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Book Name – Macroeconomics (HL Ahuja)
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1. Introduction
2. Endogenous Growth Models
3. Investment in Human Capital and Learning by Doing
4. Policy Implications of New Growth Theory
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New Theory of Growth (Endogenous Growth Model)
Chapter – 42
Introduction
Neoclassical Growth Theory dominated economic thinking during 1955–1985, but by the late 1980s dissatisfaction grew because it failed to explain several important facts about actual economic growth across countries, creating the need for a New Growth Theory.
The first major weakness of the neoclassical model was that an increase in the saving rate was predicted to have only a temporary (short-run) effect on economic growth and was not capable of raising the long-run growth rate of the economy.
The second weakness was its prediction of convergence of growth rates:
Countries with different saving rates but the same population growth rate were expected to eventually achieve the same long-run growth rate of national income.
In the long-run steady-state equilibrium, growth in per capita income was expected to converge to zero.
Thus, differences in growth performance across countries were expected to diminish over time.
The third and most important weakness was that the model treated technological change as exogenous, implying that the long-run growth rate depended on a factor whose determinants were not explained by the theory itself.
As a result, the theory could not identify the fundamental forces driving long-run economic growth.
If technological knowledge flowed freely across countries, technological progress should also converge, leading to convergence in long-run growth rates among nations.
However, real-world evidence showed that such convergence of long-run growth rates was generally absent or occurred only in a limited number of countries.
Therefore, the neoclassical model failed to explain persistent differences in growth rates across countries.
It also could not account for a large share of the actual economic growth observed in different nations.
Since a central concern of development economics is explaining why per capita incomes and growth rates differ across countries, the primary objective of New Growth Theory became:
Explaining cross-country differences in growth performance.
Identifying the contributions of various factors responsible for the growth rates observed in different economies.