Endogenous growth

1. Economic Growth:
The Short Run vs. the Long Run
Time
National
economic
output
Actual output
Potential output
Business cycles
in the short run
Economic growth
in the long run
Downswing
Upswing
The crisis of 1997-98
is irrelevant to Asia’s
long-term growth potential.

2. Economic Growth:
The Short Run vs. the Long Run
To analyze the movements of actual output
from year to year, viz., in the short run
Need short-run macroeconomic theory
Keynesian or neoclassical
To analyze the path of potential output over
long periods
Need modern theory of economic growth
Neoclassical or endogenous

3. The Neoclassical Theory of
Exogenous Economic Growth
Traces the rate of growth of output
per capita to a single source:
Technological progress
Hence, economic growth in the
long run is immune to economic
policy, good or bad.
“To change the rate of growth of real
output per head you have to change the
rate of technical progress.”
ROBERT M. SOLOW

4. The New Theory of Endogenous
Economic Growth
Traces the rate of growth of output per
capita to three main sources:
Saving
Efficiency
Depreciation
“The proximate causes of economic growth are
the effort to economize, the accumulation of
knowledge, and the accumulation of capital.”
W. ARTHUR LEWIS

5. Exogenous vs. Endogenous
Growth
The neoclassical view
that economic growth in the long run is merely a
matter of technology
The new view
that long-run growth depends on saving,
efficiency, and depreciation is more illuminating.

6. A Simple Model of
Endogenous Growth
Four building blocks:
 S = I
Saving equals investment in equilibrium.
 S = sY
Saving is proportional to income.
 I = K + K
Investment involves addition to capital stock.
 Y = EK
Output depends on quality and quantity of capital.

7. A Simple Model of
Endogenous Growth
Implication:
 g = sE - 
Rate of economic growth equals
 Saving rate
times
 Efficiency (i.e., the output/capital ratio)
minus
 Depreciation

8. Endogenous Growth in the
Harrod-Domar Model
You may recognize the
endogenous growth model as
a reinterpretation of the
Harrod-Domar model
where growth depends on
A. the saving rate
B. the capital/output ratio
C. the depreciation rate

9. Sources of Endogenous
Growth I
Saving
Important implication for economic policy:
Economic stability with low inflation and positive real
interest rates spurs saving, which is good for growth.

10. Sources of Endogenous
Growth I
100
400
300
200
1965 1990
East Asia
OECD
Africa
Income
per capita

11. Sources of Endogenous
Growth II
Depreciation
The effect of depreciation on growth is related
to that of saving and investment on growth.
Unprofitable investment in the past reduces
the quality of capital and makes it depreciate
more rapidly, necessitating more replacement
investment to make up for economic and
physical wear and tear.
The more national saving has to be set aside
for replacement investment, the less will be
available for the buildup of new capital.

12. Investment: Quantity and
Quality
Compare Botswana and Tanzania:
In Botswana, the share of State-Owned
Enterprises in total investment fell from
16% in 1985-90 to 12% in 1990-97.
In Tanzania, the SOE share of investment
fell from 46% in 1985-90 to 23% in
1990-97.
This is probably a good sign.
Privatization helps improve investment.

13. Investment: Quantity and
Quality
Investment quality, however, is not
only a question of public vs. private
enterprise.
Sound banking is also important.
It takes sound commercial banks,
usually privately owned banks
motivated by profit rather than by
political concerns, to channel
household savings into high-quality
investment.

14. Sources of Endogenous
Growth III
Efficiency
Also fits real world experience quite well
Technical progress is good for growth because it allows
us to squeeze more output out of given inputs.
And that is exactly what increased efficiency is all
about!
Thus, technology is best viewed as an aspect of
general economic efficiency.
Important implication for economic policy:
Everything that increases economic efficiency, no
matter what, is also good for growth.

15. Sources of Endogenous
Growth III
Five sources of increased efficiency
1. Liberalization of prices and trade increases
efficiency, which is good for growth.
2. Stabilization reduces the inefficiency associated
with inflation, which is good for growth.
3. Privatization reduces the inefficiency associated
with state-owned enterprises, which …
4. Education makes the labor force more efficient.
5. Technological progress also enhances efficiency.
The possibilities are virtually endless!

16. Sources of Endogenous
Growth III
This is good news.
If growth were merely a matter of technology,
we would not be able to do much about it …
… except to follow technology-friendly policies by
supporting R&D and such.
But if growth depends on saving and efficiency,
there are things that we can do, in the private
sector as well as through the public sector, to
foster rapid economic growth.
Because everything that is good for saving and
efficiency is also good for growth.

