Neoclassical Growth Models

The Solow Growth Model Assumptions Neo-Classical Theory of growth has been Propounded by modern economist like Solow,Meade, Swan etc. It based on following assumptions:- Capital and labour are the two factors of production. Substitution of Capital for labour is possible. There is a full employment in the economy. There prevails perfect competition in the economy. Prices are flexible.

Meaning and Determinants of Economic Growth Economic growth means Increase in production. Economic growth has following characteristics:- Gradual Continuous Harmonious Cumulative According to neo-classical Economist capital can be substituted for labour thus accumulation of capital is possible even without making any increase in labour power which Results into increase in NI and PCI.

Capital Accumulation Rate of Saving Level of Income & Rate of Interest Investment Economic Growth Neoclassical Economic Growth

Process of Capital Accumulation According to Neo-Classical economists: When there is technical progress in Economy, opportunities of investment increase. As a result of interest begins to rise and the process of capital formation in the country gets encouraged. But as investment increases there is corresponding increase in relative prices of capital goods remains limited. Under the circumstances, investment is confined to high-income yielding projects only. In this way, rate of interest serve as. Price controller for capital goods.

Project completed Prices of capital goods and rates of interest begin to fall No will to save in society and capital accumulation stop Stationary Stage

Y R R1 R2 O K K1K2 X I S Capital MEC/ Rate of Interest

Y K K1 K2 Capital X SS1S2 I I1 I2

Solow’s Equation According to Solow, net investment refers to the rate of increase in the capital stock and denoted by K’ The proportion of the function of real income saved is denoted by ‘S’ and regarded as constant. The rate of saving, therefore, would be sY. The basic saving an investment can be expressed as K’=sY (1) Production is the function of two factors i.e. capital (K) and Labour (L) or Y=F(K,L) (2) Solow assumes that composite product with multiple use is produced in the economy. A part of it is saved and invested. Substituting the value of Y in (1) it becomes K’=sF(K,L) (3) Eq.(3) represent the supply side of the system. Solow’s demand side is represented by (4) L(t)=L o e th

Here L(t) represents the number of workers employed in ‘t’ period of time. L o implies the level of employment or number of workers employed in initial period of time. n represent the growth of labour at a constant exogenous rate. The right hand side of equation (4)implies that labour force expands at exponential Rate n from the initial period to the ‘t’ period of time. By substituting the value of L(t)in eq.(3) it can be expressed as K’=sF(K,L o e nt ) ………..(5) Solow regards eq. (5)as the basic eq. As it helps in determining the volume of capital stock needed to provide employment to available labour.

Y yF(r,1) nr sF(r,1) 1) E O r’’ Capital Labour Ratio (r) X Output per head (Y) Saving per head sF(r,1)

Meade’s Equation Meade is of the view that production does not depend on labour and Capital alone. Beside, labour and capital it depends on natural resources (N) and Technical Progress (T) Hence Y=F(K,L,N,T) (1) If natural resources (N) remain constant then increase in (Y),depends upon the increases in the remaining three factors i.e K,L,T. Suppose the increase in the stock of capital is represented by  K and if V is marginal productivity of capital then increase in the net national income due to capital stock would be V  K. Similarly, increase in labour force  L multiplies by its marginal net productivity would raise the level of net national income by W  L.  Y’ is used to represent the increase in the net national product due to technical progress. The increase in net annual output in one year would be the sum of contribution of three factors. Hence  Y=V  K+W  L+  Y’ (2)

To find out the growth rate of net national income in terms of growth rate of capital, labour and technology the eq. Will be;  Y= VK.  K + WL.  L+  Y’ (3) Y Y K Y L Y Where  Y is the proportionate growth rate of output Y  K is the is the proportionate growth rate of capital K  L is the is the proportionate growth rate of labour force L  Y’ is the is the proportionate growth rate of technical progress during a year Y VK/Y and WL/Y represent the proportionate marginal product of capital and labour respectively. VK/Y represent the proportion of the net national income being paid as profit. WL/Y is proportion of income going to the labour force as wages if proportionate growth rates of income, capital, labour, and technical progress are represented as y=  Y/Y’, k=  K/K,I=  L/L,r=  Y’/Y and marginal productivity of capital as U and marginal productivity of labour as Q then eq. (3) can be rewritten as y=Uk+QI+r (4)

The true index of economic growth of an economy is the growth rate of real income rather than growth rate of income (y). In order to find out the growth rate of real income, the growth rate of labour (I) is to be subtracted from the growth rate of income (y). The growth rate of real per capita income is considered the true indicator of growth of any economy. Subtracting the growth of the labour force(I) from both side of eq. (4) we get modified eq. as: y-I = Uk+QI-I+r = Uk-(Q-I)+r ………….(5)

Y Total Annual Output B D A C K K1 X Total Stock of Machinery

Y K y H B C D G U X E F Growth rate of capital stock Growth Rate of National Income

Optimism Concerning Development Optimistic approach of the theory is evident from the following Facts: –It is not always necessary that growth of population may always take place according to Malthusian Theory. –Due to technical progress, production can be had in accordance with the law of decreasing returns can be postponed. –Wages rate of the labourer and rate of profit both can increase simultaneously. In order to increase the wage-rate, it is not necessary to lower the rate of profit, or to increase the rate of Profit, it is not necessary to lower the wage rate. –Whereas growth rate of population can be controlled by the spread of knowledge, the wage rate can be increased by more capital accumulation. –Class struggle is not necessary.

Criticism Unrealistic Assumptions Paradox of saving and development Incomplete explanation of saving Incomplete explanation of investment criticism of process of development Limited Applicability to Underdeveloped countries

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