Answer to Question #317769 in Macroeconomics for Shaan

Question

Show how the Romer model exhibits a scale effect in levels, that is, a larger economy will

be a richer economy. Give the demand and supply effects. Explain the two opposing effects

of SR on per capita output.

Answer 1

The three key elements of this model, namely externalities, increasing returns in the production of output and diminishing returns in the production of new knowledge. According to Romer, it is spillovers from research efforts by a firm that leads to the creation of new knowledge by other firms. The Romer Model's central premise is that growth of knowledge is cumulative. New knowledge builds on past knowledge. This is what makes knowledge (or ideas) different from physical capital. The way in which knowledge provides a foundation for the production of future knowledge is inherently non-rival. A higher saving rate does result in a higher steady-state capital stock and a higher level of output. The shift from a lower to a higher steady-state level of output causes a temporary increase in the growth rate. In some newer theories of growth, a higher saving rate may permanently raise the rate of economic growth.