Lecture 7 1

Macroeconomic Analysis 2003

Convergence

or

Conditional Convergence

Lecture 7 2

Contents• Definition of Convergence and Divergence• Evidence of divergence among UK regions• Labour and capital mobility and convergence• Steady State in Autarky and Globalisation• Evidence for Conditional Convergence• Poverty Trap: why pigs cannot become elephants?• Does more trade lead to convergence?• Results of growth studies• Exercises

Lecture 7 3

Prediction of convergence underSolow Model: Catching up

High incomeIncomeY/P

Low income

Time

Growing apart

High income

Y/P

Divergence

Low ncome

Time

Meaning of Convergence and Divergence

Poor country should growat faster rate then a rich country

Experience of African countries

Lecture 7 4

Convergence Convergence

g g Time Time

Two concepts of Economic Convergence

1

lnln 2,

N

yyi

tti

t

Standard Deviation

Dispersion Measure

tY RRRt 10ln

LIHI11

Low income regions should grow faster than high income region

Mean Differerence

Lecture 7 5

1993 1994 1995 1996 1997 1998Ann. Growth rate %

United Kingdom 9,671 10,170 10,619 11,185 11,871 12,548 4.34

England 9,852 10,349 10,771 11,384 12,141 12,845 4.42

East Riding and North Lincolnshire

9,289 9,680 10,130 10,920 11,490 11,7593.93

Kingston Upon Hull, City of

9,319 9,787 10,325 10,886 11,538 11,8504.00

East Riding of Yorkshire 8,268 8,487 8,741 9,799 9,996 10,051 3.26

North and North East Lincolnshire

10,236 10,741 11,325 12,059 12,939 13,4024.49

London 14,110 14,798 15,251 15,885 17,158 18,566 4.57

Scotland 9,614 10,168 10,818 11,162 11,429 12,117 3.86

Northern Ireland5 7,610 8,114 8,654 8,964 9,507 9,754 4.14

Wales 7,978 8,393 8,900 9,240 9,562 10,063 3.87

Sigma Convergence

Standard Deviation 1,806 1,894 1,905 1,934 2,210 2,537

Evidence for Lack of Sigma and Beta Convergence in the Per capita Income among the UK Regions, 1993-1998

Lecture 7 6

MPKRMPKP

rp

rR

KRKP

Marginal productivity of Capital in Rich and Poor Countries and Capital Accumulation in Autarky

Lecture 7 7

MPKRMPKP

rp

rR

KRKP

RG

Marginal productivity of Capital in Rich and Poor Countries and Capital Accumulation After Globalisation

rP

Lecture 7 8

MPLRMPLP

wR’

LRLP

Marginal productivity of Labour in Rich and Poor Countries Before and After Globalisation

wR

LP’LR’

Lecture 7 9

Who Gain and Who Lose From Globalisation?

MPLR

MPLR’

MPLP

MPLP’wp

wp’

wR

wR’

MPKR MPKP

rp

rR

Capitalists in rich countries and workers in poor countries gain.

Lecture 7 10

Savers

Households, Corporations and Government

Intermediaries

Banks, Insurance Companies, Building Societies, Trusts, Stock and Bonk Markets

Intermediaries

Banks, Insurance Companies, Building Societies, Trusts, Stock and Bonk Markets

InvestorsSmall, Medium and LargePrivate, Public, Domestic and Foreign

InvestorsSmall, Medium and LargePrivate, Public, Domestic and Foreign

Lecture 7 11

1 1 and 10

10 and 1

K-Mobile

L-mobile

K-Mobile

L-mobile

K-Mobile

L-mobile

Convergence

yes yes no yes yes Yes

No convergence

no no yes no no no

iii LKAY

i

Factor Mobility and Convergence

Lecture 7 12

Factors Promoting Convergence

• Domestic factors– Saving – Investment– Population growth rate– Human capital– Technology– Development of

infrastructure – Sound economic policy– Homogenous and stable

society– Transparent rules and

regulations

• Global factors– Trade of goods and services– Inflow and outflow of

capital– Emigration or immigration

of skilled and unskilled labour

– Adoption of better technology

– Growth of the global economy

– Peace/Oil prices

Lecture 7 13

Country A Country B 5.05.0AAA LKY

1.0A

2.0As What is the capital stock in the steady state in A in Autarky? How much do workers get? How much do owners of capital get?

