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1 Chapter 17 Macroeconomic Policies and Long-Term Growth © Pierre-Richard Agénor and Peter J. Montiel

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2 l Wide dispersion of output growth rates across countries. l Table 17.1: growth performance of developing countries. l Traditional neoclassical approaches: incapable of explaining the wide disparities in the pace of economic growth across countries. l “New growth” literature: existence of “endogenous” mechanisms that foster economic growth, and new roles for public policy.

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3 l The Neoclassical Growth Model. l Externalities and Increasing Returns. l Human Capital, Knowledge, and Growth. l Effects on Financial Intermediation. l Inflation Stabilization and Growth. l Government size and Growth. l Commercial Openness and Growth. l Exchange-Rate Unification and Growth.

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The Neoclassical Growth Model

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5 l Solow (1956) and Swan (1956): neoclassical growth model. l Assumptions: è Production function: aggregate, constant-returns-to- scale, and combines labor and capital in the production of composite good. è Savings: fixed fraction of output. è Technology improves at exogenous rate. l Cobb-Douglas production function: Y = AK L 1- , 0 < < 1, Y: total output; K: capital stock; A: level of technology; L: workers employed in the production process. (1)

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6 l Output per worker, y = Y/L, is given by y = Ak , l k: capital-labor ratio. l Capital accumulation is given by k = sy - (n + )k, 0 < s, < 1, s: propensity to save; n > 0: exogenous rate of population growth; : rate of depreciation of physical capital. l (2) incorporates equilibrium condition of goods market or, equivalently, equality between investment I and saving, I = sy.. (2)

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7 l Suppose that A is constant over time. l Substituting (1) in (2) and dividing both sides of the resulting expression by k yields growth rate of capital- labor stock: g k k/k = sAk -1 - (n + ), from which the rate of growth of output per worker can be derived as g y y/y = kAk -1 /Ak = g k. l Figure 17.1: behavior of capital stock per worker. l Horizontal line at n + : depreciation line.. (3)..

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9 l Curve sAk -1 : savings curve. l Savings curve is downward-sloping due to assumption of decreasing marginal returns to capital. l As implied by (3), g k is the difference between the two curves. l Point of intersection of the two curves: steady-state value of k. l If technology grows at a constant rate, steady-state values of output per effective worker and capital/effective labor ratio are è constant; è proportional to the rate of technological change. l Although s has no effect on growth rate per capita in the long run, it affects level of per capita income in steady state.

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10 l Model implies that countries with similar production technologies, and comparable saving and population growth rates should converge to similar steady-state levels of per capita income. l Figure 17.1: “poor” country starts with capital stock of k 0 has higher initial growth rate than “rich” country starting with k 0. l Poor country grows faster during the transition. l But, if both countries possess the same level of A, s, , n, they will both converge to the same steady-state level of the capital stock, k. l Convergence occurs because each increment to capital stock generates large additions to output when capital stock is initially small with diminishing marginal returns to capital. p r ~

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11 l “Sources-of-growth” approach: empirical methodology to analyze determinants of changes in output. l It uses aggregate production function to decompose growth into “contributions” from different sources plus residual. l Residual: “technical progress,” or more adequately growth in total factor productivity. l Assume: production function is y = Af(k, n).

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12 l In terms of percentage changes: g y/y = (A/A) + Af k (k/y) + Af n (n/y) = g A + k g k + n g n, h = f h h/y (for h = k, n): elasticity of output with respect to input h; g A : rate of growth of total factor productivity and is derived as a residual. l Under conditions of competitive equilibrium, factors are paid their marginal products: k ( n ) is equal to share of capital (labor) income in total output. l In the presence of constant returns to scale, sum of all share coefficients must be equal to unity......

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13 l With Cobb-Douglas production technology as in (1), assuming that factors of production are paid their marginal products implies that è k = 1- n, and è labor's share corresponds to the parameter . l Even though hypotheses of constant-returns-to-scale production function and competitive factor markets are restrictive, there are studies based on the model. Chenery (1986): l Studies based on sources-of-growth methodology in the 1960s and 1970s. l Average capital share is about 40%, which indicates that production function exhibits diminishing marginal returns to capital.

