Economic Growth in Small Open Economies Lessons From The Visegrad Countries

ECONOMIC
GROWTH IN SMALL
OPEN ECONOMIES
Lessons from the Visegrad Countries
István Kónya
Economic Growth in Small Open Economies
István Kónya
Economic Growth
in Small Open
Economies
Lessons from the Visegrad Countries
István Kónya
Centre for Economic and Regional Studies
Budapest, Hungary
ISBN 978-3-319-69316-3 ISBN 978-3-319-69317-0 (eBook)

https://doi.org/10.1007/978-3-319-69317-0
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Contents
1 Introduction 1
References 7
Part I Decomposing Growth and Development 9
2 Methodology and Stylized Facts 11

2.1 Countries and Data Sources 12
2.1.1 Real GDP 14
2.1.2 Economic Growth 16
2.1.3 The Level of Economic Development 20
2.2 The Neoclassical Production Function 23
2.2.1 Basic Assumptions 24
2.2.2 Decomposing Growth and Development 25
References 27
3 Labor Input and Labor Income 29

3.1 Employment and Hours 29
3.2 Schooling, Population, Labor Markets, and Human
Capital 33
v
vi Contents
3.3 Human Capital 40

References 45
4 Capital Stock and Capacity Utilization 47

4.1 Measuring Investment 48
4.2 Depreciation Rate 50
4.3 The Share of Capital in National Income 52
4.4 Initial Value and Capital Stock 55
4.5 Capacity Utilization 61
References 64
5 Growth and Development Accounting 65

5.1 Price Level and Population 66
5.2 Growth Accounting 69
5.3 Development Accounting 74
References 79
Part II Growth and Factor Markets 81
6 The Neoclassical Growth Model 83

6.1 Population and Technology 84
6.2 The Solow Model 85
6.3 Steady State and Relative Development 89
6.4 The Speed of Convergence 95
6.5 Households and the Ramsey-Cass-Koopmans Model 97
6.5.1 The Competitive Model 98
6.5.2 Steady State and Solution 100
References 103
7 Markets and Distortions 105

7.1 Theoretical Framework 107
7.1.1 Households 107
7.1.2 Firms 109
7.1.3 Equilibrium 109
Contents vii
7.2 Measurement Issues 111

7.2.1 Calibrating Parameters 112
7.2.2 Data and Expectations 114
7.3 Results 115
7.3.1 The Labor Wedge 116
7.3.2 The Capital Wedge 118
7.3.3 The Borrowing Wedge 120
7.4 Additional Calculations 122
7.4.1 Decomposing the Capital Wedge 122
7.4.2 Taxes on Labor 124
7.4.3 Taxes on Capital 127
7.5 Development Simulations 131
References 134
Part III Growth, Shocks, and Crisis 137
8 Growth and the Financial Environment 139

8.1 The Model 140
8.1.2 Firms 143
8.2 Model and Facts 147
8.2.1 Model Simulations 149
8.3 Growth and Shocks in the Visegrad Countries 154
References 164
9 Credit Crisis and Growth 165

9.1 Main Ingredients 166
9.2 The Model 172
9.2.2 Production 176
9.2.3 The Central Bank 178
viii Contents
9.3 Crisis and Exchange Rate Policy 183

9.3.1 Calibration 184
9.3.2 Results 188
References 198
Summary 201
Bibliography 203
Index 205
List of Figures
Fig. 1.1 Economic development before 1500. The figure

presents historical GDP per capita numbers for four
countries/regions before 1500. Source: The Maddison
Project, http://www.ggdc.net/maddison/maddison-
project/home.htm, 2013 version 2
Fig. 1.2 Economic development after 1800. The figure presents
historical GDP per capita numbers for large geopolitical
regions in the modern era. Western Europe: Austria,
Belgium, Denmark, Finland, France, Germany,
Great Britain, Italy, Netherlands, Norway, Sweden,
Switzerland. Settler colonies: Australia, New Zealand,
Canada, the USA. Eastern Europe: Albania, Bulgaria,
Czechoslovakia, Hungary, Poland, Romania, Yugoslavia.
East Asia: China, India, Indonesia, Japan, Philippines,
South Korea, Thailand, Taiwan, Bangladesh, Burma,
Hong Kong, Malaysia, Nepal, Pakistan, Singapore,
Sri Lanka. Latin America: Argentina, Brazil, Chile,
Columbia, Mexico, Peru, Uruguay, Venezuela. Africa:
changing composition. Source: The Maddison-Project,
http://www.ggdc.net/maddison/maddison-project/
home.htm, 2013 version 3
ix
x List of Figures
Fig. 2.1 Real GDP over time, Western Europe. The figure
presents chained GDP series for four Western
European countries. Source: Total Economy Database,
The Conference Board 17
Fig. 2.2 Real GDP over time, Visegrad countries. The
figure presents chained GDP series for the four
Visegrad countries. Source: Total Economy Database,
The Conference Board 18
Fig. 2.3 Relative development levels in 2014. The figure presents
GDP per capita for eight countries evaluated at market
exchange rates and PPP. Source: Total Economy
Database, The Conference Board 22
Fig. 3.1 The employment rate over time. The chart shows the
employment rate in the 15–64 age group. Source:
Eurostat 31
Fig. 3.2 Average hours worked. The chart shows average annual
hours worked in the 15–64 age group. Source: Eurostat 32
Fig. 3.3 Part-time employment as a share of total employment.
The chart shows part-time employment as a share of
total employment in the 15–64 age group. Source:
Eurostat 34
Fig. 3.4 Education levels in the general population. The chart
shows the composition of the population by education
levels in the 15–64 age group. Source: Eurostat 36
Fig. 3.5 Employment rate and education. The chart shows the
employment rate by education levels in the 15–64 age
group. Source: Eurostat 38
Fig. 3.6 Part-time employment by education. The chart shows
the share of part-time employment in total employment
by education levels in the 15–64 age group. Source:
Eurostat 39
Fig. 3.7 Total labor input. The chart shows normalized total
labor input computed with data on employment,
average hours, and human capital. Source: Eurostat and
own calculation 43
Fig. 4.1 Depreciation rates in the Penn World Table, 1998–2014.
The figure shows aggregate depreciation rates from the
PWT 9.0. Source: Penn World Table 51
List of Figures xi
Fig. 4.2 Estimating the income share of capital. The figure

shows the income share of capital in gross value added,
calculated using two methods. In the first method, we
divided mixed income between capital and labor the
same way as in the aggregate, while in the second we
assign all mixed income to labor. Source: Eurostat and
own calculations 54
Fig. 4.3 The evolution of the capital-output ratio. The figure
shows the evolution of the capital-GDP ratio, taking
into account one-time capital loss during transition
for the Visegrad countries. Source: Penn World Table,
Eurostat and own calculations 60
Fig. 4.4 The derived indicator of capacity utilization. The figure
shows the derived indicator of capacity utilization,
which is the unweighted average of full energy usage,
electric energy usage, and manufacturing capacity
utilization. Source: Eurostat and own calculations 63
Fig. 5.1 Relative GDP at constant and current PPPs. The
figure shows differences in levels of development
calculated using current and constant PPPs. The year
of comparison is 2014, and the reference country is
Germany (=100). Source: Eurostat and own calculations 68
Fig. 5.2 Changes in GDP and GDP per capita. The figure shows
a decomposition of GDP growth into contributions
of GDP per capita and population growth. Source:
Fig. 5.3 Growth accounting: Western Europe. The figure shows
the decomposition of GDP per capita growth into
contributions of capital, labor, capacity utilization, and
total factor productivity in Western Europe. Source:
Fig. 5.4 Growth accounting: Visegrad countries. The figure
shows the decomposition of GDP per capita growth
into contributions of capital, labor, capacity utilization,
and total factor productivity in the Visegrad countries.
Source: Eurostat and own calculations 71
xii List of Figures
Fig. 5.5 Decomposing relative development in Western

Europe in 2014 (Germany = 100). The figure shows
the decomposition of development levels relative to
Germany in Western Europe. Each column represents
the weighted level of a particular factor, relative to
Germany. Source: own calculations 75
Fig. 5.6 Decomposing relative development in the Visegrad
countries in 2014 (Germany = 100). The figure shows
the decomposition of development levels relative to
Germany in the Visegrad countries. Each column
represents the weighted level of a particular factor,
relative to Germany. Source: own calculations 76
Fig. 6.1 Convergence and equilibrium in the Solow model. The
picture shows the dynamics of the Solow model and
its long-run equilibrium. The functional forms and
parameter values are the following: f .k/ D k˛ , ˛ D 0:4,
ı D 0:06, D 0:02, D 0, s D 0:2. Source: own
calculations 87
Fig. 6.2 The equilibrium decomposition of relative development.
The picture shows the decomposition of the relative
development of the Visegrad countries compared
to Germany, based on the Solow model, to the
contributions of TFP, the convergence position, and
long-run equilibrium. Source: own calculations 92
Fig. 6.3 The saddle path in the RCK model. The figure shows
the phase diagram of the Ramsey-Cass-Koopmans
model. The functional forms and parameter values used
are: f .k/ D k˛ , u .c/ D log c, ˇ D 0:95, ˛ D 0:4,
ı D 0:08, D 0:02. Source: own calculations 102
Fig. 7.1 Labor wedge. The figure shows the labor wedge,
normalized appropriately. Source: Eurostat and own
calculations 117
Fig. 7.2 The capital wedge. The figure shows the capital wedge,
normalized appropriately. Source: Eurostat and own
calculations 119
Fig. 7.3 Household borrowing wedge. The figure shows the
borrowing wedge, appropriately normalized. Source:
List of Figures xiii
Fig. 7.4 Decomposing the capital wedge. The figure decomposes

the capital wedge into a domestic and international
component. Source: Eurostat and own calculations 123
Fig. 7.5 Labor wedge and labor taxation. The figure compares
the labor wedge and the combined income-consumption
implicit tax rates. Source: Eurostat and own calculations 126
Fig. 7.6 Capital tax and capital wedge. The figure compares
the capital wedge and the implicit tax rate on capital
income. Source: Eurostat and own calculations 130
Fig. 8.1 Historical shock decomposition for GDP growth. The
figure presents the historical shock decomposition of
GDP growth for the Visegrad countries. Note that the
steady state values are removed from the observed time
series. Source: own calculations 158
Fig. 8.2 Historical shock decomposition for consumption
growth. The figure presents the historical shock
decomposition of consumption growth for the Visegrad
countries. Note that the steady state values are removed
from the observed time series. Source: own calculations 159
Fig. 8.3 Historical shock decomposition for investment growth.
The figure presents the historical shock decomposition
of investment growth for the Visegrad countries. Note
that the steady state values are removed from the
observed time series. Source: own calculations 160
Fig. 8.4 Historical shock decompositions for the trade balance.
The figure presents the historical shock decomposition
of the trade balance, relative to GDP, for the Visegrad
countries. Note that the steady state values are removed
from the observed time series. Source: own calculations 161
Fig. 8.5 The implicit real interest rates. The figure plots the
implicit interest rates generated by the model structure
and the estimation. Source: own calculations 162
Fig. 9.1 CDS spreads before and during the global financial
crisis. The figure shows the evolution of the five-year
sovereign credit default swap (CDS) spread in the four
Visegrad countries. Source: Bloomberg 166
xiv List of Figures
Fig. 9.2 Crisis and indebtedness. The figure shows the maximum
increase in the sovereign CDS spread for new six EU
member states in the last quarter of 2008, against
the NFA positions relative to GDP in 2008. Source:
Eurostat and Bloomberg 167
Fig. 9.3 The importance of foreign currency lending in total
lending. The figure shows the stock of foreign currency
bank lending to the non-financial sector as a fraction of
the total stock of debt for the Czech Republic, Hungary,
Poland, and Romania. Source: Eurostat 170
Fig. 9.4 The Linex function representing the costs of changing
the wage. The figure shows the costs of changing
the nominal wage in consumption equivalent units.
The parameter values are the same as in the model
calibration. Source: own calculation 176
Fig. 9.5 The Linex specification for the interest premium
function. The figure plots the interest premium as a
function of the net foreign asset position. The parameter
values are given by the model calibration. The dashed
line is the benchmark exponential specification,
which was used in the previous chapter. Source: own
calculation 181
Fig. 9.6 Calibration of the interest premium function. The figure
shows the calibration of the interest premium function,
using the 2008Q4 increase in the CDS spreads for
the Czech Republic and Hungary and the NFA/GDP
positions before the crisis. Source: Bloomberg and own
calculation 185
Fig. 9.7 The baseline and the data, Czech Republic. The figure
shows the simulation baseline and the comparable data
points for the Czech Republic. Data is between 2008
and 2011. Source: Eurostat and own calculations 189
Fig. 9.8 The baseline and the data, Hungary. The figure shows
the simulation baseline and the comparable data points
for Hungary. Data is between 2008 and 2011. Source:
List of Figures xv
Fig. 9.9 The baseline and the data, Poland. The figure shows
for Poland. Data is between 2008 and 2011. Source:
Fig. 9.10 The baseline and the data, Slovakia. The figure shows
for Slovakia. Data is between 2008 and 2011. Source:
Fig. 9.11 Alternative exchange rate regimes, Czech Republic. The
figure shows the simulation baseline and counterfactual
simulations for extreme exchange rate regimes for the
Czech Republic. Source: own calculations 194
Fig. 9.12 Alternative exchange rate regimes, Hungary. The figure
shows the simulation baseline and counterfactual
simulations for extreme exchange rate regimes for
Hungary. Source: own calculations 195
Fig. 9.13 Alternative exchange rate regimes, Poland. The figure
Poland. Source: own calculations 196
Fig. 9.14 Alternative exchange rate regimes, Slovakia. The figure
Slovakia. Source: own calculations 197
List of Tables
Table 2.1 Growth statistics 19

Table 4.1 The relative price of investment in 2005 48
Table 4.2 Capital loss during transition in the Visegrad countries 59
Table 5.1 Growth accounting 73
Table 5.2 Convergence possibilities relative to Germany 77
Table 5.3 Labor input and relative development: the impact of
labor input components 78
Table 6.1 Parameters in the Solow model 90
Table 7.1 Simulation results 133
Table 8.1 Descriptive statistics 148
Table 8.2 Calibrated parameters 150
Table 8.3 Model simulations, low financial frictions
( D 0:00001) 151
Table 8.4 Model simulations, high financial frictions ( D 0:05) 152
Table 8.5 Estimation results 156
Table 9.1 Calibration 187
Table 9.2 Data and trends 192
xvii
1
Introduction
The question of economic development plays a central role in modern

societies. Before the Industrial Revolution, people’s worldview was funda-
mentally static, where increases in general welfare are non-systematic and
temporary. If a country was able to achieve broad-based economic growth
for a while, this was inevitably ended by wars, epidemics, or population
growth that accompanied development (Malthus 2012). It seemed that
the only road to individual success was to grab existing positions of power,
either by moving into the old elite or by replacing it with a new one.
This, however, is a zero-sum game: personal gains can be achieved not by
a general increase in welfare but by the redistribution of existing goods.
Although very imprecisely, we have estimates for verifying the above.
The database of Angus Maddison and its current successor1 paints a
rudimentary, but fundamentally accurate picture about the economic
performance of the world before the Industrial Revolution. Since there
are only a few countries with a suitably long time series, I use the output
1
For the original data and their interpretation, see Maddison (2001), while for the current version,
see Bolt and van Zanden (2014).
© The Author(s) 2018 1

I. Kónya, Economic Growth in Small Open Economies,
https://doi.org/10.1007/978-3-319-69317-0_1
2 Economic Growth in Small Open Economies
1800
Egypt
England
1600 Italy
Irak
1400
GDP per capita, 1990 PPP $
1200
1000
800
600
400
200
0
1 1000 1300 1500
Year
Fig. 1.1 Economic development before 1500. The figure presents historical GDP
per capita numbers for four countries/regions before 1500. Source: The Mad-
dison Project, http://www.ggdc.net/maddison/maddison-project/home.htm, 2013
version
measures of states that existed in the current territories of Italy, England,

Iraq, and Egypt for illustration.
Figure 1.1 clearly shows the fact that in pre-modern societies per capita
incomes basically stagnated. The main reason for this is that through-
out history technological advances led mostly to population increases.
Malthusian theories looked like fundamental laws of nature. When
there were differences across nations, the source of these seemed static:
abundant local natural resources or appropriation of these resources from
elsewhere, controlling important trade routes, or simply just plundering
other countries through war. Moreover, these differences were fragile and
temporary: it is enough to think of the fall of Roman civilization or the
destruction of the Aztec and Inca empires.
1 Introduction 3
30000
Western Europe
Settler colonies
Eastern Europe
25000 East Asia
Latin-America
Africa
GDP per capita, 1990 PPP $
20000
15000
10000
5000
0
1820 1870 1913 1950 1989 2010
Year
Fig. 1.2 Economic development after 1800. The figure presents historical GDP
per capita numbers for large geopolitical regions in the modern era. Western
Europe: Austria, Belgium, Denmark, Finland, France, Germany, Great Britain,
Italy, Netherlands, Norway, Sweden, Switzerland. Settler colonies: Australia, New
Zealand, Canada, the USA. Eastern Europe: Albania, Bulgaria, Czechoslovakia,
Hungary, Poland, Romania, Yugoslavia. East Asia: China, India, Indonesia, Japan,
Philippines, South Korea, Thailand, Taiwan, Bangladesh, Burma, Hong Kong,
Malaysia, Nepal, Pakistan, Singapore, Sri Lanka. Latin America: Argentina, Brazil,
Chile, Columbia, Mexico, Peru, Uruguay, Venezuela. Africa: changing composition.
Source: The Maddison-Project, http://www.ggdc.net/maddison/maddison-project/
home.htm, 2013 version
It is ironic that when Malthus published his important book, changes

were already under way that offered the world an escape from the
Malthusian trap. Also based on the Madison database, Fig. 1.2 is a
dramatic illustration of the extent of economic development achieved
in the past 200 years. Average per capita income has grown fourfold in
Africa, sixfold in East and South Asia, 12-fold in Eastern Europe and Latin
America, 14-fold in Western Europe, and almost 23-fold in the so-called
settler colonies. A stagnating world was replaced by a dynamic global

economy.
The figure also shows, however, that we can find large differences
behind average growth rates. Although most countries of the world are
significantly richer now than they were 200 years ago, inequalities across
countries have also grown. While Western Europe was about three times
as rich as Africa at the beginning of the period, by 2010 this ratio is close
to 11. Differences between Western and Eastern Europe have remained
basically unchanged.
Growth theory studies the oldest and most central questions of eco-
nomics. What explains the explosion of global growth after long centuries
of stagnation? Why have today’s advanced economies managed to reach
sustained, balanced economic growth? What are the reasons behind the
relative underdevelopment of the rest of the countries of the world? What
are the conditions for a successful catch-up? It is clear that answering
these questions is fundamental for the global economy and for individual
countries.
It is impossible to answer all these questions in a single book, partly
because economics itself offers only partial explanations.2 There may
be many reasons behind economic success and failure, and these are
discussed in the vast literature on development. It is difficult, however, to
gauge the relative importance and general validity of the various factors.
There are also significant methodological differences among the different
approaches, which make comparing them harder. Macroeconomic time
series are short and often patchy, so relying only on empirical findings is
not enough.
In this book I study economic growth and development from a
relatively narrow perspective. The analysis uses the toolkit of neoclassical
growth theory, which started with the seminal contribution of Solow
(1956). I view this approach as a very useful and flexible way to summarize
and interpret stylized facts. The neoclassical model is modular. At various
degrees of complexity and structure, it can serve as a simple tool to make
sense of the data and also to calculate counterfactuals and give policy
2
Helpful and accessible overviews of the successes and open questions in growth theory are offered
by Helpman (2004) and Easterly (2001).
1 Introduction 5
advise. In the book I proceed from basic exercises toward more and more
sophisticated modeling and analysis.
I focus on a particular country group, the so-called Visegrad
economies: the Czech Republic, Hungary, Poland, and Slovakia. As a
comparison group, I also include four advanced European economies:
Austria, France, Germany, and Great Britain. The Visegrad countries are a
good laboratory for studying growth and convergence. Their transition to
market economies started in the early 1990s, when they were significantly
poorer than their Western counterparts. They had capital stocks that
were partly obsolete, and production efficiency also lagged far behind.
Given their proximity to (and expected membership of ) the European
Union, they were expected to converge relatively quickly both through
productivity gains and capital accumulation. The premise of this book is
that their experience in the past 20 years can be analyzed and understood
with the help of the neoclassical model.
I begin the analysis with a mostly empirical exercise. With minimal
assumptions, the neoclassical framework can be used to identify proxi-
mate causes of economic growth. This is the classical question of growth
accounting: what are the contributions of productivity, capital investment,
and labor input to growth in a given period. The same question can be
asked not only for a single country over time but also across countries in a
given year. Development accounting decomposes differences in economic
development between two countries, to contributions of production fac-
tors on the one hand and to the contribution of total factor productivity
on the other hand.
Growth and development accounting—while not completely free from
theoretical assumptions—are primarily descriptive tools to summarize
the data. As a next step, assuming somewhat more structure, I examine
what the usage of production inputs reveals about the efficiency of
factor markets. Efficiency conditions that follow from the neoclassical
framework can quantify the extent of factor market distortions. Based on
the calculated distortions, I can also predict the growth dividend that
would follow from lowering these inefficiencies in particular countries.
In the remaining part of the book, I concentrate on particular versions
of the fully specified, general equilibrium neoclassical growth model.
After the descriptive or semi-structural approaches, I interpret observed
time series through the lens of these particular model economies. First,
I try to identify the main stochastic shocks behind the volatility of eco-
nomic growth in the Visegrad countries. This is done by econometrically
estimating a stochastic version of the neoclassical model. Using the model
and the estimation results, one can identify the main external factors in
a given period. The main question here is the extent to which growth
volatility is explained by permanent shocks to productivity or changes in
international financial conditions.
Finally, I present an even more detailed model, which has been con-
structed to understand the impact of the financial crisis of 2008–2009 on
the Visegrad economies. I show that the worsening of external financial
conditions was an important channel through which the crisis impacted
these economies. I also show that initial conditions—primarily the extend
of foreign debt—were important to understand the consequences of the
financial shock in the four countries. The model can be used to analyze
the effectiveness of the observed monetary policy responses to the shock,
given initial conditions.
I firmly believe that in order to uncover causal relationships in eco-
nomics, we need theoretical assumptions and quantitative models. It
would perhaps be better to recover these relationships without any
assumptions, using only the data. This, however, is not possible: in
economics, and in macroeconomics in particular, data are too coarse.
Without external assumptions—that cannot be independently verified—
we cannot get clear answers. The scope for controlled experiments is also
extremely limited, and the best we can hope for is to study the effects of
well-identified random shocks. I treat the global financial crisis as such a
shock, at least for the Visegrad economies.
Models are indispensable when we want to understand an economic
phenomenon. It is important to keep in mind, however, that economic
models are always very stylized and that the same model might not be
appropriate to answer different questions.3 Therefore, although the book
uses a single analytical framework, the model details are different depend-
3
This general principle is discussed in detail in Rodrik (2015). According to Rodrik, economic
models are very useful to study economic and social issues, but we do not have an all-purpose
framework that can answer all questions. Therefore, Rodrik advocates the usage of small, well-
tailored models to analyze particular problems.
1 Introduction 7
ing on the particular question. The main advantage of this approach

is that data are interpreted with the help of a unified, transparent, and
consistent framework. There is enough flexibility, however, to highlight
theoretical considerations that I feel relevant for a given problem, while
pushing the less relevant elements into the background. It is not coinci-
dental that after 60 years the neoclassical growth model is still popular
for the analysis of economic development. While I am aware that some
of the neoclassical assumptions are questionable, and the framework is
not valid under all possible conditions, I find it very useful to analyze
“well-behaved” emerging economies such as the Visegrad countries.
As always, choosing a particular modeling tool limits the applicability
of the analysis. The neoclassical model is not designed to study many
relevant and important aspects of development. Examples include the
geographical and social determinants of economic growth, ethical aspects
of development, questions of environmental sustainability, or the role and
evolution of institutions in economic development. This book does not
substitute for the exploration of these important topics, but complements
them. My hope is that what follows is a useful addition to the study of
economic growth in general and in the Visegrad countries in particular.
References
Bolt, J., & van Zanden, J. L. (2014). The Maddison Project: Collaborative
research on historical national accounts. The Economic History Review, 67,
627–651.
Easterly, W. (2001). The elusive quest for growth: Economists’ adventures and
misadventures in the tropics. Cambridge: MIT Press.
Helpman, E. (2004). The mystery of economic growth. Cambridge: Belknap Press
of Harvard University Press.
Maddison, A. (2001). Development centre studies: The world economy a millennial
perspective. Paris: OECD Pub. and OECD Development Centre.
Malthus, T. R. (2012). Essay on the principle of population. Mineola: Dover
Publications.
Rodrik, D. (2015). Economics rules: The rights and wrongs of the dismal science.
New York: W.W. Norton.
Solow, R. M. (1956). A contribution to the theory of economic growth. The
Quarterly Journal of Economics, 70, 65–94.
Part I
Decomposing Growth and Development
In this part I take the first steps to study growth and development in the
Visegrad countries. My main goal is to calculate the relative contributions
of production inputs and productivity in growth and development.
As much as possible, I want to “let the data speak” and hence focus mostly
on measurement questions. I use the aggregate neoclassical production
function as my theoretical tool, but for now only as an accounting
device. My goal here is to highlight a few basic features of growth and
development. Later I will examine these in more detail, with an expanded
theoretical and empirical toolkit.
2
Methodology and Stylized Facts
An old question in the context of growth and development is to identify

the main factors behind a country’s GDP growth. One of the most com-
mon tools in the literature to answer this question is growth accounting.1
This is a decomposition of GDP growth into contributions of production
factors (physical and human capital2 ) and total factor productivity (TFP).
Although the decomposition cannot identify the deeper causes of growth,
it is still useful to point toward the promising directions when searching
for these fundamental explanatory factors.3
Growth accounting uses the concept of the aggregate production func-
tion. This assumes that total output can be written as the combination
of aggregate capital stock, total labor input, and an efficiency term. The
1
The literature on growth accounting is huge, and it is impossible to give an overview here. A
general starting point may be the survey of Hulten (2010). For particular methodological questions,
references will be given in the main text.
2
In the following we use “capital” to indicate physical capital. When discussing human capital, we
always use the qualifier “human” to avoid confusion.
3
The calculations use the approach described in Kónya (2015). The novelty in the current analysis
lies in the cross-country comparisons on the one hand and the extension to development accounting
on the other hand.

https://doi.org/10.1007/978-3-319-69317-0_2
existence of an aggregate production function was discussed and debated

in the past in many important contributions,4 but my goal here is not to
get into this controversy. Rather, accepting that the production function is
a useful approximation to interpret output movements, I want to see what
factors were responsible for GDP changes in the countries in question.
Growth accounting and the aggregate production function are useful to
answer this question. They help interpreting macroeconomic data, and
later I can build on the results when we start a deeper and more model-
based analysis of growth and development.
The key to the approach is that with the help of the production
function, I can link observed time series—GDP, physical capital, and
human capital—and unobserved productivity. This way I can quantify
the level and growth contribution of the latter as a residual. Therefore,
the success of the accounting method relies on how precisely production
inputs can be measured. In this part I attempt to handle problems in the
measurement of physical and human capital based on recommendations
in the theoretical and empirical literature, and get a more reliable and
more credible picture of the main proximate causes of economic growth.
Moreover, the methodological improvements described below should also
help in getting a better picture about the growth contribution of TFP.
2.1 Countries and Data Sources

The analysis focuses on eight countries. Four are the so-called Visegrad
countries: the Czech Republic, Hungary, Poland, and Slovakia. These
are the primary targets of this book, with similar geography, history, and
current economic and social conditions. Three of the other four countries
are the largest economies of the European Union: France, Germany, and
Great Britain. Economic developments in these countries have a large
4
The well-known Cambridge-Cambridge debate took place in the 1960s. On one side stood
researchers who emphasized the usefulness of the aggregate production functions; their leading
figures were associated with the Massachusetts Institute of Technology (Cambridge, MA, USA). On
the other side of the debate, scholars—many from the University of Cambridge in England—argued
that the aggregate production function should be discarded. About the debate and its aftermath,
see the review of Cohen and Harcourt (2003).
influence on growth prospects in the Visegrad countries. Finally, Austria is

also included in the sample, whose size and geographical position are very
similar to the Visegrad economies. Because of historical reasons, Austria
is more advanced than its neighbors and thus serves as a natural point of
aspiration.
The book uses multiple data sources. The primary source is the
Eurostat website,5 which is used to get national accounts and labor
market data. Since Eurostat publishes relatively short time series, in this
chapter—where basic indicators of long-run growth are presented—I use
an alternative database. The Total Economy Database (TED)6 contains
GDP and population data starting in 1950 for six countries, while in case
of the Czech Republic and Slovakia, time series start in 1970.
When studying economic growth and development, it is important
to clarify a few basic concepts. I measure output in a given year and
country at current prices: I add up the domestic currency (nominal)
value added of goods and services produced over the year. The measure
that I calculate this way is Gross Domestic Product (GDP). GDP is a
measure based on value added, which means that from the final value of
products, we subtract the value of intermediate inputs used in production.
This is important to avoid double counting of the latter. Value added
in a restaurant meal does not contain the vegetables consumed, since we
already counted them as agricultural produce. The product of a restaurant
is the added value—measured in money—that is the difference between
the bill paid by consumers and the total cost of ingredients used in
cooking the meal.
When calculating the total value of production, market prices are used
whenever possible. The assumption behind this is that most products are
sold on competitive markets; hence, their prices reflect accurately both
the valuation of consumers and the cost of production. This method
cannot be used for goods and services that are not sold on markets.
The most important examples are in the public sector; in Europe the
majority of education and health services belong to this category. Without
5
http://ec.europa.eu/eurostat.
6
The Conference Board, https://www.conference-board.org/data/economydatabase/.
market prices these GDP items are evaluated at cost, using the result
that on competitive markets, product prices equal the unit cost of their
production.
Measuring aggregate, current price output is thus problematic because
of the partial lack of price data. An additional difficulty is that actual,
available prices do not necessarily reflect the “true” value of a good.
One reason for this is that for some products, the producer—or the
consumer—might have market power. Also, market prices ignore such—
positive or negative—effects that arise at third parties, who are not part of
the original transaction (externalities). Finally, GDP ignores some factors
that might influence the welfare of a country. One example is the value of
leisure, others are illegal activities such as trade in illicit drugs. To sum up,
GDP is an imperfect, but easily available measure of a country’s output in
a given period. In what follows, I will use GDP to measure the economic
development of a country.7
2.1.1 Real GDP
Economic growth is the change in GDP, which sometimes takes on

negative values (recession), but tends to be positive in recent history.
Movements in current price output can result from two sources: one is
changes in production volumes, and the other is changes in their prices.
Since we are interested in the former, we need to filter the effect of general
price changes (inflation) from nominal GDP growth. Statistical offices use
chain linking to achieve this. The time series measure of economic growth
that is the result of chain linking is called real GDP.
To calculate real GDP, we need to fix prices between periods. The
chain-linking method of Eurostat calculates real GDP growth between
two periods such that quantities in the first and second years are aggre-
gated using prices in the first year. Let yi;t indicate the quantity of product
i produced in time t, and let pi;t be similarly its unit price. For simplicity,
7
Coyle (2014) provides a detailed account of the difficulties of GDP measurement and discusses its
advantages and disadvantages.
let us ignore intermediate inputs. Real GDP growth (gY;t ) then is given
by the following formula:
P
pi;t1 yi;t
gY;t DP i :
i pi;t1 yi;t1
If we choose a basis year (t D 0), then we can recursively create a chain-

linked real GDP series (Ytcl ):
X
Y0cl D pi;0 yi;0
i
Y1cl D gY;1 Y0cl

Y2cl D gY;2 Y1cl
::
:
Ytcl D gY;t Yt1
cl
:
Why do we need chain linking? Prior to its introduction, it was

common practice to calculate real GDP using prices from the base year
fp
to calculate fixed-price GDP (Yt ):
fp
X
Yt D pi;0 yi;t :
i
This method also filters out price changes, since we keep prices fixed
during the calculations. Prices, however, can change not only because of
inflation but also because the relative prices of different products evolve
over time. Relative prices contain important information to consumers
and producers, and we need to keep track of their evolution if we want to
get a realistic picture of how the structure of the economy changes. This is
especially important when we want to investigate economic growth over
a longer time period. Mobile phones appeared during the 1980s and were
initially very expensive and could be purchased by a select few. Today they
are widely available, thanks to the drastic decrease in their prices. If we
used 1990 prices to value the volume of mobile phones today, we would
exaggerate their relative importance compared to other products, whose
relative price increased since 1990.
Since chain linking updates the base price from year to year, it filters out
price level increase, but keeps track of relative price changes. This is the
main reason why statistical offices today use chain linking instead of fixed
prices.8 A disadvantage of chain-linked GDP components, however, is
that they are not (exactly) additive. For nominal GDP, expenditure items
add up to total production:
Yt D Ct C It C Gt C Xt Mt ;
where Yt is GDP, Ct is private consumption, It is investment, Gt is gov-

ernment consumption, Xt is exports, and Mt is imports, all measured at
current prices. Since chain linking is done separately for each component,
the sum of real consumption, real investment, and so on, does not equal
the value of chain-linked real GDP. This problem is not very important
in practice, but it is good to be aware of this limitation.
2.1.2 Economic Growth
After discussing the basic concepts, I now turn toward the data. As
indicated above, time series on economic growth come from the TED. I
use the variable XRGDP to measure annual, chain-linked real GDP. This
uses 2014 as the base year and constructs real GDP using the chained
growth rates starting backwards from 2014. Base year figures are in US
dollars, and market exchange rates are used to convert national currency
values. I discuss cross-country comparisons below, for now choosing the
base year has no impact on real growth rates within countries. One can
define economic performance either by total output or by output per
8
We should not confuse the basis year used in constructing fixed-price GDP with the basis year
used in calculating chain-linked volumes. In the latter case, choosing a basis year is just a choice of
units, and it only influences the level, but not the growth rate of real GDP. In the case of fixed-price
GDP, however, the basis year has a non-trivial impact on real growth rates as well.
Austria France
60 60
GDP per capita
GDP per capita

40 40
20 20
0 0
1950 1960 1970 1980 1990 2000 2010 1950 1960 1970 1980 1990 2000 2010
Germany Great Britain

60 60
GDP per capita
GDP per capita

40 40
20 20
0 0
1950 1960 1970 1980 1990 2000 2010 1950 1960 1970 1980 1990 2000 2010
Fig. 2.1 Real GDP over time, Western Europe. The figure presents chained GDP
series for four Western European countries. Source: Total Economy Database,
The Conference Board
capita. In this chapter I use the latter, as it is a better measure of living

standards. Real GDP per capita is constructed as the ratio of total real
GDP and the population level (POP) of a country.
Figure 2.1 shows the evolution of real GDP per capita in the four
Western European countries between 1950 and 2014. It is clear from the
figure that while there are significant fluctuations, the overall picture is
that of steady growth. Over the 64 years in the sample, per capita output
grew about fivefold. It is interesting to note, however, that while France
slowed down since 1980, the opposite happened in Great Britain.
Growth in the Visegrad countries looks quite different (Fig. 2.2).
Before transition to market economies (pre 1990), we see relatively stable,
although slowing Hungarian and Czech growth. There was already a
recession in Poland in the 1980s (Slovak data only starts in 1985, so it
is too short to draw conclusions before transition). The first years of
Czech Republic Hungary

20 20
15 15
GDP per capita
GDP per capita

10 10
5 5
0 0
1950 1960 1970 1980 1990 2000 2010 1950 1960 1970 1980 1990 2000 2010
Poland Slovakia
20 20
15 15
GDP per capita
GDP per capita

