Institute of Economic Studies, Faculty of Social Sciences

Charles University in Prague

Assessing Dutch and Austrian Economic Growth

within The Solow Growth Model Framework: A
Critical Aproach

Jiri Skuhrovec

Martin Pospisil
 Institute of Economic Studies,

Faculty of Social Sciences,

Charles University in Prague

[UK FSV – IES]

Opletalova 26

CZ-110 00, Prague

E-mail : ies@fsv.cuni.cz
http://ies.fsv.cuni.cz

Institut ekonomických studií

Fakulta sociálních věd

Univerzita Karlova v Praze

Opletalova 26

110 00 Praha 1

E-mail : ies@fsv.cuni.cz
http://ies.fsv.cuni.cz

Citations: All references to documents served by this site must be appropriately

cited.

This paper can be downloaded at: http://dl.cuni.cz

 Assessing Dutch and Austrian Economic Growth
within The Solow Growth Model Framework: A
Critical Aproach

Jiri Skuhrovec1

Martin Pospisil2

Abstract: In this paper we are going to test Solow growth model on long-term data
for Austria and the Netherlands. Our main point of interest will be how their growth
dynamics were determined by foreign development. Our hypothesis is that the
model is inconsistent with reality, since it omits effects from international trade and
institutions. We have proved that a polynomial trend with a dummy variable after
the oil shock in 1979 might be the best estimation for both countries. In both
countries we found that there is some extra effect of international trade that cannot
be explained through Solow framework. We have proved that the Solow growth
model is inconsistent with the GDP post-war development of both Austria and the
Netherlands.

Keywords: Economic growth, Austria, the Netherlands, Solow growth model

JEL: E01, E13

1
Institute of Economic Studies, Charles University; The Faculty of Nuclear Sciences and
Physical Engineering, Czech Technical University in Prague; McKinsey & Company; email:
jskuhrovec@gmail.com.
2
Institute of Economic Studies, Charles University; Faculty of Business Administration,
University of Economics in Prague, Roland Berger Strategy Consultants; email:
pospisil.martin@gmail.com
Introduction

In this paper we are going to test Solow growth model on long-term data for Austria
and the Netherlands. Our main point of interest will be how their growth dynamics
were determined by foreign development - foremost by European integration.
Differences between both countries should provide some insight into effect of goods
and capital market openness, technology spillover and other factors on European
convergence in terms of GDP per capita. Explanatory power of the model will be
evaluated, and then theoretical conclusions will be made with regards to historical
conditions.

Aim of this paper is to assess real long-term predictive power of Solow growth
model, while our hypothesis is that the model is inconsistent with reality, since it
omits Ricardo's classical comparative advantage analysis. Particularly we would
like to show, that two-factor (Cobb-Douglas) production function does not reflect
extra benefits that the economy gains from international trade and that these benefits
are – in terms of GDP – significant in the long run. European integration is a very
good example to study – as milestones of international trade are clearly visible and
country data are reliable and comparable.

For detailed analysis we chose two medium-sized countries: Austria and the
Netherlands, which are small enough to benefit considerably from international
trade, but not too small to have unreliable aggregates. We looked through history of
their integration, formulated hypotheses and tried to test them - using aggregate data
for the whole Europe as a benchmark.

Motivation
The choice of the two countries – Austria and the Netherlands – was motivated by
an attempt to compare two similarly big economies that are about the size of the
Czech Republic. Second, Austria and the Netherlands have nowadays almost the
same level of GDP per capita measured by the Laspayres index. But this was not so
throughout the whole period that is of our interest, i.e. 1955-2004. At the beginning
of this period, the Netherlands was much richer in terms of GDP per capita.
However, Austria caught up.

Another issue linked with the previous one are the oil shocks. One might conclude
that oil shocks3 were responsible for the slowing down of the Dutch economy. We
will try to test the assumption. Moreover, we will try to assess whether the
convergence of these two economies was caused by the fact that the Netherlands
performed so poorly, that means below its long term potential, or that Austria
performed so well. All these are issues that lead us to choose Austria and the
Netherlands as two countries of which we will make analysis of the economic
growth.

Methodology
We used data from Penn World tables4 - namely pop (population), cgdp (gdp per
capita in constant prices) and openk (openess of economy measured like
import+export/gdp), years 1955-2004 for Austria and Netherlands. Furthermore we
summed data from same source for Germany, Italy and France, to provide robust
proxy for whole Euro-region. We needed countries with relatively lower openess
(since larger domestic market implies lesser effect of international trade) , but
sufficiently close to examined countries – in both geographical and more
importantly technological terms.

