DG 410

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DG 410

• Guest Lecture
• Theories of Economic Growth
• Rup Singh
• School of Economics
• The University of the South Pacific
• Suva (Fiji)

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A Joke in Growth Economics

• Question How to become rich?
• Answer Play Lotto!

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Contents

• In this lecture
• Analyse various growth theories (traditional
• and modern) and their merits and de-merits
• Discuss important issues in growth
• theories
• Evaluate what we have learnt from the growth
• literature so far (if we have)

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Introduction

• Main question in growth Why some countries are
  rich (or poor) and how can they become rich?
• Unfortunately, till this day, there is no
  clear-cut answers on the sources of growth (list
  is endless)
• Different factors affect growth rates in
  different countries at different points in time

5

Introduction
Hoover and Patrez (2004) argue that there are
more than 80 growth factors - imagine the
confusion for growth policy Barro and
Sala-i-Martin (1990/1) in a famous paper (I just
ran two million regressions) list top 10 most
significant growth determinants - mostly
institutional factors Changes in these
variables leads to permanent changes in growth
rates
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Introduction

• Growth development are more-or-less same (both
  explain how to raise incomes welfare)
• Development without growth is impossible and v-v.
  We cannot isolate them but some fine lines can be
  drawn
• Growth - sustained raise in output (per capita
  incomes). Its a process of structural change
  that alters almost all aspects economic activity

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Introduction

• Development - how benefits of growth trickles
  down to society (particularly at grassroots
  level)
• All economists agree that increase in welfare
  enhancing output is part of growth process
• Growth merely refers to growth of output, but
  development refers to all changes in economy
  (social, political, institutional and the
  distribution which are welfare enhancing)

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Introduction

• Lucas (198830) jokes growth theory are the
  aspects of growth that we have some understanding
  of and development is those we dont
• I think both are similar because there can be no
  sustained growth without extensive changes
  throughout economy
• Difficult to imagine sustained growth rates
  without production of welfare enhancing goods
  services

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Introduction

• But important issue is how growth can improve
  human welfare (make world a better place)
• Compared to past 200yrs, we have had incredible
  growth and development and enjoyed very high
  level of welfare
• Can we increase our happiness in further. Can
  those who are not well-off catch-up with others
  and how? (Crux of growth theory)

10
Introduction

• Growth rates have not been consistent in some
  countries per capita incomes have improved but in
  other, declined
• Excluding China and India, all other low income
  countries declined by 1.1 over the last decade
  (In 1970 and 80s they were growing by average of
  4 today around 2)
• Growth rate in long-run (few decades) is the
  result of short-run (2-3yrs) growth outcomes

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Introduction
Governments use stabilization policies to manage
short-run growth They hardly put serious growth
polices for long run, because of the political
cycle. Keynes (1938) states in the long run we
are dead We learn lessons from the past to
manage future growth but future can bring new
opportunities or challenges (AIDS, climate
change, information technology etc were not
imagined before 1950s)
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Introduction
Different growth experiences has led to large
income disparities across countries - require
different approaches (one does not fit all) The
disparities in standards of living now are
larger than ever before, e.g average Ethiopian is
1/50th as well-off as average America/Australian
The problem is not growth, but slow growth - can
we create more USAs, Japans, Asian Tigers?
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Introduction

• It is not just incomes that causes disparities
  but the way we do things (capital intensive and
  technically sophisticated production leads to
  more (quality) outputs per unit of input)
• Growth is directly related to productivity -
  ability to create inputs into outputs at least
  possible costs
• Not only through RD, but the creativity of human
  minds, learning-by-doing and innovation

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Introduction
Based on the levels of per capita incomes,
countries are grouped by into different
categories Perkins et. al (2001) also Jones
(2002) provide details. Jones gives a list of
example countries Briefly, the World Bank gives
two groups (i) developing and (ii) developed
divided by ranges of per capita incomes in USD
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Introduction

• Below 785 (1000) low income countries
• Above 785 up to 9636 (10000) middle income
  countries
• Above 9636 (10,000) - developed/industrial
  countries
• Note within the middle income group there is
  lower middle (below 3115 (3000) and upper
  middle income up to 9636 (10000)

