A CRITICAL REVIEW OF HISTORY, THEORIES AND MODELS OF ECONOMIC
GROWTH
Innocent Ellaine Coonghe
2020/MECON/13/I E COONGHE
Macro Economics (502) – MECON 2020/21
Dr. M. Ganeshamoorthy
Department of Economics: University of Colombo
7.12.2020
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I hereby, declare that I know what plagiarism entails, namely, to use another’s work and to
present it as my own without attributing the sources using Harvard Referencing. I further
understand what it means to copy another’s work.
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2. I know aware of the consequences of plagiarism. I will be given zero marks for the assessment
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my own, and where I have made use of another’s work, I will attribute the source using Harvard
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4. I acknowledge that the attachment of this document signed or not, constitutes my agreement
on it.
Student’s Signature:
Date: 7th December 2020
2
Acknowledgment
I wish to express my deep gratitude to my lecturer Dr.M.Ganeshamoorthy for his encouragement
for this article.
3
Abstract
One of the most important phenomena in the developed world is to cherish a decent living standard.
Economic growth, full employment and low population rate are some magical tools for developed
countries to portray enjoy a sustainable growth. It is indisputable that economic growth facilitates
poverty alleviation, balance of payment and solve other macro-economic problems. This brief
review paper provides a critical understanding of the main growth theories which were established
in the advancement of literature. The main objective of this paper is to determine the drivers of
economic growth along with an assessment of its practicality.
Key words: Economic growth, Growth history, Classical, Schumperian, Keynesian,
Neo-classical, Endogenous.
4
Abbreviation
UDC – Under developed countries
HDM – Harrod and Domar model
CRS – Constant return to scale
AD – Aggregate demand
MPC – Marginal propensity to consume
MPS – Marginal propensity to save
R & D – Research and Development
5
Table of Contents
Statement of Originality and Plagiarism Declaration ...................................................................2
Acknowledgment ........................................................................................................................3
Abstract ......................................................................................................................................4
Abbreviation ...............................................................................................................................5
Table of Contents ........................................................................................................................6
List of Tables ..............................................................................................................................7
List of Figures .............................................................................................................................8
1
Introduction ...........................................................................................................................9
2
Growth Theory of Mercantilism and Physiocracy ..................................................................9
3
Classical Theory of Economic Growth ................................................................................ 10
3.1 Ricardian Growth Model ..................................................................................................... 10
4
Schumperian Growth Theory............................................................................................... 11
5
Keynesian And Post-Keynesian Growth Theories ................................................................ 12
5.1 Harrod – Domar Growth Model........................................................................................... 13
6
Neo Classical Growth Theories ........................................................................................... 15
6.1 Solo-Swan Model ................................................................................................................ 15
7
New Classical Growth Theory ............................................................................................. 19
8
Conclusion and Discussion .................................................................................................. 21
References ................................................................................................................................ 23
Appendix .................................................................................................................................. 26
6
List of Tables
Table 1: Some other growth models ....................................................................................................... 26
7
List of Figures
Figure 1: Keynesian AD growth theory ..................................................................................... 13
Figure 2: Harod-Domar Model .................................................................................................. 14
Figure 3: Solo growth model-when saving increases ................................................................. 16
Figure 4: Solo growth model_when population increases .......................................................... 17
Figure 5: Solo Growth model - Technology............................................................................... 18
8
1
Introduction
Life standard differences is one of the main causes for the division between developed and under
developed countries in the world. Decreasing Economic growth rate is claimed to be one of the
most imperative reasons for many countries to be classified as under-developed. In history and
even in status-quo, increasing real output amidst rising population has been a challenge for
countries.
Economic growth is a vast area in literature. Thus economists of different schools of thoughts have
developed growth models to identify different paths to grow. In this paper we will focus on main
theories of growth starting from historical mercantilism, physiocracy to Classical, Schumperian,
Keynesian, Post-Keynesian, Neo-classical and New-classical along with the main models
developed in that era.
I have gathered secondary data from journals, books, videos, presentations and websites in order
to achieve a precise understanding of the main models of growth. Refer to table 1 in the appendix
in which the summary of some other models which were developed by the economists in the
growth literature has been included.
