Part 1
Lucas (Marshall Lectures at the University of Cambridge)
“Rates of growth of real per-capita incomes are…diverse, even
over sustained periods…Indian incomes will double every 50
years; Korean every 10. An Indian will, on average be twice as
well off as his grandfather; a Korean 32 times…
I do not see how one can look at figures like these without
seeing them as representing possibilities. Is there some
action a government of India could take that would lead the
Indian economy to grow like Indonesia’s or Egypt’s? If so,
what, exactly? If not, what is it about the “nature of India” that
makes it so? The consequences for human welfare involved in
questions like these are simply staggering: Once one starts to
think about them, it is hard to think about anything else.”
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Savings Flow OUT of the
system.
Investment Flows INTO the
system.
Macroeconomic balance is
achieved when savings just
counterbalance investment.
Fundamental to All Models
of Economic Growth
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Easterly beings by talking about the Volta
river project in Ghana in 1964.
◦ Goal: build a hydroelectric dam to provide
electricity for a aluminum smelter, leading to the
future aluminum industry…
◦ Belief: investment would generate economic
growth
◦ Idea: Investment/aid financing will spur
growth – Idea came from Harrod Domar Model
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According to Domar
(1946), what was the
critical assumption
of the HarrodDomar Model?
Why was this
assumption not very
realistic?
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Domar assumed that the
production capacity was
proportional to the stock of
machinery: that θ=K/Y is
constant or fixed
He admitted this was not
realistic.
Implication: If labor is
abundant and capital is
fixed, then firms will use
technology that uses lots of
labor and few machines –
investment is not a
constraint to growth.
His model was not really
intended as a “growth
model”
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Former Soviet Union after the Bolshevik
Revolution of 1917
In 1920s Bolsheviks controlled: industries,
trade, distribution, agriculture, food, currency
State Economic Planning Commission
(Gosplan) – 5 year plan from 1929-1933 for
economic growth
Set a target savings rate!
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Write down the main equation
of the Harrod-Domar Model
and incorporate the “financing
gap”
Briefly explain how an
economist/Western donors
would apply this formula to
achieve growth.
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We can apply HD equation to poor
countries.
We just need to determine how much
aid is needed to get savings where it
needs to be to increase growth.
Financing gap = Country’s own
domestic savings – needed savings
rate
Given knowledge of θ, δ and a
country’s own savings rate, just fill in
the difference with a financing gap
amount to achieve the targeted growth
rate g.
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Explain how the Harrod-Domar
model should also be “easy” to
apply to centrally planned
economies as described by
Rostow.
What was the “Soviet scare?”
How did Rostow use the
“Soviet scare” to influence
Western donors?
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It would be easy to implement
because the Soviet Union had a
centrally planned economy and could
force a savings rate.
The Soviet scare was based on the
idea that many in the US did feel that
the Soviet system of forced savings
was superior. Further, the Soviet
Union would become a world
economic power attracting “third
world” countries to communism.
Rostow: The Stages of Economic
Growth emphasized the only
determinant of output takeoff was
increasing investment.
So played on cold war fears and
argued: to prevent spread of
communist, the US should increase
the “financing gap” to less developed
(third world) countries
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How was actual country
savings (investment) supposed
to replace aid financing of
savings in the long run with
the HD model?
Why, according to Easterly, did
the HD model (financing gap
approach) not work? In
particular, comment on
Easterly’s motto, “people
respond to incentives.” Why
do you think economists were,
and may be still are, reluctant
to give it up?
How does Easterly argue
countries can get growth from
investment?
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Rosow predicted that countries that
received aid would naturally increase their
own savings as growth “took off” so that
eventually aid could be discontinued.
Chenery and Strought (1966) stressed
that donors relate the amount of aid
supplied to the recipients effectiveness in
increasing the rate of domestic savings.
In the end, this did not work. Countries
did not save and donors did not require
it.
People respond to incentives: Because
many in poor countries do not believe
they have a good future, they do not use
aid to invest in their future; they use aid
to buy consumption goods today.
Invest in more than just machines, invest
in new technologies, educations,
organizational capital. But more so, think
about strengthening incentives to invest
in the future and then let the various
form of investment play out as it may.