Abcd PDF

Economic policy analysis in
international development
D. Weinhold, A.S. Rigterink
DV2169, 2790169
2011
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This is an extract from a subject guide for an undergraduate course offered as part of the
University of London International Programmes in Economics, Management, Finance and
the Social Sciences. Materials for these programmes are developed by academics at the
London School of Economics and Political Science (LSE).
For more information, see: www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
Dr Diana Weinhold, Department of Development Studies, London School of Economics and
Political Science
Anouk S. Rigterink, Doctoral Candidate, Department of International Development,
London School of Economics and Political Science
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the authors are unable to enter into any correspondence relating to, or
arising from, the guide. If you have any comments on this subject guide, favourable or
unfavourable, please use the form at the back of this guide.
The University of London International Programmes
Publications Office
Stewart House
32 Russell Square
London WC1B 5DN
United Kingdom
Website: www.londoninternational.ac.uk
Published by: University of London
University of London 2007
Reprinted with minor revisions 2011
The University of London asserts copyright over all material in this subject guide except where
otherwise indicated. All rights reserved. No part of this work may be reproduced in any form,
or by any means, without permission in writing from the publisher.
We make every effort to contact copyright holders. If you think we have inadvertently used
your copyright material, please let us know
Contents
i
Contents
Chapter 1: Introduction .......................................................................................... 1
Aims of the course ......................................................................................................... 3
Learning outcomes ........................................................................................................ 3
How to use this subject guide ........................................................................................ 4
Essential reading ........................................................................................................... 5
Further reading ............................................................................................................. 7
Online study resources ................................................................................................. 10
Examination advice...................................................................................................... 11
Syllabus ....................................................................................................................... 12
Chapter 2: Introduction to quantitative methodology ........................................ 15
Aims of the chapter ..................................................................................................... 15
Learning outcomes ...................................................................................................... 15
Essential reading ......................................................................................................... 15
Further reading ............................................................................................................ 15
Introduction ............................................................................................................... 15
Sampling ..................................................................................................................... 16
Normal distribution and the central limit theorem ......................................................... 18
Hypothesis testing ....................................................................................................... 21
Basics of regression .................................................................................................... 23
Endogeneity ............................................................................................................... 28
Cross-section, time series and panel data ..................................................................... 35
Difference-in-difference estimation............................................................................... 41
Summary ..................................................................................................................... 44
Now read .................................................................................................................... 44
A reminder of your learning outcomes .......................................................................... 45
Sample examination questions ..................................................................................... 45
Chapter 3: Economic growth: basic concepts, ideas and theories ....................... 47
Aims of the chapter .................................................................................................... 47
Further reading ............................................................................................................ 48
Introduction ................................................................................................................ 48
What is growth? .......................................................................................................... 49
How important is growth? ........................................................................................... 50
Economic growth in the far distant past ....................................................................... 55
Modern growth theories: Harrod-Domar and Solow growth model ............................... 56
Modern growth theories: endogenous growth theory ................................................... 60
Solow growth model versus endogenous growth theory ............................................... 63
Chapter 4: New directions in growth theory ........................................................ 67
169 Economic policy analysis in international development
ii
Further reading ............................................................................................................ 67
Introduction ............................................................................................................... 68
Heterogeneous firms, misallocation and intermediate goods ......................................... 69
Economic geography ................................................................................................... 73
Chapter 5: Institutions and (very) long-run growth ............................................. 79
Further reading ............................................................................................................ 80
Introduction ............................................................................................................... 80
What are institutions? ................................................................................................. 80
Investigating how institutions could matter for long-run growth:
IV regression revisited .................................................................................................. 82
Property rights: Engerman and Sokoloff and Acemoglu, Johnson and Robinson ............. 85
Critiques: geography and human capital ...................................................................... 89
Chapter 6: Globalisation and trade theory .......................................................... 93
Further reading ............................................................................................................ 94
Introduction ................................................................................................................ 94
Classical trade theory: Ricardo and the Heckscher-Ohlin model ..................................... 96
New trade theory ......................................................................................................... 99
New new trade theory: heterogeneous firms ............................................................ 102
A reminder of your learning outcomes ........................................................................ 104
Sample examination questions ................................................................................... 105
Chapter 7: Finance and financial crises .............................................................. 107
Aims of the chapter ................................................................................................... 107
Learning outcomes .................................................................................................... 107
Essential reading ....................................................................................................... 107
Further reading .......................................................................................................... 108
Introduction .............................................................................................................. 108
Inflation ................................................................................................................... 109
Policy response to inflation ........................................................................................ 111
Old style Balance of Payments crises ........................................................................ 111
Structural adjustment programmes (SAPs) .................................................................. 114
New style currency crises ......................................................................................... 117
Policy options for new style crises ............................................................................. 119
Chapter 8: Microfinance ..................................................................................... 125
Further reading .......................................................................................................... 125
Introduction .............................................................................................................. 126
Contents
iii
The credit market ....................................................................................................... 127
Further reading .......................................................................................................... 127
Microfinance programmes ......................................................................................... 132
The success of microfinance: empirical evidence ......................................................... 136
Chapter 9: Aid effectiveness .............................................................................. 141
Further reading .......................................................................................................... 141
Introduction .............................................................................................................. 142
Defining aid ............................................................................................................. 143
Whether and how to give aid? The current big debate on aid effectiveness ............... 144
Is aid related to growth? Empirical evidence ............................................................... 150
Appendix A: Sample examination paper ............................................................ 155
Appendix B: Tables for Questions 1 and 2 .......................................................... 157
Table for Question 1 .................................................................................................. 157
Table for Question 2 .................................................................................................. 158
Notes
iv