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14 l Growth in capital stock had limited effect on output growth. l Average contribution of the residual was less than in developed countries. l Most countries had high growth rate of labor input. l Estimates of capital share vary across countries, ranging from 26% for Honduras to more than 60% for Singapore. l Effect of capital accumulation on growth varies across countries. l Contribution of total factor productivity to growth also varied across countries. Elías (1992): l Growth process of Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela during 1940-85.

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15 l He considers different kinds of labor and capital inputs, and defines gross and quality component for each of them. l For labor: gross component is arithmetic sum of employment across characteristics. l For capital: it is arithmetic sum of different categories of capital. l Quality component captures changes in composition of factors of production. l Output growth averaged 5.3% for the group as a whole. l Quality of labor rose on average by 1.4%, and quantity of labor by 2%. l Quality of capital fell by 0.4%, its quantity grew at 4%. l Given average labor share of 40%, labor contributed 1.3% to average growth rate.

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16 l Capital's contribution was 2.5%. l Technological progress was therefore 1.5% of rate of growth. l Thus, capital made the highest contribution to output growth (47%) because of its quantity and its share. l Quality of labor played more important role in growth of labor input. Table 17.2: l Decomposition of trend or potential output growth for developing countries during the 1970s and 1980s. l Contribution of capital to potential output growth was the most important. l Total factor productivity accounted for about the same share as labor in its contribution to growth.

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17 l Differences across regions: total factor productivity è accounts for negligible share of growth in Africa and the Middle East, è provides substantial contribution to growth in Asia. Limitations of neoclassical growth model: l Capital assumed to exhibit diminishing marginal returns. l This prevents it from providing an explanation è for the wide variations across countries in either per capita income or growth rates, and è for the fact that poor countries do not grow faster than rich ones (Figure 17.2). l It is assumed that output growth is independent of saving rate and is determined only by demographic factors and technological progress rate.

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19 l Since population growth and technological change are assumed exogenous, the model does è not explain the mechanisms that generate steady- state growth, è not allow evaluation of mechanisms through which government policies can influence growth process. l Assumption that rate of growth of output is independent of saving rate is at variance with the evidence; high- growth developing countries have higher saving rates. l New growth literature addresses these limitations by proposing variety of channels through which steady- state growth arises endogenously.

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Externalities and Increasing Returns

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21 l Two approaches were followed to relax assumption of diminishing returns to capital: l First approach views all production inputs as some form of reproducible capital, including è physical capital, è human capital (Lucas, 1988) or è “state of knowledge” (Romer, 1986). l Simple growth model along these lines: AK model proposed by Rebelo (1991). l It results from setting = 0 in (1): y = Ak, where k = K/L as before, but K includes both physical and human capital.

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22 l Thus, production function is linear and exhibits constant returns to scale, but does not yield diminishing returns to capital. l Using the capital accumulation (2), steady-state growth rate of capital stock per worker: g k = sA - (n + ). l Steady-state growth rate per capita: g y = sA - (n + ). l Growth rate is, for sA > n+ , positive (and constant over time) and level of income per capita rises without bound.

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23 l Implication of AK model: è Increase in saving rate raises growth rate per capita. è Poor nations whose production process has the same technological sophistication as other nations grow at the same rate as rich countries, regardless of initial level of income. è Thus it does not predict convergence even if countries 4 share the same technology; 4 are characterized by the same pattern of saving. l Rebelo (1991): è Implications of considering separately the production of consumption goods, physical capital, and human capital goods.

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24 è Endogenous steady-state growth obtains if “core” of capital goods is produced 4 according to a constant-returns-to-scale technology; 4 without nonreproducible factors. l Second approach: introducing spillover effects or externalities in growth process. l Externalities: if one firm doubles its inputs, productivity of inputs of other firms will also increase. l Introducing spillover effects relaxes assumption of diminishing returns to capital. l Mostly externalities take the form of general technological knowledge that is available to all firms, which use it to develop new methods of production.

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25 l Exceptions. è Lucas (1988): externalities take the form of public learning, which increases the stock of human capital and affects productivity of all factors. è Barro (1990): externalities associated with public investment. l Externalities is associated with increasing returns to scale in production function. l But, important implication of models exhibiting spillover effects and externalities is that sustained growth è does not result from the existence of external effects, è rather result from assumption of constant returns to scale in all production inputs. l Rebelo (1991): increasing returns are neither necessary nor sufficient to generate endogenous growth.

