Growth models - I

Course name: Economic Growth and Development

Lecture 6
Rajshree Bedamatta

Department of Humanities & Social Sciences

Indian Institute of Technology Guwahati
 Recapitulating from the last class

❑ Historical growth rates of the now industrialised world vis-à-vis the present day
growth rates
❑ Labour productivity seems to have increased from the late 19th century onwards.
❑ Today, we enjoy vastly improved standards of living and consumption of goods and
services
❑ Importance of Prof. Simon Kuznets and his conception of “modern” economic growth
❑ Kuznets’ reflections on six characteristics of modern economic growth
a. High rates of growth of per capita output and population
b. High rates of increase in total factor productivity (TFP)
c. High rates of structural transformation
d. High rates of social and ideological transformation
e. International economic outreach
f. Limited spread of economic growth (large parts of the world still under-
developed)
 Some models of economic development and growth

➢ The Classical Theory of Economic Development.

➢ The Marxian Theory of Economic Development

➢ The Schumpeterian Theory

➢ Lewis Theory of Unlimited Supplies of Labour.

➢ Fei-Ranis Theory of Development

➢ Harrod- Domar Model.

➢ Solow Model (Long-run growth model)

➢ Kaldor’s Model of Growth

 Trends in Development Thinking

❑ Development as Universal History: Karl Marx (writing in the 19th century) described
development as progression through a series of socioeconomic stages – culminating
in socialism – through which a society must inevitably pass during the course of
history. Each stage represents a different ‘mode of production’.

❑ Development as economic growth: In the 1950s, in a climate of cold war with the
Communist East, practical concern to promote growth in post-war Europe and the
colonies and ex-colonies led to the emergence of an entirely different model of
development based on the definition of development as economic growth – that is,
growth in national output, consumption, and material living standards.

❑ Development as modernisation: Sociologists and political scientists from America in

the 1960s responded to some of the weaknesses of early development models by
developing the concept of modernisation. They believed that traditional societies
could be transformed structurally into modern societies through the active diffusion
within developing countries of the modern values, institutions and technologies found
in the developed countries.
 Trends in Development Thinking

❑ Development as world structural change: Gunder Frank and others challenged

modernisation theory on the grounds that it ignored the external structural constraints
to development that arose from the nature of the relationship between developed and
developing countries. Writing in what is called the 'structuralist' tradition, and heavily
influenced by Marx, these writers accounted for under development in terms of an
international system of political and economic structures which favoured certain
countries or regions (the core) against others (the periphery). Dependency theory, as
this became known, enjoyed a brief period of popularity in the 1970s, inspiring
academic research and a concern for equitable development.

❑ Development as growth led by free market: At the end of the 1970s, another school of
thought rose to prominence, again led by economists. Neo-liberalism, as it has been
called, promoted the free market and reduced government intervention as the agent
of development. This marked a radical shift in thinking away from the notion of state-
led intervention, and it proved massively influential in policy-making during the 1980s
and 1990s.
 Appearance of Growth Models

LINEAR STAGES OF GROWTH MODELS

❑ Early years after World War II: Rostow’s stages growth model and Harrod-Domar
model

❑ Rostow (1960), Harrod (1948) and Domar (1947) were largely talking about the key
role played by investments in a country’s economic growth

❑ Chenery (1960), Chenery and Syrquin (1975), Morris and Adelman (1988) said that
development process is actually quite non-linear and different countries may pursue
different development paths. Economies may miss stages, or become locked in one
particular stage.
 Appearance of Growth Models

STRUCTURAL CHANGE MODELS

❑ Two-sector model of Arthur Lewis (1954) or the theory of surplus labour, labour
increasingly moves away from the agricultural sector to the industrial sector

❑ Structural change and patterns of development (Chenery, 1960): this analysis

identified that the steady accumulation of physical and human capital is among
conditions necessary for economic growth, apart from savings and investments.
Moreover structural change, occurred not only in the two sectors (agriculture and
industry) but also in all economic functions including consumer demand, international
trade and resource use.

❑ Other economists who talked on the same lines were Kuznets (1971).
 Appearance of Growth Models

INTERNATIONAL DEPENDENCE MODELS

❑ Considered an extension of Marxist theory (Hein, 1992)

❑ The poor countries were said to be dependent on the developed countries for market and
capital

❑ Poor countries are unable to control the distribution of the value added to the products
traded between themselves and the developed countries (Cohen, 1973; Dos Santos, 1973)

❑ Following the international dependency theory, developing countries should therefore end
the dependence by breaking their relationships with the developed world, as well as by
closing their doors on the developed countries (Elkan, 1995; Ghatak, 2003; Ferraro, 2008)

❑ The negative impacts of the policy of autarky rendered the theory out of favour in the
1980s.
 Appearance of Growth Models

NEOCLASSICAL COUNTER-REVOLUTION MODELS

❑ Free-market approach; the new political economy approach, and the market-friendly
approach to counter the international dependence model.

