INDIA

AND THE WORLD

ECONOMY

LECTURE 3
GROWTH, CONVERGENCE, INDIAN EXPERIENCE
1
 SUMMARY: LECTURE 2

• World Economic History

– Malthusian Stagnation; Post-Malthusian growth; Industrial
Revolution

• Economic History of different Regions/Countries

– Reversal of Fortune
– Divergence of nations

• Economic Growth Theories

K
– Harrod-Domar: Y
v

– Solow-Swan

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 SOLOW-SWAN MODEL
• Production Function: Neoclassical Model : Y= AF(K,L) or Y/L = Af(K/L) =
Af(k)
– (K- Capital; L- Labor; A-Technology)

• Diminishing returns: In a production process, output increases at a decreasing rate as

the amount of a single factor of production is incrementally increased, while the
amounts of all other factors of production stay constant.

• Labor in poor countries have little access to Capital, so their Productivity is often
low.

• At low levels of K/L, increasing the amount of capital by only a small amount can
produce huge gains in productivity.

• Countries with lots of capital, and as a result higher levels of productivity, would enjoy a
much smaller gain from a similar increase in capital.

• This is one possible explanation for the much faster growth of Japan and Germany,
compared with the United States and the UK after the WW-II and the faster growth of
several Asian 'tigers', compared with developed countries, during the 1980s and most of
the 1990s. India and the World Economy 3
SOLOW MODEL - GRAPHICALLY

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Concave Production Function: Increases in the amount of capital(any
factor) - all else equal - lead to increases in output, but at a decreasing
rate.
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 OUTPUT, CONSUMPTION, SAVINGS

• An economy consumes a part of the income and saves the rest

• This savings is used as Investment – building roads

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 DEPRECIATION AT A CONSTANT RATE

However, investment comes with depreciation – roads get pot holes that
need to be repaired.

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 SOLOW MODEL

• Complete Solow Model: Plots out the Capital growth path

• When investment is greater than depreciation, capital stock increases.
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CAPITAL ACCUMULATION

Capital stock increases until Investment equals Depreciation. After this

Capital stock falls. As Capital stock falls, income falls.
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 CAPITAL ACCUMULATION

• To sum up:
– An economy consumes a part of the income and saves the rest

– This savings is used as Investment – building roads

– However, investment comes with depreciation – roads get pot holes

that need to be repaired.

– When investment is greater than depreciation, capital stock

increases.

– Capital stock increases until Investment equals Depreciation. After

this Capital stock falls. And as Capital stock falls, income falls.

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 STEADY STATE

• At low levels of capital, additional investment mostly goes in to

producing new capital and new output as overall depreciation is also
low.
– Post war Germany, Japan

• But at higher levels of capital, overall depreciation is high. Also, due

to DMP of capital, growth in output is lower. Hence the small
amount of investment goes mostly in to funding depreciation.

• Steady state level of capital: Investment = Depreciation

– All investment is going to repair and replace the existing capital
stock. No new capital is being created.

• Since everything else is constant, capital stock not growing implies

output not growing either - steady state level of output.
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STEADY STATE AND GROWTH RATES

• Increasing the savings rate, increases the steady state level of output

• But accumulation of physical capital only generates temporary

growth

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SOLOW MODEL AND RELATIVE
GROWTH RATES

• Countries at lower levels of overall capital are further away

from the steady state and hence grow faster.

• Countries at higher levels of overall capital are closer to the

steady state and hence grow slower.

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 CONVERGENCE THEORY

• The idea of convergence (aka catch-up) is the hypothesis that poorer

economies' per capita incomes will tend to grow at faster rates than
richer economies.
– So that absolute standards of living(SOL) starts catching up.

• As a result, all economies should eventually converge in terms of per

capita income.

• Developing countries have the potential to grow at a faster rate than

developed countries
– Further away from steady state

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DIMINISHING RETURNS & INTERNATIONAL
K FLOWS

Y/L = f(K/L) = f(k)

• If income per effective worker is not equal across countries, this must
be due to different levels of capital per effective worker.

• If the capital stock differs across countries then those countries with
lower capital stocks will offer higher returns (marginal productivity) to
capital.
– Hence capital must flow to these economies
– Example: High FII and FDI in some Emerging markets

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TYPES OF CONVERGENCE

• Absolute[or Unconditional] Convergence: Lower initial GDP

will lead to a higher average growth rate.
– The implication of this is that poverty will ultimately
disappear 'by itself ’.

