SOURCES OF GROWTH

1. SOURCES OF GROWTH PRESENTED BY: REYYAN OZER GS 17791 NOORMAHAYU MOHD NASIR GS 17678 NOR FARHANA MAHARUDIN GS 17651 HARVINDER KAUR SIDHU GS 17683

2. Economic Growth Theories - Sources of Growth - Where does it come from? • Growth is not an automatic birthright for an economy. • For an economy to grow, it has to create the right conditions for growth. • Growth depends to a significant extent on the resources a country has. • The better the quantity and the quality of the resources the more potential it has to grow.

3. The main sources of growth include: • Capital • Human Capital • Labor And Employment • Technology • International Trade • Other sources of growth: • Change in Structure of Production • Inequalities in Income Distribution • Economies of Scale

4. Capital • Capital is defined as a durable built up through investment so as to provide a stream of services into the future. • It can take various forms as physical, financial or human capital. • The rate of economic growth is the product of the quantitative size of investment times the qualitative efficiency of its use.

5. Capital • As in the Harrod-Domar model, to evaluate the role of capital in growth, we note that output growth can be decomposed into the efficiency of capital use times the quantity of investment. Output growth = Efficiency of * Quantity of rate capital use investment

6. Capital • Empirical evidence across cross-sections of countries confirms a positive relationship between investment and the rate of output growth. • However, the efficiency of capital dominates the quantitative investment rate. • Countries with high investment rates tend to have more efficient use of capital. • Variations in ICOR (Incremental capital output ratio) better explain to overall efficiency, which subsumes the contribution of all factors to growth, not just capital.

7. Capital • More capital generally means more production, and more production means more growth. • To get capital, countries have to invest and so the level of investment may be a big determinant of future growth. • The quality of the capital is important as well.

8. Human Capital • The Human capital ingredient is recognized as a major input in the production function that generates growth. • Human capital represents the skills acquired by education which are complementary to the technological input to advance overall productivity.

9. Human Capital model is examined in two separate parts : • On demand side, investment in human capital is seen as a private decision based on cost and benefits faced by the individuals. • Quantification of these benefits and cost allows a country to determine the appropriate kind of education measured in terms of its social rate of return.

10. Human Capital Model • Stream of earning into future • Time • Investment • Human Capital may be viewed as just another form of capital – a durable resource that returns a stream of services into the future

11. Human Capital Model • The supply side is studied in terms of the institutional framework for providing education. • On the supply side, practical concerns are arising about financing of the educational system. • By the distinguishing between private and social benefits, the government will be able to set an optimum fee structure.

12. The Human Capital model is criticized on various grounds: • A causal link between education and productivity may be more apparent than real. • Instead, education may serve mainly as a screening function, marking out those individuals with higher innate abilities. • Directed at this construct’s reliance on perfect capital markets. • Since investors cannot bind the returns from an individual’s education, there is likely to be underinvestment in human capital.

13. Labor and Employment • The developing world has only slowly come to appreciate the crucial role of labor. • Labor’s role in the development process can be summarized as follows: • Labor is seen as a productive factor in the production function • Its marginal product certainly is not negligible. • An increase in employment is bound to increase economic output.

14. Labor’s Role • Unemployment is devastating to the morale of the individuals affected. • Unemployment can foment major social tensions, causing critical political problems for the developing society. • Thus the creation of jobs becomes an important intermediate target.

15. Labor’s Role • Another effect of unemployment is in exacerbating income inequality. • A major contributor to the problems of income inequality and poverty is the gap between employment earnings and the zero wage of the unemployment

16. Technology • Technological advance is increasingly seen as the predominant factor contributing to growth in modern times • Technological progress divide into the two forms: • Product • Process innovations

17. Technology • Production process are usefully characterized within a production function framework, in which technology defines how much output may be produced by a given amount of inputs. • The function may be presented by a map of isoquants whose relevant features are factor substitutability and economies of scale.

18. The Main Issue of Technology policy • Given the inputs of capital, labor, and human capital the main issue for technology policy is: • To ensure that the production possibility frontier advances as fast as possible • To choose the right technique, or appropriate mix of factors, given a country’s overall endowment of factors.

19. Technology • The first of this issues is taking on far greater importance in the modern world. • For many developing countries that aspire to attain newly industrialized status, the previous concerns about small is beautiful and a focus on appropriate technology appear archaic and peripheral to rapid progress.

20. The pace of technological change will depend on: • the scientific skills of the country • the quality of education • the amount of GDP devoted to research and development

21. TechnologicalProgress • This is perhaps the most widely accepted (and easiest to understand) source of economic growth. • This is because technology makes it possible to produce more from the same quantity of resources (or factors of production). • This boosts the potential level of output of the economy.

