1.1. Introduction: The Centrality of Economic Growth

The study of economic growth is a cornerstone of modern economics, addressing the fundamental questions of long-term prosperity, global poverty, and inequality. Understanding the forces that drive sustained increases in living standards is not merely an academic exercise; it is essential for designing policies that can lift nations out of poverty and ensure a prosperous future. This module lays the groundwork for our exploration by introducing the core facts and puzzles that motivate the field and providing an overview of the primary theoretical paradigms economists use to analyze them.

The importance of economic growth is most starkly illustrated by its powerful role in poverty reduction. As shown in Table I.1, India’s experience demonstrates a clear link between accelerated GDP growth and a decline in poverty.

Table I.1: Poverty Reduction in India (Headcount Ratios %)

| | Official Methodology | | Adjusted Estimates | | | :— | :—: | :—: | :—: | :—: | :—: | :—: | | | 1987-88 | 1993-94 | 1999-2000 | 1987-88 | 1993-94 | 1999-2000 | | Rural | 39.4 | 37.1 | 26.9 | 39.0 | 33.0 | 26.3 | | Urban | 39.1 | 32.9 | 24.1 | 22.5 | 17.8 | 12.0 | Source: Rodrik and Subramanian (2004)

Note: Official: Consumption data from Planning Commission Sample Survey; Adjusted: Consumption data from improved comparability and price indices.

The data reveals a marked decrease in the percentage of the population living below the poverty line between the late 1980s and the end of the 1990s, a period of significant economic acceleration in India. The “Adjusted Estimates,” which account for improved data comparability and price indices, show an even more dramatic reduction in urban poverty. While a definitive causal link is complex to establish, the strong correlation implies that economic growth is a critical, if not indispensable, engine for widespread poverty alleviation. This observation motivates one of the central questions in development economics: what policies and institutional shifts can trigger such growth accelerations?

To answer such questions, however, we must first grapple with a set of empirical puzzles that have shaped the evolution of growth theory for decades.

1.2. Five Empirical Puzzles in Economic Growth

The development of modern growth theory has been driven by a set of central empirical puzzles. These stylized facts, drawn from cross-country and historical data, are often counter-intuitive and demand rigorous theoretical models to be fully understood. Any credible theory of growth must be able to account for these phenomena.

1. The Convergence Puzzle: Figure I.1 plots countries’ average growth rates against their initial productivity levels relative to the United States. It reveals a phenomenon known as “conditional convergence”: there is a general tendency for countries to grow faster when they are further below the world productivity frontier. However, this trend is not universal. Critically, the very poorest countries often grow more slowly, diverging from the frontier rather than catching up. This raises several key questions. Is convergence driven by diminishing returns to capital, as poorer countries can accumulate capital more rapidly? Or is it the result of technological catch-up, where lagging countries can adopt and implement technologies developed by leaders? Furthermore, why have some countries, such as South Korea, China, and India, managed to join the “convergence club” with sustained, rapid catch-up growth, while many others have not?
2. The Growth and Inequality Puzzle: The relationship between economic growth and income inequality is highly complex. At a national level, the divergence between the richest and poorest countries suggests that growth is associated with increasing inequality. However, Sala-i-Martin (2006) argues that when viewed at the individual level, global income inequality has actually decreased in recent decades. This is largely because hundreds of millions of people in fast-growing, populous countries like China and India are catching up to the world average income. This complicates any simple narrative, reviving historical debates such as the “Kuznets curve” hypothesis, which posited that inequality first rises and then falls as a country develops.
3. The Wage Inequality Puzzle: In the United States, the wage gap between college-educated and high-school-educated workers—the college wage premium—has increased sharply since 1980 (Figure I.2). This trend presents a paradox. According to basic supply and demand, an increase in the relative supply of college-educated workers, which also occurred during this period, should have decreased the college wage premium. The fact that the premium rose despite an increase in supply demands a powerful explanation. Potential causes include the impacts of globalization, shifts in labor-market regulations, or, most prominently, the onset of “skill-biased technical change” that enhances the productivity of highly skilled workers more than that of the less skilled.
4. The Transition from Stagnation to Growth: For most of human history, economies were caught in a Malthusian trap, where any temporary increase in income was soon absorbed by population growth, leaving living standards stagnant. The transition from this long-run stagnation to the modern era of sustained per capita income growth is a fundamental historical puzzle. What economic forces, policies, or institutional changes triggered this profound shift and allowed humanity to escape the Malthusian regime?
5. The Finance and Growth Puzzle: Cross-country data, such as that shown in Figure I.3, reveals a strong positive correlation between the development of a country’s financial system and the growth of its industries. This correlation, however, leaves open the critical question of causality. Is a well-developed financial system a cause of economic growth, by efficiently allocating capital to its most productive uses? If so, financial reform should be a policy priority for developing nations. Or is financial development merely a symptom of growth, developing in tandem with the rest of the economy without playing a primary causal role?

