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1.

Introduction

Since the dawn of economics, there has been a heated debate on the causes of economic

growth; Economists tried to answer one of the most controversial questions: what drives

economic growth? Moreover, how to sustain it? Despite the progress achieved in

measuring and modelling economic growth, we are still not capable of finding elusive

answer to that question.

The literature of economic growth continued discussing how to encourage economic

growth in different economies. Early theories stated that countries should focus its

efforts on sectors in which they have comparative advantages. Thus they can produce

at a lower both marginal and opportunity cost compared to other economies to trigger

growth. On the other hand, While modern theories claim that countries should

concentrate on strategic sectors which have unique characteristics to encourage higher

productivity and technological advancement such as manufacturing.

Nicolas Kaldor is considered one of the leading representatives of the modern theorists

that support the idea of focusing efforts on strategic sectors that have higher productivity

and technology improvement such as manufacturing.

In his work described later as "The Three Laws of Economic Growth", in the first one

he noticed a positive correlation between the share of manufacturing in GDP and

economic growth, in other words when the share of manufacturing of GDP is rising

then the economy is increasing faster with time. Also, Kaldor found that the productivity

of manufacturing sector is positively related to the growth in the manufacturing sector


which became known as Kaldor-Verdoorn's law. The last law Kaldor argued that the

non-manufacturing sector growth is positively related to the growth of the

manufacturing sector.

This growing debate about the engines of economic growth - especially in developing

countries such as Jordan- encourages the importance to analyse the role of the

manufacturing sector in achieving satisfying economic growth rates was behind

examining the validity of Kaldor's laws, the first law in particular.

Therefore, this paper will test if the manufacturing sector is the engine of economic

growth in the Jordanian economy. Moreover, this paper aims to extend the test to cover

the service sector to accept or reject the hypothesis that the manufacturing sector is the

only engine behind economic growth in Jordan and to examine the possibility that the

service sector could act as the only escalator of economic growth. To achieve the

previously mentioned goals, Generalised Methods of Moments approach will be utilised

to improve the results presented by Kaldor.

The structure of this paper is as follows: section 2 will set the theoretical overview

regarding the theories of economic growth in general, then will discuss the kaldorian

approach to understand the economic growth mechanism highlighting the first law in

particular, also will discuss the transmission mechanisms between manufacturing and

economic growth. Section 3 summarises the literature review about the topic. Section 4

will present the contribution of both manufacturing and service sectors in GDP of

Jordan. Section 5 devoted to explaining the data and methodology and the empirical
finding of the model chosen to examine the validity of Kaldor's law. The last two

chapters 6 and 7 will report the regression results and conclusion.

Theoretical Background

2.1 Theories of Growth

After the industrial revolution in late 1800's was the changing point for the world

economy. Most of the large economies of the world witnessed an increase in the Gross

Domestic Product. All them started on the growth path. This increase in the National

Income led to analysing of the growth structure of the economies. The great depression

of 1929 was another crucial year which entailed new ideas. Economist starting from

Adam Smith to very recent have tried to explain the growth process.

1. Classical Theory developed by Adam Smith

Adam Smith in his book Wealth of nation talked about completely free and open market

where perfect competition will prevail and following Say's law, supply will create its

demand in the economy. He conceptualised division of labour and opined that it would

lead to higher productivity ultimately leading to higher level of growth. He could not

have envisaged any market failure or absence of a free market in the labour market. He

did not consider the issue of wage ceiling for which the supply cannot create similar

demand leading to depression.

2. New economic growth theories

Post great depression era in 1937 John Maynard Keynes showed that the importance of

governmental control and the need for new technologies. These new economic growth
theories emphasised on the innovation of new technology. They pointed out that in the

case of a perfect competitive market the short run profit being zero, the firms engaged

in the production process may not show interest in technological innovation as that

increases their cost of production in comparison to other competitors. They were

instrumental in advocating more govt. control and the tried to emphasise on the issue of

productivity both capital and labour. Place emphasis on increasing both capital and

labour productivity. They advocated that labour productivity and capital productivity

must increase for an economy to grow. New economic argue that labour productivity

increase not always lead to diminishing returns it might sometimes increase it.

