Economic Growth

Oded Galor

October 8, 2009
Contents

Preface i

1 Introduction 1

2 From Stagnation to Growth 2

3 The Neoclassical Growth Model 3

3.1 The Basic Structure of the Model . . . . . . . . . . . . . . . . . . 5
3.1.1 Factor Supply . . . . . . . . . . . . . . . . . . . . . . . . . 6
3.1.2 Production . . . . . . . . . . . . . . . . . . . . . . . . . . 7
3.1.3 Consumption and Saving . . . . . . . . . . . . . . . . . . 9
3.1.4 The Evolution of the Economy . . . . . . . . . . . . . . . 10
3.2 The Dynamical System . . . . . . . . . . . . . . . . . . . . . . . 11
3.2.1 Steady-State Equilibrium . . . . . . . . . . . . . . . . . . 12
3.2.2 Dynamic E¢ ciency . . . . . . . . . . . . . . . . . . . . . . 17
3.3 Testable Implications . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.3.1 Comparative Statics . . . . . . . . . . . . . . . . . . . . . 25
3.3.2 Comparative Dynamics . . . . . . . . . . . . . . . . . . . 29
3.3.3 Testable Predictions . . . . . . . . . . . . . . . . . . . . . 36
3.4 Exogenous Technological Progress . . . . . . . . . . . . . . . . . 37
3.5 The Convergence Hypothesis . . . . . . . . . . . . . . . . . . . . 42
3.5.1 Absolute Convergence . . . . . . . . . . . . . . . . . . . . 42
3.5.2 Conditional Convergence . . . . . . . . . . . . . . . . . . 46
3.6 Endogenous Growth . . . . . . . . . . . . . . . . . . . . . . . . . 53
3.6.1 The AK Model . . . . . . . . . . . . . . . . . . . . . . . . 54
3.6.2 Modi…cation of the Upper Boundary Condition . . . . . . 58
3.6.3 Endogenous Technological Progress . . . . . . . . . . . . . 61
3.7 Poverty Traps and Local Conditional Convergence . . . . . . . . 65
3.7.1 The Transition for an Old to a Modern Industrial Tech-
nology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.7.2 The Conditional Club Convergence Hypothesis . . . . . . 71

Bibliography 75

i
Chapter 1

Introduction

1
Chapter 2

From Stagnation to Growth

2
Chapter 3

The Neoclassical Growth

Model

This chapter develops the foundations of the neoclassical growth model that has
been instrumental in advancing the understanding of the role of factor accumu-
lation and (exogenous) technological progress in the growth process during the
modern era.
Since its introduction by Robert Solow in 1956, the neoclassical growth
model provided a framework of analysis that has become a landmark in the
development of growth theory and intertemporal macroeconomics. A large
fraction of subsequent advancements in growth theory, including the optimal
growth model and endogenous growth models, may be viewed as re…nements of
this basic framework of analysis.
The neoclassical growth model examines the factors that determine the evo-
lution of an economy in which economic growth is a¤ected by endogenous capital

accumulation, as well as by exogenous evolution of population and technology.

The model is strikingly simple and yet it generates powerful predictions that
are largely consistent with the signi…cant role played by factor accumulation
and technological progress in the observed pattern of development within and

across countries in the past century.

3
Oded Galor 4

The model generates two major testable predictions. First, it suggests that
due to the diminishing marginal productivity of capital, the growth rates of an
economy is inversely related to its initial level of output per capita. Second, and
perhaps more strikingly, it implies that the long-run equilibrium of an economy

is independent of its initial conditions. Thus, the income gap between countries
that are similar in their structural characteristic, but di¤er in their levels of
income per-capita, would be expected to narrow over time, and the variance in

the distribution of income across the globe would be expected to decline.

The optimistic hypothesis of the neoclassical growth model regarding the
gradual dissipation of the vast inequalities in the world economy due to the
forces of convergence, may appear at least super…cially inconsistent with some
the qualitative aspects of the growth process over the past two centuries. The
persistence of inequality across nations, despite an apparent convergence in their
structural characteristics, suggests that the underlying assumptions that leads
to the powerful prediction of the neoclassical growth model regarding the inde-
pendence of the long-run growth equilibrium from initial conditions ought to be
carefully scrutinized.
Further, despite the virtues of the neoclassical growth models and its recent
re…nements, it is prudent to acknowledge that the model is inconsistent with
the course of development over most of human history and it is unable to shed
light of the origins of the great disparity in income per capita across the globe.
In particular, the predictions of the model are at odds with the evolution of
economies during the Malthusian epoch, when capital accumulation and tech-
nological progress were counterbalanced almost entirely by an increase in the
size of the population and had thus a negligible e¤ect on the long-run level and
growth rate of income per capita. Moreover, the model fails to identify the
forces that triggered the take-o¤ from stagnation to sustained economic growth,
and the associated divergence in income per capita across countries – insights
Oded Galor 5

that are instrumental for the understanding of the contemporary di¤erences in

comparative development across the globe.
This chapter provides a comprehensive description of the neoclassical growth
model, its fundamental assumptions and testable predictions. The presentation

underlines the assumptions at the foundation of the model and their critical role
in generating the testable implications of the model and especially the power-
ful conditional convergence hypothesis. In particular, although the neoclassical

growth model was originally developed within a continuous time framework,

the analysis is conducted within a discrete time model, permitting a transpar-
ent analysis of the source of the discrepancy between the testable predictions
of this representative agent neoclassical growth model and those derived under
an overlapping-generations structure.1 In particular, a discrete time framework
permits the establishment of conditions under which the dynamical system of
the two frameworks are isomorphic, facilitating a better understanding of the
origins and the limitations of the testable predictions of the neoclassical growth
model.

3.1 The Basic Structure of the Model

Consider an economy where economic activity is performed over in…nite discrete

time, t = 0; 1; 2; : : : ; 1: In every period a single homogeneous good is produced
using two factors, capital and labor, in the production process. The output
produced can either be consumed or saved for future consumption. The economy
is closed (i.e., autarkic) and thus aggregate investments in the economy re‡ects
aggregate savings, while aggregate consumption is equal to domestic production
net of aggregate savings.2
1 Given the discreteness in the arrival of economic data, a discrete time setup is more

suitable for calibration and data analysis.

2 In a one-sector model there is no distinction between consumption goods and investment

goods. This simplifying assumption is removed in two-sector growth models where consump-
tion goods cannot be invested and investment goods cannot be consumed. See, Uzawa (1964)’s
Oded Galor 6

3.1.1 Factor Supply

The labor force and the stock of capital in every time period determine the
level of output per capita, while the evolution of these factors over time, in
conjunction with technological progress determine the growth trajectory of the
level of output per capita.

The Labor Force

The size of the population at time t + 1; Lt+1 ; is determined by the size of

the population at time t; Lt ; and the net increase in the size of the population
between time t and t + 1:
Lt+1 = (1 + n)Lt ; (3.1)

where n > 1 is the exogenous rate of population growth, assuring that

population will not become extinct within one period.3 The initial population
size at time 0, L0 ; is exogenously given, permitting the characterization of the
trajectory of population from time 0 to in…nity, fLt g1
t=0 :

Alternatively, the evolution of population can be expressed in terms of the

change in the size of the population from time t to time t + 1; Lt :

Lt Lt+1 Lt = nLt ; (3.2)

and the rate of population growth from period t to period t + 1 is therefore

Lt+1
= n: (3.3)
Lt

The Stock of Capital

The stock of capital at time t + 1; Kt+1 ; is given by the level of aggregate

investment in period t; It ; in addition to the reaming stock of capital from the
representative agent two-sector model and Galor (1992)’s overlapping-generation model.
3 Negative rates of population growth characterize many western European economies in

the past years.

Oded Galor 7

production process at time t; (1 )Kt : Hence,

Kt+1 = It + (1 )Kt ; (3.4)

where 0 1 is the rate of capital depreciation. The initial stock of capital

at time 0, K0 ; is exogenously given.

Since the economy is autarkic, the aggregate investment in period t; It ; is
equal to the aggregate level of saving, St ; and thus

Kt+1 = St + (1 )Kt : (3.5)

Alternatively, the evolution of the capital stock can be expressed in terms of

the change in the capital stock from time t to period t + 1; Kt :

Kt Kt+1 K t = St Kt : (3.6)

As will become apparent, a necessary condition for the existence of a (non-

zero) steady-state equilibrium is that the sum of n and is positive:

n + > 0: (3.A1)

3.1.2 Production

Production occurs within a period according to a constant returns to scale,

neoclassical, production technology which is invariant over time. The output

produced at time t; Yt ; is4

Yt = F (Kt ; Lt ): (3.7)

The production technology F (Kt ; Lt ) satis…es the neoclassical properties.5

Namely, for all non-negative pairs (Kt ; Lt ) :
4 Exogenous as well as endogenous technological progress is introduced in Sections 3.5 and
3.6.
5A Cobb-Douglas production function of the form Yt = Kt L1t ; where 2 (0; 1); satis…es
these properties.
Oded Galor 8

F (Kt ; Lt ) is homogenous of degree 1 in (Kt ; Lt ) (i.e., F (Kt ; Lt ) is a con-

stant returns to scale production function):

F ( Kt ; Lt ) = F (Kt ; Lt ) for all > 0:

The marginal productivity of capital and labor are positive and diminish-
ing:
Fi (Kt ; Lt ) > 0 and Fii (Kt ; Lt ) < 0 8; i = Kt ; Lt ;

where Fi (Kt ; Lt ) @Fi (Kt ; Lt )=@i and Fii (Kt ; Lt ) @ 2 Fi (Kt ; Lt )=@i2 :

Both factors are essential for production:6

F (0; Lt ) = F (Kt ; 0) = 0:

Boundary (Inada) conditions – the marginal product of each factor of

production is in…nitely large when the quantity employed is in…nitesimally
small and it diminishes monotonically to zero as the level of employment
rises to in…nity:

lim Fi (Kt ; Lt ) = 1 and lim Fi (Kt ; Lt ) = 0; i = Lt ; Kt :

i!0 i!1

The homogeneity of degree 1 of the production function (i.e., constant re-

turns to scale) makes it possible to express output per worker at time t; Yt ; as

a function of the capital-labor ratio employed in production at time t, kt
Kt =Lt :
Yt = F (Kt ; Lt ) = Lt F (Kt =Lt ; 1) Lt f (kt ): (3.8)

Hence, the level of output per worker at time t; yt Yt =Lt ; is

yt Yt =Lt = f (kt ): (3.9)

6 This assumption can be removed without a¤ecting the qualitative nature of the analysis.

In particular, CES production functions do not generally satisfy this requirement.

Oded Galor 9

The neoclassical restrictions imposed on the aggregate production function,

F (Kt ; Lt ); implies that the per-worker production function, f (kt ); is strictly
increasing, strictly concave, and satis…es several boundary conditions. That is,

f (0) = 0;

f 0 (kt ) > 0 and f 00 (kt ) < 0 8kt 0; (3.A2)

limkt !0 f 0 (kt ) = 1 and limkt !1 f 0 (kt ) = 0:

3.1.3 Consumption and Saving

Aggregate income in the economy is allocated between consumption and saving

according to a rigid and stationary rule.7 A fraction s 2 (0; 1) of aggregate
output in every period is saved while the remaining fraction, (1 s); is consumed.
The aggregate saving at time t; St ; is therefore

St = sYt = sLt f (kt ); (3.10)

while aggregate consumption at time t; Ct ; is

Ct = (1 s)Yt = (1 s)Lt f (kt ): (3.11)

It should be noted that since the saving rate is a …xed fraction of total output,
the aggregate level of saving is independent of the distribution of aggregate
income between labor and capital. Hence, the analysis is independent of the
economic systems that governs economic activity and the payments to factors

of production (e.g., market economy, centralized economy, etc.).

7 As will become apparent, this rigid allocation rule can be replaced by an optimal saving

rates, derived from utility maximization. The qualitative prediction of the model will be
altered, except for the fact that the consumption trajectory will necessarily be dynamically
e¢ cient.
Oded Galor 10

3.1.4 The Evolution of the Economy

The evolution of the economy, in the absence of technological progress, is gov-

erned by the trajectories of the capital stock and the labor force. Since pop-
ulation, and thus the labor force, grows at an exogenously given rate, n; the
endogenous evolution of the capital stock determines the time path of the level

of output, the capital-labor ratio, and output per capita.

