Salient features of endogenous growth models

Endogenous growth economists believe that improvements in productivity can be linked

directly to a faster pace of innovation and extra investment in human capital. They stress
the need for government and private sector institutions which successfully nurture
innovation, and provide the right incentives for individuals and businesses to be
inventive.
There is also a central role for the accumulation of knowledge as a determinant of
growth. We know for example that the knowledge industries (typically they are in
telecommunications, electronics, software or biotechnology) are becoming increasingly
important in many developed countries.
Supporters of endogenous growth theory believe that there are positive externalities to be
exploited from the development of a high valued-added knowledge economy which is
able to develop and maintain a competitive advantage in fast-growth industries within the
global economy.
The main points of the endogenous growth theory are as follows:
The rate of technological progress should not be taken as a constant in a growth model government policies can permanently raise a country's growth rate if they lead to more
intense competition in markets and help to stimulate product and process innovation.
There are increasing returns to scale from new capital investment.
The assumption of the law of diminishing returns which forms the basis of so much
textbook economics is questionable. Endogenous growth theorists are strong believers in
the potential for economies of scale (or increasing returns to scale) to be experienced in
nearly every industry and market.
Private sector investment in research & development is a key source of technical
progress.
The protection of private property rights and patents is essential in providing appropriate
and effective incentives for businesses and entrepreneurs to engage in research and
development Investment in human capital (including the quantity and quality of
education and training made available to the workforce) is an essential ingredient of longterm growth.
Government policy should encourage entrepreneurship as a means of creating new
businesses and ultimately as an important source of new jobs, investment and innovation.
A prominent feature of the endogenous growth theories is permanent change in a variable

that is potentially influenced by government policies cause permanent changes in the

growth rate. The policy effect in the endogenous growth models is contradictory to that of
neo-classical growth models (exogenous models).
The latter anticipate that such changes will alter growth rate only temporarily. The
endogenous growth models argue that financing through taxes may have an impact on
welfare and/or on growth.
Tax policy can affect economic growth by discouraging new investment and
entrepreneurial incentives or by distorting investment decisions since the tax code makes
some forms of investment more profitable than others or by discouraging work effort and
workers' acquisition of skills.
Most of the empirical literature reveals an inverse relationship between tax burdens and
rates of growth i.e. a lower tax burden would raise the rate of economic growth.
Therefore, future economic output would be higher with the optimal rate of taxation and
hence future tax revenues would be higher with a lower rate of taxation.
The endogenous growth models predict that permanent changes in government policies
can have permanent effects on the per capita growth rate of output.
In neo-classical growth models such policies cannot affect the per capita level of output
permanently while inendogenous growth models they can. Barro's (1979) tax-smoothing
hypothesis says that, if the marginal cost of raising tax revenue is increasing the optimal
tax rate is a martingale.
This implies that changes in the tax rate will be permanent and, given their different
effects on growth, under the two types of growth models, very useful in empirically
distinguishing between the exogenous and endogenous models.
One of the fundamental predictions of growth theory, old and new, is that income taxes
have a negative effect on the pace of economic growth rate. The endogenous growth
models predict that temporary government spending policies have a positive effect on
output but a zero effect for permanent spending shocks.
Devereux and Love (1995y consider a two- sector endogenous growth model which has
been extended to allow for an endogenous consumption leisure decision, to analyze the
effects of government spending decision.
The findings explore that a permanent increase in the share of government spending in
income that is financed with lump-sum taxes will endorse interest and the long-run
economic growth rate at the cost of social welfare.
The study argues that a permanent increase in government spending reduces the long-run

growth rate when it is funded with an income tax or wage income taxes while a
temporary rise increases output but has no impact on long-run growth rate. It also claims
that government spending may increase growth rates only if it is financed with a taxsmoothing policy.
Karras (1999) and Tomljanocich (2004) have tested empirically whether tax policies have
transitory or permanent impact on the growth rate of output. However, all these studies
deal with only developed economies and almost no work on developing ones.
Therefore, this gap in existing literature on Fiscal policies and economic growth needs to
be filled. A salient feature of models featuring a credit multiplier is that agency costs are
more severe in recessions than in booms, precisely because agency costs are inversely
related to firms' net worth, which is procyclical.
While in recessions a firm's ability to finance productive investment is constrained by its
balance sheet, financial frictions are mitigated in booms as higher net worth relaxes
incentive constraints, reducing the conflict of interest with outside investors.
The credit multiplier is more forceful the deeper the recession, but tends to disappear in a
boom as improved financial conditions mitigate the agency cost of investment finance. In
the absence of exogenous shocks that impair balance sheets, these models are therefore
unable to explain why periods of expansion may sow the seeds for future recessions.
A critical difference between the Harrod-Domar model i.e. endogeneous growth model
and the neoclassical growth model lies in the effect the savings rate has on growth rates.
In the Harrod-Domar model an increase in the savings rate increases the growth rate.
However, in the neo classical model, an increase in the savings rate increases the per
capita income but it does not result in a permanent (as compared to a temporary) increase
in the growth rate.
While Solow's neo-classical model explains the first five out of the six stylized facts quite
well, it cannot explain the fact that growth rates differ between countries for long periods
of time. This model would suggest convergence in growth rates, something that does not
seem to take place.
To explain this problem, theorists have focused their attention on technical progress and
have made attempts to make the growth rate endogenous. Various endogenous growth
theory models, proposed by economists like Robert Lucas and Paul Romer, have
constructed a dynamic model where the rate of growth of output depends on aggregate
stock of capital (both physical and human) and on the level of research and development
in an economy.
Many of the models are mathematically complex but do explain the persistent difference

in growth rates between countries and the importance of research and human capital
development in permanently increasing the growth rate of an economy.
A Beginners Guide to Endogenous Growth Theory
Filed in Economic Basics by Vanessa Cheung on November 9, 2013 0 Comments
Table of Contents [hide]
1 1 What is endogenous growth theory?
2 2 What are the factors affecting economic growth?
3 3 Share:
What is endogenous growth theory?
The endogenous growth theory was developed by economists, including Paul Romer and
Robert Lucas, in the mid-1980s. The theory came about because economists had become
increasingly dissatisfied with neo-classical growth models that did not explain where the
technological changes in economies came from.
Endogenous growth theory states that economic growth is generated internally and not by
external forces as the neo-classical model suggests. The endogenous growth theory
argues that technological change is a response to economic incentives in the market that
can be influenced by the government or private sector.
What are the factors affecting economic growth?
Endogenous growth theory states that investment in human capital, innovation and
knowledge are significant contributors to economic growth, because they help to develop
new technology and make production become more efficient.
Lets take a look at the two key factors of growth mentioned in this theory:
Human Capital
Investment in human capital can be in the form of education and training. Through
education and training, the workers will become more productive and economic growth
will increase. Endogenous growth theory also states that there will be spillover benefits
from investing in human capital.
Innovation and Knowledge
The theory emphasises that private investment in research and development (R&D) is a
key factor to technological change. Innovation will lead to better goods and better

production processes, which again increases productivity and drives economic growth.
What are the implications of this model?
Endogenous growth theorists stress the need for the government and private sector to
provide incentives for individuals to be innovative. The following government policies
can help to encourage innovation, and increase economic growth in the long run.
4

Subsidies for R&D

5 Protecting intellectual property using property rights such as patents, copyrights and
trademarks
The theory also suggests that poor countries with little human capital cannot become rich
by simply by adding more physical capital. Investment in human capital through
education and training is crucial to achieving growth.