The Harrod-Domar Growth Model

• Assumptions:
Fixed- coefficient production functions
Capital and labor need to be used in a fixed
proportion to each other to produce different
level of output.
Capital-labor ratio
Constant return to scale.
Capital-output ratio
 The Capital-Output Ratio and the
Harrod-Domar Framework
• The production function is specified as follows: Y = 1/v x K
or Y = K/v (1)
• Where v is a constant: v is capital- output ratio.
• Rearranging the terms in equation (1) we find
• v = K/Y (2)
• The capital – output ratio is a measure of the productivity
of capital or investment.
• The capital-output ratio provides an indication of capital
intensity of the production process.
• Countries use different technologies to produce the same
good or they produce a different mix of goods.
• In a countries that produce large share of capital
intensive products, v is higher than in a country
producing more labor-intensive products.
• Economists often calculate the incremental capital-
output ratio (ICOR) to determine the impact on
output of additional (or incremental) capital.
• The ICOR measures the productivity of additional
capital, while (average) capital-output ratio refers
to the relationship between a country’s total stock of
capital and its total national product.
• Harrod-Domar model assume that capital-output ratio
remain constant, then average capital –output ratio is
equal to the incremental capital-output ratio, so the
ICOR = v.
• We can relate changes in output to change in the capital
stock: ∆Y = ∆K/v (3)
• The growth rate of output, g, is simple the increment in
output divided by the total amount of output, ∆Y/Y.
• Divide both sides of equation (3) by Y, then :g = ∆Y/Y =
∆K/Yv (4)
• Change in capital stock ∆K is equal to saving
minus the depreciation of capital (∆K = sY – d x K)
(5)
• Substituting the right side of equation (5) into the
term for ∆K in equation (4):g = (sY – d xK)/Y x
1/v which can be simplified to g =(s –d x K/Y)
x1/v. Since Y/K = v, we have g = (s –dv) x 1/v
which leads to the basic Harrod-Domar
relationship for an economy: g = (s/v) – d
(6)
• Equation (6) state that capital created by
investment is the main determinant of growth in
output and that saving makes investment
possible.
• The equation state two factors to the growth
process: 1) saving (s) and the productivity of
capital (v).
• Save more and make productive investments,
and your economy will grow.
• Economic analysts can use this framework either to
predict growth or to calculate the amount of saving
required to achieve a growth target rate.
• If the saving (or investment) rate is 24 percent, the
incremental capital –output ratio is 3, and the
depreciation rate is 5 percent, then the economy can
be expected to grow by 3 percent( 0.24/3 – 0.05 =
0.03)
 Limitations of Model

 Increasing the savings ratio in developing countries is not always easy.

Developing countries have low marginal propensities to save.
 Extra income gained is often spent on new assets rather than saved.
 Lack of sound financial system. Increased saving by households does not
necessarily mean there will be greater funds available for firms to borrow to invest.
(Institutional factors)
 Efficiency (improving capital/output ratio) gains are difficult to achieve in developing
countries often due to a poorly educated work force.
 Research and Development needed to improve the capital/output ratio is often
underfunded in developing countries.
The fundamentals of economic growth

