Macroeconomic Convergence, Development And Growth - Essay Example

?Macroeconomic convergence, development and growth Table of Contents Introduction 3 Association between Economic Growth and Macroeconomic Convergence4 Empirical evidences on growth and convergence 6 Association between Financial Development and Economic Growth 8 Conclusion 12 References 13 Bibliography 15 Introduction The process in which the per capita income of the poor economies tends to grow as fast as that of the rich economies is defined as the convergence. The process eventually leads the per capita incomes to converge. As the developing countries have the advantage of diminishing returns to factors, they can converge faster than the developed economies (Alfaro et al, 2005). The convergence process is dependent on a large number of factors such as the population growth, speed of capital formation and the presence of efficient economic policies as well as appropriate financial institutions. Along with this the accumulation of human and physical capital are important as it significantly influences the savings and rate of investment (Halmai & Vasary, 2009, p.3). Technological spread, change in growth rate and total productivity of the factors are the major players in enhancing the rate of convergence (Halmai & Vasary, 2009, p.3). As per professor Jeffrey Sachs, countries following closed economic polies have not been successful in converging. The countries following closed economic policies had a growth rate of 2% whereas the countries following open economic policies have a growth rate of 4.5 %. As sited by many economists, endogenous rather than the exogenous factors triggers the growth of an economy (Alfaro et al, 2005). The Asian tigers such as Taiwan, Hong Kong, Singapore and South Korea have been successful in converging with the developed countries. An economy is said to have achieved economic growth, if it is able to produce more goods and services than what it used to produce initially. Economic growth is often related with technological progress. If an economy has achieved growth than the standard of living of its citizens also improves. In US, the economic growth occurred with the introduction of high technology in the country. Financial development also follows from the economic growth. This is due to the fact that if an economy is financially sound then its economy is also developed. Association between Economic Growth and Macroeconomic Convergence Economic growth takes place in a country whenever the resources are utilised more efficiently (Romer, 2007). As per the neoclassical growth theories, a country converges to its steady state rate, if there exists diminishing returns from investing in the physical capitals. Poorer economies have a greater tendency to converge owning to its high marginal productivity. This process of convergence which eventually leads in the equalisation of the per capita incomes amongst the countries is called absolute convergence. If for a country the convergence takes place both in terms of growth rate as well as income levels than the process becomes beta convergence. According to the idea of club convergence, if countries have similar initial conditions then they have a tendency to converge. This concept is regarded as sigma convergence. It is also emphasised that if the countries vary in their initial conditions then they will not converge, this could however be overcome if the economic policies could eliminate the variations. Solow growth model emphasise that such variations in a country’s economic policy cannot lead to long run economic growth (Romer, P, 2007). As the scatter plot alongside shows, the association between average annual growth rate and real GDP per capita need not be associated similarly for all nations, even though they are featured by similar initial characteristics. A country’s economic growth is measured by its level of technological progress. According to the endogenous growth theory, creation of enlarged market in an economy leads to a better utilisation of economies of scale. This on the other hand has a positive impact on a county’s growth prospects. As per the endogenous model of growth, Europe was able to enjoy a long term growth as it was successful to reap the fruits of economies of scale through its integration with other economies. In view of the new endogenous growth theory, convergence may not occur at all due to the absence of ample social capability. However Lucas stressed on the fact that divergences in the growth arises due to the presence of brain drain, owning to the fact that increasing returns on human capital fastens the process of growth. On the other hand many economists said that rather than convergence, economic divergences may arise between the countries, as the poor countries do not have the fund to carry on research and development for the growth process (Romer, P, 2007). The trade as well as the growth models are the two models of economic integration that are related to the income convergence (Kim, 1997, p.4). The neoclassical Solow model of growth, states that income varies at the regional level due to the different capital labour ratios. On the other hand, Hecksher Ohlin trade