ECON 1023 Economic Development Growth Theories PDF

COURSE LEARNING MODULE ECON 1023 (Economic Development) AY 2024-2025 Lesson 5 and 6: Growth Theories Topic: The Keynesian...

COURSE LEARNING MODULE ECON 1023 (Economic Development) AY 2024-2025 Lesson 5 and 6: Growth Theories Topic: The Keynesian Model and the Harrod-Domar model The Solow or Neoclassical Theory Power Balance Theory Structuralist Theory New Growth Theory Learning Outcomes: At the end of this module, you are expected to: - Explain and illustrate the different growth models through group broadcasting; - Appreciate the concepts of the different growth models. LEARNING CONTENT Introduction: There are a number of theories on how the process of economic development takes place. A very broad interpretation of these theories could consider five alternative approaches. Components of these theories have been used to explain particular aspects of the rapid growth of East Asian economies. We then look at the growth experience of the Asian region drawing on selected aspects of the theories to determine what factors have been most influential in driving regional growth. Lesson Proper: GROWTH THEORIES KEYNESIAN THEORY This model stresses the accumulation of capital. They include Rostow’s (1960) stages of growth model and the Harrod-Domar growth model (see Harrod, 1939; and Domar, 1946) which will be discussed below. Growth among countries using these models could easily diverge. The models do not explicitly consider the law of diminishing returns to capital which can take effect as growth proceeds. In this sense, they are not particularly realistic. ECON 1023-Economic Development | 1 The Keynesian Growth Theory and the Harrod-Domar Model  It is a classical Keynesian model of economic growth that is used in development economics to explain an economy’s growth rate in terms of the level of saving and productivity of capital.  The Harrod-Domar (1939, 1946) model is the simplest macroeconomic model. It begins with the assumption that saving is a constant proportion of income. We first define income Y as the sum of consumption C and saving S, and that saving equals investment. The Harrod-Domar model of growth seeks to explain two (2) basic questions relating to growth problems of developed countries. They are: 1. What are the requirements to maintain steady rate of growth of full employment income without inflation and deflation? 2. Is long run full employment equilibrium of a developed economy possible without secular stagnation or secular inflation? This model provides gainful suggestions to above questions: Regarding steady rate of growth of full employment income, Harrod_Domar model conveys that rate of investment should increase at a rate equal to the proportion between marginal propensity to save and capital output ratio. As regards second question, Harrod-Domar are of the view that it is difficult to maintain steady rate of growth of full employment in a capitalist economy. There are possibilities of secular inflation or secular deflation in the capitalist economy. The Harrod Domar Model suggests that the rate of economic growth depends on two things: 1. Level of Savings (higher savings enable higher investment) 2. Capital-Output Ratio. A lower capital-output ratio means investment is more efficient and the growth rate will be higher. A simplified model of Harrod-Domar: ECON 1023-Economic Development | 2  Source:https://www.economicshelp.org/blog/498/economics/harod-domar-model-of-growth-and-its-limitations/ Main factors affecting economic growth  Level of savings. Higher savings enable greater investment in capital stock  The marginal efficiency of capital. This refers to the productivity of investment, e.g. if machines costing $30 million increase output by $10 million. The capital-output ratio is 3  Depreciation – old capital wearing out. Three kinds of Growth according to Harrod-Domar: 1. Warranted Growth Rate – also known as “full-capacity” growth rate Roy Harrod introduced a concept known as the warranted growth rate.  This is the growth rate at which all saving is absorbed into investment. (e.g. $80 of saving = $80 of investment.  Let us assume, the saving rate is 10% and the capital-output ratio is 4. In other words, $10 of investment increases output by $2.5.  In this case, the economy’s warranted growth rate is 2.5 percent (ten divided by four).  This is the growth rate at which the ratio of capital to output would stay constant at four. 2.The Natural Growth Rate  The natural growth rate is the rate of economic growth required to maintain full employment.  If the labour force grows at 3 percent per year, then to maintain full employment, the economy’s annual growth rate must be 3 percent.  This assumes no change in labour productivity which is unrealistic. ECON 1023-Economic Development | 3 3.Actual Growth  It is determined by the actual rate of savings and investment in the country. In other words, it can be defined as the ratio of change in income to the total income in the given period. Importance of Harrod-Domar It is argued that in developing countries low rates of economic growth and development are linked to low saving rates. This creates a vicious cycle of low investment, low output and low savings. To boost economic growth rates, it is necessary to increase savings either domestically or from abroad. Higher savings create a virtuous circle of self-sustaining economic growth. Impact of increasing capital The transfer of capital to developing economies should enable higher growth, which in turn will lead to higher savings and growth will become more self-sustaining. The Main points of the Harrod-Domar Analysis 1. Investment is the central variable of stable growth and it plays a double role; on the one hand, it generates income and on the other hand, it creates productive capacity. 