2
Growth Theory of Mercantilism and Physiocracy
According to Montchrestien and Billacois, (1999) the concept mercantilism which was introduced
by Antoine de Montchrestien from 15th – 17th century as a pathway to growth, points out that a
country can produce only agriculture with the use of land and its wealth is determined by the metal
gained from international trade. As private sector contributes to the accumulation of wealth, state
encourages exports of goods and service as they create a trade surplus and restrict imports to limit
the outflow bullion from the country (McDermott, 1999).
It is true that mercantilism created employment opportunities and boosted growth. Yet what if
every country decides to export and restrict import, which will subsequently limit all trading
abilities between countries.
9
In the second half of the 18th century, mercantilism was replaced by physiocracy which was
founded by Freancois Quesnay who believed that the agriculture price should be high as the wealth
of a nation is depended on the agriculture land development. Mercantilists believed in limiting
imports but physiocrats believed in freedom of trade and productivity as a source of wealth (Marx,
1971).
Though this theory encourages freedom of trade without government influence, it is not practical
to have complete freedom in trade, this proves to us that government intervention is necessary at
least up to a certain an extent. Meanwhile, this theory considers land as the only productive factor
and the rest as unproductive. Besides most importantly they fail to state the value productivity of
agriculture (Osipian, 2007).
3
Classical Theory of Economic Growth
The classical school of thoughts which began in 18 th century pioneered by Adam Smith’s wealth
of nation primarily believed in an economy with no government intervention in which the
population growth, capital growth, division of labour and institutional framework as the main
drives of economic growth not the accumulation of wealth (Rostow, 1992).
3.1
Ricardian Growth Model
Adam Smith emphasized on capital accumulation as the source of growth which leads to division
of labour and increased production to achieve growth but due to scarcity, competition and fall in
profit, economy reaches a steady state in long run (Lavrov and Kapoguzov, 2006).
Ricardo in his model similar to Smith considers the capital accumulation, exogenous population
growth and the availability of agriculture supply as the main components of growth (Masoud,
2015). His two- sector model consists of agriculture which faces diminishing return and industry
which faces constant return together with the capitalist who engage in saving, labour and landlord
as the agents of production (Mukherji, 1982).
10
The diminishing return in agriculture shifts the investment into the industry sector in which
Fixed capital accumulation plays an important role. The increased capital stock in industry,
increases employment hence a rise in the marginal productivity of labour is apparent. Meanwhile,
the increase in the price of agriculture results in higher wage cost which shrinks the profit of the
industry. Subsequently, at zero profit there will be no incentives for the capitalist to engage in
production which ultimately result in a steady state in the long run. That’s why Ricardo encouraged
imports of agriculture so that in the long run, economy could grow without limitations (Taylor,
1960).
The contribution of the classical school to economic growth is indispensable. Classical models
consider only the supply side of economic growth ignoring the effective demand which is needed
to sustain the growth which was later incorporated by Keynes (Adelman, 1971). Classical theories
failed to deeply analyze the role of technology which will prevent the price increase of agriculture
caused by the diminishing marginal productivity, hence incorporation of technology sustains the
growth (Taylor, 1960).
Labour supply is considered as the only determinant of wages refuting the demand for labour and
the role of trade union (Spengler and Joseph, 1959). Classicalists claimed that an increase in capital
stock will increase the labour ignoring the labour displacement effect caused by the ignorance of
technology. Since they believed in Say’s law the increase in wages was considered as the main
problem. These weaknesses gave birth to the Keynesian theories of growth (Ucak, 2015).
4
Schumperian Growth Theory
In an economy with constant return where supply adjusts according to its demand, innovation is
necessary for a dynamic growth. According to Schumpeter an entrepreneur who is not a manager
or capitalist- is the hero who creates innovation and initiates development process. He needs to
occupy technical know-how, capital resources and credit facilities to generate profit which exists
until innovation becomes general to the economy (Sharipov, 2015).