model posits that regional income varies due to variations in the factor prices and factor endowments (Kim, 1997, p.5). Income convergence takes place because of trade in goods. Economic integration occurs through equalisation in prices. As the regional factor endowment varies, therefore, different regions specialise in different categories. Due to diversification in the industrial structures, which occurs because of variations in the factor endowments, the income level too diverges. Conversely, similarity in factor endowments leads to income convergence (Kim, 1997, p.5). The growth models put forward by Romer and Lucas are based on increasing returns to physical capital. It is states that income divergences are present. Krugman’s trade models states that as there occurs variations in the industrial structure so the income diverges. The industries that are well versed in high technology and high wages, converges, when subjected to external economy. Such a convergence will lead to income diversifications as the industries that are left out will have low wages and out dated technology (Kim, 1997, p.5). Between 19th and 20th century, US, emerged as an integrated economy from a pool of regional economies. Thus, an impetus was provided through economic integration. Empirical evidences on growth and convergence Boumal, in 1986 conducted a study of 16 OECD countries and concluded that there exists conditional convergence. However, he conducted the test again on 70 countries can found that there exists no convergence. So results of the above mentioned studies conducted by Boumal lead to the conclusion that there exists club convergence. Economists of World Bank conducted a study on 80 countries between the periods 1965- 1989 and found no evidence for unconditional convergence (Adabar, no date). In 1985 Meguire and Kormendi took a sample of 80 countries, both developed as well as developing and their analysis supported the presence of conditional convergence. However, Tullock and Grier got different result due to the inclusion of different factors in their models. To check the prevalence of unconditional convergence, Barro, took a sample of 98 countries. After the inclusion of the variables that relates to the initial human capital level he concluded that the data supported the presence of convergence but in modified sense. Kshamaninidhi Adabar in his research work on convergence pattern in India found that there exists differences in the context of conditional convergence for India. In his study comprising of 14 major states of India, it is observed that conditional convergence exists at the rate of 12% for each five year. The variation in the rate of convergence in India is mainly due to the difference in the investment rate, population growth rate as well as human capital (Adabar, no date, p.17) In a paper by Harold Codrington, it’s stated that the Caribbean economies, in order to fasten their pace of economic growth have been in the process of integrating their economies. The presence of currency union along with single market was declared to speed up the convergence process (Cordrington, 2008, p.1). For Caribbean countries, the variations in economic performance lead to economic convergence. Therefore in 1991, Caribbean countries had gone for convergence in exchange rate, holdings of foreign exchange and external debt services. These economies also agreed upon some convergence targets such as, firstly Exchange rate criteria secondly Import covers criteria, thirdly Fiscal criteria, fourthly Inflation criteria and finally Debt service criteria (Cordringinton,2008, p.3). However, establishment of monetary union in 1992 decelerated the pace of convergence in the Caribbean economies. Since coefficient of variation was used as the proxy for countries convergence record, it showed that convergence took place at variable time points with respect to each variable each. This measure however does not say elaborately about the country’s convergence status. Therefore it is required that the convergence process for the Caribbean countries be revaluated (Cordrington, 2008, p.15). In 2004, ten states were included in the European Union and the inclusion of these new states lead to the increase in the states GDP by 5% and GDP measured by PPP by 9%. However the convergence process in the Baltic States, Solvenia and Hungary were more dynamic. The newly included states showed a growth rate of 3.5% as compared to the old rate of 1%. The factors that are responsible in instigating the growth process were rise in factor productivity as well as capital formation. According to the study of figures available from 2000- 2005 data it is expected that the EU 10 economies will grow faster than the EU 15 economies (Halmai, 2009, p.5). In a paper presented by John Goddard, Stephen Dobson and Carlyn Ramlogan, throws light on the convergence process in the developing nations. They used unit root tests to examine the convergence process for a large sample of developing nations. Per capita real GDP was used for the analysis and covered the period from 1960-1995.According to the study, Africa showed the slowest growth and Asia Pacific showed the highest growth (Dobson et.al, 2003, p.23). The