2. The increased capacity arising from investment can result in greater output or greater unemployment depending on the behavior of income. 3. Conditions concerning the behavior of income can be expressed in terms of growth rates and equality between the three growth rates can ensure full employment of labor and full utilization of capital stock. 4. These conditions, however, specify only a steady-state growth. The actual growth rate may differ from the warranted growth rate. If the actual growth rate is greater than the warranted rate of growth, the economy will experience cumulative inflation. If the actual growth rate is less than the warranted growth rate, the economy will slide towards cumulative inflation. If the actual ECON 1023-Economic Development | 4  growth rate is less than the warranted growth rate, the economy will slide towards cumulative deflation. 5. Business cycles are viewed as deviations from the path of steady growth. These deviations cannot go on working indefinitely. These are constrained by upper and lower limits, the full employment ceiling acts as an upper limit and effective demand composed of autonomous investment and consumption acts as the lower limit. The actual growth rate fluctuates between these two limits. Criticisms of Harrod-Domar Model  Developing countries find it difficult to increase saving. Increasing savings ratios may be inappropriate when you are struggling to get enough food to eat.  Harrod based his model on looking at industrialised countries post-depression years. He later came to repudiate his model because he felt it did not provide a model for long-term growth rates.  The model ignores factors such as labour productivity, technological innovation and levels of corruption. The Harrod-Domar is at best an oversimplification of complex factors which go into economic growth.  There are examples of countries who have experienced rapid growth rates despite a lack of savings, such as Thailand.  It assumes the existences of a reliable finance and transport system. Often the problem for developing countries is a lack of investment in these areas.  Increasing capital stock can lead to diminishing returns. Domar was writing during the aftermath of the Great Depression where he could assume there would always be surplus labour willing to use the machines, but, in practice, this is not the case.  The Model explains boom and bust cycles through the importance of capital, (see accelerator theory) However, in practice businesses are influenced by many things other than capital such as expectations.  Harrod assumed there was no reason for the actual growth to equal natural growth and that an economy had no tendency to full employment. However, this was based on the assumption of wages being fixed.  The difficulty of influencing saving levels. In developing economies it can be difficult to increase savings ratios – because of widespread poverty.  The effectiveness of foreign capital flows can vary. In the 1970s and 80s many developing economies borrowed from abroad, this led to an inflow of foreign capital however, there was a lack of skilled labour to make effective use of capital. This led to very high capital-output ratios (poor productivity) and growth rates didn’t increase significantly. However, developing economies were left with high debt repayments and when interest rates rose, a large proportion of national savings was diverted to paying debt repayments.  Economic development implies much more than just economic growth. For example, who benefits from growth? Does higher national income filter through to improved health care and education. It depends on how the capital is used.  Definition of the Accelerator Effect The accelerator effect states that investment levels are related the rate of change of GDP. Thus an increase in the rate of economic growth will cause a correspondingly larger increase in the level of investment. But, a fall in the rate of economic growth will cause a fall in investment levels. ECON 1023-Economic Development | 5  SOLOW OR NEOCLASSICAL THEORY These models stress the neoclassical economic principle that factors of production should be paid the value of their marginal products. In these models, the law of diminishing returns can operate and there is mobility of factors to seek their highest return. These models have all been developed on the basis of the Solow-Swan (1956) model. They were favored by most mainstream economists for more than thirty years-from the early 1960s or late 1950s when the Solow model was first published until quite recently. These models show a convergence in growth among countries and also imply that there will be a slowdown in growth in the absence of technical progress as a result of diminishing returns. What is the Solow Growth Model? The Solow Growth Model is an exogenous model of economic growth that analyzes changes in the level of output in an economy over time as a result of changes in the population growth rate, the savings rate, and the rate of technological progress. The Solow Growth Model, developed by Nobel Prize-winning economist Robert Solow, was the first neoclassical growth model and was built upon the Keynesian Harrod-Domar model. The Solow model is the basis for the modern theory of economic growth. Simplified Representation of the Solow Growth Model Below is a simplified representation of the Solow Model. Assumptions: 1. The population grows at a constant rate g. Therefore, current population (represented by N) and future population (represented by N’) are linked through the population growth equation N’ = N(1+g). If the current population is 100 and the growth rate of population is 2%, the future population is 102. 