Human Development Index

 First component - Longevity: Life expectancy at birth (indirectly

reflecting infant and child mortality).

 Second component - Knowledge: Educational attainment –

combines two sub-indices: mean years of schooling and
expected number of years of schooling. Arithmetic mean.

 Third Component: GNI Per-capita (natural log of incomes).

 The index is obtained by taking a geometric mean of the three

dimension indices.
Human Development Index
 The HDI number lies between 0 and 1.

 The HDI has visual simplicity by giving an aggregate number.

 But the aggregation involves combining different things with

ad-hoc weights.

 Nevertheless, HDI is one way to combine important

development indicators, and hence it merits our attention.
Structural Features of Developing Countries

 Demographic characteristics: Very poor countries are

characterized by very high birth and death rates.

 With development, death rates plummet downward.

 Birth rates remain high for a while, before coming down.

 This, temporarily, leads to high population growth in

developing countries.

 High population could lower per-capita incomes, and also have

large proportion as young cohorts.
Structural Features of Developing Countries

 Occupational and Production Structures: Agriculture accounts

for a large share of production in developing countries (about
30%).

 Large share of labor force in these countries lives in rural

areas (about 72%).

 Agriculture has lower productivity than other activities.

 Capital intensity in agriculture minimum, intense pressure on the

land, no assured irrigation, etc.
Structural Features of Developing Countries

 Rapid Rural-Urban Migration: Both push as well as pull factors

are responsible for rural-urban migration.

 Urban population growth usually found to be higher than

average population growth in these countries.

 The process of migration is accelerated and puts pressure on

urban areas in developing countries.

 This leads to a large fraction of the labour force working in

urban informal sector – large share of services like in
developed countries.
Structural Features of Developing Countries

 International Trade: Differences are more with respect to the

composition of trade.

 Developing countries often exporters of primary products: raw

materials, cash crops, and sometimes food, etc; textiles and
light manufactured goods.

 This is broadly in accordance with the theory of comparative

advantage.

 Reliance on primary products is detrimental to these countries:

as they are subject to large fluctuations in world prices –
instability in export earnings.
Structural Features of Developing Countries

 Declining importance of primary products may lead to a

reduction in their prices and hurt developing countries’ terms of
trade.

 Terms of trade for a country is a measure of the ratio of the

price of its exports to that of its imports.

 An increase is a good sign for the country and vice-versa.

 Usually there is less variation in the composition of imports

between developed and developing countries.
Structural Features of Developing Countries
4. THEORIES OF
ECONOMIC GROWTH:
HARROD-DOMAR &
SOLOW

Karthikeya Naraparaju
GDP Per-capita in five countries: 1000-2015
(Source: core-econ.org)
Theories of Economic Growth
 Modern economic growth a relatively modern phenomenon.

 Throughout much of human history, appreciable growth in per

capita GDP was the exception rather than rule.

 Modern economic growth was born after the Industrial

Revolution in Britain.

 In the 19th and 20th century, the now developed countries have
managed to ‘take-off’ into sustained growth.

 Others have catching-up to do.

The Harrod-Domar Model
 Economic growth is the result of abstention from current
consumption.

 Commodity production creates income, which creates the

demand for those very commodities.

 Commodities can be classified into two groups: consumption

goods and investment/capital goods: commodities produced
for producing other commodities.

 Typically households buy consumer goods and firms buy

capital goods.
The Harrod-Domar Model
 If all income is paid out to households who spend it on
consumption goods, where does the market for capital goods
come from?

 Households save and by abstaining from current consumption,

they make available a pool of funds that firms use to buy
capital goods: Investment.

 Investment creates demand for capital goods.

 These goods add to the stock of the economy’s capital,

endowing it with greater capacity to grow in the future. No
savings, no growth.
Macroeconomic Balance
(Source: Chapter 2, Debraj Ray, Development Economics)

Macroeconomic Balance: Savings Equal Investment

The Harrod-Domar Model
 Economic growth is positive when investment exceeds the
amount necessary to replace depreciated capital: allowing
next period’s cycle to recur on a larger scale.

