Economic Growth Models: A Primer /Student's Guide, Miguel Lebre de Freitas 5 The AK model “…a level effect can appear as a growth effect for long periods of time, since adjustments in real economies may take place over decades”. [Sachs and Warner]. Learning Goals:  Understand why getting rid of diminishing returns one can obtain unceasing growth via factor accumulation.  Distinguish the case with endogenous savings.  Review different models were simple factor accumulation can generate endogenous growth.  Acknowledge the empirical challenges raised by the abandonment of diminishing returns. 5.1 Introduction Along the previous chapters, we learned that, under diminishing returns, factor accumulation cannot, by itself, explain the tendency for per capita income to grow over time. For this reason, a sustained growth of per capita income can only be achieved in the neoclassical model by postulating an exogenous rate of technological progress. In this chapter it is shown that, by getting rid of diminishing returns on capital accumulation, one can obtain continuous growth of per capita income without the need to postulate an exogenous rate of technological progress. This result is shown in terms of the so- called AK model. The AK model differs critically from the Solow model in that it relies on a production function that is linear in the stock of capital. In this model, per capita income grows continuously in the equilibrium, without any tendency to stabilize. In that model, a rise in the saving rate produces a permanent increase in the growth rate of per capita income. This contrasts with the Solow model, where a rise in the saving rate only delivers only a “level effect”. The pitfall of the AK model is that the assumption of diminishing returns plays a very central role in economic thinking. Hence, it cannot be abandoned without a well motivated https://mlebredefreitas.wordpress.com/teaching-materials/economic-growth-models-a-primer/ 28/02/2022 174 Economic Growth Models: A Primer /Student's Guide, Miguel Lebre de Freitas story. Some of the sections below describe alternative theories and models that were proposed to motivate the departure from the assumption of diminishing returns on capital. Although none the models described in this chapter shall be seen as the true model, they all offer alternative avenues to think the various factor that might contribute to economic development. Sections 5.2 describes the AK model in its simpler formulation. Section 5.3 extends the AK model to the case of endogenous savings. Section 5.4 reviews alternative models that emulate the AK model. Section 5.5 addresses the empirical evidence on the relationship between savings on economic growth. Section 5.6 concludes. 5.2 The basic AK model 5.2.1 Getting rid of diminishing returns Consider a closed economy where the population growth rate, the savings rate and the depreciation rate are all constant over time. The novelty relative to the Solow model is that the production is linear in K: Y  AK , A > 0 (5.1) t t In (5.1), the parameter A stands for the level of technology (or aggregate efficiency), and is assumed constant. In light of (5.1), production depends only on capital and there are no diminishing returns. The reader may get suspicious about this formulation: after all, does it make sense to model production without labour? In fact, we don’t need to assume that labour has no role: in the following sections, we will review alternative models that, while accounting for the role of labour in production, emulate versions of production function (5.1). For the moment, however just stick with this simple formulation. Dividing (5.1) by N, one obtains a linear relationship between per capita income and capital per worker: y  Ak (5.2) t t The remaining equations of the model are the same as in the basic Solow model: https://mlebredefreitas.wordpress.com/teaching-materials/economic-growth-models-a-primer/ 28/02/2022 175 Economic Growth Models: A Primer /Student's Guide, Miguel Lebre de Freitas Y  C  S (2.5) t t t sY  I (2.7) t t K  I K (2.8) t t t n  N N (2.9) t t From (2.7), (2.8), (2.9) and (5.2), we obtain the dynamics of the capital labour ratio:   k  sAk  n k (5.3) t t t This equation is similar to (2.14), with the only difference that now =1. This small difference has an important implication: since both terms on the right-hand side of (5.3) are linear in k, only by an exceptional coincidence of parameters would this expression be equal to zero. Hence, the general case in the AK model is that there is no steady state. Dividing (5.3) by k, one obtains the equation that describes the growth rate of capital per worker in this economy: k  sAn k Since output is linear in K, the growth rate of capital per worker is also the growth rate of per capita income. That is: sAn (5.4) This equation states that the growth rate of per capita income rises with total factor productivity (A) and the saving rate (s) and declines with the depreciation of the capital- labour ratio (n and ). As long as sAn, per capita income will expand forever, at a constant growth rate. Note that this conformity with the real-world facts is achieved without the need to postulate any exogenous technological progress. Because the growth rate of per capita income in (5.4) is influenced by the other parameters, instead as being given, the model is categorized as of endogenous growth. 