Economic Growth Model

Economic growth is defined as the increase in the ability of an economy to produce different goods and services. It is commonly measured through the Gross Domestic Product (GDP) percentage increase for a certain period of time.

The question of the determinants of economic growth and the factors influencing it have been discussed in several ‘old’ and ‘new’ theories along the passage of time. These theories or models attempt to explain how an economic growth can occur, the reasons behind it and the role certain variables play in influencing the outcome.

Savings in its most basic economic term is described as income that is not consumed. It is that portion of the disposable income (Income after taxes are deducted) which is not spent for consumption

The equation above is the essence of the model. It states that the difference between the product of MPK (marginal product of capital) with the rate of saving and the rate of depreciation of capital is equal to the growth rate. This implies that increasing the savings rate, increasing the capital stock or reducing the depreciation of capital will all result in increased economic growth. Thus a positive, direct relationship can be observed between the aggregate savings rate and growth of the economy so growth is determined by the savings rate according to this model.

Solow-Swan Model

The Solow model is also an “old” model of economic growth. It begins by stating that output (Y) is a function of capital (K) and the product of Labor (L) and effectiveness of Labor (A). This is shown in the equation below

The model assumes that capital and labor both exhibit constant returns to scale which means that if capital and labor and increased by a certain proportion, the output will increase by exactly that same proportion. This is shown in the equation 1.2

As such the first term on the right hand side of the equation is the actual investment per effective labor while the second term represents break even investment. So rate of change of capital per effective labor is the difference between actual and break even investment. The Solow model is of the view that the economy follows a balanced growth path of k* when actual investment per worker is equal to the breakeven investment.

The role of saving rate is now examined. If saving rate is increased, then from the equation, actual investment per worker will also increase and in turn so will k*. This has increased the level of the balanced growth path, and not the growth rate of the capital per worker as a greater amount is now required to break-even.

As opposed to the old theories, the new endogenous theories challenge the view of the exogenous theory that long run growth is determined by factors outside of the economic system such as technological progress. The endogenous models advocates the point that long run economic models can depend on economic reasons.

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