 Volume of savings and investment is an important determinant

of the growth rate of an economy.

 Let the time period be divided into the following: t= 0,1,2,3...

The Harrod-Domar Model
 Y(t) = C(t) + S(t)…..(3.1)
 Income = Consumption + Saving

 Y(t) = C(t) +I(t) ……(3.2)

 Output = Consumption goods + Investment goods

 S(t) = I(t)……………(3.3)
 Macro-economic balance
Change in Capital Stock Over Time
 Investment augments capital stock K and replaces worn out
part

 K (t+1) = (1-δ) K(t) + I(t)….(3.4)

 = Net of Depreciated Stock + New Investment

 Investment augments the national capital stock K and replaces

that part which is wearing out (a fraction δ)
Savings Rate
 Saving rate = s = S(t)/Y(t)

 Implies that Savings are a constant proportion of income

 S(t) = s.Y(t)

 Note: The savings rate, s, depends on a multitude of factors in

an economy. To be discussed.
Capital-Output Ratio
 Denoted by θ, this is the amount of capital required to produce
a single unit of output in the economy:

 θ = K(t)/Y(t)
Deriving the Harrod-Domar equations
 Consider: K (t+1) = (1-δ) K(t) + I(t)….(3.4)

 and Using : S(t)=I(t)……(3.3)

 K (t+1) = (1-δ) K(t) + S(t)

 We know S(t)=s.Y(t) and K(t)= θ.Y(t)

 We can write (3.4) as:

 θY(t+1) = (1- δ) θ.Y(t) + s.Y(t) …(3.5)

Deriving the Harrod-Domar equations
 θY(t+1) = (1- δ) θY(t) + s.Y(t)…..(3.5)

 θY(t+1) = θY(t) - δ θ.Y(t) + s.Y(t)

 θ[Y(t+1)-Y(t)] + δ θ.Y(t) = s.Y(t)

 Dividing LHS and RHS by Y(t), we get

 θ[Y(t+1)-Y(t)]/Y(t)] + δ θ =s, and reduces to

 Y(t+1)-Y(t)]/Y(t) =s/ θ - δ
Deriving the Harrod-Domar equations

 s/ θ = g+ δ…....(3.5)

 This is the (Roy) Harrod - (Evsey) Domar equation.

 Links growth rate to two fundamental variables: savings rate

and capital output ratio.

 This equation gives the rate of growth of the total output.

 We are interested in the growth rate of per-capita output.

Per-capita GDP growth
 Expanding LHS and re-arranging to get,
 g* ~= s/θ - δ - n ….(3.7),

 The model tells us that given a savings rate, capital-output

ratio, and population growth rate, what the per-capita growth
rate will be.

 Thus, these variables are taken as given: exogenous.

 This is a neutral theory of economic growth: it does not explain

why growth rates differ systematically differ across countries.
Different sources of endogeneity: Savings

 The rate of savings may itself be influenced by the overall

level of per capita income and also its distribution.

 At low levels of income, there is less likelihood of individuals

saving.

 Thus economies where majority of citizens are close to

subsistence unlikely to have high savings.

 As economies grow, scope for savings to grow increases.

Different sources of endogeneity: Savings

 As countries reach middle-income levels, they might start to

save with the desire to reach rich countries’ income levels.

 For rich countries, what happens to savings is ambiguous.

 They have the wherewithal to save but might not be willing

to do it because they don’t have any catching up to do.

 Thus savings rate will differ with the level of development.

Different sources of endogeneity: Population Growth

 Like savings rate, population growth rates also vary with per
capita income.

 In the course of development, countries go through

demographic transition.

 In poor countries, death rates, especially among children, are

very high. This also implies a high birth rate.

 As incomes increase, first death rates begin to fall; birth rates

adjust slowly to this transition.
Different sources of endogeneity: Population Growth

 Thus population growth rate initially shoots up.

 In the longer run, with development, birth rates also fall and
the population growth rate also falls.

 This ‘inverse-U’ shape behaviour of population growth rate

with respect to development has been referred to as
‘demographic transition’.

 This has implications for the per capita economic growth.

