GROWTH AND GROWTH POLICY

Determinants of GDP Growth
In Neoclassic Theory GDP volume and growth are determined by:
Savings rate
Rate of population growth
Rate of technical progress
A key determinant of growth is technology
However, a country needs not to invent new technology
It can grow by ‘borrowing’ technology and by investing in physical and human capita1

1. THE ENDOGENOUS GROWTH
Background
Neo-classical growth theory dominated economic thought from 1950 to 1980
The Neo-classical growth theory illustrates that:
Growth depends on capital and labour growth and factor productivity
In steady state there are zero growth of per capita savings and growth of per capita output
By 1980s dissatisfaction arose with neo-classical theory
Development in developed countries did not support the neo-classical growth theory
Savings rates and growth were positively correlated across developed countries
So, endogenous growth theory was developed

According to Neo-classical theory:
Steady-state is achieved at a point where savings and investment requirement lines cross
So long saving is more than minimum investment requirement, the economy grows, because capital is added to the economy
Development process reaches steady state and stops
Investment requirement line has a constant positive slope, but savings line flatten out in long run, so investment requirement line and savings curve are guaranteed to cross

Endogenous growth theory (Figure -1)
Modifies the shape of the production function
It denies law of diminishing marginal return
It assumes constant marginal product of capital
Saving is everywhere greater than required investment
Savings curve no longer flattens out
Production and savings curve are straight lines
Higher is the savings rate, bigger is the gap between saving and investment and faster is growth (Figure -1)

Figure -1: Production and saving function in endogenous growth theory
Y Output per head
ƒ(k)
sƒ(k)
ƒ(n+d)k
k Capital per head

Endogenous growth theory presumes capital as the only factor for growth, so:
Y = aK (1)
⇒ ΔY= a ΔK (2)
⇒ ΔY/Y = a ΔK/Y [Dividing (2) with Y]
⇒ ΔY/Y = aΔK/aK [Putting Y = aK]
⇒ ΔY/Y = ΔK/K (3)
Equation (3) says that growth of output depends on the growth of capital stock
Endogenous growth theory further assumes that:
Savings rate, s, is constant, and
There is neither population growth nor depreciation of capital, and

As there is neither population growth nor depreciation of capital, and all saving goes to increase capital stock, So:
ΔK = sY
⇒ ΔK = s (aK) [As Y = ak]
⇒ ΔK/K = sa (4)
Equation (4) says that growth rate of capital is proportional to savings rate
From equation (3) and (4) we have
ΔY/Y = sa [ΔK/K =ΔY/Y] (5)
Equation (5) expresses that growth rate of output is proportional to savings
Higher is the savings rate, higher is the growth rate of output
This is the assumption of endogenous growth theory

Savings and Investment
Higher is the savings rate chosen by a society, higher is the steady state capital and income
It means, higher is the savings rate, higher is the per capita capital and per capital income in the in the steady state.
Conclusion: Steady state can be achieved at different living standard.
Limitation
Higher is k, greater is the investment required to maintain capital-labour ratio
Hence, higher is k les is consumption
So, too high a savings rate can lead to high income but low consumption

Let us assume:
Steady-state income equals y* = f (k*)
Steady state investment is (n + d) k*,
Steady-state consumption is c*, then
c* = ƒ(k*) – (n + d)k*
Conclusion
Steady state consumption is maximised, when just enough is invested to cover the increased output
Above this level, saving should be cut and more consumed
Below this level, consumption should be increased

3. DEEPER ECONOMICS OF ENDOGENOUS GROWTH
Difference between neo-classical and endogenous growth theory:
Endogenous growth theory abolishes law of diminishing marginal returns
It imposes constant returns to scale on capital
This violates one of the basic microeconomic principles
This implies that:
Firms with twice as much capital produces twice as much output
This suggests that larger and larger firms grow more and more
It means that ultimately a single firm comes to dominate the entire economy

Endogenous Growth theory argues
Practically, there is no monopoly
Individual firm cannot capture all benefits of constant returns to scale at the same time
Some of the benefits remain external to firm
Some firms use these factors and some firms have other factors of efficiency
A firm can not use all factors of productivity at the same time
Hence, there is no monopolisation of the economy

Further endogenous growth theory separates different capitals:
There are not only new machines but new ways of doing things
Some firms assume technological advantage because of research
Some assume unforeseen (unexpected) opportunity
Benefits of new machines can be copied
But benefits of new methods and new ideas can not be copied easily
Hence monopolisation is hold up

