Course: Advanced Macroeconomics (806)

Semester: Autumn, 2021

ASSIGNMENT No. 2
Q.1 Acceleration theory of investment is a special case of more general neoclassical theory of investment.
Comment.
The accelerator principle states that an increase in the rate of output of a firm will require a proportionate
increase in its capital stock. The capital stock refers to the desired or optimum capital stock, K. Assuming that
capital-output ratio is some fixed constant, v, the optimum capital stock is a constant proportion of output so
that in any period t,
Kt =vYt
Where Kt is the optimal capital stock in period t, v (the accelerator) is a positive constant, and Y is output in
period t.
Any change in output will lead to a change in the capital stock. Thus
Kt – Kt-1 = v (Yt – Yt-1)
and Int = v (Yt – Yt-1) [Int=Kt– Kt-1
= v∆Yt
Where ∆Yt = Yt – Yt-1, and Int is net investment.
This equation represents the naive accelerator.
In the above equation, the level of net investment is proportional to change in output. If the level of output
remains constant (∆Y = 0), net investment would be zero. For net investment to be a positive constant, output
must increase.
This is illustrated in Figure 1 where in the upper portion, the total output curve Y increases at an increasing rate
up to t + 4 periods, then at a decreasing rate up to period t + 6. After this, it starts diminishing. The curve I n in
the lower part of the figure, shows that the rising output leads to increased net investment up to t + 4 period
because output is increasing at an increasing rate.
But when output increases at a decreasing rate between t + 4 and t + 6 periods, net investment declines. When
output starts declining in period t + 7, net investment becomes negative. The above explanation is based on the
assumption that there is symmetrical reaction for increases and decreases of output.

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 Course: Advanced Macroeconomics (806)
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In the simple acceleration principle, the proportionality of the optimum capital stock to output is based on the
assumption of fixed technical coefficients of production. This is illustrated in Figure 2 where Y and Y 1 are the
two isoquants.
The firm produces T output with K optimal capital stock. If it wants to produce Y 1 output, it must increase its
optimal capital stock to K1. The ray OR shows constant returns to scale. It follows that if the firm wants to
double its output, it must increase its optimal capital stock by two-fold.
Eckaus has shown that under the assumption of constant returns to scale, if the factor-price ratios remain
constant, the simple accelerator would be constant. Suppose the firm’s production involves the use of only two
factors, capital and labour whose factor-price ratios are constant.

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In Figure 3, Y, Y1 and Y2 are the firms’ isoquants and C, C1 and C2 are the isocost lines which are parallel to
each other, thereby showing constant costs. If the firm decides to increase its output from Y to Y 1, it will have
to increase the units of labour from L to L1 and of capital from K to K1 and so on.
The line OR joining the points of tangency e, e1 and e2 is the firms’ expansion path which shows investment to
be proportional to the change in output when capital is optimally adjusted between the iosquants and isocosts.

The flexible accelerator theory removes one of the major weaknesses of the simple acceleration principle that
the capital stock is optimally adjusted without any time lag. In the flexible accelerator, there are lags in the
adjustment process between the level of output and the level of capital stock.
This theory is also known as the capital stock adjustment model. The theory of flexible accelerator has been
developed in various forms by Chenery, Goodwin, Koyck and Junankar. But the most accepted approach is by
Koyck.
Junankar has discussed the lags in the adjustment between output and capital stock. He explains them at the
firm level and extends them to the aggregate level. Suppose there is an increase in the demand for output. To
meet it, first the firm will use its inventories and then utilise its capital stock more intensively.
If the increase in the demand for output is large and persists for some time, the firm would increase its demand
for capital stock. This is the decision-making lag. There may be the administrative lag of ordering the capital.
As capital is not easily available and in abundance in the financial capital market, there is the financial lag in
raising finance to buy capital. Finally, there is the delivery lag between the ordering of capital and its delivery.
Assuming “that different firms have different decision and delivery lags then in aggregate the effect of an
increase in demand on the capital stock is distributed over time. This implies that the capital stock at time t is
dependent on all the previous levels of output, i.e.
Kt = f ( Yt, Yt-1……., Yt-n).
This is illustrated in Figure 4 where initially in period t 0, there is a fixed relation between the capital stock and
the level of output. When the demand for output increases, the capital stock increases gradually after the
decision and delivery lags, as shown by the K curve, depending on the previous levels of output. The increase in

