Recent literature on endogenous growth and development has sought to explain sustained disparities of income levels and growth rates across countries. The principal mechanism whereby these models generate large and sustained divergences across countries is the existence of externalities. In Discussion Paper No. 1110, Bankim Chadha and Fabrizio Coricelli identify an alternative mechanism based on the interaction of investment with unemployment, whereby sustained divergences in outcomes can occur.

The paper presents a model of economic development of an economy comprised of an agricultural-rural sector and an urban-industrial sector. Economic development is identified with a successful and sustainable accumulation of physical capital in the urban-industrial sector. There are two elements of the mechanism that create a channel for potentially divergent long-run outcomes. The first element of the mechanism is that unemployment evolves non-monotonically during the sectoral reallocation process. The second element is that wages in the urban-industrial sector are a decreasing function of unemployment. The interaction of investment with unemployment creates a channel for potentially divergent long-run outcomes. If the urban-industrial capital stock falls short of a threshold level, the urban-industrial sector will not develop. If the capital stock is high enough, there is a unique path by which it will develop. Between these two extremes is a region of indeterminacy where expectations can play a pivotal role in determining the long-run outcome.

Unemployment, Investment and Sectoral Reallocation
Bankim Chadha and Fabrizio Coricelli

Discussion Paper No. 1110, January 1995 (IM)