new growth theory and development economics

15 New growth theory and development economicsHeinz D. Kurz and Neri Salvadori

IntroductionAfter a period of relative calm in the aftermath of the so-calledCambridgeCambridge controversies in the theory of capital (for an over-wiew, see Kurz and Salvadori, 1995, Chapter 14) which had dealt a seriousblow to the long-period version of neoclassical theory in general and theSolovian growth model based on an aggregate production function inparticular (Solow, 1956), since the mid-1980s, growth economics hasbecome again one of the most vibrant areas of research. The revival wasspurred by theoretical and empirical contributions. New modelling tech-niques imported from other areas in economics were used in order to endo-genize technological progress within a macroeconomic intertemporalgeneral equilibrium framework and thus overcome a major shortcoming ofSolows model the treatment of technological change as exogenous. Thisis also the reason why the new class of models are frequently dubbedendogenous. The construction of new data sets for a large number ofcountries, in particular the Penn World Table (Summers and Heston, 1991),Heston, Summers and Aten, 2002 and Maddison (2001), has led to arevived interest in empirical studies which in turn have thrown up new prob-lems for growth theory. The existing literature is huge and still rapidlygrowing. For summary accounts of the present state of the art in this areaof research see, in particular, Barro and Sala-i-Martin (2003), Jones (2002),Aghion and Howitt (1998), Helpman (2004) and Aghion and Durlauf(2005).

While neoclassical growth theory had rst to overcome the straitjacketof the exogeneity of the long-term growth rate in Solow, in alternativeapproaches this was not necessary. There the growth rate has always beenconsidered as endogenous, shaped by the behaviour of agents, the distrib-ution of income, social institutions and so on. The very stress classicalauthors in the tradition of Adam Smith laid on the unintended social con-sequences of purposeful activities of individuals or groups of people actingwithin a highly complex system of an ever deeper division of social labour,characterized by scarce natural resources, technical innovations and chang-ing social relations, is incompatible with the idea of an exogenously given

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growth rate. This impression is already corroborated when we look at whatmay be called their linear growth models (see Kurz and Salvadori, 1998,1999, 2006; Salvadori, 2003). Marxs scheme of extended reproductionconstitutes a two-sector, the von Neumann model an n-sector and the so-called HarrodDomar model a one-sector model of endogenous growth.An important dierence with the so-called new growth models is that thelatter are intensive models, concerned with explaining the growth ofincome per capita, not extensive ones. However, intensive models are alsoencountered in these non-neoclassical traditions, be they classical, Marxist,Keynesian or evolutionary. For summary accounts of this kind of litera-ture that is surprisingly largely ignored in Aghion and Durlauf (2005), seeDutt (1990), Foley and Michl (1999), Salvadori (2003), Nelson (2005) andBhaduri (2007).

Since sustained growth in income per capita is arguably the most import-ant determinant of living standards and since other measures of livingstandards, such as life expectancy and the Human Development Index(HDI), typically, though not always, move together with income per capita,to understand the causes of economic growth is of direct relevance to devel-opment economics.

There is also the following phenomenon that emphasizes the close con-nection between economic growth and development. For thousands ofyears incomes per capita, measured in some broad way, were not all thatdierent throughout the world, and whenever they rose somewhat in someareas due to technological innovations this rise discharged itself rst andforemost in a Malthusian way on a growing population which, in turn, dueto diminishing returns to land, tended to annihilate the increase in incomeper capita. Hence, while there were lasting increases in population in someareas of the world, there were hardly any in income per capita. It was onlywith the Industrial Revolution that sustained growth of GDP per capitabecame a normal fact of life in Europe and the Western oshoots, withlarge parts of the rest of the world at rst remaining stagnant. This led towhat the historian Kenneth Pomeranz (2000) called the Great Divergence,the spreading out especially in living standards. Seen from a long-term his-torical perspective, the problems of economic growth and those of devel-opment are thus two sides of a single coin, with the latter being perceivedas a problem only after the former had made an appearance which by allhistorical standards can only be called impressive.

