Economic Growth

Economic Growth
Mark Weder
Adelaide
August 2008
Mark Weder (Adelaide) Economic Growth August 2008 1 / 68
Worlds Economic History in one picture
Convergence and the World Income Distribution
The Convergence Hypothesis:
Fact: Enormous variation in incomes per worker across countries
Question: Do poor countries eventually catch up?
Convergence hypothesis: They do, in the right sense!
Main prediction of convergence hypothesis (and the Solow model): Poor
countries should grow faster than rich countries.
Solow Model and Convergence
Solow model without technological change
Fundamental dierence equation of Solow Model with technological
progress (and Cobb-Douglas production function):
k
t+1
=
1
(1 + n)(1 + g)
(s
t
+ (1 )
k
t
)
Production function
Y
t
= K
t
(A
t
L
t
)
1
= y
t
=
Y
t
A
t
L
t
=

K
t
A
t
L
t
=

k
t
.
Income per worker is y
t
= y
t
A
t
and A
t
= (1 + g)
t
A
0
. Solow equationn
k
t+1
k
t
=
1
(1 + n)(1 + g)
(s
t
+ (1 )
k
t
(1 + n)(1 + g)
k
t
)
=
1
(1 + n)(1 + g)
(s
t
( + n + g + ng)
k
t
).
Convergence towards steady state diagram uses: s
k
1
t
k
t+1
=
1
(1 + n)(1 + g)
(s
t
+ (1 )
k
t
).
Solow Model: comparative statics
Convergence towards steady state diagram uses:
k
t+1
k
t
k
t
=
1
(1 + n)(1 + g)
(s
k
1
t
( + n + g + ng)).
Suppose economy in steady state: what happens if savings rate goes up?
Initially
k
t+1
k
t
k
t
= 0 =
1
(1 + n)(1 + g)
(s
k
1
t
( + n + g + ng)).
Then: s
k
1
t
( + n + g + ng) > 0 and growth rate is positive. Peters
out as economy goes back to new steady state.
Solow Model: steady state
0 =
1
(1 + n)(1 + g)
(s
k
1
t
( + n + g + ng))
= s
k
1
= + n + g + ng
=

k
+
=

+ n + g + ng
s
1
1
and from y
t
=

k
t
y
+
=

+ n + g + ng
s

1
.
Further, output per worker is given by
y
+
t
= A
t
+ n + g + ng
s

1
.
Solow Model: steady state empirics
Lets take logs on both sides of
y
+
t
= A
t
+ n + g + ng
s

1
lny
+
t
= lnA
t
+

1
ln
+ n + g + ng
s
= lnA
t
+

1
ln
s
+ n + g + ng
= lnA
t
+

1
[lns-ln ( + n + g + ng)]
First of two important relationships of Solow model: given A
t
, the steady
state prediction of model is that y
+
t
should depend on
lns-ln( + n + g + ng) and this realtionship should be linear with positive
slope since

1
> 0. Slope should be around 1/2.
Solow Model: steady state empirics
Heroric assumption that all countries are in (or very close) to their steady
state in 2000 and that they had same technology in that year. OLS
regression estimation of
lny
i
2000
= lnA
t
+

1
lns
i
-ln
+ n
i
+ g + n
i
g
s
i
average investment rate 1960-2000. + n
i
+ g + n
i
g = 0.075 (and we
neglect n
i
g). Now:
lny
i
2000
=
0
+
1
lns
i
-ln
n
i
+ 0.075
lny
i
2000
= 8.8 + 1.47
lns
i
-ln
n
i
+ 0.075
R
2
= 0.55, t = 10.2
Estimate of slope,
1
, is 1.47 and model seems to be in accordance with
data. However, this is "too large" we would need a = 0.6 to match
this!
Solow Model: convergence
... the second important relationships of Solow model.
Countries with same s, n, , ...
... eventually same growth rate of output per worker and same level of
output per worker (absolute convergence).
Countries starting further below the balanced growth path (poorer
countries) should grow faster than countries closer to balanced growth
path.
... seems to be the case for the sample of now industrialized countries.
But:
Countries with same g but potentially diering s, n, , ...
... countries have dierent balanced growth path (BGP).
Countries that start further below their balanced growth path (countires
that are poor relative to their BGP) should grow faster than rich countries
(relative to their BGP). This is called conditional convergence...
Convergence in Solow model
Recall transition equation (in generic form)
k
t+1
=
1
(1 + n)(1 + g)
(s
t
+ (1 )
k
t
) = G(
k
t
).
In steady state