10 10
5 5
0 0
1950 1960 1970 1980 1990 2000 2010 1950 1960 1970 1980 1990 2000 2010
Fig. 2.2 Real GDP over time, Visegrad countries. The figure presents chained
GDP series for the four Visegrad countries. Source: Total Economy Database,
The Conference Board
transition brought recession in all four countries: in Slovakia, output loss

reached 20%, and in Hungary GDP fell by about 15% over three years.
The Polish recession was smaller, but it followed a decade of stagnation
and decline. A natural question arises about the comparability of pre- and
post-1990 data. Command economies had distorted prices, low product
quality, and a general subordination of consumer goods, so output figures
should be viewed with caution. It is nevertheless clear that regime change
brought large-scale unemployment (see below), and the fact that output
fell is uncontroversial (although its magnitude is not).
Table 2.1 presents further stylized facts about growth and its volatility
for the eight countries. For six economies, the sample period is 1951–2014,
while for the Czech Republic and Slovakia, the time series are shorter
(1971–2014 and 1985–2014). I compute statistics for the whole respective
sample periods and also for three sub-periods: 1951–1970, 1971–1990, and
1998–2014. For the Visegrad countries, measuring economic performance
Table 2.1 Growth statistics

1950–1970 1970–1990 1998–2014 1950–2014
Mean S.E. Mean S.E. Mean S.E. Mean S.E.
AUT 4.99 2.74 3.02 2.50 1.50 1.77 3.02 2.50
DEU 5.64 2.85 2.96 2.88 1.35 2.27 2.96 2.88
FRA 4.03 1.34 2.29 1.90 0.83 1.56 2.29 1.90
GBR 2.23 1.59 1.96 1.89 1.46 1.99 1.96 1.89
CZEa 1.99 3.12 2.35 2.91 1.99 3.12
HUN 3.65 3.41 2.10 3.55 2.31 2.86 2.10 3.55
POL 3.03 2.25 2.60 3.41 3.80 1.60 2.60 3.41
SVKb 2.56 4.98 3.46 3.55 2.56 4.98
Source: Total Economy Database and own calculations
a
Data starts in 1970
b
Data starts in 1985
after transition is made difficult by the sharp recession in 1990–1992

and the subsequent fast correction. I assume that the initial transition
shock dissipated by 1998. Since later analysis will focus on the 1998–
2014 period, I choose this as the third sub-sample. The first six columns
present statistics for the three sub-periods, while the last two columns
contain numbers for the whole sample (subject to data availability as
discussed above).
There are a couple of interesting observations in the table. In the
WE economies,9 we see the fastest growth in the first period. The main
reason for this is that the reconstruction period after World War II—
the 1950s and 1960s—led to temporarily faster growth and convergence.
This effect is particularly strong in countries devastated by the war, while
it is much weaker in Great Britain. I will discuss the phenomenon of
conditional convergence later. Poland and Hungary also grew fast between
1951 and 1970, but compared to Austria, France, and Germany, this was
still a period of falling behind. All countries slowed down significantly
between 1971 and 1990, but the growth deficit of the CE countries
mostly remained. The data do not support the view that before transition
the Visegrad economies converged to the more successful countries of
Western Europe.
9
From now on, I will use WE to denote the fours Western European economies, and CE to refer
to the Visegrad (“Central European”) countries.
Compared to the decades before transition, the last period after 1998
brought convergence for the Visegrad countries. All four economies grew
faster than their Western counterparts, even with the 2008–2011 global
financial crisis in the sample. Slovakia and Poland grew particularly fast,
while the Czech Republic and Hungary converged more slowly. But even
in these two countries, economic performance was superior to the 1970–
1990 period, while the opposite is true for the WE economies. Overall,
we can conclude that transition led to growth acceleration in the CE
countries. This conclusion remains even if we start the last sub-period
in 1995 instead of 1998.
I now turn briefly to discuss the volatility of GDP growth. This was
larger in the Visegrad countries in the full sample and in most sub-periods
as well. I will also examine this stylized fact in detail later: what is the
reason for growth being not only faster but also more volatile in emerging
countries compared to advanced economies?
2.1.3 The Level of Economic Development
Until now I looked at the economic performance of individual countries

over a longer time period. I compared economic growth across countries,
but did not discuss differences in the level of economic development in a
given year. I now turn to the discussion of this issue.
Comparing economic development across countries is made difficult
by the fact that conversion of nominal GDP at market exchange rates—
which was used to construct the figures in the previous section—ignores
differences in price levels across economies. Since GDP measurement is
done at current prices, output will appear higher in countries that have
generally higher prices, even when produced volumes are similar. To make
the comparison meaningful, detailed, cross-country price comparisons
are needed. The implicit exchange rate under which the price levels
of two countries are equal—and which is typically different than the
official rate—is called purchasing power parity (PPP). For example, when
Hungarian prices measured in Euros at the official exchange rate of
300 HUF/EUR are on average half of their Austrian counterparts, the
PPP exchange rate would be 150 HUF/EUR. If we want to compare
the real economic performance of Austria and Hungary, we need to

convert Hungarian nominal GDP not at the official, but the implicit PPP
exchange rate.
The most comprehensive cross-country price comparisons are done
by the World Bank, in 3–8 year intervals (International Comparison
Program, ICP). The last round was in 2011; detailed description of
the study and its results are available on the World Bank homepage.10
The 2011 survey contains a full comparison for 177 countries, while
a further 22 countries are partially covered. This survey is used by
the international Penn World Table database,11 which contains PPP
corrected data since 1950, mostly for GDP and its expenditure items.
The previously used TED also contains PPP GDP figures, out of which
I will present comparable numbers for 2014. It is worth mentioning that
the European Union (Eurostat) also carries out price surveys annually
for member states. Finally, it is important to be aware of the limitations
of PPP comparisons, which are particularly important when we want to
compare countries that are very different in space, time, or in their level of
development. Price levels represent consumption bundles for a “typical”
country, but expenditure shares are very different, for example, when
we compare a developing African economy with a developed Asian one.
Therefore, PPP conversions are useful, but imperfect tools.12 Fortunately
our eight countries are similar enough that the potential problems are not
very severe.
Figure 2.3 shows a comparison of economic development levels for the
eight countries in 2014. The figure uses TED data and presents per capita
GDP levels using both market and PPP exchange rates. For the former, I
use the variable XRGDP, while for the latter I use the variable EKSGDP. In
both cases, total GDP is divided by the level of the respective populations.
I use Germany as the point of comparison, so the two German values are
equal by definition.
10
http://siteresources.worldbank.org/ICPEXT/Resources/ICP_2011.html.
11
http://www.rug.nl/research/ggdc/data/pwt/?lang=en.
12
Interested readers should consult the important study of Deaton and Heston (2010), who present
a detailed discussion of the many pitfalls of using the Penn World Table.
45000
Market exchange rate
40000 Purchasing power parity
GDP per capita in 2014 (EUR)
35000
30000
25000
20000
15000
10000
5000
0
AUT CZE DEU FRA GBR HUN POL SVK
Fig. 2.3 Relative development levels in 2014. The figure presents GDP per capita
for eight countries evaluated at market exchange rates and PPP. Source: Total
Economy Database, The Conference Board
The figure shows that the development levels in the Western European
economies are very similar, independent of which exchange rate is used.
There are some differences both in per capita GDP and in price levels, but
these are quite small. The same is true when we compare the Visegrad
countries to each other. Price level differences tend to be small among
countries at similar levels of development. We get a different picture,
however, when we compare the CE economies to the WE economies.
Using market exchange rates, per capita output in the former is roughly
one third of per capita output in the latter. In this case, however,
price level differences are substantial. Using PPP measures, per capita
GDP in the Visegrad countries is about 60% of the levels in the four
advanced economies. This result is an illustration of the general and
well-documented relationship that poorer countries tend to have an
undervalued exchange rate relative to what PPP would suggest.
To summarize the main facts on economic growth and development,

I found the following. After World War II, countries grew fast for 2–
3 decades due to reconstruction. Growth uniformly slowed down after
1970. Until 1990, even after initially fast growth, the Visegrad countries
could not converge to the Western European economies, since growth
in the former group was consistently lower. Contrary to this earlier
period, there is significant convergence after 1998. As a result, the Czech
Republic, Hungary, Poland, and Slovakia reached roughly 60% of the
GDP per capita of the other four countries, measured at purchasing power
parity. Finally, the growth process of the Visegrad countries was more
volatile, as there are larger fluctuations in annual growth rates then in
their more advanced counterparts.
These are the basic facts that I will analyze in more detail in the
following chapters. I will study the main factors behind the differential
growth rates, development levels, and volatilities. Before the description
of the results, I now turn to the main theoretical framework that will guide
the investigations. In this chapter I look at the basic tools and refine them
later as needed.
2.2 The Neoclassical Production Function

Calculations presented in this part—and in the book in general—use
versions of the neoclassical growth model. The central element in this
framework is the neoclassical production function, which I now briefly
review. In what follows, I assume that factor markets are perfectly
competitive, and there is a representative firm that maximizes its profits
taking factor prices as given. Last but not least, the level and growth
rate of technology (production efficiency) are exogenously given. These
assumptions are standard in the literature.13
On the production side of the economy, I assume the existence of
an aggregate, value added production function. This means that total
13
See Basu (1996) for an important exception, where constant returns to scale are not assumed ex
ante.
output over a period can be written as a function of available inputs,

their utilization, and an efficiency term. In general, I write the aggregate
production function as follows:
Yt D F .ut Kt ; Xt Lt / ;
where Yt is the period output (GDP), Kt is the stock of physical capital,

Lt is the total labor input, and ut is the capacity utilization for capital,14
and Xt is labor-augmenting productivity. Improved productivity allows an
economy to produce more output for a given combination of inputs.
2.2.1 Basic Assumptions
When describing the main properties of the aggregate production func-

tion, I omit capacity utilization for simplicity. The neoclassical produc-
tion function is given by the following assumptions:
F1 ; F2 > 0
F11 ; F22 < 0
lim F1 D lim F1 D 1
KD0 ND0
lim F2 D lim F2 D 0;
KD1 ND1
where Fi indicates partial derivatives with respect to the ith argument of

the function. The first two sets of inequalities imply that the marginal
product of factors is positive, but declining. The equalities describing the
limits of marginal products are called the Inada conditions. While not
strictly necessary, they guarantee the existence of internal steady states in
the equilibrium versions of the neoclassical growth model.
14
It is possible to write capacity utilization more generally, and not just for capital, such as in Basu
(1996). For labor input this is not only (measured) fluctuation in hours, since work intensity can
vary significantly even for a given amount of hours. We return to measurement problems with
capacity utilization later.
Another important assumption is constant returns to scale (CRS). This

means that when all inputs are increased in the same proportion, output
also increases proportionally:
F .K; XL/ D F .K; XL/ :
CRS is the economic equivalent of the mathematical property of first-

degree homogeneity. For a function f that is homogeneous of degree , the
following is true: f .x/ D f .x/, where x is the vector of arguments.
Therefore, constant returns to scale is equivalent to a degree of D 1
homogeneity.
Below I list three important properties of CRS functions:

K F(K; XL)
F ;1 D
XL XL

K
Fi .K; XL/ D Fi
XL
F1 (K; XL)K C F2 (K; XL)XL D F(K; XL):
The first equation follows from the definition. The second states that
partial derivatives of a function that are homogeneous of degree 1 are
homogeneous of degree zero. Finally, the third equation is also known as
Euler’s formula, which states that the marginal products weighted by the
factor usage exhaust the total amount of production. In a competitive set-
ting, where marginal products equal factor prices, Euler’s formula implies
no economic profits, since the value of output is paid out to factor owners.
2.2.2 Decomposing Growth and Development
In the following I will use a Cobb-Douglas specification. This simplifies

the notation, but the general conclusions remain valid for more general,
constant returns to scale production functions. More specifically, let
Yt D At .ut Kt /˛ Lt1˛ ; (2.1)

where At D Xt1˛ is the level of total factor productivity (TFP). Labor

input is a combination of employment, hours, and human capital. I will
describe these in detail in the next chapter.
Growth accounting decomposes changes in GDP over time into contri-
butions of inputs and productivity. As a first step, let us introduce GDP
per capita (Yt =Nt ), where Nt stands for the size of the population. Using
Eq. (2.1), we can write GDP per capita as follows:
˛ 1˛
Yt Kt Lt
D At u˛t ; (2.2)
Nt Nt Nt
where Kt =Nt and Lt =Nt are capital and labor input per person, respec-
tively. In what follows I use “labor input” to indicate the per capita
measure, while the full amount of labor will be referred to as “total labor
input.”
We can take the logarithm of Eq. (2.2), then its first difference to arrive
at the following decomposition:
Yt Kt Lt
log D ˛ log C .1 ˛/ log C ˛ log ut C log At ;
Nt Nt Nt
(2.3)
where the log ./ function refers to the natural logarithm with base e. The
equation shows that we can decompose changes in GDP per capita into
a weighted average of changes in factor availability, changes in capacity
utilization, and finally to the contribution of the unobserved productivity
component that acts as a residual. To implement the theoretical decom-
position empirically, we need time series for GDP, inputs, and capacity
utilization. We also need a value for the parameter ˛. I will detail these
steps in the following chapters.
Development accounting is a very similar exercise, where we decompose
GDP per capita differences across countries in an analogous way. Let us
use again Eq. (2.2) and compare output per capita between two countries:
˛ 1˛ ˛
Yi =Ni Ki =Ni Li =Ni ui Ai
D : (2.4)
Yj =Nj Kj =Nj Lj =Nj uj Aj
Although we could take logarithms as above, this is less desirable here. The
reason is that the logarithmic transformation approximates percentage
changes when these changes are relatively small, which is the case for
annual growth rates. When comparing countries, however, differences
can be large, as we saw earlier in the case of the Western European and
Visegrad countries. In that case the logarithms can no longer be inter-
preted as percentage differences. Therefore, in case of the development
accounting exercise, I keep the original, multiplicative decomposition.
Notice that the decomposition assumes that the parameter ˛ is the same
across countries—I will return to this issue in a later chapter.
In what follows I will quantify the decompositions given by Eqs. (2.3)
and (2.4). I will need parameter values and time series for output and
factors of production. Although conceptually simple, the decompositions
based on the production functions raise many measurement problems. In
the next chapters, I will study the measurement of capital, labor input,
and capacity utilization in detail.
References
Basu, S. (1996). Procyclical productivity: Increasing returns or cyclical utiliza-
tion? The Quarterly Journal of Economics, 111, 719–751.
Cohen, A. J., & Harcourt, G. C. (2003). Retrospectives whatever happened to
the Cambridge capital theory controversies? Journal of Economic Perspectives,
17, 199–214.
Coyle, D. (2014). GDP: A brief but affectionate history. Princeton: Princeton
University Press.
Deaton, A., & Heston, A. (2010). Understanding PPPs and PPP-based national
accounts. American Economic Journal: Macroeconomics, 2, 1–35.
Hulten, C. R. (2010). Growth accounting. In Handbook of the economics of
innovation (Vol. 2, pp. 987–1031). Amsterdam: Elsevier.
Kónya, I. (2015). Több gép vagy nagyobb hatékonyság? Növekedés,
tőkeállomány és termelékenység Magyarországon 1995–2013 között [More
machines or increased efficiency? Economic growth, capital and productivity
in Hungary between 1995–2013]. Közgazdasági Szemle [Hungarian Economic
Review], 62, 1117–1139.
3
Labor Input and Labor Income
The factor of production “total labor input” of the previous chapter is a

combination of three components. The first component is employment,
and the second is hours worked per employed person. Finally, it is
important to take into account skills, the human capital of workers. In
this chapter I discuss these factors in detail. I show how available data can
be used to construct measures of total hours, weighted by human capital.
Since time series used in human capital measurement start in 1998, in this
and future chapters, I use 1998–2014 as my sample period.
3.1 Employment and Hours

Employment and annual average hours’ data come from the Eurostat
website, using the sectoral breakdown of production in the national
accounts.1 The statistics refer to the total economy. To get average annual
hours, I divide total annual hours by employment. The latter is reported
below relative to the size of the age group 15–64 in the population.
1
“Employment by A*10 industry breakdowns.” The variable used is nama_10_a10_e.

https://doi.org/10.1007/978-3-319-69317-0_3
Figure 3.1 shows changes in the employment rate for the Western
European and Visegrad countries. Employment increased in the four
former economies. The increase was largest in Germany and smallest in
Great Britain. On the other hand, the employment rate was uniformly
high in the UK, and Germany and Austria simply caught up with this
level by 2014. Although there were improvements, the employment rate
was consistently lower in France than in the other three countries.
The picture is less clear in the Visegrad countries. Although we see
higher employment rate everywhere in 2014 than in 1998, there were
also significant fluctuations during the period. This is particularly stark in
Poland, with a sharp decline in the early 2000s, and the following increase.
In Hungary and the Czech Republic, there was a significant increase after
2010, following the temporary decline associated with the global financial
crisis.
Comparing the two country groups, the employment rate is clearly
lower in the Visegrad countries. Only the Czech Republic has a higher
rate than France, but even Czech employment is below the level of the
other three Western European countries. Looking only at employment,
it is tempting to attribute at least some of the differences in development
levels across the two regions to labor input (see Eq. (2.4)).
This conclusion is premature, however, as Fig. 3.2 shows. Higher
employment rates in Western Europe are accompanied by lower average
hours. In Germany, where the employment rate is highest by the end of
the period, average annual hours are much lower than either in Great
Britain or in the Visegrad countries. Hours are particularly high in
Poland, but they are above the Western European level in all converging
economies. Looking at total hours—the product of employment and
average hours—labor input in the Visegrad economies is no longer lower
than labor input in Western Europe. Total hours worked, compared to
Germany, are 15% higher in the Czech Republic, 6% higher in Hungary,
and 14% higher in Poland. Total hours in Slovakia are somewhat lower,
they are 92% of the German level. The first correction, which is to include
average hours worked, changes relative labor input levels systematically.
In some cases, such as Germany during the financial crisis, it also affects
the dynamics of labor input.
What is the explanation behind lower average hours in the Western
European economies? One possibility is the higher number of vacation
Western Europe
0.75
0.7
Employment rate
0.65
0.6
0.55 AUT
DEU
FRA
GBR
0.5
1998 2000 2002 2004 2006 2008 2010 2012 2014
Visegrad countries
0.75
0.7
Employment rate
0.65
0.6
0.55 CZE
HUN
POL
SVK
0.5
1998 2000 2002 2004 2006 2008 2010 2012 2014
Fig. 3.1 The employment rate over time. The chart shows the employment rate
in the 15–64 age group. Source: Eurostat
Western Europe
2100
AUT
2000 DEU
FRA
GBR
1900
Average yearly hours
1800
1700
1600
1500
1400
1300
1998 2000 2002 2004 2006 2008 2010 2012 2014
Visegrad countries
2100
2000
1900
Average yearly hours
1800
1700
1600
1500
CZE
HUN
1400 POL
SVK
1300
1998 2000 2002 2004 2006 2008 2010 2012 2014
Fig. 3.2 Average hours worked. The chart shows average annual hours worked
in the 15–64 age group. Source: Eurostat
days, another is a shorter work week, such as the 35-hour week introduced
in France. Finally, average hours worked also depend on the importance
of part-time employment within overall employment. Since I will use this
statistic in the measurement of human capital, it is interesting to look at
part-time employment trends in the eight countries.
Figure 3.3 shows the importance of part-time employment in each
country. We can see that this is much higher in Western Europe than
in the Visegrad region. Although part-time employment grew in most
countries, in Austria, Germany, and Great Britain, every fourth worker
is part-time, while in the four East-Central European economies, the
fraction of part-timers is only 5–7%. Therefore, part-time employment
is a crucial determinant behind the differences in average hours, and it is
important to take it into account in the following calculations.
3.2 Schooling, Population, Labor Markets,

and Human Capital
Human capital plays a central role in the theoretical and empirical analysis
of economic growth and development. Workers’ skills and abilities differ,
and the composite knowledge embodied in total labor hours changes over
time and is likely to differ across countries. To be able to include human
capital in our growth and development accounting calculations, we
need to condense this heterogeneous knowledge into a single, aggregate
indicator. The most common way to do that is to treat human capital
used in production as a function of the average education level of the
general population (Caselli 2005). The database2 assembled by Barro
& Lee (2013) contains data for schooling at five-year intervals, for the
majority of the world’s countries. The standard measure of human capital
transforms school years in such a way that it assigns higher productivity
to more education. This link is quantified using a rate of return function,
which is based on microeconomic estimates.
The approach used in this book is based on this methodology, with two
important differences. First, we will see that the employment rate differs
2
http://www.barrolee.com/.
Western Europe
0.28
AUT
DEU
0.26 FRA
GBR
0.24
Part-time work
0.22
0.2
0.18
0.16
0.14
1998 2000 2002 2004 2006 2008 2010 2012 2014
Visegrad countries
0.1
0.09
0.08
0.07
Part-time work
0.06
0.05
0.04
CZE
0.03
HUN
POL
0.02
SVK
0.01
1998 2000 2002 2004 2006 2008 2010 2012 2014
Fig. 3.3 Part-time employment as a share of total employment. The chart shows
part-time employment as a share of total employment in the 15–64 age group.
Source: Eurostat
significantly between different education groups. It is thus misleading to

use average schooling in the general population to compute total labor
input, as the education level of the employed is typically higher. Second,
there are differences in the education levels of full-time and part-time
workers, which means that not only employment but also average hours
are related to human capital. In this section I present stylized facts that
confirm these statements. In the next section, I discuss how we can take
into account the heterogeneity of the labor market according to education
levels when computing total labor input.
Data for education levels comes from the Eurostat homepage. The
Labor Force Survey (LFS), which is available for all European Union coun-
tries, contains population and employment data by completed school
years and full-time/part-time status. Data are available for the eight coun-
tries from 1998 at the annual frequency.3 I use the following data series:
lfsa_pgaed is population by schooling levels, and lfsa_epgaed
is employment by schooling levels. The latter series contains employment
not only by schooling but also by employment type (part- or full-time).
The EU-LFS distinguishes three groups based on education levels:
these are people without secondary school degrees (ISCED 2011, 0-2),
people with secondary school degrees (ISCED 2011, 3–4), and people
with tertiary degrees (ISCED 2011, 5–8). In what follows I will use the
qualifiers “primary,” “secondary,” and “tertiary.” In Germany and Great
Britain, data are missing for 1998, so I linearly interpolate between 1997
and 1999. The relevant population, as in the earlier aggregate data, is the
age group 15–64.
Education levels within the population are shown on Fig. 3.4, where I
also compare the beginning of the period (1998) and the end of the period
(2014). It is clear that average education increased in all countries: the
share of people with primary education declined, the share of those with
tertiary education increased, while the share of people with secondary
education did not change significantly. There are significant differences
across countries, but these are not obviously linked to economic develop-
ment. The share of tertiary degrees is highest in France and Great Britain,
3
LFS series—detailed annual survey results (lfs_emp).
Primary
0.5
1998 2014
0.4
0.3
0.2
0.1
0
CZE DEU FRA HUN AUT POL SVK GBR
Secondary
0.8
0.6
0.4
0.2
0
Tertiary
0.4
0.3
0.2
0.1
0
Fig. 3.4 Education levels in the general population. The chart shows the com-
position of the population by education levels in the 15–64 age group. Source:
Eurostat
but the share of primary degrees is also high in these two countries. In
contrast, there are fewer university graduates in the Visegrad countries,
but there are more people with high school degrees.
On the next chart (Fig. 3.5), I plot the employment rate by education
levels, also for 1998 and 2014. In all countries, the employment rate
among the low-skilled is significantly lower than among the highly skilled.
Employment rates among people with primary education are on average
40%, while the employment rates of university graduates are around
80%. The employment rate of high school graduates falls in between,
but it is closer to the latter number. Interestingly, while cross-country
heterogeneity is substantial, it is concentrated among the low-skilled: the
employment rate for this group is twice as high in Great Britain than in
Slovakia. It is true more generally that higher employment in Western
Europe can be attributed mostly to differences in low-skilled employ-
ment. Finally, it is worth pointing out that employment rates are quite
stable over time. This means that taking account of employment rate
differences by education when computing human capital is important for
cross-country comparisons, but less so for growth accounting in a given
country.
Finally, let us look at the distribution of part-time employment by
education levels. The message of Fig. 3.6 is that there is substantial
heterogeneity both over time and across countries in this indicator. It is a
robust fact that the share of part-timers is highest among the low-skilled.
There are, however, large differences across countries: in 2014 this number
is 35% in Germany, but only 10% in Hungary. Moreover, the share of
part-time employment among the highly skilled is 20% in Germany, but
only 5% in Hungary. In contrast to the previous chart, part-time work is
more prevalent in Western Europe, and the gaps with Visegrad countries
do not appear only among the low-skilled.
The importance of part-time also changed over time, at least in some
countries. The share of part-time workers grew mostly in the Western
European countries, by 10 percentage points on average between 1998 and
2014. Among the Visegrad countries, only Slovakia shows a significant
increase. This could be the consequence of workfare programs in Slovakia,
whose participants appear as part-timers in the data (Scharle 2015).
Primary
1
1998 2014
0.8
0.6
0.4
0.2
0
Secondary
1
0.8
0.6
0.4
0.2
0
Tertiary
1
0.8
0.6
0.4
0.2
0
Fig. 3.5 Employment rate and education. The chart shows the employment rate
by education levels in the 15–64 age group. Source: Eurostat
Primary
0.4
1998 2014
0.3
0.2
0.1
0
Secondary
0.4
0.3
0.2
0.1
0
Tertiary
0.4
0.3
0.2
0.1
0
Fig. 3.6 Part-time employment by education. The chart shows the share of part-
time employment in total employment by education levels in the 15–64 age group.
Source: Eurostat
To summarize, we see the following trends in the labor market:
1. Employment rates are higher in Western Europe than in the Visegrad

countries, and they grew more between 1998 and 2014.
2. One reason for this is growth in part-time employment, which partly
explains the observed decline in average hours.
3. In the Visegrad countries, employment among the low-skilled is
particularly low compared to Western Europe.
4. Part-time employment in the Visegrad economies is significantly lower
in all education groups than in Western Europe.
These are the stylized facts which motivate the use of employment and
hours distinguished by education groups when computing total labor
input relevant for aggregate output. In what follows I discuss the details
of this computation.
3.3 Human Capital

I start with by noting that employment numbers in the EU-LFS are typi-
cally lower than employment numbers from national accounts. Therefore,
I use the EU-LFS to calculate the distribution of workers across groups,
but I scale up the absolute numbers such that the sum of employment
across groups equals the national accounts employment figure. Let Etlfs in-
dicate the number of the employed among the age group 15–64 according
lfs
to the EU-LFS, and let Eij;t denote the same statistic within a particular
group, where i = primary, secondary, tertiary indicates education and
j D part, full indicates employment type. Furthermore, let Et stand for
total employment in the national accounts. Then I scale the size of a
particular subgroup as follows:
lfs Et
Eij;t D Eij;t : (3.1)
Etlfs
Employment by education data does not contain direct information

on hours per worker; therefore, I compute hours for full- and part-time
workers the following way. Let hj;t be the average hours for employment
type j D full, part. Furthermore, let ht denote average annual hours in
national accounts (as seen above). As an identification assumption, I
assume that hpart;t D hfull;t =2, that is, I assume that part-time hours equal
one half of full-time hours. Using this, I can solve the following equation
for the average annual hours of full-time workers:
Efull;t hfull;t Epart;t
ht D hfull;t C ; (3.2)
Et 2 Et
P
where Ej;t D i Eij;t , and Eij;t is given by Eq. (3.1).
The literature (Caselli 2005) converts education into human capital
by matching completed school years to a rate of return schedule. Since
education data is only available in three groups, I need to assign average
school years to these three categories. I use the following assumptions:
• Primary school: 8 completed years

• Secondary degree: 12 completed years
• Tertiary degree: 16 completed years.
Naturally, these numbers are only estimates, behind which there may be
significant heterogeneity both within and across countries. In principle,
it is possible to measure skills more precisely, using a dataset such as
PIAAC compiled by the OECD.4 An advantage of my method is that
the indicator can be computed for a relatively long time series, which is
easily accessible and internationally comparable.
In what follows, let us simplify notation by using i D P; S; T and
j D P; F (Primary, Secondary and T ertiary, and Part-time and F ull-
time). Based on Caselli (2005) and Kónya (2013, 2015), I compute total
labor input using the following formula:
X hF;t

HCt D hF;t EiF;t C EiP;t exp Œ .i / ; (3.3)
iDP;S;T
2
4
http://www.oecd.org/skills/piaac/.
where hF;t is the average hours worked by full-time workers (Eq. (3.2)),
Eij;t is employment in a particular category (Eq. (3.1)), i is the number of
school years assigned to an education category, and the function exp ./
converts school years to human capital. I assume that the function ./ is
piece-wise linear, and the slopes correspond to returns to human capital
investment at particular education levels. Based on Caselli (2005), I set
these returns to 0:134 for the first four years of schooling, for grades 4–8
we use 0:101, and for grades above 9 the rate of return is assumed to be
0:068.
The functional form and rates of return were chosen by Caselli (2005)
based on an important, earlier contribution by Hall & Jones (1999). On
competitive labor markets wages reflect the human capital of a worker.
The link between education and wages is typically written in log-linear
form in the labor economics literature (Mincer 1958). Psacharopoulos
(1994), on the other hand, finds that the rate of return to schooling in
sub-Saharan Africa is 13.4%, the world average is 10.1%, and the rate of
return in OECD countries is 6.8%. Since average education levels in these
regions roughly correspond to the 4, 8, and 8+ cutoffs, the piece-wise log-
linear specification represents a compromise between the labor economics
literature and the aggregate, cross-country empirical evidence.
Figure 3.7 shows the evolution of total labor input per capita in the
eight countries. The indicator is normalized such that in its theoretical
maximum the employment rate relative to the total population is 0:6,
all workers work 52 40 hours annually, and all of them have a tertiary
degree.
The figure shows significant heterogeneity across countries, but these
are not systematically related to the regions. Within Western Europe, total
labor input is low in France, increasing from a low base in Germany,
and average in Great Britain and Austria. In Central Europe total labor
input is high in the Czech Republic, average in Hungary, while total labor
input rose from an average to high level in Poland and from a low to
average level in Slovakia. Therefore, the Visegrad region is not behind the
Western European countries: lower employment is balanced by higher
average hours and higher human capital among the employed.
Western Europe
0.56
AUT
DEU
0.54 FRA
GBR
0.52
0.5
0.48
0.46
0.44
0.42
0.4
0.38
1998 2000 2002 2004 2006 2008 2010 2012 2014
Visegrad countries
0.56
0.54
0.52
0.5
0.48
0.46
0.44
0.42 CZE
HUN
0.4 POL
SVK
0.38
1998 2000 2002 2004 2006 2008 2010 2012 2014
Fig. 3.7 Total labor input. The chart shows normalized total labor input com-
puted with data on employment, average hours, and human capital. Source:
Eurostat and own calculation
An alternative to the method used here in the literature is to measure

human capital indirectly by wages, as opposed to schooling (Ho &
Jorgenson 1999; O’Mahony & Timmer 2009). Measuring employment
(or hours) weighted changes in labor input in this case requires detailed
data on employment (or hours) and wage rates by education categories.
This approach is thus more data intensive than our method. It is also
unclear to what extent fluctuations in wage rates can be attributed to
changes in human capital, as opposed to other factors such as changes
in the bargaining power of different groups. Since my method is based
on a physical indicator of human capital (schooling), it is not subject to
such effects. An advantage of wage-based methods, however, is that it can
account for changes in the capacity utilization of labor, as long as wages
reflect such changes flexibly (e.g. through bonus payments). Overall, both
methods have advantages and disadvantages. I opt for the direct method,
mostly because of the relative simplicity of the calculations.
It is worth comparing my method to the calculations presented in van
Földvári & van Leeuwen (2011). They assume that human capital can be
well approximated by expected lifetime earnings, where they also assume
that wages grow at a constant rate. This method, however, is by its nature
very sensitive to the assumed wage growth rate and also to the discount
factor (see Eq. (8) in their paper). A further problem is that their method
essentially compounds annual average wages, but these increase also when
either physical capital or productivity increases, even when the stock of
human capital is constant. The production function, however, contains
the “real” quantity of human capital, and not its market value. Therefore,
I think that the method of van Leeuwen and Földvári (2011)—which
is otherwise very thorough and careful—overestimates human capital
growth in Hungary during the sample period. This can be seen on Fig. 5
in their article, which shows a doubling of human capital between 1995
and 2007. I do not feel this magnitude credible,5 and I think that it can
be attributed to wage increases caused by other factors.
5
Our calculations show that human capital per hour worked increased by only 11% between 1995
and 2013, mostly because the return function that converts school years to human capital (based
on Caselli (2005)) is strongly concave.
References
Barro, R. J., & Lee, J. W. (2013). A new data set of educational attainment in
the world, 1950–2010. Journal of Development Economics, 104, 184–198.
Caselli, F. (2005). Accounting for cross-country income differences. In
P. Aghion & S. Durlauf (Eds.), Handbook of economic growth (Vol. 1, 1st ed.,
Chapter 9, pp. 679–741). Elsevier.
Földvári, P., & van Leeuwen, B. (2011). Capital accumulation and growth in
Hungary, 1924–2006. Acta Oeconomica, 61, 143–164.
Hall, R. E., & Jones, C. I. (1999). Why do some countries produce so much
more output per worker than others? The Quarterly Journal of Economics, 114,
83–116.
Ho, M. S., & Jorgenson, D. W. (1999). The quality of the U.S. Work Force,
1948–95. Harvard University, Mimeo.
Kónya, I. (2013). Development accounting with wedges: The experience of six
European countries. The B.E. Journal of Macroeconomics, 13, 245–286.
Review], 62, 1117–1139.
Mincer, J. (1958). Investment in human capital and personal income distribu-
tion. Journal of Political Economy, 66, 281–302.
O’ Mahony, M., & Timmer, M. P. (2009). Output, input and productivity
measures at the industry level: The EU KLEMS database. Economic Journal,
119, F374–F403.
Psacharopoulos, G. (1994). Returns to investment in education: A global update.
World Development, 22, 1325–1343.
Scharle, Á. (2015). Közmunkaprogramok Szlovákiában [Public works programs
in Slovakia]. In Munkaerőpiaci Tükör 2014 (pp. 59–61). MTA Közgazdaság-
és Regionális Tudományi Kutatóközpont Közgazdaság-tudományi Intézet.
4
Capital Stock and Capacity Utilization
Growth and development accounting—and productivity measurement—

relies critically on the appropriate identification of capital input. This is
made harder by various problems of differing importance. The biggest
issue is that the level of the capital stock is not directly observable.
National accounts only contain investment, that is, gross changes in the
capital stock. To infer levels from changes in stocks, we need additional
theoretical assumptions.
To construct a capital stock measure, the literature relies primarily on
cumulating investment in an additive fashion. The simple way to do this
is to use the following equation, assuming homogeneous capital:
Kt D .1 ı/ Kt1 C It : (4.1)
According to the equation, the capital stock increases linearly with new
investment, while a ı fraction of the existing stock depreciates. Both
the assumption of linearity and of a constant depreciation rate are
simplifications, which are standard in the literature. It is possible to
distinguish depreciation rates by type of capital goods and/or calendar
time. This is what the Bureau of Economic Analysis does for the USA

https://doi.org/10.1007/978-3-319-69317-0_4
or the Penn World Table for a large set of countries. Since my analysis is
mostly a one-sector exercise, I use a constant depreciation rate, which is
consistent with the average value of the more disaggregated methods.
To derive a capital stock measure from investment data, I need to set
values for two parameters. One is the depreciation rate ı, and the other
is the initial stock of capital K0 . Given these, I can calculate the capital
stock time series for t > 0 using Eq. (4.1). This generally used tool is the
perpetual inventory method (PIM).
4.1 Measuring Investment

