Department of Economics

Faculty of Business and Economics

Chapter One
The Concept of Planning
Meaning of Economic Planning
There is no agreement among economists with regard to the meaning of the term economic planning.
The term has been used very loosely in economic literature. It is often confused with communism,
socialism or economic development.
Any type of state intervention in economic affairs has also been treated as planning. But the state can
intervene even without making any plan.
Planning is a technique, a means to an end being the realization of certain predetermined and well-
defined aims and objectives laid down by a central planning authority. The end may be to achieve
economic, social, political or military objectives.
The idea underlying planning is a conscious and deliberate use of the resources of the community with a
view to achieving certain targets of production.
The two main constituents of the concept of planning are:
 A system of ends to be pursued, and
 Knowledge as to the available resources and their optimum allocations.
Thus, planning is a technique for achieving certain self-defined and pre-determined goals laid down by a
central planning authority
As a working definition Planning is a technique or a means to achieve an end. End refers to certain
predetermined target (well defined objective).
End might be achieving:
 Economic objectives,  social objectives or  military objectives or both
. The Rationale for Planning in Developing Countries
Developing countries need economic planning in order to achieve the following objectives:
 To increase the rate of economic development
 To improve and strengthen the market mechanism
 To reduce unemployment and disguised unemployment
 To enhance the linkage between the agricultural and industrial sectors

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 To create social overhead that enhance agricultural and industrial growth
 To expand domestic and foreign trade
 To eradicate poverty
 To be Self-sufficient in food and raw materials
 To reduce inequality
Pre- requisites for planning
The formulation and success of a plan require the fulfillment of the following factors:
 Planning commission
 Statistical data
 Clear Objectives
 Fixation of Targets and Priorities
 Mobilization of Resources
 Balancing in the Plan
 Incorrupt and Efficient Administration
 Proper Development Policy
 Economy in Administration
 An Education Base
 A Theory of Consumption
 Public Cooperation
1. Planning Commission: The first prerequisite for a plan is the setting up of a planning commission
which should be organized in a proper way. It should be divided and subdivided into a number of
divisions and sub-divisions under such experts as economists, statisticians, engineers, etc, dealing with
the various aspects of the economy.
2. Statistical Data: Every act of planning needs a preliminary investigation of existing resources." Such
a survey is essential for the collection of statistical data and information with regard to the total available
material, capital and human resources of the country. It, therefore, requires the setting up of a central
statistical organization.
3. Objectives: The plan should lay down the objectives clearly. The various goals and objectives should
be realistic, mutually compatible and flexible enough in keeping with the requirements of the economy.

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 4. Fixation of Targets and Priorities: This is fixing targets and priorities for achieving the objectives
laid down in the plan. They should be both global and sectoral. Global targets must be bold and cover
every aspect of the economy. They include quantitative production targets. Sectoral targets pertains to
individual industries and products in physical and value terms both for the private and public sectors.
Global and sectoral targets should be mutually consistent in order to attain the required growth rate for
the economy.
5. Mobilization of Resources: A plan fixes the public sector outlay for which resources are required to
be mobilized. There are various internal and external resources for financing a plan. They should
encourage corporate and household savings of the private sector.
6. Balancing in the Plan: A plan should ensure proper balance in the economy, otherwise shortages or
surpluses will arise as the plan progresses. There should be balance between saving and investment,
between the available supply of goods and the demand for them, between manpower requirements and
their availabilities, and between the demand for imports and the available foreign exchange.
 Aggregate savings come from various sources must equal planned aggregate investment in fixed
capital assets and enterprise in the economy.
 The balance between the supply and demand for goods
 Balances are also required between planned demand and supply of manpower, and between import
requirements and the available foreign exchange during the plan period.
In fact, two kinds of balances must be secured in a plan.
 The physical balance which consists of balancing the planned increase in output of various goods
with the amounts and types of investment. It also requires the balancing of the outputs of the various
sectors of the economy.
 The monetary or financial balance which consists of balancing the incomes with consumption. The
lack of these financial balances will lead to disequilibrium in the supply and demand for physical goods
thereby leading to inflationary and balance of payments pressures during planning.
7. Incorrupt and Efficient Administration: A strong, efficient and incorrupt administration is the sine
qua non of successful planning. But this is what an underdeveloped country lacks the most. Lewis
regards a strong, competent and incorrupt administration as the first condition for the success of a plan.
 Competent administrative staff should be appointed in various ministries
 It should gain experience in planning and starting a project, without such administrative machinery,
development planning has no major input in an under developed country.
 Lewis “in the absence of such an administration it is often much better that governments should be
laissez-faire than they should pretend to plan”. The phenomenal success of development planning in
Russia can be attributed to "a highly trained and disciplined priestly order of the Communist Party."
 The economics of development is not very complicated; the secret of successful planning lies more in
sensible politics and good public administration.
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A. Proper Development Policy: The state should lay down a proper development policy for the success
of a development plan and to avoid any pitfalls that may arise in the development process.
8. Economy in Administration: Every effort should be made to effect economies in administration,
particularly in the expansion of ministries and state departments. The people must feel confident that
every pie that they pay to the government through taxation and borrowings is properly spent for their
welfare and development, and not dissipated away.
9. An Education Base: For a clean and efficient administration, a firm educational base is essential.
Planning to be successful must take care of the ethical and moral standards of the people. This is not
possible unless a strong educational base is built up.
10. A Theory of Consumption: Underdeveloped countries should not follow the consumption patterns
of the more developed countries. Cheap bicycles in a low-income country are thus more important than
cheap automobiles. Above all, nothing is so important, as abundant and efficiently produced food,
clothing and shelter for these are the most universal requirements.
11. Public Cooperation: Planning requires the unstinted cooperation of the people. Economic planning
should be above party politics, but at the same time, it should have the approval of all the parties. For,
without public support no plan can be success