5.2.2 A Graphical Illustration https://mlebredefreitas.wordpress.com/teaching-materials/economic-growth-models-a-primer/ 28/02/2022 176 Economic Growth Models: A Primer /Student's Guide, Miguel Lebre de Freitas Figure 5.1 describes the dynamics of the AK model. The horizontal axis measures the capital labour ratio (k). The vertical axis measures output per capita (y). The top line shows the production function in the intensity form, (5.2); the middle line corresponds to gross savings per capita (the first term in the right hand side of 5.3); the lower of the three lines is the break-even investment line (the second term in the right hand side of 5.3). Since the production function is now linear in k, the locus representing gross savings never crosses the break-even investment line (compare with Figure 2.3). This means that, as long as sA>n+ , per capita output will grow forever, without any tendency to approach an equilibrium level. Figure 5.1. The AK model yY/N y = Ak sy (n+)k k k K/N 0 When the production function is linear, the curve describing per capita savings never crosses the break-even investment line. Hence, the capital-labour ratio and per capita output will expand without limits. 5.2.3 What happens when the saving rate increase? The AK model differs drastically from the Solow model, in that changes in the exogenous parameters alter the long run growth rate of per capita income, rather than the level of per capita income. Figure 5.2 compares the paths of per capita income in the AK model and in the Solow model following a once-and-for-all increase in the saving rate at time t (the case with the 0 https://mlebredefreitas.wordpress.com/teaching-materials/economic-growth-models-a-primer/ 28/02/2022 177 Economic Growth Models: A Primer /Student's Guide, Miguel Lebre de Freitas Solow model was already discussed in detail in Figure 3.3). The top part of the diagram shows levels and the bottom part shows growth rates. Figure 5.2: The AK model and the Solow model compared for a rise in the saving rate ln y AK Solow  0  1  0 time   y / y  AK 1  Solow 0 time t t 0 1 The figure compares the response of per capita income to an exogenous increase in the saving rate in light of the AK model versus the Solow model. While in the Solow model this gives rise to a level effect, in the AK model, there is a growth effect. The figure also suggests that, in the short term, the Solow model and the AK model produce similar predictions. In the Solow model, the rate of growth of per capita income jumps initially to a higher level, but then it declines slowly over time, until returning to the previous - exogenous - rate of technological progress. Because of diminishing returns, the long run growth rate of per capita income is independent of the saving rate. In the AK model, the rise in the saving rate has a permanent effect on growth: there is no tendency for the growth rate of per capita income to decline as time goes by. The growth rate of per capita output is proportional to the saving rate. 5.2.4 The Harrod-Domar equation A useful comparison between the AK model and the Solow model regards their respective behaviours in the long run. Using (5.1) and (5.4) we get: https://mlebredefreitas.wordpress.com/teaching-materials/economic-growth-models-a-primer/ 28/02/2022 178 Economic Growth Models: A Primer /Student's Guide, Miguel Lebre de Freitas Y    s  n (5.5) K This equation is known as the Harrod-Domar equation. The difference between (5.5) and (3.11) (that holds in the Solow model in the long run) refers to the variables that are exogenous and endogenous in this equation. In both models, s, n and  are exogenous. But the two models differ in respect to the exogeneity of  and Y/K: In the AK model, Y/K is exogenous and  is endogenous. By contrast, in the Solow model,  is exogenous and Y/K is endogenous. Hence: In the Solow model, a rise in the saving rate leads to a lower average productivity of capital in the steady state. That is, Y/K declines from one steady state to the other (Figure 3.2). In the AK model, Y/K is constant (equal to A). Hence, a rise in the saving rate can only be accommodated in the model by an increase in the growth rate of per capita income, . Because the AK model predicts that changes in A or in the saving rate produce growth effects, it goes far beyond the neoclassical model in stressing the relationship between economic policies and economic growth: government policies, such as taxes and subsidies, that affect economic efficiency and consumption-saving decisions may alter the long run’ rate of economic growth, rather than simply altering the level of per capita income. 