Neoclassical growth theory proposes that the warranted rate of growth adjusts to the natural rate through the mechanism of capital accumulation. According to this theory, the natural rate of growth is determined by exogenous factors such as technological progress and population growth. The warranted rate of growth, on the other hand, is influenced by the rate of investment and savings. If the warranted rate of growth exceeds the natural rate, there will be excess capital accumulation and diminishing returns, leading to a decline in the rate of growth. Conversely, if the warranted rate is below the natural rate, there will be a shortage of capital, which incentivizes investment and leads to an increase in the rate of growth.
However, the realism of this mechanism is subject to debate. Critics argue that the neoclassical growth theory's assumption of perfect competition and constant returns to scale may oversimplify the complexities of real-world economies. In reality, various factors such as market imperfections, institutional constraints, and technological constraints can affect investment decisions and the rate of growth. Additionally, the assumption that the economy will always converge to the natural rate of growth may not hold true in practice, as other factors such as policy interventions and external shocks can influence long-term growth outcomes.
Neoclassical growth theory's essential propositions include the emphasis on the accumulation of physical capital, technological progress, and the role of diminishing returns in economic growth. It argues that in the long run, an economy's growth rate is determined by exogenous factors such as technological advancements, population growth, and the rate of capital accumulation. The theory concludes that investment does not directly affect long-run growth because, according to the neoclassical perspective, the rate of return on capital diminishes as more capital is accumulated, resulting in diminishing marginal productivity. Therefore, while investment can spur short-term growth, it does not have a sustained impact on the long-run growth rate, as the effects of diminishing returns eventually offset the benefits of additional investment.