New Growth Theory

Last Updated :

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Blog Author :

Prakhar Gajendrakar

Edited by :

Collins Enosh

Reviewed by :

Dheeraj Vaidya, CFA, FRM

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What Is New Growth Theory (NGT)?

New growth theory (NGT) states that a country's economic development relies on people’s wants and needs. An increase in personal ambition and per capita consumption directly results in economic growth.

New Growth Theory

The underlying ideology is that the collective effort of people, purchases, investments, and personal profit will increase the gross domestic product. To implement the theory, governments must support entrepreneurs, innovation, and technology. A capitalistic market is a classic example of NGT.

Table of contents
  • New growth theory explains the positive effect of people's gain, needs, and wants on the economy and GDP of any country.
  • People are more interested in personal profit and work for personal gain; technically, their desires are endless. NGT states that competitiveness and personal ambitions elevate the economy by increasing consumption and economic activities.
  • Growth-oriented individuals adapt to new technologies quickly; to elevate their status, they buy more products. Directly or indirectly, all this induces positive investments and higher consumption.
  • Paul Romer, who coined this theory, indicates that knowledge will play a key role and should be treated as a crucial intangible asset. It can potentially lead to exponential economic growth.

NGT In Economics Explained

In economics, the new growth theory (NGT) depicts a scenario where economic development depends on people’s personal needs, personal wants, and the pursuit of profit. Paul Romer formulated the theory. Romer is an American economist who won the Nobel Prize along with William Nordhaus for his endogenous theory.

According to Romer, economic development depends on the contribution of entrepreneurs and researchers (in the form of innovation and technological advancement). Romer’s economic growth concept focused on people—new ideas, learning, and knowledge. To emulate the theory, Romer suggests that governments should support innovative ideas.

NGT states that increasing people's wants and needs triggers risk-taking, innovation, and self-improvement. This becomes the driving force for economic growth. The theory postulates the importance of human capital—knowledge, learning, and education. For implementation, therefore, the theory advocates prioritizing human capital over physical capital (land, infrastructure).

Physical Capital vs Human Capital

According to the new theory, human skills and knowledge are intangible assets and should be utilized to their maximum capacity. The theory suggests that government should encourage private sector activities and business operations.

People work for personal growth and profits. Even so, in the long run, it all adds up. Collectively, even small growth leads to economic growth—gross domestic product increases.

The new growth theory definition also explains the positive changes that occur with people's endless needs and wants in the market. It is a chain reaction; first, an individual is interested in knowledge and upskilling—using relevant skills, individuals innovate and build companies—businesses generate employment and market competition.

Growth-oriented individuals adapt to new technologies quickly; to elevate their status, they buy more products. Directly or indirectly, all this induces positive investments and higher consumption—market supply and demand increase. Therefore, a capitalistic market is an example of the new growth theory.

What Is Physical Capital?

Economic theories differ when it comes to developmental factors. Exogenous theories give importance to physical capital—land, infrastructure, raw materials, etc. Exogenous theories give importance to external factors. In contrast, the endogenous theory and NGT emphasize human capital, entrepreneurship, innovation, and technology. Human capital is considered an internal factor of economic growth.

Examples

Now, let us look at some examples to understand the theory better.

Example #1

Let us assume that a village supports education and entrepreneurship. It allows women to start home businesses and work in factories. The village educates people and equips them to take jobs in nearby company offices.

The entire population is directed towards knowledge, skill development, and self-learning. Within six months, almost all the houses in the village had more than one income source. Children were taught innovation and business skills, and women showed equal participation in employment and businesses.

NGT suggests that the steady perpetual growth of such a village will, in time, boost the village's economy. The theory focuses on improvement at the individual level. The individual’s wants and needs take care of motivation and regulation.

Example #2

Let us assume that a group of young entrepreneurs convince an investor to fund their startup idea. The investor agrees but asks for an ownership stake (percentage of equity) in lieu of funding.

The company grows exponentially; becomes a million-dollar enterprise in no time. The returns were beyond the investor's expectations.

This example shows why the new growth theory heavily emphasizes people (human capital). Although motivated by personal gains, the founders also generated profits for the investor. In addition, when the firm grew, it also created employment opportunities.

Frequently Asked Questions (FAQs)

1. Who created the New Growth Theory?

Paul Romer is the former chief economist of the World Bank. He is credited for this new theory. He suggests that economies across the globe should invest in knowledge rather than land and infrastructure. Romer won the Nobel prize with William Nordhaus for his work on endogenous theory.

2. What is another name for the New Growth Theory?

It is also referred to as NGT; it postulates that the actual development of an economy depends on the wants and needs of people. Increased inclination towards improvement and innovation would lead to increased economic growth.

3. What is the new endogenous theory?

The endogenous growth concept elaborates that the growth and development of any company, economy, or entity are more dependent on internal forces than external forces. Human capital plays a critical role in innovation, investment, purchases, and market consumption. Human capital plays a crucial role in the governmental and private sectors.

4. What are the criticisms of the endogenous growth model?

One of the criticisms of the endogenous growth theory is that it relies too much on assumptions. These assumptions may not stand true—there is a lack of empirical evidence. Also, it ignores the contribution of organizations to economic growth. It considers only human capital as a key factor. In real-world scenarios, It is difficult to distinguish between physical and human capital.