Different sources of endogeneity: Population Growth
Different sources of endogeneity: Population Growth

 Under this reformulation (i.e. Endogenous population growth),

the rate of growth in the Harrod-Domar model depends on the
current income level.
 Two critical levels of income: ‘Trap’ & ‘Threshold’.
 To the left of ‘Trap’, per-capita income grows.
 Just above ‘Trap’, population growth outstrips overall growth
of income, economy will become poorer.
 Just above the ‘Threshold’, economy will in a phase of
sustained growth.
 In the absence of policy that pushes to the right of threshold,
economy will tend to be caught in trap!
Policy pushes for sustained growth
 A temporary boost to certain economic parameters may have
sustained long-run effects.

 A policy that boosts savings rate reduces the threshold.

 This can just be a temporary boost.

 Similar is the effect of a policy to reduce population growth

rates.

 Temporary changes in policy can have lasting long-run effects.

Overview
 Solow Growth Model

 Steady State

 Parameters affecting Steady State

 Level and Growth Effects

 Technological Progress

 Convergence
Solow (1956) Growth Model
 Solow’s model relies on the possible endogeneity of another
parameter in Harrod-Domar model: the capital-output ratio, θ.

 Solow’s twist on the Harrod-Domar story is based on the law

of diminishing returns to individual factors of production.

 Capital and labour work together to produce output.

 If there is plenty of labour relative to capital, a little bit of

capital will go a long way.

 If there is a shortage of labour, capital-intensive methods are

used at the margin: capital-output ratio rises.
Solow Growth Model – The Solow Equations

 K (t+1) = (1-δ) K(t) + sY(t)..............(3.8)

 Dividing through population, we have,
 (1+n) k(t+1) = (1-δ)k(t) + sy(t).......(3.9)
 Where ‘k’s and ‘y’ denote per-capita magnitudes.
 Intuition: RHS has two parts: per-capita capital (net of
depreciation) and current per-capita savings.
 Adding these two should give us the per-capita capital stock in
k(t+1).
 But population is also growing (at rate n), thus this exerts a
downward drag on per-capita capital stocks.
Solow Growth Model
 Larger the rate of growth of population, the lower is per-
capita capital stock in the next period.
 We now relate the per capita output at each date to the per
capita capital stock, using the production function.
 With constant returns to scale, we may use the production
function to relate per-capita output to per-capita input.
 Moreover, as we know, production function also exhibits
diminishing marginal returns to each input.
 In our case, it is diminishing marginal returns to per-capita
capital.
Solow Growth Model – Production Function
Evolution of Capital Stock
 (1+n) k(t+1) = (1-δ)k(t) + sy(t).......(3.9)
The Steady State
 If the initial stock of per-capita capital is “low”, the output-
capital ratio is very high and so the per capita capital stock
can expand rapidly.
 The growth of per-capita capital slows down over time and it
settles down to k*.
 Why is this slowing down happening?
 Diminishing marginal returns to per-capita capital.
 For each subsequent increase in k, the increment in y is lower,
which in turn implies that the growth of k in the next period is
lower (from eq. 3.9).
The Steady State
 Growth loses momentum if capital is growing too fast relative
to labour, as is happening to left of k*.

 The growth of capital is then brought in line with the growth of

labour.

 Thus long-run capital-labour ratio is constant – k*.

The Steady State
 Similarly, if a country is starting with a ‘high’ initial capital
stock, the output-capital ratio is low.

 So the rate of expansion of capital is low, relative to the rate

of growth of the population.

 This implies that the per-capita stock of capital falls.

 The per-capita stock of capital continues to fall until it reaches

k*, where the rate of growth of capital is equal to the rate of
growth of population.
The Steady State
 If the per-capita capital stock settles down to some “steady-
state”, so must per-capita income!

 Thus, in this version of Solow model, there is no long-run growth

of per capita output, and total output grows exactly at the
rate of growth of the population.

 The savings rate has no long-run effect on the rate of growth.

 Sharp contrast with Harrod-Domar model.

Solow v/s Harrod-Domar
 This discrepancy is coming because of diminishing returns to
capital, thus creating endogenous changes in capital-output
ratio.