We deal rst with neoclassical growth models, followed by a brief dis-cussion of approaches trying to come to grips with the fundamentalcauses of growth and development, in which the role of economic, politicaland social institutions is emphasized. We conclude with a discussion ofKeynesian and evolutionary contributions.

208 International Handbook of Development Economics, 1


Neoclassical theoryAt the forefront of research in contemporary growth economics are theproximate and fundamental causes of technological progress, which,together with human capital formation, is seen as the prime mover of thesystem and a main source of rising living standards. The main referencepoint of this literature is still the Solow model, and while the model at rsthas been rejected by major advocates of new growth theory, it recently hada comeback in an augmented form. Interestingly, it was not rejectedbecause of a lack of solid micro foundations of its technology and pro-duction side. This is somewhat surprising because one criticism levelled atit was that its treatment of savings behaviour lacked such foundations. Yetreplacing a Keynesian savings function by the assumption of an immortalrepresentative agent maximizing his or her intertemporal utility can hardlybe said to meet the criterion. The main reasons for its rejection were ratherthe following: (1) it takes as given the behaviour of the variable meant todepict the main driving force of growth: technological knowledge; (2) itimplies that decisions of agents to save more or less have no impact on thesteady-state rate of growth; (3) it has little to oer in terms of policy advicefor long-run growth; and (4) it predicts the convergence of levels of incomeper capita on a world scale. According to the logic of the model, countriesthat exhibit similar structural parameters (savings rate, population growth)should in the long run have similar levels of income per capita. This isbrought about by poor countries with a lower capital-to-labour ratiogrowing faster than rich countries. Alas, the propositions of the model asto convergence have not generally been conrmed empirically. While thereare convergence clubs (William Baumol), for example the organisationfor Economic Co-operation and Development (OECD) economies, thereis no universal catching up of the less-developed countries. In additionto remarkable success stories (for example the so-called Asian Tigereconomies) there are a number of disaster stories (for example sub-SaharanAfrica). Cross-country studies indicate by and large a strong negative cor-relation between population growth and income per capita and a strongcorrelation between the latter and the share of investment (alias savings) ingross domestic product (GDP). Another implication of Solows model hasnot been corroborated by empirical studies, namely, that poor countriesexhibit higher rates of return, because capital is relatively more scarce. Ifthis were to be true, one would expect massive ows of capital from rich topoor countries, which, however, have not been observed across poor coun-tries as a whole. The implicit assumption of Solows model that advancesin technical knowledge are both a free and a public good, cannot be sus-tained. There exist, and possibly persist, technological or idea gaps (PaulRomer) between developed and developing countries. However, a poor

New growth theory and development economics 209


economy may benet in terms of economic growth from its relative back-wardness, and there is some evidence that its openness helps in this regard.Economies that follow an isolationist strategy (for example North Korea)are cut o from the ow of ideas and in the medium term suer stagnationor even negative growth.

Let us now have a closer look at some of the new growth models. Acentral feature of them is that they abandon the conventional marginalistassumption of diminishing returns to capital accumulation. This is done bybroadening the concept of capital to encompass physical capital, humancapital and ideas or knowledge, and by invoking positive externalitieswith regard to the accumulation of capital. The rst generation of modelsattempted to integrate a range of growth mechanisms in a neoclassicalmacroeconomic framework. The most important mechanisms concern thecreation of new technical knowledge in research and development (R&D)departments of rms (Romer, 1986) and the formation of human capitalin education processes (Lucas, 1988). These two mechanisms swiftly gotaccepted as the main engines of growth. Both mechanisms rely on positiveexternalities which counteract any tendency of the marginal product ofcapital (and thus the rate of prot) to fall. Romer stipulated a researchtechnology that is concave and homogeneous of degree one:

where Ii is an amount of forgone consumption in research by rm i and kiis the rms current stock of knowledge. The production function of theconsumption good relative to rm i is:

where K is the accumulated stock of knowledge in the economy as a wholeand xi is the vector of all inputs dierent from knowledge. The function istaken to be homogeneous of degree one in ki and xi and homogeneous of adegree greater than one in ki and K. Romer assumes that factors other thanknowledge are in xed supply. This implies that knowledge is the onlycapital good utilized in the production of the consumption good. Spilloversfrom private research and development activities increase the public stockof knowledge K. A positive externality is taken to be responsible for percapita income growth. Dierent from the Solow model, agents via theirbehaviour do have an impact on the long-term growth rate.

