Impact of public investment on economic growth in vietnam

ABSTRACT Public investment is considered as the consumption of goods that reduces the saving and capital investment of an economy.. In addition, it is necessary to reduce government inte

IN VIETNAM

A DISSERTATION PAPER

Presented to the Faculty of the Graduate Program

of the College of Arts and Sciences Central Philippine University, Philippines

In Collaboration with Thai Nguyen University, Vietnam

In Partial Fulfillment

Of the Requirements for the Degree DOCTOR IN PUBLIC ADMINISTRATION

NGUYEN PHUC AI NOVEMBER, 2020

To Assoc Prof Nguyen Khanh Doanh for his advices, guidance, supervision, suggestions, and precious time in enthusiastically reading and checking the manuscript, providing the author useful materials;

To Doctor Reynaldo Nene Dusaran, his incomparable contribution and support to the development of Doctor of Public Administration program in Thai Nguyen University as well

as his invaluable thoughts, insightful suggestions, useful guidance throughout the thesis work

To the leadership of International Cooperation Center for Training and Study Abroad and their staff for their enthusiasm to support executive for the participants who completed the study program;

To the faculties and researchers of Thai Nguyen University of Economics and Business Administration for their active involvement and cooperation which made the conduct of the study possible

Finally, I specialy would like to give inmost thanks to my family and friends for their love and support in one way or another, and to all who have contributed to making this study

a success

Thai Nguyen, November 2020

Trân trọng cảm ơn PGS GS Nguyễn Khánh Doanh đã tận tình chỉ bảo, hướng dẫn, giám sát, góp ý và dành thời gian quý báu trong việc nhiệt tình đọc và kiểm tra bản thảo, cung cấp cho tác giả những tư liệu hữu ích;

Xin cảm ơn tiến sĩ Reynaldo Nene Dusaran vì những đóng góp, hỗ trợ không nhỏ của ông đối với việc xây dựng chương trình Tiến sĩ Quản lý hành chính công tại Đại học Thái Nguyên cũng như những suy nghĩ, những góp ý sâu sắc, những chỉ dẫn hữu ích của ông trong suốt quá trình tôi thực hiện luận án;

Cảm ơn Ban lãnh đạo Trung tâm Hợp tác Quốc tế Đào tạo và Du học cùng các cán bộ

đã nhiệt tình hỗ trợ giúp các học viên hoàn thành chương trình học

Xin cảm ơn các khoa, các cán bộ nghiên cứu của Trường Đại học Kinh tế và Quản trị Kinh doanh Thái Nguyên vì sự tham gia và hợp tác tích cực của họ đã giúp cho việc tiến hành nghiên cứu trở nên khả thi

Cuối cùng, xin cảm ơn gia đình và bạn bè của tôi đã dành tình cảm và sự ủng hộ cho tôi bằng nhiều cách khác nhau, cảm ơn tất cả những người đã góp phần làm cho nghiên cứu này thành công

Thái Nguyên, tháng 11 năm 2020

LỜI CAM ĐOAN

Tôi xin cam đoan: Số liệu và kết quả nghiên cứu trong luận án này là trung thực và chưa được sử dụng để công bố cho bất kỳ nghiên cứu nào khác

Tôi cam đoan rằng tất cả những trợ giúp cho việc thực hiện luận án đã được cảm ơn

và thông tin trích dẫn trong luận án đều được chỉ rõ nguồn gốc

Thái Nguyên, tháng 11 năm 2020

TABLE OF CONTENTS

ACKNOWLEDGEMENT i

LỜI CẢM ƠN ii

COMMITMENT iii

LỜI CAM ĐOAN iv

TABLE OF CONTENTS v

LIST OF TABLES viii

LIST OF FIGURES ix

LIST OF ABBREVIATIONS x

ABSTRACT xi

CHAPTER 1: INTRODUCTION 1

1.1 Background and Rationale of the Study 1

1.1.1 Background of the study 1

1.1.2 Statement of the Problem 3

1.2 Objectives of the Study 4

1.2.1 General Objective 4

1.3 The Theoretical Framework 4

1.4 Conceptual Framework 5

1.5 Operational Definition of Variables and other term 7

1.6 Significance of the Study 8

1.7 Scope and Limitations 8

1.7.1 Scope of the Study 8

1.7.2 Limitations of the Study 9

CHAPTER 2: REVIEW OF RELATED LITERATURE AND STUDIES 10

2.1 An Overview of economic growth theory and public investment 10

2.1.1 Overview of economic growth theory 10

2.1.2 Public investment theory 38

2.1.3 The role of public investment 40

2.2 Approaches to estimate relationships in macro economic variables 41

2.2.1 The Engle-Granger Two-Step Modeling Method (EGM) 41

2.2.2 The Engle-Yoo Three-Step Modeling Method (EYM) 42

2.2.3 The Saikkonen Method 43

2.2.4 The Johansen Maximum Likelihood (ML) Vector Autoregressive (VAR) Method 43

2.2.5 The ARDL bound test method 45

2.3 Review of related studies 45

2.3.1 International studies on the relationship between economic growth and public investment 45

2.3.2 Study on the relationship between economic growth and public investment in Vietnam 52

Chapter Summary 56

CHAPTER 3: RESEARCH METHODOLOGY 57

3.1 Research Design 57

3.2 Population, Sample Size and Sampling Technique 58

3.3 Research Instruments 58

3.4 Ethical Considerations 58

3.5 Data Gathering Procedure 58

Chapter Summary 65

CHAPTER 4: DATA PRESENTATION, ANALYSYS AND INTERPRETATION 66

4.1 Economic overview and public investment trend 66

4.1.1 Vietnam economic overview in the period of 1986-2015 66

4.1.2 Import and Export of Vietnam 67

4.1.3 Investment and public investment trend 69

4.1.4 Vietnamese public investment System and Issues 72

4.2 Empirical Results 76

4.2.1 Descriptive Statistics 76

4.2.2 Unit root test 77

4.2.3 Empirical results of the impact of Public Investment on Economic growth 78

4.3 Discussions 84

Chapter Summary 87

CHAPTER 5: SUMMARY, CONCLUSIONS AND POLICY RECOMMENDATIONS 88

5.1 Summary 88

5.2 Conclusions 88

5.3 Policy recommendations 89

5.3.1 Economic restructuring 89

5.3.2 Public investment restructuring 89

5.3.3 Reduce the proportion of public investment in society's total investment, improve the efficiency of public investment 90

