This document discusses GDP growth and its measurement. It provides background on GDP, noting it was developed in the 1930s/1940s to help policymakers address the Great Depression and gauge the economy. A literature review is presented on GDP's history and use. The study aims to investigate GDP growth through an OLS regression analysis of 57 countries, examining factors like education, taxes, unemployment, debt, and country status. Preliminary results found unemployment as the only statistically significant variable affecting GDP growth. The document outlines the study methodology and introduces policies on GDP growth to guide recommendations.

1.
ABSTRACT
The purpose of this research is to investigate GDP growth. The methodology used for
this particular study was ordinary least squares analysis (OLS). It is a cross­sectional analysis of
57 countries that are developed and developing nations. The model includes education
expenditure, taxes, unemployment, government debt, and a dummy variable indicating country
status­ developed or developing. The independent variable being investigated throughout is
GDP growth for the year 2009. The model is derived from the neoclassical theory under
economic development, stating that full employment can be reached with technological
advances. It is found that unemployment is the only statistically significant variable in the
model. After finding multicollinearity amongst several variables, separate regressions are run.
With these results, it is still found that unemployment is the only statistically significant variable.
Several policies on GDP growth are presented. Policy recommendations based on the results of
this model are to allow unemployed persons to collect social security early and to help fund
schooling for some skilled workers. In conclusion, it is found that addressing unemployment is
the most effective way of improving economic growth. Creating jobs and job retention are key
components in lowering the unemployment rate. Also, making existing workers more productive
boosts the economy. It is suggested for future research that the same model be utilized but used
for a single country in a time­series data set.
1

2.
CHAPTER I
INTRODUCTION
According to the Council on Foreign Relations’ author Roya Wolverson, when
comparing living standards of various countries it is a common practice to use the gross domestic
product (GDP) of each country
. But, the calculation of GDP does not include factors such as air
1
1
Roya Wolverson, “GDP and Economic Policy,” Council on Foreign Relations,
http://www.cfr.org/economics/gdp­economic­policy/p22922 (accessed February 23,2013).
2

3.
quality, leisure time, or education of these countries. She continues to state that only measuring
goods and services do not reflect the full scope of gains made by capital and labor inputs
. GDP
2
is the measure of all final goods’ and services’ monetary value at a specific period of time. In
order to calculate GDP for a country, economists compare numbers from previous quarters or
years, which then can be used to calculate GDP growth. From quarter to quarter or year to year.
One can analyze the health of a country by seeing the differences of GDP from previous years
and comparing it to rent years. GDP is seemingly one of the most important numbers calculated
due to eh federal government using this as an indicator to create monetary policy and prepare the
budge
.
3
In the United States, measuring GDP became a priority post­World War I due to the Great
Depression occurring and many nations being unable to pay off war debts. The majority of
Americans purchased big items such as cars and home appliances and tried their luck in stocks
.
4
The only issue at the time was people were purchasing these items on credit and sometimes
could not pay the lenders back. With this continuing throughout the 1920s, as more and more
goods were being produced and household debt continued to rise, the economy could not
continue to support and sustain such a system. October 29,1929 marked on the darkest hours in
United States and the world’s history: the start of the Great Depression
. On this day, the stock
5
market crashed and placed the industrial world on its head. The United States was a leading
world trading partner at the time, as it is now, and this catastrophe spread throughout the rest of
2
Ibid, 1.
3
Ibid, 1.
4
American Series, “The Great Depression,” PBS.
http://www.pbs.org/wgbh/americanexperience/features/general­article/dustbowl­great­depr… (accessed February
18,2013).
5
Ibid, 1.
3

4.
the world in no time, lasting from the 1920s until the 1940s
. With the installation of President
6
Roosevelt in 1932, the American people became dependent on government intervention;
moreover, the federal government needed a plan of action that would help them measure the state
of the economy to keep such a calamity from ever happening again
.
7
After Roosevelt won by a landslide, he commissioned Nobel Peace Prize winner Simon
Kuznets to develop a measurement that would evaluate economic activity
. A member of the
8
national Bureau of Economic Research, Professor Kuznets and a small cohort developed a set of
national accounts under the Bureau of Foreign and domestic Commerce’s Division of Economic
Research and presented their findings to Congress in 1937
. Overtime, and with the changing
9
economy, GDP estimates became available monthly and quarterly, which benefited the United
States in World War II. Before WWII, the business cycle was extremely volatile and occurred
more frequently than the post­WWII era, which included better policies and economic
institutions
.
10
In comparison to the economic start of developed country, China’s history is does not
deviate from the path. Before 1979, the Chinese economy operated under a state controlled
market
. In the 1960s and 1970s, the government contributed vastly to physical and human
11
capital. China eventually did away with trade barriers and became an open market as an effect of
6
Ibid, 1.
7
Wolverson, Policy , 2.
8
J. Steven Landefeld, “GDP: One of the Great Inventions of the 20 th
Century,” Bureau of Economic Analysis.
http://www.bea.gov/scb/account_articles/general/0100od/maintext.htm (accessed February 26,2013).
9
Ibid, 1.
10
Ibid, 1.
11
Wayne M. Morrison, “China’s Economic Rise: History, Trends, Challenges, and Implications for the United
States,” Congressional Research Service. http://www.fas.org/sgp/crs/row/RL33534.pdf (accessed
March 20,2013).
4