The evolution of the capital stock as established in equation (3.5), noting
equation (3.10), is
Kt+1 = sLt f (kt ) + (1 )Kt : (3.12)

This di¤erence equation in which the stock of capital at time t + 1 is associated

with three past state variables: the stock of capital, Kt ; the size of the popula-
tion, Lt ; and the capital-labor ratio, kt ; can be greatly simpli…ed by expressing
the variables in per-capita terms.
Dividing (3.12) by Lt+1 ; noting that Lt =Lt+1 = 1=(1 + n), it follows from
the de…nition of capital per-worker that

sf (kt ) + (1 )kt
kt+1 = (kt ): (3.13)
1+n

Alternatively, the evolution of the capital-labor ratio can be expressed in

terms of the change in this variable from period t to period t + 1; kt :

sf (kt ) (n + )kt
kt kt+1 kt = (kt ) kt = : (3.14)
1+n

The growth rate of the capital-labor ratio from period t to period t+1, kt kt =kt

is therefore

kt kt+1 kt sf (kt ) (n + )
kt = (kt ): (3.15)
kt kt (1 + n)kt (1 + n)
Oded Galor 11

3.2 The Dynamical System

The evolution of the economy is governed by a one-dimensional, …rst-order,

non-linear di¤erence equation kt+1 = (kt ) that determines the trajectory of the
capital-labor ratio over time. It is given by the sequence fkt g1
t=0 that, given the

initial condition, k0 K0 =L0 ; satis…es the nonlinear relationship kt+1 = (kt )

between kt and kt+1 in every period of time: In particular, the trajectory of

the capital-labor ratio fkt g1

t=0 uniquely determines the time paths of output per

worker fyt g1
t=0 according to their static relationship yt = Yt =Lt = f (kt ):

The properties of the function (kt ) determines the role of initial conditions
in the growth process and thus in comparative economic development. Impor-
tantly, since (kt ) is a additive-linear function of f (kt ) and kt ; the qualitative
properties of the production function f (kt ) are shared by the function (kt )
which governs the evolution of the economy.

Proposition 3.1 Given Assumptions (3.A1) and (3.A2) the properties of the
function (kt ) are:

(0) = 0;

0 sf 0 (kt )+(1 ) 00 sf 00 (kt )

(kt ) = 1+n > 0 and (kt ) = 1+n <0 8kt 0;

0 0 1
limkt !0 (kt ) = 1 and limkt !1 (kt ) = 1+n < 1:

Thus, the qualitative properties of the production function f (kt ) are mapped
to the function (kt ): That is, as depicted in Figure 3.1, the function (kt ) is
strictly increasing, strictly concave satisfying qualitatively identical boundary
properties to those implied by the Inada conditions. As kt approaches 0, the
0
value of (kt ) approaches in…nity, and as kt approaches 1; the positivity of
0
n+ assures that (kt ) < 1.
Oded Galor 12

Geometrically, (kt ) is a curve that departs from the origin with an in…nite
slope, and thus above the 450 line along which kt+1 = kt : However, as kt in-
creases su¢ ciently the slope of (kt ) drops below 1 and inevitably it crosses the

450 line.

kt +1
kt +1 = kt

φ ( kt )

k0 kt
k

Figure 3.1. The Dynamical System

Converges to the non-trivial steady-state equilibrium k

from any initial condition k0

3.2.1 Steady-State Equilibrium

De…nition 3.1 A steady-state equilibrium is a level of capital-labor ratio k

such that
k = (k);

or
kt kt+1 kt = (k) k=0
Oded Galor 13

Accordingly, in the absence of technological progress, this steady-state equilib-

rium is characterized by a constant level of income per-capita, y = f (k):
As will become apparent, the introduction of technological progress could
generate the observed pattern of sustained growth rate of income per capita

among the most developed economies. In particular, as established in section

3.4, if the rate of technological progress is constant over time, the economy
converges to a steady-state equilibrium in which the growth rate, rather than

the level, of output per capita is constant over time.

Geometrically, a steady-state equilibrium of this one-dimensional dynamical
system must reside on the 450 line along which kt+1 = kt : A steady-state equi-
librium is represented, therefore by the points of intersection between (kt ) and
the 45o line.
As follows from (3.14),

sf (kt ) (n + )kt
kt = 0 if and only if = 0: (3.16)
1+n

Hence, a steady state equilibrium, k; must satisfy the equation

sf (k) = (n + )k; (3.17)

where as follows from Figure 3.2,

sf 0 (k) < (n + ): (3.18)

Existence of Steady-state Equilibria

The dynamical system, as depicted in Figure 3.1, is characterized by two steady-

state equilibria:

k = 0 (a trivial steady-state equilibrium);

Oded Galor 14

k > 0 (a nontrivial steady-state equilibrium).

The existence of the trivial steady-state equilibrium follows directly from

the fact that as established in Proposition 3.1, (0) = 0: Namely, if capita-labor
ratio at time t; kt = 0; it is inevitable that the capita-labor ratio at time t + 1;
kt+1 = 0 and the economy is in a steady-state equilibrium characterized by no

economic activity.
The existence and the uniqueness of the nontrivial steady-state equilibrium,
as depicted in Figure 3.1, follows directly from the properties of the func-
tion, (kt ); as stated in Proposition 3.1. In particular, since (0) = 0 and
0
limkt !0 (kt ) = 1; the curve of the function (kt ) departs from the origin
with a slope that exceeds that unit-slope of the 450 line and as kt increases
0
su¢ ciently, noting that limkt !1 (kt ) < 1; the slope of (kt ) drops below 1.
Hence, there exist a level of the capital-labor ratio, k; at which the curve of the
function (kt ) inevitably crosses the 450 line. The uniqueness of this non-trivial
steady-state , k; follows from the strict concavity of (kt ):
Alternatively, as depicted in Figure 3.2, the existence of these two steady-
state equilibria can be derived directly from the equation sf (k) = (n + )k
that characterizes the steady-state equilibria. Since sf (0) = 0 , the existence
of the trivial steady-state equilibrium is straightforward. The existence and the
uniqueness of the nontrivial steady-state equilibrium, follows directly from the
neoclassical properties of f (k); as stated in Assumption (3.A2). Since sf (0) = 0
and limkt !0 sf 0 (k) = 1; the curve sf (k) departs from the origin with slope that
exceeds the slope (n + ) that characterizes the (n + )k line. As k increases
su¢ ciently, noting that limk!1 sf 0 (k) = 0; the slope of the curve sf (k) drops
below (n + ) > 0 and thus there exist a level of k at which the function sf (k)
inevitably crosses the (n + )k line. The uniqueness of this non-trivial steady-

state follows from the strict concavity of sf (kt ):

Oded Galor 15

(n + δ )k

sf (k )

k
k

Figure 3.2. Steady-State Equilibria

Stability of Steady-State Equilibria

The stability analysis of the system’s steady-state equilibria determines whether

a steady-state equilibrium is attractive or repulsive for all or at least some set
of initial conditions. It facilitates the study of the local, and often the global,
properties of a dynamical system, and it permits the analysis of the implications
of small, and sometimes large, perturbations that occur once the system is in

the vicinity of a steady-state equilibrium.

A steady-state equilibrium is globally stable if the system converges to this
steady-state equilibrium regardless of the level of the initial condition, whereas
a steady-state equilibrium is locally stable if there exists an - neighborhood of

the steady-state equilibrium such that from every initial condition within this
neighborhood the system converges to this steady-state equilibrium. Formally
the de…nition of local and global stability are as follows:8
8 The economic literature, to a large extent, refers to the stability concepts in De…nition
Oded Galor 16

De…nition 3.2 A steady-state equilibrium, k; of the di¤ erence equation kt+1 =

(kt ) is:

globally stable, if
lim kt = k 8k0 ;
t!1

locally stable, if

lim kt = k 8k0 such that k0 k < for some > 0:

t!1

Alternatively, if for su¢ ciently small perturbations the dynamical system

converges asymptotically to the original equilibrium, the system is locally stable,
whereas if regardless of the magnitude of the perturbation the system converges
asymptotically to the original equilibrium, the system is globally stable.
Global stability of a steady-state equilibrium necessitates the global unique-
ness of the steady-state equilibrium. If there is more than one steady-state
equilibrium in the relevant domain, none of the equilibria can be globally stable
since there exist at least two points in the relevant space from which there is no
escape and convergence from each of these steady-state equilibria to the other
steady-state equilibrium is therefore not feasible.

Proposition 3.2 The steady-state equilibrium, k; of the dynamical system kt+1 =

(kt ) is locally stable if and only if

j 0 (k)j < 1:9

Thus, as follows from the phase diagram in Figure 1,

k = 0 is unstable;
3.2 as global stability and local stability, respectively, whereas the mathematical literature
refers to them as global asymptotic stability and local asymptotic stability, respectively. The
concept of stability in the mathematical literature is reserved to situations in which trajectories
that are initiated from an -neighborhood of a steady-state equilibrium (a …xed point) remain
su¢ ciently close to this …xed point thereafter.
9 See Galor (2007).
Oded Galor 17

k > 0 is globally stable for all k0 > 0:

Local stability can be assessed more formally based on the condition for local
stability established in Proposition 3.2. As follows from the properties of (kt )

0 (1 ) + sf 0 (k)
lim (k) = lim = 1: (3.19)
k!0 k!0 1+n
0
Hence limk!0 (k) > 1 it follows from Proposition 3.2 that the trivial steady-
state equilibrium, k = 0; is unstable. As to the non-trivial steady-state equilib-
rium, k > 0, since

0 (1 ) + sf 0 (k) (1 ) + (n + )
(k) = < =1 (3.20)
1+n 1+n

it follows from Proposition 3.2, that the non-trivial steady-state, k > 0 is locally
stable.
Thus, as depicted in the phase diagram in Figure 3.1, for the restricted
domain of k0 > 0; the non-trivial steady-state, k > 0; is globally stable. Namely,
for any initial level of the capital-labor ratio, k0 ; the economy converges to the
nontrivial steady-state equilibrium, k:

3.2.2 Dynamic E¢ ciency

This subsection explores the e¢ ciency of the trajectories of the capital-labor

ratio and consumption per capita from time zero to in…nity, fkt ; ct g1
t=0 . In

particular, it examines whether the trajectory of the economy generates a con-

sumption path that can be dominated by an alternative, feasible, consumption
path.
Individuals derive utility from consumption and the evolution of the economy

will not be e¢ cient if one can designed a di¤erent feasible trajectory such that
consumption per capita is at least as high in all period, and strictly higher in
some period.
Oded Galor 18

As established in equation (3:5), the evolution of capital stock in the neo-

classical growth model is governed by the equation

Kt+1 = St + (1 )Kt : (3.21)

Noting that total output is entirely allocated between aggregate consumption

and aggregate investment (i.e., aggregate savings), it follows

St = Yt Ct ; (3.22)

where Ct is the aggregate level of consumption of time t:

The relationship between the evolution of capital stock and aggregate con-
sumption is therefore

Kt+1 = Yt Ct + (1 )Kt = Lt f (kt ) + (1 )Kt Ct : (3.23)

The evolution of capital-labor ratio as a function of consumption per worker,

noting that Lt =Lt+1 = 1=(1 + n); is therefore

f (kt ) + (1 )kt ct
kt+1 = ; (3.24)
(1 + n)

where ct Ct =Lt is the consumption per capita at time t:

Hence, the level of consumption per capita at time t is

ct = f (kt ) + (1 )kt (1 + n)kt+1 : (3.25)

In a steady-state equilibrium, kt+1 = kt = k and the steady-state level of

consumption per capita, c; as depicted in Figure 3.3, is a function of the steady-
state level of the capital-labor ratio, k. In particular,

c = f (k) (n + )k = c(k): (3.26)

Geometrically, the point of intersection between the curves f (k) and the line
~ If kt > k~
(n + )k is the maximal sustainable level of the capital-labor ratio, k:
Oded Galor 19

then f (kt ) < (n + )kt ; and as follows from (3.14), noting the s < 1;

sf (kt ) (n + )kt
kt kt+1 kt = < 0: (3.27)
1+n

^ the capital-labor ratio declines and k~ is the maximal

Hence, as long as kt > k,

sustainable level of the capital-labor ratio.