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 Course: Advanced Macroeconomics (806)
Semester: Autumn, 2021
output is shown by the curve T. The dotted line K is the optimal capital stock which equals the actual capital
stock K in period t.

Q.2 Both Keynes and Baumal theory of demand for money incorporate interest rate as one of the
elements of demand for money function. Does this mean that these theories are similar in nature? If
yes, how? If not list the points of difference.
The immediate effect of Keynes and Baumal 1968 AEA presidential address on the economics profession was
the introduction of an adaptive term in the Phillips curve that shifted the curve, as Keynes and Baumal
proposed, based on expected inflation. Initial formulations suggested that the shift was less than point-for-point,
but later thinking, based on the emerging idea of rational expectations, together with the experience of the
1970s, came to agree with Keynes and Baumal that the shift was by the full amount. The profession also
recognized that Keynes and Baumal point was deeper---real outcomes are invariant to the monetary policy rule,
not just to the trend in inflation. The presidential address made an important contribution to the conduct of
monetary policy around the world. It ushered in low and stable inflation rates in all advanced countries, and in
many less advanced ones.
The centerpiece of Keynes and Baumal (1968) presidential address to the American Economic Association,
delivered in Washington, DC, on December 29, 1967, was the striking proposition that monetary policy has no
longer-run effects on the real economy. Keynes and Baumal focused on two real measures, the unemployment
rate and the real interest rate, but the message was broader—in the longer run, monetary policy controls only the
price level. We call this the monetary-policy invariance hypothesis. By 1968, macroeconomics had adopted the
basic Phillips curve as the favored model of correlations between inflation and unemployment, and Keynes and
Baumal used the Phillips curve in the exposition of the invariance hypothesis. Keynes and Baumal presidential
address was commonly interpreted as a recommendation to add a previously omitted variable, the rate of
inflation anticipated by the public, to the right-hand side of what then became an augmented Phillips curve. We
believe that Keynes and Baumal main message, the invariance hypothesis about long-term outcomes, has
prevailed over the last half-century based on the broad sweep of evidence from many economies over many
years. Subsequent research has not been kind to the Phillips curve, but we will argue that Keynes and Baumal