• It does not explain why some nations have had zero growth for
many decades (e.g. in Sub-Saharan Africa)

• Conditional Convergence: A country's income per worker

converges to a country-specific long-run level as determined by
the structural characteristics of that country.

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REVERSAL OF FORTUNE: THE COLONIZED
RICH IN 1500 ARE THE LESS RICH TODAY

Source: “Reversal of Fortune: Geography and Institutions in the Making of the Modern World Income Distribution” ; Daron
Acemoglu, Simon Johnson, James A. Robinson. The Quarterly Journal of Economics, Vol. 117, No. 4 (Nov., 2002), pp. 1231-
1294
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UNCONDITIONAL CONVERGENCE - EMPIRICS

• Alternate representation: Historical level of per capital income(PCI)

on the X axis; Growth rate of PCI on the Y axis.

• Unconditional Convergence means Poorer countries on average grow

faster than Richer countries. That is, if we ran the regression

∆ ln(Y)2000−1960 = α + β · lnY1960 + e

• The estimated coefficient β must be negative. A negative slope means

convergence, the poorer you are the faster you grow.

• A zero correlation means: if you start poorer you do not grow faster
subsequently and hence standards of living (SOL) will continue to
diverge.

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LACK OF CONVERGENCE WORLDWIDE,
1960-2011

Source: Penn World Tables and the Facts of Economic Growth by Charles I. Jones, 2015

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TYPES OF CONVERGENCE

• Absolute[or Unconditional] Convergence: Lower initial GDP

will lead to a higher average growth rate.
– The implication of this is that poverty will ultimately
disappear 'by itself ’.

• It does not explain why some nations have had zero growth for
many decades (e.g. in Sub-Saharan Africa)

• Conditional Convergence: A country's income per worker

converges to a country-specific long-run level as determined by
the structural characteristics of that country.

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CONDITIONAL CONVERGENCE

• Instead, consider the regression

∆ lnY(1960−90) = α + β · lnY1960 + γ · X1960 + e

– X1960 is a set of country-specific controls, such as levels of

education, fiscal and monetary policies, market competition,
etc.

– A negative β now means if we look in a group of countries

that share similar characteristics (as measured by X), the
countries with lower initial income tend to grow faster than
their rich counterparts, and therefore the poor countries tend
to catch up with the rich countries in the same group.

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CONVERGENCE IN OECD

Source: The Penn World Tables and Facts of Economic Growth by Charles I. Jones, 2015

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CONVERGENCE THEORY

• Convergence: Growth rate of GDP (on y-axis) negatively correlated with

initial value of GDP (on x-axis): Poorer you start off the faster you grow
subsequently

• Slope of the linear regression line is average catch-up rate

• Countries around the world are converging -- but to their own steady-
states, rather than to the frontier.

• The rate at which countries converge to their own steady state -- often
called the “speed of convergence” -- seems to be around 2% per year
amongst the OECD countries
– “Barro’s iron law of convergence”

• If catch-up rate is 2% (5%), average poor country closes half the

distance with the rich in 34 (14) years
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 LIMITATIONS OF CONVERGENCE THEORY

• The fact that a country is poor does not guarantee that catch-up
growth will be achieved.
– A country needs 'Social Capabilities' to benefit from catch-up
growth.

• Need for an ability to absorb new technology, attract capital and

participate in global markets.

• Theory assumes that technology is freely traded and available to

developing countries.

• Capital often unavailable: "Lucas Paradox": capital is not flowing to

developing countries despite the fact that developing countries have
lower levels of capital per worker.

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India and the World Economy
LUCAS PARADOX

• Recall, diminishing returns to capital implies capital must flow

from capital rich to capital poor countries.

• Robert Lucas (1990) compares Indian and US markets:

Calculations indicate returns to capital (‘r’) in India is 58 times that
of the US.

• Capital is assumed to be perfectly mobile

– Given return differentials of this magnitude, capital would
flow rapidly from the US and other wealthy countries to India
and other poor countries.

• Has this been the case?

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LUCAS PARADOX: EVIDENCE ON CAPITAL
FLOWS
Equity Inflows to Rich and Poor countries, 1970- 2000

Source: IMF data from 1970- 2000 interpreted by Alfaro et al (2005)

Total equity inflows (= inflows of FDI + portfolio equity investment) much

higher in rich countries relative to poor countries
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India and the World Economy
LUCAS PARADOX: WHY K DOESN’T FLOW
TO EMERGING MARKETS

The explanations for the Lucas Paradox are generally grouped into two
categories:

1. Differences in fundamentals that affect the production structure

of the economy – differences in human capital stock, institutional
quality and infrastructure.