It is a well-documented stylized fact that the relative price of investment
goods declines with economic development (Hsieh & Klenow 2007).
The same investment spending as a percentage of GDP leads to more
real investment in a developed economy than in a poor country. Since
development levels among the eight countries in my investigation are
quite different, when doing cross-country comparisons, it is important
to take into account relative price differences. The data necessary for this
correction are available both in the Penn World Table and from Eurostat.
Since the calculations rely mostly on the second data source, the price
comparison data are also taken from Eurostat.
Table 4.1 shows purchasing power parity price indexes from Eurostat
in the case of GDP and investment goods for 2005. I take Germany
as the reference country, where by definition I normalize the prices of
GDP and investment to unity. The first two rows in the table show price
Table 4.1 The relative price of investment in 2005

AUT DEU FRA GBR CZE HUN POL SVK
PGDP 1:02 1 1:06 1:07 0:55 0:60 0:54 0:51
PINV 1:01 1 1:04 1:07 0:68 0:75 0:63 0:69
piy 0:99 1 0:97 0:99 1:23 1:26 1:18 1:36
The table shows price levels of GDP and investment across countries for the
year 2005. For both categories, Germany = 1
Source: Eurostat
levels relative to Germany, and the third row presents relative investment
prices computed from these levels (also relative to Germany), with piy D
PINV =PGDP .
Differences among Western European countries are fairly small. Gen-
eral price levels are marginally higher than in Germany, but investment
prices are basically the same in all four economies. This is not surprising:
when we compare countries at similar development level, there are no
significant differences between comparisons based on market exchange
rates or comparisons based on purchasing power parity.
Price levels in the Visegrad countries are lower than in Germany,
both for GDP and for investment goods. It is also true here that cross-
country differences within the group are relatively small, although there
is somewhat more heterogeneity than in Western Europe. The price
level of Hungary in 2005 was higher than the price levels in the other
three countries. It is clear, moreover, that investment goods—although
cheaper in absolute terms than in Germany—are relatively expensive.
The difference is significant: on average the relative price of investment
goods is 25% higher in the Visegrad countries. This means that when
we want to compare capital abundance across the two country groups,
chain-linked investment quantities in the Visegrad countries would have
to be divided by the relative prices shown in the table. One unit of GDP,
which was spent on investment in Hungary in 2005, bought only 1=1:26
times as much real investment as one unit of GDP spent on investment
in Germany.
Based on this consideration, I use the following investment time series.
The basic observations are the chain-linked investment series in national
accounts, where I define investment as gross fixed capital formation. I
convert GDP and the previously defined investment series to Euros using
market exchange rates, then I correct them with the price levels shown
in Table 4.1. Using this method, I express GDP and investment for all
countries and all periods in a common unit, using Germany in 2005 as
the reference.
Notice that the problem of international price level differences cor-
rected this way only applies when we compare countries. Since I am
using chain-linked time series, relative price changes within countries
over time are already taken into account, without the PPP correction.
In other words, the purchasing parity adjustment here means the choice
of a measurement unit, which is constant over time and common across
countries; hence, it does not influence developments over time. To see
this more precisely, let us write down the annual growth rate of the capital
stock, defined as a logarithmic difference:

Kt .1 ı/ Kt1 C It It
log D log D log 1 ı C
Kt1 Kt1 Kt1
Since the capital stock is calculated by cumulating investment, It and Kt1

are expressed in the same unit. Therefore, it is irrelevant what this unit
is, we still get the same growth rate. This is not true for cross-country
comparisons, and the purchasing parity correction can significantly affect
results when the countries are at different levels of development.
Below I provide a detailed description of how I construct capital stocks,
with a particular focus on difficulties caused by economic transition in the
Visegrad countries. Before turning to this, however, I discuss the choice
of the depreciation rate.
4.2 Depreciation Rate

As I discussed above, there are sectoral estimates for the depreciation rate
that are quite different depending on the sector and capital good type in
question. The Bureau of Economic Analysis (USA) reports detailed tables
for the depreciation rates it uses by asset type, which are based on the price
decline of assets over time.1 The aggregate capital stock and depreciation
rate are calculated using sectoral investment data and the depreciation
rates differentiated by asset type. The results of these calculations show,
according to BEA data, that the aggregate depreciation rate in the USA
was rising slowly for an extended period, but on average over the last 30
years, it fluctuated around 5% with a small standard error.
The 9.0 version of the Penn World Table contains aggregate depreci-
ation rates across countries. The database uses the sectoral values of the
1
US Department of Commerce. Bureau of Economic Analysis. Fixed Assets and Consumer Durable
Goods in the USA, 1925–97. Washington, DC: US Government Printing Office, September, 2003.
0.054
0.052
0.05
0.048
0.046
0.044
0.042
0.04
0.038
0.036
0.034
1998 2000 2002 2004 2006 2008 2010 2012 2014
Fig. 4.1 Depreciation rates in the Penn World Table, 1998–2014. The figure shows
aggregate depreciation rates from the PWT 9.0. Source: Penn World Table
BEA to calculate detailed depreciation and then aggregates these into the
level of the national economy. Figure 4.1 shows these values for the 1998–
2014 period. Based on the figure, we can see that the PWT depreciation
rate varies across countries and over time, but stays within the relatively
narrow range of 0:035–0:055. For simplicity I set the depreciation rate
uniformly at ı D 0:05.
Higher values can be found in Dombi (2013), Pula (2003),
and Leeuwen & Földvári (2011) for Hungary. Arguments for faster
depreciation—at least in the Visegrad countries—are the quick
depreciation of old assets during transition, and that assets are
replaced more quickly in emerging economies. Since I take capital
loss during transition explicitly into account (see below), assuming a
higher depreciation rate would lead to double counting of the same
phenomenon. On the other hand, it is likely that in the USA a larger
fraction of the capital stock is given by faster depreciating assets, such as
software, intellectual goods, and so on. Overall, it is not clear that using
a higher depreciation rate is warranted in the Visegrad economies.
4.3 The Share of Capital in National Income

Future calculations will use the elasticity of the production function with
respect to capital (˛). Under perfect competition this equals the share of
capital in value added. Similarly to the literature, I use this relationship
to set the value of the parameter.
In aggregate national accounts, gross value added is decomposed into
compensation of employees (W) and into the sum of capital income (gross
operating surplus, …) and mixed income of households (M). Mixed income,
however, since it is typically the income of small entrepreneurs, contains
both labor and capital compensation. Therefore, to calculate the share of
capital accurately, it is not enough to rely on the share of employees.
This is a well-known issue, which is usually handled the following
way (Gollin 2002; Valentinyi & Herrendorf 2008). Within the detailed
income accounts, mixed income appears separately for households. To
divide this into labor and capital compensation, the literature assumes
that the share of capital income within mixed income is the same as the
share of capital income within aggregate value added. Let M D w C
,
where w and
are the unobserved labor and capital components within
mixed income. Then the assumption can be written as

D ˛;
M
while the definition of the share of capital is
…C
D ˛:
W C…CM
Substituting the first equation into the second, and expressing ˛, we get
the following expression:
…
˛D ; (4.2)
W C…
that is, that the share of capital equals the ratio of gross operating
surplus relative to the sum of the compensation of employees and gross
operating surplus. The calculation thus removes mixed income and bases
the estimate of capital share on the corporate sector.
Although the calculation can easily be done using Eurostat data for
each country, I choose a different route, based on two considerations.
For a growth accounting exercise (Eq. (2.3)), using a country-specific
capital share does not cause any problems, since the method relies on time
series data in a single country. Although less common in the literature,
even time-varying capital shares can be used. In the case of development
accounting (Eq. (2.4)), however, I have to use a capital share parameter
that is common across countries. If the parameter ˛ is country specific,
the decomposition cannot be done with the method described earlier.
Therefore, and similarly to Caselli (2005), I assume a single capital share
value both across countries and over time. I discuss the choice of this value
below.
The second consideration, which casts doubt on the applicability of
Eq. (4.2) for all our countries, is that the composition of mixed income
might be very different in the Visegrad countries than in the Western
European economies. In the former group, it is much more common
to report employees as small entrepreneurs (Krekó & Kiss 2007) for tax
considerations. Therefore, besides Eq. (4.2) one can argue for a narrower
definition of capital income, where we only take into account explicit
profits:
…
˛0 D : (4.3)
W C…CM
Figure 4.2 shows the share of capital calculated with the two methods.
Caselli (2005) assume that ˛ D 1=3, which equals the long-run
average share of capital in the USA. We can see that this is close to
values calculated for the Western European countries, using the standard,
first method. Moreover, in these countries the share of mixed income
AUT CZE
0.5 0.5
With mixed income
Without mixed income
0.4 0.4
0.3 0.3
0.2 0.2
1998 2000 2002 2004 2006 2008 2010 2012 1998 2000 2002 2004 2006 2008 2010 2012
DEU FRA
0.5 0.5
0.4 0.4
0.3 0.3
0.2 0.2
1998 2000 2002 2004 2006 2008 2010 2012 1998 2000 2002 2004 2006 2008 2010 2012
GBR HUN
0.5 0.5
0.4 0.4
0.3 0.3
0.2 0.2
1998 2000 2002 2004 2006 2008 2010 2012 1998 2000 2002 2004 2006 2008 2010 2012
POL SVK
0.5 0.5
0.4 0.4
0.3 0.3
0.2 0.2
1998 2000 2002 2004 2006 2008 2010 2012 1998 2000 2002 2004 2006 2008 2010 2012
Fig. 4.2 Estimating the income share of capital. The figure shows the income
share of capital in gross value added, calculated using two methods. In the first
method, we divided mixed income between capital and labor the same way as in
the aggregate, while in the second we assign all mixed income to labor. Source:
Eurostat and own calculations
is relatively low, so the second method yields a similar capital share.

Following the literature and using Eq. (4.2), I find that the average capital
share is 0.37 in Austria, 0.36 in Germany, and 0.34 in France and Great
Britain. The same method yields much higher values in the Visegrad
countries: we get 0.47 in the Czech Republic, 0.4 in Hungary, 0.41 in
Poland, and 0.47 in Slovakia. On the other hand, the calculation is much
more sensitive to the split of mixed income, as the figure illustrates. If we
treat mixed income as labor compensation, capital shares are 0.4 (CZE),
0.35 (HUN), 0.31 (POL), and 0.37 (SVK).
To sum up, we see that for the advanced economies, the country-
specific capital share values are very close to 1/3, which is what is assumed
by Caselli (2005). For the Visegrad countries, the same method (dividing
mixed income using the aggregate shares) leads to much higher values.
Furthermore, these values are sensitive to how we split mixed income.
Based on these results, and because of the requirements of development
accounting discussed above, I assume that ˛ D 0:34 for all countries.
This is the same as the French and British value, and only marginally
below the levels calculated for Germany and Austria. The importance of
mixed income is higher in these two countries, however. If mixed income
contains labor income to a larger degree, the four WE countries have
exactly the same capital shares. Among the Visegrad countries, it is the
Czech Republic where the capital share is significantly above 0.34, even
if we allocate all of mixed income to labor. It seems unlikely that the
aggregate production function is so different in the Czech Republic than
in the other countries, so I suspect that measurement error might be
responsible for the Czech result.
4.4 Initial Value and Capital Stock

The perpetual inventory method requires an initial capital stock, upon
which the investment time series can be cumulated. Because of geometric
depreciation, if we can go back long enough into the past, the effect of
the initial value gradually disappears from estimates of the capital stock
close to the present (although this is a slow process given the assumed
depreciation rate of 5%). The initial value can be easily approximated and
hence does not pose empirical difficulties, when an economy is in steady

state. I will show later that in steady state—when an economy follows
a balanced growth path—the stock of capital and output grow at the
same rate. Let be the long-run stable growth rate, let be the long-
run capital-output ratio, and let denote the long-run investment rate.
Using Eq. (4.1) and the steady state assumption, we get that
KtC1 YtC1 Kt It
D .1 ı/ C
YtC1 Yt Yt Yt
+
D .1 ı/ C
+

D :
1Cı
Therefore, along the balanced growth path, it is easy to calculate the

capital-output ratio, if we have data on the average investment rate and
output growth. As an example, let us take the following D 1:021,
ı D 0:04, and D 0:2 parameter values, then the steady state capital-
output ratio is D 3:5. In advanced economies similar values (between
3 and 4) are found after using the PIM on long investment time series
(see our results later).
For the Western European countries, the Penn World Table contains
long enough investment time series, since for each economy, these start
in 1950. As the impact of World War II was still strong in 1950, I do
not consider the initial capital-output ratio to have been in steady state.
Instead, I assume that in all four countries K1950 =Y1950 D 1:5. Since
the level of GDP in 1950 is known, the initial capital stock can easily be
computed. Although the exact number can be disputed, as my analysis
uses the period 1998–2014, moderate changes in the assumed initial
capital-output ratio do not significantly modify the calculated capital
stocks in the Western European countries.
Data in the Penn World Table 9.0 is available until 2014. Still, to
preserve consistency with the other data, I only use the PWT until 1998.
From 1998 I switch to using Eurostat time series (in any case, there are no
significant differences between these and the PWT) and use the (PWT)
calculated 1998 K=Y ratio as the initial condition. Merging the two time
series this way gives me the full, 1950–2014 capital stock for the four
Western European countries, out of which I concentrate the analysis on
the 1998–2014 period.
The Visegrad countries pose more difficulties. Investment data in the
PWT 9.0 start in 1970 for Hungary and Poland, while for the Czech
Republic and Slovakia, the first data point is 1990. In principle, as long as
we only want to study the period after transition (1990), for the first two
countries, the time series is relatively long. It is questionable, however,
to what extent investment data before transition can be used reliably in
the construction of post-1990 capital stock. Capital goods created under
central planning were not always easily convertible for use in a market
economy. Therefore, and similar to Pula (2003), Darvas and Simon
(1999), van Leeuwen and Földvári (2011), Dombi (2013), and Kónya
(2013), I assume that economic transition led to a one-off, large-scale
depreciation of physical capital, over and above normal wear and tear. I
measure this loss the following way, based on the approach in Pula (2003)
and Kónya (2013).
For Hungary and Poland, I first construct the capital stock series with
Eq. (4.1) between 1970 and 1989, using data from the Penn World Table.
I set the initial, 1970 capital-output ratio to 2. The Penn World Table
assumes an initial value of 2.6,2 I choose a more conservative number. By
1989 the impact of the initial value is small, at least within this range. I
estimate the one-time capital loss during transition using the production
function (Eq. (2.1)). I set capacity utilization to unity (ut D 1), but there
is still an identification problem since both the capital stock I want to
compute and also productivity are unknown. I assume, therefore, that
the level of TFP remained the same during the recession that accompanied
the first years of transition. Choosing 1989 as the reference year, and
keeping TFP constant, the capital loss until end of the recession (year
t) is estimated as follows:
2
http://www.rug.nl/research/ggdc/data/pwt/v80/capital_labor_and_tfp_in_pwt80.pdf .
˛ 1˛
Yt Kt Lt
D
Y1989 K1989 L1989
+
˛1 1 ˛1
Kt Yt Lt
D :
K1989 Y1989 L1989
Since output and labor input are observable,3 capital stock is simply
estimated from the output decline not explained by labor input changes.
Although the recession in Hungary lasted until 1993, I use 1991 in
both countries as the endpoint of capital loss. The reason for this is that
employment declined dramatically in the early 1990s, and the formula
above would lead to a significant increase in the capital stock after
1992. Therefore, starting from 1991 I return to constructing the capital
stock using Eq. (4.1), assuming a 5% depreciation rate. The investment
time series between 1991 and 1997 comes from the Penn World Table,
while after 1998—setting the 1998 PWT-based capital stock as the initial
value—I switch to Eurostat as the investment data source.4
In the case of the Czech Republic and Slovakia, I use the same
approach, with two differences. Since their PWT series start only in
1990, I set the initial capital-output ratios at the 1989 Hungarian level.
Transition in Czechoslovakia started in 1990 and lasted until 1992.
Therefore, compared to Hungary and Poland, I move the calculations by
one year: the reference year is 1990, and the capital loss calculated from
GDP decline is assumed to happen in 1991 and 1992. From 1992, I use the
Penn World Table until 1998, and Eurostat investment data from 1998,
similarly to the other countries.
Results for the capital loss calculation are reported in Table 4.2. The
significant decline in GDP was accompanied by similar drops in labor
3
For this period we do not have data for employment by education levels; hence, we only use
employment and average hours when constructing labor input changes. These two series are
available in the Penn World Table.
4
Investment figures in the PWT and Eurostat differ slightly since the latter uses the ESA 2010
methodology, leading to somewhat higher numbers. In particular, Eurostat values are roughly 5%
above the PWT numbers after 1998. Since we only use the PWT to provide initial conditions for
the capital stock computation between 1998 and 2014, the impact of the statistical break should be
minimal.
Table 4.2 Capital loss during transition in the Visegrad countries

HUN POL CZE SVK
1989–1991 1990–1992
GDP decline 0:85 0:82 0:88 0:80
Total hours decline 0:88 0:87 0:98 0:81
Calculated capital loss 0:79 0:74 0:72 0:77
The table shows calculated capital loss during the first years of economic transition
Source: Penn World Table and own calculations
input, except for the Czech Republic. Overall, under the maintained
assumptions of constant capacity utilization and productivity, the one-
time capital loss is estimated to have been between 21 and 28%.5
It is important to emphasize that if TFP also fell between 1989
and 1991, the capital loss estimates overstate the true magnitude. TFP
may have declined because with transition some of the accumulated
market and organizational knowledge of corporations became obsolete.
In contrast, recall that in these calculations, I cannot control for changes
in the skill composition of workers, due to the lack of data. If, as it
seems likely, it was the low-skilled who lost their jobs in larger numbers
in 1990–1991, using total hours overestimates the true decline in labor
input. It is also possible that at least some of the employment before
transition was unproductive (“unemployment behind factory gates”), and
the observed employment loss led to an increase in measured productivity.
Overall, since these effects—pointing to opposite directions—cannot be
quantified, I assume that they roughly balanced each other out.
Figure 4.3 shows changes in the capital-output ratio, based on the
calculated capital stock series. I can observe a stable increase in capital
intensity in Western Europe until 1980, which is probably the end of the
reconstruction period following World War II. The capital-GDP ratio
was roughly stable between 1980 and 2000, with perhaps a small overall
increase. After 2000 the ratio started rising again for two possible reasons.
First, the global financial crisis after 2008 led to a significant output
decline, with a slow recovery afterwards. Since changes in the capital
5
This is remarkably similar to the magnitudes reported in Pula (2003) and Darvas and Simon
(1999) for Hungary.
Western Europe
3.5
2.5
AUT
1.5
DEU
FRA
GBR
1
1950 1960 1970 1980 1990 2000 2010
Visegrad countries
3.2
2.8
2.6
2.4
2.2
1.8 CZE
HUN
1.6 POL
SVK
1.4
1970 1975 1980 1985 1990 1995 2000 2005 2010
Fig. 4.3 The evolution of the capital-output ratio. The figure shows the evolution
of the capital-GDP ratio, taking into account one-time capital loss during tran-
sition for the Visegrad countries. Source: Penn World Table, Eurostat and own
calculations
stock are slow—even when investment drops significantly—the K=Y

ratio increases during recessions. The second reason may be the observed,
long-term decline in the relative price of capital goods (Karabarbounis
& Neiman 2014). Cheaper investment can lead to increased capital
accumulation and hence to a higher capital-output ratio.6
The trends are similar in the Visegrad countries. The K=Y ratio was
stable after transition, partly due to the method of quantifying capital
loss in the early years. Capital intensity started rising significantly during
and after the financial crisis. It is too early to decide, however, as to what
extent this phenomenon is temporary or persistent.
4.5 Capacity Utilization

Capacity utilization can play a significant role in short-run output fluc-
tuations. The reason for this is that the adjustment speeds of the capital
stock and employment are slow. In the case of employment, adjustment
is slow partly because of search costs and partly because of labor market
regulations. Therefore, companies—in response to temporary shocks—
can more easily adjust by changing the intensity with which they use their
existing capacities. To measure changes in productivity appropriately, it
is thus important to take into account capacity utilization.
Unfortunately there is no indicator that measures capacity utilization
at the total economy level. There are various proxies advocated in the
literature, out of which I will use three. In what follows I shortly discuss
the advantages and disadvantages of the various measures and then show
how I compute an aggregate indicator of capacity utilization from these.
Eurostat’s Euro Indicators database contains a direct survey question
about capacity utilization.7 Unfortunately, the scope of the survey is only
manufacturing firms, and we need additional assumptions to extend the
results to the larger service sector. Nevertheless, this is one of the indicators
6
Karabarbounis and Neiman (2014) also draws attention to the possible connection between the
decline in the relative price of investment goods and the decrease in the share of labor in national
income, also observed in many countries.
7
http://ec.europa.eu/eurostat/en/web/products-datasets/-/TEIBS070.
that I think is a good proxy for the aggregate stance. I transform the raw
data by calculating percentage deviations from the sample average.
We can also infer capacity utilization from indirect sources. An obvious
option would be the usage of total hours worked. In practice, however,
hours are quite stable, as Fig. 3.2 shows. The reason for this is that the
majority of workers work fixed hours, which is not easy to adjust for
companies. It is likely, however, that the intensity of work effort varies over
the cycle—unfortunately, we do not have data to prove this conjecture.
Finally, a frequently used indirect indicator is energy consumption.8 Its
advantage is that it is easily observable and applies to the total economy.
Energy usage proxies capacity utilization well when—at least in the
short run—it is directly proportional with the actual production time
of plants. Out of the many possible energy measures, I use full and
electric energy consumption. The time series of these indicators are not
stationary: with economic growth, and a stable production structure,
energy usage increases. On the other hand, the increasing weight of the
service sector, and with the spread of more energy efficient production
methods, energy used per unit of output declines. The net impact of these
two effects can be very different depending on the period and on the level
of development. Therefore, as a capacity utilization indicator, I use the
cyclical components calculated by the Hodrick-Prescott filter. I run the
filter between 1998 and 2014, with a smoothing parameter of 100, which
is the recommended value at the annual frequency.
Co-movement between the three measures is fairly high, but there are
discrepancies in particular years. Since there are no theoretical grounds on
which to prefer one indicator over another, the final measure of capacity
utilization is a simple average of the three time series. Figure 4.4 shows
the results for the two country groups. The cyclical indicators move
fairly closely together across the eight countries, and this co-movement
is especially strong during the 2008–2009 global financial crisis. On the
other hand, the measure also captures episodes where it is known that
different countries behaved differently. Poland was less heavily impacted
by the crisis, and reflecting this, the capacity utilization indicator falls
8
http://ec.europa.eu/eurostat/en/web/products-datasets/-/TEN00095.
Western Europe
1.05
0.95
AUT
DEU
FRA
GBR
0.9
1998 2000 2002 2004 2006 2008 2010 2012 2014
Visegrad countries
1.05
0.95
CZE
HUN
POL
SVK
0.9
1998 2000 2002 2004 2006 2008 2010 2012 2014
Fig. 4.4 The derived indicator of capacity utilization. The figure shows the
derived indicator of capacity utilization, which is the unweighted average of
full energy usage, electric energy usage, and manufacturing capacity utilization.
Source: Eurostat and own calculations
less in 2009, and stayed at a higher level until 2014, than in the other
countries. In Germany, the first year of the crisis shows a large decline,
but afterwards capacity utilization returns faster to its normal level than
in France. The indicator also captures Hungary’s significant recession in
2012. Based on these considerations, we can conclude that although it is
not possible to create a perfect capacity utilization measure, the indicator
does a good job at capturing its cyclical movements.
References
Caselli, F. (2005). Accounting for cross-country income differences, Handbook
of Economic Growth. In: Philippe Aghion & Steven Durlauf (ed.), Handbook
of Economic Growth (Vol.1(9), pp. 679–741). Elsevier.
Darvas, Z., & Simon, A. (1999). Tőkeállomány, megtakarítás és gazdasági
növekedés [Capital stock, savings and economic growth]. Közgazdasági Szemle
[Hungarian Economic Review], 46, 749–771.
Dombi, Á. (2013). The sources of economic growth and relative backwardness
in the Central Eastern European countries between 1995 and 2007. Post-
Communist Economies, 25, 425–447.
Gollin, D. (2002). Getting income shares right. Journal of Political Economy, 110,
458–474.
Hsieh, C.-T., & Klenow, P. J. (2007). Relative prices and relative prosperity.
American Economic Review, 97 (3), 562–585.
Karabarbounis, L., & Neiman, B. (2014). The global decline of the labor share.
The Quarterly Journal of Economics, 129, 61–103.
Krekó, J., & P. Kiss, G. (2007). Adóelkerülés és a magyar adórendszer [Tax Evasion
and the Hungarian Tax System], MNB Occasional Papers.
Leeuwen, B., & Földvári, P. (2011). Capital accumulation and growth in
Hungary, 1924–2006. Acta Oeconomica, Akadémiai Kiadó, Hungary, 61(2),
143–164.
Pula, G. (2003). Capital Stock Estimation in Hungary: A Brief Description of
Methodology and Results. MNB Working Papers.
Valentinyi Á., & Herrendorf, B. (2008). Measuring factor income shares at the
sector level. Review of Economic Dynamics, 11, 820–835.
5
Growth and Development Accounting
In the previous chapters, I studied factors of production and capacity

utilization. With the help of these, I will now examine the components
of GDP growth in the eight economies, and I will study the differences
in development levels between the Visegrad and Western European
countries. The analysis also sheds light on the evolution of total factor
productivity (TFP).1
The analysis uses the tools of growth and development accounting,
which were defined in Eqs. (2.3) and (2.4). Let us reproduce these for the
sake of completeness here:
Yt Kt Lt
log D ˛ log C .1 ˛/ log C log ut C log At ;
Nt Nt Nt
1
The main references were already cited in previous chapters. For the international evidence, these
are Caselli (2005), Hall and Jones (1999), and Hulten (2010). For the case of Hungary, the main
references are Darvas and Simon (1999), Dombi (2013), Földvári and van Leeuwen (2011), Földvári
and van Leeuwen (2013), Kónya (2015).

https://doi.org/10.1007/978-3-319-69317-0_5
and
˛ 1˛
Yi =Ni Ki =Ni Li =Ni ui Ai
D ;
Yj =Nj Kj =Nj Lj =Nj uj Aj
where Y is the GDP, N is the size of the population, K is the capital

stock, L is the total labor input that includes human capital, u is the
capacity utilization, and A is the total factor productivity. The first
equation decomposes economic growth—annual change in GDP per
capita—into contributions of factors of production, capacity utilization,
and productivity. The second equation contains a similar decomposition
to compare the level of development (again, defined by GDP per capita)
between two countries. Since productivity is an unobserved component,
it is calculated as a residual once all other factors are accounted for.
5.1 Price Level and Population

Before I present the decomposition exercises, it is worth taking a look
at the role of two factors in the eight countries: these are differences in
price levels and population changes. I discussed purchasing power parity
earlier, both in the context of GDP (Chap. 2) and in the construction of
the capital stock (Chap. 4). Development accounting raises an additional
issue that I discuss here.
Eurostat annually reports GDP comparisons corrected for price level
differences for the countries of the European Union. I presented such a
cross-sectional comparison in Fig. 2.3 in Chap. 2, although not using
Eurostat data directly. Now I would like to track purchasing parity
comparisons over time, which can be done in two ways. One can use
the cross-sectional, current price comparisons of Eurostat for each year.
These accurately reflect differences between national incomes that are at
the disposal of citizens in each country at a given year.
From year to year, however, it is not only output that changes but
also relative prices. The PPP correction in the Eurostat tables uses average
European prices each year and compares price levels in individual countries
to this benchmark. If EU average relative prices and relative prices in a

given country evolve differently, then following current price comparisons
over time reflects not only different output growth rates but also changes
in these “relative-relative” prices. Therefore, when comparing differences
in output levels over time, it is better to use constant PPP. In this case the
full time series is corrected with PPP price levels from a single year, as I did
in case of investment data. Changes in relative prices within countries are
tracked by chain linking. This way one can take into account both cross-
sectional differences, and times series changes within countries.
It is instructive to present the impact of changing relative prices more
formally. Let us assume that there are two main sectors in the economy,
services and manufacturing. Let production in period t be Ys;t in the
former sector and Ym;t in the latter. Moreover, let pt and pt denote the
domestic and international relative price of services, respectively. Using
this notation, we can write the differences in chain-linked GDP growth
based on international versus domestic relative prices as follows:
Ym;t C pt1 Ys;t Ym;t C pt1 Ys;t

gt gt D ;
Ym;t1 C pt1 Ys;t1 Ym;t1 C pt1 Ys;t1
where gt is the gross GDP growth based on international prices and gt
is the growth based on domestic prices. Simple algebraic manipulation
leads to the following expression:

Ys;t1 Ym;t1 pt1 pt1 .gs;t gm;t /
gt gt D :
Ym;t1 C pt1 Ys;t1 .Ym;t1 C pt1 Ys;t1 /
The denominator is positive; thus, the sign of the expression depends

on the relative growth rates of the two sectors between two years.
GDP growth calculated using international prices is higher than growth
computed using domestic prices if (1) there are sectoral differences behind
aggregate growth rates (gs;t ¤ gm;t ), and (2) the international relative
price of the faster growing sector is higher than its domestic relative price.
How important is this distinction in practice? Figure 5.1 shows relative
GDP per capita in the Visegrad countries in 2014, using current and
70
Current PPP
Constant 2005 PPP
65
60
55
50
45
40
CZE HUN POL SVK
Fig. 5.1 Relative GDP at constant and current PPPs. The figure shows differences
in levels of development calculated using current and constant PPPs. The year of
comparison is 2014, and the reference country is Germany (=100). Source: Eurostat
and own calculations
constant price PPPs. For the latter, I use the 2005 Eurostat relative price
levels. The reference country for both years is Germany. Differences in the
Czech Republic and Slovakia are small, but for Poland and especially for
Hungary, the two indicators are substantially different. Hungarian relative
development is about 50% when constant PPP is used, but under current
PPP it climbs to about 54%. Since I am interested in the production side
of GDP, I will use data converted at fixed PPPs, but it is worth keeping
in mind that relative price changes can also play an important role in
international comparisons.
Besides changes in relative prices, GDP per capita developments are
also influenced by population growth. Figure 5.2 shows the total change
in GDP in the sample period, as the sum of GDP per capita growth
and population growth. While in France, Great Britain, and Austria the
Real GDP growth between 1998-2014

60
Per capita GDP
Population
50
40
30
20
10
-10
Fig. 5.2 Changes in GDP and GDP per capita. The figure shows a decomposition
of GDP growth into contributions of GDP per capita and population growth.
Source: Eurostat and own calculations
increase in population was substantial, in Germany, Poland, and especially

in Hungary, GDP per capita grew faster than total GDP, because the
population was shrinking. Although in my approach I treat population
growth as exogenous, it is important to keep in mind that demography
can play an important role in economic growth.
5.2 Growth Accounting

Let us now turn to the study of economic growth in the eight countries
between 1998 and 2014. In the following I decompose the growth rate
of chain-linked GDP per capita into contributions of the capital stock,
total labor input, capacity utilization, and total factor productivity, using
AUT DEU
0.08 0.08
0.06 0.06
0.04 0.04
0.02 0.02
0 0
-0.02 Capital -0.02

Capacity
-0.04 Labor -0.04
-0.06 TFP -0.06

GDP/capita
-0.08 -0.08
1998 2000 2002 2004 2006 2008 2010 2012 2014 1998 2000 2002 2004 2006 2008 2010 2012 2014
FRA GBR
0.08 0.08
0.06 0.06
0.04 0.04
0.02 0.02
0 0
-0.02 -0.02
-0.04 -0.04
-0.06 -0.06
-0.08 -0.08
1998 2000 2002 2004 2006 2008 2010 2012 2014 1998 2000 2002 2004 2006 2008 2010 2012 2014
Fig. 5.3 Growth accounting: Western Europe. The figure shows the decompo-
sition of GDP per capita growth into contributions of capital, labor, capacity
utilization, and total factor productivity in Western Europe. Source: Eurostat and
own calculations
Eq. (2.3). As I discussed earlier, throughout the analysis I assume that

˛ D 0:34, mostly to be consistent with the development accounting
calculations in the next section.
Results for Western Europe are shown in Fig. 5.3. The contribution
of capital was positive, but modest in each country and in most of the
sample period. Labor input changes are important in some years, but
with opposing signs. Total factor productivity was the most important
driver of growth before the global financial crisis, but afterwards its overall
contribution is less clear. Fluctuations in capacity utilization are mostly
important—as expected—in the first years of the crisis, in 2009 and 2010.
In the first year companies reacted to the negative shock by a significant
decline in capacity utilization. Similarly, recovery from the crisis started by
using existing capacity more intensively. In other years the contribution
of capacity utilization was modest.
CZE HUN
0.1 Capital 0.1
Capacity
Labor
TFP
0.05 0.05
GDP/capita
0 0
-0.05 -0.05
1998 2000 2002 2004 2006 2008 2010 2012 2014 1998 2000 2002 2004 2006 2008 2010 2012 2014
POL SVK
0.1 0.1
0.05 0.05
0 0
-0.05 -0.05
1998 2000 2002 2004 2006 2008 2010 2012 2014 1998 2000 2002 2004 2006 2008 2010 2012 2014
Fig. 5.4 Growth accounting: Visegrad countries. The figure shows the decom-
position of GDP per capita growth into contributions of capital, labor, capacity
utilization, and total factor productivity in the Visegrad countries. Source: Eurostat
and own calculations
Figure 5.4 presents results for the Visegrad countries. The most impor-
tant driver of economic growth—especially before the financial crisis—
was productivity. The contribution of capital accumulation was also
significant, but generally much lower. TFP growth was particularly im-
pressive in Slovakia, but the Czech Republic and Hungary also produced
significant productivity improvements before 2007. On the other hand,
TFP growth stops in these two countries following the crisis, while it
slowed in Slovakia and also stopped in Poland after 2011.
Labor input overall did not play a significant role, except for Poland
between 2005 and 2008 and Slovakia 2004 and 2008. In Hungary,
important positive contributions can also be seen at the very beginning
and at the very end of the period; the latter may continue after 2014
as well. Fluctuations in capacity utilization—similarly to the Western

European countries—significantly influenced GDP growth in the Viseg-
rad economies during the financial crisis. This is particularly true for
Hungary, where during the second, European phase of the crisis (in 2012–
2013), capacity utilization again fell as output declined. It is interesting
to note that while Poland escaped the financial crisis lightly, capacity
utilization also declined there in 2009.
Besides the annual changes, it is worth calculating the growth account-
ing decomposition for longer periods. Table 5.1 shows the components
of per capita growth for 1998–2006 and 2006–2014. I decompose the
contribution of total labor input into its three components: the em-
ployment rate, average hours per worker, and human capital per hour
worked. Since over an eight-year period total growth can be significant,
the decomposition in the table is presented not as an additive logarithmic
one (as on the figures above), but as a multiplicative one (analogously to
Eq. (2.4), which I present in the next section). Total GDP change (first
column) is thus the product of columns 2–6. Note that I present gross
growth components in percentages.
It is a consequence of the 2008–2009 global financial crisis, and of the
subsequent 2011–2012 European crisis, that in the second period growth
in most countries was low. The main exception to this is Poland, and to
a slightly lesser degree, Slovakia. The other two Visegrad countries were
essentially stagnating, after significant development in the first period.
While growth in Germany was low overall, it was stable before and after
the crisis, while in the other three Western European economies, there
was a strong slowdown by the second period.
As we saw on the figures, the contribution of capital is non-trivial,
and interestingly we do not see large differences between the two periods.
In contrast, with the exception of Germany productivity growth slowed
significantly, and in four countries actually turned negative. This is
particularly surprising in the Czech Republic and Hungary, where despite
slower output growth we expect productivity improvements along their
convergence paths. Before 2006, TFP growth was uniformly high in all
four Visegrad countries. After the crisis, however, productivity growth
continued only in Slovakia and Poland, although at a slower rate. A deeper
analysis of TFP growth thus seems to be crucial to understand the reasons
for the lack of second period growth in Hungary and the Czech Republic.
Table 5.1 Growth accounting