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 Course: Advanced Macroeconomics (806)
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exposition of the invariance hypothesis in terms of a 1960s-style Phillips curve is incidental to his main
message.
Today, monetarism is mainly associated with Nobel Prize–winning economist Milton Keynes and Baumal.
In his seminal work A Monetary History of the United States, 1867–1960, which he wrote with fellow
economist Anna Schwartz in 1963, Keynes and Baumal argued that poor monetary policy by the U.S. central
bank, the Federal Reserve, was the primary cause of the Great Depression in the United States in the 1930s.
In their view, the failure of the Fed (as it is usually called) to offset forces that were putting downward
pressure on the money supply and its actions to reduce the stock of money were the opposite of what should
have been done. They also argued that because markets naturally move toward a stable center, an incorrectly
set money supply caused markets to behave erratically.
Monetarism gained prominence in the 1970s. In 1979, with U.S. inflation peaking at 20 percent, the Fed
switched its operating strategy to reflect monetarist theory. But monetarism faded in the following decades
as its ability to explain the U.S. economy seemed to wane. Nevertheless, some of the insights monetarists
brought to economic analysis have been adopted by nonmonetarist economists.
The foundation of monetarism is the Quantity Theory of Money. The theory is an accounting identity—that
is, it must be true. It says that the money supply multiplied by velocity (the rate at which money changes
hands) equals nominal expenditures in the economy (the number of goods and services sold multiplied by
the average price paid for them). As an accounting identity, this equation is uncontroversial. What is
controversial is velocity. Monetarist theory views velocity as generally stable, which implies that nominal
income is largely a function of the money supply. Variations in nominal income reflect changes in real
economic activity (the number of goods and services sold) and inflation (the average price paid for them).
The quantity theory is the basis for several key tenets and prescriptions of monetarism:
Long-run monetary neutrality: An increase in the money stock would be followed by an increase in the
general price level in the long run, with no effects on real factors such as consumption or output.
Short-run monetary nonneutrality: An increase in the stock of money has temporary effects on real output
(GDP) and employment in the short run because wages and prices take time to adjust (they are sticky, in
economic parlance).
Constant money growth rule: Keynes and Baumal, who died in 2006, proposed a fixed monetary rule,
which states that the Fed should be required to target the growth rate of money to equal the growth rate of
real GDP, leaving the price level unchanged. If the economy is expected to grow at 2 percent in a given year,
the Fed should allow the money supply to increase by 2 percent. The Fed should be bound to fixed rules in
conducting monetary policy because discretionary power can destabilize the economy.
Interest rate flexibility: The money growth rule was intended to allow interest rates, which affect the cost
of credit, to be flexible to enable borrowers and lenders to take account of expected inflation as well as the
variations in real interest rates.

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 Course: Advanced Macroeconomics (806)
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Although monetarism gained in importance in the 1970s, it was critiqued by the school of thought that it
sought to supplant—Keynesianism. Keynesians, who took their inspiration from the great British economist
John Maynard Keynes, believe that demand for goods and services is the key to economic output. They
contend that monetarism falters as an adequate explanation of the economy because velocity is inherently
unstable and attach little or no significance to the quantity theory of money and the monetarist call for rules.
Because the economy is subject to deep swings and periodic instability, it is dangerous to make the Fed slave
to a preordained money target, they believe—the Fed should have some leeway or “discretion” in conducting
policy. Keynesians also do not believe that markets adjust to disruptions and quickly return to a full
employment level of output.
Keynesianism held sway for the first quarter century after World War II. But the monetarist challenge to the
traditional Keynesian theory strengthened during the 1970s, a decade characterized by high and rising
inflation and slow economic growth. Keynesian theory had no appropriate policy responses, while Keynes
and Baumal and other monetarists argued convincingly that the high rates of inflation were due to rapid
increases in the money supply, making control of the money supply the key to good policy.
Aggregate demand (AD) is the total demand for final goods and services in a given economy at a given time
and price level.
There are four components of Aggregate Demand (AD); Consumption (C), Investment (I), Government
Spending (G) and Net Exports (X-M). Aggregate Demand shows the relationship between Real GNP and the
Price Level.
1. Net Export Effect
When domestic prices increase, then demand for imports increases (since domestic goods become relatively
expensive) and demand for export decreases.
2. Real Balances
When inflation increases, real spending decreases as the value of money decreases. This change in inflation
shifts Aggregate Demand to the left/decreases.
3. Interest Rate Effect
Real Interest is the nominal interest rate adjusted to the inflation rate. When inflation increases, nominal interest
rates increase to maintain real interest rates. Lower real interest rates will lower the costs of major products
such as cars, large appliances, and houses; they will increase business capital project spending because long-
term costs of investment projects are reduced.
4. Inflation Expectations
If consumers expect inflation to go up in the future, they will tend to buy now causing aggregate demand to
increase or shift to the right.
Any increase in any of the four components of aggregate demand leads to an increase or shift in the aggregate
demand curve as seen in the diagram above.