To dissect these puzzles, economists have developed a set of powerful theoretical tools.

1.3. A Roadmap: The Four Major Growth Paradigms

To address the empirical puzzles outlined above, economists have developed four major theoretical frameworks, or paradigms, each offering a distinct perspective on the engine of long-run growth. This section provides a high-level overview of these paradigms, setting the stage for deeper analysis in subsequent modules.

1. The Neoclassical Growth Model This is the benchmark model in growth economics, focusing on capital accumulation as the primary driver of output. Its core mechanism is governed by two equations: an aggregate production function, Y = F(K, L), which relates output (Y) to the stocks of capital (K) and labor (L), and a capital accumulation equation, ΔK = sY – δK, where net investment (ΔK) equals total savings (sY) minus depreciation (δK). The model’s power lies in its incorporation of diminishing returns to capital, which leads to a paradoxical but crucial implication: in the long run, economic policy (such as changing the saving rate s) cannot affect the economy’s growth rate. Instead, sustained per capita growth is determined entirely by an exogenous rate of “technical progress,” a force that the model itself cannot explain. This framework provides a powerful explanation for the Convergence Puzzle among similar economies.
2. The AK Model As the first major version of endogenous growth theory, the AK model seeks to explain sustained growth from within the model. It achieves this by lumping physical, human, and intellectual capital into a single aggregate capital stock, K, and assuming there are no diminishing returns to this broad measure of capital. The aggregate production function is simplified to Y = AK, where A is a constant productivity parameter. This linearity leads to a straightforward growth rate: g = sA – δ. The key implication is that the long-run growth rate is now endogenous—it depends on economic behavior and policy. Specifically, policies that increase the saving rate (s) will permanently increase the growth rate. Its primary strength is explaining sustained growth without exogenous factors, though it struggles with the Convergence Puzzle.
3. The Product-Variety Model This is the first of two major “innovation-based” growth theories. It posits that growth is driven by the creation of new varieties of products, which increases aggregate productivity through greater specialization. The aggregate production function takes the form Y = N^(1-α) * K^α, where N represents the number of different product varieties. In this framework, N acts as the aggregate productivity parameter. Growth is endogenous because profit-seeking entrepreneurs invest in research and development (R&D) to create new product varieties, motivated by the prospect of monopoly rents. This paradigm grew out of trade theory and notably does not feature “creative destruction,” as old products are not rendered obsolete by new ones. This model is essential for tackling the Wage Inequality Puzzle and understanding the Transition from Stagnation to Growth by modeling the innovation process itself.
4. The Schumpeterian Model The second branch of innovation-based theory is the Schumpeterian model, which places “creative destruction” at the heart of the growth process. Here, growth is driven by quality-improving innovations that make existing products and processes obsolete. The model is often specified at the industry level, with a production function like Y_it = A_it^(1-α) * K_it^α, where A_it is the productivity parameter of the latest technology in industry i. Aggregate growth is the result of entrepreneurs investing in R&D to achieve these quality improvements. A unique feature of this paradigm is its prediction that the effects of institutions and policies on growth can vary with a country’s distance to the technological frontier. This incorporates Gerschenkron’s “advantage of backwardness” and, like the product-variety model, provides a framework for analyzing the Wage Inequality Puzzle and the Transition from Stagnation to Growth.

Subsequent modules will systematically unpack each of these paradigms, using them to analyze the intricate process of economic growth and to inform the design of effective growth-enhancing policies.