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Introduction

• Varied definitions are provided by others. Here
  is an example by Jones (2002)
• Rich (USA, Japan, UK)
• Poor (Kenya, Rwanda, Fiji)
• Growth miracles (Hong Kong, Singapore, Korea)
• Growth disasters (Mali, Chad, Venezuela)

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Introduction
Such comparisons have limitations - have to be
PPP adjusted to be compared (read on PPP) cost
of living differences exchange rate differences
between countries There are countries whose
average incomes are high, e.g in Arab countries,
but welfare of average Arabian is remarkably
low High per capita income (growth) does not
imply high welfare (standard of living)
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Introduction

• Thus countries should be re-ranked based on a
  broader measure of development such as HDI- Human
  Development Index
• The HDI is a composite index of average income
  together with a host of socio-economic factors
  like (access to water, doctors, transportation,
  basic food, congestion etc)
• It is useful to analyse the WBs HDI index and
  find out where Fiji or your country stands read

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Growth Models (Traditional)

• Most textbook in development have expositions of
  these models. Today they are less prominent
  following the path breaking work of Solow (1956)
• I will discuss these models very briefly because
  they are outdated. I will also skip all algebra
  and graphs in these models

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Adam Smiths Model

• Early economists thought that raising growth
  rates of some industries or sectors could
  increase aggregate growth rate
• They thought that economic growth was synonymous
  to growth of strategic industries
• In late 1700s it was popular to favor certain
  industries through subsidies, grants and tariff
  protection, etc Smith opposed this view

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Adam Smiths Model
Smith thought Growth and development must
benefit all sections of the society Specializatio
n leads to comparative advantages and economies
of scale - economies should do what they can do
the best rather than doing a little of
everything Specialization sharpens human skills
(LBD) creates avenues for technical progress
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Adam Smith Model

• Growth rate is an increasing function of
  productivity that continuously pushes LGP higher
• Productivity raises from specialization which
  leads to RD, innovations/discovery and LBD
• The continuous push results from exogenous
  factors - institutional reforms, RD, etc that
  increases rate of growth and level of income

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Two Sector Models
Long before measurement of GDP was developed,
economists recognized the fundamental
relationship between agriculture and
industries The best known 2-sector model is
Ricardo (1817) which has two assumptions (i)
Agriculture is subject to diminishing returns
(ii) Surplus labour exists in agriculture that
industries could draw from
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Two Sector Models
The most recent version of Ricardo model is Lewis
(1955) and a variant of this is Fei-Rani
(1964) Ricardo assumes diminishing returns in
output because land is fixed - output cant raise
at an increasing rate Its costly to produce
more agricultural output because farmers need to
use more and more poor land
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Two Sector Models
Assume surplus labour which can be attracted
without any effects on wage rates of either
sectors Because of unemployment/under/disguised
employment in rural labour shortage in
urban Main issues are (i) If industrial sector
grows, how fast must the agriculture grow to any
avoid drag on the industries (ii) Is increase in
population useful for development
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Two Sector Models

• Wa is determined by APL. It is equal to wages
  paid on farm and cannot fall below a minimum of
  APL - institutionally fixed wage
• If labour is withdrawn from farms, agriculture
  output is unaffected because of surplus labour
• Labour needs to be paid slightly higher wages
  than Wa to attract them from agriculture to
  industries

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Two Sector Models

• But there comes a point where further drawing of
  workers are hard, it leads to decline in
  agricultural output
• The cost of hiring workers will raise as the food
  cost raises due to low supply from falling
  agriculture
• The TOT (PI/PA) will worsen for industries but in
  favor of agriculture affecting urban sectors
  productivity and ability to attract more workers

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Two Sector Models
These models imply that industries can lead
growth to a point where isn't self destructive
Above this point it will drag its own growth and
consequently that of agriculture and
economys They imply that agriculture can
neglected as long as there is surplus labour -
drawing labour is actually beneficial to
agriculture (unbalanced growth can drive economic
growth)
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Two Sector Models

• Fei-Rani extends Ricardos model mainly to test
  the effects of raise in population on growth and
  development
• He thinks that labour supply is unlimited until
  Wa, an increase in population (labour force) will
  not increase output
• Therefore population growth is a disaster harms
  welfare because limited output now needs to be
  distributed to higher population