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Aggregate Demand = C + I + G + (X-M)

Consumption
This is made by households, and sometimes consumption accounts for the larger portion of aggregate
demand. An increase in consumption shifts the AD curve to the right.
1. Consumer Confidence
If consumers are confident about their future income, job stability, and the economy is growing and stable,
consumer spending is likely to increase. However, any job insecurity and uncertainty over income is likely to
delay spending. An increase in consumer confidence shifts AD to the right.
2. Interest Rates
Lower interest rates tend to increase consumption because consumers purchase larger goods on credit. If
interest rates are low, then it’s cheaper to borrow. Consumers mostly borrow to buy houses, which is one of the
biggest purchases and lower interest rates mean lower mortgage payments so that households can spend more
on other goods. Some Economists argue that lower interest rates also make saving less attractive, but there is no
real evidence. So, lower interest rates increase Aggregate Demand.
3. Consumer Debt
If a consumer has a lot of debt, he is unlikely to buy more since he would have to pay his debt off first. Low
consumer debt increases consumption and aggregate demand.
4. Wealth
Wealth is assets held by a household, such as property or stocks. An increase in property value is likely to
increase consumption.
Investment, second of the four components of aggregate demand, is spending by firms on capital, not
households. However, investment is also the most volatile component of AD. An increase in investment shifts
AD to the right in the short run and helps improve the quality and quantity of factors of production in the long
run.
1. Interest Rates

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 Course: Advanced Macroeconomics (806)
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Firms borrow from banks to make large capital intensive purchases, and if the interest rate decreases, it
becomes cheaper for firms to invest and provides an incentive for firms to take on risk.
2. Business Confidence
If firms are confident about the economy and its future growth, they are more likely to invest in capital, new
projects, and buildings/machinery.
3. Investment Policy
If governments provide incentives such as tax breaks, subsidies, loans at lower interest rates then investment
can increase. However, corruption and bureaucracy deter investment.
4. National Income
As firms increase output, they would need to invest in new machines. This relationship is known as The
Accelerator. The assumption behind the accelerator is that firms will want to main a fixed capital to output
ratio, meaning that if a factory uses one machine to produce 1000 goods, and the firms needs to produce 3000
goods more, then the firm will buy 3 more machines.
Q.3 Discuss how the following changes would affect the nature of structural rate of unemployment?
Comment also on the side effects of these changes.
a) Elimination of unions.
Trade unions have a track record of action against violence against women, both in the workplace and at home.  
Research conducted by the European Trade Union Confederation* shows that
 The vast majority of trade unions in Europe are involved in tackling violence against women.
 Action taken includes collective agreements at national, sectoral and company level featuring clauses on
dealing with violence against women.
 Agreements have included obliging employers to develop procedures for dealing with violence, training
for managers and employees to identify signs of workplace violence and how to prevent it, and medical
and psychological support for employees who are victims of domestic violence.
 Many trade unions offer legal and other support for members who are victims of violence in the
workplace, and in some cases victims of domestic violence.
 Many trade unions have organised events to discuss violence against women, and taken part in
Government initiatives to combat violence against women.       
 National trade unions have used the 2007 European ‘Framework agreement to prevent, manage and
eliminate violence at work’ negotiated and signed by the ETUC and European employers
(BUSINESSEUROPE, UEAPME and CEEP) to press for measures to protect women from violent
behaviour.  
b) Increased participation of women in the labour market.
In Pakistan, women work primarily in the home or on the farm. Their participation in work outside these areas,
particularly in formal employment, is extremely low. It is possible that some forms of work by Pakistani women

