Assignment Ppt

ASSIGNMENT: GROUP 5

MIB/MIT2010/2011

Question

• Explain and give critic to the Harrod Domar model in relation to economic growth in Africa.

Introduction

• Economic growth is an increment of attribute characterized the economy of a given nation, custom territory regional or global eg. GDP, GNP, Employment/unemployment rate and Balance of payment.

Introduction cont..

• Or, a positive change in the level of production of goods and services by a country over a certain period of time. Nominal growth is defined as economic growth including inflation, while real growth is nominal growth minus inflation. Economic growth is usually brought about by technological innovation and positive external forces.

Introduction Cont…

• Economic growth is central problem of almost all nations and capital accumulation is at the center of economic growth - especially in less developed countries. Although the importance of capital accumulation was recognized long time ago (see Harrod, 1939; Domar, 1946; Lewis, 1954.


• Less developed countries have generally failed to finance the desired level of investment out of their own resources (savings). This condition called for foreign aid as an optimal means to break the ‘vicious circle of poverty’ experienced by these poor countries and fasten the transformation process.


• Early ‘structural’ development models such as Harrod-Domar growth model and two-gap model of Chenery and Strout (1966) showed how foreign aid would enable developing countries to transform their economies.

Harrod-Domar Growth Model

• This model is named after two famous economists: Sir Roy Harrod of England and Professor Evesey Domar of the US who independently formulated the model during the 1940s.

Harrod-Domar Growth Model

• They developed an economic growth model based on a fixed-coefficient, constant returns to scale function (this function assumes that capital and labor are used in a constant ratio to each other to determine total output – see graph). Outputs in this graph are isoquants (combinations of labor and capital that produce output).

Assumptions of Model

• The model assumes that labor and capital are always used in a fixed proportion to produce out equal amounts of output. The model’s equation is Y = K/v where v is a constant found by dividing capital (K) by investment (Y) – v is the capital-output ratio. This ratio is primarily a measure of the productivity of capital or investment.

Assumptions cont…..

• 1: Output is a function of capital stock• 2: The marginal product of capital is constant;

the production function exhibits constant returns to scale. This implies capital's marginal and average products are equal.

• 3: Capital is necessary for output.

Assumptions cont…..

• 4: The product of the savings rate and output equals saving, which equals investment.

• 5: The change in the capital stock equals investment less the depreciation of the capital stock

.

Graphical representation of Harrod-Domar Model

How the Model works

• The model focuses on two critical aspects of the growth process: saving and the efficiency with which capital is used in investment. This model can provide accurate short term predictions of growth and has been used extensively in developing countries to determine the “required” investment rate or “financing gap” to be covered in order to achieve a target growth rate.

How the Model works

• The basic model assumes that it is a closed economy and that there is no government, no depreciation of existing capital so that all investment is net investment, and that all investment (I) comes from savings (S).

• Assume that there is a relationship between the total capital stock, K, and total GDP, Y.

How the Model works

• For example, if Tshs 3 of capital is always necessary to produce Tshs 1 of GDP, it follows that any net additions to the capital stock in the form of new investment will bring about a corresponding increase in national output, GDP.

How the Model works

• Now suppose that this ratio, known as the capital-output ratio, is 3 to 1, and we define this as v.

• Assume that the national saving ratio, s, is a fixed proportion of national output.

• Assume that total new investment is determined by

the level of total savings.

How the Model works

Therefore:Savings, S, is some proportion, s, of national income, Y, such that

S = s (Y)

Investment, I, is defined as the change in capital stock, K, such that:

I = ∆K

How the Model works• Total capital stock, K, bears a direct relationship

to total national output(or income), Y, as expressed by the capital-output ratio, v, (new investment as a percentage of GDP) then:

K = vY or K/Y = v or

∆K/∆Y = v or

∆K = v (∆Y)

How the Model works

• The Harrod-Domar Equation of economic development that states that:

The rate of growth of GDP (∆Y/Y) is determined jointly by the national saving ratio (usually expressed as a percentage), s, and the national capital-output ratio (expressed as an integer), v.

How the Model works

• Therefore:1.The growth rate of national income is directly

(positively) related to the savings ratio, i.e., the more an economy is able to save – and therefore invest – out of a given GDP, the greater will be the growth of that GDP.

How the Model works

2. The growth rate of national income is indirectly (negatively) related to the economy’s capital-output ratio, i.e., the higher is k, the lower will be the rate of GDP growth.

In order to grow, economies must save and invest a certain portion of their GDP.

How the Model works• How can we use this formula?• Assume that the national capital-output ratio of an LDC

is 3 and that the aggregate savings ratio is 6% of GDP, then it follows that this country can grow at a rate of 2% per year.

• ∆Y/Y = s/v • % growth of GDP = 6%/3 • % growth in GDP = 2%

How the Model works

• Now, if national savings rate can be increased from 6% to 15%, then GDP Growth can be increased from 2% to 5% as seen below.

• ∆Y/Y = s/v

• % growth of GDP = 15%/3

• % growth in GDP = 5%

How the Model works

• The ‘tricks’ of economic growth, according to this model, are simply a matter of increasing savings and investment.

• The main obstacle to or constraint on development then is the relatively low level of new capital formation or investment in most LDCs.

How the Model works

• Therefore, the ‘savings gap’ or what is later referred to as the ‘Financing Gap’ can be filled either through foreign aid or private foreign direct investment.

Application of the Model in Africa

• The Harrod-Domar model is still applied today to calculate short-run investment requirements for a target growth rate. Development economists calculate a ‘Financing Gap’ between the required investment and available resources and often fill the ‘Financing Gap’ with foreign aid.


• ‘Financing Gap’ equals difference between the required investment and the LDC’s savings

• This model promised LDCs growth in the short-run through aid and investment.


• Majority of African countries and other Less Developed Countries have used this model to foster for economic growth and development.

• This model is said to be the mostly widely used among economic theories and models.


• Foreign aid and borrowing have been used by African countries since the years of independence.

• African countries have been obtaining between 40% to 70% of their budgets from foreign aids and foreign loans.

Criticism of the model

• It is not possible to state that development is simply a matter of removing obstacles and supplying various ‘missing components’ like capital, foreign exchange, skills and management – a task in which DCs could theoretically play a major role.


• Besides physical capital which is the definition of capital in the Harrod-Domar model, there is human capital, organizational capital and technological knowledge which all come into play in economic growth and development.


• Another problem with the Harrod-Domar model is that more labor is a factor in increasing total GDP, but only Investment in capital (machines) is taken into account.


• Taking Tanzania as an example of a developing country in Africa the main criticism of the Harrod – Domar model is the level of assumption, one being that there is no reason for growth to be sufficient to maintain full employment; this is based on the belief that the relative price of labor and capital is fixed, and that they are used in equal proportions.


• The model explains economic boom and bust by the assumption that investors are only influenced by output (known as the accelerator principle); this is now widely believed to be false, in Tanzania investors are influenced by a number of factors which include political stability, technological advancement, capital, labour and market.


• In terms of development, critics claim that the model sees economic growth and development as the same; in reality, economic growth is only a subset of development. This can vividly been seen in Tanzania where by the economic growth has been growing at the 7% average in the past ten years but the life of most Tanzanian does not reflect this growth as object poverty is still very severe, especially in rural areas.


• Another criticism is that the model implies poor countries should borrow to finance investment in capital to trigger economic growth; however, history has shown that this often causes repayment problems later.

Conclusion

• It is difficult to conclude the usefulness of Harrod-Domar Model as empirical studies came up with mixed results. Some argued that aid has positive impact when used in good policy environment (see Durbarry et al., 1998; Ali et al., 1998;Khan, 2003; Burnside and Dollar, 2000) while others argued that aid, at best, has no demonstrable effect (Griffin and Enos, 1970; Weisskoff, 1972; Dowling and Hiement, 1983; Mosley et al.,1987).

Conclusion

• But our quick observation suggests that borrowing has caused big repayment problems to LDCs, such that instead of putting much effort in their citizens, significant resources of these poor countries are used to repay loans.

Conclusion

• According to A research paper by Conchesta Nestory Kabete (2008) “Foreign Aid and Economic Growth: The Case of Tanzania”, the main findings are that foreign aid and total debt service have a negative impact on GDP growth.

Conclusion

• On the other hand, export growth and net national savings have shown a positive impact on GDP growth as it was expected because they increase the country’s capacity to invest. Both government’s development and recurrent expenditures of foreign aid resources have shown a negative impact on GDP growth.

Conclusion

• This implies that the development expenditures undertaken were not enough or not productive enough to impact on GDP growth positively. The overall aid and aid for development expenditures have shown to have more negative impact in the 1990s than in the early 2000s.

Conclusion

• In the case of Botswana, one of the fastest developing countries in Africa, the countries development has proved to be not resulting from borrowing or foreign aid, but rather institutions of private property are what made this country different from other countries of Africa.

Conclusion

• In Botswana a broad cross section of people have effective property rights ie Rule of law, Sanctity of contract, and minimal state or private predation; relatively efficient, business-friendly bureaucracy and conservative fiscal policy.

Documents

Assignment Ppt