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Neo-Classicals Two Sector Model
Increase in population or labour can take care of
its food requirement any removal of labour from
agriculture will reduce production MPL is never
zero - wages are above MPL No surplus labour in
agriculture for industries
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Neo-Classicals Two Sector Model

• Neo-classicals imply that there should be
  balanced growth rather than one sector having
  negative effects on other
• Therefore growth policies should focus on all
  sectors what Adam Smith emphasized
• If industries are to grow simultaneous efforts
  must be made to ensure that argriculture grows
  fast enough to feed workers in both sectors

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Neo-Classicals Two Sector Model
Stagnant agriculture with little investment or
technical progress will cause urban wages to
raise affecting profits, re-investment and
growth In labour surplus models this is ignored
- that is unbalanced growth is possible This is
not true for neoclassical model because sectors
have backward and forward linkages on which each
other depends
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Schumpeters Model of Creative Destruction
He thinks that policies for better allocation of
resources are useless because they protect
existing inefficient structures/capitalists He
argues for creation of new efficient institutions
and to destroy old ineffective ones Innovation
create technology and destroys monopoly power of
competitors society benefit from creative
destruction
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Schumpeters Model

• Creative destruction prevents societies from
  developing permanent monopolies leading to
  continuous growth
• He attributes tremendous increases in growth and
  welfare of last 200yrs to technical progress
• Innovation allows enjoying monopoly status, at
  least temporarily - in long run, technology
  transfer makes innovation less attractive

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Schumpeters Model

• It is the quest of monopoly profits, (although
  for brief period) generated by innovations will
  cause continuous growth
• These ideas are taken by Romer (1986) and others
  who are the proponents of new growth theory
  (little later)
• Unlike others who think that monopolies and
  supernormal profits are costly, Schumpeter
  implies that such profits are growth necessity

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Schumpeters Model

• Central to his theory is entrepreneur not the
  capitalist but an innovator, thinker or manager
  who can generate new ideas
• Schumpeter thinks that there is a clear role of
  institutions in the up-raising of entrepreneurs
  to provide incentives for innovation, conditions
  to take risks, avenues to reduce cost of doing
  business and an education systems that generates
  new entrepreneurs

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Harrod-Domer Model

• Harrod-Domer assumed that there exists large
  amount of unemployed labour
• Output can be increased by hiring more labour
  without causing higher wages or inflation
• This implies that MPL is positive but they
  assumed that MPK is constant

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Harrod-Domer Model
Constant MPK implies that each unit increase in K
will increase Y in the same proportion (theres
enough labour to maintain K/L ratio
constant) Output becomes a linear function of
capital and constant MPK. Constant K/L ratio
means a constant capital-output ratio Thus
growth rate of output is directly proportional to
growth rate of capital (or net investment)
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Harrod-Domer Model
Another assumption they made was that productive
investment is always equal to savings This made
their model very attractive to many developmental
economists In order to increase growth rate,
increase savings (investment rate), however even
forcefully
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Harrod-Domer Model

• But for economy to invest, it must save. Normally
  savings is a proportion of income S sY

• Divide both sides by Y to get

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Harrod-Domer Model

• Since H-D model assumes constant (K/Y) ratio,
  growth rate is a linear function of savings rate
• They say Save and invest in productive capital
  and the economy will grow
• This seemed an easy explanation to the long
  debated sources of growth

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Harrod-Domer Model

• Their assumption that (K/Y) remains constant in a
  phase of rapid technical progress does not hold
• Further surplus labour exists - also not correct
• In light of these issues some proposed
  incremental (K/Y) ratio. In practice, they use
  average capital output ratios, not incremental
  K/Y

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Harrod-Domer Model

• COR range from 1.5 5.0 (larger in developing
  counties implies (i) intensity of capital in
  output (ii) productivity of capital are
  conflicting
• The H-D model gained attention because it was
  very simple without serious data requirement
• The model has no limits of growth- not correct

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Harrod-Domer Model

• Armed with ICOR, planners did not bother about
  institutions, entrepreneurs, technology etc
• Higher savings/investment leads to growth-you
  will later see this is not correct
• H-D model is good for short but not for long run.
  Doesn't consider diminishing returns to K. Uses
  fixed coefficient production function (no one
  believes in this anymore)

