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Real convergence of the Czech Republic based on the Solow model of economic growth** Věra Tunkrová* The importance of the economic and social cohesion has been evident since the 1980s not only among EU member states and for this reason, the member states of this integration group started to cooperate in this field. The Czech Republic, as well as some EU member states, has to cope with considerable regional disparities. According to this fact, it is obvious, that the regional policy has had a permanent substantial role and it is one of the most important areas among common interest of the EU member states. Regional policy helps EU member states to increase their economic level. It is clear, that the economic levels of the EU member states differ. The question is: how are poorer countries able to catch up with the advanced level of richer countries and which factors affect them? The main objective of this paper is to confirm or disprove the hypothesis of absolute / conditional convergence of the Czech Republic to the average level of the EU member states according to the Solow model of economic growth. At first, the Solow model and its main assumptions are described. Furthermore, the paper is devoted to the economic level of the EU member states and especially to the real convergence of the Czech Republic to the average level of this integration group. At the end, factors that influence the economic growth of the country will be described, based on the specific conditions of the Czech Republic. JEL Codes: O11, 047 ______________ *Ing. Věra Tunkrová, Department of World Economy, Faculty of International Relations, University of Economics, Prague. Email: [email protected] ** This article was created under the solving the IGA project “Politics of the European Union: plans and changes in the background of the Lisbon Treaty” No. F2/24/2010. 1. Introduction: The importance of the economic and social cohesion has been evident since the 1980s not only among EU member states and for this reason, the member states of this integration group started to cooperate in this field. The Czech Republic, as well as some EU member states, has to cope with considerable regional disparities. According to this fact, it is obvious, that the regional policy has had a permanent substantial role and it is one of the most important areas among common interest of the EU member states. The EU member states are committed to adopt a common currency Euro and it is only a matter of time, before this promise will be fulfilled. The important aspect in this area is the need to achieve a certain level of real convergence to the former and richer member states. It is clear, that the economic levels of the EU member states differ. Regional policy helps EU member states to increase their economic level. The question is: how are poorer countries able to catch up with the advanced level of richer countries and which factors affect them? The main objective of this paper is to confirm or disprove the hypothesis of absolute / conditional convergence of the Czech Republic to the average level of the EU member states according to the Solow model of economic growth. At first, the Solow model and its main assumptions are described. Furthermore, the paper is devoted to the economic level of the EU member states and especially to the real convergence of the Czech Republic to the average level of this integration group. At the end, factors that influence the economic growth of the country will be described, based on the specific conditions of the Czech Republic. 2. Literature Review: This paper deals with the hypotheses of absolute and conditional convergence according to the paper of R. Solow (Solow, 1956) and its application in macroeconomic literature (Soukup, et al., 2007). Several theories of regional development deal with a similar issue. For example the New growth theory (Barro, Sala-i-Martin, 1992). The authors differentiate three types of convergence. The first type is the absolute beta – convergence. This is a situation, when underdeveloped regions grow faster than mature ones. The second type is the so called delta – convergence, when it comes to the decrease of variability between regions (e.g. GDP per capita). The authors follow the neoclassic theory and claim that each economy (and also region) reaches another equilibrium or as they call this the “stable state”. This is defined as the conditional beta – convergence (the third type of convergence). According to the authors, it comes to the convergence rather at a regional level than at an international level. This is caused by similar social, institutional, structural and technological parameters of geographically closed regions. The conditional beta – convergence is the process, when the pace of economic growth (of the whole economy or region) shows a positive correlation with the distance of equilibrium. 