 Smaller is the diminishing returns, closer is the curve to a

straight line, larger is k*.

 The different predictions of these models are driven by

different assumptions about technology.
Parameters and Steady State
 The rate of savings does not affect the long-run growth rate of
per-capita income (which is zero).

 But savings rate affects the long-run level of income.

 Similarly the rate of depreciation of capital (δ) and the growth

rate of population (n) will have an effect on the steady-state
level of per capita output.

 At steady-state, k*/y* = s/(n+ δ).

Parameters and Steady State
 An increase in s, will increase k*/y*.

 This means lower output-capital ratio which can happen only at

a higher level of k*.

 On the other hand, a higher depreciation (δ) or population

growth rate (n) implies a lower steady-state k*.

 This can be seen graphically but also through reasoning.

Level and Growth Effects
 A growth effect is an effect that changes the rate of growth of
a variable.
 A level effect, leaves the growth rate unchanged while shifting
the entire path, up or down.
Level and Growth Effects: Population

 The parameter of population growth (n) has an interesting

double effect.
 An increase in ‘n’ lowers the steady-state per-capita income,
i.e. It has a level effect.
 But at steady-state the rate of total income should equal
population growth rate.
 Which means as population growth increases, the total income
should also grow at faster rates in the steady-state!
 Population is both an input as well as a consumer of final
goods.
Level effects of Savings Rate
 Savings rate on the other hand, has only level effects.

 It does not have any growth effects on the total income in the
long-run.

 Higher savings rate pushes the economy to a higher trajectory

in the short and the medium run but ultimately, in the long-run,
per-capita income settles down to a steady-state level.

 Savings only has a level effect in Solow’s model, unlike the

Harrod-Domar model!
Solow Model – so far
 Solow model has a strong prediction:
 Regardless of the initial per-capita capital stock, two countries
with similar savings rate, depreciation rates, and population
growth rates, will converge to similar standards of living “in the
long-run”!
 How seriously should we take the Solow model?
 The real world is actually different: with growth and also
different standards of living across countries.
 But that is no reason to discard a model!
 Models are only pointers to important aspects of reality.
Solow Model With Technical Progress
 We can think of economic growth as having broadly two
sources:

 technical progress – better and more advanced methods of

production
 Through build-up of plant, machinery, etc.

 The Solow Model claims that without the first, the second
component alone cannot generate growth.
 With technology improvements, we can think of our production
function to keep on moving upwards in each period.
 We will then have some growth to be sustained in the steady-
state.
Solow Model With Technical Progress
 We can think of technical progress as a way of improving the
efficiency, or economic productivity of labour.

 We can make a distinction between working population P(t)

and the amount of labour in ‘efficiency units’ L(t) used in
production.

 L(t) = E(t) P(t).............(3.11).......Effective Population

 E(t): efficiency or productivity of an individual at time t.

 With this we can amend the capital accumulation equation.

Solow Model With Technical Progress
Solow Model With Technical Progress
 Capita per efficiency unit of labor produces output per efficiency unit
of labour.

 Just as in the original model, if there too much of Capita per

efficiency unit of labor, then we have a shortage of (effective)
labour and the output-capital ratio falls.

 That is there are diminishing returns to efficiency units of labour.

 If the capital per effective labour rises, it means physical capital is

growing faster than the rate of population growth and technical
progress combined.
Solow Model With Technical Progress
 The analysis runs exactly parallel to the earlier case.

 However, the interpretation of the steady-state level of capital

per effective labour changes.

 Even though the capital per effective labour converges to a

stationary steady state, the amount of capital per member of
the working population continues to increase!

 At what rate will this increase?

 Thus there is long-run growth in the model!

Convergence - Unconditional
 The strongest prediction of the Solow model is called
unconditional convergence.

 Suppose countries, in the long-run, have same rates of technical

progress, savings rate, population rates and depreciation
rates,

 then in all countries, capital per efficiency labour will converge

to a common value, k^*.

 History in terms of countries’ initial conditions does not matter.

Convergence - Unconditional
Convergence – Unconditional (Baumol
1986)
Convergence – Unconditional (De Long
1988)