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Take a break

• 2 Minutes

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Prominent Growth Theories

• Although much was said on sources of growth
  nothing was systematic until Solow (1956)
• In Solow (1957) both quantity quality of
  factors are important for growth. He showed the
  importance of technical progress on growth
• Solow employed a systematic approach to growth
  accounting exercise (GAE). This is beauty of his
  (1957) work discuss this first

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Solow (1957)

• He concluded that in developed countries
  productivity (quality of factors) is most
  important long-run growth determinant
• For developing countries- which are at their
  initial stages of development, factor
  accumulation (quantity of factors) is important
• This is well supported in literature, see Hoover
  and Patrez (2003) for a survey

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Growth Accounting

• In what follows, we use Solow (1957) approach of
  GAE to determine the source of growth for Fiji
  (an example)
• GAE is an empirical measure of relative
  importance of factor accumulation vs.
  productivity in growth rates
• The factors are K L and those that improve
  efficiency (e.g. institutional environment)

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Growth Accounting

• GAE is important because it gives some initial
  insights into practical growth policy
• According to Barro (1998) GAE is the first step
  in analyzing the determinants of growth
• If you are doing a paper/writing a thesis on
  determinant of growth whether on Fiji, Kiribati
  or USA, GAE must be done first

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Warning!

• At the outset, it must be made clear that
  productivity growth is unobserved in data and
  computed residually
• It includes effects of other possible growth
  enhancing factors, effects of measurement errors,
  policy effects, random errors etc.
• For this reason its measure of our ignorance,
  not TFP as is normally understood

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Growth Accounting

• Y is the level of output, A, K and L are
  technology, capital stock and quantity of
  labor/employment, respectively
• Alpha is the share of profits and (1-alpha) is
  that of wages

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Growth Accounting

• The growth rate of output can be partitioned into
  factor intensity and productivity of factors
• Take logs and differentiate the above yields the
  GAE formula

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Growth Accounting

• Stylised value profit share is 0.3 therefore,
  labour share is 0.7 in developing countries
• In advanced economies profit share is higher
  around 0.4-0.5
• Data on Y, K and L are available for advanced
  countries. Hard to get data on K in developing
  countries (see me if you are interested)

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Fiji Data

• Period 1972 to 2002
• Average growth rates

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Growth Accounting - Fiji

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Growth Accounting

• Results imply that factor accumulation is most
  important for Fijis growth - contributes 90 to
  annual growth rate
• Productivity which grows by about 0.3 per annum
  contributing only 10 to growth
• For a quick turnaround in growth, policy makers
  in Fiji should enhance accumulation of K and L

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Weaknesses in Solow's GAE

• Dont know which factors determine TFP its
  evolution, although it is as high as 50 in USA
  (list is not exhaustive sources of growth are
  unclear or unknown)
• MRW(1992) show that the residual can be further
  reduced by including H in Solow model
• Solos does not include quality classes, see Barro
  (1998)

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Solow (1956)

• I think textbook expositions of Solow model are
  difficult, including that in Jones (2002)
• Although I could have used a simpler procedure
  for you, theres a fair bit of challenging
  algebra
• We dont have time and you are not prepared to
  take that kind of algebra, so I will only produce
  the first and last equations

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Solow Model (1956)

• The Solow (1956) CD production function with
  Harrod neutral technical progress

We can use this to derive the BJP values of Y
its rate of growth
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The Balanced Growth Path
61
Results

• In ss, growth rate of output (per worker) is
  determined by rate of technical progress only
  exogenous growth model
• However, determinants of technical progress is
  unknown- (Endogenous models gives some insights)
• Convergence or divergence? depends on the pace
  of technical progress. (countries can speed-up
  growth by RD, more easily by LBD)

62
Solow Diagram
ss
63
Policy
Suppose if savings rate (investment) raises, what
happens? Higher investment increases capital and
output per worker. This causes a movement along
the y curve, but there is a shift of the sy line
upwards However, the level of depreciation
remains unchanged assuming that new investment
adds to the capital stock in net, see following
graph
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Increase in Savings or Investment
ss2
ss1
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Policy