3. The Methodology and Model: The starting point of this paper will define the Solow model of economic growth and its main assumptions. Without such characteristics, it would be very difficult to understand the other context. As it was already mentioned in the Introduction of this paper, the economic level of relatively poorer EU member states always converges to the average of all EU member states. We can examine the real convergence, in this sense, through the Solow model of economic growth (Solow, 1956). This model is based on the assumption of a closed economy, in which we consider the existence of only two sectors – households and firms. The basis for the Solow model is the following production function: Y*=A f (C,L), where Y* stands for the potential product, A for the technological progress, C for capital and L for labour. We consider changes in the amount of capital, labour and technological progress for the factors of economic growth. The production factors of capital and labour can be freely changed. Furthermore we consider full employment. We consider the technological progress for an exogenous variable, as its development is independent of the economic cycle, but it also affects the size of the product. The population growth rate is also considered to be an exogenous variable, as it is also not dependent on the development of the economy. “An important conclusion that follows from the Solow model is, the claim of process of gradual convergence of the economic level (that means the product per capita) of the states” (Soukup, et al., 2007). We assume that countries have the same aggregate production function, as they are open economies and the technological progress is available to all. The only thing, which differs with these countries, is their stock of labour and capital. According to the Solow model it’s true, that a relatively poorer country will show higher economic growth, so it will catch up to other countries and all will reach a common stable state and have similar economic growth. We call this fact the hypothesis of the absolute convergence. In practice this hypothesis is not too common, poorer countries often have lower economic growth than wealthier ones. This is explained through the hypothesis of the conditional convergence that argues with exogenous variables. Countries can have different rates of savings, and the assumption of the same stock of labour and capital is also not true. The economic growth of countries is influenced by many other factors that are not accounted for in the production function of this model. 4. The Findings: In this part of the paper, I will consider the exogenous variables (the rate of savings, the rate of population growth and technological progress) as variable. The rate of savings significantly influences the rate of investments and this influences the stock of capital in the economy. I will therefore examine the change of rate of savings, hence the impact of the changes of capital in the economic growth. According to the Solow model, the economy in a stable state shows zero economic growth. “If the economy shows a higher rate of savings, it will show higher investments and then also higher stock of capital and higher rate of product per capita” (Soukup, et al., 2007). If it comes to the increase of savings, it will temporarily increase the economic growth of the country. This increase will only have a temporary character, as the economy will come to a new stable state and the rate of economic growth will again turn back to its original level. Graph No. 1 Relationship between the share of investments and level of product per capita among countries of the EU eastern enlargement 17000 15000 GDP per capita (EUR) 13000 11000 9000 7000 5000 3000 1000 -1000 0 20 40 60 80 Share of investment in GDP (%) Source: EUROSTAT and own calculations. According to this graph, it is clear that in conditions of countries of the EU east enlargement, the claim of the Solow model in regards to the relationship of the rate of savings (rate of investments) and the rate of product per capita was confirmed. I came to the conclusion through the regression analysis of the countries of the EU eastern enlargement, that between these two variables exists a relatively close relationship – GDP per capita in PPP depends on a share of investment of 74.5%. This claim is obvious, as