2. All consumers in the economy save a constant proportion, ‘s’, of their incomes and consume the rest. Therefore, consumption (represented by C) and output (represented by Y) are linked through the consumption equation C= (1+s)Y. If a consumer earns 100 units of output as income and the savings rate is 40%, then the consumer consumes 60 units and saves 40 units. 3. All firms in the economy produce output using the same production technology that takes in capital and labor as inputs. Therefore, the level of output (represented by Y), the level of capital (represented by K), and the level of labor (represented by L) are all linked through the production function equation Y = aF(K,L). The Solow Growth Model assumes that the production function exhibits constant-returns-to-scale (CRS). Under such an assumption, if we double the level of capital stock and double the level of labor, we exactly double the level of output. As a result, much of the mathematical analysis of the Solow model focuses on output per worker and capital per worker instead of aggregate output and aggregate capital stock. ECON 1023-Economic Development | 6  4. Present capital stock (represented by K), future capital stock (represented by K’), the rate of capital depreciation (represented by d), and level of capital investment (represented by I) are linked through the capital accumulation equation K’= K(1-d) + I. Implications of the Solow Growth Model There is no growth in the long term. If countries have the same g (population growth rate), s (savings rate), and d (capital depreciation rate), then they have the same steady state, so they will converge, i.e., the Solow Growth Model predicts conditional convergence. Along this convergence path, a poorer country grows faster. Countries with different saving rates have different steady states, and they will not converge, i.e. the Solow Growth Model does not predict absolute convergence. When saving rates are different, growth is not always higher in a country with lower initial capital stock. Source:https://corporatefinanceinstitute.com/resources/knowledge/economics/solow-growth-model/ POWER-BALANCE THEORY These models stress international power balance as an important factor in development, including the terms and patterns of trade which tend to keep some countries poor while other countries get richer. In one sense, the international power-balance model can be considered as a subclass of the neoclassical model where there is a lack of factor mobility in international trade. In addition, these theories, which were popular when North-South issues were being stressed, were based on the assumption that the poor “southern” economies were being exploited by the rich industrial “northern” countries. In these models, the poor countries export raw materials to the industrial countries in exchange for industrial goods. Because the terms of trade (that is, the price of raw materials vis-a-vis manufactured goods) tend to deteriorate over time, the power balance theories assert that the poor countries have to export more and more raw materials in order to keep from slipping backward. As a result, their development is retarded. The development of industrial capacity in East and Southeast Asia, and in some Latin American countries, has caused these theories. to become discredited generally, although there are elements of truth in this paradigm in Africa, where raw materials are still the main exports. These theories also assume that when incomes are low, these countries will not be able to save much. Thus, the assumption is that the saving rate is not independent of income, as in the Harrod-Domar model. In addition, because of poverty, it is difficult to achieve high productivity in agriculture or even to improve productivity in agriculture. Balance of power (International relations) (Source:https://www.britannica.com/topic/balance-of-power) Balance of power, in international relations, the posture and policy of a nation or group of nations protecting itself against another nation or group of nations by matching its power against the power of the other side. States can pursue a policy of balance of power in two ways: by increasing their own power, as when engaging in an armaments race or in the competitive acquisition of territory; or by adding to their own power that of other states, as when embarking upon a policy of alliances. The term balance of power came into use to denote the power relationships in the European state system from the end of the Napoleonic Wars to World War I. Within the European balance of power, Great Britain played the role of the “balancer,” or “holder of the balance.” It was not permanently identified with the policies of any European nation, and it would throw its weight at one time on one side, at another time on another side, guided largely by one consideration—the maintenance of the balance itself. Naval supremacy and its virtual immunity from foreign invasion enabled Great Britain to perform this function, which made the European balance of power both flexible and stable. ECON 1023-Economic Development | 7  STRUCTURALTHEORY These models emphasize the shifts in resources between different sectors on the supply side. These theories discuss the transition from labor-intensive agriculture, which relies on traditional, low-productivity farming techniques, to modern, high productivity industries which have benefited from innovation and more intensive use of capital and technology. The structuralist approach models economic growth as a process of shifts in resources among sectors. It stresses rigidities that hinder this shift in resources and it studies how the shift in output among different sectors takes place over time as development progresses. In particular, a systematic shift in output has been observed in the process of development in the industrial countries, as well as in many developing countries. This process involves a decline in agriculture’s contribution to GDP, an increase in