k
+
= G(
k
+
). Linearize transition equation around the
steady state (local dynamics!)
k
t+1
k
+
= G
/
(
k
+
)
k
t
k
+
.
A (linear) rst order dierence equation in

k
t
. Term G
/
(
k
+
) is given by
G
/
(
k
+
) =
1
(1 + n)(1 + g)
(s
k
+1
+ 1 )
=
1
(1 + n)(1 + g)
(s
+ n + g + ng
s
+ 1 )
=
1
(1 + n)(1 + g)
( ( + n + g + ng) + 1 )
k
t+1
=
1
(1 + n)(1 + g)
(s
t
+ (1 )
k
t
) = G(
k
t
).
0 < G
/
(
k
+
) < 1, hence stable equation (and

k
t

k
+
as t ).
Convert transition equation into changes in natural log-values rather than
absolute changes.
Note that ln
k
t
ln
k
+
-
k
+
1/(
k
t
k
+
).
k
t+1
k
+
= G
/
(
k
+
)
k
t
k
+
=

k
+
ln
k
t+1
ln
k
+
= G
/
(
k
+
)
k
+
ln
k
t+1
ln
k
+
= ln
k
t+1
ln
k
+
= G
/
(
k
+
)
ln
k
t+1
ln
k
+
.
With Cobb-Douglas production function
y
t
=

k
t
=ln y
t
ln y
+
=
ln
k
t
ln
k
+
last equation becomes (rst order equation in y

t
)
ln y
t+1
ln y
+
= G
/
(
k
+
) (ln y
t
ln y
+
) .
Rate of convergence
ln y
t+1
ln y
t
= G
/
(
k
+
) (ln y
t
ln y
+
) ln y
t
+ ln y
+
= ln y
t+1
ln y
t
=

1 G
/
(
k
+
)
(ln y
t
ln y
+
)
Lets dene = 1 G
/
(
k
+
), where 0 < < 1 :
ln y
t+1
ln y
t
= (ln y
t
ln y
+
)
In words, relative change in ln y
t
is the fraction of the current relative
deviation between y
t
and its long run equilibrium (the remaining gap).
is time-invariant measure of rate at which ln y
t
converges to ln y
+
("rate
of convergence").
Say if = 0.02, then every year two percent of gap will be closed.
Growth rate of ln y
t
larger (in absolute terms) the further away economy
from steady state.
= 1 G
/
(
k
+
) = 1
1
(1 + n)(1 + g)
( ( + n + g + ng) + 1 )
=
(1 + n)(1 + g) ( ( + n + g + ng) + 1 )
(1 + n)(1 + g)
- (1 )(n + g + )
For realistic parameters, - 1/3 and n + g + - 0.075, the convergence
rate, , is about 5 percent.
ln y
t+1
= ln y
+
+ (1 )ln y
t
Lets solve this rst order dierence equation.
ln y
t+1
= ln y
+
+ (1 )ln y
t
1. Particular solution (a time path that solves equation for every year):
ln y
t+1
=ln y
+
.
2. Homogenous solution (set constant term zero):
ln y
t+1
(1 )ln y
t
= 0 =ln y
t
= (1 )
t
C C is arbitrary constant.
3. Complete solutions (sum of 1. and 2.):
ln y
t
= ln y
+
+ (1 )
t
C.
4. For solution to be compatible with initial value, y
0
, we must have
C =ln y
0
ln y
+
.
Therefore, unique solution
ln y
t
= ln y
+
+ (1 )
t
(ln y
0
ln y
+
)
=

