Page 30 - FINAL CFA II SLIDES JUNE 2019 DAY 4

LOS 12.k: Describe the economic rationale for
governments to provide incentives to private READING 11: CURRENCY EXCHANGE RATES: UNDERSTANDING EQUILIBRIUM VALUE
investment in technology and knowledge.
MODULE 12.3: GROWTH AND CONVERGENCE THEORIES

Under EGT, private sector investments in R&D and knowledge capital benefit the society overall. The effects of ‘social returns’ or
externalities are captured, concluding that economies may not reach a steady state growth but may permanently increase growth
by expenditures that provide both benefits to the company (private benefits) and benefits to society (externalities).

When the external benefits to the economy of investing in R&D are not considered, many possible R&D projects do not have
expected returns (private benefits) high enough to compensate firms for the inherent riskiness of R&D investments. From an
aggregate, economy-wide viewpoint, the resultant level of R&D investment will be sub-optimal or too low. Government incentives
that effectively subsidize R&D investments can theoretically increase private spending on R&D investments to its optimal level.

LOS 12.l: Describe the expected impact of removing trade barriers on capital investment and profits, employment and
wages, and growth in the economies involved.

The foregoing growth theories do not account for potential international trade and capital flows. Removing trade barriers helps:
(1) Increased investment from foreign savings; 2) Allows focus on industries where the country has a comparative advantage; (3) Increased
markets for domestic products, resulting in economies of scale; (4) Increased sharing of technology and higher total factor productivity growth;
(4) Increased competition leading to failure of inefficient firms and reallocation of their assets to more efficient uses.

The neoclassical model’s predictions in an open economy focus on the convergence. Since developing economies have not reached the point
of significant diminishing returns on capital, they can attract capital through foreign investment and experience productivity growth as a result.
Eventually, these economies will develop; their growth will slow and will converge to the steady state growth rate of developed economies.

The endogenous growth model also predicts greater growth with free trade and high mobility of capital since open markets foster increased
innovation. As foreign competition increases, more efficient and innovative firms will survive. Those firms permanently increase the growth
rate of the international economy by providing benefits beyond those simply captured by the firm.

Economies of scale also increase output as firms serve larger markets and become more efficient. In terms of convergence, removing barriers
on capital and trade flows may speed the convergence of standard of living of less developed countries to that of developed countries.
Research has shown that as long as countries follow outward-oriented policies of integrating their industries with the world economy and
increasing exports, their standard of living tends to converge to that of more developed countries. Countries following inward-oriented policies
and protecting domestic industries, can expect slower GDP growth and convergence may not occur.