MSc (Economic Development Policy)

Macroeconomic Policy Analysis

Lecture Notes

Economic Growth: Theory and Policies

Prepared by

Prof. Andrew S. Downes SALISES, UWI Cave Hill Campus

November 2010

Economic Growth: Theory and Policies 1 Review of Theories of Economic Growth

A Classical Economists
A. Smith, D. Ricardo, K. Marx and T.Malthus were all concerned with the growth of the economy (i.e., the increase in the production of goods and services over time. A. Smith: The Wealth of Nations What determines long-term economic growth rate and hence the prosperity of nations. The classical economists focused on: the savings-investment nexus by capitalists specialisation and trade institutions (property rights, the market mechanism) as the main forces influencing the growth process.

Smith: the importance of the invisible hand (the forces of supply/demand in a competitive economy) competition in a market economy specialisation/division of labour limited by the extent of the market ( this underlies the increasing returns/economies of scale argument of modern growth theory) accumulation of physical capital (investment) which is dependent on the profit rate technological progress rolel of trade and exports

Smiths 3 stages of growth Stage 1: Low Level Equilibrium Trap ----due to poor governance, inadequate property rights/human rights, low savings and cultural backwardness. Stage 2 : Freedom in the environment with ongoing growth. Stage 3: Long Run Steady/Equilibrium State---the natural environment limits growth beyond a given level. Growth is constrained by falling profit rates, decreases in investment opportunities, changes in relative factor scarcity ( eg. Land). Hence we have a long run steady (equilibrium) state. Economic growth will occur as long as capital is accumulating and new technology is introduced. Competition and free trade allow the process to be cumulative.

Malthus: rapid population growth can constrain economic growth leading to a low-level equilibrium trap. Population growth ( greater than the production of food) leads to a fall in the profit rate and reduced investment effective demand is seen as a determinant of output growth

Ricardo: diminishing returns in the production process can constrain the growth process, hence the need for technological change free trade based on a countrys comparative advantage and specialisation can enhance economic growth

Smith-Malthus-Ricardo model of economic growth the rate of capital accumulation determines the rate of economic growth, the rate of capital accumulation (investment) is determined by the rate of profit earned by capitalist investors. The distribution of income is regarded as important. diminishing returns and population growth can constrain economic growth, international trade and technology can overcome these constraints and avoid a stationary state.

Marx: focus on societys institutional structure and role of class struggle to determine distribution; capital accumulation important to economic growth investment depends on the profit rate (which is dependent on the rate of surplus value. Surplus value is a measure of the degree of worker exploitation and the capital intensity of production). Pr= s/(v+c) where Pr is profit rate, s is surplus, v is variable capital or wages (wL) and c is constant capital. Total Output (y) = s + (v+c). The rate of exploitation ( rate of surplus value Er= s/v. Pr = Er/ (1+kl) where kl is the capital =labour ratio crisis and cycles can occur with capitalist production. Arthur Lewis: Theory of Economic Growth (1955) wrote in the classical tradition and emphasized: savings capital accumulation

growth of knowledge and application of new ideas international trade the framework of private-public sector relations institutions property rights, economic freedom in determining the growth/development of countries Lewis dual economy growth and development model is based on the expansion of the capitalist/modern sector through capital accumulation (domestic and foreign) and the transfer of labour from the subsistence sector at a given wage rate.

B.

Harrod-Domar Model (Keynesian Type Growth Model)

Model focuses on the instability of growth rates caused by a mismatch between (a) (b) the natural rate of growth determined by the growth of the labour force and labour productivity; and the warranted rate of growth which depends on the savings rate and the capital requirement per unit of output We therefore have three types of growth rates: actual growth rate (g), the warranted rate of growth (gw) and the natural rate of growth (gn) Formally: Let the savings function be S=sY The investment relationship is given by the accelerator I=k.DY (2) (1)

where S is Savings, Y is income or output, I is investment ( or change in capital), k is the incremental capital output ratio, DY is the change in output. In equilibrium S=I hence we have sY=k.DY The actual growth rate is given as (3)

g=DY/Y=s/k investment to match planned saving and keep the economy at the full employment level.