1 (1 )
t
ln y
+
+ (1 )
t
ln y
0
.
For specic year T:
ln y
T
=

1 (1 )
T
ln y
+
+ (1 )
T
ln y
0
= ln y
T
ln y
0
=

1 (1 )
T
(ln y
+
ln y
0
) .
Using ln y
t
=lny
t
lnA
t
:
lny
T
lny
0
T
=
lnA
t
lnA
0
T
+
1 (1 )
T
T
(lnA
0
+ ln y
+
lny
0
) .
Recall output per worker was given by
y
+
=

+ n + g + ng
s

1
then
ln y
T
ln y
0
T
- g +
1 (1 )
T
T
lnA
0
+

1
[lns-ln ( + n + g + ng)] lny
0
.
This is the convergence equation of Solow model. Left hand side is
average (annual) growth in GDP per worker from zero to T. Sums of two
terms: steady state growth rate and term that increasingly depends on
initial relative gap between steady state growth path and the actual GDP
per worker, y
0
.
Empirical convergence
Assume countries are technologically similar (same g and A
0
), regression
across countries
g
i
T,0
=
lny
i
T
lny
i
0
T
-
0
+
1
lny
i
0
+
2
lns
i
-ln
n
i
+ 0.075
.
Sample over 90 countries 1960-2000.
g
i
T,0
= 0.063 0.006
(0.0015)
lny
i
0
+ 0.02
(0.0025)
lns
i
-ln
n
i
+ 0.075
R
2
= 0.40.
(Assumption of same access to technology not too far fetched.)
1
is equal
1(1)
T
T
implying = 1 (1 T
1
)
1/T
. With T = 40,
= 0.007.
Annual rate of convergence is 0.7 percent ...
... data for full sample lend support to conditional convergence.
If we limit to OECD countries, rate is 2 percent.
Convergence of the rich
Convergence of the rich
No convergence
No convergence (and thats persistent)
No convergence and the Solow model
The Basic Solow Model...
... oers a nice account of a number of growth facts. However:
1. leaves unexplained factors that make countries leave (or not attain)
their BGP.
2. leaves unexplained why certain countries have higher s, n than others.
3. leaves unexplained technological progress, the source of growth.
4. More importantly it insuciently accounts for long run per capita
dierences in output.
So what could be missing?
There are insucient dierences in inputs to account for the huge
dierences in outputs that we observe.
So what is needed is a theory of dierences in z.
Institutions, schooling, taxation, corruption, red tape, inecient use of
technologies.
Imagine (in the context of the Solow model without technical progress)
that all countries share the same technology but they they dier in how
much of output is wasted.
Now output is
Y = (1 )zK
N
1
in per capita terms
Y
N
= y = (1 )zk
The steady state condition was

k
+
=
1
1 + n
k
+
+ szf (k
+
) =(n + )k
+
= szf (k
+
).
Hence
k
+
=

sz(1 )
n +
1
1
Then
y
+
= (1 )z(k
+
)
= (1 )z

zs(1 )
n +

1
= (1 )z
1
1
s(1 )
n +

1
Assume = 0.36, s = 0.2, = 0.05, n = 0.02 and z = 1, then
s
n+

1
= 1.81.
If = 0,
y
+
=

s(1 )
n +

1
= 1.81
If = 0.36 then (1 )
1
1
= 0.50:
y
+
= (1 )
1
1
s(1 )
n +

1
= 0.90
For a fty percent dierence in income, the distortion needs to be
greater than 35 percent (easy to cook up more extreme numbers).
So large dierences in are needed to account for the data.
How
How?
How
Education?
Human capital
Education levels are very dierent across countries.
Rich countries tend to have higher educational levels than poor countries.
We have the intuition that education (learning skills) is an important
factor in economic growth.
Mankiw, Romer & Weil (1992)
Their workhorse: Cobb-Douglas augmented Solow model. Suppose that
Y
t
= K
t
H
t
(A
t
L
t
)
1
where , _ 0, + _ 1. Y is total output, H is human capital, L is
labor and A is labor-augmenting technological change.
(1) Constant returns to scale.
(2) Elasticity of substitution between three factors is unitary.
(3) All technical progress is labor-augmenting.
(4) Human capital is taken to be a dierent factor of production rather
than simply labor augmenting.
Transform variables in per capita eective units:
k =
K
AL
h =
H
AL
y =
Y
AL
then
y = Ak
Population grows at rate n. Common technology advances at zero rate (to

