Economic Growth and Institutions Efficiency

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Final Assignment SEM1 EGfD 7007D

Economic Growth and Institutions Efficiency

UB: 12024938 8th January 2013

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Economic Growth and Institutions Efficiency

Introduction During the last few decades, economists throughout the world have tried to study and identify the macroeconomic determinants of economic growth. Among various models generated to explain the process of growth in an economy, one of the best-known is the Solow model of economic growth, created by Robert Solow in 1956. According to this model, output (production) is produced by the combination of capital and labour, assuming a constant return to scale. This means that doubling the inputs (i.e. the capital and labour) will double the output. Further, it is an endogenous growth model that distinguishes between human capital and physical capital, and determines the quantity of output, and growth in general, by the efficiency of investment as well as technological progress (Jones, 2002). Studies have found that the conventional elements of growth (like physical capital, human capital, technological progress, level of investment and international integration) have not been able to stimulate growth in some countries, especially in South Asia and the Sub-Saharan region (Aron, 2004; Sebastian, 2010). Historically, poor investment management and lack of institutions and accountability have caused insufficient return on public investment in low income countries; private investment has been affected as well (Dable et al., 2012). Moreover, differences in growth among countries around the world are much more pronounced than differences in their level of technological development. Therefore, variations in productivity and output can be better explained in terms of efficiency of investment (Wiel, 2013). This essay examines the importance and role of institutions in enhancing the efficiency of investment and furthering economic growth, and tries to find out the ideal set of institutions required for it. It also points out the critical role of governance for the economy and identifies some governance indicators to measure government efficiency. Further, it goes on to discuss the appropriate relationship between the public sector and private sector in order to achieve growth and development. Finally, it takes up the case study of Indonesia in reforming its government and institutions, and examines the impact of these reforms on its economic growth during the last decade.

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Literature Review: According to Douglas North, the 1993 Nobel laureate in Economics, institutions can be defined as the guidance of human interactions and structuring of everyone’s activities in order to reduce the coordination costs and uncertainties which may occur in people’s lives (North, 1990). Institutions can be of two types - formal and informal - and both play an essential role in maintaining the rule of law, private property rights and economic growth (Ahrens, 2005). In 1985, the GDP of the Soviet Union was less than one-third of that of the US, even though the rate of investment in physical capital was greater and the human capital was of high quality, consisting of well-qualified and highly educated personnel (Wiel, 2013). This poor performance can be ascribed to lack of efficiency, as the Soviet economy was under a centrally planned system directed by a bureaucratic government. All the labour force as well as the huge capital investment in the economy was allocated and guided by only one entity (i.e. the government). Inefficiency in the economy and lack of institutions fostering efficiency are considered to be the main reason behind the demise of the Soviet Union.

Another example illustrating the role of intuitions in growth is that of North and South Korea. In 1944, both Northern and Southern parts of Korea were very similar. Both had the same people, same culture, same language and same history; the only difference was that the Northern part was more industrialized while...
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