Similarly in the model of human capital formation by Lucas (1988)in which agents are assumed to have a choice between two ways of spend-ing their (non-leisure) time: to contribute to current production or to

Yi F(ki, K, xi)

ki G(Ii, ki)



accumulate human capital. Lucass conceptualization of the process bymeans of which human capital is built up is the following:

where is a positive constant. With the accumulation of human capitalthere is said to be associated an externality: the more human capital societyas a whole has accumulated, the more productive each single member willbe. This is reected in the following macroeconomic production function:

where the labour input consists of the number of workers, N, times the frac-tion of time spent working, u, times h which gives the labour input ineciency units. Finally, there is the term h*. This is designed to representthe externality. The single agent takes h* as a parameter in his or her opti-mizing by choice of c and u. However, for society as a whole the accumu-lation of human capital increases output both directly and indirectly, thatis, through the externality.

In both models we are confronted with a variant of a public goodproblem: the individual optimizing agent faces constant returns to scale, yetfor society as a whole returns are taken to be increasing.

The lessons to be drawn for developing countries are straightforward: itis not so much a lack of physical capital relative to population (as in the so-called HarrodDomar model) or relative to the labour force (as in theSolow model) that accounts for low levels of income per capita, but a lackof human capital and technical knowledge. In order to catch up, a less-developed country is well advised to invest in its education system andinfrastructure and to try to get closer to the frontier of technologicalknowledge by providing incentives to domestic rms to imitate and inno-vate and by encouraging foreign direct investments of technologicallyadvanced rms.

Given the stress laid on knowledge and human capital in these models,it comes as a surprise that hardly any attempt was made to clarify whetherand how these magnitudes can be measured. Obviously, if and only if theyare cardinally measurable can anything be said about returns to scale, mar-ginal and average products, growth rates, and so on (see Kurz, 1997 [2003];Steedman, 2003). One aspect of the problem can be highlighted with refer-ence to Lucass model, who for simplicity assumed that all workers are pos-sessed of the same amount of human capital. Yet if this is the case, whereincould the externality consist? Similarly in Romers model, there is theproblem of multiple counting of the same particles of knowledge in

Y AK(uhN)1h*

h h(1 u)



building up an aggregate measure of the social stock of knowledge. Inshort, while the models are suggestive, they lack conceptual clarity.

The simplest and for a while most popular new growth model was thelinear or AK model according to which:

where K represents a broad measure of aggregate capital, consisting ofphysical capital C and human capital H, and A is a given and constantproductivity parameter. The net rate of prot is exogenously given andequals A , where is the overall rate of depreciation. In long-run com-petitive equilibrium the two kinds of capital receive the same rate ofreturn. As capital accumulates, total output expands proportionally, andwith a constant population income per capita grows with the same rate astotal output. In this model savings (alias investment) assume centre stage.The higher the savings (alias investment) rate, the higher is the growth rateof income per capita. The lesson to be drawn from an economic policypoint of view is simple: The process of development is speeded up bywhichever policy leads to an increase in savings in physical and humancapital.

