5.4 Growth and development strategies

1. 5.4 Growth and development strategies INTERNATIONAL BACCALAUREATE

2. 5.4 Growth and development strategies • As a general rule, growth models describe how growth has occurred and so suggest that this may be replicated. Growth strategies are economic policies and measures designed to gain growth, and development strategies are economic policies and measures designed to achieve human development.

3. Harrod-Domar growth model • In the 1940's Roy Harrod (1948) and Evsey Domar (1946) separately developed a macro-dynamic model through an extension of Keyns's theory. The model's original intent was to identify the source of instability in the growth of developed economies where effective demand is normally exceeded by supply capacity. In the 1950's and 1960's this model was applied to economic planning in developed economies.

4. Harrod-Domar growth model • The model states that the rate of growth of GDP is determined by the national savings ratio and the ratio of capital to output in the economy. • Rate of growth of GDP = savings ratio/ Capital output ratio • So if the savings ratio in the country is 5% and the capital/output ratio is 2.5, then the country can grow at a rate of 2% per annum.

5. Harrod-Domar growth model • If the model is correct then we can say that the rate of growth of an economy may be increased by one of two things. • Increasing the level of saving in the economy • Reducing the capital/output ratio in the economy (capital use becomes more efficient)

6. Harrod-Domar growth model

7. Harrod-Domar growth model • The main criticism of the model is the level of assumption, one being that there is no reason for growth to be sufficient to maintain full employment; this is based on the belief that the relative price of labor and capital is fixed, and that they are used in equal proportions. The model explains economic boom and bust by the assumption that investors are only influenced by output (known as the accelerator principle); this is now widely believed to be false.

8. Harrod-Domar growth model • In terms of development, critics claim that the model sees economic growth and development as the same; in reality, economic growth is only a subset of development. • Another criticism is that the model implies poor countries should borrow to finance investment in capital to trigger economic growth; however, history has shown that this often causes repayment problems later.

9. Harrod-Domar growth model • Perhaps the most important parameter in the Harrod–Domar model is the rate of savings. Can it be treated as a parameter that can be manipulated easily by policy? That depends on how much control the policy maker has over the economy. In fact, there are several reasons to believe that the rate of savings may itself be influenced by the overall lever of per capita income in the society , not to mention the distribution of that income among the population. • LDC’s savings rates are low due to poverty, poor financial infrastructure, and capital flight.

10. Harrod-Domar growth model • growth rate in the Harrod-Domar model is given by the ratio between the savings (S) ratio and the capital-output (K) ratio G = S/K • on the very basic assumptions of no foreign sector and no government sector the Harrod-Domar model states that the rate of economic growth “G” is positively dependent on the savings ratio “S” and negatively dependent on the capital output ratio “K” where k is the productivity of capital in the economy

11. dual sector model • Lewis's Dual Sector Model of Development: The theory of trickle down • Lewis proposed his dual sector development model in 1954. It was based on the assumption that many LDCs had dual economies with both a traditional agricultural sector and a modern industrial sector. • The traditional agricultural sector was assumed to be of a subsistence nature characterized by low productivity, low incomes, low savings and considerable underemployment. • The industrial sector was assumed to be technologically advanced with high levels of investment operating in an urban environment.

12. dual sector model • Lewis suggested that the modern industrial sector would attract workers from the rural areas. Industrial firms, whether private or publicly owned could offer wages that would guarantee a higher quality of life than remaining in the rural areas could provide. • Furthermore, as the level of labor productivity was so low in traditional agricultural areas people leaving the rural areas would have virtually no impact on output. Indeed, the amount of food available to the remaining villagers would increase as the same amount of food could be shared amongst fewer people. This might generate a surplus which could them be sold generating income.

13. dual sector model • Those people that moved away from the villages to the towns would earn increased incomes and this crucially according to Lewis generates more savings. The lack of development was due to a lack of savings and investment. The key to development was to increase savings and investment. Lewis saw the existence of the modern industrial sector as essential if this was to happen. Urban migration from the poor rural areas to the relatively richer industrial urban areas gave workers the opportunities to earn higher incomes and crucially save more providing funds for entrepreneurs to investment.

14. dual sector model • A growing industrial sector requiring labor provided the incomes that could be spent and saved. This would in itself generate demand and also provide funds for investment. Income generated by the industrial sector was trickling down throughout the economy.

15. Problems of the Lewis Model • The idea that the productivity of labor in rural areas is almost zero may be true for certain times of the year however during planting and harvesting the need for labor is critical to the needs of the village. • The assumption of a constant demand for labor from the industrial sector is questionable. Increasing technology may be labor saving reducing the need for labor. In addition if the industry concerned declines again the demand for labor will fall.

