The Fundamentals of

Economic Growth
Topic outcomes
• By the end of this topic you will be able to
• Deliberate logically about economic growth: its causes and consequences.
• Outline Kaldor’s stylized facts of economic growth.
• Observe the differences in growth rates across countries.
• Discuss the Solow growth model assumptions.
• Track the growth in GDP per capita for Eswatini over the past 20 years.
• Analyse the impact of capital accumulation on economic growth.
• Show the effect of an increase in the labour force on economic growth.
• Examine the consequence of technical progress on economic growth
Economic growth vs. economic development
• How are the two different and what causes other countries to grow or develop faster than
others?
• What are the measures of economic growth and economic development? Are they the same?
Explain in detail using your prior knowledge from development theory learnt in semester 1 level
3. Should you have difficulty answering these questions, you should go back to your material
used back then or go online and find the explanations there. Try to use credible sources.
• Its is important to relate the material we will cover in this topic to the Eswatini situation. Always
try to look at the data to follow what is happening in Eswatini. Research topics (for level 4) are
easily found if you make it a habit to know your country data especially.
• Why do countries experience fluctuations in their growth rates? Use the CBE quarterly reports
to find GDP growth rates for Eswatini. You will find explanations on why in some years growth
was higher and in others it was lower.
Three main forces of growth as well as
specification of production functions
• 1) Capital (K) stock increase. What is included in the capital stock?
• (2) Labour (K) force growth
• (3) Technological progress, which leads to increased knowledge and improved techniques, hence higher productivity.

• Activity; From the above we can sketch a production function (standard) where output is function of K and L; Y=f(K, L) and in
intensive form production y = f(k). Go ahead and plot both types of production functions. How are they different? (a) How
does the figure Y=f(k,L) depict diminishing marginal productivity?
• (b) Use same figure used in (1) above to explain the concepts of constant, increasing and decreasing returns to scale.
• (c) Explain the intensive form production function given by y = f(k) .
• (d) Discern between average productivity and marginal productivity of labour. Use prior knowledge to tackle these questions.
• (e) Go through Box 3.2 pg. 61, (Burda and Wyplosz (2017). Use the resource provided here to enhance your
understanding of the Cobb-Douglas production function.
http://users.wfu.edu/cottrell/ecn207/cobb-douglas.pdf
Kaldor’s five stylized facts of economic growth after looking at
growth rates for long periods for a number of countries
• (i)
• Output per capita (Y/L) and capital intensity (K/L) keep increasing.
• Real GDP growth is boundless. But labour input (person hours of work, L) growth ( ) is slower than K, and output Y. Income per capita is
closely related to Y/N so that economic growth implies improving standards of living (N is population size). See figure 4 below to show this
fact.
• (ii) The capita-output ratio shows little or no trend over time.
• The capital stock and output tend to track each other.
• (iii) Hourly wages keep increasing
• The long run increases in Y/L and K/L leads to more output produced per hour of work i.e. workers become more productive. As this
happens wages per hour should also increase.
• (iv) The rate of profit is trendless
• K/Y is the inverse of the average productivity of capital Y/K. We know from (ii) that K/Y has no clear trend so Y/K will also have no clear
trend. We expect that the same amount of equipment will deliver the same output. So we expect profit to be also trendless. With stable
profit, income from capital increase proportionately to the capital stock.
• (v) The relative income shares of GDP paid to labour and capital are trendless.
• Incomes from labour and capital tend to increase at about the same rate so that distribution of total income (GDP) between capital and
labour is relatively stable.
Capital accumulation and economic growth
• From the circular flow of income GDP equals household income from wages and salaries
and income to owners of firms who get profit shares. Income is either saved or consumed.
Savings flow into financial system where they are channeled to various investments
(purchase of capital goods) which further increase savings leading to more investment as
more capital is accumulated.
• Is it best to save more and forgo current consumption in favour of future consumption? Will
faster growth result from increased savings? And is capital accumulation boundless?
• We are going to use the Solow Growth Model developed by Nobel Prize winner Robert
Solow in 1952 in the analysis that will follow. There are many graphs used in the analysis.
Students have to understand what each curve represents and then characterize how the
economy moves from one equilibrium to another.
• You also have to note the terminology used here.
Capital accumulation and depreciation
• Earlier in level 2 macroecon. You were exposed to these equations.
• (1)
• where
•
•
•
• If the government budget is in balance and if the current account surplus is equal to zero.