11
The innovation in Schumperian theory can be a new product, new production method, new market,
new industry or a new source of supply. Once the innovation becomes successful it will induce
innovation in other industries which creates economic growth (Schumpeter, 1989)
Though the author considers innovation as a factor which creates cyclical fluctuation in a capital
economy, in reality, there are many other factors which contribute to the development apart from
the personality and behavior of the innovator. Meanwhile in actual fact, there is no major
difference between a businessmen and innovator. The entrepreneur who was considered strong
according to Schumpeter, might be weak and not capable of adjusting to the political changes in
the real world (Masoud, 2015).
Schumpeter assumes the functioning of Say’s law where demand creates its own supply which is
unrealistic. Additionally, the importance of savings have been ignored in this model as innovations
are funded by bank credit but actually credit is a temporary source of finance whereas high savings
is needed for funding innovations (Schumpeter., 1989). Therefore its non-applicable for the UDC,
as the innovation level is quite minute and unlike the Schumperian theory which says private
entrepreneurs are the main innovators in UDC government is the main innovator (Sharipov, 2015).
Although it has certain limitations and misinterpretation. It is irrefutable that this theory is a great
contribution to the growth literature.
5
Keynesian And Post-Keynesian Growth Theories
John Maynard Keynes’s growth theory which was innovated as the solution for the great
depression in 1930’s has created yet another dimension to economic growth. In contrast to the
classical economists who focused only on the supply side of the economy, Keynes incorporated
the effective aggregate demand into his theory (Sharipov, 2015).
He assumed that in a closed economy, perfect competitive market where technology and capital
remain constant, the output will grow at diminishing marginal return. He stated that during
depression there will be unemployment which decreases the income, consumption and investment,
hence government has to intervene to boost the AD through fiscal to revive the business activities
as shown in the figure below (Jones and Vollrath, 2013).
12
Figure 1: Keynesian AD growth theory
Source: Economichelp.org
Though Keynes’s theory was regarded as incomparable and accurate in western countries. We
must take into consideration that it was applied to heavy unemployment situations, in which he
insisted on more government spending until the unemployment reaches a stable level but increased
AD will lead to inflationary pressure which will discontinue the government spending. Keynes
failed to consider the problem of stagnation with inflation in the long run. His incorporation of the
AD and state influence is widely followed by countries (Palley, 1996). Let us now focus on a postKeynesian model.
5.1
Harrod – Domar Growth Model
The HDM depends on saving and capital-output ratio which is held constant in short run and makes
saving which turns into capital formation as the main factor determining the growth assuming full
employment, CRS and constant MPS and APS. (Sato, 1964).
The growth equation of HDM,
∆𝑌
𝑆
= − 𝛿
𝑌
𝑉
Where ∆Y/Y is the growth rate; S – Saving ratio; v – capital-output ratio which shows efficiency;
𝛿 – depreciation.
13
Some authors have considered the net aspect, so the growth equation is
∆𝑌
𝑆
=
𝑌
𝑉
An increase in saving and a decrease in capital output ratio is required for growth but this growth
will last for a short term. In order to enjoy long run steady growth there should be an ever- growing
capital which will balance the AD and AS. This balance is complicated because of the dual role of
investment where higher investment creates higher demand due to multiplier effect and it increases
the supply as the productive capacity increases (Masoud, 2015). In contrast Classicalists and
Keynes considered only one role of investment (Sharipov, 2015).
In order to retain growth, a country has to maintain the actual growth equal to the guaranteed
growth which occurs when the economy functions at the full capacity. If the actual growth is higher
than the guaranteed growth, the growth of income exceed the growth of output which will lead to
excess demand and inflation which results in fall of investment (Dutt, J and Amadeo, 1993).
Stable dynamic equilibrium is achieved when the guaranteed growth rate is equal to the natural
growth rate which is determined by the exogenous factors such as population, natural resource and
technology. When the actual growth rate deviates from guaranteed rate it moves the economy away
from the steady path which is known as the knife edge instability (Hochstein, 2020).