AAAA KLsK 5.05.0

AA KK 1.0102.0 5.0

400AK

200AY

5.05.0BBB LKY

1.0B

0Bs What is the capital stock in the steady state in B in Autarky? How much do workers get? How much do owners of capital get?

BB KK 1.0100.0 5.0

0BK 0BY Becomes a beggar country.

Autarky and Saving and Capital (Gartner (2003:262) has similar example)

Lecture 7 14

Country A Country B KKK BA

Country A saves for both countries. It receives rental income from country B.

KKKK 1.0105.0102.0 5.05.0

22515 2 K 15010225 5.05.05.0 AA LKY

GNP in country B = GDP+Investment Receipts GNPA = 150+75 = 225 Capitalists gain and workers lose in country A.

KKK BA Country B does not save but can borrow capital from country A.

15010225 5.05.05.0 BB LKY Country B need to pay capital income to Country A. GNP in country B = GDP- Investment Payments GNPB = 150-75 = 75 Country B gains from the capital transfers.

Impacts of Globalisation in Output and Income

What is the capital stock in the steady state in A and Bif there is a free mobility of capital?

Lecture 7 15

Evidence of Converngence in Europe

0.000

0.500

1.000

1.500

2.000

2.500

3.000

3.500

4.000

4.500

0 5000 10000 15000 20000 25000 30000

Per capita income in 1960

An

nu

al g

row

th r

ate

of

pe

r ca

p in

com

e gr

Power (gr)

Evidence for Beta-Convergence in Europe: Growth Rate of Per Capita Income and Its level in 1960

Lecture 7 16

GDP per capita (constant 1995 US$) 1960 2000 Y00/Y60 growth rate (1960-2000)

Austria 10596 32763 3.092016 2.822Belgium 10335 30830 2.983067 2.732Denmark 16287 38521 2.365138 2.152Finland 9769 32024 3.278125 2.968France 10611 29811 2.809443 2.582Greece 3818 13105 3.432425 3.083Hungary 1514 5425 3.584302 3.191Ireland 5462 27741 5.079002 4.063Italy 6606 20885 3.161663 2.878Luxembourg 15772 56372 3.574182 3.184Netherlands 11999 30966 2.580715 2.370Norway 11322 37954 3.352235 3.024Portugal 2735 12794 4.678735 3.858Spain 4620 17798 3.852798 3.372Sweden 13165 31206 2.370376 2.158Switzerland 26245 46737 1.780796 1.443United Kingdom 9496 21667 2.281698 2.062

Lecture 7 17

1960 angrrateCentral African Republic457 -0.746708 1960 agrrateChad 290 -0.713465 China 112 4.989179Ghana 450 -0.2145 Hong Kong, China3008 5.214552Haiti 547 -0.997717 Ireland 5462 4.062741Madagascar 383 -1.106759 Korea, Rep. 1325 5.720737Nicaragua 638 -0.785382 Japan 8399 4.186912Niger 386 -1.606578 Malta 1177 5.404178Senegal 670 -0.238649 Portugal 2734 3.858026Sierra Leone 223 -1.041848 Singapore 2676 5.890155Venezuela, RB 3720 -0.299503 Thailand 465 4.492804Zambia 648 -1.256572

Lack Evidence of Convergence among Middle and Low Income Countries:Average Annual Growth Rate of Per

Capita Income (%) and Its level in 1960

Conditional Convergence

Lecture 7 18

A low initial level of income is associated withhigher growth rate in subsequent period when othervariables are held constant.

Growth rates are higher when the ratio of investmentto GDP is higher.

Growth rates are higher in countries which havelarger stock of human capital per capita. These arereflected in terms of enrolment in the primary andsecondary schools.

Population growth rates are negatively associatedwith growth rates.

Results from Cross Country Growth Studies -1

Lecture 7 19

Results from Cross Country Growth Studies -2

Countries with distorted markets have lower growthrates. Distortions occur in exchange rates and pricesor by impediments to a free and fair trade.

Countries with efficient financial system have highergrowth rates. Size of the financial markets ismeasured as a ratio of liquid assets to the GDP.

Countries with political instability have lower growthrates. Frequency of revolutions, wars and coups areused to measure political instability.

