What are the salient features of endogenous growth models?

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 long- term 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 tax-smoothing 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.