The Convergence Phenomenon

Convergence
1900 US GDP per capita is 3.5 times larger than Japans. 2003 US GDP per capita is only 1.3 times larger than Japanese GDP per capita in PPP terms.

GDP per capita, PPP (constant international 1995 dollars)

1000000

100000 Japan United States

band 80 %

10000

1000
1975 1985 1995 2005 2015 2025 2035 2045 2055 2065 2075 2085 2095

The convergence hypothesis

Nations with low levels of productivity tend to have high productivity growth rates, so that international productivity differences shrink over time. The productivity growth rates of poorer countries tend to be higher than those of rich countries.
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Conditions for convergence

Difference in the levels of productivity (technological leaders and laggards) Positive differential in productivity growth rates in favor of the LDCs Long-run time horizon
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Approximate productivity growth rates with GDP/P growth rates.

Justification

GDP L GDP L

GDP Pop

L GDP Pop L

d log

GDP Pop

d log

L Pop

d log
+ productivity growth rate

GDP L

growth rate = growth rate of hours worked of GDP per per person capita

Approximate productivity growth rates with GDP/P growth rates.

The growth rate of hours worked per person does not change much Example: Real GDP per capita in US has increased about 2% per year while real GDP per hour has increased 2.1% per year hours worked per person decreased approximately 0.1% per year.
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Why interested in convergence in GDP per capita and not GDP?

GDP per capita reflects the standard of living. GDP gives just the size of an economy.

Example: GDP in 2003 in Netherlands and India approximately the same. Population in India is 66 bigger, making India relatively poorer country as compared to Netherlands.
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Why should countries per capita outputs converge?

The neoclassical growth model: If all countries have the same production function, saving and population growth rate Absolute convergence

Why should countries per capita outputs converge?

If there are no barriers to technology and capital flows Absolute Convergence (irrespective of preference parameters)

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Why should countries per capita outputs converge now?

1. 2.

3.

Decline in fertility rates Transfer and dissemination of technologies to LDCs The demise of the Soviet Union

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Decline in fertility rates

A reversal of the population growth rate has been observed since the 70s no population time bomb

d log

( ) = d log ( GDP ) d log ( Pop )

GDP Pop

growth rate = growth rate of GDP of GDP per capita

populations growth rate

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Decline in fertility rates

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Transfer and dissemination of technologies to LDCs

It is much cheaper now for LDCs to adopt/imitate technologies used in advanced countries than in the past The new wave of technologies are characterized by low overhead, low sunk costs, and low capital cost (semiconductors, software, communications)
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The demise of the Soviet Union

A wave of democratization followed the collapse of the Soviet Union Centrally planned economies grew at slower rates than market oriented countries did from 1970 to 1990 After a decade of transition, East European countries are on convergence path with Western countries
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Other contributing factors

4. Urbanization 5. Universal education 6. Decline in transportation costs 7. Decline in communication costs 8. Regional synergies 9. Creation of institutions that would enhance economic freedom, protection of property rights, and democracy
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Testing for absolute convergence

The growth rates of per capita GDP should be negatively correlated to the initial level of GDP per capita, i.e. poor countries with low levels of GDP per capita should have higher growth rates. Estimate this equation:

GDP GDP GDP ln ln = + ln + P 2003 P 1994 P 1994

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Testing for absolute convergence

GDP GDP GDP ln ln = + ln + P 2003 P 1994 P 1994
The LHS is just the cumulative growth rate Negative significant estimate for can be interpreted as an evidence of absolute convergence
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Results
a

s.e. t-value

1994-2003 1975-2003 0.0078 (0.135) [0.06] 0.0206 (0.016) [1.26] -0.1664 (0.392) [-0.42] 0.0629 (0.048) [1.31]
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s.e. t-value

Absolute Convergence (1994 - 2003)

log(GDP/P, 2003) - log(GDP/P, 1994)

1.5

1.0

0.5

0.0

-0.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

10.0 10.5
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log(GDP/P, 1994)

Absolute Convergence (1975-2003)

2.5
log(GDP/P, 2003) - log(GDP/P, 1975)

2.0

1.5

1.0

0.5

0.0

-0.5

-1.0

-1.5 6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5 10.0 10.5 11.0

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log(GDP/P, 1975)

The magic of compounding

Growth rates , like interest rates, compound so that, for example, 100 years of growth at 3% per year leaves the economy more than 300% larger. How much more exactly? 1800%!

GDP2104 = (1 + 0.03) GDP2004 = 19.21GDP2004

100
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Doubling rule
If GDP is growing at g% per year, how long will it take to double? Answer: Approximately 70/g years Example: If US is growing at 2% per year, after 35 years the per capita output will double
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Determining per capita convergence

Country A is growing at ga % / year, country B at gb % / year. Country As GDP/capita is (GDP/P)a, and country Bs GDP/capita (GDP/P)b When will both countries converge, if at all?
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Check the conditions for convergence

1.

2.

3.

(GDP/P)a should be different from (GDP/P)b .Otherwise both countries have converged already Say (GDP/P)a < (GDP/P)b . Then ga > gb .Otherwise no convergence. Find n, numbers of years till convergence
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Solving for convergence

The GDP/capita in n years in both countries will be:

GDPcap GDPcap
A n

A 2004 + n B 2004 + n

= (1 + g ) GDPcap
A n

A 2004 B 2004

= (1 + g ) GDPcap
B n B n

Find n such that:

(1+ g ) GDPcap

A 2004

= (1 + g ) GDPcap

B 2004
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Solving for convergence

Take logarithms on both sides:
A B log GDPcap2004 + n log(1 + g A ) = log GDPcap2004 + n log(1 + g B )

Solve for n:

log GDPcap 2004 log GDPcap n= A B log(1 + g ) log(1 + g )

B

A 2004

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Data
Use Real GDP/capita, i.e. GDP/capita in constant dollars Two options for converting foreign countries GDP/capita in USD: 1. Use the nominal exchange rate 2. Use the PPP exchange rate
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PPP
A theory that states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services.
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PPP
When a country's domestic price level is increasing (a country experiences inflation), that country's exchange rate must be depreciated in order to return to PPP. The basis for PPP is the law of one price
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In our study
If a country is within 60% of US GDP/cap in PPP terms, that country has joined the convergence pack The long-run growth rates in GDP/cap are extrapolated by using the average of the growth rates between 1994 and 2003
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Results
The majority of the LDCs will catch up, or have the potential to catch up within the 21st c. or shortly thereafter Out of 77 countries, 12 have converged, 37 have shown potential to converge, and 28 countries will diverge unless they enhance their performances in the near future
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