make my point, not in paper, set A = 1).
Countries dier in technology level, but they share the same common
technology growth rate = 0. In absence of this assumption, world
income distribution would become more and more dispersed. Constant
savings rates for physical and human capital
K
t+1
= s
k
Y
t
(1
k
)K
t
and
H
t+1
= s
h
Y
t
(1
h
)H
t
where s are constant depreciation rates.
Then
K
t+1
= s
k
Y
t
(1
k
)K
t
H
t+1
= s
h
Y
t
(1
h
)H
t
become
k
t+1
k
t
= s
k
y
t
(n +
k
)k
t
h
t+1
h
t
= s
h
y
t
(n +
h
)h
t
Dynamics very complicated (two dierence equations to be solved at the
same time) so lets look at the BGP.
k
t+1
k
t
= 0 = s
k
k
t
h
t
(n +
k
)k
t
h
t+1
h
t
= 0 = s
h
k
t
h
t
(n +
h
)h
t
From rst equation
s
k
k
= (n +
k
)k
= h =
(
n +
k
s
k
)k
1
1

Math
Now use
s
h
k
= (n +
h
)h
and insert
h =
(
n +
k
s
k
)k
1
1
into it
s
h
k
(
n +
k
s
k
)k
1
= (n +
h
)(
n +
k
s
k
)
1
k
1
= s
h
(
n +
k
s
k
)k = (n +
h
)(
n +
k
s
k
)
1
k
1
= s
h
k = (n +
h
)(
n +
k
s
k
)
1
1
k
1
= s
h
= (n +
h
)(
n +
k
s
k
)
1
1
k
1
1
Math
s
h
k
(
n +
k
s
k
)k
1
= (n +
h
)(
n +
k
s
k
)
1
k
1
...
= s
h
= (n +
h
)(
n +
k
s
k
)
1
1
k
1
= s
h
= (n +
h
)(
n +
k
s
k
)
1
1
k
1
= s
h
= (n +
h
)(
n +
k
s
k
)
1
1
k
1

Still going
into it
...
= s
h
= (n +
h
)(
n +
k
s
k
)
1
1
k
1
= k
=
n +
h
s
h
(
n +
k
s
k
)
1
1
= k
=
n +
h
s
h
(
n +
k
s
k
)
1
= k
=
1
s
h
(
1
s
k
)
1
(n +
k
)
1
= k =

1
s
h
(
1
s
k
)
1
(n +
k
)
1

1
= k =
s
h

s
k
(n +
k
)
1
1
= k =
s
h

s
k
1
n +
k
1
1
Human capital
k
+
=
s
h

s
k
1
n +
k
1
1
and some algebra yields
h
+
=
s
h
1

s
k
n +
k
1
1
The central issue for growth is the value of .
If = 1/3 we have that small dierences in {s
h
, s
k
, n, } can account for
(relatively) large dierences in output per capita across countries.
According to Jones dierences in k account for a factor of 2 dierences in
output, dierences in educational attainment account ro 2.2 (using
educational attainment dierentials and the return to schooling). The
reminder is still 7 or 8 times that have to be imputed to dierences in TFP.
Human capital
Substituting back in (2) and taking logs, we obtain for a country j
ln y
ss
j
= ln A
j
+ gt +

