Explaining Theories of Economic Growth

Different models of economic growth stress alternative causes of economic growth. The principal theories of economic growth include:

1. Mercantilism – Wealth of a nation determined by the accumulation of gold and running trade surplus
2. Classical theory – Adam Smith placed emphasis on the role of increasing returns to scale (economies of scale/specialisation)
3. Neo-classical-theory – Growth based on supply-side factors such as labour productivity, size of the workforce, factor inputs.
4. Endogenous growth theories – Rate of economic growth strongly influenced by human capital and rate of technological innovation.
5. Keynesian demand-side – Keynes argued that aggregate demand could play a role in influencing economic growth in the short and medium-term. Though most growth theories ignore the role of aggregate demand, some economists argue recessions can cause hysteresis effects and lower long-term economic growth.
6. Limits to growth – From an environmental perspective, some argue in the very long-term economic growth will be constrained by resource degradation and global warming. This means that economic growth may come to an end – reminiscent of Malthus theories.

Theories in more detail

Mercantilism

Popular at the start of the industrial revolution, Mercantilism isn’t really a theory of economic growth but argued that a country could be made better off by seeking to accumulate gold and increasing exports.

Classical model

Developed by Adam Smith in Wealth of Nations (1776), Smith argued there are several factors which enable increased economic growth

1. Role of markets in determining supply and demand
2. The productivity of labour. Smith argued income per capita was determined by “the state of the skill, dexterity, and judgment with which labour is applied in any nation” (Wealth of Nations I.6)
3. Role of trade in enabling greater specialisation.
4. Increasing returns to scale – e.g. specialisation we see in modern factories and the economies of scale of increased production

Ricardo and Malthus developed the classical model. This model assumed technological change was constant and increasing inputs could lead to diminishing returns. This led to the gloomy predictions of Malthus – that the population would grow faster than the world’s capacity to feed itself. Malthus under-predicted the capacity of technological improvements to increase food yields.

Neo-Classical model of Solow/Swan

The neo-classical theory of economic growth suggests that increasing capital or labour leads to diminishing returns. Therefore, increasing capital has only a temporary and limited impact on increasing the economic growth. As capital increases, the economy maintains its steady-state rate of economic growth.

To increase the rate of economic growth in the Solow/Swan model we need:

• An increase in proportion of GDP that is invested – however, this is limited as higher proportion of investment leads to diminishing returns and convergence on the steady-state of growth
• Technological progress which increases productivity of capital/labour

It suggests poor countries who invest more should see their economic growth converge with richer countries.

Criticisms of this neo-classical (Exogenous model)

• It doesn’t explain why countries have different levels of investment as % of GDP
• Some developing countries don’t attract higher levels of investment because of structural problems such as corruption, lack of infrastructure.
• It doesn’t explain how to improve rates of technological progress.

Harrod Domar model – Savings Ratio and Investment

The Harrod-Domar model is a type of neo-classical model. It states growth rate depends on a function of the savings rate.

Some growth theories place a large emphasis on increasing domestic savings. Savings provide the necessary funds to finance investment. It is this investment which creates further growth. This has been an important factor behind the economic growth in Asia.

However, it depends on how efficient the investment is. If savings is too high it leads to lower growth because people cannot afford to consume.

New Economic Growth Theories (Endogenous growth)

Endogenous growth models, developed by Paul Romer and Robert Lucas placed greater emphasis on the concept of human capital. How workers with greater knowledge, education and training can help to increase rates of technological advancement.

They place greater importance on the need for governments to actively encourage technological innovation. They argue in the free market classical view, firms may have no incentive to invest in new technologies because they will struggle to benefit in competitive markets. The model

• Places emphasis on increasing both capital and labour productivity.
• States that increasing labour productivity does not have diminishing returns, but, may have increasing returns
• They argue that increasing capital does not necessarily lead to diminishing returns as Solow predicts. They say it is more complicated; it depends on the type of capital investment.
• Increased importance of spillover benefits from a knowledge-based economy.
• Emphasis is placed on free-markets, reducing regulation and subsidies. The argument is that we need to keep economies open to the forces of change.

Joseph Schumpeter argued that an inherent feature of capitalism was the ‘creative destruction’ – allowing inefficient firms to fail was essential for allowing resources to flow to more efficient channels.

Unified growth theory

Developed by Oded Galor, unified growth theory tries to combine many different elements of economic growth

• Economic stagnation that characterized most of human history until the eighteenth century
• First industrial revolution and the beginning of economic growth
• The role of human capital formation in economic growth
• Explaining divergence in economic growth across countries.

Economic Growth for Developing Countries

Other theories have been suggested for developing countries. Amartya Sen and Joseph Stiglitz.

The Malthus Predictions

It is argued that economic growth may have limitations caused by lack of raw materials, climate change and overcrowding. Given the failure of T.Malthus predictions to come true, these theories are often rubbished. Nevertheless, there may come a time when growth is constrained by environmental factors.

Readers Question: undertake an evaluation of what governments can learn from economic theory about raising their economies long-term growth rate?

The long-term growth rate depends upon the underlying trend rate of economic growth rate. This underlying trend rate of growth depends primarily on the growth of aggregate supply and productivity.

To increase the long-term growth rate, Aggregate Demand plays a very limited role. In the Classical model of economic growth, an increase in AD would only cause inflation. However, you could argue that AD does have a role to play.

If an economy experiences a recession for a long time, the average long-run growth rate will be lower. This is related to the theory of hysteresis. What has happened in the past is likely to happen in the future. Thus, if governments can manage aggregate demand, they can prevent recessions and help increase the average growth rate.

Apart from that – different theories of economic growth stress

• Role of saving (Harrod-Domar)
• Role of capital investment (classical model)
• Rate of technological improvement (Endogenous growth and others)
• Human Capital (Endogenous growth and unified growth)
• Institutional factors
• The openness of markets (Endogenous growth and classical models)