(4)

The Warranted growth rate refers to that rate which induces just enough

Let the potential supply of investment goods be given by the accelerator model I=kr.Dy where kr is the accelerator coefficient. Hence the Warranted Rate of Growth (that rate of growth required for a dynamic full employment equilibrium) is given as gw= s/kr (6) Expenditure on goods equals the production of goods and entrepreneurs are satisfied with their investment plans. Higher economic growth depends on: i. ii. higher saving, and lower capital-output ratio ( the productivity of capital stock) (5)

If output grows over time by the percentage value s/kr, then the economy will be in Steady-state Equilibrium, where output, capital, labour and the capitallabour ratio all grow at the same rate. Implications of Harrod-Domar Model 1. Instability of Equilibrium Growth Rate In equilibrium, g=gw (a) or k.g=kr.gw if the actual economy grows faster than the warranted rate ( g>gw), then actual investment falls below the level required (k<kr) to meet the increase in output, hence there is an incentive for investors invest more and more output is produced;

(b)

if the actual growth rate is less than warranted rate ( g<gw), then the economy slows down as investors invest and produce less because there is a surplus of capital goods (k>kr)

Departure from equilibrium is self aggravating and represents a short term trade cycle problem in the growth model. The unstable growth path in a closed economy is due to: (1) fixed technical coefficients production function with no factor substitution and (2) the existence of an independent investment function given investors expectations with respect to the future demand for goods and services

2. Knife-Edge Equilibrium If the economy is not growing at the rate suggested by the s/kr factor (i.e., warranted rate of growth), then the economy moves away from its equilibrium path. We need to determine what rate of growth of investment is needed to ensure that supply equals demand at full employment. Let y= L.(y/L), then in growth terms we have the natural growth rate as gn=gl +gpl (7) where gl is the growth of the labour force and gpl growth of labour productivity. Gn defines the rate of growth of productive capacity or the long run employment equilibrium growth rate and sets the upper limit to the actual growth rate ( ie if g>gw, then g tends to gn). With fixed technical coefficients of production , full employment of resources require that g= gw= gn This is the Golden Age. (8)

Where gw>gn, there is a tendency towards depression as the actual rate will be insufficient to stimulate investment demand to match the amount of saving at full employment. If investors expect less that the warranted rate, then the actual rate would be less than expected, hence there is a fall in production. Where gw<gn, there is a tendency towards demand inflation and actual growth exceed that needed to induce investment to match savings. If investors expect more than the warranted rate , then the actual growth rate of demand would be greater than anticipated, thus leading to inflation. The model can be used to show how a country can be caught in a poverty trap. These implications provide a basis for governmental action with respect to the savings rate via financial development. Note Lewis problem of development is how to raise the savings rate of a country to say 20 percent. (see C. Kennedy: Domar-type Theory in an Open Economy, Social and Economic Studies, vol 15, no 3, September 1966, pp 175-188, which examines the roles of trade and foreign borrowing).

C. Neoclassical Model
developed by R. Solow and T. Swan in the 1950s in response to the two implications of the Harrod-Domar model. To overcome the implications, the production process was designed to reflect input substitution rather than the non-substitution assumption in the Harrod-Domar model. The production process was also subject to diminishing returns ( eg a Cobb-Douglas production function)

the capital-output ratio is assumed to depend on endowment of capital (K) and labour (L). Hence the per capita stock of capital (K/L) converges to its steady-state level which implies that the longrun growth of output converges to the rate of population growth( ie in long run steady state, output growth is determined by the growth of the labour force in efficiency units); economic growth in the basic Solow neoclassical model is determined by technological change (exogenously determined); the savings ratio (s) has no effect on economic growth as in the Harrod-Domar growth model ( that is, output growth is independent of the savings ration and the investment output ratio, since higher values of these ratios would be offset by lower capital productivity because of diminishing returns to capital)

the long-run level of output per capita is determined by savings and investment rates
The steady-state equilibrium is given as: q= (l/s).k where q is output per capita , l is the growth of the labour force, s is the savings ratio or the ratio of Savings to Income, and k is capital -output ratio. This formulation implies a steady state level of per capita income towards which all countries must converge irrespective of their starting points. There are different concepts of convergence: i. Unconditional/Absolute Convergence: If all countries have the same d, s, n and technical progress, then they all converge on a common level (steady state) of per capita income

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regardless of initial conditions. These initial conditions only determine the rate of disequilibrium growth This implies a strong negative relationship between (a) growth rate of per capita income and (b) the initial value of per capita income [g(y)= -y*+ other determinants] In neoclassical growth theory, the following results emerge: Economies will converge to their respective steady states because of diminishing marginal returns to the accumulation of capital; The level of income in the steady state is determined by the positive influence of the savings rate and the negative influence of population growth; The steady state growth rate is governed purely by the rate of technological progress ii. Conditional Convergence If the assumptions of unconditional convergence are relaxed, then convergence now means that all countries converge to their own steady states. This occurs when the (capital) rich economy grows towards its steady state at a faster rate than the (capital) poor economy and the rich economy is initially further from its steady state than the poor economy. Conditional convergence is due to diminishing marginal returns to capital in the neoclassical model. In the open economy endogenous model convergence is due to gains from technological diffusion.

