Consider the following canonical Post Keynesian model. Assume a closed economy w

Question

Consider the following canonical Post Keynesian model. Assume a closed economy without a government sector and a classical saving hypothesis so that there is no saving from wages. Further, the homogenous output (Y) is produced combining direct labour and a non-depreciating capital stock in the production process. The rate of profit (r) is given by 6. r=-= - hu where h is the profit share (p), u is the capacity utilization (5), where Y' denotes the potential output, and v is the ratio of the inverse of capital stock to potential output The rate of saving (a) based on the classical saving function is given by S Snl where sn is the propensity to save out of profits I7 (1> s0). Answer the following questions intuitively using graphs: 0) Using the model closure in the tradition of Solow's growth model, explain the mechanism by which the long-run growth equilibrium is achieved. Using the model closure in the tradition of AK models (endogenous growth models), explain the mechanism by which the long-run growth equilibrium is achieved 13.3] (ii) 120]

Explanation / Answer

Ans) Given :

Long - run growth in Solow Model:

In order to remove the instability inherent in Harrod's model, Solow has used capital - labour ratio as a variable and says that there is inherent tendency in the system to achieve equilibrium. Starting from any capital - labour ratio, equilibrium will be established without any outside interference. This means K/L ratio will adjust itself to establish equilibrium in the economy. The major role played in the long- run growth is of capital accumulation. This means how growth in capital stock affects growth in labour force and knowledge and this have an overall effect on nation's total output . Economic growth occurs with the increase in capital accumulation.

Solow describes the Steady State which is long- run equilibrium as regardless of what the initial capital stock is there in the economy , the economy ends up in the steady state . Steady state is also characterised when growth rate of capital is equal to the growth rate of labour , then K/L will also be constant. In his model, saving rate and capital accumulation have positive correlation. This has important implication from policy point of view. If there is budget deficit then it will necessarily have reduced saving rate leading to low level of private investment. So, the ultimate consequence of reduced saving rate is low level GDP or income of the economy. Thus, to maintain long run growth or rather steady state economy should have higher rate of saving and investment which will lead to higher levels of capital and income per worker in the long-run.

Long run growth in AK model :

Neoclassical growth models conclude that growth rate of an economy is independent of saving rate. This means increase in saving rate increases capital per worker but growth rate of output remains unaffected.

Endogenous growth model has been developed to explain this contradiction. This group of economists explain that how with increase in per capita income, growth rate decreases and vice versa. There is negative realtionship between growth rate of economy and its per capita income. They propose that countries with higher per capita income will achieve slow growth. Developing countries will achieve high growth rate and developed countries will achieve lower growth rate. This will lead to unconditional convergence . This means growth rate of developing and developed countries will become equal.

Another major proposal of endogenous growth model is constancy of capital -output ratio. To explain this, a production function has been suggested which gives constant returns to scale in terms of capital . AK model is given as Y= aK where a is constant and A is greater than 0. MPK = a which is a constant . As a result capital - output ratio will also be constant. Change in K = I = S = sY = s. a K . Therefore, Change in K / K = s.a

This means there is proportional savings function. Hence, growth rate of an economy is not independent of savings rate as propounded by neo-classical economists. There is no steady state described in AK model. So, we can make out how this model differs with Solow model. In AK model , a rise in saving rate has a permanent effect on growth rate of the economy. There is only level effect. There is no instances that growth rate of per capita income decline. There is always a consistent rise leading to proportional relationship between growth rate of output and savings rate. A very important implication of this model is that it lead to no convergence between two economies having same growth rate and same technologies. So, there is no tendency for poorer nations to catch up with the richest economies.

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