Figure 2: Harod-Domar Model
Source: www.economichelp.org
14
HDM which only partly Keynesian is the foundation of neoclassical theory, hasn’t incorporated
technology which increases the efficiency of production. Since the economy is subjected to knife
edge instability, inflation can occur at any period of time. Meanwhile, long term investment plans
are not considered as it assumes that producers invest only to meet the expected demand. HDM
ignores the factor prices, labour productivity and corruption (Pesaran and Smith, 1995).
At the same time, many developing countries refuted this theory as it was created to solve the
depression and it considers saving as the main source of growth whereas the developing countries
generally face a saving investment gap. Countries who lack good financial system will not result
in increased investment due to savings. Even though government intervenes and urged people to
save more, there is no guarantee that the economy will face a steady growth. Though this model
has its limitation, it created the base for the neo classical growth theory (Crooty, 1980).
6
Neo Classical Growth Theories
We could see that Keynesians considered only on capital and under estimated market mechanism
but in contrast we can see that neo-classicalists believed in technology as a factor determining
growth and competition that provides a balanced growth. Neo-classicalists considered technology
as exogenous and their growth theory was mainly explained by using the model created by Robert
Solo and Swan (Solow, 1994).
6.1
Solo-Swan Model
The Solo Swan model which is an extension to the HDM considers capital which depends on
investment and depreciation (𝛿), labour force and technology which are exogenous as the
determinant of growth while assuming of non-government intervention, CRS and factor
substitutability along with other classical assumptions (Solow, 1994). The capital accumulation is
determined by the AD which is depended on investment and consumption in which investment per
worker is equal to a fixed MPC times per capita output and the aggregate supply is depended on
production function represented by
𝑌 = 𝐴𝑄. 𝑓(𝐾, 𝐿)
15
In which AQ is the total factor productivity which is called as the solo residual (Moroianu and
Moroianu, 2012).
Assuming labour and technology remain a constant increase in capital result in higher per capita
output, in the long run economy will reach a steady state with a flatter production curve shown in
figure 3 as the marginal productivity of capital decreases with the fixed labour (Mankiw, 2005).
Figure 3: Solo growth model-when saving increases
Source-Macro Economics by N.G Mankiw
Though capital per worker is high due to saving which shifts the production beyond the steady
state, the investment will be used to replace the existing capital and not be used by workers. At
steady state, capital, output and labour growth will be equal and unchanged. The change in capital
stock per worker (k) is shown as
∆𝑘 = 𝑖 − 𝛿𝑘
Increase in labour force accompanied by capital reduces capital per labour. It’s important to note
that saving increases investment along with depreciation and the change in capital per worker will
be
∆𝑘 = 𝑖 − (𝛿 + 𝑛)𝑘
16
Increased savings offset the negative impact of depreciation and labour force growth represented
by ‘n’ in the equation which reaches the steady state at a stagnant level in the long run as shown
in the figure below.
Figure 4: Solo growth model_when population increases
Source - Macro Economics by N.G.Mankiw
Technology is the only variable which increases the productivity and allows the economy to enjoy
a sustained cutting- edge growth. He didn’t suggest to replace labour with machine but the labour
augmenting technology which increases the efficiency of the labour (Mankiw, 2005). He called
this factor as Solow residual as it is the reason for the increased slope in the production function.
The change in the capital per efficiency unit of worker will be
∆𝑘 = 𝑖 − (𝛿 + 𝑛 + 𝑔)𝑘
Where ‘g’ is the efficiency growth. Economy can increase its steady state capital by increasing the
capital per efficiency unit of labour.
17
Figure 5: Solo Growth model - Technology
Source- Macro Economics by G.N.Mankiw-page 224
The ultimate neo classical growth equation is
𝑘𝑡+1 = 𝑘𝑡
(1 − 𝛿)
𝑠𝐴
+
𝑘𝛼
1 + 𝑔𝑒
1 + 𝑔𝑒 𝑡
𝑘𝑡+1 – Next year capital, 1 + 𝑔𝑒 - growth rate of efficiency unit of labour and ∝ - capital elasticity.
Though Solo innovated the technology as the growth variable, he considers it as an exogenous
factor.
