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The Relationship between Capital Accumulation and Economic Growth

How Capital accumulation is directly related to economic growth? Explain.

Capital accumulation is directly related to economic growth. As capital per labour increases for a given technology, marginal productivity of the labour rises. Excess employment of capital per labour reduces productivity of the labour, when amount of labour is fixed. As productivity of labour rises, this results in rise in total production in a sector. Accumulated capital across different sectors of the country raises GDP of the country (Piketty and Ganser 2014).

The above diagram depicts that with the increase in capital stock, marginal product of capital decreases. The classical theorists regarded capital and labour as complimentary to each other, where the neo classical economists showed labour and capital as substitute factors to each other. Capital accumulation is determined by rate of investment. According to Harrod-Domar model of capital accumulation, rate of saving and investment together determine the capital growth rate. This capital growth rate in turn signifies capital accumulation (Iwaisako and Futagami 2013). The equation of this model is represented as follows:
Gk= s/v where v is capital output ratio (K/Y) in a sector. Again s = P/Y, which depicts that all profits made by organisations are saved and all the wages are exploited.
Therefore, Gk = (P/Y)/ (K/Y) = P/K, which represents that, rate of profit earned per unit of capital is equal to the rate of growth of capital. In this model, one important assumption is full employment level in the economy. This unrealistic assumption is relaxed in the Keldor’s model of capital accumulation. Keldor assumed that, there is a maximum population growth rate in the economy. Hence, Gn= λ. λ is determined by the fertility rate of the economy. If Gk > Gn, the economy would grow at the rate of Gk. As argued by Marxian theory, this circumstance may lead to crisis for the economy. If accumulated capital is greater than labour supply, the demand for labour rises, which further induces wage rate to rise. Therefore, all the profits would be wiped out. As profit reduces, saving and investment are also reduced. As result, capital accumulation reduces further to decrease overall growth rate of the economy. Therefore, it is critical for the economy to choose correct level of capital output (Mankiw 2014).
Economy’s capital stock remains unchanged, when investment equals to depreciation. At this point the economy reaches steady state level, where both capital stock and output remain unchanged. Beyond steady state level, investment is less than depreciation and thus capital stock starts to fall.

Harrod-Domar Model of Capital Accumulation

Total factor productivity is a useful indicator to measure economic growth of the economy. Total factor productivity cannot be measured directly. It is measured through productivity of labour or capital of economy or industry or any sector. Investment positively affects total factor productivity. Growth in capital formation and efficient resource allocation are important medium term indicators of TFP. Well structured institutions, geographical location are long term indicators, which influence the foreign direct investment to come in the economy (Robinson 2013). FDI also contributes significantly to capital accumulation in the economy. Country’s trade policy, liberalisation policy affects the extent of FDI entering into the country. Domestic investment is affected by financial market regulation. Level of investment is negatively related to rate of interest. Any rise in interest rate decreases level of investment higher interest rate raises cost of borrowing. Ease of doing business is an index, which indicates business environment in an economy (Van Beveren 2012).

Human capital such as knowledge is another indicator, which influence factor productivity. Perfect knowledge about job increases productivity of labour and output of the organisation. If capital and labour are regarded as complimentary to each other, without to increase productivity of labour, it is needed to provide a certain amount of capital (Campbell et al. 2012). If a country has sufficient human capital along with physical capital and labour, the country can grow at a rapid pace. Investment increases productivity of both capital and labour. Investment in new technology, research and development in an organisation increases total factor productivity of the organisation. However, if capital per labour exceeds the required level, this may decrease productivity of labour and vice versa (Dettori et al. 2012). As a result total production falls. With increase in technology, the efficiency frontier line shifts upward as shown in below figure.

Innovation is another major determinant of total factor productivity. There are two aspects of investment in research and development. One is innovation and other is developing understanding to imitate other. Second aspect represents absorptive capacity, which helps to transfer technology. University, several research organisations plays important role in innovation being a think tank (Ludwig et al. 2012). Investment in research and development at institution level helps to increase productivity and economic growth. Knowledge is an important part of innovation. Patent right encourages innovation in different sectors. New innovation may be in the form of new technology or new ideas, which increases competitive advantage of an industry over other competitors in the market. New technology enhances marginal productivity of capital. As MPk increases, TPk also increases (Moseley 2012).