The model
The Solow model can be described as follows:

(1) Y(t) = K(t) α ( A(t ) L(t ))1−α , where 0< α < 1

3
The 1973 oil crisis began on October 17, 1973, when the members of Organization of Arab
Petroleum Exporting Countries (OAPEC, consisting of the Arab members of OPEC plus Egypt and
Syria) announced, as a result of the ongoing Yom Kippur War, that they would no longer ship oil to
nations that had supported Israel in its conflict with Syria and Egypt (the United States, its allies in
Western Europe, and Japan). The 1979 (or second) oil crisis in the United States occurred in the wake
of the Iranian Revolution. Amid massive protests, the Shah of Iran, Mohammad Reza Pahlavi, fled
his country in early 1979, allowing Ayatollah Khomeini to gain control. Source (Wikipedia,
downloaded 11/11/2007)
4
Heston et al (2006)
and the notation is standard: Y is output, K is Capital, L labour, and A is the level of
technology. L and A are assumed to grow exogenously at rates n and g.5

(2) ln[Y(t)/L(t)] = ln A(0) + gt + α/(1 - α )ln(s) - α/(1 - α )ln(n + g + δ )

The central predictions of the Solow model concern the impact of saving and
population growth on real income. We derive (2) by classical steps from the basic
Solow model. (2) is therefore steady-state income per capita. If we assume that ln
A(0) = a + ε , where a is constant and ε is a country-specific shock, we get (3).

(3) ln(Y/L) = a + (α/(α - 1)(ln(s)) - (α/(1 - α )(ln(n + g + δ ) + ε ))

In this respect we will try to analyse to what extent were supply shocks of the 1970s
country specific. Again, we assume that Austria was not so highly affected by these
shocks.

We assume that the rates of saving and population growth are independent of
country-specific factors shifting the production function. That is, we assume that s
and n are independent of ε . That means that we can use OLS to estimate the
equation (2). Moreover, because the capital's share income ( α ) is roughly 1/3, the
model implies an elasticity of income per capita with respect to saving rate of
approximately 0.5

We will assume δ is constant across countries. As Mankiw et al (1990) note, there

is neither any strong reason to expect depreciation rates to vary greatly across
countries nor any data that would allow us to estimate country-specific depreciation
rates. Therefore we will assume depreciation rates to be the same in both countries.

The variable g reflects primarily the advancement of knowledge, which is not

country-specific. However we would like to make some estimate of g so that we
avoid using common notion6 that g+ δ is 0.05. We get n by regressing
log(population) on time for each of two countries. Getting good estimate for g
(which is unobservable) is more complicated. However using both OLS and LWS

5
It is not of purpose of this paper to fully describe the Solow growth model. For details see
for example Mankiw (1990) or Romer (2000)
6
g+ δ = 0.05 is a common assumption in cross-country analysis.
(see regressions 1 and 2) we get that g is around 0.057.7 We explain this by different
institutional framework within the EU mainland than in the US. Furthermore there is
certainly some upwards bias caused by post-war shock, this bias in fact should be
included, since Austria and Netherlands experienced similar one.

One of the feature of the neoclassical model is the so called 'convergence property'.
That means that a country's per capita growth rate tends to be inversely related to its
starting level of income per person. Therefore, in the absence of shocks, poor and
rich countries would tend to converge in terms of levels of per capita income.
However, as Barro (1989) writes, this convergence hypothesis seems to be
inconsistent with the cross-country evidence, which indicates that per capita growth
rates are uncorrelated with the starting level of per capita product. On the other hand
as Mankiw at al (1990, p.19) note the Solow model does not predict convergence; it
predicts only that income per capita in a given country converges to that country's
steady-state value. In other words, the Solow model predicts convergence only after
controlling for the determinants of the steady state, a phenomenon which might be
called 'conditional convergence'.

Detrending of time series8

At first we have estimated a linear trend with the dependent variable GDPpcA (GDP
per capita for Austria, data for 1955-2004). We use logarithm of the GDP and we
get the quadratic trend as the best trend. As we can see the Austrian GDP was above
the trend in these periods: 1961-1963, 1971-1978 and after 1998. The period after
the second oil shock is tested as a structural shock with a positive but not very
significant result. The GDP was below trend in the large part of 1980s.
Now, we need to test for a structural shock. We use the so called Chow test. Zero
hypothesis says that there is no structural shock. That means that there is a structural
shock in the data for Austria in the year 1979. However the result is not very robust.

The same model we use for the Netherlands. At first we plot the basic linear model.
If we use the linear trend only, we see that on average, the Dutch economy grew on
average with 2.43% per year, which is less than the Austiran economy (3.37% per

7
0.58 for OLS and 0.56 for LWS.
8
All regressions can be found in the attachment
year). Looking at the previous picture, there are several periods, when the Dutch
GDP was above the trend: 1955-1958, 1969-1980, and after 1998. The oil shock of
1979 influenced the performance of the 1980s.
Now, we need to test for a structural shock. We use the so called Chow test. The
summation of the result means that there is a structural shock in the data for the
Netherlands and this structural shock is more significant than for Austria which has
proved our assumption from the introduction.

Using the results from the Chow test, we have assumed that a polynomial trend with
a dummy variable after the oil shock might be a better estimation than the linear
model for both countries. Without dummy it seems that the quadratic member of the
equation is not very significant and the variation deletion test says that this member
can be omitted.

Regression results
Now we are ready to assess trade contribution towards permanent country growth
(within Solow framework). This is to be done in three steps:

Step 1) Assuming that Solow model works, we need to obtain n and g parameters.
We get n by regressing log(population) on time for each of two countries. Getting
good estimate for g (which is unobservable) is more complicated. We gather data for
population and GDP growth through Western Europe, and we regress log(GDP per
capita) time. There are three basic problems with such regression:

a) GDP time series is apparently autocorrelated. This fact automatically stems from
almost every business cycle theory and is here empirically proven by high
significance AR(1) test. However, since we move within Solow framework, we
should not estimate GDP as time series as the theory denies possibility of moving
average rate of growth. This is in fact just a part of the more general problem solved
in c), we noted it separately only because this argument is purely statistical. c)
Explains both dealing with this argument, and with its economical counterpart - the
cyclical development.

b) Another problem of our estimate can be that it already contains the effect of
opening of economy - the benefit of international trade. This is partly eliminated by
using big countries as EU proxy - since in their case the international trade effect
should be only mediocre. Further we experimented with introducing of aggregate
international trade volume into model, in order to control for its effect - but the
results were in fact qualitatively worse, due to high collinearity of such data. Hence
we decided rather not to perform such control and let g be slightly upwards biased.

c) We implicitly assume there is no serious change in aggregate saving rate over

time - which could create some bias by introducing temporary growth fluctuations
(this bias goes asymptotically to zero, but our sample is not large enough). We
treated this by using Least Weighted Squares (LWS - described for example in
Visek (2002)) estimate of g which should provide us more robust result.

Resulting rate of technological growth from OLS is somewhat higher than one of
LWS - as it is biased upwards by post-war boom. We shall use LWS result which
should have lower sensitivity to such leverage points and therefore describe long-
term trend in better way.

As "European" data we chose sum of Germany + Italy + France in terms of

population and real GDP.

Results (Regressions 1-3)

g= 0.056
n= 0.017

Step 2)
Now we will compute a GDP_potential variable series for each country as follows:
we use previously computed rate of growth of GDP per capita g to predict a GDP in
2004, using every single year as a base, hence we get 55 predictions. An average of
these predictions gives us estimate of GDP potential for year 2004 - free of cyclical
influence (as we assume that cycles move randomly around average of GDP
potential). From this value we can simply compute rest of GDP_potential time serie
- by dividing it with respective power of (1+g). In fact this averaging is not as
important procedure for getting right results. As will be clear further, we could
choose any of historical years as base one, instead of our average, with same result -
as estimators we shall further use are scale invariant, and their intercept will be of no
interest. Only reason for choosing GDP_potential serie this way is that it the most
intuitive- it fits well to Solow framework.

Finally we introduce potential_gap serie as follows:

potential_gap = GDP_potential – GDP

This serie reflects distance of a country from its balanced growth path, predicted by
Solow model. Theory now predicts, it should be autocorrelated, but moving around
zero (=balanced path) in average,since E[GDP(t)] = GDP_potential(t).

Step 3)
Having the potential_gap serie for both countries we can come to our final step -
measuring the effect of international integration (=trade openess) on persistent shifts
of gdp_potential. This is equivalent as proving openess variable has additional
explanatory power for potential_gap serie. From standard Solow framework this
should not happen - as the openess development is hardly cyclical (to explain short-
term fluctuations), nor it can have any long term effect as this is in Solow always
contained in g. This effect was already plugged into model through GDP_potential
serie. Though openess should have no, or little significance in following model:
potential_gap = openess + ε
(no intercept is needed here, as potential_gap should be by our assumptions just
white noise with expected value of 0)

In order to use standard t-statistics for hypothesis testing we again use OLS as first
method to get approximation of our results. Once we are sure about significance and
sign of parameters, we perform OLS with intercept and LWS estimations to get
more precise results (again - there are strong leverage points in overall distribution).
Since we do one-dimensional regression we can easily check, how these damage our
result - by plotting the regression line and observations (graphs 1 and 2), which
seems alright.

