Different economies from across the globe register different levels of economic performance. This is especially because the different economies have different resources and capabilities. What is more is that they each focus on different core economic activities. According to Jones, (1998) another reason for the considerable differences in economic performance is usually based on the approaches that the economy uses to monitor its economic indicators as well as the strategies that they use to achieve desirable outcomes. One strategy that economies adopt after experiencing economic downturn is the Solow-Swan model. The Solow model has been described by Jones (2008) as an economic growth model that focuses on the long term improvement of the performance of an economy. The model commonly focuses on achieving the economic growth through facilitating capital accumilation, as well as increase in labor and productivity. The model was introduced by Robert Solow and Trevor Swan in 1965 hence the name Solow Swan Model. The theorists separately proposed the model which offered extensive culculations in the evaluation of economic performance and determination of alternative approaches to improving economic growth.
Features of the Solow Growth Model
The main features of the Solow Growth Model include capital per worker and output per worker. The model aims to achieve economic growth through ensuring that the economy effectively utilises its capital with regards to facilitating the effeciency of laborers within the economy and that the economy records an increasing size of workforce, and that the workforce performs optimally. It is with this regard that the theory focuses on constant returns to scale (CRTS) with regards to production function. In line with the CRTS, the theory suggests that increasing each input by a particular factor will ultimately increase the output by a certain amount. The basic principles in relation to the link betweeen output per worker and capital per worker is represented by Diagram 1 below. In the diagram ‘y’ represents output per worker while ‘k’ represents capital per worker.
The main assumptions of the Solow Model theory are that an economy usually starts out with specifc amount of capital per worker as well as a specific population size and growth rate. Other factors that the economy starts out with include specific investment and depreciation rate. Based on these attributes, the growth of the economy is seen to improve in line with the output of the workers. Changes in the amount of investment per person significantly affects their productivity levels. Depreciation and growing workforce commonly dillutes the amount of capital per person.
The amount of savings within an economy are commonly a reflection of the amount of investments within the economy. Increase in the investment increases the capital stock of the economy and this is what Ecuador aimed at achieving through dollarization. The country aimed at increasing the level of output through the dollarisation strategy, so that it would increase its investment. Depreciation usually reduces capital stock and this means that the investments will in the long run be reduced. In Diagram 2 below, the point at which investment and depreciation offset one another is called the steady state level of capital stock and when it is experienced it means that the economy is experiencing capital deepening, hence it needs to make adjustments to its economic policies. governments including the Ecuador government usually strive to ensure that they make adjustments that ensure that consumption is maximised and this is what they did when they engaged in dollarisation.
Before dollarisation, Ecuador was not increasing its capital per worker. This means that the change in the economy in relation to the Solow Model was zero hence captal widening was occuring because capital stock which is represented by population size, continued to grow but the investment per person was zero. Dollarization resulted in positive change because capital per worker/ investment per person was increasing.
Different nations have different currencies. The currencies usually serve different functions including that they act as the main unit of exchange, hence they facilitate trade. Currency also acts as a store of value and unit of account. As a result of adverse external economic factors, an economy may experience shock which may directly impact on the effeciency of the currency of the economy to serve its functions. The shocks may include a number of reasons that are capable of resulting in economic downturn/recession. When they occur, the currency of a country can become weak and as a result the public who are also the consumers in the economy, begin loosing trust in the currency and its value as well as exchengability. When this happens, it is likely that investment per person is reduced in the economy and so is the capital stock of the economy in line with the Solow growth Model. One strategy of reversing such adverse outcomes is currency substitution, which is what Ecuador did.
Ecuador almost experienced total breakdown of its monetary system as a result of macroeconomic shocks. This prompted the country to susbtitute its currency to the US Dollar from its Sucre. This significantly increased the investment per person and as a result output of workers. That is why Ecuador was able to increase its exports after dollarization, while the exports of Peru and Colombia which are all larger than Ecuador, recorded stagnated growth in their export levels.
In the long run, with increased investments the country began to experince increasing savings. Transactions costs in global trade were reduced and the consumers in the economy were able to afford products and services, and they began to increase their consumption level which is benefitial for economic growth.
- Correa, R., & Wang, S. (2016, July 26). Examining the Effects of Dollarization on Ecuador. Retrieved October 26, 2016, from Council of Hemisphere Affairs: http://www.coha.org/examining-the-effects-of-dollarization-on-ecuador/
- Jones, I. C. (1998). Introfuction to Economic Growth. New York: W. W. Norton & Company Inc.
