Growth and Development
Models
Introduction
• Every nation strives after development as it is an essential component but
not only the component
• Development is not merely an economic phenomenon
• It should be perceived as a multidimensional process
• It involves the reorganization and reorientation of entire economic and
social systems
• Understanding the process of economic development is important
• Theories of economic growth and development help us in understanding
how and why development does or does not take place
• Each theory provides valuable insights on the nature of the development
process
4 Approaches to the Classic Theories of
Economic Development
• Post world war II to till 1990s literature on economic development
has been dominated by four major thoughts
(1) The linear-stages-of-growth model
(2) Theories and patterns of structural change
(3) The international-dependence revolution
(4) The neoclassical, free market counterrevolution
• In recent years, an eclectic approach has emerged that draws on all of
these classic theories
(1) The linear-stages-of-growth model
• This view is of 1950s & 1960s
• According to this view the process of development consists of a series of
successive stages of economic growth through which all countries must
pass
• This view was primarily an economic theory of development
• According to this the right quantity and mixture of saving, investment,
and foreign aid were necessary for developing nations for achieving
economic growth
• They argued that such path is historically been followed by the more
developed countries
• If developing countries follow the same then it helps in achieving it
(2) Theories and patterns of structural change
• This view focused on theories and patterns of structural change
• Used modern economic theory and statistical analysis
• Attempted to portray the internal process of structural change that a
“typical” developing country must undergo if it is to succeed in
generating and sustaining rapid economic growth
(3) The international-dependence revolution
• This refers to a significant shift in development thinking during the 1960s and
1970s
• It challenged the previously dominant view of stages of growth
• It argued that structural imbalances were not due to internal factors alone, but
also the result of historical and ongoing exploitation by more powerful nations
• Argued that dependency on developed countries hindered the ability to pursue
their own path of development
• It has criticized the traditional development models that focused solely on
economic growth
• It emphasized the importance of regional cooperation and solidarity among
developing countries by focusing on self reliance
• Explored alternative economic models that prioritized local development and
production
(4) The neoclassical, free market counterrevolution
• Throughout much of the 1980s and 1990s, a fourth approach
prevailed.
• This economic thought emphasized the beneficial role of free
markets, open economies, and the privatization of inefficient public
enterprises.
• Failure to develop, according to this theory, was not due to exploitive
external and internal forces as expounded by dependence theorists.
• Rather, it was primarily the result of too much government
intervention and regulation of the economy.
Rostow’s Stages of Growth
• American economic historian Walt W. Rostow
• Published The Stages of Economic Growth
• The most influential and outspoken advocate of the stages-of-growth
model of development
• According to Rostow, the transition from underdevelopment to
development can be described in terms of a series of steps or stages
through which all countries must proceed
• According to his theory a country passes through sequential stages in
achieving development
The traditional society
• This stage represents the starting point of economic development
• Subsistence farming
• Limited use of modern technology
• Agriculture is the primary economic activity
• Traditional customs and practices
The preconditions for takeoff into self-
sustaining growth
• In this stage, a country undergoes significant changes
• Key preconditions include:
• The establishment of infrastructure
• Development of markets
• Expansion of education and healthcare
• Adoption of modern technologies
The take-off
• This stage marks the beginning of sustained economic growth
• Industries start to emerge
• Investments in infrastructure and technology increase
• Entrepreneurship and innovation become important drivers of
economic progress
• Gradual shift from a primary sector to an industrial one
The drive to maturity
• During this stage, the economy experiences steady growth across
multiple sectors
• Diverse range of industries develops
• Emphasis on technological advancements, research and
development, and innovation
• Economic growth becomes more self-sustaining
• Domestic and international investments increase
The age of high mass consumption
• This final stage
• Represents a mature, high-income economy with widespread
affluence and high standards of living
• Economy is primarily driven by the service sector
• The majority of the population has access to education, healthcare,
and a variety of social services
The Harrod-Domar Growth Model
• If a country wants to replace its worn-out or impaired capital goods
(buildings, equipment, and materials) then it just needs to save a
certain proportion of its national income
• But if it wants its economy to grow then new investments
representing net additions to the capital stock are necessary
• Assume that there is some direct economic relationship between the
size of the total capital stock (K), and total GDP (Y)
• Now if there is any net additions to the capital stock in the form of
new investment then it will bring about corresponding increases in
the flow of national output, GDP
Model of Economic Growth
• To construct the model we need to understand following concepts
• Capital-output ratio
• Net savings ratio
• National output
Capital-Output Ratio
• A ratio that shows the units of capital required to produce a unit of
output over a given period of time
• Example: $3 of capital is required to produce $1 stream of GDP annually
• This is called capital output ratio i.e. 3:1
Net Savings Ratio
Savings expressed as a proportion of disposable income which is not
spent or invested over some period of time
National Output
“National output” is defined as the total market value of all final
goods and services produced and sold during a particular year
Assumptions
• Capital-output ratio (k), is 3 to 1
• National net savings ratio (s), is a fixed proportion of national output
(e.g., 6%)
