Economics of Emerging Markets

Contents

1)

The Solow Model        2

Use the Solow model to explain how addressing the challenges facing India through key reforms would foster growth. If necessary, feel free to use expanded versions of the model as appropriate.

2) The Lorenz Curve        8

Draw the Lorenz curve and compute the GINI coefficient for the distribution of income across major Indian States. Analyse the evolution over time of the percentage of people living under the poverty line. Use both to analyse the distribution of income across major Indian States, critically establishing wherever possible links to the rest of the indicators in Exhibit 7. Using your analysis, outline whether and how regional policies should be actively used by the Indian government to promote growth.

3) The evolution of the sectoral GDP composition        12

Critically compare the evolution of the sectoral GDP composition in India (Exhibit 3) with that of other appropriately chosen emerging markets and comment on the need and scope of further reforms in this area.

4) Corruption        12

Critically compare the evolution of the Corruption Perception Index (Exhibit 8) over the last 15 years between India and appropriately chosen emerging markets, using a developed country as a benchmark. Explain briefly how corruption impacts growth. What could India learn from its neighbours (e.g. Singapore) when it comes to tackling corruption?

5) Current account        15

Identify the main patterns emerging from India's current account (Exhibit 4)  and try to establish links with the evolution of the Rs/US$ (and others, if necessary). Critically comment on the evolution of India's economic performance.

6) Conclusion        16

Critically summarise and conclude on the challenges facing India on its path to continued growth and development.

1. The Solow Model

The Solow model explains economic growth and the differences regarding countries and regions in their economic growth rates. Economic growth is defined as the change in the real GDP or GDP per capita of an economy in a given time period (Miles & Scott & Breedon, 2012). The theory of the Solow model points out how investment and income influence the overall output.

The basis of the model is the production function (Cobb-Douglas function): [pic 1]

.[pic 2]

per worker:

[pic 3]

This formula states that the GDP per capita is dependent on the capital per worker while assuming that the productivity (A) and the quantity of labour input (L) are constant (Weil, 2013). However, capital is decreasing at the same time due to depreciation of existing capital. Depreciation is the reduction over time in the productive capabilities of capital (Miles & Scott & Breedon, 2012). Therefore the change in the capital stock per worker equals investment subtracted by depreciation:[pic 4]

[pic 5]

[pic 6]

[pic 7]

Additionally, the Solow Model assumes diminishing returns. [pic 8]

Diminishing returns occur when the marginal product, defined as the additional output that can be produced by adding one more unit of input, ceteris paribus, (Miles & Scott & Breedon, 2012) declines. [pic 9]

Due to diminishing marginal product of capital, there is a point where output will stop growing from capital accumulation. This point is called the steady state and occurs when investment equals depreciation, so that capital accumulation equals zero and output does not change.

The Solow Model states that the economy will always end up at the steady state, meaning that it will grow if its capital is below the steady-state level, when investment is higher than depreciation, and shrink if it is above this level, hence when investment is lower than depreciation. This process is called convergence.

[pic 10]

[pic 11]

Challenges to India and the Solow Model

India, as a member of the BRIC states, belongs to the emerging markets in the world. However, its growth slowed down in the last years (Iyer and Vietor, 2015). India faces many challenges and therefore needs reforms to deal with them and to accelerate its economic growth. [pic 12]

The Solow Model provides information about how to foster growth. The production function  indicates that India has to increase the capital per worker to raise the output per worker. However, due to the law of diminishing returns, growth through physical capital accumulation is limited by the steady state. The Solow Model predicts, that “a country that raises its level of investment will experience an increase in its rate of income growth” (Weil, 2015), showing that India has to increase its investment by raising the savings rate: . [pic 15][pic 13][pic 14]

India is highly restricted at a score of 0.263 (Figure 4, OECD) regarding foreign direct investment (Iyer and Vietor, 2015). However, FDI is a major investment source nowadays. Therefore, if India becomes more open towards FDI, investment will rise and foster economic growth since this will increase the state level of GDP per capita.

[pic 16]

Figure 4: FDI Restrictiveness Index 2014, Non-OECD Members, Source: OECD, Available from: http://stats.oecd.org/Index.aspx?datasetcode=FDIINDEX#

Moreover, India’s infrastructure, especially regarding telecommunications, is despite already conducted investment still relatively weak (Iyer and Vietor, 2015). A further investment in infrastructure and telecommunications would therefore lessen regional disparities (Iyer and Vietor, 2015) and according to the Solow Model foster growth.

Human capital

The Cobb-Douglas-Function only considers physical capital, but there is also human capital. Human capital can be defined as a worker’s skills and knowledge (Miles & Scott & Breedon, 2012). If capital accumulation reaches the steady state, a country can still increase its GDP through human capital (Miles & Scott & Breedon, 2012). Skills and knowledge are mainly influenced by education and health (Weil, 2013).

An expansion of the Solow Model supports this thesis: a new variable for the amount of labour input per worker added (h) helps to understand the impact of labour: