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The Great Recession and Developing Countries
accounting for the effects of cyclical variables and internal—or external— shocks on the level of output (and, hence, growth rate). In practice, this is usually addressed by including variables representing short-run fluctuations in demand (e.g., the capacity utilization rate for capital stock or average working hours for labor) in the production function. The output (national income) of an economy can be described by using a Cobb-Douglas type of production function. The function is expressed in logarithmic form and has the property of constant returns to scale: ln Yt = C0 + α1 * ln Kt + (1 – α1) * ln Lt + γTt + et
(11.1)
where Y, K, and L stand for output, capital stock, and employment, respectively, and T is the time variable. C0 is the constant term, α is the output elasticity of capital stock, (1 – α) is the output elasticity of employment, γ represents the shift in the production function (the rate of technical change or TFP growth), e is the usual error term, and t is observations (years). Capital stock can be defined as the accumulated sum of previous investments after allowing for depreciation. Employment may be defined as depending on the labor supply (e.g., population growth or wage level), capital stock or investments, and the structure and functioning of the labor market. Technical change accounts for disembodied technical change and can be linked to such things as improvements in human capital, innovation, competitive pressures, sectoral reallocation of resources from less productive to more productive activities, or organizational changes in the firms. As noted earlier, the output level in an economy is subject to cyclical changes in demand and external/internal shocks to the economy. These variables, in turn, lead to biased estimation results on the coefficients of the production function. One way to solve the problem is to include variables representing cyclical changes and external/internal shocks in the production function. Capacity utilization rates and average working hours are two widely used variables representing these factors. After taking into account these variables, equation 11.1 can be redefined as ln Y t = C0 + α1 * ln(Kt * CUt) + (1 – α1) * ln(Li * WHt)+ γ * Tt + εt (11.2) p
where CU is the capacity utilization rate and WH is working hours. In equation 2, K * CU represents the effective capital stock and L * WH is