Traditional or Old Growth Theory:
According to traditional or old growth theory output growth results from one or more of three factors:
(i) Increase in the quality and quantity of labor, (ii) increase in capital through saving and (iii) investment and improvement in technology.
But as far as the poor closed economies are concerned they are furnished with very low rates of savings. Accordingly, their growth rates remain very low. On the other hand the economies where the saving rates were higher their per capita incomes rose very sharply. In the presence of open economies the capital out flowed from the rich economies to the poor economies where capital labor ratios were lower and thus the returns on investment were higher. Therefore, the measures to impede the inflow of foreign investment on the part of governments of UDCs retorted their growth.
Thus, the cornerstone of neo-classical free market theory is attached with the liberalization of domestic markets which will attract domestic and foreign investment. In this way, the capital accumulation in the 3rd World Countries will increase.. In terms of GNP growth, this will be equivalent to raising domestic saving rates which will enhance capital labor ratios and per capita incomes in capital poor developing countries.
Modern or New Growth Theory (NGT):
The traditional neo-classical growth theory stressed upon foreign inflow of capital to meet the saving gap in UDCs. But practically, such all led to ‘debt crises’ in Latin American and African countries etc. during 1980’s and 1990’s. In such situation the disparities between the rich and the poor countries widened, rather decreasing. The World Bank and IMF imposed free market reforms on highly indebted countries. Such all should have promoted the higher investment, higher productivity and improved standard of living for the masses of the 3rd world countries. But after such prescribed liberalization of trade markets, many UDCs experienced little or no growth and failed to attract new foreign investment or to halt the flight of domestic capital (the case of Pakistan which failed to bring any drastic change in its economic life even following ‘Stand by Arrangements’ and
‘Structural Adjustments programs’ imposed by IMF and World Bank). With this back ground the economists have presented a new approach to the economics of growth and development which is known as ‘Endogenous Growth’ or ‘New Growth Theory’. Now we discuss its features.
The New Growth Theory or the Endogenous Growth Theory provides a theoretical framework to analyze the endogenous growth, i.e., the increase in GNP of a country. Here the growth of GNP depends upon the system of production function where the variables of the system are endogenous rather than exogenous. Contrary to traditional neo-classical growth theory the supporters of the New Growth Theory are of the view that the increase in the GNP of a country is the natural result of long run equilibrium. The endogenous growth theory analyses what determines the growth rate in a country and why the growth rates differ among the countries. In other words, in this theory, it is analyzed that what are the determinants of the rate of growth of GDP (shown by λ) which Solow calls Residual Factor in his model.
Difference between Old and New Growth Theories:
Despite certain resemblances with neo-classical theory, the new growth theory is different from the neo-classical theory on the basis of its assumptions and implications. The differences in these two theories occur due to three factors:
(i) The new growth theory rejects the neo-classical assumption that the marginal returns decrease along with increase in investment.
(ii) This theory stresses upon increasing returns to scale.
(iii) The externalities also play their role in the determination of returns from investment.
As the supporters of this theory are of the opinion that there arise so many externalities due to public and private investment in human capital. They increase productivity. Hence, the natural tendency of falling or diminishing returns can be checked. Thus, when there applies increasing returns to scale, the incomes of the countries will move away from equilibrium levels of the income. The role of technology in the endogenous growth theory, but it does not play necessary role in the determination of equilibrium level of national income.
Like H-D model, the new growth theory is also expressed with this simple equation:
Y = AK
Where A is some factor which influences technology, while K represents the physical and human capital. This equation does not show the decreasing returns from the capital. Thus there exists the possibility that because of investment in physical and human capital the External Economies and Productivity increases could occur which offset the decreasing returns. As a result, an economy experiences a sustainable growth in long run which is not accepted by traditional growth theory.
The new growth theory, in order to attain rapid economic growth not only stresses upon the capital formation in human capital and savings, but it also describes following implications for growth which are contrary to the traditional theory.
(i) In closed economies there does not exist any force which could take the economy to equilibrium level.
(ii) National growth rates remain constant and differ across countries depending upon national saving rates and technology levels.
(iii) There is no tendency for per capita income levels in capital poor countries to catch up with those in rich countries with similar saving rates. As a result of these facts a temporary or a prolonged recession in one country leads to a permanent increase in the income gap between itself and the richest countries.
The different models of ‘New Growth’ theory also give this view that the international capital flows increase the wealth disparities between the First World and Third World. This theory thinks that the expected higher rates of return on investment in UDCs which have low K/L may be offset by the lower levels of ‘Complementary Investments’ in human capital (education and training), infra-structure and research and development. Again, it has also been found out that the poor countries benefit less from the capital expenditures made on human capital formation etc. As the individuals receive no personal gain from the positive externalities created by their own investments, the free market leads to the accumulation of less than the optimal level of complementary capital.
Where complementary investments produce social as well as private benefits, govts. may improve the efficiency of resource allocation by providing public goods or encouraging private investment. Therefore, the new growth theory on the contrary to counter revolution theory, suggests for an active role for public policy in promoting economic development. Thus, the new growth theory, despite similarities with neo-classical theory, is a departure, from dogma of ‘free markets’ and ‘passive role of governments’.
According to New Growth Theory (NGT), the complementarily investment results in private and public investment. The complementarily investment can do so by providing infrastructure and promoting private investment in knowledge-based industries. As a result, not only the human capital formation will increase, but increasing returns will also emerge.
Thus, quite against Solow model, the models of NGT accord the technical progress as an endogenous result of public and private investment in human capital and the existence of knowledge-based industries. Hence, the NGT models emphasize upon enhancing investment in human capital directly and indirectly for the sake of economic growth. Again, these models encourage the foreign direct investment in the fields of computer software while establishing knowledge or information-based industries.