DevelopmentMarket Approaches

1
Chapter 3- Explaining growth Economic Theories

• Outline
• Stylized Facts on growth developed and
  developing countries
• Structural Diversity Common Characteristics of
  Developing Countries
• Developed and Developing Countries evolution of
  growth in income per capita
• 4. Convergence or Divergence in Living Standards
  as measured by income per capita developing Vs
  developed countries.
• 5. Economic Theories how economies develop over
  time.
• 6. Rostows Stages of Economic Growth and Harrod-
  Domar model on savings

2
Economic Growth the importance of growth in
development

• Stylized Facts
• For present developed countries, the GDP per
  worker has accelerated since 1820s. The average
  growth rate of 2 is impressive if one factors in
  compounding.
• Growth (see Table 3.1) was not uniform across all
  countries current developing countries only
  began the process after WW II.
• Table 3.2 shows the growth rates of selected
  developing countries relative to the US. For many
  if not all, there is clear need for accelerated
  growth if these countries have to catch-up with
  developed countries. i.e. they must grow at high
  rates to catch with developed economies.
• Many theories related to economic growth
  emphasize particular pathways that these
  societies might pursue
• (a) Linear view of history as societies move from
  agriculture to industrialization Rostow (b)
  Delayed consumption or savings where savings
  produce growth effects Harrod-Domar (c )
  savings is important for only level effects (SR
  MR but not in the LR) where technology matters
  Solow Model (d) new growth theories Chapter 4
  and so forth.

3
The Structural Diversity of Developing Economies
Common Characteristics of Developing Nations

• Structural Diversity of Developing Economies
• 1. Size and income level
• 2. Historical background
• 3. Physical and human resources
• 4. Ethnic and religious composition
• 5. Relative importance of public and private
  sectors
• 6. Industrial structure
• 7. External Dependence
• Common Characteristics of Developing Nations
• 1. Low levels of living
• 2. Low levels of productivity
• 3. High rates of population growth and dependency
  burdens
• 4. Substantial dependence on agricultural
  production and primary exports
• 5. Prevalence of imperfect markets or simply
  missing markets.

4
Development is a very recent phenomenon dating
back to 1800s for todays Developed Economies
5
How Developing Countries Today Differ
fromDeveloped Countries in Their Earlier Stages

• Physical and human resource endowments
• Per Capita incomes and levels of GDP in relation
  to the rest of the world,
• 4. Climate distance from the Equator
• Population size,
• Distributions and growth,
• Historical role of international migration,
• international trade benefits unfettered movement
  of goods finance
• Basic RD capabilities --
• Stability and flexibility of political-social
  institutions,
• Efficacy of domestic economic institutions

6
Are living standards of developing anddeveloped
countries converging?
1.Evidence of unconditional convergence is hard
to find (Figure 2.5) 2. There is some
(controversial) evidence of conditional
convergence
Divergence no clear pattern
Convergence clear pattern
7
Economic Theories

• Economic development theories and models seek to
  explain and predict
• how
• Economies develop (or not) over time
• Barriers to growth can be identified and overcome
• (c ) Government can induce (start), sustain and
  accelerate growth with appropriate development
  polices
• 2. Theories are generalizations. While LDC's
  share similarities, every countrys unique
  economic, social, cultural, and historical
  experience means the implications of a given
  theory vary widely from country to country.
• 3. There is no one agreed model of development.
  Each theory, like Rostow, gives an insight into
  one or two dimensions of the complex process of
  development. e.g. Rostow helps us to think about
  the stages of development LDC's might take and
  the Harrod-Domar model explains the importance of
  adequate savings in that process.

8
ROSTOW, Walt W.(UT Austin 1969-2003)

• This is a linear theory of development. Economies
  can be divided into primary
• secondary and tertiary sectors. The history of
  developed countries suggests a common
• pattern of structural change The Stages of
  Economic Growth An Anti-Communist
• Manifesto (1960)
• Stage 1 Traditional Society
• Characterized by subsistence economic activity
  i.e. output is consumed by producers
• rather than traded, but is consumed by those who
  produce it trade by barter where
• goods are exchanged they are 'swapped'
  Agriculture is the most important industry
• and production is labor intensive, using only
  limited quantities of capital.
• Stage 2 Transitional Stage
• The precondition for takeoff. Surpluses for
  trading emerge supported by an emerging
• transport infrastructure. Savings and investment
  grow. Entrepreneurs emerge (
• how they emerge is not spelt out)
• Stage 3 Take Off
• Industrialization increases, with workers
  switching from the land to manufacturing.
• Growth is concentrated in a few regions of the
  country and in one or two industries.
• New political and social institutions are
  evolving to support industrialization.
• Stage 4 Drive to Maturity Growth is now diverse
  supported by technological
• innovation.

