Economic Growth Models - Essay Example

Economic Growth Models “It is obviously true that there are many countries, not essentially different either in the degree of security which they afford to property, or in the moral and religious instruction received by the people, which yet, with nearly equal natural capabilities, make a very different progress in wealth.” Thoman Malthus, Essay on Population, 1887 The theory of economic growth has a long history that can be traced back at least to David Hume, Adam Smith’s older friend and colleague (Gylfason 1999, p.18). It has deep roots that extend as far back in time as economics itself (1999, p.29). The wide dispersion of output growth rates1 across countries is a well-documented economic fact. Countries that at one time had similar levels of per capita income have subsequently followed very divergent patterns, with some seemingly caught in an “underdevelopment trap” or long-term stagnation, and others able to sustain high growth rates (Agénor and Montiel 1999, p.669). There was even a time when economists regarded economic growth in the long run as being essentially immune to all but technological progress (Gylfason 1999, p.1). In 1960 average real per capita incomes in Asian and African countries were roughly similar. After thirty years, income per capita had increased more than threefold while it had risen only moderately in Africa. During the past two decades alone, real output expanded more than 6% per annum in Asia in contrast to the 2.8% reached in Africa and 3.7% in Latin America (Agénor and Montiel 1999, p.669). Why is it that some countries grow faster than others? Do modern approaches to economic growth have a say on this phenomenon? Can the Solow-Swan economic growth model shed light into this issue? The Neoclassical Growth Model The neoclassical growth model was developed by Solow (1956) and Swan (1956). It is built upon an aggregate, constant returns to scale production function that combines labor and capital (with diminishing marginal returns) in the production of a composite good. Savings are assumed to be a fixed fraction of output, and technology improves at an exogenous rate. Let Y denote total output, L the number of workers employed in the production process, K the capital stock, and suppose that the production function is Cobb-Douglas, so that: Y = AKL1-, 0 <  < 1 where A measures the level of technology. Output per worker, y = Y/L, is thus given by y = Ak where k denotes the capital-labor ratio. Capital accumulation is given by k = sy – (n + )k, 0 < s,  < 12 where s denotes the propensity to save, n > 0 the exogenous rate of population growth, and  the rate of depreciation of physical capital(Agénor and Montiel 1999, p.671). The Solow-Swan growth model predicts that growth should be uncorrelated with the ratio of national investment to total output (gross domestic product or GDP). If capital markets are open, the model predicts instantaneous convergence of output per capita across countries. Convergence is achieved by capital flows from rich to poor countries and a consequence of these flows is that the ratio of national savings to GDP in each country should differ substantially from the ratio of investment to GDP since there is no reason to expect that countries with high savings rates should be those with large investment opportunities. In the presence of capital market imperfections, such as the inability to borrow to finance human capital accumulation, convergence is predicted to occur more slowly (Farmer and Lahiri, 2003). Figure 1. Equilibrium in the Solow-Swan Model Source: Kalyvitis (n.d., p.6) Assuming that all regions possess similar technology and similar preferences, and that there are no institutional barriers to the flow of both capital and labor across state borders, the Solow-Swan neoclassical growth model predicts that states would have similar levels of real per capita income in the long run (convergence). Across regions of a given country that share such a common long-run level of real per capita income, convergence of per capita incomes is driven by diminishing returns to capital. That is, each addition to the capital stock generates large increases in output when the regional stock of capital is small. If the only difference between regional economies lies in the level of their initial stock of capital, the neoclassical growth model predicts that poor regions will grow faster than rich ones—regions with lower starting values of the capital-labor ratio will have higher per capita income growth rates. Other channels through which convergence can occur are interregional capital mobility; the diffusion of technology from leader to follower economies; the redistribution of incomes from relatively rich regions to relatively poor regions of a federal country by its central government; and flows of labor from poor to rich