Results 4-8 tell us, that in all cases the estimate of openness effect is positive and
highly significant. R-squared's between 19 and 64 prove some real importance of
openness contribution towards GDP growth, however even form graphs we see, that
trend contained in cyclical potential_gap development is quite weak and unstable,
so the predictive power of our results should not be weighted much.

Conclusion
Using the results from the Chow test, we have proved that a polynomial trend with a
dummy variable after the oil shock might be a better estimation than the linear
model for both countries. Without dummy it seems that the quadratic member of the
equation is not very significant and the variation deletion test says that this member
can be omitted. Therefore we proved that oil shock in 1979 was significant for both
countries, however stronger influence it had on the Dutch economy that was more
dependent on oil than Austria at the time. It is interesting that oil shock in 1979 had
more impact than the first oil shock in 1973. Unfortunately due to insufficient data
we could not reliably test for significance of Eurozone entry which would be of our
interest.

In both countries we found there is some extra effect of international trade. This
effect cannot be explained through Solow framework, as it is persistent, and it is not
contained in linear technological growth trend - which should be the only
determinant of long term growth of GDP per capita. However the strength of this
result is very modest since only two countries were examined, for relatively short
period of time - which furthermore contained serious fluctuations such as post-war
boom or oil shocks. We can conclude our findings, that Solow model cannot well
explain recent growth patterns of Netherlands and Austria. We suggest that this can
be explained by moderate size and large openess of both countries - which could
bring more growth of GDP per capita, than a sole (linear!) technological
advancement.
The critique of the Solow growth model is that it omits institutional framework and
international trade. We have proved that the Solow growth model is inconsistent
with the GDP post-war development of both Austria and the Netherlands.
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Regressions used
1) OLS estimate of g
Dependent variable: eudata3[GDPpercap]
Number of observations: 55
Variable Coefficient St. Error t-
statistic Sign.
1 Constant 5.4952534099 0.0304208653
180.64093034 [0.0000]
2 eudata3[year] 0.0581189936 9.686548E-04
59.999694241 [0.0000]

2) LWS estimate of g
Constant 5.4908
eudata3[year] 0.0561

3) OLS estimate of n
Dependent variable: ln(eurpop[population])
Number of observations: 35
Variable Coefficient St. Error t-
statistic Sign.
1 Constant 6.8634671859 0.1408429939
48.731335474 [0.0000]
2 eurpop[year] 0.0026938464 7.088132E-05
38.005028539 [0.0000]
4) OLS estimate of Austria openess effect without intercept
Dependent variable: aut2[potential_gap]
Number of observations: 55
(Regression without a constant!)
Variable Coefficient St. Error t-
statistic Sign.
1 aut2[openess] 37.588883743 4.3930447249
8.5564536893 [0.0000]
R^2adj. = 40.884379861% DW = 0.0280
5) OLS estimate of Netherlands openess effect without
intercept
Dependent variable: nld2[potential_gap]
Number of observations: 55
(Regression without a constant!)
Variable Coefficient St. Error t-
statistic Sign.
1 nld2[openess] 12.077125932 2.1518673208
5.6123933918 [0.0000]
R^2adj. = 19.667799258% DW = 0.0640

6) OLS estimate of Austria openess effect with intercept

Dependent variable: aut2[potential_gap]
Number of observations: 55
Variable Coefficient St. Error t-
statistic Sign.
 1 Constant -2915.5365644 486.94357692 -
5.987421752 [0.0000]
2 aut2[openess] 84.805135354 8.5974886808
9.8639426585 [0.0000]
R^2adj. = 64.071226343% DW = 0.0617

7) OLS estimate of Netherlands openess effect with intercept

Dependent variable: nld2[potential_gap]
Number of observations: 55
Variable Coefficient St. Error t-
statistic Sign.
1 Constant -1075.8317882 439.84698216 -
2.4459228591 [0.0178]
2 nld2[openess] 24.122475038 5.3377606298
4.5192125895 [0.0000]
R^2adj. = 26.4538465% DW = 0.0771

