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Chapter 17 Macroeconomic Policies and Long-Term Growth

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

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

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

4 The Neoclassical Growth Model

5 Solow (1956) and Swan (1956): neoclassical growth model.
Assumptions: Production function: aggregate, constant-returns-to-scale, and combines labor and capital in the production of composite good. Savings: fixed fraction of output. Technology improves at exogenous rate. Cobb-Douglas production function: Y = AKL1-, <  < 1, Y: total output; K: capital stock; A: level of technology; L: workers employed in the production process. (1)

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

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


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

10 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. Figure 17.1: “poor” country starts with capital stock of k0 has higher initial growth rate than “rich” country starting with k0. Poor country grows faster during the transition. 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. 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 ~

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

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

13 With Cobb-Douglas production technology as in (1), assuming that factors of production are paid their marginal products implies that k = 1-n, and labor's share corresponds to the parameter . 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): Studies based on sources-of-growth methodology in the 1960s and 1970s. Average capital share is about 40%, which indicates that production function exhibits diminishing marginal returns to capital.

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

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

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

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


19 Since population growth and technological change are assumed exogenous, the model does
not explain the mechanisms that generate steady-state growth, not allow evaluation of mechanisms through which government policies can influence growth process. 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. New growth literature addresses these limitations by proposing variety of channels through which steady-state growth arises endogenously.

20 Externalities and Increasing Returns

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

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

23 Implication of AK model:
Increase in saving rate raises growth rate per capita. 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. Thus it does not predict convergence even if countries share the same technology; are characterized by the same pattern of saving. Rebelo (1991): Implications of considering separately the production of consumption goods, physical capital, and human capital goods.

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

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

26 Human Capital, Knowledge, and Growth

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

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

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

30 Rate of human capital growth, and ratio of physical to human capital converges to a constant.
In the long run, income is proportional to the economy's initial stock of human capital. Saving rate has no effect on growth rate. Implication of the model: 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. Equilibrium growth rate is thus smaller than optimal growth rate. Growth would be higher with more investment in human capital.

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

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

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

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

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

36 K = KKA1-L1-, K  s(1-K)(1-L)1-.
Population growth is exogenous: L = nL, n  0. Begin analyzing te model by substituting (9) in (11): K = KKA1-L1-, K  s(1-K)(1-L)1-. Dividing both sides of this expression by K: gK  (K/K) = K{AL/K}1-. Its rate of change: gK = (1-)(gA + n - gK). . . . . (14)

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


39 A = KA(qL), q  B. . K L
gA is increasing (falling) if right-hand side of (15) is positive (negative), and constant if it is zero. Curve AA in Figure 17.3: combinations of gA and gK for which gA is constant over time. Slope of AA is (1-)/, which is ambiguous in sign. Figure assumes that  < 1, so that the slope is positive. Above (below) AA, gA is rising (falling). (9) exhibits constant returns to scale in K and A. 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. This equation can be rewritten as A = KA(qL), q  B. . K L

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

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


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



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


48 Effects of Financial Intermediation

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

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

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

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

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


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

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

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

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

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

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

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

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

63 Inflation Stabilization and Growth

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

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

66  c1- (18) e-tdt, 0 <  <1, b = (1 - )(y + rb) – c - , 1- .
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. c1- 1- e-tdt, <  <1, (18) . (19)

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

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

69 -( ) = r +   m = (r + )I,  = 1/ < 0,
Solution yields -( ) = r +   m = (r + )I,  = 1/ < 0, q/q = r – (A/q), q = 1 + ( ) ( ), q: shadow price of capital. (23) m I . (24) m I m I m I (25) (23): firm's demand for money. 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.

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

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

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

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

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

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

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

77 Government Size and Growth

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

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

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

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

82 Commercial Openness and Growth

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

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

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

86 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. Qualifiers grew more rapidly, and both political and trade variables had significant partial effects on growth. No country which maintained substantially opened trade failed to grow by at least 2% per year during Conclusion: safeguarding property rights and maintaining open trade regime are conducive to growth, and constitute sufficient conditions for attainment of rapid economic growth.

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

88 Exchange-Rate Unification and Growth

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

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

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

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

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

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