ENDOGENOUS GROWTH THEORY

Philippe Aghion and Peter Howitt

Problems and Solutions by Cecilia Garcia-Peiialosa

Coordinated by Maxine Brant-Collett

The MIT Press

Cambridge, Massachusetts
London, England
 Toward Endogenous Growth
1
1.1 The Neoclassical Model of Exogenous Growth

The most basic proposition of growth theory is that in order to sustain a positive
growth rate of output per capita in the long run, there must be continual
advances in technological knowledge in the form of new goods, new markets,
or new processes. This proposition can be demonstrated using the neoclassical
growth model developed by Solow ( 1 956) and Swan'('1956), which shows that
if there were no technological progress, then the effects of diminishing returns
would eventually cause economic growth to cease.
The basic building block of the neoclassical model is an aggregate produc-
tion function exhibiting constant returns in labor and reproducible capital. We
abstract initially from all issues concerning population growth and labor sup-
ply by assuming a constant labor supply normalized to equarl unity. Thus the
aggregate production function can be written as a function of capital alone:
Y = F ( K ) . This function expresses how much output Y can be produced,
given the aggregate capital stock K , under a give11 state of knowledge, with a
given range of available techniques, and a given array of different capital, in-
termediate and consumption goods.' We assume that all capital and labor are
fully and efficiently employed,* so F ( K ) is not only what can be produced but
also what will be produced.
A crucial property of the aggregate production function is that there are
diminishing returns to the accumulation of capital. If you continue to equip
people with more and more of the same capital goods without inventing new
uses for the capital, then a point will be reached eventually where the extra
capital goods become redundant except as spare parts in the event of mul-
tiple equipment failure, and where therefore the marginal product of capital
is negligible. This idea is captured formally by assuming the marginal prod-
uct of capital to be strictly decreasing in the stock of capital: F f ( K ) > 0 and
F U ( K )< 0 for all K , and imposing the Inada conditions:

lim F 1 ( K )= 0, and lim F ' ( K ) = oo.

K-+w K-to
Because we are assuming away population growth and technological change,
the only remaining force that can drive growth is capital accumulation. Output
will grow if and only if the capital stock increases. To determine whether and
at what rate the capital stock will increase in any given situation, we follow
Solow and Swan in assuming that people save a constant fraction s of their
gross income3 Y, and that the constant fraction 6 of the capital stock disappears

1. Of course, K is an aggregate index of the different capital goods, and should be interpreted
broadly so as to include human as well as physical capital.
2. In Chapter 4 we deal with the question of unemployed workers.
3 W P :>ren c c ~ ~ r n i nnon t:lw~c c n thnt nntinnnl i n r n m ~:ind nlltnllt are irlentir;~I
1 12 Chapter 1

each year as a result of depreciation. Because the rate at which new capital
accumulates4 is s Y , and the rate at which old capital wears out is 6 K, therefore
the net rate of increase of the capital stock (i.e., net investment) is:

The differential equation (1.2) is the fundamental equation of neoclassical

growth theory. It indicates how the rate of change of the capital stock at any
date is determined by the amount of capital already in existence at that date.
Together with the historically given stock of capital, (1.2) determines the entire
time path of capital. The time path of output is then determined by substituting
this path of capital into the aggregate production function.
Figure 1.1 shows how the fundamental equation (1.2) works. The depreci-
ation schedule shows how the flow of depreciation depends on the stock of
capital. It is a straight line through the origin, with a slope equal to the depreci-
ation rate 6. The saving schedule shows how the gross flow of new investment
depends on the stock of capital. Because the marginal product F' ( K ) is posi-
tive but diminishes as K increases, therefore the saving schedule has a positive
but diminishing slope.
Given any stock of capital, such as KOin figure 1.1, the rate of increase of
that stock is the vertical distance between the saving schedule and the depre-
ciation schedule. Thus whenever the saving schedule lies above the depreci-
ation schedule, as it does when K = KO in figure 1.1, the capital stock will
be increasing. Moreover, it will continue to increase monotonically, and will
converge in the long run to K*, the capital stock at which the two schedules
intersect."hus K* is a unique, stable, stationary state of the economy.
The economic logic of this dynamic analysis is straightforward. When capi-
tal is scarce it is very productive, so national income will be large in relation to
the capital stock, and this will induce people to save more than enough to off-
set the wear and tear on existing capital. Thus the capital stock K will rise, and
hence national income F (K) will rise. But because of diminishing returns,
national income will not grow as fast as the capital stock, which means that
saving will not grow as fast as depreciation. Eventually depreciation will catch
up with saving, and at that point the capital stock will stop rising.
Thus, in the absence of population growth and technological change, dimin-
ishing returns will eventually choke off all economic growth. For as the capital
stock approaches its stationary level K * national income will approach its sta-
tionary level, defined as Y* a F (K*), and the growth rate of national output

