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Prepared by Jan Gottschalk.
This model has been developed by Tokhir Mirzoev.
The parameter r represents the (inverse) of the intertemporal elasticity of Substitution in consumption.
For example, private capital in efficiency labor terms is defined as
Given that all tax revenue in this model is used for investment, the tax rate has been set equal to the share of government investment in GDP over past years, using the national accounts definition of government investment.
In the model outlined above, the steady state growth rate is given by the sum of g1 and g2, representing labor force and productivity growth respectively. The fact that both growth rates are exogenous—i.e., they are determined outside the neoclassical growth model—implies that the model’s steady state growth rate is exogenous as well; consequently, the model’s main analytical contribution is not an explanation of the steady state growth rate, but the economic adjustment processes that occur if the economy is outside its steady state, as shown in the model simulations above. While a large Strand of literature has been developed to endogenize the steady state growth rate, a review of the endogenous growth literature is outside the scope of this paper.
Note that the baseline deviations cannot be interpreted as deviations in percent, unless otherwise indicated, because the model variables are not expressed in logarithms; the absolute deviations have no meaningful economic Interpretation. Thus, the focus should be on the qualitative response.
In the actual simulations, the shock is highly persistent but not permanent because of computational problems.
Results available upon request.
In fact, the decline in the marginal productivity of private capital—which reflects the diminishing returns characteristic of neoclassical models—implies that for maintaining a given growth rate, ever-larger increases in the investment-to-GDP ratio would be needed.
Raising the savings rate may be optimal if this overcomes distortions that keeps the savings rate suboptimal low; such mechanisms can be present in poverty-trap models, but a recent review by Kraay and Raddatz (2005) finds little evidence that these distortions are empirically relevant.
Consumption also increases on impact; initially, the increase in public capital substitutes to some extent for private capital accumulation, and the resulting decrease in private investment facilitates the increase in consumption. Over the medium term, though, private investment increases to take advantage of the rise in the marginal productivity of private capital.
The location of the Laffer curves depends on the parameter choices for the model. The simulations here are meant to illustrate the general economic principles, and not to identify the numerical values for tax rates that maximize disposable income, output, or tax revenue.
From an empirical viewpoint, the convergence process has another drawback: the high marginal rate of productivity of private capital for countries with low capital stocks would suggest that the real interest rate in these economies is initially high and then declines over the development process, but there is little evidence for substantial changes of the real interest rate through this process. This drawback could be addressed, however, by modifying the theoretical model to include human capital with a fairly large income share, which would dampen the real interest rate movements implied by the model.