5.3.4 Changing the role of public investment in the economy 91

5.3.5 Strict control of public investment 92

5.3.6 Improve the quality capital and effectively use capital for public investment

activities 94

5.3.7 Improve the efficiency of the implementation of the National Target Program (NTP) and others 96

5.3.8 Prioritize public investment for infrastructure projects 97

5.3.9 Strengthen public investment in agriculture and rural development 98

5.3.10 Promote reformation of SOE sector 99

Chapter summary 100

REFERENCES 101

APPENDICES 107

LIST OF TABLES

Table 4.1 Statistics of Variables 77

Table 4.2 Unit root test 78

Table 4.3 Bound test results 79

Table 4.4 Estimation of ARDL model 79

Table 4.5 Estimation of long -run variables 80

Table 4.6 Estimation of ECM variables 81

Table 4.7 Serial correlation test 82

LIST OF FIGURES

Figure 1.1 Conceptual Framework 6

Figure 2.1 The classical theory of growth 10

Figure 2.2 Fix proportion Production function 17

Figure 2.3 Equilibrium output change with investment 17

Figure 2.4 Production function with some factor substitution 19

Figure 2.5 Production function 22

Figure 2.6 Output, consumption and investment 24

Figure 2.7 Depreciation 24

Figure 2.8 Investment, depreciation and steady state 25

Figure 2.9 Steady state consumption 27

Figure 2.10 The saving rate and the golden rule 28

Figure 2.11 The saving rate is reduced 29

Figure 2.12 The saving rate is increased 29

Figure 2.13 Effects of depreciation and population growth 31

Figure 2.14 Effect of population growth 32

Figure 2.15 Steady - state with technical progress 33

Figure 4.1 GDP growth rate 67

Figure 4.2 Total import and export 68

Figure 4.3 Trade deficit 69

Figure 4.4 Capital/GDP ratio 69

Figure 4.5 Investment at constant 2010 prices by types of ownership 70

Figure 4.6 Structure of Investment by types of ownership (%) 71

Figure 4.7 Change of GDP and Investment 75

Figure 4.8 Description of variables 77

Figure 4.8 Cusum test 83

Figure 4.9 Cusum of square test 83

Figure 4.10 TFP growth rate for 2006-2015 period 85

LIST OF ABBREVIATIONS

ABSTRACT

Public investment is considered as the consumption of goods that reduces the saving and capital investment of an economy For low-income countries, public investment is a problem because they spend their scarce resources on the purchase of raw material rather than

on infrastructure, and other economic factors Public investment also causes inequality behavior in an economy The de-unionization cause inequality when public investment increase and employment reduce which create the phenomenon of wage inequality Therefore, the mechanism by which economic growth and inequality related is simply straightforward

This study uses both qualitative and quantitative methods to assess the impact of public investment on economic growth in Vietnam based on data from GSO and the World Bank over 30 years (1986-2015) by applying the autoregressive distributed lag (ARDL) method The method was applied to study the effects of public investment on Vietnam‟s economic growth in both short and long terms The findings indicate that public investment in Vietnam in the past period does affect economic growth in the long - run, with positive effects, while there is no empirical evidence of the impact of public investment on economic growth in the short - run This result implies that when the economy needs an investment environment to attract private investment, public investment does not play an important role Meanwhile, in the long term, the role of public investment is significant due to the coefficient

of positive impact This can be explained by the low efficiency and inadequate management

in public investment together with improperly spread investment portfolio lead to the situations of capital shortage, prolonged projects, and increases in costs Therefore, the critical issue in improving the efficiency of public investment is to assure appropriateness in project evaluation and selection To make the right choice, preventing imperfections throughout the process of the project proposal, project approval in central government and local authority by checking and developing a well-tailored procedure of project proposal, project selection, and public investment capital distribution, avoiding overlapping situations, is highly required It also may be to continue to privatize public investment projects where appropriate In addition,

it is necessary to reduce government intervention in the production business sector, to promote equalization for increasing investment in infrastructure to reduce public debt, to create an investment environment that attracts domestic private investment and FDI capital, ultimately boosting economic growth

Keyword: Public Investment, Private Investment, Economic Growth, ARDL

bound test

CHAPTER 1 INTRODUCTION

1.1 Background and Rationale of the Study

1.1.1 Background of the study

Public investment can be defined as an investment that is procured based on the sovereignty of the state or taxpayer‟s money and a huge amount of public investment has been made on improving economic infrastructures such as roads, railways, etc and social infrastructure such as welfare, education, etc across the world Economic infrastructure plays

a crucial role in the improvement of national industrial competitiveness and economic development since investment in infrastructure provides long-term economic benefits through increases in output, income, employment, and productivity, or reductions in costs of production So many countries around the world have consistently made a huge amount of investment to improve the level of public economic infrastructure In recent years, there has been also a growing need for investment in social infrastructure according to population growth, aging, and growing gaps in income However, government financial resources are limited and many countries across the world have paid a lot of attention to improving the efficiency of public investment Public investment has a great impact on the national economy and requires substantial costs And, it is very difficult to suspend in the middle of the project once its implementation is confirmed Therefore, it is crucial to prepare detailed plans and appraise the feasibility of the public investment projects accurately It is also important to manage and evaluate the investment projects in an intermediate phase whether they are being implemented as originally planned and whether they are still feasible in new contexts if the plan has been modified It is also important to evaluate the investment projects or programs in

an ex-post phase to check if they are effective In this way, it is very important to establish an integrated evaluation system (ex-ante, intermediate, and ex-post) over the project life cycles

to improve the efficiency of the overall public investment management

Public investment is considered as the consumption of goods that reduce the saving and capital investment of an economy For low-income countries, public investment is a problem because they spend their scarce resources on the purchase of raw material rather than on infrastructure, and other economic factors Public investment also causes inequality behavior in an economy The de-unionization causes inequality when public investment increase and employment reduce which create the phenomenon of wage inequality Therefore, the mechanism by which economic growth and inequality related is simply straightforward

Vietnam has been making much progress in different fields including economic growth rate during 30 years since “Doi Moi” from 1990 to 2016 ranging around an average of 6.66 percent, inflation rate controlled at an acceptable level, and growing exports One of the key factors in this success is policy renovation in public finance According to the new public investment policy (Vietnam Public Investment Law, 2014), public investment consists of the following fields: (i) investment in programs/projects developing social-economic infrastructure; (ii) investment in serving activities of governmental organizations, political and social-political organizations, both domestically and abroad; (iii) investment in supporting supplies of public services and goods; (iv) and investment from public investment capital under shares of government in public-private partnership projects

Vietnam's economy is now integrating into the global economy, improving fiscal policy (Budget revenue and expenditure suits the economy scale, and overspending rate is in allowed restriction) which creates trust for international investors and sponsor organizations Since 2007, Vietnam became an official member of World Trade Organization (WTO); and since early 2019, Vietnam has been a member of the Comprehensive and Progressive Agreement for Trans Pacific Partnership - CPTPP As a result, Vietnam has been gradually cutting tariffs as an integrated commitment Tax reduction means that a part of budget income through the tax will decrease, and a sharp drop in crude oil price also leads to decreased budget income However, Vietnam Government needs to maintain public expenses for social economics, and infrastructure development, which is far too weak In the context of high budget pressures, the need to save government expenses is set However, to achieve economic growth and improve the competitiveness of the economy to attract private domestic investment and foreign direct investment (FDI), it is necessary to improve the investment and business environment To improve the investment and business environment, the role of the Government is to provide public goods and services through investment in technical infrastructure (e.g., roads, bridges, ports, industrial parks, and so on) and social infrastructure (e.g., hospital, school, and so on) It is, therefore, necessary to increase public investment by the government, and public investment must ensure efficiency by attracting private investment and economic growth

