LECTURE 2 - Economic growth: basic concepts, ideas and
theories
Outline
1. How important is aggregate growth? Inequality-Growth
2. Problems with measuring growth
3. Theories: Harrod-Domar, Neoclassical/Solow, Endogenous growth
4. Historical growth: Malthus trap
5. Neo vs. End: empirical evidence
1. How important is aggregate growth? Inequality -Growth
General questions: do poor benefit from global growth? Is growth pro-poor? Do poor
people benefit in absolute terms only but disproportionately less than average
(increasing within country inequality)?
Specific questions:
A. Decomposition global inequality: What is driving global movements in income
inequality: changes in the distribution of income between countries, or
changes within countries?
There is strong empirical evidence from many authors that within-country income
inequality is relatively stable over time: it has been increasing in many countries
recently but it usually doesn’t display large swings from one year to the next. As a result,
when you look at evolution of global income distribution, most of the change seems to
be coming from changes in the relative distribution of income across countries.
Depending on methodology chosen/question they ask, authors have reached different
conclusions:
Quah (2002): There has been slight increase in global income inequality and most
important determinant is between country inequality.
“For determining world inequalities, the forces assuming first-order importance are
those macroeconomic ones that determine cross-country patterns of growth and
convergence. The relation between a country’s growth performance and its within-
country inequality has only a small role to play in determining global inequality
dynamics.”
His results are nevertheless driven by China and India: the one that was initially richer,
China, has grown faster and thus increased inequality between them.
1
,Argument: aggregate growth tends to move the whole distribution forward
simultaneously, so within-c inequality would have to increase to unrealistic levels for
poverty to rise when there is growth (the left-hand tail of the distribution would have to
stretch to the left even as the mean of the distribution moved rightwards). Empirical
evidence suggests that this is indeed approximately correct (see Dollar). Ex: although
income inequality within China has increased, it hasn’t been dramatic enough to cancel
out the big forward shift of the entire distribution, ensuring that more and more people
have their incomes lifted and are brought out of poverty.
Xavier Sala-i-Martin (2009): he finds not only that global inequality has decreased (also
due primarily to fast growth in China and India), but that both poverty rates and absolute
head counts of people in absolute poverty have declined significantly. Most of the
decline in inequality is a decline in population-weighted between-c inequality. (Diff
methodology.)
Dollar et al. (2000, 2013):
- Incomes of the poor increased, approximately one for one, with the overall
growth in mean income during periods of significant growth (1-to-1 relationship
btw aggregate growth and poor’s growth)
- The incomes of the poor do not fall disproportionately during periods of “crisis”
or negative growth.
- Aggregate GDP growth is not associated with increases in income inequality
within countries.
- Little evidence about which macro policies are more pro-poor then others
Lant Pritchett (2018): what achieves greater poverty reduction, aggregate economic
growth or redistribution/targeted anti-poverty programs? He compares the poverty
reduction achieved from economic expansions (and the losses from aggregate
contractions) with the best returns so far achieved from targeted anti-poverty programs
→ $1 billion spent in anti-poverty programme in Ethiopia would increase ipc by $17 vs.
gains from an aggregate growth acceleration in 1992 followed by another in 2002 are
$255 pc; gains from a billion dollars invested in an anti-poverty program are a factor of
100 to 1000 smaller than the gains and losses from growth episodes (!).
Summary: inequalities mainly BTW countries + aggregate growth generally dominates
any changes in WTN-country inequality in such a way that most growth is pro-poor.
B. Causal link btw growth and inequality: Does the growth process itself have any
contributing role influencing the evolution of within-country inequality?
Could it be possible that growth increases/decreases within country inequality?
Banerjee and Duflo (2000): there is no robust relationship between these two variables
as any results hinge crucially on what kind of data are used and on fragile assumptions
about the functional form of the relationship.
2
,Lundberg and Squire (2001): inequality is jointly determined with growth and thus these
two variables are endogenous. Without controlling for this endogeneity, one cannot
expect a stable empirical relationship between the two variables.
Easterly: looking into historical trends, they find a strong correlation between initial
inequality and current gaps in income per capita. The more unequal a country was when
it was founded, the worse its institutional quality and hence the worse its long run
growth.
Summary: The data do not show any evidence for the kinds of anti-poor effects of
growth that many of the more radical anti-growth people claim. But it could be that
some kinds of growth could hurt certain groups.
2. Problems with measuring growth
GDP is not an ideal measure of growth (leaves out important development
determinants), but even GDP is poorly measured in many developing countries.
GDP = gross domestic product = total monetary or market value of all the finished goods
and services produced within a country's borders in a specific time period.