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Human Capital, Knowledge, and Growth

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27 l The Production of Human Capital. l The Production of Knowledge.

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28 The Production of Human Capital l One of the sources of externalities: accumulation of human capital and its effect on productivity of the economy. l Lucas (1988): è Spillover effects of human capital accumulation. è Individual workers are more productive, if other workers have more human capital. l Simplified version of Lucas' model is examined here. l Human capital is accumulated through explicit “production”: part of individuals' working time devoted to accumulation of skills. l Let k denote physical capital per worker and h human capital per worker (“knowledge” capital).

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29 l Production process: y = Ak [uh] 1- , 0 < u < 1, u: fraction of time that individuals devote to producing goods. l Growth of physical capital depends on saving rate. l Growth rate of human capital depends on time devoted to its production: h/h = (1-u), > 0. l Long-run growth rate of both capital and output per worker is (1-u)..

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30 l Rate of human capital growth, and ratio of physical to human capital converges to a constant. l In the long run, income is proportional to the economy's initial stock of human capital. l Saving rate has no effect on growth rate. Implication of the model: l Under purely competitive equilibrium there will be underinvestment in human capital since private agents do not take into account external benefits of human capital accumulation. l Equilibrium growth rate is thus smaller than optimal growth rate. l Growth would be higher with more investment in human capital.

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31 l Thus government policies are necessary to increase the equilibrium growth rate.

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32 The Production of Knowledge l Romer (1986): source of externality is stock of knowledge. l Knowledge is produced by individuals. l But since newly produced knowledge can be partially and temporarily kept secret, production of goods and services depends on both è private knowledge, and è aggregate stock of knowledge. l Since individuals only partially reap rewards to production of knowledge, market equilibrium results in underinvestment in knowledge accumulation.

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33 l Romer (1990): è Explains endogenously decision to invest in technological change; è uses a model based on distinction between research sector and rest of the economy; è firms cannot appropriate all the benefits of knowledge production; è tax and subsidy can be used to raise rate of growth. l Simplified version of Romer's (1990) model is presented here. l Two production sectors: è goods-producing sector uses physical capital, knowledge and labor in the production process; è knowledge-producing sector (same inputs are used).

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34 L ( K ): fraction of labor force (capital) is used in the knowledge-producing sector. 1– L (1- K ): fraction of labor (capital) in the goods- producing sector. l A: total stock of knowledge that can be used in both production activities. l Assuming Cobb-Douglas technology, output in goods- producing sector: Y = [(1- K )K] [A(1- L )L] 1- 0 < <1. l Constant returns to both capital and labor. (9)

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35 l Production of new knowledge (changes in A) is determined by generalized Cobb-Douglas form: A = B( K K) ( L L) A , B > 0, 0, , 0, B: shift parameter. l There is either diminishing returns in production of new ideas or increasing returns, depending on , , and . l can be equal to unity, or strictly greater or smaller than unity. l Assuming s is constant and there is no depreciation of capital stock, then K = sY, 0 < s < 1.. (10). (11)

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36 l Population growth is exogenous: L = nL, n 0. l Begin analyzing te model by substituting (9) in (11): K = K K A 1- L 1- , K s(1- K ) (1- L ) 1- . l Dividing both sides of this expression by K: g K (K/K) = K {AL/K} 1- . l Its rate of change: g K = (1- )(g A + n - g K ).... (14).

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37 l g K is rising (falling) if g A +n-g K is positive (negative), and remains constant if g A +n = g K. l Curve KK in Figure 17.3: combinations of g A and g K for which g K is constant over time. l Slope of KK is unity; above (below) KK, g K is falling (rising). l Dividing both sides of (10) by A: g A A/A = A K L A -1, A B . l This implies that g A = g K + n + ( -1)g A... KL (15)

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39 l g A is increasing (falling) if right-hand side of (15) is positive (negative), and constant if it is zero. l Curve AA in Figure 17.3: combinations of g A and g K for which g A is constant over time. l Slope of AA is (1- )/ , which is ambiguous in sign. l Figure assumes that < 1, so that the slope is positive. l Above (below) AA, g A is rising (falling). l (9) exhibits constant returns to scale in K and A. l Thus whether there are on net increasing, decreasing, or constant returns to scale to A and K depends on whether (10) exhibits constant returns to scale. l This equation can be rewritten as A = K A (qL ), q B . KL.

