Question

In: Economics

On June 4, 2013, the Financial Times reported on the 10 fastest growing economies so far...

On June 4, 2013, the Financial Times reported on the 10 fastest growing economies so far in 2013. These countries include South Sudan (32.1% GDP change), Libya (20.2%), and Sierra Leone (17.1%). On the other hand, on June 7 the German central bank predicted growth in Germany will be 0.4% in 2013, and the first quarter annualized GDP growth for the U.S. is 2.5%. Are these very disparate numbers consistent with the Solow growth model? Why or why not? Explain verbally and graphically.

Solutions

Expert Solution

Over the years, the life style of numerous countries which previously used to be very bad has changed. This is because they have enabled themselves to embrace global trade, have taken active measures to stabilize the economy, and have given considerable importance to investment both government as well as private. They have also created opportunities by expanding their healthcare and education sectors over a period of time.

However, it is crucial to note, that we see countries which have just entered the growth path such as Sudan, Libya and Sierra Leonne to have GDP growth rates as high as 15-35%. This as per the Solow Model is defined as the Catch-Up Effect. On the other hand, we have developed countries such as Germany and the United States of America which only grow at 1-2%.

The core reason behind this as explained by the Solow Model, is the fact that these countries are new to development, and see increasing returns on capital which they never did earlier. On the other hand, developed countries will not gain if they expand their operations as there is no room for developing just on the basis of capital investment for them.

As a country is underdeveloped at first, its resources do not produce at maximum capacity. When investment increases, the capacity begins to increase at a high rate, and then gradually gives lesser returns. This increase at a higher rate is where countries such as Sudan and others lie. Developed countries on the other hand, see decreasing returns because they would have to innovate to produce any further.

In simple terms, it is easy to go from 0-10 for an economy than to go from 100-200 this is because over a period of time, additional capital investment does not give equal results for an economy.

The valuation of the GDP growth has also to be considered here. The US growing at 2% is much higher than the total economy size of countries such as Sudan and others.

The Solow Model clearly defines, that poor countries see a catchup effect as they are able to produce more goods and services now due to the increase in capital investment. Rich countries stagnate in development, primarily because their returns decline over a period of time.

For example, a country having a GDP size of 10 Million dollars can easily grow to 12 million dollars with increased investment capacity. This is considered to be a growth of 20%. However, countries such as the United States grow in trillions, even though the percentage is low, yet the valuation remains high.

Graph and Explanation:-

Graphically here we see that on deploying additional capital between U1 and U2 a low income country grows higher from Point G1 to G2 as compared to a high income country which on deploying similar level of capital from point U3 o U4 results in a GDP growth which is only from G3 to G4.

This is because as we go on increasing capital, the benefit increases at a diminishing rate.

Please feel free to ask your doubts in the comments section if any.


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