TOPIC 2: MODELS AND

THEORIES OF ECONOMIC
GROWTH AND
DEVELOPMENT
THE INTERNATIONAL-
DEPENDENCE
REVOLUTION(IDR)
The IDR models reject the exclusive
emphasis on GNP growth rate as the
principal index of development

Instead they place emphasis on

international power balances and on
fundamental reforms world-wide.
IDR models view developing countries
as beset by institutional, political, and
economic rigidities in both domestic and
international setup
The IDR models argue that developing
countries are up in a dependence and
dominance relationship with rich countries

Three streams of thought:

 Neoclassical dependence model
 False-paradigm model
 Dualistic-development thesis
The Neo-colonial Dependence Model
 “Dependence is a conditioning situation in which the
economies of one group of countries are conditioned
by the development and expansion of others.”

 “Dependence, then, is based upon an international

division of labor which allows industrial development
to take place in some countries, while restricting it in
others, whose growth is conditioned by and subjected
to the power centers of the world.”
Theotonio Dos Santos
 The False-Paradigm Model
Attributes underdevelopment to the faulty and
inappropriate advice provided by well-meaning
but biased and ethnocentric international “expert
advisers”

The policy prescriptions serve the vested

interests of existing power groups, both
domestic and international
In addition, according to this argument,
leading university intellectuals, trade unionists,
high-level government economists, and other
civil servants all get their training in
developed-country institutions where they are
unwittingly served an unhealthy dose of alien
concepts and elegant but inapplicable
theoretical models.
 The Dualistic- Development Thesis
 Dualism represents the existence and persistence
of increasing divergences between rich and poor
nations and rich and poor peoples at all levels.

 The concept embraces four key arguments:

1. Superior and inferior conditions can coexist in
a given space at given time
2. The coexistence is chronic and not transitional
3. The degrees of the conditions have an inherent
tendency to increase

4. Superior conditions serve to “develop under

development”

In extremes they advocate for state ownership

of productive assets
 Weaknesses of IDR Models
Do not offer any policy prescription for how
poor countries can initiate and sustain
economic development

Actual experience of developing countries that

have pursued policy of autarky/closed
economy has been negative
 Neo-classical Growth Theory
 The Solow Growth Model
 Named after the economist Robert Solow because of his
work on growth analysis which he did in the 1950s

 According to this model, output growth results from one

or more of three factors:
I. Increases in Labour,
II. Increases in capital, and
III. Technological changes
 More precisely, the model shows how saving,
population growth and technological progress
affect the growth of output overtime

 According to Solow, closed economies with low

savings rates grow slowly in the short-run and
converge to lower per capita income levels

 Open economies converge at higher levels of per

capita income levels
 The model further argues that capital
flows from rich to poor countries as
capital-labour (K-L) ratios are lower and
investment returns are higher in the latter

By impeding the flow of foreign

investment, poor countries choose a low
growth path.
 Building the Model
The first step in building the model is to
examine how the supply and demand for goods
determine capital accumulation

Initially, it is assumed that population growth

and technological progress are fixed
The Impact of the Supply and Demand for
Goods on Capital Accumulation
 Assume fixed labour and technology
i. The supply of goods and the Production Functions
1. The supply of goods in the Solow growth model is
based on the production function
𝑌 = 𝐹(𝐾, 𝐿) ………………..(1)

Where Y=output
K=capital input
L=labour input
 Equation (1) states that output depends on the capital
stock and the labour force
2. The Solow growth model assumes that the production
function has constant returns to scale (CRS).
 A production function has constant returns to scale if
the following is true

𝛼𝑌 = 𝐹(𝛼𝐾, 𝛼𝐿) ……………………(2)

Where α is a positive number

 Equation (2) shows that if we multiply both K and L by

α, we also multiply the amount of output by α

 This simply means that increasing both inputs by the

same proportion will increase output proportionally
3. To simplify the analysis, all quantities are expressed relative to the size of the labour
force i.e. In the context of the size of the labour forces

 Production functions with CRS are convenient for their purpose because output per
capita depends only on the capital stock per worker

 This can be proved as follows:

1
Set 𝛼 = 𝐿 in equation (2) to obtain:

𝑌 𝐾
= 𝐹( 𝐿 , 1) …………………………….(3)
𝐿

𝑌
 This equation shows that output per worker, is a function of capital stock per
𝐾 𝐿
worker, 𝐿 .