There is a close similarity between this model and the HarrodDomarmodel, because in both models diminishing returns to capital are absent byconstruction. The important dierence is that whereas the HarrodDomarmodel assumes a given and constant input proportion of labour and capitaland thus allows for labour unemployment, the AK model has eectivelyreplaced the concept of labour by that of human capital. What in the Solowmodel (as well as in the HarrodDomar model) was a non-accumulablefactor of production, labour, has now become an accumulable one. WhileSolow had subsumed land (and, more generally, scarce natural resources)under capital, the AK model can be said to have gone to the extreme by alsosubsuming labour under it. With only a single accumulable factor contem-plated, the possibility of perpetual growth should come as no surprise (seeKurz and Salvadori, 1998). Of William Pettys famous 1662 dictum thatLabour is the father and active principle of Wealth, as Lands are theMother, nothing is left in this class of models: the parent of wealth isCapital.

The class of horizontal innovation models was started by Romer (1990)who combines: (1) the endogenous production of new industrial designsas in Romer (1986); with (2) the formalization of the role of human capitalin economic growth as in Lucas (1988); and (3) a product-diversityspecication of physical capital which he derives from the model ofmonopolistic competition with regard to consumption goods of Dixit and

Y CH AK



Stiglitz (1977). Romers argument relies on three premises: (1) technologicalprogress is the prime mover of economic development; (2) such progress isin large part the result of deliberate actions of agents responding to marketsignals; (3) technical instructions of how to use raw materials and otherinputs are fundamentally dierent from other goods. While the develop-ment of an industrial design or of some other economically useful knowl-edge incurs costs, once this knowledge is available it can be used time andagain without generating signicant further costs. Hence the cost underconsideration is a kind of xed cost. Dierently from human capital, indus-trial designs are said not to need to be embodied, and dierently from ordi-nary goods they are non-rival and also only partially excludable. Growthis driven fundamentally by the accumulation of a partially excludable,nonrival input (Romer, 1990, p. S74). Knowledge per capita can be accu-mulated without limit, and because of its incomplete excludability therewill be spillovers which drive the process of growth. The presence of non-rival inputs of necessity involves non-convexities. Concavities in techniquesare disruptive of the received concept of equilibrium and imply a moreopen-ended vision of economic development and growth. As Romerspaper shows, it takes some considerable eort to tame the model andsubdue it again to the equilibrium method.

Economic development is typically bound up with an expanding varietyof intermediate products. Romer tries to capture this fact in terms of thefollowing formalization. The nal product is taken to be produced accord-ing to the production function:

where HY denotes the amount of human capital employed in the naloutput sector, L the number of workers, and the employmentof intermediate products. Since at a given moment in time there is only anite number Z of them, xi0 for all iZ. Final output is thus seen as anadditive separable function of the various intermediate products. It is anever-growing number of (patented) designs, Z, that propels economicexpansion and makes income per capita grow. On the one hand an increas-ing Z increases the productivity of labour and human capital in the pro-duction of nal output. On the other hand the non-excludability ofknowledge in research involves a direct positive relation between the totalstock of designs and knowledge, Z, and the productivity of human capitalemployed in research. The research technology Romer postulates has therate of increase of Z as a linear function of Z (and of human capitalemployed in the research sector). This implies that unbounded growth ismore like an assumption than a result of the model (Romer, 1990, p. S84).

i1xi1

Y(HY, L, x) HYL

xi

i1

1



Romers model has a number of disquieting features. We have alreadypointed out that knowledge and human capital must boldly be assumed tobe cardinally measurable. The postulated heterogeneity of intermediateproducts is more apparent than real. Since they all exhibit the same inputproportions in production, they cannot be distinguished and all representunspecically given amounts of forgone consumption. Once introduced,an intermediate product will be used forever: it neither depreciates norbecomes economically obsolete. New economic knowledge is never theenemy of existing knowledge. If, say, nal output happens to be wheat, thenwheat in ancient Egypt was produced by means of digging sticks only,whereas today it is taken to be produced by means of digging sticks andploughs and oxen and tractors and combine harvesters and so on, allemployed simultaneously. This is certainly an extreme conceptualization ofa growing capital input diversity which is squarely contradicted by an evencasual observation of facts. New capital goods frequently replace old onesin a similar way as new particles of knowledge supersede their ancestors.

