Review questions L7 Flashcards
- Please describe at least two reasons for why savings rates differ across countries,
and briefly explain each of the reasons/implications for development policy?
The explantions can be spilt into two types: endogenous and exogenoues.
The endogenous explanation rests on the fact that savings rise with development - there ar emultiple causes for this: first, as income rises so does the savings rate. The explanation here is that in poverty almost everything is consumed; beyond poverty there is an opportunity for savings to rise (because you dont need to consume everything). Another explanation is that as capital stock rises, so does the output (pr capita) and the savings rate.
This raises the question whether differences between lox, middle, and high income economies is due to differences in the savings rate? Given these endogenous explanations we must that a higher savings rate equals more development.
Then there are the exogenous explanations. We have the life cycle theory: saving for old age, based on expected life time income. This implies that younger cohorts save more than older cohorts. Another implication is that fatser growth may induce a greater savings ratio (S/Y), due to an increase in incomes. This explanation is somewhat demography dependent and when considering this, the explanation is not in accordance with theory. Generally theres a tendency to younger population in developing countries, which, according to the explanation, should lead to a higher savings rate for developing countries (compared to developed). However this is not the case in reality.
Another endogenous explanation is based on goverment savings, which tend to be higher in rivher countries, compared with poor, as the size of the government is larger in richer compared to poor economies. In this context, the impact of saving depends on the extent to whihc the Ricardian equvalence holds.
- Based on the 3 figures below (from Gourinchas and Jeanne - see notes) explain the allocation puzzle and whether it is an investment or a savings puzzle
The allocation puzzle considers the correlation between productivity growth and net capital inflow, where theory suggests that capital should flow to countries which have higher productivity growth. So why does more capital not flow to developing countries?
The first figure shows the correlation between capital inflows and observed productivity growth, which has a downward sloping line. This contradicts the neoclassical statement that countries with a high productivity should recieve more capital inflow (the allocation puzzle).
To answer this we have to consider whether problem is an investment or savings issue.
Figure 2 tries to explain the problem with an investment/capital wedge, where investors only recive a fraction of the gross return to capital. The idea is, that the higher productivity growth a country has, the higher should the gross return on investment/capital be. This is also the case in the figure, where the slope is positive. So the allocation puzzle is not an investment problem.
The third figure introduces a savings wedge, which creates a distortion such that a country is either subsidizing or taxing savings. There is a strong negative correlation between the savings wedge and the productivity catch-up. This means that countries that subsidize savings are the ones that catch up, while countries that tax savings fall behind. So the allocation puzzle (negative relationship between capital inflow and productivity growth) is a savings puzzle.
- Outline and describe the main pros and cons of attracting FDI.
The pros are that FDI increases total investment and foreign exchange reserves (short term), as well as the tax revenue. Further it promotes technology and knowledge transfers.
The cons are that FDIs lower domestic savings - thereby lowering total investment. It decreaces foreign exchange reserves over time. There is no increase in tax revenue because of transfer pricing and ‘race to the bottom’, reffering to countries lowering prices in order to attract FDIs. There is no technology transfer, but inhibiting domestic entrepreneurship and innovation. And there is an influence on political decisions.
- describe the key FDI knowledge transfer/spillover mechanisms
FDI spillovers refer to the positive or negative effects that foreign direct investment in a host country has on the local economy beyond the direct impact of the investmnet itself. The spillovers can be split into horizontal and vertical. The horizontal spillovers of the FDI technology/knowledge transfer occurs when local firms in the same industry as the foreing investor adopt new technologies or practices introduces by the foregin firm. This can happen through imitation, worker mobility (hiring of trained personnel) or supplier relationships (business or other networks). The vertical spillovers are either backward or forward. Backward linkages occur through interactions between foreign firms and local (domestic) suppliers, if for example foreign firms increase the demand for supplies from domestic firms, creating a upstream spillover. (e.g. the foreign firm requires specialized or higher-quality inputs.)
Forward linkages occur if foreign firm increase production of more advanced products creating a downstream spillover to domestic firm, when these products are used in the supply chain.
- Describe the positive and negative mechanisms of vertical FDI spillovers (backward
and forward spillovers)
Positive backwards spillovers are knowledge and technology transfer, as well as higher requirements for product quality and timing. This provides incentives for domestic firms to upgrade their production. In this context, negative spillovers are that the domestic firms are not developed enough to handle the demands from the foreing firms, who also have asymmetric barganing power. Another negative spillover is that domestic firms face increased competition from other MNEs who can supply inputs (cheaper) or competition from imported inputs.