❑ Meier (2000), Bauer (1984), Lal (1983), Johnson (1971), and Little (1982) focused on
promoting free markets, eliminating government-imposed distortions associated with
protectionism, subsidies and public ownership

❑ Traditional neoclassical growth theory originating from Harrod-Domar and Solow

Growth models

❑ Neoclassical economists focused on the market to find a way out for the developing
countries. Policies of liberalization, stabilization, and privatization therefore became
the central elements of the national development agenda.
 Appearance of Growth Models

NEW GROWTH THEORY

❑ Also known as endogenous growth theory (1990s) to explain poor performance of the
less developed countries

❑ Unlike Solow model that considers technological change as an exogenous factor, the
new growth model notes that technological change has not been equal nor has it
been exogenously transmitted in most developing countries.

❑ New growth theorists linked technological change to production of knowledge

❑ Economic growth results from increasing returns to the use of knowledge rather than
labour and capital.

❑ Romer (1986), Lucas (988), Aghion and Howitt (1992)

 Models we will concern ourselves with

❑ Doctrine of Balanced Growth

❑ Concept of Unbalanced Growth
❑ Schumpeter’s Analysis of Growth
❑ Rostow’s Stages of Growth
❑ Big Push Theory
❑ Critical Minimum Efforts Thesis
❑ Harrod-Domar Growth Model
❑ Solow Growth Model
 Doctrine of Balanced Growth

Major proponents:

❑ Paul Narcyz Rosenstein-Rodan (1902-1985; economist of Jewish origin, born in

Krakow, trained in Austrian tradition under Hans Meyer in Vienna)

❑ Ragnar Nurkse (1907-1959; Estonian International Economist and policy maker in

the fields of international finance and economic development)

❑ William Arthur Lewis (1915-1991; English economist and contributed to the fields of
development economics, and pioneering contributions in dual sector models,
industrial structures, and history of the world economy; was awarded the nobel
memorial prize in economics in 1979)
 What does the doctrine say?

Ragnar Nurkse’s views:

❑ Major obstacle to development of the underdeveloped countries is the vicious circle

of poverty.
Low income Low savings
Low savings Low investment
Low investment Less production
Low production Low income
Low income Low demand for goods

❑ Smaller markets or limited extent of markets

❑ And there will be no inducement to invest

❑ In order to break the vicious circle of poverty in the under-developed countries, it is

essential to have a balance between demand and supply.
 How to break the vicious circle?

(i) Complementary demand: Instead of making investments in one industry or the other
there should be an overall investment in all the sectors. When investment will be
made in several industries simultaneously, it will increase the income of many people
who are employed in various industries. They will purchase foods made by each
other for consumption. Thus with increase in supply demand will also go up and
extent of market will increase. This will lead to capital formation and vicious circle of
poverty will get broken. Same would be the case of wage-earners of different
industries or sectors.

(ii) Government intervention: Government must intervene in productive activities through

economic planning. Private entrepreneurs can be encouraged by the government by
providing an inducement to invest.

(iii) External economies: Will accrue because of setting up of new industries and
expansion of the existing industries. This will lead to increasing returns of scale, fall
in cost of production and hence fall in prices. Increase in demand may be
experienced.

(iv) Economic growth: Increase in investment in different branches of production can

enlarge the total market which can break the bonds of stationary equilibrium of
underdevelopment.
 Two key ideas

Nurkse’s balanced growth theory was also referred to as the high development theory
and there are two key ideas here:

(i) Financing for development has to come to a large extent from the developing country
itself (“Capital is made at home:, Nurkse, 1961)

(ii) The key areas to be financed need to exhibit increasing returns in order to trigger
dynamics of development or, as Myrdal argued, virtuous circles of growth.

Ragnar Nurkse considered balanced-growth approach to be financially more stable.

 Harrod- Domar Model

• R.F Harrod and E.Domar gave the Harrod –Domar model, which is a theory of
growth.

• Both these models stress on the conditions which are very essential for achieving and
maintaining steady growth.

• They stress on the crucial role played by capital accumulation and investment in the
process of growth.

• Investment affects the level of income as well as production.

• Effect of Investment on Income – “ Multiplier Effect”

• Effect of Investment on Production – “ Productivity Effect”

 Assumptions of Harrod-Domar Model

➢ An initial full-employment level of income has already been achieved.

➢ No government intervention i.e. “Laissez Faire”.

➢ The model is based on the principle of “closed economy”.

➢ Average Propensity to Save (APS) = Marginal Propensity to Save (MPS)

i.e. S/Y = ∆S/∆Y

➢ Propensity to save and “ Capital Coefficient” (i.e. capital-output ratio) are constant.

➢ Depreciation charges are not included in income, investment and saving.

➢ Saving and Investment are equal .

So = Io (Observed saving and observed investment)
So = Ic (Expected saving and expected investment)
 Domar’s Model

• Domar emphasised the necessity of viewing growth from both demand as well as
supply side.

• Domar also emphasised on the dual character of investment, investment increases

the productive capacity and also generate income.