The sources of growth: the aggregate

production function
 Theories of Economic growth
Output of goods andquantities of available
inputs such as capital and labour, and on the
productivity of these inputs. The relationship
between output and inputs is described by the
production function as follow service depends
on the :
• Y = AF(K, N) (1)
• Where: Y = real output produced in a given period of
time
• A = measure overall productivity
• K = the capital stock
• N = the number of worker employed in the period
• F = a function relating output, Y to capital K and labor,
N
• Equation (1) relates total output , Y, to the economy’s
use of capital, K and labor, L and to productivity, A.
• If inputs and productivity are constant, the production
function states that output also will be constant- there
will be no economic growth.
• The relationship between the rate of output growth
and the rates of input growth and productivity growth
is: ΔY/Y = ΔA/A + αKΔK/K + αNΔN/N (2)
• Where: ΔY/Y = rate of output growth;
• ΔA/A = rate of productivity growth;
• ΔK/K = rate of capital growth;
• ΔN/N = rate of labor growth
• αK = elasticity of output with respect to capital
• αN = elasticity of output with respect to labor
• Equation (2) the elasticity of output with respect
to capital, αK is the percentage increase in output
resulting from a 1% increase in the capital stock.
• Elasticity of output with respect to labor, αN is the
percentage increase in output resulting from a
1% increase in the amount of labor used.
• Equation (2) is called the growth accounting
equation.
 Growth Accounting
• According to (2) output growth, ΔY/Y , can be
broken into three parts:
 output resulting from productivity growth, ΔA/A
 Output that resulting from increased capital
inputs, αKΔK/K
 Output that resulting from increased labor inputs,
αNΔN/N.
 The rate of productivity change , ΔA/A is
calculated from the formula:
ΔA/A = ΔY/Y - αKΔK/K - αNΔN/N, which is the
growth accounting equation ( 2) rewritten with
ΔA/A on the left side.
Where ΔY/Y is output growth, ΔK/L capital
growth, ΔN/N is labor growth.
αK is elasticity of output with respect to capital ,
αN is elasticity of output with respect to labor.
The contributions to growth of capital and labor
would be found by:
• Contribution to output growth of growth in
capital:
• αK ΔK/K
• Contribution to output growth of growth in
labor:
• αN ΔN/N
• Productivity growth: ΔA/A = ΔY/Y - αKΔK/K -
αNΔN/N.
 Solow growth model
• Production function relates the output of an
economy – its GDP to productive inputs.
• Y = F(K(+) , L(+) ). The plus (+) signs beneath the
two inputs signify that output rises with either
more capital or more labor.
 • Figure 1. Output, (Y)

Production function,
Y =F(K,L)

Capital, K
Holding labor input , L unchanged, adding to the capital stock (K) allows an
economy to produce more, but in smaller and smaller increments –
diminishing marginal productivity
 Return to scale
• Return to scale – if inputs of capital and labor
were both doubled- result an increased of
output by the same proportional.
• If a doubling of inputs leads to a more than
doubling of output – increasing returns to
scale.
• Decreasing return to scale – when output
increases by less than increase in inputs.
• With constant return to scale – the property of
production function emerges: output per hour of
work- the output-labor ratio ( Y/L)- depends only on
capital per hour of work- the capital-labor ratio (K/L).
This simplification allows us to write the production
function in the following: y = f(k)
• Where y = Y/L and k = K/L. The output-labor ratio (Y/L)
is called the average productivity of labor.
• It show how much on average is being produced with
one unit (one hour) of work. The capital-labor ration
(K/L) measures the capital intensity of production.
 Capital accumulation and economic
growth
• Saving, Investment, and capital accumulation
• Assume that the size of the population, the
labor force and the numbers of hours worked
are all constant.
• Can capital accumulation proceed without
bound? Does more saving mean faster
growth? And since saving means postponing
consumption, is it always a good idea to save
more?
Capital accumulation and depreciation
• Let us start from the national account identity
• I = S + (T – G) + X – M).
• As a description of the long run or a steady state,
suppose that the government budget is balance (
T = G), current account surplus equals zero (X =
M). In this case the economy’s capital stock is
financed by saving of resident households.
Therefore in steady state, I = S. investment
expenditures are financed by domestic savings.
We can save , we can invest, we grow
• Let s be the fraction of GDP which households save to
finance investment. Equality of investment and saving
implies:
• I = sY, therefor I/L = sY/L = sy = sf(k)
• Gross investment- the amount of money spent on new
capital.
• Net investment – the increase in the capital stock.
Gross investment represents new additions to the
physical capital stock, but does not represent the net
change of the capital stock because, over time
equipment depreciate – it wear out, loses some of its
economic value.
• The fraction of the capital stock that is lost each period
is called depreciation, and the proportion of the total
stock lost each period δ is called depreciation rate. The
depreciation rate for the over all economy is stable and
will be taken as constant.
• When gross investment exceeds depreciation, net
investment is positive and the capital stock rises. If
gross investment is less than depreciation, the capital
stock falls. Net investment is therefore:
• ΔK =sY –δK or equivalently , written in intensive from:
• Δk = sy - δk
• Net accumulation of capital per unit of labor is
positively related to the saving rate s and
negatively related to the depreciation rate δ.
 The steady state
• Figure 2 Depreciation, (δk)