4. Recall that with no taxes, no government expenditures, and no international trade, saving and
investment are identical. That is, saving and investment are just two different words for the flow of
income spent on investment goods rather than on consumption goods.
5. It will never quite reach K*, however, for as it approaches K* its rate of increase will fall to
zero.
I :I Toward Endogenous Growth

saving, depreciation
depreciation = 6K

/
/ saving = s F(K)

Figure 1.1
The level K* of capital is a unique, stable, stationary state to the Solow-Swan model with no
population growth. It is an increasing function of the saving rate s and a decreasing function of
the depreciation rate 6.

will fall to zero. According to this model, economic growth is at best a tempo-
rary phenomenon.
This means that any attempt to boost growth by encouraging people to
save more will ultimately fail. Although an increase in the saving rate s will
temporarily raise the rate of capital accumulation, it will have no long-run
effect on the growth rate, which is doomed to fall back to zero. An increase in
s will, however, cause an increase in the long-run levels of output and capital,
by shifting the saving schedule upward in figure 1.1. Likewise an increase in
the depreciation rate S will reduce the long-run levels of output and capital by
shifting the depreciation schedule up.
1.1.1 Population Growth
The same pessimistic conclusion regarding long-run growth follows even with
a growing population. To see this, suppose that the flow of aggregate output
depends on capital and labor according to a constant returns to scale produc-
tion function Y = F ( K , L). (Constant returns to scale makes sense under our
assumption that the state of technology is given, for if capital and labor were
14 Chapter 1

both to double, then the extra workers could use the extra capital to replicate
what was done before, thus resulting in twice the output.) Suppose every-
one in the economy inelastically supplies one unit of labor per unit of time,
and that there is perpetual full employment. Thus the labor input L is also
the population, which we suppose grows at the constant exponential rate n
per year.
With constant returns to scale, output per person y = Y / L will depend on
the capital stock per person k = K / L . To' simplify, suppose we consider the
Cobb-Douglas case: Y = L'-@Ka, 0 < a! < 1, in which the per capita produc-
tion function can be written as:

The rate at which new saving raises k is the rate of saving per person, s y . The
rate at which depreciation causes k to fall is the-*mount of depreciation per
person Sk. In addition, population growth will cause k to fall at the annual rate
nk. The net rate of increase in k is the resultant of these three forces, which by
equation ( I .3) is:
k = s f ( k ) - ( n + S ) k = s k f f - (n +S) k. ( 1.4)

Note that the differential equation (1.4) governing the capital-labor ratio is al-
most the same as the fundamental equation (1.2) governing the capital stock
in the previous section, except that the depreciation rate is now augmented
by the population growth rate, and the per-capita production function f has
replaced the aggregate function F. This is because under constant returns to
scale the absolute size of the economy is irrelevant. All that matters is the
relative factor proportion k . Moreover, the per capita production function f
will have the same shape as the aggregate production function F of the previ-
, ~ that the per capita saving schedule sf (k) in figure 1.2 will
ous ~ e c t i o n so
look just like the saving schedule in figure 1.1. Although the absolute size
of population is irrelevant, its rate of increase is not, because faster popu-
lation growth will tend to reduce the amount of capital per person in much
the same way as faster depreciation would, not by destroying capital but by
"diluting" it-by increasing the number of people that must share it. This is
why the depreciation rate must be augmented by the population growth rate in
equation (I .4).
As figure 1.2 shows, diminishing returns will again impose an upper limit
to capital per person. Eventually a point will be reached where all of people's
saving is needed to compensate for depreciation and population growth. This
- ----

6. Constant returns implies that the marginal product of each worker, f' (k) = f' ( K I L ) is the
same as the marginal product in the aggregate production function, FI ( K , L) .
saving per person
depreciation and dilution per person depreciation plus dilution per person = (n + 6)k

capital per person

Figure 1.2
The level k* of capital per person is a unique, stable, steady state to the Solow-Swan rnodel with
population growth. It is an increasing function of the saving rate s, and a decreasing function of
the depreciation rate 6 and of the population growth rate n .

point is the "steady-state"' value k*, defined by the condition:

The capital stock will converge asymptotically to k* in the long run, while the
level of output per capita converges to the corresponding steady-state value
y* = f ( k * ) . In this steady state equilibrium, output and the capital stock will
both continue to grow but only at the rate of population growth. Growth as
measured by the rate of increase in output per person will cease in the long
run.