5.
Foreign Direct Investment
.
12
Wolverson affirms the importance of GDP with this statement:
Since its creation, GDP has been credited by economists with improving the
ability of policymakers, economists, and businesses to analyze the impact of
various tax and spending policies and the impact of monetary policy on the
economy.
13
Around the 1940s, the use of the GDP measure spread throughout the world. The World Bank
and International Monetary Fund were then created due to this global extension
. These
14
institutions assist in funding international projects. In theory, growth in GDP of a country
indicates that the citizens are being benefited, but this is not necessarily true. From the 1950s
until the 1980s, GDP came to be interpreted as the totality of a nation’s wealth, which is also
beyond the truth. According to Elizabeth Dickinson, in the 1950s, Moses Abramovitz is the first
person to speak out about the faults that GDP carries and whether or not it is a viable source for
measuring the overall state of the economy
. One of the most important economic theories to
15
arise from this time period was Okun’s Law. Created By Arthur Okun, the law states that for
every 3­point rise in GDP, unemployment will fall by 1 percentage point.
Prior to the 1700s, economic output was solely based on population size: the bigger the
population, the more output a country could produce. Following the Industrial Revolution that
spread around the world, starting in Britain, population size mattered nothing because machines
12
Ibid, 2.
13
Wolverson, Policy , 2.
14
Ibid, 2.
15
Elizabeth Dickinson, “GDP: A brief history,” ForeignPolicy.com.
http://www.foreginpolicy.com/articles/2011/01/02/gdp_a_brief_history (accessed March 3, 2013)
5

6.
could produce twice as much in a shorter amount of time than human labor. As the decades
rolled on, new advances in technology and human capital occurred, which directly affected GDP
and the way it came to be measured.
The International Human Dimensions Programme on Global Environmental Change
(IHDP) created the Inclusive Wealth Report , which measures the stock within a country rather
than the outflow
. The Organisation for Economic Cooperation and Development (OECD)
16
stated that the United States spends more than twice the average on healthcare than the average
OECD country but still is not a global competitor in that aspect
. Another hindrance of GDP is
17
its inability to measure the income disparity in a nation. Although the poor could be getting
poorer in a country, GDP would only account for the overall growth shown
. This income
18
inequality can lead to decreased human productivity. Because of the shortcomings in the
calculation of GDP, Heukelom states that measures such as the Human Development Index have
been established to make up for what present calculations lack
. Some economists argue that
19
the total measure of GDP should be replaced while other economists argue that it only needs to
be tweaked to include additional indicators for policy makers
. Among these could include
20
investments in human capital, which leads to this study.
The purpose of this thesis is to investigate GDP growth in a selected group of countries.
This is done by using percent of GDP spent on tertiary education tax rates, unemployment, and
government debt as the explanatory variables. The research is a cross­sectional analysis of 57
16
Floris Heukelom, ”Inclusive Wealth and History of GDP,” Institute for New Economic Thinking.
http://ineteconomics.org/blog/playground/inclusive­wealth­and­history­gdp (accessed March 5, 2013)
17
Wolverson, Policy , 2.
18
Ibid, 2.
19
Heukelom, Inclusive Wealth , 1.
20
Ibid, 1.
6

7.
countries, including advanced and developing countries for the time period 2008 to 2009. The
functional model is:
GDP = f(EDUexp, TAX, UE, GOVDe)
where:
GDP= gross domestic product
EDUexp= percent of GDP spent on education
TAX= tax rates
UE= unemployment
GOVDe= government debt.
The regression model derived from the above equation is:
GDP growth= B 0 + B 1 (EDUexp) B 2 (TAX) + B 3 (UE) + B 4 (GOVDe) B 5 (DEV) + u
where:
GDP growth= annual percentage growth rate of GDP at market prices based on constant
local currency, 2009
EDUexp= total public expenditure per student on tertiary education as a percentage of
GDP per capita, 2009
TAX= the amount of taxes and mandatory contributions payable by businesses after
7

8.
accounting for allowable deductions and exemptions as a share of commercial profits,
2009
UE= the share of the labor force that is without work but available for and seeking
employment, 2009
GOVDe= entire stock of direct government fixed­term contractual obligations to others
outstanding on a particular date, 2009
DEV= dummy variable for a developed nation, 1, or a developing nation, 0.
U= error term, which is assumed to be zero
B 0 = constant term
B 1­5 = coefficient values for their corresponding independent variable.
The expected relationship between education expenditure and GDP growth is positive. Tax rates
and GDP growth are expected to have a positive relationship while unemployment and GDP
growth are expected to display a negative relationship. Government debt is also expected to
have a negative relationship with GDP growth. For the dummy variable, it is expected that a
developed country will have a positive relationship with GDP growth and vice versa for a
developing nation.
This thesis consists of seven chapters. Chapter I, Introduction , contains background
information, expected relationships of the independent variables and the dependent variable, and
explains the purpose of the research. Chapter II, Literature Review , is a review of the literature
8

9.
on GDP growth. Chapter III, Theoretical Framework , presents the underlying economic theories
and explains the econometric model used in the research. Chapter IV, Methodology and Sources
of Data , discusses the methodology and identifies the sources of data. In Chapter V, Empirical
Results , the regression results are presented and analyzed. Chapter VI, Policy Recommendations
and Implications , discusses current policies in place and makes recommendations for new
policies. The last chapter is Chapter VII, Summary and Conclusions . This concludes the
findings in the thesis as well as makes future research suggestions.
9

10.
CHAPTER II
LITERATURE REVIEW
In preparation of this thesis, several scholarly articles, majority Economics journals with
a few coming from other fields, were reviewed on the topic of GDP growth. Most of the articles
contained information on the relationship between economic growth and social welfare. There
were some that spoke to social welfare contributing to economic growth, while some spoke to
economic growth improving social welfare. Two of the articles include information on education
expenditure and the effects it has on GDP growth, which is the basis of this study. Of course
these are only a small part of the numerous journals dealing with GDP growth.
Mazumdar proposes that many developing nations saw a push to increase human capital
and overall welfare of their citizens; moreover, economic growth is not an indicator that the
population is in a state of “economic happiness”
. The issue with policy makers is their
21
indecisive actions as to whether to promote human capital growth or to strictly pay attention to
economic growth as a whole. There are four different views on the relationship of social
development and economic growth: “economic growth and social development are unrelated,
social development and economic development are inter­dependent, social development is a
product of economic growth, and economic growth is a product of social development” . The
22
21
Krishna Mazumdar, “Causal Flow Between Human Well­Being and Per Capita Real Gross Domestic Product,”
Social Indicators Research , 50 (2000), 297.
22
Ibid,297.
10