There are two opposite trends in public investment research As for the first trend, the research of Khan and Kumar (1997), Ramirez and Nazmi (2003), Bukhari et al (2007) and Haque (2013) showed positive impacts of public investment on economic growth

On the contrary, some other studies proved that public investment has no or negative effects

on economic growth and creates the situation in which public investment crowds out private investment (Vedder and Gallaway, 1998; Ghani and Din, 2006; Swaby, 2007; Hatano, 2010)

However, not many studies were conducted for the Vietnamese case so far mainly due to the inconsistent or reliability of the data, and there is no study employing ARDL method to assess the impact of public investment on economic growth

Within the scope of this research, the author would like to consider whether public investment in Vietnam has a positive effect, i.e public investment has an impact on attracting private investment and economic growth or not The questions to be answered in this study are: What is the role of public investment in Vietnam today? What is the impact of public investment on economic growth?

Therefore, the author chooses the title: “Impact of public investment on the economic growth of Vietnam” for the topic of the Ph.D thesis majoring in Public

Administration This research is to assess both short - term and long - term influences of public investment on economic growth The approach utilized in this study is quantitative for the empirical studies and qualitative to analyze the impact of public investment on economic growth in Vietnam for the period of 1986-2015 Moreover, studying the impact of inputs in general and public investment in particular on economic growth in combination with the analysis of public investment efficiency to propose some solutions to enhance public investment efficiency on economic growth is of necessity and importance both in a practical

and theoretical way

1.1.2 Statement of the Problem

The relationship between public investment and economic growth has attracted a lot of attention of researchers in the last twenty years but their results also many contradictions There have been many buildings in the world to drill test the relationship between public investment and economic growth The first direction of research studies focusing on the relationship between public investment and economic growth, one of the research projects that are of Barth and Bradley (1987), Easterly & Rebelo (1993), Devarajan et al (1996), Aschauer (1998, 2000) Their conclusion is not the same as giving two opposite argument: this relationship is positive or negative

Currently, the causal connection between public investment and economic growth in Vietnam has not yet been fully explored The previous studies are limited to the assessment of the effectiveness of government spending to the economic sector or the phenomenon of crowding out public investment or individual studies the impact of infrastructure investment

on economic growth So this study is carried out to address the following research questions:

- Does Public investment impact positive or negative or have no impact on economic growth in Vietnam?

- What are the weaknesses in public investment in Vietnam in the last 30 years?

- What are some recommendations for improving the effectiveness of public investment as well as promoting the economic growth?

Therefore, the author through qualitative and quantitative research will seek plausible answers to these questions above and fill the gap of knowledge as well as the method employing

1.2 Objectives of the Study

1.2.1 General Objective

The aim of this research is to identify the impact of public investment on economic growth in Vietnam for the period of 1986-2015 Then, it proposes some solutions to enhance the effectiveness of public investment in order to encourage sustainable growth in public investment, contributing to the economic development of Vietnam in the context of globalization

Specific Objectives:

This study aims to assess the long-term impact of public investment on economic growth in Vietnam (period of 1986-2015) and the public investment and economic growth of Vietnam for the last ten-year period from 2006 to 2015 Specifically, this study aims to find the answers to the following objectives:

- To assess the impact of public investment for economic growth in Vietnam to find out whether the impact is positive or negative for the period 1986-2015;

- To propose a recommendation to enhance public investment efficiency in order to encourage sustainable growth in public investment and economy of Vietnam

Hypothesis

- H1: Public investment have positive impact on economic growth in long - run

- H2: Public investment have positive impact on economic growth in short - run

1.3 The Theoretical Framework

The simplest and famous growth model applied is Harrod - Domar which was introduced in the 1940s, named after its originators, Roy Harrod - British and Evsey - American The model focuses on the ICOR ratio or capital-outcome ratio, showing the relationship between investment and growth in the gross product While the low ICOR ratio infers the lack of investment, the high one infers the situation of capital wasting The theory that explains the relationship between inputs and growth in a national product is called the production function The production function is one of the key concepts of mainstream neoclassical theories, used to define marginal product and to distinguish allocated efficiency, the defining focus of economics Cobb-Douglas production function (1928) represent the technological relationship between the amounts of two or more inputs, particularly physical capital (K) and labor (L), and the amount of output (Y) that can be produced by those inputs

Growth models are fundamental of two folds: the neoclassical growth model, also known as the exogenous growth model developed primarily by Solow (1956), and the new growth theory, also known as the endogenous growth model, pioneered by Romer (1986), Lucas (1988), Barro (1990), and Rebelo (1991) Economic growth has been emphasized as a significant factor in many countries for decades As a discipline, core economic growth theory was born in the late 1960s After two decades, growth theory became popular again in the mid-1980s with the emphasis on long-run growth, which is now called endogenous growth theory It is understood that long-run economic growth is at least as important as short-run fluctuations of growth and in fact, it is even more important than that For instance, it might

be important to know why the GDP of a country raised three or four percent in the last couple

of months However, it might be even more important to know why African countries have quite low GDP rates than their European counterparts Or why a country‟s GDP fell during the last century The new growth theory or the endogenous growth theory underlines the importance of the latter questions, related to the long-run growth performances, rather than the former The name of endogenous growth models is given to these theories since according

to these theories determination of long-run growth rates are explained within the models, rather than by some exogenous variables The development of endogenous growth theory has followed the neoclassic growth theory Romer (1990, 1997) introduced the incorporation of resource and development and imperfect competition into the growth framework Other researchers, especially, Aghion and Howitt (1992), and Grossman and Helpman (1991) also considered research and development (R & D) in the growth model

Robest Solow (1956) tried to explain the origin of growth by a different kind of production function that allows analysis of the different causes or origins of growth called the Solow model The main assumptions of the Solow model relate to the characteristics of the production function and the evolution of the three inputs of the product (capital, labor, and knowledge) over time Public investment which affects strongly the economic growth is also reflected by aggregate supply and demand Public investment directly impacts aggregate demand as government expenditure and aggregate supply as a production function (capital factor) Public investment has a spillover effect and indirectly impacts aggregate demand by stimulating private investment and aggregating supply through attracting private investment

1.4 Conceptual Framework

The neoclassical growth model framework of Solow (1957) should be the basis for this study The framework of the growth model takes as its starting point an aggregate production function of Cobb-Douglas function which related to output to factors inputs and variable referred to as total factor productivity

Now separate the capital: K= Kg + Kpd + Kpdf

Where: Kg is Public capital (State sector);

Kpd is Domestic Private Capital (Non-State sector);

Kpdf is Foreign Direct Capital (Foreign invested sector)

Then (1) can be rewritten as follows:

(2) Y= f(L, Kg, Kpd, Kdf)

To examine the relationship between public investment and economic growth, we need to put it in interaction with other control variables (Private Investment, FDI, Labor force) as shown in Figure 1.1

Figure 1.1 Conceptual Framework

Dependent Variables: Economic growth;

Independent Variables: Public Investment;

Control Variables: Private Investment, Foreign direct investment, Labor force

Economic growth is influenced by many factors However, investment and labor should be the most important factors for economic growth Furthermore, investment consists

Growth

Domestic private investment

Labour force Foreign direct

investment

of several components such as foreign direct investment, private investment, public investment and they might have a positive or negative impact on economic growth (in some cases, there is no empirical evidence of the relationship between those variables)

1.5 Operational Definition of Variables and other term

- Economic growth:

In the conceptual framework of the study, Economic growth is represented by the Gross domestic product index Gross domestic product (GDP) is a general indicator reflecting the final results of production and business activities of the whole economy in a given period GDP is calculated at current and constant prices In the conceptual framework of the study, GDP is calculated at constant prices (Real Gross domestic product)

The GDP growth rate measures how fast the economy is growing It does this by comparing one year of the country's gross domestic product to the previous year The GDP growth rate is the most important indicator of economic health It changes during the four phases of the business cycle: peak, contraction, trough, and expansion When the economy is expanding, the GDP growth rate is positive If the GDP growth rate turns negative, then the country's economy is in a recession

- Public investment:

Public investment is the investment of the State in the programs and projects to build economic - social infrastructure and activities investment programs and projects for economic

- social development (Public Investment Law No 49, the National Assembly of Vietnam

issued in 2014, article 4, paragraph 14, page 3) Public investment in this study is understood

that public sector capital investment for development

- Private Investment:

In the conceptual framework of study, Private Investment is understood that Domestic Private sector capital investment for development

- Foreign direct investment:

In the conceptual framework of study, Foreign direct investment is understood that the

Foreign invested sector capital investment for development

- Labor force:

Labor force is the number of individuals in an economy who either are employed or are seeking employment In the conceptual framework of study, Labor force is the number of individuals in the economy who are employed

Economic growth is dependent variable; while Public Investment are independent variables Private Investment, Foreign direct investment, Labor force are Control Variables

1.6 Significance of the Study

This research is going to be significant in the following aspects:

As regards the policy makers:

Public investment is one of the economic development policy - a very important social

of any state, especially significant for countries in transition and developed market economy

as Vietnam

Firstly, the results of this study indicate the relationship between public investment and economic growth in both the short term and long term, help policymakers develop policies accordingly

Secondly, the results of this study point out the weaknesses of public investment in today's Vietnam and propose solutions to improve the efficiency of public investment So it provides a platform to help policymakers develop a plan of public investment with high efficiency, thereby promoting economic growth

As regards administrators: This study provides managers of public investment picture

in Vietnam today Research results indicate the strengths and the weaknesses of Vietnam's public investment, thereby promoting the management strengths and overcome weaknesses, and enhancing the efficiency of public investment

As regards the researcher:

- This study constitutes an important contribution to the empirical literature investigating the relationship between public investment and economic growth

- The author of this research can gain more in-depth knowledge about public investment The author can also improve their ability to carry out a study qualitatively and can implement new researches at a higher level in the future

As regards future learners:

- This can be a useful reference with a relatively abundant amount of information and data about the field of public investment and economic growth in Vietnam

- Through this dissertation, future learners can form their research targets

1.7 Scope and Limitations

1.7.1 Scope of the Study

The authors collected data through the statistical yearbook of the Vietnam General Statistics Office and the World Bank for the period of 2006 - 2015 Even there are many factors that may affect economic growth, the main focus of the research is to examine the relationship (or impact) between public investment and economic growth in Vietnam The study relies on secondary data collected

Research publications released by the General Statistics Office of Vietnam and can be accessed via the electronic portal of the General Statistics Office Furthermore, the author also directly contacts the General Department of Statistics and the Ministry of Finance or through the website to get the report to additional information required

The author made the data collection from February 2016 to September 2016

1.7.2 Limitations of the Study

The main data are taken from the Vietnam General Statistics Office and some from the World Bank, which may cause the inconstancy of the data Data that is not separated for a long time should not apply time series methods, for example, public investment data for specific areas are available only from 2005 to now

On the other hand, the gross figures of public investment and domestic private investment, economic growth and are only available from 1986 to the present If data are available for a longer period, it will have higher reliability

Data from the General Statistics Office of Vietnam are also inconsistencies together Besides, the statistical criteria of the phase difference have the effect of restricting the study

On the other hand, the concept of public investment in Vietnam has much different from those

in other countries, for example, investment activities of state-owned enterprises are not separate but overall investment in the state Enterprises data that this study carried out for purely business purposes does not serve public purposes This makes evaluating the effectiveness of public investment difficult and imprecise

CHAPTER 2 REVIEW OF RELATED LITERATURE AND STUDIES

This chapter is to present the review of literature and studies that have significant effect on the conduct of the study

2.1 An Overview of economic growth theory and public investment

2.1.1 Overview of economic growth theory

2.1.1.1 Introduction

The Classical Theory of Growth (Lanza, 2012) can be explained in a simple way - given a certain amount of labor (assuming labor theory of value), at a certain level of production, wages will be paid to each worker according to the level of subsistence and any surplus (TP - TC = Total Surplus) accumulated by the capitalist Such accumulation will increase the demand for labor and, with a given population, wages will tend to rise

As the wage exceeds temporarily the level of subsistence, the population will increase according to the Malthusian Theory of Population With a growth of population, the supply of labor will increase and wages will again fall back to the subsistence level

The dynamics of growth ends as the law of diminishing returns sets in and wages eat up the whole production - leaving no surplus for accumulation, expansion, and growth of population The „magnificent dynamics‟ ends not with a bang but a whimper as Fig 2.1 shows

Figure 2.1 The classical theory of growth

E

W

TP‟

TP

E2

E1

W2

W1

P

Labor

The vertical axis measures TP and the horizontal axis measures L = Labor and OW line is a subsistence wage line With ON1 population, production is OP, wage per unit is

N1W1 and surplus or profit is N1E1, when TP = Wages + Profits

The emergence of a surplus engenders accumulation which leads to an increase in the demand for labor Wages rise to E1N1 since the demand for L rises with accumulation but population, and, thus L supply remains constant at ON1 But once the wages are above the level of subsistence, i.e N1E1 > N1W1, growth of population is stimulated to ON2

Once the population is ON2, a surplus emerges again, i.e W2E2, as wages are driven back to the level of subsistence and the whole process is repeated until the economy reaches a point E where the stationary state is reached As W = TP, there is no surplus and the day of doom is reached If technical progress is introduced (a shift of TP to TP‟), then the day of doom is postponed, but not eliminated

Limitations of the Model:

(1) The role of technical progress has been underestimated in the model The experience has shown that the role of DR, as the pointer to the day of doom, has certainly diminished

(2) The iron law of wages, which suggests that wages cannot be above the subsistence level because the Malthusian Law of Population has been discredited as the sole-explanation

of wage determination The iron law of wages is based only on supply, whereas wages are determined both by demand and supply It does not take into account the role of trade union

on wage determination

(3) The Malthusian Theory of Population Growth has been found to be misleading in the light of the experience of economic-development of the economically advanced European countries The Malthusian argument that, whenever wages are above the subsistence level, people like to have more babies rather than other things seems to be unacceptable, both logically and empirically

(4) The classical model seems to be too simplistic to account for the complex factors which influence the growth (Lanza, 2012)

2.1.1.2 Keynesian Theory and the Classical Theory

It is significant to observe that, in classical theory, money is a „veil‟ and has nothing to

do with the determination of real factors like output and employment; money plays no role in the equilibrium analysis of value and distribution in the classical system, whereas in the Keynesian model money tends to influence the equilibrium values of output and employment Later, Patinkin (1954) tried to integrate value and monetary theory by introducing the real balance effect

One of the main sources of conflict between the Keynesian and classical theories lying

in the way the difference between the demand for and supply of money should be corrected

In the classical theory, an increase in money supply will raise unwanted cash holding and, since a rational individual does not hold money for its own sake, excess money would be spent on goods and services, pushing the price upwards, with a given level of output

The mechanism is explained with the help of the quantity theory: MV = PT, where M

= quantity of money, V = Velocity, P = Price Level and T = total transaction It is assumed that V and T are unlikely to change substantially in the short-run In such a situation, an expansion of M will have a direct and positive impact on prices The critics, however, have argued that, if either V or T or both change with the change in M, then the direct relationship between M and P is unlikely to hold (Ghatak, 2003)

To this „new monetarists‟ point out that, as long as the demand for money remains stable, an expansion of M will always lead to a rise in prices, though the effect may not be seen instantaneously At a higher price, the expansion of money supply would be consistent with ordinary transaction demand (k) which is assumed to be a fixed proportion of income (Y)

or M = kY

In the Keynesian theory, an expansion of money supply will raise bond prices and reduce the interest rate, increase the level of investment, output, and employment and perhaps lead to a secondary effect on prices Should there be excess capacity, the effect on prices of a rise in money supply will be even less If we are concerned with an underemployment situation, prices should not be affected so long as the supply of output with respect to the money supply is elastic Thus, the effect could well be on income, output, and employment (Ghatak, 2003)

2.1.1.3 Marxist Theory of Economic Growth

Marx rejected some principal features of the Classical theory of economic growth and offered his own theory within a socio-historical framework in which economic forces play a major role In Marxist theory, the law of diminishing returns has been discarded because Marx believed that the Classical theory of the Stationary State was actually a creation of human actions rather than the end product of natural, immutable law For a similar reason, Marx also castigated the Malthusian theory of Population (Ghatak, 2003)

Marx looked at economic development from a social and historical stand-point Each stage of economic growth was regarded as the product of Hegelian dialectics of a game of contradictions where a thesis created its anti-thesis and the conflict between the two produced

a synthesis Marx emphasized that, with capitalism, social relations of production were much more important than exchange relations between goods

The social character of labor has been stressed in particular Marx argued that labor productivity „is a gift, not of nature, but of history embracing thousands of centuries‟ However, the Marxist concept of relations of production is rather vague It has been interpreted as an „organic whole‟ characterized by labor organization and skill, the standing of labor in society, technological and scientific knowledge, and its use in a certain environment

In the Marxist analysis, these „relations of production‟ determine the socio-cultural

set-up of society Marx believed that capitalism would not end set-up in a quiet classical „stationary‟ state; rather, it would break up with a „bang‟ „when the expropriators are expropriated‟ Here we shall only analyze the economic views in the Marxist theory (Ghatak, 2003)

The Marxist model of economic growth depends on some major dynamic „laws‟:

(1) The law of capital accumulation, which says that the prime desire of the capitalists

is to accumulate more and more capital

(2) The law of falling tendency of the rate of profit which plays a crucial role in the breakdown of the capitalist system

(3) The law of increasing centralization and concentration of capital, which tells us that, with the growth of capitalism, cut-throat competition among capitalists will lead to the annihilation of the smaller firms by bigger ones, which will lead to the growth of monopoly and concentration of economic power

(4) The law of increasing „pauperization‟ which implies the growth of the misery of the working class with the advancement of capitalism, reflected in wages being tied to the subsistence level coupled with a rise in the proportion of unemployed people - or, what Marx called the „industrial reserved army of labor‟- made possible by the substitution of capital for labour in the process of technical change

The simultaneous working of these laws would generate contradictory forces, which would eventually sharpen the class conflict between capitalists and workers or between „haves‟ and „have-not‟s‟ Capitalism would face a violent death in the final confrontation when the expropriators would be expropriated Hence, Marx gave the clarion call: „workers of the world unite‟, as they have nothing to lose except their „chain‟ and „the whole world to conquer‟

The Marxist notion of the falling tendency of the rate of profit plays a crucial role in the whole process of change and can now be illustrated According to Marx, the value of a commodity (W) is given by the sum of „constant capital‟ (c) + the „variable capital‟ (q) + the

„surplus value‟ (s)

If the working day consists of 8 hours and only 4 hours are required to produce a commodity for subsistence then for the remaining 4 hours, the worker is producing a surplus value, which is expropriated by the capitalists More formally, W = c + q + s and X = s/q where x is the rate of surplus value or the rate of „exploitation‟ Thus, in the above example,

4 hrs/4 hrs = 100% = X

The rate of profit (P) in the Marxian analysis is given by

Let S/q = X, i.e the rate of exploitation, and c/q = J or the „organic composition of capital‟ Then we have p = X/1 + J Now, it is clear that, if X remained constant, P and J would be inversely correlated A rise in J would take place as capitalism developed with continuous accumulation Also, capitalists would substitute capital for labour whenever wages tended to rise above the subsistence level to maintain their rate of profit

The process would lead to higher unemployment among the working class and sharpen the polarization of forces On the other hand, the crisis of capitalism would be reflected in the periodic fluctuations of growth and a falling tendency of the rate of profit, which would lead to cut-throat competition among the capitalists which, in turn, would lead to monopoly Eventually, the conflict between the „immiserated proletarians‟ and the capitalists would toll the death-knell of capitalism

It is interesting to observe that the falling tendency of the rate of profit may not always

be seen within an economic system This can easily be demonstrated within the Marxist model We have P = X/1 + J Differentiating P concerning the time we get

Note that the profit rate will rise if the rate of exploitation rises more rapidly than the organic composition of capital Even if the rise in the organic composition of capital is higher than that of the rate of exploitation, whether or not profit will fall depends on the difference between dx/dt and the product of profit rate and dj/dt