3. Neoclassical growth theories

Neo classical growth theories are more reliant on the theories developed by Adam

Smith, David Ricardo, and Malthus. They opined that the increased productivity leads

to diminishing returns. Therefore, only increase savings rate will not be sustainable in

the long run. The increase in the savings rate only increases the capital available to the

hands of the firms, but once the economy reaches a steady state, then an exogenous

factor will be needed for that economy to grow further. They opined that is possible

only if there happens a technological progress which will lead the economy from the

steady state or the low-level equilibrium. They also showed that low-income economies

or the developing economies having same savings rate and population increase rate

might not reach the same steady state in the long run. Neo classical economists were

successful in explaining the huge economic gap between the developed countries and

the developing countries. Sometimes empirically it can be visible that developed

countries have ten times more per capita income than the developing countries of low-
income countries. They emphasised the importance of growth as that leads to increase

in technological know-how and increase in the workforce and capital to increase. One

point needs to be mentioned here that the empirically it has been observed that in some

economies the labour force increased many folds even with the absence of growth.

4. Endogenous growth theory

By early 1970's and 1980's, it was observed that the neo classical growth theories could

no longer explain the economic phenomenon of the world. The previous theories took

the savings rate, technological growth rate to be exogenous. They could not explain why

technological advancement takes place across continents. One has to remember that

U.S. and other developing countries experienced a bane in their productivity growth

rate around this time. After the Bretton wood conference in 1944, the importance of

equal distribution of wealth or wealth inequality became a burning topic. Neo classical

growth theories could not explain the vast difference in income in countries. As the

saving and investment rate was exogenous in these models, the policy makers could not

find the way to influence the economic variables so that they reach higher growth

trajectory. Paul Romer in his seminal work in 1986 showed that the main underlying

assumption of diminishing returns by the neoclassical growth theorist was

counterintuitive. This was a major move from the prior assumptions to facilitate such

significant departure. Romer and the other endogenous growth modellers included the

human capital and the knowledge capital in the capital function. They showed that if

capital is not limited to only physical capital, then it might be the case that the

production function has increasing returns. They included both embodied and
disembodied technological change in their models. They incorporated the technical

change in their model so that productivity of labour increases.

Kaldor's growth laws

In his attempt to explain the economic growth patterns for the UK economy, Nicholas

Kaldor (1966,1978) has highlighted the vital role of manufacturing in economic growth;

he described a group of economic laws to explain the economic growth differences

between industrialised (developed) countries. These laws presented the role of the

manufacturing sector as an escalator of economic growth and as an answer to why

economic growth differs between developed economies.

The first law describes the relationship between manufacturing and economic

growth as known as Engine of economic growth, Kaldor stated that the faster the

manufacturing sector value added (MVA) grows, the faster the GDP grows. In this

regard, he is considered the first to find empirical evidence indicates to the

correlation between MVA and (Egez, 2014).

The mathematical formulation of the model built on pooled cross sectional data

from 12 different developed countries. The regression model as follows:

= + + ..(1)

Where is the growth rate of gross domestic product and is the growth

rate of manufacturing sector value added. Kaldor concluded that when grows

1%, the will increase by 0.614. Although the previous formula reflects a

relatively strong and positive correlation, but it is also significantly less than unity,

which implies that there is excess growth in manufacturing over nonmanufacturing


sectors (EMN for short) allows the economy to grow rapidly, in other words, the

larger EMN the faster the overall economy growth rate (Thirlwall, 1983). The next

equation captures this fact

= + ( ) + ..(2)

Where represents EMN in the economy, Kaldor findings were

strongly supporting the positive relationship between GDP growth and EMN. In

his model, he estimated the value as 0.95.