Chapter 1: Introduction
1
Welcome to 169 Economic policy analysis in international
development. The purpose of this course is to provide an accessible, yet
rigorous, introduction to evidence-based policy analysis for development
that is suitable for students from a wide variety of backgrounds. You must
have passed 171 Introduction in international development
before you study this course.
The design of development policies must be derived from development
theory. There is no single theory of economic development, but we strive to
provide a background review of competing theories of how many complex
processes, both at the macroeconomic (country and international) level
and the microeconomic (individual, household and firm) level, may lead to
development. Given the large number of topics in development economics,
this course will focus on macroeconomic theories, although the chapter on
microcredit in particular, and the chapter on aid to a lesser extent, include
some microeconomics. If these topics are particularly interesting to you, we
suggest you consider taking a course in microeconomics of development.
Theoretical questions we address in this course include: through what
mechanisms are trade and growth related? Will providing microcredit
enable farmers to improve their living standards? Does international aid
promote growth? How can we explain large differences in living standards
between developed and developing countries?
For each of these topics there may be several theoretical answers,
each theory corresponding to a unique, but not necessarily mutually
incompatible, mechanism through which the variables of interest are
related. Which policy design will be most successful will in turn depend
on which underlying mechanism turns out to be most true. If all the
competing theories are on first inspection logical and internally consistent,
which policy should we choose?
Even if one theory sounds more appealing (or plausible to our ears),
how can we assess the validity of our intuition? For many years most
debates surrounding development policies were characterised by rhetorical
arguments about which theoretical approach was more intrinsically
persuasive, something determined at least as much by ideological and
political position as by anything else. However in the last 30 years or so,
with access to comparable cross-national, household, and individual level
data dramatically increasing, the discipline has completely shifted its
approach. Today, we strive to evaluate theories and policies on the basis of
empirical data; this is what we mean by evidence-based analysis.
Broadly speaking, there are three possible approaches to evidence-
based analysis that have been used in social science disciplines such as
economics, political science and sociology. The first is to derive some
testable implications from theory, and then use statistical methods
to examine whether these implications are consistent with the observed
data. Ideally we look for testable implications that differentiate between
theories, or some relationship that is highly unlikely unless the associated
theory had strong explanatory power.
The second approach arises because sometimes it is difficult to differentiate
between many possible theoretical mechanisms, so as a first pass to
the problem we focus on a reduced form relationship (in which the
2
underlying mechanism is something of a black box) and use observed
data empirically to test directly whether some policies have had the causal
effect that they were supposed to generate. For example, did trade opening
increase growth? Did microfinance reduce poverty? Did building more
schools increase enrolment?
However, one of the major methodological challenges facing both of these
approaches is to convincingly draw out causal conclusions from non-
experimental data. Many social and economic variables are correlated,
but how can we discern whether there really is a causal relationship? In
this course we will explore several different empirical strategies that have
been utilised to identify causal relationships, but these statistical methods
may not be applicable, or may be unconvincing, in some cases. As a result
in the past decade it has become very popular, when feasible, to design
and conduct a randomised controlled experiment to test the effects
of a given policy. For example, if new textbooks are assigned randomly to
different schools, then the differences in learning outcomes between those
schools with and without the new textbooks can be considered to be the
impact of the textbook policy.
Despite the recent enthusiasm for randomised controlled experiments,
it is important to keep in mind that no single methodology provides the
most convincing answers to all possible research questions, and that
sometimes choosing between particular techniques involves trade-offs.
Consider the following: a randomised controlled trial may provide the
most convincing evidence on a causal relationship between textbooks
and pupil performance. However, designing such an experiment can be
very costly and time-consuming, requiring significant financial resources.
Non-experimental research could possibly be done using already existing
data. Furthermore, the costs of running an experiment will likely force
researchers to focus on a small subset of children that may benefit from
receiving textbooks children in a particular province in Kenya, for
example. If we find that textbooks increase pupil performance in Kenya,
can we say with confidence that they will have the same effect on children
in the whole of Kenya? All children in Africa? All children in developing
countries? The experiment may have conclusively proven that the results
hold for this particular subgroup (it has high internal validity), but
it may not generalise to other cases (its external validity may be
doubtful). In the case of a different research question, researchers may be
unable or unwilling to randomise. It seems highly unethical to withhold
life-saving drugs from people for the sake of an experiment. It seems
infeasible to ask countries to randomise their trade policies. Imagine if
policymakers exclusively focus on policies that could be randomised; this
would limit their options to a specific category of policies, and these types
of policies are not necessarily the most effective.
As policymakers depend more and more heavily on evidence-based
analyses to guide their decisions, it has become ever more important for a
wide range of policymakers and other interested individuals to be able to
read and critically assess the ever increasing quantity of quantitative
studies. Many politicians, decision-makers, and other policy stakeholders
(including the general public) have not had the several years of post-
graduate training in statistics and econometrics (the statistical analysis
of economic data) that it takes to master the sophisticated methodological
tool kit used by modern-day social scientists. In sum, many more people
really need the skills to critically read and consume the information
conveyed in the academic quantitative literature than possess the time or
desire to finish a PhD required to produce those studies.
3
Thus for over more than a decade of teaching in the Department of
International Development at the London School of Economics and
Political Science, we have focused on conveying the underlying
intuition behind the structure of quantitative work, teaching students not
how to actually do econometrics, but rather how to read and consume
quantitative analyses critically and rigorously. Each year our starting group
of students ranges from many with no formal economics or mathematics
backgrounds at all to those with extensive statistical educations, from
English literature majors to lawyers to geologists to central bankers. By the
end of the course they can all pick up any World Bank technical working
paper or a good quality academic article in economics or political science
and be able to read, critically assess, and come to their own conclusions
about the validity of the empirical strategy and policy conclusions.
A key lesson that we teach is that good quality quantitative policy analysis
is not a purely technical or statistical exercise, but is firmly embedded
within the theoretical framework of the processes under study. With a few
basic concepts and some new vocabulary, we show you how econometric
equations map back to the economic theories we have been discussing
in each chapter. Good econometric analysis simply reflects good analysis,
full stop, so critically engaging with the quantitative material is more
a matter of learning how to think rigorously and thoroughly through a
problem (whether it be quantitative or qualitative), and then being able to
translate that intuition into the quantitative framework.
The authors of this subject guide include one academic with many years
of quantitative training and practice and a young researcher, who prior to
taking a similar MSc course to this course, had not had any formal training
in quantitative methods at all. We are both passionate about passing on
the lessons of rigorous, analytical thinking in the context of economic
development policy to students from all backgrounds. The process of
integrating these new ways of thinking can be time consuming and, at
times, frustrating, but we hope you will find that the rewards are well
worth the effort. And this subject guide will be there to assist you along
your way.
Aims of the course
The aims of this course are:
to provide a critical overview of current growth and welfare policies in
developing countries
to demonstrate how the underlying theories that inform development
policies are evolving in light of continuous empirical testing
to provide a comprehensive introduction to evidence-based policy
analysis, including a non-technical but operational ability to read and
comprehend regression analyses used in quantitative policy evaluation.
Learning outcomes
On completion of this course, you are expected to be able to:
describe the main theories, debates and concepts in development
economics
demonstrate a clear understanding of the major economic policy issues
in developing countries
read, comprehend and critique empirical analysis in the context of
development policy evaluations at a non-technical level
4
demonstrate an understanding of how theories of development
economics have evolved and shaped policy over the past 50 years.
How to use this subject guide
The aim of this subject guide is to help you understand the required
material, highlight the main points and explain how various readings
are connected. Each chapter will start by outlining aims and learning
outcomes of the chapter and by listing essential and further reading. It will
then take you through the relevant material. To enable you to test yourself,
the learning outcomes are restated at the end of each chapter and sample
examination questions are provided.
We recommend that from Chapter 3 onwards you work through the topics
in the order they are given in the subject guide. Read the essential reading
at the points at which you are asked to do so. The subject guide will
then explain the main points you should take away from what you have
just read, and how these relate to other material. If you did not pick up
these main points from the reading, you might find it useful to revisit it.
When you are particularly interested in a specific topic and feel you have
mastered the required material, you can read some of the further reading.
Keep in mind that understanding the basics is the sure way to pass the
course, but that showing a deeper understanding of how various pieces of
research relate to each other and referring to extra material can earn you a
higher grade.
An essential element of this course is empirical analysis: the quantitative
testing of the predictions of theories and the evaluation of policies
using real-world data. Understanding regression analysis, an often-used
technique for doing so, is therefore essential. In every chapter we will
include at least one reading that uses quantitative analysis so that as you
progress through the course you will get plenty of practice reading and
engaging with regression tables. An outline of the essential knowledge you
will need for understanding empirical analysis to the level required in this
course is provided in Chapter 2. This chapter contains all methodological
concepts necessary to understand the remainder of the subject guide, so
it is very important to read it carefully (even if you have already taken
or are taking another Statistics course). However, it is not necessary to
understand all methodology after the first read: you will practise with the
concepts throughout the subject guide and should refer back to Chapter
2 whenever necessary. Please note that you are not required to know how
to do regression yourself or to remember numerical results. However, it
is important to understand the intuition behind empirical analysis and
why any given analysis was set up the way it was. For each reading the
particulars may be slightly different, but all the quantitative analyses have
the following points in common:
The specification should reflect one or more testable implications of
some underlying theories.
Given the theory, the specification should take into account and try to
control for possible omitted variables.
Given the theory, the specification should take into account and
try to control for possible reverse causality or simultaneity (or
endogeneity).
The assumptions required to ensure that the results are free from
omitted variable and endogeneity bias introduce caveats and
limitations to the results interpretation and policy implications. As
5
all empirical work requires some assumptions along these lines, each
analysis will be limited in its own way.
When reading empirical analyses, it is important to revisit each of these
points and be able to show whether (and how well) the analysis handles
possible biases and, as a result, how comfortable you are with the resulting
policy implications. The subject guide will give you guidance in this as well
on a reading-by-reading basis.
Empirical analysis plays dual roles in development policy; on the one
hand, quantitative analysis is often used to differentiate between
competing theoretical explanations of economic phenomena, and
empirical policy evaluation is used to help judge the effectiveness of
policies derived from those underlying theories. On the other hand, the
basic theoretical evolution itself is highly influenced by the outcomes of
empirical results. Quantitative analysis may find one set of theories more
consistent with observed data and reject another set of theories, which
then fall by the historical wayside. Often careful empirical work generates
new stylised facts that inspire a new generation of academics to develop
new theories.
The amount of real-world data and empirical evidence is constantly
increasing, and at least partially as a direct result, theory and policy
designs are also evolving. You will therefore see that the subject guide
does not proclaim one true theory or the best policy in an absolute sense.
It will, however, explain from what evidence or observations a theory
followed, and how the theory is or is not able to explain what we observe
in the real world. We want you to think creatively and critically, but also
rigorously and in a disciplined manner. In the end, you should have the
tools not only to explain the current state of development policy, but also
to track progress in this area going forward through critical reading of
academic and popular literature.
Essential reading
You need to purchase one book:
Ray, Debraj Development Economics. (Chichester: Princeton University Press,
1998) [ISBN 9780691017068].
This textbook is an overview of theories in development economics. We
will assign relevant parts of this textbook to read throughout the subject
guide. There is no need to read specific parts of the book that are not
assigned. In some assigned pages and articles there may be some technical
material presented that is beyond the scope of this course. This subject
guide will point out the sections that you will not be responsible for
reproducing, and help you to understand the non-technical intuition.
Textbooks often cannot keep up with recent developments in theory.
Equally, empirical research is mostly published in academic journal
articles. Therefore, the remainder of the essential reading consists of
journal articles. These are available through the University of London
Online Library. All International Programmes students have free access to
this resource and you will be able to find the full-text articles here. You
will need a username and password to get access. Alternatively, Google
Scholar is a useful searching device. Finding literature can be time-
consuming, but remember that finding literature yourself is an important
skill you will need to develop throughout your studies.
For each topic, we also provide an extensive list of further reading. You
can read extra material if you are particularly interested in the topic at
6
hand. Read extra material selectively: we by no means expect you to
read all, or even most of it. If you are truly struggling with the course,
we do not expect you to do any extra reading. Take into account that a
student who has mastered the essential reading fully and has done no
extra reading will generally do much better on the exam than a student
who moved on to further reading before having understood the essential
reading. However, when you can show yourself to be proficient in the
essential material, showing knowledge of additional readings can take
your grade up that extra notch.
Full list of Essential reading
Acemoglu, Daron, Simon Johnson and James A. Robinson The colonial
origins of comparative development. An empirical investigation, American
Economic Review 2001, 91(5), pp.1369401.
Amiti, Mary and Josef Konings Trade liberalization, intermediate inputs and
productivity: Evidence from Indonesia, American Economic Review 2007,
97(5), pp.1611638.
Banerjee, Abhijit, Esther Duflo, Rachel Glennerster and Cynthia Kinnan The
miracle of microfinance? Evidence from a randomized evaluation, Working
Paper. (Boston: Massachusetts Institute of Technology, 2009). Available
at: www.povertyactionlab.org/sites/default/files/publications/The%20
Miracle%20of%20Microfinance.pdf
Bernard, Andrew et al. Firms in international trade, Journal of Economic
Perspectives 2007, 21(3), pp.10530.
Bhagwati, Jagdish N. and Anne O. Krueger Exchange control, liberalization
and economic development, The American Economic Review 1973, 63(2),
pp.41927.
Bleakley, Hoyt Disease and development: Evidence from hookworm eradication
in the American South, The Quarterly Journal of Economics 2007, 122(1),
pp.73117.
Burnside, Craig and David Dollar Aid, policies and growth, The American
Economic Review 2000, 90(4), pp.84768.
Dollar, David and Aart Kraay Growth is good for the poor, Journal of Economic
Growth 2002, 7(3), pp.195225.
Dornbusch, Rudi A primer on emerging market crises, NBER Working Paper
series No. 8326, 2001. Available at: www.nber.org/papers/w8326
Easterly, William Foreign aid goes military! Review of The bottom billion by
Paul Collier, The New York Review of Books 2008, 55(19). Available at:
www.nybooks.com/articles/archives/2008/dec/04/foreign-aid-goes-
military/
Easterly, William The Big Push dj vu. Review of The end of poverty by Jeffrey
Sachs, Journal of Economic Literature 2006, 44(1), pp.96105.
Easterly, William, Ross Levine and David Roodman New data, new doubts:
A comment on Burnside and Dollars Aid, policies and growth (2000),
NBER Working Paper No. 9846, 2003. Available at: www.nber.org/papers/
w9846
Engerman, Stanley L. and Kenneth L. Sokoloff Factor endowments, institutions
and differential paths of growth among new world economies, NBER
Working Paper No. 9259, 1997. Available at: www.nber/org/papers/w9259
Galor, Oded and David N. Weil Population, technology and growth. From
Malthusian stagnation to the demographic transition and beyond, The
American Economic Review 2000, 90(4), pp.80628.
Glaeser, Edward L., Rafael La Porta, Florencio Lopez-De-Silanez and Andrei
Shleifer Do institutions cause growth?, Journal of Economic Growth 2004,
9(3), pp.271303.
Hsieh, Chang-Tai and Peter J. Klenow Misallocation and manufacturing TFP
in China and India, The Quarterly Journal of Economics 2009, 124(4),
pp.1403448.
7
Jones, Charles I. Intermediate goods, weak links and superstars. A theory of
economic development, NBER Working Paper series No. 13834, 2008.
Available at: www.nber.org/papers/w13834
Kaplan, Ethan and Dani Rodrik Did the Malaysian capital controls work?,
NBER Working Paper series No. 8142, 2001. Available at: www.nber.org/
papers/w8142
Morales, Juan Antonio and Jeffrey Sachs Bolivias economic crisis, NBER
Working Paper series No. 2620, 1988. Available at: www.nber.org/papers/
w2620
Morduch, Jonathan The microfinance promise, Journal of Economic Literature
1999, 37(4), pp.1569614.
Puga, Diego and Anthony J. Venables The spread of industry. Spatial
agglomeration in economic development, Centre for Economic Policy
Research Discussion Paper No. 1354, 1996. Available at:
http://eprints.lse.ac.uk/20683/
Sachs, Jeffrey How to help the poor: piecemeal progress or strategic plans?
Review of The white mans burden by William Easterly, The Lancet 2006,
376, pp.1309310. Available at: www.thelancet.com/journals/lancet/
article/PIIS0140-6736(06)68561-9/fulltext
Sachs, Jeffrey D. Institutions dont rule. Direct effects of geography on per
capita income, NBER Working Paper No. 9490, 2003. Available at: www.
nber.org/papers/w9490
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed below. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the virtual learning environment (VLE) regularly for updated guidance on
readings.
Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
For ease of reference, here is a full list of all Further reading referred to in
this subject guide:
Acemoglu, Daron and Simon Johnson Unbundling institutions, Journal of
Political Economy 2004, 113(5), pp.94995.
Banerjee, Abhijit V. and Esther Duflo Inequality and growth. What can the data
say?, Journal of Economic Growth 2003, 8(3), pp.26799.
Berkowitz, Daniel and Karen Clay American civil law origins. Implications
for state constitutions, American Law and Economics Review 2003, 7(1),
pp.6284.
Burnside, Craig, Martin Eichenbaum and Sergio Rebelo Prospective deficits
and the East Asian currency crisis, World Bank Policy Research Working
Paper No. 2174, 1998.
Chari, Varadarajan, V., Patrick J. Kehoe and Ellen R. McGrattan Business cycle
accounting, Econometrica 2007, 75(3), pp.781836.
Clemens, Michael A. and Gabriel Demombynes When does rigorous impact
evaluation make a difference? The case of the Millennium Villages, World
Bank Policy Research Paper #5477, 2010. Available at: http://papers.ssrn.
com/sol3/papers.cfm?abstract_id=1709849
8
Coleman, Brett E. The impact of group lending in Northeast Thailand, Journal
of Development Economics 2000, 60(1), pp.10541.
Collier, Paul The bottom billion. Why the poorest countries are failing and what
can be done about it. (Oxford: Oxford University Press, 2007)
[ISBN 9780195311457].
Dell, Melissa The mining Mita: Explaining institutional persistence, MIT
Mimeo, 2008.
Diamond, Jared Guns, germs and steel. (New York: W.W. Norton & Company,
1997) [ISBN 9780393038910].
Easterly, William The cartel of good intentions: the problem of bureaucracy in
foreign aid, The Journal of Policy Reform 2002, 5(4), pp.22350.
Easterly, William The elusive quest for growth. Economists adventures and
misadventures in the Tropics. (Cambridge MA: MIT Press, 2001) [ISBN
9780262050654].
Easterly, William The White Mans Burden. Why the Wests efforts to aid the Rest
have done so much ill and so little good. (Oxford: Oxford University Press,
2006) [ISBN 9780199210824].
Easterly, William What did structural adjustment adjust? The association of
policies and growth with repeated IMF and World Bank adjustment loans,
Journal of Development Economics 2005, 76(1), pp.122.
Easterly, William When is fiscal adjustment an illusion?, World Bank draft
working paper, 1998. Available at www-wds.worldbank.org/
external/default/WDSContentServer/IW3P/IB/1999/09/14/000094946_9
9060201522384/additional/103503322_20041117150007.pdf
Easterly, William and Ross Levine What have we learned from a decade of
empirical research on growth? Its not factor accumulation: stylized facts
and growth models, World Bank Economic Review 2001, (15)2, pp.177219.
Edwards, Sebastian How effective are capital controls? The Journal of
Economic Perspectives 1999, 13(4), pp.6584.
Eichengreen, Barry Capital account liberalization. What do cross-country
studies tell us?, The World Bank Economic Review 2001, 15(3), pp.34165.
Eichengreen, Barry, Ricardo Hausmann and Ugo Panizza Currency mismatches,
debt intolerance and original sin. Why they are not the same and why it
matters, NBER Working Paper series No. w10036, 2003.
Fernald, John G. and Brent Neiman Measuring the miracle. Market
imperfections and Asias growth experience, FRB of San Francisco Working
Paper No. 200617, 2006.
Grossman, Gene M. and Elbahan Helpman Trade, knowledge spillovers and
growth, European Economic Review 1991, 35(2), pp.51726.
Helpman, E. and P. Krugman Market Structure and Foreign Trade. (Cambridge,
Massachusetts: MIT Press, 1985) [ISBN 9780262580878].
Henderson, Vernon, Todd Lee and Yung Joon Lee Scale externalities in Korea,
Journal of Urban Economics 2001, 49(3), pp.479504.
Henderson, Vernon J., Adam Storeygard and David N. Weil Measuring
economic growth from outer space, NBER Working Paper No. w15199,
2009.
Kanbur, Ravi The economics of international aid in Kolm, Serge-Christophe
and Jean Mercier Ythier (eds) Handbook of the economics of giving, altruism
and reciprocity. (Amsterdam: Elsevier B.V., 2006) [ISBN 9780444506979]
pp.155988.
Klenow, Peter J. and Andres Rodriguez-Clare The Neoclassical revival in
growth economics. Has it gone too far? NBER Macroeconomics Annual
1997, 12, pp.73103.
Kopits, George and Steve Symansky Fiscal policy rules, International Monetary
Fund Occasional Paper. (Washington D.C.: International Monetary Fund,
1998).
9
Krugman, Paul A model of innovation, technology transfer and the world
distribution of income, The Journal of Political Economy 1979, 87(2),
pp.25366.
La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert Vishny
Law and finance, Journal of Political Economy 1998, 106(6), pp.111355.
Levitt, Steven D. Using electoral cycles in police hiring to estimate the effect of
police on crime, The American Economic Review 1997, 87(3), pp.27090.
Limao, Nuno and Anthony J. Venables Infrastructure, geographical
disadvantage, transport costs and trade, World Bank Economic Review
2001, 15(3), pp.45179.
Melitz, Marc J. The impact of trade on intra-industry reallocations and
aggregate industry productivity, Econometrica 2003, 71(6), pp.1695725.
Moretti, Enrico Social returns to education and human capital externalities.
Evidence from cities, Unpublished working paper, 1998. Available at:
http://darp.lse.ac.uk/PapersDB/Moretti_(98).pdf
Moyo, Dambisa Dead Aid. Why aid is not working and how there is another way
for Africa. (New York: Allen Lane, 2008) [ISBN 9780262580878].
North, Douglas Institutions, institutional change and economic performance.
(Cambridge UK: Cambridge University Press, 1990) [ISBN
9780521397346].
Nunn, Nathan and Diego Puga Ruggedness: The blessing of bad geography in
Africa, Mimeo, 2007.
Pavcnik, Nina Trade liberalization, exit and productivity improvements:
Evidence from Chilean plants, The Review of Economic Studies 2002, 69(1),
pp.24576.
Pritchett, Lant Divergence, big time, Journal of Economic Perspectives 1997,
11(3), pp.317.
Quah, Danny Empirics for growth and distributions. Stratification, polarization
and convergence clubs, Journal of Economic Growth 1997, 2(1), pp.2759.
Quah, Danny Some simple arithmetic on how income inequality and economic
growth matter, Working Paper, 2001. Available at: http://citeseerx.ist.psu.
edu/viewdoc/download?doi=10.1.1.64.4890&rep=rep1&type=pdf
Rajan, Raghuram G. and Arvind Subramanian Aid and growth: What does the
cross country evidence really show?, The Review of Economics and Statistics
2008, 90(4), pp.64365.
Reinhart, Carmen M. and Kenneth Rogoff Banking crises. An equal opportunity
menace, NBER Working Paper series No. w14587, 2008.
Rodrik, Dani Why we learn nothing from regressing economic growth on
policies, Harvard University Working Paper, 2005. Available at: http://
international.ucla.edu/media/files/rodrik.pdf
Sachs, Jeffrey The end of poverty: Economic possibilities for our time. (New York:
Penguin Press, 2005) [ISBN 9780141018669].
Sala-i-Martin The disturbing rise of global income inequality, NBER Working
Paper No. w8904, 2002a.
Stiglitz, Joseph E. and Andrew Weiss Credit rationing in markets with
imperfect information, The American Economic Review 1981, 71(3),
pp.393410.
Williamson, Jeffrey G. Five centuries of Latin American inequality, NBER
Working Paper No. w15305, 2009.
Young, Alwyn The African growth miracle, Working Paper, 2009. Available at:
http://econ.as.nyu.edu/docs/IO/11950/AfricanGrowthMiracle.pdf.
Young, Alwyn The tyranny of numbers. Confronting the statistical realities of
the East Asian growth experience, The Quarterly Journal of Economics 1995,
110(3), pp.64180.
10
Journals
These academic journals are particularly relevant to (development)
economists:
American Economic Journal: Applied Economics
American Economic Journal: Economic Policy
American Economic Review
Econometrica
Journal of Development Economics
Journal of Economics Perspectives
Journal of International Economics
Journal of Political Economy
Journal of Public Economics
NBER working paper series
Review of Economic Studies
Quarterly Journal of Economics
World Bank Economic Review.
Unless otherwise stated, all websites in this subject guide were accessed in
April 2011. We cannot guarantee, however, that they will stay current and
you may need to perform an internet search to find the relevant pages.
Online study resources
In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave
on your application form. You have probably already logged in to the
Student Portal in order to register! As soon as you registered, you will
automatically have been granted access to the VLE, Online Library and
your fully functional University of London email account.
If you forget your login details at any point, please email uolia.support@
london.ac.uk quoting your student number.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
Self-testing activities: Doing these allows you to test your own
understanding of subject material.
Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
11
Past examination papers and Examiners commentaries: These provide
advice on how each examination question might best be answered.
A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials
and conclusions.
Recorded lectures: For some courses, where appropriate, the sessions
from previous years Study Weekends have been recorded and made
available.
Study skills: Expert advice on preparing for examinations and
developing your digital literacy skills.
Feedback forms.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
Making use of the Online Library
The Online Library contains a huge array of journal articles and other
resources to help you read widely and extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login:
http://tinyurl.com/ollathens
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please see the online help pages:
www.external.shl.lon.ac.uk/summon/about.php
Unless otherwise stated, all websites in this subject guide were accessed in
2007. We cannot guarantee, however, that they will stay current and you
may need to perform an internet search to find the relevant pages.
Examination advice
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Regulations for
relevant information about the examination, and the VLE where you
should be advised of any forthcoming changes. You should also carefully
check the rubric/instructions on the paper you actually sit and follow
those instructions.
The examination paper for this course is three hours in duration and
you are expected to answer three questions, from a choice of 10. The
Examiners attempt to ensure that all the topics covered in the syllabus and
subject guide are examined. Some questions could cover more than one
topic from the syllabus since the different topics are not self-contained.
12
The most important thing to do in the exam is first to read the question
carefully and fully understand what is asked. In answering the question,
provide a clear argument, using the theories and empirical analyses you
have learned. Remember that it is very important to provide evidence.
Answering that institutions lead to growth because the theory says it will
is not sufficient. Provide examples of empirical analyses or real-world
observations that support this claim.
A Sample examination paper appears as an appendix to this guide. The
Examiners commentaries contain valuable information about how to
approach the examination, so you are strongly advised to read them
carefully. Past examination papers and the associated commentaries are
valuable resources in preparing for the examination.
Remember, it is important to check the VLE for:
up-to-date information on examination and assessment arrangements
for this course
where available, past examination papers and Examiners commentaries
for the course which give advice on how each question might best be
answered.
Syllabus
Chapter 2: Introduction to quantitative analysis
Sampling
Hypothesis testing
Normal distribution and central limit theorem
Regression: basics, control variables, dummy variables, interaction
terms
Endogeneity
Regression: IV regression, difference-in-difference estimation
Cross-section, time series and panel data
Chapter 3: Economic growth: basic concepts, ideas and theories
Introduction to growth and GDP
Growth and inequality
Historical growth experience
Neoclassical or Solow growth model
Endogenous growth models
Chapter 4: New directions in growth theory
Extensions to the neoclassical model: heterogeneous firms,
misallocation and intermediate goods
Economic geography
Chapter 5: Institutions and (very) long run growth
Introduction to institutions and growth
Property rights: Acemoglu, Johnson and Robinson
Factor endowments: Engerman and Sokolof
Geography and growth
Human capital and growth
13
Chapter 6: Globalisation and trade theory
Ricardian comparative advantage
Heckscher-Ohlin model
New trade theory
New new trade theory
Chapter 7: Finance and financial crises
Causes and consequences of inflation
Old style financial crises: balance of payments crises and structural
adjustment programmes
New style financial crises and currency crises
Policy options during financial crises
Chapter 8: Microfinance
The credit market: incomplete information and limited liability
Consequences of imperfect credit markets for developing countries and
the poor
Introduction to microfinance
Evaluating the success of microfinance
Chapter 9: Aid effectiveness
Introduction to ODA
Big debate on aid: Jeffrey Sachs, William Easterly, Paul Collier and
Dambisa Moyo
Empirical evidence on aid and growth on country and programme level
Notes
14
Chapter 2: Introduction to quantitative methodology
15
Chapter 2: Introduction to quantitative
methodology
Aims of the chapter
This chapter aims to familiarise you with some quantitative methodology,
mainly regression analysis, to the point where you are able to consume
(understand and critically assess) empirical academic papers in
development economics. It is meant as a reference chapter that you can
return to when reading the remaining chapters of this subject guide.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
Activities, you should be able to:
recognise when the topics introduced in this chapter are applied in
subsequent chapters and reading.
When you have completed the course you should be able to:
read and critically assess empirical research employing the aspects of
quantitative methodology covered in this chapter.
One purpose of this chapter is to familiarise you with quantitative
techniques used in the papers you will read throughout the course.
Therefore, we urge you to read this chapter thoroughly now (even if
you have taken another Statistics course) and review this chapter when
reading these papers.
Essential reading
1998). Appendix 2, pp.777804.
Further reading
Levitt, Steven D. Using electoral cycles in police hiring to estimate the effect of
police on crime, The American Economic Review 1997, 87(3), pp.27090.
Introduction
The second chapter of this course is about quantitative methodology,
mainly regression analysis. The techniques reviewed here are used
extensively, but by no means exclusively, in research in development
economics and development policy analysis. Scholars use regression
analysis in their attempts to answer questions such as: What are the
drivers of economic growth? Is openness to trade related to growth? Can
a particular aid programme (a microfinance programme, a programme
providing books to school children, budget support for developing country
governments) be considered successful? As you can see from these
questions, the aspects of quantitative methodology covered in this chapter
can be applied to every topic in the remainder of the subject guide:
economic growth, international trade, aid, credit, etc.
16
There is a reason why we start with methodology and not with any of
these topics specific to international development. The knowledge about
methodology that you will need is similar for all these topics, and we
wanted to provide you with a chapter where it is all neatly put together.
In fact, the basics of all the methodology you will need to know are in
this chapter. In the subsequent chapters, you will see these basics being
applied to different areas again and again. This is to say that while the
subject matter of this chapter is very important for understanding the
rest of the course, you do not need to have fully grasped it all by the end
of this chapter. You will practise with it again and again throughout the
whole course. You can revisit relevant sections of this chapter every time
you are asked to read an empirical paper and will probably understand the
material better every time you do so.
A disadvantage of providing you with a methodology reference chapter is
that you may feel a bit overwhelmed reading it for the first time. Again,
please remember that reading empirical papers and understanding their
methodology is a skill that will be built up with time and practice. And
as with many skills (like playing the piano, or public speaking), once you
learn them, they stick with you and they can be applied in other contexts.
If you learn the piano playing Mozart, you will probably do pretty okay
playing Bach. Like piano-playing skills, the skills you learn reading an
empirical paper about trade can be employed reading empirical work on
child labour, the environment or even topics that are completely unrelated
to development.
A final thing to remember is that this course aims to teach you how to be
a good consumer of empirical research. After working through the subject
guide, we hope that you can read an empirical paper, understand most
of the quantitative methodology being employed and make an informed
argument about how convincing you find the empirical strategy. We do
not ask you to be a producer of empirical research. You are not expected
to be able to do regression analysis, use statistical programmes or do
any calculations whatsoever. You will also never be asked to reproduce
numerical results of an empirical paper. In terms of our earlier example,
an examination question will never be: By what percentage does the
productivity of firms go up, if trade barriers are lowered by 10 per cent,
according to paper X? but it may be similar to: Why would we expect
lower trade barriers to increase firm productivity? How does paper X test
this expectation? Do you feel that the authors of paper X have successfully
avoided [potential problems with this analysis]?.
Sampling
When carrying out research, we often want to draw conclusions about a
large number of entities: a population. We may want to know the average
income of all people in a country, the productivity of all firms in a
country, the effect of having new schoolbooks on the attendance of all
school children in a region. We can go and collect data on the whole
population, but this is likely to be time consuming and expensive. When done
correctly, sampling can provide a much cheaper alternative to a complete
census at a small accuracy cost. Sampling is the process by which we select
a subset of observations from all possible observations in a population.
When taking a sample, the first step is to define the target population.
This consists of all the observations about which the research aims to
draw conclusions. The sampled population consists of all observations
17
that have some chance of ending up in the sample. Ideally, the target
population and the sampled population should be the same. An example:
you want to investigate the average number of rooms in London houses.
You take a sample from all houses in a London landline phone register.
In this case the target population is all houses in London. The sampled
population, however, is all houses in London with a landline. Houses
without a landline have no chance of ending up in the sample: they are in
the target population, but not in the sampled population.
Once the target population is determined and we have a suitable sample
frame, we take a sample. Various sampling techniques exist, but here we
will focus on a simple random sample. In a simple random sample,
every member of the population has an equal, known probability of ending
up in the sample. You can think of this as throwing all population members
into a hat and randomly picking a number of them. Proper random
samples of a sufficient size can deliver strikingly accurate predictions
about the total population.
If it is not the case that each possible observation has an equal, known
probability of ending up in the sample, and/or if the target population
is different from the sampled population, the sample is biased. It is
important to think about the impact that bias can have on the conclusions
of the research. When observations that are more or less likely to end up in
the sample are systematically different from each other on a characteristic
relevant for the outcome, this impact is especially serious. Return to
our earlier example: you want to draw conclusions about the average
number of rooms in all houses in London, but take a sample of all houses
in London with landlines. Houses with landlines may be significantly
different from houses without landlines. Maybe older inhabitants are more
likely to have a landline, whereas younger ones only have a mobile phone.
Age of the inhabitants of a house may be relevant for the number of rooms
in the house, as older people may be able to afford bigger houses. Then,
the average number of rooms in your sample may be higher than that in
the total population of all London houses.
There are many types of sampling biases of which consumers of research
have to be aware. We will review a number of them. First, self-selection
bias. This occurs when subjects themselves have some say over whether
or not they are included in the sample. An example: when mailing
out surveys, receivers can choose whether or not to send them back.
People interested enough to send the survey back may be systematically
different from non-respondents. Secondly, strategic bias occurs when
subjects feel they can manipulate policy choices by participating in the
research, impacting the composition of the sample. An example: imagine
a microfinance organisation doing a survey of poverty in a village where
the organisation will set up a programme. If villagers feel that they can
increase their chances of obtaining credit by participating in the survey,
the eventual sample may be very different compared to a situation
where villagers believe participating will not benefit them (for example
when a government statistics bureau is doing a regular poverty survey).
Finally, interviewer bias. This occurs when the subject responds to
characteristics of the interviewer in such a way that the composition of the
sample is influenced. When the subject of research is of a sensitive nature
this may be especially serious. Consider doing a survey on condom use for
example. Whether the interviewers are male or female is likely to impact
the willingness of men and women to participate, biasing the sample.
18
Normal distribution and the central limit theorem
A probability distribution is a graphical or mathematical
representation that tells us what the relative probabilities are of any
of the possible outcomes of a process. For example, we can plot all
possible outcomes of a process on the horizontal axis of a graph, and the
percentage of the time that these outcomes occur on the vertical axis.
Consider the following example: we observe the number of absent children
in a 5-child village school, for 45 days. This may have the following result:
No. of children
absent
No. of days this
is observed
Relative
frequency
Probability
0 1 1/45 0.022
1 5 5/45 0.111
2 12 12/45 0.267
3 19 19/45 0.422
4 6 6/45 0.133
5 2 2/45 0.044
Table 2.1
The probability distribution can be represented by the following graph:
ProbabiIity distribution