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Implications of Rostow's theory

• Development requires substantial investment in
  capital equipment (K) to
• foster growth in developing nations, the right
  conditions for such investment
• would have to be created i.e. the economy needs
  to have reached Stage 2.
• For Rostow
• Savings and capital formation (accumulation) are
  central to the process of growth, hence
  development
• 2. The key to development is to mobilize
  savings to generate the investment to set in
  train self generating economic growth.
• 3. Development can stall at Stage 3 for lack of
  savings. Suppose the deficiency in savings is on
  the order of 15-20 of GDP. If S 5 then
  foreign aid/loans of about 10-15 plugs this
  savings gap. Resultant investment means a move
  to Stage 4-Drive to Maturity and self generating
  economic growth, i.e. virtuous cycles (e.g.
  Botswana)and not vicious cycles (e.g. Argentina).
• 4. Once Stage 5(High Mass Consumption ) is
  achieved, this society continues to have high
  consumption and maintains such by incentives to
  savings plus additional key ingredients (good
  governance, property rights, human capital and
  functioning institutions)

10
Limitations of Rostow's Model

• 1.Rostow's model is limited. The determinants of
  a country's stage of
• economic development are usually seen in broader
  terms i.e. dependent on
• the quality and quantity of resources
• a country's technologies
• a countries institutional structures e.g. law of
  contract
• 2. Rostow explains the development experience of
  Western countries, well.
• However, Rostow does not explain the experience
  of countries with different
• cultures and traditions e.g. Sub Sahara
  countries which have experienced
• little economic development.
• Comment Rostows Stages of Economic Development
  was essentially a statement repudiating The
  Communist Manifesto!

11
Harrod-Domar Model

• Introduction to the Harrod-Domar model
• 1.The Harrod-Domar model developed in the l930s
  suggests savings provide the funds which are
  borrowed for investment purposes by firms
  (entrepreneurs). The economy's rate of growth
  (g)depends on
• a. the level of saving (S) and the savings ratio
  (s S/Y)
• b. the productivity of investment i.e. economy's
  capital-output ratio (K/Y ?). With depreciation
  (d0), g s/?
• Example if 8 (K) worth of capital equipment
  produces each 1 of annual output (Y), a
  capital-output ratio (?8/18)of 8 to 1 exists.
  A 3 to 1 ratio indicates that only 3 of capital
  is required to produce each 1 of output
  annually.

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The figure above plots the relationship between
historical rates of saving and recent income
levels. It is clear for both developing and
developed countries that the relationship is not
a fixed proportion as suggested by the H-D model.
Rather, the relationship appears to be nonlinear!
13
The Table provides further evidence of the
variability of the relationship between
investment ( and growth .
Notice that the ratio of investment to the change
in real GDP varies greatly not only among
countries but across countries as well. Thus, the
focus of the H-D model on rates of saving and
investment does not inform us very much about a
countrys rate of economic growth.
14
Harrod-Domar Model

• Growth-theoretical Problems not addressed by
  Smith and his
• followers.
• Dynamic interactions among macro variables and
  the associated distinction between flows (saving
  and investment, say as dollars per year) and
  stocks (capital, measured in dollars or pounds at
  a point in time). The distinction between flows
  and stocks is inherently a dynamic problem easily
  dealt with by mathematics.
• By definition, net investment (the increase in
  the capital stock depreciation) due to
  physical or economic wear. A high level of
  investment entails an increasing level of the
  capital stock. Thus high saving and investment
  are good for growth even if they are stationary,
  that is, not increasing.
• Without net investment, economic growth would be
  zero. Rapid depreciation due to investments of
  low quality is an important source of slow or
  even negative economic growth over long periods
  (SSA for example).

