UNIVERSITÄT POTSDAM - Prof. Dr. Paul JJ Welfens

UNIVERSITÄT POTSDAM
EUROPÄISCHE WIRTSCHAFT
UND
INTERNATIONALE WIRTSCHAFTSBEZIEHUNGEN
Paul J.J. Welfens
Stabilization and Growth: A New Model
Diskussionsbeitrag 90
Discussion Paper 90
Europäisches Institut für internationale Wirtschaftsbeziehungen (EIIW), Potsdam
European Institute for International Economic Relations, Potsdam
ISSN 1430-5445

Diskussionsbeitrag Nr. 90
Discussion Paper No. 90
Europäische Wirtschaft und Internationale Wirtschaftsbeziehungen
European Economy und International Economic Relations
Paul J.J. Welfens
Stabilization and Growth: A New Model
October 2001
Editor: Prof. Dr. Paul J.J. Welfens
University of Potsdam, European Economy and International Economic Relations
Karl-Marx-Str. 67, D-14482 Potsdam, Germany, Tel.: (0)331-9774614, Fax: (0)331-
9774631
EUROPÄISCHES INSTITUT FÜR INTERNATIONALE WIRTSCHAFTSBEZIEHUNGEN (EIIW)
ISSN 1430-5445
Key words: Macroeconomics, Growth, Fiscal Policy, Trade, Investment.
JEL classification: C1, E1, F00, O41

Prof. Dr. Paul J.J. Welfens, Jean Monnet chair in European Economic
Integration and president of European Institute for International
Economic Relations (EIIW) at University of Potsdam, August-Bebel-Str.
89, D 14482 Potsdam, Tel. +49 (0)331 977-4614,
Welfens@rz.uni-potsdam.de
www.euroeiiw.de
Stabilization and Growth: A New Model
1. Introduction ………………………………………………………………………….1
2. Growth Theory and Medium-term Macroeconomic Analysis ………………………2
2.1. Investment Theory and Empirical Analysis for
the US and Germany ………………………………………………………………2
2.2. Stationary Economy………………………………………………………………..6
2.3. Growing Economy..………………………………………………………………11
3. Conclusions ...………………………………………………………………………15
References.…………………………………………………………………………….17
I am grateful for discussions with Albrecht Kauffmann and Andre Jungmittag, EIIW at
the University of Potsdam; and to Manfred Kremer, ECB. I also have benefited from
my research at AICGS/The Johns Hopkins University
The usual disclaimer applies
Publication of this paper has been made possible by financial support of a major
central bank in Europe; this is the first paper in our special series:
Monetary and Real Aspects of European Integration and Globalization

Summary
This paper shows a way to integrate Keynesian macroeconomic analysis and growth
modeling. Within a medium term model – with forward-looking investors – we present
an approach which combines macro analysis and (modified) neoclassical growth
modeling. The fiscal multiplier can be higher or lower than the familiar expression
from the Mundell-Fleming model; the multiplier can even be negative. We highlight
the dual nature of the savings rate and suggest finally some possible extensions for
future research.
Zusammenfassung
Dieser Beitrag zeigt einen neuen Weg, um Keynesianische Makroanalyse und
Wachstumsmodellierung miteinander zu verbinden. Im Rahmen eines mittelfristigen
Modells – mit vorwärts schauenden Investoren – präsentieren wir einen Ansatz, der die
Makroanalyse mit einem (modifizierten) neoklassischen Modell verbindet. Der
Fiskalmultiplikator kann größer oder kleiner sein als im herkömmlichen Mundell-
Fleming-Modell, sogar ein negativer Multiplikator ist denkbar. Die doppelte und
uneindeutige Rolle der Sparquote wird aufgezeigt, zudem werden Ideen für weitere
Modellanalysen vorgeschlagen.