5.2.5 No convergence The AK model does not predict convergence of per capita incomes, even among similar economies. According to (5.4), two economies having the same technology and savings rates will enjoy the same growth rate of per capita income, regardless of their starting position. In that case, the respective per capita incomes will evolve in parallel without any tendency to approach each other. This contrasts to the Solow model, where countries with similar parameters should approach the same per capita income level in the steady state. Moreover, since changes in technology (A) and in the saving rate (s) affect growth rates permanently, countries with different parameters should exhibit different growth rates of per capita income. In a world where policies differ substantially across countries, the rule should be that of divergence of per capita incomes, rather than of convergence. https://mlebredefreitas.wordpress.com/teaching-materials/economic-growth-models-a-primer/ 28/02/2022 179 Economic Growth Models: A Primer /Student's Guide, Miguel Lebre de Freitas 5.3 Incarnations of the AK model 5.3.1 The Harrod-Domar model The true predecessor of the AK model was developed independently by two economists, Roy Harrod, and Evsey Domar76. The Harrod Domar model preceded that of Solow by several years and obviously it was not motivated by any explicit intention to improve on the Solow model. The HD model was developed in the aftermath of the Great Depression, as a dynamic extension of Keynes’ general theory. The aim was to discuss the business cycle in the U.S. economy. Since at that time, unemployment was very high, the focus of the model was on the relationship between investment in physical capital and output growth. The main assumption of the Harrod-Domar model is that capital and labour are pure complements, meaning that they cannot substitute for each other in production. The underlying production function is Leontief: Y  minAK ,BN , (5.6) t t t where A and B are positive constants. The Leontief production function contrasts with the Cob-Douglas production function in that inputs cannot substitute for each other. As an illustration, suppose that your output (Y) was a meal consisting in a “steak with two eggs”. To produce any amount of this output you would need steaks (K) and eggs (N) in a proportion of two eggs per one steak. Figure 5.3 illustrates this, by displaying the isoquants corresponding to A=1 and B=0.5. Thus, to produce one meal (Y=1), you need at least one steak and two eggs (point R). If you employed one steak and 8 eggs, your maximum production would still be equal to one meal (point S). Figure 5.3: The Leontief production function 76 Harrod, R. , 1939. "An essay in dynamic theory". Economic Journal 49, 14-33. Domar, E., 1946. "Capital expansion, rate of growth and unemployment", Econometrica 154, 137-47.. https://mlebredefreitas.wordpress.com/teaching-materials/economic-growth-models-a-primer/ 28/02/2022 180 Economic Growth Models: A Primer /Student's Guide, Miguel Lebre de Freitas K k  B A  1 / 2 2 Y = 2 T 1 Y = 1 R S 2 4 8 N The figure describes two isoquants where inputs to production are complementar. The straight line A B corresponds to the efficient combinations. If the economy’ endowment point lies on the right-hand side (left hand side) of this line, there will be unemployment of labour (capital). Now think that this production function applied to the economy as a whole and that K and N referred to capital and labour. If the economy’ endowments were K=1 and N=8, the economy would be producing Y=1 only, wasting 6 unit of labour (point S). From that point, expanding the quantity of labour would not deliver higher output, because labour cannot substitute for capital. The only way to expand production will be increasing the stock of physical capital. If one managed to increase the stock of capital to K=2, the output level would jump to Y=2 (point T), and unemployment would be reduced to 4 units of labour. Raising production by incrementing the stock of capital (K) in an economy with surplus labour (N) is basically how the Harrod-Domar model works. Mathematically, a situation of employment surplus occurs when K/N<B/A. In that case the relevant branch of the production function (5.6) is the first, implying a linear relationship between output and K, Y=AK. This is basically the AK model. Then, given the exogenous saving rate and the population growth rate, from (2.5)-(2.9), you’ll obtain the growth rate of per capita income as described by (5.4). The main limitation of the Harrod-Domar is that factor prices play no role in driving the economy towards full employment of labour and capital. This contrasts with the Solow model, where real wages and the real interest rate adjust to ensure full employment each moment in time. Thus, even if output is expanding over time