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THE ECONOMIC AND SOCIAL REVIEW
impact is quite small. Even a halving of r*, from .05 to .025, increases long run
GDP by only 15 per cent. Since the share of capital in output is relatively
small, the interest elasticity of steady state output is quite small. As a result,
the reduction in the required rate of return on capital cannot account for the
scale of the growth, at least given the current calibration of the model.
The second shock in the Table is an increase in labour supply resulting
from a rise in Θ, where we arbitrarily set the increase in Θ to 10 per cent. But
this has the counterfactual implication that the rise in GDP is less than the
increase in labour supply itself (although the difference between the two are
very small). In fact, GDP grew much faster than employment.
Finally, a 10 per cent rise in total factor productivity raises long run GDP
by more than 30 per cent, while increasing employment by about 15 per cent.
Thus, shocks to total factor productivity differ from the other shocks in having
the potential to dramatically raise both GDP and employment while raising
the former more than the latter.
How big a role did labour market openness play in the Irish growth
experience? To investigate this, we conduct the following experiment. Assume
that structural changes in the economy in the mid-1980s raised the long-run
path of GDP. We set this shock as an exogenous rise in total factor
productivity, although it may be attributed to various alternative factors, as
discussed above. We choose the size of the shock so that, given the other
parameter values, GDP trebles in a twenty year period, to conform with the
Irish experience. Simultaneously, we pick the elasticity of the labour supply
function (7) so that employment rises 70 per cent during the growth process.
This implies an elasticity of approximately unity. We then ask, how much
would GDP have risen, for the same shock, in the absence of labour market
openness? That is, if employment had not risen endogenously in response to
the rise in total factor productivity, how much would output have risen? We
find that labour market openness played a highly significant role. As shown in
Table 1, the implied increase in GDP in the absence of labour market openness
would have been 77 per cent, as opposed to the 200 per cent increase that
actually occurred. This translates to an average GDP growth of 3 per cent, as
opposed to the actual growth of around 6 per cent.
We also investigate the role of capital market openness in the growth
experience. We take the same total factor productivity shock as before, but
now, assuming labour market openness, we increase the debt elasticity of
external interest rates by a factor of 10, from 0.01 (as in Lane and Milesi-
Ferretti’s estimates) to 0.1. The results indicate that this would have had only
a minor dampening effect on the growth of GDP and employment. GDP still
rises by 194 per cent, and employment by 68 per cent. In fact even if we
increase the elasticity 50-fold, to 0.5, we find that GDP and employment would