De…nition 3.3 (The Golden Rule). The Golden Rule level of the capital-labor
ratio is the steady-state level of the capital-labor ratio that maximizes the steady-
state level of consumption per capita.

The Golden Rule level of capital-labor ratio, k GR ; is therefore

k GR = arg max c(k) = arg max[f (k) (n + )k]: (3.28)

Hence, it follows from the necessary and su¢ cient conditions for the maximiza-
tion problem (3.28) that the Golden Rule level of capital-labor ratio, k GR
equates that marginal productivity of capital in the steady-state to the sum of
the rate of population growth and the rate of capital depreciation. Namely,

f 0 (k GR ) = (n + ); (3.29)

or
0
k GR = f 1
(n + ): (3.30)
Oded Galor 20

(n + δ )k

f (k )

k
k GR k~

~
k
k GR k c(k )

Figure 3.3 The Golden Rule Level of the Capital-Labor Ratio

Since the saving rate in the neoclassical growth model is not derived from op-
timization, a-priori the steady-state equilibrium of the economy appears unlikely
to generate the Golden Rule level of the capital-labor ratio and the correspond-
ing Golden Rule level of consumption per worker, cGR .
Indeed, as follows from equations (3.17) and (3.29), at a steady-state equi-
librium, sf (k) = (n + )k, whereas at the Golden Rule, f 0 (k GR ) = (n + ):
Oded Galor 21

Hence, upon substitution,

sf (k) = f 0 (k GR )k: (3.31)

Thus, as depicted in Figure 3.4,

k = k GR if and only if s = f 0 (k GR )k GR =f (k GR ) sGR : (3.32)

The steady-state equilibrium of the neoclassical growth model, therefore, may

be characterized by over-investment or under-investment relative to the Golden

Rule. As depicted in Figure 3.4, if the saving rate, sH ; is higher than the
saving rate that corresponds to the Golden Rule, the economy’s steady-state
equilibrium is characterized by over-investment relative to the Golden Rule,
whereas if the saving rate, sL ; is lower than the saving rate that corresponds
to the Golden Rule, the economy’s steady-state equilibrium is characterized by
under-investment relative to the Golden Rule.

(n + δ )k
f (k )

s H f (k )
n +δ
s GR f (k )
s L f (k )

~ k
kL k GR kH k

Figure 3.4. The Economy’s Steady-state Equilibrium in Relation

to the Golden Rule
Oded Galor 22

De…nition 3.4 Consider the steady-state equilibrium level of the capital labor
ratio, k.

If k > k GR the steady-state of the economy is characterized by over-

investment relative for the Golden Rule.

If k < k GR the steady-state of the the economy is characterized by under-

investment relative for the Golden Rule.

Nevertheless, deviations from the Golden Rule do not necessarily indicate

the presence of dynamic ine¢ ciency and the evaluation of the trajectory of the
economy in comparison to the Golden Rule necessitate a proper de…nition of
the concept of dynamic e¢ ciency.

De…nition 3.5 (A feasible allocation). An allocation fkt ; ct g1

t=0 is feasible if

for all t
ct f (kt ) + (1 )kt (1 + n)kt+1 :

Hence, a feasible allocation is a consumption-investment trajectory that does

not violate the resource constraint (3.25) at any point in time.

De…nition 3.6 (Dynamic e¢ ciency). A feasible allocation fkt ; ct g1

t=0 is dy-

namically e¢ cient if there exists no other feasible allocation fkt0 ; c0t g1

t=0 such

that
c0t ct for all t

c0t > ct for some t

Thus, the trajectory of an economy is dynamically e¢ cient if there is no alterna-

tive feasible trajectory that could provide at least the same level of consumption
in all period and strictly higher level of consumption in some periods.
Oded Galor 23

Clearly, if the economy is characterized by over-investment relative to the

Golden-Rule (i.e., if k > k GR ), a reduction in the level of investment, and thus in
the level of the capital-labor ratio to that associated with the Golden Rule will
increase consumption in the transition period. Moreover, since the consumption

associated with the Golden Rule is the highest feasible one (and in particular
higher than that level of consumption associated with k > k GR ), consumption
will increase in all future period as well. Hence, over-investment relative to the

Golden-Rule is dynamically ine¢ cient.

However, if the economy is characterized by under-investment relative to the
Golden Rule, an increase in the level of investment to the one associated with
the Golden-Rule will be associated with a decline in consumption during the
transition period, while increasing consumption in all future periods. Hence,
since it is not feasible to increase consumption in all time periods, the economy
is dynamically e¢ cient.
More formally, a feasible allocation fkt ; ct g1
t=0 is dynamically ine¢ cient

if there exists a 2 N such that kt > k GR 8t (i.e., if there exists a

time point beyond which the capital-labor ratio exceeds the Golden Rule). In
particular, if k is characterized by over-investment relative to the Golden Rule,
the economy is dynamically ine¢ cient. The argument is straight forward. Let
fkt0 ; c0t g1
t=0 be such that
kt0 = kt 8t <

kt0 = k GR 8t :
Hence, since k GR is associated with the highest level of steady-state consumption

c0t = ct 8t <

c0t = cGR > ct 8t > :

Clearly, fkt0 ; c0t g1 0 0

t=0 is a feasible allocation since fkt ; ct gt=0 = fkt ; ct gt=0 and

fkt0 ; c0t g1
t= = fk
GR GR 1
; c gt= where fkt ; ct gt=0 is the original feasible allocation
Oded Galor 24

and {k GR ; cGR g1
t= is feasible since its value in every period it is an element

of the function c(k) that as follows from equations (3.25) and (3.26) function
re‡ect only feasible allocations. Hence, fkt0 ; c0t g1
t=0 is a feasible allocation that

dominates fkt ; ct g1
t=0 :

Thus, if there exists a time point beyond which the capital-labor ratio
exceeds the Golden Rule, the economy is dynamically ine¢ cient.

3.3 Testable Implications

The neoclassical growth model in its simplest form generates a variety of im-
plications regarding the e¤ects of initial conditions as well as the structural pa-
rameters of the model on the rate of economic growth and the long-run steady
state equilibrium of the economy. In particular, the model permits that exam-
ination of the e¤ect of the structural parameters of the model (i.e., the rate of
population growth, n; the saving rate, s; and the rate of capital depreciation, )
on the the long-run level of income per capita, y; and the growth rate of income
per capita, yt : Moreover, the model generates testable predictions regarding
the e¤ect of the initial position of the economy, y0 ; (where y0 = f 0 1
(k0 )); or
its contemporary position, yt ; (where yt = f 0 1
(kt )); on the growth rate of the
economy and its long-run steady state equilibrium. As will become apparent,
some of these implications are non-robust, re‡ecting the abstraction from tech-
nological progress and thus the convergence of economies to a constant level of

output per capita in the long-run. However, the implications of the model for
the e¤ect of the structural characteristics of the economy and its current level
of output per capita on the rate of growth of the economy constitute robust

testable implications.
Oded Galor 25

3.3.1 Comparative Statics

As will become apparent, the qualitative e¤ects of the structural parameters

of the model on the steady-state level of income per-capita, y; are identical to
their e¤ect on the steady-state level of the capital-labor ratio, k: Thus, since the
geometrical representation of these e¤ects are more transparent in the context

of the steady-state level of the capital-labor ratio, k, the geometrical analysis is

customarily conducted in this setup.
The e¤ect of the structural parameters of the economy and its current level
of development on the long-run steady-state equilibrium can be obtained by
the examination of the e¤ects of these factors on the steady-state level of the
capital-labor ratio, k; as given by the equation sf (k) = (n + )k: Alternatively,
it can be derived geometrically, as depicted in Figures 3.5 and 3.6.
Using the steady-state equilibrium condition, let

G(k; n; s; ) (n + )k sf (k) = 0: (3.33)

Hence, since G(k; n; s; ) is identically equal to zero, it follows from the Im-
plicit Function Theorem that if @G=@k 6= 0; then @k=@s = [@G=@s]=[@G=@k];
@k=@n = [@G=@n]=[@G=@k]; and @k=@ = [@G=@ ]=[@G=@k]. Thus not-
ing that as stated in equation (3.18), sf 0 (k) < n + ; the following proposition
summarizes the comparative static results.

Proposition 3.3 The e¤ ects of an increase in the rate of population growth,

n; the saving rate, s; the rate of capital depreciation, ; and the initial level of
the capital-labor ratio, k0 ; on the steady-state level of the capital-labor ratio, k;
are:
h i
@k f (k)
@s = n+ sf 0 (k)
> 0;
h i
@k k
@n = n+ sf 0 (k)
< 0;
Oded Galor 26

h i
@k k
@ = n+ sf 0 (k)
< 0;

@k
@k0 = 0:

Since the steady-state level of income per capita y = f (k) and since y is

monotonically increasing in k (i.e., @ y=@ k = f 0 (k) > 0); the direction of the
e¤ect of the structural parameters and the initial condition, y0 = f (k0 ); on the
steady-state level of income per capita, y; is identical to their e¤ect on the level

of the capital-labor ratio in the steady-state, k. In particular,

Corollary 3.1 The e¤ ects of an increase in the rate of population growth, n;

the saving rate, s; the rate of capital depreciation, ; and the initial level of the
capital-labor ratio, k0 ; on the steady-state level of income per capita, y; are:

@y
@s = f 0 (k) @k
@s > 0;

@y @k
@n = f 0 (k) @n < 0;

@y
@ = f 0 (k) @k
@ < 0;

@y
@y0 = 0:

The e¤ect of an increase in the savings rate on the steady state level of the
capital-labor ratio is depicted in the top panel of Figure 3.5 depicting its e¤ect
on the dynamical system, kt+1 = (kt ); and in the bottom panel of Figure 3.5,
focusing on its e¤ect on the steady-state condition, sf (k) = (n + )k: Similarly,
the e¤ect of the rate of population growth on the steady state level of capital-
labor ratio is depicted in Figure 3.6.
Oded Galor 27

kt +1
kt +1 = kt

s H f (kt ) + (1 − δ )kt
φ ( kt ; s H ) =
1+ n

s L f (kt ) + (1 − δ )kt
φ ( kt ; s L ) =
1+ n

kt
k (s L ) k (s H )

(n + δ )k

s H f (k )

s L f (k )

k (s L ) k (s H ) k

Figure 3.5. The E¤ect of an Increase in the Saving Rate on

the Steady-state Level of the Capital-Labor Ratio

sH > sL ) k(sH ) > k(sL )

Oded Galor 28

kt +1
kt +1 = kt

sf (kt ) + (1 − δ )kt
φ ( kt ; n L ) =
1 + nL

sf (kt ) + (1 − δ )kt
φ ( kt ; n H ) =
1 + nH

kt
k (n H ) k (n L )

(n H + δ )k

(n L + δ )k

s H f (k )

k (n H ) k (n L ) k

Figure 3.6. The E¤ect of an Increase in the rate of Population Growth

on the Steady-state Level of the Capital-Labor Ratio

nH > nL ) k(nL ) > k(nH )

