The models discussed thus far all have the characteristic that consumption and output (capital) are always on their respective balanced growth paths; there are no transitional dynamics. Instead, the economy adjusts with infinite speed to any exogenous shock, thus contradicting the empirical evidence pertaining to the speed of convergence. One of the main conclusions of this literature is that the economy in fact adjusts relatively slowly, with the benchmark estimate of the speed of adjustment being around 2-3% per annum. While the original estimates have been challenged on various empirical and methodological grounds, the consensus remains that the speed of convergence may be somewhat higher than originally suggested, but probably less than 6% per annum. In any event, this implies that the economy is mostly off its balanced growth path, on some dynamic path that converges only gradually to a steady state. It is therefore important to modify the model to allow for such transitional dynamics, and this can be achieved in several ways, all of which assign a central role to a second state variable in determining the equilibrium dynamics.

In this chapter we consider two important modifications to the basic onesector model that accomplishes this objective. These include: (i) limited access to the world financial market; and (ii) the introduction of public capital. In Chapter 5 we shall show that extending the model to two sectors, having traded and nontraded capital, will also introduce transitional dynamics, the nature of which will depend in part upon the relative sectoral capital intensities.