This latter fact is taken into account in so-called Schumpeterian growthmodels with quality-improving innovations championed by Aghion andHowitt (1998). These models revolve around Schumpeters concept of cre-ative destruction. Accordingly, new technical devices are hardly ever ageneral good. While innovators may benet, those that have invested theircapital in previous vintages of technical knowledge suer from them. Thedouble-edged character of innovations raises the problem of the sociallyoptimal rate of technological advancement.

Some broader issues regarding the fundamental causes of growthSchumpeter, when talking about innovations, the main force of economicdevelopment, referred to new combinations. The idea that new knowledgeof whichever sort consists of the (re)combination of given pieces of knowl-edge can be traced far back in natural philosophy. It was referred to by AdamSmith who in a famous passage in The Wealth of Nations discussed the com-bination of existing ideas in order to create new ones in the context of theemergence of a new profession in an ever deeper division of labour, that is:

philosophers or men of speculation, whose trade it is, not to do anything, but toobserve everything; and who, upon that account, are often capable of combiningtogether the powers of the most distant and dissimilar objects. In the progress ofsociety, philosophy or speculation becomes, like every other employment, theprincipal or sole trade and occupation of a particular class of citizens. (Smith,1976 [1776], I.i.9; emphasis added)

Weitzman (1998), in an attempt to get inside the black box of innova-tion and build up an explicit model of knowledge production, gave the



combinatoric metaphor a more precise form. New ideas, he maintainedagainst Romer and others, are not some exogenously determined functionof research eort in the spirit of a humdrum conventional relationshipbetween inputs and outputs. Rather, when research eort is applied, newideas arise out of existing ideas in some kind of cumulative interactiveprocess (p. 332). What happens may be compared to the activities in anagricultural research station in which pairs of existing idea-cultivars arecombined to bring about new hybrid ideas (where the word cultivar is anacronym for cultivated variety). With I as the number of idea-cultivars, thecorresponding number of dierent binary combinations that can be gotfrom I is C2(I ), which is given by:

For example, with I5, we have C2(5)10; and with I6, we have C2(6) 15, and so on.

The important message of Weitzmans otherwise rather mechanisticargument is that the growth in the number of ideas that results from com-bining recongured existing ideas is remarkable and well exceeds exponen-tial growth. If the entire potential of recombinatory possibilities wouldalways be exploited, then the growth of the number of knowledge particleswould over time increase almost without limit. Yet the capacity to processnew ideas depends on the resources devoted to the task and the productiv-ity of these resources. According to Weitzman it is sensible to assume thatthe ultimate constraint on economic expansion is linear. This implies thatsteady-state growth rates are linearly proportional to aggregate savings not unlike the situation in the HarrodDomar model.

Reaching beyond the connes of economics, narrowly dened, therehave been studies focusing on what are frequently called the fundamentalcauses of growth. The emphasis is on the role of economic and politicalinstitutions; see, for example, Alesina and Rodrik (1994). These studies typ-ically proceed by superimposing upon one of the endogenous growthmodels some mechanism designed to capture the interaction of social,political and economic institutions and the role of income inequality.Factors such as property rights and their enforcement, social capability(Moses Abramovitz), the quality of governance, corruption, religion andso on, are investigated with respect to their impact on the growth and devel-opment performance of countries. Economic institutions decide the incen-tives of economic agents and the constraints they face. Because dierentgroups of society benet from dierent economic institutions, there is typ-ically a conict over the alternatives. Political power which depends onpolitical institutions and the distribution of resources decides the outcome

C2(I )I!

(I 2)! 2!



of the conict. Political power may, however, be eroded by socio-economicdevelopments. Thus a picture emerges showing the complex dynamics ofthe interaction of economic, institutional, political and social forces.