Oded Galor 29

3.3.2 Comparative Dynamics

As will become apparent, the qualitative e¤ects of the structural parameters of

the economy on the growth rate of income per-capita, yt ; are identical to their
e¤ect on the growth rate of the capital-labor ratio, kt : Moreover, the qualitative
e¤ect of the current level of development of the economy on the growth rate

of income per-capita, yt ; is identical to its e¤ect on the growth rate on the

capital-labor ratio, kt provided that either: (i) the production technology is
of the Cobb-Douglas type, (ii) the economy is below its steady-state and the
production technology is of the CES type, where the elasticity of substitution is
smaller than 1, (iii) the economy is in the vicinity of the steady-state.10 Thus,
since the geometrical representation of these e¤ects are more transparent in the
context the growth rate of the capital-labor ratio, kt , the geometrical analysis
is conducted in this setup.
The growth rate of the capital-labor ratio, kt ; is
sf (kt ) (n + )
kt k (kt ; s; n; ); (3.34)
(1 + n)kt (1 + n)
Figure 3.7 depicts the growth rates of the capital-labor ratio as the vertical

distance between the curve sf (kt )=(1 + n)kt and the horizontal line (n + )=(1 +
n). The curve sf (kt )=(1 + n)kt is downward slopping, i.e.,
sf (kt ) s f 0 (kt )kt f (kt )
@ =@kt = < 0; (3.35)
(1 + n)kt 1+n kt2
noting that f (kt ) is strictly concave and thus f 0 (kt )kt f (kt ) < 0:. Furthermore,
the curve sf (kt )=(1 + n)kt approaches 0 as kt approaches in…nity, and it
approaches 1 as kt as approaches 0, i.e., using L’Hospital rule,
h i
sf (kt ) s
limkt !0 (1+n)k t
= 1+n limkt !0 f 0 (kt ) = 1;
h i (3.36)
sf (kt ) s 0
limkt !1 (1+n)kt = 1+n limkt !1 f (kt ) = 0:
1 0 In an historical context, the inital postion of an economy, and its growth trajectory, is

palusbilly below its steady-state. However, an adverse shock to an economy that lowers its
steady-state equilibrium may place an economy above its long-run-steady-state.
Oded Galor 30

Thus, the curve sf (kt )=(1 + n)kt necessarily intersects the horizontal line
(n + )=(1 + n) at the steady-state equilibrium k; where the growth rate of
the capital-labor ratio as well as of output per capital is zero, re‡ecting the
abstraction from technological progress. Moreover, the farther kt is below the

steady-state level of capital-labor ratio, the higher the growth rate, whereas if
kt exceeds k the growth rate is negative.

γ kt

n +δ
1+ n

sf (kt )
(1 + n)kt

kt k kt

Figure 3.7. The Growth Rate of the Capital-Labor Ratio

The e¤ect of the structural parameters of the model and its initial position
on the growth rate of the economy can be obtained by the examination of the
e¤ect of these factors on the growth of the capital-labor ratio, kt : In particular,
the e¤ect of an increase the capital labor ratio on the growth rate can be de-
rived geometrically, as depicted in the Figure 3.8. For a given set of structural
characteristics, the higher is the level of the capita-labor ratio the lower is the
growth rate.
Oded Galor 31

γ k1t

γ k2t
n +δ
1+ n

sf (kt )
(1 + n)kt

kt1 kt2 k kt

Figure 3.8. The E¤ect of the Current Capital-Labor Ratio on the

Economy’s Growth Rate

kt1 > k 2 ) 1
kt < 2
kt

Similarly, the e¤ects of an increase the saving rate and the rate of population

growth on the growth rate are depicted in the Figure 3.9. For a given set of
structural characteristics and for a given level of the capital-labor ratio, the
higher is saving rate the higher is the growth rate of the capital-labor ratio, and
the higher is the rate of population growth the lower is the growth rate.
Oded Galor 32

γ kt ( s H )

γ kt ( s L )
n +δ
1+ n
s H f ( kt )
s L f (kt ) (1 + n)kt
(1 + n)kt

kt k (s L ) k (s H ) kt

γ kt ( s H )

γ kt ( s L )
nH + δ
1 + nH
nL + δ
1 + nL
sf (kt )
sf (kt ) (1 + n )kt
L

(1 + n H )kt

kt k (n H ) k (n L ) kt

Figure 3.9. The E¤ect of a Higher Saving Rate (Top Panel) and
Higher Fertility Rates (Bottom Panel) on the Growth Rate

sH > sL ) H
kt (s ) > L
kt (s )
nH > n L ) L
kt (n ) > H
kt (n )
Oded Galor 33

Alternatively, the e¤ect of the structural parameters of the economy and its
current level of development on the growth rate of the capital-labor ratio can
be obtained by the examination of the e¤ects of these factors on kt ; as given

by equation (3.34): These e¤ect are summarized in the following proposition.

Proposition 3.4 Let the rate of growth of the capital-labor ratio between time
t and time t + 1, be kt :

h i h i
@ kt sf (kt ) n+ s f 0 (kt )kt f (kt )
@kt =@ (1+n)kt 1+n =@kt = 1+n kt2
< 0;

@ kt f (kt )
@s = (1+n)kt > 0;

@ kt
h i
sf (kt ) (n+ )kt sf (kt )+(1 )kt
@n =@ (1+n)kt =@n = (1+n)2 kt < 0;

@ kt 1
@ = 1+n < 0:

The examination of the e¤ect of the current level of development on the

growth rate of income per-capita, yt ; based on the e¤ects derived in Proposition
3.4 is more intricate. The growth rate of income per capita, yt , can be expressed
as a function of the growth rate of the capital labor ratio, kt and kt ; noting
that kt+1 = kt (1 + kt ) :

yt+1 yt f (kt+1 ) f (kt ) f (kt (1 + kt )) f (kt )

yt = = y ( kt ; kt ):
yt f (kt ) f (kt )
(3.37)
:
Thus, the growth rate of income per-capita, yt ; is monotonically increasing
in the growth rate of the capital-labor ratio, kt : Namely,

@ yt f 0 (kt+1 )kt
= > 0: (3.38)
@ kt f (kt )

Moreover, the growth rate of income per capita, yt , is not a¤ected directly
by the parameters of the model s; n, and : Their e¤ects operates only via

kt = k (kt ; s; n; ): Since the e¤ects of structural parameters of the model, s;

Oded Galor 34

n, and on the growth rate of income per-capita, yt ; operate only via their
e¤ect on the growth rate of the capital-labor ratio, kt = k (kt ; s; n; ); their
e¤ects on the growth rate of income per-capita, yt are qualitatively identical

to their e¤ects on the growth rate of the capital-labor ratio, kt : In particular,

@ yt f 0 (kt+1 )kt @ kt
@s = f (kt ) @s > 0;

@ kt f 0 (kt+1 )kt @ kt
@n = f (kt ) @n < 0; (3.39)

@ kt f 0 (kt+1 )kt @ kt
@ = f (kt ) @ < 0:

However, despite the fact that the growth rate of income per-capita, yt ; is
monotonically increasing in the growth rate of the capital-labor ratio, kt ; the
examination of the e¤ect of the current position of the economy on the growth
rate of income per-capita is much more intricate. As established in equation
(3.37), yt = y ( k t ; kt ) and thus the growth rate of income per-capita, yt is
a¤ected directly by kt ; and indirectly via kt = k (kt ; s; n; ):
In particular, as follows from (3.37),
@ kt
@ yt f 0 (kt+1 )[(1 + kt ) + kt @kt ] f 0 (kt )f (kt+1 )
= : (3.40)
@kt f (kt ) f (kt )2

Noting that (1 + kt ) = kt+1 =kt ; it follows that

@ yt f 0 (kt+1 )kt @ kt f (kt+1 ) f 0 (kt+1 )kt+1 f 0 (kt )kt

= + : (3.41)
@kt f (kt ) @kt f (kt )kt f (kt+1 ) f (kt )

where [f 0 (kt )kt ]=f (kt ) kt is the share of capital in output in period t: Thus,

@ yt f 0 (kt+1 )kt @ kt f (kt+1 )

= + kt+1 kt ; (3.42)
@kt f (kt ) @kt f (kt )kt

and the qualitative e¤ect of the current position of the economy on the growth
rate of income per-capita, yt ; is identical to its e¤ect on the growth rate of the
capital-labor ratio, kt ; as long as either of these su¢ cient (but not necessary)
conditions is satis…ed: (i) the share of capital is non-increasing over time or
Oded Galor 35

(ii) the economy is su¢ ciently close to the steady-state and thus kt+1 kt is
su¢ ciently close to zero. That is,
@ yt @ kt
sign = sign < 0 if [ kt+1 kt ] or [8 > 0; kt+1 kt < ].
@kt @kt
(3.43)

Direct derivation of yt with respect to kt provides additional su¢ cient con-

ditions for the negativity of @ yt =@kt :

@ yt f 0 (kt+1 )f (kt+1 )) f (kt ) 0 f 0 (kt )

= (kt ) : (3.44)
@kt f (kt )2 f (kt+1 ) f 0 (kt+1 )
As long as the capital labor-ratio at time t is below its steady-state equilibrium
level, kt+1 > kt ; and the properties of f (kt ) imply that f (kt )=f (kt+1 ) < 1 and
0
f 0 (kt )=f 0 (kt+1 ) > 1: Hence, @ yt =@kt < 0 if (kt ) 1: As follows from the
0
local stability of the non-trivial steady-state equilibrium, (k) < 1; and thus
^ k]; for which
there exists an interval of the capital-labor ratio at time t; [k;
@ 0 ^ = 1; and thus as follows from properties of
yt =@kt < 0: In particular, (k)
^ = (n + )=s.
the function (kt ), f 0 (k)
Thus, the qualitative e¤ect of the current level of development, kt ; on the
growth rate of income per-capita, yt ; is identical to its e¤ect on the growth rate
of the capital-labor ratio, kt ; provided that (i) the production function is of the
Cobb-Douglas type (and thus the share of capital is constant independently of
the level of the capital-labor ratio), (ii) the economy is below the steady-state
equilibrium and the production function is a CES with elasticity of substitution

< 1 (i.e., the share of capital declines as the capital-labor ratio decreases;
(iii) the economy is su¢ ciently close to the economy’s steady-state equilibrium
and thus for any > 0; kt+1 kt < ; (iv) the capital-labor ratio at time
^ k]; where k^ = f 0
t is in the interval [k; 1
(n + )=s; and k is the steady-state

equilibrium.
Moreover, noting that yt = f (kt ) is invertible, it follows that kt = f 0 1
(yt );
and thus the comparative dynamics results with respect to kt are qualitatively
Oded Galor 36

identical to to those with respect to yt : The comparative dynamics results are

summarized in the following proposition.

Proposition 3.5 Let the rate of growth of the income per capita between time
t and time t + 1, be yt :

@ yt @ yt @ yt
@s > 0; @n < 0; @ < 0:

@ yt
@yt <0 if [ kt+1 kt ] or [kt 2 [k; k]]

where kt [f 0 (kt )kt ]=f (kt ) is the share of capital in output in period t; k
is the economy’s steady-state equilibrium, and k = f 0 1
(n + )=s:

3.3.3 Testable Predictions

While the comparative static results re‡ect the abstraction from technological
progress, and thus do not generate viable testable implications, the predictions
of the model about the e¤ect of the structural characteristics of the economy
and its current level of output per capita on the rate of growth of the economy
constitute robust testable implications. In particular, the comparative dynamics
results constitute a variety of testable predictions:

The rates of population growth and capital depreciation have negative

e¤ects on rate of growth of income per capita.

The saving rate has a positive e¤ect on the growth rate of income per
capita.

The historical level of income per capita does not a¤ect the long-run per-
formance of the economy.

The current level of income per capita has a negative e¤ect on the growth
rate of income per capita.
Oded Galor 37

3.4 Exogenous Technological Progress

Historical as well as contemporary evidence suggest that within the modern

growth regimes the most advanced economies have grown steadily at an average
rate of nearly 2% per year over the past 140 years. Furthermore, other regions
of the world economy do not appear to converge to a steady-state equilibrium
with a zero growth rate of income per capita.

The neoclassical growth model presented, thus far, is characterized by growth

rates that are declining sympathetically to zero as the as economies converge to
their steady-state equilibrium. This characterization of the steady-state equi-
librium appears inconsistent with the evidence, re‡ecting the abstraction of the
basic model from technological progress.
This section incorporates into the basic neoclassical growth model a simple
mechanism that could generate a steady-state equilibrium in which the growth
rate rather than the level of income per capita is constant over time. As will
become apparent, exogenous process of sustained technological progress will
permit the economy to reach a steady-state equilibrium with a zero growth rate
of output per capita. However, the exogeneity of the process of technological
progress does not permit the examination of the factors that may a¤ect the rate
of economic growth in the steady-state. Consequently, following the more recent
development of endogenous growth theory, the basic neoclassical growth model
will be augmented in section 3.6, with alternative mechanisms that generate
sustained economic growth that is related to the structural parameters of the
model.

