Taking Stock
This section presented a number of different models of stochastic growth. My selection of topics was geared towards achieving two objectives. First, I introduced a number of workhorse models of macroeconomics, such as the neoclassical growth model under uncertainty and the basic Bewley model.
These models not only useful for the analysis of economic growth but also have a wide range of applications in the macroeconomics literature.Second, the model in Section 17.6 demonstrated how stochastic models can significantly enrich the analysis of economic growth and economic development. In particular, this model showed how a simple extension of our standard models can generate an equilibrium path in which economies spend a long time with low productivity and suffer frequent crises. They take off into sustained and steady growth once they receive a sequence of favorable realizations. The takeoff process not only reduces volatility and increases growth but is also associated with better management of risk and greater financial development. Though stylistic, this model provides a good approximation to the economic development process that much of Western Europe underwent over the past 700 years or so. It also emphasizes the possibility that luck may have played an important role in the timing of takeoff and perhaps even in determining which countries were early industrializers. Therefore, this model provides an attractive formalization of the luck hypothesis discussed in Chapter 4. Nevertheless, underlying the equilibrium in this model is a set of market institutions that enable households to working competitive markets and invest freely. Thus my interpretation would be that the current model shows how random elements and luck can matter for the timing of takeoff among countries that satisfies some prerequisites for takeoff. This could account for some of the current-day cross-country income differences and may provide important insights about the beginning of the process of sustained growth.
However, institutional factors—whether those prerequisites are satisfied—are more important for understanding why some parts of the world did not takeoff during the 19th century and have not yet embarked on a path of sustained and steady growth. These are topics that will be discussed in the rest of the book.It is also worth noting that the model in Section 17.6 introduce a number of important ideas related to incomplete markets. The Bewley model presented in Section 17.4 is a prototypical incomplete markets model and as most incomplete markets models in the literature, it takes the set of markets that are open as given. In contrast, the model in Section 17.6 is a model with endogenously incomplete markets. The analysis showed that the fact that the set of markets that are open (the set of sectors that are active) is determined in equilibrium with a free entry condition can lead to a novel type of Pareto inefficiency due to pecuniary externalities (even though all households take prices is given). Although this type of Pareto inefficiency is different from those we have encountered so far, there are some important
parallels between the fact that an insufficient number of markets are open in this model and too few intermediate goods being produced in the baseline endogenous technological change model of Chapter 13.
17.8.