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40 l Degree of returns to scale to A and K in production of new knowledge is + . l Consider the three separate cases, depending on whether + is less, equal, or greater than unity. If + < 1: l (1- )/ is greater than unity and AA is steeper than KK. l This case is illustrated in Figure 17.3. l Regardless of initial values of g A and g K, they converge to equilibrium point E. l Equilibrium values g A and g K are obtained by setting g A = g K = 0 in (14) and (15), and are given by g A = n, g K = n + g A. ~ ~.. + 1 – ( + ) ~~ ~

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41 l From (9), aggregate output and output per worker are growing at rates given by g Y = g K + (1- )(n + g A ) = g K, g Y/L = g K – n = g A. l Thus, economy's growth rate is endogenous: increasing function of n and is zero if n is zero. l L, K and s have no effect on growth rate. If + > 1: l AA and KK diverge (Figure 17.4). l Regardless of economy's initial position, it enters the region between two curves. ~~~~ ~ ~~

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43 l Once this occurs, growth rates of A and K increase without bound. l There cannot be steady-state growth. If + = 1: l (1- )/ is equal to unity and AA and KK have the same slope. l If n is positive, KK lies above AA: è upper panel of Figure 17.5; è there is no steady-state level of growth. l If n = 0, AA and KK are identical: è lower panel of Figure 17.5; è regardless of initial position of the economy, balanced growth path is reached; è this path is unique;

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46 è economy's growth rate on that path depends on all the parameters of the model including s. l Existence of knowledge-producing sector may explain positive correlation between s and rate of economic growth (Figure 17.6).

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Effects of Financial Intermediation

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49 l Introduce financial factor, following Pagano (1993), to assume that 1- of saving is “lost” as a result of financial disintermediation activities: l sy = I, 0 < < 1. l Assuming that production technology is constant returns to scale to capital, steady-state growth rate per capita: g = s A - . l How financial development affects economic growth: è raise s; è raise A (marginal productivity of the capital stock); è increase in (“conduit” effect).

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50 l Effects on the Saving Rate. l Effects on the Accumulation of Capital. l The “Conduit” Effect, Financial Repression, and Growth. l Financial Development and Growth: Empirical Evidence.

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51 Effects on the Saving Rate l Early development literature: existence of positive effect of financial development on s. l New growth literature: direction of this effect is not consistent. l Jappelli and Pagano (1994): è development of financial markets offers households possibility of diversifying their portfolios and increases their borrowing options; è this affects proportion of agents subject to liquidity constraints, which may affect s. l Financial development also è reduces overall level of interest rates;

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52 è modifies structure of interest rates by reducing spread between rate paid by borrowers and that paid to lenders. l In each case effect on s is ambiguous. l Ambiguous effect of financial intermediation on s may be compounded when all partial effects associated with financial development are taken into account. l Bencivenga and Smith (1991): direct effect of banking activities may be reduction in s. l But, if positive effect of financial development on productivity of capital and efficiency of investment is taken into account, net effect on growth may be positive.

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53 Effects on the Allocation of Capital l Figure 17.7: investment and output growth are positively correlated in developing countries. l Role of financial intermediaries: facilitate efficient allocation of resources to investment projects that provide the highest marginal return to capital. l Financial intermediation increases average productivity of capital A in two ways: è by collecting, processing, and evaluating relevant information on alternative investment projects; è by inducing entrepreneurs, through their risk-sharing function, to invest in riskier but more productive technologies.

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55 Greenwood and Jovanovich (1990): l Link between informational role of financial intermediation and productivity growth. l Capital may be invested in safe, low-yield technology or risky, high-yield one. l Return to risky technology is affected by è aggregate shock; è project-specific shock. l Financial intermediaries with their large portfolios can è identify the aggregate productivity shock; and è induce their customers to select technology that is most appropriate for current shock.

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56 l Efficient allocation of resources channeled through financial intermediaries raises productivity of capital and thus growth rate of the economy. Pagano (1993): l Another function of financial intermediation: it enables entrepreneurs to pool risks. l “Insurance” function: financial intermediaries allow investors to share uninsurable and diversifiable risk from rates of return differences on alternative assets. l Risk sharing affects saving and investment decisions. Liquidity: l In the absence of banks, households can guard against idiosyncratic liquidity shocks by investing in productive assets that can be liquidated.