regions (Cashin and Sahay 1996, p.49). Agénor and Montiel (1999, p.677) note that the neoclassical growth model only predicts “conditional” convergence, that is a tendency for per capita income to converge across countries only after controlling for the determinants of the steady-state level of income – saving and population growth rates. Cashin and Sahay (1996, p.50) also cite the two commonly used measures of regional income convergence. The first asks whether initially poor economies tend to grow faster than initially rich ones. The second asks whether the standard deviation (the dispersion of observations around an average measure) of per capita income is shrinking across economies over time. Both concepts are important, as it is interesting to know how fast the average poor economy becomes rich, independently of whether the variance of the per capita incomes of a group of economies is rising or falling. Do empirical findings support this “converging” concept of the Solow-Swan growth of economic theory? Gylfason’s (1999, p.74) assessment of 105 low- and middle-income countries showed neither convergence [or divergence] among the sample countries using the relationship between GDP per capita in 1992 and initial GDP per capita [i.e. in 1970] in these countries. However, Gylfason noted that there seems to be empirical evidence of convergence among rich countries, but not among poor countries (1999, p.74). Figure 2. A Rise in the Savings Rate Source: Kalyvitis (n.d., p.7) However, Cashin and Sahay’s (1996) study seems to show the opposite: their study did find convergence in the growth of Indian states. (Figure 3). For example, Manipur and Himachal Pradesh had below-average real per capita incomes in 1961, and relatively high rates of growth in the 30 years thereafter. While Delhi clearly had the highest real per capita income in 1961, its 1961–91 growth rate was close to that which would be predicted given its initial level of per capita net domestic product (NDP). After taking into account exogenous shocks to the agricultural and manufacturing sectors, our study found that income convergence of the initially poor states to the initially rich states occurred at a rate of 1.5 percent per year. Such a value implies that it takes about 45 years to close one-half of the gap between any state’s initial level of per capita income and the 20 states’ common long-term level of per capita income. This estimated speed of convergence is slower than that found in most of the earlier studies of regional economies of industrial countries (Australia, Canada, Japan, and the United States), and where the rate of convergence has been found to be about 2 % per year. Moreover, the speed of convergence of Indian states is slower than that between European Organization for Economic Cooperation and Development (OECD) countries, a surprising result since one would expect convergence within national boundaries to be faster than across borders (Cashin and Sahay 1996, p.50-51). Figure 3. Convergence of real per capita income across 20 Indian States Source: Cashin and Sahay 1996, p.51 Can Economic Growth and Inflation Happen Together? Edwards (1984, p.4) argues that there has been a failure to appreciate the linkages between the flows of funds provided by credit institutions and the results in the real economy in terms of growth and inflation, specifically, in understanding Anglo-Saxon economies. According to Edwards, theories relating money supply to inflation rates are interesting but have perhaps a rather haphazard approach to the problem. Edwards cites that when Friedman argues that increases in the money supply by governments are ‘everywhere and always’ at the root of the inflationary process of economic growth. For example, Japan’s monetary authorities [by diverse and subtle means have pursued an expansionary monetary policy since the end of the Second World War. During the 1960s, money supply in Japan usually expanded by about 15% per year, resulting in a growth than the inflation. On the other hand, Edwards provides, successive British governments have sought (increasingly unsuccessful during the 1950s and 1960s) to control inflation and maintain the value of the pound by periodic credit squeezes and, except for the period 1970-1973, by a low rate of expansion in money supply, and this produced a low growth and a rising cyclical trend rate of inflation. Another example is Brazil; the country had very high inflation and high growth (Edwards 1984, p.4). Using annual data to examine long-run and short-run dynamics of the inflation-economic growth relationship for four South Asian countries, study done by Mallik and Chowdhurry (2001) found that inflation and economic growth are positively related. Also, the sensitivity of inflation to changes in growth rates is larger than that of growth to changes in inflation rates. These findings