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 Chapter Two
Classifications of Development Planning
There are various types of economic planning as there are patterns of economic systems.
• Planning takes different forms on the basis of:
– Differences in time periods – Institutions affected
– Extent of activities covered – Modes of executing the plan, et
Therefore, the types of planning are:
– long-term, medium-term, and short-term planning – Authoritarian and Democratic Planning
– General and Partial Planning – Functional and Structural Planning
– Planning by Inducement and Direction – Centralized and Decentralized Planning
– Physical and Financial Planning - Rolling and Fixed Planning
1. long-term, medium-term, and short-term plans
– long-term plan is a perspective plan that covers a period of fifteen, twenty, or even twenty-five years.
• strictly speaking, it’s more of a projection into the future than a plan for the future.
– It predicts certain major variables, such as population, labor force, and productivity in the distant
future to serve as a background for the formulation of medium-term plans.
• The long-term plan is basically a supply-side plan.
– This is because, in the long run, economic growth is a result of increases in production capacity rather
than in demand.
– medium-term plan is a pan whose duration varies from three to seven years.
• However, it is by no means necessary that a country always stick to the same duration in its medium-
term planning.
• medium-term plan consists of variables on both the supply side and the demand side.
– short-term plan is an annual plan, used for adjustment in order to keep development planning close to
reality. • It is also used to link economic plans to government budgets.
• It is a plan on the demand side simply because potential supply is fixed in the short run.
2. Authoritarian and Democratic Planning
• Authoritarian planning:
– the government is the sole centralized agency which draws the plan and implements it.
– There is central control and direction of all economic activities in accordance with a single plan.

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 – Planning authority is supreme body; it decides about targets, schemes, allocations, methods,
procedures of implementation
– No opposition-accept and implement
• It is more comprehensive, systematic and rigid and is more efficient.
Democratic planning:
– People are engaged at every step in the formulation and implementation of the plan
– It respect institutions of private property
– Price mechanism is allowed to play its due role.
– The private sector plays side by side with public sector
– Individual freedom prevails and people enjoy social, economic, and political freedom
3. General and Partial Planning
– General planning: a comprehensive and integrated plan that covers all aspects of the economy.
– Partial planning: a sort of piece-meal planning in which the plan covers only some important sectors of
the economy.
4. Functional and Structural Planning
– Functional planning: doesn’t alter the existing socio-economic framework.
• It attempts to modify or improve the existing structure or repair or rehabilitate it (if it is damaged)
– Structural planning: changes the existing order radically.
Note: – Functional planning assumes that planning is possible even in a capitalistic economy, whereas
advocates of structural planning think that planning and capitalism are incompatible.
– Functional planning is evolutionary while structural planning is revolutionary
– A country may begin with structural planning and may end up with functional planning.
– Functional and structural planning may go on side by side in an economy at the same time
5. Planning by Inducement and Planning by Direction
– Planning by inducement; - indicative planning is the case where the government seeks to influence
economic and investment decisions by offering incentives to entrepreneurs via fiscal and monetary
policies but does not control or regulate the functioning of the economy directly.
• The State tries to manipulate the market by means of incentives and inducements through price
fixation, taxation and subsidies.
– it is planning by persuasion rather than compulsion; there is freedom of enterprise, freedom of
production and consumption subject to some regulation or control by the state