Number of chiIdren absent
P
r
o
b
a
b
i
I
i
t
y

t
h
i
s

i
s

o
b
s
e
r
v
e
d
Figure 2.1
The normal distribution is a special kind of probability distribution. It
is bell-shaped and symmetric, as in the graph below.
19
x
Figure 2.2
As it is symmetric, the mean of the normal distribution lies exactly in the
middle of the distribution. In the graph above, the mean is 0. Here we will
call the mean of this normal distribution (mu). The bulk of observations
is concentrated around the mean. This means that extreme outcomes
(such as 3 in the graph above) are very unlikely, whereas outcomes close
to the mean are more likely.
The standard deviation of a normal distribution is a number that
represents how widely observations are spread around the mean. A large
standard deviation means a wide spread, a small standard deviation
means a small spread. In the graph below, the dashed curve has a smaller
standard deviation than the solid curve.
x
Figure 2.3
20
Regardless of how wide or narrow they are, all normal distributions have
the following properties in common:
68 per cent of the probability density of a normal distribution is located
within 1 standard deviation around its mean. In Figure 2.4 below: 68
per cent of observations lie between the dashed lines at 1.
95 per cent of the probability density of a normal distribution is located
within 2 standard deviations around its mean. In Figure 2.5 below: 95
per cent of observations lie between the dashed lines at 2.
For example: suppose we know that the height of UK men is normally
distributed, with a mean of 175cm and a standard deviation of 5cm. Using
this information, we know that 68 per cent of UK men are between 170
(1755) cm and 180 (175+5) cm tall. We also know that 95 per cent of
UK men are between 165 (1752*5) cm and 185 (175+2*5) cm tall.
x x
Figure 2.4 and Figure 2.5
Imagine that you draw a large number of random samples from the same
target population. You calculate the sample mean of each of these samples.
You then draw a probability distribution of the sample mean: what shape
would it have? The central limit theorem states that as you draw an
increasing number of successively random samples from a population,
the distribution of sample means will approach a normal distribution. As
the number of samples tends to infinity, then the sampling distribution
converges to N(,
2
/n). The distribution of the population itself
is irrelevant for this statement.
Activity
Experiment with the central limit theorem on this website:
http://onlinestatbook.com/stat_sim/sampling_dist/
Instructions:
1. When you arrive on this website, press Begin. You see four graphs. The first graph
shows the distribution of the population from which a sample is taken (the parent
population).
2. You can choose between normal, uniform, skewed and customised distributions.
Choose the uniform distribution first. A black block will appear because each outcome
is equally likely to appear in a (continuous) uniform distribution.
21
3. The second graph is entitled Sample Data. Press the Animated button and you will
see how a sample is drawn from the distribution above. Press Animated a few times.
Each time a new blue column is added to the third graph representing the distribution
of the sample means. It is the mean of each sample that you obtained by pressing
Animated.
4. You can choose to draw 5, 1,000, or 10,000 samples at a time. Accordingly, 5, 1,000,
or 10,000 blue sample means are added to the distribution of sample means. Press
these buttons a few times. Soon you will see a normal distribution appear. Note that
this happens even though the target population is not normally distributed.
5. On the right-hand side of the Distribution of Means graph you can choose the
sample size of the samples you draw. When you choose N=2 a sample mean
distribution with a large standard error (standard error is the technical name for the
standard deviation of the sample mean) will appear. If you choose a higher value, e.g.
N=25 a more narrow distribution will appear.
6. Now repeat the exercise for a skewed distribution and you will see that again the
distribution of means will become normal. Experiment with the simulation as much as
you like!
Hypothesis testing
As explained in the introduction, theories or observations of the real world
can give rise to certain predictions. To test these predictions, we formulate
them as hypotheses. For each prediction, we formulate two hypotheses:
the null hypothesis (H
0
) and the alternative hypothesis (H
1
).
Together, these hypotheses should cover all possible outcomes. Usually, H
0
concludes that nothing happened, whereas H
1
concludes that something
happened. For example:
H
0
H
1
A treatment has had no effect on an
outcome variable
A treatment has had an effect on an
outcome variable
Group A is not different from group B Group A is different from group B
Variable X is unrelated to variable Y Variable X is related to variable Y
Table 2.2
H
0
is the hypothesis to be tested effectively the working hypothesis.
We observe something in the real world and then calculate how likely it
would be for us to observe what we did, assuming that H
0
is correct.
If this is sufficiently unlikely, we reject H
0
in favour of the alternative
hypothesis.
Consider the following example: we may think that UK men aged 1825
are taller on average than all UK men. We know that UK men are 175cm
tall on average. We formulate the null and alternative hypotheses:
a. H
0
: UK men aged 18-25 are not taller on average than all UK men.
b. H
1
: UK men aged 18-25 are taller on average than all UK men.
We take a random sample of all UK men aged 1825. The men in our
sample are 179cm tall on average. Now we ask ourselves: what is the
probability that we would get a sample with a mean of 179cm, when the
true population mean height of men aged 1825 is 175cm (assuming that
H
0
is true)? We calculate (do not worry how for now) that this probability
is 4 per cent.
22
So we now know that getting this sample with an average of 179cm is
unlikely if H
0
were true. But is it sufficiently unlikely to reject H
0
? The
researcher chooses the probability level at which to reject H
0
. This is
called the significance level. Common significance levels are: 10 per cent,
5 per cent and 1 per cent. When the probability that H
0
is true given our
observations is below 10 per cent, 5 per cent or 1 per cent respectively,
H
0
is rejected at the respective significance level. In our example, H
0
is
rejected when we choose a significance level of 10 per cent or 5 per cent,
but we fail to reject H
0
when we choose a significance level of 1 per cent.
(Note the phrase fail to reject we never accept H
0
merely we state that
we have insufficient evidence to reject it.)
When deciding whether or not to reject the null hypothesis we can make
two types of error:
A Type I error occurs if we reject H
0
even though it is in fact correct.
A Type II error occurs if we fail to reject H
0
even though it is in fact
wrong.
The researcher controls the probability of making a Type I error by setting
the significance level. If we choose a decision rule to reject H
0
when the
probability that it is correct is below 5 per cent, there is a maximum 5
per cent chance that we reject H
0
when it is in fact correct. (Basically this
would occur if we obtained an unlucky or unrepresentative sample.) If we
set our significance level at 1 per cent, the probability of making a Type I
error gets smaller. As may be evident from this example: the smaller the
chance of a Type I error, the larger the chance of a Type II error hence
a trade-off between the two error types exists (for a given sample size).
Because we do not know the truth we cannot calculate the probability of
a Type II error.
So how do we calculate the probability that H
0
is true given our
observations? We have an observed sample mean (x) and hypothetical
population mean (
0
). Because of the central limit theorem, we know that
the sample mean is (approximately) normally distributed. We also have
a good approximation of the standard error of the sampling distribution
(s/n, which approximates /n, where is the population standard
deviation).