The capital- labor

Output- labor ratio, (y = Y/L)
Production function, y =f(k)
ratio stops changing
B
when investment is Saving, sf(k)
equal to C
depreciation. This
D A
occurs at point A,
the intersection
between the saving
schedule sf(k) and
the depreciation
line δk. k2
k1 k*
The corresponding output –labor ratio is determined by the production Capital –labor ratio (k = K/L)
function f(k) at point B. When away from point A, the economy moves
towards its steady state. Starting below the steady state at k1, investment
(point C) exceeds depreciation (point D) and capital-output ratio will
increase until reaches its steady state level k*
 Characterizing the steady state
• Δk=sf(k) – δk
• In figure 2 Δk is the vertical distance between the
savings schedule sf(k) and the depreciation line
δk. When Δk >0 , the capital stock per capita is
rising and economy is growing. When Δk <0, the
capital per capita and output per capita are both
declining. At the intersection of the saving
schedule and the depreciation line (point A),
gross investment and depreciation are equal, so
the capital-labor ratio (point B) no longer
changes. This is the steady state.
 Catching up
Catching up occurs when a country start s below its
steady state GDP (lower curve ) and embarks on a
faster growth path, approaching the steady state (
• Figure 3 the upper curve) from below

Suppose that the economy Steady state

is to the left of the steady
state capital-labor ratio, k*
say at k1. Figure 2 shows y=Y/L
that gross investment
exceeds depreciation δk1 at
point D. Catch- up

time
The distance CD represents net investment, the increase in the capital-labor ratio, k which
rises towards its steady state level k*. As the economy gets closer to point A, net
investment becomes smaller and smaller as the steady state is approached, it equal nil
when k = k*. This process is called Catch- Up. When k2 > k*, gross investment sf(k2) is less
than depreciation δk , the capital-labor ratio declines and we move leftward towards k*,
the economy’s stable resting point.
 An increase in the saving rate
• Figure 4 depreciation

An increase in saving rate

Output-labor
from s1 to s2 shift savings- f(k)
investment schedule

ratio
upwards, while production s2f(k)
function schedule remains B
s1f(k)
unchanged. The new steady
state output-labor and A
capital-labor ratios are both
high at point B than they
were at point A beforehand.
k1 k2 Capital-labor ratio
At the initial steady-state (point A), an increase in the saving causes gross investment to rise.
Since depreciation is unchanged, net investment must be positive. The capital-labor ratio starts
rising, which raises the output-labor ratio. This will go until the new steady state is reached at
point B. During this interim period, growth is higher, which give impression that higher investment
cause higher economic growth. The boost is only temporary, once the steady state has reached
no further growth effect can be expected from a higher saving rate.
• According to Solow Model a higher saving rate
implies higher living standards in the long run. An
increase in saving rate leads to high output,
consumption and capital per worker in the long run.
Although a higher saving rate raises consumption per
worker in the long run, an increase in the saving rate
initially causes consumption to fall. This decline
occurs because at the initial level of output, increases
in saving and investment leave less available for
current consumption. Society’s choice of a saving
rate should take into account this trade-off between
current and future consumption
 The Golden Rule
• In the steady state, when the capital stock per
capita is k*, savings equal depreciation and
the steady-state level of consumption c* ( the
part of income that is not saved ) is given by:
• c* = y –sy = f(k*) – δk*
 Golden Rule
• Figure 5 y=f(k*)

depreciation

Output-labor ratio
In figure 5 consumption per capita
is given by the vertical distance
consumption
between the production function
and the depreciation line. Figure 5 C
shows that consumption is highest
A
at the capital stock for which slope sf(k)
of the production function is
parallel to the depreciation line. investment
D