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may be undercounted in surveys, as a large proportion of survey respondents may be working in agriculture or
doing informal work at home, which is not counted and reported as work. However, the study analysis of the
2007 Pakistan Time Use Survey suggests that this is not a major driver of the patterns. The survey evidence
clearly indicates that a very low proportion of Pakistani women work outside the home, where best-paid work
opportunities abound.
 Despite increases in recent years, female labor force participation in Pakistan, at 25%, is well below
rates for countries with similar income levels. Even among women with high levels of education, labor
force participation lags: only around 25% of women with a university degree in Pakistan are working.
 This low female labor force participation represents a major loss of potential productivity. It also has
important implications for women’s empowerment, as working women are more likely to play a role in
household decision making compared with nonworking women in the same villages or even in the same
families.
 The study found that many women in Pakistan would like to work; there are multiple reasons why they
do not. One of the key reasons—on which policy could have an effect—is that women face restrictions
on their physical mobility outside the home.
 Several interconnected factors restrict women’s mobility outside the home, among them (i) social,
cultural, and religious norms; (ii) safety and crime; and (iii) the quality of available transport services.
c) an increase in unemployment benefits.
We examine the relationship between unemployment benefits and unemployment using Swedish regional data.
To estimate the effect of an increase in unemployment insurance (UI) on unemployment we exploit the ceiling
on UI benefits. The benefit ceiling, coupled with the fact that there are regional wage differentials, implies that
the generosity of UI varies regionally. More importantly, the actual generosity of UI varies within region over
time due to variations in the benefit ceiling. We find fairly robust evidence suggesting that the actual generosity
of UI does matter for regional unemployment. Increases in the actual replacement rate contribute to higher
unemployment as suggested by theory. We also show that removing the wage cap in UI benefit receipt would
reduce the dispersion of regional unemployment. This result is due to the fact that low unemployment regions
tend to be high wage regions where the benefit ceiling has a greater bite. Removing the benefit ceiling thus
implies that the actual generosity of UI increases more in low unemployment regions.
d) Elimination of minimum wages.
Minimum wages have been defined as the minimum amount of remuneration that an employer is required to
pay wage earners for the work performed during a given period, which cannot be reduced by collective
agreement or an individual contract.

Following this definition, minimum wages exist in more than 90 per cent of the International Labour
Organisation's (ILO) member States.

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The purpose of minimum wages is to protect workers against unduly low pay. They help ensure a just and
equitable share of the fruits of progress to all, and a minimum living wage to all who are employed and in need
of such protection. Minimum wages can also be one element of a policy to overcome poverty and reduce
inequality, including those between men and women.

Minimum wage systems should be defined and designed in a way to supplement and reinforce other social and
employment policies, including collective bargaining, which is used to set terms of employment and working
conditions.   

Historically, the purpose of minimum wages has evolved from a policy tool to be used selectively in a few low-
wage sectors to an instrument of much broader coverage.

ILO Conventions reflect this evolution:

 The Minimum Wage Fixing Machinery Convention, 1928 (No. 26) , encouraged countries to implement
minimum wages where “no arrangements exist for the effective regulation of wages by collective
agreement or otherwise and wages are exceptionally low”.
 Later, the Minimum Wage Fixing Convention, 1970 (No. 131)  called for coverage of “all groups of
wage earners whose terms of employment are such that coverage would be appropriate”. The principle
of full consultation with social partners lies at the heart of this Convention.
In defining a minimum wage, it is important to be specific about which components of a wage can be counted in
the minimum, the extent and conditions under which payment in-kind can be allowed, how the minimum is
calculated for workers with piece rate pay, and if the minimum is an hourly and/or a monthly rate.
Q.4 Whether there is a trade off between inflation and unemployment is basically a question of whether
labour is subject to money illusion. Comment.
The Harrod–Domar model is a Keynesian model of economic growth. It is used in development economics to
explain an economy's growth rate in terms of the level of saving and of capital. It suggests that there is no
natural reason for an economy to have balanced growth. The model was developed independently by Roy F.
Harrod in 1939, and Evsey Domar in 1946, although a similar model had been proposed by Gustav Cassel in
1924. The Harrod–Domar model was the precursor to the exogenous growth model.
Neoclassical economists claimed shortcomings in the Harrod–Domar model—in particular the instability of its
solution—and, by the late 1950s, started an academic dialogue that led to the development of the Solow–Swan
model.
According to the Harrod–Domar model there are three kinds of growth: warranted growth, actual growth and
natural rate of growth.

