Indian Economic Problem Set Assignment
Student Name
Institution Affiliation
ECON 164: The Indian Economy
PROBLEM SET-1
Due on Canvas by 4:45pm on Monday, 13 April 2020 (as PDF: see instructions)
Q1. Why according to the Solow model should we expect poor countries to grow faster? In
practice, was this the case from 1950-80? Does this appear to be the case in the 2010s? What
changes in the world economy do you think played the biggest role in this change? Why do you
think this was the case?
| The Solow model is a theory of economic growth developed by Robert Solow in 1987. The model analyses changes in output levels in an economy due to changes in the economy’s population graphics over an extended period of time. The model states that developing countries grow faster as they have a higher influx of capital investment, leading to increased labour capital (Stein, 2010). As a result, the countries experience higher marginal returns to capital. Moreover, developing countries experience a slower pace of technological change, and therefore they adapt existing technologies rather than inventing new ones, which is an easier choice, leading to faster economic growth. Such robust economic growth was experienced in the past between 1950-1980 in countries such as China, Hong Kong, Taiwan, India, Singapore and South Korea who experienced an increased economic growth rate. However, the same trend was not replicated in the 2010s due to convergence as the emerging countries have grown up to the per-capita levels of income in developed countries. The idea of globalization that led to increased movement of people, capital and ideas is the reason behind convergence, as it facilitated the flow of knowledge and innovations from rich countries to poor countries, enabling them to catch up. |
Q2. What do we mean by a “poverty trap”? Explain the rationale behind three reasons for
poverty traps discussed in class – one based on “low savings”, second based on “absence of
market-facilitating institutions (like property rights, law and order etc.)”, and a third based on
“coordination failure”.
| A poverty trap refers to a mechanism within an economic system that makes it extremely difficult for individuals to evade poverty. The trap is created when such a system requires outstanding amounts of capital to get out of poverty, creating a vicious cycle of self-sustaining poverty if individuals within the economic system cannot access the funds. Poverty traps based on low savings suggest that if individuals or countries are too impoverished to save, they are unable to amass. The capital of such countries or individuals, therefore only grows at the same rate as the factor for total productivity. Their income becomes stagnant if productivity growth is zero or low. Coordination failure suggests that in the manufacturing sector of economies, there are increasing returns to scale, while in the agricultural industry, there are constant returns. Devoting most of the economy’s resources to production within the traditional sector will cause the equalization of wages across all sectors at a low level (Kraay & McKenzie, 2014, p. xx). Conversely, allocating most of the economy’s resources to the manufacturing industry due to a “big push” will lead to the realization of benefits resulting from high wages, increasing returns and high levels of overall income. However, if an economy fails to find an equilibrium in the allocation of capital between the two sectors, it can result in a poverty trap. The absence of market-facilitating institutions allows the existence of inefficient institutions that propagate inequality and prevent individuals and countries from accepting better egalitarian institutions. As a result, institutional poverty traps result, trapping the economies or individuals in perpetual poverty. |
Q3. For the most part, our focus on this course is on economic prosperity as measured by
GDP/Capita. Yet, prominent economists including Nobel Prize winner Amartya Sen have argued
that GDP/Capital may not be an adequate measure of development. Why do they argue this?
What is the HDI (define the components)? How does the HDI attempt to solve this problem? In
practice, there may not be much of a difference in rankings of countries when ranked by
GDP/capita and when ranked by HDI. Why is this the case?
| GDP/Capita is not an adequate measure of development as it is a measure income and poverty, which is the deprivation of capability but not of development which focuses on the expansion of human rights and freedoms. For it to be termed a measure of progress, GDP/Capita ought to focus on democracy, social choice, the expansion of access to markets, equality in countries to provide all citizens with a broad set of options, and the importance of the expansion of women’s freedoms to the society. Moreover, GDP/Capita emphasizes on the income and neglects the economic welfare of a nation, is not adjusted for proper distribution and the costs of pollution (Costanza, 2014). The Human Development Index (HDI) is a measure of economic development that uses health, education and living standards as performance measures (Undp, 2019). HDI solves the problem by attempting to include the multiple dimensions of development in its measurement. However, ranking countries using their HDI or GDP/Capita may not produce different results as the two measures are highly correlated. |
Q4. According to Arvind Panagariya, Phase-II of India’s economic history between 1950 and
2010 was characterized by a socialistic turn in India’s growth history. Give some examples of
these “socialist” policies/regulations.
| An example of socialist policies was the policy response of the World Bank and Aid India Consortium that devaluated the rupee in 1996, boosted productivity by lowering the protection on intermediate inputs of imports, and removed subsidiaries of exports. Additionally, Ms. Indira Gandhi advanced the socialist agenda by prevailing over the “Syndicate” and enforcing industry regulations, foreign investment and land ownership restrictions, labor laws, and nationalization of banks. |
Q5. India is the only large country in the world to have democratized before development.
What unique challenges has this raised for the process of economic development in India?
| India’s democratization before development creates challenges like skewing the trade-off between redistribution and public goods towards redistribution. Moreover, it is much easier for citizens of India to vote for redistribution than policies for long-term development, as shown in the elections of 2014 which were a defining moment for development. However, a debate on how to achieve development has still not been presented to the public. |
Q6. Commodity Baskets, Price Indices, and Purchasing Power Parity (PPP)
Read the slides on PPP and answer the following question
Suppose that you share an apartment with a roommate and in order to succeed at university
you pay monthly for tutoring. You have an old computer and are now considering buying the
new Microsoft Surface. You live far away from the university and you commute every day,
consuming approximately 30 gallons of gas per month.
