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Summary of Economic Growth Theory

While economists do not agree on exactly how to promote economic development, there is general agreement that development requires economic growth, a real increase in per capita income, and the social and political institutions necessary to support an expansion of the national economy. It also requires citizens who can work effectively in the enterprises. Asthe production of goods and services rise at a rate higher than increases in population there is economic growth. Economic development, in addition to increased per capita income, also includes fundamental changes in the structure of the economy. These changes are characterized by a growing industrial sector combined with a declining agriculture share of Gross Domestic Product (GDP) as well assignificant changes in population growth, rural to urban migration, and employment opportunities. [1]

Basic Economic Growth Model – Primary factors of production under a basic model are capital stock (roads, bridges, factories, land, etc.) and labor (economically active population). Output is a function of capital and labor. At a national level, an aggregate production function can berepresented by the formula Y = F (K, L) where Y is output, K is capital and L is labor. Increased output (Y) depends on increases in the capital stock (K) through investment and depreciation, and increases in labor supply (L) through population growth. The amount of investment in capital stock depends on savings and is calculated by multiplying the average savings rate in a country by national output.Labor supply is based on demographics. As capital and labor increase, economic output grows. The aggregate production function represented in the graph below is basic to economic growth models.

Basic Economic Growth Model

Harrod-Domar Growth Model – During the 1940s economists Roy Harrod and Evsey Domar independently developed an economic growth model based on a fixed-coefficient,constant returns to scale function (this function assumes that capital and labor are used in a constant ratio to each other to determine total output – see graph). Outputs in this graph are isoquants (combinations of labor and capital that produce output). The model assumes that labor and capital are always used in a fixed proportion to produce out equal amounts of output. The model’s equation is Y =K/v where v is a constant found by dividing capital (K) by investment (Y) – v is the capital-output ratio. This ratio is primarily a measure of the productivity of capital or investment.

Harrod-Domar Growth Model

The Harrod-Domar model focuses on two critical aspects of the growth process: saving and the efficiency with which capital is used in investment. This model can provide accurateshort term predictions of growth and has been used extensively in developing countries to determine the “required” investment rate or “financing gap” to be covered in order to achieve a target growth rate. At MCC, the “financing gap” approach was inferred in the first slide, second bullet of Franck Wiebe’s “Growth Diagnostics” presentation in terms of the need for MCC to provide foreign assistancewhich will in turn promote “… private capital investment, both foreign and domestic, eventually displacing aid.”[2] The Harrod-Domar model is simple with relatively small data requirements and the equation is easy to use. However, the model only remains in equilibrium with full employment of both labor force and capital stock causing inaccurate longer term economic predictions[3] and fails toaccount for technological change and productivity gains considered essential for long-term growth and development.

Solow (Neoclassical) Growth Model – In the 1950s, MIT economist Robert Solow presented a new model of economic growth that addressed limitations in the Harrod-Domar model. He replaced the fixed-coefficients production function with a neoclassical production function. This model...