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This implies convergence in growth rates but not in per capita income levels. Existence of diminishing marginal returns to capital. iii. Beta () Convergence: This is also called convergence to the mean where poor economies grow faster than rich ones. This type of convergence exists when the coefficient on initial income is negative in a cross-sectional regression equation with growth rate as the dependent variable ( ie catch up growth across countries). It is related to unconditional/absolute convergence. If countries differ only in their initial level of income and if poorer countries are growing faster than richer ones in the long run then they will all converge to the same steady state income ( that is, absolute beta convergence). Conditional Beta Convergence occurs if countries are different with regards to technology, population growth rates etc, then they will converge to different steady states

iv.

Sigma () Convergence This occurs when the dispersion of income levels of a cross-section of economies falls over time (that is, a reduced dispersion in income levels over time).

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For research on convergence in Latin America and the Caribbean: (a) (b) (c) (d) Atkins and Boyd : International Review of Applied Economies 12(3), 1998, pp 381-396. Mamingi: Journal of Eastern Caribbean Studies 24(3), September 1999, pp 15-40. Carter and Greenidge: Journal of Eastern Caribbean Studies 25(1), March 2000, pp 20-38. Dobson and Ramlogan: Applied Economics, vol 34, 2002, pp 465-70.

Endogenous Growth Models

The models examine the endogeneity of n, s and the rate of technological change which are assumed to be exogenous in the neoclassical model. Empirical results on the neoclassical model raised several questions about the diminishing marginal returns to capital, the exogeneity of technical change and hence researchers have focused on these elements. A simple model can be specified, the so-called AK model. Let y(t) =AK(t) Where y is output and K is capital broadly defined to include physical, human , social, research etc, and A is a constant multiplier defined as the output-capital ratio. [ A can change over time---rising with increasing returns and falling with decreasing returns]. We can modify the above equation as

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y(t)=A(K). K(t) where A(K) is induced or endogenous technological change imparted to the economy by the stock of capital broadly defined. We can take a Growth Accounting approach to growth analysis. Let the production function be given by Q = q(K, L, A) change. Totally differentiating the function with respect to time and dividing by q, we have: Gq = k gk + L gL + A gA Therefore gA = gq (k gk + l gl) Where A = 1, g = growth rate, k, L are capital and labour elasticities (or factor shares). Once the capital and labour (human capital) growth variables are taken into account, then we need to account for the residual of total factor productivity growth, gA. Hence gA = f(X) of the factors identified in endogenous growth theory include: 1. human capital accumulation (education, training, health and nutrition); (6) where X is a of variables influencing total productivity growth. Some (4) (3) Where q output, K capital, L labour (human capital), A technical

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2. 3.

the accumulation of knowledge and the discovery of new ideas (also learning by-doing); product innovation, rising product quality and variety arising from improvements in intermediate goods (case of creative destruction as new products replace old ones);

4. 5. 6. 7. 8. 9.

investment in research and development; new investment in machinery and equipment; the existence of externalities or spill over effects associated with knowledge accumulation; international trade and human capital formation; the existence if increasing returns to scale in the production process; public spending on public goods and infrastructure (communications networks, information services, etc) which increase the productivity of private factors (e.g., crowding-in effect)

10.

institutions maintenance of free market, establishment of property rights, etc.

2 Empirical Evidence on Growth Theories

There has tremendous growth in the empirical literature on economic growth over the past two decades. The approaches have been either (i) growth accounting/components analysis (using equation 5); (see, for example, Maddison: Journal of Economic Literature, vol xxv, no 2, June 1987, for a good summary of this approach) Growth accounting provides a preliminary examination of the factors affecting economic growth by focusing on:

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Capital accumulation Employment growth A residual factor which can be influenced by systematic, cyclical and irregular/ad hoc elements. (ii) regression analysis: a cross-section of countries a time series of a country a panel of a set of countries over time Regression analysis of economic growth has been a growth industry with the identification of several factors. Assessments of these regression studies are given in J. Temple, J of Econ Lit, 1999, Kenny and Williams, World Development, 2001, and Capolupo, Economics-eJournal 2009. These studies have also been subjected to sensitivity tests (Levine and Renelt, American Econ Review, 82 (4), September 1992; Sala-i-Martin, American Econ Review, 87(2), May 1997; Temple, Bulletin of Economic Research,52(3), 2000).