16. Problems of the Lewis Model • The idea of trickle down has been criticized. Will higher incomes earned in the industrial sector be saved? If the entrepreneurs and labor spend their new found gains rather than save it, funds for investment and growth will not be made available. • The rural urban migration has for many LDCs been far larger that the industrial sector can provide jobs for. Urban poverty has replaced rural poverty.

17. Structural change modelFisher Clark's Theory of Structural Change • Two economists, Fisher and Clark, put forward the idea that an economy would have three stages of production • Primary production is concerned with the extraction of raw materials through agriculture, mining, fishing, and forestry. Low-income countries are assumed to be predominantly dominated by primary production. • Secondary production concerned with industrial production through manufacturing and construction. Middle income countries are often dominated by their secondary sector. • Tertiary production concerned with the provision of services such as education and tourism. In high-income countries the tertiary sector dominates. Indeed having a large tertiary sector is seen as a sign of economic maturity in the development process.

18. Structural change modelFisher Clark's Theory of Structural Change • Countries are assumed to first pass through the primary production stage then the secondary stage and finally the tertiary stage. As economies develop and incomes rise then the demand for agricultural goods will increase but due to their low income elasticity of demand at a proportionally lower rate than income. However, the demand for manufactured goods will have a higher income elasticity of demand. So as incomes grow further the demand for these goods will grow at a proportionately higher rate. Hence the secondary industry will grow. As incomes continue to grow then people will start to consume more services as these have an even higher income elasticity of demand. Thus the tertiary sector will then grow and develop.

19. Structural change modelFisher Clark's Theory of Structural Change • However, this may be misleading. Some LDCs may have a large tertiary sector due to a large tourist industry without having developed a secondary industry. Economists argue that this could be somewhat risky. If the economic base is dominated by an economic activity such as tourism that has a high income elasticity of demand then a recession in the consuming nations will have a disproportionately large impact on the export earnings. A fall income will bring about a proportionately greater reduction in demand for the service and this will have severe impact on the economy. If it does not have a primary or secondary production to fall back on then borrowing and debt might be the only prospect.

20. Structural change modelFisher Clark's Theory of Structural Change

21. Types of aid: • Aid: Assistance given to an individual, firm, region or government. Usually used in the context of overseas aid where governments give assistance to other countries. • Bilateral aid: Official development assistance that takes place between a donor country and a recipient country. • Multilateral aid: Aid channeled through international organizations.

22. Types of aid: • Grant: A form of foreign aid that involves a direct transfer payment from one country to another. • Soft loan: A loan made to a country on a concessionary basis such as a lower rate of interest. • Official Development Assistance (ODA): Disbursements of loans and grants at concessionary rates by governments

23. Types of aid: • Tied aid: Assistance given on condition that it is spent on items produced by the donor country. • Foreign Aid: The international transfer of public and private funds in the form of loans or grants from donor countries to recipient countries.

24. The Benefits of Receiving Aid • Economic ReasonsClearly the most important reason why countries seek and accept aid is for the purpose of economic development. • To improve the investment climate, develop human capital, promote entrepreneurship, as well as provide direct support in fostering trade • To enable payment of interest on foreign debt • To supplement the lack of domestic resources such as foreign exchange • To enable infrastructure changes to be made to the economy such as dams and roads

25. The Benefits of Receiving Aid • Political reasonsIn some cases foreign aid is seen as being necessary in order to maintain power. Often foreign aid in the form of military goods provides the power base that suppresses opposition and maintains the existing government in power. The ending of the Cold War between NATO and the Soviet Union has contributed to the fall in Official Development Assistance (ODA) to the continent of Africa, while Israel and Egypt, for example, were the two major recipients of ODA in 2003.

26. The Benefits of Receiving Aid • Moral reasonsMany people within the Less Developed Countries (LDCs) and the More Developed Countries (MDCs) consider that the MDCs have a moral responsibility to provide development assistance for the poorer countries. This may be because of basic humanitarian reasons or a feeling that the colonial powers such as the UK that occupied countries such as Zambia have a responsibility to redistribute resources, having exploited so many of the resources of the LDCs during colonization.

27. The Arguments Against Foreign Aid • Foreign aid often falls into the hands of corrupt officials who affect the projects that are chosen to be financed. • Aid money is often misspent, even when handled honestly. By imposing solutions from outside, it may be used for projects that generate large numbers of jobs and are beneficial to the government in the short run while providing few long-term benefits. Their creation and maintenance draw scarce local resources and entrepreneurial initiative from other uses, crowding out private investment and initiative. • Transfers of low interest concessionary finance or grants to fill the savings or foreign exchange gaps will interfere in the market determination of interest rates and exchange rates.