We calculate by how many standard errors the observed sample
mean and the hypothetical population mean are apart. This number is
called the t-statistic.
For example, our calculated sample mean and the mean under H
0
are two
standard errors apart: the t-statistic is 2. Written down as a formula:

t =
x
0
s/n
The t-distribution is very similar to the standard normal distribution
N(0,1), but for small samples it has slightly fatter tails, as we had to
estimate the standard error of the sampling distribution and therefore
introduced a bit more uncertainty. However, these distributions are very
similar when we take a sample of reasonable size. (As a rule of thumb,
we may use the standard normal distribution as an approximation for the
t-distribution for large sample sizes, for example n50.)
An overview of critical values of when the t-statistic converges to the
standard normal (i.e. when the sample size is (very) large):
If the observed sample mean and hypothetical population mean are
further apart than 1.96 standard errors we can reject H
0
at the 5 per
cent level.
23
0
at the 10 per
cent level.
0
at the 1 per
cent level.
When sample sizes are a bit smaller, the tails of the t-distribution are a bit
fatter and the critical values are a bit larger. Critical values for different
degrees of freedom are included in the back of most statistics textbooks.
For the most part, using a rule of thumb value that you will reject the
null hypothesis for any t-statistic that is 2 or larger in absolute value (for
statistical significance at the 5 per cent level) is a pretty common and
relatively benign practice.
The p-value reports the probability mass in the sampling distribution that
lies outside of your estimate. For example, a p-value of .035 means that 3.5
per cent of the probability mass of the sampling distribution under the null
lies outside your sample estimate (technically this definition is for a one-
sided test but you do not need to worry about one-sided and two-sided
tests). Thus if you want to test the null at 5 per cent you will look for a
p-value of .05 or lower. From the example above, our p-value of .035 means
we can reject the null hypothesis at 5 per cent, but not at 1 per cent.
Basics of regression
In this section, we are going to bring together the material we have covered
so far to learn the basics of regression. Regression analysis in essence
does two things: it establishes a conditional correlation between two variables
and it determines how likely it is that this correlation is due to chance.
A correlation is a systematic relationship between two variables. For
example: aid spending is related to poverty reduction, or: trade openness
is related to growth. Note that a correlation may be positive or negative:
more aid spending is related to less poverty (a negative correlation) and
more trade openness is related to more growth (positive correlation).
Note that a correlation between X and Y does not necessarily mean that X
causes Y. Correlation does not necessarily imply causation. You will see
why in the next section.
Establishing that two variables are correlated in a sample might tell us
something, but is of limited policy relevance by itself. Between most
variables, there will be some correlation due to pure chance. If you let
100 people roll a die three times, you will probably be able to find people
whose rolls seem to be correlated. However, as rolling a die is random, we
can comfortably say that this correlation is due to chance.
We need to apply what we learned about hypothesis testing here: if
the probability of observing a particular relationship between X and Y,
when they are in fact unrelated, is below a certain significance level (say
there is less than a 5 per cent chance that we would observe a particular
relationship in a sample if in fact there was none in reality in the
population), we conclude that there is a significant relation between X
and Y. For example: we observe a positive correlation between education
and wage: the more education the higher the wage. From the central limit
theorem we know there is less than a 3 per cent chance of observing this
relationship if education and wage were unrelated. If our significance
level was set at 5 per cent, we can now say that the positive relationship
between education and wage is statistically significant, at the 5 per cent
level. Note that the relationship is not significant at the 1 per cent level.
24
How does establishing a correlation work more technically? Although we
do not go into the full technical details, we will illustrate this graphically.
Imagine that you have two variables that you think are related: X and Y.
We can plot these on a graph.
Figure 2.6
Now we think about a single line that will best depict the relationship
between X and Y, given these points (see below). In this case, the line is
upward-sloping suggesting a positive relationship. A negative relationship
can be depicted as a downward-sloping line.
Figure 2.7
How can we determine which is the best line? Statisticians have defined
the best line as the line that minimises the sum of squared errors. The
error is the vertical distance of each individual point to the regression line.
Statistical software can single out the one line for which the sum of these
squared distances is smallest. Since the sum of squared errors is central
in this type of regression, it is also termed Ordinary Least Squares
(OLS).
25
Figure 2.8
The graph illustrates how a regression line is derived.
You may remember that lines are usually described using a slope, a, and
an intercept, b:
y = ax + b
Analogously, the regression equation is:
y = + x +
This simply says that each point in our graph can be described by the
regression line (with an intercept, , and a slope, ) plus the error, (the
vertical deviation of a given point from the regression line). We call y
the dependent variable or outcome variable, and x the independent
variable or explanatory variable. is a regression coefficient
(or slope coefficient). Note that a positive indicates a positive
relationship between x and y, whereas a negative indicates a negative
relationship. No linear relationship at all would mean = 0. In this
equation, there is one explanatory variable. In practice, we will mostly
see regressions with more than one explanatory variable, resulting in a
multiple linear regression equation:
y = +
1
x
1
+
2
x
2
+
3
x
3
+ .+
k
x
k
+
Activity
On this website www.calpoly.edu/~srein/StatDemo/All.html, you will see a regression
graph. Add, delete or move points in the graph and see how the regression line changes.
In particular, try the following:
When the regression model opens, you see an example of a negative correlation. Add
points to turn it into a positive correlation.
Click on show residuals to see how large the error for each point is.
Clear all points by clicking on clear all points. Add two points that display a clear
positive relationship. Now add one more point that does not confirm this relationship
(having a large error; being very far from the line). Observe the impact of adding this
one point on the position of the regression line.
Clear all points. Add twenty points that display a clear positive relationship. Again add
one more point that does not confirm this relationship. How does the impact on the
position of the regression compare to the previously observed impact?
26
Clear all points and temporarily remove the regression line by clicking on no
regression line. Attempt to add twenty-five points that are completely randomly
distributed over the graph. Bring back the regression line by clicking on show
regression line. Did you succeed in creating no correlation between x and y
whatsoever?
Clear all points and temporarily remove the regression line. Add twenty points that
have a U-shaped relationship: high levels of y for both very low and very high levels
of x and low levels of y for medium levels of x. Perhaps this represents the level of
health care an individual needs at various ages: high levels of health care as a more
vulnerable child or senior and low levels of health care as a resilient adult. Bring
back the regression line. How well do you feel that the regression line reflects the
relationship created?
At the bottom of the graph, you can see the regression equation that describes the
regression line you can create by adding, deleting and moving points.
The values of and when the regression model opens are =70.08 and =-0.472
respectively. Try the following, clicking clear points each time you start a new item:
Create a line with a large negative value of .
Create a line with a small negative value of .
Create a line with a positive value of .
Attempt to create a line with = 0.
Attempt to create a line with = 0.
Returning to the one explanatory variable model, we reformulate our
question: how likely is it that we observe a given relationship between
X and Y in our sample when in reality, in the whole population, X and Y
are unrelated? Alternatively, if we estimate a slope coefficient to be 5.46,
we want to know, how likely is it that we could derive a slope estimate
of 5.46 from a sample when the true underlying relationship (true slope
coefficient) in the population was 0?' Or, more simply: How likely is it that
we observe a given
^
(where
^
(beta hat)is our point estimate of the true
), whereas in reality =0?
To distinguish the relationship between X and Y observed in a sample from
the true, unknown relationship, we call the observed relationship
^
. We
now need to apply what we learned in previous sections. From hypothesis
testing:
We set H
0
: =0. There is no linear relationship between X and Y.
H
1
: 0.ThereisalinearrelationshipbetweenX and Y.
From the central limit theorem we can analytically derive the shape of the
sampling distribution of
^
and derive a t-statistic. We use the t-statistic to
determine the level of statistical significance of our estimate.
If we observe a
^
that is sufficiently unlikely given H
0
, we reject H
0
and say
the slope coefficient is statistically significantly different from 0. Note that
we are using the term significantly very specifically here! The researcher
can determine what is sufficiently unlikely his/herself by choosing a
significance level.
The sample distribution of
^
under H
0
: = 0 can be visualised as in the
graph below.
27
5%
= 0
2
Figure 2.9
We omit technical details, but for
^
to be significant at the 5 per cent level
the criteria listed below hold. If one of these is true, this automatically
means they are all true, so in practice it is only necessary to check one:
The chance of observing
^
when the true =0 is smaller than 5 per
cent. This 5 per cent is represented by the blue shaded area in the
graph. The p-value is smaller than 0.05.
The observed
^
is at least two times the standard error away from 0.
The distance between
^
and 0 (which is simply
^
) divided by the
sample standard error is also called the t-statistic. The t-statistic of
^