2. Capital market imperfections, mainly sovereign risk and

asymmetric information. Capital does not to flow to high return
countries because of market failures.

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DIFFERENCES IN INSTITUTIONAL QUALITY

• Institutions are ‘the rules of the game in society’: ‘they consist of both
informal norms (traditions, customs) and formal rules (regulations, laws
and constitutions). They create the incentive structure of an economy.’

• Institutional quality is shown to be an important determinant of capital

inflows, especially those indices that are closer to proxies of property
rights protection, such as the no-corruption index and protection from
expropriation.

• Institutional quality proxied by the International Country Risk Guide’s

(ICRG) political safety variables:
– Composite index made from sum of indices of e.g. government
stability, no-corruption, law and order, bureaucratic quality, etc.
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DIFFERENCES IN INSTITUTIONAL QUALITY
EXPLAINS REVERSAL OF FORTUNE

• This theory was proposed by Acemoglu, Johnson and Robinson

(2002) which became very influential.

• They suggest that institutions, that promote growth of business, are

the reason for the reversal of fortunes.
– Example: Property Rights

• European colonizers established institutions that were designed to

exploit the natives in countries where settler mortality was high due to
the prevalence of contagious diseases.

• By contrast, sparsely populated colonies like North America and

Australia were conducive for the Europeans to settle and hence they
created good institutions in their own interest.
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 INSTITUTIONS OF
PROPERTY RIGHTS
A F F E C T C A P I TA L I N F L O W

Property rights of
entrepreneurs:

- Ensures protection
against expropriation of
profits
- Encourage innovation
and investment
Source: IMF data from 1970- 2000 interpreted by Alfaro et al (2008)

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 POLICY
U N C E R TA I N T Y

• Discourages
investment

• Snippet from
2020 Budget

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LUCAS PARADOX: WHY K DOESN’T FLOW
TO EMERGING MARKETS

The explanations for the Lucas Paradox are generally grouped into two
categories:

1. Differences in fundamentals that affect the production structure

of the economy – differences in human capital stock, institutional
quality and infrastructure.

2. Capital market imperfections, mainly sovereign risk and

asymmetric information. Capital does not to flow to high return
countries because of market failures.

India and the World Economy 32

 MARKET IMPERFECTIONS
• Foreign capital might not flow to high ‘r’ country:
– Risk entailed by imperfect information matters. Lack of transparency,
more so in developing countries.

• Even the effect of foreign capital flows depends on the structure of the
economy in question (Raghuram Rajan’s analysis of the Asian Crisis of 1997)
– Due to lack of transparency in balance sheets, foreign investors might
keep their credit in foreign currency (currency mismatch) and with short-
term maturity (maturity mismatch).
– When crisis hits, investors do not roll-over the short-term debt and the
consequent economic crisis and restructuring becomes much more
severe.

• Back to Savings: it is the driver of Investment and reliance on foreign capital

not necessary for fast growth.
– E.g. South Korea, development largely financed by corporate debt and
loans from overleveraged state-owned banks.
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 CREDIT RISK AND
S E R I A L D E FA U L T

- Reinhart and Rogoff (2004):

When the odds of non-
repayment for some low-income
countries are as high as 65%,
credit risk seems a much more
suitable explanation for capital
not flowing in.

- Poorest countries default most,

despite having much lower debt
levels

- Discourages flow of capital to

poor countries
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 MARKET IMPERFECTIONS
• Foreign capital might not flow to high ‘r’ country:
– Risk entailed by imperfect information matters. Lack of transparency,
more so in developing countries.

• Even the effect of foreign capital flows depends on the structure of the
economy in question (Raghuram Rajan’s analysis of the Asian Crisis of
1997)
– Due to lack of transparency in balance sheets, foreign investors might
keep their credit in foreign currency (currency mismatch) and with
short-term maturity (maturity mismatch).
– When crisis hits, investors do not roll-over the short-term debt and
the consequent economic crisis and restructuring becomes much
more severe.

• Back to Savings: reliance on foreign capital not necessary for fast growth.
– E.g. South Korea, development largely financed by corporate debt and
loans from overleveraged state-owned banks.
35