A Theoretical Growth Model for Ireland

A THEORETICAL GROWTH MODEL FOR IRELAND

and labour however, as in the regional-economy model.⁴ Furthermore, all
goods are tradable and all capital is foreign owned so the export-base
perspective is embedded in our story.⁵

Having set up the model, we then submit it to several shocks which we
believe capture important elements of the factors that have driven the Irish
boom. The shocks are of three broad types: (i) an increase in the country’s
attractiveness to foreign capital, (ii) a reduction in labour-market distortions,
and (iii) an increase in total factor productivity.

The first of these serves as shorthand for a number of different
developments that occurred in the late 1980s and early 1990s. Honohan and
Walsh emphasise the beneficial effects of fiscal stabilisation. Our modelling of
this is influenced by the work of Miller, Skidelsky and Weller (1990), which
was, interestingly, one of the first papers in the literature on “expansionary
fiscal contraction”, a phenomenon that has been much discussed in the Irish
literature. This paper, and others in the literature such as Bertola and Drazen
(1993) and Sutherland (1997), are based on critical levels of government debt
- or “trigger points” - being reached, beyond which the effects of fiscal policy
on expectations are reversed. In Miller, Skidelsky and Weller (1990), the
critical level is reached when fiscal policy raises the rate on government bonds
substantially through an increased risk of taxes on bond holders being
imposed to prevent the public debt becoming unsustainable. We thus model
fiscal consolidation as a reduction in the risk premium on investments in
Ireland.⁶

Other shocks which also increase the inflow of capital for a given interest
rate include the advent of the Single European Market and the substantial
increase in EU regional aid flows from 1989 onwards. The Single Market led
to a substantial increase in FDI inflows into Europe and between European
countries, as evidenced by Dunning (1997), while the effect on Ireland was
compounded by the outlawing of restrictive public procurement policies within
the EU.⁷ The announced reduction in the rate of corporation tax on services in
the late 1990s can also be modelled in this way. This shock also captures

⁴In the extreme case of perfect factor mobility, our model collapses to the AK model of endogenous
growth theory.

⁵Note that ours is not a growth accounting exercise such as de la Fuente and Vives (1997) and
Ahearne, Kydland and Wynne (2004), which are also based on the neo-classical growth model, but
a theoretical contribution, the importance of which we attempt to quantify.

⁶De la Fuente and Vives (1997) concur, suggesting that "... fiscal consolidation may have acted as
a catalyst, helping to change foreign investors’ perceptions of the country”.

⁷MacSharry and White (2000) explain how restrictive procurement policies on the part of some of
the larger EU member states had offered a strong incentive to transnational corporations to locate
there rather than in Ireland. With the outlawing of these practices, the attractiveness of Ireland
as a destination for FDI increased.

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