Neoclassical Growth Theory

Published Oct 25, 2023

Definition of Neoclassical Growth Theory

Neoclassical growth theory is an economic theory that focuses on the long-term growth of an economy by examining the factors that determine the rate of economic growth. It is based on the principles of neoclassical economics, which emphasize the role of capital accumulation and technological progress in driving economic growth.

Example

To illustrate neoclassical growth theory, consider an economy that is characterized by a fixed supply of labor and a fixed level of technological progress. According to the theory, the growth of this economy can be explained by changes in the level of capital accumulation.

In this scenario, an increase in savings and investment leads to an increase in the capital stock. As a result, the economy can produce a larger quantity of goods and services, leading to economic growth. The theory also suggests that there are diminishing returns to capital, meaning that the marginal productivity of capital decreases as the capital stock increases. This implies that the initial increase in the capital stock leads to a larger increase in output compared to subsequent increases.

Furthermore, neoclassical growth theory highlights the role of technological progress in driving economic growth. Technological progress is assumed to be exogenous, meaning it is independent of economic factors. As technology advances, the production process becomes more efficient, leading to increased productivity and economic growth.

Why Neoclassical Growth Theory Matters

Neoclassical growth theory provides insights into the factors that contribute to long-term economic growth. By understanding the role of capital accumulation and technological progress, policymakers can make informed decisions to promote economic growth. For example, policies that encourage savings and investment can help accelerate capital accumulation, while investments in research and development can foster technological progress. Additionally, the theory highlights the importance of promoting stable and efficient markets to facilitate the allocation of resources and maximize economic growth.