Solow Swan model is considered as one of the major developments of HDM as we know that the
latter is subjected to knife edge instability and factor non substitutability so there is a high chance
of an inflation, whereas Solo’s model focuses on long run cutting edge growth and assumes factor
substitutability. Though it incorporates labour force and technology, it hasn’t addressed other
difficulties in Keynesian such as downward price rigidity and liquidity trap (Solow, 1994).
18
Absence of an investment function based on profit and saving function associating the entire
production has shown the stability in this model, hence when these functions, there will be
instability. Together with this there is no evidence of considering entrepreneur expectations for the
future (Nelson and Pack, 1999).
Capital is homogeneous and included as one function, but in reality, capital has different forms
and like physical capital, even human capital is subjected to obsolete which as a result requires
investment to offset the decline. This reality can make it difficult to compare the return and achieve
higher steady state growth (Bosworth and Collins, 2008).
Solo has removed the balance between guaranteed and natural growth but failed to remove the
balance between actual and guaranteed growth. He has focused more on the supply side and the
assumptions of flexible price, closed economy, convergence of the progress and flexible capital
output ratio which in reality is fixed by technology, which questions the model (Romer, 1993).
This model includes technology as an exogenous variable but not explained the path, meanwhile
it considers labour augmenting technology rather than neutral technology. There are other factors
such as labour incentives to improve the efficiency of labour which is not included. The ignorance
of the idea that technology can be induced by learning by doing, research and development gave
birth to the endogenous growth theories developed by new classical economists (Romer, 1993).
7
New Classical Growth Theory
The endogenous growth theories which bloomed in 1980’s emphasized technology which was
considered exogenous in neo classical, is actually internal to the production process which leads
to the creation of new knowledge, is a non-rival good (Masoud, 2015). The major factor which
makes this theory stands out from others is that the economists proved the possibility of the long
run growth. The models developed by the economist Kenneth Arrow, Robert Lucas and Paul
Romer who were the pioneers, can be related to research and development and human capital
(Romer, 1993).
19
Arrow in his learning, by doing model, claimed that the freely available knowledge which arises
from the past investment is related to the entire economy and the learning of one firm is from the
investment of another (Arrow, 1962).
Lucas in his human capital model based on growth accounting insisted that the investment on
education leads to the production of human capital which will be internally beneficial to the worker
and externally spilled over, allowing the economy to experience growth as a result of increasing
return to scale (Lucas, 1988).
Romer considered Arrow’s model as the base, insisted that new technology is the unique
determinant which enters the firm in the form of a new design used for intermediate goods and
human capital which lead to long term growth by raising the stock of knowledge (Romer, 1986).
The production function of the learning by investment model is
𝑌 = 𝐴(𝑅)𝑓 (𝑅𝑖, 𝐾𝑖, 𝐿𝑖)
Where Y = output. A= public stock of knowledge from research and development, Ri result of
research of firm i. He assumed that knowledge is partially excludable and retained by firm,
presence of market incentives, fixed aggregate supply of human capital, externalities and usage of
new design with added cost. The new knowledge which is created by existing knowledge and
human capital will face a diminishing return while it creates opportunities for other firms leading
to an increasing return in the economy (Romer, 1993).
Endogenous growth theories have set a new trend in economic growth by emphasizing that the
long run growth is possible but collectively the economists didn’t give a clear explanation on the
non-convergence. Srivanasan in his literature insisted that he didn’t find anything new in the
endogenous theory as Kaldor already proved the increasing return and endogeneity of variables.
Economists felt that the new classical theories enforced much on human capital and neglected the
role of institutions and it didn’t pay attention on infrastructure and other facilities which result in
growth (Schilirò, 2019).
20
Romer considered the accumulated human capital embodied with physical capital becomes the
driver of growth but the distinction between physical capital and human capital is not clearly stated.
The theory goes deep on production function and steady state and it is based on many assumptions
which has set a limit to this theory. Above all, there is no successful empirical study which leaves
us with a confusion on the reality (Neto, 2016). So, it is evident that the endogenous models have
created paths for growth, but it has not solved all the issues in the growth process.
