Growth mode, writing homework help

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timer Asked: Apr 11th, 2017
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The article below does a great job in summarizing the relevance of institutions for economic performance. We also saw how the growth model can accommodate the notion of institutional quality through the lens of a tax on capital.

For next class, your task is to seamlessly blend the two perspectives in an essay. Your only sources shall be the textbook and the article. The theme question is what explains income differences across countries.

Also, I have a good answer which is my previous classmate did it and sent to my, it will help you to write the answer.

the article and the answer in the attachment. (You almost doing paraphrasing for the answer).

What Explains Income Differences Across Countries Equation Theory Economies in Developed Countries Economies in Developing Countries Institutional Theory Income Level Explaining why some countries are rich and why some are poor can be explained through two theories: equation theory and institutional theory. Equation allows us to algebraically look at how we manipulate the different inputs to maximize output while institution focuses on the practices within a country and its effect on the economy. The main point of focus here is how the rental rate on capital, less depreciation and capital income taxes, affects the rate of return on capital. By looking at the equation, we must set an equilibrium. Households demand a certain after-tax and after-depreciation return on capital (as denoted in the equation by 1 less tax rate and capital less depreciation). That figure leftover is equal to the rate of return on capital. Therefore, the tax rate greatly affects the rate of return on capital as seen in the equation. Labor (income tax) and capital must go hand-in-hand. High capital income tax rates will discourage accumulation of capital which will then lead to lower wages. Higher rates of taxation on capital income actually tends to make workers worse off. So, when tax rates on capital are relatively high, the levels of capital output and wages are relatively low. In a poorer countries, corrupt government entities impose a higher capital income tax (i.e. bribes). Therefore, because of this high tax, firms are unable to accumulate capital. Thus they are unable to pay their workers sufficient wages and therefore, the economy is unable to flourish as they don’t have the income to then Growth Volatility Policies put back into the economy. The opposite holds true for wealthier, developed nations such as the US. Institutional theory, on the other hand, is based on concepts and policies within a country. Institution theory looks at the policies that a particular country has in place and how it affects the economy and real GDP. Institutional theory is studied by looking at four components: income level, growth, volatility, and policies and how they are all correlated. When looking at income, economic outcomes could be substantially improved if developed countries strengthen their institutions. The income gain is much larger if institutional quality rises to the level of advanced economies as we see in developed countries. Institutions are also directly correlated to volatility. Therefore, the better the institutions, the lower the volatility of growth. Institutional improvements could have significant impact on growth rates and as a result, institutions have a strong and significant impact on GDP growth. When institutional and policy variables are considered together, institutions are found to be the dominant influence on economic performance, with policies having little independent influence. However, acountry’s level of financial development, which may be highly influenced by policy, has a significant positive impact on growth. Institutions are very important as seen in developed countries because lack of them can lead to corruption and stagnant growth as seen in the developing countries. Institutional theory is based on concepts. Equation theory stipulates income tax and deprecation are driving factors as seen through the equation. This theory depicts institution theory by using numbers to algebraically show how changes in taxes and depreciation affect real-GDP. Both theories suggest growth and development be allocated towards finding equilibrium with the rate of return on capital and also having a solid foundation such as institutions to ensure growth. In summation, both concepts are looking to find an equilibrium within the country to ensure a growing economy. Equation theory looks at how increases/decreases in taxes or depreciation affect that equilibrium while institution theory looks at social factors and their effect on the equilibrium. Both theories are vital for economic growth and development and both illustrate the same concept but demonstrate them in different ways.
Testing the Links How strong are the links between institutional quality and economic performance? Hali Edison aggregate governance index for the illustrations. Given the GREAT deal of economic research in recent years dominance of institutional factors in explaining economic suggests that institutions are vital for economic performance, is there a role for policies? The results show development and growth. Typically, economists that there is. have looked at the level of economic development, as measured by per capita GDP, and have found that Institutions and income level differences in per capita incomes around the globe—ranging We began by looking at the impact of institutions on incomes. from only about $100 a year in parts of sub-Saharan Africa The research found that institutions have a statistically signifito over $40,000 in some of the advanced economies—are cant influence on economic performance, substantially closely related to differences in the quality of institutions. increasing the level of per capita GDP. These findings hold The aim of an IMF research study has been to take stock of whether institutional quality is measured by broad-based indirecent work relating to the impact of institutions on three cators (such as an aggregate of various perceptions of public dimensions of economic performance—level of economic sector governance) or by more specific measures (for example, development, growth, and volatility of growth—and the extent of property rights protection or application of the advance the debate through new empirical analysis. In parrule of law). Furthermore, the empirical results take into ticular, the study tries to estimate the empirical strength of account the possibility of reverse causation (see Box 2). these relationships; the impact that improvements in instituThese results suggest that economic outcomes could be tions could have on incomes and growth in different regions; substantially improved if developing countries strengthened and the role that economic policies play, both in contributthe quality of their institutions. As shown in Chart 1, for ing to stronger institutions and in supporting better ecoexample, an improvement in sub-Saharan Africa’s institutions nomic outcomes more generally. from their current average quality To determine to what extent to that of developing Asia would institutions affect economic perforChart 1 represent an 80 percent increase in mance, we developed a simple Impact on income per capita incomes in sub-Saharan econometric framework relating Better institutions could boost income. For example, Africa (from about $800 to over the macroeconomic outcomes for the red line shows how much income grows if sub$1,400). The potential benefits each country to (1) a measure of its Saharan Africa improves its institutions to match the to sub-Saharan Africa continue institutions (see Box 1); (2) a meaquality of those in other regions. to rise markedly as its institutions sure (or set of measures) of macroimprove. There is a 2!/2-fold economic policy; and (3) a set of 300 exogenous variables. This frameincrease in regional income if sub250 work allows one to consider comSaharan Africa’s institutions are 200 peting explanations that have been strengthened to the all-country 150 put forward in the literature— average; the income gain is much 100 notably, the roles of institutions, larger if institutional quality rises policies, and geography—and to to the level of advanced economies. 50 assess their quantitative impact. While these calculations are mainly 0 Middle Developing Latin America SubAll The study finds that institutional for illustrative purposes, since such Saharan East and and Asia countries quality does have a significant gains would be neither immediate Turkey Africa Caribbean average effect, not only on the level of nor automatic in practice, the Institutional quality1 income but also on growth and the results are striking, providing an Source: IMF staff calculations. Note: Figures are not to scale. They understate differences in the volatility of growth. The findings empirical sense of the importance quality of institutions across countries. 1Measured by the aggregate governance indicator. are also consistent for all measures of institutions for economic of institutions, but we rely on the development. Percent change in per capita real GDP A Finance & Development June 2003 35 What do we mean by institutions? The term institutions has been defined in different ways. Douglass North describes institutions very broadly, as the formal and informal rules governing human interactions. There are also narrow (and easier to grasp) definitions of institutions that focus on specific organizational entities, procedural devices, and regulatory frameworks. At a more intermediate level, institutions are defined in terms of the degree of property rights protection, the degree to which laws and regulations are fairly applied, and the extent of corruption. It is narrower than North’s definition, which includes all of the norms governing human interactions. Much of the recent research into determinants of economic development has adopted the intermediate definition. How is institutional quality measured? Recent empirical analyses have typically considered three relatively broad measures of institutions—the quality of governance, including the degree of corruption, political rights, public sector efficiency, and regulatory burdens; the extent of legal protection of private property and how well such laws are enforced; and the limits placed on political leaders. The measures themselves are not objective but, rather, the subjective perceptions and assessments of country experts or the assessments made by residents responding to surveys carried out by international organizations and nongovernmental organizations. The first of these measures—the aggregate governance index—is the average of the six measures of institutions developed in a 1999 study by Daniel Kaufman, Art Kraay, and Pablo Zoido-Lobaton. These measures include (1) voice and accountability—the extent to which citizens can choose their government and have political rights, civil liberties, and an independent press; (2) political stability and absence of violence—the likelihood that the government will not be overthrown by unconstitutional or violent means; (3) government effectiveness—the quality of public service delivery and competence and political independence of the civil service; (4) regulatory burden—the relative absence of government controls on goods markets, banking systems, and international trade; (5) rule of law—the protection of persons and property against violence and theft, independent and effective judges, and contract enforcement; and (6) freedom from graft—public power is not abused for private gain or corruption. A second measure focuses on property rights. This measure indicates the protection that private property receives. Yet another measure, constraints on the executive, reflects institutional and other limits placed on presidents and other political leaders. In a society with appropriate constraints on elites and politicians, there is less fighting between various groups for control of the state, and policies are more sustainable. Institutions and growth We then looked at the role of institutions in economic growth. Just as with the level of per capita GDP, the results indicate that institutions have a strong and significant impact on per capita GDP growth. This impact may partly reflect the role of institutions in enhancing the sustainability of policies. 36 Finance & Development June 2003 Chart 2 Impact on growth Institutional improvements could have a significant impact on growth rates. Average annual growth rate of per capita real GDP Defining and measuring institutions 5 4 3 2 1 0 SubSaharan Africa Middle Developing Latin America All Advanced East and and Asia countries economies Turkey Caribbean average Institutional quality1 Changes in the policy environment could also exert an important, though somewhat smaller, impact. Average annual growth rate of per capita real GDP Box 1 1.0 0.8 0.6 0.4 0.2 0 –0.2 SubSaharan Africa Middle East and Turkey Developing Latin America All Advanced and Asia countries economies Caribbean average Policies2 Source: IMF staff calculations. Note: Figures are not to scale. They understate differences in the quality of institutions and in the total private credit ratio across countries. 1Measured by the aggregate governance indicator. 2Measured by the ratio of private credit to GDP. On average, improving institutional quality by one standard deviation—corresponding roughly to the difference between institutional quality in Cameroon and the average quality of institutions in all countries in the sample—would lead to an increase of 1.4 percentage points in average annual growth in per capita GDP. The implications of institutional improvements for growth across different regions are illustrated in Chart 2. Again, the empirical results suggest substantial gains. For instance, annual growth in per capita GDP in subSaharan Africa would increase by 1.7 percentage points if countries there had institutions as good as the average quality for the entire sample. Countries from other regions would also gain from adopting higher-quality institutions, as shown in the chart. Institutions and volatility The results also indicate that institutions have a strong effect on volatility (measured as the standard deviation of the growth rate of per capita GDP): the better the institutions, the lower the volatility of growth. In addition, the impact of institutions appears to be significant even when policy measures such as differences in inflation, exchange rate overvaluation, openness, and government deficits are controlled for. The results suggest that an increase of one standard deviation in the aggregate governance index measure would cut volatility by about 25 percent. The impact of gradual Box 2 Empirical problems There are two distinct and important problems related to identifying the effect of institutions. First, because of their subjective nature, all of the measures of the quality of institutions contain errors. Second, institutions are endogenous. Economies are not exogenously endowed with institutions; rather, good institutions require time and resources to develop, suggesting that richer countries are more likely to enjoy good institutions. So one needs to be careful in the empirical assessment not to capture reverse causality—that stronger economic performance is itself likely to contribute to better institutions. In econometric terms, researchers must identify a good set of instruments for measuring institutions. One approach has been to include an instrumental variable for institutions using historically determined components of institutions. For instance, some studies have used settler mortality as an instrument. These studies argue that settler mortality had an important effect on the type of institutions that were built in the lands colonized by the European powers (see article on page 27). An alternative approach, which allows for a larger sample of countries and was used in the 2003 IMF staff study, has relied on instruments based on language use, namely, the fraction of the population that speaks English and the fraction of the population that speaks other European languages. Impact on growth volatility Improvements in institutions could help reduce instability. 0 Per capita real GDP growth rate volatility Institutions and policies Given the strength of these findings for institutional influences, what role do policies play in economic development? There is an extensive literature showing that policies have a significant impact on macroeconomic outcomes. Typically, though, when institutional and policy variables are considered together, institutions are found to be the dominant influence on economic performance, with policies having little independent influence. In the empirical work, some positive results are found for macroeconomic policies: a country’s level of financial development, which may be highly influenced by policy, has a significant positive impact on growth (Chart 2); and the extent of exchange rate overvaluation, possibly reflecting broader macroeconomic imbalances, increases the volatility of growth (Chart 3). On the whole, however, the impact of policies appears to be weaker than that of institutions for several reasons. In the case of per capita GDP, these results are probably not surprising. The cross-country differences in income reflect the impact of policies conducted over centuries and may be poorly proxied Chart 3 –0.5 –1.0 –1.5 –2.0 –2.5 –3.0 SubSaharan Africa Middle Developing Latin America All Advanced East and Asia and countries economies Turkey Caribbean average Institutional quality1 Sustainable macroeconomic policies could also make an important contribution. Per capita real GDP growth rate volatility improvements in institutional quality across different regions is illustrated in Chart 3. For example, if institutions in sub-Saharan Africa were as good as those in the average country in the sample, countries in that region would experience a 16 percent reduction in economic volatility. 0.4 0.3 0.2 0.1 0 –0.1 –0.2 –0.3 –0.4 –0.5 SubSaharan Africa Middle East and Turkey Developing Latin America All Advanced Asia and countries economies Caribbean average Policies2 Source: IMF staff calculations. Note: Figures show change in standard deviation and are not to scale. They understate differences in the quality of institutions and in the exchange rate overvaluation. 1Measured by the aggregate governance indicator. 2Measured by the exchange rate overvaluation. by policies measured only over recent decades, as in the analysis. Moreover, measures of institutional quality and of policies are often closely related, partly because the subjective measures of institutions used in the analysis—for example, perceptions of government effectiveness and regulatory burdens—represent an amalgam of policy and institutional factors. More generally, the correlation between institutions and policies points to the fact that sound policies need to be supported and sustained by good institutions, while weak institutions may reduce the chance that good policies will be adopted or may undermine policy effectiveness. In other words, the bottom line is not that policies are unimportant but that their influence on economic performance is already reflected in the strength of institutions. Hali Edison is a Senior Economist in the IMF’s Research Department. This article draws on Chapter 3 of the IMF’s World Economic Outlook April 2003. This chapter was prepared by Maitland MacFarlan, Hali Edison, and Nicola Spatafora, and is available at http://www.imf.org/external/ pubs/ft/weo/2003/01/index.htm. Finance & Development June 2003 37

Tutor Answer

maciej
School: University of Maryland

Hi buddy,Here is the answer to your question. Have a look at it and in case you need any edits, in regards to content and format, please inform me.

Explanations for
income differences
across countries

Equation Theory

Economies in
Developed
Countries

Economies in
Developing
Countries

Institutional Theory

Income Level

There are two theories that can be used to
explain why some countries are rich while others
are poor; the equation theory and the
institutional theory. Generally, the equation
theory explains how rate of return on capital is
affected by depreciation and capital income
taxes while the institutional theory explains the
effect that practices within a country have on
that country’s economy.
The equat...

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Anonymous
Outstanding Job!!!!

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