Although, during the last three and a half decades, growth theorists have used the standard neoclassical growth model as a workhorse, they have been perplexed by certain of its equilibrium properties. For example, the model indicates that an increase in the saving rate, while raising the level of per capita real income, has no effect on the growth rate of output. The paper suggests, however, that this surprising result can easily be explained. Although a higher saving rate raises the growth rate of output by increasing the investment rate, the increase in economic growth occurs only during the transition to the next steady-state equilibrium. Sooner or later, the labor input creates a bottleneck, limiting further output growth, and the growth rate of output eventually falls back to the constant natural rate of growth.
The time it takes the economy to reach this balanced growth path is also of considerable interest, particularly to policymakers. In the context of the standard neoclassical model, if the objective of economic policy is to raise the equilibrium level of per capita real income (for example, by raising the government saving rate), a fast adjustment is desirable.
The model of this paper modifies the standard neoclassical growth model by allowing technical change to be determined endogenously. This modification changes the standard model’s equilibrium behavior. For example, an increase in the saving rate that raises the rate of technical progress has a permanent positive effect on the steady-growth rate of output.
This study is both theoretical and empirical. The model developed in the paper postulates that learning through experience (measured in either cumulative past investment or output) plays a critical role in raising labor productivity over time, with three major consequences. First, the steady-state growth rate (of output) becomes endogenous and is influenced by government policies. Second, the speed of adjustment to steady-state growth is faster, and enhanced learning further reduces adjustment time. Third, both steady-state growth and the optimal net rate of return to capital are higher than the sum of exogenous rates of technical change and population growth. Simulation results confirm the model’s faster speed of adjustment, while regression analysis explains a large part of divergent growth patterns across countries in terms of basic determinants that include openness, human development, and fiscal policies.