From the point of view of development economics, of particular rele-vance are studies of self-reinforcing mechanisms that perpetuate poverty;see, for example, Azariadis (1996). These mechanisms typically involve anadverse impact on the formation of human and physical capital and theadoption of best-practice technology. They can be traced back to market,institutional and political failures. There is strong empirical evidence thatweak law and contract enforcement, an insucient protection of propertyrights, conscatory taxation and a corrupt bureaucracy act as disincentivesto enterprise and capital accumulation and entail unproductive rent-seeking behaviour. Despotism is considered incompatible with sustainableeconomic development, while democracy and good political institutionscan be expected to foster it. Then there are studies that investigate the roleof largely exogenous factors on growth, such as the geography of a country(natural resources, climate, topography), its culture and ethnic diversity.Here, nally, the received division of labour amongst the (social) sciencesis somewhat overcome and economics, sociology, political science andhistory are brought together in order to come to grips with inherently intri-cate problems.

Such multidisciplinary approaches are indeed badly needed as the fol-lowing case also shows. However, the case testies to some economistsinsistence on what they consider rigorous explanations, that is, the explan-ation of some grand historical fact in terms of an utterly simple model inwhich some utility-maximizing agents faced with changing budget con-straints shape centuries or, as in the present case, even millennia. What isdubbed unied growth theory purports to capture the complexity of theprocess of growth and development over the entire course of humanhistory (see Aghion and Durlauf, 2005, Chapter 4, p. 174). The approachfocuses attention on the take-o from what is called an epoch of stableMalthusian stagnation to a Post-Malthusian Regime of persistent growthin income per capita which occurred in Europe and the Western oshootsat the beginning of the nineteenth century. The main reasoning is simpleand goes something like this. Any rise in income per capita above subsis-tence levels due to small technological improvements in the Malthusianperiod was swiftly followed by an expansion of population that madeincome per capita fall again to around its former level. (One wonders how,for example, the Roman Empire could ever get o the ground and wherethe surplus product it needed in order to do so came from.) It was only theacceleration in technological progress during the Post-Malthusian Regimethat broke the vicious circle. The increase in income per capita was no



longer fully channelled into an increase in population, but stimulated theaccumulation of human capital in the form of literacy rates, schooling andhealth. Then, during the second phase of the Industrial Revolution, indus-trial development was based more and more on increased skills of workers.The human capital formation in turn brought about a demographic transi-tion and paved the way to an era of sustained economic growth. The latteris characterized by a signicant increase in the average growth rate ofoutput per capita and a decline in population growth. This broad develop-ment is then explained in terms of a model where utility-maximizing fertil-ity behaviour implies that households at low levels of income nd itpreferable to allocate a large part of their time to raise children and only athigher levels of income change their allocation of time from child rearingto human capital formation and consumption.

Karl Marx in the preface to the rst edition of volume I of Capitalstressed: One nation can and should learn from others [but] . . . it canneither clear by bold leaps, nor remove by legal enactments, the obstaclesoered by the successive phases of its normal development. But it canshorten and lessen the birth-pangs (Marx, 1954, p. 20). The conclusiondrawn from unied growth theory is similar and adds a new meaning toMarxs reference to birth-pangs: a state of sustained economic growth canonly be reached after the forces shaping fertility behaviour have broughtabout the transition to the Post-Malthusian Regime. The advocates of theunied approach appear to be optimistic that sooner rather than later alleconomies will have gone through the transition phase to the regime of sus-tained economic growth worldwide. After an epoch of Great Divergencesome economists see even an epoch of Great Convergence ahead formankind in which the problem of development will vanish.

The idea of unbounded growth of income per capita on a world scaleimplies that we can escape the limits to growth imposed by environmentalconstraints. This is a highly controversial claim (see Aghion and Durlauf,2005, Chapter 28). Industrial pollution, global warming and climaticchange, soil erosion, the reduction of biodiversity, and so on, point towardsproblems that cannot adequately be dealt with in terms of the usual macro-economic growth models. Measuring living standards vis--vis fundamen-tal changes in the quality of the environment and life becomes a tantalizingtask and ought to prevent social scientists from getting complacent abouttheir achievements as to explaining the world.

Alongside an avalanche of theoretical contributions there has been ano less impressive avalanche of empirical ones. The rst round of paperswas motivated by the observation that there need not be a convergence ofper capita income levels worldwide, as predicted by the Solow model. Thenew growth models were expected to do a better job. Yet Mankiw et al.



(1992) contested this and insisted that the empirical performance of theconventional Solow approach was superior to the endogenous growthmodels. While on the surface this may well be so, Felipe and McCombie(2005) have shown that there is no reason to become complacent, for thegood t of the Solow model is simply a reection of the fact that anaccounting identity has been tested. For summary accounts of the empir-ical ndings see, for example, Temple (1999) and Bosworth and Collins(2003).

Non-neoclassical contributionsAghion and Durlauf (2005) give the impression that the revival of growtheconomics was largely restricted to the neoclassical camp whose character-istic feature is that the problems at hand are redened in such a way thatthey can be subjected to constrained optimization. This neglects contribu-tions coming from other traditions. Here is not the place to provide a com-prehensive account of classical, Marxian, Keynesian and evolutionaryapproaches to the problem of growth and development; see, therefore, Dutt(1990), Foley and Michl (1999), Salvadori (2003), Nelson (2005) andSalvadori and Panico (2006).

Neoclassical models, old and new, typically assume full employment oflabour and full capacity utilization and thus follow Solows example, whoin his 1956 contribution explicitly set aside problems of eective demandand assumed what he called a tight-rope view of economic growth. Thisdoes not mean that there are no such problems, as Solow was to stress timeand again and also recently (see Aghion and Durlauf, 2005, p. 5). Despitehis warnings, neoclassical growth theorists continue to be concernedalmost exclusively with the evolution of potential output and ignore alleective demand failures. Interestingly, the subject index of the Handbookjust referred to has no entry on capacity or capital utilization. Ignoring thedemand side, that is, assuming Says law, is justied in terms of the over-whelming importance of long-run growth compared with short-runuctuations. However, there appears to be a misunderstanding involvedhere, as the following example can clarify. Assume two identical economiesexcept for the fact that one, due to a better stabilization policy, manages torealize on average, over a succession of booms and slumps, a higher averagerate of capacity utilization than the other economy. With Y as actual andY* as potential output, s as the savings rate, v as the actual and v* as theoptimal output-to-capital ratio and uY/Y* as the average degree of uti-lization of productive capacity, we have:

gi SY

YK

sv

SY

Y*K

YY*

sv*ui (i 1,2)



Assume now that s0.2 and v*2, but u10.8 and u20.7. Then the rsteconomy would grow at 8 per cent per year, whereas the second would growat only 7 per cent. This may seem a triing matter, and in the short run it surelyis, but according to the compound (instantaneous) interest formula afterabout 70 years the rst economy would be larger than the second one by theamount of their (common) size at the beginning of our consideration. Henceeective demand matters. Experience also suggests that there is no reason topresume that actual savings can be expected to move suciently close aroundfull employment and full capacity savings. Persistently high rates of unem-ployment in many countries, both developed and less-developed ones,strongly indicate that the problems of growth and development cannot ade-quately be dealt with in terms of the full employment assumption.

A recurrent tenet of Keynesian models is that dierent components ofeective demand aect the rate of growth dierently. It was already RoyHarrod who stressed that government policies have to be used both to sta-bilize the economy and to achieve higher growth. This theme was taken upby Nicholas Kaldor who discussed the interaction between public debt andinterest rates. A monetary policy causing widely uctuating short-run inter-est rates is said to raise the long-term rate to levels which may curb accu-mulation unless the rate of prot is raised too. This, Kaldor maintained,can be accomplished by stimulating eective demand via tax cuts and byscal policy.