11.
first argument states that economic growth can occur with or without social promotion. The
second dispute is that they are inter­dependent upon each other. There must be a balance of how
much emphasis is placed on social welfare programs. Development policies are in favor of the
third option stating that through economic programs, human welfare will expand; furthermore,
this idea implies that not only will economic growth be determined by output but also by
distribution of income and quality of life, to name two. The fourth argument is in favor of better
schools and cleaner environments, of which will promote economic growth. The paper attempts
to pinpoint the causal relationship between economic growth and social welfare
.
23
Mazumdar includes information for low income, middle income, and high­income groups
in the model. She uses life expectancy, quantitative expectation of someone’s durability, infant
survival rate, number out of 1000 babies that die before their first birthday, and adult literacy
rate, percentage of the educated population above 15 years old. The researcher then repeated
these measurement three times
. The years 1960,1970,1980, and 1990 were used and collected
24
from World Tables and World Development Reports. Mazumdar then groups high­income
countries, such as Australia and Italy, middle­income countries, such as Colombia and Congo,
and low­income countries, such as Ghana and Sudan. Her model includes a lagged dependent
variable to observe the causal relationship. For the high income group, it is shown that there is
no causal relationship between human well­being and per capital real GDP; however, human
well­being is a factor in determining per capita real GDP in middle and low income countries.
Life expectancy and infant survival also have an effect on PCCRGDP, while adult literacy does
23
Ibid,299.
24
Ibid. 302.
11

12.
not.
In conclusion, Mazumdar finds that the relationship of human well­being and economic
growth varies depending on the level of income
; moreover, depending which indicator of
25
human welfare, like life expectancy, also contributes to the causal relationship. Future studies
could possibly be conducted and add other factors of social welfare, such as air quality and
education level.
Researchers Islam and Clarke purpose for this paper is to see the positive benefits
contributed by welfare economics to development economics through cost­benefit analysis
(CBA)
. They start their study by introducing the idea that economists and social scientists alike
26
have similar desires in wanting to find a quantitative way to measure social welfare in relation to
economic and social mediations. Because there is no current ability to accurately make such a
calculation, GDP is the method used
. The researchers point out the various setbacks that can
27
make such a practice difficult to carry out such as finding a feasible solution to summing social
welfare and can welfare among various individuals of different countries be compared. Due to
GDP being a widely understood measurement and it being an easy number to compare amongst
countries, it is the more common practice in measuring social welfare. The simple logic
formulated is that if GDP is growing then so must the welfare of the nation
.
28
Islam and Clarke note that within economics lie several subcategories of the subject;
moreover, they indicate that their research falls under welfare economics and the tools used to
25
Ibid, 307.
26
Sardar M. N. Islam and Matthew Clarke, “The Relationship Between Economic Development and Social Welfare:
A New Adjusted GDP Measure of Welfare,” Social Indicators Research , 57 (2002)..
27
Ibid, 203
28
Ibid,207.
12

13.
contribute to development economics, which solely looks at economic growth because when
GDP rises, welfare gets better. With a cost­benefit analysis adjusted GDP, more realistic and
effective policies can be created; furthermore, by developing a social welfare function (SWF),
states can be ranked, which in turn leads to effective policy formation
.
29
Islam and Clarke compose a partially developed model based on “welfare economic
analysis of social benefit comparisons of dynamic changes and growth in the Thai economy” for
the years 1980 to 1990
. The importance of the model created in this research is that it adds
30
socio­economic costs into national income accounting, which is done by using cost benefit
analysis. The model that was used is based on a previous study’s model:
NSW= f (GDP­CL) + (B­ GC) – AL
where NSW is net social welfare, GDP is gross domestic product, CL is capital equipment
destroyed, B is benefits of economic growth, GC is costs of economic growth, and AL is the loss
in natural resources
. The costs and benefits have not been previously studied in development
31
economics. With the added cost benefit analysis, Islam and Clarke came up with the following
model:
SWF t = W t (DNB t )
where W t is welfare, DNB t is discounted net benefits, and SWF is social welfare
. The SWF
32
model is then divided into costs and benefits. The researchers also claim that cost benefit
29
Ibid,209 .
30
Ibid,213 .
31
Ibid,213 .
32
Ibid, 214.
13

14.
adjusted GDP is a far better measurement of social welfare than GDP that is unadjusted
.
33
Personal income, household production, and expenditure on education are three of several
benefits that Islam and Clarke include. The costs contain commuting, private health care
expenditure, and car accidents, to name a few. Clarke and Islam indicate that the recent increase
in sex tourism have led to a rise in costs of healthcare due to the contraction of STDs.
In the results, Islam and Clarke found that the adjusted GDP grew only 20% during
1980­1990, which is a shock due to unadjusted GDP growing at about 50% during the time
frame. They also found that the adjusted GDP decreased when there periods of economic growth
occurring
. Because the adjusted GDP is seen as “welfare”, the results show that GDP was
34
increasing during 1980­88 but welfare was decreasing.
In conclusion, Islam and Clarke found that using the measurement of GDP equally for
welfare economics as it is used in development economics will continue to weaken the welfare,
specifically those living in third world countries
. Although the cost benefit adjusted GDP does
35
not completely alleviate the problems of using GDP as a welfare measure, it does speak to the
faults of GDP. They also found that the CBAGDP is a widely accepted new measure because it
takes into accounts both the costs and benefits of economic growth
.
36
Baldwin and Borrelli provide a sub­national study on education and income growth using
various educational measures
; furthermore, this paper investigates educational spending and
37
how it affects economic growth both directly and indirectly. They entertain the idea that many
33
Ibid, 216.
34
Ibid,217.
35
Ibid,220.
36
Ibid, 220.
37
Ibid, 220.
14