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Warranted growth rate is the rate of growth at which the economy does not expand indefinitely or go into
recession. Actual growth is the real rate increase in a country's GDP per year. (See also: Gross domestic
product and Natural gross domestic product). Natural growth is the growth an economy requires to maintain full
employment. For example, If the labor force grows at 3 percent per year, then to maintain full employment, the
economy’s annual growth rate must be 3 percent.
Let Y represent output, which equals income, and let K equal the capital stock. S is total saving, s is the savings
rate, and I is investment. δ stands for the rate of depreciation of the capital stock. The Harrod–Domar model
makes the following a priori assumptions:

1: Output is a function of capital stock

2: The marginal product of capital is constant; the production function exhibits constant returns to scale. This
implies capital's marginal and average products are equal.
3: Capital is necessary for output.
4: The product of the savings rate and output equals saving, which equals investment
5: The change in the capital stock equals investment less the depreciation of the capital stock

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First, assumptions (1)–(3) imply that output and capital are linearly related (for readers with an economics
background, this proportionality implies a capital-elasticity of output equal to unity). These assumptions thus
generate equal growth rates between the two variables. That is,

In summation, the savings rate times the marginal product of capital minus the depreciation rate equals the
output growth rate. Increasing the savings rate, increasing the marginal product of capital, or decreasing the
depreciation rate will increase the growth rate of output; these are the means to achieve growth in the Harrod–
Domar model.
Q.5 Prove mathematically as well as graphically that Golden Rule requires all savings to be invested and
all wages consumed.

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Economists have had an enormous impact on trade policy, and they provide a strong rationale for free trade and
for removal of trade barriers.  Although the objective of a trade agreement is to liberalize trade, the actual
provisions are heavily shaped by domestic and international political realities. The world has changed
enormously from the time when David Ricardo proposed the law of comparative advantage, and in recent
decades economists have modified their theories to account for trade in factors of production, such as capital
and labor, the growth of supply chains that today dominate much of world trade, and the success of
neomercantilist countries in achieving rapid growth.
The law of comparative advantage also holds equally well for many factors of production. In addition to labor
and capital, other factors of production include natural resources such as land and technology, and these can be
subdivided. For example, land can be land for mining or land for farming, or technology for making cars or
computer chips, or skilled and unskilled labor. Additionally, over time factor endowments may change. For
example, natural resources, such as coal reserves, may be used up, or a country’s educational system may be
improved, thereby providing a more highly skilled labor force.
Furthermore, some products do not utilize the same factors of production over their life cycle.[6] For example,
when computers were first introduced, they were incredibly capital intensive and required highly skilled labor.
Over time, as volume increased, costs came down and computers could be mass produced. Initially, the United
States had a comparative advantage in production; but today, when computers are mass produced by relatively
unskilled labor, the comparative advantage has shifted to countries with abundant cheap labor. And still other
products may use different factors of production in different countries. For example, cotton production is highly
mechanized in the United States but is very labor intensive in Africa. The fact that factors of production may
change does not nullify the theory of comparative advantage; it just means that the mix of products that a nation
can produce relatively more efficiently than its trade partners may change.
Traditional economic theories expounded by Ricardo and Heckscher-Ohlin are based on a number of important
assumptions, such as perfect competition with no artificial barriers imposed by governments. A second
assumption is that production occurs under diminishing or constant returns to scale, that is, the costs of
producing each additional unit are the same or higher as production increases. For example, to increase his
wheat crop, a farmer may be forced to use less-fertile land or pay more for laborers to harvest the wheat,
thereby increasing the cost of each additional unit produced.
Another key assumption of traditional economic theory is that basic factors of production—such as land, labor,
and capital—are not traded across borders. Although Ohlin believed that such basic factors of production were
not traded, he argued that the relative returns to factors of production between countries would tend to be
equalized as goods are traded between the countries. Subsequently, Samuelson argued that factor prices would
in fact be equalized under free trade conditions, and this is known in economics as the factor price equalization
theorem. This might mean, for example, that international trade would cause wage rates for unskilled workers to
fall in the high-wage country in relation to the rents available from capital and to the same level as wages in the