is bigger than 2 or smaller than 2. Note that the actual critical
value associated with the 5 per cent level may be slightly smaller or
slightly larger than 2, depending on the sample size. But we use 2 as a
rule of thumb.
Now, we have all the information we need to read a regression table.
When reading a regression table, pay attention to these features:
The dependent variable y is usually mentioned at the top or bottom of
the table.
All explanatory variables included in the regression (the different xs),
are listed in the rows of the table.
The resulting
^
s, or coefficients, are in the corresponding rows.
In parentheses under these coefficients, we are provided with
information on the significance of the coefficient. This can be provided
in 3 forms, analogous to the three criteria that hold when
^
is
significant.
A p-value, indicating the chance that
^
is observed when =0. A p-value
lower than 5 per cent indicates significance at the 5 per cent level.
A standard error. A coefficient that is larger than twice the standard
error is significant at the 5 per cent level.
A t-statistic. A t-statistic larger than 2 indicates significance at 5 per
cent level.
Often, the author indicates significance using asterisks (*).
28
An example of a regression table is given below. The authors attempt to
investigate the impact of independent media on public food distribution
and calamity relief expenditure.
These variables
(newspaper
circulation,
turnout, political
competition, and
election dummy)
are not included
in regression 4
Figure 2.10
From: Besley, Timothy and Robert Burgess The political economy of government responsiveness.
Theory and evidence from India. The Quarterly Journal of Economics 117(4), 2002, pp.1415451.
Used with kind permission.
Endogeneity
In the previous section we have said correlation does not imply causation.
Although there may be a (significant) correlation between A and B, this
does not necessarily mean that A has some causal effect on B. A number of
endogeneity problems may inhibit us from drawing such a conclusion. We
will discuss omitted variable bias and reversed causality. Before
going into this, this section will give an introduction to endogeneity.
Figure removed due to copyright restrictions
29
Imagine we want to investigate the effect of a treatment on an outcome.
Ideally, we would like all observations to be identical and to differ
only in whether or not they get the treatment (as in panel A in the figure
below). This way, we can have confidence that the observed effect on the
outcome variable is due to the treatment, and not due to anything else.
For example: We want to examine the effect of taking vitamins on health.
We can administer vitamins to a group of genetically identical mice in a
laboratory and observe any changes in their health.
$ % &
Figure 2.11
Please see the PDF on the VLE for a colour version of this Figure.
However, ideal experiments like A will rarely occur in the social sciences.
Most analyses must be done on non-experimental data. Observations
are likely to be different across many characteristics, not only whether
or not they get the treatment. We want to make sure that any effect we
observe on the outcome variable is solely due to the treatment, not due to
these other characteristics.
One way to ensure this would be for the treatment to be distributed
at random, which makes it likely that the observations receiving the
treatment will not be systematically different from the observations not
receiving the treatment (as in panel B). To go back to our example: we
can bring in a group of participants, randomly assign half of them to take
vitamins, give the rest a placebo and observe any health effects.
Conducting an experiment as in B is not always possible. We may have
to rely on observed data on treatment and outcome. It is possible
that individuals who received the treatment are systematically different
with respect to some characteristics, from those who did not receive
the treatment, as in panel C. We cannot be completely sure that any
observed effect on the outcome is due to the treatment, rather than these
characteristics. It may also be difficult to observe what came first: the
outcome or the treatment.
Go back to our example once more: we observe the health status of a
number of people and ask them about their vitamin use. People taking
vitamins are on average healthier than people who dont. However, people
choosing to take vitamins may be different with respect to a number of
characteristics: they may have a healthier lifestyle in general, be better
informed about health issues, etc. These characteristics may influence both
their health status and their decision to take vitamins. We cannot conclude
that taking vitamins improves health necessarily.
30
These examples illustrate the difference between an exogenous and an
endogenous variable:
Variation in an exogenous variable is determined outside the
model.
Variation in an endogenous variable is determined within the
model.
When we allocate vitamins at random, variation in vitamin use is not
determined by some process relevant to health. The variation can be
considered exogenous. However, when we observe vitamin use, variation
is a function of processes within the system (peoples choice to take
vitamins is related to all the other choices they make, their preferences),
that may be relevant to health. This variation can be considered
endogenous.
One endogeneity problem is omitted variable bias. This section will
explain what omitted variable bias is and how it can impact conclusions
drawn from a regression. An omitted variable is correlated with both
an explanatory variable and the outcome variable in a regression, but is
itself not included in the regression. If such an omitted variable exists, the
relationship between an explanatory variable and the outcome variable
observed in a regression, may be different from the true relationship
between these variables. This is called omitted variable bias.
An example
We run a regression with the number of babies born in a particular area
as a dependent variable and the number of storks in that area as an
explanatory variable. The regression shows that the number of storks is
significantly correlated to the number of babies born. We may conclude
that babies are delivered by storks. Schematically:
Observed relationship
Regression equation: #babies = + #storks +
#storks #babies born
Figure 2.12
You may already suspect that the observed relationship is different from
the actual relationship. The omitted variable in this case may be whether
or not the area is in the countryside. Countryside is correlated to the
number of babies born, as people may prefer raising their children in a
greener, safer environment. We can also expect storks to prefer to live in
the countryside. Hence, the omitted variable causes variation in both the
dependent and independent variables: areas in the countryside have both
a higher number of storks and a higher number of children born. There is
no actual causal relationship between the number of children born and the
number of storks. Schematically:
31
Figure 2.13
The previous example is an example of upward bias: because of the
omitted variable, the relationship between the modelled explanatory
variable and the outcome variable appears more strongly positive than
the true relationship. An omitted variable can also result in downward
bias: because of the omitted variable, the relationship between the
explanatory variable and the outcome variable appears more strongly
negative than it is in reality. Schematically:
Downward bias
Regression equation: y = + x
1
+
X
1
Y
X
2
+
Figure 2.14
An example
We want to investigate whether government financial support to schools
increases pupil performance. We find a negative relationship between
the amount of money a school received from the government and the
average performance of its pupils. We may conclude that the more
money a school receives from the government, the worse its students do.
However, an omitted variable may be school wealth. The government may
target financially needy schools, so wealthier schools are less likely to
Actual relationship
Regression equation: #babies = + #storks +
#storks #babies born
Countryside
More storks in
countryside
Families move to
countryside
32
receive government support. Pupils in wealthier schools can be expected
to perform better, as the school can afford better teachers, materials
etc. In this case, the omitted variable makes the impact of government
spending on pupil performance appear more negative than it is. In
reality, government spending may still improve student performance, but
the effect of the omitted variable may be stronger, and the regression
coefficient may have a negative sign.
Reversed causality is another problem associated with endogeneity.
Reversed causality occurs when variation in the outcome variable causes
variation in the explanatory variable, rather than the other way round.
Reversed causality can make an explanatory variable appear a stronger
cause of the outcome variable than it is in reality. For example, we may
observe a positive correlation between the number of policemen and the
crime rate. This may mean that policemen cause people to commit crimes.
It may also mean that in cities with a higher crime rate, more policemen
get hired (which sounds more likely).
Activity
Consider the following explanatory and outcome variables. For each of these cases,
answer the following questions:
What is a possible omitted variable?
Which mechanisms connect this omitted variable to both the explanatory and
outcome variable?
What is the direction of the bias (upward or downward)?
Explanatory variable Outcome variable
A microfinance programme Poverty
Trade openness GDP growth
Taking a statistics course Knowing that correlation does not
equal causation
Educational attainment Earnings
Distance of individuals' houses to
the town centre
Expenses made for travel ()
Farm size Farm productivity
Table 2.3
Control variables, dummy variables and interaction terms
This section will cover different types of variables that are commonly used
in regression analysis, and their interpretation.
Including a control variable in a regression is one way to attempt
to deal with omitted variable bias. Take the following example: we are
interested in the question of whether a lower student-teacher ratio (str)
improves students performance. To assess this, we regress average test
scores of students in a district on the average student teacher ratio:
test score = +
1
str +
The regression shows a negative relationship between the average student-
teacher ratio in a district and the average test scores. Students in districts
with lower student-teacher ratios achieved higher test scores on average.
33
We may suspect that this result is biased downward, as we can think of
several potential omitted variables:
Perhaps district wealth is both related to higher test scores (students
in richer districts are in a more conducive environment to learn) and a
lower student-teacher ratio (schools in richer districts can afford to hire
more teachers).
Perhaps the value that parents put on education is correlated with test
scores (parents valuing education more require their children to work
harder in school) and with student-teacher ratios (parents putting high
value on education push the school to hire more teachers).
To address the first problem, we include district wealth in our regression:
we control for district wealth.
test score = +
1
str +
2
wealth +
You can think about this as artificially holding wealth across districts
constant; we compare student-teacher ratios and test scores of districts
that artificially have the same wealth. If our suspicion that district wealth
is an omitted variable was correct, we would see that
1
^
increases (it
becomes less negative) compared to our regression without a control
variable. We expect that omitting district wealth makes the relationship
between student-teacher ratios and student test scores seem more negative
than it is in reality and controlling for district wealth should bring
1
^
closer
to its true value.
Variables that you include in a regression to exclude a source of omitted
variable bias, while not being primarily interested in its causal effect
on the outcome variable, are sometimes called control variables. The
distinction between explanatory variable and control variable, however,
is very loose and is not always made. The name control variable has
to do with the function of the variable in relation to the purpose of the
regression analysis, not because there is anything intrinsically different
about them compared to other variables.
Including control variables cannot solve all omitted variable problems.
Consider our second potential omitted variable: parents valuation of
education. This is very hard to observe, let alone to measure and to
include in a regression. Some sources of omitted variable bias can be dealt
with by including control variables, others cannot.
Some variables we may want to include in a regression are dichotomous:
they can take only one of two values:
a persons gender (male/female)
whether a person has a college degree (yes/no)
whether a person has been to jail (yes/no)
This information could be captured using a dummy variable. A dummy
variable is a variable that can take on only one of two values: coded
either zero or one.
We may, for example, be interested in investigating the effect of education
on wage. We suspect that whether an individual is male or female
also has an impact on wage. We have a database with information on
individuals, including their level of education, gender and the wage they
earn. We construct a dummy variable (male) equalling 1 if a person is
male and 0 if a person is not. Ignoring omitted variable problems for now,
we estimate the following regression:
34
wage = +
1
years of schooling +
2
male +
We can interpret
2
as the effect of being male on wage.
1
can be interpreted
as the effect of schooling, controlling for gender. Graphically, including the
dummy variable allows for two regression lines representing the relationship
between schooling and wage, one for men and one for women, with different
intercepts (but the same slope,
1
). In the graph below:
captures the wage of a woman without schooling.
+
2
captures the wage of a man without schooling.
For both genders, the effect of schooling on wage is captured by
1
. The
wage of a man with one year of schooling, is reflected by +
2
+
1
* 1.
The wage of a woman with one year of schooling is reflected by +
1
* 1.
Figure 2.15
Note that we did not include dummy variables for being female and male
plus an intercept term in our regression. Doing so would violate one of
the basic assumptions of OLS regression. It would become impossible to
estimate the regression equation. All you have to remember about this is
that a researcher will omit one category of the dummy variable from the
equation if an intercept term is included.
In our example, we assumed that the effect of education is the same for
men and women. We did not consider the possibility that the effect of
education on wages might be different for men and women. Say we expect
that one year of education will steeply increase a mans wage, whilst it has
a weaker effect on a womans wage.
An interaction term allows us to incorporate this idea into a regression.
An interaction term consists of two explanatory variables multiplied
together. A regression with interaction term can take this form:
y = +
1
x
1
+
2
x
2
+
3
(x
1
* x
2
) +
In this equation,
1
captures the effect of x
1
,
2
captures the effect of x
2
and
3
captures the additional effect of the combination of x
1
and x
2
.
For our example, the regression equation would be:
wage = +
1
years of schooling +
2
male +
3
(years of schooling *
male) +
35
where
3
captures the additional effect of being male and having a certain
amount of schooling on wage. Graphically, an interaction term allows for
different slopes (as well as intercepts) of the regression line for different
categories of observations. Remember that a dummy variable allows for
different intercepts only.
Figure 2.16
In the graph above:
captures the wage of a woman without schooling.
The effect of schooling on wage for women is captured by
1
.
As before, the wage of a woman with one year of schooling, is reflected
by