8
Conclusion and Discussion
In this study it has been possible to provide a critical review framework which links different
growth concepts starting from mercantilism to endogenous growth in order to understand how
sources of growth vary from time to time. The failure of mercantilism in which accumulation of
wealth was considered the source of growth was replaced by physiocrats who believed in growing
by trading agriculture.
As already indicated, classical economists who focused on supply side emphasized on division of
labour as the driver for growth while they failed to include the demand side and other variables.
Furthermore, Schumpeter incorporated the role of innovation and entrepreneurship into his model
to elaborate the growth. As under developed countries face a saving investment gap, increasing
innovation isn’t feasible.
Keynes, the father of modern economics made a remarkable contribution to the growth theory by
including the demand side aspect to growth refuting the Say’s law. At the same time his theory
isn’t focused on long term growth as it was developed to solve the great depression in the western
world.
Post-Keynesians Harod and Domar’s model was a turning point in the growth of literature which
incorporated the saving and capital-output ratio and proved that saving is the pioneer for growth
while showing knife edge instability.
Building of the premises of achieving growth, Solo identified exogenous technology which
facilitates growth as it exposes the relationship between investments, labour force with it.
21
Meanwhile, Solo failed to consider the neutral technology which is internal to the production and
ignored other factors of growth.
Nevertheless, the birth of endogenous theories has allocated long- term growth by integrating
human capital and R & D into the growth theory. At the same time, it stresses too much on human
capita and its success in UDC which lacks saving and sound financial behavior as it hasn’t
explained the non-convergence.
Therefore, it is evident that there is still a void for more hypothesis which integrates the abovementioned variables along with the government investment, social and behavioral factors,
incentives and other factors which will empirically prove the feasibility of the theory so that the
world sustains the steady path of growth.
22
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25
Appendix
Table 1: Some other growth models
ECONOMIST
MODEL
Driver of growth
Adam Smith
Smith model of
Division of labour leads to growth
growth
David Ricardo
Ricardian model of
Agriculture supply leads to growth
growth
Thomas Malthus
Exponential model
Population growth will set limitation to
economic growth.
Karl Marx
John Stuart Mill
Marxian model of
Social exploitation and oppression of the less
growth
privileged doesn’t lead to growth.
Mill’s model
The economy will grow if land and capital
increases the production faster than labour.
Walt Witman
Rostow’s growth
Rostow
model
John Maynard
Keynesian growth
Keynes
theory
Raul Prebish
Dependency theory Focus on inward looking approach and state
Saving is the main driver of growth.
Increase in AD increases growth.
intervention in controlling imports
Roy Harrod and
Harrod- Domar
Increased saving and decreased capital output
Evsey Domar
model
ratio will result in growth.
Joan Robinson
Model of capital
Capital accumulation is the engine of growth.
accumulation
Nicholas Kaldor
Kaldorian growth
Relates technical progress and capital
model
accumulation.
Capital output ratio depends on the relationship
between growth of capital and productivity.
Luigi Pasinetti
Pasinetti growth
Economic depends on the profit earned by
model
capitalist
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James Meade
Alfred Marshall
Meadian growth
Growth is based on capital accumulation,
model
workforce and technology
Marshallian model
External economies reconciling with perfect
competition will increase the productivity.
William Stanley
Jevon’s paradox
Jevons
Michael Kremer
Technology with given amount of resources
allow the economy to produce more goods.
O ring theory
Small component of a complex production
process should be performed with efficiency.
Arthur Lewis
Lewis model
Transfer of labour from agriculture to industry
along with capital leads to growth.
Michal Kalecki
Kaleckian model
Investment determines the long run growth.
Sala-I-Marin and
Barro -Sala-i-
Accumulation of physical capital, human
Robert Barro
Martin model
capital, education, diversity of institutions, free
movement of capital, technology, idea, foreign
investment and information flow.
Hirofumi Uzawa
Uzawa theorem
Applied solo-swan model for consumer good
and investment goods.
Frank Ramsey
Ramsy-Cass-
Endogenous saving is depended on the
Cass
Koopmans model
consumer
Aghion Howitt
Country with high level of human capital grow
technical progress
faster.
Koopmans
Aghion-Howitt
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