The Solow model in an open economy
The aim of this article is to extend the traditional Solow model to a small open economy. The hitherto made attempts insufficiently analyse the adjustment mechanism leading to the path of sustained growth (Benge M., Wells G., 2002). We attempt to fill this gap mainly by underlining the role of the speed of technological progress at the moment of a full opening to the international capital market. We are primarily interested in two fundamental issues: firstly, what advantages may a small economy gain from its opening to the international capital flow, and secondly, what is the role of savings in the open economy growth. The considerations are based on the assumption that the interest rate is formed exogenously. With regards to the first issue, the effects are ambiguous. To a large extent they are determined by the relation of the dynamics of technological progress to world interest rates at the moment of opening to the world capital market. A country which is relatively strong technologically profits (in national product, national income and consumption) from opening borders to capital if world rates are below the domestic rate in a closed economy. It loses if the world rate is higher than the domestic rate. A country with relatively low technological progress is in an exactly opposite situation. For such a country a higher level of world interest rate is more profitable, for although it loses in national product, it gains in national income and consumption. A change of interest rate has no impact on the gross national product and gross investments, while it plays an important role in creating national income, consumption, net exports and the accumulated national wealth of citizens. Generally, the growth of the savings rate favourably influences the level of national income and citizens' wealth, regardless of the pace of change in technological progress and the level of world interest rate. These two variables again become of key importance in the case of the course of consumption and net exports. A country which is relatively strong technologically loses in consumption and profits from net exports. This results from the need to allocate to the required flow of capital more than the additional income earned from foreign net assets (or saved in the form of reducing its export) amounts to. The lacking means come from decreased consumption. On the other hand, a country ￼with relatively low technological progress allocates less to the required flow of net foreign assets than the additional income gained (or saved due to reducing its export) from net foreign assets amounts to. This surplus increases consumption. (original abstract)
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