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The Harrod-Domar model of growth

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The Harrod-Domar model was developed in the 1930’s. The suggestion is made that high levels of savings are important to growth as savings provide funds, which can then be borrowed for investment purposes. The economy’s rate of growth therefore depends on the level of saving and the productivity of the investments that were made. The productivity of investments can be summarised by the economy’s capital-output ratio, e.g., if $5 dollars worth of capital equipment was required for $1 of annual output, the capital-output ratio 5:1 would exist. A lower ratio is more favourable, 4:1, would indicate that only $4 of capital equipment was needed to produce $1 of annual output.

The model itself shows long-term growth. It tends to show that there will be no natural tendency for the economy to have a balanced rate of growth. Growth is split into different types and analysed accordingly. The overall conclusion of the model is that the economy does not naturally find a full-employment equilibrium. The policy implication of the conclusion is that the government has to intervene to try to manage the level of output with its policies.

The above production possibility frontier summarizes the importance of capital growth. I is the change in capital stock, The national income increases if consumption C, is reduced in the short run from Ca to Cb to release savings, and resources for additional I from Ia to Ib. In the long run the increase in the economy’s capacity shifts the production possibility frontier outwards to the pecked line, which can then allow both higher consumption and investment.

The development process is multidimensional. It involves changes over time, not only in the economy, but also in institutions, political and social structures and cultural values. Development implies progress or improvement, which in turn means that we make value judgements as to what is deemed desirable or undesirable. If we accept that economic development embodies value judgements, it is clear that economic growth and economic development are not synonymous. GDP per capita may be rising, but at the same time poverty might be increasing, inequality in the distribution of income may be rising and massive environmental damage could be occurring. Economic growth may well be a necessary condition for economic development, but it is not a sufficient condition.

Todaro argues that there are three basic values, which should serve as a basis and guideline for understanding development. Firstly, sustenance, the ability to meet the basic needs of food, health, shelter and protection. Secondly, self-esteem, a sense of worth and self respect implying dignity, honour and recognition. Finally, there should be freedom, and an expanded range of choices for societies.

The diversity of theoretical inputs, historical experience and political expediency has meant that development economists, while using the tools of orthodox economic analysis, have nevertheless often been highly unorthodox in their approach to development problems.

Most approaches however have shared a number of common concerns. Attention has been focused on the long run, with economic growth usually taking priority over considerations of static allocative efficiency. Economic growth and changes in the structure of output, employment and consumption, and patterns of trade, have been closely linked to one another. The focus has been on savings and investment and the policies and institutions required to encourage and sustain the accumulation process. The development of human resources, through expenditure on health and education, has always been seen as an important aspect of the development process.

Development economists have perhaps been more prepared than others to recognise the need for, and the existence of, a variety of theoretical approaches to the study of economic development. We are able to identify three different schools of thought, orthodox, structuralist and radical.

The orthodox or neoclassical school, focuses attentions on the efficiency with which resources are allocated. Unnecessary government intervention in product and factor markets will give rise to ‘distorted’ relative prices. This in turn gives rise to a misallocation of resources because industry is overprotected, relative to agriculture for example. The World Bank’s recommendation that countries should ‘get prices right’ illustrates the view that markets lead to the most efficient resource allocation, and that government intervention should be confined to the provision of macroeconomic stability, security to the owners of property, and any action necessary to overcome market failures.

The structuralists argued that LDCs were characterised by a variety of constraint, which meant that either markets did not exist or that they operated imperfectly – with outcomes that were considered undesirable. For example, it was argued that the growth of incomes and urbanisation would lead to an increase in demand for foodstuffs. This increase in demand however would not stimulate an increase in supply because of the structure of land ownership in the agricultural sector. The large estates would not respond to higher prices because they were not profit maximisers. And on the other hand the small landowners were at the margins of subsistence and would not be able to take the risk of supplying the market for fear of jeopardizing their own survival.

Within the radical school some argued that poor countries will never develop as long as they remain part of the global capitalist economy. Others have argued that only ‘dependant development’ is possible, because of the subordinate position of poor countries in the global economy and the absence of key sectors in those economies.

Over the past two decades, ideas on economic policies for development have changed dramatically. Firstly, the results of attempts at economic planning have in general been disappointing. The collapse of the previously planned economies of eastern and central Europe and the former Soviet Union has further discredited the notion that resources can be allocated more efficiently by state than market. Public sectors have been over expanded. In many countries this has led to the creation of overstaffed, inefficient, loss making enterprises. Governments have allowed public spending to exceed revenue, leading to excessive borrowing, increases in money supply and aggravation of inflationary pressures,

The 1980s saw a change in emphasis in development policy, with the following coming to the top of the agenda; liberalization (especially of trade), structural adjustment, and privatisation. A more limited role for government was envisaged focusing on proper macroeconomic management of the economy; the creation of an efficient regulatory and promotional framework; Investment in education and health (human capital) and infrastructure (physical capital); protection of poor and vulnerable members of society.

Most development economists would now accept that governments must try to create a ‘market friendly’ environment in order to encourage economic development. The recognition that poor countries share common characteristics and face similar problems gives a ‘unity in diversity’ to the study of development problems. This should not, however, obscure their diversity and the need to design policies that reflect the often-unique characteristics of individual countries.

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