Production and Technological Progress

Suppose that the economy experiences an exogenous labor-augmenting techno-

logical progress that transforms the labor force and makes it more e¢ cient in
Oded Galor 38

the production process.11 The output produced at time t; Yt ; is governed by

a neoclassical production function that satis…es the neoclassical conditions. In
particular,
Yt = F (Kt ; At Lt ); (3.45)

where At is the level of technology at time t; and At Lt is the number of e¢ ciency

units of labor employed in production at time t: Technology evolves over time

at a constant exogenous rate :

At+1 = (1 + )At ; (3.46)

where > 0 is the rate of labor augmenting technological progress, and the
level of technology at time 0, A0 ; is exogenously given.12 Thus, while due
to population growth, the number of workers employed in period t + 1 is (1 +
n) times larger than that in period t; the number of e¢ ciency units of labor
employed in production in period t + 1 is (1 + n)(1 + ) time larger than that
in period t.
The output produced at time t can expressed as a function of the ratio of
capital to e¢ ciency units of labor employed in production, Kt =At Lt : Noting the
homogeneity of degree one of F (Kt ; At Lt ) in (Kt ; At Lt );

Yt = F [Kt ; At Lt ] = F [Kt =At Lt ; 1] At Lt f (kt ); (3.47)

where kt Kt =At Lt is ratio of capital to e¢ ciency units of labor employed in

production at time t; and the production function f (kt ) satis…es Assumption
(3.A2).
1 1 Capital-augmenting technological progress (i.e., Y = F (A K ; L )) or Hicks-neutral tech-
t t t t
nological progress (i.e., Yt = F (At Kt ; At Lt )) do not lead to a steady-state equilibrium char-
acterized by a constant rate of growth in income per capita and are therefore not the focus of
the discussion.
1 2 Theoretically, one can consider rates of labor augmenting technological progress > 1:
However, in the modern era, which is the focus of the neoclassical growth model, negative
rates of labor augmenting technological progress have not been observed.
Oded Galor 39

The Dynamical System

The evolution of the capital stock, noting equations (3.5) and (3.10), is

Kt+1 = sLt At f (kt ) + (1 )Kt : (3.48)

This di¤erence equation in which the stock of capital at time t + 1 is associated

with three past state variables: the stock of capital, Kt ; the size of the popula-
tion, Lt ; and the ratio of capital to e¢ ciency units of labor, kt ; can be greatly
simpli…ed by expressing all variables in per-capita terms.
Dividing equation (3.48) by At+1 Lt+1 ; noting that At Lt =At+1 Lt+1 = 1=(1+
n)(1 + ), the evolution of the ratio of capital to e¢ ciency units of labor is
governed by a one-dimensional, …rst-order, non-linear di¤erence equation

sf (kt ) + (1 )kt
kt+1 = (kt ): (3.49)
(1 + n)(1 + )

As depicted in Figure 3.10, (kt ) has the same qualitative properties as the
function (kt ) that governs the evolution of the economy in the basic model.
It is increasing, strictly concave, departs from the origin with an in…nite slope,
(i.e., above the 450 line along which kt+1 = kt ); and as kt increases su¢ ciently
the slope of (kt ) gradually declines and falls below 1; inevitably crossing the
450 line.
Oded Galor 40

kt +1
kt +1 = kt

ψ ( kt )

k0 kt
k

Figure 3.10. The Dynamical System

The economy converges from any initial condition k0 to the a steady-state

equilibrium level of the ratio of capital to e¢ ciency units of labor, k; in which
output per worker grows at a constant rate :

The dynamical system is therefore characterized by an unstable trivial steady-

state equilibrium at k = 0 and a stable nontrivial steady-state equilibrium at
k > 0. As follows from (3.49),

sf (kt ) [n + + (1 + n)]kt
kt = 0 if and only if = 0: (3.50)
(1 + n)(1 + )

Hence, a steady state equilibrium, k; must satisfy the equation

sf (k) = [n + + (1 + n)]k: (3.51)

Oded Galor 41

Output Per Capita Growth in a Steady-State Equilibrium

The growth rate of the capital-labor ratio, kt ; is

sf (kt ) [n + + (1 + n)]
kt k (kt ; s; n; ; ); (3.52)
(1 + n)(1 + )kt (1 + n)

In the nontrivial steady-state equilibrium the ratio of capital to e¢ ciency

units of labor, k; is constant. The testable implications derived in the basic

framework based on the comparative statics and dynamic analysis with respect
to the saving rate, s; population growth, n; and capital depreciation, ; remain
intact, while the rate of labor-augmenting technological progress reduces, k;
In the nontrivial steady-state equilibrium the ratio of capital to e¢ ciency
units of labor, k; is constant and thus the output per e¢ ciency units of labor,
Yt =At Lt ; is constant as well. However, at this steady-state equilibrium, capital
per worker, At k; and output per capita grow at a constant rate, : In particular,

yt Yt =Lt = At f (k);

and thus the growth of output per capita, yt ; is

yt+1 yt At+1 f (k) At f (k)

yt = = : (3.53)
yt At f (k)

Thus, the incorporation of exogenous labor-augmenting technological progress

permits the economy to exhibit a steady-state growth rate in output per capita.
The testable implications derived in the basic framework based on the compara-

tive dynamic analysis remain intact. However, unlike the basic model, countries
converge in the long-run to a steady state equilibrium with an exogenous con-
stant growth rate of output per capita. Despite the improvement in the ability
of the model to match the pattern of sustained economic growth, the growth

rate in the steady-state is exogenously given and the model is therefore not
properly positioned to examine the factors that may govern the growth rate of
an economy in the steady-state. This de…ciency is addressed in section 3.6.
Oded Galor 42

3.5 The Convergence Hypothesis

The most powerful and in‡uential prediction of the neoclassical growth model

is the convergence hypothesis. As established in the comparative dynamics

analysis, the growth rates of an economy is inversely related to its initial level
of output per capita and its long-run equilibrium is independent of its initial
conditions.

3.5.1 Absolute Convergence

Despite the fact that the neoclassical growth model does not imply an absolute
(i.e., unconditional) convergence, ironically, the rejection of absolute conver-
gence was one of the prime motivations that has led some of the originators of
the endogenous growth literature to reject the use of the neoclassical growth
model as a framework for the study of economic growth and to advance the
alternative that has been entitled, endogenous growth models.13

Proposition 3.6 (The Absolute Convergence Hypothesis). Among all coun-

tries in the world economy, one would observe two forms of convergence:

converge:

Proposition 3.7 The lower is the level of income per capita the higher
is the growth rate of income per capita.

convergence:

Proposition 3.8 (i) The distribution of income per capita across coun-
tries contracts over time.
1 3 As discussed in section 3.6, the second motivation for the development of endogenous

growth models has been the desire to shed light on the factors that contribute to the phenom-
enon of sustained economic growth among the most developed countries in the past century.
Indeed, the inability of the neoclassical growth model to shed light on this important aspect
of the growth process is a major de…ciency that necessitated further advancements.
Oded Galor 43

(ii) The growth rates converge over time

The absolute convergence hypothesis is not implied by the neoclassical growth

model. For instance, suppose that a poor economy has a lower saving rate, sP ;
than that of a rich one, sR : Suppose further that the capital-labor ratio at time
t is smaller in the poor economy, i.e., ktP < ktR : As depicted in Figure 3.11,
and in contrast to the absolute convergence hypothesis, the poor economy may

grow at a slower rate than the rich one.

γ kt ( s R )

γ kt ( s P )
n +δ
1+ n
s R f ( kt )
s P f (kt ) (1 + n)kt
(1 + n)kt

ktP ktR k (s P ) k (s R ) kt

Figure 3.11. Absence of Absolute Convergence

ktR > ktP and and R

t > P
t

Thus, since an economy’s long-run equilibrium depends on its structural

characteristics (e.g., technology, preferences, population growth, government
policy, factor market structure, etc.) absolute convergence would be observed
only if the structural characteristics across countries would converge as well.
Oded Galor 44

An early test of the version of the absolute convergence hypothesis was

conducted by Baumol (1986). Using a sample of 16 industrialized (OECD) coun-
tries, he linearly regressed log per-capita income growth of country i between
the years 1870 and 1979 against log per-capita income of country i in the year

1870, estimating the linear equation,

ln[(yi;1979 yi;1870 )=yi;1870 ] = + ln yi;1870 + i ; (3.54)

where i is a country speci…c disturbance.

A con…rmation of the absolute convergence hypothesis would require that
; the coe¢ cient on the initial level of income per capita for countries in the
sample would be negative and signi…cant statistically. In particular the closer is
to 1 the larger is the degree of convergence across economies in the sample
period.
The …ndings of the study provided an apparent con…rmation for the absolute
convergence hypothesis. The coe¢ cient of interest, ; was estimated to be

= 0:99 (with a standard error of 0:09); suggesting the during this time
period convergence of countries in the sample was nearly complete. The results
suggest that countries which had lower per-capita income in 1870 tended to grow
faster from 1870 to 1979 than countries with higher per-capita income in 1870.
However, as was demonstrated by Delong (1988), the results were an artifact
of biases that were generated by sample selection as well as by measurement

errors.
Sample Selection Bias: A sample of OECD economies in 1979 consists of
relatively advanced industrial economies and is clearly not a random sample. In
particular, countries with low income per capita in the year 1870 were included

in the sample only if they grew rapidly during the subsequent century and
quali…ed to be members of the OECD. In contrast, countries with high income
per capita in the year 1870 were su¢ ciently rich to be included in the sample
Oded Galor 45

even if they grew rather slowly over this century. Thus, the sample selection
biased the results in favor of convergence.
Measurement Errors: Lager measurement errors in 1870 than in 1979 biased
the results in favor of convergence. In particular, if income per capita of an

economy was over-estimated in the year 1870, while being precisely estimated
in 1979, the growth rate of this economy would be under-estimated, favoring
convergence. Similarly, if income per capita of an economy was under-estimated

in the year 1870, while being precisely estimated in 1979, the growth rate of this
economy would be over-estimated, favoring convergence.
Once these two biases are removed there is no correlation between income in
1870 and growth from 1870 to 1979, refuting the absolute convergence hypoth-
esis In particular, Delong (1988) demonstrate that if one restricts the sample
to the richest countries in 1870 and corrects for measurement error in the data,
the coe¢ cient, ; is insigni…cantly di¤erent from 0.
A number of subsequent research papers (e.g., Barro, 1991) have tested the
absolute convergence hypothesis on modern and more reliable data that consists
of virtually all countries in the world for which reliable data is available. Using
a large sample of countries, they linearly regressed log per-capita income growth
of country i between the years 1960 and 2000 against log per-capita income of
country i in the year 1960 , estimating the linear equation,

ln[(yi;2000 yi;2000 )=yi;2000 ] = + ln yi;2000 + i ; (3.55)

where i is a country-speci…c disturbance term.

These regression analysis, as depicted for instance in Figure 3.12, provide
evidence against the absolute convergence hypothesis, demonstrating that the
coe¢ cient is in fact slightly positive and signi…cant statistically.
Oded Galor 46

log per capita income growth 1960-2000

2

BWA
KOR SGP
CHN MLT
OMN HKG
THA
1

MYS LBY PRT IRL JPN

IDN PRI
ESP
LSO EGY BLZ HUN GRC ISR LUX
NOR
SYC ITAFIN
AUT
PAK LKA
IND
DOM
BRA CHL
BEL
FRAISL
NLD
SYR VCT GAB
CRI MEX
PAN AUS SWE
GBR USA
DNK
0

MRT PNG PHL

MAR PRYCOLFJI
GTM TTO CHE
NPL
MWI BFA BGD KEN ECU URYARG NZLBHS
TGO SDN COG
GUY
HND DZASLV ZAF
CMR
NGA ZWE PER
BDI BEN CIV BOL
RWA
GHA SEN VEN
-1

NIC
TCD CAF
SLE MDGZMB HTI
NER
-2

ZAR LBR

-2 -1 0 1 2 3
Log per capita income 1960
coef = .14449788, se = .05213904, t = 2.77

Figure 3.12. Evidence Against Absolute Convergence

Subsequent research examines the hypothesis over the same time period in
the context of a panel of countries, and the evolution of the distribution of
income across nations (Quah, 1997), reinforcing the …ndings about the lack of
absolute convergence.

