Can someone please explain the Neo growth theory diagram on page 18 of Schweser to me?Just don’t seem to get it…
you have to look at the big picture here. the key is that population doesn’t matter like it does for the classical growth theory (eg technology increase results in wage increase, leading to diminishing returns for labor, decreased labor productivity). the determining factor for economic growth is the real interest rate vs the required rate of return. for neoclassical growth theory, the economy will keep expanding from technology advances until the real interest rate is less than the required rate of return. this makes sense because once the required return is greater than real interest rates, there’s no point in saving any more, which reduces technology and growth in the economy. enter the graph. required rate of return = slope of line tangent to productivity curve where economy is currently producing real interest rate = slope of line tangent to productivity curve where economy will produce if technology increases and labor productivity goes up since the shape of the productivity curve accounts for diminishing returns to labor (ie it flattens out as capital per labor hour increases), if labor productivity increases, the slope of the line tangent to the new productivity curve (which is higher than the original due to the technology increase), will be greater than the slope of the line tangent to the original productivity curve, thus indicating that real interest rates are greater than the required rate of return. since real rates > required return, people will save money, resulting in an increase of capital per labor hour. this moves the economy ALONG the productivity curve, to a point where the slope of the line tangent to this new point on the curve (point 3 in the book) is equal to the slop of the line tangent to the original productivity curve. here real rates = required return, people don’t save any more, capital per labor hour stays constant and the economy stops growing.
I studied this today, so i should be able to help if i do remember what I studied. Firstly, i think this question is unimportant, cuz i also learnt today that there are only 120 questions and neoclassical growth theory can’t be big enuf of a topic in economics to have a vignette for so i am not going to pay much attention to it. But if you must, heres my explanation: The diagram is simply saying this: move from point 1 to point 2 first. This happens due to technological advancement by basic R&D. productivity curve shifts. move from point 2 to point 3. movement along the curve happens only cuz more capital per hour is added. And how are you able to add more capital per hr? because when you arrived at poitn 2 from poitn 1, the economy grew. the growth in economy in turn brought better wages and prosperity to invest in capital. So essentially graph is saying that when you are at point 2, you still have incentives to save and invest and grow the economy cuz real interest rate is much higher than what you desire as a return. And so you say let’s save. So you continue to save, but how long before you stop saving? well when you are at point 3. the rate of return you want is same as the rate of return u get from savings. so now savings stagnate or declines, ie. in return lowering the effective expenditure on technological advances or R&D. now you are stuck at point 3. game over. Let me know if you have any questions or if i am wrong, i’d like to get this in my head right atleast 