28. The Arguments Against Foreign Aid • Aid can create an impression amongst receiving countries that More Developed Countries (MDCs) are wealthy, free-handed donors which provide what seem like huge sums of money by local standards. The impression can also be that this is given without moral judgment, since many of the people who administer aid may be seen as authoritarian and corrupt. As well as leading to a sense that there is some sort of right to aid, it can also distort values of openness, self-help and honesty. It encourages many people in recipient countries to consider migrating to the source of this wealth, since they assume that it must be a rich place where all can prosper.

29. The Arguments Against Foreign Aid • The flow of aid is not always dependable, both because it is manipulated for political reasons and also because in times of recession in developed countries, the aid budget makes an easy target for a reduction in spending. • Aid is often seen, like most forms of charity, as quite a patronizing concept, one party acknowledging its own superiority and aiding the other party not on merit but out of a sense of wanting to help. Dependency theory argues that aid ensures the continuation of the Less Developed Countries (LDC’s) on the periphery and the dominance of the MDC’s in the core.

31. Types of Foreign Aid • To be considered foreign aid a flow of funds should meet two simple criteria: • It should be non-commercial from the donors point of view • It should be concessional so that the interest and repayment is less stringent or softer than commercial terms

32. Types of Foreign Aid • Foreign aid can be divided into • Public Development Assistance and • Private Development Assistance • Public or Official Development Assistance • Individual government assistance, known as bilateral aid • Multilateral donor agencies such as the IMF and World Banks offering multilateral aid • Private Development Assistance • Private non-governmental organizations (NGOs) such as the Red Cross, Oxfam

33. Types of Foreign Aid • A considerable amount of foreign aid is tied aid. Here the grants or concessionary loans have conditions laid down by the donor country about how the money should be used. Tied aid by source means that the recipient country receiving the aid must spend it on the exports of the donor country. Tied aid by project means that the donor country requires the recipient country to spend it on a specific project such a road or a dam. Often this might be to the commercial or economic benefit of the firms in the donor country. For example their engineers might be the designers of the project.

34. Export-led growth/outward-oriented strategies • Export-led growth is an economic strategy used by some developing countries. This strategy seeks to find a niche in the world economy for a certain type of export. Industries producing this export may receive governmental subsidies and better access to the local markets. By implementing this strategy, countries hope to gain enough hard currency to import commodities manufactured more cheaply somewhere else.

35. Export-led growth/outward-oriented strategies • Tariffs are reduced or eliminated, and imports rise • Domestic production is displaced and unemployment rises in domestic industries that compete with imports • Costs for intermediate goods fall leading to an increase in exports and a fall in unemployment in the external sector • Countries specialize in the sectors in which they have a comparative advantage

36. Export-led growth/outward-oriented strategies • Export promotion benefits • There is more rapid growth in both GDP and GDP per capita • Technology transfer takes place through imports of capital goods • Exports of manufactured goods rise compared to primary sector exports • Gains from trade: lead to a higher standard of living • Specialization allows economies of scale and rapid learning by doing • Even if growth is more uneven, the huge increase in productive capacity will lead to rapid investment and linkage adjustment in other sectors (backward and forward integration)

37. Export-led growth/outward-oriented strategies • Export promotion costs: • MDC tariffs and quotas block imports of labor intense manufacturing goods where LDC’s have a comparative advantage • Growth is more uneven • Vertical integration is lost, workers may be confined to assembly and some fabrication • There is a risk that new technology may render a sector obsolete • There may be an overemphasis on natural resource exports which could lead to deteriorating terms of trade

38. Import substitution/inward-oriented strategies/protectionism • Import substitution industrialization (also called ISI) is a trade and economic policy based on the premise that a country should attempt to reduce its foreign dependency through the local production of industrialized products. The term primarily refers to 20th century development economics policies, though it was advocated since the 18th century United States.

39. Import substitution/inward-oriented strategies/protectionism • Tariffs are imposed and imports fall • The first to be protected are final stage assembly and simple consumer goods • Over time, parts fabrication and more sophisticated manufacturing is protected • Domestic production increases and unemployment falls • Capital and intermediate goods become more expensive, otherwise why would tariff barriers be needed to promote sales of domestic equivalents? • Costs rise for exports, exports fall, and unemployment rises in the export sector

40. Import substitution/inward-oriented strategies/protectionism • Benefits from import substitution • There is greater vertical integration within industries (both upstream and downstream) • Research, development, engineering, design, fabrication, assembly, marketing, and financing provide a richer variety of jobs • There is greater integration amongst industries (both backward and forward linkages) • Learning by doing takes place • There is less dependence on other countries, therefore less specialization and more evenly distributed development in the economy

41. Import substitution/inward-oriented strategies/protectionism • Costs of import substitution • Infant industries never grow up because the lack of international competition leads to higher costs • With few imports of capital goods, there is virtually no technology transfer • The export sector collapses so there are no gains from trade • Economies of scale cannot be achieved because the market is too small • Balance of payments problems lead to a reduction in imported capital which is often needed for industrialization to proceed: • Producers are cut off from new technology in international markets.

