Macroeconomic convergence, development and growth - Essay Example

?Macroeconomic convergence, development and growth Table of Contents Introduction 3 Economic growth and macroeconomic convergence: an empirical investigation 4 Macroeconomic convergence and financial development 7 Conclusion 11 References 12 Introduction Macroeconomic convergence is a process adopted by the adjoining economies across regions for economic integration amidst themselves. As the developing economies have the advantage of diminishing returns to factors, so they can converge faster than the developed economies (Alfaro et al, 2005). Such a step is needed to formulate the region into a single political and monetary entity which can establish its rights and serve its interests. It is especially found among the financially weaker nations of the world who need to unite to signify their global power. Convergence depends on various factors such as the speed of capital formation, population growth and the presence of efficient economic policies as well as appropriate financial institutions. There are actually two kinds of macroeconomic convergence that nations might indulge into, namely, ‘sigma-convergence’ and ‘beta-convergence’. While sigma-convergence signifies the rate at which the disparity in the income levels of nations is reducing over time, beta-convergence implies the rate at which the poorer nations are growing compared to their richer counterparts (Hossain, 2000). Some of the most vigorous of all attempts towards macroeconomic convergence is noted among the African economies which are highly pestered by the issue of poverty. These nations have realized the importance of macroeconomic convergence to make their meek presences felt and to ensure monetary, financial and political stability as well as security (Zyuulu, 2010). Convergence is highly conducive for economic growth and financial prosperity on account of a variety of reasons. The rate of convergence highly depends on the initial condition of the economy as well the growth potential of the economy. Along with this the accumulation of human and physical capital are important as it significantly influences the savings and rate of investment (Halmai & Vasary, 2009, p.3). Technological spread, change in growth rate and total productivity of the factors are the major players in enhancing the rate of convergence. Macroeconomic convergence could effectively be brought about by drawing integration between the macroeconomic policies of the underlying nations. The nations might take an initiative to characterize themselves with similar economic features so as to lend themselves on comparative grounds with their neighbours (Maruping, 2005, p.130). Thus the concept of convergence is especially found to be popular among the poorer nations of the world whose primary aim is to raise their respective per capita incomes. Economic growth and macroeconomic convergence: an empirical investigation Integration of national as well as regional economies with world economy is the salient feature over many years. Two models of economic integration which relates to income convergence are firstly growth models and secondly trade models (Kim, 1997, p.4). According to the neoclassical Solow model of growth, the regional level of income varies due to the different capital labour ratios. Whereas the Hecksher Ohlin trade model says that the income varies across the regions due to the difference in the factor prices and factor endowments (Kim, 1997, p.5). Income convergence occurs due to trades in goods and economic integration via equalisation in prices. Factor endowments vary across the regions and therefore various regions specialise in different industries. The growth models generated by Romer and Lucas, which are based on increasing returns on physical capital, states the chances of such income divergence. Even the trade models by Krugman states that income divergence may arise due to the differences in the industrial structures. If the industries equipped with high technology and high wages are subjected to external economy then the trade transactions will cause all high wage and high technology industries to concentrate in specified regions. Such a concentration will then lead to income differences as the left over industries will be equipped with low technology and low wages (Kim, 1997, p.5). A country’s economic growth is measured by its level of technological progress. As per the endogenous model of growth, Europe was able to enjoy a long term growth as it was successful to reap the fruits of economies of scale through its integration with other economies. In view of the new endogenous growth theory, convergence may not occur at all due to the absence of ample social capability. However Lucas posited that diversification in growth occurs due to brain drain, since increasing returns to human capital accelerates growth. Many economists said that rather than convergence, economic divergences may arise between the countries, as the poor countries do not have the fund to carry on research and development for the growth process (Romer, 2007). Although in the beginning of the convergence process the growth rates of the EU-10 countries were slow but soon they have been catching up with the EU-15 countries. However the rates of convergence in the Baltic States, Solvenia and Hungary have been more dynamic. Increase in factor productivity and capital formation has been assigned to be the driving force for the economic growth in the EU-10 countries (Halmai, 2009, p.1-2). This dynamic growth rate is consistent with the theory of convergence and in the future it is expected to grow even more. In the EU-10 countries the labour market is characterised by a high rate of structural unemployment and a low rate of unemployment. Despite these irregularities in the labour market the growth rate in the EU-10 countries did not fall due to the positive effect of the capital formation. Based on 2001-2005 figures, the growth potential of the EU-10 countries is more than that of the EU-15 countries except for Malta. It is thus estimated that if the rate of growth of the EU-10 countries increases at such a pace then the real GDP of the EU-10 nations will catch up with that of EU-15 countries in duration of 35 years (Halmai, 2009, p.5). Through rising market integration inter-regional variations disappear. This is almost a global proposition. Although in developed economies many evidences usually support such a thing but not