Lecture 7 20

Economic Convergence Acrross Major Industrial Countries

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

45,000

50,000

Pe

r C

ap

ita In

com

e in

19

95

US

do

llars

France

Italy

Japan

United Kingdom

United States

Japan had lower income in the beginning and had an astonishing growth rate from 1960 to 1990 and it overtookall OECD countries in per capita income

France, Germany UK and USAshow significant process of convergence

Lecture 7 21

Disparity in GNP Per Capita at Purchasing Power Parity,2001 (US $): A Lot of Divergence

0

5000

10000

15000

20000

25000

30000

35000

GNP at Purchasing Pow er Parity,2001

Lecture 7 22

Evidence for Convergence of Output Gap Among Major Industrail Countries (IMF)

-10

-8

-6

-4

-2

0

2

4

6

Pe

rcen

t o

f G

DP

FRANCE

GERMANY

JAPAN

UNITED KINGDOM

UNITED STATES

Output gap% =100*[(Trend GDP-Actual GDP)/Actual GDP]

Lecture 7 23

Growth Rates against the Initial P er Capita Income 97 Countries

-2.00%

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

0 5000 10000 15000 20000 25000 30000

Per capita income in 1960

Grates

Evidence for Conditional Convergence Across All Countries

Low income countries grow slowerthan middle income countries, which grow faster than high income countries.

Conditional Convergence

Lecture 7 24

Investment and Saving in OECD Countries: average 1980-2000(WDI2002)

0.00

5.00

10.00

15.00

20.00

25.00

30.00

35.00

0.00 5.00 10.00 15.00 20.00 25.00 30.00 35.00

Investment ratio

i/y

s/y

P ower (s/y)

Why the investment rate is not the same across all OECD Countries? Feldstien-Horioka Puzzle

Lecture 7 25

Openness and Growth: Evidence from the OECD Countries 1980-2000

0.00

1.00

2.00

3.00

4.00

5.00

6.00

0.00 50.00 100.00 150.00 200.00 250.00

Ratio of Trade Volume to GDP

Ave

rage

ann

ual g

row

th r

ate

of

py

Series1

Poly. (Series1)

Lecture 7 26

Conditional convergence1. There is no relation between initial GDP (most studies take

1960 as the base year) and the growth rates if bothdeveloped and developing economies are taken together.

2. Many studies suggest evidence for convergence amongOECD countries(so called rich country club), states of theUS, provinces of Canada and prefectures of Japan.

3. There are arguments suggesting that developingeconomies have different steady state than of developedeconomies.

Why?

Story of squirrel and elephant.

Lecture 7 27

MPK

e cost

Capital stock

Productivity of capital does not only depend upon the

amount of capital but depends upon amount of

human capital.

Countries with lower human capital are in danger of

being caught in poverty trap.

Marginal product of capital is less than the cost ofcapital and capital stock gradually diminishes beforepoint e. Cost is less than MPK after e more capital isaccumulated.

Poverty Trap

Lecture 7 28

Is this caused by the barriers to adopt a good technology? Or by Lauddites?

Lecture 7 29

Can a Penguin become a Cat or a Pig become an Elephant?

Lecture 7 30

y

k1k0Poor SS

k2Poverty TH

Increasing Return, Poverty Threshold and Stability of the Steady State

y=f(k)

I =(n+d)k

sya

b

o

Big Push

Points b and o are unstable steady states

Lecture 7 31

Critical Capital Stock for Control in Population Growth Rate

ky

L

Yy

L

Kk

sksyS

kLnLi

KssKH

kHnHi

yH

yL

a

b

nH > nL

PovTHLow ss trap

Lecture 7 32

Increase in public and private saving Development of human capital Removal of distortions in investment Institutional reform (rule of law) Macroeconomic stability Carefully designed redistribution policy Social security reform

Economic Growth Policies

Lecture 7 33

Policy Issues:Tax, Saving and Consumption

• What is the impact in consumption and saving in the above model– If there is a 20 percent tax on interest income?– If there is a 20 percent subsidy in it?– What sort of tax system is better for increasing the

ratio of saving? Does a higher rate of VAT promote saving or consumption?

– Does a higher rate of tax on labour income encourage or discourage saving?

– Does a higher rate of tax on pension income increase saving or consumption?

Lecture 7 34

Exercises

• Calculate annual growth rates between 1960 and 2000 across G7 and for countries with growth miracles and growth disasters

• Calculation of positive externality and economic growth (Spill-over Effects).

• Closing the productivity gap

• Conditional convergence