Page 29 - FINAL CFA II SLIDES JUNE 2019 DAY 4

READING 11: CURRENCY EXCHANGE RATES: UNDERSTANDING EQUILIBRIUM VALUE
LOS 12.j: Explain and evaluate convergence
hypotheses.
MODULE 12.3: GROWTH AND CONVERGENCE THEORIES

Empirical evidence suggests there are large differences between productivity of different countries, with less developed countries
experiencing much lower output per capita than their developed counterparts.

Will less developed countries experience productivity growth to match (converge with) the productivity of developed nations?

Absolute convergence hypothesis agrees absolutely: per neoclassical model assumes that every country has access to
the same technology. This leads to countries having the same growth rates but not the same per capita income.

Conditional convergence hypothesis states that convergence will only occur for countries with the same savings rates,
population growth rates, and production functions. Under this, the growth rate will be higher for less developed countries
until they catch up. Per the neoclassical model, once a developing country’s standard of living converges with that of
developed countries, the growth rate will then stabilize to the same steady state growth rate as that of developed countries.

Club convergence hypothesis: Countries may be part of a ‘club’ (i.e., countries with similar institutional features such as
savings rates, financial markets, property rights, health and educational services, etc.). As such, poorer countries that are
part of the club will grow rapidly to catch up with their richer peers. Countries can ‘join’ the club by making appropriate
institutional changes. Those countries that are not part of the club may never achieve the higher standard of living.

Empirical evidence shows that developing economies often (but not always) reach the standard of living of more developed
ones. Over the past half century, about two-thirds of economies with a lower standard of living than the US grew at a faster
pace than the US. Though they have not converged to standard of living of the US, their more rapid growth provides at least
some support for the convergence hypothesis. The club convergence theory may explain why some countries that have not
implemented appropriate economic or political reforms still lag behind.