The prices of renting an apartment, tutoring, the Microsoft Surface and gas in the U.S. and India
are given below for years 2015 and 2016.
For the following questions, consider a basket of annual rent, annual tutoring cost, 1 Microsoft
Surface/year and annual cost of gas.
| U.S. Dollars | Indian Rupees | |||
| 2015 | 2016 | 2015 | 2016 | |
| Monthly rent for a two bedroom apartment | $1,300 | $1,450 | Rs 4,000 | Rs 4,200 |
| Monthly Tutoring | $240 | $240 | Rs 1,200 | Rs 1,300 |
| Microsoft Surface Pro | $1,100 | $1,155 | Rs 55,000 | Rs 58,850 |
| Gas per gallon | $4.00 | $4.49 | Rs 240 | Rs 270 |
- a) Using 2015 and 2016 data for the above basket, calculate the rates of inflation in the U.S. and
India. [Hint: Clearly identify the reference “basket” of goods first and then calculate how much
it would cost to buy that basket of goods in 2015 and 2016]
| Basket of goods USA India 2015 2016 2015 2016 Annual rent $16,600 $17,400 Rs 48,000 Rs 50,400 Annual tutoring $2,880 $2880 Rs 14,400 Rs 15,600 Microsoft Surface $1,100 $1,115 Rs 55,000 Rs 58,850 Annual gas $1,440 $1,616.4 Rs 86,400 Rs 97,200 Annual consumption $22,020 $23,011.4 Rs 203,800 Rs 222,050 Price index 100 100 CPI ($23,011.4/$22,020) x 100 (Rs 222,050/ Rs 203,800) x 100 104.5 109 Inflation rate (104.5-100)/100 (109-100)/100 0.045 or 4.5 % 0.09 or 9%
|
- b) Suppose you only have access to a local tutor. State which of the above goods (rent, tutoring,
Microsoft Surface and gas) are likely to be tradable and which are not. Calculate market
exchange rate in Rs/$ using these criteria of tradable and non-tradable and the 2015 data.
| If only a local tutor is available, annual rent and tutoring is likely to be untradeable, while Microsoft surface and annual gas are likely to be tradable. US Dollars Indian Rupee Annual rent (non-traded) 16,600 48,000 Annual tutoring (non-traded) 2,880 14,400 Microsoft surface (tradable) 1,100 55,000 Annual gas(tradable) 1,440 86,400 Total 2,540 141,400 Market Exchange Rate 55.7 |
- c) Calculate PPP-adjusted exchange rate in 2015 and 2016. Did this rate change between 2015
and 2016? Why or why not?
| US Dollar Indian Rupee 2015 2016 2015 2016 Annual rent (non-traded) 16,600 17,400 48,000 50,400 Annual tutoring (non-traded) 2,880 2,880 14,400 15,600 Microsoft surface (tradable) 1,100 1,115 55,000 58,850 Annual gas 1,400 1,616.4 86,400 97,200 Total 22,020 23,011.4 203,800 222,050 PPP Exchange Rate 2015 2016 9.3 9.6 The PPP between 2015 and 2016 did not change because the real exchange rates on the basket of goods remained constant. |
- d) Suppose that in 2015, GDP per capita was roughly $48,100 in the U.S. and Rs 82,000 in India.
Calculate Indian GDP in dollars first using market exchange rate and then using PPP-adjusted
rate. Does the use of market exchange rate overstate or understate the social welfare in India?
Why is that the case?
| The GDP in dollars; At market exchange rates = 82,000/55.7 =$1,472 At PPP-adjusted rates = 82,000/9.3 = $8,817 The use of market exchange rates understates the social welfare of India because the PPP-adjusted GDP/Capita measure is higher than the Market GDP/Capita, implying higher living standards than those implied by the Market GDP/Capita. |
- e) Now suppose that your friend told you about online tutoring services offered by an Indian
company. Given that your tutoring options are no longer limited to local tutors, calculate the
2015 market exchange rate using information for above goods. Is the new exchange rate higher
or lower the one you calculated in part (b)? How do you explain the difference between the
new exchange rate and the one in part (b)?
| US Dollars Indian Rupee Annual rent (non-traded) 16,600 48,000 Annual tutoring (tradable) 2,880 14,400 Microsoft surface (tradable) 1,100 55,000 Annual gas(tradable) 1,440 86,400 Total 5,420 141,400 Market Exchange Rate 26.1 The new exchange rate is lower than the one previously calculated, implying that that the traded goods will be cheaper than the non-traded commodities. |
References
Costanza, R. (2014, December 9). Why GDP is not an accurate measure of economic growth. World Economic Forum. https://www.weforum.org/agenda/2014/12/why-gdp-is-not-an- accurate-measure-of-economic-growth/
Kraay, A., & McKenzie, D. (2014). Do poverty traps exist? Assessing the evidence. Journal of Economic Perspectives, 28(3), 127-148. https://doi.org/10.1257/jep.28.3.127
Stein, S. H. (2010). A Beginner’s Guide to the Solow Model. The Journal of Economic Education, 38(2), 187-193. https://doi.org/10.3200/JECE.38.2.187-193
Undp. (2019). Human development index (HDI). Human Development Reports | United Nations Development Programme. https://hdr.undp.org/en/content/human-development-index-hdi