Globalisation Flashcards
Lucas model assumptions
There are two countries, a poor and a rich country or in this case the US and India.
ß is assumed to be an average between the two aka 0.4 rather than having two different levels of ß for each country
Aindia = Ausa - there would be technological spillovers
Lucas model
Let us start with 2 economies; the US, and India.
Y=AKß(Le)1-ß
A=composite of technological and institutional factors
K=capital; Le=effective labour accounting for human capital
ß= average share of capital = constant taking value of 0.4
A=Bhγ where B = common level of technology, γ = external benefit to human capital
Y=BhγKß(Le)1-ß
Lucas model (continued)
We wish to find the marginal product of capital per effective worker
y=Bhγxß; x=(yB-1h-γ)1/ß
Take ∂Y/∂x and sub in x for r=B1/ßßy(ß-1)/ßhγ/ß
rIndia/rUSA=(B1/ßßyIndia(ß-1)/ßhIndiaγ/ß)/(B1/ßßyUSA(ß-1)/ßhUSAγ/ß)
Lucas takes data from Krueger (1968) and Denison (1962) to get hUS=5hIndia and γ=0.36 respectively
Recall that ß was assumed to be 0.4
Subbing in, we get (YIndia/3YIndia)(ß-1)/ß(hIndia/5hIndia)γ/ß, which cancels to ≈1.04
Thus, capital does not flow from rich to poor states as a result of the rate of return not being much higher in the latter, and poor states do not benefit from investment that could boost their economy
Lucas model - the colonial case
Lucas explains the relatively larger capital flows from rich to poor states in the pre-WWI environment as the result of capital market imperfections – namely, monopoly
2 market participants; an imperialist state and a colonial state
No political risk as the colony can’t stop the imperialists repatriating profits
Imperialist is a monopolist and chooses the K/L ratio by choosing how much they wish to invest
Lucas model - the colonial case (continued)
We wish to find the profit-maximising capital/labour ratio
π(x)=f(x)-(f(x)-x(f’(x)))-rwx
f(x)=income, f(x)-x(f’(x)=colony’s wage payments, and rwx = opportunity cost of capital
∂π/∂x=0=f’(x)-(f’(x)-(xf’’(x)+f’(x)))-rw
rw=f’(x)+xf’’(x); f’(x)=rw – xf’’(x)
Now, let us calculate rw
Recall y=f(x)=Axß; therefore, f’(x)=Aßxß-1 & f’’(x)=(Aß2-Aß)xß-2
Recall f’(x)=rc=Aßxß-1
Therefore rw=Aßxß-1ß=ßrc=0.4rc
Therefore rc=2.5rw
Much higher than return from investing elsewhere in the world; therefore, higher capital flows relative to current period
Reasons for Lucas paradox
Missing factors of production Government policies Institutional structure and total factor productivity Asymmetric information Sovereign risk
Missing factors of production
The existence of other factors—such as human capital and land—that positively affect the returns to capital but are generally ignored by the conventional neoclassical approach. if the production function is given by:
Yt = AtF(Kt, Zt, Lt)
Zt = another factor of production that affects the production process
In this case there is a misrepresentation of the capital flows so the true return for the two countries (i and j) are:
Atf’(kit, zit) = rt = Atf’(kjt, zjt)
Government policies
Differences across countries in government tax policies can lead to substantial differences in capital-labor ratios. Inflation may work as a tax and decrease the return to capital. In addition, the government can explicitly limit capital flows by imposing capital controls.
The effect of a distortive government is modeled by assuming that governments tax capital’s return at a rate T:
Atf’(kit, zit)(1 - Tit) = rt = Atf’(kjt, zjt)(1 - Tjt)
Asymmetric information
under asymmetric information, the main implications of the neoclassical model regarding capital flows tend not to hold
Souvereign risk
The problem stems from the fact that repayment incentives for a sovereign debtor might differ from its obligations specified in a contract because the ability of courts to force a sovereign entity to comply is extremely limited.
Lucas (1990), dismisses sovereign risk as an explanation for the lack of flows from rich to poor countries. He maintains that investors in India faced the same rules and regulations as the investors in the United Kingdom.
Reinhart and Rogoff (2004) argue, the numerous rebellions in colonial India indicate that the perceived ex ante risk of expropriation was greater than the ex post one.
Institutions
We presume institutions affect economic performance through their effect on investment decisions by protecting the property rights of entrepreneurs against the government and other segments of the society and by preventing elites from blocking the adoption of new technologies.
In general, weak property rights due to poor institutions can lead to lack of productive capacities or uncertainty of returns in an economy. Thus institutional weaknesses create a wedge between expected returns and ex post returns.
We model these as differences in the parameter At, which captures differences in the overall efficiency in the production across countries.
Institutions and Lucas Paradox
We add our index of institutional quality. Upon this addition, we see that the Lucas Paradox disappears. The institutional quality is the “preferred” variable by the data.
The ordinary least squares (OLS) estimates show that improving the quality of institutions to the United Kingdom’s level from that of Turkey’s implies a 60% increase in foreign investment.
Problems with Lucas Paradox
There is no paradox - countries that do not repay debt face difficulties in borrowing (Reinhart and Rogoff, 2004).
Lucas was writing at a time with high capital account controls. Richer countries do export more capital and poorer ones do import more capital if their capital accounts are open. Thus neoclassical model does hold if capital account openness is taken into account (Reinhardt et al., 2013).
No real justification given to the beta and gamma values so that the model, in general, feels tailored to fit the specific conclusions.
Problems with the Lucas paradox (continued)
Franken and van Wijenbergen (2010) state that Lucas Paradox does not take into account different types of flows of capital. When they disaggregated the capital flows, it was found that while the Lucas Paradox holds for portfolio investments, it wasn’t true in the case of FDI and debt flows.
Clemens and Williamson (2000) point out that while the Lucas paradox is correct in that capital does not flow from rich to poor countries, the reasons for this are not accurate. They argue that two-thirds of the capital really flowed to labour scarce new world economies while the remaining 1/3 only flowed to the labour abundant Asian and African economies. This was due to a number of factors such as human capital levels, investment profitability, international migration, natural resources etc and not colonial status and market failure.