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57 l Bencivenga and Smith (1991): banks increase productivity of investment by è directing funds to illiquid, high-yield technology; è reducing investment waste due to premature liquidation.

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58 The “Conduit” Effect, Financial Repression, and Growth l Financial intermediation operates as a tax in transformation of saving into investment. l Financial intermediation thus has growth-deterring effect because intermediaries appropriate share of private saving. l Costs associated with financial intermediation represent payments that are received by intermediaries in return for their services. l In developing countries: è Such absorption of resources results from explicit and implicit taxation and by excessive regulations.

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59 è This leads to higher costs and thus inefficient intermediation activities. l If financial system reforms reduce cost and inefficiencies associated with intermediation process, growth rate will increase. l Role of financial repression in growth models: l In countries where collecting conventional taxes is costly, governments choose to repress their financial systems to increase revenue. l Roubini and Sala-i-Martin (1995): inflation is viewed as proxy for financial repression. l Courakis (1984): constraints on bank portfolio choices may reduce volume and productivity of investment by è reducing funds channeled to deposit-taking financial intermediaries;

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60 è causing less efficient distribution of any given volume of such funds.

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61 Financial Development and Growth: Empirical Evidence. l Recent research has explored empirical relationship between financial “deepening” and economic growth. King and Levine (1993a, 1993b): l Four alternative measures of financial depth: è ratio of liquid liabilities of financial system to GDP; è share of total credit allocated by banks; è share of total domestic credit received by private sector; è ratio of credit to private enterprises to GDP. l Contributions of such indicators in explaining è long-term real GDP growth;

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62 è share of investment in GDP; è rate of growth of total factor productivity. l All of financial depth indicators are statistically significant with large positive effects on variable being explained. l This association did not reflect reverse causation from growth to financial indicators. l Evidence linking financial depth to long-term economic growth, both through è incrementation of resource accumulation, and è enhancement of productivity growth, is strong in cross-country record.

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Inflation Stabilization and Growth

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64 l High rates of inflation can be expected to reduce economic growth through variety of mechanisms which can influence both è rate of capital accumulation; è rate of growth of total factor productivity. l Fischer (1993): government which tolerates high inflation is one which has lost macroeconomic control, and this deters domestic investment in physical capital. l Other arguments: high inflation è means unstable inflation and volatile relative prices; è reduce information content of price signals; è distort efficiency of resource allocation, affecting growth of total factor productivity.

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65 l Simplified version of De Gregorio’s model (1993) is presented here. l Assumptions: è Closed economy consists of households, firms, and government. è Households hold no money but hold indexed bond issued by government. è Capital is only input in production process, which takes place under constant returns to scale. è Firms hold money because it reduces transactions costs associated with purchases of new equipment. è Capital mobility is precluded, so that domestic investment must equal domestic saving. è Inflation is exogenous.

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66 l Representative household maximizes present value of utility stream subject to flow budget constraint b = (1 - )(y + rb) – c - , 1/ : elasticity of intertemporal substitution; b: real stock of government indexed bonds; 0 < < 1: income tax rate; r: real rate of return on bonds; y: total factor income; : net lump-sum taxes paid by households. c 1- 1- 0 e - t dt, 0 < <1,. (18) (19)

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67 l Maximization of (18) subject to (19) yields c/c = [(1- )r - ]. l Production exhibits constant returns to scale: y = Ak. l Firms require money to purchase new capital goods. l Cost of investing I units is thus equal to I[1+ (m/I)], where m is firms' real money holdings. l 0: holding money reduces transactions costs but entails diminishing returns..

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68 l Representative firm maximizes present discounted value of its cash flow, net of opportunity cost of its holdings of money balances. l This opportunity cost is equal to (r + )m, where is inflation rate. l Thus firm maximizes: subject to k = I. 0 I – (r+ )m – m Ak - m I 1 + ( ) e -rt dt,..

