Neo-Classical Theory of Economic Growth:

We know that Hicks, J.E. Meade, Mrs. Joan Robinson, Salow and Prof. Swan are Neo-Classical economists. They have presented their growth models individually as Meade model (1961), Solow model (1956, 1960), Swan model (1956), and Mrs. Joan Robinson model (1956, 1999). Now we present all these models in a single model which wee simply call Neo-Classical Model of Economic Growth, where we discuss the salient features of neo-classical theory and this model is called a reaction to H-D model.

(i) According to H-D model economy is always prey to instability. But according to Neo-Classical, if capital - output ratio is made flexible, the instability will come to an end.

(ii) The basic Neo-Classical model assumes that in long run the constant - returns to scale applies and no technical progress takes place in the economy. The stock of capital can be adapted in capital intensive technology, more or less. It means that labor and capital are substitute table. Accordingly, by changing the capital labor ratio the equality can be brought in changes in labor, capital and output. This model also assumes that the factor prices are equal to their marginal productivities. Accordingly in this model, there exist flexibility of wages, prices and rate of interest.

(iii) Whenever warranted growth rate exceeds natural growth rate the economy will cross the ceiling of full-employment. In such situation the labor saving technology will be used. As a result the capital-output ratio will increase. This will depress down the warranted growth rate till it becomes equal to natural growth rate. On the other band, if warranted growth rate is lower than natural growth rate the excess amount of labor will emerge. As a result, real rate of interest will fall as compared with real wage rate. This will induce the firms to adopt labor intensive technology. In this way, the capital-output ratio will fall. This will lead to increase warranted growth rate  (s/v) till it becomes equal to natural growth rate.

(iv) According to neo-classical model because of changes in v and s/v the Harrodian instability and Raisor's Edge will not persist, and economy can attain a steady-state equilibrium. Its means to say that in neo-classical model the equilibrium growth rate coincides with dynamic disequilibrium where output, stock of capital, supply of labor

and change investment, all will grow at the same exponential rate. In such situation there will be no change in K, L and Y, This situation is accorded as Golden Age following Mrs. Joan Robinson. Thus in Golden Age, the following situation will occur:

Q = Q_o e^qt, K = K_o e^ht, L = L_o e^mt, I = I_o e^mt

Where Q = output, K = Capital, L = Labor, and I = Investment. The signs of bars on all the variables represent the constant values in the golden age, while the m, n, h and q represent constant growth rates.

(v) According to neo-classical model at the level of full employment, the investment will be equal to the level of savings at the level of full employment and net investment (I) will be equal to level of stock of capital (dk/dt).          As I = dk/dt = sQ, hence  I_o e^mt = h K_o e^ht = sQ_o e^q. For all the values of t, last equation will hold true if growth rates of m, h and q are equal to each other. It is reminded that according to neo-classical theory, the growth rate of Golden Age is not influenced by growth of savings, and it is contrary to H-D model. It is due to the reason that whenever the proportion of savings increase there will by growth of capital and output. But such increase will be temporary because due to operation of law of decreasing returns the initial growth rate will be existing. As if growth of capital increases more than labor, the marginal productivity of capital will decrease leading to decrease the growth rate of output. Thus according to neo-classical growth model, because of changes in capital-labor ratio and flexibility of wages, prices and interest rate the economy will attain a stable equilibrium. Here, growth of savings (sQ), growth of capital (sQ/k), growth of output (q) and growth of population (n) will be equal to each other, as:

q = sQ = (sQ/k) = n

It is shown with fig.

Diagram/Figure:

Here the schedule sQ/k shows the growth of capital which is function of output - capital ratio (Q/K), and slope of this curve shows the saving ratio (s). The growth of output curve q₁ passes in between growth of labor schedule (n) and growth of capital schedule (sQ/k). The output is divided on the basis of elasticities of capital and labor (a and B). In this figure, after E, the growth of capital is more than growth of output. This leads to decrease Q/K, hence equilibrium is established at E. While before E, growth of output is more than growth of capital. This will lead to increase Q/K. Thus Q/K₂ is an equilibrium Q/K which is stable one where growth of capital (sQ/K) growth of output (q) and growth of population are equal.

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