General Literature
1. 2. 3. human capital formation (especially health) has a + effect: Mixed results for education and training; openness to trade has a + effect; institutions are important i. rule of law, political rights, civil liberties, social capital are good for growth ii. coups, wars political instability are bad for growth

Some of the main conclusions emerging from the literature are as follows:

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4.

market distortions (real exchange rate distortions, black market premium, labour market rigidities, negative real interest rates) have a - impact on growth.

5. 6. 7. 8. 9. 10. 11.

investment in plant and equipment impact positively on growth; inflation has a - impact on growth; initial income (GDP) has a negative coefficient suggesting convergence (i.e., conditional convergence); population growth or fertility is negatively associated with per capita growth; better developed financial markets bring higher growth (financial regression negative real interest rates retard growth) deterioration in the terms of trade has a negative impact on growth; policy uncertainty depresses growth

We can classify the causes of growth into: i. ii proximate causes capital (physical/human/research) accumulation - technological change fundamental causes structures/institutions - policies Recent work on Growth Diagnostics seeks to identify the binding constraints on economic activity using the concept of a Problem Tree. It examines the factors which keep the level of investment and entrepreneurship low. For a Caribbean example, Mizuho Kida: Caribbean Small States-Growth Diagnostics (available on the World Banks website)

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Caribbean Literature
Very little work on economic growth has taken place in the Caribbean. Most of the research has been on Barbados. General research undertaken by the World Bank has identified three (3) factors which have had a positive impact on economic growth: i the export of goods and services ii foreign direct investment iii human capital investment Econometric research undertaken by Central Bank and University economists has pointed to the following determinants of economic growth in Barbados: capital stock growth (capital investment): + human capital investment: + exports (e.g., tourism services): + inflation and terms of trade: (-)

Research on Jamaica and Trinidad and Tobago indicate: i. labour force growth: + for both; ii. domestic credit: + for T&T iii. external debt: - for Jamaica iv. devaluation: contractionary in short-run but expansionary in long-run for Jamaica; contractionary in long-run for T&T (see Downes, 2002 for a summary of the research on Barbados and some new results). Recent work by ECLAC (2009) indicates that education, trade, physical investment and government expenditure play a critical role in economic growth in the Caribbean. Peters (Savings and Deevlopment, 2001) also found the same results.

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3 Implications for Economic Development Policy

The empirical results from the growth literature have raised a number of implications for the formation of economic development policy. There are however caveats relating to the robustness of the results (see, for example, Kenny/Williams, World Development, January 2001, 29(1), pp 1-22). The implications of growth theory for economic development policy are discussed in Ruttan (1998); Barros (1993) , Pio (1994) , Banerjee and Duflo (2004) and Islam (2004) Empirical research suggests a role for public policy to aid economic growth: i. education , training, health/nutrition and entrepreneurial development to improve labour productivity TVET programs in the region, EduTech in Barbados, health sector reform program (problem of HIV/AIDS); ii. development and introduction of innovative production processes/techniques use of fiscal incentives for R&D expenditure, strategic alliances with more technologically developed partners; iii. government measures to: encourage the export of goods and services (e.g., tourism promotion) promote macroeconomic stability (low inflation, fiscal deficits, exchange rate stability) support financial development (institutions and capital market development)

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minimize market distortions (commodity, factor and financial markets) promote good governance, democracy, political stability, social capital iv v Structural reform measures to enhance the supply side of the economy regional integration policies re: CSME, FTAA as avenues for promoting export and obtain resources for production Statistical data suggest a slowing down of economic growth over the past 4 decades: 5-6 percent in the 1960s to 1-3 percent in the 2000s. Economic growth can be seen as a necessary but not sufficient condition for economic, human and sustainable development in the region.

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EXERCISES i. Using the results of the empirical growth literature, identify two programs in the Caribbean which are indicative of the empirical results. ii. Calculate the growth rates of real GDP at factor cost for Barbados, Jamaica and Trinidad and Tobago over the past 15 years and prepare a report on their relative performance. iii. iv. Indicate how endogenous growth theory has enhanced economic development policy in developing countries. Evaluate the contribution of Lewis and Schumpeter to the development of growth theory.