Economic growth and cycles - Neoclassical and endogenous gro...

Learning Outcomes

After reading this article, you will be able to explain how neoclassical and endogenous growth models differ, identify the determinants of long-term economic growth, and evaluate convergence hypotheses. You will also be able to apply these growth theories to exam-style scenarios and understand their implications for investment strategies and government policy.

CFA Level 2 Syllabus

For CFA Level 2, you are required to understand the primary economic growth models and their implications. In particular, focus your revision on these syllabus areas:

• Compare classical, neoclassical, and endogenous growth theories.
• Interpret how steady-state growth rates are determined in neoclassical models.
• Explain the role of innovation, human capital, and government policies in endogenous growth models.
• Evaluate absolute, conditional, and club convergence hypotheses.
• Assess the expected effects of investment in technology on long-run growth.
• Discuss why governments may subsidize private investment in knowledge and innovation.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. In the neoclassical growth model, which factor has the most impact on sustained long-run growth?
   1. Capital accumulation
   2. Population growth
   3. Technological advancement
   4. Government spending
2. According to the endogenous growth model, what is a primary driver of permanent increases in growth rate?
   1. Diminishing returns to capital
   2. Exogenous technological progress
   3. Persistent investment in R&D
   4. Labor force expansion
3. What type of convergence is hypothesized when only countries with similar savings rates and technologies reach equivalent living standards over time?
   1. Absolute convergence
   2. Conditional convergence
   3. Club convergence
   4. Instant convergence

4. True or false? Under neoclassical theory, capital deepening alone can raise the steady-state growth rate indefinitely.

Introduction

Understanding how economies grow—and why some grow faster than others—is central to macroeconomic analysis. Neoclassical and endogenous growth models offer two distinct frameworks for explaining the drivers of long-term economic growth and productivity improvements. These theories underpin expectations for living standards, investment returns, and policy design. In the CFA context, recognizing their assumptions and implications will enable you to interpret growth forecasts and government interventions in exam scenarios.

THE NEOCLASSICAL GROWTH MODEL

The neoclassical growth model explains long-run economic growth as driven primarily by labor, capital, and exogenous technological progress. The most common functional form is the Cobb-Douglas production function:

Key Term: Cobb-Douglas production function
A mathematical equation expressing output as a function of labor, capital, and a technology factor, typically with diminishing marginal returns to each input.

Key Term: steady-state growth rate
The rate at which output per worker grows when capital per worker and technology are constant, and the economy is in long-run equilibrium.

The neoclassical model assumes that:

• Returns to capital (and labor) diminish as more of each is used.
• Technological progress is exogenous (set outside the model).
• In the long run, increases in capital per worker (capital deepening) raise output, but only until the steady state is reached; after this, only continued technological advancement sustains further growth in living standards.

Worked Example 1.1

Suppose Country X increases its savings rate, raising investment and capital per worker. According to neoclassical theory, will this lead to permanently faster GDP growth?

Answer:
The higher savings rate allows capital per worker to increase and temporarily raises GDP growth. However, as diminishing returns set in, the economy reaches a new, higher steady-state output level per worker—long-run growth reverts to the rate of technological progress. Thus, the boost is not permanent.

ENDOGENOUS GROWTH THEORY

Endogenous growth theory challenges the neoclassical model's treatment of technological progress as exogenous. Instead, it argues that economic policies and investment decisions can influence the rate of technological progress and, therefore, long-run growth:

Key Term: endogenous growth model
A theory of economic growth where rates of innovation, technological change, and human capital accumulation are determined within the model—explicitly affected by policy, R&D, and incentives.

Key features of endogenous growth models include:

• Constant or increasing returns to some productive activities (e.g., R&D, education).
• Investment in human capital, research, and innovation can permanently raise the growth rate.
• Knowledge spillovers and positive externalities mean that private investment in technology can benefit the entire economy.

Key Term: knowledge spillover
The process by which new ideas or technologies developed by one person or firm benefit others, increasing overall economic productivity beyond the original inventor's gain.

Worked Example 1.2

Country Y increases R&D subsidies for private companies. According to endogenous growth theory, what is the expected long-run effect on growth?

Answer:
The model predicts that additional investment in R&D raises the innovation rate and can permanently lift the economy’s growth path. Knowledge spillovers create positive externalities, so the total benefit exceeds the private return.

Exam Warning

Do not assume that increasing physical capital alone will sustain long-run growth under either model—neoclassical theory holds that only ongoing technological progress can do so, while endogenous growth theory clarifies that targeted policies can boost innovation and thus growth.

CONVERGENCE HYPOTHESES

The question of whether poorer countries will "catch up" to richer ones is central to growth theory. Several convergence concepts are tested in the CFA exam:

Key Term: absolute convergence
Hypothesis that poor countries will eventually reach the same income per capita as rich countries, assuming similar access to technology.

Key Term: conditional convergence
The idea that economies converge to similar living standards only if they share characteristics like savings rates, population growth, and institutional quality.

Key Term: club convergence
Suggests that only countries with certain institutional and policy characteristics will catch up to each other, but not necessarily to all nations.

Empirical evidence supports conditional and club convergence rather than absolute convergence.

Worked Example 1.3

A group of developing countries with strong property rights and high education investment experience rapid growth, but several nearby nations do not. Which convergence concept best explains this?

Answer:
Club convergence provides the most accurate explanation: countries meeting certain structural prerequisites tend to converge, while others are left behind.

POLICY IMPLICATIONS AND GROWTH

Both models make distinct predictions about the effectiveness of government policy:

• Neoclassical theory: Policies should raise savings and investment but have only a temporary effect on growth. Long-run growth comes from technological improvement, which is treated as exogenous.
• Endogenous growth theory: Policies that support innovation, education, and knowledge creation can have permanent effects on the growth rate. Government subsidies for R&D and knowledge diffusion may correct for underinvestment due to knowledge spillovers.

Summary

Neoclassical and endogenous growth theories shape our understanding of sustainable economic growth and convergence. Neoclassical models suggest that, after adjusting for diminishing returns, only technological advancement sustains growth in living standards. Endogenous models argue that policy choices and investments in human capital, innovation, and knowledge can permanently influence growth rates. Convergence to high income levels depends on institutional quality and policy choices, not just initial poverty.

Key Point Checklist

This article has covered the following key knowledge points:

• Definitions and implications of neoclassical and endogenous growth models
• The concept of steady-state growth and capital deepening
• Why technological progress sustains long-run growth in neoclassical theory
• How knowledge spillovers and innovation policies drive growth in endogenous models
• The distinction between absolute, conditional, and club convergence
• Policy implications for investment in technology and human capital

Key Terms and Concepts

• Cobb-Douglas production function
• steady-state growth rate
• endogenous growth model
• knowledge spillover
• absolute convergence
• conditional convergence
• club convergence