for developing economies. Boumal saw no evidence of a productivity convergence while taking a collection of the developing countries for years 1870-1986. These results are also consistent with the latest findings on the convergence for the developing nations. Developing countries often follow the Lewis model type development process .This process often leads to a short run fluctuation in the investments between commercialised capitalist sector and the traditional agricultural sector. It is attributed to the co existence of the non market and market institutions (Anderson & Edgerton, 2011, p.3). Paper presented by Stephen Dobson, John Goddard and Carlyn Ramlogan, sheds light on the process of convergence for the developing nations. It used the unit root tests to evaluate the process of convergence for a huge sample of developing nations. The per capita real GDP has been used for the purpose of study covering the period’s 1960-1995.On the basis of this study Africa showed the slowest growth and lowest per capita GDP in contrast to Asia/Pacific which showed the highest growth (Dobson et.al, 2003, p.23). The literature on productivity and income convergences suggest that the developing countries have benefitted less due to being backward. In the last 40 years very few developing nations could join the so called converging club. This failure of the poor nations to catch up with the wealthier nations has recently gained the attention of many economists. As a result many growth models have been developed by various economists that could explain such a result (Lipsey & Zejan, 1992, p.3). Macroeconomic convergence and financial development One of the primary factors that must be taken care of while deciding upon a particular economic action is to anticipate the possible impact that the change could bring forth. The importance of an equitable distribution of income has often been cited by researchers. It has been said that macroeconomic convergence could be reached more rapidly when there is an equitable distribution of wealth among nations. Based on empirically proven evidences it could be said that the richer the nation is, better are the prospects of picking up the momentum and gradually moving into a path of convergence. In fact, this is found to be the story even among the middle income nations of the world, though the same might not be said about the poorer nations of the world. Poorer nations depict different results based on the condition of their respective financial sectors. In case that the financial sector is found to be robust in nature, they might pick up on their economic growth and financial development aspects thus eventually causing macroeconomic convergence. On the other hand, if the financial sector is characterized by very weak policies, the result of economic policies to convert the nation into a convergent one might prove disappointing, causing a high degree of divergence between the poorer and richer nations of the world (Fung, 2008). Thus, financial sector growth could also be regarded as one of the most stimulating of all factors which cause economic growth in the nation and eventually assist in the realization of macroeconomic convergence. There have been many literatures in the recent times which showed the importance of having sound financial system leads to economic growth. For those countries that are associated with financial deepening, an integration of financial system with that of the world economy may turn beneficial. Most of the studies have been done from the perspective of an open economy. Here it is important to know that having a well developed financial market helps in building an integrated international financial market. At the same time financial reforms that take place in the developing countries helps them to create a capital account which would lead the domestic financial markets to be more competitive as well as integrated with world (Gregorio, 1999, p.3). Economic growth basically occurs from two processes either increases in the amount of factors of production or an increase in the level of efficiency in the manner in which they are used. An increase in the investment and its efficiency induces growth. For a closed economy savings equals the investment and due to this savings is regarded to trigger the pace of growth. Investment efficiency not only includes the growth in overall factor productivity but also includes other factors apart from human capital that fosters the pace of growth. Financial developments have twin effects on the rate of economic growth (Gregorio, 1999, p.3). Firstly the improvement of domestic financial market enhances the efficiency for capital accumulation and on the other hand investment and savings rate increases through financial intermediation. Goldsmith was the person who first analysed the importance of the development of a domestic financial market in increasing the efficiency of capital accumulation. He also posited the positive relation between per capita real GNP and financial development. He further argued that the growth process has a link with the financial market through incentive effects which leads to further financial development. McKinnon and Shaw had extended the previous argument of Goldsmith and stated that financial deepening not only implies higher capital productivity but also leads to high rate of savings and investment. Unlike Goldsmith, the focus of McKinnon and Shaw was on the effects of the public policies on investment and savings (Gregorio, 1999, p.3). They argued that the policies which lead to financial repression, reduces the incentive to save. Lower savings rate results in a lower rate of investment and hence low level of growth. However the empirical validation of the research made by McKinnon and Shaw has been questioned by many economists. In the framework presented by Bencivenga and Smith, financial integration leads to growth via channelling the savings into the activity which has higher productivity. One interesting result posited by Bencivenga and Smith, is that the growth increased even when the savings rate reduced due to the financial development (Gregorio, 1999, p.4). The reason for such an interesting result is the dominance of the financial development on the investment efficiency. Diaz Alejandro argued that the experiences by the Latin American countries showed that savings rate did not increase due to financial deepening. So he concluded that rise in the marginal capital productivity is the