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 Demerits
• The private entrepreneurs care more for profit than for the growth of the economy.
• The fiscal and monetary policies of the government are not so successful in the underdeveloped
countries;
• incentives offered is often unattractive and disincentives may not be deterrent enough to follow the
state guidelines. Thus, It fails to achieve the objectives of planning or targets of production
• the market forces fail to bring about proper adjustment between demand and supply
-Planning by direction: minute and detailed instructions being given both to producers and consumers.
• A list of all commodities to be produced with the quantity of each has to be prepared as well as a
separate list for each of the complements and substitutes.
• is very comprehensive; covers the entire economy.
Demerits – It is undemocratic (no economic freedom): It is bureaucratic and totalitarian and, as such,
involves the treatment of human beings as mere pegs in a big bureaucratic machine. Rationing and
control result in black marketing and corruption.
– Often fails to yield satisfactory results: due to the complexity and many-sidedness of modern
economic system.
– There is bound to be shortage of some and surplus of other commodities.
– Inflexible: The plan once prepared must be adhered to, no part of the plan can be altered affecting the
whole plan.
– Black markets emerge to overcome the imperfections of the plan
– leads to excessive standardization which impinges on consumer's sovereignty.
– involves huge administrative costs-elaborate censuses, numerous forms and army of clerks
 the choice between these two types of planning is determined by the system of government
prevailing in the country.
– A democratic government adopts indicative planning whereas a' socialist state will adopt planning by
direction.
6. Centralized Planning and Decentralized Planning
– Centralized planning: planning is done by a central authority (from the top) and each citizen (producer
or consumer) is simply expected to carry out the instructions or the job or duty assigned to him without
questioning about its viability
– Decentralized planning: planning from the bottom.

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• each village shall prepare a plan for the economic development of the village and each industry may be
asked to prepare its own plan.
• Out of these plans, an integrated plan may then be evolved for the country as a whole
7. Physical and Financial Planning:
– This is whether we fix the size of investment in terms of real resources or in terms of money.
– physical planning: fix the size of investment in terms of real resources
• Allocation of resources is made in terms of men, material, machinery, etc
• example how much iron, how much coal, oil and electricity will be required to produce some specific
amount of steel.
– financial planning: fix the size of investment in terms of money
• Measurement and allocation of resources is made in terms of money
-In financial planning, the planners determine how much money will have to be invested in order to
achieve the pre-determined objectives or targets.
• Total outlay is fixed in terms of money on the basis of growth rate to be achieved, the various targets
of production, estimates of the required quantity of consumer goods and the various social services,
expenditure on the necessary infrastructure, etc., as well as revenue from taxation, borrowings and
savings.
– Challenges:
• Owing to smallness of organized money sector and the existence of a larger non-monetized sector, the
estimates of financial resources may go wrong
– In physical planning, the planning authority has to work out how much land, labour, materials and
capital equipment will be required to implement the plan and achieve the targets set out for it.
• the planners have to determine not only the amount of investment but also work out its composition in
terms of the various goods and services required to' obtain a certain increase of output of product
• It is an input-output analysis: requires proper evaluation of the relationship between investment and
output
• In the under-developed countries, there is statistical blackout
– Physical planning has to be supplemented with financial planning.
• Both of them are necessary to assure the success of the plan.
• They are complementary to each other just as the right and left legs are needed for walking.
– There has to be a proper balance between the two.
• Both techniques must be integrated.

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 8. Rolling and Fixed Planning
– In a rolling plan, every year three new plans are made and acted upon.
• First, there is a plan for the current year which includes the annual budget and the foreign exchange
budget.
• Second, there is a plan for a number of years, say three, four or five. It is changed every year keeping
with the requirements of the economy. It contains targets and techniques to be followed during the plan
period, along with price relationships and price policies.
• Third, a perspective plan for 10, 15 or 20 or even more years is presented every year in which the
broader goals are stated and the outlines of future development are forecast
Example. • if the plan starts in 2021, there will be an annual plan in every subsequent year that
is, 2022, 2023, and so on. The five-year plan for 2021-2025 will also roll on for the subsequent periods
by shedding each previous year so as to become a plan for 2022-2026, 2023-2027 and so on.
– Rolling plan is devised to overcome the rigidities encountered in the fixed five-year plans
– Being flexible, a rolling plan is more realistic than a fixed plan.
• It takes into consideration such unforeseen natural and economic changes as floods, drought, war,
hike in oil prices, etc. which may affect the economy adversely
– Critics
• since the targets are likely to be revised every year, it is not possible to achieve the targets laid down in
the plan within a fixed time period
• when the plan is continuously revised, it creates uncertainties in the private and public sectors •
constant revisions of the targets of the plan develop an attitude of non-commitment and apathy among
the planners
-Fixed Plan • Lays down definite aims and objectives which are required to be achieved during the plan
period
– the contents of the plan are fixed in relation to a fixed time period. These contents consisting of
targets, priorities, strategies and resources, etc. will not be changed during the particular time period for
which the plan has been prepared except for severe unforeseen events
Merits and demerits of fixed planning
Merits: a. There is a boldness in planning.
This is the essence of planning that the planners and implementing machinery will not bow down before
the obstacles.
b) There is effective implementation of plan.
c) The targets of fixed plan are certain and this certainty in objectives brings stability to the economy.