Total Factor Productivity

According to the convergence theory, the poor country will catch developed economy at some point of time in future. According to Solow growth model, convergence is of two types such as absolute convergence and conditional convergence. Absolute convergence occurs, when all the countries use same technology with equal rate of population growth and national saving rate. The growth rate differs only because of difference in capital labour ratio with which the economy has started. If these criteria follow, then all the countries converge to the equal level of growth rate and per capita output (Korotayev and Zinkina 2014). On the other hand conditional convergence occurs in long run if two countries start with same technology and same rate of population growth rate, however, diverge in marginal propensity to save and beginning capital-labour ratio.
However, differences in human capital may restrict the convergence of developing country with a developed country. The country, which has high skilled labour force and high quality human capital, it will have higher level of MPk and a country with low education level will have lower level of MPk. Therefore, investment in education by government matters in human capital growth (Jones et al. 2015).

With low level of human capital the country ends growth process at B starting from A, because of diminishing MPk. However, if MPk is associated with high level of human capital, the MPk curve shifts upward and end at C. Thus two countries with different level of MPk cannot converge to attain same level f economic growth rate. As per neo classical growth theory, countries with low capital grow at faster rate compared to the counties which possess higher capital. Endogenous growth theory contradicts with neo classical growth theory. Endogenous theory says that it is not logical to say that the poorer country will catch up the richer country in future. Therefore, there will be a difference between the richer and poorer country as the richer country will be growing eve (Cetorelli and Peretto 2012). As per 1960s data, the country with higher GDP grew at slower rate due to diminishing rate of return.
There is Iron law of Convergence, which says that if there is 2% gap between a poor and rich country, they are likely to be converge within one year. Otherwise, if the initial output gap is more and rate of growth is slow, convergence may take almost 35 years.
Growth prospects of the eight emerging countries
Based on the above ranking, the long term growth prospect of the countries can be followed. The ranking of the countries has been done based on global competitiveness report published by World Economic Forum. Among the eight nations, Jordan is showing consistency for the indicators except national saving rate.
GDP per capita is highest in Ecuador among the eight countries. It indicates that possibility of highest capital accumulation is in Ecuador. Jordan ranks second. Higher per capita income generally indicates higher rate of personal saving and high rate of capital accumulation. However, the table shows contradictory result. Jordan, which has high per capita income has low national saving rate. National saving rate is determined by both private and public saving. National saving = (Y-T+TR-C) + (T-G-TR)

The first part is private saving and second part is public saving. Increase in tax rate increases public saving and reduces private saving. Now, as most of the investment comes from private saving, increase in tax rate reduces disposable income of individual. Therefore, to increase private saving, they reduce their consumption. Fall in consumption reduces aggregate demand, which further leads to fall in output. If this process continues, the economy may enter into recessionary phase. On the other hand, increase in tax rate or reduction in government spending increases public saving, which can be used in infrastructure and other development of the economy. Investment in different sectors of economy requires good infrastructure. Therefore, both the aspects have impact on economic growth (Crespo Cuaresma and Feldkircher 2013).

Expansionary fiscal policy can increase aggregate demand and induces to produce more output. It has both backward and forward linkages. However, consumption and spending depend on the attitude of individual towards spending. As per Global competitive Report 2015-16, Jordan, Ecuador and Mongolia are in stage 2 of economic development, as these economies have GDP per capita between US$3000-8999; where as other five countries are first stage of development. In order to converge with other developed countries, these economies need to increase growth rate. According to Keynesian theory, one way to boost up economy is to increase aggregate demand and raising investment.

Long term prosperity of the country depends on several microeconomic factor, economic environment, infrastructure development, human capital, investment in research and development. Therefore it can be inferred that, the country, which has higher ranking in the ten indicators have good long term growth prospect. Rate of capital accumulation is determined by saving rate and investment rate according to capital accumulation theory (Blonigen and Piger 2014). Based on the given data and raking, it can be assessed that Jordan performs in these respect. As per the intellectual property index, it can be said that Jordan enforces the right effectively and it invest sufficiently in protecting intellectual property rights in innovation. As innovation increases total factor productivity, Jordan has been able to increases productivity of factor. Increase in total factor productivity helps to increase national output. Performance of Burundi and Madagascar is poor in terms of major indices.