+
1
* 1.
+
2
captures the wage of a man without schooling.
The additional effect on wage of the combination of having schooling
and being male is captured by
3
.
The wage of a man with one year of schooling, is reflected by +
2
+
1
* 1 +
3
* 1.
Cross-section, time series and panel data
This section will consider three kinds of data that could be used to run
a regression: cross-section, time series and panel data. Different types of
data may be more or less suitable to answer different research questions.
Cross-section data contains information on different cross-section
units at the same point in time (or an average over time). Cross-section
units may be countries, people or any unit of observation arrayed across
space. The cross-section dataset only contains information on different
values of the cross-section units, and no information on variation within
these cross-section units over time. Thus, cross-section data may contain
characteristics (wealth for example) of different countries, provinces,
individuals, households, etc. at a single point in time or an average over a
single time period. It may give information about the differences in wealth
between countries or households, but no information on how the wealth of
individual countries or households developed over time.
36
An example
Imagine that we want to investigate whether a lower national tax rate
attracts more investment from abroad. Cross-section data we could use to
try to answer this question could look as follows:
Tax rates and FDI inflows
in 1998
Country Tax rate (%) FDI inflow (million$)
Argentina 32 461
China 21 3650
France 42 996
Nigeria 20 210
United States 28 1680
Zambia 17 30
Table 2.4
Time series data contains information on a single unit of analysis at
different points in time. It contains variation over time only. Thus, time
series data may contain information on how the wealth of an individual
country or household developed over time. We could use only one time
series, using information about past wealth in a country to predict
future development of its wealth. Alternatively, we could investigate
the relationship between multiple time series, for example research the
relationship between changes in trade policy and changes in wealth in one
country.
Returning to the earlier example, investigating the potential relationship
between taxes and foreign investment, time series data could look like
this:
Tax rate and FDI inflow
in China
Year Tax rate (%) FDI inflow (million$)
1960 23 501
1970 35 713
1980 41 278
1990 33 1044
2000 21 3650
2010 26 4120
Table 2.5
Panel data contains information on different cross-sectional units at
different points in time. In other words, it combines cross-section and time
series data. Panel data contains both variation between units of observation
and within units of observation over time. Thus, panel data may contain
information on how the wealth of an individual country or household
developed over time, and information on differences in wealth between
various countries or households.
37
Panel data that could be used to do our example research into the
relationship between taxes and FDI could look like this:
Tax rates and FDI
inflows
Country Year Tax rate (%) FDI inflow (million$)
China 1990 33 1044
China 2000 21 3650
China 2010 26 4120
Nigeria 1990 13 199
Nigeria 2000 20 210
Nigeria 2010 26 861
Zambia 1990 11 59
Zambia 2000 17 30
Zambia 2010 13 150
Table 2.6
We have identified three kinds of data: cross-section, time series and
panel data. None of these types of data is intrinsically better than others.
However, when we have a particular research question in mind, a specific
type of data may be better suited to answer it. Here is a (non-exhaustive)
list of examples:
Cross-section data can be useful when the research question concerns
differences between observations, for example in the following cases:
When one or more of the variables we wish to research changes very
little over time.
Do countries with a legal system of Anglo-Saxon origin provide
better protection for investors than countries with a legal system of
a different origin?
In a country with low household mobility: do households that live
in an area with TV reception have a different attitude towards
the ruling government than households in areas without such
reception?
Even when we do expect the variables of interest to change over time,
data may only be available at one point in time.
A research question that concerns only one cross-section unit (there is only
one world price of oil, exchange rate between the euro and the dollar, Dow
Jones index) will necessarily use time series data, for example:
How does the world price of grain respond to changes in the
production of bio diesel?
Given past US interest rates and other variables, what is the most likely
US interest rate one month from now?
Panel data can be useful when the research question concerns both
differences between entities and over time, for example:
When we want to investigate the effect of some treatment.
Do women that participate in a microfinance scheme experience a
greater increase in their sense of empowerment over time than non-
participating women?
38
In the context of panel data, you may come across the term fixed effects.
To understand this concept, lets go back once more to our example,
investigating whether low tax rates attract foreign investment with a panel
data set. There are a number of possible omitted variables that might bias
the analysis if we run a regression with FDI as a dependent variable and
tax rates as an independent variable. Perhaps countries with a low tax rate
also have other policies that attract investors. Or perhaps some attribute
of Chinese culture both favours low taxes and draws investors. We could
introduce numerous control variables to address the omitted variable
problems. However, there could still be something about China we do not
observe or that we cannot measure, that may make it both prone to have a
low interest rate and high levels of FDI.
To (partially) address omitted variable problem(s), we can introduce
country-fixed effects. We add a dummy variable that equals one if the
observation concerns China and zero otherwise. We construct such dummy
variables for all countries in the sample, which will make our data look
like this:
Tax rates and
FDI inflows
Country Year Tax rate (%) FDI inflow
(million$)
Dummy
China
Dummy
Nigeria
Dummy
Zambia
China 1990 33 1044 1 0 0
China 2000 21 3650 1 0 0
China 2010 26 4120 1 0 0
Nigeria 1990 13 199 0 1 0
Nigeria 2000 20 210 0 1 0
Nigeria 2010 26 861 0 1 0
Zambia 1990 11 59 0 0 1
Zambia 2000 17 30 0 0 1
Zambia 2010 18 43 0 0 1
Table 2.7
You can think of the variable dummy China as a control for being China.
It controls for both observed and unobserved characteristics of China that
do not change over time. In our example, fixed effects might control
for some attribute of Chinese culture, if we expect this to be stable over
the research period. Including fixed effects would not adequately control
for GDP differences between research countries: we would expect GDP to
change substantially over time.
When estimating a model using panel data and including fixed effects,
it includes dummy variables for each individual entity, controlling for
characteristics of these entities that do not change over time. We can
thus introduce country-fixed effects, province-fixed effects, household-
fixed effects, individual-fixed effects, etc. depending on the data at hand.
Another type of fixed effects we can introduce is time-fixed effects.
When including time-fixed effects, one includes a dummy for each
relevant time period (a year dummy, or decade dummy). This controls for
characteristics of a period that do not vary between cross-section
units.
39
Instrumental variable (IV) regression
Problems of endogeneity make it hard for researchers clearly to identify
causal relationships. Using instrumental variable regression can
potentially solve, or at least mitigate, problems of endogeneity and
identify causal relationships. The challenge is to find a truly valid
instrument. This section will provide an introduction to instrumental
variable regression.
Consider a regression equation:
y =
0
+
1
x +
We suspect that x is an endogenous variable. We can thus not interpret
1
as the causal effect of x on y. Attempting to solve this problem, we search
for a valid instrumental variable or instrument. Let us call our
instrument z. For z to be a valid instrument, it has to be exogenous and
satisfy two conditions:
Relevance condition: z is correlated with x.
Exclusion restriction: z is not related to y, except through its
correlation with x.
Using the instrument z we can extract out some exogenous variation in
x. If we then use this extracted exogenous variation in x to estimate the
effect of x on y, we can measure the unbiased causal effect of x on y.
This is all rather abstract, so let us consider an example (after Levitt 1997,
further reading). We want to assess the effect of police presence in a city
on crime. Variation in police presence, however, is endogenous. Reversed
causality is an especially pressing concern: in cities that have a high crime
rate, more police officers get hired. Running a regression that looks like
this:
crime rate = + # police officers +
is unlikely to give us unbiased estimates of the effect of police presence on
crime.
Now say that we think that a dummy indicating whether a given year is an
election year is a valid instrument for the number of police officers. Would
this satisfy our two conditions?
Is being in an election year correlated to the number of police officers?
Maybe, if we expect that officials aiming to get re-elected would hire more
police officers to satisfy voters. It is easy to check this condition: we can
run a regression with the number of policy officers as a dependent variable
and the election year dummy as an explanatory variable and see if the two
are significantly correlated.
Is being in an election year unrelated to crime except for its effect on
crime through the number of police officers?
It may seem reasonable to believe that an election year does not have an
independent effect on crime. There is no way to prove this definitively,
however, and we have to use our common sense to assess whether the
exclusion restriction is satisfied. For example, if we believe that there are
more protests in an election year, which may be related to crime (throwing
rocks at the police, smashing cars or shop windows), our instrument is not
valid. Equally, if we think that an increase in crime will lead citizens to
force officials out of office, leading to new elections, our instrument is not
valid. In the USA (where the study was done) municipal elections occur
40
on a fixed schedule, and not too many riots occur surrounding mayoral
races. So we are probably okay. Authors using instrumental variables often
spend a large part of their paper arguing that their instrument is indeed
exogenous and trying to disprove counterarguments like the ones above.
If both conditions are met, we use our instrument to isolate exogenous
variation in police presence. In this case, exogenous variation is change
in police presence as a result of being in an election year.
Variation in police presence due to other factors may be endogenous to the
model. We would like to filter out the first type of variation. Schematically:
Figure 2.17
Note that an election year does not have to be the only, or even the most
important determinant of the number of police officers. It just has to be a
source of exogenous variation.
How does this work more technically? Instrumental variable estimation
consists of two stages: the First Stage Regression and the Second Stage
Regression, together known as an IV regression or often a Two-Stage
Least Squares (2SLS) regression.
In the first stage, we regress the number of police officers (our endogenous
variable) on a dummy for election year (our instrument):
# police officers = + election year dummy +
If our instrument satisfies the relevance condition, the election year
dummy and the number of police officers will be significantly correlated.
We now know the size of the effect of being an election year on the
number of police officers. We also know which year in our dataset was
an election year. We can use this information to predict how many police
officers there are in any given year. In this case: for a non-election year
and + for an election year. Call this predicted number of police officers
# of police officers
^
. Because # of police officers
^
only contains variation in
police presence due to the election year, we have isolated some exogenous
variation in police presence.
41
Now we use this exogenous variation in police presence to estimate the IV
regression. We estimate:
crime rate = + # of police officers
^
+
Note that we use the predicted number of police officers, not the
actual number of police officers (which is endogenous). If the exclusion
restriction is satisfied, this should allow us to estimate the causal effect of
police presence on crime.
In terms of the abstract model, the two stages of a two-stage least squares
model are:
Stage 1: x = + z + . We use this regression to construct predicted
x or , isolating exogenous variation in x.
Stage 2: y = + x
^
+ . Estimating the causal effect of x on y.
To sum up, the instrumental variable approach can potentially solve
endogeneity issues due to reverse causality and establish a causal
relationship between two variables. We must be convinced, however,
that the instrument is exogenous, reasonably correlated with the original
(endogenous) variable, and that the exclusion restriction holds. Assessing
these assumptions is key to assessing the credibility of a paper using
instrumental variable estimation. The most important tool for doing so is
your common sense!
Difference-in-difference estimation
Difference-in-difference estimation may be employed when we
want to investigate the effect of some treatment on an outcome and we
have information both over time and across space (or cross-section units)
for both the treated and the untreated. In the context of development,
this is often the effect of a particular aid programme (providing schools
with textbooks, providing microcredit, etc.) on the well-being of the poor
(pupil performance, income). Call the cross-sectional units receiving the
treatment the treated group. We often know the score of the treated
group on the outcome variable before and after the treatment.
For example, we know that pupils on average scored 210 points on a
test before they received schoolbooks and 220 points on average after.
The difference between pupils scores before and after they received
schoolbooks is 10 points. We might say that the schoolbook programme
caused the pupils scores on tests to increase by 10 points. However, we
would be wrong in drawing such a causal conclusion: maybe something
else changed during the time that the programme was running, causing
performance of pupils to go up irrespective of the programme. Maybe the
government has increased its budget on education and all children in the
country (those receiving books and those not receiving books through the
programme) score better on the test.
To draw credible causal conclusions, we need a control group. Ideally,
the treatment and control group should have identical characteristics
and differ only in whether or not they receive the treatment. The control
group is our counterfactual: we believe that, in absence of the
treatment, the outcome variable for the treatment and control group
would follow the same trend. Any difference between the trends of the
control group and the treatment group can then be attributed to the
treatment.
42
In terms of our example, say that the schoolbook programme has been
randomised. A group of potential recipient schools was selected, a
lottery was held and only half of these schools received books. Pupils in
the schools not receiving books form our control group. We also measure
the performance of control group pupils before and after the programme:
they score on average 220 points before and 228 points after the
programme is executed. The difference between control group pupils
scores before and after programme execution is 8 points. The difference
between the differences in test scores in the control and treatment
group before and after the programme is 2 (10 8). (You may understand
now why this method is called difference-in-difference estimation.) We
conclude that the programme caused pupils scores to rise by 2 points.
For this conclusion to hold, we must credibly argue that the trends in test
scores would be the same for the pupils receiving books and those not
receiving books, in absence of the programme.
More technically, a difference-in-difference regression set-up will look like
this:
Outcome
ti
=
1
+
2
treatment
i
+
3
post
t
+
4
(treatment * post)
ti
+
ti
We observe the outcome variable for an entity (i) in two time periods (t),
before and after the treatment could have been received. Treatment is a
dummy indicating whether an individual entity has received the treatment
and post is a dummy indicating whether the observation is made before
or after the treatment period.
Graphically, we could represent the interpretation of the coefficients in the
following series of graphs:
Figure 2.18
Note that the regression equation includes a dummy variable (treated).
This allows for two separate regression lines, each with their own
intercept.
1
captures the effect of being in the non-treated group. It is the
intercept term for the non-treated group.
43
Figure 2.19
3
captures the effect of being in the post-treatment period. In absence
of the treatment, the treatment and the control group should display
the same trend in outcome. This allows us to draw a (hypothetical) line
showing how outcome in the treatment group would have developed, in
absence of the treatment.
Figure 2.20
2
captures the effect of being in the treated group. It is the intercept for
the regression line for the treatment group, minus the intercept of the
regression line for the control group (
1
).
44
Figure 2.21
Finally,
4
is our variable of interest. Note that this is the coefficient on an
interaction term. It captures the additional effect of the combination
of being in the treatment group and being in the post-treatment period. In
other words, it captures the effect of having received the treatment.
Summary
Difference-in-difference estimation is an approach to estimate the causal
effect of a policy on a treatment group. Its credibility, however, depends
entirely on the validity of the key assumption and chosen control group:
In the absence of treatment the difference in outcomes between treatment
and control group would not have changed. Is it reasonable to assume that
this assumption is true? An important way of assessing the validity of this
assumption is to use your common sense. The researcher can also supply
evidence that suggests that the key assumption is valid, for example, if
the researcher can show a graph of the trend in the outcome before the
treatment. If trends look similar, we may be inclined to think the research
strategy is valid. Furthermore, a researcher may show that treatment and
control group do not differ significantly in characteristics that may be
relevant to the research, using certain statistical tests.
Now read
1998) Appendix 2, pp.777804.
Ray treats some of the material above in Appendix 2. Generally, he does
so in a more technical way. If it helps you to see the same thing explained
using a different approach, please use the material in Ray.
Again, if you do not fully understand the material yet, do not worry. You
have just laid the basics of all the methodology you will need to learn for
the course. It is only natural for you to need more practice to grasp it all.
More practice will follow in each chapter from now on.
45
A reminder of your learning outcomes
Having completed this chapter, and the Essential reading and Activities,
you should now be able to:
recognise when the topics introduced in this chapter are applied in
subsequent chapters and reading.
When you have completed the course you should be able to:
read and critically assess empirical research employing the aspects of
quantitative methodology covered in this chapter.
Sample examination questions
There will be no examination questions exclusively testing your knowledge
of methodology. However, if you look at the examination questions in the
subsequent chapters, you will realise that being able to apply the material
in this chapter to the topics in subsequent chapters is necessary to get a
good score in the examination.
Notes
46
47
Chapter 3: Economic growth: basic
concepts, ideas and theories
Aims of the chapter
In this chapter we will: (a) explain how economic growth is measured
and discuss some associated advantages and disadvantages of different
approaches; (b) examine the empirical relationship between economic
growth, poverty and inequality, and (c) review the two primary theoretical
models of economic growth showing how they can be used to shed light
on observed patterns of development.
Learning outcomes
By the end of this chapter, and having completed the relevant reading and
activities, you should be able to:
explain how we conventionally measure economic growth and the
problems associated with this
illustrate some alternative ways of measuring growth
explain potential relationships between economic growth and both
poverty reduction and between/within country inequality
discuss empirical evidence regarding these relationships
roughly sketch the pattern of economic growth from the far distant past
to today and understand the processes behind it
know the crucial assumptions and implications of the following growth
models:
Harrod-Domar model
Crucial assumptions: output is proportional to the stock of capital,
investment is proportional to output.
Implications: indefinite growth is possible by increasing the
stock of capital. Model is unstable except under very particular
parameterisations.
Solow or neoclassical growth model
Crucial assumptions: output is a function of capital, labour and
technology, with diminishing returns to capital.
Implications: long-run growth solely depends on the rate of
technological progress; increase in capital stock, savings rate or one-
off increase in efficiency will only lead to a higher level of output,
not to an increased long-term growth rate. Limited scope for policy.
Conditional convergence, flow of capital to capital-scarce regions.
Endogenous growth theory
Crucial assumptions: human capital displays increasing returns at an
aggregate level due to externalities. Ideas have non-rival characteristics.
Implications: one-off increase in human capital can lead to permanent
growth increases. Scope for policy intervention. Human capital flows
to places where human capital is abundant. Poverty traps.
discuss empirical evidence on how well both the neo-classical model
and the endogenous growth model explain observed growth patterns.
48
Essential reading
Growth 2002, 7(3), pp.195225.
American Economic Review 2000, 90(4), pp.80628.
Ray, Debraj. Development Economics. (Chichester: Princeton University Press,
1998). Paragraph 2.2.1, pp.1016, Chapter 3, pp.4797, Chapter 4,
pp.99129.
Further reading
Banerjee, Abhijit V. and Esther Duflo Inequality and growth. What can the data
say?, Journal of Economic Growth 2003, 8(3), pp.26799.
misadventures in the Tropics. (Cambridge MA: MIT Press, 2001).
Paper 2006, No. 200617.
Henderson, Vernon J., Adam Storeygard and David N. Weil Measuring economic
growth from outer space, NBER Working Paper No. w15199, 2009.
growth economics. Has it gone too far?, NBER Macroeconomics Annual
1997, 12, pp.73103.
11(3), pp.317.
growth matter. Working Paper, 2001. Available at: http://citeseerx.ist.psu.
Paper No. w8904, 2002a.
http://econ.as.nyu.edu/docs/IO/11950/AfricanGrowthMiracle.pdf.
110(3), pp.64180.
Introduction
Economic growth is at the core of development; for poor countries, no
long-term, significant and sustained social progress can occur without it.
As co-features of the dynamics of the income distribution, the evolution of
poverty and inequality is inexorably linked to the rate of economic growth.
Theoretically, academic economists have made considerable progress in
the past 50 years in understanding some of the fundamental causes of
economic growth. However, despite its centrality and the recent theoretical
progress, in practice economists have very little idea how actually to
achieve sustained high growth rates (hence the title of one of our core
readings, The elusive quest for growth (Easterly 2001)).
This chapter will introduce basic concepts, ideas and theories regarding
growth. We will ask questions such as: What is economic growth? Why
is growth important for development? We will introduce two main
theories of economic growth and discuss the insights produced by each.
We will then build upon these fundamental insights in further chapters
as we explore more recent alternative theoretical frameworks and
complementary empirical work.
47
What is growth?
Now read
1998). Paragraph 2.2.1, pp.1016.
Further reading
Henderson, Vernon J., Adam Storeygard and David N. Weil Measuring
economic growth from outer space. NBER Working Paper No. w15199,
