The Correlation Of U.S Stock Returns With Overseas Stock Returns The Neoclassical Growth Model and Global Poverty

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The Neoclassical Growth Model and Global Poverty

When using any economic model to portray a real world problem and to study the effects of various resolutions, the usefulness of the model is most contingent upon its ability to simulate the real world without excessive oversimplification. One of the questions this may lead to is whether or not the neoclassical growth model is a useful tool for economists and policymakers in understanding global poverty and developing policies to reduce poverty. This will be the topic of discussion in this paper and we will find that while there are reasons one would use the neoclassical growth model to analyze the plight of the world’s poorest, it fails to account for many important factors that are key to scrutinizing this problem from every possible viewpoint.

Foremost on the agenda, we must explore the ideas and concepts that underline this model. The neoclassical growth model emphasizes the role of technological progress and labor productivity in maintaining a sustained long-run rate of growth. Population growth, depreciation of capital, and, most notably, technological progress directly affect the dynamics of the growth process.

One major idea that encompasses the frameworks of this model underlines the assumption that over the long run, economic growth is independent of the savings rate (or equivalently, investment). However, the economy experiences a transitional state of growth or decline in the capital stock, which could be prolonged over a period of decades, due to fluctuations in investment generated from savings that is greater or less than required investment. In steady state, therefore, the growth rate of output is equal to the rate of population growth and the rate of technological progress. This shows that output per worker will grow at the rate of technological progress in a state of balanced growth over the long run.

The neoclassical growth model is achieved by assuming a diminishing marginal product of capital, in which the economy gradually moves to a point where savings provides only sufficient enough investment to cover depreciation. In order to make saving and investment equal, we assume that the economy is closed. This is a significant and unrealistic assumption to make, yet allows the issues of trades surpluses and deficits to be overlooked. Taxes and government spending is also ignored in order to put focus on the behavior of private savings. Lastly, we assume private savings to be proportional to income.

The first idea we want to explore is whether or not the idea of economic growth is relevant to developing policies that reduce poverty in developing countries. Indeed, the neoclassical growth model does effectively highlight an important correlation between economic growth and poverty reduction. This model theorizes that economic growth is contingent upon the accumulation of capital-both human and physical-and technological progress. Human capital refers to the increase in labor productivity due to levels of education, skills and experience, and the health of people. Physical capital represents the tools used in production. Lastly, technological progress has a two-fold meaning: it is the ability of larger quantities of output to be produced with the same quantities of capital and labor. Equivalently, technological progress represents the key ingredient in developing new, better and a larger variety of products for the public to consume.

Studies have shown that “literacy and other indicators of education remain woefully low across much of the developing world,” and a policy that helps poor people acquire human capital would result in their earning higher wages (Besley and Burgess, 2003). The neoclassical growth model could be used to argue that a climate that is more conducive to investment and entrepreneurship would help to reduce poverty. This idea follows from the premise that heavy regulation of business ownership is not in the public interest because it results in low capital intensities, low human capital per worker, and low productivity (Bigsten and Levin, 2000).

The implication that the economy is closed, which is used to develop the neoclassical growth model, severely limits our ability to accurately portray real world scenarios related to the plight of the poor. One of the handicaps that it causes is in our inability to consider foreign capital inflows along with domestic investment. Developed countries may find it beneficial to stimulate the economy of a developing nation by investing in research and development (R&D) in that nation, for instance. The encouragement of new technologies may help poor people living in agricultural and rural areas attain higher levels of output per capita and to better maximize their land and resources. The incentive for the developed country could be to establish new trading partners and open up new markets for its own economy.

Evidence shows that the opening up of international markets is conducive to economic growth, as seen in the fact that “growth problems have been most pronounced in countries that have pursued an inward-oriented policy” (Bigsten and Levin, 2000). This may be one of the reasons that many African countries have had low levels of output per capita, low growth rates, and decreases in standard of living over time. Other possible reasons for the economic stagnation in African countries will also be explored to reflect issues of poverty.

Other assumptions in developing the neoclassical growth model come at the price of simulating the realistic nature of the model in reflecting the real world. Any major component of social infrastructures or the political arenas of countries lies primarily outside the workings of this model. This, therefore, limits the ability of economists and policymakers to explore a full spectrum of ideas concerning the reduction of poverty. For instance, one major component of social infrastructure that lies outside the workings of this model is the idea of “eliminating social barriers for women, ethnic minorities, and socially disadvantaged groups in making growth broad based” (World Bank, 2001). Other considerations that lay beyond the reaches of the neoclassical growth model include such areas as “policies, institutions, history and geography” (World Bank, 2001). Government policies, for example, play an important role in the level of the steady state, especially in regards to its influences on property right, public consumption and on both domestic and international markets. Poor policies could be the underlying reason that many developed countries have experienced slow growth or even a low-level steady state (Bigsten and Levin, 2000).

Another problem to consider with the neoclassical growth model is the idea that investment and various other factors will affect the rate of growth of per capita output for as long as long as it takes for the economy to adjust from one steady-state growth path to another. In actuality, investment and other factors could influence growth in the long run because there are circumstances in which they could be considered the equivalent to an improvement in technology. For instance, education and external trade will lift the level of output that can be produced from given inputs through increased efficiency. Thus, levels of income per capita (or standard of living) will rise as a result because this is equivalent to an improvement in technology. As we discovered earlier, low levels of literacy, characteristic of unskilled workers, has hampered the growth in much of the developing world.

In conclusion, the neoclassical growth model is of some use in helping economists and policy makers develop effective policies to reduce poverty. It is extremely thorough and complete in its manner of analyzing the plight of the poor through the frameworks of economic growth. Technology is realized in this model to be the key factor in sustaining long-term economic growth. The idea of investing in physical and human capital implied by the neoclassical growth model has powerful implications that could indirectly lead economists and policymakers to suggest social policies that would promote health, education and other safety nets to help the poor. The underlying argument against this model is in the fact that many factors that may indeed influence economic growth and world poverty simply is not quantifiable, such as legal structures, the political environment and the social infrastructure. These are very relevant forces in the real world with lasting impacts on economies, yet we are unable to analyze these effects through the lens of this model. Nonetheless, the neoclassical growth model does steer us in the right direction in thinking about the long run effects various policies have on the welfare of an economy by looking at the situation in terms of economic growth and technological progress.

Bibliography:

Bigsten, Arne and Levin, Jorgen. 2000. “Growth, Income Distribution, and Poverty: A Review.” Working Papers in Economics 32, Goteborg University, Department of Economics.

Besley, Timothy and Robin Burgess. 2003. “Halving Global Poverty.” Journal of Economic Perspectives. Summer, 17:3, pp.3-22.

Blanchard, Olivier. 2003. Macroeconomics-3rd Ed. New Jersey: Prentice Hall, Ch. 11-13.

World Bank, 2001. “Chapter 3. Growth, Inequality and Poverty, in World Development Report 2000/2001: Attacking Poverty, New York: Oxford University Press, pp.45-59.

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