Question Asatsuyu Finance & Economics

Economic Growth Models and Policy Implications

Can you highlight a number of theoretical models that are set to explain the sources of economic growth and the role of government in minimising the surprised demand and supply shocks and encouraging growth

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Answer Internal Staff

1) Solow Model

The Solow model is a major paradigm widely used in policy making. In addition to this, it is a benchmark against which most recent growth theories are compared. The Solow model looks at the determinants of economic growth and standard of living in the long run.

A key term is ‘steady-state economy’, which is an economy with stable or mildly fluctuating size. The ‘Golden Rule’ level of capital accumulation is the steady state with the highest level of consumption. The idea behind the Golden Rule is that if the government could move the economy to a new steady state, where would they move? The answer is that they would choose the steady state at which consumption is maximised. To alter the steady state, the government must change the savings rate.

So, if there is a demand shock affecting household or firm spending and investment, such as a change in savings, then a government would look at the Golden Rule steady state. If, for example the UK is below the GR steady state: Increasing the UK saving rate would increase consumption in the long run, and this will encourage economic growth.

2) Harrod-Domar Model

Growth strategies are the things a government might introduce to replicate the outcome suggested by the model. Basically, the model suggests that the economy's rate of growth depends on:

  • The level of national saving (S)
  • The productivity of capital investment (this is known as the capital-output ratio)

3) Endogenous growth model

Augmentation to the Solow Swan model. The Endogenous growth model posits that growth is generated from within the system. It places emphasis on the role of human capital. Productivity of factors (especially labour) and changes in use of technology can cause supply side shocks. An implication of this theory is policies that embrace change and innovation, investing more on R&D and having greater stocks of human capital will promote growth. An example of an endogenous growth model is the Romer model.