2009.
http://econ.as.nyu.edu/docs/IO/11950/AfricanGrowthMiracle.pdf
When we say development we often think of economic growth.
Indeed both terms are sometimes used interchangeably. However, we will
see shortly that activities we do not generally think of as contributing
to development (such as market-based child labour) do contribute to
economic growth as we conventionally measure it, as growth of GDP.
Thus, a good start of any course in development is to ask: What is
economic growth theoretically, and how is this distinct both from how
we measure growth empirically, and from broader conceptual notions of
development?
One component of economic development that development economists
pay a lot of attention to is poverty reduction. Although we expect
(and have seen in the past) that poverty will generally be reduced as the
economy grows, the extent to which this occurs may vary considerably
from country to country, and in some cases growth may occur without
much poverty alleviation at all, or may actually be associated with
increased poverty, so we will want to examine this relationship more
closely. Another important and related question is this: What is the
relationship between growth and inequality? Or, how important is
growth for poverty reduction? This chapter and the associated readings
will go some way towards answering these questions.
The most common measure of economic growth is an increase in Gross
Domestic Product (GDP). Nominal GDP is the market value of all
final goods and services made within the borders of a country in a year.
Nominal economic growth is thus the change from one year to the next
in the value of all final goods and services; real economic growth is
nominal economic growth adjusted for inflation.
This approach to measuring economic wealth has the advantage that it
is objective, not easily influenced by politicians, and can be consistently
applied across countries and through time. However, the approach does
have some limitations, and for some uses of GDP statistics it is important
to be aware of these caveats. For example, when comparing the GDP
figures for developing countries we want to keep in mind that:
Companies in the formal sector are required to keep records of their
income, sales and transactions. However, a significant part of economic
activity in many developing countries takes place in the informal
sector, made up of small, unlicensed firms and individuals who do not
report their activity to the government and generally do not pay taxes.
As this activity is underground it is hard to measure and often is very
inaccurately estimated, or not included at all, in GDP estimates.
GDP counts every transaction as positive, even if it is associated with
misery: a child working, sales of weapons/drugs, a company receiving
a contract to dump toxic waste, etc.
48
GDP fails to take into account non-market activity, such as household
work and childcare.
GDP estimates do not take into account the reduction of finite stocks of
resources or pollution of the environment.
These problems are aggravated by the limited capacity of many developing
countries to collect and report national statistics, increasing measurement
error. Furthermore, to correct nominal GDP estimates for inflation to create
real GDP measures, it is necessary to construct price indices based on a
set bundle of consumption goods. For many poor countries it is difficult
to ascertain what the appropriate bundle of goods would be, and in many
countries these price indices are not created at all (see Young, 2009).
So given these problems, are there any viable alternatives to the GDP
statistics? Green accounting is one proposed approach in which
researchers adjust GDP statistics to take into account the depletion
of natural stocks and the negative costs of environmental damage of
production. While these alternative figures can be very interesting,
producing them requires a considerable number of assumptions and value-
judgments, and researchers can disagree about the underlying theoretical
models used to generate some of the adjustments. These statistics thus
lack the robust simplicity, universality and objectivity of the plain (but
flawed) GDP and thus can be useful complements to, but probably not
universal substitutes for, the standard national accounts.
Other alternatives address the measurement problems of poor data
availability and large informal sectors in developing countries. Young
(2009) reports measures of real consumption based on the more easily
available statistics on ownership of durable goods, the quality of housing,
the health and mortality of children, the education of youth and the
allocation of female time in the household. This indicates that sub-Saharan
living standards have, for the past two decades, been growing at more
than three times the rate indicated in international data sets! Henderson
et al. (2009) use changes in the amount of electrical lighting at night to
measure economic growth from outer space. Take a look at the results
presented in their tables to see that they conclude there are large under-
and over-estimations in official growth rates.
Summary
You are expected to be able to explain what GDP growth is, why
measuring GDP is problematic, especially in developing country contexts,
and how economic growth can be distinct from development. In addition,
you should be able to identify alternative ways of measuring economic
growth and contrast their outcomes to conventional GDP estimates.
How important is growth?
Now read
Growth 2002, 7(3): 195225.
Further reading
Banerjee, Abhijit V. and Esther Duflo A reassessment of the relationship
between inequality and growth: Comment. Manuscript, MIT, 2000.
growth matter, Working Paper, 2001. Available at: http://citeseerx.ist.psu.
47
Paper No. w8904, 2002a.
Even if measuring GDP was unproblematic, we are still left with the
question of how important is economic growth for poverty reduction?
Is it possible that the poor do not benefit from economic growth? Or
perhaps the poor may benefit in absolute terms, but relatively less than
the richer parts of society, increasing inequality. We can certainly
think of situations in which certain groups of people have not benefited
from growth, so the argument should be taken seriously. What does the
empirical evidence on growth and inequality suggest?
It is tempting to conclude that if income inequality increases with
economic growth, growth is bad for the poor. However, the relationship
is much more subtle than that. In particular, inequality within a country
must increase at a sufficiently high rate relative to economic growth if the
number of people in poverty is to increase; historically we rarely observe
within-country inequality changing at the rates that would be required to
observe increasing poverty given the historically observed growth rates.
Time t=1 Time t=2
Time t=1 Time t=2
Figure 3.1
It is also important to distinguish between income inequality between
countries and income inequality within a country. Consider the following
examples. There are two countries: a rich one and a poor one. In these
countries, there are six people that can be of four types: very rich (VR)
rich (R), poor (P) and very poor (VP). For simplicity, assume that the same
nominal income increase is required to jump from each group to the next.
There are two time periods, in between which growth may occur at different
rates in the rich and the poor country. In example 1, pro-poor growth occurs
in the rich country: some people that were poor in t=1 are rich in t=2. There
is no growth in the poor country. Even though growth is pro-poor in the sense
that it has increased poor individuals incomes more than rich individuals,
the inequality between the poor and the rich country increases, as the rich
as a whole country grows richer and the poor countrys income is stagnant.
Note that the inequality within the rich country decreases in contrast.
48
The inequality within the poor country is unchanged. In example 2 the
rich economy encounters a decline in GDP, that hits the poor individuals
disproportionately. Again, the poor economy is stagnant. Even though GDP
decline is anti-poor in the sense that it decreased poor individuals incomes
more than rich individuals, the inequality between the poor and the rich
country decreases, as the difference between the average income in the rich
and the poor country is smaller in t=2 than in t=1. Within the rich country
however, inequality increases.
These examples do not tell us that growth will do any of the things
depicted. However, they illustrate that we cannot draw the simple
conclusion that growth is anti-poor/pro-poor if we observe increased/
decreased inequality between countries. It also tells us that both within-
and between-country inequality can change (potentially in opposite
directions). It would be interesting to see which has the largest influence
on changes in global inequality.
Activity
Draw some diagrams like Figure 3.1 above (two countries, with six inhabitants each of
four potential types, in two time periods in between which growth or decline occurs).
Illustrate some of the following situations where pro- (anti-) poor growth is defined as
growth disproportionately increasing the incomes of poor (rich) individuals respectively:
Pro-poor growth decreasing both within- and between-country inequality.
Pro-poor growth increasing within country inequality and decreasing between-country
inequality.
Anti-poor growth increasing within-country inequality and increasing between
country inequality.
Anti-poor growth increasing within-country inequality and decreasing between-
country inequality.
Can you show any other combinations of these?
You are required to understand potential relationships between growth
and poverty reduction and between- and within-country inequality. Now
let us turn to the empirical evidence on these relationships.
On the question of what determines global inequality, within-country or
across-country inequality, there is very strong evidence from many authors
that within-country income inequality is relatively stable over time. Thus
much of the change in the global income distribution of individuals
seems to be coming from changes in the relative distribution of income
across countries (see Quah, 2001, for an example).
On the question whether global inequalities have increased or decreased
the evidence is very mixed: Quah (2001) has found a slight increase in
global inequality. However, using a different methodological approach,
Xavier Sala-i-Martin (2002a, 2002b) finds that global inequality has
decreased. He also concludes that both poverty rates and absolute head
counts of people in absolute poverty have declined significantly. When
assessing these results it is important to remember that they are largely
driven by what happens in China and India. Because these countries
are so populous, when we look at the global distribution of income at
the individual level, whatever happens in these two countries takes on
enormous importance. Both of these countries have grown dramatically
over the past decades, and although income inequality within each country
(especially China) has increased, this increase has not been dramatic
enough to cancel out the dramatic forward shift of the entire distribution.
47
The paper by Dollar and Kraay in the reading list draws the following
conclusions:
The incomes of the poor increased, approximately one for one, with
the overall growth in mean income. This can be interpreted as poor-
neutral growth; the poor neither benefit nor suffer disproportionately
from growth. (Note this is an average result; other studies since have
found much more heterogeneity in the poverty elasticity of growth.)
The incomes of the poor do not fall disproportionately during periods
of crisis or negative overall growth.
Aggregate GDP growth is not associated with increases in income
inequality within countries.
When you read the Dollar and Kraay paper, do not worry about the
more technical aspects of the estimation techniques (primarily discussed
on pages 20304 and which you can ignore). For example, they use
an instrumental variables estimator in some equations, and run some
regressions with levels data, others with differenced data, and one
estimator that combines the two. You do not need to understand the
difference between these estimators, and you do not need to understand
the technical estimation method. We will study instrumental variables
estimators in later papers, but for now there is no need to understand
the technical methodology. Instead, focus on the basic specification of the
regressions and the results.
In order to explore the relationship between poverty and growth, they
start with a basic estimating equation (1) on page 202 that looks like:
y
p
ct
=
0
+
1
y
ct
+
2
X
ct
+
c
+
ct
They show that this is equivalent to estimating equation (2), but we
can still interpret the coefficient estimate
1
in the same way in either
model. Since equation (1) is more intuitive, we will stick with that for our
purposes. The variable y
p
is the log of per capita income of the poor, and
y is the log overall average income. The subscripts c and t correspond to
countries and year, so y
p
ct
means the log of the per capita income of the
poor in country c in year t. The variable X is actually a vector of variables
i.e. it corresponds to a set of control variables. The variable
c
corresponds
to time invariant country characteristics that are not controlled for in the
regression (and are thus part of the error term). In the original regression
(1) in Table 3 (with no control variables X), it is because the presence
of these country-specific time invariant characteristics (or country-fixed
effects) in the errors could bias the estimates. Therefore in regressions
(3) and (4) they use differences instead. What this means is that instead
of looking y
ct
in each time period and comparing to the level of y
p
ct
to see
whether when y
ct
is higher (or lower) there is a systematic relationship
with y
p
ct
being higher (or lower), they look at the relationship between
changes over time, or the correlation of (y
ct
y
ct-1
) and (y
p
ct
y
p
ct-1
).
Because both y
p
ct
and y
p
ct-1
will incorporate any country specific time
invariant characteristic, by subtracting one from the other we will cancel
out (difference out) these factors. Thus regressions (3) and (4) control
for the country-fixed effects, or
c
. However, the authors are worried
that by only looking at change over time within a country they will not
have enough data to see an effect, so regression (5) combines the two
approaches.
In Table 4 the authors introduce some additional control variables, X
ct
,
into the analysis. Each set of columns presents the coefficient estimates
and corresponding t-statistic for a different set of control variables. For
48
example, in the first regression they control for regional dummies. Thus,
if there are systematic differences between average incomes and incomes
of the poor across different regions that might have been driving the
results from Table (3), these are now taken into account. In other words,
the regression is now asking whether, within each region, you see a
systematic relationship between average incomes and incomes of the
poor. The coefficient estimate of interest is still
1
, the coefficient on the
log of per capita GDP, and as we can see it is 0.905, which is statistically
significantly different from zero (with a standard error of 0.094), but not
statistically different from one (with a p-value of 0.313). On page 208
the authors further describe how to interpret the results for each set of
control variables. At this point, you do not need to understand fully each
of these regressions, but notice that they are exploring how robust their
conclusions are to different ways of looking at the relationship.
Although you do not need to understand all the equations in the
remainder of the paper, do the following activity.
Activity
Choose one or two variables that interest you, such as trade (globalisation) or social
spending.
Locate the table in which the authors explore the relationship between your chosen
variable and the incomes of the poor.
What is the coefficient of interest?
What does it mean? Interpret the coefficient in the following way: as [variable of
interest] increases/decreases, the incomes of the poor increase/decrease. Increase
[variable of interest] seems to be good/bad for the poor.
The text of the article walks you through the results so you may use the discussion as a
guide.
Although we observe growth and income inequality both evolving over
time, is there a causal relationship between them? Does increasing
growth cause increased (or decreased) income inequality? As the Dollar
and Kraay article discusses, the evidence here is very mixed. Some papers
have found a negative relationship, but others have found a zero, non-
linear or even positive relationship between inequality and growth.
Banerjee and Duflo (2000) come to the conclusion that there is no robust
relationship between these two variables.
While all these results should be interpreted with some caution as this is
an ongoing research question, it is important to recognise that the data
do not show evidence of the kinds of anti-poor effects of growth that
some people fear. There seems to be no systematic relationship between
growth and inequality over the time horizon of our recent data sets (i.e.
20 or 30 years). In absolute terms, there is solid evidence that in fast-
growing economies, such as India and China, millions have been lifted
out of poverty. The evidence suggests that great scope for massive poverty
alleviation lies in encouraging aggregate growth. It seems growth is indeed
very important for development.
Summary
You are not expected to reproduce exact or numerical results from the
outlined papers. However, you should be able to discuss the overall picture
that emerges from empirical research on growth and inequality/poverty
reduction.
47
Economic growth in the far distant past
Essential reading
American Economic Review 90 2000(4), pp.80628.
We have seen that when we speak of development, a lot of attention is paid
to economic growth per capita. Over the past decades, per capita growth
has been the norm to the extent that when developing countries fail to grow,
we start to wonder what they are doing wrong. However, it is important
to realise that per capita economic growth is a very new phenomenon if we
take into account the far distant past. As you can see in the table on page 4 of
Galor and Weils article, per capita income in Western Europe did not grow at
all in the period 5001500 and only after 1820 did per capita growth exceed
1 per cent. When reading the article, it is important to realise that peoples
living standards (per capita GDP) can only increase when population growth
is smaller than the growth of total output. The total wealth in the economy
may increase, but if this increase is matched or outpaced by population
growth, wealth per person will remain equal or decrease.
Galor and Weil distinguish three stages of growth and reconcile them
in their model. You should be able to describe this pattern of economic
growth and understand the processes behind it.
Stage 1: Malthusian growth
Some factor of production is fixed (it cannot increase). Usually this is
land. This implies decreasing returns to scale for all other factors of
production.
Any increase in the standard of living will lead to increased population
growth. Any increase in the available resources (more land, increases
in the quality of technology) will be offset by an increase in population.
The net effect is that per capita income does not increase. Increases
in the availability of resources are rare in this stage and population
growth is very slow.
A testable hypothesis that follows is that differences in technology
across countries will be reflected in different population densities
but not in different living standards.
There is historical archival and archaeological evidence that the
Malthusian model was consistent with reality for a long time: per capita
GDP did not grow for long periods of time, population growth was very
small, increased living standards were strongly related to fertility and
differences in living standards between countries were relatively small
prior to 1800.
Stage 2: Post-malthusian growth
As the population slowly grows, the rate of technological progress
increases (a standard result of the endogenous growth model we will
encounter shortly). This progress translates into a faster increase in output
compared to Stage 1. Population growth speeds up as a result, as in the
previous stage. The crucial difference from Stage 1 is that total output
now increases faster than the population and per capita income starts to
increase. This increase is small by todays standards, estimated to be well
under 1 per cent per year in Western Europe.
48
Stage 3: Demographic transition
Due to the faster population growth in the previous stage, technological
progress continues at increased pace, as does growth in total output.
However, in this stage, the rate of population growth begins to fall. The
Malthusian link between output growth and population growth is broken
and only now per capita income starts to increase at the levels that we
consider normal today. At the same time, the level of education increases
dramatically. As more educated children are more likely to invent new
things as adults, technological progress (and per capita growth) continues.
Why do people decide to have fewer, better-educated children in this
stage? Galor and Weil argue that this is a logical choice in the face of
technological progress. If technology (for example farming practices)
is constant, farmers over many generations will have learned from
experience (trial and error) how to farm efficiently. Children can
learn how to do this by observing their parents and schooling will not
necessarily lead to better farming outcomes. However, when farming
technology changes quickly, there is little time to figure out how to farm by
trial and error and the knowledge of parents is less relevant. Children now
need to be able to analyse and evaluate production possibilities and there
is a value in education.
Modern growth theories: Harrod-Domar and Solow
growth model
Now read
1998) Chapter 3, pp.4797.
Further reading
misadventures in the Tropics. (Cambridge MA: MIT Press, 2001) Chapter 2
and 3, pp.2571.
11(3), pp.317.
We now move on to growth models that attempt to help us understand
growth in modern times. You are required to be able to explain crucial
assumptions and implications of these models.
The first model Ray discusses is the Harrod-Domar model. This model
(published by Eversy Domar in 1946) was originally intended to explain
the relationships between short-term recessions and investment in the
USA. It was not meant to be a model of long-run growth, nor was it meant
to be applied in developing countries. Essentially, the idea is that output
is proportional to the stock of capital. Some fixed fraction of output is
invested and investment adds to the capital stock. This in turn will make
output grow and the whole process starts over. The implication of this
model is that you just have to increase the amount of physical capital in
order to grow. Early development economists thus thought that insufficient
physical capital was a binding constraint to growth in developing
countries. The Harrod-Domar model was used to calculate the financing
gap, the gap between actual investment in a developing country and the
investment needed to attain some desired growth rate. This financing gap
could then be filled with foreign aid.
47
There is very little to no evidence that supports this model, as Easterly
humorously illustrates with the following example of Zambia: given the
amount of aid that Zambia has received over the last 40 years, the Harrod-
Domar model predicts that the Zambian GDP would be over 40 times
larger than it actually is. Even so, a number of the International Financial
Institutions (IFIs) (such as the World Bank and the IMF) still occasionally
use the model.
The second model described in Ray is the Solow growth model, or
Neoclassical growth model. Easterly (2001) provides a non-technical
understanding of both the Harrod-Domar and Solow model, you may find
useful to read.
According to the Solow, or neoclassical, model, the total output of an
economy is a function of the basic inputs, capital and labour. This function,
called a production function, describes how capital and labour are
transformed into output, and can be denoted:
Y = A*F(K, L)
Where Y is total output, K and L denote capital and labour respectively,
and A is a technology constant. This neoclassical production function has
two essential properties:
If you double capital and labour, output will double. This is called
constant returns to scale. Note however, that when doing so,
the amount of output per worker and thus total wealth per worker
remains the same. Also, the amount of capital per worker does not
change.
However, if you hold labour constant and only increase capital,
eventually capital will display decreasing marginal returns. For
example, imagine that you start out with 10 workers and no sewing
