Page 26 - FINAL CFA II SLIDES JUNE 2019 DAY 4

LOS 12.i: Compare classical growth theory, neoclassical READING 11: CURRENCY EXCHANGE RATES: UNDERSTANDING EQUILIBRIUM VALUE
growth theory, and endogenous growth theory – 3 Models!

MODULE 12.3: GROWTH AND CONVERGENCE THEORIES

Classical Growth Theory: Posits that, in the long-term, population growth increases whenever there are increases in per capita
income above subsistence level due to an increase in capital or technological progress.

It contends that growth in real GDP per capita is not permanent, because when real GDP per capita rises above the subsistence
level, a population explosion occurs; this leads to diminishing marginal returns to labor, which reduces productivity and drives
GDP per capita back to the subsistence level.

This mechanism would prevent long-term growth in per capita income (This theory is not supported by empirical evidence).

New Classical Growth Theory (NCGT): Focusses on estimating the economy’s long-term steady state growth rate
(sustainable growth rate or equilibrium growth rate). The economy is at equilibrium when the output-to-capital ratio is
constant. When the output-to-capital ratio is constant, the labor-to-capital ratio and output per capita also grow at the
equilibrium growth rate, g*.

Steady state growth rate does not assume a constant level of technology and hence differs from the definition of steady state
discussed earlier.

Per Cobb-Douglas function, NCGT states that:
Sustainable growth of output per capita (or output per worker)(g*) = the growth rate in technology (θ) divided by labor’s share of GDP (1 – α).

Sustainable growth rate of output (G*) is equal to the sustainable growth rate of output per
capita, plus the growth of labor (ΔL).

In the equations for sustainable growth (per capita or total), growth rate is not affected by capital (K). Hence, we say that capital
deepening is occurring but it does not affect growth rate once steady state is achieved.