How useful is growth literature for policies in the developing countries?

Abstract

Growth literature has focused mainly on the long-term growth outcomes, but policy makers of the developing economies need rapid improvements in the short- to medium-term growth rates. In this article, we argue that this widening gap can be reduced by distinguishing between the short- to medium-term growth effects of policies from their long-run growth effects. With data from Singapore, Malaysia and Thailand, we show that an extended Solow (1956) model can narrow this gap. We find that the short to medium term growth effects of an increase in the investment ratio are quite significant and persist for up to 10 years.

Notes

¹ A referee has pointed out that developing countries have other important objectives (other than growth) such as ‘reducing inflation, reducing unemployment, creating stability, promoting ‘harmony’ (for the case of China), or avoiding financial and exchange rate crises’. While we agree with this referee, these objectives are analysed with different frameworks but not with the endogenous or exogenous growth models. The empirical literature on economic growth is based on either the Solow (1956) exogenous growth model or variants of the endogenous growth models of Romer (1986, 1990), Lucas (1988) and Barro (1990). These canonical endogenous models use different factors to explain the observed persistent growth in per capita incomes in the advanced countries. In Romer (1986), growth is due to investment with externalities. In Romer (1990), this is due to accumulation of knowledge through research and development. In Lucas (1988), it is human capital and in Barro (1990) government expenditure on infrastructure causes growth. In the exogenous model of Solow (1956), persistent growth is due to the exogenous (unexplained) growth of knowledge i.e. growth in total factor productivity (TFP).

² MRW (1992) have argued that the Solow model can explain observed facts better than the endogenous models. Jones (1995) showed that observed time-series facts do not support the conclusions of the endogenous models. Solow (2000, p. 153) himself said that ‘The second wave of runaway interest in growth theory – the endogenous growth literature sparked by Romer and Lucas in the 1980s, following the neoclassical wave of the 1950s and 1960s – appears to be dwindling to a modest flow of normal science. This is not a bad thing’. See also Parente (2001) for other criticisms of endogenous models.

³ These are: initial conditions, life expectancy, external shocks (proxied by the terms of trade shocks), macroeconomic conditions (proxied with inflation rate, public consumption, real exchange rate, ratio of reserves to imports and level of external debt), trade regime (current account and capital account convertibility) and political stability (proxied by the ratio of war casualties to the population).

⁴ In the East Asian countries, with an average value of α = 0.48, factor accumulation contributed to 77.5% of growth. In the South Asian countries, where the average α = 0.56, TFP's contribution was only 12%. The rate of growth of TFP was negative in Sub-Saharan Africa, the Middle East and North Africa and Latin America.

⁵ This is set by assuming a value for the initial stock of knowledge so that initial income is 1000.

⁶ These are: (a) estimation of the production function, (b) obtaining the Solow residual to estimate TFP from the growth accounting exercise and (c) regressing this on some potential explanatory variables.

⁷ This type of extension to the Solow (1956) growth model has been used in several studies by Rao and coworkers. A few recent studies are Rao (2010a, b), Rao et al. (2010a, c) and Rao and Takirua (2010) etc.

⁸ UN database is used for output, investment, government expenditure, exports and imports, World Development Indicators for employment, and Bosworth and Collins (2003) for education and human capital. Their data up to 2000 are extrapolated to 2004 by the authors. Capital stock is estimated with the perpetual inventory method with data on capital formation from the UN database.

⁹ The short-run growth effects are computed as follows. where d is the depreciation rate which is assumed to be 0.04. It is also assumed that employment is constant during the two periods. The above can be expressed as:

The average value during 2000 to 2004 of capital to output ratio is 3.4 and therefore a = 0.306. The average IRAT is 0.24 implying that when IRAT is 0.35, the value of Δ ln k = 0.073. This causes a 0.056 point increase in short-run growth.

¹⁰ For the entire sample period, permanent and transitory growth effects are roughly equal in Singapore at about 50% each. For Malaysia and Thailand, the proportion of the transitory growth effects are 68.4% and 58.8%, respectively. By the period 2000 to 2004, the proportion of the transitory growth effects seem to have declined significantly in Singapore and Malaysia. Singapore is growing near its SSGR and in Malaysia the significance of the transitory growth rate has declined to 25%. In Thailand, there is no significant improvement.

¹¹ A referee pointed that increasing the investment rate should have worsened the effects of the East Asian financial crisis. However, while the referee's conjecture may be true, we are not aware of any study supporting this conjecture.

¹² In another cross-country study by Levine and Renelt (1992), the growth effects of aggregate investment ratio are much higher and somewhat implausible.

¹³ Furthermore, changes in the institutional structure are usually sudden after a war, an upheaval and at the time of independence of a country; see Frankel (2003). Therefore, institutional changes may be reflected as structural changes in the estimated equations.

¹⁴ The t-ratios of the adjustment coefficient λ of the preferred equations for Singapore and Malaysia exceed the critical values of Ericsson and McKinnon (2002) test for cointegration, but the equation for Thailand failed this test.