1998–2006
GDP Capital H. capital Employment Hours TFP Capacity
AUT 116 105 102 103 98 107 101
CZE 138 111 101 100 97 124 101
DEU 112 104 101 102 97 107 101
FRA 113 105 103 102 96 106 100
GBR 122 109 104 103 98 105 101
HUN 141 110 103 103 99 120 102
POL 137 114 103 99 100 118 100
SVK 140 112 102 101 98 122 101
2006–2014
GDP Capital H. capital Employment Hours TFP Capacity
AUT 104 103 103 104 96 101 98
CZE 105 109 102 100 99 98 98
DEU 111 104 101 106 97 103 99
FRA 101 104 104 98 100 96 99
GBR 102 104 102 100 100 96 100
HUN 103 107 102 101 96 98 99
POL 133 115 102 106 99 109 99
SVK 125 110 101 102 100 112 98
The table shows the contribution of different factors to changes in per capita
GDP for two sub-periods
Source: own calculations
The decomposition of labor input shows that hours fell somewhat in

both periods, while the human capital of the employed increased slightly.
The contribution of employment was mostly positive, but small.
Finally, let us discuss what happened with capacity utilization. We can
see that its contribution was positive in the first period and negative in
the second. This is consistent with the worldview that at least some of the
observed pre-crisis growth was cyclical. On the other hand, the differences
are small. In Hungary, for example, capacity utilization explained about
two percentage points out of a total growth rate of 41%, while in the
second period declining capacity utilization led to a total of 1% decline
in output.
5.3 Development Accounting

After the growth decomposition, let us now turn toward the level of
economic development. To do this, I use Eq. (2.4), with which I can
decompose the development level of a particular country relative to a
reference country. In particular, I calculate the fraction of development
differences that can be attributed to either the relative amounts of factors
of production or to relative productivity. The analysis is carried out for
2014. It is useful to recall that both GDP per capita and the capital stock
are constructed using chain-linked times series and a constant purchasing
power parity. As a reference country, I use Germany, which is the largest
economy in Europe and also the most important trading partner for the
Visegrad countries.
Figure 5.5 presents development accounting results relative to Ger-
many for the other three Western European countries. As we saw earlier,
GDP per capita differences are not very big, although France lags sig-
nificantly behind the other countries. The decomposition, however,
highlights a few interesting observations. The biggest contributor behind
lower French GDP per capita is lower labor input, while productivity and
capital intensity are very similar to Germany. Austrian output per capita,
on the other hand, is marginally higher than in Germany, but Austrian
productivity is much lower. The high level of Austrian output—relative
to the other Western European countries—is attributed to a stronger
mobilization of labor and capital input. The case of Great Britain is also
interesting, where labor input is just as high as in Austria, but productivity
is close to the German level. Capital intensity, however, is lower than in
the other countries. The net result of these components is that British
GDP per capita is a bit lower than in Austria or Germany.
Let us now turn to the Visegrad countries (Fig. 5.6). GDP per capita
in the Czech Republic, which is the most advanced in the region, is 67%
of the German level, while it is 50% in Hungary, the region’s laggard. The
gap with Germany is mostly attributed to productivity and capital. With
the exception of Slovakia, the contribution of productivity is somewhat
higher. According to the estimates, total factor productivity in the region
is highest—somewhat surprisingly—in Slovakia, and in the Slovak case
120
100
80
DEU 2014 = 100%
60
40
20
0
GDP per capita Capital-labor ratio Labor input Productivity
AUT FRA GBR
Fig. 5.5 Decomposing relative development in Western Europe in 2014 (Ger-

many = 100). The figure shows the decomposition of development levels relative
to Germany in Western Europe. Each column represents the weighted level of a
particular factor, relative to Germany. Source: own calculations
relative capital scarcity explains more of the development difference. In

Hungary, however, the lower level of TFP is clearly the most important
explanatory factor behind the GDP per capita gap with Germany.2
As I stressed earlier, total labor input in the Visegrad countries is not
lower than labor input in the Western European economies. Therefore,
labor input cannot be behind their relative underdevelopment. Although
German employment is higher, average hours worked are much lower, and
the additional employment in Germany is mostly among the low-skilled
and tends to be part-time. Therefore, even if the Visegrad economies
manage to increase employment without a decrease in average hours, they
2
Kónya (2013) also calculates TFP series, but as his goal is to compare development levels, he does
not do growth accounting. His methodology is very similar, except for taking into account capacity
utilization, and that he does not incorporate capital loss during transition in his baseline scenario
(this only appears as a robustness check).
120
100
80
DEU 2014 = 100%
60
40
20
0
GDP per capita Capital-labor Labor input Productivity
ratio
CZE HUN POL SVK
Fig. 5.6 Decomposing relative development in the Visegrad countries in 2014

(Germany = 100). The figure shows the decomposition of development levels rel-
ative to Germany in the Visegrad countries. Each column represents the weighted
level of a particular factor, relative to Germany. Source: own calculations
cannot expect significant increases in output. Moreover, economic history

teaches us that economic development is accompanied by increases in
leisure, and there are no reasons to expect otherwise in the Visegrad
countries.
After the decomposition of development differences, it is interesting to
examine a very similar question: what would be the additional increase in
GDP per capita in the Visegrad countries if capital intensity, productivity,
and labor input would all reach the German level (in the case of the
latter, this would be a decline). I am interested in the partial effects of
the individual factors, and also the total increase, which are summarized
in Table 5.2.
The cells in the table show how much GDP per capita growth
(expressed in percentages) a country can expect if the level of the factor
Table 5.2 Convergence possibilities relative to Germany

Capital TFP Labor Total
CZ 16:16 45:24 12:43 47:75
HU 35:80 59:73 6:95 101:83
PL 46:74 49:99 13:27 90:90
SK 34:89 25:96 3:60 63:80
The table shows the percentage increase in GDP per capita in the Visegrad
countries when the level of the different factors reaches 100% of the
German level
in the respective column would change to its German level. The product
of the first three columns—after the obvious transformations—is given
in the last column, which is the total convergence effect. This is naturally
the reciprocal of the differences reported in Fig. 5.6.
In Hungary and in the Czech Republic, increasing productivity would
be far more important than capital accumulation: for Hungary, increasing
capital intensity would raise GDP per capita by 36%, while increasing
TFP would lead to a 60% jump in output. The relative contributions
would be similar in the Czech Republic. In Poland, the productivity effect
is marginally higher than capital’s contribution, while in Slovakia capital
intensity is more important. Decreasing total labor input to the German
level would lead to a drop in GDP per capita, where the magnitudes are
around 10% on average.
Let us further decompose the effect of total labor input into its three
components. We can rewrite Eq. (3.3), which defines human capital used
in production, in the following way:
HCt X EiT;t
1 EiR;t Ni;t
D hT;t C exp Œ .i / :
Nt iDA;K;F
Ni;t 2 N i;t Nt
The formula shows that total labor input is the sum of three components:
(1) average hours worked by those employed full-time, (2) full-time
and part-time employment rates in a given education category, and (3)
schooling levels in the total population.
Table 5.3 Labor input and relative development: the impact of labor input com-
ponents
Schooling Employment Hours
CZ 97:64 99:48 91
HU 102:32 104:77 88:08
PL 97:85 106:77 82:54
SK 99:29 106:56 91:48
The table shows the change in GDP per capita in the Visegrad countries
when the level of the different components of total labor input reach the
German level (100% indicates no change in GDP per capita)
Table 5.3 shows changes in GDP per capita when we change a com-
ponent of total labor input—keeping the other two constant—to their
German level. The first column shows the impact of average schooling
in the population. Since education levels in the Visegrad countries are
similar to Germany, no significant convergence effects can be expected
from expanding schooling. In fact, Hungary is the only Visegrad country
where education levels are (slightly) behind Germany, but even in that
case, GDP per capita would only rise by about 2% if the schooling of the
Hungarian population increased to the German level.
The second column quantifies the impact of employment. As we saw
earlier, the German employment rate is higher than the employment rate
in the Visegrad countries. The difference, however, is most pronounced
among the low-skilled and part-time workers. Therefore, increasing em-
ployment rates to the German level would only increase GDP per capita
slightly. In the case of Hungary, the increase would be just below 5%, and
even in Poland and Slovakia, the rise would be below 7%.
The third column shows the impact of changing full-time hours per
worker. This measure is much lower in Germany, even after taking into
account the higher prevalence of part-time work. Therefore, decreasing
average hours to the German level would significantly (between 9 and
18%) decrease per capita output in all four countries.
To summarize the above, reaching German levels of employment and
schooling would raise GDP modestly in three of the Visegrad coun-
tries (the Czech Republic is the exception). This statement is, however,
conditional on average hours’ work not having declined. This is not
necessarily unrealistic, since German hours are low even among the
Western European countries. When I compute full-time equivalent hours
using Eq. (3.2), the result is 1580 for Germany, 1882 in Austria, 1919
in Great Britain, and 1915 in Hungary. If Hungarian hours followed the
patterns seen in Austria and Great Britain, instead of declining to the
German level, the overall increase in GDP per capita would be 7%. This is
not trivial, but it is still well below the potential increase that would follow
from productivity convergence, or from increasing capital intensity.
Finally, let us examine whether it would be possible to converge
to Germany through increased capital investment, without increasing
productivity. Using Eq. (2.4), the required increase in the capital stock
in Hungary is given by
0 ˛1 1
kHU =yDE yDE
D ;
kHU =YHU yHU
0
where kHU is the counterfactual capital stock. Since the calibration uses
˛ D 0:34, the current capital-output ratio would have to increase
by more than a factor of 3. The actual Hungarian value in 2014 is
2.89, while the highest Western European ratio (in France) is 3.63.
Compared to these, convergence driven solely by capital accumulation
would lead to a capital-output ratio of around ten, which is clearly
unrealistic. Just to maintain a capital stock this large at its steady state
level with a 5% depreciation rate, the investment rate would need to
be 60%. The magnitudes are similar in the other Visegrad countries.
Therefore, without significantly improving productivity, convergence in
the Visegrad economies is not possible.
References
Caselli, F. (2005). Accounting for cross-country income differences, Handbook
of Economic Growth. In: Philippe Aghion & Steven Durlauf (ed.), Handbook
of Economic Growth (Vol.1(9), pp. 679–741). Elsevier.
Darvas, Zs., & Simon, A. (1999). Tőkeállomány, megtakarítás ás gazdasági
növekedés [Capital stock, savings and economic growth]. Közgazdasági Szemle
[Hungarian Economic Review], 46, 749–771.
Dombi, Á. (2013). The sources of economic growth and relative backwardness

in the Central Eastern European countries between 1995 and 2007. Post-
Communist Economies, 25, 425–447.
Hungary, 1924–2006. Acta Oeconomica, 61, 143–164.
Central Europe 1920–2006. Eastern European Economics, 51, 69–93.
Hall, R. E., & Jones, C. I. (1999). Why do some countries produce so much
more output per worker than others? The Quarterly Journal of Economics, 114,
83–116.
Hulten, C. R. (2010). Growth accounting. In Handbook of the economics of
innovation (Vol. 2, pp. 987–1031). Amsterdam: Elsevier.
Review], 62, 1117–1139.
Part II
Growth and Factor Markets
Until now I discussed mostly measurement issues and basic features of

growth and development. Theory was kept to a minimum: I assumed
that there is an aggregate, neoclassical production function, which defines
output as a function of capital and labor input, and productivity. I have
not yet studied, however, the decisions that determine factor usage. To do
this, I need to move on to modeling economic decision making, through
which demand and supply are determined endogenously. I continue using
the neoclassical growth model, which is a simple but flexible, general
equilibrium framework. I first present a version of the full model that
includes a simple demand side. Using this model, I carry out an alternative
decomposition exercise. Then I introduce stochastic elements into the
deterministic framework. I seek to answer the following question: in the
sample of countries, what are the main distortions behind the differential
usage of production factors?
6
The Neoclassical Growth Model
In this chapter I present the most common approach to study growth

and development, the neoclassical growth model. The central elements of
the model are the aggregate neoclassical production function, exogenous
population growth, exogenous productivity growth, and savings and cap-
ital investment. I already introduced the neoclassical production function
in Chap. 2 (Eq. (2.1)) and capital accumulation in Chap. 4 (Eq. (4.1)).
I now turn to the other ingredients, and I also discuss a few important
technical assumptions that guarantee that the model is well-behaved.
I present two versions of the model here, which differ in their as-
sumptions about savings behavior. The simplifying assumption of the
Solow model is that the savings rate is constant and exogenous. This
makes it particularly useful to study a few simple questions of growth
and development. The Ramsey-Cass-Koopmans (RCK) model endogenizes
the savings and investment decision of households and is therefore more
suitable for welfare and policy analysis. As in subsequent chapters I will
rely on various versions of the RCK model, I briefly present its main
properties here.

https://doi.org/10.1007/978-3-319-69317-0_6
6.1 Population and Technology

I already introduced the aggregate production function in Chap. 2. Let
us recall its general specification:
Yt D F .Kt ; Xt Lt / ;
where Yt is the aggregate production (GDP) over period t, Kt is the

capital stock, Lt is the total labor input, and Xt is the productivity of the
workforce. In what follows, I omit capacity utilization, which is important
to understand annual fluctuations, but less so when analyzing long-run
growth.
Both in the Solow and RCK models, population and productivity
growth rates are exogenous. For the former, I assume that
Nt D .1 C / Nt1 ; (6.1)
where Nt is the size of the population and is its exogenous growth rate.
A similar assumption applies to the productivity of labor:
Xt D .1 C / Xt1 ; (6.2)
where is the growth rate of labor-augmenting productivity growth.

Let us now define the concept of long-run equilibrium.
Definition. Long-run equilibrium is defined as a steady state where all

endogenous variables grow at a constant rate.
The next proposition states the basic connection between productivity
growth and the steady state in the neoclassical growth model.
Proposition. A steady state exists in the neoclassical growth model if and

only if technological growth is labor augmenting (Harrod neutral), or the
production function is Cobb-Douglas.
Proof. I show sufficiency later. For the other direction, see King, Plosser,
and Rebelo (2002). t
u
Let us briefly discuss the Cobb-Douglas case. It is easy to see that

when the production function is Cobb-Douglas, Harrod and Hicks
neutral productivity processes are equivalent.1 In other words, in this case
technological growth can always be represented as labor augmenting with
an appropriate variable transformation.
6.2 The Solow Model

The Solow model (Solow 1956) is a special case of the neoclassical growth
model, with an important simplifying assumption. Let us assume that the
savings rate is constant and exogenous, that is,
St D sYt ;
where St denotes savings and s is a constant parameter. I assume a closed

economy and ignore both international trade and international financial
and capital movements. In a closed economy, aggregate investment has
to equal aggregate savings (income not spent on consumption), and it
follows that
It D sF .Kt ; Xt Lt / : (6.3)
Using the above, we can now write down the main equation of the
Solow model. Let us substitute the savings-investment condition (6.3)
into the law of motion of the capital stock (4.1), which leads to:
KtC1 D .1 ı/ Kt C sF .Kt ; Xt Lt / :
1
We already introduced Harrod neutral—or labor-augmenting—productivity growth. Hicks neu-
tral productivity growth is the same as total factor productivity growth, that is, when the production
function is written as Yt D At F .Kt ; Lt /.
In the steady state, the growth rate of capital—and output—is constant.

To determine this growth rate, let us introduce the following, modified
variable:
Kt
kt :
Xt Nt
The variable kt is known as effective capital, since it is the amount of

capital per “effective labor,” which is labor input corrected for the level of
productivity.
Now let us substitute effective capital into the Solow equation:
ktC1 XtC1 NtC1 D .1 ı/ kt Xt Nt C sXt Nt F .kt ; lt / ;
where lt D Lt =Nt . We can divide both sides by Xt Nt and use Eqs. (6.1)
and (6.2). Further, for simplicity let per capita labor input (lt D Nl) be
time invariant, but possibly different across countries. These lead to the
modified Solow equation now expressed in terms of effective capital:

sF kt ; Nl . C C ı C / kt
ktC1 kt D : (6.4)
.1 C / .1 C /
Using Eq. (6.4), it is easy to prove that the model has a unique positive
steady state, and given an arbitrary k0 > 0, initial condition effective
capital converges to this value.2 The long-run equilibrium (ktC1 D kt D
N is defined by the following condition:
k)

. C C ı C / kN D sF k;
N Nl : (6.5)
Given
the Inada conditions discussed earlier, and the concavity of the
F ; Nl , it is clear that the equation has exactly one interior solution.
Convergence is illustrated in Fig. 6.1. The two functions depict the
two sides of Eq. (6.4), and the vertical distance between them measures
2N
k D 0 is also a steady state, but it is unstable. Since for any k0 > 0 the economy converges to the
positive long-run equilibrium, we only discuss this in the text.
Fig. 6.1 Convergence and equilibrium in the Solow model. The picture shows the
dynamics of the Solow model and its long-run equilibrium. The functional forms
and parameter values are the following: f .k/ D k˛ , ˛ D 0:4, ı D 0:06, D 0:02,
D 0, s D 0:2. Source: own calculations
the increase (or decrease) of effective capital. The figure shows that when
effective capital is below its steady state value (k0 < k),N it is growing.
Alternatively, when effective capital is above its steady state value (k0 >
N it is falling. These are indicated by the arrows below the horizontal
k),
axis. In both cases the economy clearly converges toward the long-run
equilibrium; hence, for any k0 > 0 the steady state is globally stable.
I have just shown that in the long run, the level of effective capital is
constant. From this it trivially follows that in the steady state, capital per
capita grows at the rate of labor-augmenting productivity growth:
KtC1 =NtC1 ktC1 XtC1

D ! 1 C :
Kt =Nt kt Xt
In addition, the growth of the total capital stock includes population

growth. Moreover, it can easily be seen using the production function
that GDP per capita growth also equals the rate of productivity growth.
Since the long-run evolution of endogenous variables is determined by
exogenous improvements in technology, the Solow (and more generally,
the neoclassical) model is known as an exogenous growth model.
Based on these results, the central prediction of the Solow model is con-
ditional convergence. According to the model, in the long run all countries
grow at the same rate, as long as they have access to the same technology.
The existence of a common, global technology is an assumption, but it is
a reasonable one. International trade, capital movements, and migration
are all channels through which technical innovations sooner or later reach
all countries. All economies have the option to use newer, more efficient
production methods, although not all of them are able or want to use
these opportunities.
Conditional convergence means that the relative development level of
countries can be different, even in the long run. Even when the rate of
technological growth is common, the level of technology across countries
can be different, when the spread and adoption of new methods is slow
or incomplete. It is also important to note that TFP in the aggregate
production function is the sum of many ingredients. An important factor
is the composition effect. Even when firm-level productivities are the same
in two countries, but there is heterogeneity within economies, aggregate
productivity is also influenced by how efficiently production factors are
allocated across companies. When the capital and labor markets allocate
resources inefficiently, aggregate TFP is lower.
Besides relative productivity, other factors also influence relative wel-
fare. In the Solow model these are the rate of population growth, the
savings rate, and the depreciation rate. It is easy to introduce other
parameters—such as the tax rate on capital income—that also influence
long-run relative output. While these parameters do not have a growth
effect in the neoclassical framework, they do have a level effect.
Another consequence of the Solow model is that in the short run
economic growth can come from different sources. When a country’s
(effective) capital is below its long-run equilibrium level, we observe
temporarily higher investment and an increase in the (effective) capital
stock. As we saw above, in the long run the level of effective capital is
constant, and economic growth is driven solely by productivity growth.

In the next section I show how the transitory and permanent components
of economic growth can be separated using the neoclassical growth model.
6.3 Steady State and Relative Development

The simplicity of the Solow model makes it ideal to examine a few basic
questions of economic growth and convergence.3 Until now our approach
was basically statistical, where I highlighted the role of capital scarcity and
productivity in the relative (under)development of the Visegrad countries.
Now I seek an answer to the following question: are these patterns in the
data transitory or permanent features?
As we saw in the earlier section, a fundamental prediction of the Solow
model is conditional convergence, which means that (relative) per capita
GDP in a country will converge to a level that is a function of its specific,
fundamental parameter values. From this it follows that relative under-
development can be a temporary or permanent phenomenon depending
on how far along the country in question is on its own convergence path.
Figure 6.1 highlights that relative development is a function of the initial
N
capital stock (k0 ) and the long-run capital stock (k).
Using the definition of the effective variables, we can write per capita
output as Yt =Nt D Xt yt . The relative development level of country i can
then be written as follows:
i i i i
Yti =Nti Xti yit yN yt =Ny Xt
D D : (6.6)
Yt =Nt Xt yt yN yt =Ny Xt
Therefore, relative development can be decomposed into three structural

components, which are: (1) long-run differences, (2) convergence posi-
tion, and (3) relative productivity.
Let us assume again that the production function is Cobb-Douglas, so
that yt D kt˛ lt1˛ . Using Eq. (6.5), GDP per effective worker is given by
the following:
3
Two classic articles about the empirical relevance of the Solow model are Mankiw, Romer, and
Weil (1992) and Klenow and Rodríguez-Clare (1997).
1˛
˛
s Nl:
yN D (6.7)
C C ı C
In the neoclassical framework, the growth rate of technology is exogenous

and the same across countries, but the level of productivity can be
different. The reason for this is that the long-run growth of technology is
viewed as a global process, which applies to all countries with possibly some
lags. On the other hand, the level of productivity is influenced by many local
factors: the implementation lag for the leading technologies, the allocation
of production factors across sectors and firms, and so on. Based on this, in
the following I treat the variable X i as country-specific, while is assumed
to be the same across economies. Similarly to the previous chapter, I
assume that the depreciation rate (ı) and the capital share (˛) are also
common across countries. Since the term is quantitatively very small,
for simplicity I ignore it in the following calculations.
Table 6.1 shows the calibrated parameter values for Eq. (6.7). For the
depreciation rate and capital share, I continue using values set previously.
To calibrate long-run productivity growth, I use the per capital real GDP
growth rate of the USA between 1949 and 2015.4 As standard in the
literature, I proxy the savings rate with the investment rate,5 where I
Table 6.1 Parameters in the Solow model

Savings rate (s) 0.283 0.254 0.265 0.261 0.216 0.226 0.185 0.229
Pop. growth () 0.004 0.001 0.001 0.005 0.006 0.002 0.000 0.000
Labor input (l) 1.160 1.223 1 0.882 1.163 1.115 1.241 1.057
Prod. growth () 0.02
Depreciation (ı) 0.05
Capital share (˛) 0.34
The table shows the country-specific and common parameter values of the Solow
model
Source: Penn World Table 9.0
4
Source: FRED, https://fred.stlouisfed.org/.
5
Note that this is also the appropriate thing to do in open economies, where the savings-investment
identity does only holds on an intertemporal sense.
take the time series average of the PPP investment rates in the Penn
World Table 9.0. For the Western European countries and for Poland
and Hungary, I take the average over the period 1970–2014. Since the
time series for the Czech Republic and Slovakia start in 1990, for these
two countries I use the average between 1990 and 2014.6 For average
population growth, I again rely on the Penn World Table 9.0 and compute
the average over the 1998–2014 sample period. Total labor input was
computed in Chap. 3. In the table I report relative values compared to
Germany in 2014.
With these parameter values, I can quantify the second and third terms
in Eq. (6.6). The ratio of long-run equilibrium levels can be expressed
using Eq. (6.7):
1˛
˛
Nli
yN i si C C ı
D : (6.8)
yN s i C C ı Nl
Using the production function, we can write the capital-output ratio as

follows:
1˛ 1˛
kt kt kt yt ˛
D ˛ 1˛ D D
yt kt lt lt lt
+
kN s
D : (6.9)
yN C C ı C
The position along the convergence path is then defined by the following
expression:
6
An obvious alternative would be to use the sample period 1998–2014 for all countries. This would
lead to very similar results to what we can see in the table, except for Germany. The German
investment rate between 1998 and 2014 is only 21%, which in the light of earlier periods we view
as too low for a long-run equilibrium value.
1˛
˛
yt kt =yt
D ; (6.10)
yN N y
k=N
where I used the earlier assumption that lt D Nl.

Figure 6.2 shows the Solow model-based decomposition of relative
development in the Visegrad countries; I continue using Germany as the
reference country. The columns on the left show the gap in purchasing
parity adjusted real GDP per capita already seen in previous chapters. The
next three times four columns report the factors on the right-hand side
of Eq. (6.6) by country.
The long-run equilibrium of the Visegrad countries is similar to Ger-
many. The Czech’s effective output is almost 20% higher, but for the
other three countries, the difference is below 5%. Although the steady
120
100
DEU 2014 = 100%
80
60
40
20
0
GDP per capita Long run Convergence Productivity
CZE HUN POL SVK
Fig. 6.2 The equilibrium decomposition of relative development. The picture

shows the decomposition of the relative development of the Visegrad countries
compared to Germany, based on the Solow model, to the contributions of TFP, the
convergence position, and long-run equilibrium. Source: own calculations
N is significantly higher in Germany, this is

state effective capital stock (k)
balanced by lower total labor input. Compared to its own long-run equi-
librium position, the Visegrad region is in a similar position as Germany.
Because of the higher investment rate, the German actual and equilibrium
capital-output ratios are both higher (see Eq. (6.9)), but the differences
between the two are similar in the Visegrad countries. Based on these, we
can attribute all the differences in relative development to productivity!
In the development accounting exercise of the previous chapter, the
measured role of TFP was crucial, but much smaller than here (Fig. 5.6).
While about one third of the growth potential in Hungary in Table 5.2
was attributed to capital investment, in the current calculations capital
deepening has no independent role. What explains these differences, and
is there a contradiction between the two sets of results?
Notice that while in Chap. 4 I measured capital scarcity with the per
capita capital stock, the decomposition based on the Solow model uses
the capital-output ratio. The former, however, is directly proportional to
the level of labor-augmenting productivity:
Kt
D Xt kt :
Nt
From this it follows that

1˛
1
Kt s Nl;
D A˛t
Nt C C ı C
where At D Xt˛ is total factor productivity (TFP).

Development accounting is basically a mechanical exercise, which is
based on absolute differences in the capital stocks. In contrast, the Solow
model takes into account that investment is an endogenous process,
which reacts to economic incentives. Capital investment continues until
its rate of return is higher than depreciation broadly defined (taking into
account population and productivity growth). The marginal product of
capital is proportional to productivity:
MPK D AK ˛ L1˛ I
hence, higher productivity implies a higher equilibrium capital stock. The

higher per capita capital stock in Germany I found in the development ac-
counting exercise is therefore induced by the higher German productivity
level if viewed through the lens of the Solow model.
Based on this, the Solow model—and the neoclassical growth model in
general—defines capital scarcity as the situation when a country is behind
its own long-run equilibrium position. As we saw in Fig. 6.2, this is not
the case for the Visegrad countries: they are not significantly different
from Germany with respect to their position on their (own) convergence
paths. The ultimate reason for their lower GDP per capita—according to
the quantified Solow model—is lower productivity, which operates both
directly and also indirectly through the lower level of the capital stock.
The explanation of the neoclassical model for the relative under-
development of the Visegrad countries is therefore the lower level of
productivity. Before we downplay the direct effects of capital and invest-
ment, it is important to briefly discuss the limitations of the model. The
most important drawback is that in the Solow model both the level and
growth rate of productivity are exogenously given. In new growth theory,
technological progress is endogenous, and itself is a result of investment.
As long as capital investment and spending on research and development
(R&D) are driven by the same factors, relative TFP is not the ultimate
cause of underdevelopment, but both are driven by the institutional
environment.
Another important factor is the measurement of investment. The
traditional definition of the capital stock is that it is the sum of machines
and buildings. On the other hand, intangible capital plays an increasingly
important role, which is composed partly of information technology,
and partly of corporate organizational and reputation capital.7 These
have presumably an increasing weight in the total capital stock, but they
are considered—with a few exceptions such as software acquisition—
not as investment, but as consumption in the national accounts. Since
7
For the role of intangible capital in production, see Corrado, Hulten, and Sichel (2009).
I construct the capital stock by cumulating investment, ignoring many

categories of intangible capital investment leads to underestimation of the
true capital stock. It is therefore possible that the true differences in the
capital stocks of the Visegrad and Western European countries are larger
than what we can measure from the national accounts. In this case some of
the development differences that are residually attributed to productivity
might be explained by the broadly defined capital stocks.
6.4 The Speed of Convergence

One of the most important predictions of the Solow model is conditional
convergence: GDP growth is higher when a country is further below its
own long-run equilibrium position. The appropriately calibrated model
can be used not only for this qualitative but also for a quantitative
statement. Using the parameter values from the previous section, we can
compute the additional growth that follows from relative underdevelop-
ment.
Using Eq. (6.4) and the Cobb-Douglas specification, the growth rate
of the capital stock is given by
ktC1 kt sk˛1Nl1˛ . C C ı C /

gk;t D t :
kt .1 C / .1 C /
Let us log-linearize the right-hand side of the expression about the steady
N
state (k):
N ˛1
s .1 ˛/ k kt kN
gk;t Š
.1 C / .1 C / Nl kN
.1 ˛/ . C C ı C / kt kN
Š : (6.11)
.1 C / .1 C / kN
Moreover, we can apply the

kt kN kt
Š log
kN kN
and the
ytC1 yt ytC1
Š log
yt yt
approximations, and the logarithmic form of the production function,

log yt D ˛ log kt C .1 ˛/ Nl. Then we get that
ytC1 ktC1
log D ˛ log ;
yt kt
and
yt kt
log D ˛ log :
yN kN
Using all these in Eq. (6.11), we get the convergence equation for
effective output:
.1 ˛/ . C C ı C / yt yN
gy;t Š : (6.12)
.1 C / .1 C / yN
„ ƒ‚ …

The speed of convergence is the coefficient on the right-hand side of

Eq. (6.12). It shows how quickly the deviation of the effective output from
its long-run equilibrium level is closed.
Using the calibration of Table 6.1, the estimate for the speed of
convergence is around 4% in all countries; for Hungary it is D 0:0376.
For an easier interpretation, let us introduce the concept of half-life. Half-
life is the length of the period over which the total initial distance from
the long-run equilibrium is halved.
To calculate half-life, we can write Eq. (6.12) in a different form:
ytC1 yt
log D .1 / log :
yN yN
Using backward substitution, we can solve the difference equation as a

function of the initial condition:
yt yt1
log D .1 / log
yN yN
yt2
D .1 /2 log
yN
+
y0
D .1 /t log :
yN
Half-life T is formally defined as the solution to the following equation:
1 y0 y0
log D .1 /T log
2 yN yN
+
log .1=2/
TD :
log .1 /
Under our parameterization, for Hungary the half-life is T D 21.
6.5 Households and the

Ramsey-Cass-Koopmans Model
The simplicity of the Solow model makes it very useful to study some
basic aspects of convergence and development. However, the model
lacks some important details, and it is worth expanding it both from a
theoretical and empirical point of view.
The main drawback of the Solow model is that it depicts the savings
behavior as a mechanical rule. For some purposes it is desirable to view
savings as a decision that reacts to changes in the economic environment

and economic policy. The Ramsey-Cass-Koopmans (RCK) model is the
version of the neoclassical growth model where the consumption-savings
decision is endogenous.8
The model has two fundamental versions. On the one hand, we can
define the problem of the social planner, where this “planner” directly
determines the allocation of consumption and investment to maximize
the long-run (intertemporal) utility of households. The other version
assumes decentralized competitive markets, where households and firms
exchange final goods and production factors, under prices that their
individual behavior cannot influence. In this case it is the adjustment of
the price system that leads to general equilibrium, where all markets clear.
It is easy to show that in the RCK model the planner’s allocation is the
same as the competitive equilibrium. This is the first theorem of welfare
economics: when markets are perfectly competitive and complete, and
there are no externalities, the competitive equilibrium is Pareto efficient.
Out of these approaches, which in our case lead to equivalent outcomes,
I describe the decentralized equilibrium version. Although this is slightly
more complicated, this is what I will build on in later chapters.
6.5.1 The Competitive Model
Households I assume that households in the economy are identical, or at

least the aggregate decision can be well approximated by the behavior of
a representative household. Incorporating fundamental household hetero-
geneity is well beyond the scope of these investigations, and the literature
is also ambivalent on the importance of such heterogeneity in modeling
aggregate behavior.
The decision problem of the representative household is the following:
1
X Ct
max ˇ t Nt log
tD0
Nt
8
Ramsey (1928), Cass (1965) and Koopmans (1965).
k:f: Ct C BtC1 D Wt Lt C .1 C rt / Bt C …t ;
where Ct is the total consumption of the representative household, Nt is

the size of the household (population), Lt is the total labor input, Bt is
the stock of household deposit holdings (savings), Wt is the wage rate,
rt is the interest paid on deposits, and …t is the dividends paid by firms
(who are owned by households). In the intertemporal utility function, I
weigh each period with the actual size of the household (dynastic utility
function). As in the Solow model, for now I assume that Lt is exogenous.
The RCK model is a one-sector economy: there is a single
consumption-investment good, whose price I always normalize to
unity (numeraire). One can show that only relative prices matter in
the competitive RCK model; hence, changes in the price level do not
affect the evolution of real variables.
The first-order conditions to the problem of the representative house-
hold are given by the following equations:
Nt
D t
Ct
t D ˇ .1 C rtC1 / tC1 ;
where t is the Lagrange multiplier associated with the household budget

constraint.
Firms and Equilibrium Firms who produce the final product are per-
fectly competitive and convert capital and labor input into output using
the neoclassical production function that I assumed and described previ-
ously. Capital investment is also done by the firms. The problem of the
representative company, assuming a Cobb-Douglas production function,
is the following:
t h ˛ i
1
X
t 1˛
max …0 D ˇ K .Xt Lt / Wt Lt KtC1 C .1 ı/ Kt :
tD0
0 t
The discount factor takes into account that firms are owned by house-
holds; hence, profits streams are discounted by the relative marginal utility
of income (t =0 ). The first-order conditions are the following:
Wt Lt D .1 ˛/ Kt˛ .Xt Lt /1˛

h i
˛1 1˛
t D ˇ ˛KtC1 .XtC1 LtC1 / C 1 ı tC1 :
Combining the first-order conditions of households and firms, and

assuming market clearing, we get the following equilibrium conditions:
Nt NtC1
D ˇ .1 C rtC1 /
Ct CtC1
Nt h iN
tC1
˛1
D ˇ ˛KtC1 .XtC1 LtC1 /1˛ C 1 ı (6.13)
Ct CtC1
Ct D Kt˛ .Xt Lt /1˛ C .1 ı/ Kt KtC1 :
6.5.2 Steady State and Solution
Equation (6.13) define the competitive equilibrium in our model econ-

omy. The second and third equations define the dynamics of consump-
tion and the capital stock, while from the first equation we can derive the
equilibrium real interest rate. Since the real interest rate is determined
residually, I ignore the first condition for now.
To solve the dynamic system—similarly to the Solow model—we have
to introduce transformed variables, since the system is not stationary. Let
ct D Ct = .Xt Nt /, kt D Kt = .Xt Nt /, and let lt D Lt =Nt . Then we get the
following, modified system of equations:
" #
ctC1 ˇ ktC1 ˛1
D ˛ C1ı
ct 1C ltC1
ct D kt˛ lt1˛ C .1 ı/ kt .1 C / ktC1 : (6.14)