 Equation (3) is known as the intensive form of the production function

3. We use lower case letters to denote quantities per worker.

𝑌 𝐾
 Thus; 𝑦 = , 𝑘=
𝐿 𝐿

 Therefore, equation (3) is re-written as follows:

𝑦 = 𝑓(𝑘) ……………………………….(4)

𝐾
Where 𝑓 𝑘 = 𝐹( , 1)
𝐿
= 𝐹(𝑘, 1)

 Equation 4 shows that output per worker is a function of

capital stock per worker
 It is assumed that 𝑓′(𝑘) > 0 and 𝑓′′(𝑘) < 0

 This shows diminishing marginal return of capital

stock.

 That is, an additional unit of capital stock

contributes less to total output

 Graphically, the production function is shown as a

positively sloped function increasing at a
diminishing rate with capital stock per worker on
the X-axis and output per worker on the Y-axis
ii. The Demand for Goods and the Consumption
Function
5. In the Solow growth model, the demand from goods
comes from consumption and investment

 In other words, output per worker, y is divided between

consumption per worker, c and investment per worker,
𝑖. That is:
𝑦 = 𝑐 + 𝑖..................(5)
Where all the variables are as defined before

 Equation (5) is essentially the GDP (or GNP) identity

for a closed economy except for two major differences:
a. There is no government expenditure in this case

b. Quantities are expressed relative to the size of the labour

force

6. The model assumes that the consumption function takes the

form:
𝑐 = 1 − 𝑠 𝑦...............(6)

Where s = saving rate, i.e. the MPS, 0 < 𝑠 < 1.

 Equation (6) says that each year, a fraction,

(1 − 𝑠), of income (output) is consumed and a fraction, s, is
saved
7. To see the implications of the consumption function i.e.
equation (6), we substitute equation (6) into equation (5)
and solve for 𝑖 :
𝑦 = 𝑐 + 𝑖..............(5)

 Substituting (6) into (5), we get:

𝑦 = 1−𝑠 𝑦+𝑖
= 𝑦 − 𝑠𝑦 + 𝑖

 Solving for 𝑖, we get:

𝑖 = 𝑦 − 𝑦 + 𝑠𝑦
 Implying that:
𝑖 = 𝑠𝑦..............(7)
 Equation (7) shows that investment, like
consumption is proportional to national income
and it is equal to saving

 Substituting the production function, equation (4),

into (7) yields:
𝑖 = 𝑠𝑓(𝑘).............(8)

 Equation (8) shows that the higher the level of

capital stock per worker, k, the greater the level of
output and investment
9. The national income identity, equation (5),

𝑦 = 𝑐 + 𝑖 implies that: 𝑐 = 𝑦 − 𝑖

 Substituting equations (4) and (8), we get:

𝑐 = 𝑓 𝑘 − 𝑠𝑓(𝑘)……….(9)

 Equation (9) shows that consumption per worker is the

difference between output, f(k) and investment, sf(k)

 In other words, at any level of k, output is defined as

f(k), investment is defined as sf(k) also saving function
and the difference between them is consumption, c.
10. In the Solow growth model, increases in capital stock,
k result in economic growth i.e. increase in output, f(k)

 Two forces cause the capital stock to change overtime:

(a) Investment: the capital stock rises as firms buy new
plants and equipment
(b) Depreciation: the capital stock falls as some old
output wears out

 To incorporate depreciation in the model we assume

that a certain fraction, δ, of the capital stock wears out
each year
 δ in this case in the depreciation rate.

 Therefore, the amount of capital stock that depreciates each year is

δk

 Since δ is a constant fraction, it follows that depreciation is

proportional to capital stock

 Formally, capital stock adjustment equation is stated as follows:

∆𝑘 = 𝑖 − 𝛿𝑘 ……………..(10)

Where ∆𝑘 = change in capital stock

 This equation shows that change in capital stock is equal to

investment minus depreciation
11. From (8), 𝑖 = 𝑠𝑓(𝑘)

 substituting this into (10), we get:

∆𝑘 = 𝑠𝑓 𝑘 − 𝛿𝑘.......... (11)

 This is another way of stating the capital stock

adjustment equation and it shows that two factors
namely investment and depreciation act to change the
capital stock overtime.

