Jan 30 2012
As we study economic development in year 2 IB Economics, we examine different models for economic growth. Growth in GDP is not the only determinant of economic development, which in order to be measured effectively must account for human welfare determinants such as life expectancy, literacy rates, child mortality rates, distribution of income, and so on. However, it has been shown throughout history that economic growth, or the increase in real output and income, correlates directly with improvements in development factors like those above.
The reason? Increases in national income usually mean at least some levels of improvement in access to basic necessities for the average citizen in a developing country. Also, higher incomes mean more savings, which means greater access to capital for investment by entrepreneurs. More investment leads to greater productivity and rising incomes for those who join the emerging industrial and service sectors that usually accompany economic growth. Furthermore, rising incomes mean more tax revenue for governments, whose spending on public goods like education, health care, and infrastructure result in real improvements in standard of living for not just the emerging upper and middle classes, but the poor as well.
Of course, the following models can be observed to varying degrees among the world’s developing economies today. Some of these models will fail to play out if the institutional and political environment fails to create a stable atmosphere for savings and investment. What you should notice, however, is the underlying importance of savings in all three models. Poor countries suffering from low savings and, even worse, capital flight, are doomed to a cycle of poverty, where funds for investment leading to productivity increases are never made available due to instable institutions like banking and politics. To put a poor country on a path towards economic growth and development, a strategy is needed. Such strategies will be covered in a later post. For now, let’s look at the models:
The model suggests that the economy’s rate of growth depends on:
- the level of saving
- the productivity of investment i.e. the capital output ratio
The Harrod-Domar model was developed to help analyse the business cycle. However, it was later adapted to ‘explain’ economic growth. It concluded that:
- Economic growth depends on the amount of labour and capital.
- As LDCs often have an abundant supply of labour it is a lack of physical capital that holds back economic growth and development.
- More physical capital generates economic growth.
- Net investment leads to more capital accumulation, which generates higher output and income.
- Higher income allows higher levels of saving.
Lewis Structural Change (dual-sector) Model:
Many LDCs have dual economies:
- The traditional agricultural sector was assumed to be of a subsistence nature characterised by low productivity, low incomes, low savings and considerable underemployment.
- The industrial sector was assumed to be technologically advanced with high levels of investment operating in an urban environment.
Lewis suggested that the modern industrial sector would attract workers from the rural areas.
- Industrial firms, whether private or publicly owned could offer wages that would guarantee a higher quality of life than remaining in the rural areas could provide.
- Furthermore, as the level of labour productivity was so low in traditional agricultural areas people leaving the rural areas would have virtually no impact on output.
- Indeed, the amount of food available to the remaining villagers would increase as the same amount of food could be shared amongst fewer people. This might generate a surplus which could them be sold generating income.
Those people that moved away from the villages to the towns would earn increased incomes:
- Higher incomes generate more savings.
- Increased savings meant more fund available for investment.
- Increased investment meant more capital and increased productivity in the industrial sector, higher wages, more incentive to move from low productivity agriculture to high productivity industry, the circle continues…
In 1960, the American Economic Historian, WW Rostow suggested that countries passed through five stages of economic development.
According to Rostow development requires substantial investment in capital. For the economies of LDCs to grow the right conditions for such investment would have to be created. If aid is given or foreign direct investment occurs at stage 3 the economy needs to have reached stage 2. If the stage 2 has been reached then injections of investment may lead to rapid growth.
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