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d) Fixed plans ensure discipline for the planning process.
Demerits
a) Fixed plans are inflexible plan. They cannot be altered in later phases.
b) There is no revision of economic objectives and targets as there is no alteration allowed under fixed
planning.
c) If the state is an under-developed country, the fixed plan would give the economy a hard time to
achieve the basic objectives like employment, industrialization, education, health, etc.
d) Fixed plans, if not properly formulated and implemented, lead to wastage of resources.
• Merits and demerits of Rolling Plan:
Merits
a) Rolling plans are flexible and can be altered in later phases.
b) The rolling plan allows for revisions and adjustments. In rolling plan, review of the plan is a
continuous exercise.
c) Rolling plans enable the planners to keep the time horizon moving, along with making revisions and
adjustments so as to prepare a new plan every year in accordance with the changing circumstances.
Demerits
a) Rolling plan is furnished with uncertainty, as there is no fixation of economic objectives.
b) In rolling plans, the planners are always reluctant in taking difficult decisions or taking courageous
decisions.
c) Under rolling plan, there is a lack of commitment

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 Chapter Three
Strategic Planning
Concept of Strategic Planning
planning can be defined as follows: The anticipation of possible future situations, the selection of
desirable situations to be achieved (objectives) and the determination of relevant actions that need to be
taken in order to reach those objectives at a reasonable cost.
In other words, planning implies thinking about the future and trying to assume control over future
events by organizing and managing resources in such a way that they will bring about the successful
completion of the objectives set forth.
So, what is strategic planning?
Is a disciplined effort to produce fundamental decisions and actions that shape and guide what an
organization is, what it does, and why it does it, with a focus on the future. (Bryson, 1988).
Is a management tool for several key purposes.
-to help an organization do a better job,
-to focus on its energy/resources,
-to ensure that members are working toward the same goals and
-to assess and adjust its direction in response to an ever-changing environment.
Origin and History; - Strategic planning has its origin in warfare. The word ‘strategy’ derives from the
Greek word stratos (a combination of stratos =army, and agein =to conduct).
The Greek term referred to the civil-military officials elected by the citizens of Athens to assume
leadership during times of war.
The strategoi were expected to prepare and implement overall, top-level plans in order to achieve the
long-term goal of winning the war (through battles, negotiations, or any other means available,
according to the changing situation).
They were not directly in charge of daily short-term operations of managing troops to win specific
battles, which was the responsibility of lower ranking officers.
From its military roots, strategic planning has kept at least two essential characteristics:
- to think big, by taking into consideration all possible options and paying due attention to the changing
environment; and
-to focus on a clear, final and firm long-term goal to be achieved.
Adoption in the business world
-The extended use of strategic planning in the business world started after the WW II.

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During the 1960s, it became a standard management tool in all big and in many small companies
-Included in the curricula of all respectable business schools.
-At least two interrelated important evolutions, as compared to the original military-rooted concept, are
worth mentioning here.
-First, it was gradually realized that, at least in complex enterprises, strategic planning should not only
take place at the executive level but that it should also be undertaken at the different levels and functions
within the organization.
-Every manager is a strategy maker and strategy implementer for the area which he/she has authority
over and supervises.
Second, it also became clear that in order to increase the chances of successful implementation, the
preparation of a strategic plan could not be left to external consultants or even internal planning units
alone.
-Unless those in charge of implementation identify with what is being proposed, plans tend to become
paper exercises.
-A good plan will take into consideration the whole organization or management unit and, therefore, all
staff should be involved in its preparation in one way or another.
Adoption in the Public Sector
- Strategic planning entered the public and semi-public sectors during the mid-1980s, at a moment when
the liberal market philosophy began to dominate all management thinking T
-The era when public management reform was in the air.
-It was felt that government administration should become more cost-effective and that this implied
becoming more result (service) oriented, which could best be obtained by applying strategic
management principles.
The basic assumption behind the introduction of strategic management in the government sector is
that, in spite of their differences, strategic planning is an approach which is relevant to all kinds of
organizations simply because all organizations have specific long-term goals to reach and, since
resources are always limited, they have to find the most efficient way to attain these.
-At the same time, different types of organizations have their own features, which means that strategic
planning can never be applied in a blue-print manner but has to be adapted to the specificity of the type
of organization under consideration.
3. Characteristics of SP :- In line with the definition and concepts discussed above, some key
characteristics of a strategic planning approach are worth highlighting.
I. Strategic planning is guided by an overall sense of direction

