Explain and evaluate the neo-classical theory of long-run economic growth. In light of this theory what useful insights can be gained concerning the economic growth process of the UK economy over the past few decades?
In recent year’s macroeconomists have become increasingly dissatisfied with Solow’s neoclassical theory of long run economic growth, through scrutiny of its application to the real world. (Gordon, 2006). In this essay these criticisms are going to be addressed first by explaining the theory, then considering the effect of changing different variables such as the savings rate, population growth and technical progress. The theory will then be applied to the UK economy over ...view middle of the document...
It is defined by the equation S= (n+d) K where ‘S’ represent the national saving, ‘n’ the growth of labour input and ‘d’ the fixed depreciation rate. Solow integrated these two parts to form the growth theory defined by the equation ‘s(Y/N) = (n+d)(K/N)’ (Gordon, 2006). The left hand side shows the total national saving rate per person (s) as a percentage of the production function. The right side shows the amount of investment needed to maintain the capital intensity. These two sides are plotted separately shown in figure 2.
At any point on the left of the steady state equilibrium (C in figure 1), saving and investment is higher than the investment required. This extra investment causes the economy to rapidly grow till it reaches the steady state. At any point on the right, saving and investment is below the investment required hence moving the economy back to its steady state.
Solow’s theory so far asserts that an increase in the saving rate does not create a permanent increase in the growth rate of output. This is shown by considering the effects of a higher saving rate on his model. Figure 3 illustrates the introduction of a higher saving rate, where sy shifts upwards to s’y. The vertical difference between the new savings line and the point C is known as the additional saving available to fuel growth in capital intensity. The economy then moves along the new savings line to the point C’, where capital intensity is higher. The growth rate of output is temporarily raised above the growth rate of N achieving a higher standard of living; but due to this raise being temporary capital intensity does not continue to grow.
The effect of a rise in the rate of population growth can also be considered in neoclassical theory. A rise in the rate would require the per capita investment line to increase and shift upwards where it meets the savings line at a new steady state with a higher level of income per capita and a higher level of capital intensity. This would cause the country to become more capital intensive and therefore enjoy a higher living standard. However, this makes no difference to the growth rate of capital or income. One factor that does help to continue growth is the case in changes of exogenous technological progress
Solow introduced technological progress to the model to account for sharp increases in growth observed in the past decades (Blanchard, 2006). He assumed that technological change makes both labour and capital input more efficient, and is illustrated by an increase in autonomous growth mentioned in the production function equation earlier. This increase in autonomous growth raises both the output per person and capital intensity. The magnitude of autonomous growth is also contributed by the elasticity of output; which according to Gordon (2006) Solow defined as the share of capital income in total GDP. The rate of technical progress is estimated as the residual between the growth...