Welcome to the last video, which presents the neoclassical economic view of growth. In this video I will present two neoclassical growth theories, the standard one and one called, without much creativity, the new growth theory. Both neoclassical growth theories are important for understanding debates about economic policy and economic development. The theories are central, for example, in discussions about whether the market should be leading or whether the government should actively promote growth. In neoclassical economics, it is the supply side of the economy which drives growth through aggregate supply, AS. Economic growth is simply a function of capital K and labor L. The more of each, the higher GDP. In the short run, just as with diminishing marginal utility, the returns to these production factors K and L are decreasing. This means that for every addition to the capital stock, such as more laptops for workers, the growth effect is less. The same counts for labor use. This characteristic of neoclassical growth theory leads to a much debated prediction about growth of real world economies, namely the prediction of growth convergence. This means that richer and faster growing countries will have lower and lower economic growth rates over time. So the UK will never experience the growth that it had mid-20th century. And China will never achieve its 10% rate anymore. Why not? Because the last added capital item, or worker, is always less productive than the previous added one. So they contribute less to growth, but they cost the same as the previously added units of capital and labor. In the long run, new technology and increases in human capital result in more productivity even with the same size of K and L. So whereas in the short run, an economy grows by building more factories and hiring more workers. In the long run, the economy grows through innovation, for example, by having robots producing goods in factories directed by highly educated workers sitting in neat offices. So what can a government do to promote growth? The answer by a neoclassical economist is that in the short run, you should simply expand the stock of capital K and hire more workers, L. For the long run, the answer by a neoclassical economist is that it can do nothing. Why not? Because the positive shocks of technology and human capital are not systematic, but random. You cannot plan this, but simply hope that the market will generate useful innovations such as robots, and skills courses to work with them. Unfortunately, standard neoclassical growth theory has no mysterious x factor. It's all simply K and L, and waiting for innovations that make K and L more productive. The diagram on the slide shows two growth curves. First, look at the axis. On the horizontal axis, we see K over L, capital output ratio. On the vertical axis, we see Y over L, the output per unit of labor, which shows the labor productivity. The curves have a positive slope, but they are decreasing, showing decreasing returns to capital. Moving along a curve shows short run growth which is gradual, and less and less over time with more capital. It's like climbing a ladder, getting higher step by step, but slower and with more difficulty the higher you get. The red curve shows that the economy has experienced a positive shock of new technology and is now on a higher growth trajectory. The positive shock is like the invention of the steam engine or the computer. It is as if the economy has taken a leap forward or as if someone jumped from one curve up to the next, a higher placed one. If we agree that we cannot plan positive shocks, the only policy that would support growth in neoclassical theory is a policy that gives as much space to the market as possible to generate technological innovations. Also, to stimulate workers to get more training and parents to invest in their children's education to get higher wages. Such policies are generally known as neo-liberal policies, and in developing countries as structural adjustment policies or SAPs. They consist of a core set of six policies. Fiscal discipline, with lower taxation and lower government spending, so that firms have more money available to invest in capital and labor. Labor market flexibilization leading to more supply, as was discussed in week six, the abolition of minimum wages and less labor regulation. Privatization of state-owned companies, to generate more competition for these firms. Flexible exchange rate and open capital markets, to attract foreign investments from the rest of the world. Deregulation of domestic markets, generating more competition between firms through less bureaucracy. And finally, trade liberalization, not only to generate more exports but also more imports in order to force domestic firms to produce cheaper than foreign firms. Now, have SAPs been successful? To be honest, not really. The results are mixed. Many countries were forced from the 1980s onwards by the World Bank to follow theses policies in exchange for loans. But economic growth has remained low or even absent. While at the same time in countries that did not have SAPs, economic growth was high, such as in China and India. So what was the lesson learned? The lesson was a new growth theory. First, we got structural adjustment policies were not so successful. And second, because the prediction that high growth countries would see their growth go down and low growth country would see their growth go up, as in a process of convergence, did not come true. There is no growth convergence in the world. Some countries do well for a long time. Others don't do well for a long time. And many move up and down between low and high growth. The convergence idea appeared to be a utopia. So the solution is that a new growth theory adds context in particular institutions. And it adds endogeneity, changes from within, as in post-Keynesian economics. These two insights from institutional economics and post-Keynesian economics help to explain productivity growth of both K and L. In other words, neoclassical economists realized that the quality of growth matters too. This has led to a new neoclassical growth equation, in which growth is not only a function of the size of K and L, but also of the quality of capital expressed as T from technology, and the quality of labor expressed as H from human resources. So the change in Y growth is a function of capital and technology, and a function of labor and human resources. The addition of T and H allows for a move from decreasing returns to increasing returns. And this is where the x factor comes into neoclassical economics. It consists of the qualitative features of capital and labor, T and H. This final slide shows the production function of the new growth theory with increasing returns. As you will see, it's no longer limited to the decreasing returns part that we see beyond point D. That only comes after all growth opportunities at a certain level of technology and human resources have been exhausted. First comes the part up to point A with increasing returns, resulting in high growth rate. Then the part up to point B of constant returns, where growth slows down to become constant. And only then, in the last part beyond B, growth suffers from decreasing returns to capital. But by then, hopefully, a new technology shock will arrive to move the economy up to a higher plateau. And the cycle will start all over again at a higher level of income. Why? As you will have noted, neoclassical economists are optimists, hoping for free markets to stimulate the innovations that will spur growth. I suggest that we take some of this optimism with us, and realize that we have reached 80% of the course by now. The next video introduces the key macroeconomic topic of trade. For those using the course book, note that this is not the next chapter, but chapter 14. We will get to chapter 13 in week 8. So I hope to see you back in the video lectures about trade.