The neo-classical model of growth
was first devised by Robert Solow. The model believes that a sustained increase
in capital investment increases the growth rate only temporarily. This is
because the ratio of capital to labour goes up (there is more capital available
for each worker to use) but the marginal product of additional units of capital
is assumed to decline and the economy eventually moves back to a long-term
growth path, with real GDP growing at the same rate as the workforce plus a
factor to reflect improving “productivity”.
A "steady-state growth
path" is reached when output, capital and labour are all growing at the
same rate, so output per worker and capital per worker are constant.
Neo-classical economists believe that to raise an economy's long term trend
rate of growth requires an increase in the labour supply and an improvement in
the productivity of labour and capital. Differences in the rate of
technological change are said to explain much of the variation in economic
growth between developed countries.
The neo-classical model treats productivity
improvements as an "exogenous variable
meaning that productivity is assumed to be independent of capital investment
(IMF, 2001). According to Nnanna, Englama, and Odoko (2004), based on Solow’s
analysis of the American data from 1909 to 1949, he observed that 87.5% of
economic growth within the period was attributable to technological change and
12.5% to the increased use of capital.
The result of the growth model was that
financial institutions had only minor influence on the rate of investment in
physical capital and the changes in investment are viewed as having only minor
effects on economic growth.