12 Growth Theory

pg 368-399

Misconception - The essential ingredient of economic growth is physical capital such as factories, infrastructures and other tools.

How do macroeconomic theories evolve?

• The Evolution of Growth Theory

Figure 12.1 The Interplay between the Real World and Economic Theory
Observations of the real world shape economic theory. Economic theory then informs policy decisions that are designed to meet certain economic goals. Once there polices are implemented, they affect the real world. Further real world observations contribute to additional advances in economic theory, and the cycle continues.

What is Solow growth model?

A Nation's Production Function

• A production function for a firm describes the relationship between the inputs the firm uses and the output it creates. In equation form, the production function for a single firm is

$q = f(physical \: capital, human \: capital)$

where $q$ is the firm's output.

• The aggregate production function describes the relationship between all the inputs used in the macro-economy and the economy's total output (GDP). We can state the aggregate production function in equation form as

$GPD = Y = F(physical \: capital, human \: capital, natural resources)$

• The Focus on Capital Resources

Figure 12.2
US government, and GDP Growth, 1965-2014
Growth in real investment is positively correlated with growth in real GDP. The big question is whether this correlation implies causation.

Diminishing Marginal Products

• The marginal product of an input is the change in output divided by the change in input.
• Diminishing marginal product occurs when the marginal product of an input falls as the quantity of the input rises.

US Interstate Highways and the Aggregate Production Function

Figure 12.4
The Aggregate Production Function
The aggregate production function graphs the relationship between output (Y, or real GDP) and capital input (K). The shape of the production function illustrates two important features of production. First, the marginal production of resources is positive, as indicated by the positive slope. Second, the marginal product of additional resources declines as more resources declines as more resources are added. This result is evident in the declining slope of the function.

Implications of the Solow Model

The Steady State

• The steady state is the condition of a macro-economy when there is no new net investment.
• Depreciation is a fall in the value of a resource over time.
• Net investment is investment minus depreciation.

Convergence

Convergence is the idea that per capita GDP across nations will equalize as nations approach the steady state.

Figure 12.5
Convergence
In 1980, the United State has much more capital than China did; this was one reason why real GDP for the United State was much higher. But in the years since, China has increased its capital stock substantially and has grown much more rapidly than the United States. The Solow model implies that the United States is closer to its steady state and therefore grows more slowly than China.

How Does Technology Affect Growth?

Technology and the Production Function

Figure 12.6
New Technology and the Production Function
New Technology increases the slope of the production function as the marginal production of capital increases. The old production function is shown as $F_1$, and the new production function is shown as $F_2$. After the technologies innovation (represented by $A$), capital is more productive, and this outcome leads to new economic growth. If technology continues to advance, economic growth can be substantial.

We can also use an equation to see how the production function is altered. The aggregated production function now includes an allowance for technological advancement:

$Y = A \times F(physical \: capital, human \: capital, natural \: resources)$

Exogenous Technological Change

Exogenous growth is growth that is independent of any factors in the economy.

Policy Implications of the Solow Model

Why are institutions the key to economic growth?

Endogenous growth is growth driven by factors inside the economy.

• The Role of Institutions

$Y = A \times F(physical \: capital, human \: capital, natural \: resources, institutions)$

• Institutions Determine Incentives

Figure 12.8
Institutions, Incentives, and Endogenous Growth
The goal is economic growth, but it all starts with institutions. Institutions provide the incentives that motivate choices made by people in an economy. The right institutions provide incentives for people to invent new technology and to invest in human and physical capital. These actions lead to economic growth.

End