Essay on the basic structure of the AK model of endogenous growth

Basic structure of the AK model of endogenous growth

AK growth models predict that permanent changes in government policies affecting investment rates should lead to permanent changes in a country’s GDP growth. Charles Jones sees no evidence for this prediction in data for 15 OECD countries after World War II: rates of investment, especially for equipment, have risen while GDP growth rates have not.

This article provides evidence supporting the AK models’ prediction. Data back to the 19th century show a strong positive relationship between investment rates and growth rates and short-lived deviations from trends. A strong positive relationship also exists between average rates of investment and growth in postwar data for a large cross-section of countries.

To account for the short-run deviations in rates that Jones highlights, the model he used is extended to allow policies to affect not only investment/output ratios but also capital/output ratios and labour/leisure decisions. Over the past 200 years, many countries have experienced sustained growth in gross domestic product (GDP) per capita.

Accounting for this sustained growth has been a central goal of modern economic growth theory. Early models simply assumed some positive rate of technological progress which translated into positive GDP growth. Now models have been developed that generate growth endogenously.

One class of such models, commonly called AK models, relies on the assumption that returns to capital do not diminish as the capital stock increases. Without diminishing returns, a country with a high stock of capital is not deterred from continued investment and, therefore, continued growth.

The AK class of models has been heavily criticised. Most critics have attacked the main assumption, the absence of diminishing returns, as having little empirical support. However, such criticisms are themselves difficult to support if capital is viewed broadly to include human capital and intangible capital, both of which are difficult to measure.

More serious critiques analyse the testable predictions of AK models. Jones, for example, argues that a key prediction of AK models is inconsistent with the data. Unlike the earlier exogenous growth models, AK-models predict that permanent changes in government policies affecting investment rates should lead to permanent changes in a country’s GDP growth.

Jones tests this prediction by comparing investment as a share of GDP and the growth rate of GDP for 15 countries that belong to the Organisation for Economic Co-operation and Development (OECD). Using data for the post-World War II period, Jones argues that AK models are inconsistent with the time series evidence because during the postwar period, rates of investment, especially for equipment, have increased significantly, while GDP growth rates have not.