1. Introduction
In economic analysis there is a rather strict dichotomy between business cycle analysis
– often cast within the Mundell-Fleming approach – and growth theory. However, in
reality, short term macroeconomic changes and growth trends are overlapping
phenomena. Therefore it could be useful to model both phenomena in a consistent
integrated framework. Standard contributions in the field of integrating cyclical aspects
and growth aspects within the literature are the model from PHILLIPS (1961) and
GOODWIN (1965); OBSTFELD (2001) gives a survey on progress in international
macroeconomics (“Beyond the Mundell-Fleming Model”), important contributions
along the lines of optimal growth theory for open economies came from BARDHAN
(1967), HAMADA (1969), and BRUNO (1970). While these approaches have their
merits the old problem of bridging short-term Keynesian analysis and growth theory
has not been solved.
A typical question in macroeconomics concerns the role of fiscal and monetary
policy. In particular the role of fiscal policy has been debated. In a simple
macroeconomic model a rise of government consumption G raises real income Y so
that consumption is raised; if government is financing additional expenditures via
bonds there is some risk of crowding out private investment demand in the case that the
real interest rate is rising. The standard Keynesian model is unusual in the sense that we
are not informed whether the increase in G occurs in an economy which is growing or
in an economy which is stationary.
In the following analysis we will argue that forward-looking investors will take
into account this issue: They will anticipate the future steady-state per capita income in
a stationary economy; and in a growing economy they will take into account both the
long term level of the growth path and the growth rate itself. In such a setting we can
take into account the double role of the savings rate in a consistent way: In the
Keynesian macro model a high savings rate generates a small output multiplier; by
contrast, growth theory shows a positive impact of the savings rate on the level of the
growth path. In the model proposed we combine both aspects and identify a critical
savings rate s’– below the fiscal multiplier is negative, above the critical savings rate it
is positive (and the positive multiplier falls with s).
It will be emphasized that investors – even in an economy with temporary
underutilization of capacity – are forward-looking in their decision-making.
Neoclassical investment theory and empirical findings for the investment output ratio
support the approach suggested here.
On the bottom line our analysis suggests new ways to analyze issues of cyclical
development in market economies. With respect to economic policy government must
carefully decide whether it prefers a short term expansion of government consumption
or to adopt measure which raise anticipated steady state variables (level of growth path,
1

or growth rate itself). The model also implicitly suggests that a distinction between
government consumption and government investment is quite important.
The paper is organized as follows: At first we will take a brief look at
investment theory and also take a closer look at the empirical results for the US and
Germany. Then we turn to the theoretical case of a stationary economy with forwardlooking
investors who will anticipate the steady state results; here we merge the
traditional macro model and growth theory in a straightforward way. Then we take a
look at the case of growing economy where both exogenous growth and endogenous
growth can be considered. Finally, we draw some conclusions.
2. Combining Growth Theory and Medium-term Macroeconomic
Analysis
2.1 Investment Theory and Empirical Analysis for the US and Germany
In the following analysis we consider a simple framework in which investors are
rational decision-makers; output is determined by a Cobb-Douglas function with
Horrod-neutral progress: Y=K ß (AL) 1-ß . Gross investment I is the sum of optimal net
investment dK#/dt plus depreciation.
(i) I = dK#/dt + δK
With the Cobb Douglas production function we have ∂Y/∂K=ßY/K; profit
maximization requires (r+δ) = ß(Y/K), and at a given expected real interest rate (this
might be interpreted as the natural real interest rate which is stationary in the long run
in the OECD) we therefore have dK#/dt =[ß/(r+δ)]dY/dt which results in optimum
gross investment being equal to:
(ii) I = [ß/(r+δ)]dY/dt + δY (1/ß) /(AL) (1--ß)/ß
Dividing by Y and using the symbol y‘=Y/(AL) we obtain:
(iii) I/Y = [ß/(r+δ)]gY + δ y‘ (1--ß)/ß
2

Hence the investment output ratio is a negative function of r and a positive function of
the growth rate of output and of the ratio Y/(AL).
If in reality there are adjustment costs we can use a more realistic investment
function – with an adjustment parameter: investment in period t is investment of the
previous period plus an adjustment factor which is proportionate to the difference
between optimum investment and investment in the previous period. Optimum
investment is determined as in equation (ii) and (iii), respectively.
It = It-1 + λ(It# - It-1) + δK = λIt# + (1-λ)It-1+ δK
Such an approach was empirically tested for Germany and the US. We used
annual data for Germany, 1972-99): It / It-1=(It*/ It-1) ζ . We use a dummy variable with
D=1 for 1994 when the reunited Germany had an investment boom due to
reunification; in all other years D=0; and we have a normally distributed error term U
in the logarithmically specified investment function.
ln I= ζ ln It-1 +lnb+ φln(1+rt-1) + εgY + θlnY/L + ξD+U
Results for USA
As regards the empirical results for the US in the period 1972–99 the investment output
ratio (IQ_U) significantly depends on:
• lagged investment output ratio (IQ_U(-1))
• growth rate of real income (GY_U)
• level of per capita income (YPC_U)
• lagged (by one year) real interest rate (long term interest rate minus
inflation rate, R_U(-1)).
The test statistics are quite satisfactory.
3

