industries are leading industries that pull the rest of the economy along with them.

Potential Growth Policies (?)  Promote innovation  Encourage entrepreneurial activity  Make education widely available  Ensure political stability and good governance  Establish well-defined property rights  Protect intellectual property rights  Promote aggregate demand policies  Establish private enterprise zones  Build industrial policies that promote technological innovation  Lower tax rates  Privatize government owned businesses  Increase openness to international trade by reducing trade restrictions