It can be shown that the solution of the (6.14) system is a saddle path,
along which consumption and investment converge monotonically to
their unique steady state values. Long-run equilibrium is described by
the following conditions:
1˛
1
˛
kN D Nl
.1 C / =ˇ 1 C ı
cN D kN ˛ Nl1˛ .ı C / kN (6.15)
Knowing the capital stock, effective output can also be expressed easily:
1˛
˛
˛ Nl
yN D (6.16)
.1 C / =ˇ 1 C ı
Let us compare Eq. (6.7) with Eq. (6.16): the first gives the long-run
effective output level in the Solow model, while the second gives the
same variable in the RCK model. The two expressions are very similar,
but while in the Solow model the exogenous savings rate (s) is the key
parameter, now this role is played by the capital share (˛) and the discount
factor (ˇ).
The dynamics of the system are depicted in Fig. 6.3. Given an exoge-
nous initial capital stock k0 , the initial consumption level (c0 ) is uniquely
determined. The yellow schedule indicates the equilibrium saddle path,
and the arrows show the dynamics of the system. If the (effective) capital
stock is lower (higher) than the long-run value (k), N investment is above
(below) depreciation, and the capital stock grows (declines). For any
initial condition, the economy converges to the steady state, although
it only reaches it in an infinite number of time periods.
We can decompose relative economic development into contributions
of productivity, long-run differences, and the relative position on the
convergence path in the same way as in the case of the Solow model. Since
the methodology is identical to what I already presented in the previous
section, and there are minor differences only in the parameterization, I
Fig. 6.3 The saddle path in the RCK model. The figure shows the phase diagram
of the Ramsey-Cass-Koopmans model. The functional forms and parameter values
used are: f .k/ D k˛ , u .c/ D log c, ˇ D 0:95, ˛ D 0:4, ı D 0:08, D 0:02. Source: own
calculations
do not present any details here. I only discuss one issue that did not arise
earlier, which is the calibration of the discount factor of households (ˇ).
To do this, let us now return to the first equation in (6.13), which
defines the real interest rate. The steady state version of this equation is
1C
D 1 C rN : (6.17)
ˇ
Therefore, the long-run equilibrium level of the real interest rate depends
on the growth rate of technology (and hence GDP per capita), and the
discount factor. Assuming that the advanced countries are on (or fluctuate
around) their balanced growth paths, the parameter can be quantified
as a time series average, as I did it in the previous section. If in addition we
have a reasonable estimate for the average real interest rate, the parameter
ˇ can be calibrated using the equation above.
References
Cass, D. (1965). Optimum growth in an aggregative model of capital accumu-
lation. Review of Economic Studies, 32, 233–240.
Corrado, C., Hulten, C., & Sichel, D. (2009). Intangible capital and U.S.
Economic Growth. Review of Income and Wealth, 55, 661–685.
King, R. G., Plosser, C. I., & Rebelo, S. T. (2002). Production, growth and
business cycles: Technical appendix. Computational Economics, 20, 87–116.
Klenow, P., & Rodríguez-Clare, A. (1997). The neoclassical revival in growth
economics: Has it gone too far? In NBER Macroeconomics Annual (pp. 73–
114). Cambridge: National Bureau of Economic Research.
Koopmans, T. C. (1965). On the concept of optimal economic growth.
In Johansen, J. (Ed.), The econometric approach to development planning.
Amsterdam: North Holland.
Mankiw, N. G., Romer, D., & Weil, D. N. (1992). A contribution to the
empirics of economic growth. The Quarterly Journal of Economics, 107,
407–437.
Ramsey, F. (1928). A mathematical theory of saving. Economic Journal, 38,
543–559.
Solow, R. M. (1956). A contribution to the theory of economic growth. The
Quarterly Journal of Economics, 70, 65–94.
7
Markets and Distortions
In this chapter I study the role of productivity and factors of production

in the determination of economic development. As we saw in the earlier
chapters, for a deeper investigation, we need to take into account that
measured inputs are endogenous and are the results of equilibrium
allocations on various markets. The quantity and usage of production
inputs are thus influenced by political and institutional factors, and
random events. In this chapter I identify those factors—distortions—
that affect the equilibrium on the labor and capital markets, besides
the level of productivity. It is important to note that at the aggregate
level developments on a particular market can influence other markets.
Distortions on the labor market can affect capital accumulation and vice
versa. To be able to separate the different effects, we need a general
equilibrium framework. Although there is no consensus in the literature
on which is the most suitable model for this purpose, I find the RCK
model a good starting point.
Given parameter values and exogenous conditions, the model can be
used to derive the optimal allocation of aggregate resources. Comparing
this optimal allocation with the observed outcome, and using the structure
of the model, we can trace back the differences to the different markets

https://doi.org/10.1007/978-3-319-69317-0_7
operating in the economy. Development accounting decomposed dif-

ferences in relative wealth into contributions of productivity and factor
inputs. In this chapter I show how factor input usage is different from
the optimal level, given productivity and economic development, and
to what extent the differences can be attributed to inefficiencies on the
capital and/or labor markets.
The methodology is very similar to business cycle accounting. Chari,
Kehoe, and McGrattan (2007) (CKM, henceforth) use the stochastic
version of the RCK model to identify a few key relationships among the
observed macroeconomic variables. These are (i) the production function,
(ii) the consumption-saving Euler equation, and (iii) the labor market
equilibrium condition. Fitting the theoretical relationships on actual data,
we can identify error terms, which CKM define as (i) efficiency, (ii)
capital market, and (iii) labor market wedges. CKM also show that many
more complex and more detailed macroeconomic models can be reduced
to the RCK model, once we include the wedges. The precise content
of the wedges naturally depends on the underlying structural model.
Nevertheless, CKM argue that studying the reduced form wedges is
informative when we want to evaluate the explanatory power of different
model families.1
The calculations below mostly follow the logic of Chari et al. (2007),
with a few important modifications. While CKM concentrates on busi-
ness cycles and therefore use filtered data, I work with the raw time series,
just as in the previous chapters. The big advantage of this is that the
computed wedges will be comparable across countries. This, compared
to development accounting, takes us one step further to understand the
differences more deeply. The second difference is that in contrast to
the CKM approach, who model the wedges as first-order vector auto-
regressive (VAR) processes, and calculate them through estimating the
general equilibrium system, with the use of auxiliary data, I will be able
to compute them equation-by-equation. The advantage of this approach
1
The methodology of business cycle accounting is used in Cavalcanti (2007) for Portugal, Kersting
(2007) for Great Britain, and Inaba and Kobayashi (2006) for Japan.
is that we do not have to assume anything about the stochastic properties

of the model, and we can let “the data speak.”2
The chapter updates and expands results in Kónya (2013). Relative to
that study, I now have newer and longer time series, and I also extend
the calculations to additional countries. Using the methodology of the
previous chapters, I measure capital and labor input more precisely, and
I can take into account capacity utilization. It is of particular interest to
see what happened in our countries of interest since the financial crisis.
7.1 Theoretical Framework

The theoretical tool used for measurement is a version of the RCK model.
Relative to the basic model described in the previous chapter, I make three
additional assumptions.
1. Households value leisure; hence, labor supply becomes endogenous.

2. I assume an open economy: households have access to international
credit markets.3
3. Uncertainty: the economic environment is stochastic, and agents have
expectations about the future.
7.1.1 Households
Using the additional assumptions, the decision problem of the households

is modified as follows:
1
X
tCt
maxE0 ˇ Nt log C log .1 Lt /
tD0
Nt
2
This also means that we take into account and handle the serious critiques of the BCA approach
described in Christiano and Davis (2006), and Baurle and Burren (2011).
3
Similar to us, Otsu (2010) also uses an open economy framework, but in contrast to the current
approach, analysis the business cycle.
BtC1 l

s:t: Ct C D 1 t Wt Lt C 1 C r t1 Bt C …t C Tt :
1 C tb
I introduce the following new notation. Let rt be the reference world
interest rate, which is the opportunity cost of real and financial assets
for a small open economy. The variable Tt is the net amount of taxes
and subsidies paid and received by the household; I only include this
for completeness as it does not play a role in future calculations. The
utility function includes leisure, whose maximum amount is normalized
to unity; Lt continues to measure the total labor input relative to the
leisure endowment.
Because of various frictions, costs, and taxes, households face debt
costs that are higher than the world interest rate. I define the gap as
the borrowing wedge (tb ). I introduce the labor wedge (tl ) in a similar
fashion: with perfectly flexible and efficient markets, the opportunity cost
of leisure is the gross wage rate, but due to taxes and other distortions, the
household only takes into account a 1 tl fraction of this.
The first-order conditions that include these wedges can be rearranged
to yield the following conditions:
Ct
D 1 tl Wt
1 Lt
1 Ct =Nt
b
D ˇ 1 C rt Et : (7.1)
1 C t CtC1 =NtC1
The borrowing and labor wedges distort the inter- and intratemporal
decisions. Notice that while I introduced them formally as taxes, this
is without loss of generality. Any factor that opens a gap between the
marginal rate of substitution between consumption and leisure, and the
wage rate, is part of the labor wedge. Similarly, any factor that leads
to a discrepancy between the marginal rate of substitution between
current and future consumption, and the world interest rate, increases
the borrowing wedge. As I discussed above, the wedges contain all tax
and non-tax market distortions in a reduced form manner.
7.1.2 Firms
The problem of firms is also an extended version of the decision problem

I described for the RCK model:
t h ˛
1
X
max …0 D E0 ˇ Kt .Xt Lt /1˛ Wt Lt
t
tD0
0

1 C i KtC1 C .1 ı/ Kt :
The exogenous factor ti is the investment wedge, which distorts the capital
investment decision of firms. As in the previous chapter, I include the
marginal utility of income (t ) in the discount factor.
Let us write down the first-order conditions:
.1 ˛/ Kt˛ .Xt Lt /1˛ D Wt Lt

h i
i ˛1 1˛
1 C t t D ˇEt ˛KtC1 .XtC1 LtC1 / C 1 ı tC1 :
(7.2)
The investment wedge appears in the intertemporal condition of capital

investment and in a reduced form contains all factors that distort this
decision from its optimal level.
7.1.3 Equilibrium
Let us now combine the household and firm optimality conditions and
write down the relevant equilibrium conditions, using also the production
function:
Ct Lt
D 1 tl .1 ˛/ Yt
1 Lt
1 Ct =Nt
b
D ˇ 1 C rt Et
1 C t CtC1 =NtC1

YtC1 Ct =Nt
1C ti D ˇEt ˛ C1ı :
KtC1 CtC1 =NtC1
The three equations determine the labor, borrowing, and investment

wedges. The empirical calculations are complicated by the fact that the
intertemporal conditions contain expectations. To handle these, we need
additional steps.
First, notice that combining the second and third equations we get an
arbitrage condition between the investment and debt markets. Let us use
the following approximation in the third equation:

YtC1 Ct =Nt YtC1
Et ˛ C1ı Š Et ˛ C1ı
KtC1 CtC1 =NtC1 KtC1
Ct =Nt
Et ;
CtC1 =NtC1
which means ignoring the covariance term between the two factors. This
is satisfied, for example, under a first-order approximation. Using this in
the second equation, we arrive at the following condition:
YtC1
1 C tb 1 C ti 1 C rt D Et C 1 ı:
KtC1

Let us introduce the 1 C tk D 1 C tb 1 C ti notation, where tk can
be thought of as a capital wedge. The capital wedge measures the extent
to which the rate of return on physical capital investment and the cost of
borrowing differ from each other, due to various distortions. In a small
open economy, the latter is the opportunity cost of investment for firms.
To summarize the above, I define the labor and capital market distor-
tions with the following equations:
Ct Lt
1 tl D (7.3)
1 ˛ Yt 1 Lt
˛Et .YtC1 =KtC1 / C 1 ı

1 C tk D (7.4)
1 C rt
1 C tC1 CtC1
1 C tb D Et : (7.5)
ˇ 1 C rt Ct
Writing the last condition, I assume that the rate of population

growth (NtC1 =Nt ) is known one period ahead, and I also used the
1=Et .Ct =CtC1 / Š Et .CtC1 =Ct / approximation.
The first equation measures labor market distortions, that is, the
extent to which the marginal rate of substitution between consumption
and leisure differs from the marginal product of labor. For an optimal
allocation, the two are equal, but this is typically not the case in the data.
The larger the difference, the more inefficient is the operation of the labor
market.
The second equation shows how much capital investment is below (or
possibly, above) its optimal level. When capital markets operate efficiently,
the expected net marginal product of capital equals the opportunity
cost of investment (borrowing), which is the international reference real
interest rate.
The third equation measures the extent of household consumption
smoothing. When households can borrow without frictions on domestic
and/or international credit markets, the growth rate of consumption
equals the gap between the relevant discount factor and the real interest
rate. If in the data we see different behavior, we attribute this to distortions
in household borrowing and lending.
7.2 Measurement Issues

Now I turn to the measurement of the wedges I defined in the previous
section. Calculating the labor wedge (Eq. (7.3)) is relatively easy, since we
do not have to worry about expectations. The consumption share (Ct =Yt )
is easily observed, and I describe the calibration of the parameter values
below. To quantify the dynamic wedges, in addition to the parameters, we
also need to handle the expectation terms. After the calibration details, I
explain the method used for this purpose.
7.2.1 Calibrating Parameters
To measure the wedges, we need the following parameters: the capital

share (˛), the depreciation rate (ı), the relative weight of leisure in utility
(), and households’ discount factor (ˇ). I follow the earlier chapters for
the capital share and the discount factor and set them identically to ˛ D
0:34 and ı D 0:05 in each country.
The other two parameters essentially mean normalizations. Let us write
down the steady state of the dynamic system including the wedges, which
is analogous to the RCK conditions from the previous chapter (6.15):
Ncy LN
1 N l D
1 ˛ 1 LN
˛=kN y C 1 ı
1 C N i 1 C N b D
1 C rN
1C
ˇ 1 C N b D (7.6)
1 C rN
cN y D 1 kN y .ı C / ;
y y
where ct D Ct =Yt and kt D Kt =Yt , and I assume for simplicity that
BN D 0. The consumption-output ratio (Ncy ), the long-run world real
N are considered observable, at
interest rate (Nr ), and total labor input (L)
least in countries that fluctuate around their steady states. These values
can be computed in these cases as long-run averages. Note that the
capital-output ratio cannot be used as an independent observation, since
it is uniquely determined by the GDP identity (the last equation), as a
function of calibrated parameters and the consumption share. Therefore,
I have the first three equations to determine two unknown parameters,
and three long-run wedge values. This is obviously not possible, so I
proceed the following way.
Let us write down the steady state assuming the optimal allocations,
which means that all wedge values are zero:
˛
kQ y D
.1 C / =ˇ 1 C ı
cQ y D 1 kQ y .ı C / (7.7)

1˛ 1
D 1 ;
cQ y Ql
where the xQ notation indicates the optimal long-run value of a variable.

From the third equation of the (7.6) system, we can see that the observed
average real interest rate does not identify the discount factor, because
the relationship between the two is distorted by the long-run borrowing
wedge. Since the discount factor is not identified, I use a value that is
common in the literature, ˇ D 0:96. Using this and the other parameter
values, we can compute the optimal capital-output and consumption-
output ratios (kQ y and cQ y ) from the first two equations of the system (7.7).
Now let us turn to the calibration of the parameter . Recall that in the
utility function I normalized the physical maximum of total labor input
to unity. Based on this, let us define the absolute level of maximum labor
input, which will be the reference point below. I assume that the total
time endowment per day is 16 hours, every day of the year (this means
we allocate eight hours daily for sleep). To get the maximum amount of
human capital, I assume that all workers have a tertiary degree. Finally,
I set the maximum possible employment rate of the age group 15–64 to
0:8, which takes into account that the younger generation is still in school.
Then the maximum total labor input is defined as follows:
Lmax D 0:8 .16 7 52/ e160:0927 ;
where the last term includes the average return to schooling (see Chap. 3).
In the next step I define the optimal amount of labor input (system
(7.7)). This is naturally lower than the theoretical maximum, since
households value leisure. Let us assume that the efficient level of the
employment rate among the 15–64 age group is 0:8, which is the largest
value among the OECD countries (Scandinavia).4 Let us take the optimal
level of average annual working hours to be 48 40, assuming a five-day
workweek and four weeks of vacation per year. To determine the optimal
level of schooling, I use the maximum average years of schooling in the
data among all countries, which is 13.5 Using all these, the optimal level
of total labor input is defined by the following equation:
Lopt D 0:8 .8 5 48/ e130:0985 ;
where I computed the average rate of return to 13 years of schooling based

on Chap. 3.
Using the above definitions of Lopt and Lmax , the normalized level of
optimal labor input is Ql D Lopt =Lmax D 0:2688. From the third equation
of system (7.7) and using cQ y that we calculated earlier, I can now compute
the relative weight of leisure in the utility function:
D 2:2767:
In what follows I assume that both ˇ and are common across countries.
Any long-run differences between labor and capital markets are thus
attributed solely to differences in the average levels of the wedges.
7.2.2 Data and Expectations
The computation of the labor wedge defined by Eq. (7.3) is simple. I

calculate total consumption as the sum of household and government
consumption. Both for consumption and GDP, I use nominal time series.
For total labor input, the data series is created using the method described
in Chap. 3, with the normalization based on the concept of maximum
labor input (Lmax ).
4
This equals the value used to define the maximum employment rate above. But we need to take
into account that while in our maximum calculations the age group 15–24 is still in school, in the
data the majority of the young are already working.
5
UNDP, http://hdr.undp.org/en/content/mean-years-schooling-adults-years.
To calculate the capital market wedges, I need to measure the expec-

tations of certain variables. One way to do this is to use the approach of
Chari et al. (2007): they assume that the unknown wedges follow a joint
VAR process and then estimate them by full information methods using
the structural model. I use a different strategy, described in Kónya (2013).6
This method is based on the assumption that public forecasts, such as
the projections of the OECD, can be used to measure expectations.
This is naturally true under rational expectations, when the information
sets of decision makers and forecasters are the same, or the former use
the forecasts when forming their expectations. A great advantage of this
approach is that there is no need to estimate the full general equilibrium
system, and I do not have to assume anything about the behavior of the
wedges.7
For quantification I use the December forecasts published in the
OECD Economic Outlook8 to measure one period ahead expectations
for real GDP, consumption growth, and inflation. Inflation expectations
are needed because the real interest rate used in Eqs. (7.4) and (7.5) is
forward looking. The approximate definition of this is the following:
rt D Rt Et
tC1 ;
where Rt is the reference nominal interest rate and

t is the inflation rate.
To measure the world nominal interest rate, I use the annual average of
the German three-month money market interest rate.
7.3 Results
After describing the theoretical framework and discussing measurement
issues, let us now turn to the results.
6
A third option is to use the deterministic version of the model, see, for example, Jones and Sahu
(2017).
7
For using empirical expectations in DSGE models, see Milani (2011).
8
http://www.oecd.org/eco/economicoutlook.htm.
7.3.1 The Labor Wedge
Let us start with the evolution of the labor wedge in the eight countries
(Eq. (7.3)). The calculated time series are presented in Fig. 7.1.
There are significant differences in labor market distortions across
countries. The wedge is highest in Germany, France, and Slovakia. The
German level may be surprising, since the German employment rate is
high. On the other hand, as we saw already in Chap. 3, hours per worker
are particularly low in the German economy. Interestingly, despite the
lower level of employment in France, the German and French labor
market wedges are very similar to each other in the sample period.
While in these two countries we can see a continuous—although slow—
improvement between 1998 and 2014, the operation of the Slovak labor
market did not generally improve relative to the beginning of the period,
although the initial deterioration was later corrected.
In Austria, the Czech Republic, and Hungary, the labor market looks
more efficient. The Czech and Hungarian developments were mirror
images of each other: at the beginning of the period, the efficiency of the
Czech labor market worsened, while that of the Hungarian labor market
improved somewhat. After 2006, there is improvement in the Czech
Republic, while in Hungary the efficiency of the labor market declined.
There is a turning point again in Hungary after 2012, but I have too little
data to judge whether the current improvement is persistent. The lowest
labor wedges can be seen in Great Britain and Poland. In both countries
there have been significant improvements by the end of the period; in
Poland, the improvement only started in 2004.
It is important to note that while cross-country heterogeneity is
significant, we cannot see large differences across the two regions. On
average, the labor markets in Western European countries do not seem to
work more efficiently than the labor markets in the Visegrad countries.
The volatility of the labor wedge, however, is larger in the latter region:
in Western Europe we see stable trends, while in the Visegrad countries
the wedge behaves more cyclically.
Finally, let us examine the magnitude of the observed wedges. Recall
that the labor wedge appears in the equilibrium condition as an income
Western Europe
0.55
0.5
0.45
0.4
Labor wedge
0.35
0.3
0.25
AUT
DEU
0.2 FRA
GBR
0.15
1998 2000 2002 2004 2006 2008 2010 2012 2014
Visegrad countries
0.55
0.5
0.45
0.4
Labor wedge
0.35
0.3
0.25
CZE
HUN
0.2 POL
SVK
0.15
1998 2000 2002 2004 2006 2008 2010 2012 2014
Fig. 7.1 Labor wedge. The figure shows the labor wedge, normalized appropri-
ately. Source: Eurostat and own calculations
tax rate. According to the calculations, the distortions captured by the

labor wedge are equivalent to an income tax rate of 20–50%. It would be
natural to compare these values to income tax rates we observe in the data
for our countries. I leave this comparison to a later section in this chapter.
7.3.2 The Capital Wedge
I quantify the capital wedge as the difference between the expected

marginal product of capital and the global—in this case, the German—
expected real interest rate (Eq. (7.4)). Results are shown in Fig. 7.2.
The capital wedge is basically the same in the three continental Western
European economies. It is fairly stable before the global financial crisis and
started growing after that. Low real interest rates should induce higher
investment activity than what we see in the data. The dynamics of the
capital wedge are very similar in Great Britain, but the level of the wedge
is significantly higher. I already discussed the low level of investment and
the capital stock in the UK earlier. It is possible, however, that in Great
Britain a larger fraction of the capital stock is unobserved (intangible
capital), which means that I may have underestimated capital investment
and hence overestimated the capital wedge.
There were similar movements in the Visegrad countries. Before the
crisis, the capital wedge was declining, and the drop was particularly
pronounced in Hungary. The crisis, on the other hand, affected Hungary
the most, especially since 2011. Overall, the capital market distortions
are the lowest in the Czech Republic and the highest in Poland. It is
interesting to observe that the capital wedge is highest in countries with
a low labor wedge (Poland and Great Britain).
In contrast to the labor wedge, we can now see systematic differences
across the two regions in the efficiency of the capital market. Let us
calculate the average capital market distortions in the two regions, using
the simple arithmetic average of the four countries in each. The difference
between the regional averages fluctuates between 2.5 and 4%, with
the Visegrad countries being systematically worse off. The operating
efficiency of the Czech and Hungarian capital markets is similar to Great
Britain, but is well behind the other three Western European countries.
Western Europe
0.15
0.1
Capital wedge
0.05
AUT
DEU
FRA
GBR
0
1998 2000 2002 2004 2006 2008 2010 2012 2014
Visegrad countries
0.15
0.1
Capital wedge
0.05
CZE
HUN
POL
SVK
0
1998 2000 2002 2004 2006 2008 2010 2012 2014
Fig. 7.2 The capital wedge. The figure shows the capital wedge, normalized
appropriately. Source: Eurostat and own calculations
Capital market distortions in Poland and Slovakia are higher than in any
other country.
As with the labor market, we can compare the measured distortions
to the actual tax rates that fall on capital. This is a somewhat more
complicated issue, which needs further calculations. I again leave these
to a later part of this chapter.
7.3.3 The Borrowing Wedge
Now I examine the third wedge, which compares the extent of household
consumption smoothing to the world real interest rate. Time series for
the borrowing wedge are shown in Fig. 7.3.
In contrast to the capital wedge, the household borrowing wedge does
not significantly differ across the two regions. The Western European
time series are very similar, except for Germany between 2001 and 2007.
The borrowing wedge in the Visegrad countries is much more volatile
and less homogeneous among the four economies.
A particularly interesting case is Hungary, where we can see a significant
decline between 2005 and 2009, and even negative values in 2008–2009.
During this time period foreign currency lending became widespread in
Hungary, which shows up nicely in the borrowing wedge. There is no
similar pattern in the other Visegrad countries, where foreign currency
lending was not important (with the partial exception of Poland).
Both regions show the effect of the global financial crisis, which shows
up as an increase in the borrowing wedge after 2009. Similarly to capital
investment, the efficiency of the household credit market also worsened
after the crisis. The extent of consumption smoothing fell behind its
earlier value, especially compared to the lower interest rate environment.
Our macroeconomics measurement exercise thus confirms the picture
that the global crisis led to a persistent worsening in the efficiency of
financial intermediation.
Western Europe
0.1
0.08
0.06
Borrowing wedge
0.04
0.02
AUT
0 DEU
FRA
GBR
-0.02
1998 2000 2002 2004 2006 2008 2010 2012 2014
Visegrad countries
0.1
0.08
0.06
Borrowing wedge
0.04
0.02
CZE
0 HUN
POL
SVK
-0.02
1998 2000 2002 2004 2006 2008 2010 2012 2014
Fig. 7.3 Household borrowing wedge. The figure shows the borrowing wedge,
appropriately normalized. Source: Eurostat and own calculations
7.4 Additional Calculations

After computing the wedges, I continue their analysis with a few addi-
tional steps. First I decompose the capital wedge into a domestic and
an external component, then I compare factor market distortions with
observed tax rates.
7.4.1 Decomposing the Capital Wedge
When calculating the capital wedge, I compared the expected marginal

product of capital to an international reference rate of return. It is
interesting to see what fraction of the difference can be attributed to
the gap between the external and domestic interest rates, and to the
difference between the local interest rate and the expected return to capital
investment. To do this, I use the following simple decomposition:
1 C rt ˛Et .YtC1 =KtC1 / C 1 ı

1 C tk D ;
1 C rt 1 C rt
„ ƒ‚ …
Domestic component
where rt is the difference between the nominal money market rates and
expected the inflation rates in a given country. Figure 7.4 depicts the
decomposition of the capital wedge. The columns show the domestic
component, while the lines indicate the total value of the wedge.
In most countries the domestic components behave very similarly to
the total capital wedge (in Germany the two are equal by definition).
Especially in the Eurozone countries, but also in Great Britain, the dif-
ferences between the domestic real interest rate and the global (German)
reference rate are minimal. In the advanced Western European countries,
capital markets are integrated, and financial market yields are equalized.
Although the capital wedges are substantial, these can be attributed to the
difference between returns on real investment and returns on domestic
financial markets, and not to the segmentation of financial markets.
The Visegrad countries show a more interesting picture. In the Czech
Republic and Slovakia, the domestic component is on average higher than
Austria Czech Republic

0.15
Domestic 0.1
Total
0.1 0.08
0.06
0.05 0.04
0.02
0 0
1998 2002 2006 2010 2014 1998 2002 2006 2010 2014
Germany France
0.15 0.15
0.1 0.1
0.05 0.05
0 0
1998 2002 2006 2010 2014 1998 2002 2006 2010 2014
Great Britain Hungary

0.15 0.15
0.1 0.1
0.05 0.05
0 0
1998 2002 2006 2010 2014 1998 2002 2006 2010 2014
Poland Slovakia
0.15 0.15
0.1 0.1
0.05 0.05
0 0
1998 2002 2006 2010 2014 1998 2002 2006 2010 2014
Fig. 7.4 Decomposing the capital wedge. The figure decomposes the capital
wedge into a domestic and international component. Source: Eurostat and own
calculations
the total labor wedge. This means that the Czech and Slovak real interest
rates were typically below the German level. Notice that this is not the
result of a common nominal interest rate and a higher inflation rate,
since Slovakia only joined the Eurozone in 2009, and the Czech Republic
had its own currency and independent monetary policy throughout the
sample period.
Hungary and Poland are the two countries where the domestic compo-
nents are significantly below the total capital wedge in most of the period.
With the exception of the mid-2000s, Hungarian and Polish real interest
rates were significantly above the German reference value. Therefore, in
these two countries it is not only the distortions related to real investment
activity that show up in the capital wedge, but the financial environment
was also more restrictive than in Western Europe, or in the Czech and
Slovak economies. In the case of Hungary, this might be attributed to the
high level of indebtedness and to the disinflation policy of the Hungarian
national bank.
Although I do not plot it separately, the same conclusions can be drawn
for the borrowing wedge, since its external component—the difference
between domestic and global real interest rates—is the same as what I
calculated for the capital wedge. Once more, it is worth emphasizing
that Hungary and Poland are the two economies where the external
component significantly increased the capital (and borrowing) wedge. I
return to the issue of domestic and external interest rate differentials in a
future chapter.
7.4.2 Taxes on Labor
It is interesting to compare the estimated labor wedge with the extent of

taxes on labor. In the theoretical framework, the factor market distortions
appear as tax rates. Therefore, it is expected that the actual tax burden
is an important part of the wedges that we compute as residuals. It is
important to note that in the neoclassical framework—and hence in the
RCK model—we have to include consumption taxes among the various
forms of taxes on labor. The economic reason behind this is that in
the trade-off between consumption and leisure—which is the central
determinant of labor supply—not only the taxation of labor income

matters but also the taxation of consumption, since income is ultimately
spent on consumption. It is easy to see that the relevant total tax wedge
can be calculated as follows:
1 tlab
ttot D 1 ; (7.8)
1 C tcons
where tlab is the tax rate on labor and tcons is the tax rate on consumption.
Measuring the tax wedge precisely is difficult, especially in a one-
sector, representative agent macroeconomic model. Both the average
and the marginal tax rates are strongly heterogeneous across households.
Furthermore, while the intensive margin of labor supply responds to the
marginal tax rate, the extensive margin—the labor force participation
decision—is influenced by the average tax rate. Since in our model the
two margins are combined, it is not clear which tax rate is more relevant.
Since the main goal is the interpretation of the labor wedge and not the
precise measurement of the impact of taxation, I use a simple approach.
The Eurostat website contains implicit tax rates, which are computed as
the ratio of total tax revenue for a given tax type, divided by the tax base
in that category.9 These implicit rates are available for both income and
consumption, so I use these in Eq. (7.8) to calculate the total tax burden
on labor. Since at the time of writing Eurostat reports time series only
between 2000 and 2012, I use this period in the comparison.
Figure 7.5 shows the combined income-consumption implicit tax rates,
and the labor wedge. In the majority of the countries, the tax rate is
higher than the wedge, but it has to be kept in mind that the optimal
labor market allocation—and defined the level of no distortions—was
chosen fairly arbitrarily. This makes the level comparison in a country not
particularly informative, but studying the dynamics and comparing the
relative differences across countries are still possible. That said, the picture
suggests that the calibrated optimal level of total labor input appears
too low, since in addition to taxes, the wedges contain other types of
9
http://ec.europa.eu/eurostat/web/products-datasets/-/gov_a_tax_itr.
0.5 0.5
0.4 0.4
0.3 0.3
Labor wedge
0.2 Implicit labor tax 0.2
2000 2005 2010 2000 2005 2010
Germany France
0.5 0.5
0.4 0.4
0.3 0.3
0.2 0.2
2000 2005 2010 2000 2005 2010
0.5 0.5
0.4 0.4
0.3 0.3
0.2 0.2
2000 2005 2010 2000 2005 2010
Poland Slovakia
0.5 0.5
0.4 0.4
0.3 0.3
0.2 0.2
2000 2005 2010 2000 2005 2010
Fig. 7.5 Labor wedge and labor taxation. The figure compares the labor wedge
and the combined income-consumption implicit tax rates. Source: Eurostat and
own calculations
distortions. Since I do not have a better reference point, however, I keep

the average level of the wedges unchanged.
The largest difference between the tax burden and the wedge level
can be seen in Austria, and somewhat surprisingly, in Hungary. In these
two economies, the level of the labor wedge is relatively low, despite the
high tax burden. On the other hand, in Germany and France similar
levels of tax rates are accompanied by much higher overall distortions.
Recall that in Hungary the level of total labor input is not low, although
the employment rate is below the Western European figures. On the
other hand, Hungarian labor market regulation is quite flexible, especially
compared to the German and French economies.
Let us mention an interesting detail when comparing labor taxes
and wedges. The decrease in the implicit tax rates in Slovakia after
2000, in Poland after 2005, and in the Czech Republic after 2007 was
accompanied by a decline in the labor wedge. Since the wedges are
reduced form combinations of taxes and other inefficiencies, these do not
necessarily imply a causal relationship.
7.4.3 Taxes on Capital
When comparing capital taxes and the capital wedge, we have to take into
account that the former are defined on capital income, while the latter is
defined on the capital stock. Therefore, I convert the capital tax to the
same base, using the steady state of the theoretical model.
Let us write down the steady state of the RCK model when the
investment and borrowing wedges are replaced with a tax on capital
income. It is now convenient to assume that capital investment is carried
out by households,10 and they lend their capital to firms at the competitive
rental rate rk . The problem of households is then modified as follows:
10
This assumption does not change the equilibrium conditions, but makes the derivation a bit more
transparent.
1
X
t Ct
maxE0 ˇ Nt log C log .1 lt /
tD0
Nt

s:t: Ct C KtC1 C BtC1 D Wt Lt C 1 C rt1 Bt

C 1 ı C rtk Kt C Tt ;
where ttk is the tax rate on capital income.

The first-order condition on capital investment is the following:
Nt k NtC1
D ˇEt rtC1 C1ı :
Ct CtC1
The firm problem is now static, and its first-order conditions are defined
by the equality of the marginal product of factors with their unit costs.
For capital this condition is the following:

1 C ttrk rtk D ˛Kt˛1 .Xt Lt /1˛ :
Combining the household and firm first-order conditions, we get the

following capital market equilibrium condition:

Nt ˛ YtC1 NtC1
D ˇEt C 1 ı ;
Ct 1 C ttrk KtC1 CtC1
which in the steady state becomes
y 1 ˛
kN D :
1 C Nt .1 C / =ˇ 1 C ı
rk
I want to compare this condition to the case when the tax base is the
capital stock. This is completely analogous to the model version that
includes the wedges. The steady state of that model was given in the
system of equation (7.6), assuming that N l D N b D 0, and Nt D N k is
the tax rate on the capital stock. In this case the long-run capital-output
ratio is the following:
˛
kN y D :
.1 C Ntk / .1 C / =ˇ 1 C ı
The equilibrium quantities should be the same, since we are describing

the same allocation in two different ways. This implies that the conversion
between a capital income tax and a capital stock tax (or the capital wedge)
is given by

rk
1C k
1C
1 C Nt 1 C ı D 1 C Nt 1Cı
ˇ ˇ
+

1C 1C
Ntrk 1 C ı D Ntk
ˇ ˇ
+
Ntk ˇ .1 ı/
D 1 : (7.9)
Ntrk 1C
Similarly to the labor and consumption taxes, I downloaded the

implicit capital income tax rate from the Eurostat website. Multiplying
the time series by the (7.9) factor derived above, I calculate the tax rate
relative to the capital stock. Figure 7.6 presents the derived tax rate time
series and the capital wedge for the eight countries.
The capital tax is fairly close to the capital wedge in Austria, France, and
to a lesser extent in Germany, at least before the financial crisis. In these
countries the tax rates are high, but apparently there are not many other
distortions present on the capital market. In the four Visegrad countries,
and in particular in Poland and Slovakia, the difference is large: capital tax
rates are low, but despite this the level of the capital wedge is on average
high. In Great Britain, the Czech Republic, and Hungary, the differences
are significant, but somewhat lower than in the two former economies.