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69 l Solution yields - ( ) = r + m = (r + )I, = 1/ < 0, q/q = r – (A/q), q = 1 + ( ) - ( ), q: shadow price of capital. m I m I m I m I. l (23): firm's demand for money. l Since cash flows are not subject to direct taxation, opportunity cost of holding money is sum of before-tax real interest rate plus inflation rate. (23) (24) (25)

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70 l (24): shadow price of capital is equal to present discounted value of marginal product of capital. l (25): q exceeds unity due to existence of transactions costs incurred in buying new unit of capital. l Substituting (23) in (25) yields q = 1 + [ ( )] + (r + ) ( ) = q(r + ), q > 0. l (26): q is constant (at q) if is constant. l From (24, real interest rate is: r = A/q. (26) ~ ~~

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71 l Government budget constraint: m + b = g - y - - m, g: public expenditure, which is taken to be a constant fraction of output. l Assume b = 0, and government adjusts lump-sum taxes to maintain fiscal equilibrium. l Aggregate resource constraint of the economy: y = c + 1 + ( ) I + g.... m I

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72 l Consumption, output, capital, and real money balances grow at constant rate in the steady state: g = [(1- )r - ]. l Model has no transitional dynamics; that is, economy grows continuously at rate given by (30). l This model generates an inverse relationship between output growth and due to negative effect of inflation on profitability of investment. è Higher raises “effective” price of capital goods, which incorporates opportunity cost of holding money to facilitate purchases of capital goods. ~ (30)

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73 è Increase in transactions costs raises shadow value of installed capital, dampens investment, and reduces growth rate. Barro (1997): l Cross-country evidence on relationship between inflation and growth. l Data set consists of 100 countries, with annual observations on macroeconomic data during 1960-90. l Three periods: 1965-75, 1976-85, and 1986-90. l Other things equal, 10% increase in reduces long-run growth by about 0.025% per year. l It is level of , rather than its variability, that affects growth adversely. l Results are robust with respect to exclusion of few high- inflation outliers.

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74 l Interesting aspect of Barro's work: introduction of some novel instruments for inflation. l Barro uses prior colonial history: these are uncorrelated with innovations in recent growth experience, but correlated with long-term inflation performance. l Using these as instruments for leaves previous results in place. l Transition from high to low may not be associated with contemporaneous acceleration in economic growth. l Favorable growth effects from disinflation materialize with a lag, so that growth may slow during transition, and perhaps for some time thereafter.

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75 Bruno and Easterly (1998): l Evidence about growth effects of transition from high to low . l Methodology: è compiling a sample of countries that had experienced successful stabilization over 1961-92; and è comparing their growth rates relative to world average before, during, and after, their inflationary episodes. l Growth fell by an average of 2.8% during high-inflation episode, but rose by an average of 3.8% during successful stabilization. l This pattern was repeated for growth of total factor productivity. l But investment ratio did not rise above world average.

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76 l Conclusion: growth accelerates during and just after stabilization when initial level of inflation is high. l Inflation stabilization component of market-oriented reform policies should be growth-enhancing.

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Government Size and Growth

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78 l Inflation stabilization implies the need for reduction of fiscal deficits that can be reduced by decreasing expenditures or increasing revenues. l Difference between two approaches: resulting size of government sector. l Both level and composition of government expenditures may matter for long-term growth: è Holding fiscal deficit constant, larger government expenditures imply need for additional revenues. 4 But such revenues would be raised through distortionary taxation. 4 This would reduce rate of growth through adverse effects on efficiency of resource allocation. è Some government expenditure may be productive.

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79 4 Expenditures on health and education may be interpreted as investments in human capital. 4 Other expenditures may represent investment in “social capital” in form of institutions that safeguard property rights. Barro (1991): l Examines coefficients of government spending variables when other long-term growth determinants are controlled for in the regression. l Government expenditures are disaggregated into è government investment; è government consumption excluding spending on defense and education;

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80 è spending on defense and education separately; è spending on transfer payments. l Government consumption net of defense and education and transfers may affect growth adversely through distortionary effects of taxation. l Government investment and defense and education spending add to productive resources and thus would have ambiguous effects on growth. l Empirical results are mixed: è Government investment has positive and statistically significant partial correlation with growth. è Government consumption net of defense and education is negative and significant.

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81 è Neither education nor defense spending is related to long-run growth. è Spending on transfers is positively related to growth, but Barro interprets this as reverse causation. l Barro (1997) confirms negative effect of government consumption on long-term growth. l However, interpretation of these results remains open to question, due to potential for reverse causation. l To identify separate effect of government size on economic growth appropriate instrument is required. l Such instruments have not been easy to find. l Thus, interpretation of negative partial correlation between government consumption and growth remains ambiguous.

