A THEORETICAL GROWTH MODEL FOR IRELAND
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of capital with respect to investment of 0.3. Finally, we set r* = 0.05 and using
evidence on the sensitivity of interest rates to external debt from Lane and
Milesi-Ferretti (2001), we assume that (a) the elasticity of Φ(K) is equal to .01
and (b) the debt related risk premium is 2 per cent.
Figure 4 illustrates the role of labour market openness in the growth
process. In the Figure, we compare two alternative convergence processes,
where in one case, the labour force is constant throughout, and in the second
case, employment responds endogenously to capital accumulation through the
process described in Equation (8). In both cases, we have set the initial capital
stock equal to 30 per cent of its steady state level, so that initial GDP is below
steady state GDP.13 As we can see from the Figure, the channel of endogenous
employment expansion during the growth process implies a higher steady
state GDP and a much higher growth rate during the convergence, beginning
from an initial low level of GDP. As capital accumulation takes place,
beginning from an initial low capital stock, the real wage in the home economy
rises, drawing in labour from outside, magnifying the process of accumulation
itself.
Figure 4: Labour-Market Openness and Growth
Figure 5 illustrates the role of international capital markets. The Figure
again shows the convergence process, beginning from an initial capital stock
equal to 30 per cent of steady state capital, but now contrasting the baseline
calibration against a case where the opportunity cost of borrowing is sharply
rising in foreign debt - we set the elasticity of the function Φ(K) equal to unity.
This implies a much higher degree of restrictiveness of international capital
markets. Again we see that capital market openness is a critical feature of the
convergence process, in the same way as is labour market openness. With
13Figures 4 and 5 have time in years on the horizontal axis and an index of GDP on the vertical.