0.15 0.15
Capital wedge
Implicit capital tax
0.1 0.1
0.05 0.05
0 0
2000 2005 2010 2000 2005 2010
Germany France
0.15 0.15
0.1 0.1
0.05 0.05
0 0
2000 2005 2010 2000 2005 2010

0.15 0.15
0.1 0.1
0.05 0.05
0 0
2000 2005 2010 2000 2005 2010
Poland Slovakia
0.15 0.15
0.1 0.1
0.05 0.05
0 0
2000 2005 2010 2000 2005 2010
Fig. 7.6 Capital tax and capital wedge. The figure compares the capital wedge
and the implicit tax rate on capital income. Source: Eurostat and own calculations
It is interesting to see that the size of the capital tax rate does not on
its own determine the efficiency of investment activity. These taxes are
uniformly lower in the Visegrad countries, but there are still significant
distortions on their capital markets. Presumably factors such as the
predictability of economic policy and the regulatory environment or
the general level of development of the economy and markets are also
important for investors, and the relative backwardness of the Visegrad
countries is particularly big in these areas.
7.5 Development Simulations

In the previous chapters, I already tried to quantify the convergence
possibilities of the Visegrad countries relative to Germany. A similar
exercise is to calculate the additional growth that would follow from
a decrease in the labor and capital wedges. I focus on the production
side: in addition to the labor wedge, I will change the capital wedge.
The borrowing wedge influences the extent of consumption smoothing
for households, but does not modify the level of GDP. Since in this
chapter the emphasis is on factor markets, I do not change the level of
productivity. It was shown earlier that underdevelopment of the Visegrad
region is mostly due to productivity. Now I want to see how much
the more efficient operation of factor markets would raise output, for
a given level of productivity. In contrast to the previous comparisons,
now the reference point is not Germany, but the absolute first best. Recall
that even in the Western European countries significant factor market
distortions were found. Therefore, this exercise is not limited to the
Visegrad countries, but it is relevant for all economies.
It is also worth emphasizing again that lowering distortions on one
factor market is likely to increase the usage of both production inputs.
The reason for this is that capital and labor are complements. When
the marginal product of labor increases, this induces additional capital
investment and vice versa. The earlier development accounting exercise,
where I identified the role of relative labor and capital usage in the relative
underdevelopment with respect to Germany, did not identify the factors
behind the differences. The current calculations can take us a step further
to see which factor market is the likely candidate.
I use the following procedure to quantify the effect of decreasing the
wedges. I assume that in all countries the level of the wedges in 2014
corresponds to the long-run equilibrium. Then I decrease the wedge levels
first individually, than jointly to a reference point. Finally, I compute
how output and factor usage would change under the lower wedge levels
compared to the original, 2014 values.
Formally I use the system of equation (7.6), which I reproduce here for
completeness:
Ncy Nl
1 N l D
1 ˛ 1 Nl
˛=kN y C 1 ı
1 C N k D
1 C rN
cN y D 1 kN y .ı C / ;
Let Nli , kN i , and yN i denote the long-run equilibrium quantities where instead
of the observed wedges I use the lower wedge values in the steady-state
equations. In the simulations i D l; k; lk, since I first decrease only
the labor wedge, than only the capital wedge, and finally I lower both
wedges.
I set the degree of decrease such that I assume the lowest observed labor
and capital wedges for all countries in 2014. On the labor market, this is
l;gbr
the British value (2014 D 0:19), and on the capital market, it is the
k;aut
Austrian value (2014 D 0:06). I set the international real interest rate
to the German level, rN D 0:012. I show the calculations for all eight
countries, and the results are presented in Table 7.1.
The first panel shows the effects of decreasing the labor wedge. Since
the capital-output ratio does not depend on the extent of labor market
distortions (Eq. (7.6)), the two factors and GDP increase by the same
factor. The additional growth is between 3 and 36%, for example, in Hun-
gary per capita GDP and factor usage would rise by 27%. The implied
Table 7.1 Simulation results

l
GBR labor wedge (N D 0:19)
GDP per capita 17 20 34 36 0 27 3 36
Capital stock 17 20 34 36 0 27 3 36
Labor input 17 20 34 36 0 27 3 36
AUT capital wedge (N k D 0:06)
GDP per capita 0 10 6 3 21 17 33 28
Capital stock 0 27 17 7 64 51 109 87
Labor input 0 2 1 1 4 3 5 5
Both wedges (N l D 0:19, N k D 0:06)
GDP per capita 17 32 42 40 21 49 37 73
Capital stock 17 52 56 45 64 91 116 153
Labor input 17 22 35 37 4 31 9 42
The table shows the hypothetical percentage output and factor usage gains that
would follow from a decrease in the labor and capital wedge. The lower labor
wedge equals the British level, while the lower capital wedge equals the Austrian
level
potential growth is much lower in the Czech Republic and Austria, and
in Poland the impact would be minimal. In the two large continental
economies (Germany and France) and in Slovakia, the increases are
somewhat above the Hungarian level.
The middle panel shows the effects of decreasing the capital to the
Austrian level. The impact is muted in the three continental Western
European countries and in the Czech Republic, but it is significant in
the other Visegrad countries and in Great Britain. The growth surplus
is between 3 and 33%; for Hungary GDP per capita would be higher
by 17%. There are significant increases in the capital stock behind the
expansion of output: in Poland, where we see the highest values, the
capital stock would double. The induced increase in labor input is small,
but in Poland and Slovakia, it would reach 5%.
The joint decrease in both wedges would have a significant growth
impact in all countries. In the Visegrad economies, the effects are all above
30%, and in Hungary GDP per capita would rise by almost 50%. The
growth potentials on the factor markets are even larger in Slovakia, where
the more efficient labor and capital markets would lead to a 73% increase
in GDP per capita. In most countries the bigger part of additional growth
would be driven by capital investment.
Let us mention a few additional implications. The capital stock would
significantly increase in all countries, with the exception of Austria.
The reasons for this, however, differ across economies. In the Visegrad
countries and in Great Britain, the increases in the capital stock are driven
by a more efficient capital market, while in France and Germany, the main
cause is a more efficient labor market. We can thus see that the low usage
of a production factor is not necessarily explained by distortions on its
own market.
Decreasing both wedges is not necessarily a realistic goal. The labor
wedge is lowest in Great Britain, but the country has a high capital wedge.
The latter is lowest in Austria, where the level of the labor wedge is in the
middle ranges. For example, if Hungary manages to reach the efficiency
level of the Austrian factor markets, its output would increase by 40%.
This means that while higher productivity would have a bigger impact
on Hungarian growth, the role of factor market (and in particular, capital
market) inefficiency is also significant.
References
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tent expectations. Economics Letters, 110, 18–19.
Cavalcanti, T. V. (2007). Business cycle and level accounting: The case of
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Chari, V. V., Kehoe, P. J., & McGrattan, E. R. (2007). Business cycle accounting.
Econometrica, 75, 781–836.
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NBER Working Papers No. 12647.
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perspective. Review of Economic Dynamics, 11, 179–191.
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10, 1–39.
Part III
Growth, Shocks, and Crisis
Until now I have shown that productivity growth and to a lesser extent
the efficiency of the capital market are key to understand the convergence
process and the relative underdevelopment of the Visegrad countries.
In this part I take additional steps to understand the role of these
two factors in the economic development of the region in the last 20
years. After an almost purely descriptive (Chaps. 2–5) and later semi-
structural (Chaps. 6–7) approach, I now turn to a fully structural analysis.
The main tool continues to be the neoclassical growth model and its
stochastic version in particular. In contrast to the previous chapter, where
I computed distortions as residuals, now I assume that the economy
is driven by structural shocks. I seek answers to two questions. First, I
want to identify the main exogenous factors that are responsible for
the fluctuations in the growth rates of the Visegrad countries. Second,
I analyze the impact of the 2008–2009 global financial crisis, with a
particular interest in indebtedness and exchange rate policy.
8
Growth and the Financial Environment
One of the main assumptions of the real business cycle (RBC) model1 is
that the growth and fluctuations of an economy can be traced back to ex-
ogenous, stochastic movements of productivity (technology). Extensions
of the RBC model, including New-Keynesian (DSGE) models2 that rely
on price and wage rigidities, allow for other stochastic processes besides
technology shocks to affect the decisions of agents. These additional
shocks can come from the behavior of the government, from the time
preference of households, from the value of leisure, and from many other
sources. These shocks are considered structural if they are independent
of each other and are drawn from a well-defined—typically normal—
distribution. The wedges in the previous chapter were not structural,
since I made no independence assumption for the distortions calculated
residually. In the theoretical framework, the wedges were combinations of
persistent inefficiencies and structural shocks. The latter, however, cannot
be measured purely empirically, and a well-defined theoretical model is
needed to identify them separately.
1
See, for example, Long and Plosser (1983), or the survey article of King and Rebelo (1999).
2
See, for example, Christiano, Eichenbaum, & Evans (2005), or Smets and Wouters (2007).

https://doi.org/10.1007/978-3-319-69317-0_8
For small, open emerging economies like the Visegrad countries,

the literature has identified two main structural shocks that influence
growth and its fluctuations (Aguiar & Gopinath, 2007; García-Cicco,
Pancrazi, & Uribe, 2010). One shock, similar to the RBC assumption,
hits productivity, but instead of its level, it affects its growth rate. The
other shock captures changes in the global financial environment, which
can be assumed exogenous for a small open economy. Later I show what
are the main considerations behind focusing on these two shocks. Before
that, however, I describe the version of the previously used RCK model
that also includes structural shocks. I will use this model to empirically
identify the main structural shocks behind the fluctuations of economic
growth in the Visegrad countries, with a particular attention to the two
abovementioned shocks.3
8.1 The Model

The model is a version of the RCK framework, which is very similar
to the flexible price approach found in García-Cicco et al. (2010). In
a one-sector economy, output is used for consumption, investment,
government expenditure, and net exports. The production of the final
good requires labor and capital. For simplicity I abstract away from
population growth, which is minimal in the Visegrad countries. I also
ignore human capital, which is important for long-run growth, but less
so for shorter fluctuations.
8.1.1 Households
The problem of households is very similar to the earlier models, although

I change the specification of the period utility function:
3
The chapter draws on work in Baksa and Kónya (2017).
1
X d
E0 ˇ t et log Ct ! 1 Xt Lt!
tD0
DtC1
s:t: Ct C Dt D Wt Lt C C …t C „t ;
Rt
where Ct is the household consumption, Lt is the work effort, Dt is the

net external debt, Rt is the gross interest rate on foreign debt, Wt is the
wage rate, …t is the profits received from firms, and „t is the taxes net
of subsidies paid to the government. I discuss the role of the variable Xt
below. The term td is a demand shock, which influences the consumption-
savings decision of households.
The representative household participates in international financial
markets, where it can take on debt. The total interest rate paid by the
household is a combination of the world interest rate, an endogenous
term, and a premium shock. Notice that I assume a particular form for
the borrowing wedge; I will specify this explicitly below. As seen in the
budget constraint, I introduce the government in the form of a lump-sum
tax. For simplicity, government spending is assumed to be pure waste,
which means that an increase in government spending decreases private
income and spending. The same conclusion would hold if government
consumption entered the utility function additively.
I use a somewhat different specification for the consumption-leisure
trade-off. Notice that the ct ! 1 Xt h!t specification implies that the
relationship is quasilinear, which means that there is no income effect in
the labor supply equation (see below). The adjustment of labor supply is
crucial in RBC type models, and it is necessary that an increase of the real
wage leads to an increase in labor supply. The quasilinear specification
guarantees this, since there is no offsetting income effect. Since I assume
that there is long-run growth in this economy, the labor input has a steady
state value only if the relative utility of leisure contains a trend (Xt , to be
discussed below).
The first-order conditions are as follows:

1
D ƒt
Ct ! 1 Xt Lt!
Xt Lt!1
D ƒt Wt
Ct ! 1 Xt Lt!
d d
ˇRt Et ƒtC1 etC1 D ƒt et ;
where ƒt is the Lagrange multiplier associated with the budget constraint.

Combining the first two conditions yields the labor supply equation,
where—as I discussed above—work effort only depends on the real wage
(and exogenous terms) because of the quasilinear specification.
The interest rate paid by the small open economy is given by the
following:
r
Rt D RN C eDt =Yt dy 1 C et 1; (8.1)
where RN is the long-run world interest rate, tr is a mean zero premium
shock, and the middle term is an endogenous interest premium paid by the
economy. I assume that the interest premium depends positively on total
indebtedness: the higher the debt level relative to GDP (relative to a long-
run equilibrium level dy ), the more financial markets penalize further
borrowing.
This mechanism plays a dual role in the model. First, it is well
known in the literature (Schmitt-Grohé & Uribe, 2003) that assuming
an endogenous interest premium solves the indeterminacy issue associated
with long-run debt in models of small, open economies. Second, Eq. (8.1)
can be interpreted as a reduced form representation of financial frictions,
which may come from default risk, although this is not explicitly included
in the model. Although it would be theoretically more elegant to build
financial frictions more explicitly into the model, this would lead to
significant technical complications, mostly for the estimation.
The key parameter in the interest rate equation is the semi-elasticity
of the interest premium with respect to debt, . To make the model
stationary, it is enough to have a very small feedback from debt to the

interest rate. Originally, Schmitt-Grohé and Uribe (2003) assumed that
D 0:00173 so that the dynamics of the model are only slightly different
from the exogenous interest rate benchmark. When the parameter is
interpreted as capturing financial frictions more broadly, one can choose
much higher values. In their calibration, Benczúr and Kónya (2016) use
D 0:05, which is similar to what Magyari (2010) estimated for Central
European countries. Moreover, García-Cicco et al. (2010) estimates a
value of D 2:8 using Argentine data. I return to this issue later in
the calibration section.
8.1.2 Firms
The problem of the representative firm is also similar to earlier specifica-

tions, with one exception. The optimization problem is the following:
ƒt h at ˛
1
X
max …0 D E0 ˇt e Kt .Xt Lt /1˛ Wt Lt KtC1
tD0
ƒ 0
2 #
KtC1
C .1 ı/ Kt gN Kt ;
2 Kt
where Kt is the capital stock. The last term in the square brackets is a
capital adjustment cost. Many papers argue that without such a term the
adjustment of capital to shocks is too fast (Christiano, Eichenbaum, &
Evans, 2005; Cooper & Haltiwanger, 2006; Smets & Wouters 2007;
Wang & Wen, 2012). Introducing a capital adjustment cost is an example
of real rigidities often used in DSGE models. While the microeconomic
foundations of these devices are debatable, they are a quick and easy
way to improve the empirical fit of the macro model. Notice that the
adjustment cost is written in such a way that it equals zero in the steady
state equilibrium: I will show later that in the deterministic steady state
the growth rate of the capital stock equals gN . The first-order conditions
of firms are the following:
Wt Lt D .1 ˛/ Yt

KtC1 ˛YtC1
1C gN D ˇEt C1ı
Kt KtC1

KtC2 KtC2 ƒtC1
C gN C gN :
KtC1 KtC1 ƒt
Output is also influenced by technology shocks. Similarly to Aguiar

and Gopinath (2007), and García-Cicco et al. (2010), I allow for both
transitory and persistent productivity shocks. Besides the transitory shock
(at ) that is typical in the RBC literature, I assume that trend growth (Xt )
is a stochastic process:
Xt
D gt
Xt1
g
log gt D 1 g log gN C g log gt1 C t :
Although the growth rate of the economy returns to its long-run average
after a positive or negative shock, the level of production is permanently
higher (or lower) following a trend shock. As I will see later, this
implication makes the impact of a trend shock different from a transitory
productivity shock, as discussed also in detail by Aguiar and Gopinath
(2007).
8.1.3 Equilibrium
As usual, we can combine the optimality conditions of households and

firms and include the necessary market clearing conditions to get the
following system of equations:
Xt Lt! D .1 ˛/ Yt
1
D ƒt
Ct ! 1 Xt Lt!
ƒtC1 d td
ˇRt Et e tC1 D1
ƒt

KtC1 ˛YtC1
1C gN D ˇEt C1ı
Kt KtC1

KtC2 KtC2 ƒtC1 d td
C gN C gN e tC1
KtC1 KtC1 ƒt
2
DtC1 KtC1
Yt C D Ct C It C Dt C „t C gN Kt
Rt 2 Kt
.1 ı/ Kt C It D KtC1
Yt D eat Kt˛ .Xt Lt /1˛
Dt =Yt dy r
Rt D RN C e 1 C et 1:
To be able to simulate and estimate the model, the system has to be

made stationary. In the RCK model, I normalized growing variables by the
deterministic growth factor of productivity. I use the same principle here,
except that I now use the stochastic growth factor. Let us define the new
variables as yt D Yt =Xt , ct D Ct =Xt , it D It =Xt , ktC1 D KtC1 =Xt , dtC1 D
DtC1 =Xt , t D „t =Xt , and t D Xt ƒt . Using these, the equilibrium
conditions can be rewritten as follows:
Lt! D .1 ˛/ yt
1
D t
ct ! 1 Lt!
1 tC1 d td
ˇRt Et e tC1 D1
t
gtC1

ktC1 1 ˛gtC1 ytC1
1 C gt gN D ˇEt C1ı
kt gtC1 ktC1

ktC2 ktC2 tC1
C gtC1 gN gtC1 C gN
2 ktC1 ktC1 t
(8.2)
2
dtC1 dt ktC1 kt
yt C D ct C it C t C C gt gN
Rt gt 2 kt gt
dt dtC1
tbt D
gt Rt
kt
.1 ı/ C it D ktC1
gt
˛
at kt
yt D e Lt1˛
gt
dtC1 =yt dy r
Rt D RN C e 1 C et 1
It is easy to see that the modified system of difference equations has a

unique deterministic steady state, where all the endogenous variables are
constant. Therefore, the original variables—GDP, consumption, invest-
ment, the capital stock, and debt—all grow in the long run at the average
growth rate of labor-augmenting productivity growth (Ng).
To close the model, we need to write down (or reproduce from above)
the stochastic processes of the structural shocks. Following the literature,
I assume that all shocks follow a first-order autoregressive process:
td D d t1
d
C td

log t D 1 N C log t1 C t
tr D r t1
r
C tr
at D a at1 C ta
g
log gt D g log gN C 1 g log gt1 C t :
The ti innovations are independent, identically distributed random

variables; during simulation and estimation, I assume that they are drawn
from a normal distribution with mean zero.
8.2 Model and Facts

After presenting the model, I now turn to the question of why it is inter-
esting to study trend and interest rate shocks to understand the growth
process of the Visegrad countries. The three panels of Table 8.1 show
the volatility of the key macroeconomic variables, their correlation with
GDP, and their first-order autocorrelation. The data series come from
Eurostat, for the period 1995–2016. The sample is the same that I will
use below for the estimation. Although the Penn World Table contains
earlier data for all eight countries (for the Czech Republic and Slovakia,
the time series start in 1990), the early 1990s are a period of transition
in the Visegrad region. Therefore, 1995 is a more suitable starting point
to uncover systematic properties of the data that are comparable across
the eight economies. For GDP, consumption, and investment, I use the
growth rates of chain-linked real series, while the trade balance is the
difference between nominal exports and nominal imports, divided by
nominal GDP.
Fact 1: the volatility of GDP, consumption, and investment The first

stylized fact that motivated the study of trend growth shocks (Aguiar &
Gopinath, 2007) is the relative volatility of consumption and GDP. In
the basic RBC model, which relies on transitory productivity shocks, con-
sumption is usually less volatile than GDP, because the concavity of the
utility function implies that households want to smooth consumption.
I will show below that this property does not apply under trend growth
shocks, since the permanent income of households changes much more.
In terms of the data presented in the first panel, the relative volatility of
consumption compared to GDP tends to be below one in the Western
Table 8.1 Descriptive statistics

Volatility
GDP Consumption Investment Trade balance
AUT 0:0167 0:0088 0:0319 0:0163
CZE 0:0282 0:0191 0:057 0:0345
DEU 0:0204 0:0074 0:0411 0:0236
FRA 0:0147 0:0096 0:035 0:018
GBR 0:0175 0:018 0:0495 0:0091
HUN 0:0268 0:0335 0:0697 0:0457
POL 0:0167 0:0207 0:092 0:0277
SVK 0:0334 0:048 0:116 0:0465
Correlation with GDP
AUT 1 0:6352 0:662 0:2687
CZE 1 0:5632 0:8688 0:0651
DEU 1 0:3213 0:8908 0:0459
FRA 1 0:6958 0:9235 0:489
GBR 1 0:8599 0:8541 0:2362
HUN 1 0:7979 0:5546 0:4121
POL 1 0:7182 0:8821 0:3778
SVK 1 0:6308 0:6839 0:2768
Autocorrelation
AUT 0:2407 0:5646 0:0406 0:9027
CZE 0:3866 0:4671 0:0877 0:9354
DEU 0:057 0:4717 0:1056 0:9177
FRA 0:3576 0:4643 0:3174 0:9504
GBR 0:4272 0:7434 0:0996 0:8268
HUN 0:4028 0:6575 0:461 0:947
POL 0:4378 0:5323 0:5941 0:8089
SVK 0:2954 0:6052 0:0712 0:8205
The table contains descriptive statistics for the growth rates of GDP, consumption,
and investment and for the trade balance relative to GDP, for the time period
1995–2016. Growth rates are for chain-linked real-time series, while the trade
balance per GDP is calculated from nominal export, import, and GDP
Source: Eurostat
European countries and above one in the Visegrad economies. The partial
exceptions are Great Britain and the Czech Republic, but the pattern is
quite robust otherwise. Note also that all macro variables are more volatile
in the Visegrad countries, even in the Czech Republic.
Fact 2: the co-movement of output and the trade balance If interna-

tional financial markets were fully efficient, the path of consumption
would be independent of local shocks (full insurance). When hit by an
idiosyncratic negative income shock, a small open economy can borrow
from international financial markets to smooth out temporary drops in
consumption. We can assume that the more advanced a country, the
better this mechanism works. When a country borrows, its trade balance
is typically negative, and when it repays the debt, its trade balance is
positive. This means that if temporary shocks dominate and a country
has access to international borrowing and lending, its GDP and its trade
balance are positively correlated. Again, there is a marked difference in
this statistics between the Western European and Visegrad countries. The
latter tend to have a negative correlation between GDP and the trade
balance, while the former tend to have a positive (or zero) correlation. At
this point the lack of a positive correlation in the Visegrad countries can
both be a sign of trend shocks and financial frictions.
Fact 3: the autocorrelation of the trade balance When growth is driven

by trend shocks, the autocorrelation of the trade balance—as I will show
below—should be close to unity. The autocorrelation is high, but below
unity in all three countries, and only marginally lower in some of the
Visegrad economies. From a first look at this feature of the data, it is thus
hard to determine whether other types of shocks are important in the
determination of the trade balance. The full information estimation of
the model below will shed more light on this issue.
8.2.1 Model Simulations
Let us now see how the model can reproduce the stylized facts listed above,
given different external shocks. Based on the literature, I discuss three
shocks: two productivity shocks (a, g) and an interest premium shock
( r ). Since the properties of the model differ significantly depending on
the exact specification of the premium function, I present two varieties.
I call the first the case of low financial frictions ( small) and the second
the case of high financial frictions ( large).
Table 8.2 Calibrated parameters

Parameter Notation Values Source
Discount factor ˇ 0:96 Literature
Labor supply elasticity ! 1:6 Literature
Value of leisure 2:40 Normalization
Capital share ˛ 0:34 National accounts
Depreciation ı 0:05 Literature
Government cons. N y
=N 0:1 National account
Average growth gN 1:02 (Estimated)
Average debt level dy 0 (Estimated)
Capital adjustment cost 5 (Estimated)
0:0001
Interest premium elasticity (Estimated)
0:05
Shock autocorrelations i 0:5 (Estimated)
The table shows the calibrated values of the model parameters, and the source of
the calibration
I solve the log-linearized version of the model numerically. To do this,

values for the various parameters have to be selected. I pick some of
these by matching data moments, and others by relying on the literature.
Table 8.2 contains the selected parameter values. The simulations in this
section serve only as illustrations, especially for the shock processes that I
will estimate in the next section.
I introduce one shock at a time in the simulations, and I normalize
the standard error of the shock innovations to unity. The solutions and
simulations are carried out by the software package DYNARE,4 using a
first-order, log-linear approximation. A nice property of linearized models
is that the statistics presented below can be computed analytically, using
the policy rules.
Table 8.3 shows the results when financial frictions are low. These
are essentially replications of the model results of Aguiar and Gopinath
(2007), who contrast the impact of transitory and trend productivity
shocks. We can see that in the latter case consumption volatility is the
same as output volatility, while investment is much more volatile than
GDP. In the case of transitory shocks, both consumption and investment
4
http://www.dynare.org/.
Table 8.3 Model simulations, low financial frictions ( D 0:00001)

Volatility relative to GDP
TFP shock Trend shock Premium shock
GDP growth 1 1 1
Consumption growth 0:6386 1:0131 3:9214
Investment growth 0:2543 1:9424 25:6604
Trade balance 3:4904 17:6528 19:1032
Correlations with GDP
GDP growth 1 1 1
Trade balance 0:0775 0:0078 0:1936
Autocorrelation function of the trade balance
t1 0:9894 0:9999 0:8984
t2 0:9841 0:9998 0:848
t3 0:9814 0:9997 0:8232
t4 0:98 0:9995 0:8112
t5 0:9793 0:9993 0:8056
The table contains basic model statistics for growth rates of GDP, consumption,
and investment and for the trade balance relative to GDP. Since the model is log-
linearized, the statistics are theoretical moments
are less volatile than GDP. The correlation of the trade balance with GDP
is low and somewhat lower—and very marginally negative—for trend
shocks. Overall, trend shocks seem somewhat more plausible driving
forces for the Visegrad countries in this case, which was precisely the point
of Aguiar and Gopinath (2007).
Note, however, the autocorrelation coefficients in the last panel of the
table. In the case of both technology shocks, the trade balance is essentially
a random walk, since we see values close to one even for the fifth-order
autocorrelation coefficient. As we saw in Table 8.1, the trade balance is
highly persistent, but far from random walk. Therefore, when financial
frictions are low, the model driven by technology shocks cannot reproduce
the trade balance persistence seen in the data.
Table 8.4 Model simulations, high financial frictions ( D 0:05)

Volatility relative to GDP
GDP growth 1 1 1
Trade balance 0:3705 0:241 8:0601
Correlations with GDP
GDP growth 1 1 1
Trade balance 0:7005 0:2194 0:3262
Autocorrelation function of the trade balance
t1 0:3676 0:862 0:3538
t2 0:0787 0:7261 0:0605
t3 0:0441 0:6046 0:0623
t4 0:0883 0:501 0:1048
t5 0:0967 0:4149 0:1111
The table contains basic model statistics for growth rates of GDP, consumption,
and investment and for the trade balance relative to GDP. Since the model is log-
linearized, the statistics are theoretical moments
Let us briefly discuss what happens when the model is driven by

the interest premium shock. Consumption, investment, and the trade
balance are more volatile than GDP, which is mostly consistent with
the stylized facts for the Visegrad countries. The relative volatilities,
however, are an order of magnitude higher than what we see in the
data. The autocorrelation of the trade balance is close to the data, and
the trade balance is weakly counter-cyclical. While the interest premium
shock predicts the right directions for the main statistics, the endogenous
variables are too volatile. Therefore, neither technology nor premium
shock can explain fully the data behavior when financial frictions are low.
Table 8.4 reports the same statistics, but for the case of high financial
frictions ( D 0:05). It is worth interpreting the magnitude of this
parameter. Let us assume that the debt level relative to GDP increases
by ten percentage points. In the previous case, the interest rate premium
expected from the small, open economy increases by a tiny amount, 0.01
basis points. In the second case, when the parameter is relatively high,
the interest premium increases by about 50 basis points. This is a sizable
increase and strongly discourages a quick rise of indebtedness. It is likely,
therefore, that the behavior of the model changes significantly relative to
the low friction case.
Let us see how the model now behaves when it is hit by TFP
shocks. Under both a transitory and trend shock, the relative volatility
of consumption is lower than unity. The relative volatility of investment
is higher than one when the model is driven by a trend shock and lower
than one when it is hit by a transitory productivity shock. The correlation
of the trade balance with GDP is positive and highly so for the transitory
shock. As was shown in the data, this is plausible for at least some
advanced countries, but less so for the emerging economies.
The autocorrelation function of the trade balance is quite different
from the previous case. The persistence of the trade balance is very
similar to the data (high, but well below random walk) in the case of the
trend shock, but implausibly low for the transitory shock. The intuition
behind these results is that an increase in indebtedness leads to a higher
interest rate, which dampens further borrowing incentives. This means
that households are unable to smooth consumption to the degree we saw
in the case of low financial frictions. Overall, the model does a much
better job—especially when driven by a trend shock—in matching the
stylized facts of the Visegrad countries than earlier.
The effects of a premium shock are similar to the previous case. Relative
volatilities are too high, and the persistence of the trade balance is too low.
It seems that on their own, exogenous interest rate fluctuations are unable
to explain the growth facts in the Visegrad countries. It is still possible,
however, that in some periods and in some countries premium shocks did
play an important role. In order to be able to examine the joint impact of
the various shocks, we have to go beyond the analysis of the behavior of
isolated shocks. I now turn to this in the next section.
8.3 Growth and Shocks in the Visegrad

Countries
In the previous section, I studied whether productivity or interest pre-
mium shocks can alone explain important stylized facts of economic
growth in the Visegrad countries. The answer is mostly no, although trend
productivity shocks are a promising candidate. To be able to say more, I
now turn to the econometric estimation of the shock processes driving the
model economy when fit to the Visegrad countries. I estimate the model
using Bayesian methods. Since the data series are quite short, I focus
mostly on the shock processes and a few key parameters and calibrate
or set the rest of the parameter values as described in Table 8.2. Having
the shock parameters, one can invert the model to uncover the unknown
shocks that drove growth in our four economies.
Bayesian estimation is a full information method, which uses all the
statistical properties of the data. One needs to specify prior distributions
for the model parameters, which contain subjective information available
for the econometrician, but which are external to the data. Such informa-
tion can be that the autocorrelation coefficients of the shock processes
fall between zero and one. From the prior distributions and from the
data, posterior distributions are calculated using the Bayes’ theorem. The
posteriors therefore contain both information from the observed time
series and from the subjective knowledge of the econometrician.
I use annual data, as I do not think that a quarterly frequency would
add too much to the study of the growth process. The estimation proce-
dure is described in An and Schorfheide (2007). I again use the software
package DYNARE. As in García-Cicco et al. (2010), the observed time
series are the growth rates of per capita real GDP, household consumption
and investment, and the trade balance as a percentage of nominal GDP.
It is easy to see that these are stationary in the model, and hence the
empirical observations can be directly matched to model variables. Using
Eq. (8.2) and the effective variables defined there, we can write down the
following correspondence:
Yt yt
D gt
Yt1 yt1
Ct ct
D gt
Ct1 ct1
It it
D gt
It1 it1
TBt dt =gt dtC1 =Rt
D :
Yt yt
I add these observed variables to the equation system (8.2) and then log-
linearize the system. I estimate the autoregressive shock processes in the
approximated model.
I calibrate some of the structural parameters due to the short time
series. The top panel in Table 8.2 contains the parameter values that are
common across economies. The estimation is done separately for each
country. I estimate the average long-run growth rates (Ng), the capital
adjustment cost parameter (), the debt semi-elasticity of the interest rate
( ), and the long-run trade balance to GDP ratio. I use uninformative
priors (except for the range restrictions) so that I let the data determine
the values within a reasonable range.
Motivated by the simulations in the previous section and also by results
in Magyari (2010) and Benczúr and Kónya (2016), I restrict the support
of the interest premium function parameter to 00:2. García-Cicco et al.
(2010) estimate the parameter on Argentine data and get a much higher
value, 2.8. Such a magnitude implies that a ten percentage point increase
in the debt-GDP ratio would lead to a 30 percentage point increase in
the interest rate, which is clearly unrealistic even when one views the
parameter as standing in for a broad range of financial frictions. Therefore
I use a range that contains much smaller values, but still includes ones that
are high enough to make the dynamics of the model more in line with
the data, as was shown in the previous section.
García-Cicco et al. (2010) assume flat, uniform priors for the shock pa-
rameters. I also do this for both the standard errors of the shock distribu-
Table 8.5 Estimation results

Posterior
Prior CZ HU PL SK
Dist. RangeMean S.E. Mean S.E. Mean S.E. Mean S.E.
Parameters
gN Uniform 1 1.05 1:017 0:008 1:020 0:010 1:027 0:009 1:032 0:009
Uniform 0 10 8:209 1:268 7:170 1:694 3:236 1:697 6:441 1:892
Uniform 0 0.2 0:019 0:013 0:079 0:051 0:066 0:051 0:084 0:051
tby Uniform 0:05 0.05 0:015 0:020 0:018 0:019 0:016 0:017 0:018 0:022
a Uniform 0 1 0:605 0:284 0:670 0:240 0:686 0:306 0:577 0:282
g Uniform 0 1 0:099 0:074 0:247 0:205 0:319 0:176 0:345 0:177
r Uniform 0 1 0:616 0:268 0:841 0:138 0:869 0:088 0:800 0:124
Uniform 0 1 0:837 0:175 0:576 0:232 0:648 0:214 0:862 0:094
d Uniform 0 1 0:754 0:137 0:862 0:131 0:901 0:073 0:692 0:154
Standard errors
a Uniform 0 0.2 0:005 0:004 0:008 0:005 0:005 0:005 0:006 0:005
g Uniform 0 0.2 0:066 0:012 0:049 0:020 0:036 0:015 0:076 0:020
r Uniform 0 0.2 0:007 0:004 0:011 0:005 0:008 0:006 0:028 0:012
Uniform 0 0.2 0:150 0:023 0:151 0:023 0:137 0:024 0:172 0:018
d Uniform 0 0.2 0:016 0:010 0:014 0:011 0:007 0:003 0:027 0:015
The table contains the prior distributions for the shock process and the estimated
posteriors by country
tions, which are assumed to be uniform with a support interval of Œ0; 0:2 ,
and for the autoregressive parameters, which have a support Œ0 1 .
Let us now turn to the estimated parameter values (Table 8.5). The
long-run growth rates are lower for the Czech Republic and Hungary and
higher for Poland and Slovakia, in line with the data averages. Note that
the estimation does not simply calculate the average GDP growth for each
country, since the model imposes a restriction that all GDP components
grow at the same rate in the long run, which is not necessarily true in our
sample period. The two adjustment cost parameters are not very strongly
identified, and the posterior means are quite similar to the prior means.
The long-run trade balances are also not very precisely estimated and are
not very different from the sample means.
The shock processes are fairly persistent, with the transitory productiv-
ity shock and the interest rate shock having autocorrelation coefficients
between 0.6 and 0.9 annually. This means that households might have
difficulty distinguishing trend and transitory productivity shocks on the
one hand and transitory and permanent interest rate shocks on the other
hand.
Let us now turn to our main question, which is the importance of
particular shocks in explaining the volatility of the main macro time
series. To answer this, I decomposed the endogenous variables into
the estimated contributions of the shocks, along with initial conditions
through historical shock decompositions. Using the estimated parameters
and the policy rules that describe the model solution, I inverted the model
to see what should have been the unobserved shocks that generated the
observed variables. Naturally this decomposition depends on the model
used for the analysis. That said, an advantage of the RCK framework is
that given its simplicity, it is a versatile tool to make sense of the empirical
observations. Also, it is robust to moderate differences in the underlying
economic environment (Chari, Kehoe, & McGrattan, 2007).
The historical shock decompositions for the four countries and four
variables are presented in Figs. 8.1, 8.2, 8.3, and 8.4. Besides the five
shocks, the decomposition also includes the impact of estimated initial
values. This is because while the solution and estimation are based on
log-linearization around the steady state, the actual initial observations
in the sample period might be significantly different from the long-run
equilibrium. This is quite plausible in the case of emerging economies
such as the Visegrad countries. It would be an interesting challenge
to incorporate convergence into the estimation, but here I choose the
simpler option, partly to be as close as possible to the exercise in García-
Cicco et al. (2010).
The shock decomposition of GDP growth (Fig. 8.1) shows that the
main driver of growth volatility is the trend productivity shock in all
countries. No other shock seems significant, with the partial exception
of the transitory technology shock in some years (the financial crisis)
and in some countries (Poland). The interest premium shock, somewhat
surprisingly, does not seem to drive growth volatility, which is in contrast
to the findings of García-Cicco et al. (2010), but in line with Aguiar
and Gopinath (2007). Even in Hungary, where a credit-driven boom and

0.06 0.04
0.04 0.02
0.02 0
0 -0.02
-0.02 -0.04
TFP -0.06
-0.04 Trend
Premium
Government
-0.06 Demand -0.08
Initval
Total
-0.08 -0.1
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Poland Slovakia
0.05 0.08
0.06
0.04
0.04
0.03
0.02
0.02 0
0.01 -0.02
-0.04
0
-0.06
-0.01
-0.08
-0.02 -0.1
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Fig. 8.1 Historical shock decomposition for GDP growth. The figure presents the
historical shock decomposition of GDP growth for the Visegrad countries. Note
that the steady state values are removed from the observed time series. Source:
own calculations
bust episode seemed most likely between 2001 and 2009, the estimation
does not favor a premium-based explanation. Instead, it seems that the
primary reason for the pre- and post-crisis growth behavior is long-run
expectations about income growth. Since the model assumes rational
expectations, actual and perceived changes in trend productivity growth
cannot be separated. It would be interesting, but hard, to study the
possible independent role played by growth expectations.
Turning now to consumption growth (Fig. 8.2), we see much more
heterogeneity, both across countries and in terms of shocks. Trend pro-
ductivity shocks are still important, but the role of demand shocks is
similarly large. Demand shocks essentially act as errors in the consump-
tion Euler equation, so this result may mean that the model is missing

0.06 0.08
0.06
0.04
0.04
0.02
0.02
0 0
-0.02 -0.02
-0.04
-0.04 TFP
Trend
Premium -0.06
Government
-0.06 Demand
Initval -0.08
Cons. growth
-0.08 -0.1
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Poland Slovakia
0.06 0.15
0.05
0.04 0.1
0.03
0.05
0.02
0.01
0
0
-0.01 -0.05
-0.02
-0.03 -0.1
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Fig. 8.2 Historical shock decomposition for consumption growth. The figure
presents the historical shock decomposition of consumption growth for the Viseg-
rad countries. Note that the steady state values are removed from the observed
time series. Source: own calculations
some mechanisms that explain consumption behavior. Introducing habit

formation is one way in the literature to deal with this issue.
Again, the interest premium shock is not particularly important in
the fluctuations of consumption growth. An exception is Hungary in
2010–2011. As the crisis progressed and Hungarian households—who
had borrowed heavily in foreign currency—were facing sharply increased
debt financing costs, they had to start a strong balance sheet adjustment,
decreasing consumption and increasing savings. Note, finally, that gov-
ernment spending shocks play a moderate role in some years.
When looking at investment growth (Fig. 8.3), I again find a fair
amount of heterogeneity. In contrast to consumption growth, however,
the interest premium shock is an important determinant of investment

0.15 0.15
0.1 0.1
0.05 0.05
0 0
-0.05 -0.05
TFP -0.1
-0.1 Trend
Premium
Government
-0.15 Demand -0.15
Initval
Inv. growth
-0.2 -0.2
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Poland Slovakia
0.2 0.25
0.2
0.15
0.15
0.1
0.1
0.05 0.05
0 0
-0.05
-0.05
-0.1
-0.1
-0.15
-0.15 -0.2
-0.2 -0.25
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Fig. 8.3 Historical shock decomposition for investment growth. The figure
presents the historical shock decomposition of investment growth for the Visegrad
countries. Note that the steady state values are removed from the observed time
series. Source: own calculations
growth volatility. Although the decomposition is noisy, I find some

evidence that the financial crisis at least partly operated through the
interest premium. In Hungary, this is most evident in 2010–2011, while in
Poland and Slovakia, the interest premium shock is depressing investment
in the second phase of the crisis in 2012.
Trend productivity shocks are also important, especially in the Czech
Republic and during the initial phase of the crisis in all four countries. The
other shocks play a minor role at best: the demand shock, for example,
played some role in maintaining investment activity in Poland after the
financial crisis. The transitory technology shock and the government
spending shock are essentially negligible explanations for investment
growth volatility.