1
ln
s
h
j
n
j
+ g +
h
+

1
ln
s
k
j
n
j
+ g +
k
(a) This can be estimated using cross-country data, if we have measure of

s
h
j
. Proxy they use: fraction of working age population enrolled in school,
(b)
k
=
h
, (c) s
k
j
investment rates (averages), (d) Common technology:
A
j
= A, (e) + g = 0.05.
Human capital
They estimate (standard errors in parenthesis); g + = .05
ln y
j
= 5.48
(1.59)
+ 1.42
(0.14)
ln s
k
j
1.97
(0.56)
ln(n
j
+ g + )
R
2
= 0.59 implied capital share = 0.60!
ln y
j
= 6.89
(1.17)
+ 0.69
(0.13)
ln s
k
j
1.73
(0.41)
ln(n
j
+ g + ) + 0.66
(0.07)
ln(SCHOOL
j
)
R
2
= 0.78 implied capital share = 0.31
SCHOOL = average percentage of the working age population in
secondary school. Mankiw et al. estimate - 1/3, - 1/3 and
R
2
- 0.78. Strong support of augmented Solow model: is capital share
(at right ballpark) and almost 80 percent of dierences in income can
be explained by investment decisions (in physical and human
capital). If human capital is not included in regression, the coecient on
s
k
j
is estimated too high (typically around 2/3) and R
2
is signicantly
less (0.59).
Human capital
Problems with the Mankiw et al. approach:
(1) Common technology assumption too strong. When A
j
varies across
countries, it will be plausibly be correlated with s
k
j
and s
h
j
. Thus, omitted
variable bias to overestimate of , and exaggeration of R
2
(that is, the
regression picks up something that is spurious). In fact, substantial
correlations across countries: ln(H
i
/L
i
) and ln(A
i
) = 0.52 and
ln(K
i
/L
i
) and ln(A
i
) = 0.25.
Human capital
Problems with the Mankiw et al. approach:
(2) The coecient on s
h
j
is too large. Implications: Fraction of working
age population in enrolled in school ranges from under 1 to over 12 in
sample. Their estimates imply that a country with 12 should have
income per capita 6 times that of a country with s
h
j
= 1 (ceteris paribus)
0.66 (ln(12) ln(1)) - 1.8 and exp(1.8) - 6. Labor literature suggests
that additional years of schooling is associated with a 6 to 10 percent
increase in individual earnings. From Mincer regression
ln w
i
= X
/
i
+ E
i
where X
/
i
is a set of demographic controls and E
i
is years of schooling.
-estimates range typically around 0.06.
So a country with 12 more years of schooling should be at most three
times as rich not 6 times as rich (exp(0.06 + 12) - 2)!
Human capital
To understand the point, consider the following: Each rm has technology
y = k
1
(Ah)
Firms face interest rate, r . Human capital is fraction of schooling with

standard exponential form
h
i
= exp(E
i
)
(standard means labor-economics literature). First-order condition implies
r = (1 )(Ah/k)
All workers, irrespective of their level of schooling, will work with at the
same physical to human capital ratio. Wages are equal to
w = y rk = k
1
(Ah)

Human capital
Then
k =

1
r
1
Ah
implies
w(h) = k
1
(Ah)
= (1 )
1
Ar
1
h
Human capital
w(h) = k
1
(Ah)
= (1 )
1
Ar
1
h
so wages are linear in human capital (from constant returns). Taking logs
gives the standard wage equation:
log w
i
= c + E
i
Consider two economies with same technology and interest rate but
dierent schooling. They will have same physical to human capital ratio.
From
Y
j
= K
1
j
(AH
j
)
and
K
j
=