15.
policymakers have made valiant efforts to approach economic growth from another perspective
other than an income measure. The major studies have revolved around the improvement of
human capital through better education
. The researchers note that some of the previous
38
literature on the subject lacks the acknowledgment of similar research and the importance of
comparing similar literature. Along with this fault, Baldwin and Borrelli realize the lack of
consensus on the measure of how education affects economic growth; many of the measurements
for education involve only costs but cannot measure the overall quality contributed
. The
39
researchers determine that using human capital in terms of their place in the policy chain will be
a better fit of measurement. They believe that with educational policy, there are inputs,
throughputs, outputs, and outcomes. Graduation would be an outcome and test scores would be
an outcome. An input would be the teacher­to­pupil ratio.
Borrelli and Baldwin constructed a model by using returns to investment in education
from economic growth
. They use a cross­sectional regression for 48 of the 50 states, and the
40
data sources used was the Bureau of economic Analysis to collect 18 years of data. Per capita
effects are placed on educational expenditure, highway disbursements, and savings
. The
41
researchers start with measuring public investment in education, which includes spending on
primary and secondary education. The idea is that it takes the amount of schooling, K­12, to
actually apply the effects of economic growth produced from that specific generation. Next, the
researchers find a measure for human capital using higher education per capita spending
. The
42
38
Norman Baldwin and Stephen A. Borrelli, “Education and Economic Growth in the United States: Cross­National
Applications for an Intra­National Path Analysis,” Policy Sciences , 41 (2008).
39
Ibid, 184.
40
Ibid, 186.
41
Ibid,187.
42
Ibid, 190.
15

16.
time frame for this research is 1980s­early 2000s. Baldwin and Borrelli collect data for citizens
25 and older and analyze it to see who had high school diplomas or equivalent and who held at
least a Bachelor’s degree; the last measure for this paper is the teacher­to­pupil ratio. The
researchers gather other data for the study from the Digest of Education Statistics and the US
Department of Transportation. They then divide the aggregate level data for spending, savings,
and the dependent variables to produce the per capita state level measurements
. Lastly, the
43
researchers develop a multiple regression model for the direct and indirect effects of growth in
income.
Baldwin and Borrelli use per capita income as the dependent variable of the research.
Between the years 1988 and 2005, the researchers find a high correlation between higher
education and growth in per capita income, and this also occurs for highway spending
. The
44
K­12 expenditures and the student­teacher ratio show a significant negative correlation with
growth. Surprisingly, Baldwin and Borrelli assess that college attainment holds a negative
relationship with income growth while high school attainment had a positive relationship. The
study shows that per capita income grew when higher education and highway expenditures
increased
.
45
In conclusion, Baldwin and Borrelli use the independent variables higher education,
highway expenditures, and student­teacher ratios to determine per capita income growth. The
researchers strongly suggest controlling for taxation, as this greatly affects the coefficients of the
variables used. They do not recommend taking away taxes completely but to add it as a separate
43
Ibid, 195.
44
Ibid, 196.
45
Ibid, 198.
16

17.
variable to see directly how it affects economic growth. They also note that, expenditure on
education and how it affects economic growth has and will always be the topic of discussion of
policymakers and scholars alike
. Baldwin and Borrelli find that reducing the pupil­teacher
46
ratio in K­12 schools will greatly increase per capita income. With growing education costs and
burdens rising for families, it is important to continue this particular area of economics.
Economist Al­Yousif establishes that there has been a rise in American income due to the
growth in human capital. The topic of education and its impacts on economic growth has
become a widely discussed issue
. The researcher follows the economic growth of the Gulf
47
Cooperation Council (GCC) countries, which were established in the 1980s to promote
coordination between the member countries to reach unity, from 1977 until 2004 and identified
the role that human capital played during these years
. He finds that there are several ways to
48
relate growth to human capital. Yousif notes that one can add human capital as a variable in the
production function and states “that by increasing savings and investing part of it in education, a
society can increase its rate of economic growth.”
Also, he states that human capital can lead to
49
economies of scale and its disequilibrium; therein, human capital hurries production and causes a
change in resources
. His other observation is that educated workers also have the tendency to
50
affect others . Furthermore, Yousif proclaims that “human capital can also induce economic
growth through its effect on the expansion of research and development” and continues saying
that it promotes innovation
. He shows that countries can witness a significant amount of
51
46
Ibid, 199.
47
Yousif Khalifa Al­Yousif, “Education Expenditure and Economic Growth: Some Empirical Evidence from the
GCC Countries,” The Journal of Developing Areas , 42 (2008).
48
Ibid, 69.
49
Ibid, 70.
50
Ibid, 70.
51
Ibid,71 .
17

18.
growth if, for instance, extra income earned were spent promoting human growth through
education rather than on recreational items. The researcher points out countries some 30 years
ago that showed noteworthy economic growth but poor human growth due to misallocation of
resources. Moving to the empirical side of the subject, the researcher found that shows growth
and contains comparisons of human capital to real GDP change
. Yousif addresses one study
52
that exhibited that GDP grew .3% for every additional year of school while another study
reviewed was not significant at all. Subsequently, the researcher finds that people who are
currently enrolled in school show reduced costs and increased benefits for future schooling
.
53
Using previous studies as guides, Yousif sees that correlation between human capital and
economic growth has been shown although not necessarily having causality between the two.
Another weak point lies in previous research using a different production function that includes
human capital as an independent variable to economic growth
. With this function, the
54
researcher implies that causality goes from education to economic growth; however, there are
stronger arguments that give reason to believe that causality actually circuits from economic
growth to education
. The issue with using cross­sectional data for this relationship is that it
55
only captures a single point in time; whereas, time­series data gives a broader scope of change
over time, which is what the methodology is for Yousif’s research.
Yousif proceeds by gathering information from 1977­2004 for the 6 GCC countries,
which are the Gulf oil­exporting countries, in a time­series analysis to see if returns to education
52
Ibid, 71.
53
Ibid, 71.
54
Ibid, 71.
55
Ibid, 73.
18