1.1.2 Exogenous Technological Change

It follows that the only way to explain the observed long-run growth in output
per person is through technological change that continually offsets the damp-
ening effect of diminishing returns. How this might work can be seen in terms

7. The aggregate capital stock is not stationary, but growing at the same steady rate as the work
force.
16 Chapter I

of the Solow-Swan model, by supposing that there is a productivity parameter

A in the aggregate production function that reflects the current state of techno-
logical knowledge, and that this productivity parameter grows at the constant
exponential rate g. The exogenous value of g is assumed to reflect progress in
science.
Thus, suppose that the aggregate production function is:

This way of writing the production function makes technological progress

equivalent to an increase in the "effective" supply of labor AL, which grows
not at the rate of population growth n but at the rate of growth of population
+
plus productivity8: n g. As before, the rate of increase of the aggregate
capital stock is just aggregate saving minus depreciation: s Y - 6 K .
Formally, the only difference from the model of the previous section is that
we have effectively replaced the population L,#by the "effective" population
AL. Wherever L used to appear in the model, now A L appears. The only
difference this makes is to raise the "effective" population growth rate from
+
n to n g. Thus by following exactly the same reasoning as before, we see
that the supply of capital per "effective person" K I A L will approach a steady
state. In this steady state, output and capital will grow at the same proportional
rate as the effective population AL. But this means that output and capital per
person will grow at the exogenous rate of technological progress g.
Intuitively, as capital accumulates, the tendency for the outputlcapital ratio
to fall because of diminishing returns to capital is continually offset by tech-
nological progress. The economy approaches a steady state in which the two
conflicting forces of diminishing returns and technological progress exactly
offset each other and the output/capital ratio is constant. Although the height
of the steady-state growth path will be determined by such parameters as the
saving rate s, the depreciation rate 6, and the rate of population growth n , the
only parameter affecting the growth rate is the exogenous rate of technological
progress g.
1.1.3 Conditional Convergence
The transitional dynamics of the model with population growth are shown
diagrammatically in figure 1.2. As long as the economy begins close enough
to the steady state k*, the greater the shortfall of the actual capitaVlabor ratio

8. That A enters the aggregate production function multiplicatively with L is in most cases a
very special assumption, amounting to what is sometimes referred to as "Harrod-neutrality," or
"purely labor-augmenting technical change." There is no good reason to think that technological
change takes this form; it just leads to tractable steady-state results. In the present Cobb-Douglas
framework, however, the assumption is innocuous. Because all factors enter multiplicatively in a
Cobb-Douglas production function it would make no observable difference if A multiplied L , K ,
or both.
 Toward Endogenous Growth

below k*, the greater the gap between the two curves in figure 1.2, and hence
the higher will be the rate of growth of capital per person.
This implies that the transitional dynamics of the model will exhibit what
is called "conditional convergence." That is, consider two economies with the
same technologies, and with the same values of the parameters s, 8, and n that
determine the steady-state capitaUlabor ratio. The country that begins with the
lower level of output per capita must have a higher growth .,. rate of output per
capita. In that sense the two countries' levels of output per capita will tend to
converge to each other.
To see this more clearly, note that the country with the lower initial level
of output per person also has the lower level of capital per person (because
they share the same production function). As you can see in figure 1.2, this
>
means that the lagglng country (as long as it is not too far behind) will have
-3
a faster growth rate of the capitalllabor ratio. Because, from equation (1.3),
j / y = a k l k , and the two countries share the same value of a, therefore the
lagging country will also have a faster growth rate of output per capita.
Notice that there would be no tendency to convergence if the countries
had different steady states. For example, one country might have the higher
initial level of output per person, because of some historical accident, and yet
have the lower steady-state level because of a low saving rate. In other words,
convergence is conditional on the determinants of the countries' steady-state
levels of output per person.
In the empirical literature on cross-country growth regressions, authors often
estimate equations of the form,

where i indexes economies and Xi,, is a vector of variables (such as s, 6 and

n) that control for the determinants of steady-state output per person. The left-
hand side of (1.6) is the growth rate of economy i measured over an interval of
T years. Thus, the equation says, growth rates can vary from country to country
either because of differences in the parameters determining their steady states
(captured in the term y.Xi,,) or because of differences in initial positions
(captured in the term -b. log(yi,,)). An estimated value of b > 0 is taken as
evidence for conditional convergence.

1.2 Extension: The Cass-Koopmans-RamseyModel

1.2.1 No Technological Progress

As simple hypotheses go, the assumption of a fixed saving rate is not a bad
approximation to long run data. But many writers believe that the subtleties