Policy distortions, size of government, and growth

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Policy distortions, size of government, and growth, Volume 1

Author:	Easterly, William R.;	Collection Title:	Policy, Planning and Research Department working papers ; no. WPS 344
Date Stored:	2001/04/27	Document Date:	1989/12/31
Document Type:	Policy Research Working Paper	Language:	English
Major Sector:	(Historic)Economic Policy	Report Number:	WPS344
Sub Sectors:	Macro/Non-Trade	SubTopics:	Environmental Economics & Policies; Achieving Shared Growth; Economic Theory & Research; Economic Conditions and Volatility; Economic Growth
Volume No:	1

Summary: This paper analyzes the structural relationship between policies that distort resource allocation and long-term growth. It briefly reviews the Solow model in which steady-state growth depends only on exogenous technological change, but finds it unsatisfactory as a model of long-term growth. The author proposes an increasing-returns model in the spirit of the new literature on economic growth. With increasing returns, endogenous economic variables - and thus policy - will affect the steady-state rate of growth. This model gives output as a linear function of total capital, but a decreasing function of each of two types of capital. The distortion is defined as a policy intervention that increases the cost of using one of the types of capita. The results suggest that simple linear relationships between distortions and growth, or between size of government and growth, are untenable. Easterly's model shows that reducing the distortions does not have an equal effect on growth in all circumstances. The effect depends on how flexible the economy is, how large the share of the factor being penalized in production is, and how high the distortions are initially. Small changes in either very low or very high levels of initial distortions have a minimal effect on growth.


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