• It gives us both the sides of the equation (i.e. demand side as well as supply side)
which ultimately gives us the required rate of growth.
 Notations used in Domar’s Model

• Yα = level of net national income or level of effective demand at full employment

(Demand Side)

• Ys = level of productive capacity or supply at full employment level (Supply Side)

• K = Real Capital

• I = Net investment, which results in increase of real capital i.e. ∆k

• α= Marginal Propensity to Save

• δ = Productivity of capital or net investment

 Explaining Domar’s model through equations

Demand Side:

Yα = I/α ........................ (i)

The equation explains :

➢ The level of effective demand (Yα) is directly related to the level of investment (I).

➢ The effective demand is inversely related to the MPS (α).

Explaining Domar’s model through Equation Cont..

Supply Side:

Ys = δK .............(ii)

The equation explains:

➢ Supply of output (Ys) at full employment level depends upon two factors, i.e.
Productivity of Capital (δ) and amount of Capita (K).
Explaining Domar’s model through Equation Cont..

At Equilibrium :

For equilibrium, demand and supply should be equal, therefore:

Yα = Ys

I/ α = δK

or I = αδK ................(iii)

Equation (iii) is the condition for “achieving steady growth rate”

Explaining Domar’s model through Equation Cont..

Condition for maintaining Steady Growth Rate:

➢ For this we need to add increments to demand as well as supply equations

∆Yα = ∆I/α ................(iv)

Increments have been shown in effective demand and investment as they are variables but on α as it is a constant.

∆Ys = δ∆K .................(v)

Change in supply of output (∆Ys) can take place because of change in real capital (∆K) as productivity of capital (δ)
remains constant. Moreover,
∆K = I ,
Substituting value of ∆ K in (S) we get,

∆Ys = δI ..................(vi)
Therefore equality between equations (iv) and (vi) will give us condition for steady growth,

∆Yδ = ∆ Ys or ∆I/ α = δI or ∆I/I = δα

This shows that the rate of growth of net investment (∆I/ I) should be equal to the product of marginal propensity to
save (α) and productivity of capital (δ)
 Harrod’s Model

In Harrod’s model R.F Harrod, raised three sets of issues:

➢ How can steady growth rate be achieved in the model with a fixed capita-output ratio
(capital coefficient) and fixed saving income ratio (propensity to save)?

➢ How can the steady growth rate be maintained? Or What are the conditions for
maintaining the stable growth?

➢ How do natural factors put a ceiling on the growth rate of the economy?

In order to discuss three issues, Harrod has explained three growth rates are:

❖ Actual Growth Rate

❖ Warranted Growth Rate
❖ Natural Growth Rate
 Harrod’s Model (Actual Growth Rate)

Actual Growth Rate:

It is the growth rate, which is determined by the actual amount of saving and
investment in the country. It can be defined as the ratio of change in income (∆Y) to
the total income (Y) in the given period. Actual Growth Rate is denoted by G, then

G = ∆Y/ Y

G is determined by two factors, saving-income ratio and capital-output ratio, which

remains fixed in a given period. The relationship between the actual growth rate and
its determinants, can be expressed as:

GC = S ...............(i)

Where, G is actual rate of growth, C represents the capital output ratio or ∆K/ ∆Y, S
refers to the saving – investment ratio (S/Y)
 Harrod’s Model (Actual Growth Rate) Cont..

Equation (i) explains that saving and investment are equal to each other, therefore
this can be explained as:

G = ∆Y/ Y and C = ∆K/ ∆Y

or C = I/ ∆Y [ since ∆K = I] and S = S/ Y

Substituting the values of G, C and S in equation (i), we get

∆Y/ Y × I/ ∆Y = S/ Y

I/ Y = S/ Y or I = S

Thus, equation (i) explains that the condition for achieving the steady growth rate or
dynamic equilibrium is that ex-post saving must be equal to ex-post investment.
 Harrod’s Model (Warranted Growth Rate)

Warranted Growth Rate:

Warranted growth rate refers to that growth rate of the economy, where it is working at full capacity
by making full and optimum use of machine and manpower. It is also known as “Full capacity
Growth Rate” or “ Full- Employment Growth Rate” or “Potential Growth Rate”.

Warranted growth rate (Gw) is determined by two factors:

❖ Capital - Output Ratio

❖ Saving - Income Ratio

The relationship can be expressed as :

Gw = Cr = S

According to Harrod, the economy can achieve stable growth if G = Gw and C = Cr i.e actual
growth rate must be equal to the warranted growth rate must be equal to warranted growth rate
and the capital - output ratio needed to achieve G, must be equal to the required capital – output
to maintain Gw, given the saving coefficient (S).
 Harrod’s Model (Natural Growth Rate)

Natural Growth Rate:

Harrod points out that generally there is an upper limit to expansion of output, which
is determined by natural resources, capital equipment and state of technical
knowledge. This limit is called “ Full Employment Ceiling”. This upper limit may
change as the factors of production grow, and technological progress takes place.

Harrod calls the growth in this upper full employment ceiling the natural growth rate.
In other others, it is the maximum growth rate, which an economy can achieve with its
available natural resources. Natural growth rate is denoted by Gn.