industrial output up to a point when it too begins to decline, and finally an increase in the component of services income as a share of GDP, which has not yet begun to decline. As a result, very rich countries, such as the United States, have a very large proportion of GDP in the services sector-as much as 60 to 70 percent. Agriculture contributes a very small part in terms of value added to GDP, perhaps 6 percent, while industry makes up the difference. In rapidly-growing industrializing countries, the share of industry would be larger and still growing, while agriculture would be large but falling. Although services would be rising, it would have a smaller share in GDP. A very poor country would have most of its resources in agriculture and very little in services or manufacturing. The source of rapid growth, from the structuralist point of view is manufacturing. Productivity increases faster in manufacturing and remains high for many years as technological developments are made or copied from other countries. The reason that industrial countries grow slowly, from this perspective, is that productivity in the services sector has historically been low and has not grown as fast as productivity in manufacturing. Although this may be changing as a result of the technological revolution, leading to higher rates of growth, this “new productivity revolution” has not yet been firmly established. Lower growth in the services sector is still a drag on the economic performance of the industrial countries. Another contributing factor to slower growth in the industrial countries is that their rates of saving and investment are lower than in rapidly growing poorer countries. Therefore, the industrial countries have to depend to a greater extent on TFP and new innovations, as well as human capital development through education for their growth. The Lewis-Fei-Ranis Model This model is under the structuralist theory. A very well-known theory of development is the so-called Lewis Fei-Ranis (LFR) model (Lewis, 1954; and Fei and Ranis, 1961). There are elements of this model which are very important to understanding the pattern of development in many countries. It tries to explain how the process of industrialization takes place and how inefficiencies can arise. There are two sectors in the LFR model: a modern sector and a traditional sector. The former is primarily based in cities and the latter in the countryside. The rural sector has low capital accumulation and low labor skill. Its productivity and earnings capabilities are also very low. The modern sector has high productivity and pays higher wages. Labor thus moves from the countryside to the city to take advantage of wage differentials. Fei–Ranis model of economic growth (source: https://en.wikipedia.org/wiki/Fei%E2%80%93Ranis_model_of_economic_growth) The Fei–Ranis model of economic growth is a dualism model in developmental economics or welfare economics that has been developed by John C. H. Fei and Gustav Ranis and can be understood as an extension of the Lewis model. It is also known as the Surplus Labor model. It recognizes the presence of a dual economy comprising both the modern and the primitive sector and takes the economic situation of unemployment and underemployment of resources into account, unlike many other growth models that consider underdeveloped countries to be homogenous in nature. According to this theory, the primitive sector consists of the existing agricultural sector in the economy, and the modern sector is the rapidly emerging but small industrial sector. Both the sectors co-exist in the economy, wherein lies the crux of the ECON 1023-Economic Development | 8 development problem. Development can be brought about only by a complete shift in the focal point of progress from the agricultural to the industrial economy, such that there is augmentation of industrial output. This is done by transfer of labor from the agricultural sector to the industrial one, showing that underdeveloped countries do not suffer from constraints of labor supply. At the same time, growth in the agricultural sector must not be negligible and its output should be sufficient to support the whole economy with food and raw materials. Like in the Harrod–Domar model, saving and investment become the driving forces when it comes to economic development of underdeveloped countries. Fei–Ranis model of economic growth has been criticized on multiple grounds, although if the model is accepted, then it will have a significant theoretical and policy implications on the underdeveloped countries' efforts towards development and on the persisting controversial statements regarding the balanced vs. unbalanced growth debate.  It has been asserted that Fei and Ranis did not have a clear understanding of the sluggish economic situation prevailing in the developing countries. If they had thoroughly scrutinized the existing nature and causes of it, they would have found that the existing agricultural backwardness was due to the institutional structure, primarily the system of feudalism that prevailed.  Fei and Ranis say, "It has been argued that money is not a simple substitute for physical capital in an aggregate production function. There are reasons to believe that the relationship between money and physical capital could be complementary to one another at some stage of economic development, to the extent that credit policies could play an important part in easing bottlenecks on the growth of agriculture and industry." This indicates that in the process of development they neglect the role of money and prices. They fail to differ between wage labor and household labor, which is a significant distinction for evaluating prices of dualistic development in an underdeveloped economy.  