0.08 0.1
TFP
Trend 0.08
0.06 Premium
Government
Demand 0.06
0.04 Initval
Trade bal. 0.04
0.02 0.02
0 0
-0.02
-0.02
-0.04
-0.04
-0.06
-0.06 -0.08
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Poland Slovakia
0.06 0.06
0.04
0.04
0.02
0.02 0
0 -0.02
-0.04
-0.02
-0.06
-0.04 -0.08
-0.1
-0.06
-0.12
-0.08 -0.14
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Fig. 8.4 Historical shock decompositions for the trade balance. The figure
presents the historical shock decomposition of the trade balance, relative to GDP,
for the Visegrad countries. Note that the steady state values are removed from
the observed time series. Source: own calculations
Finally, let us look at the behavior of the trade balance (Fig. 8.4). In
contrast to the growth rates, initial conditions are quite important, except
for Hungary. In the Czech Republic, the trade balance is generally more
positive than the shocks alone can explain, at least after the first two years.
In Poland and Slovakia, the opposite is true: the trade balance is much
more negative than what the shocks alone can explain. This latter finding
is consistent with convergence dynamics, since an emerging economy that
is not heavily indebted should borrow against future income gains. The
Czech Republic remains a puzzle, however—it is unclear why the country
is borrowing less than its regional counterparts.
In terms of the regular shocks, the interest premium shock is now the
key to understand the trade balance, and particularly so in Hungary. This
is not surprising, since Hungary was—and remains—the most heavily
0.085
0.08
0.075
0.07
0.065
0.06
0.055
0.05
CZ
0.045 HU
PL
SK
0.04
0.035
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
Fig. 8.5 The implicit real interest rates. The figure plots the implicit interest rates
generated by the model structure and the estimation. Source: own calculations
indebted country in the region, and hence we expect interest premium

shocks to be particularly important determinants of its borrowing from
abroad. The results nicely show that after the first year of the crisis it is
the increased interest premium that explains the persistently large trade
surpluses, just as it was the same shock (with an opposite sign) that
explained the negative trade balance before the crisis.
Although I estimated the model only on four time series, the esti-
mation procedure—using the Kalman filter—generates observations for
all endogenous variables. It is an interesting exercise to see how similar
constructed variables are to actual data. I concentrate on one variable,
which is the implicit real interest rate generated by the model and the
estimation. It is worth emphasizing that this interest rate is not directly
connected to any observable interest rate measure, since I only used the
growth rate of GDP components and the trade balance in the estimation.
I can thus carry out the famous “smell test” of Robert Solow: if the
behavior of the model-generated real interest rate “makes sense” given
our intuitive understanding of developments during the sample period,

trust in the other implications of the model is strengthened as well.
Figure 8.5 plots the real interest rate series in the four countries
as predicted by the model and the estimation procedure. Note that
interest rate levels are relatively high, which is standard in RCK type
models. Given much lower benchmark real interest rates, consumption
and investment behave as if the relevant interest rate is significantly higher.
In the previous chapter, I attributed this gap to intertemporal wedges;
here, I simply define the relevant interest rate to include these wedges.
The implicit interest rates are broadly in line with general under-
standing of the sample period, especially—and most dramatically—in
Hungary. The Czech and Polish rate is relatively stable, with a gradual fall
post-crisis, especially in Poland. In Hungary, there was a dramatic decline
before the crisis, particularly in the 2006–2009 period. This is the time
when foreign currency lending really took off, lowering the effective rate
even when headline domestic currency interest rates were still high. The
model is able to replicate this even though I did not use interest rate data,
and after 2006 the Hungarian economy was already slowing down and
the trade balance was improving.
To summarize the results, we see that the volatility of GDP growth
in the Visegrad countries is primarily explained by changes in trend
productivity growth. Although I cannot prove this formally, I suspect that
the right interpretation of this result is that the trend shocks represent
growth expectations of agents, which may not necessarily prove correct
ex post. The interest premium shock played a more limited role, but
was important to explain the composition of GDP growth. Although
I do not show the results, this is confirmed by looking at the shock
decomposition of consumption and investment shares in GDP, where
the role of the premium shock is very pronounced. Demand shocks also
played a role, especially for consumption and the trade balance. Finally,
initial conditions are estimated to be different from the steady state,
probably because the Visegrad countries were on a convergence path
during the period. Investigating the role of transition dynamics more
explicitly would be a useful exercise, which I leave for future research.
I now turn to a particularly interesting episode for the region, which is
the global financial crisis.
References
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is the trend. Journal of Political Economy, 115, 69–102.
An, S., & Schorfheide, F. (2007). Bayesian analysis of DSGE models. Economet-
ric Reviews, 26, 113–172.
Baksa, D., & I. Kónya (2017). Interest Premium and Economic Growth: The Case of
CEE. NBP Working Papers 266, Narodowy Bank Polski, Economic Research
Department.
Benczúr, P., & I. Kónya (2016). Interest premium, sudden stop, and adjustment
in a small open economy. Eastern European Economics, 54, 271–295.
Chari, V. V., Kehoe, P. J., & McGrattan, E. R. (2007). Business cycle accounting.
Econometrica, 75, 781–836.
Christiano, L. J., Eichenbaum, M., & Evans, C. L. (2005). Nominal rigidities
and the dynamic effects of a shock to monetary policy. Journal of Political
Economy, 113, 1–45.
Cooper, R. W., & Haltiwanger, J. C. (2006). On the nature of capital adjustment
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García-Cicco, J., Pancrazi, R., & Uribe, M. (2010). Real business cycles in
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Magyari, I. (2010). Disentangling the Impact of Eurozone Interest Rate Movements
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Smets, F., & Wouters, R. (2007). Shocks and frictions in US business cycles: A
Bayesian DSGE approach. American Economic Review, 97, 586–606.
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9
Credit Crisis and Growth
In the previous chapter, I used a simple version of the RCK model to

identify the role of various exogenous shocks in the growth process of
the Visegrad economies between 1995 and 2016. I identified the trend
productivity shock as the main driver of growth fluctuations, but I also
found the interest premium shock to be important for some GDP items
in particular episodes. In this chapter I focus more closely on the global
financial crisis, where I can zoom in on the role of the external financial
environment. I view the crisis as a natural experiment for the Visegrad
countries: essentially a “sudden stop” episode where external financing
suddenly became much more costly.
Although the global financial crisis of 2008 started in the USA, it
quickly spread to the rest of the world. While the problems originated
in the US financial system, the crisis reached many small open economies
as an external shock. Our goal is to build a simple model to trace out
the impact of a long-lasting increase in the external interest premium and
see if the model can match the main developments in our four economies
over the crisis. If the answer is yes, I want to examine the role of monetary
(exchange rate) policy in mitigating the external shock. The core of the

https://doi.org/10.1007/978-3-319-69317-0_9
model is still the RCK framework, which I extend as needed to capture

key stylized facts in the Visegrad countries.1
9.1 Main Ingredients

Interest Premium I model the worsening of the external financial
conditions with the interest premium function described in the previous
chapter. I think of the credit crisis as an unexpected, sudden increase
in the external interest rate. The main motivation for this is shown
in Fig. 9.1, where I plot credit default swap (CDS) spreads in the four
Visegrad countries. The CDS spread on the one hand measures the
500
CZE
450 HUN
POL
SVK
400
5 year sovereign CDS spread
350
300
250
200
150
100
50
0
Q1-07 Q2-07 Q3-07 Q4-07 Q1-08 Q2-08 Q3-08 Q4-08 Q1-09 Q2-09 Q3-09 Q4-09 Q1-10
Fig. 9.1 CDS spreads before and during the global financial crisis. The figure
shows the evolution of the five-year sovereign credit default swap (CDS) spread
in the four Visegrad countries. Source: Bloomberg
1
The chapter is based on Benczúr and Kónya (2013), who analyzed the case of Hungary only.
riskiness of a given country as perceived by global financial markets, and

on the other hand, one can infer changes in the general global appetite
for risk from its time series behavior. It can be seen that at the end
of 2008—when the financial crisis started to spread—the CDS spread
drastically increased in all countries. Since changes in the appetite for
risk are the main determinants in the interest rate premium, the figure
indicates that the financial crisis was a massive interest rate shock for the
Visegrad economies.
Notice, however, that the crisis did not impact all the Visegrad coun-
tries to the same extent. We can see the largest relative and absolute
increase in Hungary, which was in the worst situation before the crisis.
A more formal demonstration is given in Fig. 9.2, which plots the
maximum increase in the sovereign CDS spread against the net foreign
550
ROM
500
HUN
450
CDS spread increase, b.p.
BUL
400
350
300
250
POL
200
CZE
150
SLV
100
-120 -110 -100 -90 -80 -70 -60 -50 -40 -30 -20
Net foreign assets, % GDP
Fig. 9.2 Crisis and indebtedness. The figure shows the maximum increase in the
sovereign CDS spread for new six EU member states in the last quarter of 2008,
against the NFA positions relative to GDP in 2008. Source: Eurostat and Bloomberg
asset position (NFA) at the beginning of the crisis. For a more complete
picture, I include two additional EU member states in the region, Bulgaria
and Romania.
The figure shows a strong negative relationship between the initial
level of indebtedness2 and the size of the financial shock. The CDS
spread increased most in countries where the initial debt level was highest.
Comparing the two figures, we can see a strongly non-linear relationship
between the level of debt and the interest premium. When external
financial conditions are favorable—before 2008—financial markets did
not differentiate among the Visegrad countries. The global crisis changed
this, and the more fragile economies were hit by a much larger financial
shock. I capture this non-linear relationship with a modified interest
premium function, which I describe in detail later.
Nominal Side The second modification is to allow for a role for nom-
inal variables. Until now I have worked with real models, where the
classical dichotomy held. In models of this type, allocations of quantities—
consumption, investment, output, labor input—are determined by rela-
tive prices, and the price level has no independent role.
Ignoring nominal variables—inflation, nominal wage, the exchange
rate—is justified in the growth literature by assuming that prices adjust
flexibly, at least in the medium and long run. In models where wages
and prices change infrequently (Christiano, Eichenbaum, & Evans, 2005;
Smets & Wouters, 2007), the classical dichotomy is only violated in the
short run. There are other approaches, however, where the neutrality of
money does not hold even in the long run (Rebelo & Vegh, 1995; Végh,
2013). In this chapter I follow the approach of Benczúr and Kónya (2013),
who examine the impact of the nominal exchange rate regime on the
convergence path of a small open economy. The nominal side of the
economy is introduced with the assumption of money in the utility (MIU).
2
Although they are somewhat different concepts, we use the NFA position and indebtedness as
synonyms. The former also contains non-debt obligations, which come together with ownership.
Since in our model the two types of obligations are perfect substitutes, we use the two terminologies
interchangeably.
Models using the MIU assumption put the quantity of the real money
stock directly into the utility function. This captures in a reduced form
way all the advantages of holding liquid money. These are typically related
to lower transaction costs in trading, and having a store of value that is
easy to liquidate when needed. The MIU approach is popular because of
its simplicity: it is a good tool when our goal is not to explain the demand
for money per se, but examine the impact of this on the real economy.
In this chapter, where I want to study the role of the nominal exchange
rate regime during the crisis, the MIU framework is a good compromise
between tractability and policy relevance.
Currency Mismatch The third additional assumption is that while

households in the model economy can participate in international
financial markets, they can only borrow in foreign currency. This is the so-
called original sin hypothesis, which is common in emerging economies.
The reason is that financial markets do not trust the fiscal and monetary
policy of the debtor country, and they worry that domestic currency
denominated debt would eventually be inflated away. Financial markets
therefore insure themselves against inflation in the debtor country by
lending in an international currency considered trustworthy, such as the
US dollar, the Euro, or the Swiss Franc.
Figure 9.3 plots the fraction of total bank lending denominated
in foreign currency in four countries, the Czech Republic, Hungary,
Poland, and Romania.3 We can see that for Hungary (and Romania)
foreign currency lending was of first-order importance before and during
the crisis. Roughly 60% of bank lending was denominated in foreign
currency in 2008, when the crisis hit. Economic policy, therefore, was
highly constrained by the link between the nominal exchange rate and
the level and value of debt. Under “original sin,” a depreciation of the
nominal exchange rate is dangerous, since it increases the debt burden
measured in domestic currency of borrowers (households, firms, and the
3
Slovakia joined the Eurozone in 2009 and was part of the European Exchange Rate Mechanism
well before that, so it was not subject to currency mismatch during the crisis. Similarly, Bulgaria
had a fixed exchange rate (currency board), which again makes a currency mismatch irrelevant as
long as the exchange rate regime is credible.
1
CZE
0.9 HUN
POL
ROM
0.8
Foreign currency loans, % total
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Fig. 9.3 The importance of foreign currency lending in total lending. The figure
shows the stock of foreign currency bank lending to the non-financial sector as a
fraction of the total stock of debt for the Czech Republic, Hungary, Poland, and
Romania. Source: Eurostat
government). This is essentially a negative wealth shock, which can even

lead to mass defaults. While I do not include explicit default in our model,
I will study the impact of the exposure of the household balance sheet to
changes in the nominal exchange rate.
Under an external credit crisis, the depreciation of the exchange rate
also has significant positive effects. In Keynesian and New-Keynesian
models (Corsetti 2008; Jakab & Kónya, 2016; Obstfeld & Rogoff, 1995),
a nominal depreciation stimulates exports and depresses imports, hence
helping the adjustment of the economy to the credit shock. This effect
will also be present in the model, although the balance sheet adjustment
process will be different. In the current framework, a tightening in the
external borrowing conditions leads to a balance sheet adjustment of
households, and the main channel of debt repayment is the improving
current account. Here the improvement of net exports is not a cause, but
rather a consequence of the underlying, fundamental processes.
Two Sectors Although it is not essential to understand crisis behavior,

instead of the one-sector approach I’ve used so far, I now distinguish
a tradable (T) and a non-tradable (N) sector. In the adjustment of
the economy, sectoral reallocation plays an important role, along with
changes in relative prices that facilitate this. The internal real exchange
rate is particularly important: this is the relative price of tradable versus
non-tradable goods, which can be approximated by the relative price of
manufacturing goods versus services.
Similarly to the previous chapter, I continue to assume that changing
the capital stock is subject to adjustment costs. In line with the two-sector
approach, I assume that capital is sector-specific, and the adjustment costs
apply separately to sectoral investment. This makes sectoral reallocation
more difficult, because capital goods cannot be transferred between the T
and N sectors. I believe this assumption makes model predictions more
realistic. For simplicity I keep labor perfectly mobile between the sectors.
Wage Rigidity As I discussed earlier, the main tool to introduce a

nominal side into the analysis is to assume MIU function. Prices adjust
flexibly, in contrast to New-Keynesian models. In the case of wages,
however, I only assume partial flexibility. While wages can be changed
at any time, workers dislike nominal wage decreases. This is known as
downward nominal wage rigidity (DNWR), and it is fundamentally
asymmetric. I thus assume that changing wages is possible, but wage
cuts have psychological costs. Many papers in the literature document
the relevance of DNWR (Babecký et al., 2010; Bewley, 1999; Kézdi &
Kónya, 2009) which—in contrast to other types of wage stickiness—is
not a particularly short-run phenomenon. This is one of the reasons why
I introduce DNWR into the analysis.
The other reason is that a small, open economy can adjust to an
external shock in two fundamental ways. If it has a floating currency,
the main mechanism is a nominal depreciation of its currency. With a fixed
exchange rate, or with a significant currency mismatch, depreciation is not
a feasible option. In this case, an internal devaluation is needed: to decrease
production costs and to improve competitiveness, wages need to be cut.
In practice, however, this is a slow and difficult process, mostly because
of the downward rigidity of nominal wages (Eichengreen, 2012; Schmitt-

Grohé & Uribe, 2003). In the current framework, I want to examine how
exchange rate policy influences the adjustment of the economy, when
external devaluation is constrained by currency mismatch, and internal
devaluation is hampered by costs to cutting wages.
9.2 The Model

After listing the main modifications relative to the RCK model, I now
turn to the detailed description of the model. Besides the household and
firm decisions, I pay special attention to monetary policy and the central
bank balance sheet. It important to understand the channels through
which the nominal exchange rate influences the behavior of the real
economy, and why the classical dichotomy is violated in this framework.
9.2.1 Households
The economy is composed of many identical households, whose total

mass is unity. The representative household can hold three types of assets:
sector-specific capital (Kjt ),4 interest-bearing foreign bonds in foreign
currency (Bt ), and non-interest-bearing domestic currency (Ht ). I assume
that domestic money is not accepted by the rest of the world as a means
of exchange (the original sin hypothesis). For accounting purposes I also
introduce a household bond (Dt ), which households use to get cash from
the central bank.5 I assume that this bond does not pay interest: since the
central bank would rebate interest revenue to households, this assumption
is harmless. Since the bond is non-interest bearing, households supply as
much as the central bank is willing to accept. I discuss monetary policy
in detail below. Both the domestic and foreign bonds can be negative,
4
The model is somewhat more transparent if we allocate capital accumulation to households. The
equilibrium conditions are independent of this assumption.
5
In the model we do not distinguish private households and the government. Therefore, we can
think of this instrument as a domestic currency government bond.
which means debt; money holdings and the two types of capital are always
positive.
Households earn income from three sources: (i) they receive wages, (ii)
they get the rental rate on capital loaned to firms, and (iii) they pay/receive
interest on foreign debt/assets. Income is spent on consumption, invest-
ment, and the purchase of financial instruments. As was said earlier, cash
does not pay interest, but gives direct utility to households. Its foreign
currency value can also increase or decrease when the nominal exchange
rate changes.
To model wage rigidity, I assume that households supply differentiated
labor. Therefore, each household sets the wage rate of its specialized labor
as a monopolist, similarly to Erceg, Henderson, and Levin (2000). Firms
use a constant elasticity of substitution (CES) aggregate of the individual
labor types, accepting the wages set by households:
Z 1 ww1
1 1
Nt D Ni;t w di ; (9.1)
0
where Ni;t is the labor supply of household i. Changing the nominal wage
is costly, where the loss expressed in utility terms is given by the function
.Wi;t =Wi;t1 /, where Wi;t is the nominal wage set by household i. I
discuss wage setting later below.
The formal household optimization problem is given by the following:
1
" #
X Hi;tC1
1C!
Ni;t Wi;t
t
max ˇ log Ci;t C log
tD0
Pt 1C! Wi;t1
X
k
s:t: Wi;t Ni;t C rj;t Kij;t D Di;tC1 Di;t St .Bi;tC1 Rt1 Bi;t /
jDX;T
Pt Ci;t Hi;tC1 C Hi;t

X Iij;t

I
Pt 1C Iij;t C Ti;t
jDX;N
2 Kij;t1
Kij;tC1 D .1 ı/ Kij;t C Iij;t ;

where Rt D 1 C rt is the interest rate on a bond that matures next period,

St is the nominal exchange rate, and Tt is a transfer from the central bank.
The first-order conditions—apart from labor supply—can be derived
the usual way. After some simplification, they are written as follows:
.PtC1 =StC1 / Ci;tC1

D ˇRt (9.2)
.Pt =St / Ci;t
1 ˇ
D (9.3)
Hi;tC1 Pt Ci;t PtC1 Ci;tC1
Iij;t
Qij;t D 1 C (9.4)
Kij;t1
" k
PItC1 =StC1 rj;tC1
Qij;t D C .1 ı/ Qij;tC1
PIt =St PItC1
#
Iij;tC1 2 1
C (9.5)
2 Kij;t Rt
Kij;t D .1 ı/ Kij;t1 C Iij;t : (9.6)
The first condition is the consumption Euler equation, the second is

money demand, the third is the investment equation for sector j (Qj;t is
Tobin’s q), the forth is the arbitrage condition between foreign borrowing
and capital investment, and the last is the capital accumulation condition
already included above. Since the model has two sectors (j D T; N), the
last three conditions have to hold separately for both sectors.
Wage Setting Demand for labor from household i can be easily derived
from Eq. (9.1) (Erceg et al. 2000):
w
Wi;t
Ni;t D Nt :
Wtw
Let us substitute the demand function into the utility function and use
the marginal utility of consumption (ƒt D 1=Ct ) to convert wage income
into utility. After keeping the relevant term, the wage-setting problem is
the following:
" w 1C!
1
X 1 1w Nt Wi;t Nt =Wtw
max ˇ ƒi;t Wi;t
tD0
Pt Wtw 1C!

Wi;t
;
Wi;t1
2
Wi;t w 1 Wi;t
s.t. D 1
Wi;t1 2 Wt1
exp Œw .Wi;t =Wi;t1 1/ C w .Wi;t =Wi;t1 1/ 1
C :
w2
I assume that the functional form of the cost of changing the wage is
the same as the Linex specification in Fahr and Smets (2010). The Linex
function is continuously differentiable, but it is highly asymmetric and
can be parameterized so that on the side of wage decreases it can be
arbitrarily steep. The calibrated ./ function can be seen in Fig. 9.4:
the cost of a wage increase is essentially zero, while significant wage cuts
are disliked by households. I return to the choice of parameters in the
calibration section, and I will also discuss why I assign insignificant costs
to small wage decreases.
The first-order condition is given by the following equation:

Wi;t 0 Wi;t Wi;t 1C'
D .1 w / Ni;t ƒi;t C w Ni;t
Wi;t1 Wi;t1 Pt

Wi;tC1 0 Wi;tC1
Cˇ ; (9.7)
Wi;t Wi;t
where
h
i
1 exp w WWi;t1
i;t
1
Wi;t Wi;t
0 D .w 1/ 1 C :
Wi;t1 Wi;t1 w
0.04
0.035
Cost of wage change (% cons.)
0.03
0.025
0.02
0.015
0.01
0.005
0
0.94 0.96 0.98 1 1.02 1.04 1.06 1.08 1.1
Wage change
Fig. 9.4 The Linex function representing the costs of changing the wage. The
figure shows the costs of changing the nominal wage in consumption equivalent
units. The parameter values are the same as in the model calibration. Source: own
calculation
Since households are ex ante identical, they will all choose the same
wage. Therefore, households remain identical ex post, and aggregation
is trivial. Given this, in what follows I drop the household index i from
the equations.
9.2.2 Production
The consumption and investment goods (Ct , IT;t , and IN;t ) studied until
now are composite goods. I assume that they are assembled from im-
ported traded and domestic non-traded goods. The domestic production
sector also produces exported tradable goods. I thus assume, similarly
to Burstein, Eichenbaum, and Rebelo (2005, 2007), that all traded
goods used domestically are imported, and all domestically produced
tradable goods are exported. This is the so-called Armington assumption

(Armington 1969) often used in the international trade literature, which
is natural for a small open economy. The domestic production sectors use
capital and labor, which are rented from households.
Final Goods The consumption and investment goods are Cobb-Douglas

aggregates of domestic and imported intermediate goods:
N 1
Ct D .1 /1 CtM Ct

Ij;t M I N 1I
1C Ij;t D I I .1 I /I 1 Ij;t Ij;t ;
2 Kj;t1
where I included the necessary capital adjustment costs where needed.

It is important to note that index j refers to the composite investment
good and denotes investment in sectors T and N. The upper indices
M; N, on the other hand, indicate the amounts of imported tradable
and domestically produced non-tradable intermediate goods used to
assemble the composite goods. Due to the lack of data and based on
the literature (Bems 2008), I assume that while the import intensity of
the consumption and the investment composite goods differ, in case of
the latter I do not distinguish between sectors T and N.
I assume perfect competition on the market for final goods. Using the
first-order conditions and the zero-profit conditions yield the following
demand functions for the various components:
St CtM D PCt Ct (9.8)

PNt CtN D .1 / PCt Ct (9.9)

T I Ij;t
St Ij;t D I Pt 1 C Ij;t (9.10)
2 Kj;t1

N N I Ij;t
Pt Ij;t D .1 I / Pt 1 C Ij;t : (9.11)
2 Kj;t1
The consumption and investment price indexes are given as follows:
1
PCt D St PNt (9.12)
1I
PIt D St I PNt : (9.13)
Intermediate Goods The export and non-tradable sectors use capital and
labor, and technologies are also given by a Cobb-Douglas production
function:
j ˛ 1˛j
Yt D Kj;tj Nj;t : (9.14)
Firms are perfect competitors, and their factor demands are given by the
following equations:
˛j 1
k j Kj;t
rj;t D Pt ˛j (9.15)
Nj;t

j Kj;t ˛j
Wt D Pt 1 ˛j ; (9.16)
Nj;t
j
where j D T; N and Pt is the price of the product in sector j expressed in
domestic currency.
9.2.3 The Central Bank
When describing the central bank balance sheet and the fixed and flexible
exchange rate regimes, I follow Végh (2013). Central bank assets include
foreign exchange reserves (Bct ) and the household bonds (Dt ) introduced
earlier. On the liability side, we find domestic currency (Ht ) issued by the
central bank. I assume that foreign currency reserves do not pay interest,
which is realistic in the very low interest rate environment during the
crisis. As Benczúr and Kónya (2013) show, it would be enough to assume
that the interest rate earned on reserves is lower than the central bank
policy rate.
Based on all these, we can write down the budget constraint of the
central bank as follows:

St BctC1 Bct C DtC1 Dt C Tt D HtC1 Ht :
I characterize the monetary policy regime with two parameters. First, I

assume the following monetary policy rule:
s 1 s
HtC1 St
D 1; (9.17)
Ht St1
where s 2 Œ0; 1 . If s D 0, the central bank maintains a fixed exchange

rate system and uses its foreign exchange reserves to cover changes in
money demand. If s D 1, then money supply is exogenous (and
constant), and the exchange rate floats freely. Intermediate values of the
parameter capture the degree of the central bank’s (in)tolerance toward
exchange rate movements.
In the model the role of foreign exchange reserves is to provide foreign
currency liquidity to agents when the exchange rate does not float freely.
I define the amount of reserves exogenously:
Ht
Bct D h ; (9.18)
St
where h 2 Œ0; 1 . Under a pure float h D 0, while under a currency

board h D 1. For the Visegrad countries, I will set the value according
to the actual size of reserves; I show the precise values in the calibration
section.
Notice that the central bank influences the exchange rate through its
reserves. Let us substitute Eq. (9.18) into the policy rule (9.17):
1 s
HtC1 BctC1
D :
Ht Bct
When the exchange rate is fixed, money supply changes proportionately

with reserves, while under a floating exchange rate, the money supply is
fixed and DtC1 D Dt . This latter assumption can be generalized to the
case when money supply grows exogenously, but for simplicity I ignore
this complication.
9.2.4 Equilibrium
Interest Premium Similarly to the previous chapter, I assume that the

relevant interest rate on foreign debt is a function of indebtedness. As I
already mentioned in the introduction, I use a highly asymmetric and
non-linear function to represent this relationship. In particular, I use
the Linex specification introduced earlier to model the costs of changing
wages. Now the function is defined as follows:

e .BtC1 =Yt by / BtC1 =Yt by 1
log Rt D log ˇ C ;
2
(9.19)
X X N N
where Yt D Pt =St Yt C Pt =St Yt is GDP expressed in foreign
currency.
The Linex interest premium function is depicted in Fig. 9.5, com-
pared to the previously used exponential specification.6 It is worth
mentioning three important properties of the current functional form:
(i) an almost constant premium for small or positive NFA values, (ii)
a quickly rising interest rate in the case of debt, and (iii) at high debt
levels an absolute borrowing constraint can be approximated arbitrarily
well. Choosing parameter values appropriately, we can approximate the
theoretical benchmarks for properties (i) and (iii) to an arbitrary precision.
An important assumption is that the interest premium depends on
household debt (also including public debt), which means that I do not
consolidate debt (Bt ) with central bank reserves (Bct ). This implicitly
6
The first-order approximation of the exponential function (8.1) is equal to the first-order
approximation of the Linex function when D 2=.
0.1
Linex
0.09
Exponantial
0.08
0.07
Interest rate
0.06
0.05
0.04
0.03
0.02
-1.5 -1 -0.5 0 0.5 1
NFA/GDP
Fig. 9.5 The Linex specification for the interest premium function. The figure
plots the interest premium as a function of the net foreign asset position.
The parameter values are given by the model calibration. The dashed line is the
benchmark exponential specification, which was used in the previous chapter.
Source: own calculation
means that reserves are used solely for liquidity purposes and cannot be
used to bail out households or the government. This was definitely the
case in the study period (2008–2011), at least in the Visegrad countries.
Even in Hungary, where foreign currency loans were eventually converted
to domestic currency, this only changed the currency composition of total
debt, but not its size. Although the assumption on reserves is a strong one,
for the qualitative results we only need that external debt and foreign
currency reserves are less than perfect substitutes from the point of view
of financial markets.
Markets Let us now turn to the intermediate good markets. In the case
of the non-traded sector, domestic usage has equal domestic production:
˛N 1˛N N N
KN;t NN;t D CN;t C IX;t C IN;t : (9.20)
In the case of exports—and in line with the Armington assumption—I

assume that external demand is not fully elastic:

PXt
YtX DA : (9.21)
St
The magnitude of export sales is thus determined by the foreign currency

price (with an elasticity of ) and a term which measures the overall
strength of foreign demand (A).
The last equilibrium condition is the current account of households,
which is given by the following expression:
h;tC1 HtC1 h;t Ht PX

BtC1 Rt Bt C D t YtX CT;t iTT;t iTN;t : (9.22)
StC1 St St
When the exchange rate is fully flexible ( h D 0), money does not
enter the equation and classical dichotomy holds (money is determined
residually). Benczúr and Kónya (2013) show that in this case the interest
rate expressed in domestic currency is constant at its steady state level. In
the case of a currency board ( s D 0 and h D 1), changes in money
demand are accompanied by equal changes in foreign currency reserves.
Therefore, when a country wants to increase its money supply, it has to
run a current account deficit.
It is worth considering the consolidated current account, where we take
into account foreign exchange reserves. Let Btot c
t D Bt C Bt , then
Ht
Btot tot c
tC1 Rt Bt D TBt h Rt Rt ;
St1
where TBt is the trade balance and Rct is the gross interest rate received on
reserves (I assumed earlier that in our case Rct D 1).
The equation makes it clear that currency mismatch influences the
real economy through two channels. First, when the central bank earns
a lower interest rate on its foreign currency reserves than households pay
on foreign debt, holding cash is costly. Moreover, the effect of the crisis
is different depending on the nature of the exchange rate regime ( h ).
Second, if reserves and external debt are imperfect substitutes, then in
addition to the size of consolidated debt Btot t , its composition is also
important for the interest premium determination.
In the model both channels are operational, since Rt > Rct D 1
and the interest premium is a function of Bt . It can be shown that in
the simulations I present later, the second channel dominates. Defending
the exchange rate allows households to pay back foreign debt (Bt ) from
their domestic currency assets (Ht ). This decreases central bank reserves
proportionately, which means that the consolidated position (Btot t ) does
not change. The assumption implies, however, that the interest premium
decreases, since gross debt declines. If, in contrast, the exchange rate
depreciates, households are less able to repay debt from domestic currency
assets, since their value measured in foreign currency declines.
To summarize the above, the equilibrium of the model is given by
conditions (9.2)–(9.22), which together form a system of non-linear
difference equations. Since the model is deterministic (see below), it can
be solved with arbitrary precision without linearization, with the help
of DYNARE. This is very important, since both the interest premium
function and wage rigidity are strongly and fundamentally non-linear,
which I want to preserve during the simulations.
9.3 Crisis and Exchange Rate Policy