3.5.2 Conditional Convergence

A careful examination of the neoclassical growth model and its testable pre-

diction has led to the conditional convergence hypothesis, as the dominating

hypothesis of the model in the context of comparative economic development.

Proposition 3.9 (The Conditional Convergence Hypothesis). Among coun-

tries that are identical in their structural characteristics (e.g., production tech-
nologies, the rates of technological progress and capital depreciation, population
Oded Galor 47

growth, saving rates, government policy, etc.), one would observe two forms of
convergence:

converge:

The lower is the level of income per capita the higher is the growth rate of
income per capita.

convergence:

(i) The distribution of income per capita across countries contracts over time.
(ii) The growth rates converge over time

This prediction of the neoclassical growth model regarding the gradual dissi-
pation of the vast inequalities in the world economy due to the forces of conver-
gence, is intimately related to several features of the neoclassical growth model.
In particular, since output per capita is a strictly concave function of the capital
labor-ratio, the assumption of …xed saving rates out of aggregate income implies
that the evolution of the economy is governed by a strictly concave function
of the capital labor ratio. Namely, the economy is characterized by a unique,
globally stable, (non-trivial) steady-state equilibrium and its rate of economic
growth is higher the further the economy is from its steady-state equilibrium.
In contrast, however, as discussed in section 3.7, if the dynamical system
that governs the evolution of economies over time would be characterized by

multiple locally stable steady-state equilibria, (e.g., if poverty traps are present),
local (rather than global) conditional convergence would characterize the world
income distribution and convergence clubs would emerge.
Thus, among countries that are identical in their structural characteristics

(and thus in the properties of their dynamical system), one would observe
convergence. Namely, as depicted in Figure 3.13, a poorer country would be
expected to have a higher growth rate of income per capita than a richer one.
Oded Galor 48

γ kPt

γ kRt
n +δ
1+ n

sf (kt )
(1 + n)kt

ktP ktR k kt

Figure 3.13. Convergence

ktR > ktP =) P

kt > R
kt

Moreover, since the growth rates in each economy tend to converge towards
a steady-state rate of economic growth, among countries that are identical in
their structural characteristics and thus in their rate of economic growth in
the steady-state, one would observe convergence, as depicted in Figure 3.14.
Namely, the growth rates across economies would tend to converge over time,
regardless of their initial conditions. In particular, suppose that each of the

economies experience an exogenous rate of technological progress at a rate of

and suppose that the distribution of growth rate across countries in the world in
time t is given by the function t (kt ); as depicted in the middle panel of Figure
3.14. Over time, as economies converge towards their steady-state equilibrium,
k; the variance of the distribution gradually declines, and after period , as
Oded Galor 49

depicted in the bottom panel of Figure 3.14, the support of the distribution
contracts, and the distribution of growth rates in the world economy converges
toward a zero growth rate in the ratio of capital to e¢ ciency unit of labor, but
a growth rate of out put per capita at a rate of :

γ kt
n +δ
1+ n
sf (kt )
(1 + n)kt
kt ≡ K t / At Lt
k

ξ t ( kt )
kt
k

ξt +τ (kt +τ )

kt +τ
kt k

Figure 3.14. Convergence

The distribution of growth rates of k and thus y across countries

converge to the growth rates that characterize all economies in
their steady-state equilibrium.
Oded Galor 50

In addition, the ratio between the levels of income per capita of rich and
poor economies would gradually decline in the growth process as they converge
to a steady-state with a constant growth rate of income per capita. However,
although the initial gap in the levels of income per capita will be narrowed

in the transition to a steady-state equilibrium, since economies convergence to

the same rate of economic growth in the long-run, an earlier arrival to this
long-run equilibrium by richer economies, would sustain the remaining gap in

income per capita once the long-run equilibrium is reached by all economies.
Hence, in the long-run, despite the forces of convergence, the remaining gap in
income per-capita will persist and will remain constant over time. In particular,
suppose that each of the economies experience an exogenous rate of technological
progress at a rate of and suppose that the distribution of the ratio between
capital and e¢ ciency units of labor across countries in the world in time t is
given by the function t (kt ); as depicted in the middle panel of Figure 3.15.
Over time, as economies converge towards their steady-state equilibrium, k; the
variance of the distribution gradually declines, and after period , as depicted in
the bottom panel of Figure 3.15, the support of the distribution contracts, and
the distribution converges towards k = Kt =At Lt ; where income per e¢ ciency
units of labor is constant but rate of output per capita grows at a rate of :
Oded Galor 51

kt +1 kt +1 = kt

φ ( kt )

kt ≡ K t / At Lt

ζ t ( kt ) kt

ζ t +τ (kt +τ )
kt +τ
kt k

Figure 3.15. Convergence

The distribution of income per capita across countries converge in their

transition to a steady state equilibrium. However, once the steady-state
is reached, the remaining disparity in income per capita is maintained
.

The conditional convergence hypothesis has been tested repeatedly on a wide

sample of countries that consists of virtually all countries in the world for which

reliable data is available. Using a large sample of countries, these studies linearly
regressed log per-capita income growth of country i between the years 1960 and
2000 against log per-capita income of country i in the year 1960 „ controlling
Oded Galor 52

for a vector of other factors that may a¤ect economic growth over this period,
Xi;1960 2000 :

ln[(yi;2000 yi;1960 )=yi;1960 ] = + ln yi;1960 + Xi;1960 2000 + i (3.56)

The vector of additional characteristics, Xi;1960 2000 ; included typically, the rate
of population growth, the average education attainment, investment rates, as
well as country speci…c …xed-e¤ects such as institutional, cultural and geograph-
ical factors over the sample period.
These cross country regressions, as depicted for instance in Figure 3.16 pro-
vide evidence in support of the conditional convergence hypothesis, demonstrat-
ing that the coe¢ cient is indeed negative and highly signi…cant.14
1

SDN
Log per capita income growth 1960-2000

KOR

GRC
DOM
.5

THA
PAN IRL
HUN KEN ZWE
MWI TGO
PRT GTM
SGP
CHL
GUYLKAPRY AUS ZAFARG
DZA
SLV
FINNORESP BRA
ECU MYS
COL
BOL
0

HND PNG
IDN
GHA
CRI SYRBEL
PERMEX DNK
SEN URY
PAK TTO ITA
SWENZL AUTFRA JPN
PHL
GBR NLD BGD
SLE HTI
ISR
USA
-.5

NIC NER
IND ZMBZAR LBR
CHE
VEN
-1

-2 -1 0 1 2
Log per capita income 1960
coef = -.26896338, se = .07846831, t = -3.43

Figure 3.16. Conditional Convergence

1 4 This evidence is to a large extent consistent with local conditional convergence as well, as

discussed in section 3.7.

Oded Galor 53

Subsequent research examines the hypothesis over the same time period in
the context of a panel of countries, providing further support for the conditional
convergence hypothesis. However the empirical methodology that has been
employed have been persistently challenged, underlining signi…cant endogeneity

issues, and measurement errors in this speci…cation that may invalidate the
…ndings.15

3.6 Endogenous Growth

This section explores the economic characteristics that a¤ect the growth rate
of the economy in the long-run. In light of recent development in the …eld of
endogenous growth theory, the basic neoclassical growth model is augmented
with some of the mechanisms that were proposed in this literature, generating
sustained economic growth that, in contrast to the process driven by exogenous
technological progress, can be linked to the structural parameters of the model.
The declining rates of economic growth in the basic neoclassical growth
model re‡ect the declining marginal productivity of capital as the capital-labor
ratio increases in the process of development. Hence, growth in the steady-
state requires that the production function at least asymptotically will not be
subjected to diminishing returns. The various mechanisms that were proposed
in order to generate sustained economic growth in the steady-state have changed
the structure of the neoclassical production function directly, or indirectly via
technological progress, so as to generate non-diminishing marginal productivity
of capital and thus growth in the steady-state.
1 5 Duraluf and Quah (1999) provide a comprehensive discussion of the new empirics of

economic growth, underlying some the methodological de…ciencies of this approach, local
versus global conditional convergence, club convergence, and tendency towards bimodality in
the evolution distribution of income across the world.
Oded Galor 54

3.6.1 The AK Model

The crudest mechanism that was proposed is the AK Model. This model simply
postulates that the production function is linear in the stock of capital, or in
the capital-labor ratio. While it generates growth in the steady-state it neglects
the attractive features of the neoclassical growth model that have generated the

conditional convergence hypothesis.

The Ak model is commonly viewed as a stepping stone in the construction
of a realistic growth model that could capture the main growth features of ad-
vanced economics in the modern world. It is refuted by the data and it should be
viewed as a useful pedagogical devise in the development of the understating of
the type of mechanisms that are needed in order to generate sustained economic
growth, while maintaining the attractive feature of conditional convergence.
The origin of this production function can be traced to the era that preceded
the renaissance in the …eld of economic growth in the 1980s. Nevertheless, this
early use has not been linked to the issue of the lack of sustained economic
growth in the neoclassical growth model.

Production

Suppose that the production function is of the form

Yt = ALt kt ; (3.57)

where A is a constant technological parameter that is bounded from below:

n+
A> : (3.A3)
s

Thus, output per worker produced at time t is linear in kt , i.e.,

yt = Akt : (3.58)
Oded Galor 55

Perpetual Growth

The time path of the capital-labor ratio as established in equation (3.13) for
any level of output per capita yt is therefore

sAkt + (1 )kt
kt+1 = (kt ); (3.59)
1+n

where as follows from Assumption 3.A3

(0) = 0;

0 (1 )+sA (1 )+n+
(kt ) = 1+n > 1+n = 1;

00
(kt ) = 0;

Hence, (kt ) is linear in kt ; and as depicted in the top panel of Figure 3.17,
for every initial condition k0 > 0; the economy is in a state of perpetual growth.
In particular, as follows from (3.34) and depicted in the bottom panel of Figure
3.17,

sf (kt ) (n + )kt sA (n + )
kt = = k (s; n; ) > 0: (3.60)
(1 + n)kt 1+n
Oded Galor 56

kt +1
φ ( kt )
kt +1 = kt

kt

sA
(1 + n)

γk
n +δ
1+ n

kt

Figure 3.17. Economic Growth in the Ak Model

Oded Galor 57

Proposition 3.10 Let the rate of growth of the capital-labor ratio between time
t and time t + 1, be kt ; then in the Ak model

@ k
@kt = 0;

@ k A
@s = (1+n) > 0;

@ k sA+(1 )
@n = (1+n)2 < 0;

@ 1
@
k
= 1+n < 0:

The main virtue of the Ak Model is that it generates a perpetual economic

growth in the steady-state that is linked to the parameters of the model. In
particular, unlike the neoclassical growth model with exogenous technological
progress, in which these factors has no e¤ect on the growth rate in the steady-
state, in the AK model, the parameters of the model (i.e., n; s; and ) a¤ect the
rate of economic growth in the steady-state.
In line with the direction of the e¤ects of parameters of the model (i.e., n; s;
and ) on transitional growth in the basic framework, the AK model generates
the predictions that: (a) an increase in the rate of population growth or capital
depreciation decreases the growth rate in the steady-state equilibrium, while
(b) an increase in the savings rate increases the growth rate in the steady-state
equilibrium. These predictions are consistent with correlations between these
variables that are observed in the data.
Nevertheless, the advancement of the Ak model is associated with several
unattractive features. In particular, the model is incompatible with the cross-
section evidence that supports the conditional convergence hypothesis (either
locally or globally). In contrast, the Ak model predicts that among countries
that are similar in their structural characteristics, the growth rate will be similar
and existing gaps in income per capita and growth rates between economies
Oded Galor 58

will be sustained over time. Moreover, contractually, the model predicts that
countries that di¤er in their structural characteristics (e.g., in their saving rates)
will experience di¤erent growth rates and will thus inde…nitely drift apart in
their income per-capita.

