Economic development

Topics: Investment, Capital accumulation, Macroeconomics Pages: 5 (1641 words) Published: November 24, 2014
Development Economics Web Guide, Unit 5B
The causes of economic growth in
developing countries.
The significance of economic growth
for development
· The role of both physical and
human capital
· Technological progress

Examine the sources of
economic growth and the
extent to which they can be
affected by government

Evaluation of the impact of
government policies.

Factors affecting economic growth in developing countries
Keynesian Approaches

Savings and Investment

There are some economic facts of life that underpin all macroeconomic explanations of growth. Perhaps the most important is that in order for capital goods to be accumulated to produce greater quantities of consumer goods in the future, consumer goods have to be given up in the present. For example, if workers are building a textile factory they cannot simultaneously be making textiles – these will only appear in the future as a result of the sacrifices of the present.

Increases in the amount of capital goods are called investment. For growth to occur the level of investment has to be greater than the amount of depreciation, i.e. the amount by which machines wear out or become obsolete during the year. The higher the level of investment above depreciation the greater the potential output of the economy in the future.

Unfortunately, the resources to enable investment have to come from somewhere. The only way that workers can be freed from making cars to build car factories is by an increase in savings by households – i.e. by the postponement of any decision to buy goods today in favour of future consumption. Look now at the investment figures for your six case study countries and think about the differences between them, particularly those between Asian and Latin American countries. Notice also the very marked regional differences in investment and savings rates. The analysis above gives the traditional PPF model of economic growth. In the diagram below, a country starting with high levels of current consumption will have few resources available for investment. Its PPF will increase only slowly, if at all. A country succeeding in restricting consumption today will have an expanded PPF in the future, and can move to a point of higher consumption.

Issue 1 – May 2003
Authorised by Peter Goff

Development Economics Web Guide, Unit 5B




Consumer goods
In the diagram two countries starting with the same PPF, achieve two very different growth paths. The first country, by consuming less and therefore saving more, has a high degree of investment and moves from A to B. The second country consumes more initially, at C, but this allows a much smaller expansion of the PPF, resulting in less of both consumption and investment in the future at D.

This analysis suggests that a high rate of savings is a necessary condition for a high rate of growth in GDP. Government policy may have to make savings compulsory, or provide effective incentives for people to postpone consumption e.g. increased taxes. Governments may also feel the need to do the investment themselves, having enforced savings through taxation. An alternative is to borrow the necessary funds from other governments or from official aid agencies, paying back the interest from future growth.

Another important variable implicit in the diagram is the effectiveness of capital goods in producing consumer goods. Clearly, some new car factories are more productive than others – a lot depends on the technology employed and the human capital of the workers. The analysis therefore suggests that a growth orientated government should also target research and development and the education and skills of its workers.

The analysis above is an informal representation of the Harrod-Domar model. This model has been extremely influential in development economics. Evaluation of the model:

An increased level of savings is not a sufficient...
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