In Discussion Paper No. 1372 Micael Castanheira and Research Fellow Gérard Roland focus on general equilibrium interactions between capital accumulation and the speed of economy-wide restructuring. They construct a general equilibrium model to analyse the characteristics of the optimal path of transition under various utility functions and intertemporal elasticities of substitution, and perform a sensitivity analysis. In particular, the effects of adverse productivity shocks on the state sector during the transition process are examined.

Economic intuition suggests that such shocks tend to always accelerate the optimal rate of restructuring since they increase the return to investment. It turns out that the opposite may be true when such shocks occur at the beginning of transition. The reason is that negative productivity shocks create an output contraction which has an adverse effect on savings. This income effect may dominate the substitution effect due to increased return to investment. An adverse productivity shock occurring early in the transition may have important macroeconomic contractionary effects, since it not only represents a supply shock but, importantly, also leads to a slow down in investment and the economy-wide process of restructuring and transition.

If policy-makers can influence the timing of productivity shocks by sequencing reforms, the model suggests it is better to avoid adverse productivity shocks too early in transition. This finding fits the empirical observation of a strong output contraction in Central and Eastern Europe as a result of trade and price liberalization as well as of the break-up of the Soviet Union. In China, by contrast, where liberalization was much more limited, an impressive and sustained process of capital accumulation has occurred and structural shifts are taking place in a context of high growth.


Restructuring and Capital Accumulation in Transition Economies: A General Equilibrium Perspective
Micael Castanheira and Gérard Roland