For-profit rate to fall, Pdj/dt (which is negative) must be greater than dx/dt However,

a fixed rate of exploitation and an increase in capital intensity may not go together because a rise in the organic composition of capital would raise labor productivity which would either raise the rate of exploitation or raise real wages Inevitably, the internal consistency of the Marxist model has been questioned

Further, a rise in the organic composition of capital could increase the rate of profit with an increase in productivity and a change in technology Under such circumstances, the intensity of competition among capitalists declines Technical progress may be neutral or even labor-using Thus, the rise in the industrial reserve army of labor and a fall in the wage share

in national income may not occur

Other criticisms usually leveled against the Marxist model may also be briefly mentioned It is contended that Marx‟s correlation between the growth of the average firm size and an increase in the degree of concentration need not always happen However, the proportion of unemployment has increased in recent decades

Empirically, the wage share of national income in most developed economies remained fairly constant for a long time and this phenomenon seems to have weakened the Marxist law of increasing pauperization On the other hand, the Marxist prediction about the increasing concentration and centralization of capital is not rejected However, the rise in the output-capital ratios in developed economies probably reflects the growth of both accumulation and real wages, a phenomenon which Marx probably did not envisage within the strict framework of his analysis

2.1.1.4 Rostow‟s „Stage‟ Theory of Development

This theory states that the transition of an economy from being less developed to developed is possible through a series of steps The most important of these is the so-called take-off stage when resistance to change in traditional values and, in the social, political, and economic institutions of an underdeveloped economy is finally overcome and modern industries begin to expand The theory may be criticized for viewing development as simply a matter of higher saving and investment ratios (Ghatak, 2003)

Saving and Investment:

Physical capital has always been at the center of economic development To invest, the country must save or, else, must have access to foreign savings through loans and aid If domestic saving is the prerequisite for capital accumulation, then attention must focus on policies to promote saving

Saving does depend on the availability of saving instruments - a banking system that offers convenient deposit services There is evidence that extreme financial instability interferes with saving When the return on saving becomes negative one of three things happens: households reduce their savings or they shift their savings abroad or they accumulate their savings in unproductive assets, such as gold The financial environment for savings is thus an important factor in channeling saving from households to investing firms

In addition to the private sector, the government affects national savings through its budgetary policies It can also draw foreign savings to finance investment A developing economy can tap foreign savings in three ways One possibility is that foreign firms invest directly in a country The second way is that a country can tap foreign resources by borrowing

in the world capital market or from institutions, such as the World Bank The third possibility

is that a country may receive foreign aid from industrialized countries

The importance of these three sources of external saving has varied over time and between countries But, there is no doubt that external savings can supplement domestic savings as it always has done Of course, foreign savings is all the more important the lower the per capita income

The amount of saving, whatever, maybe its source, determines how much investment will take place in a country But the productivity of investment may vary widely The larger differences in productivity of investment across countries focus attention on development policies and strategies that affect the efficiency of resource utilization (Ghatak, 2003)

2.1.1.5 Harrod - Domar Growth Model

This model assumes that (Ghatak, 2003):

(a) The economy is closed with no government Thus, the condition for equilibrium is that, planned investment is equal to planned savings;

(b) There are only two factors of production, Labor (L) and Capital (K)and there is no technical progress;

(c) Labour is homogeneous, measured in its own units and grows at the constant natural rate of growth, n.;

(d) There are constant returns to scale This means that, if both L and K are increased

by a given proportion, output also increased by that proportion

(e) Savings (S) are a fixed proportion of income (Y) That is, S = sY where s is both APS and MPS Investment (I) is autonomous and there is no depreciation

(f) The potential national income (YP) is proportional to the quantity of K and L Thus,

we can write L = uYP and K = vYP, where u is a constant capital-output ratio and u is a constant labour-output ratio This is a fixed proportional production function with L-shaped isoquant as in Fig 18.2 Both K and L have to be employed in fixed proportions: as the Fig 2.2 shows, increased capital and labor from OK1 and OL1 to OK2and OL2 increased output from Q1 to Q2 (from A to B) Increasing only one of the factors would keep output unchanged (from A to C)

Figure 2.2 Fix proportion Production function

Source: Ghatak (2003)

In Fig 2.3, we start from equilibrium A and the initial investment I1which is equal to 5

at the income level OY1 Over time, the investment adds to the capital stock and so increases the economy‟s potential output, say to OY2 The following analysis shows what the increase

in potential output (∆YP) will be: K = vYP, thus, ∆K = v∆YP But ∆K + I1, so we have ∆YP =

I1/ v…… (1)

Figure 2.3 Equilibrium output change with investment

Source: Ghatak (2003)

K1 K2 K

Fixed Proportion Production Function

Q1

B C

A

I1

B A

S.I

S = SY

The new level of income, OY2, will be an equilibrium Y if AD increases Assuming that the C and S functions are stable, thus, increase in demand must come from an increase in

I Investment must rise to l2 as in Fig 2.3, where l2 intersects the savings line at Point B where

OY2 is an equilibrium income

As the new K from this extra I comes into operation, potential output will rise yet again, say to OY3 For this to be an equilibrium Y, investment must rise again - and so on as the growth-process continues

This is Harrod‟s warranted rate of growth (gw) which can be derived as follows: ∆Y = I/v (from equation 1) In equilibrium, we have I = S = sY

By substitution ∆Y = sY/v Rearranging, ∆Y/Y = s/v = gw This is the rate of growth

of output required to keep the economy in equilibrium at its potential output level It is Harrod‟s warranted rate of growth For example, suppose v = 4 and that the savings proportion, s = 0.2 The warranted rate of growth (gw) would be gw = 0.2/4 = 5%

This means that 5% growth would be necessary to keep the potential and equilibrium output levels equal Thus, the warranted rate of growth can be increased by policies designed

to increase the propensity to save or to reduce the capital-output ratio by measuring the productivity of K

In this model output can only grow at the warranted rate, s/v, if sufficient labour is made available It is assumed that the labour force is growing at the constant rate n; if n > s/v, the warranted rate can be achieved but will lead to an increasing rate of unemployment; if n < s/v, the actual rate of growth will fall short of warranted rate and unemployed capital will be created Thus, for an equilibrium growth path which maintains full employment of both L and

K, the following condition must be satisfied: n = s/v That is, warranted rate of growth must

be equal to the natural rate of growth

Unfortunately, s, v and n are all constants in the Harrod-Domar model and unrelated to one another It would be a complete „fluke‟ if n = s/v We can conclude that the equilibrium rate of growth in this model is highly unlikely to be achieved automatically Furthermore, when s/v ≠ n, the economy will either experience increasing labor unemployment (when s/v < n) or increasing under-utilization of K (when s/v > n) When such disequilibrium occurs, there are no forces generated to restore the equilibrium growth path In other words, the equilibrium

in the Harrod-Domar model is an unstable, or „knife- edge‟, equilibrium (Ghatak, 2003)

Criticism:

(1) The model‟s major drawback is its dependence on an inflexible production function, where no substitution is possible between L and K It is more realistic to assume

that there is some substitution between labor and capital If there is some factor substitution; the isoquant map will have the more familiar shape as in Fig 2.4 It is now possible to increase output from Q1 to Q2 by increasing the capital stock from OK1 to OK2, keeping the labor force unchanged, or by increasing the labor force from OL1 to OL2, keeping the capital stock unchanged

Figure 2.4 Production function with some factor substitution

Source: Ghatak (2003)

With a production function of this kind, the capital-output ratio (v) can vary Suppose that the warranted and natural rate of growth are not equal As an example, let s/v > n; this means that the capital stock is growing faster than the labor force and also faster than output Consequently, the capital-output ratio will rise and so s/v will fall This tendency will continue until s/v = n again, which is the steady-state growth; all economic variables grow at the constant proportional rate which is equal to the natural rate of growth

Then the economy is on its long-run equilibrium growth path This view, that any s/v

≠ n will be corrected by a change in u, is the basis of the so-called neoclassical growth model, which will be developed in the latter sections In the meantime, we shall see some of the interesting uses of the model in national planning

Uses of Harrod-Domar Growth Model in National Planning:

The central point in the growth theories developed by Harrod - Domar is concerned with the existence of a unique equilibrium rate of growth which may or may not be achieved

L1 L2 L

Production Function with Some Factor Substitution

0

K1

Q1

B

A

K2

K

in practice Given a community s propensity to save and the state of its technical progress, its income, investment, and capital stock have a uniquely determined uniform rate of growth at which the condition of dynamic equilibrium is satisfied This is the fundamental proposition that goes into this growth model in the post-Keynesian theory

There are two interesting implications of this type of equilibrium growth model First, if the two countries have the same equilibrium growth rate, but if income in one country is higher than the other, the absolute gap between the two incomes will increase with the passage of lime

Second, if life-income in one country is larger than that in the other, but if the latter has a slightly higher rate of growth than the former, the income in the latter will catch up with the income of the former in course of time That is, perhaps, the reason why a late starter in the development race must grow at a faster rate than its already developed neighbor

The equilibrium growth rate determined by the saving-income ratio and the output ratio has some policy implications for the developing economies; that aspire for higher rates of growth The equilibrium rate of growth that can be achieved varies directly with the saving-income ratio and inversely with the capital-output ratio If the saving-income ratio can

capital-be raised above the existing level, the higher rate of growth can capital-be realized thereby

The policy of maximizing the rate of growth would require the measure to increase the marginal propensity to save of the community If the marginal propensity to save can be raised above the average propensity, the saving-income ratio will rise above the growth of income and, then, the alternative equilibrium growth rate will also increase over time

The growth rate may also be maximized by reducing the capital-output ratio Different commodities have different capital-output ratios, and the same commodity may be produced with different processes that may have different capital-output ratios

Thus, by a suitable choice of processes and composition of output, the over-all output ratio of the whole economy may be reduced to maximize the growth rate The choice

capital-of technique is an important device in the process capital-of economic growth The macro-economic significance of the choice of technique in increasing the rate of growth with a given saving-income ratio is a direct outcome of the Harrod - Domar growth model

Another application of the Harrod - Domar growth model can be found in the analysis of the role of foreign aid in the economic development of a developing economy To start with, a developing economy has a low saving- income ratio which produces a very low rate of growth It may be possible to increase the rate of growth of an economy by increasing the marginal propensity to save above the average propensity which will raise the saving- income ratio

If the domestic saving is supplemented by foreign aid, the rate of growth may be raised above what is attainable without it The higher rate of growth may produce a faster rise in the saving-income ratio, and, hence, the higher rate of growth may be achieved at an earlier date

Now we can fix a target rate of growth that may be higher than the current attainable rate Domestic saving may be incapable of realizing it at the beginning; but if the saving-income-ratio rises with the growth of income, the target rate of growth will be possible to realize at some future date even without the foreign aid If we know the saving function, we can calculate the date of achieving the target rate of growth

If t is the date of realizing the target rate of growth without foreign aid, then, with foreign aid, it may be possible to realize the target rate much earlier; and with the rise in the saving-income ratio, it will be possible to realize the target rate domestically attainable at a future date when foreign aid may not be available or required

The date of terminating the foreign aid is t* which must be higher than t as the growth rate with foreign aid is higher than without it The difference between t* and t is the contribution of the foreign aid, which may be calculated by the simple Harrod - Domar Model Though we have discussed the use of these simple models in examining the various policy implications in the economic development in an under-developed economy, we must emphasize that the problems of economic development are more complex than the simple Harrod - Domar model can handle

Economic development means a radical restructuring of the economy Structural rigidities, socio-economic and many socio-political factors are responsible for economic backwardness Economic theory alone cannot deal with the structural problems of underdeveloped economies

In fact, the growth models have been developed to deal with the problems of maintaining steady growth in industrially developed economies The question of development

in a developing economy cannot be dealt with by the economic theory alone It requires the help of other branches of studies, such as sociology, politics, religious inhibitions, and so on (Ghatak, 2003)

2.1.1.6 The Solow growth model

The Solow growth model provides a framework with which we can address one of the most important questions in economics - how much of the economy‟s output should be consumed today and how much should be saved for future?

Since saving equals investment, saving determines the amount of capital an economy will have for future production National saving is influenced by government policies Evaluating these policies requires an understanding of the costs and benefits to society of alternative rates of saving (Ghatak, 2003)

Accumulation of Capital:

The Solow Growth Model shows how growth in the capital stock, growth in the labour force, and advance in technology interact, and how they affect output As a first step in building the model, we examine how the supply and demand for goods determine the accumulation of capital To do this, we hold the labour and technology fixed We relax these assumptions later

Supply and Demand for Goods:

The supply of goods determines how much output is produced at any given moment in time, and the demand determines how this output is allocated among alternative uses

Supply of Goods and Production Function:

Supply of goods in the Solow Model is based on the production function Y = F (K, L), output depends on the capital stock and the labour force The Solow Growth Model assumes that the production function has constant returns to scale ZY = F (ZK, ZL), for any positive number Z That is, if we multiply K and L by Z, we also multiply the amount of output by Z

Production function with constant return to scale are convenient, because output per worker depends only on the amount of capital per worker For this, set Z = 1/L in the equation above to obtain Y/L = F (K/L, 1) Thus, output per worker Y/L is a function of capital per worker K/L, where Y = Y/L is output per worker, and k = K/L is capital per worker We can now write the production function as Y = f (k), where we define f (k) = F(k, 1) It is more convenient to analyze the economy using this production function as Fig 2.5 shows

Figure 2.5 Production function

The slope of this production function shows how much extra output per worker is produced from an extra unit of capital per worker This is the MPK Mathematically, we can write: MPK =f(k + 1) -f(k) The production function becomes flatter as k increases, indicating diminishing MPK

Demand for Goods and Consumption Function:

The demand for goods in this model comes from consumption and investment That is, output y is divided between c and i: Y = c + i This equation is the national income account identity except government purchases and it expresses y, c and i as per worker

The model assumes that the consumption function takes the form:

c = (i -s)Y where the saving rate, O <s < 1 This consumption function states that consumption is proportional to income Each year a fraction (I - S) of Y is consumed, and a fraction is saved Substituting (I - S) Y for C we get the national income identity: Y = (I - S)

Y + i Rearranging the terms we obtain: i = SY This states that, investment, like consumption, is proportional to Y Since I = S, the rate of saving S is a fraction of output devoted to investment

Evolution of Capital and Steady State:

Having introduced the production and consumption functions - main ingredients of the model, we can examine how increases in the capital stock overtime result in economic growth Two forces - investment and depreciation - cause the capital stock to change The saving rate S determines the allocation of output between consumption and investment At any level of k, output is f(k), investment is sf(k), and the consumption is f(k) - sf(k)

The higher the level of capital k, the greater the levels of output f(k) and investment i This equation relates the existing stock of capital k to the accumulation of new capital i, Fig 2.6 shows how the saving rate determines the allocation of output between c and i for every value of k

Figure 2.6 Output, consumption and investment

Aconstant function δ of the capital stock depreciates every year Depreciation is, therefore; proportional to the capital stock For example, if capital lasts an average o years, then the depreciation rate is 4% per year The rate of depreciation is δk Fig 2.7 shows how depreciation depends on the capital stock

Figure 2.7 Depreciation

y

Output per worker

Capital per worker

f(k)

S f(k)

Capital per worker k

δk

0

δk

We can express the impact of i and δ on the capital stock with this adjustment equation Change in capital stock = Investment - Depreciation, ∆k = i - δk Since s = i, we can write the change in the capital stock as: ∆k = sf(k) - δk This equation states that the change in capital stock equals investment sf(k) minus the depreciation of existing capital δk

Investment, Depreciation and the Steady State (Ghatak, 2003).:

Since the rate of saving S is constant and saving equals investment, the amount of investment is sf(k) Since capital depreciates at a constant rate δ, the amount of depreciation is

δk The steady-state level of capital k* is the level at which depreciation equals investment; at k* the two curves cross as in Fig 2.8 Below k* investment exceeds depreciation, so the capital stock grows Above k* depreciation exceeds investment, so the capital stock shrinks

Changes in Saving

Figure 2.8 Investment, depreciation and steady state

Rate:

An increase in S implies that, the amount of I for any given stock of capital is higher

It thus shifts the saving function upward At the old steady state, i > δ, the capital stock rises until the economy reaches a new steady state with more capital and output

The Solow Model shows that the saving rate is a key determinant of the steady-state capital stock If S is high, the economy will have a large capital stock and a high level of output If S is low, the economy will have a small capital stock and a low level of output

The relationship between saving and economic growth is that a higher saving leads to

a higher economic growth, but only in the short-run However, in the long-run, a high rate of saving will not maintain a high rate of growth

Golden Rule Level of Capital (Ghatak, 2003).:

Since we have examined the link between the rate of saving and the steady- state levels of capital and income, we can discuss what amount of capital accumulation is optimal

We first present the theory behind government‟s policy regarding saving rate, which will be discussed later on We assume, for the moment, that a policymaker can set economy‟s saving rate at any level By setting the saving rate, the policymaker determines the steady-state they

choose Comparing Steady-State:

When choosing the steady-state, the policymaker‟s goal is to maximise the well-being

of the society Individuals in the society may not care about the amount of capital and even output in the economy They only care about the amount of goods and services they can consume However, the policymaker would wish to choose the steady-state with the highest consumption level

The steady-state with the highest consumption is called the Golden Rule Level of Capital Accumulation (k gold) To know the Golden Rule Level, we must determine steady-state consumption per worker We can then see which steady-state provides the most consumption

To find steady-state consumption per worker, we start with the national Y accounts identity: y = c + i and rearrange it as c = y - i Since we want steady-state consumption, we substitute steady-state values for output and investment Steady-state output per worker is f(k*), where k* is the steady- state capital per worker Moreover, since the capital stock does not change in the steady-state, investment is equal to depreciation 8k* Substituting f(k*) for y and δk* for i we write steady-state consumption per worker as C* = f(k*) - δk*

Thus, steady-state C* is the difference between steady-state output and depreciation It shows that increased capital has two effects on C*: it causes greater output, but more output must be used for δk

Steady-State Consumption (Ghatak, 2003).:

Fig 2.9 shows steady-state output and depreciation as a function of the steady-state capital stock Steady-state C* is the gap between output of f(k*) and depreciation δk The figure shows that, there is one level of capital stock - the Golden Rule level k* gold-that maximizes consumption At the Golden Rule level of Capital, the production function and the δk* line have the same slope, and consumption is at its greatest level

Figure 2.9 Steady state consumption

To make the point somewhat differently, suppose the economy starts at some capital stock k* and that the policymaker wants to increase the capita stock at k* + 1 The amount of extra output would then be f(k* +1) ) = MPK The amount of extra depreciation from having one more unit of capital is δ

The net effect of this extra unit of capital on consumption is MPK - δ If the state capital stock is below the Golden Rule level, increases in capital increase consumption because the MPK > δ If the steady-state capital stock exceeds the Golden Rule level, increases in capital reduce consumption because the MPK < δ Thus, the following condition describes the Golden Rule: MPK =δ or MPK - δ=0

steady-The Saving Rate and the Golden Rule:

Fig 2.10 shows there is one saving rate that produces the Golden Rule level of Capital k* gold A change in the saving rate would shift the sf(k) curve, which would move the economy to a steady-state with a lower level of consumption

Figure 2.10 The saving rate and the golden rule

Transition to the Golden Rule Steady-State:

So far, we have been assuming that the policymaker can simply choose the economy‟s steady state, which means they would choose the steady state with highest consumption - the Golden Rule steady-state Now suppose, the economy has reached a steady-state other than Golden Rule What would happen to consumption, investment and capital when the economy makes the transition between steady-state? Might the impact of transition deter them from achieving the Golden Rule?

We must consider two cases: the economy might begin with more or less capital than

in Golden Rule Steady-State Too little capital presents far greater difficulties; it forces policymakers to evaluate the benefits of current consumption relative to future consumption

Starting with more Capital than in the Golden Rule:

Reducing saving - Fig 2.11 shows what happens over time to output, consumption and investment when economy begins with more capital than the Golden Rule as the investment saving rate is reduced The reduction in the saving rate (t0) causes an immediate increase in consumption and an equal decrease in investment

Over time, as the capital stock falls, output, investment and consumption fall together Since the economy began with too much capital, the new steady-state has a higher level of consumption than the initial steady- state The new steady-state is the Golden Rule Steady-State

k*glod k*

Steady-state output, depreciation and investment per worker

per

0

Sgold f(k)

δk C*gol

d

I *glod