4
Dependent Variable: LOG(IQ_U)
Method: Least Squares
Date: 01/30/02 Time: 14:49
Sample(adjusted): 1973 1999
Included observations: 27 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
C -0.550039 0.215238 -2.555492 0.0180
LOG(IQ_U(-1)) 0.920949 0.082838 11.11748 0.0000
GY_U 0.031049 0.004001 7.760834 0.0000
LOG(YPC_U) 0.120200 0.073713 1.630647 0.1172
LOG(1+R_U(-1)) -0.679036 0.304985 -2.226459 0.0365
R-squared 0.884941 Mean dependent var -1.658063
Adjusted R-squared 0.864021 S.D. dependent var 0.101567
S.E. of regression 0.037453 Akaike info criterion -3.565878
Sum squared resid 0.030860 Schwarz criterion -3.325908
Log likelihood 53.13935 F-statistic 42.30153
Durbin-Watson stat 1.942696 Prob(F-statistic) 0.000000

Empirical Results for Germany
The picture for Germany is similar to the US, the lag structure slightly differs. All
variables are highly significant and the Durbin Watson statistic is satisfactory. Iq_G is
investment GDP ratio, Germany The lagged investment output ratio and the real
interest rate variable show relatively large coefficients, the coefficient for per capita
income is 0.06, the coefficient for the growth rate of output is 0.002.
GY_G is growth of real GDP; YPC_G Per capita income
R_G real interest rate
Dependent Variable: LOG(IQ_G)
Method: Least Squares
Date: 12/05/01 Time: 17:48
Sample(adjusted): 1973 1999
Included observations: 27 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic Prob.
C -1.099276 0.218467 -5.031774 0.0000
LOG(IQ_G(-1)) 0.552913 0.087420 6.324823 0.0000
GY_G 0.017731 0.002382 7.444623 0.0000
LOG(YPC_G) 0.129929 0.060921 2.132734 0.0444
LOG(1+R_G) -2.454491 0.668044 -3.674147 0.0013
R-squared 0.842550 Mean dependent var -1.547979
Adjusted R-squared 0.813923 S.D. dependent var 0.066318
S.E. of regression 0.028607 Akaike info criterion -4.104725
Sum squared resid 0.018004 Schwarz criterion -3.864756
Log likelihood 60.41379 F-statistic 29.43183
Durbin-Watson stat 1.825568 Prob(F-statistic) 0.000000
5

2.2 Stationary Economy
Neoclassical growth theory (JONES, 1998) is rather solid body of knowledge. It
assumes that savings will determine gross investment and that a steady state value for
capital intensity K/L (K and L stand for capital and labor/population, respectively). If
one uses a Cobb-Douglas production (0

This implies that capital intensity k#=K/L and per capita output (y#) in
equilibrium are given by:
(4b) k# = Aoe at [[s(1-τ)]/(n+a+δ)] 1/(1-ß)
(4c) y# = Aoe at [[s(1-τ)]/(n+a+δ)] ß/(1-ß)
We now turn to the familiar Keynesian system in which effective demand
determines output Y. An important point in the following approach of merging the
Keynesian system with a growth model is the investment function.
It has been shown for an economy with proportionate capital deprecation that
neoclassical profit maximization leads – with gY denoting the growth rate of output - to
an investment output ratio z which is given by
(5a) z = z(r, y’, gY)
The investment output ratio negatively depends on the real interest rate r; z
depends positively on y’=Y/(AL) because reinvestment depends on k’ (k in an
economy with zero Harrod-neutral progress) which in turn is equivalent to a certain per
capita income figure (Y/L in a model with A=1, otherwise Y/(AL)) in a full
employment economy. In the context of a medium term model it is obvious that profitmaximizing,
forward looking investors will take into account the long term growth rate
of output which is exogenous in the neoclassical model – but endogenized in the New
Growth Theory. The higher the anticipated steady state values of y and gY, the higher
the level of investment. From this perspective the question arises whether government
policy not only affects short term aggregate demand and output, respectively, but also
the long term (steady state) values of y and gY, respectively. The traditional IS-LM
model completely ignores this issue.
Empirical analysis for Germany and the US supports the approach chosen here.
Hence we have for gross investment
(5b) I = z(r,y’,gY) Y
We will assume a linear function for the investment output ratio, namely:
(5c) I/Y = {[b/r] +hy’ +vgY}; b, h, v>0
7