19.
increased human capital thereby increasing GDP
. He then uses a Granger­causality test within
56
an error­correcting model (ECM). By having stationary variables, the tests will not produce
senseless data. The model the researcher utilized for this research is:
deltaY 1 = (sigma – 1)y 1­t + E 1.
If the above model comes out higher than one, the following differentiated model should be
adhered to:
deltaY 1 = u + BetaT + (theta ­1)y 1 + Sigma beta 1 deltaY t­i + E i .
Economic growth is the growth rate of real GDP per capita, which is denoted by G; also,
expenditure on education per worker as well as the government to education expenditure ratio is
used as human capital variables, denoted H1 and H2
. After running the tests for the three
57
variables, Yousif achieved stationary levels after the augmented model was used. Regardless of
H1 or H2, his results both showed co­integration in five countries with economic growth
. As
58
far as the Granger­causality tests, Saudi Arabia shows no significant causality when using
education expenditure in the short­run. The researcher finds that in the long run there is some
causality of human capital to economic growth
; his results are just the opposite for Kuwait.
59
In conclusion, Yousif’s find that the results of this research are very country specific.
Each of the six GCC countries from 1977­2004 showed varying causalities between human
capital and GDP growth. As a result of these findings, the author suggests further studies that
56
Ibid, 76.
57
Ibid, 76.
58
Ibid, 77.
59
Ibid, 78.
19

20.
would include countries of the same socio­economic standing for clarification
.
60
Kehoe’s and Ruhl’s purpose for constructing this paper is to find the reasons behind
Mexico’s failed reforms in terms of seeing no economic growth although China made
tremendous gains economically. The researchers then present information on the Mexican
economy and its recessionary like crisis in the 1980s. They assess that because of the issues the
country faced, the Mexican government created the North American Free Trade Agreement in
1994
. The researchers recount the changes made by the government and determined they were
61
fiscal policy reform and changing the economy into an open economy. Although these various
changes have been made, the Mexican economy has seen very little economic growth since the
1980s. In 1995, Mexico was number two on the list of largest merchandise traders
. The
62
authors pinpoint reforms that helped develop Mexico into a world­trading partner
. Due to
63
tremendous increases in trade and foreign investment, they state that Mexico became more open.
It is noteworthy that trade levels in Mexico could be compared to that of China; however, still,
the researchers comment that economic growth lagged. Chinese real GDP per working age
individual grew at an astounding 510% from 1985­2008 while Mexico only grew a mere 10%
.
64
As of 2008, Kehoe and Ruhl log that Mexico ranks seventh on the largest foreign direct
investment (FDI) list globally. Their goal is to find the factor/s that contributes the most to
growth in China while economic growth in Mexico remains relatively stagnant. The researchers’
60
Ibid, 78.
61
Timothy J. Kehoe and Kim J. Ruhl, “Why Have Economic Reforms in Mexico Not Generated Growth?” Journal
of Economic Literature 48 (2010). http://jstor.org/stable/29779708 (accessed February 12, 2013).
62
Ibid, 1005.
63
Ibid, 1005.
64
Ibid, 1006.
20

21.
model includes a measure of the import price bias that occurs when changes in varieties happen
65
. The authors also use 164 goods to survey the level of importation for Mexico and China.
Kehoe and Ruhl noted growth in China for real income per capita was 8.33% compared to 8.99%
growth in the real GDP. Shockingly, the authors found Mexico’s real GDP was only 1.7% and
real income per capita was only 2%. To assess why Mexico remained stagnate for the designated
time period, the researchers utilize an augmented Cobb­Douglas production function, which is
Y/N = A 1/ (1­a)
(K/Y) a/(1­a)
(L/N). Kehoe and Ruhl realized when A grows constantly, the
capital­output ratio and the labor ratio remain constant as well
. Some of their data concludes
66
that total factor production (TFP) growth was low which lead to real GDP being low. They state
that although GDP per person grew at about 3% from 1995­2000, overall Mexico only saw a
1.7% increase. Kehoe and Ruhl also found that capital was not an important factor rather
productivity influenced economic growth the most.
In conclusion, Kehoe and Ruhl determine a possible reason for China’s rapid growth and
not Mexico’s is that Mexico has one primary trading partner, the US. The authors then imply
that Mexican and American manufacturing are complements; whereas, Chinese manufacturing
could be a substitute for the two. The authors see it is much easier for an economy to grow that
is already behind versus an economy that is already established with constant growth rates, the
researchers proclaim. At some future point, the researchers state China’s economic growth will
cease as in every other developed nation. Kehoe and Ruhl determine that because of the US
contraction period of manufacturing, Mexico has received the trickling down of its effects and
65
Ibid, 1007.
66
Ibid, 1012.
21

22.
has seen little growth since 2000
. They suggest it is important for Mexico to construct a more
67
efficient financial system and better policies to revive their economic growth.
Chen’s purpose is to display the impact of migration on economic growth through the use
of human capital
. He contributes to the literature on economic growth with his ideas of
68
emigration. An upside to migration, the author notes, would be the integration of highly trained
and skilled workers into the market. This paper takes into account three things that previous
research on the subject has not: fertility and education, stochastic model, and private versus
public school expenditure. Chen reviewed previous studies which assumed population to be
constant when in reality procreation never ceases. The researcher also suggests that the type of
education, private or public, matters in the accumulation of human capital
. His research shows
69
that high­skilled parents would rather have fewer children and spend more on private education;
moreover, under public education, high skilled parents would prefer to have fewer children in
that they would spend less time rearing children and more time in the market making money. In
the long run, the researcher finds that having a surge in emigration would only temporarily
increase economic growth and will damage it in the future
. Fertility is more sensitive in the
70
decision to migrate when education is not free.
Chen develops a model for this paper based on “an infinite­horizon, discrete­time,
overlapping­generations model”
. For every time period, he breaks the population into
71
childhood and adulthood. Real wage for the foreign country exceeding the real wage in the
67
Ibid,1011 .
68
Hung­Ju Chen, “International Migration and Economic Growth: A Source Country Perspective,” Journal of
Population Economics, 19 (2006).
69
Ibid, 726.
70
Ibid, 727.
71
Ibid, 727.
22

