This chapter discusses the representative consumer theory of distribution (RCTD), highlighting the insights it offers into the growth–inequality relationship. It begins by embedding the RCTD in a basic Ramsey growth model, which presents its equilibrium structure in the most transparent manner. It then extends the analysis to include: (i) fiscal instruments; (ii) distribution of abilities across agents; (iii) a progressive tax structure; (iv) accumulation of human capital; and (v) public investment. The tradeoffs between inequality and other aggregates, both concurrent and over time, are stressed. RCTD introduces path dependence into the evolution of wealth and income inequality. Finally, while the tractability of RCTD makes it appealing and may provide many useful insights, it is based on strong assumptions adopted in much of contemporary macrodynamics. To understand the nature of the growth–inequality relationship, one needs to embed it within a consistently specified general equilibrium growth model, recognizing that different frameworks offer different perspectives and may lead to different conclusions.

The models discussed thus far all have the characteristic that consumption and output (capital) are always on their respective balanced growth paths; there are no transitional dynamics. Instead, the economy adjusts with infinite speed to any exogenous shock, thus contradicting the empirical evidence pertaining to the speed of convergence. One of the main conclusions of this literature is that the economy in fact adjusts relatively slowly, with the benchmark estimate of the speed of adjustment being around 2-3% per annum. While the original estimates have been challenged on various empirical and methodological grounds, the consensus remains that the speed of convergence may be somewhat higher than originally suggested, but probably less than 6% per annum. In any event, this implies that the economy is mostly off its balanced growth path, on some dynamic path that converges only gradually to a steady state. It is therefore important to modify the model to allow for such transitional dynamics, and this can be achieved in several ways, all of which assign a central role to a second state variable in determining the equilibrium dynamics.

In this chapter we consider two important modifications to the basic onesector model that accomplishes this objective. These include: (i) limited access to the world financial market; and (ii) the introduction of public capital. In Chapter 5 we shall show that extending the model to two sectors, having traded and nontraded capital, will also introduce transitional dynamics, the nature of which will depend in part upon the relative sectoral capital intensities.

Introduction

As we noted briefly in Chapter 2, an important potential difficulty associated with endogenous growth models is that they may exhibit “scale effects,” meaning that variations in the levels of key variables pertaining to the size of the economy, such as the population, number of people employed in the research sector, or the capital stock, exert permanent influences on national growth rates. In addition, they also suggest that policy variables, most notably tax rates, may have a profound effect on the equilibrium growth rate. These theoretical predictions run counter to recent empirical evidence obtained from studies based on the USA and other OECD countries. This has led to the development of a new class of so-called “non-scale” growth models, in which technology and capital accumulation are still endogenous, but long-run growth rates are now independent of changes in policy and other scale variables. Instead, long-run growth rates are determined by the exogenous growth rate of labor in conjunction with production elasticities. In this respect these new models are closer in spirit to the traditional Solow–Swan neoclassical growth model, which in fact emerges as a special case.

The non-scale specification has both advantages and disadvantages. One attractive feature is that a balanced growth equilibrium obtains with few restrictions on returns to scale. This is in contrast to endogenous growth models, which require constant returns to scale in the accumulated factors of production for balanced growth to prevail.

Introduction

Investment in public infrastructure is widely recognized as being an essential component of economic development and growth. Services associated with the use of infrastructure account for roughly 7 to 9 percent of GDP in lowand middle-income countries. Infrastructure in these countries typically represents about 20 percent of total investment and 40 to 60 percent of public investment. The stock of physical infrastructure is thus an important input in the production process of such economies, raising the efficiency and productivity of the private sector, and thereby providing a crucial channel for growth, distribution of output, and ultimately higher living standards.

The significance of infrastructure has assumed a central role in the context of the expansion of the European Union (EU). In several instances, the per capita level of GDP of members acceding to the Union has been below the EU average. For example, in 1988, the per capita GDPs (in purchasing power parity) of Greece, Ireland, and Portugal were only 54.4, 64.6, and 53.8 percent, respectively, of the EU average. Moreover, these countries were also experiencing low growth rates that even exhibited tendencies to decline. As a consequence, the EU introduced pre-accession aid programs to assist these and other potential member nations in their transition into the Union. This process of “catching up” began in 1989 with unilateral capital transfers from the EU through its Structural Funds Program, and subsequent programs were introduced in 1993 and 2000.

This book is an extension of three lectures presented as the first set of “Centro Interuniversitario Crescita & Sviluppo Economico (CICSE) Lectures on Growth and Development” in Lucca, Italy, in July 2007. When I was invited to present this series, I was delighted that CICSE asked me to lecture on capital accumulation and economic growth in a small open economy. Both international macroeconomics and the theory of economic growth have interested me for a long period, so this seemed like a good opportunity to discuss them in a unified way. Over the past two decades economic growth has evolved into an enormous area of research, drawing increasingly on contributions from other areas of economics, as well as from other disciplines. The approach I adopt in these lectures is a traditional one, extending the standard models of capital accumulation to the open economy.

The lectures and this resulting short book draw heavily on research that I have undertaken in this area since the mid 1990s. At the appropriate places in each chapter, I have indicated the original source of the research from which the presentation has been adapted, although in many cases the material has been extensively revised. As will be seen from the appropriate references much of the research has been undertaken jointly and I am grateful to have had the opportunity to work with many talented coauthors over the years.

Introduction

The one-sector production model, while an essential analytical tool of aggregate economics, is inevitably limited as a framework for analyzing the full economy-wide impacts of policy shocks and structural changes. This is particularly problematic in an international economy, one of the key characteristics of which is the fact that international trading activities affect different parts of the economy to varying degrees. Some parts of the economy are specialized in exports or export-related activities, others in imports or importrelated activities, while other sectors, notably service industries, operate more or less independently of the international environment. The differential impacts on these various sectors were a central issue in the debate over the Dutch disease and the discovery of oil in Northern Europe, as well as in assessing the effects of mineral discoveries in Australia. In both cases the discovery of the resource led to a change in the country's terms of trade, and this in turn had an effect on the country's traditional export sectors, as well as on its importcompeting sectors. Or, to take another example, a tariff imposed on a country's imports, by changing the country's terms of trade, will also have consequences elsewhere in the economy. To capture these relative price effects one needs to augment the basic model to introduce a second, or perhaps even more, sectors.

Two-sector models of economic growth were pioneered by Uzawa (1961), Takayama (1963), and others in the context of a closed economy.

Economic growth is arguably the issue of primary concern to economic policy makers in both developed and developing economies. Economic growth statistics are among the most widely publicized measures of economic performance and are always analyzed and discussed with interest. As a consequence, growth theory has long occupied a central role in economics.

The study of economic growth illustrates the power of compound interest. A seemingly small growth differential can accumulate over time to substantial differentials in levels. To take one very simple example, suppose two countries begin with the same level of income. A sustained 1% growth differential in output between the two economies implies that in seventy years – just one lifetime – the output level of the faster-growing economy will be double that of the slower-growing economy. Indeed, the dramatic changes in relative incomes among the OECD countries that one can observe between the end of World War II and the present are in some cases the accumulated results of these seemingly small differences in growth rates.

Some background

Long-run growth was first introduced by Solow (1956) and Swan (1956) into the traditional neoclassical macroeconomic model by specifying a growing population coupled with a more efficient labor force. The direct consequence of this approach was that the long-run equilibrium growth rate in these models was ultimately tied to demographic factors, such as the growth rate of population, the structure of the labor force, and its productivity growth (technological change), all of which were typically taken to be exogenously determined.