ECON 450 Development Economics - University Of … · 2017-06-26 · ECON 450 Development Economics Linear Stages Theories of ... In this lecture we’ll introduce the Linear Stages

The Harrod-Domar Growth ModelRostow’s Stages of Growth

The Harrod-Domar Growth Model Revisited

ECON 450Development Economics

Linear Stages Theories of Development

University of Illinois at Urbana-Champaign

Summer 2017

Henrique Veras de Paiva Fonseca ECON 450 Development Economics



Introduction

In this lecture we’ll introduce the Linear Stages Theory.Point: Economic growth is linearly related to investment levels.

We’ll discuss the Harrod-Domar Model, which presents themathematical representation of the theory.Next, we will see the Rostow’s Stages Theory as a set of steps inwhich every country should go through in their developmentprocess.Finally, the weak empirical evidence supporting the theory andthe surprising policy suggestions by international developmentagencies to poor countries will be reviewed.




Outline

1 The Harrod-Domar Growth Model

2 Rostow’s Stages of Growth

3 The Harrod-Domar Growth Model Revisited




The Harrod-Domar Growth Model

In April 1946, economics professor Evsey Domar published anarticle named "Capital Expansion, Rate of Growth andEmployment" discussing the relationship between short-termrecessions and investment in US.





Previously, in 1939, the British economist Roy Harrod hadpublished a similar article.Thus, the model became to be known as the Harrod-Domar (HD)Growth Model.





The HD model became, and still is, the most widely appliedgrowth model in economic history.The most attractive feature of the model is its simple prediction:"GDP growth will be proportional to the share of investmentspending in GDP."





Every economy must save a certain proportion of its nationalincome, if only to replace worn-out or impaired capital goods(buildings, equipment, and materials).However, in order to grow, new investments representing netadditions to the capital stock are necessary.The Harrod-Domar Growth Model builds up on the Solow’sframework. The basic equations are presented next.





Net saving (S) is some proportion, s, of national income (Y )

S = sY

Net investment (I) is defined as the change in the capital stock,K , such that

∆K = I





The capital-output ratio is defined as

c =KY

=∆K∆Y

Because net national savings, S, must equal net investment, I,we can write

I = S





It therefore follows that we can write the "identity" of savingequaling investment as

S = sY = c∆Y = ∆K = I

Dividing both sides of the above first by Y and then by c, weobtain the following expression

∆YY

=sc





The previous equation states simply that the rate of growth ofGDP (∆Y/Y ) is determined jointly by the net national savingsratio, s, and the national capital-output ratio, c.





More specifically, in the absence of government, the growth rateof national income will be directly or positively related to thesavings ratio and inversely or negatively related to the economy’scapital-output ratio.





The more they can save and invest, the faster they can grow.It follows that multiplying the rate of new investment, s = I/Y , byits productivity, 1/c, will give the rate by which national income orGDP will increase.





In addition to investment, two other components of economicgrowth are labor force growth and technological progress aspresented in the Solow Model.In the context of the Harrod-Domar model, labor force growth isnot described explicitly.





Technological progress can be expressed in the Harrod-Domarcontext as a decrease in the required capital-output ratio, givingmore growth for a given level of investment.




The Harrod-Domar Growth ModelObstacles and Constraints

We learn that one of the most fundamental strategies ofeconomic growth is simply to increase the proportion of nationalincome saved.If we assume that the national capital-output ratio in some lessdeveloped country is, say, 3 and the aggregate net saving ratio is6% of GDP, we have

∆YY

=sc

=6%

3= 2%

The main obstacle to or constraint on development, according tothis theory, is the relatively low level of new capital formation inmost poor countries.





Advocates of the model applied the model to poor countries todetermine a "required" investment rate for a target growth rate.The difference between the "required" and actual investment rateis called the financing gap.

That is, the amount of foreign investment needed to achieve thetarget growth.




The Harrod-Domar Growth ModelExample

1 Given a capital-output ratio of 1.5, find the savings rate a societyneeds to have in order to grow at a rate of 8.2%.

2 The target GDP growth rate of a country is 9.3%. In a givenperiod, the stock of capital was worth 21,000 million dollars,while the product reached $55,000 million. The savings rate ofthis economy is 1%. Find the financing gap.




