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Neo-classical Growth ModelNeo-classical growth model (also known as the Exogenous or Solow growth model) is a term used to sum up the contributions by various authors in the framework of neoclassical economics. The most important contribution was probably the work by Robert Solow. In the 1950s he developed a relatively simple growth model, which fit the data on US economic growth with some success. In neoclassical growth models, the long-run rate of growth is exogenously determined. In other words, it is determined outside of the model. A common prediction of these models is that an economy will always converge towards a steady state rate of growth, which depends only on the rate of technological progress and the rate of labor force growth. Policy measures like tax cuts or investment subsidies can affect the steady state level of output but not the long-run growth rate. Growth is affected only in the short-run as the economy converges to the new steady state output level. The rate of growth as the economy converges on the steady state is determined by the rate of captital accumulation. This is in turn determined by the savings rate (the proportion of output used to create more capital rather than being consumed) and the rate of capital depreciation. The key assumption of the neoclassical growth model is that capital is subject to diminishing returns. Given a fixed stock of labor, the impact on output of the last unit of captial accumulated will always be less than the one before. Assuming for simplicity no technological progress or labor force growth, diminishing returns implies that at some point the amount of new capital produced is only just enough to make up for the amount of existing capital lost due to depreciation. At this point, because of the assumptions of no technological progress or labor force growth, the economy ceases to grow. Assuming non-zero rates of labour growth and technological progress complicates matters somewhat, but the basic logic still applies - in the short-run the rate of growth slows as diminishing returns take effect and the the economy converges to a constant steady-state rate of growth. Within the Solow growth model, the Solow Residual or total factor of productivity is an often used measure of technological progress. Empirical Evidence A key prediction of neoclassical growth models is that the income levels of poor countries will tend to 'catch up to' or converge towards the income levels of rich countries. If anything, the opposite is observed empirically. If average growth rates of countries since, say, 1960 is plotted against initial GDP per capita (i.e. GDP per capita in 1960), one observes a positive relationship. In other words, the developed world appears to have grown at a faster rate than the developing world, the opposite of what is expected according to a prediction of convergence. However, a few formally poor countries, notably Japan, do appear to have converged with rich countries. The evidence is stronger for evidence of convergence within countries. For instance the per-capita income levels of the southern states of the United States have tended to converge to the levels in the Northern states. These observations have led the adoption of the concept of conditional convergence. Whether convergence occurs or not depends on the characteristics, such as institutional arrangements, of the country or region in question. Evidence for conditional convergence comes from mulitivariate, cross-country regressions. Shortcomings of the Model The main drawback of the neo-classical growth theory is that it does not explain how or why technological progress occurs. This failing has led to the development of endogenous growth theory, which endogenizes technological progress and/or knowledge accumulation.
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