In a situation of unemployment – if labor demand L exceeds exogenous labor supply
N’ – one could use a modified investment function which reflects the hypothesis that
the investment-output ratio will be reduced in the presence of (temporary)
unemployment; I/Y would reduce proportionate to L-N’. We will ignore this aspect
here and rather focus on investment function (5c): Therefore the familiar goods market
equilibrium condition can be written for the case of a small open economy (and with *
for foreign variables) as:
(6) Y = C(Y,τ) + G + z(r, y’, gY)Y + [X(q*,Y*)-q*J(q*,Y)]
Consumption is assumed to depend on real income Y and the income tax rate τ,
government consumption is exogenous, investment is as given by (5b) and the current
account by a standard export function and import function – with q* denoting the real
exchange rate eP*/P. Chosing a linear specification for z(...) and standard export
function X =x(q*)Y* and import function J=j(q*)Y we have:
(7a) Y = cY(1-τ) + G + {[b/r] +hy’ +vgY}Y + [x(q*)Y* -q*j(q*)Y]
It is quite implausible to assume – as it is done in the standard Keynesian model - that
investors are not forward-looking in their decisions and thus ignore the long term per
capita income level or the growth rate. We therefore consider equation (7a) as a
consistent medium term approach, and we will argue that quasi-rational investors –
which are forward-looking - will take long term y and gY from the growth model. In a
growth approach with technological progress being zero, the setup comes close to the
standard Keynesian model. Therefore we will initially use a combination of this special
case of the growth model with the Keynesian macro approach. As we argue that
investors will anticipate the long term steady state solution, we implicitly assume that
investors are not living in a “super-Keynesian” environment which would never again
reach a steady state of an equilibrium under profit maximization. The way steady state
is defined is slightly different from the standard notion in growth theory, which
assumes full employment in the steady state; here it is emphasized that “equilibrium
unemployment” u can occur in a growth model, and it is easy to show that the
assumption of a zero savings rate for the unemployed will lead in a model without
technological progress – with s being the savings rate of workers –in the long run to
steady state per capita worker output: y#:=[[s(1-τ)] (1-u)/(n+δ)] ß/(1-ß) . In the following
we will not assume long term unemployment.
8

For the simple case of a stationary economy without population growth (a=0,
n=0) the long term equilibrium per capita income is given by:
(8) y#= ([s(1-τ)]/δ) ß/(1-ß)
Assuming that investors anticipate the steady state value y# (and gY=0 in the steady
state) we can replace y in equation (7a) and get:
(7a‘) Y = cY(1-τ) + G + {[b/r] +h[(s(1-τ)/δ) ß/(1-ß) ]}Y + [x(q*)Y* -q*jY]
Note that in r-Y-space our medium term ISK curve (portraying equation 7a’) is steeper
than the standard IS curve – if we set h=0 and assume that dr/dY>0. This would also
have implications for monetary policy which, however, will not be considered here;
rather we will assume that the (long term) interest rate is given – or the interest
elasticity of the demand for money is infinity.
The fiscal multiplier clearly differs from the standard multiplier, and it is also
interesting to see the more complex role of the savings rate we now have: It is true that
a high savings rate implies a priori a small fiscal policy multiplier – according to the
standard IS-LM result -, but our approach also takes into account the anticipated effect
of s and the investment-output ratio, respectively, on the steady state. To highlight this
aspect assume that b=0 and j=0 or that q*j-(b/r)=0; moreover, we assume ß=1/3 which
is rather realistic for OECD countries. For a given real interest rate r, the multiplier for
expansionary fiscal policy (dG>0) is no longer the familiar multiplier 1/[[s(1τ)+τ+q*j];
rather we have
(8a) dY/dG = 1/{[s(1-τ)+τ] – h(s[1-τ]/δ) 1/2 }
The denominator is negative if
(9a) s(1-τ)+τ >h[s(1-τ)]/δ) 1/2
(9b) [s(1-τ)+τ] 2 >h 2 s(1–τ)/δ
(9c) s(1–τ)+2τ+τ 2 /(s(1–τ))> h 2 /δ
9