8) LWS results (with intercept):

nld2[constant] -1750
nld2[openess] 32.4

aut2[constant] -3182
aut2[openess] 85.3

Graph 1

Graph 2
 9) OLS regression of log(GDP) for Austria: linear trend
(linear regression)
Dependent variable: ln(gdp[GDP_pc_A])
Number of observations: 55
Variable Coefficient St. Error t-
statistic Sign.
1 Constant 8.2862136376 0.0124226343
667.02548223 [0.0000]
2 Trend 0.0583722202 0.0011021171
52.963718189 [0.0000]
3 $t^2 -4.751646E-04 2.054697E-05 -
23.12577444 [0.0000]
R^2adj. = 99.689188121% DW = 0.6823
Graph 3: OLS regression of log(GDP) for Austria: linear trend
 10) OLS regression of log(GDP) for Austria: Quadratic trend
Ordinary least squares
(linear regression)
Dependent variable: ln(gdp[GDP_pc_A])
Number of observations: 55
Variable Coefficient St. Error t-
statistic Sign.
1 Constant 8.2862136376 0.0124226343
667.02548223 [0.0000]
2 Trend 0.0583722202 0.0011021171
52.963718189 [0.0000]
3 $t^2 -4.751646E-04 2.054697E-05 -
23.12577444 [0.0000]
R^2adj. = 99.689188121% DW = 0.6823

9
11) Chow test for a structural shock: Austria
Austria (19552004: Residual sum of squares (restricted):
0.03876856354107
Austria (19551979): Residual sum of squares:
0.01779748190384
Austria (1980-2004: Residual sum of squares:
0.00761405194467
Residua sum of
squares(unrestricted)=0.025411533
Chow statistics for Austria: F(3,41)= 7.18

9
The Chow test statistics is F=[(RRSS-URSS)/g]/[URSS/(n-2*k)]. g is total number of
parameters in the model. In our case=3. (n-2*k)=41
 12) Linear trend for the Netherlands

13) OLS regression for the Netherlands: quadratic trend

Ordinary least squares
(linear regression)
Dependent variable: ln(gdp[GDP_pc_N])
Number of observations: 55
Variable Coefficient St. Error t-
statistic Sign.
1 Constant 8.7829341863 0.0183494749
478.64771203 [0.0000]
2 Trend 0.0356218124 0.0016279373
21.881562258 [0.0000]
3 $t^2 -2.174456E-04 3.034993E-05 -
7.1646164587 [0.0000]
R^2adj. = 98.686449549% DW = 0.3651
Graph 4: OLS regression for the Netherlands: quadratic trend
 14) Chow test for a structural shock for the Netherlands
Netherlands (1955-2004: Residual sum of squares (restricted):
0.08458621474283
Netherlands (1950-1979): Residual sum of squares:
0.0298658332193
Netherlands (1980-2004): Residual sum of squares:
0.00742067862804
Residua sum of
squares(unrestricted)=0.03728567
Chow statistics for the Netherlands F(3,41)= 17.34

15) Testing for polynomial trend with a dummy variable after the
oil shock in 1979 using OLS: The Netherlands
Ordinary least squares
(linear regression)
Dependent variable: ln(gdp[GDP_pc_N])
Number of observations: 55
Variable Coefficient St. Error t-
statistic Sign.
1 Constant 8.7708705637 0.0135526782
647.16880625 [0.0000]
2 Trend 0.0359537637 0.0011922375
30.156544012 [0.0000]
3 $t^2 -1.593218E-04 2.392375E-05 -
6.6595679971 [0.0000]
4 gdp[dummy_after_1979]
-0.1176697614 0.0180166096 -
6.5311822701 [0.0000]
R^2adj. = 99.29675447% DW = 0.8871
Graph 5: Polynomial trend with a dummy variable after the oil shock in 1979 for
Dutch GDP

16) Testing for polynomial trend with a dummy variable after the
oil shock in 1979 using OLS: Austria
Ordinary least squares
(linear regression)
Dependent variable: ln(gdp[GDP_pc_A])
 Number of observations: 51
Variable Coefficient St. Error t-
statistic Sign.
1 Constant 8.2800938354 0.0108484266
763.25296891 [0.0000]
2 Trend 0.0585406171 9.543428E-04
61.341285847 [0.0000]
3 $t^2 -4.456787E-04 1.915009E-05 -
23.272926718 [0.0000]
4 gdp[dummy_after_1979]
-0.0596931524 0.0144216416 -
4.1391371373 [0.0001]
R^2adj. = 99.767372543% DW = 1.0190
Graph 5: Polynomial trend with a dummy variable after the oil shock in 1979 for
Austrian GDP