In the Solow growth model, dimishing returns to capital per worker has important implications for growth dynamics. Dimishing returns to capital means that capital accumulation cannot be a source of constant growth. As more capital per worker is accumulated, the additional output produced decreases, while the output required to cover capital depreciation and to equip new workers with capital constantly increases. Eventually any given investment rate will become sufficient only to cover capital depreciation and the capital needs of new workers. Thus investment will not contribute to increasing output.
The investment rate, along with the workforce growth rate, determine the level of the sustainable growth path. An increase in the investment rate will shift the sustainable growth path upwards. For a given investment rate, a reduction in the workforce growth rate will also shift the sustainable growth path upwards. In the chart above, an increase in the investment rate or a decrease in the workforce growth rate shifts the growth path upward from growth path 1 to growth path 2.
While an increase in the investment rate or a decrease in the workforce growth rate can create a limited period of rapid growth, the rate of technical progress determines the sustainable growth rate. An increase in the investment rate or a decrease in the workforce growth rate can create rapid growth as the economy shifts to a higher growth path. For example, rapid growth occurs during the transition from growth path 1 to growth path 2 in the above chart. However, the rate of growth along a sustainable path depends only on the rate of technical progress. Thus to create a permanent increase in economic growth, the rate of technical progress has to rise.
An important issue is the extent to which growth in the high performance East Asian economies represents a transition between growth paths and the extent to which it represents an increase in the sustainable growth rate. The sharp increases in savings and investment rates and the reductions in the workfore growth rates are consistent with an upward shift of the growth path and a temporary increase in the growth rate. The relatively low rate of technical progress in the high performance East Asian economies raises concern that the sustainable growth rate may be significantly lower than this transitional growth rate. The Soviet growth experience provides a warning about how the returns from capital accumulation can be exhausted. A key policy challenge in the high performance East Asian economies is to ensure the development of institutions that promote ongoing technical progress and sustainable growth.
Economic Growth in East Asia