the investments represent a relatively large portion of produced GDP of these countries. According to the economist Petr Sedlacek investments significantly contribute to the shaping of the economic cycle and it is very important to support a healthy investment climate to the economy (Sedlacek, 2006). In graph No. 2 the results are shown from the regression analysis for the rate of savings (investments) and the pace of economic growth among countries of the EU eastern enlargement. In this case, I came to the opposite conclusion that the pace of economic growth depends on the rate of investments in conditions of countries of EU eastern enlargement of 18.7%. According to Petr Kral the middle and eastern region did not belong to significant areas of FDI flows in recent years (Kral, 2004). It is obvious, that I came to the right conclusion for the selected sample of countries. If we considered this relationship for other countries of the world, then the investments (savings) would represent an important factor of economic growth. The conclusion would also be different for the group of advanced economies of the world, where the investments represent the engine of economic growth. Graph No. 2 Relationship between the share of investments and the pace of economic growth among the countries of EU eastern enlargement 5 Pace of economic growth (%) 0 0 20 40 60 80 -5 -10 -15 -20 Share of investment in GDP (%) Source: EUROSTAT and own calculations. Furthermore, I will consider the rate of population growth as an inconsistent variable. If we presume the increase of the rate of population growth and the rate of investments remains unchanged, the average capital – labour stock will decrease. However, the economy reaches a new stable state, with lower capital – labour stock and also lower product per capita. According to the Solow model, we can assume two conclusions – countries with a higher rate of population growth will have a lower product per capita and furthermore, due to population growth, there is growth of capital volume and constant economic growth of the whole product (Soukup, et al., 2007). In graph No. 3, there is the regression analysis of the EU eastern enlargement countries, specifically in relationship to the GDP per capita and the population growth. In case of these specific groups of countries I came to a conclusion that the GDP per capita is quite strongly dependent on the population growth – 76.1%. According to the chosen sample of countries I came to a different conclusion than that of Soukup – with a higher rate of population growth the product per capita also increases. This conclusion of the regression analysis is strongly influenced by higher living standards of Slovenia, Cyprus and Malta. The conclusion would be different, if I were to consider another group of countries. Graph No. 3 Relationship between the population growth and GDP per capita among countries of the EU eastern enlargement 18000 16000 GDP per capita (EUR) 14000 12000 10000 8000 6000 4000 2000 0 -10 -5 0 5 10 Population growth (%) Source: EUROSTAT and own calculations. The last variable according to the Solow model that influences economic growth of the country is the technological progress. Solow differentiates two types of technological progress – a labour expanding technological changes and a neutral technological progress. Generally we can say that the technological progress allows an increase in labour efficiency. The higher the labour efficiency each country shows, the higher the economic growth we can presume. This fact explains to us, why it leads to constant growth of product per capita. From the state perspective it is necessary to invest financial resources for science and research in order to reach the highest degree of technological progress and higher labour efficiency. So in future invested financial resources it will surely cause the multiplier effect and that country will gain a comparative advantage over the other states that will ignore technological changes. 