Problems: in a typical developing country, a much smaller fraction of economic
activity is conducted within the formal sector, the degree of economic integration and
price equalization across regions is lower, and the government statistical infrastructure
is much weaker.
PPP = purchasing power parity = uses the prices of specific goods to compare the
absolute purchasing power of the countries' currencies.
Problems: Consumption measures derived as a residual, after subtracting other
major components of expenditure from the production side. Production side estimates
of subsistence and informal production and other untaxed activities are, however, very
poor, leading to gross errors in the calculation of consumption levels.
When alternative measures of economic growth are used (like ownership of durable
goods, the quality of housing, the health and mortality of children, the education of
youth), sometimes a dramatically different picture emerges, especially in the poorest
countries. For example, with these measures, sub- Saharan living standards have, for the
past two decades, been growing more than three times the rate indicated in
international data sets.
3. Classic Growth Theories
NEOCLASSIC/SOLOW MODEL
In the Solow model, aggregate output (Y) in the economy is a function (not just a
proportion) of the basic inputs, physical capital (K) and labor (L). This function describes
3
, the relationship between the quantity of inputs and the resulting quantity of output,
and is called a production function:
Y = A*F(K, L)
Y/per worker = A*F(K/worker)
‘Given some technological progress has occurred or is occurring (A), how will that fact
interact with other aspects of the economy (such as the investment rate, K, L) to
produce what we observe as economic growth (Y)?’
Assumption: if you double both K and L, then output will be doubled (constant returns
to scale). However, if you only increase capital without increasing labor, there will be
diminishing returns: at first the existing L will be able to use the additional K to produce
more output, but as more K is introduced, the existing L will be less able to utilize it.
Thus, additional units of capital will progressively produce a smaller and smaller
increases in output.
An increase in output Y per worker can come from:
1. Capital accumulation: an increase in physical capital per worker (increase K).
2. Technological progress: could take the form of more efficient production, or the
ability to produce new or improved goods (increase A).
From current production f(k), some portion is saved/invested (to cover for depreciation)
and the rest is consumed. At:
- K1: only a smaller part of savings is needed to cover for depreciation (dep. eats
up less capital than is saved), so remaining K will be accumulated -> endogenous
K growth towards equilibrium
- K2: K depreciated faster than it accumulates -> K endogenously decreases
- K*: equilibrium state -> savings/investment = depreciation rate
Implications:
4
theories
Outline
1. How important is aggregate growth? Inequality-Growth
2. Problems with measuring growth
3. Theories: Harrod-Domar, Neoclassical/Solow, Endogenous growth
4. Historical growth: Malthus trap
5. Neo vs. End: empirical evidence
1. How important is aggregate growth? Inequality -Growth
General questions: do poor benefit from global growth? Is growth pro-poor? Do poor
people benefit in absolute terms only but disproportionately less than average
(increasing within country inequality)?
Specific questions:
A. Decomposition global inequality: What is driving global movements in income
inequality: changes in the distribution of income between countries, or
changes within countries?
There is strong empirical evidence from many authors that within-country income
inequality is relatively stable over time: it has been increasing in many countries
recently but it usually doesn’t display large swings from one year to the next. As a result,
when you look at evolution of global income distribution, most of the change seems to
be coming from changes in the relative distribution of income across countries.
Depending on methodology chosen/question they ask, authors have reached different
conclusions:
Quah (2002): There has been slight increase in global income inequality and most
important determinant is between country inequality.
“For determining world inequalities, the forces assuming first-order importance are
those macroeconomic ones that determine cross-country patterns of growth and
convergence. The relation between a country’s growth performance and its within-
country inequality has only a small role to play in determining global inequality
dynamics.”
His results are nevertheless driven by China and India: the one that was initially richer,
China, has grown faster and thus increased inequality between them.
1
,Argument: aggregate growth tends to move the whole distribution forward
simultaneously, so within-c inequality would have to increase to unrealistic levels for
poverty to rise when there is growth (the left-hand tail of the distribution would have to
stretch to the left even as the mean of the distribution moved rightwards). Empirical
evidence suggests that this is indeed approximately correct (see Dollar). Ex: although
income inequality within China has increased, it hasn’t been dramatic enough to cancel
out the big forward shift of the entire distribution, ensuring that more and more people
have their incomes lifted and are brought out of poverty.
Xavier Sala-i-Martin (2009): he finds not only that global inequality has decreased (also
due primarily to fast growth in China and India), but that both poverty rates and absolute
head counts of people in absolute poverty have declined significantly. Most of the
decline in inequality is a decline in population-weighted between-c inequality. (Diff
methodology.)
