Development Economics Web Guide, Unit 5B

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Authorised by Peter Goff

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
intervention.

Evaluation of the impact of
government policies.

Factors affecting economic growth in developing countries

Keynesian Approaches

1

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.

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Capital
goods

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 condition for growth. For a

start, the savings funds have to find their way to people who are willing to take
the risk of investing. Provided they get the funds at reasonable rates of interest
they then have to be able to make informed choices about the kind of
investment needed e.g. what consumer tastes in the future are likely to be.

A

B

D

C

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· There are also problems coordinating investment projects – often firms will

only invest if other firms are also investing, e.g. providing intermediate goods,
infrastructure support or external economies of scale. Indeed, the two-good
PPF model illustrated in the diagram may be rather misleading because it
leaves out of the picture the extent to which the various sectors of the
economy are in tune with each other.

· The extent to which the savings rate can be influenced by government policy

may be very limited. The trouble is that the savings rate cannot really be taken
as independent of the level of GDP. To some extent people’s willingness to
save depends on their income – with people generally less inclined to save
when their incomes are low. For example, in developed countries it is usual
for people to borrow money when starting employment and only to start
saving when their salaries are higher later on in their careers.

· The situation is much more acute for people below the poverty line in

developing countries. The prospect of future growth in GDP may act as a
disincentive to do the savings necessary for that growth. What makes sense for
the economy as a whole may not appear to be at all sensible for the individuals
making the decisions.

· A further major problem with the arguments of the Harrod-Domar model is its

assumption that increases in capital automatically expand the PPF.
Unfortunately, extra capital for a given quantity of labour can only bring a
certain amount of growth. At some point the economy will run into
diminishing returns, i.e. a shortage of labour. This suggests that the level of
savings is much less important than the rate of technological change.

Some countries have compulsory savings laws e.g. Singapore. But perhaps this works
only if the economy is already growing fast enough to provide the economic and
political basis on which to sustain compulsory savings. There is also a need for
potential savers to trust the financial system – e.g. that there will be a low inflationary
environment and that institutions are safe places to deposit money.

2

Government-Financed Investment

It may be the case that governments are not well enough informed to make investment
decisions which reflect market circumstances. However, some kinds of investment are
subject to market failure and government provision may therefore be necessary.

For example, the provision of infrastructure is difficult to achieve in a free market – it
has too much of a public good aspect to be provided effectively by private companies.
There are also obvious positive externalities associated with an efficient, well
maintained, and reliable infrastructure.

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Market-Based Approaches

3

Macroeconomic Stability

General macroeconomic conditions are very important in terms of the general climate
under which investment decisions are made. So economic growth will depend to some
extent upon the stability of the economy e.g. fiscal balance, and reasonably
predictable levels of inflation.

Macroeconomic stability reduces the risks of investment and might therefore be seen
as a necessary condition for growth. Fiscal balance ensures that there is less risk of
inflation, because there will be less risk of governments printing money. This may
also stabilise the exchange rate and allow interest rates to be set at a reasonably low
level - so further encouraging investment.

Stability is also an important factor in the amount of foreign direct investment a
country may be able to attract. For developing countries this may be the only realistic
source of investment funds.

4

Trade Liberalisation, Capital Mobility and Exchange Rate Policy

The abolition of trade restrictions (tariffs and quotas) is often seen as a necessary
condition for growth. The idea is to widen markets and thus allow economies of scale
in exporting industries.

It is often argued that exchange rates need to be adjusted downwards at the same time,
to ensure that potential exporters can compete on world markets.

To encourage direct foreign investment restrictions on international capital flows may
need to be reduced.

These policies have often been introduced to satisfy the conditions of IMF loans – this
is discussed in more detail under structural adjustment policies. However, such
policies are extremely controversial. Free trade did not seem to be a necessary
condition for European growth. Certainly, exposure to foreign competition may
increase the productivity of companies that survive but the side-effects for what are
likely to be some of the poorest people in developing countries are likely to be severe.

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Resources for Pupils

http://www.worldbank.org/research/growth/

- a selection of articles of varying levels

of difficulty discussing factors affecting growth rates in developing countries.

http://www.bized.ac.uk/virtual/dc/copper/theory/th5.htm

The Bized ‘virtual Zambia’

site.

Suggested Activity

Go to the Bized virtual Zambia site listed above. Work through the following
subsequent theory pages on the Harrod-Domar model. How do these theories apply to
Zambia?

Compare and contrast the growth rates of two Sub-Saharan countries, e.g. Ghana and
Uganda. What factors might explain the difference in these growth rates?

Questions for Discussion

1

Examine the proposition that high levels of savings are a necessary but not a

sufficient precondition for economic growth.

2

“No single factor can explain differences in growth rates between developing

countries.” Discuss

3

Using the data in your “country at a glance” sheets, compare and contrast the

savings and growth rates of your six case study countries.

4

To what extent can a government influence the rate of growth of a developing

country?