• Total new investment is determined by the level of total savings
Model
1. Net saving (S) is some proportion, s, of national income (Y)
S = sY (….1)
Model
2. Net investment (I) is defined as the change in the capital stock (K), and can be
represented by ΔK such that
I = ΔK (….2)
• But because the total capital stock (K), bears a direct relationship to total national
income or output (Y), as expressed by the capital-output ratio (c) it follows that
K/Y = c
or
ΔK/ΔY= c
or, finally,
ΔK = cΔY (….3)
• 1/c is a measure of the efficiency of capital utilization
Model
• Finally, because net national savings (S), must equal net investment
(I), we can write this equality as
S=I (….4)
• But from Equation 1 we know that S = sY, and from Equations 2 and 3
we know that
I = ΔK = cΔY
• It therefore follows that we can write the “identity” of saving
equalling investment shown by Equation 4 as
S = sY = cΔY = ΔK = I (….5)
Model
• or simply as
sY = cΔY (….6)
• Dividing both sides of Equation 6 first by Y and then by c, we obtain
the following expression:
ΔY/Y=s/c (….7)
• Note that the left-hand side of Equation 7, ΔY/Y, represents the rate
of change or rate of growth of GDP
Model
• Equation 7 is a simplified version of the famous equation in the Harrod-
Domar theory of economic growth
• Eq 7 simply states that the rate of growth of GDP (ΔY/Y) is determined
jointly by the net national savings ratio(s) and the national capital-output
ratio (c)
• More specifically, it says that in the absence of government, the growth
rate of national income will be directly or positively related to the savings
ratio (i.e., the more an economy is able to save—and invest—out of a given
GDP, the greater the growth of that GDP will be) and inversely or
negatively related to the economy’s capital-output ratio (i.e., the higher c
is, the lower the rate of GDP growth will be)
Model
• Equation 7 is also often expressed in terms of gross savings (sG), in
which case the growth rate is given by
(….7’)
• where δ is the rate of capital depreciation
• The logic of equation 7 & 7’ is very simple. To grow, economies must
save and invest a certain proportion of their GDP.
• The more they can save and invest, the faster they can grow.
Model
• The actual rate of economic growth with given level of savings and
investment can be measured by the inverse of the capital-output
ratio, c, because this inverse, 1/c, is simply the output-capital or
output-investment ratio.
• It follows that multiplying the rate of new investment, s = I /Y, by its
productivity, 1/c, will give the rate by which national income or GDP
will increase.
Model
• In addition to investment, two other components of economic
growth are labor force growth and technological progress
• In the context of the Harrod-Domar growth model, labor is assumed
to be abundant in a developing country context and can be hired as
needed in a given proportion to capital investments (this assumption
is not always valid).
• In a general way, technological progress can be expressed in the
Harrod-Domar context as a decrease in the required capital-output
ratio, giving more growth for a given level of investment, as follows
from Equation 7 or 7’.
Model
• This is obvious when we realize that in the longer run, this ratio is not
fixed but can change over time in response to the functioning of
financial markets and the policy environment. But again, the focus
was on the role of capital investment.
Obstacles and Constraints
• As per quation 7 of Harrod-Domar growth model, one of the most fundamental
strategies of economic growth is simply to increase the proportion of national
income saved (i.e., not consumed). If we can raise s in Equation 7, we can
increase ΔY/Y, the rate of GDP growth.
• For example, if we assume that the national capital-output ratio in some less
developed country is, say, 3 and the aggregate net saving ratio is 6% of GDP, it
follows from Equation 7 that this country can grow at a rate of 2% per year
because
Obstacles and Constraints
• Now if the national net savings rate can somehow be increased from
6% to, say, 15%—through some combination of increased taxes,
foreign aid, and general consumption sacrifices—GDP growth can be
increased from 2% to 5% because now
Obstacles and Constraints
• Rostow and others defined the takeoff stage in precisely this way
• Countries that were able to save 15 to 20% of GDP could grow (“develop”)
at a much faster rate than those that saved less. Moreover, this growth
would then be self-sustaining. The mechanisms of economic growth and
development, therefore, would be simply a matter of increasing national
savings and investment.
• The main obstacle to or constraint on development, according to this
theory, is the relatively low level of new capital formation in most poor
countries. But if a country wanted to grow at, say, a rate of 7% per year
and if it could not generate savings and investment at a rate of 21% of
national income (assuming that c, the final aggregate capital-output ratio,
is 3) but could only manage to save 15%, it could seek to fill this “savings
gap” of 6% through either foreign aid or private foreign investment.
Obstacles and Constraints
• Thus, the “capital constraint” stages approach to growth and
development became a rationale and (in terms of Cold War politics)
an opportunistic tool for justifying massive transfers of capital and
technical assistance from the developed to the less developed
nations. It was to be the Marshall Plan all over again, but this time for
the nations of the developing world.
Necessary versus Sufficient Conditions: Some
Criticisms of the Stages Model
• Unfortunately, the mechanisms of development embodied in the theory of stages
of growth did not always work. And the basic reason they didn’t work was not
because more saving and investment isn’t a necessary condition for accelerated
rates of economic growth but rather because it is not a sufficient condition.
• The Marshall Plan worked for Europe because the European countries receiving
aid possessed the necessary structural, institutional, and attitudinal conditions
(e.g., well-integrated commodity and money markets, highly developed transport
facilities, a well-trained and educated workforce, the motivation to succeed, an
efficient government bureaucracy) to convert new capital effectively into higher
levels of output. The Rostow and Harrod- Domar models implicitly assume the
existence of these same attitudes and arrangements in underdeveloped nations.
Yet, in many cases, they are lacking, as are complementary factors such as
managerial competence, skilled labor, and the ability to plan and administer a
wide assortment of development projects.