The Harrod-Domar Growth ModelExample

1 Given a capital-output ratio of 1.5, find the savings rate a societyneeds to have in order to grow at a rate of 8.2%.

2 The target GDP growth rate of a country is 9.3%. In a givenperiod, the stock of capital was worth 21,000 million dollars,while the product reached $55,000 million. The savings rate ofthis economy is 1%. Find the financing gap.




Outline







Rostow’s Stages of Growth

The next step in the evolution of the financing gap (HD model)was to persuade developed countries to provide the required aidto the poor nations.The most influential and outspoken advocate of thestages-of-growth model of development was the Americaneconomic historian Walt W. Rostow.





According to Rostow, the transition from underdevelopment todevelopment can be described in terms of a series of steps orstages through which all countries must proceed.

1 the traditional society,2 the preconditions for take-off into self-sustaining growth,3 the take-off,4 the drive to maturity,5 the age of high mass consumption





The advanced countries, it was argued, had all passed the stageof "takeoff" into "self-sustaining growth".The underdeveloped countries that were still in either thetraditional society or the "preconditions" stage had only to followa certain set of rules of development to take off in their turn intoself-sustaining economic growth.





One of the principal strategies of development necessary for anytakeoff was the mobilization of domestic and foreign saving inorder to generate sufficient investment to accelerate economicgrowth.The economic mechanism by which more investment leads tomore growth can be described in terms of the Harrod-Domargrowth model.





How to convince rich nations to finance development policies indeveloping nations?During the cold war, Rostow saw in Russia "a nation surging asan industrial power of first order".

"Soviet willingness to extract large forced savings".





The fear of the Third World becoming communist made richnations to increase their foreign aid to those countries.Rostow was part of the government on both Kennedy’s andJohnson’s administrations.

During this time, American foreign aid increased by 25 percent inconstant dollars.








Outline








The HD model proposes the following linkage:

Foreign aid ⇒ Investment ⇒ Growth

Can this linkage be observed in the real world?




The Harrod-Domar Growth Model RevisitedTesting the Model

The economist William Easterly tested this model for a sample of88 countries on which data were available spanning the period1965 to 1995.Take the first link: aid to investment.This link should pass two tests:

1 There should be a positive statistical association between aid andinvestment;

2 Aid should pass into investment at least one for one.





How did the first link do on these tests?On the first test, only 17 of the 88 countries passed.Just 6 of these 17 countries also passed the second test.

Why do we see these results?Poor countries have little incentive to invest.Foreign aid would be more beneficial if used to buy moreconsumption goods.





The next question Easterly addresses is: Does investment havea quick growth payoff, as the HD model assumes?To answer this question, he observes data on growth andinvestment for 138 countries.Again, two tests:

1 Countries should display a positive statistical association betweengrowth and last year’s investment.

2 The investment-growth relationships should be in what he calls"usual range" to give reasonable financing gaps.

Only 4 countries passed both tests.





Overall, in his empirical exercise, Easterly found only one countrythat passed all four tests.That is, he found no evidence supporting the HD model.





In fact, Domar himself admitted that the assumption of productioncapacity being proportional to the stock of capital is unrealistic.He argued that his earlier purpose was to comment on ashort-run relationship between capital and business cycle.What is interesting is the fact that his model has been used forpolicy interventions around the world!




The Harrod-Domar Growth Model RevisitedStill being used

World Bank economist John Holsen developed a computerprogram that he called the minimum standard model (MSM),which calculates the financing gap given the target growth rate.A group of co-workers revised the MSM later on and renamed itthe revised minimum standard model (RMSM).

The growth part of the RMSM was the HD model.




The Harrod-Domar Growth Model RevisitedStill being used

World Bank and other international financial institutions (IFIs)today still use the HD model to make aid, investment, and growthprojections.

Total GDP in Guyana fell sharply from 1980 to 1990 as investmentwas increasing from 30 percent to 42 percent of GDP, and whileforeign aid every year was 8 percent of Guyana’s GDPYet, a World Bank report in 1993 argued that Guyana "will continueto need substantial levels of foreign capital inflows.. to providesufficient resources to sustain economic growth."




The Harrod-Domar Growth Model RevisitedOne last piece of evidence


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ECON 450 Development Economics - University Of … · 2017-06-26 · ECON 450 Development Economics Linear Stages Theories of ... In this lecture we’ll introduce the Linear Stages