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How much do distortions affect growth?

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  • Easterly, William

Abstract

The author presents a simple endogenous growth model (with two types of capital) that shows the sizable long-run effects on growth of distortionary policies. The model applies to many different types of distortions of relative prices common in developing countries - for example, price controls, black market exchange rates, and differential taxes and tariffs. The model shows that distortions of relative input prices can greatly affect growth and welfare. The magnitude of the effect depends on the production elasticity of substitution. With high substitutability, the effects on growth and welfare, although possibly large, are bounded, no matter how high the rate of distortion. Subsidizing inputs and investment goods can increase growth, even though it worsens welfare. But a subsidy to one capital good financed by a tax on another capital good unambiguously reduces growth. Empirical results show strong negative effects from variance in the relative prices of investment goods across sectors, while also confirming and extending earlier results showing that penalizing investment goods and distorting financial markets reduce growth.
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Suggested Citation

  • Easterly, William, 1993. "How much do distortions affect growth?," Journal of Monetary Economics, Elsevier, vol. 32(2), pages 187-212, November.
  • Handle: RePEc:eee:moneco:v:32:y:1993:i:2:p:187-212
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    1. Romer, Paul M, 1986. "Increasing Returns and Long-run Growth," Journal of Political Economy, University of Chicago Press, vol. 94(5), pages 1002-1037, October.
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    6. Rebelo, Sergio, 1991. "Long-Run Policy Analysis and Long-Run Growth," Journal of Political Economy, University of Chicago Press, vol. 99(3), pages 500-521, June.
    7. Kormendi, Roger C. & Meguire, Philip G., 1985. "Macroeconomic determinants of growth: Cross-country evidence," Journal of Monetary Economics, Elsevier, vol. 16(2), pages 141-163, September.
    8. Alwyn Young, 1991. "Learning by Doing and the Dynamic Effects of International Trade," NBER Working Papers 3577, National Bureau of Economic Research, Inc.
    9. King, Robert G. & Plosser, Charles I. & Rebelo, Sergio T., 1988. "Production, growth and business cycles : I. The basic neoclassical model," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 195-232.
    10. Lucas, Robert Jr., 1988. "On the mechanics of economic development," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 3-42, July.
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