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Endogenous Growth Theory

Posted: Monday, 18 August, 2014. | By: Equipoise Bot

The endogenous growth theory argues that economic growth is generated from within a system as a direct result of internal processes. More specifically, the theory notes that the enhancement of a nation's human capital will lead to economic growth by means of the development of new forms of technology and efficient and effective means of production.

The Basic Model  
Consider a simple production function:
Y=AK
where Y is output, K is the capital stock, and A is a constant measuring the amount of output produced for each unit of capital. This production function does not exhibit the property of diminishing returns to capital. One extra unit of capital produces A extra unit of output. Assuming ‘s’ to be the fraction of income saved and invested, the capital accumulation equation can be written as:

Combining this with Y=AK, we obtain
The factor forms the growth rate and as long as sA>the economy’s income grows forever even without the assumption of exogenous technological progress.

Endogenous Vs Exogenous growth theory
In neo-classical growth models the long run growth is exogenously determined. In Solow model savings leads to temporary growth, but diminishing returns to capital eventually force the economy to return to the steady state in which growth depends on exogenous technological growth. However, the savings rate and rate of technological progress remain unexplained. Endogenous growth theory tries to overcome this shortcoming by building macroeconomic models out of microeconomic foundations. Households are assumed to maximize utility subject to budget constraints while firms maximize profits. Crucial importance is usually given to the production of new technologies and human capital. The engine for growth can be as simple as a constant return to scale production function (the AK model) or more complicated set ups with spill over effects (spillovers are positive externalities, benefits that are attributed to costs from other firms), increasing numbers of goods, increasing qualities, etc.

Implications

Endogenous growth theory economists believe that improvements in productivity can be linked to faster pace of innovation and extra investment in human capital. They stress the importance of policies which embrace openness, competition, change and innovation.

Hyperinflation
Hyperinflation is the condition where inflation in a country is very high or out of control.In this condition, the real prices of goods stay stable in terms of foreign exchange but the nominal price in that country increases at a very high rate owing to sharp drop in the value of the currency. Theoretically Hyperinflation is said to have arrived when a cumulative inflation of 100% occurs in three years which boils down to 26% annual inflation rate for three consecutive years. Inflation exceeding 50% per month is also called Hyperinflation.
Hyperinflation also occurs when there is an uninterrupted increase in money supply accompanied by unwillingness of people to hold on the money for fear of further value erosion. It is generally associated with wars, currency meltdown or political upheavals.

Characteristics

  1. People prefer to keep their wealth in non-monetary assets or foreign currency. Local currency is immediately invested to buy goods.
  2. Sales and purchase on credit take place at adjusted prices that would compensate for the credit period.
  3. Interest rates, wages and prices are linked to Price Indices.

Causes of Hyperinflation

  1. The primary reason for the emergence of Hyperinflation in an economy is a huge disparity existing between demand and supply of a specific type of money. Such disparities normally arise when very little confidence is left on that particular currency, parallel to a bank run.
  2. Excess printing of paper currency is considered to be one of the principal causes of Hyperinflation. This is simply because printing of paper notes is much easier than other forms of currency.
  3. Hyperinflation may as well affect the economy of a country, due to lack of central banks.Owing to lack of central banks, the process of "independent banking"goes on within the country full-fledged. This kind of banking is curbed by the government by permitting a handful of banks to postpone their convertibles, on the ground of violating both the hard-core and absolute contracts and promises made by them to the government.

Instances of Hyperinflation
There have been many instances of hyperinflation in history. Four of the worst hyperinflation examples are following:

Germany(1922-23)
In 1922,the highest denomination in Germany was 50,000 marks which became 1014marks in 1923. In December 1923, the exchange rate was 4.2 * 10^12marks per $ whereas the inflation was 3.25 * 10^6 % per month. Prices doubled every 2 days.

Hungary(1945-46)
The highest denomination in 1944 was 1000 pengo which became 2×10^21pengo at the peak. The inflation rate was 1.3 × 10^16 % per month.This is the worst case of hyperinflation ever recorded. Prices doubled every 15hours.

Yugoslavia(1989-94)
The peak inflation hit 5 × 10^15 % cumulative and many currency revisions were done. Prices doubled every 1.4 days.

Zimbabwe(2004-07)
The rate of inflation in 2004 was 624% which climbed to 7× 10^108 % yearly in 2007. Prices doubled every 24.7 hours. Zimbabwe Central bank issued a Zimbabwean $ 100 trillion banknote in 2007. In early 2008, the Zimbabwean $ was actually suspended and trading was mostly done in foreign currencies.

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