 To analyse how the two factors act to change capital

stock overtime, we first define the steady-state
iii. The steady-State
12. There is a single capital stock at which the amount of
investment equals depreciation.

 This is called the steady-state level of capital and is denoted by

𝑘∗

 The steady-state is the situation in which capital does not

change overtime

 In other words, at the steady-state, change in capital stock,

∆𝑘 = 0 because the two factors (investment and depreciation)
acting on the capital stock are equal
 From (11), in the steady-state:
∆𝑘 = 0 = 𝑠𝑓 𝑘 − 𝛿𝑘

 Implying that;
𝑠𝑓 𝑘 ∗ = 𝛿𝑘 ∗ ............(12)

Where 𝑘 ∗ = steady-state k

 The steady-state represents the long-run equilibrium of

the economy

 Note that the economy ends up with k* regardless of

the level of capital with which it begins
 Suppose that the economy starts with less than the
steady-state level of capital stock such as 𝑘1

 In this case, the level of investment exceeds the amount

of depreciation i.e 𝑖1 > 𝛿𝑘1

 Thus, the capital stock will rise over time and continue
to rise until we approach the steady-state capital stock,
𝑘∗

 𝑘1 represents the case of developing countries.

 At 𝑘1 , the 𝑀𝑃𝑘 is relatively high

The Neoclassical factors are paid their
marginal products, therefore, the relatively
high 𝑀𝑃𝑘 at 𝑘1 will attract capital inflow from
developed countries

As a result, the capital stock in developing

countries will rise overtime until it reaches the
steady-state level of capital stock

Thus, the Solow growth model predicts that

capital will flow from rich to poor countries
 Suppose on the other hand the economy starts with
more than the steady-state capital stock level such as 𝑘2

 In this case, investment is less than depreciation i.e.

𝑖2 < 𝛿𝑘2 at 𝑘2

 This means that capital is wearing out faster than it is

being replaced

 As a result, the capital stock will fall and continue to

fall until it reaches the steady-state level of capital, 𝑘 ∗
 This represents the case of developed countries

 At 𝑘2 , the 𝑀𝑃𝑘 is relatively low

 In neoclassical theory, factors are paid their marginal

products

 Therefore, the relatively low 𝑀𝑃𝑘 at 𝑘2 will induce

capital outflow from developed countries and the
capital stock will decrease in these countries

 Thus, the Solow model predicts that capital will flow

from rich to poor countries
iv. The Golden Rule Level of Capital Accumulation
 One of the key principles of the Solow growth model is
the golden rule level of capital accumulation

 To understand this principle, it is assumed that:

a. A policymaker can set the saving rate, s

 By setting the saving rate, the policymaker determines

the economy’s steady-state

 When setting the saving rate, the question is “what

steady-state should the policymaker choose?”
b. When choosing the steady-state the policymaker’s
goal is to maximize the well-being of individuals who
make up society

c. Individuals themselves do not care about the amount

of capital in the economy rather they care about the
amount of goods and services they can consume

 Thus the policymaker would want to choose the steady-

state with the highest level of consumption

 The steady-state with the highest level of consumption

is called the Golden Rule Level of Capital
∗
Accumulation and is denoted by 𝑘𝑔𝑜𝑙𝑑
 To determine the golden rule level of capital accumulation:
i. We first find the steady-state consumption per worker
ii. Then we find which steady-state provides the most consumption

13. To find the steady-state consumption per worker, we begin with the
consumption function, equation (9),
𝑐 = 𝑓 𝑘 − 𝑠𝑓(𝑘) ............(9)

 Since 𝑖 = 𝑠𝑓 𝑘 ∗ = 𝛿𝑘 ∗ in steady-state, the steady-state

consumption per worker is:
𝑐 ∗ = 𝑓 𝑘 ∗ − 𝛿𝑘 ∗ in st.st .................(13)

 Equation (13) means that the steady-state consumption per worker is

the difference between steady-state output, f(k*) and steady state
depreciation, δk*
14. To determine which steady-state maximizes consumption,
we obtain:
𝑑𝑐 ∗
and set it equal to zero
𝑑𝑘 ∗

 From equation 13, we get the derivative:

𝑑𝑐 ∗ 𝑑𝑓(𝑘 ∗ ) 𝑑 𝛿𝑘 ∗
= − = 0 at the maximum of c*
𝑑𝑘 ∗ 𝑑𝑘 ∗ 𝑑𝑘 ∗

Note that:
𝑑𝑓(𝑘 ∗ )
= 𝑀𝑃𝑘 : slope of the production function
𝑑𝑘 ∗

𝑑 𝛿𝑘 ∗
= 𝛿: slope of the depreciation line
𝑑𝑘 ∗
 Substituting the definitions into the equations above we
get:
𝑑𝑐 ∗
= 𝑀𝑃𝑘 − 𝛿 = 0 at the max of c*...........(14)
𝑑𝑘 ∗

 This implies that

𝑀𝑃𝑘 = 𝛿 at the max of c* .........(14’)

 Equation (14’) shows that at the max of c*, the slope of

the steady-state production function equals the slope of
the steady-state depreciation

∗
 Thus, 𝑘𝑔𝑜𝑙𝑑 occurs where the slope of the steady-state
output equals the slope of the steady-state depreciation.
v. The Saving Rate and the Golden Rule
 The saving rate which produces the golden rule is referred to as,
𝑠𝑔𝑜𝑙𝑑

 Thus, the investment/saving function is denoted as: 𝑠𝑔𝑜𝑙𝑑 𝑓(𝑘 ∗ )

∗ ∗
 At 𝑘𝑔𝑜𝑙𝑑 , consumption, 𝑐𝑔𝑜𝑙𝑑 is the difference between 𝑓(𝑘 ∗ ) and
∗
𝑖𝑔𝑜𝑙𝑑

 Furthermore, we know that:

∗
𝑖𝑔𝑜𝑙𝑑 = 𝛿𝑘 ∗

∗ ∗
i.e. 𝑐𝑔𝑜𝑙𝑑 = 𝑓 𝑘 ∗ − 𝑖𝑔𝑜𝑙𝑑
 Changes in Population Growth and
Technological Progress
 Removing the assumption of fixed labour and technology,
we let labour force grow at the rate, n which equals the rate
of population growth

 We also let technological progress grow at the rate, g

 With labour force and technological progress, the change in

capital stock per worker is given by the equation:

∆𝑘 = 𝑖 − 𝛿 + 𝑛 + 𝑔 𝑘

Where all the variables are defined before

 𝛿 + 𝑛 + 𝑔 𝑘 is the break-even investment defined as
the amount of investment necessary to keep the capital
stock per worker constant

 Sources of Growth in the Solow Growth Model

 The sources of growth in this model are the factors that
in the long-run cause changes in capital stock, output
and consumption per worker.

 Three sources:
i. The saving rate, s
ii. The rate of population growth, n
iii. The rate of technological progress, g
i. Changes in the Saving Rate
 Changes in the saving rate affect the level of
investment and therefore, the capital stock and output
per worker

 In particular, higher saving rate enables more

investment to occur and this in turn raises the capital
stock and output

 Changes in the saving rate can be caused by

(i) Changes in taxes, which make it more attractive to
save
(ii) Maintaining a government budget surplus
(iii) Reductions in the government budget deficit
ii. Changes in Population Growth
Population growth rate has a positive effect on
the growth of total output

If population growth rate increases, it will

reduce the steady-state capital stock and
therefore steady-state output

Thus, the Solow growth model predicts that

countries with high population growth rates
will have lower levels of GDP per capita
iii. Changes in Technological Progress
In this model, technology is exogenous, that is,
“it falls like manna from heaven”

 Technological progress changes can affect

growth by raising productivity which in turn
increases output and incomes.

 The increase in incomes raises saving and

capital stock per worker
 Conclusion
 Given the production function such as:

𝑌 = 𝐴𝐾 𝛼 𝐿(1−𝛼)
Where Y = output; A= technological progress or
knowledge or measure of the effectiveness of labour;
K= capital and L= labour
 Then economic growth can be written as:
∆𝑌 ∆𝐴 ∆𝐾 ∆𝐿
= +𝛼 + (1 − 𝛼)
𝑌 𝐴 𝐾 𝐿

𝑦 = 𝑔 +∝ 𝑠 + 1 −∝ 𝑛
This implies that growth rate in output depends
on technological progress, capital and labour

Solow’s model of economic growth implies that

economies will conditionally converge to the
same level of income, given that they have the
same rates of savings, depreciation, labour force
growth, and productivity growth

47
~END~