Introduction to Modern Economic Growth 10.4 Neoclassical Growth with Physical and Human Capital Our next task is to incorporate human capital investments into the baseline neoclassical growth model This is useful both to investigate the interactions between physical and human capital, and also to generate a better sense of the impact of differential human capital investments on economic growth Physical-human capital interactions could potentially be important, since a variety of evidence suggests that physical capital and human capital (capital and skills) are complementary, meaning that greater capital increases the productivity of high human capital workers more than that of low skill workers This may play an important role in economic growth, for example, by inducing a “virtuous cycle” of investments in physical and human capital These types of virtue cycles will be discussed in greater detail in Chapter 22 It is instructive to see to what extent these types of complementarities manifest themselves in the neoclassical growth model The potential for complementarities also raises the issue of “imbalances” If physical and human capital are complementary, the society will achieve the highest productivity when there is a balance between these two different types of capital However, whether the decentralized equilibrium will ensure such a balance is a question that needs to be investigated The impact of human capital on economic growth (and on cross-country income differences) has already been discussed in Chapter 3, in the context of an augmented Solow model, where the economy was assumed to accumulate physical and human capital with two exogenously given constant saving rates In many ways, that model was less satisfactory than the baseline Solow growth model, since not only was the aggregate saving rate assumed exogenous, but the relative saving rates in human and physical capital were also taken as given The neoclassical growth model with physical and human capital investments will enable us to investigate the same set of issues from a different perspective Consider the following continuous time economy admitting a representative household with preferences (10.19) Z ∞ exp (−ρt) u (c (t)) dt, 474