1
r
1
AH
j
we obtain
Y
j
= (1 )
1
Ar
1
H
j
= (1 )
1
Ar
1
exp(E
j
)
Human capital
log Y
2
log Y
1
= (E
2
E
1
).
So if economy has on average on year more schooling, income should be 6
to 10 percent higher. Data (1985), there are much larger dierences
log Y = c + 0.313
(0.027)
E
which is too strong given micro evidence. Not simply explained by
dierences in interest rate (as control)
r = (1 )
Y
K
Taking logs of
Y
j
= (1 )
1
Ar
1
exp(E
j
)
gives
log Y
j
= c
1
log r + E
j
or = c
/
log
Y
K
+ E
j
Human capital
Estimate equation leads to
log Y = c + 0.266
(0.033)
E + 0.408
(0.178)
log
Y
K
so there is still a large eect of education on income (coecient on Y/K
should be near 1/2). Relationship may reect human capital externalities
(Mincer equations private returns)...
... or everything is captured in A : An alternative interpretation is that
there are dierent patterns in technology, A, and these are correlated with
human capital dierences.
Hall & Jones
Thats what Hall & Jones (1999) try to tackle. Assume
Y
j
= K
j
(A
j
H
j
)
1
with H
j
eciency units of labor given by Mincer-type relationship
H
j
=
E
exp(E
j
)L
j
(E)
where (E
j
) is return to schooling, and L
j
(E) is number of individuals
with schooling years E. Microeconomic studies suggest that the
percentage increase in earnings from additional schooling falls as amount
of schooling rises. (E
j
) is piecewise linear function with slope 0.134 for E
below 4 years, 0.101 for E between 4 and 8 years and 0.068 for E above 8
years (this follows work by Psachropoulos (1994) and the numbers are a
bit larger than in the mentioned Mincer regressions yet, higher values
will make human capital more important in the analysis below and we will
see that it is not.).
Hall & Jones
One can rewrite production function in per capita termsOne can rewrite
production function in per capita terms
Y
j
= K
j
(A
j
H
j
)
1
= Y
1
j
=
K
j
Y
j
(A
j
H
j
)
1
= Y
j
=

K
j
Y
j

1
A
j
H
j
=
Y
j
L
j
=

K
j
Y
j

1
H
j
L
j
A
j
Hall & Jones (1999) use this equation to estimate contributions to output
per worker in each country. Average output per worker in ve richest
countries (USA, Luxembourg, Canada, Switzerland, Australia) exceeds
average in poor group (Burundi, Malawi, Burkina Faso, Myanmar, Niger)
by factor 31.7 (based on geometric average).
Hall & Jones
Now, the dierence in (Hall & Jones set = 1/3)
K
Rich
Y
Rich

1
K
Poor
Y
Poor

1
is 1.8. The dierence in
H
Rich
L
Rich
H
Poor
L
Poor
is 2.2. And the dierence in
A
Rich
A
Poor
8.3 (that makes 1.8 2.2 8.3 = 31.7). Thus most of the gap
between richest and poorest countries is due to the residual, A.
... with no dierence in A the output dierence would be only 3.96
(= 1.8 2.2). Why?
Hall & Jones
Because:
Investment rates are relatively similar. Moreover, the dierence gets raised
to the power 1/2:
K
j
Y
j