driving force for which growth occurs for financial deepening. Levine (1992) in his model emphasised, financial institutions increases total savings devoted for investment and thus avoids premature capital liquidation. Mutual funds, stock markets and investment banks raise growth by enhancing efficient reallocation of investment via several channels (Gregorio, 1999, p.5). On the other hand Roubini as well as Salai Martin emphasised the role of government policies in analysing the relation between growth as well as financial integration. In a model developed by them, they used financial repression as a tool by the government to broaden the base for inflation tax. They showed that in order to retrieve high revenue from inflation tax, policymakers repress the financial system via imposing high income tax. Thus growth is hampered as the financial repression reduces capital productivity and lowers savings rate (Gregorio, 1999, p.5). In a paper presented by Michael Graff, he posed the question that whether financial development leads to economic growth. Causal relation between economic growth and financial development is still not well understood. There are many literatures that deal with this question and are grouped into four categories (Graff, 2001, p.3). Firstly it is seen that economic growth and financial activity are not causally related. In this respect what is observed is that the relation between the two is spurious. The economy grows and so does the financial sector but on its own. Secondly it is stated that economic growth leads to financial development, thus financial development is demand driven. Thirdly the financial development often is viewed to be the factor causing economic growth. In the recent models that were developed emphasise on the fact that a well developed monetary system and banking system as well as capital markets are important for economic growth. Fourthly, according to some scholars, financial activity occasionally is viewed as an instrument for economic growth. Here financial system is viewed to be inherently unstable (Graff, 2011, p.4). Jappelli and Pagalo analysed the effectiveness of the developments of financial markets on the rate of savings. Their study concentrated on the impact of borrowing constraint. Here there has been a shift on the focus of effectiveness of financial market on production side to that on the household. A conclusion drawn from the study is full or partial inability of the individual to borrow against future income causes them to increase savings. Therefore the study reveals that financial deepening on the consumer credit side will not increase savings. The result is also consistent according to the happenings sited in Latin America in which financial liberalisation did not lead to increased rate of savings. On the other hand De Gregorio showed that relaxation of the borrowing constraint increases the chances for accumulation of human capital. This will increase the marginal productivity of capital and cause higher rate of growth despite low savings (Gregorio, 1999, p.5). However there is no simple procedure that would determine the empirical validation of the above mentioned views since the instruments that lead to economic growth include many other instruments apart from financial development. In the empirical test conducted by Graff it was found financial development indeed caused economic growth in the 1980’s, but the causation mainly ran from financial development to real development with very little evidence on mutual causation and no evidence for the reverse causation. Even the division of economies into developed and less developed, it was sited that the relationship between financial development and economic growth is unstable. Although the relation between financial development and output increase is stable for economies experiencing a vast period of boom, the scenario is drastically opposite in case of countries that are still developing (Graff, 2001, p.16). Conclusion Macroeconomic convergence is a process adopted by the adjoining economies across regions for economic integration amidst themselves. The trade and growth models are two models depicting economic integration and are related to convergence of income convergence. Macroeconomic convergence could be reached more rapidly when there is an equitable distribution of wealth among nations. The rate of convergence highly depends on the initial condition of the economy as well the growth potential of the economy. Economic growth basically occurs from two processes either increases in the amount of factors of production or an increase in the level of efficiency in the manner in which they are used. Financial developments have twin effects on the rate of economic growth. Therefore it can be said that despite different approaches been followed by researches and economists, they all found a common thread binding growth convergence and financial development. References Alfaro, L. et al. 2005. Why doesn’t capital flow from rich to poor countries? An empirical investigation [Pdf]. Available at: http://www.people.hbs.edu/lalfaro/lucas.pdf [Accessed: September 23, 2011]. Anderson, F & Edgerton, D. 2011. A matter of time: Revisiting growth convergence in developing countries [Pdf]. Available at: http://www.nek.lu.se/publications/workpap/papers/WP11_23.pdf [Accessed on: September 23, 2011]. Dobson, S et.al. 2003. Convergence in developing countries: evidence from panel unit root tests [Pdf]. Available at: http://www.business.otago.ac.nz/econ/research/discussionpapers/DP0305.pdf [Accessed: September 23, 2011]. Graff, M. & Karmann, A. 2001. Does financial activity cause economic growth? [Pdf]. Available at: http://econstor.eu/bitstream/10419/48121/1/328043052.pdf [Accessed: September 23, 2011]. Gregorio, J. 1999. Financial integration, financial development and economic growth [Pdf]. Available at: http://www.econ.uchile.cl/uploads/publicacion/c6b5fc4b-498f-462e-9453-2ae0325e0b2f.pdf [Accessed: September 23, 2011]. Halmai, P & Vasary, V. 2009. Economic growth and convergence in the European Union [Pdf]. 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Romer, P. 2007. Economic Growth [Pdf]. Available at: http://www.stanford.edu/~promer/EconomicGrowth.pdf [Accessed on: September 23, 2011]. Zyuulu, I. (2010). Convergence in the SADC and African economic integration process: Prospects and statistical issues [PDF]. Available at http://www.bis.org/ifc/publ/ifcb32f.pdf [Accessed: September 23, 2011]. Read More