4. CONVERGENCE
Endogenous growth theory assumes that higher savings rate leads to higher growth rate
Countries those invest more grow faster
However, impact of higher investment on growth is transitory
Country with higher investment achieves higher per capita income
But afterward growth rate slows down
Endogenous growth theory predicts convergence for economies
It predicts all economies should reach same steady state and same per capita income ultimately

For Endogenous growth theory says:
Economies converge and converge conditionally
Those save and invest more converses fast
Those save and invest les converses slowly
Hence, international differences in growth rates and per capita income sustain in the time being
But growth rate of faster growing countries slows down
The growth rate of slowly growing countries goes up
Ultimately all economies should reach same steady state and same per capita income

Endogenous growth theory remarks that:
Till 1980s
Convergence was taking place at a rate of 2% annually
India’s income level was 5% of USA in 90s
Hence, it was concluded that India would achieve the US level in 151 years
However, the period of convergence could be shorten considerably by:
Increasing savings rate, and labour productivity in India
Some of such options are discussed below

Illustrations
Let’s per capita income of USA and India in 2005 were $35000 and $700 respectively. If per capita income of India converges at the rate of 2%, 5%, 8% 10% and 15% to that of USA, how many years India will require achieving USA standard
Let the convergence rate is 2%
India’s present per capita income is $ 700
US present per capita income is $ 35000
India is converging at the rate 2% to the USA

We know that:
Future Income = Present Income (1+r)n
Where n is the years and r is the rate of growth
35000 = 700 (1+2%) n
50 = (1+2/100) n
Log 50 = Log (102/100) n
Log 50 = n [Log 102 – Log 100)
1.699 = n [2.0086 – 2]
1.699 = n ×. 0086
n = 197 Years
It means India requires 197 years to converse to USA

Let the convergence rate is 5%
We know that:
Future Income = Present Income (1+r)n
Where n is the years and r is the rate of growth
35000 = 700 (1+5%) n
50 = (1+5/100) n
Log 50 = Log (105/100) n
Log 50 = n [Log 105 – Log 100)
1.699 = n [2.0212 – 2]
1.699 = n ×. 0212
n = 84 Years
It means India requires 84 years to converse to USA

Let the convergence rate is 8%
We know that:
Future Income = Present Income (1+r)n
Where n is the years and r is the rate of growth
35000 = 700 (1+8%) n
50 = (1+8/100) n
Log 50 = Log (108/100) n
Log 50 = n [Log 108 – Log 100)
1.699 = n [2.0334 – 2]
1.699 = n ×. 0334
n = 51 Years
It means India requires 51 years to converse to USA

Let the convergence rate is 10%
We know that:
Future Income = Present Income (1+r)n
Where n is the years and r is the rate of growth
35000 = 700 (1+10%) n
50 = (1+10/100) n
Log 50 = Log (110/100) n
Log 50 = n [Log 110 – Log 100)
1.699 = n [2.0414 – 2]
1.699 = n ×. 0414
n = 41 Years
It means India requires 41 years to converse to USA

Let the convergence rate is 12%
We know that:
Future Income = Present Income (1+r)n
Where n is the years and r is the rate of growth
35000 = 700 (1+12%) n
35000 = 700(1+12/100) n
Log 50 = Log (112/100) n
Log 50 = n [Log 112 – Log 100)
1.699 = n [2.0792 – 2]
1.699 = n ×. 0492
n = 34.67 Years
It means India requires 21.4 years to converse to USA

Let the convergence rate is 15%
We know that:
Future Income = Present Income (1+r)n
Where n is the years and r is the rate of growth
35000 = 700 (1+15%) n
50 = (1+15/100) n
Log 50 = Log (115/100) n
Log 50 = n [Log 115 – Log 100)
1.699 = n [2.0607 – 2]
1.699 = n ×. 0607
n = 27 Years
It means India requires 27 years to converse to USA

Up to 1990 India conversed only at rate of 2%
So, she had to wait 151 years to achieve USA standard
However, relying on neo-classical force of convergence, India cannot look forward to catch up with USA
If, India saves and invests more as Endogenous Growth Theory predicts:
It can magically reduce convergence period as above
If it can achieve only a growth rate of 8% annually that She is doing now:
Convergence time is reduced to 50 years only
This is true for all developing countries

Actually India convergence rate is 8%
We know that:
Future Income = Present Income (1+r)n
Where n is the years and r is the rate of growth
35000 = 700 (1+8%) n
50 = (1+8/100) n
Log 50 = Log (108/100) n
Log 50 = n [Log 108 – Log 100)
1.699 = n [2.0334 – 2]
1.699 = n ×. 0334
n = 50 Years
It means India requires 50 years to converse to income of USA