After describing the model, I show how it can capture the effects of the
2008–2009 global financial crisis in the Visegrad countries. I model the
crisis mostly as an increase in the interest premium. On the other hand,
the short-run, 2009 collapse of international trade was also important for
the Visegrad countries. Therefore, as a secondary shock I add a one-period
decline in export demand.
The baseline simulations are calibrated to reproduce a few stylized
facts during the crisis in each economy. As I already mentioned, I use
deterministic simulations, where the economy is in steady state before the
initial period.7 In period zero two unexpected shocks hit the economy:
first, a permanent shift in the interest premium function and second, a
one-period decline in export demand. There are no other shocks from
the first period onward, and the simulations trace out the paths that lead
to the new steady states with lower indebtedness. I implement the export
demand shock by changing parameter A in Eq. (9.21). I discuss the shift
in the interest premium function in detail below.
9.3.1 Calibration
The central element of the model is the Linex interest premium function
and its parameterization. I use the following procedure. As the main crisis
shock, I assume that the function shifts permanently because the long-run
level of debt tolerated by financial markets (by ), which corresponds to
a zero interest premium, decreases. I thus need to find four parameter
values: the coefficients and that determine the shape of the Linex
function and the long-run NFA/GDP ratios before and after the crisis.
The calibration is based on Fig. 9.5, where I target the increases in
the CDS spread in the Czech Republic and Hungary. First I assume
that initial Hungarian debt level—without central bank reserves—was
the steady state before the crisis (BN 0 =YN 0 D 1:235). I assign a long-
run, constant premium level (120 bp) to this, which was the average CDS
spread for Hungary between October 2007 and October 2008. Finally, I
calculate the highest increase in CDS spreads in the two countries, before
the level of NFA starts adjusting endogenously.
I thus have three observations: the maximum CDS spread increases in
the two countries (HUN: 120 bp ! 605 bp, CZE: 35 bp ! 232 bp),
and the initial CDS spread for the Czech Republic at its initial NFA
level (BCZ
0 =Y0
CZ
D 0:58753). I fit three parameters to these three
observations, which are D 0:0145, D 2:095, and B= N YN D 0:228.
The procedure is depicted in Fig. 9.6, which clearly shows the increase
7
The assumption that the Visegrad countries were in steady state before the crisis is questionable. We
use it mostly for technical reasons, since it greatly simplifies the model solution and the simulations.
The time series used for calibration and model validation are treated accordingly (see below).
Before crisis
0.05
After crisis
0.04
0.03
0.02
HUN
0.01
0 CZE
-0.01
-1.5 -1 -0.5 0
Fig. 9.6 Calibration of the interest premium function. The figure shows the
calibration of the interest premium function, using the 2008Q4 increase in the CDS
spreads for the Czech Republic and Hungary and the NFA/GDP positions before the
crisis. Source: Bloomberg and own calculation
in the level and curvature of the premium function. The latter is an

important element in our approach: the interest premium rises more
during the crisis in the country that was more heavily indebted.
It is worth mentioning that based on the current calibration, the debt
semi-elasticity of the log-linearized exponential function that I used in
the previous chapter would be 2= D 0:0138. This is quite close to
the estimated values for the four countries. In the current non-linear
specification, however, an increase in the debt-GDP ratio can lead to a
much larger rise in the interest premium. When the initial level of debt
is zero, a one percentage point increase in the debt-GDP ratio leads to
an interest rate increase of 1.4 basis points. When the initial debt level is
100%, the interest rate increase is 6.3 basis points, and when the initial
debt level is 150%, the interest rate increase is 16.7 basis point. The non-
linear specification thus implies that the effect of an identical increase
in debt has a very different interest rate impact depending on the initial
position.
I normalize the level of the export demand parameter to A D 1 in
steady state. I calibrate its one-period shock to match the observed decline
in export volume. This yields A D 0:25 for the Czech Republic,
A D 0:2 for Poland, and A D 0:3 for Hungary and Slovakia.
Notice that although these values are country specific, they are fairly
similar to each other. Also, the sizes of the shocks make sense, since Poland
is the least exposed to foreign demand, and Slovakia is the most, given the
country sizes.
The elasticity of export demand is chosen to be 0:5, based on the
Hungarian estimate of Jakab and Világi (2008). Parameters for the
DNWR function are based on Fahr and Smets (2010), with an additional
consideration. The model has neither trend growth nor trend inflation.
In the Visegrad countries, the inflation target is 2–3%, and trend growth
is also around 2–3%. This means that without explicitly cutting nominal
wages, real wages relative to productivity can decrease by about 5%.
To approximate this in the model, I calibrate the wage cost function so
that it becomes steep when Wt =Wt1 < 0:95. This leads to w D 1 and
w D 100.
The other parameters are given in Table 9.1. The discount factor and
depreciation rate are the same that I used in the previous chapter. The
import shares and capital shares are calculated from national accounts;
the latter are subject to caveats we discussed earlier. I categorize sectors A,
B, C, H, and J as traded and the others as non-traded.
The elasticity of labor supply is small, but in line with New-Keynesian
models. I use this small value to try to match the relatively small observed
decline in labor input in the first crisis year. The capital adjustment cost
parameter is based on the studies of Cummins, Hassett, and Hubbard
(1996) and Cummins, Hassett, and Oliner (2006). These estimate values
between 2 and 7:5, so we set D 5. The long-run labor input is simply
a normalization; I choose the value such that it replicates an average
employment rate of 0:7 and weekly hours of 40 (relative to a theoretical
maximum of 7 16). The relative weight of money in the utility function
is chosen to match the sample average M2/GDP ratio between 2001 and
2008.
Table 9.1 Calibration

Parameter Notation Value
ALL Discount factor ˇ 0:96
Depreciation rate ı 0:05
Labor supply elasticity 1=! 1=3
w
Wage markup w 1
1:4
Capital adj. cost 5
Average labor input NN () 0:23 (150)
Export demand elasticity 0:5
Premium Linex ; 0:0145; 2:095
DNWR Linex w ; w 1; 100
CZ Import share (C,I) 0:429; 0:381
Capital share (T,N) ˛T 0:477; 0:405
Money (% GDP) N YN ()
H= 0:64
Monetary policy s 0:6
Initial and final reserve rate h 0:272I 0:29
B0 B N
Initial and final NFA (% GDP) ;
Y0 YN
0:588; 0:228
Export demand shock A 0:25
Reserves AR coefficient 0:5
HU Import share (C,I) 0:315; 0:478
H= 0:5
Monetary policy s 0:15
B0 B N
Y0 YN
1:235; 0:228
PL Import share (C,I) 0:337; 0:443
H= 0:45
Monetary policy s 1
B0 B N
Y0 YN
0:7068; 0:228
SK Import share (C,I) 0:393; 0:435
H= 0:58
Monetary policy s 0
B0 B N
Y0 YN
0:837; 0:228
Reserves AR coefficient 0
The table shows the calibrated values of model parameters
Source: National accounts and own calculation
The reserve-money ratios are calibrated to the data, using again M2 as

the relevant monetary aggregate. Since reserves in most countries changed
over the crisis, I assume that the new steady state value is reached relatively
quickly, through the following auto-regressive process:

h;t D h;t1 C 1 Nh :
Finally, the monetary policy rule s is chosen such that I match the
observed exchange rate change in 2009 for each country.
9.3.2 Results
Overall, I show two types of simulation results. First, I show how well
the calibrated model can replicate the crisis experience of the Visegrad
countries. The goal is to show that the relatively stylized model does a
good job at capturing the key macroeconomic developments during the
crisis not only qualitatively but also quantitatively.
After the baseline I show counterfactual simulations. Monetary policy
was characterized by various degrees of exchange rate flexibility: the Czech
Republic and Poland had a relatively free float, Slovakia just joined the
Eurozone, and Hungary was in between. I can use the model to simu-
late what would have happened if the countries had followed different
exchange rate policies, that is, either of the two extremes. Slovakia is a
particularly interesting case, as joining the Eurozone is different from
operating a fixed exchange rate regime in one crucial aspect, as I will
discuss below.
It is important to note that I do not do a proper welfare analysis
when comparing the counterfactuals and the baseline. The main reason
for this is that it is not clear what a reasonable welfare function would
be. Without household heterogeneity and involuntary unemployment,
a lower employment in the model leads to higher utility. In actual
economic policy considerations, however, increasing employment is the
goal. Another problem is the role of money: although I put it directly
into the utility function, it is a shortcut to capture transaction demand for
money, and the utility implications are not necessarily reliable. For these
0.055 1.15 -0.2
Exchange rate
Interest rate
NFA/GDP
0.05 1.1 -0.4
0.045 Baseline 1.05 -0.6

Data
0.04 1 -0.8
0 5 10 0 5 10 0 5 10
1 1.1 1.1
NT relative price
Money stock
Exports
1
0.95
0.9 0.9
0.9 0.8 0.8

0 5 10 0 5 10 0 5 10
1 1 1.05
Employment
Investment
Consumption
0.98 0.95 1
0.96 0.9 0.95
0.94 0.85 0.9

0 5 10 0 5 10 0 5 10
Fig. 9.7 The baseline and the data, Czech Republic. The figure shows the simu-
lation baseline and the comparable data points for the Czech Republic. Data is
between 2008 and 2011. Source: Eurostat and own calculations
reasons, I follow an “intuitive” path: I compare the different exchange

rate regimes in their impact on employment and consumption. This
ad hoc, implicit welfare function thus includes both consumption and
employment with a positive sign, but I do not put an explicit weight on
the trade-off between the two.
The Baseline Figures 9.7, 9.8, 9.9, and 9.10 show the baseline sim-
ulations for the Visegrad countries, along with data points for years
2008–2011. A discrepancy between the raw data and the model is that
the latter does not contain trends, while at least for some variables the
data do. One option would be to detrend the data using sample average
growth rates. The problem with this is that we do not know what fraction
0.1 1.15 -0.5
Exchange rate
Interest rate
NFA/GDP
0.08 1.1 -1
0.06 Baseline 1.05 -1.5

Data
0.04 1 -2
0 5 10 0 5 10 0 5 10
1.5 1 1.1
NT relative price
Money stock
Exports
1 0.9 1
0.5 0.8 0.9
0 0.7 0.8
0 5 10 0 5 10 0 5 10
1 1 1.2
Consumption
Employment
Investment
0.9 1
0.5
0.8 0.8
0.7 0 0.6
0 5 10 0 5 10 0 5 10
Fig. 9.8 The baseline and the data, Hungary. The figure shows the simulation
baseline and the comparable data points for Hungary. Data is between 2008 and
2011. Source: Eurostat and own calculations
of pre-crisis growth was a long-run phenomenon, and what fraction was

just a short-run overshooting driven by temporary factors.8
To handle this, I simply assume that consumption, investment, exports,
and the money stock all contain a long-run trend of 2% annually. Since
converging economies are subject to the Balassa-Samuelson effect, the real
exchange rates of the Visegrad countries are not expected to be constant.
Therefore, I remove the sample trends from both the external exchange
rate, and also from the internal T-N relative price, using the period
2001–2008 (due to data availability). Finally, I use data for the interest
rate, NFA/GDP, and employment as they are, without any additional
treatment. Table 9.2 contains the data definitions and sources.
8
Chapter 8 gives an answer to this question, but the estimation results were very much model
dependent. We view those results as qualitatively important, but not precise enough to use
quantitatively in a more detailed model environment.
0.06 1.3 -0.4
Exchange rate
Interest rate
NFA/GDP
1.2
0.05 -0.6
Baseline 1.1
Data
0.04 1 -0.8
0 5 10 0 5 10 0 5 10
1.15 1 1.1
NT relative price
Money stock
Exports
1.1
0.9 1
1.05
1 0.8 0.9
0 5 10 0 5 10 0 5 10
1.05 1.1 1.02

Consumption
Employment
Investment
1 1 1
0.95 0.9 0.98
0.9 0.8 0.96

0 5 10 0 5 10 0 5 10
Fig. 9.9 The baseline and the data, Poland. The figure shows the simulation
baseline and the comparable data points for Poland. Data is between 2008 and
In general, the model does a good job at explaining the main macroe-
conomic developments during the crisis years. The directions are almost
always predicted well, and the model also does well quantitatively, es-
pecially over the entire crisis period. Note that only two data moments
are targeted: the exchange rate and exports in 2009. Therefore, even the
subsequent behavior of these two variables can be used to evaluate the
model’s performance.
Given the relative simplicity of the model, some discrepancies with the
data are natural. The behavior of employment is not matched very well,
especially in the first period where the model predicts a sharp, temporary
drop. Introducing adjustment costs for employment would help, but at
the cost of model simplicity. It is true more generally that many variables
are more sluggish in the data than in the model. Again, adjustment costs
would help, but since I am interested in the medium run, I feel that
introducing many real rigidities would hinder the understanding of the
main mechanisms.
0.06 2 -0.4
Exchange rate
Interest rate
NFA/GDP
0.05 1 -0.6
Baseline
Data
0.04 0 -0.8
0 5 10 0 5 10 0 5 10
1.2 1.05 1.1
NT relative price
Money stock
Exports
1 1 1
0.8 0.95 0.9
0.6 0.9 0.8

0 5 10 0 5 10 0 5 10
1 1 1.1
Consumption
Employment
Investment
0.98 0.9 1
0.96 0.8 0.9
0.94 0.7 0.8

0 5 10 0 5 10 0 5 10
Fig. 9.10 The baseline and the data, Slovakia. The figure shows the simulation
baseline and the comparable data points for Slovakia. Data is between 2008 and
Table 9.2 Data and trends

Time series Definition Source Notes
NFA/GDP Net foreign assets Eurostat Raw data
Interest rate Sovereign CDS spreads Bloomberg
Employment Domestic concept Eurostat
Exchange rate Euro exchange rate Eurostat Data trend
N-T rel. price Services vs. manufact. Eurostat
Money stock M2 Central banks Assumed trend
Exports Goods and services Eurostat
Consumption Final consumption Eurostat
Investment Gross fixed capital Eurostat
The table shows the definition, source, and treatment of data points displayed
along the baseline simulations
Also, in some cases the trend removal from the data might be done
more carefully. In particular, the money stock grew much faster before
the crisis in the Visegrad countries than the assumed 2% trend growth
rate. Using a higher trend for the money stocks would allow the model to
fit even better along this dimension. On the other hand, as I said earlier,
it is hard to decide what fraction of this pre-crisis growth was sustainable,
so I chose to opt for the common trend.
The exchange rate, interest rate, and NFA paths are very well matched,
especially over the three-year period in the last case. It is interesting to
note that although I assumed a fully flexible exchange rate ( s D 1) for
Poland, the model cannot replicate the extent of the full depreciation of
the Zloty. This may be because I use the Euro as the benchmark currency,
instead of effective exchange rates. Another reason could be that Poland is
much larger and more closed than the other economies, which is not fully
reflected in the calibration, and the exchange rate is more disconnected
from the real economy.
Let us return to the money stock, which in the model is an important
adjustment channel. In the model economy households—in response to a
more expensive external financing—use their local currency assets to pay
down foreign debt. In the model this conversion can be done quickly and
costlessly. In reality, because of heterogeneity and transaction costs, this
process lasts much longer. In Hungary, where foreign currency lending
was the most pronounced, the conversion of foreign debt into domestic
debt took place after 2011. Since other shocks—such as the second,
European wave of the crisis—started to play an increasingly important
role in later years, I decided to focus only on the period 2008–2011 so as
not to contaminate the simulations.
Counterfactual Simulations Figures 9.11, 9.12, 9.13, and 9.14 show the
counterfactual simulations along with the baseline. The counterfactual
cases are a fixed exchange rate regime and a pure float. Note that for
Hungary, the float assumes s D 0:6, since the solution method cannot
handle a higher level of flexibility. The reason is likely to be that the initial
indebtedness level is very high in Hungary, and the numerical method
moves onto the very steep part of the Linex premium function.
Another issue is choosing the second parameter of the monetary policy
regime, h . In principle a more flexible exchange rate regime allows for
a lower level of reserves. On the other hand, if the role of reserves is to
1.15 1.055 -0.5

Fixed
Domstic interest rate

Flexible -0.6
Exchange rate
1.1 Baseline 1.05
NFA/GDP
-0.7
1.05 1.045
-0.8
1 1.04 -0.9
0 5 10 0 5 10 0 5 10
1.05 1.05 1
1 1
Consumption
Employment
0.98
Exports
0.95 0.95
0.96
0.9 0.9
0.85 0.85 0.94

0 5 10 0 5 10 0 5 10
Fig. 9.11 Alternative exchange rate regimes, Czech Republic. The figure shows
the simulation baseline and counterfactual simulations for extreme exchange rate
regimes for the Czech Republic. Source: own calculations
provide liquidity in the case of a crisis, it is less obvious that under a

flexible regime lower levels are needed. Also, as I will discuss in the Slovak
case, the model predictions are quite sensitive to movements in reserves.
Therefore, for a more clear comparison, I keep the path of reserves the
same as under the baseline simulations and focus on the pure effect of the
exchange rate flexibility as captured by the parameter s . The exception
is Slovakia, where in the counterfactuals I keep reserves at their original
level in 2008. I explain the reason below.
As I discussed earlier, I concentrate on the main policy variables,
employment, and consumption. For the Czech Republic (Fig. 9.11), the
flexible baseline exchange rate regime was a good choice. The differences
between the baseline and a pure float are minor. Employment would have
fell much more under a fixed exchange rate, and the initial response of
consumption is also more favorable if the exchange rate can depreciate.
1.8 1.09 -0.5

Fixed

Flexible 1.08
1.6 -1
Exchange rate
Baseline
NFA/GDP
1.07
1.4 -1.5
1.06
1.2 -2
1.05
1 1.04 -2.5
0 5 10 0 5 10 0 5 10
1.2 1.1 1
1 0.95
1.1
Consumption
Employment
Exports
0.9 0.9
1
0.8 0.85
0.9
0.7 0.8
0.8 0.6 0.75

0 5 10 0 5 10 0 5 10
Fig. 9.12 Alternative exchange rate regimes, Hungary. The figure shows the
simulation baseline and counterfactual simulations for extreme exchange rate
regimes for Hungary. Source: own calculations
Although from the third-period consumption in the fixed regime is

higher, the differences are small, and it is unlikely that this would overturn
the first conclusion. Overall, for a lightly indebted economy with a low
level of currency mismatch, the traditional macroeconomic argument for
exchange rate floating dominates the policy choice. Poland (Fig. 9.13) is
very similar to the Czech Republic, if anything, the case for exchange rate
flexibility is even stronger.
Hungary (Fig. 9.12) is a very different case: recall that it is the most
heavily indebted country, with a large foreign currency debt stock.
Accordingly, while the employment response would have been much
better under floating, the consumption path is clearly more favorable
under a fixed exchange rate. The baseline is close to the fixed regime, so it
leads to basically the same outcomes. Moreover, the drop in employment
is unrealistically large: as I discussed under the baseline, the model over-
predicts the first-period employment decline. I believe that the qualitative
1.2 1.055 -0.5

Fixed

Flexible -0.6
1.15
Exchange rate
Baseline 1.05
NFA/GDP
-0.7
1.1
-0.8
1.045
1.05
-0.9
1 1.04 -1
0 5 10 0 5 10 0 5 10
1.05 1.05 1
1 1 0.98
Consumption
Employment
Exports
0.95 0.95 0.96
0.9 0.9 0.94
0.85 0.85 0.92

0 5 10 0 5 10 0 5 10
Fig. 9.13 Alternative exchange rate regimes, Poland. The figure shows the simu-
lation baseline and counterfactual simulations for extreme exchange rate regimes
for Poland. Source: own calculations
conclusions are robust, in that a flexible regime protects employment

more. A more realistic (but necessarily more complex) framework would
probably favor the fixed regime even more. Also, the exchange rate
depreciation would have been very large (close to 80%) under a float.
Although the Linex premium function allows for fundamental non-
linearities in the debt-premium relationship, it does not fully capture the
vulnerability of the banking system to large depreciations. This is the
second reason why I think the policy conclusion is even stronger than
the simulations suggest.
Slovakia is an interesting case (Fig. 9.14). If we just compare the two
counterfactuals, we can see it as an intermediate case, where employment
is less hit under the flexible regime, but the consumption paths are
not easy to rank. The really stark difference, however, is relative to the
baseline. Recall that the Slovak baseline is very different from the other
countries, since Slovakia joined the Euro just when the crisis hit. The
main difference from the fixed regime is that belonging to a large and
1.25 1.06 -0.4

Fixed

1.2 Flexible 1.055 -0.6
Exchange rate
Baseline
NFA/GDP
1.15
1.05 -0.8
1.1
1.045 -1
1.05
1 1.04 -1.2
0 5 10 0 5 10 0 5 10
1.05 1.05 1
1 1 0.98
Consumption
Employment
Exports
0.95 0.95 0.96
0.9 0.9 0.94
0.85 0.85 0.92
0.8 0.8 0.9

0 5 10 0 5 10 0 5 10
Fig. 9.14 Alternative exchange rate regimes, Slovakia. The figure shows the
simulation baseline and counterfactual simulations for extreme exchange rate
regimes for Slovakia. Source: own calculations
almost closed economy allowed Slovakia to draw down its reserves to

almost zero. Holding reserves is costly, both because of the interest rate
differential and because financial markets are assumed to focus on gross
debt. Initial reserves in Slovakia stood at about 55% of the money stock,
while after joining the Eurozone this came down immediately to 6% of
the money stock. This large positive wealth effect allowed households
in the model to keep consuming at a much higher level than in the
case of either a regular fixed or a floating exchange rate regime. This
aspect of entering the Eurozone is underappreciated, but according to our
simulations, it has a quantitatively large effect on the welfare of a country.
To summarize, the model developed and quantified in this chapter
captures the main crisis events in the Visegrad countries qualitatively and
mostly quantitatively as well. Based on this, I was able to draw important
policy conclusions regarding the nature of exchange rate policy during the
crisis. Two main results stand out. First, for a heavily indebted country
with a currency mismatch, defending the exchange rate is the best policy.
For less indebted countries, floating the exchange rate dominates. Second,
reserve policy has a quantitatively large impact on welfare. Joining the
Eurozone allows a country to wind down its reserves and benefit from a
one-time, large positive wealth effect.
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Summary
This book studied the growth experience of the Visegrad countries:

the Czech Republic, Hungary, Poland, and Slovakia. The first part
contained growth and development accounting, comparing the Visegrad
economies with each other and also with four Western European bench-
mark countries. I carefully accounted for the main production inputs,
then concluded that the main components of growth and convergence
are productivity and to a lesser extent capital investment. Although
employment in the region is lower than in Western Europe, this is more
than compensated by more hours worked. The careful measurement
of human capital is important especially for development accounting
purposes.
The second part studied the neoclassical growth model. First I showed
that when we take into account the endogeneity of capital investment,
productivity is the dominant explanation behind the relative underdevel-
opment of the Visegrad countries. Next, I used the model to measure the
overall efficiency of factor markets in the eight economies. To a varying
extent, I found inefficiencies in all countries relative to the first best.
It follows that improving the operation of the factor markets would lead to
sizable GDP growth, on the order of 20–50% depending on the country.

https://doi.org/10.1007/978-3-319-69317-0
202 Summary
The third part extended the model and deepened the structural anal-
ysis. First, using Bayesian econometric techniques, I identified the main
stochastic shock that drove the growth process in the Visegrad countries.
I found that GDP growth volatility is mainly explained by shocks to trend
productivity, which I prefer to interpret—thinking outside the model—
as shocks to expectations of growth prospects. For GDP components,
however, other shocks were also important, including those to the external
financing environment. Finally, I zoomed in to the episode of the global
financial crisis, which I interpreted as an exogenous sudden stop event for
the Visegrad countries. The conclusions were that exchange rate policy
was—as it should have been—highly contingent on initial indebtedness
and currency mismatch. I also identified a quantitatively significant
benefit of joining the Eurozone, which is the possibility to eliminate costly
foreign exchange reserves.
There are naturally many aspects of economic growth that I could not
study in this book. It would be interesting to analyze the efficiency of
factor markets in more detail. Also, studying the role of government and
fiscal policy would be important. Another very important direction is to
identify the structural determinants—the institutional environment, the
structure of the economy, the quality of public goods—behind aggregate
productivity. Nevertheless, my hope is that the analysis in the book is
a useful starting point, and apart from the specific results, the tools
developed here can be used for further investigations into the topic.
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https://doi.org/10.1007/978-3-319-69317-0
Index
Note: Page numbers followed by ‘n’ refer to notes.
A C
Adjustment costs, 171, 177, 191 Calibration, 79, 96, 102, 111–113, 143,
Aggregate production function, 12, 175, 176, 179, 181, 184–188, 193
12n4, 55, 84 Capacity utilization, 24, 24n13, 27,
Autocorrelation, 147, 149, 151–154, 44, 47–64, 66, 69–73, 75n2,
156 84, 107
Average hours, 29, 31–33, 35, 40–43, Capital intensity, 61, 74, 76, 77, 79
58n3, 72, 75, 77, 78 Capital loss, 51, 57–60, 75n2
Capital-output ratio, 56–61, 79, 91,
93, 112, 132
B Capital stock, 5, 11, 47–64, 66, 69,
Bayesian estimation, 154 74, 79, 84, 85, 87, 89, 93–95,
Borrowing wedge, 108, 120–121, 124, 100, 101, 118, 127–129, 133,
127, 131, 141 134, 143, 146, 171
Business cycle accounting, 106, 106n1 Capital taxation, 127, 129–131

https://doi.org/10.1007/978-3-319-69317-0
206 Index
Capital wedge, 110, 118–120, 122–124, Emerging economies, 7, 51, 140, 153,
127, 129–134 157, 161, 169
Central bank, 172, 174, 178–180, Employment, 26, 29–35, 37–44, 58,
182–184 58n3, 59, 61, 73, 75, 77, 78,
Chain linking, 14–16, 16n8, 49, 67, 113, 114n4, 116, 127, 186–191,
69, 74, 148 194–196, 201
Cobb-Douglas, 25, 84, 85, 89, 95, Employment rate, 30–31, 33, 37–38,
99, 177, 178 40, 42, 77, 78, 113, 114n4, 116,
Competitive equilibrium, 98, 100 127, 186
Conditional convergence, 19, 88, 89 Eurozone, 122, 124, 169n3, 188, 197,
Convergence, 5, 19, 20, 23, 72, 77– 198, 202
79, 86–89, 91, 92, 94–97, 101, Exchange rate policy, 137, 165, 172,
131, 137, 157, 161, 163, 168, 201 183–198, 202
Correlation, 147, 149, 151–154, 156 Exogenous growth, 84, 88
Currency mismatch, 169–172, 169n3, Expectations, 107, 110–112, 114–115,
182, 195, 198, 202 115n7, 158, 163, 202
Export demand, 183, 184, 186
External financial conditions, 6, 165,
D 166
Debt dependent interest rate, 108,
140–143, 155, 180, 183, 185,
186, 197 F
Depreciation, 47, 48, 50–52, 55, 57, Factor markets, 5, 23, 81, 122, 124,
58, 79, 88, 90, 93, 101, 112, 131–134, 201, 202
169–171, 186, 193, 196 Firms, 23, 61, 88, 90, 98–100,
Development accounting, 5, 11n3, 109, 110, 120, 127, 128, 141,
26, 33, 47, 65–79, 93, 106, 131, 143–144, 169, 172, 173, 178
201 Fixed exchange rate, 169n3, 179, 188,
Distortions, 5, 81, 105–134, 137, 139 193–195
DYNARE, 150, 154, 183 Flexible exchange rate, 193
Fluctuations, 17, 23, 24n13, 31, 44,
70, 72, 84, 137, 139, 140, 153,
E 159, 165
Economic growth, 1, 4, 7, 12–20, 23, Foreign currency borrowing, 120, 159,
33, 62, 66, 69, 71, 88–89, 202 163, 169, 170, 178, 181–183,
Education, 13, 33, 35–42, 44, 58n3, 193, 195
77, 78 Foreign debt, 6, 141, 173, 180, 183,
Efficiency, 5, 11, 23, 24, 106, 116, 118, 193
120, 131, 134, 137, 201, 202 Full-time, 35, 41, 42, 77–79
Index 207
G Labor wedge, 108, 111, 114, 116–118,

GDP per capita, 2, 3, 17, 22, 26, 124–127, 131–134
66–71, 74–79, 88, 92, 94, 102, Level effect, 88
133–134 Linex function, 176, 180n6
Global financial crisis, 6, 59, 62, 70, Long-run equilibrium, 84, 86–88,
72, 118, 120, 137, 163, 165, 166, 86n2, 91, 91n6, 92, 94–96,
183 101–102, 132
Growth accounting, 11, 11n1, 12, 26,
37, 53, 69–73, 75n2
Growth effect, 88 M
Growth prospects, 13, 202 Monetary policy, 6, 124, 172, 179,
188, 193
Money in the utility (MIU), 168,
H 169, 171, 186
Human capital, 11, 11n2, 12, 26, 29, Money stock, 190, 192, 193, 197
33–44, 66, 72, 73, 77, 78, 113,
140, 201
N
Neoclassical growth model, 5, 7, 23,
I
24, 81, 83–102, 137, 201
Initial conditions, 6, 57, 58n4, 86,
Neoclassical production function, 9,
97, 101, 157, 161, 163
23–27, 81, 83, 99
Intangible capital, 94, 94n7, 95
Net foreign asset position, 181
Interest premium shock, 149, 151,
Nominal variables, 168
157, 159–161, 163, 165
Non-linear relationship, 168
Investment, 5, 16, 42, 47–50, 55–58,
Non-tradable (T), 171, 177, 178
61, 61n6, 67, 79, 83, 85, 88, 90,
91, 91n6, 93–95, 98, 99, 101,
110–111, 118, 120, 122, 124, 127,
128, 131, 134, 140, 147, 148, O
150, 151, 153, 154, 159, 160, Original sin, 169, 172
163, 168, 171, 174, 176–178,
190, 201
Investment wedge, 109 P
Parameters, 26, 27, 48, 52, 53, 56,
62, 85, 87–91, 95, 101, 102,
L 105, 111–114, 142, 143, 152–157,
Labor share, 52, 54, 55, 61n6 175, 176, 179–181, 184, 186,
Labor taxation, 126, 127 187, 193, 194
208 Index
Part-time, 33–35, 37, 39–41, 75, School years, 33, 41, 42, 44n5
77–78 Shock decomposition, 157–161
Population growth, 68, 69, 83, 88, Simulations, 131–134, 147, 149–153,
91, 140 155, 183, 184, 184n7, 188–197
Posteriors, 154, 156 Small open economies, 108, 140, 142,
Price level, 16, 20–22, 48, 49, 66–69, 149, 153, 165, 168, 171, 177
99, 168 Solow model, 83, 85–89, 89n3, 90,
Priors, 15, 154–156 92–95, 97, 99–101
Productivity shock, 144, 147, 149, Speed of convergence, 95–97
153, 154, 157, 160, 165 Steady state, 24, 56, 79, 84, 86,
Projections, 115 86n2, 87, 89–95, 100–102, 112,
Purchasing power parity, 20, 48, 49, 113, 127, 128, 132, 143, 146,
66 157–161, 163, 182–184, 184n7,
186, 188
Stochastic shocks, 6, 202
R Structural shocks, 137, 139, 140, 146
Ramsey-Cass-Koopmans (RCK) Stylized facts, 4, 11–27, 35, 40, 48,
model, 84, 97–102, 105–107, 147, 149, 152–154, 166
109, 112, 124, 127, 140, 145, Sudden stop, 165, 202
157, 163, 165, 166, 172
Real business cycle (RBC), 139–141,
144, 147
Real interest rate, 100, 102, 113, 115, T
118, 120, 122, 124, 132, 162, 163 Total factor productivity (TFP), 5,
Relative price, 15, 16, 48, 49, 61, 11, 12, 26, 57, 59, 66, 69–75,
61n6, 66–68, 99, 171, 190 75n2, 77, 85n1, 88, 92–94, 153
Representative household, 98, 99, Total hours, 29, 31, 59, 62
141, 172 Total labor input, 11, 24, 29, 35, 42,
Reserves, 178–184, 188, 193, 194, 197, 43, 66, 69, 72, 75, 77, 78, 84,
198, 202 91, 93, 99, 108, 112–114, 125,
Risk premium, 142, 167 127
Tradable (T), 171, 176, 177
Transition, 5, 17–20, 50, 51, 57–61,
S 75n2, 147, 163
Sample period, 18, 29, 44, 68, 70, 91, Trend growth shock, 147
91n6, 116, 124, 156, 157, 163 Two sectors, 67, 171, 174
Index 209
U 157–161, 163, 166, 168, 179,

Underdevelopment, 4, 75, 94, 131, 181, 183, 184n47, 186, 189, 190,
137 193, 197, 201, 202
Volatility, 6, 18, 20, 23, 116, 120,
V 147, 148, 150–153, 157, 160,
Visegrad countries, 5–7, 9, 13, 17–20, 163, 202
22, 23, 27, 31, 37, 40, 49–51,
53, 55, 57, 59–61, 67, 71,
72, 74–79, 89, 92–94, 116, W
118, 120, 122, 129, 131, 133, Wage rigidity, 171–173, 183
137, 140, 147–149, 151–154, Wedges, 106, 108–134, 139, 141, 163

Economic Growth in Small Open Economies Lessons From The Visegrad Countries

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Economic Growth in Small Open Economies Lessons From The Visegrad Countries

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ECONOMIC

ISBN 978-3-319-69316-3 ISBN 978-3-319-69317-0 (eBook)

Library of Congress Control Number: 2017962413

© The Editor(s) (if applicable) and The Author(s) 2018

Cover illustration: Chaichan Ingkawaranon / Alamy Stock Photo

Printed on acid-free paper

This Palgrave Macmillan imprint is published by Springer Nature

Part I Decomposing Growth and Development 9

2 Methodology and Stylized Facts 11

3 Labor Input and Labor Income 29

3.3 Human Capital 40

4 Capital Stock and Capacity Utilization 47

5 Growth and Development Accounting 65

Part II Growth and Factor Markets 81

6 The Neoclassical Growth Model 83

7 Markets and Distortions 105

7.2 Measurement Issues 111

Part III Growth, Shocks, and Crisis 137

8 Growth and the Financial Environment 139

9 Credit Crisis and Growth 165

9.3 Crisis and Exchange Rate Policy 183

Fig. 1.1 Economic development before 1500. The figure

Fig. 4.2 Estimating the income share of capital. The figure

Fig. 5.5 Decomposing relative development in Western

Fig. 7.4 Decomposing the capital wedge. The figure decomposes

Table 2.1 Growth statistics 19

The question of economic development plays a central role in modern

© The Author(s) 2018 1

measures of states that existed in the current territories of Italy, England,

It is ironic that when Malthus published his important book, changes

settler colonies. A stagnating world was replaced by a dynamic global

ing on the particular question. The main advantage of this approach

An old question in the context of growth and development is to identify

© The Author(s) 2018 11

existence of an aggregate production function was discussed and debated

2.1 Countries and Data Sources

influence on growth prospects in the Visegrad countries. Finally, Austria is

2.1.1 Real GDP

Economic growth is the change in GDP, which sometimes takes on

If we choose a basis year (t D 0), then we can recursively create a chain-

Y1cl D gY;1 Y0cl

Why do we need chain linking? Prior to its introduction, it was

where Yt is GDP, Ct is private consumption, It is investment, Gt is gov-

2.1.2 Economic Growth

GDP per capita

Germany Great Britain

GDP per capita

capita. In this chapter I use the latter, as it is a better measure of living

Czech Republic Hungary

GDP per capita

GDP per capita

transition brought recession in all four countries: in Slovakia, output loss

Table 2.1 Growth statistics

after transition is made difficult by the sharp recession in 1990–1992

2.1.3 The Level of Economic Development

Until now I looked at the economic performance of individual countries

the real economic performance of Austria and Hungary, we need to

To summarize the main facts on economic growth and development,

2.2 The Neoclassical Production Function

output over a period can be written as a function of available inputs,

where Yt is the period output (GDP), Kt is the stock of physical capital,

2.2.1 Basic Assumptions

When describing the main properties of the aggregate production func-