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Curiosity 6.1: What Is Endogenous Growth Theory?
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Keynesian analysis viewed investment spending as a component of aggregate demand and focused on its multiplier impact on income. A longer-run view, however, recognizes that investment affects the supply side of the economy by increasing the capital stock and making the economy more productive. In round terms, 60 percent of investment offsets depreciation of existing plant and equipment, 20 percent increases capital in line with annual labor force growth, and the remaining 20 percent serves to increase capital per worker, thus enhancing productivity.
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Early attempts to formalize this role of investment viewed GDP as being determined, through an algebraic formula, by the stock of labor, the capital stock, and a term representing productivity. GDP grew because each year the labor force grew thanks to population growth, the capital stock grew thanks to investment, and productivity grew each year (by about 2 percent) thanks to technical change brought about by a continuous stream of innovations. A key assumption was that this rate of technical change is unaffected by the saving and investment levels it helps determine through its influence on the growth rate. The independence of the rate of technical change from investment and saving activity is what is meant by the statement that technical change is exogenous. The lack of such independence means that technical change is determined endogenously by the interaction of saving, investment, growth, and technical change.
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Modern growth theory questions this exogenous view of technical change, claiming that technical change is determined endogenously: the level of technical change can be influenced by investment in education to improve the quality of labor and by investment in research and development to improve the quality of capital. Furthermore, the success of such investments could induce more such investment and higher saving to finance it. It is therefore possible that a virtuous circle could develop in which investment creates more knowledge, which in turn spurs more investment. Some have claimed that the United States was experiencing such a virtuous circle during the late 1990s. This endogenous growth theory raises the profile of national saving and investment.
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cies to protect existing industries and jobs, making the introduction of technological change very costly. The United States is thought to have a relatively flexible labor market in this respect. From 1973 to 1983 the U.S. economy created 18 million jobs, whereas the German economy lost almost a million jobs.
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5.
Structural changes.
Over time, changes in tastes and technology affect what is produced, where it is produced, how it is produced, and the skills required of the labor force. Although such structural changes reflect the needed flexibility noted earlier, they can lead to slowdowns in further growth. Examples of such changes include a shift of economic activity into the service industries where productivity increases are more difficult to attain; a change in the composition of the workforce, including more young people and former homemakers with less experience and fewer market-oriented skills; and a slowdown in the movement of labor from the farm to the city as the great technological advances in agriculture become fully integrated into the economy. Increases in energy prices require that the economy shift to a new profit-maximizing
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