5. GROWTH TRAPS AND TWO SECTOR MODELS
To explain no-growth and high growth, neo-classical and endogenous growth theories is used
There are two kinds of investment opportunities
Some investments follow the law of diminishing marginal product
Some follow rule of constant marginal product
So, society must choose investment in sectors that follow constant marginal product

Societies investing in research and development have ongoing growth
Because it helps developing technology for growth
Societies that direct investment toward physical capital may have higher output in the short run but at the price of lower long-run growth
Least developed countries
Low-income causes les savings
Les savings do not meet capital requirement for growth
So, growth rate remains low, which leads to low a steady growth state
At high income savings and investments are more than the capital requirement
It leads to ongoing growth

6. PULATION GROWTH AND ECONOMIC GROWTH
Regarding population growth one oldest view is that:
Population growth functions against achievement of high incomes
Solow’s growth model predicts that
High population growth (n) means lower income (and lower steady growth state)
Because high population growth means less capital per worker
Rich Countries
With rising incomes birth rates fall
Rich countries are approaching zero population growth

Poor Countries
Poor countries have high birth resulting high population growth
And as incomes rise, death rates fall and population growth rises
Poor countries are recognizing need to reduce population growth
So, contraceptives are being persuaded and policies instituted
Reducing population growth in poor countries is difficult
In poor countries large families function as a social security system
Children ensures that parents are taken care of in their old age

8. LESSONS FROM THE ASIAN TIGERS
Because of high economic growth and quick development
Hong Kong, Singapore, South Korea, and Taiwan are called ‘Asian Tigers’
From 1966 to 2000 per capita GDP grew annually in average in (Table-1):
Hong Kong 5.7%
Singapore 6.8%
South Korea 6.8%
Taiwan 6.7%
They are seen as model for developing countries

They followed some policies, which are worthy of copying:
These policies are hard work and sacrifice
These countries have:
Saved more and invested more
Put more people to work
Hence, labour force increased from 1966 to 2000 in (Table-1):
Hong Kong 38-49%
Singapore 27-51%
South Korea 27-36%
Taiwan 27-37%

They concentrated on education in order to raise human capital
People with SSC and Higher Education grew from 1966 to 2000 in (Table-1):
Hong Kong 27-71%
Singapore 16-66%
South Korea 27-75%
Taiwan 26-68%
Total Factor Productivity in these countries however, did not grew fast

From 1966 to 2000 TFP grew (Table-1):
2.3 times in Hong Kong
0.2 times in Singapore
1.7 times in South Korea
2.6 times Taiwan
They have relatively stable governments
They follow an export-oriented economic policy
Encourage their industries to export
They liberalize their market and encourage their industries to compete in free market
They directed their investments

Table 4.1: Growth in the Tiger Countries (1966-2000)

They have encouraged foreign investment to bring in new technologies
The Tigers Countries have achieved something extraordinary in human history
Their high growth rate transformed them from poorest countries to rich countries
This is done in the old-fashioned way
Through saving, investment, hard work of the labour force and competition

9. THE GROWTH OF POOR COUNTRIES
Growth of Bangladesh illustrates a striking problem
Till 1990 it had actually no economic growth
This is true also for: Burma, Nepal, Ghana, etc
Income in these is so low that much of the population lives under subsistence
So, savings are very low
From 1960 to 1985 investment in Bangladesh was only 4.6% of GDP
In the same time, it was 36.6% to 24% in Japan and USA respectively

What to do
Population growth in poor countries was much higher than in Japan & USA- It must be reduced
They must invest in human capital
They have hostile climates for foreign investment – It must be liberalized
Enabling economic and legal environment for foreign investment must be ascertained
Repatriate investments and profits must be guaranteed for foreign investments
Export must be discouraged

Questions
Describe the factors on which the growth of the economy depends?
Explain indigenous growth theory.
Explain the relationship between output and savings according to indigenous growth theory.
What is the deeper significance of indigenous growth theory?
What is meant by two-sector model of the economy in indigenous growth theory?
Discuss the factors those determine the convergence of the economies.
Lets per capital annual income of USA is $60000 and of Bangladesh is $700. Let the economy of Bangladesh grows in average at the rate of 6%. How many years will Bangladesh require to the economy standard USA if the economy of USA stagnates?
Explain the theoretical lesson from the ‘Asian Tiger Countries’.
Explain the impact of rate of population growth on economic growth of a developing economy.