If we assume for simplicity that τ is rather small, so that τ 2 approaches zero, we
have a straightforward critical value s’:
(10) s’ = (h 2 /δ–2τ)/(1-τ)
If the savings rate s is slightly larger than s’ we have a positive multiplier, if s is
slightly smaller the fiscal multiplier is negative (see figure 1):
Fig. 1: Fiscal Multiplier in Growth-Oriented Macro Model
10
dY/dG
0
s‘
We thus have an interesting empirical issue. Moreover, if s should rise in poor societies
along with y until a certain value y## has been reached - with s falling if y>y## - there
are two aspects of interest: In a situation of relatively low y we will have negative fiscal
multipliers.
The more general multiplier expression for a stationary economy is:
(8b) dY/dG = 1/{[s(1-τ)+τ]+q*j - (b/r) -h[[s(1-τ)]/δ) ß/(1-ß) ]}
s

It no longer holds that the smaller s is the larger is the multiplier (the standard case in
the Keynesian macro model), rather, that once we are below a critical savings rate s’,
the case may occur that the multiplier becomes negative. One may note that h could
indeed be equal to the depreciation rate. On the bottom line the crucial point to make is
that our medium term model suggests different fiscal multipliers to standard analysis.
Moreover, the savings rate has an ambiguous effect:
2.3 Growing Economy
For considering a growing economy – with the progress rate a>0 - equation (7) can be
divided by AL so that we have under the assumption that A*L*=AL (and with G’
denoting G/(AL)): The ISK curve now can be drawn in an r-y’ diagram.
(7a) y’ = c(1-τ)y’ + G’ + {[b/r] +h([s(1-τ)]/δ) ß/(1-ß) +va}y’ + [x(q*)y’* -q*j(q*)y’]
The ISK curve has a negative slope if s(1-τ) -{[b/r] +h([s(1-τ)]/δ) ß/(1-ß) +va}>0. The
fiscal multiplier now is
dy’/dG’=dY/dG =1/{[s(1-τ)+τ]+q*j - (b/r) -h[[s(1-τ)]/δ) ß/(1-ß) ] -va}
Again, this multiplier can be positive or negative; if it is positive it holds that
the larger the steady state growth rate is, the larger the multiplier effect. The smaller the
real interest rate the larger the multiplier provided it is positive.
A more complex and interesting case of a growing economy is one in which
technological progress is endogenized. If we take into account a hybrid growth model
(WELFENS, 2002) the long term growth rate is determined by the export ratios at
home (x in country I) and abroad (x*), by the ratio of researchers (R) to total
population (L) and by a deprecation rate for technological progress as well as
exponential parameters. The progress rate is assumed here to depend positively on the
export-GDP ratio at home and abroad; import competition has indeed significantly
contributed to technological progress in the US (MANN, 1998); for Sweden there also
exists positive evidence about the link between openness and total factor productivity
(ANDERSSON, 2001). Moreover the ratio of researcher to total population is also
assumed to contribute to a rise of the progress rate which is assume to be subject to a
kind of depreciation effect (parameter µ)
11

(A.I) da/dt = {[(X/Y)(X*/Y*)] θ (R/L) ω }a Ω - µa
We assume positive exponential parameters and in particular 0

(11) y’=c(1-τ)y’+G’+{[b/r]+h[[s(1-τ)]/(n+δ] ß/(1-ß) +
v{[[xj] θ (R/L) ω ]/µ} 1/(Ω) }y’+[x(q*)y’*-q*jy’]
Therefore the multiplier expression is given by:
(12) dY/dG =1/([s(1-τ)]+jq*-[h[s(1-τ)]/[{[xj] θ (R/L) ω ]/µ} 1/(1-Ω) +δ] ß/(1-ß) ] +
v{[[xj] θ (R/L) ω ]/µ} 1/(1-Ω) )
The following graphs shows the IS and the ISK curve the case of the stationary
case (a) and expansionary fiscal policy in a growing economy (b), respectively.
Fig. 2: Growth-Oriented Macroeconomic Model
r
a) Stationary Case b) Fiscal Policy in the Case of
Growing Economy
IS 0
ISK 0
0 y# y
y 0
E F
r 0
r
0
ISK 0
ISK 1
LMK 0
y‘ 0 y‘ 1 y# y‘=Y/AL
If one assumes that G can actually be split into G C – for government
consumption – and G R – for hiring researchers one can see the real challenge of fiscal
policy. The structure of fiscal policy become decisive:
13

