Economic growth has been a key area of study for Economists. Various models and theories have been developed to explain how and why economies flourish; notably, Adam Smith’s idea that growth arises from the division of labour. By simplifying multistage tasks into smaller, simple components, one can accomplish it quickly. Workers may also find faster or more efficient ways to complete their tasks, increase productivity, and, in doing so, grow the economy. Another noteworthy example is the Solow-Swan model, which illustrates that growth stems from the accumulation of capital, thereby allowing for greater total output. It also describes technological progress as a constant rate (g) per worker. As it increases, worker productivity rises, leading to more long-term economic growth.
However, various models treat certain factors as exogenous: they originate outside the model, are implicitly assumed, and are not given a reason for their existence or change. The New Growth Theory (NGT), put forward by Nobel Memorial Prize winner in Economics Paul Romer, introduces new assumptions and concepts to explain these factors and why they can change.
A core idea of the NGT is that technology is endogenous and produced and changed within the model. First, let us consider the Solow-Swan model, where technology is assumed to originate from outside the model:
This is the most basic equation for output in the model. It presents output (Y) as a function of capital (K), technology (A), and labour (L). Looking at technology individually:
Where is technology, as a function of time (or level of technology at ), is the initial level of technology, which grows at an exponential rate of ‘egt,’ and ‘g’ is the rate of technological progress.
We can see here it has been given, and there is no other mathematical reasoning for g: it is assumed that technology will grow at this constant rate.
On the other hand, NGT says that the rate at which technology advances and changes depends on factors we can measure and observe. The key idea is that technological progress stems from innovation and creativity. Firms that intend to maximise profits forgo their scarce inputs (skilled labour, capital) and invest in R&D, creating innovative ideas, or, in this case, advancements in technology. In NGT, technology changes according to equations like this from Romer’s ‘Endogenous Technological Change’:
Where is the change in technology over time, is level of R&D, is current level of knowledge and is productivity. In this equation, dividing by leaves us with on the left, which is an expression for growth rate of technology. On the right, we are left with , where productivity is set to be constant so that the model remains accessible, and to emphasize as the main character of the equation. Now we can see that assuming (the productivity of research) is constant, any changes in growth rate of technology depend entirely on how much firms invest in R&D, showing that technological progress can tracked and explained, otherwise known as endogenous.
Another core concept of NGT, stemming from ideas, is that certain types of ‘special’ capital can actually combat diminishing returns to capital. Let us take the Solow-Swan model again first:
This is the equation for change in capital over time, where is the savings rate multiplied by a function which maps capital per worker, and is a term that incorporates capital depreciation, population growth, and technological progress. is a function of time,. More simply, it is gross investment (that creates new capital) minus break-even investment (that maintains capital). The former is a curve that flattens out due to diminishing marginal returns to capital, which is due to factors such as depreciation, and the latter is a straight line.
At low k, gross investment is higher than the break-even investment, as machinery is new and efficient, so capital per worker is higher, leading to more output in the economy and more growth. However, at higher k, the gross investment curve flattens as capital succumbs to wear and tear and falls below the break-even curve. Where the two curves intersect is where the two investments are equal, also known as the ‘steady state.’ In practice, each new machine now only replaces an old one, and is no better than it.
The NGT, on the other hand, does not deny that physical capital brings diminishing returns, but instead argues that the loss in returns can be offset by ‘special’ capital: knowledge, ideas. These things have key characteristics that make them different from physical capital: they are non-rival, meaning many firms can use them at once, unlike machines. They do not wear out or depreciate, and reusing them has zero marginal cost, thereby increasing productivity. Linking this with investment in R&D – new ideas and knowledge, being both efficient and one of the prime drivers of growth, partially offsets the issue of diminishing returns and allows for more growth in the long run.
Historically, there have been several examples of growth rates for which economists deduced the reasons to be elements of the New Growth Theory. One example is the 1990s, when extraordinary growth rates were recorded in East Asia, in places such as Singapore, Taiwan, South Korea, and Hong Kong. One of the main reasons for their surge in growth was investment in R&D, a key idea behind NGT. Early in 1962, South Korea launched its own 5-year economic development plan, focusing on developing domestic capacity to digest and improve on it. In 1982, amid the increasing complexity of Korea’s industry and foreign companies’ reluctance to transfer tech to their Korean counterparts due to Korea’s potential as a strong competitor in international markets, the government launched the National R&D Program to promote domestic R&D. In a world filled with competition and innovative technology, firms realised that it was the only way to keep up. Thanks to the government’s promotion of R&D, productivity and competitiveness increased, rising from $526m or 0.81% of GDP in 1981 to $13.5b or 2.6% of GDP in 1996, and $26.3b or 2.9% of GDP in 2005.
Another example can be seen behind China’s development of high-speed rail. In the last few decades, China has seen phenomenal economic growth, starting at $150b in GDP in 1979 (in nominal terms) and reaching $20t in 2025 – a 120x increase over about 45 years. One of China’s many successes in this time is its High-Speed rail. The decision to bring foreign HSR technology was made in 2004, when the two main train manufacturing conglomerates signed contracts with four international technology providers (Alstom, Siemens, Bombardier and Kawasaki Heavy Industries). They had access to the Chinese market in exchange for providing production methods and designs for ‘early generation’ HSR trains. This is an intentional knowledge spillover, a trait of one of NGT’s ‘special’ capital. In turn, internal information spillovers increased workers’ productivity, allowing China to construct hundreds of kilometres of rail in a short time. And thanks to China’s firms’ investment in R&D, it was able to develop its own HSR, leading to what we see today: a fast and efficient transport system that stretches across the country, superior to many in the West. In summary, it achieved all this through the use and distribution of knowledge and ideas, key components of NGT.
Although NGT’s claims may seem quite persuasive and positive, it definitely has its limitations – the theory heavily focuses on the importance of innovation, knowledge, ideas and how these bring growth; it’s rather difficult to keep track of or measure such things, making it quite challenging to test against real-world data to see whether it’s true or accurate. NGT’s claims also lack specificity in some areas: how much R&D is needed to offset diminishing returns, and when this happens. Innovation also does not happen constantly, so, according to NGT, growth would have to appear sporadically through sudden ideas, breakthroughs, or even accidents.
Overall, Paul Romer’s ‘New Growth Theory’ brings an optimistic yet realistic solution to the problem of achieving sustained economic growth; the core concepts of NGT can be seen in various places, both on a global and domestic level. However, its limitations do indeed restrict how effective it would be for sustained growth, making this an imperfect solution, and not viable as a standalone policy blueprint: it tells governments that ideas drive growth, but not how much to spend, or when the returns arrive.