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 -Strategic planning is not just a cold technical undertaking that spells out future objectives to be reached
and actions to be taken.
- It needs a global sense of purpose and direction capable of guiding implementers in making everyday
choices about what actions should be taken in order to produce the expected results.
II. Strategic planning is result-oriented I Strategic planning: concentrate on whether the expected
results have been obtained. This is called performance/result monitoring.
-Results of a specific activity are then usually measured at three successive levels:
-Immediate outputs (e.g. the number of schools built),
-Intermediate outcomes (e.g. the increased enrolment rates) and
-Long-term impacts (e.g. the increased average number of years of schooling of the population).
III. Strategic planning is sensitive to the environment
-Strategic planning is based on the belief that the successful development of an organization is the
result of finding the right fit between its internal strengths and weaknesses and the external opportunities
and threats stemming from the environment.
-In order to be effective, organizations must be responsive to their environment, which is continuously
changing.
-Consequently, a careful scanning of the environment is important not only at the stage of making the
initial diagnosis for preparing a plan, but also, and even more so, at the stage of monitoring the plan
implementation.
IV. Strategic planning is a mobilization instrument
- Strategic planning cannot succeed without the commitment of the plan implementers and the different
stakeholders. Commitment can only be obtained if people identify with the plan, so that they are
motivated to produce the expected results.
-Strategic planning should therefore not be carried out in isolation by experts alone, but rather as an
inclusive process in which the implementers and stakeholders are actively involved in one way or
another.
- If organized in a participatory way, the preparation of a strategic plan in itself becomes a learning
experience.
V. Strategic planning is flexible in its implementation
-Strategic planning is based on the belief that no neat, final plan can be prepared.
Environments are too unpredictable, and it is impossible to foresee every possible consequence of future
decisions that will be made.

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 -An essential characteristic of strategic planning is, therefore, to proceed by ‘intelligent trial and error’
rather than by linear adherence to a detailed, polished plan document.
4. The strategic planning process
Strategic planning is basically about systematically answering four key questions. And each question
corresponds to a set of specific planning activities as illustrated below.
questions planning activities
where do we stand today? Diagnosis:- analyzing the current situation in the sector and its
environment
where would we like to be Policy formulation;- selecting over all goals and strategies
in the future ?
how shall we get there? Plan preparation;- defining precise objectives and balancing
objective and means
how shall we know we are Monitoring:- measuring progress and taking corrective action
moving in the right
direction?
Although there is a logical, sequential order in raising the questions, there is no clear-cut order in
answering them.
Strategic planning has to be looked at as an iterative process that involves going back and forth between
the different questions and the corresponding planning activities.
In the broad sense of the term, planning covers the four different activities from diagnosis to monitoring.
In the narrow sense, it is often equated only with plan preparation.
However, within a strategic planning approach, plan preparation should not be opposed to plan
implementation as is often the case.
planning does not stop when plan implementation starts.
5. Steps in strategic planning
There is no single model that fits all;
Develop mission and vision, assess environment, formulate strategy, implement, monitor and evaluate
Vision = dream Mission = purpose
Goals & objectives
Objectives - the end results of planned activity
Goal - an open ended statement of what one wants to accomplish, with no quantification of what is to
be achieved and no time criteria for completion.
For example, a simple statement of “increased profitability”
Goal is stated in past tense showing the result after achievement of objectives

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 N. B. Objectives are usually achieved within the time frame of the strategic plan not necessarily the
goals.
Goals vs objectives
Goals: -
-A greater purpose
-A long term outcome
-May not be easy to measure
Objectives: -
-A specific short term action that will contribute to achieving a goal
-must be measurable

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 Chapter Four
Aggregated Planning Models and Their Application
Models Planning involves a set of social and economic variables. These variables are assumed to be
interrelated and the relationship can be very complex.
Models are used to analyze the complex relationships between the different variables; however,
some of the variables may be unrelated. One of the advantages of models is that they are essential
aids for clear understanding or different relationships between variables.
Characteristics of analytical models
Models have some common characteristics. The most common characteristics include: -
1. Coverage: - Overall (national) models, Sect oral (regional) models, or Project
2. Degree of aggregation: aggregated models, Main sector models, Multi sector models
3. Time dimension
i. based on the capacity to predict the future development: Long-term models; Medium-term models’
Short-term models
ii. based on time treatment with in the models: Static models or Dynamic models.
4. Behavioral relationships: Stochastic models or Deterministic models:
5. Degree of closure: Open models, fully closed models, or Partially closed models
6. Accounting Framework. Consistency models and Programming models
Aggregate Development Planning Models
Development planning models can be aggregative. Here the entire economy is taken into account and
the behavior of some of the major variables such as output, income; saving and capital are taken into
consideration. These are also regarded as macro models and as an example the use of the Harrod-Domar
model can be cited. In many Less Developing Countries, relevant data for the entire economy may not
be available although enough information could be obtained for a single project.
Aggregate Models: The Harrod-Domar Models
The model which is most used is the one developed by Harrod and Domar (H-D) in the context of
growth theory. In a simple form, the model could be set out as follows:

St = It --------------------------1
It= Kt+1 – KI-----------------2
St= sYt-t----------------------3
Kt = v Yt-1------------------- 4

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 Where S is savings I is investment K is capital stock Y is income
v is the capital-output ratio or capital coefficient and s is the propensity to save.
After making the necessary substitutions from equations 1, 2 and 3we get
i.e. sYt-t = vYt - vYt-1--------------5
i.e. sYt-t = v(Yt - vYt-1)-----------6
Yt-yt -1 =S
Yt-1 V  --------------------------------------7
Since growth of income (g) is defined as :
g= Yt -yt -1
Yt-1
We get the familiar HD equation
g=S
V--------------------------------------------------- 8
The model helps the planner to predict the required savings rate once the target growth rate and the
capital-output ratio v are given. In any economy, if the actual growth rate is 3 % per annum, given s = 9
% and v = 3: 1, then in order to achieve a target growth rate (g) of 5 %, the planner will have to
recommend a rise of s to 15 % with given v (3: 1)..
Application of the Harrod-Domar Model
To sum up Domar’s model was not intended as a growth model and was rejected to accept as a growth
model forty years ago by its creator. So it was ironic that Domar’s growth model became, and continues
to be today, the most widely applied growth model in economic history. Then, Economists still do apply
the model to poor countries to determine a required investment rate for a target growth rate. The
difference between the required investment and their own saving is the financing gap. Donors fill the
financing gap with foreign aid to attain target growth in the short-run through aid and investment
The invention of development (A. Lewis)
For centuries, nobody had paid much attention to the economic problems of poor countries. But it
changed after World War II and having ignored poor countries for centuries, called attention to their
urgent problems. Everyone suddenly agreed that the poor countries should develop. Economists rushed
to give policy advice to the newly independent governments of the poor countries. The development
economists were influenced by two simultaneous historical events.
i. Like Domar, the great depression, and
ii. The industrialization of the USSR through forced saving and investment.
The Depression and large number of unemployed rural people in poor countries motivated A. Lewis to
suggest a surplus labor model in which only capital was a constraint.
A. Lewis suggested that building factories would soak up this labor without causing a decline in rural
production.

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How many new machines? Lewis and other development economists assumed a fixed ratio in
production between people and machines, ie, Leontief production function. Since there is surplus
labor, machines were the binding constraint on production. Production was proportional to machines,
just as in Domar because the supply of available workers was unlimited. Lewis cited a particular
example of an economy that had grown through pulling in excess labor from the countryside of the
Soviet Union. Economists usually discussed the growth to investment ratio the other way round, ie, the
ratio of required investment to desired growth.
They call this ratio the incremental capital output Ratio (ICOR), and thought it was somewhere between
2 and 5. Lewis said the central fact of economic development is rapid capital accumulation.
A country that wanted to develop had to go from an investment rate of 4 % of GDP to 12-15 % of GDP.
Investment had to keep a head of population growth.
Example: a country with an investment rate of 4% of GDP and an ICOR of 4 will have growth one %
per year. This doesn’t even keep up with population growth of 2% a year.
If the country gets investment up to the Lewis magic number of 12% of GDP, then it will have GDP
growth of 3% a year. Then, the country's GDP per capita increase at one % per year.
How do we get investment high enough? Say current national saving is 4 % of GDP. The early
development economists thought that poor countries were so poor that they had little hope of increasing
their saving. There is a financing gap of 8% of GDP between the required investment (12% of GDP for
3% GDP growth) and the current 4% of GDP level of national saving. Therefore, western donors should
fill the financing gap with foreign aid in order to achieve the target output growth.
The stages of growth (Rostow)
The next step in the evolution of the financing gap was to persuade rich nations to fill the gaps with aid
is Rostow’s stages of growth (1960). Anticipating the self-help boom, Rostow figured out five stages of
growth (traditional society, pre-take off, take off, self sustained maturity, and high consumption) and the
stage that stuck in people’s mind was the take off into self-sustained growth.
But how was take off accomplished? The only determinant of output take off that Rostow cited was
investment increasing from 5-10% of income. This is exactly the same as what Lewis said earlier, take
off just reasserted donor and Lewis with examples.
Rostow tried to show that the investment led take off fit the stylized facts. Stalin’s Russia influenced
Rostow a great deal, as it had everyone else, because it fit the takeoff story. Then Rostow considered a
number of historical and third world cases. However, his evidences were weak because only three out of
fifteen cases he cited fit the story of an investment led takeoff. Many economists noted that soviet’s
economy grow faster than other because of their willingness to extract large forced savings.
There was a danger that the third world may be attracted by certain advantages and would go to
communist camp
Rostow wanted to show the third word that communism was not the only form of effective state
organization that can launch a takeoff. Rostow tried to offer a non–communist way, that is Western