• The model shows that even if growth rate is zero
  (at ss), ss level of capital and output per
  worker depends on savings and investment rates
• The higher these rates, the higher will be the
  level of per capita income
• But these results are based on comparative
  statistics of moving from one equilibrium to
  another when the adjustment is fully completed

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Policy

• But how does adjustment takes place and is the
  transition smooth? - answer this by studying
  transition dynamics
• Note when s was increased, k and y increased,
  the level of y increased but eventually tapped
  off
• This means the rate of growth eventually tapers
  of with higher investment/savings policy

67
Growth Path of Increased Savings (Investment) on
Per Capita Income
68
Growth Path of Increased Savings (Investment) on
Rate of Growth
69
Policy
Growth rate suddenly jumps-up due to higher
savings (capital per worker) but declines to its
ss value after sometime Can determine using Sato
(1963) closed form solution how long it takes for
growth effects to taper off - not for you
today Policies based on investment will only
increase growth rate in s/run and will have
permanent level effects, but no permanent effects
on rate of growth
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Policy

• Further, there is a limit on policies based on
  savings rate - cannot be increased indefinitely
• A major drawback of Solow model is that it has
  little scope for policy
• The only growth determinant (productivity) grows
  at an exogenous rate - do not know how this
  happens

71

The New Growth Theory

• In endogenous models (ENGMs), growth factors such
  as technology or knowledge capital produces
  increasing returns enabling output (per worker)
  to raise without bound
• The intuition behind these models is not
  different from Solows - technical progress can
  produce permanent growth effects
• Some think that EXGM/ENGMs are substitutes, but
  the ENGMs complement Solow (1956)

72

The New Growth Theory

• Solow takes technology as given (that's why it's
  called exogenous growth model)
• In ENGMs, technology is endogenous to other
  factors such as costly RD, FDI or manna from
  heaven type LBD, or some other factors
• In Solow, per capita income declines due to
  diminishing returns to capital - is not the case
  in ENGMs due to increasing returns

73

The New Growth Theory

• ENGMs have attracted attention since Romer's
  works in early 1980s. Today there are many
  proponents of ENGMs
• These models are useful for policy - ENGMs
  explain how to enhance productivity
• If we know how, growth rates can be increased as
  proposed by Solow

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The New Growth Theory
However, ENGMs are hard to estimate because they
violate workable assumptions of Solow There are
reservations on ENGMs, see Jones (1995, 1997,
2005), Kocherlakota (1996), Gong et.al (2004)
particularly from empirical viewpoint Growth
literature is unsettled. Not all economists
including Solow himself believe in ENGMs
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Types on ENGMs
Two types of ENGMs - based on assumptions
regarding the creation of technology If
technology is enhanced without the need to
allocate resources to create new technology, then
it is free - manna from heaven type Costly RD
undertaken in developed economies can easily be
copied into developing economies - no need to
re-invent the wheel
76

Types on ENGMs
In this case, all firms might use the available
technology at no added costs. This technology
is not rival and non-excludable This is type of
technology (or other similar factors) creating
positive externalities can be modeled using Solow
(1956) with extensions will show an example
with trade
77

Types on ENGMs
The second type of ENGMs is where technology is
not free, excludable and rival Firms investing
in massive RD need to enjoy patents for brief
period because they allocate additional resources
to create new technology Make savings-investment
decisions based on risk preference and
inter-temporal substitution
78

The New Growth Theory
Technology
Growth models become much more complicated, see
Romer (1985/6, 1991/2), Gong et.al (2005) and
Cass-Koopmans-Ramsey (1965) However, some
simplified versions of both can be discussed But
before we go into details, we need to understand,
what we call technology
79

The New Growth Theory
Technology
Romer (1992) defines technology as ideas the
efficiency with which inputs are transformed into
welfare enhancing outputs It is called quality
of inputs- better still the ability of economy to
produce outputs at least cost Technical progress
takes a continuous, but gradual path because it
takes a long time before generated ideas come
into practice
80

Technology
Because diffusion is faster now, developing
economies can have faster pace of transition
from one ss to another, thus have higher growth
rates The traditional view that capital
endowment and low levels of technology may limit
growth is now less valid FDI is mobile and
therefore, capital gap is not a growth constraint
for developing economies - the problem however is
capital retention
81