1
=

K
j
Y
j
1/3
11/3
=

K
j
Y
j
1
2
.
Similarly, the average educational attainment in the ve richest countries
is about 8.1 years greater. The dierence gets reduced when converted
into an eect on output (via Mincer return to schooling assumption).
Hall & Jones
To sum up, Hall & Jones nd that
(1) Dierences in physical and human capital matter but
(2) there are also signicant productivity dierences.
Endogenous Growth
Models so far: no sustained long-run growth; relatively little to say about
sources of technology dierences.
Models in which technology evolves as a result of rmsand workers
decisions are most attractive in this regard (and we will discuss these).
But sustained economic growth is possible in the neoclassical model as
well: AK model prevents diminishing returns to capital.
Capital accumulation could act as the engine of sustained economic
growth.
Neoclassical version of the AK model: Very tractable and applications in
many areas.
Shortcoming: capital is essentially the only factor of production,
asymptotically share of income accruing to it tends to 1.
Ak model
Rebelo (1991)
Y
t
= AK
t
A > 0
Does not depend on labor, thus w
t
will be equal to zero. Dening
k
t
= K
t
/N
t
as the capital-labor ratio
y
t
=
Y
t
N
t
= A
K
t
N
t
= Ak
t
Notice output is only a function of capital, and there are no diminishing
returns. But introducing diminishing returns to capital does not aect the
main results in this section.
Ak model
More important assumption is that the Inada conditions are no longer
satised
lim
k
f
/
(k) = A
In fact, The marginal product of capital is alwyas equal to A.
Ak model
Capital accumulates as
k
t+1
k
t
= k
t
+ sy
t
= k
t
+ s (w
t
+ r
t
k
t
) = k
t
+ sr
t
k
t
= k
t
+ sAk
t
thus
k
t+1
k
t
= k
t
+ sAk
t
=
k
t+1
k
t
k
t
= + sA
If sA > 0 economy grows endogenously (ie with exogenous
technological change).
No transitional dynamics: growth rates of consumption, capital and output
are constant and given in last equation.
Ak model and policy
Suppose there is an eective tax rate of on the rate of return from
capital income.
The eective marginal return to capital will be (1 )Ak. Repeating the
analysis above this will adversely aect the growth rate of the economy,
now:
k
t+1
k
t
k
t
= + s(1 )A
Since saving rate is constant, dierences in policies will lead to permanent
dierences in the rate of capital accumulation.
Even small dierences in can have very large eects.
Endogenous Growth via learning by doing and externalities
Romer (1986), Arrow (1962), Sheshinski (1967)
Romer (1986): model the process of knowledge accumulation.
Dicult in the context of a competitive economy.
Solution: knowledge accumulation as a byproduct of capital accumulation.
Technological spillovers: arguably crude, but captures that knowledge is a
largely non-rival good.
Non-rivalry does not imply knowledge is also non-excludable.
But some of the important characteristics of knowledge and its role in
the production process can be captured in a reduced-form way by
introducing technological spillovers.
No population growth (we will see why this is important). N
t
= 1.
Production function with labor-augmenting knowledge (technology) that
satises Assumptions on Continuity, Dierentiability, Positive and
Diminishing Marginal Products, and Constant Returns to Scale and the
Inada conditions.
Instead of working with the aggregate production function, assume that
the production side of the economy consists of a set i [0, 1] of rms.
The production function facing each rm i is
y
i ,t
= Ak
i ,t
t
n
1
i ,t
0 < < 1
t
stands for aggregate stock of capital.
Key assumption: Firms take
t
as given, but this stock of technology
(knowledge) advances endogenously for the economy as a whole.
t
=

t
I (v)dv
Extreme assumption of suciently strong externalities such that
t
can
grow continuously at the economy level. Motivated by learning-by-doing:
"each new machine produced and put into use is capable of
changing the environment in which production takes place, so
that learning takes place with continuous new stimuli." (Arrow,
1962, 157)
Alternatively, could be a function of the cumulative output that the
economy has produced up to now.
Prot maximization subject to
y
i ,t
= Ak
i ,t
t
n
1
i ,t
yields
Ak
1
i ,t

t
n
1
i ,t
= r
t
(note that this is the private not social marginal product!).
In symmetric equilibrium
Ak
+1
t
n
1
t
= r
t
and
(1 )Ak
+
t
n
t
= w
t
Ak
+1
t
= r
t
and
(1 )Ak
+
t
= w
t
Then per capita output is given by
w
t
+ r
t
k
t
= (1 )Ak
+
t
+ Ak
+1
t
k
t
= Ak
+
t
and capital evolves as
k
t+1
k
t
= k
t
+ sAk
+
t
Endogenous Growth
Capital evolves as
k
t+1
k
t
k
t
= sAk
+1
t
.
Increasing returns to scale not sucient for endogenous growth! We need
very increasing returns such that + = 1:
k
t+1
k
t
k
t
= sA .
Endogenous Growth
Romer (1987)
Researchers

Economic Growth

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Economic Growth

last equation becomes (rst order equation in y

The steady state condition was

Population grows at rate n. Common technology advances at zero rate (to

Mark Weder (Adelaide) Economic Growth August 2008 38 / 68

Mark Weder (Adelaide) Economic Growth August 2008 40 / 68

(a) This can be estimated using cross-country data, if we have measure of

Firms face interest rate, r . Human capital is fraction of schooling with

Mark Weder (Adelaide) Economic Growth August 2008 47 / 68

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