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nations should provide third world nations with aid to fill the financing gap between the necessary
investment for takeoff and actual national saving. He used the Harro-Domar growth model to figure out
the necessary investment (using on ICOR of 3-3.5) for takeoff.
Under US presidency of Kennedy, advised by Rostow, foreign aid reached at $14 billion in 1985 dollars,
equivalent to 0.6 % of America GDP. Therefore, over the entire period of 1950-95, the western countries
gave one trillion dollars (measured in 1995 dollars) in aid. Since virtually all of the aid advocates used
the Harrod- Domar /Financing gap model/ this was one of the highest policy experiments ever based on
a single economic model.
Don’t Forget to save- Need for national saving (Bhagwati, Chenery)
While there was a remarkable degree of consensus that aid to investment for growth was substantially
valid, there was a warning (by Bhagwati) about excessive indebtedness to donors. He noted that debt
servicing problems by some countries on past aid loans.
Getting prices right ( Meier ,Todaro )
The neoclassical critics thought resource allocation more important than resource quantity. They pointed
out growth failures in some countries with high investment but wrong prices. This is to mean that
although physical accumulation may be considered a necessary condition for development, it had not
proved sufficient. The basic reason why investment–led take off didn’t work was not because more
saving and investment is not a necessary condition but rather because it is not a sufficient
Harrod – Domar in the new growth literature (Solow and Rebelo)
At first the new growth literate seemed to support the Harrod-Domar linear growth and investment relationship.
The Solow model ( Y=AKaL 1-a ) suggested that there was a learning by doing, that is externality from physical
capital to technological knowledge (KB ) so that production function was given by:
Y =Aka L1-a KB -------------------------------9

If we assume that A+B =1, then growth was significantly and linearly related to the investment rate,
however, latter changed with the arbitrary that physical capital would lead to technological spillover.
Developing countries suffer not from an object gap (like lack of physical capital) but rather on idea gap
(lack of technology).
Another production function in the new growth literature that seemed in the spirit of Harrod– Domar
was Rebelo’s classically simple model that Y=AK. He said to mean k to include not just physical
capital, but all kinds of capital such as human capital, organizational capital and technological
knowledge
Harrod- Domar in the 90s and computer technology
World Bank economists developed Minimum standard model ( MSM ) with the initial motivation for the
modeling to try predict w/c countries were going to get into difficulties. The minimum model was
having a useful life of about six weeks. It was expected country economists to build more elaborate
country specific models.

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Conclusion: The World Bank is not alone, virtually all international institutions addressing the needs of
poor countries stress the short- run necessity of both investment & aid for growth. So the circle of irony
closes. The communist economies have partly inspired the ICOR, the cold war inspired foreign aid, &
now the capitalist economies gave foreign aid to ex-communist economies in amounts influenced by the
ICOR
The Two- Gap Models
. The two-gap approach introduces the assumptions that an imported commodity not produced
domestically is essential for the production of investment goods. If the availability of foreign exchange
to purchase these imported capital goods constrains the growth of the economy, the growth would be
Exogenous, since it depends on foreign investment goods and technology. Foreign capital can be in
introduced in the form of official flows, or foreign direct investment (FDI).
On the other hand, if the above assumption does not hold, and the economy can domestically produce
investment goods, then a shortage of domestic savings could be an essential constraint on growth. If the
economy produces only enough consumption and investment goods to maintain the current production
level, it doesn’t save or grow. If the availability of foreign capital to compensate for the lack of domestic
savings constrains the growth of the economy, we may call the growth Endogenous, since the economy
has own technology and human resources.
Most of the successful economic growth in the Asian countries during the 1990s initially took an
exogenous and export-led development path. Latter, the foreign exchange earned by strong exports
increased their domestic saving and changed their development pattern to fit in the endogenous growth
path.
Development Assistance debate
Development assistance can be defined as capital and technology transfers provided by industrialized
countries for the purpose of improving the welfare of the poor. Various economic models have been
designed to explain how these transfers would affect the macro economies of the recipient countries.
One of the various theories of development assistance and foreign capital inflows is exhaustively
reviewed by two-gap model or three gap models. The gap model has three basic steps, it begins with the
general macroeconomic identity then calculates the gap using some formulae and finally identifies and
targets for that gap
I. Macroeconomic identity
Supply Demand Interaction
Y=C Y=C
C+S C+I S-I= saving gap
C+S+T C+I+G T-G =fiscal gap
C+S+T+X C+I+G+M X-M = foreign exchange gap
II. Using formula for calculating the gap
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In order to look the saving constraint:
I< F+SY
where I = domestic investment F = amount of capital inflows S = saving income Y= notional income
III. the two–gap model compares the two constraints and identifies which of the two is the most
critical for growth
External Financial needs to meet the Poverty Reduction Target
a) Making the investments needed to end poverty?
The extreme poor lack six major kinds of capital
1. Human capital: - health, nutrition and skills needed for each person to be economically productive.
2. Business capital: - the machinery, facilities, motorized transport used in agriculture, industry and
services.
3. Natural capital: - arable land, healthy soils, biodiversity and well-functioning ecosystems that
provide the environmental services needed by society.
4. Public institutional capital: - commercial law, judicial systems, government services and policing
that underpin the peaceful and prosperous division of labor.
5. Knowledge capital: - the scientific and technological know-how that raises productivity in business
output and the promotion of physical and natural capital.
6. Infrastructure: - roads, power, water and sanitation, air ports and sea ports and telecommunication
systems that are critical inputs into business productivity.
b) How the poverty trap works and foreign aid helps to overcome it?
1. The basic mechanics of capital accumulations.
Economic Growth Population Growth and depreciation (-Ve)
Consumption
Household Saving