k*’ Capital-labor ratio

The corresponding optimal steady-state capital-labor ratio is indicated
as k*’ . The slope of the production function is the marginal productivity
of capital (MPK) while the slope of the depreciation schedule is the rate
of depreciation δ. Therefore the maximum level of consumption is
achieved when the slope of the production function, the MPK is equal
to the slope of the depreciation line: MPK = δ.
• To the left of k*, gross investment sf(k) at point C
exceed depreciation at point D. CD represent net
investment, increase in the capital-labor ratio
which rise towards its steady state level k*. To the
right of k* net investment becomes smaller then
depreciation rate. Capital labor ratio declines and
economy move leftward toward, k*. The golden
rule states that the economy maximizes steady-
state consumption when marginal gain from an
additional unit of GDP saved and invested in
capital (MPK) equals the depreciation rate.
 The consequences of disobeying the
golden rule
Dynamic inefficiency- when capital labor ratio
exceed, capital labor ratio at steady state too much
capital has been accumulated and the MPK is lower
than the depreciation. By reducing saving today an
economy can increase per capita consumption both
today and future. Dynamic inefficiency economies
save and invest too much - in order maintain a
capital stock which is too large and consume too
little as a result.
• A different situation arise if the economy is to the left of
k*’. Steady-state income and consumption per capita
may be raised by saving more, but not immediately;
consumption can be increased only in the long run after
the adjustment has occurred. More consumption in the
future in the steady state must be earned by increasing
saving and reducing consumption at the outset. This
requires current generations to sacrifice so future
generations can enjoy more consumption which will
result from more capital and income in the steady state.
An economy in such a situation is called dynamic
efficient, because it is not possible to do better without
paying the price for it.
 Dynamic inefficient Dynamic efficient
• Figure 6(a) • Figure 6(b)

Consumption
consumption

Time
It is possible to permanently raise
consumption by consuming more now
and during the transition to the new
steady state. reducing saving.
Time
A higher future steady sate level of
consumption is not free and requires
early sacrifices.
 Population growth and economic
growth
• If L grows at an exogenous rate n, output Y, and capital
K will also grow at rate n. The role of saving and capital
accumulation remains the same as we discuss above.
When we take into account population growth, the
capital accumulation condition now become:
• Δk = sf(k) – (δ +n)k.
• In order for capital-labor ration to increase, gross
investment must not just compensate for depreciation,
it must also provide new workers with the same
equipment as those already employed. This process is
called capital-widening and it explains the presence of
n in the equation.
• Figure7 ( δ+ n2)k

Output-labor
ratio ( y=Y/L
( δ+ n1)k

f(k)
The capital-labor ratio remains
B
unchanged when investment is A Saving, sf(k)
equal ( δ+ n1) k. This occurs at
point A, the intersection between
the saving schedule sf(k) and the
capital-widening line ( δ+ n1)k. An
increase in the rate of growth of k2* k1* Capital labor-ratio
the population from n1 to n2, is (k=K/L)
shown as a counter-clockwise
rotation of the capital-widening The Solow model with population growth implies
line. The new steady-state capital that, all things equal, countries with a rapid growing
labor ratio declines fro k*2 to k1*. population will tend to be poorer than countries with
lower population growth.
• At what level of investment does an economy with
population growth maximize consumption per
capita?
• Because the number of people who are able to
consume and save is growing continuously, the
golden rule must modified accordingly.
• Note that steady state investment per person-hour
is ( δ+ n)k*, so consumption per person-hour c* is given by: c* = f(k*)- ( δ+ n)k*.
Therefore consumption is at a maximum when: MPK= δ+ n. A growing population
will necessitate
a higher MPK at steady state. The
principle of diminishing marginal productivity
implies that the capital-labor ratio must be lower.
Consequently output per capita will also be lower.
• The model argued that an increase in the
population growth rate means that workers are
entering the labor force more rapidly than before.
These new workers must be equipped with capital.
When work force is growing rapidly a large part of
current output must be devoted just to provide
capital for the new workers to use. This implies that
increased population growth will lower living
standards
 Technological progress and economic
growth
• As far we ignored technological or technical progress. Technological progress means that more
output can be produced with the same quantity of equipment and labor. In the production
function, we add a measurement of the state of technology, A, which raises output at given
levels of capital stock and employment.
• Y = F( A+, K+, L+)
• When A increase, Y rises, even if K and L remain unchanged. A is frequently called total factor
productivity. Yet A is not really a factor of production, but a method or technique of production.
let us assume that A increases at a constant a, therefore technological progress is exogenous.
We modify production function as:

• Y = F(K,AL))
• In this formulation technological progress acts directly on the effectiveness of labor. The term
AL is known as effective labor to capture the idea that with the same equipment one hour of
work today produces more output than before because A is higher. Effective labor AL grows for
two reasons: 1) more labor, L and 2) greater effectiveness A. therefore rate of growth of AL is
now given by a +n. We redefine y and k as ratios of output and capital relative to effective
labor: y = Y/AL , k= K/AL
• The ratio of capital to effective labor is given by: Δk=sf(k) – (δ+ a+ n)k.
• To keep the capital-effective labor ratio , k= K/AL constant, the capital stock, K must also rise to
keep up with workers’ enhanced effectiveness ( a). So k will increase if saving sf(k) and hence
gross investment, exceeds the capital accumulation needed to make up for depreciation, δ
population growth, n and increased effectiveness, a.
• The steady state is now characterized by
constant ratios of capital and output to
effective labor (y= Y/AL and k = K/AL). If Y/AL is
constant, it means that Y/L grows at the same
rate as A. if the average number of hours
remains unchanged, then income per capita
must grow at the rate of technological
progress a. The continuous increase in
standard of living is due to technological
progress.
• In the steady-state the higher the a is the faster Y/L and
standards of living will grow. To address golden rule
condition, we redefine c as ratio of aggregate consumption,
C to effective labor (AL), the following consumption per
work will hold
• c = f(k*) – (δ +a +n )k*
• The marginal productivity of capital is the sum of
depreciation, of population and of technological change:
MPK = δ + a + n. maximum consumption per capital is equal
to consumption per unit of effective labor. The economy
now needs to invest capital per effective unit of labor to the
point at which its marginal product covers the investment
requirements given by technological progress (a),
population growth (n) and capital depreciation (δ ).
• The productivity improvement raises output per
worker for any level of the capital-labor ratio. A
productivity improvement raises steady state output
and consumption per worker in two ways: it directly
increases the amount that can be produced at any
capital-labor ratio. Productivity improvement causes
the long run capital-labor ratio to rise. Thus a
productivity improvement has a doubly beneficial
impact on the standard of living.
 The convergence Hypothesis
• The convergence hypothesis predicts that
countries with low initial per capita GDP will
grow faster than those that started richer.
• Under the assumption that the countries have
more or less the same steady state value of
GDP per capita, it make sense to expect a
negative relationship between initial
condition( per capita GDP) and the growth
which followed.
• While standard of living among the wealthier
countries seem to be organized around convergence
clubs, many poor countries seem to be stuck in
growth traps, with low per capita GDP and low or
even negative growth.
• How can we explain this contradiction with the
discussion we discuss already?
 Countries with low income per capita suffer from
insufficient capital accumulation because of
inadequate savings or destruction by war or natural
disaster.
• Low domestic alone cannot explain the situation.
Investment could be financed through borrowing.
 Poor countries suffer from technological
backwardness or a lack of a properly functioning
economy. It must be that for some reasons, the
poor countries have not yet been able to reach a
steady-state level attained by rich countries. In
that case when and if they eliminate the barriers
that prevent them from moving towards their
steady states, they should catch up and therefore
grow faster than the wealth economies.
• The convergence hypothesis can be expressed in
the following way:
• ΔYt /Yt – α = βY*t – Yt /Yt
• Which asserts that the growth rate of an economy
in period t, ΔYt /Yt will be higher than its steady
state growth rate (α) when GDP ( Yt) is less than
steady state (Y*t ) predicted by savings and
technology. The parameter β captures the speed
