Optimal Endogenous Growth in a Two-Sector Model with Learning-by-Doing and Spillovers

Optimal Endogenous Growth in a Two-Sector Model with Learning-by-Doing and Spillovers

I derive the optimal choice of public policy, explicitly characterize the optimal rate of endogenous economic growth, and compare it to the competitive growth rate in a two-sector model with learning-by-doing and spillovers, based on the Krugman-Lucas model, with the innovation of an endogenous labor supply. I find that the optimal growth rate exceeds the competitive growth rate, since both the optimal level of labor supply and share of labor in the progressive sector exceed the competitive levels. Furthermore, looking at optimal as opposed to competitive paths is shown to have important implications for divergence of growth rates and comparative advantage in the open economy. Implications for trade, labor migration, and economic integration are discussed. Finally, I introduce asset pricing in the model; I demonstrate that, along the optimal paths, there is no a priori reason to expect the positive correlation between growth rates and interest rates which is a feature of the competitive equilibrium.