The ‘R – G’ rule under structural transformation

Structural transformation is the changes in the composition of sectoral output, employment and consumption in a country. This paper studies the ‘r – g’ rule to assess dynamic efficiency and sustainability of public debt under rapid structural transformation observed in developing economies (DE) like India. Since DEs have large share of agriculture, we construct a two-sector economy comprising an agricultural and a non-agricultural sector. The model incorporates non-homothetic preference, heterogeneous sectoral production functions with heterogeneous and exogenous total factor productivity growth to reflect heterogenous nature of growth in DEs. We show that the steady state real interest rate (the ‘r’ in ‘r – g’ rule) depends on (i) the way the inter-sectoral relative price changes, (ii) whether aggregate consumption is intertemporally substitutes or complements, (iii) capital intensities in two sectors, (iv) relative preference for agricultural goods, and (v) relative total factor productivity growth rates. Using India-KLEMS data we estimate that r < g for India and therefore the Indian economy is not dynamically efficient implying that the current level of public debt may be sustainable.