17. What to Do to Encourage
Economic Growth
Maintain strong incentives to save
Keep inflation low and real interest rates positive
Maintain financial system in good health
so as to channel saving into high-quality investment
Foster efficiency
1. Liberal price and trade regimes
2. Low inflation
3. Strong private sector
4. More and better education
5. Limited, or well managed, natural resources

18. Liberalization and Economic
Growth
Liberalization of prices means that markets,
not bureaucrats, are allowed to set prices.
Mixed market economy is more efficient than
central planning.
 Compare former Soviet Union with the US and Europe
Liberalization of trade allows specialization
according to comparative advantage.
Free trade is more efficient than self-sufficiency.
 North Korea and Cuba vs. Hong Kong and Singapore
Applies to trade in goods, services, capital.
1

19. Liberalization Increases
Economic Efficiency
G
E
C
Traditional
output
Modern output
H
D Domestic,
distorted
price ratio
O

20. Liberalization Increases
Economic Efficiency
G
F
A B
C
Output
gain
Traditional
output
Modern output
D
H
E
Price
distortion
World price ratio
Domestic,
distorted
price ratio
If output gain = E and
price distortion = c,
then E = mc2
OC = modern output
CA = traditional output
OA = total output
O

21. Liberalization Increases
Economic Efficiency
G
F
A B
C
Output
gain
Traditional
output
Modern output
D
H
E
Price
distortion
World price ratio
Domestic,
distorted
price ratio
O
J K
Imports
Exports
Welfare
gain

22. Liberalization Increases
Economic Efficiency
G
F
A B
C
Traditional
output
Modern output
D
H
E
Price
distortion
O
J
Welfare
gain
M
N
Q
Transition
takes time:
From E to F
via M, N,
and Q

23. Liberalization Increases
Economic Efficiency
D
G
F
E
A
B
Price
distortion
J
O
H
World price
ratio
C
AB = static gain
BC = dynamic gain
AC = AB + BC = total gain
Productivity
gain
K
Welfare
gain
Traditional
output
Modern output

24. Growth and Trade,
1965-98
105
countries
-6
-4
-2
0
2
4
6
8
10
0 50 100 150 200 250 300 350
Trade (% of ppp-adjusted GDP)
Growth
per
capita
(%
per
year)
NB: UAE, Hong Kong, and Singapore.
Singapore
Hong Kong
United Arab Emirates
China
Korea
Botswana
Each 50 percentage point increase
in the trade ratio is associated
with an increase in per capita
growth by almost 1% per year.

25. Growth and Trade,
1965-98
32 sub-
Saharan
African
countries
-6
-4
-2
0
2
4
6
8
10
0 20 40 60 80 100
Trade (% of ppp-adjusted GDP)
Growth
per
capita
(%
per
year) Each 20 percentage point
increase in the trade ratio is
associated with an increase in per
capita growth by 1% per year.

26. Growth and Foreign Direct
Investment, 1965-98
100
countries
-4
-2
0
2
4
6
8
10
0 2 4 6 8 10 12 14
Foreign direct investment (% of ppp-adjusted GDP)
Growth
per
capita
(%
per
year)
Qualification: Relationship rests on Botswana and Singapore.
Botswana
Singapore
Each three percentage
point increase in the
FDI ratio is associated
with an increase in
per capita growth by
almost 1% per year.

27. Growth and Foreign Direct
Investment, 1965-98
-4
-2
0
2
4
6
8
10
0 2 4 6 8
Foreign direct investment (% of ppp-adjusted GDP)
Growth
per
capita
(%
per
year) Each one percentage point increase in the
FDI ratio is associated with an increase in
per capita growth by almost 1% per year.
31 sub-
Saharan
African
countries
Relationship depends on the inclusion of Botswana.
Botswana

28. Stabilization and Economic
Growth
Stabilization of prices means that distortions
associated with inflation are reduced.
 Inflation distorts the choice between real and
financial capital by punishing money holdings,
and thus creates inefficiency in production.
 Inflation thus involves a tax, the inflation tax.
An inefficient tax compared with most other taxes.
 Inflation also creates uncertainly which tends
to discourage trade and investment.
 Inflation also tends to result in overvaluation
of currency, thus hurting exports and growth.
2

29. Stabilization Increases
Economic Efficiency
Financial capital
Real
capital
Undistorted
price ratio
G
F
E
A
Inflation
distortion
45°
Output after
Output before
Distorted
price ratio
C
D
H
O B
Output
gain
If output gain = E and
inflation distortion = c,
then, again, E = mc2

30. Privatization and Economic
Growth
Privatization means that profit-oriented
owners and able managers are allowed to
direct enterprises.
Profit motive replaces political considerations as
the guiding principle of business operations.
Profit-maximizing owners generally want to appoint
managers and staff on merit rather than on the
basis of political connections, for example.
Private enterprise is generally more efficient
than state-owned enterprises.
3

31. Privatization Increases
Economic Efficiency
Private output
Public
output
Undistorted
price ratio
D
G
Distorted
price ratio
F
E
A B
N
Price and
quality
distortion
H
O
J
K
45°
Output
gain

32. Same Story Time and
Again
Free trade is good for growth
Reduces the inefficiency that results from
restrictions on trade
Price stability is good for growth
Reduces inefficiency resulting from inflation
Privatization is good for growth
Reduces inefficiency resulting from SOEs
Education is good for growth
Reduces the inefficiency that results from
inadequate education

33. Same Story Time and
Again
Can describe this by simple arithmetic
The efficiency gain from eliminating an
economic distortion (trade restrictions,
inflation, unnecessary state intervention,
insufficient education) is directly
proportional to the square of the
distortion:
E = mc2
E stands for efficiency gain, m is a multiplicative
constant, and c is the distortion

34. E = mc2
If the distortion is substantial (severe
trade restrictions, high inflation, big SOE
sector, poor education), then reducing or
eliminating the distortion can increase
efficiency and growth a great deal.
We can see this by plugging appropriate
numbers into the formula and also by
econometric research, where the theory
is compared with experience (i.e.,
economic statistics).