Growth Policy
Endogenous models claim that 1 raise in
knowledge capital will generate more than 1
raise in income per worker It also show that
nothing else, except knowledge capital generates
long run growth Growth rate is unbounded
-investment in knowledge capital (education
subsidy, education reforms etc) gives permanent
growth effect
82

Growth Policy

• Technical progress is not exogenous appropriate
  government policies can permanently raise a
  countrys growth rate
• There are potential increasing returns from
  higher capital investment, particularly if
  private sector involvement in RD is encouraged
• Today many economists model varied factors within
  endogenous framework not always conceptually
  correct

83

Growth Theory Today Solow Model Within
Endogenous Framework
Now lets extend the exogenous growth model of
Solow to include and test significance of growth
enhancing factors (trade) I use the Solow model
with endogenous framework - this is a new and
latest addition to the literature I will only be
brief here because of limitations of time,
details can be found in Rao et.al (2007/8)
84

Growth Theory Today
Trade can be added as a shift variable or as a
LGP shift variable. I am of the view that we do
the latter, see below
85

Growth Theory Today
The second last equation is what you estimate. -
remember we are estimating a production function
not a growth equation (many have this
misconception) Using this equation we can
derive the growth effects of trade What you
expect is that growth effects would be small and
marginally significant. This is what you get
using Fiji data
86
Growth Theory Today
Step-1 Estimate Solow equation without trade
87
Growth Theory Today
Full results
88
Growth Theory Today
Not withstanding the usual time series issues
(which can be corrected), we can say Trade has
a permanent and positive level effect - 1 raise
in trade will increase Fijis aggregate income
(GDP) by 0.4. In per worker terms this will
also be 0.36 You can estimate the above in
per worker terms
89
Growth Theory Today
Step- 8 Estimating effects of trade on growth
rate of output
Without trade, SR is as high as 1. Trade
captures about 1/3 of this (0.003/0.009) and the
other 2/3 determinants of SR (or growth) is still
unknown
90
Temporary or Permanent Effect?
How long will the effects of trade last - exact
answers can be obtained by simulations using
Sato(1963) closed form solution I quickly ran a
regression to find out if TR has non-linear
effect (effects that may taperoff) If we see
this behaviour, we can say that TR might have
temporary growth effects this is the case
91
Temporary or Permanent Effect?
92
Why Transitory Effects?
Trade provides positive but temporary effects but
there is evidence Fiji endures high business
costs and lack productive capacity, see Singh and
Prasad (2007) forthcoming in Journal of World
trade) In addition, developments in trade
prices including preferential prices have had
negative effects There is justification for
continued support in adjustment adaptation
funds to develop institutions, infrastructure
competitive domestic products
93
Conclusion
We can have continued improvements in human
welfare and standard of living, if there are
technical progress, fair trade, right
institutions (the list is not ending because
sources of growth is unknown) This implies that
massive unemployment and eternal poverty are not
inevitable - many still remain skeptical about
future We have to encounter climate change,
resources depletion, energy crisis - are centre
stage of global growth debates
94
Conclusion

• Many fear that developed countries are polluting
  the environment whose effects are felt by other
  economies
• China, USA and Japan are asked to cut down their
  emissions of CFCs and other pollutants
• The limit to growth literature fears that earth
  may be unable to support ever lasting higher
  incomes and welfare for all living beings in
  future

95
Conclusion
Future growth in welfare will come at an expense
of depletion of environmental standards and
natural resources Growth brings structural
change - can be disruptive because some
industries will eventually shrink while others
may grow at very high rates Some workers may
have to change jobs while others might be
laid-off (unless absorbed into high growth
sectors - somehow)
96
Conclusion
Imagine the extent of income disparities with
such changes - theres always a possibility that
income distribution will become more uneven with
higher growth Some economists think that income
disparities cause growth - others think that fair
distribution is required before growth can take
place But whatever the case, income disparities
cannot be eliminated altogether
97
Conclusion
Human welfare really depends on how per capita
income is distributed The more uneven is income
distribution, the more poor you are and more is
the concern for growth economists and policy
makers Poverty cannot be eradicated altogether-
note growth is a process of change, it will
itself generate income disparities
98
Thank you

• End of Lecture