14
• Expansionary fiscal policy which raises government consumption might
raise the level of the growth path; however, there also could be
parameter constellations which lead to a negative multiplier.
• Fiscal policy as growth policy, namely financing a higher number of
researchers relative to population, will affect – in our model – the
growth rate of output positively.
This may suggest that fiscal policy as growth policy should be more emphasized than
traditional fiscal policy in the form of higher government consumption. If the fiscal
multiplier for government consumption is positive, the question of optimum fiscal
policies arises in a new way as – depending on the time horizon of government (and
potential lags for fiscal and growth policies, respectively) – government eager to raise
per capita output as much as possible until a given point in time, say election day, will
have to focus on the optimum policy mix in the sense of raising G C and G R at the same
time while taking into account economic/institutional financing constraints.
Our rather simple modeling shows that it is possible to integrate the Keynesian
approach and growth theory in a rather straightforward way; and that there are new
theoretical and empirical aspects which require further research.
A special problem occurs if government considers temporary effects and steady
state effects within a finite time horizon: Government will consider the temporary
effects of an increase in output – in a situation of an output gap – plus the effect on the
level of the growth path and the benefit from an anticipated future increase in the
steady state output growth. An important issue occurs with the finite time horizon of
politicians: They might prefer rather a policy of shifting upwards the level of a given
growth path (“shift policy”: see line ABCD in the following figure) than raising the
growth path itself (line ABE). If the time horizon of politicians is shorter than a critical
span tn the discounted utility of the inferior policy strategy which brings a rather quick
output increase (point C) will be higher than the true growth policy. In volatile
demcracies – indeed in any society with short time horizons of policy makers – true
growth policies might be rare. This also points to empirical issues of measuring the
lengths politicians’ time horizon.

Fig. 3: Shift Policy versus True Growth Policy
lnY
lnY 0
A
3. Conclusions
α
C
B
β
0 t 1 t n t
There are five basic conclusions to be drawn: (i) It is indeed possible to create a hybrid
macroeconomic model which takes into account both short term and medium term
aspects of macroeconomic dynamics. (ii) The medium term model suggests that
government policy which reduces the average savings rate could be rather inefficient to
the extent that investors anticipating a reduced level of the steady state growth path will
reduce investment – if investors are both backward-looking, that is consider past output
development and the future steady state as relevant for investment behavior there is the
case of an optimum savings rate in the sense that government – having a long term time
horizon - can systematically try to influence s(1-τ)+(τ-γ) in a way which brings an
optimum increase of cumulated temporary output increase dY/dG and increase of the
steady state output. (iii) There are new empirical questions to be analyzed, in particular
whether countries have strongly different fiscal multipliers which would make
E
D
15

international cooperation more difficult. (iv) Fiscal policy has to be considered in more
detail: raising public consumption is different from raising public investment (v) There
are new challenges for model building in the sense that taking into account the now
more complex real sector and money demand equilibrium and equilibrium conditions
for the foreign exchange market will be rather cumbersome. For policymakers the new
approach suggested could be useful for gaining a more realistic understanding of
available policy options.
Some aspects of the proposed new approach may be subject to criticism; and
there is certainly room for refinements. However, the proposed way of combining
macro analysis and growth analysis is an important element of this interesting new
research. Future refinements will highlight many new aspects of stabilization policy
and growth. The proposed investment function also points to new empirical issues. For
policymakers solutions to the issues raised here could be quite useful. There are,
however, several interesting issues to be solved. One aspect in our model concerns the
role of fiscal policy, namely whether the rise of G will be interpreted – and indeed must
be interpreted – as a permanent rise of G/Y=γ and the deficit-GDP ratio, respectively.
In a growth model, assuming that the current account is balanced in the long run, it is
the overall savings rate s + which matters for growth, namely s + = [s(1-τ)]+(τ-γ ). The
issues also become more complex as soon as we fully consider the dynamics and
repercussions from the money market and the foreign exchange market under
alternative exchange rate regimes. An interesting case could be considering the severity
of a recession and cyclical unemployment, respectively: The stronger the recession, the
more the value of the future steady state will be discounted; it is easy to introduce such
a correction factor into our growth-oriented macroeconomic model. This also points to
an interesting empirical issue, namely how market participants form their long term
growth (and per capita income) expectations.
16

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