35. Education and Economic
Growth
Education means a better trained and hence
more efficient work force.
 Need to provide primary and secondary
education to all, especially females
 Need to provide tertiary education to a greatly
increased number of people
 Need increased public commitment to education
 This requires both increased public expenditure
on education and probably also increased scope
for private sector involvement in education.
4

36. Growth and Education,
1965-98
86
countries
-4
-2
0
2
4
6
8
10
0 20 40 60 80 100 120 140
Secondary-school enrolment 1980-97 (%)
Growth
per
capita
(%
per
year)
An increase in
secondary-school
enrolment by 40%
of each cohort goes
along with an
increase in per
capita growth by
1% per year.

37. Growth and Education,
1965-98
-6
-4
-2
0
2
4
6
8
10
0 1 2 3 4 5 6 7 8
Public expenditure on education (% of GNP)
Growth
per
capita
(%
per
year) Each two percentage point
increase in the education
expenditure ratio is associated
with an increase in per capita
growth by about 1% per year.
33 sub-
Saharan
African
countries

38. Natural Resources and
Economic Growth
Natural resources, if not well managed,
may turn out to be, at best, a mixed
blessing.
Three possible channels
 Education
 Dutch disease
 Rent seeking
What is the evidence?
5

39. Natural Resources and
Economic Growth 1965-98
Abundant natural resources, if not well managed,
appear harmful to growth.
-4
-2
0
2
4
6
8
10
0 10 20 30 40 50 60
Share of natural capital in national wealth (%)
Growth
per
capita
(%
per
year)
86
countries
A ten percentage point
increase in the natural
capital share goes along
with a decrease in per
capita growth by nearly
1% per year.

40. Natural Resources and
Education
90
countries
0
1
2
3
4
5
6
7
8
9
0 10 20 30 40 50 60
Share of natural capital in national wealth (%)
Public
expenditure
on
education
(%
of
GNP) An 18 percentage point
increase in the natural
capital share is associated
with a decrease in public
expenditure on education
by 1% of GNP.
Abundant
natural
resources
appear to
crowd out
human
resources.

41. Natural Resources and
Corruption
Abundant
natural
resources
appear to
go along
with
corruption.
0
1
2
3
4
5
6
7
8
9
10
0 5 10 15 20 25
Share of natural capital in national wealth (%)
Corruption
index
New Zealand
45
countries

42. What Is the Upshot?
Economic growth responds to public
policy.
In particular, by encouraging
saving and investment of high quality
foreign trade and investment
education
... the government can help foster
rapid economic growth.

43. Sir Arthur Lewis Got It Right
Since the second world
war it has become
quite clear that rapid
economic growth is
available to those
countries with
adequate natural
resources which make
the effort to achieve it.
W. ARTHUR LEWIS
(1968)

44. What Else?
These lessons are borne out by experience
from around the world.
Additional lessons:
Too much inflation hurts saving, investment,
and trade — and thereby also growth.
Too much SOE activity hurts the quality of
investment and education — and growth.
Too much agriculture and, more generally,
natural resource dependence, if not well
managed, hurts education and trade — and
thereby also growth.
Too rapid population growth also tends to
impede economic growth.

45. Reservations
Even so, the question of rapid growth is, of
course, a bit more complicated.
We also need to address a host of political,
social, and cultural questions as well as
questions of natural conditions, climate,
and public health — which would take us
too far afield.
But the main point remains:
 To grow or not to grow is in large measure a
matter of choice.
 Many of the constraints on growth are man-
made, and can be removed.

46. In Conclusion: It Can Be
Done
Economic growth makes a difference,
especially in poor countries.
A question literally of life and death
And not only in poor countries,
for there is poverty amid plenty in rich countries
Recall the main point of Gunnar Myrdal’s Asian
Drama (1968):
It was that the Asian economies were incapable of
rapid economic growth!
New growth theory suggests that similar claims
about Africa will also be proven wrong.

47. In Conclusion: It Can Be
Done
There has been much progress in economic
policy and performance around the world in
the 1990s.
Growth-friendly reforms have been widely
embraced
among ordinary people and politicians across the
political spectrum, not only in Asia, but also,
increasingly, in other parts of the world, including
Africa.
Yet, various special interest groups try to
resist.

48. ‘Reformers have the
idea that change can be
achieved by brute
sanity.’
George Bernard Shaw
To grow or not to grow
is in large measure a
matter of choice.
These slides can be viewed on my website:
www.hi.is/~gylfason/copenhagen.ppt
In Conclusion: It Can Be
Done