Investment prospects can be assessed by burden of government regulation, FDI and technology transfer and nature of competitive advantage. For the three indicators, Jordan ranks at the top among these emerging economies. It indicates, trade policy and domestic government regulation is liberal in Jordan compared to other economies. Tax exemption policy of Jordan government for FDI inflow facilitates the investors to invest more in the country, although suffering from friendly business environment. In order to attract more funds, government has planned to invest in larger infrastructure project. Free trade zone and policy of private public partnership create path of more FDI inflows, which helps in country’s internal capital formation.

If human capital formation is considered, Jordan is progressive compared to other emerging countries listed above. In both primary school enrolment rate and quality management in school, Jordan is at higher rank in comparison to other economies. Improvement in management at school improves quality of education. The ranking table indicates that Jordan government invests more in education than other country do. Investment in knowledge formation can improves perception of people towards life and country’s development. It also helps people to get rid of poverty (Hanushek 2013). When people are educated, they require better job, which increases per capita income and increase standard of living. Consumption level of people increases. Middle-income group in the country is maximum saver. Therefore, increase in income in turn raises marginal propensity to save. Many economists think that investment in term project is prospective for economic development than short-term project.

Investment and Human Capital

Conclusion

From the above analysis, it can be concluded that among the eight countries, Jordan has prospect for long term growth compared to other emerging economies. If this country can improve infrastructure in favour of investment and industrial development, it has possibility to catch up developed economies in long run. Ecuador has good growth prospect. It lacks to attract investment due to stringent government policies and burden of government regulations. If this country can overcome that problem, it can achieve a prospective growth rate. Barundi and Bangladesh are below in the rank. Although Bangladesh has high national saving rate, it may not use saving effectively in capital formation. This may be due to lack of capital mobility within sectors. Other countries, which rank below the list, need to take fiscal and monetary policy in favour of economic growth. Liberal trade policy helps the country to attract more foreign capital, which can be used effectively in economic growth if domestic funds are not available for invest.

References

Bartelsman, E., Haltiwanger, J. and Scarpetta, S., 2013. Cross-country differences in productivity: The role of allocation and selection. The American Economic Review, 103(1), pp.305-334..
Blonigen, B.A. and Piger, J., 2014. Determinants of foreign direct investment. Canadian Journal of Economics/Revue canadienne d'économique, 47(3), pp.775-812.
Campbell, B.A., Coff, R. and Kryscynski, D., 2012. Rethinking sustained competitive advantage from human capital. Academy of Management Review, 37(3), pp.376-395.
Cetorelli, N. and Peretto, P.F., 2012. Credit quantity and credit quality: Bank competition and capital accumulation. Journal of Economic Theory, 147(3), pp.967-998.
Crespo Cuaresma, J. and Feldkircher, M., 2013. Spatial filtering, model uncertainty and the speed of income convergence in Europe. Journal of Applied Econometrics, 28(4), pp.720-741.
Dettori, B., Marrocu, E. and Paci, R., 2012. Total factor productivity, intangible assets and spatial dependence in the European regions. Regional Studies, 46(10), pp.1401-1416
Hanushek, E.A., 2013. Economic growth in developing countries: The role of human capital. Economics of Education Review, 37, pp.204-212.
Iwaisako, T. and Futagami, K., 2013. Patent protection, capital accumulation, and economic growth. Economic Theory, 52(2), pp.631-668.
Jones, C.I., 2015. Pareto and Piketty: The macroeconomics of top income and wealth inequality. The Journal of Economic Perspectives, 29(1), pp.29-46.
Korotayev, A. and Zinkina, J., 2014. On the structure of the present-day convergence. Campus-Wide Information Systems, 31(2/3), pp.139-152.
Ludwig, A., Schelkle, T. and Vogel, E., 2012. Demographic change, human capital and welfare. Review of Economic Dynamics, 15(1), pp.94-107.
Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.
Moosa, I., 2016. Foreign direct investment: theory, evidence and practice. Springer.
Moran, T.H., 2012. Foreign Direct Investment. John Wiley & Sons, Ltd.
Moseley, F., 2012. A critique of the marginal productivity theory of the price of capital. real-world economics review, 59, pp.131-137.
Piketty, T. and Ganser, L.J., 2014. Capital in the twenty-first century.
Robinson, J., 2013. The accumulation of capital. Palgrave Macmillan.
Robinson, J., 2013. The accumulation of capital. Palgrave Macmillan.
Rodrik, D., 2012. Unconditional convergence in manufacturing. The Quarterly Journal of Economics, p.qjs047.
Van Beveren, I., 2012. Total factor productivity estimation: A practical review. Journal of economic surveys, 26(1), pp.98-128

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