5. Summary and Conclusions The main conclusion of the Solow model is the hypotheses of the absolute and conditional convergence. In this part, I will examine these hypotheses in concrete conditions of the group of the EU eastern enlargement countries. To assess the degree of real convergence of a state, we can use two macroeconomic indicators – GDP per capita in PPP or the comparative price level. I chose the indicator of GDP per capita in PPP for a comparison. In table No. 1 (See Annex), there is a percentage increase of real GDP in the EU-27 countries in 2009. If the hypothesis of the absolute convergence according to the Solow model should have been proven, relatively poorer countries would show higher rates of economic growth than wealthier countries. From this table and graph it is clear, that this hypothesis was not proven. I will support this conclusion with a concrete example of the Czech Republic. In 2009 The Czech Republic is 81% of the average level of EU27 countries and Slovenia is 88% (EUROSTAT). The Czech Republic, as a relatively poorer country should show higher rates of economic growth during this period. According to table No. 1 this is not true. Comparing the table and the graph, we also come to this conclusion in other examples (Slovakia and Poland, Cyprus and Malta). We can not presume that the hypothesis of absolute convergence is always true in conditions of the EU eastern enlargement group of countries. The explanation gives the hypothesis of conditional convergence which accounts for some exogenous factors. There are many approaches how to examine exogenous factors which influence the economic growth of a country. Undoubtedly it depends on the specific conditions of a country and its actual position in the economic cycle. Soukup defines several exogenous factors, included among them the human capital of the country. Not one of the countries disposes of the educational system of the same quality and with this it’s related to the special qualification of labour. These factors influence the production function of the country, which will be the country with quality human capital at a higher level. Furthermore the exogenous factor is the political capital of the country. It is clear, that among these countries there are differences in a political and legislative environment that furthermore influences other areas such as business conditions, foreign direct investments and so on. Economic growth also indirectly depends on the infrastructure of the country. A qualitative road and railway net will be an advantage for trade and services. According to Sohn and Lee the economic growth is largely influenced by trade. They examine the relationship between trade and economic growth and confirm the assumption that a free trade area as an integration that supports economic growth. This fact depends on the region where the integration group is located (Sohn; Lee, 2010). M. Castano examines the influence of socioeconomic factors of the economic growth of a country. She comes to the conclusion that public capital has a negative effect on economic growth, the social capital on the other hand supports economic growth (Castano, 2007). Now it is time to devote to the specific factors that influence the economic growth of the Czech Republic. Firstly I must mention the dependence on the economy of our neighbour – Germany as the bigger export partner. Especially at this time, when the economies are recovering from the financial crisis, it is very important how Germany is dealing with this situation and this will have a significant influence on the economic growth of the Czech Republic. Furthermore a specific factor is the competitiveness of the Czech Republic in the middle and eastern region. It is necessary to support the awareness of the Czech Republic as a qualitative and innovative potential economy. According to the analysis of meeting the Maastricht convergence criteria and the degree of alignment of the Czech Republic and Eurozone the economic growth of the Czech Republic was influenced by the rapid increase of food and energy prices, with an increase of VAT from 5% to 9%. The Czech Republic furthermore introduced ecological tax and medical fees and increased excise tax as well. An important exogenous factor is the increase of petroleum prices (MF CR and CNB, 2010). The Czech Republic has been a part of the European Union since 2004 and not only since this time, it is very important to examine its economic level in comparison to other member states of this integration group. At this time, the Czech Republic has 81% of the economic average level of this group. Only Slovenia and Cyprus show a better economic level from countries of the EU eastern enlargement. I came to the conclusion, that in conditions of the EU eastern enlargement group of countries, the main indicator, which influences the economic growth, is the share of investments (74.5%) and population growth (76.1%). On the other hand, the pace of economic growth that depends on the share of investments is very low (18.7%). References: Barro, R. and Sala-i-Martin, X. 1992. Convergence, The Journal of Political Economy, vol. 100, no. 2. pp. 223-251. Castano, M. S. 2007. The influence of socioeconomic factors on economic growth. International Advances in Economic Research, vol. 13, no. 2. pp. 139-45. Dubská, D. 2007. Porovnání úspěšnosti konvergence deseti nových členských zemí EU [online]. Praha: ČSÚ [cit. 2011-01-04]. Available from WWW: <http://notes2.czso.cz/csu/2007edicniplan.nsf/p/1606-07>. EUROSTAT. 