Universidad de Montevideo

Macroeconomia II
Danilo R. Trupkin
Class Notes (very preliminar)

Endogenous Growth
The models we have seen so far do not provide satisfying answers to our central questions
about economic growth. If capitals earnings reflect its contribution to output and if its
share in total income is modest, then capital accumulation cannot account for a large part
of either long-run growth or cross-country income differences. And the only determinant of
income in the models, other than capital, is a variable representing technological progress,
whose exact meaning in fact is not specified and whose behavior is taken as exogenous.
Now, we investigate the fundamental questions of growth theory more deeply. First,
notice that, without technological change, the models predict that the economy will eventually converge to a steady state with zero per capita growth. The fundamental reason is
the diminishing returns to capital. One way out of this problem was to broaden the concept
of capital by including human components, and then assume that diminishing returns did
not apply to this broader class of capital.
Another view was in fact that technological progress in the form of the generation of
new ideas was the only way that an economy could escape from diminishing returns in
the long run. Thus, it was necessary to go beyond the treatment of technological progress
as exogenous and, instead, to explain this notion within the model of growth. The new
generation of models differed from the earlier models in explicitly interpreting technological progress as knowledge and in formally modeling its evolution over time. However,
endogenous approaches to technological progress encountered basic problems within the
neoclassical model the essential reason is the nonrival nature of the ideas that underlie
technology. These conceptual difficulties motivated researchers to introduce some aspects
of imperfect competition to build satisfactory models in which the level of technology can
be advanced by purposeful activity, such as R&D expenditures.
Let us start, now, by developing the first stream of escapes to the neoclassical model,
the one which is related to a broader concept of capital, while still assuming exogenous
technological progress.

The AK Model

The so-called AK model is a very simple but rather insightful framework, which despite
its simplicity can be quite useful for the analysis of some questions. In particular, it is the
simplest way to think about an economy that in its steady state (more appropriately
called here the balanced growth path) results in a positive rate of growth of per capita
capital, income and consumption. The reason for this result, so different from the standard
RCK model, is the presence of a linear production function, with capital being the only
input: since the production function is CRS, and there is only one factor, then the curse of
diminishing marginal product of capital is no longer present.
In this model, the assumptions concerning individuals behavior are the same as in the
standard RCK model, except that there is no labor involved. The production function
is a function:
Y = AK,

A > 0,

(1)

i.e., a linear function in the stock of capital, where A is an exogenous variable, that
for the moment we assume to be constant. Notice that for this expression to make sense,
capital should be interpreted in a very broad sense, including human capital.
In per capita terms, (1) can be expressed as
y = Ak.

(2)

As before, we assume that the population (denoted as L) grows at the rate n, and we
further normalize L(0) = 1, so that L(t) = ent . Assuming there are identical households,
in fact we can work as if there is only one household in the economy, and then apply the
usual representative-agent framework, in which the equilibrium derives from the choices of
a single household (even though, the members of this household is increasing at the rate
n).
The instantaneous utility of the household (at any given time) is now u(c)L(t) = u(c)ent .
Then, each household maximizes lifetime utility as given by
Z
U=

u(c)e(n)t dt,

where we assume > n in order to ensure U is bounded if c is constant over time.

The budget constraint is,

(3)

dk
dt

= Ak k nk c
= (A n)k c.

(4)

Maximization of (3) subject to (4) yields

dc
uc
[A ( + )].
=
dt
ucc

(5)

Assume, as before, that the utility function is of the CRRA form. Then,
c
uc
= ,
ucc

and the Euler equation (5) can be re-expressed as

dc 1
A ( + )
=
.
dt c

(6)

We will assume that A > ( + ), what assures that

dc 1
>0
dt c
at all times.
In turn, from the budget constraint, the proportional rate of change of per capita capital
is
c
dk 1
= (A n)
dt k
k

(7)

Notice that the capital stock will not be changing when

c
= A n.
k

(8)

From (6) and (7), a balanced growth path (a path at which all variables are changing
at the same proportional rate), requires
A ( + )
c
= (A n) ,

k
or,
c
= (A n ),
k
where =

A(+)

(the growth rate of per capita consumption).

3

(9)

The dynamics of the model can be represented as in the graph below. A superficial
analysis would suggest that the model has no adjustment dynamics: given any level of
per capita capital (the state variable), it results in the immediate attainment of the level of
consumption at the balanced growth path (in the figure, labeled as the saddle path),
provided there are no anticipations of future changes. If the system is in the balanced
growth path, and a future event (a change in some parameter) is anticipated, then the
economys response will be, in general, an adjustment along some path, other than the
balanced growth path, fulfilling the optimality condition expressed in (6).
Note that, still, the equilibrium in the AK model is Pareto optimal. This makes sense
because the elimination of diminishing returns to capital does not introduce any sources of
market failure into the model.
c

k =0

Saddle Path

One interpretation of the AK model is that capital should be viewed broadly to include
physical and human components. For instance, one could assume the following production
function:
Y = F (K, H),

(10)

where H is human capital, and F () exhibits the standard neoclassical properties, including
constant returns to scale in K and H.
We can use the condition of CRS to write the production function in an intensive form:
Y = Kf (H/K) ,
where f 0 (H/K) > 0.
4

(11)

Perfect competition among firms, absence of barriers to entry, and profit maximization
will imply that the marginal product of each input equal its rental price. If we further
assume that output can be used on a one-for-one basis for consumption, for investment
in physical capital, or for investment in human capital, then the two types of capital will
be perfectly substitutable with each other and with consumables on the production side
(prices of these capital goods would be fixed at unity), and both rates of return will also
be equal in equilibrium to the interest rate. Finally, if we define A f (H/K), a constant,
then equation (11) implies Y = AK. Therefore, this model with two types of capital is
essentially the same as the AK model analyzed before.