• If this means that the increase in the capital stock is financed by resident households and firms. In the long
run (or steady state) the economy will grow if domestic residents save then invest.
• If a fraction (s) of GDP (Y) is saved in order to be invested, then (3)
• Now if we divide equation (3) by labour (L) to get and this equation can be rewritten as follows; (4)
• From earlier we know that k is capital already accumulated, and
Figure 1 The Steady State
Figure 1 The Steady State contd.
• From figure 1 it is important to note the following;
• (i) The savings function lies below the production functions , why? This is because savings are only a
portion of total income so they are lower when compared to total income.
• (ii) Capital accumulation, Δk is given by the distance between curve and the depreciation
• line (δk). This indicates the net change in the capital stock per unit of labour input. If Δk>0 then
• capital stock per capita is increasing leading to rising economic growth as more output is produced.
• If Δk<O, then the opposite holds.
• (iii) At point A, gross investment implying that K/L no longer changes. So newly accumulated capital
exactly matches capital lost to depreciation. This is the steady state. The economy will always move
towards this point over time.
• (iv) At point C gross investment , so the distance CD equals net investment so the K/L ratio increase
towards the steady state k, denoted as . The economy cannot get to any point beyond the steady state k,
because when the economy approaches the steady state net investment shrinks until it equals zero as k
reaches the steady state point. This is called catching up (happens as economy begins below steady state
GDP and then grows faster approaching steady state from below) as shown in figure 2 below.
Figure 2 Catching up
Savings and growth
• From growth literature and discussions we have learnt that when countries increase savings then investment
should increase leading to higher steady state K/Y ratio hence a to high Y/L ratio. The expectation is that higher
savings which increase investment should eventually lead to higher per capita incomes. Economists looked at
data to see if this assertion is supported by the data. Take a look at figures 6. What do you observe?
• Main takeaway from figure 3.7 is that countries that save more will have a higher standards of living in the
steady state but they will not necessarily grow faster forever. There is also an observed positive relationship
from data between per capita GDP and growth but other factors are important as well.
• Looking at the role of savings, we allow capital to depreciate by a rate given by (δ). This rate is stable and
constant so in figure3.8 in textbook it is given by the ray form the origin with its slope given by (δ). If gross
investment is greater (δ)then net investment is positive and the capital stock must be rising. It therefore follows
that net investment is given by; and in intensive form this can be written as; which shows that net capital
accumulation per unit of labour is positively related to the savings rate (s) and negatively related to the
depreciation rate (δ)
• Given the above information on savings, we are now ready to analyse the impact of increased savings in our
Solow model
Increase in savings rate figure 3
Explanation figure 3 above
• (i) shifts up to with unchanged.
• (ii) Higher steady state Y/L and K/L ratios at B compared to A. Recall that the new higher steady state
will be reached over time.
• (iii) At point A an increase in savings will lead to an increase in gross investment and because
depreciation is unchanged net investment must be positive.
• (iv) K/L ratio increases which results in an increase in the Y/L ratio. This continues until new steady
state is reached at B. As all this is happening economic growth is higher implying that increased
investment results in higher economic growth.
• From figure 3 for a country to be richer there is need to save and invest more. Also bear in mind that
saving today means you forgo consumption today in the promise of higher future consumption. Is this
true? Not entirely We know that savings is income that is not consumed, so at steady state k, savings
must be equal to depreciation plus steady state consumption (c). In notation this is;
• (5)
Golden rule
• In fig. in next slide (figure 3.9 in textbook) consumption is the distance between
and the depreciation line. Here consumption is highest at point A where slope of
is parallel to the depreciation line. We know that the slope of is the marginal
productivity of capital )and the slope of the depreciation line is δ (the rate of
depreciation). So c is at a maximum when
• This is referred to as the golden rule. In a case without population growth and
technical progress golden rule states that the economy maximizes c when
marginal gain from an additional unit of GDP saved and invested in capital (MPK)
equals the depreciation rate. What transpires where this golden rule is violated?
• Go to textbook and find and show definitions of dynmanic efficiency and dynamic
inefficiency.
Additional resources
• https://www.karlwhelan.com/Macro2/slides-9.pdf
• https://www.karlwhelan.com/MAMacroSem1/Notes11.pdf
• https://corporatefinanceinstitute.com/resources/knowledge/economics/solow-g
rowth-model/
• http://qed.econ.queensu.ca/pub/faculty/head/econ421/lecsl3w08.pdf