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low wage country, and for wages to rise in relation to the rents available from capital in the low-wage country
and equal to the level of the country where labor was less abundant. (The implications of this are important and
are explored further in chapter 8.)
In static terms, the law of comparative advantage holds that all nations can benefit from free trade because of
the increased output available for consumers as a result of more efficient production. James Jackson of the
Congressional Research Service describes the benefits as follows: Trade liberalization, “by reducing foreign
barriers to U.S. exports and by removing U.S. barriers to foreign goods and services, helps to strengthen those
industries that are the most competitive and productive and to reinforce the shifting of labor and capital from
less productive endeavors to more productive economic activities.”
Many economists, however, believe that the dynamic benefits of free trade may be greater than the static
benefits. Dynamic benefits, for example, include the pressure on companies to be more efficient to meet foreign
competition, the transfer of skills and knowledge, the introduction of new products, and the potential positive
impact of the greater adoption of commercial law. Thus trade can affect both what is produced (static effects)
and how it is produced (dynamic effects).
Economists have developed a number of sophisticated models designed to simulate the changes in economic
conditions that could be expected from a trade agreement. These models, which are based on modern economic
theories of trade, are helpful where the barriers to trade are quantifiable, although the results are highly sensitive
to the assumptions used in establishing the parameters of the model.
One type of model used extensively by economists to estimate the economy-wide effects of trade policy
changes, such as the results of a multilateral trade round, is the Applied General Equilibrium Model, also called
the Computable General Equilibrium (CGE) Model. James
Jackson of the Congressional Research Service notes: “These models incorporate assumptions about consumer
behavior, market structure and organization, production technology, investment, and capital flows in the form of
foreign direct investment.”
CGE models may be used to estimate the impact of a trade agreement on trade flows, labor, production,
economic welfare, or even the environment.  They may consider the effects of the agreement on all countries
involved, and are ex ante; that is, they attempt to forecast changes that would result from a trade agreement.
General equilibrium models are based on input-output models, which track how the output of one industry is an
input to other industries. General equilibrium models use enormous data inputs that reflect all the elements to be
considered.
One of the great strengths of these models is that they can show how the effects on industries flow through the
entire economy. One of their disadvantages is that because of their complexity, the assumptions behind their
projections are not always transparent. Economic models are useful to give a sense of what might happen as a
result of a trade agreement.  They give the appearance of being authoritative, but users need to be aware that
economic models are not predictive of what will actually happen and that they have significant weaknesses.

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First, the results of any model depend on the assumptions underlying it, such as the degree to which imported
products and domestically produced products can be substituted for one another, or whether or not there is
perfect or imperfect competition. Differing assumptions can produce a wide range of results, not only in
magnitude but also sometimes even in the direction of projected changes.
Consider, for example, a country that starts off with a GDP per capita of $40,000, which would roughly
represent a typical high-income country today, and another country that starts out at $4,000, which is roughly
the level in low-income but not impoverished countries like Indonesia, Guatemala, or Egypt. Say that the rich
country chugs along at a 2% annual growth rate of GDP per capita, while the poorer country grows at the
aggressive rate of 7% per year. After 30 years, GDP per capita in the rich country will be $72,450 (that is,
$40,000 (1 + 0.02)30) while in the poor country it will be $30,450 (that is, $4,000 (1 + 0.07) 30). Convergence has
occurred; the rich country used to be 10 times as wealthy as the poor one, and now it is only about 2.4 times as
wealthy. Even after 30 consecutive years of very rapid growth, however, people in the low-income country are
still likely to feel quite poor compared to people in the rich country. Moreover, as the poor country catches up,
its opportunities for catch-up growth are reduced, and its growth rate may slow down somewhat.

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