2010. Regional gross domestic product (PPS per inhabitant in % of the EU27 average), by NUTS 2 regions. [cit. 2011-03-22] Available from http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&init=1&plugin=1&languag e=en&pcode=tgs00006. Fifth report on economic, social and territorial cohesion: Investing in Europe’s future [online]. 2010. Belgium: Publications Office of the European Union [cit. 201103-22]. Available from WWW: <http://ec.europa.eu/regional_policy/sources/docoffic/official/reports/cohesion5/index _en.cfm>. ISBN 978-92-79-17800-9. Fondy Evropské unie [online]. 2007 [cit. 2011-03-21]. Strukturální fondy EU Regionální politika EU. Available from WWW: <http://www.strukturalnifondy.cz/Informace-o-fondech-EU/Regionalni-politika-EU>. Jetmar, M. 2003. Druhá zpráva o pokroku v oblasti hospodářské a sociální soudržnosti [online]. Praha [cit. 2011-03-21]. Available from WWW: <http://www.svses.cz/skola/akce/konf/peu03/texty/jetmar.pdf>. Kolektiv autorů MF ČR a ČNB. 2010. Vyhodnocení plnění Maastrichtských konvergenčních kritérií a stupně sladěnosti ČR s eurozónou. [online]. Praha: Ministerstvo financí ČR a ČNB [cit. 2011-01-04]. Dostupné z WWW: https://www.cnb.cz/cs/menova_politika/strategicke_dokumenty/download/maastricht_ vyhodnoceni_2010.pdf Král, P. 2004. PZI a jejich vliv na tempo dlouhodobého růstu v ČR [online]. Praha: ČNB [cit. 2011-01-08]. Dostupné z WWW: < http://www.cnb.cz/cs/verejnost/pro_media/clanky_rozhovory/media_2004/cl_04_0402 19b.html>. Sedláček, P. 2006. Analýza investičního cyklu [online]. Praha: ČSÚ [cit. 2011-01-08]. Available from WWW: <http://panda.hyperlink.cz/cestapdf/pdf06c6/sedlacek.pdf>. Sohn, Ch. and Lee, H. 2010. Trade structure, FTAs, and Economic Growth. Review of Development Economics, vol. 14, no. 3, pp. 683 – 698. Solow, R. M. 1956. A contribution to the Tudory of Economic Growth. Quarterly Journal of Econometric, vol. 70, pp. 65 – 94. Soukup, J., et al. 2007. Makroekonomie: Moderní přístup. Praha: Management Press, 514 p. ISBN 978-80-7261-174-4. UNCTAD. 2010. UNCTADSTAT – Real GDP Growth Rates, total and per capita, Antal, 1970 2009. [cit. 2011-03-22] Available from http://unctadstat.unctad.org/TableViewer/tableView.aspx. Wooldridge, J. M. 2009. Introductory Econometrics. A modern approach. Fourth Edition. Canada: South-Western, a part of Cengage Learning. pp. 21-68. ISBN 13: 978-0-324-78890-7. Appendix Table No. 1 Annual increase of real GDP in the EU-27 countries (%) Annual average growth rates of real gross domestic product – EU 27 PERIOD 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 ECONOMY Austria 3,56 3,32 3,36 0,83 0,86 1,21 2,31 2,04 3,30 3,38 1,80 Belgium 1,68 3,42 3,74 0,79 1,51 0,99 2,97 1,67 2,85 2,71 1,10 Bulgaria 4,01 2,30 5,39 4,07 5,59 5,01 6,64 6,25 6,09 6,17 6,00 Cyprus 5,04 4,85 5,04 3,98 2,10 1,91 4,20 3,95 4,04 4,36 3,70 -0,76 1,34 3,65 2,46 1,90 3,60 4,48 6,37 6,36 5,80 3,50 Denmark 2,16 2,56 3,53 0,70 0,47 0,38 2,13 3,06 3,52 1,82 -1,10 Estonia 4,44 0,31 7,85 7,66 8,02 7,24 8,26 10,15 11,19 7,11 -3,60 Finland 5,19 3,89 5,01 2,64 1,64 1,77 3,73 2,92 5,01 4,40 0,90 France 3,50 3,30 3,91 1,85 1,03 1,09 2,47 1,71 1,99 1,90 0,70 Germany 2,03 2,01 3,21 1,24 0,00 -0,22 1,06 0,78 2,87 2,48 1,30 Greece 3,36 3,42 4,48 4,49 3,90 5,04 4,58 3,83 4,19 4,00 2,90 Hungary 4,86 4,15 5,20 4,07 4,37 4,18 4,81 4,13 3,88 1,33 0,50 Ireland 8,05 10,39 9,37 6,07 6,58 4,46 4,38 6,02 5,74 4,92 -2,30 Italy 1,44 1,93 3,58 1,80 0,34 0,04 1,20 0,09 1,87 1,46 -1,00 Latvia 4,73 3,28 6,91 8,04 6,47 7,20 8,68 10,60 12,24 10,31 -4,60 Lithuania 7,49 -1,47 4,09 6,65 6,92 10,32 7,32 7,94 7,66 8,78 3,20 Luxembourg 6,49 8,42 8,44 2,52 4,10 2,10 4,88 5,02 6,12 5,24 -0,90 Malta 5,13 4,72 5,03 -1,62 2,62 -0,31 0,21 3,29 3,38 3,92 2,30 Netherlands 3,92 4,68 3,94 1,93 0,08 0,34 2,24 1,51 3,01 3,46 2,00 Poland 4,98 4,52 4,25 1,21 1,44 3,87 5,34 3,62 6,13 6,52 4,80 Portugal 4,85 3,84 3,92 2,02 0,76 -0,81 1,52 0,74 1,20 2,22 0,00 Romania -4,82 -1,15 2,15 5,75 5,12 5,22 8,46 4,18 7,86 5,97 7,10 Slovakia 3,69 0,32 0,72 3,23 4,12 4,16 5,42 6,04 8,27 8,70 6,30 Slovenia 3,59 5,33 4,13 3,10 3,66 2,81 4,44 4,15 5,72 6,07 3,50 Spain 4,47 4,75 5,05 3,65 2,70 3,10 3,27 3,62 3,86 3,83 1,20 Sweden 3,81 4,60 4,40 1,06 2,41 1,91 4,13 3,30 4,09 2,58 -0,20 UK 3,35 3,04 3,80 2,37 2,05 2,77 3,26 1,84 2,85 3,12 0,70 Czech Republic Source: UNCTAD Graph No. 1 GDP per capita in PPP in the EU-27 countries Source: Eurostat, 2009