have important policy implications: contrary to the policy advice of the international lending agencies, attempts to reduce inflation to a very low level (or zero) are likely to adversely affect economic growth. However, attempts to achieve faster economic growth may overheat the economy to the extent that the inflation rate becomes unstable. Thus, these economies are on a knife-edge. The challenge for them is to find a growth rate which is consistent with a stable inflation rate, rather than beat inflation first to take them to a path of faster economic growth. They need inflation for growth, but too fast a growth rate may accelerate the inflation rate and take them downhill (Mallik and Chowdhurry 2001; Bruno and Easterly 1998). Cutting Inflation: Understanding Inflation Dynamics Sargent (1993) cites two contrasting theories as to how inflation can be driven out or reduced in an economy: “Momentum” or “core inflation” theories posit that there are two possible sources of sluggishness of inflation. One is the notion of adaptive or autoregressive expectations (Sargent 1993, p.117). According to this doctrine, workers and firms form expectations about future inflation rates by computing a moving average of current and lagged rates of inflation. Another determinant of inflation is the unemployment rate with which, by means of a Phillips curve mechanism, inflation varies inversely. According to this notion, the only way to eliminate inflation through conventional monetary and fiscal restraint is by moving along the short-run Phillip’s curve and suffering a high period of unemployment that is long enough to break the slowly moving inflationary expectations. In this model the momentum in the inflation process and the high cost in unemployment of ending inflation is caused by the irrational nature of agents’ expectations. Reductions in inflation are costly because it takes agents a long time to understand that they are in a less inflationary environment. If they learned faster, reducing inflation would be less costly (Sargent 1993, p.118). Rational expectations and equilibrium theories of inflation on the other hand maintain that essentially all of the characteristics of the serial correlation of inflation are inherited from the random properties of the deeper causes of inflation, such as monetary and fiscal variables (Sargent 1993, p.120). These theories hold that under the proper hypothetical conditions a government can eliminate inflation very rapidly and with virtually no Phillips curve costs in terms of foregone real output r increased unemployment. The “measure” that would accomplish this would be a once-and-for-all, widely understood and agreed upon change in the monetary or fiscal policy regime. Here, a regime is taken to be a function or rule for repeatedly selecting the economic policy variable or variables in question as a function of the state of the economy. Particular models within this class differ widely with respect to the particular policy variables [e.g., high-powered money, a wider monetary aggregate or total government debt] (Sargent 1993, p.121). According to these two theories, to reduce the rate of inflation is a formidable task. The momentum view obviously implies that she could use monetary and fiscal variables to depress inflation at the cost of also depressing the real activity of the economy [in our case, employment activity]. On the other hand, the rational expectations equilibrium view suggests that it is not in the power of a prime minister or even a united political party to create the circumstances required to bring about a quick and costless pill to inflation. Reference List Agénor PR and Montiel, P 1999, Development Macroeconomics, 2nd ed., Princeton University Press, United States of America. Cashin, P and Sahay, R 1996, ‘Regional Economic Growth and Convergence in India’, Internal Migration, Center-State Grants and Economic Growth in the States of India, IMF Working Paper 95/58, International Monetary Fund, United States of America. Cukierman, A 1984, Inflation, stagflation, relative prices, and imperfect information, Cambridge University Press, United States of America. Dowrick, S and Rogers, M 2001, Classical and Technological Convergence: Beyond the Solow-Swan Growth Model. Retrieved 10 March 2006 from http:// ecocomm .anu.edu.au/people/info/dowrick/conv.pdf Edwards, G 1984, How Economic Growth and Inflation Happen, The Macmillian Press Ltd, Great Britain. Farmer, R and Lahiri, A 2001, Economic Growth in an Interdependent World Economy. Retrieved 10 March 2006 from http:// farmer. sscnet. ucla.edu /NewWeb /Working %20 Papers/EconGrow.pdf Gylfason, T 1999, Principles of Economic Growth, Oxford University Press, United states of America. Sargent, T 1993, Rational Expectations and Inflation, 2nd ed., Harper Collins College Publishers, United States of America. Read More