Balanced Growth Revisited: A Two-Sector Model of Economic Growth

The one-sector Solow-Ramsey model is the most popular model of long-run economic growth. This paper argues that a two-sector approach, which distinguishes the durable goods sector from the rest of the economy, provides a far better picture of the long-run behavior of the U.S. economy. Real durable goods output has consistently grown faster than the rest of the economy. Because most investment spending is on durable goods, the one-sector model’s hypothesis of balanced growth, so that the real aggregates for consumption, investment, output, and the capital stock all grow at the same rate in the long run, is rejected by postwar U.S. data. In addition, to model these aggregates as currently constructed in the U.S. National Accounts, a two-sector approach is required. ∗Mail Stop 89, 20th and C Streets NW, Washington DC 20551. Email: [email protected]. I am grateful to Michael Kiley, Steve Oliner, Michael Palumbo, and Dan Sichel for comments on an earlier draft. The views expressed are my own and do not necessarily reflect the views of the Board of Governors or the staff of the Federal Reserve System. Since the 1950s, the Solow-Ramsey model of economic growth, which models all output in the economy in terms of a single aggregate production function, has been the canonical model of how the macroeconomy evolves in the long run. The model has also featured prominently in the analysis of economic fluctuations: Business cycles are commonly characterized as correlated deviations from the model’s longrun “balanced growth” path, which features the real aggregates for consumption, investment, output, and the capital stock, all growing together at an identical rate determined by the pace of technological progress. While multisector models, in which disaggregated sectors have different production functions, have been used to shed light on certain aspects of growth and business cycles, the one-sector growth model remains the workhorse for explaining the long-run evolution of the economy.1 The purpose of this paper is to make a simple point: Despite its central role in economics textbooks and in business cycle research, the traditional one-sector model of economic growth actually provides a poor description of the long-run behavior of the U.S. economy. A simple alternative two-sector model, which distinguishes the behavior of the durable goods sector from the rest of the economy, explains a number of crucial long-run properties of U.S. macroeconomic data that are inconsistent with the one-sector growth model, and is far better suited for modelling these data as currently constructed. As such, this two-sector approach provides a better “baseline” model for macroeconomic analysis. Two principal arguments are presented in favor of this position. 1. The U.S. evidence firmly rejects the one-sector model’s prediction of balanced growth, but is consistent with a two-sector approach. The real output of the durable goods sector has consistently grown faster than the rest of the economy. Because most investment spending is on durable goods while the bulk of consumption outlays are on nondurables and services, real investment has tended to increase relative to real consumption. While a number of other factors masked this pattern for much of the past 40 years, real investment has grown For example, Mankiw (2000) and Romer (1996) are two well-known undergraduate and graduate texts that place a central emphasis on the one-sector growth model. Long and Plosser (1983) is a well-known model of how multi-sectoral linkages can affect the business cycle. Hornstein and Praschnik (1997) and Huffman and Wynne (1999) are two more recent contributions in this area.