Consequently, the correlation between agricultural sector value added ( )

and must not differ from zero due to the fact that the economy is industry

led economy. Also the agricultural sector exhibit diminution return to scale

(Drakopoulos and Theodossiou, 1991), on the other hand the, Kaldors model

also implies that the regression coefficiant of the relation between Service sector

value added growth ( ) and should not be significantly different from

unity because of the fact that the demand on service is derived from the demand

on manufacturing output (McCausland and Theodossiou, 2012).

The first law has attracted considerable attention of many economists over the

past decades, many researchers criticism was on the basis of the uncertainty in

the causality direction, in the first formulation it is clear that affects

but it could be true the other way around, and the model does not reflect a very

soled theoritical explanation or theoritical derivation (deeper discusion of the

limitations and critiques in the literature review chapter).


The Second Law or Kaldor Verdoorn Law states that the labour productivity

in manufacturing sector ( ) growth rate is higly influeced by the , the

faster then the faster due to increasing return to scale. The idea

behind this formulation is that the bigger size of a certain sector the lower

average cost of production, also from dynamic point of view the effect that

output has on capital acumulation and tichnical progress are vital in the context

of increasing labour productivity.

There are two versions or two main ways of testing Kaldor-Verdoorn law, a

faster growth rate of manufacturing output the faster rate productivity grows.

The starting point would be a standard Codd-Douglas production function as

follows:


= ..(3)


Where is manufacturing sector output, and is the capital used as inputs in


the manufacturing sector, and finally is imployment used as inputs in the

manufacturing sector.

Differencing equation (3) after taking logs:

= + ..(4)

Alternatively, for simplicity:

= + ..(5)

Where km and em are the growth rates of capital and employment in

manufacturing, respectively. Productivity is the outcome of the difference

between the output growth rate and imployment in manufacturing sector

growth rate , as appers in equation (6).


= + ..(6)

Rearranging equation (6) and substituting in equation (5):

= + ( ) ..(7)

1
= ..(8)


Assuming that the ratio between capital and output is fixed = , taking logs

and rearranging we get = + . Subistituting in equation (8) we get:

(1)
= ..(9)

= 0 + 1 ..(10)

or as in most empirical studies:

= 0 + 1 ..(11)

The second version of Kaldor Verdoorn law was suggested by Kaldor; he

pointed out that the previous formulation might suffer from spurious regression

since if = 0 then there will be a perfect correlation between and

(Mamgain, 1999). The model is simply derived by substituting equation (6) in

equation (10), then rearranging to get:

= 0 + (1 1 ) ..(12)

This formulation has also criticised by ( Rowthorn, 1975)


2.2.

Bibliography

Drakopoulos S and Theodossiou I (1991) Kaldorian Approach to Greek Economic

Growth. Applied Economics 23(10): 16831689.

Egez MEA (2014) Manufacturing the only engine of growth? An extension of

Kaldors first law. Available from: http://othes.univie.ac.at/32548/1/2014-04-

12_1006024.pdf.

Mamgain V (1999) Are the Kaldor-Verdoorn Laws Applicable in the Newly

Industrializing Countries? Review of Development Economics 3(3): 295309.

McCausland WD and Theodossiou I (2012) Is manufacturing still the engine of growth?

Journal of Post Keynesian Economics 35(1): 7992. Available from:

http://mesharpe.metapress.com/openurl.asp?genre=article&id=doi:10.2753/PKE0

160-3477350105.

Society RE and Journal TE (2017) What Remains of Kaldor TM s Law? Author ( s ):

R . E . Rowthorn Published by: Wiley on behalf of the Royal Economic Society

Stable URL: http://www.jstor.org/stable/2230525. 85(337): 1019.


Thirlwall AP (1983) A plain man TM s guide to Kaldor TM s growth laws. Journal

of Post Keynesian Economics 5(3): 345358.