A large and growing body of empirical evidence supports the notion of conditional convergence across economies, in the sense that economies grow faster in per capita terms if they start further from their steady-state positions. This has been interpreted in the light of the neoclassical growth model for a closed economy, which fits the speed of convergence (found to be about 2% per year) if capital is viewed broadly to encompass human investments, so that diminishing returns to capital set in slowly, and if differences in government policies or preferences about saving lead to heterogeneity in steady-state positions. The problem with this interpretation is that it is hard to argue that the states within the US, the prefectures within Japan or the regions within European countries are actually closed economies. Open economy versions of the theory predict higher rates of convergence than those observed empirically.

In Discussion Paper No. 1019, Robert Barro, Gregory Mankiw and Research Fellow Xavier Sala-i-Martin show that the open economy model conforms with the evidence if an economy can borrow to finance only a portion of its capital: &nbspif, for example, human capital must be financed by domestic savings. Furthermore, the open economy model conforms with the evidence if it is assumed an economy can finance only a portion of its capital (even if 50% or more of the total) with foreign debt. The model is also found to be consistent with another empirical finding: GNP and GDP behave very similarly across economies and their speed of convergence does not differ substantially.

Capital Mobility in Neoclassical Models of Growth
Robert J Barro, N Gregory Mankiw and Xavier Sala-i-Martin

Discussion Paper No. 1019, September 1994 (IM)