23.
home country is what the researcher believes is the motivation behind migration. Public
education is provided by government funding from tax revenues; whereas, he defines private
education as a privately funded expenditure. Under this condition, Chen determines fertility will
naturally be higher with free education
. In the first section of his research, all people are
72
considered homogeneous with the same chance of migration. However, it is well­known that
everyone does not have equal opportunities when it comes to relocation, the author affirms. A
source country is more willing to accept advanced workers than low skilled workers due to the
potential output level. For the heterogeneous model, the researcher makes the assumption of two
classes of workers: low human capital and high human capital workers
.
73
Chen’s model results show different possibilities in terms of migration: high probabilities
of migration for high and low skilled workers, high probability for high skilled workers and low
probability for low skilled workers to migrate, and low probabilities for high and low skilled
workers
. For his first observation, public education correlates to high fertility rates, and per
74
capita income is shorter in the short run. However, he sees that the long run produces an increase
in per capita income under the public education system. Chen also notices that there will be a
“brain gain” in the short run and a “brain drain” in the long run due to high skilled workers
fertility rates decreasing
. For the Chen’s second situation, the results show that fertility will
75
increase 35% while per capita income decreases 13% under the private education system. The
author’s results show public education will see a 34% rise in fertility and a 9% decrease in per
72
Ibid, 727.
73
Ibid, 727.
74
Ibid, 727.
75
Ibid, 728.
23

24.
capita income
. In the last case presented, fertility and income are more volatile for private
76
education than that of public education. Fertility increase 1% while income decreases by .4% for
private education
. For public education, fertility rises 1% and income lowers .275%.
77
Presented in the conclusion, Chen proposed a paper based on a stochastic model to study
migration and its effects on economic growth. He also affirms adults migrated based on fertility
and education options
. Parents make the trade­off between having more kids or fewer kids
78
with higher human capital. This then affects the economic growth in both the short run and long
run. One of the policy recommendations the author presented was to restrict emigration to a
source country for highly trained workers. Also, Chen found that migration is more sensitive
when dealing with a private education system versus a public education
.
79
Due to the current slowdown and increasing unemployment, the talk of strengthening
fiscal policy has become a popular topic according to researchers Pelagidis and Desli. The
authors state that in terms of the real business cycle, creating fiscal policy solely for increasing
growth rates and reducing unemployment would not be a viable solution
. They also assert that
80
higher growth rates are needed to escape the current stagnation but question whether stronger
fiscal policy would mesh with loose monetary policy
. On the other hand, they pose the
81
question: will monetary policy be strong enough to go solo in combatting the slowdown?
Furthermore, Pelagidis and Desli realize having budget deficits would in turn increase the
76
Ibid, 728.
77
Ibid,730.
78
Ibid, 731.
79
Ibid, 742.
80
Theodore Pelagidis and Evangelia Desli, “Deficits, Growth, and the Current Slowdown: What Role for Fiscal
Policy?” Journal of Post Keynesian Economics , 26 (2004)..
81
Ibid, 461
24

25.
public’s debt and affect interest rates
. If fiscal policy is negligent now, the authors say whoever
82
is in the market would tend to save more due to a future increase in tax rates. Another
observation they make is that high unemployment rates cause trade negotiations for a region, in
this case the European Union, to be relatively weak. The authors go on to state that inflation in
developed countries tends to stay under control; whereas deflation in these countries tend not to
be
.
83
Pelagidis and Desli note both monetary and fiscal policies have the capacity to alleviate a
slowdown in an economy. They assess that devaluing the exchange rate as well as expanding
credit under stricter fiscal policy can soften the blow of a recession
. As the authors state, if an
84
economy is in a deflationary period, monetary policy cannot be the sole factor in stabilization
because many will not jump at low interest rates for investments. It would then be the
government’s responsibility to increase demand in the market by using discretionary fiscal
policy. The authors use Bruce Kasmon’s analysis of the Fed’s macroeconomic model, which
found that a reduction in federal funds rate only increased GDP by .6%
. These results indicate
85
that monetary policy cannot stand alone. Crowding out happens when there is fully employment
in an economy. In a recent issue of the Journal of Post Keynesian Economics, an author states
that I , investment, is the main variable in public spending and getting an economy out of
stagnation
. Demand increases when exports are greater than imports or if investments are
86
greater than savings.
82
Ibid, 462.
83
Ibid, 462.
84
Ibid, 463.
85
Ibid, 463.
86
Ibid, 464.
25

26.
Pelagidis and Desli state that when there are budget deficits the possibility of potential
profits in the market are reassured. For a continued growth, the expenditure must be higher than
taxes; thus, the authors’ model should be applied:
I + X + G > S + M + T
where I is investment, X is exports, G is government expenditure, S is savings, M is imports, and
T is taxation. The authors suggest for future research the examination of the relationship
between budget deficits and the impact on business profits
. For countries like Germany and
87
France, their data showed that after surpluses changed to deficits, profits displayed bending back,
which is a flow of business profits. Their data on Portugal’s profits showed a tremendous
decrease in the face of increasing budget deficits
. The researchers assert there is no need to
88
induce causation into the equation due to other factors in the market that affect business profits.
The decision to finance a budget deficit lies in printing new money or selling bonds to the public.
Their review of previous literature promotes the idea of creating new money versus the
bond­financed stabilization plan
. Real interest must be below economic growth rates for the
89
bond decision to work effectively.
To conclude, Pelagidis and Desli found that hesitating to run budget deficits can cause a
decrease in the growth rates
. The majority view budget deficits as a crisis that will increase
90
interest rates and cause harm to economic growth. In opposition of that, they assess that failure
to act in such a situation could have worse effects. The growth and stability pact that is present
87
Ibid, 464.
88
Ibid, 467.
89
Ibid, 468.
90
Ibid, 468.
26