at the rate Y Y  sA, this may not be enough for per capita income to increase: in case sA n, the economy does https://mlebredefreitas.wordpress.com/teaching-materials/economic-growth-models-a-primer/ 28/02/2022 181 Economic Growth Models: A Primer /Student's Guide, Miguel Lebre de Freitas not save the enough to keep the capital labour ratio unchanged. Population will be expanding faster than output, surplus labour will be increasing (chronic underproduction) and per capita income will be declining. If, on the contrary, the capital stock grows faster than population ( sA n  0), then per capita income will be increasing over time, and eventually the surplus labour will be eliminated in the long run. Still, the mechanics of the model is such that per capita income cannot growth indefinitely. The reason is that at the time the full employment locus is crossed, the relevant segment of the production function in (5.6) shifts to , and the binding constraint in production becomes the availability of labour: beyond this point output is be bound to expand at the same rate as population, implying a constant level of per capita income thereafter77. Box 5.1: The ghost of financing gap One of the reasons why the Harrod Domar equation (5.5) became so popular is that it offers a simple and appealing formula to forecast economic growth. This formula was also extensively used by international organizations, such as the World Bank, to calculate a country’ financing needs. If equation (5.5) was true, one could easily forecast a country’ economic growth, using the saving rate, the depreciation rate and an estimate for the average product of capital, A. Since the later is not readily available in national accounts, a possible proxy would be the ratio of net investment to the change in real GDP over two consecutive years: K net investment ICOR   Y change in GDP 77 Alternatively, one may assume that, after unemployment is eliminated, wages start increasing and the economy enters in “modern economic growth”. A seminal contribution along this avenue is due to Arthur Lewis (1954). [Lewis, W., 1954. “Economic Development with Unlimited Supplies of Labour”. The Manchester School of Economic and Social Studies 22, 139-191]. https://mlebredefreitas.wordpress.com/teaching-materials/economic-growth-models-a-primer/ 28/02/2022 182 Economic Growth Models: A Primer /Student's Guide, Miguel Lebre de Freitas This is the known as the "Incremental Capital-Output Ratio", ICOR. As an example, consider a poor economy where the ICOR = 3 and the observed investment ratio (s) is 15%. Assuming a depreciation rate equal to 4%, equation (5.4) implies that output will grow at 0,15 30,040,01. Now suppose you were a consultant for that economy, advising on poverty alleviation. You could well conclude that the saving rate in this economy was too low. If, for instance, population was growing at 2%, that would imply a fall in per capita income… You could, then, use the HD equation the other way around: how much should the investment rate in this country, for per capita income to increase at some desired rate? Suppose you wanted income per capita to expand at 2% per year. With the population growing at 2% and a measured ICOR equal to 3, following (5.5), you would need a net investment amounting to 24% of GDP. Since domestic savings were only 15%, you could request the international donors to fill the "financing gap", equal to 9% of GDP. Economists in international institutions, such as the World Bank, the IMF, the Inter- American Development Bank, the European Bank for Reconstruction and Development used models based on the HD equation to estimate the amount of savings (and/or aid) necessary for poor countries to achieve some desired rate of economic growth. This philosophy was supported by the understanding that people living near the subsistence level cannot save the same as rich people. To illustrate the argument, we refer to figure 5.4. This figure is similar to 5.1, the difference being that the saving rate starts out very low and then increases with per capita income. In that case, a bifurcated growth pattern emerges, whereby per capita income increases forever or decreases forever, depending on the initial level of capital per worker. Now suppose that a poor country was trapped in situation with insufficient savings. Say, because a natural disaster caused the capital stock to fall below the critical level, or because a demographic explosion tilted the break-even investment line upwards, turning the existing capital stock insufficient. In that case, per capita income would start decreasing over time. Arguably, foreign aid could fix this: if the external aid succeeded in raising savings above the critical level, it could be that the country engaged in a self-sustained growth path. In this case, foreign aid would need only to be temporary. https://mlebredefreitas.wordpress.com/teaching-materials/economic-growth-models-a-primer/ 28/02/2022 183