42. Import substitution/inward-oriented strategies/protectionism • Costs of import substitution • The poor gain little, the major beneficiaries are the wealthy and the MNC’s operating behind tariff walls • Government tends to subsidize capital, and currencies are held artificially high to encourage the use of imported capital and intermediate goods: • Industry becomes less labor intense, leading to unemployment. • Exporters of primary goods (the poor) are hurt: because LDC’s face perfectly elastic demand, they have to lower their prices to compensate for the higher currency value. • The elite benefit from importing luxury goods more cheaply.

43. Commercial Loans • As the government draws its income from much of the population, government debt is an indirect debt of the taxpayers. Government debt can be categorized as internal debt, owed to lenders within the country, and external debt, owed to foreign lenders. Governments usually borrow by issuing securities, government bonds and bills. Less creditworthy countries sometimes borrow directly from supranational institutions. Some consider all government liabilities, including future pension payments and payments for goods and services the government has contracted but not yet paid, as government debt.

44. Fair trade organizations • Fair Tradeis an organized social movement and market-based approach that aims to help producers in developing countries obtain better trading conditions and promote sustainability. The movement advocates the payment of a higher price to producers as well as social and environmental standards. It focuses in particular on exports from developing countries to developed countries, most notably handicrafts, coffee, cocoa, sugar, tea, bananas, honey, cotton, wine, fresh fruit, chocolate and flowers.

45. Fair trade organizations • Fair Trade is a trading partnership, based on dialogue, transparency and respect, that seeks greater equity in international trade. It contributes to sustainable development by offering better trading conditions to, and securing the rights of, marginalized producers and workers – especially in the South. Fair Trade Organizations, backed by consumers, are engaged actively in supporting producers, awareness raising and in campaigning for changes in the rules and practice of conventional international trade.

46. The commodity crisis • Fair trade advocate also often point out that unregulated competition in global commodity markets ever since the 1970s and 1980s has encouraged a price "race to the bottom". During the 1970-2000 period, prices for many of the main agricultural exports of developing countries, such as sugar, cotton, cocoa, and coffee, fell by 30 to 60 percent. According to the European Commission, “the abandonment of international intervention policies at the end of the 1980s and the commodity market reforms of the 1990s in the developing countries left the commodity sectors, and in particular small producers, largely to themselves in their struggle with the demands of the markets”. Today, “producers… live an unpredictable existence because the prices for a wide range of commodities are very volatile and in addition follow a declining long-term trend”. The total loss for developing countries due to falling commodity prices has been estimated by the Food and Agricultural Organization (FAO) to total almost $250 billion during the 1980-2002 period.

47. The commodity crisis • Millions of poor farmers are dependent on commodities and on the price they receive for their harvest. In about 50 developing countries, three or fewer primary commodity exports constitute the bulk of export revenue. • Many farmers, often without other means of subsistence, are obliged to produce more and more, no matter how low the prices are. Research has shown that those who suffer most from declines in commodity prices are the rural poor — i.e. the majority of people living in developing countries. Basic agriculture employs over 50% of the people in developing countries, and accounts for 33% of their GDP. • Fair trade supporters believe current market prices do not properly reflect the true costs associated with production; they believe only a well-managed stable minimum price system can cover environmental and social production costs.

49. Micro-credit schemes • Micro-credit is the extension of very small loans (micro-loans) to those in poverty designed to spur entrepreneurship. These individuals lack collateral, steady employment and a verifiable credit history and therefore cannot meet even the most minimal qualifications to gain access to traditional credit. Micro-credit is a part of microfinance, which is the provision of a wider range of financial services to the very poor.

50. Micro-credit schemes • Micro-credit is a financial innovation that is generally considered to have originated with the Grameen Bank in Bangladesh. In that country, it has successfully enabled extremely impoverished people to engage in self-employment projects that allow them to generate an income and, in many cases, begin to build wealth and exit poverty. Due to the success of micro-credit, many in the traditional banking industry have begun to realize that these micro-credit borrowers should more correctly be categorized as pre-bankable; thus, micro-credit is increasingly gaining credibility in the mainstream finance industry, and many traditional large finance organizations are contemplating micro-credit projects as a source of future growth.