27.
in the EU has some negative effects on growth
.
91
Lago and Lopez estimate Cuban GDP using physical indicators due to lacking data
produced by the Cuban government throughout the years
. They share with the economics
92
world the difficulty in measuring economic performance in Cuba because of the lack of data
present. In the 1960s, the authors present the Cuban government’s decision to switch to central
planning in order to pursue a socialist society
. The Cuban peso has not been freely traded in
93
the world economy making it impossible to convert to another monetary system for comparisons
to be made. The researchers state that data collection has improved over the years although the
Cuban government provides very minimal data. The dependent variable of their research is
Cuban GDP per capita in dollars. The authors utilized several reference countries used, like
Haiti and the Dominican Republic, to estimate Cuban GDP using exchange rates for the year
1970. The independent variables, or the physical indicators, for their study must meet the
following criteria: non­monetary, highly correlated with GDP, available for all the countries, and
comparable
. They must also relate to education, consumption, public health, and other factors.
94
Lago and Lopez include 24 of the original physical indicators due to lack of information
across the board. International organizations were the primary sources of data they used due to
the nature of comparing countries and the need to keep definitions and criteria consistent. They
use data from FAO Production Yearbook, UNESCO, Demographic Yearbook, and Statistical
Yearbook. The data has some setbacks in that the consumption is only “relative” and not actual,
91
Ibid, 468.
92
Carmelo Mesa­Lago and Jorge Perez­Lopez, “Estimating Cuban Gross Domestic Product Per Capita in Dollars
Using Physical Indicators,” Social Indicators Research , 16 (1985). .
93
Ibid,275.
94
Ibid, 276.
27

28.
which could have an effect on the data. For some of the data, production numbers were used
instead of the consumption numbers. Lago and Lopez list 28 reference countries’ is primarily
made of Latin American countries because of the similarities in economic systems. Also stated
within the paper, the researchers indicate that when numbers for one country seem stable and
consistent for a given time period, it is easy to estimate values for a similar country; therefore,
when using a country such as Venezuela, Cuban data can be calculated based off the former’s
information
. The authors then conduct two different studies: univariate and multivariate, which
95
they find to be consistent in the results. Their results show that from 1965­70, the Cuban
economy showed some expansion as well as from 1970­75. In the former, growth was about
0.9%, and in the latter growth was about 2.9%.
In conclusion, Lago and Lopez sought to make an estimate of Cuba’s GDP by using
lacking data. Univariate and multivariate experiments helped them to calculate the growth rates
seen from 1965­77. Within the univariate approach, the researchers produced ten forms of an
equation of which the double logarithmic form, lny = a +b (lnx), showed the more variation for
GDP in the reference countries
. Their data suggests that some of the results could be called
96
into question due to the insufficient information provided by the Cuban government. It is
difficult for developing countries to use the physical indicators method for proper measurement.
Shocks like disproportionate national product could also affect consumption. Lago and Lopez
suggest further investigation of the resourcefulness of physical indicators should be conducted.
The literature displays some consensus within the results and shows various findings
95
Ibid, 278.
96
Ibid.
28

29.
about GDP growth. Both Baldwin and Borrelli (2008) and Yousif (2008) extend their
contribution to the literature with articles referencing the relationship between education
expenditure and economic growth. The two sets of researchers agreed that education plays a
tremendous roll in economic growth. Baldwin and Borrelli find that using several countries to
develop one model did not work as efficiently as using one country over many years, such as
Yousif’s work on the United States. Mazumdar (2000) and Islam and Clarke (2002) find that
GDP was not a strong indicator of social welfare. They conquered on the point that when using
GDP as a social welfare indicator in welfare economics, welfare will continue to diminish
because policies will only be created to continue strengthening GDP and not the state of the
nation’s people. The effects of the social welfare and GDP relationship will also hold different
outcomes depending on a person’s income level. Pelagidis and Desli (2004) and Kehoe and Ruhl
(2010) both address the role of fiscal policy and how it contributes to economic growth. Both
come to the conclusion that strong, reliable fiscal policy is the best answer when attempting to
grow an economy. Taking Mexico as an example, the economy was not as open as many
developed nations, which made it harder to trade and to increase the inflow of income into the
economy. It is also important to take into account amending fiscal policy to address social
welfare, which in turn will have an impact on GDP growth.
29

30.
CHAPTER III
THEORETICAL FRAMEWORK
This thesis falls under development economics. By definition, economic development is
the “sustained, concerted actions of communities and policymakers that improve the standard of
living and economic health of a specific locality”
. Within the subcategory of development
97
economics, there are ten theories and models: vicious circle theory, Adam Smith’s production
function, Rostow’s stages of growth model, the Harrod­Domar model, the Lewis model of
transformation, the Fei­Ranis model (a modification of Lewis’), Ricardo’s classical theory
dependency theory, new growth theory, and neoclassical theory
.
98
As a graduate of Balliol College at Oxford, Adam Smith developed a wealth of
knowledge in European literature
. Deviating away from the grammar realm, Smith made his
99
mark on the world by explaining self­interest as it relates to free­markets. One of his most
notable pieces of work is the book entitled An Inquiry into the Nature and Causes Of the Wealth
of Nations (1776)
. During his lifetime, wealth was determined by a nation’s stock of gold and
100
silver. Exports were favored over importing because it would mean giving up wealth to purchase
another country’s goods and services. Smith’s ideals argued against this idea stating that free
exchange ultimately led to a better economy
. Eventually, the Wealth of Nations influenced
101
97
E. Wayne Nafziger, “Theories of Economic Development,” in Economic Development , 120.
98
Ibid, 120.
99
The Concise Encyclopedia of Economics, “Adam Smith,” Library of Economics and Liberty.
http://www.econlib.org/library/Enc/bios/Smith.html (accessed March 7, 2013).
100
“Introduction,” Adam Smith Institute. http://www.adamsmith.org/adam­smith (accessed April 20, 2013).
101
Ibid, 2.
30