theories on income and productivity convergences stresses on the fact that the developing countries for being backward are the least beneficiaries. As a result very few developing nations could join the convergence club in last 40 years (Lipsey & Zejan, 1992, p.3). Association between Financial Development and Economic Growth Many literatures of the recent past throw light on the fact that if a country has a well developed financial system; it contributes towards economic growth (Ray, no date). Financial integration with the world economy turns out to be beneficial for an economy, if it is related with financial deepening. Presence of a well developed financial market in an economy favours in building an integrated international financial market (Gregorio, 1999, p.3). Economic growth occurs from two processes; firstly rise in factors of production and secondly increase in the efficiency level. Increase in investment as well as efficiency causes growth. In a closed economy, the savings rate matches the investment rate. Due to this, savings is considered to fasten the speed of growth. Financial developments have dual effect on economic growth (Gregorio, 1999, p.3). Firstly, the efficiency of capital accumulation rises for the domestic financial market and secondly, investment and savings rises via financial intermediation. Goldsmith first analysed the importance of the development of a domestic financial market in increasing the efficiency of capital accumulation. He also stated that the there exists a positive relation between per capita GNP and the financial development. He further stated that growth process is related with financial market via incentive effects. This causes further financial development. McKinnon and Shaw extended the earlier argument of Goldsmith and found that financial deepening not only leads to high capital productivity but even high savings and investment rate. McKinnon and Shaw stated that policies which leads to financial repression, lowers the urge to save. Lower savings causes lower investment and thus a low growth level. However, McKinnon and Shaw could not empirically validate their findings. Diaz Alejandro based his statement on the experiences of the Latin American countries and found that financial deepening did not lead to an enhancement in the savings. Therefore, he stated that rise in the marginal capital productivity causes financial deepening and hence growth. In a model by Greenwood and Jovanovie, growths as well as financial intermediation were considered endogenous. They showed two-way causation between growth and financial development. On one hand growth raises participation in financial markets and thus facilitates the expansion of financial institutions (Gregorio, 1999, p.4). On other hand investment in the financial institutions leads to growth which occurs on the basis of the information collected by different investors. Bencivenga and Smith stated that financial integration causes economic growth via channelling the savings into the activities which has higher productivity. One interesting fact sited by Bencivenga and Smith, is that the growth increased with the fall in savings as a result of financial development (Gregorio.1999.p.4). The reason was the dominance of the financial development over the investment efficiency. Levine (1992) stressed on the fact that financial institutions raises total savings that is devoted to investment. Banks, mutual funds, investment banks and stock markets increases growth by promoting efficient allocation of investment through several channels (Gregorio, 1999, p.5). Roubini and Salai Martin depicted the relation between growth and financial development that occurs through various policies taken by the government. They found that in order to reap high revenue from inflation tax, financial system is repressed by the policy makers by charging high taxes. Therefore the growth gets hampered (Gregorio, 1999, p.5). Demetriades and Hussein stated that economic growth causes financial development. They showed this by taking ratios of banks deposit liabilities to the nominal GDP and ratio of banks claim on private sector to the nominal GDP. Darrat too stated that there is a positive relation between growth and financial development. He used currency ratio to prove his point (Ince, 2011, p.8). Jappelli and Pagalo analysed the effectiveness of financial markets on savings rate. Their study was based on the effectiveness of borrowing constraint. Conclusion that was drawn from their study is that the partial or full inability of an individual to borrow from future income leads them to raise their savings. The result is consistent with the observation in Latin America where savings rat did not rise due to financial liberalisation. However, De Gregorio found that on relaxing the borrowing constraint, incentive for human capital accumulations increases. This will enhance the marginal capital productivity and hence cause growth despite fall in the savings (Gregorio, 1999, p.5). Rajan and Zingales, showed evidences from various industries that financial development leads to economic growth through external finance supply (Khan, 1999). Michael Graff, in his paper posed the question