machines (capital). If you add one sewing machine you will probably
increase production by a lot. Adding further sewing machines will
continue to increase total output, but at some point after labour is
fully utilised, adding yet more sewing machines will not increase
total output as much as earlier additions. Furthermore, some sewing
machines will break down and there wont be enough people to
fix them. Thus at some point additional sewing machines will not
increase production any more at all. In other words at some level of
capital, increasing the amount of capital per worker will give you
a progressively smaller return in terms of production. This is called
diminishing returns to capital.
In order to increase the amount of capital in the economy, you have to
invest using savings. Saving or investment (they are assumed to always be
equal) in the simplest version of the Solow model is some proportion (say
20 per cent for example) of the total output. This assumption is made for
convenience and can be relaxed. The main implications of the model are
not changed by specifying another form of savings function.
Another parameter to notice in the Solow model is technological progress,
or the growth of A in the production function above. Growth in A causes the
production possibilities frontier to expand so that it is possible to produce
more and more goods (Y) using the same amount of capital and labour (K
and L). However the Solow model says nothing about how technology (A)
might increase. It is exogenous, a set parameter that can be arbitrarily set
by a researcher, and is not endogenously determined within the model.
48
Graphically, this is illustrated by Figure 3.2, below. Because it is difficult to
graph three variables on 2-dimensional paper, we normalise by dividing both
Y and K by L, denoting our new per capita variables with lower case letters.
Thus on the horizontal axis is k, amount of capital per worker. The curve
F(k), is the output per worker. We can see that this increases as the
amount of capital per worker (k) increases. However, we can also see that it
increases ever more slowly as k increases. These are the diminishing returns
to capital. An increase in technology A will shift the entire curve upwards:
more output per worker can be attained with the same amount of capital
per worker. In the graph, we can also see savings or investment s*F(k).
Some fixed proportion of output is saved, so this curve has approximately the
same shape as F(k). The last curve represents depreciation d(k). Over time
the value of capital goods decreases, things such as machines or computers
are worn down or get outdated. So the capital stock per worker loses value at
some fixed rate, hence d(k) is a straight line. Again, these assumptions about
savings and depreciation rates are purely for convenience you can draw
them in any shape you like in the graph below and the basic conclusion of
the neoclassical model will still hold. In other words, the insights generated
by the neoclassical growth model are invariant to the savings behaviour and
depreciation rates of capital.
Figure 3.2 Solow growth model
What are those insights? What does the Solow model tell us about
growth? We can see that at any point to the left of k* saving is higher
than depreciation. Investment in that period is greater than depreciation,
so the capital stock increases and in the next period capital per worker,
k, is increased and thus we move along the F(k) curve and increase per
capita output, y. However at points to the right of k*, depreciation is
greater than investment, total capital stock falls in the next period and
k decreases, as does per capita output, y. Only at k*, where savings and
depreciation are equal, is k, the amount of capital, and hence output, per
worker, stable. k* and y* are thus the equilibrium levels of capital and
output per worker. If all the curves in the graph stay where they are, y and
k will automatically return to these equilibrium levels. In other words per
capita growth will eventually cease.
47
Note that it is possible for per capita output to grow temporarily by
increasing the savings rate, moving the sF(k) curve upwards. This would
move point A to the right, and an equilibrium value of k* would be
attained at a higher level of output per worker. In the period before this
point is reached, growth will occur. However, it is important to see this is
only temporary: once the economy has reached a new point like A, growth
will stop. A new equilibrium, with higher levels of capital per worker and
income per worker, will be reached.
A one-off increase in efficiency of production will have a similar effect. It
will shift the F(k) curve upwards and the equilibrium amount of capital
per worker will result in higher output per worker. In other words point B
will shift upwards. If this increase in efficiency is one-off, an equilibrium
will again be reached and growth will only be temporary.
However, if we picture technological progress as a continuous upward
shift of the F(k) curve, it is possible to have growth in the long term. As
technological progress will make it possible to attain ever more output per
worker with the same amount of capital and workers, growth does not
cease. In fact, as technological progress is the only source of permanent,
long-term growth in this model, the long-run rate of growth will equal the
rate of technological progress.
The Solow models primary insight was that capital accumulation alone
cannot drive long-term per capita growth (unlike in the Harrod Domar
model). Instead, you need technological progress for permanent growth.
But after fingering technological growth as the key to sustained economic
progress, the Solow model leaves this main factor in long-run economic
growth unexplained.
For policymakers, it follows from the above that unless their policy
succeeds in increasing the rate of technological progress (and how
this could be done is left unexplored), any policy will only result in a
temporary increase in growth, not a permanent one. Scope for policy is
thus relatively limited in the Solow model.
Activity
Draw a copy of the Solow graph and:
Increase the savings rate. Convince yourself that a new equilibrium will be reached.
What does this mean for growth? What does this mean for total output?
Imagine a one-off large inflow of aid that increases the amount of capital per worker.
Convince yourself that in the long run, the model will return to the same equilibrium.
What does this mean for growth and total output?
Draw a one-off efficiency increase. Convince yourself that a new equilibrium will be
reached. What does this mean for growth? What does this mean for total output?
Draw a number of new curves representing continuous technological progress. Convince
yourself that output per worker keeps increasing. What does this mean for growth?
The Solow model also has some implications for global differences
in wealth. Imagine that the world consists of countries that are all in
equilibrium. This does not mean that they are in the same equilibrium
(that they all have the same production structure, hence the same graph
and the same equilibrium values of y and k). It means that they are all
in their own, country-specific equilibrium (they all have their own,
country-specific graph and equilibrium values). We further assume that
technological progress occurs at a global scale and thus that the rate of
progress is the same for all countries. This would mean that all countries
are growing at the same long-run rate, the rate of technological progress.
48
Now lets relax some of these assumptions and imagine that some
countries, the rich ones, have already reached their equilibrium but the
poor ones have not done so yet (they are still at some point to the left of
k* in the graph). The rich countries grow only at the rate of technological
progress and have the equilibrium amount of capital; they are at the
technological frontier. Technological progress equally moves the
technological frontier of poor countries outwards but in addition, these
countries grow because they move towards the technological frontier.
This implies that poor countries grow faster than rich ones and that
the gap in wealth between them will shrink. As long as the underlying
parameter values (such as the savings rate, the production function, etc.)
of rich and poor countries are different they will not converge to the
same level, but they will converge to a level that is similar to that of other
similar countries. This is called conditional convergence. It does not
mean that the rich-poor gap will disappear (absolute convergence). The
equilibrium level of output specific to the poor countries might be lower
than that of the rich ones. Ray (1998) gives an overview of empirical
evidence on the convergence hypotheses.
Another relevant implication of the Solow model follows from its
decreasing returns to capital. If capital can flow freely across the world
(i.e. if we increase globalisation and openness), we expect capital to go
to the place where it earns the highest returns. The Solow model predicts
that this will be in a country where there is initially comparatively little
capital as returns to capital decrease when you have more of it. Thus
the model predicts a flow of investment to regions that do not have a
lot of capital yet, increasing the rate of the transitional growth towards
equilibrium. Therefore the Solow model predicts that increased trade and
openness will accelerate convergence (or conditional convergence), and
thus medium term growth in poor countries, but will not permanently
increase per capita growth. As you will see in the chapter on trade theory,
however, empirical evidence does not support this prediction.
You are expected to know the crucial assumptions and the implications of
both the Harrod-Domar and Solow growth model. As emphasised, these are:
Harrod-Domar
Implications: indefinite growth is possible by increasing the stock of
capital.
Solow
technology, with diminishing returns to capital; saving and investment
are proportional to output, constant rate of depreciation.
technological progress; increase in stock of capital, savings rate or
one-off increase in efficiency will only lead to a higher level of output,
not to an increased growth rate. Limited scope for policy. Conditional
convergence, flow of capital to capital-scarce regions.
Modern growth theories: endogenous growth theory
Now read
1998) Chapter 4, pp.99129.
47
Further reading
Paper 2006, No. 200617.
growth economics. Has it gone too far? NBER Macroeconomics Annual
1997, 12, pp.73103.
110(3), pp.64180.
We have seen that the Solow model explains the growth effects of the
accumulation of capital, but leaves changes in the rate of technological
increase unexplained (or exogenous). Endogenous growth models, on
the other hand, endogenise technological change, or make technological
change an outcome of internal processes within the model. Endogenous
growth models endeavour to illustrate the underlying mechanisms
through which technological change is generated within an economy,
just as the neoclassical models endeavoured to illustrate the underlying
mechanisms behind the relationship between capital accumulation and
growth. They each focus on a completely different aspect of the growth
process, and by simplifying away the other complicating factors, give us
a much deeper and clearer picture of the particular process under study.
Our understanding of the whole growth process must incorporate insights
from both of these types of models (and a few more as well, as we shall
see later). Chapter 4 in Ray (1998) deals with endogenous growth models.
You can ignore any equations, just focus on the following main ideas.
There are many versions of endogenous growth models (as there are
multiple versions of neoclassical models). Thus it is best to think of these
as two families of models. Although the specifics vary, there are a few
primary mechanisms that these models have in common, and in this
course we will focus on one of the primary engines of endogenous growth:
spillovers or externalities to knowledge. A certain good is characterised by
a positive/negative externality if either the consumption, production or
exchange of this good has positive or negative consequences for the well-
being of a party not involved in the transaction. In the case of a positive
consequence, we say that the benefits associated with the good spill
over to a third party. Knowledge and ideas are usually considered to be
characterised by externalities, as the below will illustrate.
A key insight from endogenous growth theory (and reflected in the Galor and
Weil story from above) is that ideas, or knowledge, have a large component
that is non-rival. This means that if an idea is used in one production
process, it is not diminished but can be used by others in their production as
well. Sometimes firms or people will try to keep certain knowledge private,
through patents or secret formulas, but this only partially or temporarily
works, and if the ideas escape, their use by the original firm in no way
diminishes their usefulness to subsequent users. In many, if not most cases,
knowledge and ideas can flow freely across people. Thus knowledge is
broadly a non-rival input. Take the example of producing a bike: if you
allocate steel, labour etc. to producing a bike, they cannot be used to produce
something else. They are rival inputs. However, the idea that a wheel with
spokes is superior to a solid wheel is non-rival, i.e. it can be used in many
bike-producing processes at the same time and indeed for simultaneously
producing many other goods. Others are now also able to make superior bikes
etc. without going through the trouble of reinventing the wheel.
48
While ideas are mostly non-rival, human capital of a person, or the
ability of the individual to assimilate and generate ideas, is rival. If you
hire a scientist to work for your firm, she cannot work for another firm.
Therefore she gains some private return (her wage) from her human
capital (if her human capital were free for everyone to use, nobody would
pay her for it!). However the ideas generated by the scientist may leak
out to other firms. Furthermore, your scientist will engage socially and
professionally with other people. Her interesting ideas, good feedback
and analytically insightful social interactions will augment the ability of
other people around her to come up with good ideas themselves. Thus
although an individuals human capital is rival, it displays spillovers or
externalities. Your scientist cannot herself capture all the benefits of her
education (human capital) other people around her benefit too. In turn,
she benefits from her interactions with other people of high human capital.
Indeed, two heads are not only better than one, they are better than the
sum of one head alone and another head alone.
A key implication of the presence of rival human capital with externalities is
that the private returns to human capital do not equal the benefits for
society. For a young woman calculating how many years to go to school,
she will observe that after some point, increasing the years of schooling will
not increase her earnings (if you dont believe this, ask your professor!). So,
for her there are diminishing returns to human capital accumulation and at
some point it will not make economic sense to continue in school. However,
the social benefit of her education will be greater than the increase in
wages, because of the positive externalities discussed above. Her education
makes her more productive (and thus earning higher wages), but it also
increases the productivity of other people around her. Thus the optimal
level of education for her will be lower than the optimal level of education
that society would like her to have; this is one of the primary theoretical
justifications for government subsidies to education.
Furthermore, because of human capital spillovers, the gain in productivity
(and hence the increased wage) she will get from an extra year of education
will be greater if there are more educated people around her. In other words,
at the aggregate level, the return to an additional unit of human capital
(in this case an additional year of schooling) will be higher the higher the
aggregate level of human capital is. This means that human capital displays
increasing returns to scale at the aggregate level (although still
diminishing returns at the individual level). Note this aggregate relationship is
the exact opposite of that of physical capital in the neoclassical model.
A number of interesting policy implications can be derived from these
insights from endogenous growth models. Given the increasing returns
to human capital at the aggregate level, a one-off increase in the stock
of human capital can permanently increase the rate of growth. This is
because an increase in the aggregate stock of human capital increases the
return to further increments of human capital (i.e. schooling), which in
turn increases investment in human capital, which increases the size of the
aggregate stock of human capital, and so on
This leaves far greater scope for big long-term impacts from policy
intervention than were implied under the Solow growth model: in a
world characterised by endogenous growth, a one-off government policy
increasing the human capital stock can translate in permanent long-term
per capita growth. Furthermore, because individuals on their own would
invest less in human capital than the societal optimum, a subsidy to
education will improve societal welfare as well as growth.
47
Another implication of the model is that human capital is expected to flow
to places where a lot of human capital is already available (the opposite of
the Solow prediction for physical capital). This is indeed what we observe
in the real world most educated people generally want to work/study
in places with other educated people. Internationally, educated migrants
tend to move from less educated countries to more educated places. Even
within the same country, say the USA, more educated people are more
likely to move to New York or Boston than to Goodland, Kansas or Gering,
Nebraska. They might not understand the concept of externalities, but they
do expect to earn more for their education in real terms.
Another key insight (also mirrored in the Galor and Weil story) of
endogenous growth theory is the importance of population size. With
more people, there is a higher chance that someone will come up with
a new (non-rival) idea. If there are more people around to use the new
idea, it has greater benefit and it is also more likely that someone else
will improve or add to that idea, and so on. So the bigger the population
size, the faster the rate of idea generation. Also, to the extent that part of
the idea can be held privately (by patents, for example) at least for some
time, then the larger population implies greater returns to the individual
for generating ideas, and increases the probability that ideas will be
generated.
This is an example of a virtuous circle. However, the flip side of this is that
a vicious cycles (or poverty trap) can also occur when there are increasing
returns. For example, if the total stock of human capital is low, the returns
to investment in human capital (education) are also low, leading people to
invest very little in human capital and keeping the total stock low.
Summary
You are again required to know the crucial assumptions and implications
of this endogenous growth model:
Crucial assumptions: human capital has increasing returns at an
aggregate level, due to externalities.
Implications:
A one-off increase in human capital can lead to permanent per capita
growth increase.
Larger scope for policy intervention compared to the Solow growth
model.
Human capital flows to places where human capital is abundant,
rather than to areas where capital is scarce (as the Solow model would
predict).
There is a possibility of vicious circles, where poorer countries are likely
to grow more slowly than richer countries: poverty traps.
Solow growth model versus endogenous growth theory
The final question of this chapter is: What model does a better job of
describing observed growth patterns, the Solow model or the endogenous
growth model? Remember, it neednt be one or the other; they can both
shed important insight into different components of the growth process.
However, it is important to know, for example, whether recently observed
growth miracles such as those that occurred in Korea and Taiwan
from the 1960s to the 1990s can be explained primarily by neoclassical
models i.e. by the increase in factor accumulation (increases in factor
48
inputs of production like physical capital and labour), or by endogenous
growth processes i.e. by increases in total factor productivity or
technological innovation.
Researchers investigate how much of the observed growth is due to
increases in factor accumulation and how much is due to an increase
in total factor productivity (TFP) using a technique called growth
accounting. Essentially, the technique involves estimating the extent to
which changes in factor inputs can explain changes in output, then any
output growth that is not explained by factor accumulation is assumed to
be due to an increase in TFP.
Ray quotes a paper by Alwyn Young (1995), which concludes that factor
accumulation alone largely explains East Asian growth. He concludes that
neoclassical growth theory does a reasonable job explaining their growth
miracle.
However, others have debated this conclusion based on methodological
grounds. Klenow and Rodriguez-Clare (1997) argue that increased
productivity growth will increase returns to investment, increasing
investment rates. The increased output due to this increase in investment
should be attributed to TFP, not factor accumulation. They find that the
explanatory power of factor accumulation decreases somewhat once this is
taken into account.
More recently Fernald and Neiman (2006) use an alternative approach
to growth accounting that takes into account that firms face differential
costs of factor inputs, due to varying levels of access to subsidised credit
and other political wedges. When taking this into account, they even
find negative growth of technology in those firms receiving the most
subsidies. Note that the idea that not all firms are similar, that they are
heterogeneous, is also sparking new ideas in growth theory that will be
discussed in the next chapter. In any case, although the evidence seems to
be tipping towards neoclassical models lately, research into the underlying
explanations of the Asian Miracle is mixed and ongoing, with no definitive
answers available yet.
Summary
You are expected to discuss empirical evidence on how well both the
neoclassical model and the endogenous growth model explain observed
growth patterns.
A reminder of your learning outcomes
Having completed this chapter, and the relevant reading and activities, you
should now be able to:
explain how we conventionally measure economic growth and the
problems associated with this
illustrate some alternative ways of measuring growth
explain potential relationships between economic growth and both
poverty reduction and between/within country inequality
discuss empirical evidence regarding these relationships
roughly sketch the pattern of economic growth from the far distant past
to today and understand the processes behind it
47
know the crucial assumptions and implications of the following growth
models:
Harrod-Domar model
Implications: indefinite growth is possible by increasing the
stock of capital. Model is unstable except under very particular
parameterisations.
Solow or neoclassical growth model
technology, with diminishing returns to capital.
technological progress; increase in capital stock, savings rate or one-
off increase in efficiency will only lead to a higher level of output,
not to an increased long-term growth rate. Limited scope for policy.
Conditional convergence, flow of capital to capital-scarce regions.
Endogenous growth theory
Crucial assumptions: human capital displays increasing returns
at an aggregate level due to externalities. Ideas have non-rival
characteristics.
Implications: one-off increase in human capital can lead to permanent
growth increases. Scope for policy intervention. Human capital flows
to places where human capital is abundant. Poverty traps.
discuss empirical evidence on how well both the neoclassical model
and the endogenous growth model explain observed growth patterns.
Sample examination questions
1. Given the historical experience of developed countries, it is unrealistic
to expect that all developing countries will be able to create growth in
the short term. Discuss.
2. What is the difference between the role of human and physical capital
accumulation in the Solow growth model and the neoclassical growth
model respectively?
3. It is sometimes said that the rising tide [of economic growth] will
lift all boats. Discuss this statement with reference to theoretical and
empirical evidence on the impact of growth on inequality.
Notes
66

Abcd PDF

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Abcd PDF

Uploaded by

Copyright:

Available Formats

Economic policy analysis in

You might also like