Hence, while the Ak model is successful in generating sustained economic

growth that is a¤ected by the structural characteristics of the model, its incom-
patibility with the conditional convergence hypothesis has diminished its value

and minimized its role the …eld of economic growth to merely a pedagogical
devise.

3.6.2 Modi…cation of the Upper Boundary Condition

In light of the failure of the Ak model to generate conditional convergence,

attempts have been made to integrate the virtues of the neoclassical growth
model, and its compatibility with the conditional convergence hypothesis, with
that of the Ak model and its compatibility sustained economic growth in the
long-run.
As suggested correctly by Jones and Manuelli (JPE 1990), if the neoclas-
sical production technology will feature Ak properties in the limit (i.e., non
decreasing returns to capital as the level of capital approaches in…nity), then

this hybrid production technology would capture the virtues of the neoclassical
growth model as well as the Ak model and would capture transitional growth
as well steady-state growth.

Suppose that the neoclassical features of the production technology satisfy

Assumption 3.A2 except for the boundary condition that requires that the
limkt !1 f 0 (kt ) = 0: Suppose instead that this limit is bounded from below
by (n + )=s; i.e.,
n+
lim f 0 (kt ) > : (3.A4)
k!1 s
Oded Galor 59

It follows that the evolution of the capital-labor ratio is given by the dynam-
ical system kt+1 = (kt ), where, noting Assumption 3.A4, (kt ) satis…es the
properties stated in Proposition 3.1, except for the upper boundary property:

0 (1 ) + sf 0 (kt ) (1 )+n+
lim (kt ) = lim > = 1: (3.61)
kt !1 kt !1 1+n 1+n

Thus, as depicted in the top panel of Figure 3.18, the economy does not
converge to a steady-state equilibrium in the level of the capital-labor ratio and

thus in the level of income per capita. The economy’s capital-labor ratio grows
at a positive rate, declining asymptotically to a positive steady-state level, k.

In particular, the growth rate of the economy, kt , as derived in (3.34) and

depicted in Figure 3.18, is

sf (kt ) n+
kt = = k (kt ): (3.62)
(1 + n)kt 1+n
As established in equations (3.35) and (3.36), [sf (kt )=(1 + n)kt ] decreases
in k and the limkt !0 [sf (kt )=(1 + n)kt ] = 1. However, using L’Hospital Rule,
noting Assumption 3.A4,

sf (kt ) n+ sf 0 (kt ) n+
lim k (kt ) = lim = lim > 0: (3.63)
kt !1 kt !1 (1 + n)kt 1 + n kt !1 1 + n 1+n

Thus,
lim k (kt ) = k (s; n; ):
kt !1
Oded Galor 60

kt +1
φ ( kt ) kt +1 = kt

kt

sf (kt )
(1 + n)kt

γ kt
n +δ
1+ n

kt

Figure 3.18. Steady-Sate Growth

limkt !1 f 0 (kt ) > (n + )=s > 0

Oded Galor 61

Thus, the modi…cation of the upper boundary conditions on the production

technology f (kt ) enables the model to capture conditional convergence as well
sustained economic growth in the long-run. Nevertheless, this hybrid generates
a major inconsistency with empirical observations that is present in the Ak

model as well. It suggests that the share of capital in income per capita, t;

approaches 1 as the capita labor ratio approaches in…nity. Namely,

f 0 (kt )kt
lim t lim = 1: (3.64)
kt !1 kt !1 f (kt )

Indeed, using L’Hospital Rule, noting Assumption 3.A4

kt 1
lim t = lim f 0 (kt ) lim = lim f 0 (kt ) lim 0 = 1: (3.65)
kt !1 kt !1 kt !1 f (kt ) kt !1 kt !1 f (kt )

Thus, as economies converge to their steady state equilibrium, the growth

rate is sustained due to the fact that the share of capital is approaching 1.
However, most empirical evidence suggests in contrast that the share of capital
is approximately 1/3 across countries in di¤erent stages of their industrial de-
velopment, falsifying the source of perpetual growth in this endogenous growth
model.

3.6.3 Endogenous Technological Progress

The failure of the Ak model as well as the removal of the upper boundary
conditions in generating an empirically viable alternatives to the neoclassical
growth model have ultimately lead to a search for more plausible modi…cations
of the basic models, based on endogenous technological progress, that could
capture the phenomena of sustained economic growth as well as conditional

convergence (locally or globally) without violating the basic properties of the

distribution of income across factors of production.
Oded Galor 62

Production

Consider a perfectly competitive economy in which aggregate output is produced

by a large number of perfectly competitive, pro…t maximizing …rms. Suppose
that the output produced at time t; Yt ; is governed by a neoclassical production
function that is subjected to an endogenous Hicks-neutral technical progress. In

particular,
Yt = At F (Kt ; Lt ) (3.66)

where At is the level of technology at time t:

The aggregate level of technology at time t; At is a positive function the
capital-labor ratio, kt = Kt =Lt ; in the economy as a whole.

At = A(kt ); (3.67)

where,

A(0) = 0;

A0 (kt ) > 0 and A00 (kt ) < 0 for all kt 0;

limkt !0 A0 (kt ) = 1 and limkt !1 A0 (kt ) > 0:

Namely, the capital-labor ratio in the economy (capturing the overall level of
development) permits advances in the technological frontier at a positive but in
diminishing rates. Moreover, this e¤ect remains bound above zero even when
the capital-labor ratio in the economy approaches in…nity.
As follows from the homogeneity of degree one of F (Kt ; Lt ) in (Kt ; Lt );

Yt = At F [Kt ; Lt ] = At F [Kt =Lt ; 1] At Lt f (kt ); (3.68)

where the production function per worker, f (kt ); satis…es Assumption (3.A2).
Thus, the output per worker produced by at time t is

yt = A(kt )f (kt ) g(kt ); (3.69)

Oded Galor 63

where g(kt ) is assumed to be increasing and strictly concave, and it remains

strictly positive when the capital-labor ratio approaches in…nity, i.e.,
g(0) = 0;

g 0 (kt ) > 0 and g 00 (kt ) < 0 8kt 0; (3.A5)

limkt !0 g 0 (kt ) = 1 and limkt !1 g 0 (kt ) > (n + )=s:

The Dynamical System

The evolution of the economy is governed by the time path of the capital-labor
ratio as given by equation (3.13). Thus,

sg(kt ) + (1 )kt
kt+1 = (kt ); (3.70)
1+n

where

(0) = 0;

0 sg 0 (kt )+(1 ) 00 sg 00 (kt )

(kt ) = 1+n > 0 and (kt ) = 1+n < 0 8kt 0;

limkt !0 0 (kt ) = 1:

However, in contrast to the properties of the dynamical system in the neo-

classical growth model,

sg 0 (kt ) + (1 ) (1 )+n+
lim (kt ) = lim > = 1: (3.71)
kt !1 kt !1 1+n 1+n

Thus, as depicted in the top panel of Figure 3.18, the economy does not
converge to a steady-state equilibrium in the level of the capital-labor ratio. The
economy’s capital-labor ratio grows at a positive rate, declining asymptotically
to a positive steady-state level, k. In particular, the growth rate of the economy,

kt , as derived in (3.34) and depicted in Figure 3.18, is

sg(kt ) n+
kt = = k (kt ): (3.72)
(1 + n)kt 1+n
Oded Galor 64

As established in equations (3.35) and (3.36), [sg(kt )=(1 + n)kt ] decreases in

k and the limkt !0 [sg(kt )=(1 + n)kt ] = 1. However, using L’Hospital Rule,
noting Assumption 3.A5,

sg(kt ) n+ sg 0 (kt ) n+
lim k (kt ) = lim = lim > 0: (3.73)
kt !1 kt !1 (1 + n)kt 1 + n kt !1 1 + n 1+n

Thus, the incorporation of endogenous technological progress that is external

to the …rm enables the model to capture the conditional convergence as well

sustained economic growth.

Factor Shares

Moreover, the share capital in total output may be constant over time. Since
all …rms are identical, the aggregate capital-labor ratio in the economy is equal
to the capital-labor ratio in each individual …rm. However, each competitive
…rm is too small to a¤ect the aggregate level of technology. Firms, therefore,
consider the level of technology as independent of their employment decisions.
In particular each …rm chooses the level of employment of capital and labor so
as to maximize pro…ts, taking factor prices, wt and rt; as well as the level of
technology, At ; as exogenously given. Thus,

fKt ; Lt ) = arg max Lt At f (kt ) rt K t wt Lt (3.74)

and the inverse demand for factors of production is therefore:

rt = At f 0 (kt ) = A(kt )f 0 (kt )

(3.75)
wt = At [f (kt ) f 0 (kt )kt ] = A(kt )[f (kt ) f 0 (kt )kt ]

For instance, if the production function is of the Cobb-Douglas type, i.e., if

f (kt ) = kt ; then

A(kt )f 0 (kt )kt f 0 (kt )kt

t = = : (3.76)
A(kt )f (kt ) f (kt )
Oded Galor 65

3.7 Poverty Traps and Local Conditional Con-

vergence

The conditional convergence hypothesis is intimately related to the notion that

each economy is characterized by a unique, globally stable, (non-trivial) steady-

state equilibrium. Hence countries that are identical in their fundamentals (and
therefore in their dynamical systems) converge towards one another regardless
of their initial conditions. Transitory shocks in this scenario may a¤ect relative
economic performance only temporarily.
In contrast, if the inherent features of the each economy generate a dynamical
system characterized by multiple locally stable steady-state equilibria, a quali-
tatively di¤erent hypothesis would emerge. That is, countries that are similar
in their structural characteristics converge to the same steady-state equilibrium
if their initial per capita output levels are similar as well. Transitory shocks in
this scenario may a¤ect the economic performance of a country permanently.
As will become apparent, the introduction of empirically plausible features
into the neoclassical growth model could generate multiplicity of locally stable
steady-state equilibria and thus local, rather than global conditional conver-
gence. In particular, multiplicity of locally stable steady-state equilibria could
emerge if the economy is characterized by local increasing returns to scale,
credit market imperfections (Galor and Zeira (1993), heterogeneity in income
and human capital, subsistence consumption constraint (Galor and Weil, 2000),
comparative advantage within the household (Galor and Weil, 1996), saving as a
fraction of wage income (Galor and Ryder, 1989, Galor 1992, and Galor, 1996).
This section develops a simple mechanism the could generate within the neo-
classical growth framework either multiple locally stable steady-state equilibria,
or non-monotonic evolution of the growth rates in the process of development,
leading to local conditional convergence, and thus convergence clubs, rather
Oded Galor 66

than global conditional convergence.

3.7.1 The Transition for an Old to a Modern Industrial

Technology

Consider a perfectly competitive economy in which output is produced by a

large number of perfectly competitive, pro…t maximizing …rms. The output

can be produced in either an old industrial sector or if proper technological
infrastructure is developed, in a modern industrial sector characterized by a
superior modern technology.

Production

As long as the modern sector is not operative, the output produced in the old
industrial sector at time t; YtO ; is

YtO = AO F (Kt ; Lt ); (3.77)

where F (Kt ; Lt ) is a neoclassical production technology and AO > 0 is a con-

stant technological parameter: Thus, the output per worker produced in the old
industrial sector at time t, ytO is

ytO = AO f (kt ); (3.78)

where f (kt ) satis…ed Assumption 3.A2.

A superior modern industrial technology becomes available to all competi-

tive …rms in the economy if the government is engaged in a investment in the
technological infrastructure of the economy Suppose for simplicity that cost of
this investment is Lt per period. Namely, the cost associated with the onset

of the modern industrial sector is proportional to the number of workers in the

economy as a whole.16 The payment is …nanced by a lump sum tax rate on all
1 6 The independence of the …xed cost on the scale of employment in the modern industrial

sector assures that once the modern sector is operative, the entire production takes place in
the modern sector.
Oded Galor 67

individuals in the economy and it is paid to foreign nationals (e.g., technicians)

and has therefore no e¤ect of the gross domestic product.
Once the modern industrial sector becomes operative, the output produced
in this sector at time t; YtM ; ; is

YtM = AM F (Kt ; Lt ); (3.79)

where F (Kt ; Lt ) is a neoclassical production technology and AM is a constant

technological parameter; where AM > AO : Thus, the output per worker pro-
duced in the modern industrial sector is

ytM = AM f (kt ); (3.80)

Moreover, since AM > AO ; once the modern industrial sector becomes op-
erative, production takes place only with the modern industrial technology.

The Onset of the Modern Sector

The investment in the infrastructure of the economy required for the operation
of the modern production technology is undertaken by benevolent government
if it will increase aggregate output net of investment costs. Namely,

YtM > 0 if AM f (kt ) > AO f (kt ) (3.81)

Hence, as follows from equation (3.81), and depicted in Figure 3.19, there exists
^ above which production shifts from
a critical level of the capital-labor ratio, k;
the old industrial sector to the modern one.

^ =
f (k) (3.82)
(AM AO )

and therefore
k^ = f 1
; (3.83)
(AM AO )
Oded Galor 68

^ is lower the higher is the tech-

where the threshold level of the capital-labor, k;
nological gap between the two sectors, (AM AO ); and the lower is the per
worker infrastructure cost, .

AM f (k )

AO f (k )

kˆ kt

−µ

Figure 3.19. The Transition for a Old to a Modern Industrial Sector

The Evolution of the Economy

The evolution of the economy is governed by the trajectory of the capital-labor

ratio, fkt g1
t=0 which uniquely determines the time paths of output per worker

fyt g1
t=0 according to their static relationship
8 O
< A f (kt ) if kt k^
yt = (3.84)
: M
A f (kt ) if kt k^

:Following equation (3.13)

Oded Galor 69

8
> sAO f (kt )+(1 )kt O ^
< 1+n (kt ) if kt k;
kt+1 = (3.85)
>
: sAM f (kt ) s +(1 )kt M
(kt ) if kt ^
k:
1+n

Thus, as depicted in Figure 3.20, under additional restrictions on the para-

meters of the model, the dynamical system is characterized by multiple locally
stable steady-state equilibria. In particular, economies whose income per capita

is below the level k U converge to the lower steady-state equilibrium, k L ; whereas

those whose income per capital is above the level k U converge to the higher
steady-state equilibrium, k H ; i.e.,
8
< = kL if kt < k U ;
lim kt (3.86)
t!1 :
= kH if kt < k U

kt +1 = kt
kt +1
φ M ( kt )

φ O ( kt )

kt
kL kU kH

sµ
−
1+ n

Figure 3.20. Poverty Traps: Multiple Locally Stable

Steady-state Equilibria
Oded Galor 70

The introduction of …xed cost associated with the development of the mod-
ern industrial sector generates therefore potential poverty traps and leads to

qualitatively di¤erent testable predictions. In particular, local conditional con-

vergence rather the a global one emerges as the prediction of the model and
the distribution of income across economies in the world converges towards a

bimodal distribution, as depicted in Figure 3.21.17

Labor-augmenting technological progress, as discussed in section 3.6, would
not a¤ect the qualitative nature of dynamical systems and thus the conditions
that lead to the club convergence hypothesis remain intact. However, other
forms of technological progress may transform the system in the long run into
one characterized by a unique globally stable steady-state equilibrium. Never-
theless, provided that for some technological levels the system is characterized
by multiple steady state equilibria, the transition to the long-run steady-state
is associated with non-monotonic evolution of the distribution of income across
countries. Thus, long-run convergence may be preceded by polarization and
clustering, and club convergence will be observed in the short and possibly the
medium run, but not in the very long-run.
The existence of perfect international capital movements eliminates the im-
portance of initial conditions in neoclassical growth models in which the evolu-
tion of the economy is dictated uniquely by the evolution of the capital-labor
ratio.18 Thus, in light of the presence of some movements of capital across
countries, one may view this observation as an element that weakens the club
convergence hypothesis.19 However, in more realistic settings, where the evo-
1 7 Moroever, even if the parameters of the model do not generate multiple locally stable

steady-state equilbria, the growth rate of ecoonmies is not inversely related to their levels of
steady-state equilibria.
1 8 However, if the production function exhibits locally increasing returns to scale, then a

single interest rate may be associated with several wage rates and, despite perfect capital
mobility, economies may experience persistent di¤erences in output per capita.
1 9 One may argue however that in light of the arguments raised by Lucas (1990) this e¤ect
Oded Galor 71

lution of the economy is based upon the evolution of human capital as well as
physical capital, international movements of capital will not resolve the depen-
dency of an economy on initial conditions with respect to human capital. In
particular, in light of imperfect mobility of educated individuals across countries

club convergence would emerge as a viable and plausible hypothesis.

3.7.2 The Conditional Club Convergence Hypothesis

Thus minor perturbations of the fundamental structure of the neoclassical growth

model would lead the club convergence hypothesis.

Proposition 3.11 (The Club Convergence Hypothesis). Among countries that

are:
(a) similar in their structural characteristics (e.g., production technologies,
the rates of technological progress and capital depreciation, population growth,
saving rates, government policy, etc.),
20
(b) similar in their current levels of income per capita

one would observe two forms of convergence:

Proposition 3.12 converge:

The lower is the level of income per capita the higher is the growth rate of
income per capita.

convergence:

(i) The distribution of income per capita across countries contracts over
time.
is not very signi…cant.
2 0 Clearly, similarity in current levels of income per-capita” requires further re…nement in

the context of the empirical implementation. Countries that are close to one another and
are on di¤erent sides of an unstable steady-state equilibrium diverge from one another. A
more precise, but somewhat less tangible de…nition would refer to countries with similar
fundamentals that belong to the same basin of attraction of a given steady-state equilibrium.
Oded Galor 72

(ii) The growth rates converge over time

kt +1
kt +1 = kt

φ ( kt )

kt
kL kU kH

ζ t ( kt ) kt

ζ t +τ (kt +τ )
kt +τ
kL kU kH

Figure 3.21. Club Convergence

This hypothesis has been tested by Durlauf and Johnson (1995), as well
others, who have searched for the presence of local conditional convergence in
the data that was used in order to established global conditional convergence.
Using the method of regression tree analysis that determines whether the …t
of the data to the regression line could be improved by an endogenous split
in the sample they …nd the sample over the period 1960-1980 supports the
club convergence hypothesis and refutes the conditional convergence hypothesis.
This debate, however, has not been resolved.
Oded Galor 73

Moreover, the club convergence hypothesis is consistent with the …ndings of

Quah (1997). Tracing the dynamics of the unconditional distribution of income
across countries , Quah …nds signi…cant evidence in favor of the evolution of
the world income distribution towards a twin-peak distribution. This apparent

con…rmation of club convergence, however, may merely re‡ect the formation

of clubs based on di¤erences in structural characteristics, rather than on dif-
ferences in their income per capita among countries similar in their structural

characteristics. Stronger evidence in support of the club convergence hypoth-

esis are provided by Canova (2004) who detects the emergence of a bimodal
distribution even among region in Europe that could be viewed as relatively
similar in their structural characteristics.
Nevertheless, the quest for an empirical determination of the forces that have
contributed to the existence of multiple growth regimes and the emergence of
convergence clubs, although central for the understating of the process of devel-
opment, has not been universally shared by researchers in the …eld of economic
growth.21 Contributors to the empirical literature on multiple growth regimes
have faced an increasing challenge of motivating their …ndings in the context
of growth models that are widely perceived as plausible. The dominating ten-
dency to rationalize and interpret these empirical explorations in the context
of growth models characterized by multiple long-run equilibria, and thus, con-
vergence clubs, based on initial conditions has been confronted by skepticism
that has undermined this important endeavor and has deprived it from a cen-
tral place in the growth literature.22 If indeed there exists a threshold level of
development that poor economies ought to surpass in order to join the club of
2 1 Growth non-linearities and convergence clubs were explored theoretically by Galor and
Ryder (1999), Azariadis and Drazen (1990), Galor (1992), and Galor (1996), and empirically
by Durlauf and Johnson (1995), Quah (1997), Durlauf and Quah (1999), Feyrer (2008), among
others.
2 2 A notable exception is Durlauf and Johnson (1995) who provide a broader interpretation

that includes, in addition to multiple long-run equilbria, a world characterized by a unique

long-run equilibrium, but di¤erent stages of development.
Oded Galor 74

the rich, and if this threshold is insurmountable in the absence of an exogenous

shock, then how did the rich economies in today’s world surpass this thresh-
old in the distant past when their level of development was similar to the one
experienced by those countries that are in poverty traps today?

Uni…ed Growth Theory (Galor, 2005, Galor and Weil, 2000, Galor and Moav,
2002) provides a fundamental framework of analysis that uncovers the forces
that contributed to the existence of multiple growth regimes and the emergence

of convergence clubs. Furthermore, it sheds light on the characteristics that de-

termine the association of economies with each of the clubs. The theory suggests
that, although the long-run equilibrium may not di¤er across economies, di¤er-
ential timing of takeo¤s from stagnation to growth would segment economies
into three fundamental regimes that di¤er in their growth structure: slow grow-
ing economies in the vicinity of a Malthusian regime, fast growing countries in
a sustained growth regime, and a third group of economies in the transition
from one regime to another. Convergence clubs, therefore, may be temporary,
and endogenous forces would permit economies to shift from the Malthusian
Regime into the sustained growth regime. Consistently with contemporary
evidence about the existence of multiple growth regimes and non-linearities in
the evolution of growth rates, the di¤erential pace of transition from stagnation
to sustained economic growth across countries suggests that in any time period
in which the transition has not been completed across the globe, there exists
variation in the position of economies along the distinct phases of development.
Economies would be segmented into three fundamental groups. Two conver-
gence clubs of rich and poor economies and a third group of countries in the
transition from one club to another.23 Importantly, this segmentation does not
2 3 Technological leaders largely experience a monotonic increase in the growth rates of their

per capita incomes along the process of development. Their growth is slow in early stages
of development, it increases rapidly during the take-o¤ from the Malthusian epoch, and it
continues to rise, often stabilizing at higher levels in the sustained growth regime. In contrast,
technological followers that made the transition to sustained economic growth more recently
Oded Galor 75

re‡ect the long-run steady state of these economies, as would be implied by

models characterized by multiple steady-state equilibria. Rather, it is a repre-
sentation of variation in the timing of the escape from a Malthusian trap and
thus in the position of countries along the growth trajectory from Malthusian

epoch to sustained economic growth.

In contrast to existing research that links membership in each of the clubs
and the thresholds that permit economies to switch from one club to another,

to critical levels of income and human capital, Uni…ed Growth Theory suggests
that they are in fact associated primarily with critical rates of technological
progress, population growth and human capital formation. The theory suggests
that two major transformations in the growth process determine the thresh-
olds between the club of the slow growing economies, countries in a transition
from one club to another, and the club of the fast growing economies. The
…rst threshold is associated with a rapid increase in the rates of technological
progress and population growth, and the second with a signi…cant rise in human
capital formation along with a rapid decline in population growth. Variations
in the levels of income, human capital, and population growth across countries,
in contrast, would not be indicative of these thresholds, and would only re‡ect
the country-speci…c characteristics (e.g., geographical factors and historical ac-
cidents and their manifestation in the diversity of institutional, demographic,
and cultural factors, as well as in trade patterns, colonial status, and public
policy) rather than the actual stage of development.24
experience a non-monotonic increase in the growth rates of their per capita incomes. Their
growth rate is slow in early stages of development and it increases rapidly during their take-
o¤ from the Malthusian epoch, boosted by the adoption of technologies from the existing
technological frontier. However, once these economies reach the technological frontier, their
growth rates drop to the level of the technological leaders.
2 4 For instance, although during the 18th century education levels were signi…cantly lower

in England than in continental Europe, England was the …rst to industrialize and to take
o¤ towards a state of sustained economic growth. Similarly, the demographic transition that
marked a regime switch to a state of sustained economic growth occurred in the same decade
across Western European countries that di¤ered signi…cantly in their income per capita.
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