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Commercial Openness and Growth

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83 l Under conditions of financial openness, increased commercial openness may reduce risk premium that external creditors require. l Under neoclassical assumptions, this may result in larger steady-state capital stock and thus more rapid accumulation-driven growth during transition. l Endogenous growth models: exporting and importing, by increasing economy's exposure to new technologies, è facilitate their adoption; è thus increase rate of growth of productivity. l Implication: trade liberalization, which promotes commercial openness, should induce è increase in the level of income; è increase in its rate of growth.

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84 Dollar (1992): l Relevant definition of openness: one that combines liberal trade regime with stable real exchange rate. l To measure outward orientation of trade regime, he uses deviations of Summers-Heston price levels from values predicted from regression of price levels on è per capita GDP, and è measure of population density. l Distorted trade regime would result in appreciated real exchange rate, and thus high price level. l Results: è Asian developing countries had the most liberal trade regimes. è African countries are the least liberal.

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85 è Latin American countries in between. è Increased trade distortions and increased real exchange rate variability have significant and large negative effects on economic growth. Sachs and Warner (1995): l Factors that determine whether countries with low income per capita will achieve convergence. l Two conditions are critical: preservation of private property rights and commercial openness. l Their methodology involves classification of countries into two groups: è those which safeguarded property rights and maintained commercial openness (“qualifiers”), è those which did not (“nonqualifiers”).

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86 l Trade openness was defining characteristic of two groups, since almost all countries that failed to qualify on openness criterion also did so on political criterion. l Qualifiers grew more rapidly, and both political and trade variables had significant partial effects on growth. l No country which maintained substantially opened trade failed to grow by at least 2% per year during 1970-89. l Conclusion: safeguarding property rights and maintaining open trade regime è are conducive to growth, and è constitute sufficient conditions for attainment of rapid economic growth.

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87 Frankel, Romer, and Cyrus (1996): l Both of the previous studies leave open direction of causality between growth and openness. l They addressed this issue by using gravity model to instrument for openness in cross-country growth equation. l They found strong positive correlation between exogenous component of openness and economic growth.

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Exchange-Rate Unification and Growth

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89 l Restrictions on financial trades involves foreign exchange transactions. l Most common form involved capital account transactions in balance of payments. l Such restrictions have been intensified when domestic economic distortions have created incentives for residents to remove funds from the country. l Private agents have sought to circumvent restrictions by trading foreign exchange outside official markets. l This gives rise to parallel exchange market at which foreign exchange trades at substantial premium over its official value. Effects of removal of restrictions: l Removal of restrictions on capital inflows can generate resources for investment.

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90 l Removing restrictions on outflows may do so as well, by è assuring foreign creditors that they will be able to repatriate their funds when desired, and è reassuring both domestic and foreign investors that their capital will be less subject to taxation. l Enhanced liquidity provided to domestic residents may induce them to undertake less liquid but more productive investment projects. l Financial integration may affect growth indirectly by fostering deeper domestic financial markets, thus reinforcing growth benefits of financial deepening. Evidence: l Evidence on effects of easing of foreign exchange restrictions on economic growth is of two types:

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91 è Use of premium on foreign exchange in parallel markets as a proxy for capital-account restrictions in cross-country growth regressions. è Assessing whether international financial integration affects economic growth through indirect channel of promoting domestic financial depth. Levine and Zervos (1996): l Provided evidence of the first type. l Used cross-country sample of 119 countries. l In testing for effects of parallel market premium, they investigated robustness of its role since large premium may reflect variety of policy distortions. l Result: premium had robust negative partial correlation with long-term growth.

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92 l Implication: foreign exchange restrictions exerted independent negative effect on growth. De Gregorio (1992): l Provided evidence of the second type. l Explained cross-country differences in measures of financial depth on the basis of è set of control variables (initial GDP per capita, average rate of inflation, and measure of commercial openness), and è measures of degree of international financial integration.

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93 l Results: è Three of his measures of international integration had statistically significant partial correlation with measures of financial depth. è This is interpreted as evidence in support of indirect effect. è No evidence of direct effect of openness on growth is found.

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