Macroeconomics for Development

Prof. Alessandro Flamini

Lectures 17

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 Outline of the lecture

Endogenous Growth: productive externalities

Reference: Introducing Advanced Macroeconomics

by Peter Birch Sorensen and Hans Jorgen Whitta Jacobsen,
chapter 8.

2 2010
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A. Flamini
Question

What was the major limitation of the Solow model?

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 From Exogenous Growth to
Endogenous Growth

• Solow models succesful to account for many aspects of

economic growth but

• have a major limitation: long-run growth is

unexplained, it is exogenous!

 Big question: how to explain the source of long-run

growth?

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INTRODUCTION TO ENDOGENOUS GROWTH
• In typical Western countries, income per capita has increased
by factors between 6 and 8 over the last 100 years. How has
this been possible?

• Technological growth: in all of our models, long-run

economic growth is rooted in technological growth. But
technological growth is unexplained in these models.

• An endogenous growth model explains/endogenizes the

long-run technological growth rate and hence the long-run
growth rate of output per worker. That is, the model shows
how these growth rates depend on model parameters.

• Thereby, the model implies statements on how economic

policy affects long-run growth. ©The McGraw-Hill Companies, 2010
TWO TYPES OF ENDOGENOUS GROWTH MODELS
1. R&D based: Explicitly describe the production of
technological progress, i.e., contain a production function
with output, At +1 − At , depending on certain inputs.

2. Externality based: No explicit production function for

technological progress, but an assumption that (labour
augmenting) technology in every firm, At , depends
positively on aggregate capital (or output) because of
”productive externalities”.

• This hp implies increasing returns in the aggregate

production function

 growth of GDP per worker in the long run without

exogenous technological growth. ©The McGraw-Hill Companies, 2010
Question

Consider the basic Solow model without technological

progress. Recall its main assumption of constant
return to scale.

1.What is the very reason why we do not have long

run growth?

2. What would we need to have growth?

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 A MODEL OF ENDOGENOUS GROWTH BASED ON
PRODUCTIVE EXTERNALITIES

• There is one representative firm, which we can see in

two roles:

1. As the sole producer of aggregate output

2. As the individual, small firm that takes all aggregates
as given

• When the firm decides its capital demand, K t , it takes

d

the aggregate capital stock, K t , as given because the

firm is too small to influence the economy’s aggregates.

• But ”at the end of the day”, that is, in equilibrium, one
must have Ktd = Kt because there is only this one firm.
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 A MODEL OF ENDOGENOUS GROWTH BASED ON
PRODUCTIVE EXTERNALITIES

• HP: constant returns at the firm level and increasing

returns at the aggregate level.

• At the level of the individual firm, the production

function is:

Yt = ( K t) (AL )
d  d 1−
t t , 0    1,

where t is taken as given, and there is CRS to ( t t ) ,

d d
A K ,L
in accordance with the replication argument.

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• Because of productive externalities, the individual
firm’s At depends on aggregate capital, K t :

At = K t ,   0.

• At the aggregate level the production function (in

equilibrium) is:
Yt = Kt ( Kt Lt )
  1−  + (1− ) 1−
= Kt Lt .
The sum of the exponents of Kt and Lt is 1 +  (1 −  )
implying that there is IRS when   0 .

• We have CRS at the individual firm level and IRS

at the aggregate level.

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Motivation for productive externalities?

• Empirics: estimates of the equivalent of our model’s

1 +  (1 −  ) are often larger than one, e.g., around 1.5 (a fairly
large estimate, however). This gives a  of around ¾, not
completely ruling out  = 1.

• Theory (reasoning): learning by doing. Workers get more

skilled (they are learning) as they use new capital (by doing).
Workers become more productive, not only because there is
more capital (the direct/internal effect), but because they
learn new skills, which they keep if they are deprived of
the new capital, e.g., if they get another job (the
indirect/external effect).

• The last effect does not (in the longer run) accrue particularly
to the individual firm, but to all firms. ©The McGraw-Hill Companies, 2010
 THE COMPLETE MODEL
…consists of the equations for the factor prices plus:

Yt = ( Kt ) (AL )
 1−
t t , 0  1

At = K t ,

St = sYt ,

Kt +1 = St + (1 −  ) Kt ,

Lt +1 = (1 + n ) Lt .

Parameters:  , ,s, ,n .
State variables: K t and Lt .
No equation At +1 = (1 + g ) At .
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• Take another look at the aggregate production function:
Yt = Kt ( Kt Lt )
  1−  + (1− ) 1−
= Kt Lt .