of convergence. The greater the distance is
between the current GDP and its steady state
value, the faster the rate of growth.
 Unconditional convergence
• Unconditional convergence mean that the poor
countries eventually will catch up to the rich
countries so that in the long run living standard
around the world become more or less the same.
The Solow model predicts unconditional
convergence under certain special conditions:
 world’s economies differ in terms of their capital-
labor ratios, with rich countries having high
capital-labor ratios and high level of output per
worker, and poor countries having low capital –
labor ratios and low level of output per worker.
 However, in terms of saving rates, population growth rate,
and production functions to which they have access – rich
and poor countries were the same.
 If each of a group of countries has the same saving rate,
population growth rate and the production function, the
Solow model predicts that- despite any differences in initial
capital-labor ratios, these countries all eventually reach the
same steady state.
 If countries have the same fundamental characteristics,
capital-labor ratios and living standard will unconditional
convergence even though some countries may start from
way behind.
 Conditional convergence
• But if countries differ in characteristics such as their saving
rates, population growth rate and access to technology,
according to the Solow model they will converge to different
steady sates, with different capital-labor ratios and different
living standards in the long run. if countries differ in
fundamental characteristics, the Solow model predicts
Conditional convergence – mean that living standards will
converge only within groups of countries having similar
characteristic. For example, if there is conditional
convergence, a poor countries with a low saving rate may
catch up someday to a richer country that also ahs a low
saving rate , but it will never catch up to a rich country that
has a high saving rate
 Missing inputs
• The most important reason why production functions are
different is the existence of the other observable inputs to
the production function which make capital and labor more
productive. Research has identified a long list of such
influence.
1) Human capital
 education and training – better trained and educated
workers are more productive, and more productive
workers can earn higher wages. More educated workers
tend to enhance the productivity of other factors. Skilled
workers are better at operating complex machines and
may be used to manage other labors and organize the
production process.
• Thus, production function now becomes:
• Y = AF(K+, L+ , H+)
• Human capital is accumulated over time and is
subject to depreciation as knowledge progress
and people age. This implies that countries
that invest more in education and training
tend to be better off in the long run- they
would tend to a have a production function in
panel (a).
 Health – human capital is not just education. It
includes anything that raises labor productivity
for a given capital stock. Human capital also
includes the state of health of workers. Freedom
from disease and chronic illness as well as access
to adequate medical care are considered by many
to be fundamental human rights. In a place where
health services are poor or access is limited to the
richest segment of the population, life expectancy
will be low. Reduced life expectancy reduces
incentives for individuals to invest in education,
and can lead to emigration of wealthy elites.
• 2 Public infrastructure
 A second important factor which is missing from
the production function is public infrastructure.
This includes streets, public transport,
telecommunication, postal services, airports,
systems of water distribution, electricity provision
and sewage treatment etc. Public infrastructure
are goods which contribute to general
productivity and are widely available to all users
at low cost or no cost.
• At the aggregate level, the production
function can be further augmented to include
the stock of public capital, which we will call
KG
• Y = AF (K+ , L+ , H+, KG+ )
 Social infrastructure