Household Income Capital per person

Public Budget
Tax payments Public Investment
2. The poverty gap
Basic Needs
Impoverished Zero Household Decline in Capital Negative Economic Growth
Household Saving per person
Zero tax
Payment Zero Public Investment population growth and depreciation

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c.A Millennium Development Goal MDG- based poverty reduction strategy
A true MDG- based poverty reduction strategy would have 5 parts:

a) A differential diagnosis, which identifies the policies and investments that the country needs to
achieve the MDGs.
b) An investment plan, which shows the size, timing, and costs of the required investments
c) A financial plan to fund the investment plan, including the calculation of the MDF Financing Gap,
the portion of financial needs that the donors will have to fill.
d) A donor plan, which gives the multiyear donor commitments for filling the MDG financing gap.
e) A public management plan that outlines the mechanisms of governance and public administration
that will help implement the expanded public investment strategy
d) Can the rich afford to help the poor (methods of estimating financial needs)?
As an example, the financial needs to meet the first MDG, that is Eradicate Extreme Poverty and
Hunger can be calculated as follows:
The World Bank estimates that meeting the basic needs requires $1.08 per day per person, measured in
1993 purchasing-power. According to the Bank’s estimated, 1.1 billion people lived below the $1.08
level (2001), with an average income of $0.77 per day ($281 per year). Then, the poor had a relative
short fall to basic needs of $0.31 per day ($1.08 - $0.77) or $113 per year. World wide, the total income
shortfall of the poor in using the same accounting units, the income of the 22 donor countries of the
development assistance committee (DAC) in 2001 was $20.2 trillion. Thus, a transfer of 0.6% of donor
income, amounting to $124 billion, would raise all 1.1 billion of the world’s extreme poor to the basic
needs level.
e) The needs assessment approach has six steps:
- Identify the package of basic needs
- Identify, for each country, the current unmet needs of the population
-Calculate the costs of meeting the unmet needs through investments, taking into account future
population growth.
-Calculate the part of the investments that can be financed by the country itself
- Calculate the MDG financing gap that must be covered by donors.
- Assess the size of donor contributions relative to donor income.
f) The Millennium Development Goals There are 8 Goals, 18 Targets and 48 Indicators for Monitoring
Progress. These are described as follows:
The eight Millennium Development Goals (MDGs) – which range from halving extreme poverty to
halting the spread of HIV/AIDS and providing universal primary education, all by the target date of
2015
– form a blueprint agreed to by all the world’s countries and all the world’s leading development
institutions. They have galvanized unprecedented efforts to meet the needs of the world’s poorest.
External Financial need
The two and three-gaps models are not frequently used for financing developing countries because
under projected rapid and sustainable growth finance with external resources, the savings gap model
rather than the other (foraging exchange or the fiscal gap models) becomes the key binding constraint
while we agree that the gaps approach has limitation ,it should be clear that saving gap prove useful in

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estimating long- term financing needs for countries expected to experience sustainable growth and it is
also an empirical evident to a stable long– term clanship between and growth .
When using the saving gap model, it involves two basic steps:
Step 1: Based on the ICOR, the investment rate required for achieving a certain growth rate is
calculated,
Step 2.The gap between the investment required and national saving is calculated
The model takes into account four major determinants of the current account
, - The saving investment gap - Profit remittances -Interest payments on external debt - Unilateral
transfers
It tried to give the annual average external financing needs under a base scenario (2004-2010) and
estimates of the annual financing required to halve poverty by 2015 under the poverty reduction target
scenario for six developing regions comprising 106 countries. The model starts with a Harrod-Domar
production function in which the investment rate required to meet a predetermined growth rate is
i  y, ICOR Where i = Investment rate yt = GDP growth rate at time t ICOR= increment
capital output ratio

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