Fei and Ranis assume that MPPL is zero during the early phases of economic development, which has been criticized by Harry T.Oshima and some others on the grounds that MPPL of labor is zero only if the agricultural population is very large, and if it is very large, some of that labor will shift to cities in search of jobs. In the short run, this section of labor that has shifted to the cities remains unemployed, but over the long run it is either absorbed by the informal sector, or it returns to the villages and attempts to bring more marginal land into cultivation. They have also neglected seasonal unemployment, which occurs due to seasonal change in labor demand and is not permanent NEW GROWTH THEORY The most recent growth theories, simply called “new growth theories” try to endogenize technical progress and make use of assumptions of increasing returns to scale and positive externalities. These assumptions contrast sharply with the neoclassical model which stresses diminishing returns and a slowdown of growth to a steady-state rate. The new growth theory has been developed in the last decade by a number of younger economists who became dissatisfied with the Solow-Swan (1956) model. The new growth theory attempts to endogenize technical change by using external economies and spillovers. These operate on the basis of beneficial effects which new technology and higher levels of education have on other sectors of the economy. These externalities help to generate increasing returns to scale and drive the growth process to higher levels of income, instead of slowing growth through diminishing returns. One of the important features of this model is the mechanism by which technology is transferred from one firm to another within an industry in a single country and then across international borders. One group of economists working on this model contends that ECON 1023-Economic Development | 9 the development of new technology in industrial countries is passed on to other countries quite slowly so that there is little tendency for convergence to take place. Others argue that the process is swifter (Barro and Sala-I Martin, 1995; and Grossman and Helpman, 1991). New Growth Theory (Source:https://www.economicsonline.co.uk/global_economics/new_growth_theory.html) New Growth theory is closely associated with American economist, Paul Romer. A central proposition of New Growth theory is that, unlike land and capital, knowledge is not subject to diminishing returns. The importance of knowledge Indeed, a focus on the development of knowledge is seen as a key driver of economic development. The implication is that, in order to develop, economies should move away from an exclusive reliance on physical resources to expanding their knowledge base, and support the institutions that help develop and share knowledge. Governments should invest in knowledge because individuals and firms do not necessarily have private incentives to do so. For example, while knowledge is a merit good, and acquiring it does not deny anyone else that knowledge (the principle of nonrivalry of knowledge), its usefulness to individuals and firms may be undervalued, and yet knowledge can generate increasing returns and drive economic growth. Government should, therefore, invest in human capital, and the development of education and skills. It should also support private sector research and development and encourage inward investment, which will bring new knowledge with it. The role of the public sector Because ‘public’ investment in social capital is subject to market failure, New Growth theorists argue that government should allocate resources to compensate for this failure. Public Utilities and infrastructure Essential utilities like electricity, gas, and water are natural monopolies, and in many countries are provided by the public sector. However, if these utilities are under-supplied due to inadequate public funds, the private sector will suffer and growth will be limited. This is because the industrial sector relies on energy and water for its production and distribution, without which it will not produce efficiently or competitively. The accumulation of private capital, therefore, depends up the correct level of expenditure by government. Similarly, New Growth theorists argue that government should also finance, or seek finance for, infrastructure projects, such as road, rail, sea, and air transport. Such projects involve the creation of quasi- public goods, and the theory of market failure suggests that they would be ‘under-supplied’ without government. The huge fixed costs and the difficulty of charging users prevents the private sector supplying, and the state may choose to act like a producer and financier, and provide necessary legislation for and co- ordination of such projects. These projects also generate positive externalities, and as such justify government involvement. For example, an improved infrastructure increases the likelihood of tourist revenue as well as reducing production costs. *** END of LESSON *** REFERENCES ECON 1023-Economic Development | 10 Dowling, J.Malcolm, Valenzuela, Ma.R.,Brux, J. (2019) Economic Development Philippine Edition. Cengage learning Asia Pte Ltd. Online references https://en.wikipedia.org/wiki/Fei%E2%80%93Ranis_model_of_economic_growth) https://www.economicsonline.co.uk/global_economics/new_growth_theory.html) https://www.economicshelp.org/blog/498/economics/harod-domar-model-of-growth-and-its-limitations/ https://corporatefinanceinstitute.com/resources/knowledge/economics/solow-growth-model/ https://www.britannica.com/topic/balance-of-power) WARNING: No part of this E-module/LMS Content can be reproduced, or transported or shared to others without permission from the University. Unauthorized use of the materials, other than personal learning use, will be penalized. Please be guided accordingly. ECON 1023-Economic Development | 11