• Social infrastructure refers to those “soft”

factors which facilitate economic relations
and thereby make all factors of production
more effective. These factors include
property rights and human rights, and the
rule of law and the sustainable absence of
armed conflict.
• 3) Social infrastructure
Property rights – clearly defined rights of
ownership or property rights, which are
respected by others and enforced by the state.
Property rights require clear, credible and
enforceable legislation or constitutional
provisions which guarantee that individuals and
firms cannot be dispossessed of their belonging.
• If investors cannot be sure that they will own
their investments tomorrow why bother to
invest today? This explain why capital does not
always seem to flow from rich to poor
countries. Even if the rate of return on capital
in poor countries is much higher, the risk of
expropriation or restriction of property rights
may convince investors to keep their money in
richer, more stable places.
 Endogenous Growth Theory
• According to Solow model, productivity growth is the
only source of long run growth of output per capita.
The model takes the rate of productivity growth as
given, rather than trying to explain how it is
determined. The model assumes rather than explains
the behavior of the determinants of the long run
growth rate of output per capita. In response to this
shortcoming of the Solow model a new branch of
growth theory endogenous growth theory has been
developed to try to explain productivity growth and
hence the growth rate of output – endogenously or
within the model.
• Simple endogenous growth model is based on the aggregate
production function:
• Y = AK (1)
• Where y is aggregate output and K is aggregate capital stock.
The parameter A is a positive constant. According to the
production function in equation (1) each additional unit of
capital increases output by A units, regardless of how many
units of capital are used in production. The marginal product
of capital equal to A, and it does not depend on the size of
capital stock, K, the production function (1) does not imply
diminishing marginal productivity of capital. The assumption
that the marginal productivity is constant, rather than
diminishing is a key departures from the Solow growth model
•
• Endogenous theories have provided a number of
reasons to explain why marginal productivity of
capital may not be diminishing.
 Role of Human capital – knowledge, skills and
training of individuals. As economies accumulate
capital and become richer, they devote more
resources to investing in people, through
improved nutrition, schooling, health care and
on-job training. This investment in people
increases the country’s human capital, which in
turn raises productivity.
• As an economy’s physical capital stock
increases, its human capital stock tend to
increase in the same proportion. Thus, when
physical capital stock increases, each unit of
physical capital effectively works with the
same amount of human capital, so marginal
productivity of capital need not decrease.
R&D - firms have incentives to undertake
research and development activities. These
activities increase the stock of commercially
valuable knowledge including new products
and production techniques. Increase in capital
and output tend to generate increases in
technical know-how and resulting productivity
gains offset any tendency for marginal
productivity of capital to decline.
• Assume that national saving, S is a constant
fraction s of aggregate output, AK so that S =
sAK. In a close economy investment must equal
saving. Note that total investment equals net
investment plus depreciation or
• I =Δ K + dK. (2)
• We divide both sides of equation (2) by K and
then subtract d from both sides , we get:
• ΔK/K = sA-d (3)
• Because output is proportional to the capital stock, the
growth rate of output ΔY/Y equals the growth rate of
the capital stock, ΔK/K. therefore equation (3) implies
• ΔY/Y = sA-d (4)
• Equation (4) shows that in the endogenous growth
mode, the growth rate of output depends on the
saving rate s. As we assume that the number of
workers remains constant over time, the growth rate of
output per worker equals the growth rate of output
given in equation (4), and thus depends on the saving
rate, s.

Endogenous Growth model
• Figure 1
Output-effective labor
If the capital labor ratio is initially at k1,
savings and investment correspond to point
A, and lie above the capital-widening line
Production point B. The ratio of capital to effective
function f(k) labor ratio k=K/AL will thus increase by the
distance AB. As this ratio grows to reach the
level k2, saving is determined by point C and
Saving sf(k) the capital-effective labor ratio keeps rising

even faster as indicated by the distance CD.

C Because the marginal productivity of
capital does not decline, more of it produces
A Capital
ratio(y=Y/AL)

more income and therefore more saving.

accumulation (δ Therefore the output-labor and capital-
D
B +a +n labor r ratios never stop growing. Another
implication of non-declining is that an
increase in the saving rate makes the saving
k1 k2 schedule rotates upwards, leading to faster
Capital-effective labor accumulation of the capital stock and
ratio (k=K/AL) permanent growth in GDP per capita.
• Saving affects long run growth in the
endogenous growth framework because higher
rates of saving and capital formation stimulate
greater investment in human capital and R&D.
 Government policies to raise long-run
living standards
• 1)Policies to affect the saving rate –
policymakers should not try to force saving rate
upward because more saving means less
consumption in the short run. If the “invisible
hand” of free markets is working well the saving
rate freely chosen by individuals should be the
one that optimally balance the benefit of saving
more ( higher future living standards) against
the cost of saving more (less present
consumption)
 If the existing tax laws discriminate against saving by
taxing away part of the returns to saving, a “pro-saving”
policy is necessary to offset this bias.
 Individuals are too shortsighted in their saving decisions
and must be encourage to save more. If saving were
highly responsive to real interest rate, tax breaks that
increase the real return that savers receive would be
effective.
• For example taxing households on how much they
consumer rather than on how much they earn, thereby
exempting income that saved.
 Increase government saves – the government should try
to reduce deficit or increase its surplus.
• 2) policies to raise the rate of productivity
growth: Possible ways of increasing
productivity involve investing in public capital (
infrastructure), encourage the formation of
human capital – government affect human
capital development through education
policies, worker training, health programs.
• increasing research and development and
industrial policy – in which the government uses
subsidies and other tools to influence industrial
development