The relationship between the rate of growth of eective demand and therate of prots in the simplest framework possible is expressed by the so-called Cambridge equation:

where sc is the propensity to save of capitalists. This relationship, or somevariant of it, holds in a large number of cases. In more recent times, takingup suggestions especially by Michal Kalecki and Joseph Steindl, there havebeen attempts to analyse investment behaviour more carefully. The pres-ence of an investment function in addition to and independently of thesavings function is indeed a characteristic feature of Keynesian models.This has led to a class of investment-led growth models, in which growth istypically seen to depend on two main, but interrelated factors: protabilityand eective demand. As regards the second factor there is wide agreementand strong empirical evidence that investment responds positively (nega-tively) to rising (falling) levels of capacity utilization. Protability in turn isgoverned by the innovative potential that can be exploited at a givenmoment of time and by income distribution. Put in a nutshell, the type ofinvestment function typically employed looks as follows:

r scg



where is the share of investment, r the current rate of prot as an indica-tor of the possibilities of internal nancing, re the expected rate of prot, ithe long-term rate of interest, and u the degree of capacity utilization. Thecharacteristic features of these models are essentially three. Firstly, incomedistribution and growth are simultaneously determined. Secondly, theparadox of thrift is not limited to the short run: an increase in the overallpropensity to save, other things being equal, reduces both the rate ofgrowth and the rate of prot. This is exactly the opposite of what neoclas-sical models typically predict. Finally, the rate of growth depends nega-tively on the real wage rate provided the system is in what is called aprot-led growth regime. However, this need not be the case. There existconstellations of the parameters which give the model an underconsump-tionist avour with the growth rate rising together with the real wage rateover a certain range. For a summary account of this class of models, seeCommendatore et al. (2003).

Recent economic history shows that the Keynesian approach can be usedto interpret reasonably well, for example, the economic development of theUnited States, which for many years followed a policy of massive budgetdecits. The remarkable growth performance of China can also beexplained with reference to the leading role of investment and, via the mul-tiplier, of eective demand, whereas an explanation presupposing the fullemployment of labour is bound to lead astray with respect to an economicsystem in transition from a dominantly agricultural to an industrialeconomy, with hundreds of millions of workers from rural areas in searchof jobs in cities.

There is also evidence that sluggish economies have less potential toadopt and develop new technology. This brings us to contributions in whichtechnical progress is endogenous. There are several mechanisms discussedin the literature as to how the growth of output aects the growth of labourproductivity, especially in the manufacturing sector, from Adam Smithsconcept of the division of labour to Verdoorns and Kaldors laws. The vir-tuous circle contemplated in this kind of literature sees protability posi-tively related to the growth of labour productivity, which is seen to bepositively related to the growth in output. High rates of prot in turn willfeed high rates of investment growth and thus high rates of output growth.

Another class of contributions comes from evolutionary economics. Thisis a rapidly growing eld and its main concern, following in the footsteps ofJoseph A. Schumpeter, is to analyse why and how the economic systemincessantly changes from within. The focus of attention is more on devel-opment than growth, or rather it is insisted that the economic process

(r, re, i, u)



generates rapid qualitative change that cannot be captured in terms of theusual highly aggregate growth models. The origins of the evolutionaryapproach can be traced back to the classical economists, especially AdamSmith. The approach was taken up in parts by Alfred Marshall and thenSchumpeter. The modern discussion was largely shaped by Nelson andWinter (1982). The evolutionary approach centres on a dynamic analysis inwhich random elements change the population of rms or the technologythey use via a selection mechanism on existing variety. Discovery, learningand imitation assume centre stage in the argument which is about popula-tion dynamics and the economic eects it entails. For obvious reasons, evo-lutionary economics rejects such neoclassical concepts as the representativeagent or the aggregate production function. Necoclassical growth theoryis said to suer from a detachment between formal and appreciative theory(Nelson, 2005), where the latter is close to empirical studies of the actualbehaviour of rms. Important contributions to evolutionary growth eco-nomics came from, among others, Giovanni Dosi, Stanley Metcalfe andGerald Silverberg. For a summary account see Santangelo (2003).

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