31.
policymakers and economists and the free­trade idea was adopted.
The classical theory revolved around the idea that growth was limited due to the scarcity
of land resources. Ricardo’s major facet of the classical theory is the law of diminishing returns.
Because a nation’s population was continuously growing but the land remained constant, growth
would not be able to occur. An increase in capital would in turn offset the long­run effects of
diminishing returns
. The following cycle relates to Ricardo’s train of thought: the natural
102
wage in the long­run sustains the population, wage rises and causes excessive food production,
and then the population grows because there are fewer deaths due to nobody starving; the
population will continue to grow and reduce the natural wage rate and eventually will reach
subsistence again
. Wage will increase as the labor force increases. As the population grows,
103
output increases until it reaches the maximum level due to the fixed land. Ricardo believed that
the only way to balance out diminishing returns would be to increase capital per worker
.
104
Employers then benefit from diminishing surplus, that being rent and interest, from their capital
investments; however, when the labor force increases over time, no new investments in capital
are made, which then decreases the worker­capital ratio. Eventually, the economy becomes
stagnant, according to the Ricardian model
. Ricardo’s theory is flawed in that his claims were
105
stated during the industrial revolution and a time when he could not foresee future advances,
such as birth control and new technologies.
The Harrod­Domar model is based on Keynes’ macroeconomic growth model, which
102
Nafziger, 122.
103
Ibid, 122.
104
Ibid, 122.
105
Ibid, 122.
31

32.
only focused on short­run economic processes and not long­run activities and later led to them
being coined the fathers of neo­Keynesian modern growth. The basic model starts as follows:
S= sY
where S is savings and Y is output; savings is a function of output
. The level of capital K,
106
needed to produce level of output, Y becomes the following equation:
K = σY
where σ is the capital­output ratio. Because investment, I, is defined as the change in capital
stock, a new equation can be derived:
I = ΔK = σΔY
Investment equals savings, S = I; so, the final equation can be written as:
σΔY = sY.
The weakness in the Harrod­Domar model lies in that it does not account for depreciation of
stock goods. It assumes that capital remains constant over time. The model only emphasizes
economic growth through factor buildup
. Harrod and Domar assumed that there would always
107
be a constant capital­output ratio and an elastic labor supply; however, these assumptions are
false due to a limited labor supply. In Figure 1, the Harrod­Domar rationale is presented: an
increase in savings will lead to an increase in investment because S = I. The capital stock will
106
San Jose Department of Economics, “Theoretical Models of Economic Growth,” San Jose State University.
http://www.sjsu.edu/facult/watkins/growthmodels.htm (accessed March 7, 2013).
107
Hendrik Van Den Berg and Joshua J. Lewer, International Trade and Economic Growth (New York: M. E.
Sharpe, Inc), 1­90.
32

33.
then increase, which leads to an increase in productivity. As productivity grows, output
increases; therefore, income will also increase. When individuals have higher incomes they can
save more and the cycle continues.
Figure 1
Source: http://welkerswikinomics.com/blog/wp­content/uploads/2008/02/growthmodels_1.jpeg
The vicious circle theory is somewhat simpler than the other models. For the supply side, a
country remains in poverty due to its prior inabilities to save and properly invest; vice versa
happens for richer countries, they are wealthy due to their previous abilities to save and invest in
capital
. On the demand side, the market remains small due to low income and lack of
108
investors willing to participate in the market, which in turn creates low productivity. Figure 2
illustrates this theory.
108
Ibid, 127.
33

34.
Figure 2
Source: http://home.swipnet.se/~w­18076/sida2ram.htm
The Rostow growth model is known as the Stages of Growth Theory. It states that a country
is in one of five economic dimensions: the traditional society, the preconditions for take­off, the
actual take­off stage, the drive to maturity, and high mass­consumption
. Stage 1 describes the
109
“pre­Newtonian” era of thinking. The known world was subject to only a handful of rules and
production could be greatly manipulated. The traditional society devoted the majority of their
time to agriculture due to limited productivity. Chances for advancement for future generations
were limited to that of their ancestors. If a person’s father was a farmer, one was more often than
not raised to farm. For societies in the pre­take off stage, they are just beginning to lean away
from traditional society’s values and customs and starting to embrace new age technology. This
happened around the 1600s and 1700s in Europe
. A tremendous amount of influence on these
110
109
W. W. Rostow, The Stages of Economic Growth: A Non­Communist Manifesto (New York: Cambridge University
Press, 1991), 4.
110
Ibid, 6.
34

35.
developing nations came from outside invasions of countries that were already ahead of the
game. Banks, communication advances, and greater investments were some of the
advancements made during this era. Next, the take off stage is reached. All former thoughts
from the traditional way and pre­take off are now forgotten. The maturity stage follows take­off
and no longer requires the industries that led and sustained the take­off phase
. Rostow
111
indicates that it takes around 60 years for a society to go from initial take­off to full maturity. A
country is mature when it is no longer dependent on other nations for support. The final stage of
growth is high mass­consumption. More contributions to social welfare and national security
have been made as well as more investments in consumer durable goods. Figure 3 demonstrates
the five stages in action.
Figure 3
111
Ibid, 10.
35