• If  = 0 : the basic Solow model. Assume therefore that

,  0 , then increasing returns to Kt and Lt in the aggregate
production function.
 3 cases: 1: f <1, 2 : f =1, 3: f >1

• If   1 , then  +  (1 −  )  1 : diminishing returns to the

factor, capital, alone. This leads to ”semi-endogenous
growth”.

• If f = 1 , then  +  (1 −  ) = 1 : constant returns to capital alone.

Leads to truly endogenous growth.

• What about   1 ? Gives an extreme model. ©The McGraw-Hill Companies, 2010

 SEMI-ENDOGENOUS GROWTH (  1 )

• Define technolgy-adjusted variables:

and
.

From Yt = ( Kt ) (AL ) ,
 1−
t t we get:


• From t
A = K t we get:

At +1  K t +1 
=  .
At  Kt  ©The McGraw-Hill Companies, 2010
 SEMI-ENDOGENOUS GROWTH (  1 )

• Then:

• Inserting Kt +1 = St + (1 −  ) Kt and recalling gives:

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 SEMI-ENDOGENOUS GROWTH (  1 )

• Rearranging gives the transition equation:

Note: the exponents in the last expression are all positive.

• To study convergence we look at the properties of this

equation.
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• This transition equation has the following properties:

1. It passes through (0,0). 2. It is everywhere increasing.

3. There is a unique positive intersection, , with the 45o
line: inserting gives:

4. The slope in is less than one (differentiate, etc. and

use n +   0 ). ©The McGraw-Hill Companies, 2010
Question

Consider the transition equation

With the following properties:

1. It passes through (0,0).
2. It is everywhere increasing.
3. There is a unique positive intersection, , with the 45o
line.
4. The slope in is less than one.
In an appropriate Cartesian plane plot the transition equation
along with the 450 line, draw the dynamics of and discuss
the long run evolution.
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• converges to implying that converges to:

This defines the steady state. ©The McGraw-Hill Companies, 2010

 GROWTH IN STEADY STATE

• When and have converged to the

constant steady state values and , respectively, kt
and yt must grow at the same rate as At . Why?

• The growth rate of At is endogenous! We can easily find its

value in steady state:

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 GROWTH IN STEADY STATE

Consider the previous equation (first part):

• In steady state . Then


At +1  K t +1   / (1− )
=  = (1 + n ) 
At  Kt 
At +1 − At  / (1− )
= (1 + n ) − 1  g se .
At ©The McGraw-Hill Companies, 2010
• Thus, our model implies convergence to a steady state with
a common constant growth rate of kt , yt and At :
 / (1− )
g se = (1 + n ) − 1.

• In fact, there is balanced growth in steady state

• We have a steady state with endogenous growth:

positive growth in yt without exogenous technical progress,
and the growth rate depends on model parameters.

• But we only have g se  0 if n  0 : labour force growth is

required for economic growth.

• Our steady state is therefore one of semi-endogenous

growth: there is only economic growth if the labour force
grows! ©The McGraw-Hill Companies, 2010
• Considering f a technical parameter not easily affected
by policy, the most obvious implication for structural
policy is: in order to promote long-run economic
growth, promote population growth!

• Reasons for being cautious with such a policy:

– the well-known ”thinning-out of capital” effect

– the empirics

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 EMPIRICS FOR SEMI-ENDOGENOUS GROWTH
• Plotting g i against n i , 1951-2003, across 44 countries:

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 In contradiction to semi-endogenous growth, there is a clear
negative correlation between and across countries, but:
i i
g n

1. Direction of causality?

2. Is our model a country by country model or is it for the world?

3. Outside the steady state there is transitory growth in addition

to the underlying endogenous steady state growth. Now,
transitory growth depends negatively on labour growth in the
Solow models. So we have two channels at work where n has
opposite effects.

 Perhaps we should look at even longer periods and not look

across countries.
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• Country by country tendency: population growth decreases
and economic growth increases from the first to the second
subperiod. This speaks against semi-endogenous growth.

• However, in an even wider, global perspective, one can

counterargue that the last 200 years form both

- the period in which the World has seen non-negligible

average annual growth rates in income per capita and

- the period in which there has been non-negligible average

annual population growth rates.

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Question

Consider the Agricolture Revolution (Neolithic Revolution).

How could population growth have positively impacted on
economic growth?

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