Question

The Solow Model was originally conceived for a single-good, closed economy. In the ensuing decades, it has been expanded to account for endogenous growth and free trade. We want to consider what kinds of phenomena such models should encompass. Imagine a small developing country initially with a closed economy, with income per capita well below that of advanced nations. The policymakers in this country are considering opening the country to trade. Consider this country’s initial steady state and growth, and discuss how these might change were the country to allow free trade. In particular, focus your response on

1. What would the closed economy steady-state income be relative to advanced nations (and what may cause it to differ)? What about consumption?

2. Would you expect an accelerated speed of growth (capital accumulation) under free trade as compared to a close economy or not? Why yes or why no? What about changes in consumption?

3. What new opportunities for growth may be created by free trade?

Answer 1

1.A. A poorer economies per capita incomes will tend to grow at faster rates than richer economies. 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 because diminishing returns are not as strong as in capital-rich countries. Furthermore, poorer countries can replicate the production methods, technologies, and institutions of developed countries.

A closed economy does not enter into any one of the following activities.

(i) It neither exports goods and services to the foreign countries nor imports goods and services from the foreign countries.

(ii) It neither buys shares, debentures, bonds etc. from foreign countries nor sells shares, debentures, bonds etc. to foreign countries.

(iii) It neither borrows from the foreign countries nor lends to the foreign countries.

(iv) It neither receives gifts from foreigners nor sends gifts to foreigners.

(v) Normal residents of a closed economy cannot go to other countries to work in their domestic territory. No foreigner is allowed to work in the domestic territory of a closed economy.

Due to all these seasons, Gross Domestic Product and Gross National Product are the same in a closed economy.

2A.Accumulation is a cyclical process in which forces unique to capitalism work to reassert the cycle of accumulation and investment. As unemployment rises, the real wage falls and profits rise, leading to a new cycle of accumulation and investment. The dynamic nature of the capitalist mode of production is identified with several elements that are inherent to the system.

Those firms which grow faster will benefit from economies of scale and increasing returns through an expansion of their market share and subsequent higher profits. However, the process of capital accumulation does not proceed in a smooth and orderly manner because when expected profits are low, capitalists halt the process of investment and accumulation and hence precipitate a general crisis involving unsold goods and high unemployment.

3A.It is claimed that an open economy, with given productive resources, can have a higher GDP. Alternatively, for producing a given GDP, it spends a smaller quantity of productive resources.This happens due to its enhanced access to improved and better technology which provides an upward thrust to economic development.

Open economies are able to get cheaper imports and can sell exports at higher prices. In other words, both importers and exporters of open countries [and therefore, their consumers] benefit from price differentials.

International trade in goods and services enables each country to concentrate on the production of those goods in which it has a comparative cost advantage, and import those in which it has a comparative cost disadvantage. That way, it can add to the volume, variety and quality of goods and services that go into determining its GDP.

Traditional economic thinking dealing with international economic transactions assumed that there was near absence of mobility (flow) of capital and other factors of production between countries.

Over time, however, the realities of international trade have belied this theory. Currently, enormous volumes of a variety of capital funds are circulating between world economies.

In addition, international flows of other inputs (raw materials and intermediate products, technology, institutional set ups, work ethos and, to some extent, even labour) have increased in varying degrees.