Dollar et al. (2000, 2013):
- Incomes of the poor increased, approximately one for one, with the overall
growth in mean income during periods of significant growth (1-to-1 relationship
btw aggregate growth and poor’s growth)
- The incomes of the poor do not fall disproportionately during periods of “crisis”
or negative growth.
- Aggregate GDP growth is not associated with increases in income inequality
within countries.
- Little evidence about which macro policies are more pro-poor then others
Lant Pritchett (2018): what achieves greater poverty reduction, aggregate economic
growth or redistribution/targeted anti-poverty programs? He compares the poverty
reduction achieved from economic expansions (and the losses from aggregate
contractions) with the best returns so far achieved from targeted anti-poverty programs
→ $1 billion spent in anti-poverty programme in Ethiopia would increase ipc by $17 vs.
gains from an aggregate growth acceleration in 1992 followed by another in 2002 are
$255 pc; gains from a billion dollars invested in an anti-poverty program are a factor of
100 to 1000 smaller than the gains and losses from growth episodes (!).
Summary: inequalities mainly BTW countries + aggregate growth generally dominates
any changes in WTN-country inequality in such a way that most growth is pro-poor.
B. Causal link btw growth and inequality: Does the growth process itself have any
contributing role influencing the evolution of within-country inequality?
Could it be possible that growth increases/decreases within country inequality?
Banerjee and Duflo (2000): there is no robust relationship between these two variables
as any results hinge crucially on what kind of data are used and on fragile assumptions
about the functional form of the relationship.
2
,Lundberg and Squire (2001): inequality is jointly determined with growth and thus these
two variables are endogenous. Without controlling for this endogeneity, one cannot
expect a stable empirical relationship between the two variables.
Easterly: looking into historical trends, they find a strong correlation between initial
inequality and current gaps in income per capita. The more unequal a country was when
it was founded, the worse its institutional quality and hence the worse its long run
growth.
Summary: The data do not show any evidence for the kinds of anti-poor effects of
growth that many of the more radical anti-growth people claim. But it could be that
some kinds of growth could hurt certain groups.
2. Problems with measuring growth
GDP is not an ideal measure of growth (leaves out important development
determinants), but even GDP is poorly measured in many developing countries.
GDP = gross domestic product = total monetary or market value of all the finished goods
and services produced within a country's borders in a specific time period.
Problems: in a typical developing country, a much smaller fraction of economic
activity is conducted within the formal sector, the degree of economic integration and
price equalization across regions is lower, and the government statistical infrastructure
is much weaker.
PPP = purchasing power parity = uses the prices of specific goods to compare the
absolute purchasing power of the countries' currencies.
Problems: Consumption measures derived as a residual, after subtracting other
major components of expenditure from the production side. Production side estimates
of subsistence and informal production and other untaxed activities are, however, very
poor, leading to gross errors in the calculation of consumption levels.
When alternative measures of economic growth are used (like ownership of durable
goods, the quality of housing, the health and mortality of children, the education of
youth), sometimes a dramatically different picture emerges, especially in the poorest
countries. For example, with these measures, sub- Saharan living standards have, for the
past two decades, been growing more than three times the rate indicated in
international data sets.
3. Classic Growth Theories
NEOCLASSIC/SOLOW MODEL
In the Solow model, aggregate output (Y) in the economy is a function (not just a
proportion) of the basic inputs, physical capital (K) and labor (L). This function describes
3
, the relationship between the quantity of inputs and the resulting quantity of output,
and is called a production function:
Y = A*F(K, L)
Y/per worker = A*F(K/worker)
‘Given some technological progress has occurred or is occurring (A), how will that fact
interact with other aspects of the economy (such as the investment rate, K, L) to
produce what we observe as economic growth (Y)?’
Assumption: if you double both K and L, then output will be doubled (constant returns
to scale). However, if you only increase capital without increasing labor, there will be
diminishing returns: at first the existing L will be able to use the additional K to produce
more output, but as more K is introduced, the existing L will be less able to utilize it.
Thus, additional units of capital will progressively produce a smaller and smaller
increases in output.
An increase in output Y per worker can come from:
1. Capital accumulation: an increase in physical capital per worker (increase K).
2. Technological progress: could take the form of more efficient production, or the
ability to produce new or improved goods (increase A).
From current production f(k), some portion is saved/invested (to cover for depreciation)
and the rest is consumed. At:
- K1: only a smaller part of savings is needed to cover for depreciation (dep. eats
up less capital than is saved), so remaining K will be accumulated -> endogenous
K growth towards equilibrium
- K2: K depreciated faster than it accumulates -> K endogenously decreases
- K*: equilibrium state -> savings/investment = depreciation rate
Implications:
4