15
Harrod-Domar Model (continued)

• c. Link between efficiency and growth is a little
  complex. High levels of efficiency (via foreign
  trade or high human capital investment)
  contributes to growth by amplifying the effects
  of a given level of saving and investment on the
  growth of output. A steady accumulation of
  capital through saving and investment, given a
  level of efficiency and technology, translates
  capital accumulation into economic growth.
• d. Around the 1950s, Roy Harrod and Evsey Domar
  expressed these relationships in a simple
  equation which formalized over 200 years of
  theorizing about economic growth. According to
  Harrod-Domar, economic growth depends on just 3
  factors (a) saving rate --- determined by
  households (b) the capital/output ratio ----
  reflects the way firms base their demand for
  capital on the amount of output they want to
  produce and (c ) the depreciation rate ---- a
  consequence of the quality of investment
  decisions in the past.

16
Three Problems in the Harrod -Domar Model

• Assumption about the way households choose to
  between consumption (C ) and saving (S). Assumed
  households save a fixed proportion of income. Has
  a reasonable basis in theory.
• The way firms choose to adjust their capital
  stock to output. The assumption that firms want
  to keep their capital stock in a fixed proportion
  to their output (K/Y), which makes the
  capital/output ratio an exogenous behavioral
  parameter in the model. This requires further
  examination of the link between capital and
  output.
• H-D did not allow any room for a crucial factor
  of production, labor. H-D explains output growth
  solely by saving and efficiency and yet there was
  evidence even in the 1950s that population or
  labor-force growth should be included.
• These omissions and implausible assumptions lead
  to the Second Revolution the Neoclassical Model
  by Solow.

17
The Harrod-Domar Model
g is the rate of per capita growth. Given ?,d, s
and n, were should be able to achieve a desired
level of per capita growth (g). Problem this
assumes that d, ?, n, and s are exogenous. It
urns out that (1). savings (s) is endogenous, and
so is (2) population growth (n). Endogenous
Savings savings f(income per capita)
societies with different income levels exhibit
different savings (capital accumulation) and
hence investment, thus economic
growth. Endogenous population population growth
does change with the level of development, i.e.
the demographic transition model impacts
savings and hence economic growth.
18
Further Analysis of the H-D Model

• The Harrod-Domar model developed in the 1930s to
  analyze
• business cycles. it was later adapted to
  explain economic
• growth. Economic growth depends on the amount of
  labor and
• capital i.e. Y f(K,L) ceteris paribus on all
  other factors.
• Developing countries have an abundant supply of
  labor (L). So it
• is a lack of physical capital (K) that holds back
  economic growth
• hence economic development.
• (b) More physical capital generates economic
  growth(use Production Possibility Frontier (PPF)
  for illustration.)
• (c ) Net investment (i.e. investment over and
  above that needed
• to replace worn out capital (deprecation) leads
  to more producer goods
• (capital appreciation) which generates higher
  output and income. Higher
• income allows higher levels of saving
• Question Does an ?S??Y OR Does an ?Y??S?
• Older Theories suggested that ?S??Y BUT newer
  theories point to the possibilities that ?Y??S? .
  It is a causality issue and not correlation.

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Implications of the Harrod-Domar Model

• Economic growth requires policies that encourage
  saving and/or generate
• technological advances ( no explanation as to
  how to promote this), which
• lower capital-output ratio.
• Criticisms of the model Domar on Domar My
  purpose was to comment on
• business cycles, not to derive "an empirically
  meaningful rate of growth."
• (a) It is difficult to stimulate the desired
  level of domestic savings
• (b) Meeting a savings gap by borrowing from
  overseas causes debt repayment problems later and
  other associate issues (HIPC Bonos crusade)
• (c) Diminishing marginal returns to capital
  equipment exist so each successive unit of
  investment is less productive and the capital to
  output ratio rises. Attempts to stimulate FDI is
  less successful for slow-growing economies unless
  they possess oil and other strategic natural
  resources, e.g. Nigeria
• (d ) The amount of investment is just one factor
  affecting development e.g. supply side approach
  (free up markets) human resource development
  (education and training)
• (e ) Economic growth is a necessary but not
  sufficient condition for development
• (f) Sector structure of the economy important
  (i.e. agriculture v industry v services)