Palestine: A Theoretical Model of an Investment- Constrained Economy

The sixty-year-old Israeli-Palestinian conflict has deeply influenced the evolution of the Palestinian economy. In the last two decades persistent political instability and the Israeli closure policy have been sources of protracted economic stagnation and poor capital formation. This paper describes the consequences on the Palestinian economy of two particular conditions: high transaction costs and market fragmentation. We use a simple one-sector model which describes Palestine as a demand-driven economy and Palestinian capital accumulation as linked to desired investments by Palestinian firms. Within this framework, we show that high transaction costs discourage capital formation by curtailing expected profitability. Market fragmentation further reduces domestic investments by reducing the size of the market and depressing entrepreneurs’ animal spirits. We show that in the short-run, where expectations are given, the above two facts induce low levels of capacity utilization and of capital accumulation. The situation is even more worrying in the long-run, when entrepreneurs can adapt their expectations. Depressed animal spirits and low levels of capacity use feed back into each other and give rise to a low-growth trap; escape from this trap would prove extremely difficult. We also highlight the possible positive impact of the removal of high transaction costs and of market fragmentation, and the ensuing benefits on long-term equilibrium values of both capital accumulation and capacity utilization. The conclusions try to set this analytical results within the historical situation of the Palestinian economy, and to envisage the roles of economics and politics in order to establish a sustained process of development.