that whether financial development causes economic growth. There are various literatures which deal with this question and are hence grouped in four categories (Graff, 2001, p.3). Firstly it has been observed by many researchers that economic growth does not cause financial development. Financial development occurs according to its on logic. Secondly many economists found that economic growth does lead to financial development but such a development is demand driven. Thirdly, financial development is seen as a vehicle triggering economic growth. Models that were recently developed emphasised that a highly developed banking system, a properly functioning monetary system and a capital market is vital for economic growth. Fourthly, as per various scholars, financial activity is temporarily causes economic growth (Graff, 2011, p.4). In an empirical test Graff found that financial development often lead to economic growth especially in the year 1980. After dividing the countries into developed as well as less developed the relation between economic growth and financial development was unstable. Although output growth and financial development have a fairly stable relation for the economies that have experienced a long period of boom, the situation is different for less developed economies (Graff, 2001, p.16). Turkey is one of the developing countries that have been stricken by financial crisis twice. So in such a situation it is very difficult to have economic growth. Therefore, the policymakers are keen to implement policies that would enhance the economic growth in the light of financial instability (Ince, 2011, p.17). Conclusion The process in which the per capita income of the poor economies tends to grow as fast as that of the rich economies is defined as the convergence process. As the developing countries have the advantage of diminishing returns to factors, so they can converge faster than the developed economies. Countries following closed economic policies have not been successful in converging. The convergence process is dependent on an array of factors. An economy is said to have achieved economic growth, if it is able to produce more goods and services than what it used to produce initially. As per the neoclassical growth theories, a country converges to its steady state rate, if there exists diminishing returns from investing in the physical capitals. According to the endogenous growth theory, creation of enlarged market in an economy leads to a better utilisation of economies of scale. This on the other hand has a positive impact on a county’s growth prospects. The trade as well as the growth models are the two models of economic integration that are related to the income convergence. In 2004, ten states were included in the European Union and the inclusion of these new states lead to economic growth. Many literatures of the recent past throw light on the fact that if a country has a well developed financial system; it contributes towards economic growth. However there are also research studies that showed that there exists no relation between economic growth and financial development. References Romer, P. 2007. Economic Growth [Pdf]. Available at: http://www.stanford.edu/~promer/EconomicGrowth.pdf [Accessed on: September 13, 2011]. Kshamaninidhi Adabar. No date. Economic growth and convergence in India [Pdf]. Available at: http://www.isid.ac.in/~planning/ka.pdf [Accessed on: September 13, 2011]. Kim, S. 1997. Economic integration and convergence: US regions, 1840-1987 [Pdf]. National Bureau of Economic Research, Working paper series 6335. Available at: http://www.nber.org/papers/w6335.pdf?new_window=1 [Accessed on: September 13, 2011]. Cordrington, H. 2008. Macroeconomic convergence in Caricom [Pdf]. Available at: http://www.soegw.org/files/program/53-codrington.pdf [Accessed on: September 13, 2011]. Anderson, F & Edgerton, D. 2011. A matter of time: Revisiting growth convergence in developing countries [Pdf]. Available at: http://www.nek.lu.se/publications/workpap/papers/WP11_23.pdf [Accessed on: September 13, 2011]. Dobson, S et.al. 2003. Convergence in developing countries: evidence from panel unit root tests [Pdf]. Available at: http://www.business.otago.ac.nz/econ/research/discussionpapers/DP0305.pdf [Accessed: September 13, 2011]. Lipsey, R & Zijan, M. 1992. What explains developing countries growth? [Pdf]. National bureau of economic research, working paper series 4132. Available at: http://www.nber.org/papers/w4132.pdf?new_window=1 [Accessed: September 13, 2011]. Gregorio, J. 1999. Financial integration, financial development and economic growth [Pdf]. Available at: http://www.econ.uchile.cl/uploads/publicacion/c6b5fc4b-498f-462e-9453-2ae0325e0b2f.pdf [Accessed: September 13, 2011]. Graff, M. & Karmann, A. 2001. Does financial activity cause economic growth? [Pdf]. Available at: http://econstor.eu/bitstream/10419/48121/1/328043052.pdf [Accessed: September 13, 2011]. Ince, M. 2011. 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Financial development and growth in the short run and long run [Pdf]. National Bureau of Economic Research, Working paper series 10236. Available at: http://www.nber.org/papers/w10236 Read More