Long Term Growth: Savings and Institutions - Research Proposal Example

LONG TERM GROWTH: SAVINGS AND S LONG TERM GROWTH: SAVINGS AND S Introduction Recent research oneconomic growth has discovered the existence of a significant relationship between saving and long-term economic growth. Savings has been identified as an independent variable towards long-term economic goals (Harris et al, 2003). It is because in the situation of increased savings rate in a particular country there are availability of more financial capital hence proportionately more investment rates. The higher rates of investment have thus resulted in higher growth rates in a given country. This research finding has been found to be consistent with the Solow growth model whereby higher savings lead to higher levels of income per Capita in a steady state (Kaufmann, Kraay and Masturuzzi, 2009). Another economist Modigliani through life-cycle model also predicts that high growth precipitates great savings hence in the long term effect substantial savings is directly linked to high investment and long-term growth (World Bank Group, 2012). This academic paper aims at exploring the relationship between savings and long term growth with reference to different theories. The Solow Growth Model The Solow model formulated by Robert Solow ignores the temporary changes in the business cycle as it seeks to explain potential income obtained in the long run. The production function for Solow’s growth model is as follows: Y = F (K, L) = = ( ) = y=f (k). With reference to the above formula, k refers to the amount of capital per worker while y is the workers output level. The slope concerning this function measures the marginal output per worker as a result of a unit increase in capital per worker. The slope represented as M.P.K hence f(k) = M.P.K. The basic Solow model maintains the labour force at its fixed at its average level (World Bank Group, 2012). In order to identify the potential output level generated by the economy in the long run equilibrium, we need to establish the capital stock maintained in the long-run equilibrium. Whenever firms invest, capital is added and as a result of depreciation it also gets lost. Whenever investment levels are higher than depreciation, the capital stock grows, and when investment falls below depreciation levels, the capital stock shrinks (Woods, 2000). The capital share remains unchanged if investment equals depreciation hence it is referred to as the steady state. Since the Solow model assumes no Government or international trade, then investment equals saving which equals depreciation at the steady state. The number of probable stable states is infinite in the different economies, and thus our output is dependent on where the s f (y) curve meets the k curve (Nonneman and Vanhoudt, 2006). The k curve is dependent on the savings rate in the economy. If the capital level is at K0 investment will be higher than depreciation hence net investment remains positive. At the steady state, capital equals depreciation hence economic growth remains constant through investment in the long term. From Solows model of economic growth, saving is treated as an independent variable while economic growth is regarded as a dependent variable (Azariadis et. al, 2001). The basic idea behind Keynesians theory (IS/LM) is that prices and wages are not flexible in the short-run. This is because producers and sellers of goods do not change the prices of goods on a continuous basis (Mc Adam, Peter and Alpo, 2003). One of the primary components of the classical models is a relation between saving and investment represented as below. A change in the spending levels of the Government results in a shift to the right of the IS curve. With reference to the above figure, S=I whereby aggregate demand equals aggregate supply at the income levels Y, r and the initial G. This implies that in the situation G is increased from G to G and G" the national levels of public savings fall due to reduced saving propensity. The reduction in domestic savings leads to higher interest rates (r). A higher interest rate reduces the aggregate demand level and restores the demand between demand and supply at the initial output level. Should the r level remain constant at the initial r level, the excess demand at point E is controlled through an increase in the output from Y to Y". This is represented by the movement from E to E". In contrast it is observed that the savings function plays an active role towards long-term economic growth while in the short term effect it leads to inflation. Therefore, this indicates that it is not an independent variable of economic growth (Shisido et al, 2000). Why institutions and their Quality are among the factors that affect long-term growth Rodrik (2004) argues that political decision makers can ignite economic growth in several different ways without the presence of high-quality institutions. He however, states that sustaining economic growth requires the presence of suitable systems since these institutions ease the adoption of resilience policies against shocks while maintaining productive dynamism. Sound systems through reducing Government failures contribute to the development of investment in the private sector. The increase in the private investment results to an increase in the total factor productivity as a consequence of the positive externalities of private investment accumulation on workers skill (Aron, 2000). Furthermore, private investors invest with the aim of maximizing profits while minimizing costs. The most significant way of enhancing this objective is through minimization of the investment costs. Although private investors face different investment costs, costs related to the creation of new enterprises among others should be reduced (North, 2009).Institutions can affect long-term growth through setting up appropriate legal policies that enhance protection of private property rights which goes along in developing private investment and economic growth. In the situation whereby the security property rights is, the private investors fear of failing to appropriate a significant share of their investment return is confirmed(Acemoglu, Johnson and Robinson, 2005). On the other hand, democracy reduces risks associated with distortive policies and contributes to the reduction of costs and the development of private investment. Through the favouring of the development of private investment, democracy involves an increase in total factor production (Davis and Kevin, 2010). Institutions should also ensure increased productivity that goes along to facilitate economic growth and competitiveness for growth sustainability. Even if an economy records positive growth, yet it is non-competitive, it is most unlikely to maintain the good results (Welfe, 2009). An example of such like is scenario is when a non-competitive economy records an increase in the volume of exports. This could be to the cheapness of their products. This will mean that they would be operating at a loss thus would not be able to maintain the competitiveness for long (Satyanath, Shanker and Subraminian, 2004). On the contrary, corruption has been discovered to have an adverse impact on investment and general economic growth in a given nation. Transparency International has defined corruption as improper use International entrusted public power for private personal gains. Through the perceived corruption index measures the perceived level of corruption in the public sector in different countries (Nickell, Stephen and Layard, 2000). Past research has exhibited a link between corruption and the investment rate between corruption and growth rates. As a result of corruption, national development is stalled, or cash swindled so as to be used to develop others on an individual basis. Another international organization "The Heritage Foundation, "has produced data on economic freedom around the world since 1995. The information provided is for 185 countries on corruption levels, fiscal performance, Government expenditure, entrepreneurial freedom, labour freedom, financial freedom, and economic freedom among many more others. All the features named above have been found to be to economic development hence independent variables (Knight and Santaella, 1997). Investigating empirical evidence about the quality of institutions and level of GDP per capita for two different countries Research from the international monetary fund has established that all the various institutional measures have significant impacts statistically on the Gross domestic product per capita. The results of stronger institutions on economic developments are in two ways (Vreeland, 2003). The first method considers the general effect on the income level of institutional quality by a single standard deviation. The second method measures the implications caused by changes in institutional quality concerning average earnings in particular regions regarding the above two methods; I shall focus on Cameroon and Canada. Cameroon is found in Sub-Saharan Africa while Canada is in the Western Hemisphere. The real GDP per capita squared for Cameroon is 803 while for Canada in the Western Hemisphere is 2887. This indicates that the change brought about as a result of institutional quality from the most efficient institutional change is nine times below the mean of developing countries. Further, it is 3.5 times behind the western hemisphere countries (US. IMF, 2004). When compared to developing economies it is found out to be 29.26 times below. With reference to the second method that measures the implications of institutional measures and aggregate governance the level for Cameroon is -0.49 from the sub-Sahara category while that of Canada from the Western Hemisphere is -0.03. 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