22. Countries respond differently to fundamental drivers • - Opening up of product and service markets • Flexibility of the regulatory framework • Opening the way for small highly innovative companies to flourish • Macroeconomic policies • low and stable inflation • moderate tax burdens • openness to international trade

23. INTERNATIONAL TRADE • Country’s openness degree to which it engages in international trade • Trade theory based on principle of comparative advantage is most efficient for country to export those goods that it is relatively best at producing & to import the others • Source of comparative advantage evolved over 3 versions : • Ricardian version – attributed this to a country natural resource endowment or special talents • Heckscher-Ohlin theory – base comparative advantage on given endowment of factors (capital & labor) • - It would be most efficient for labor – abundant LDCs to concentrate on production & export of L-intensive goods • 3. Modern trade theory – instead that comparative advantage is not immutable, it can be change by learning-by-doing gain by competition in world market

24. Standard trade theory claims about virtue of free trade is simply a once-for-all rise in income stemming from static efficiency gains • Standard neoclassical trade theory claim that greater trade orientation can be given credit only for temporary acceleration of growth • Some critics that increase international trade may harm the poor, especially in developing countries • Some influential policy makers in developing countries argue that trade promotes growth • Some says that faster growing economies is those economies expanded foreign trade, the most underscore the important of structural change to process of economic growth

25. East Asian exporters have prospered by produce & export goods that based on production efficiencies rather than cheap labor • Countries that concentrated largely on Ricardian- type exports shown worst growth performance • ISI strategy, once considered a promising alternatives, has not performed too well • Best performance for those countries that achieved fastest technical progress by pursue manufactured exports in competitive world markets • Structure of LDC’s exports rely more on primary (natural resources & agricultural) exports

26. Others sources of growth: • Change in structure of production • Process of economic growth → process of structural change that change almost all aspect of production & consumption. • Fisher & Clark, put forward the idea that an economy would have 3 stages of production: • Primary production is concerned with the extraction of raw materials through agriculture, mining, fishing, & forestry. Low income countries are assumed to be predominantly dominated by primary production. • Secondary production concerned with industrial production through manufacturing & construction. Middle income countries are often dominated by their secondary sector. • Tertiary production concerned with the provision of services such as education & tourism. In high-income countries the tertiary sector dominates. Indeed having large tertiary sector is seen as a sign of economic maturity in the development process.

27. Structural change involve decrease agricultural activities give problem to agricultural workers who have to move to industrial or service sectors. • Economies with highest per capita levels of output have smallest agricultural sectors & largest service sectors. • Economies can increase its output & provide its citizens with more goods & services & a better lifestyle if every people willingly to move or transfer to other sectors.

28. Inequalities in income distribution. • Reduce inequality in income distribution of one country will lead to grow the economy. • This reduction will also lead to decrease poverty & indirectly increase social welfare. • Thus, per capita income have positive relationship with social welfare, but negative relationship with poverty & income inequality. • Alternatives policy approaches to problem of inequality : • A policy or set of policy designed far-reaching structural change in the distribution of assets, power, and access to education & associated income-earning opportunities. • Policies designed to modify the size distribution of income at the upper levels through the enforcement of legislated progressive taxation on income & wealth & at the lower levels.

29. Different assumptions about the links between growth and inequality produce different outcomes for the poor, as illustrated in Chart 1 • The base scenario, represented by the top line, assumes an egalitarian economy where the poorest group's share of total income does not change over a 60-year period • In this case, economic growth ( assume a rate of 4 percent a year) would raise the incomes of the poor.

30. The second scenario (represented by the middle line in Chart 1) is based on the famous Kuznets hypothesis, first formulated by Simon Kuznets more than 40 years ago. • At low levels of per capita income, inequality increases with rising per capita income and decreases only in the later stages of development • Resulting in an inverted U-shaped relationship between per capita income and income inequality • Based on a model where individuals migrate from a low-wage rural sector with little inequality to an urban sector characterized by high income inequality and high average income. • The poorest group's share of total income would decrease as economic growth takes off and would not be restored to initial levels for 60years; • as a result, the poor's per capita incomes are lower by an average of 10 % over two generations.

31. 3. Economies of scale • Given amount of productive sources result in more output when they are bought together in a single large production facility rather than being spread among a large number of small production units. • Economies of scale accompany economic growth as increasing specialization of workers, machines, plants, and firms occur & as certain kinds of overhead functions (such as financial management) do not need to expand at the same rate as the growth in output • These generate cost savings as output expands • it is easier to innovate when the production capacity is increase rather than when the capacity is being replaced. • Thus, a growth in production contribute to productivity gains through economies of scale & associated reductions in costs & prices.

32. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH A Sensitivity Analysis of Cross-Country Growth Regressions by Ross Levine and David Renelt (1992) Method used: Leamer’s (1983) extreme bounds analysis Equation applied: The equation above is linear explaining output and growth.

33. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH Y: per capita GDP growth or share of investment in GDP; I: a set of variables that are always included in the regression; M: variable of interest; Z: a subset of variables chosen from a large pool of variables identified by past studies as important explanatory variables of growth

34. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH Data:Primarilyfrom the World Bank National Accounts Data Base for 119 countries (excluding major oil exporters) Time Period: 1960 – 1989 Findings: A positive and robust correlation between average growth rates and the average share of investment in GDP.

35. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH A positive and robust correlation between average growth rates and the average share of investment in GDP. A positive and robust correlation between share of investment in GDP and the average share of trade in GDP over the 1960 – 1989 period. A negative and robust correlation between level of initial income and growth (investment & initial level of human capital are included).

36. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH Cross-country growth studies when applying export as indicators concludes studying the relationship between growth and trade (broadly defined). Fiscal indicators, economic and political variables are not robustly correlated with growth. Measures of trade (average growth rates, shares of GDP) not robustly correlated with growth when investment share is included.

37. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH In conclusion: This paper highlights the importance of considering the alternative specifications in cross-country growth regressions. Hence, need to go beyond aggregate macroeconomic indicators in linear cross-country growth regressions to more fully understand economic growth.

38. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH I Just Ran Two Million Regressions by Xavier X. Sala-I-Martin (1997) Critisized the study done by the Levine and Renelt (1992) paper. The findings were shown previously. As nothing can be learned from this empirical growth literature as no variables are robustly correlated with growth. Leamer’s extreme bound test is too strong for any variable to pass it.

39. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH I Just Ran Two Million Regressions by Xavier X. Sala-I-Martin (1997) Do not use the Leamer’s extreme bound test. Assign some level of confidence to each of the variables. Focus on the entire distribution of the estimators z Apply 2 assumptions: On distribution of the estimates of z across models when it is normal and another not normal.

40. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH I Just Ran Two Million Regressions by Xavier X. Sala-I-Martin (1997) Result: 22 out of 59 variables were significant. These variables include Regional variables, Political variables, Religious variables, Market distortions & Market Performance, Types of Investment & Non-Equipment Investment, Primary Sector Production, Openness, Type of Economic Organization. Table 1 shows the main results

41. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH Human Capital and Growth in Cross-Country Regressions by Robert J. Barro (1998) Reveal a pattern of conditional convergence where growth rate per capita GDP is inversely related to the starting level of per capita GDP. Holding fixed measures of Government policies and institutions and the character of the national population.

42. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH Human Capital and Growth in Cross-Country Regressions by Robert J. Barro (1998) However, growth is said to be: positively related to the starting level of average years of school attainment of adult males at the secondary and higher levels. insignificantly related to years of school attainment of females at these levels or to years of primary attainment by either gender.

43. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH Human Capital and Growth in Cross-Country Regressions by Robert J. Barro (1998) the weak effect of female schooling suggests that women’s human capital is not well exploited in the labour markets of many countries. In this study the determinants of economic growth and investment are analyzed in a panel of 100 countries observed from 1960 to 1995.

44. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH Human Capital and Growth in Cross-Country Regressions by Robert J. Barro (1998) Framework for the Empirical Analysis of Growth Dy: growth rate of per capita output; y: current level of per capita output; y*: long-run or target level of per capita output

45. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH Human Capital and Growth in Cross-Country Regressions by Robert J. Barro (1998) In this model, a permanent improvement in Government policy initially increases the growth rate , Dy increases level of per capita output y gradually over time. As output increases, diminishing returns eventually restore the growth rate. In the Long-Run the impact of improved policy is on the level of per capita output not its growth rate.

46. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH Human Capital and Growth in Cross-Country Regressions by Robert J. Barro (1998) Empirical Findings As shown in Table 1 It shows panel regression estimates for the determination of the growth rate of real per capita GDP and the ratio of real investment to real GDP.

47. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH Human Capital and Growth in Cross-Country Regressions by Robert J. Barro (1998) • Independent Variable: • Level of per capita GDP (Figure 1) • Simple relation between growth rates and initial levels of per capita GDP is virtually nil. • When the policy and other independent variables are held constant, there is a strong relation between growth rate and level.

48. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH

49. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH

50. EMPIRICAL EVIDENCE ON SOURCES OF GROWTH • Figure 2 shows the partial relation between the growth rate and log (GDP) • Relation is overall negative but not linear. Example for the poorest countries contained in the sample the marginal effect of log (GDP) on the growth rate is small and may even be positive. • Ethiopia in 1965 shows a rise in per capita GDP by 10% would raise growth rate by about 0.2% per year.