Basic Neo-Classical Growth Models

Abstract

The models of aggregate economic behavior that represent short-period analysis demonstrate that the necessary condition for full employment is that the level of investment generated in an economy be offset by the volume of saving made at the full employment income. This conclusion is based on the assumption that the labor force and the productive capacity of a given economy are fixed. In the short run these assumptions are realistic but labor force as well as productive capacity change over time. Population may be increasing and therefore what is full employment today may not be full employment tomorrow. Secondly, investment in a given year adds to the productive capacity of the economy thereby increasing its potential output. It is this dual aspect of investment (i. e. investment on the one hand offsetting saving and on the other increasing productive capacity) that is central in theories of economic growth. A second reason why productive capacity might increase is technical progress. Improvements in technology bring about increases in the efficiency of the factors of production thereby raising potential output.