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QUESTION:

Although the rate of capital accumulation is an important determinant of economic growth in developing countries, it is the type of capital, rather than the rate at which it is accumulated, which determines the nature and pattern of growth and development in LDCs. Discuss this view.

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This is the outline

"Capital Accumulation in economic growth" by Takahiro MIYOSHI

Introduction

The Harrod-Domar model : focusing on the importance of investment

Opened economy model : introducing foreign trade

The Mahalanobis model and The Lewis Model:multi-sectoral approach

Conclusion

 

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This is the text of my "first" essay, which had got mark 58. (not good but not so bad .. ha ha.)

QUESTION:

Although the rate of capital accumulation is an important determinant of economic growth in developing countries, it is the type of capital, rather than the rate at which it is accumulated, which determines the nature and pattern of growth and development in LDCs. Discuss this view.

 

Introduction

In the history of development economics, accumulation has been thought of as a key factor in the process of economic growth. Accumulation can be defined as " the continuous acquisition and growth of the capital stock through the savings and investment process". (Harrigan, 03/10/95) Although the importance of capital accumulation in the development process has been widely accepted among development economists, there has been a crucial argument about the effective allocation; what type of capital must be accumulated for rapid and sustainable growth? In this essay, the role of accumulation in development process is considered and the various types of capital are examined by discussing some applicable growth models. It starts with the Harrod-Domar growth model and critically reviews other important models in turn, such as the Open economy model, the Mahalanobis's model, the Lewis model and other related works of development economists. Moreover, other relative factors in growth are also discussed.

The Harrod-Domar growth model : as a start point

The first theoretical approach to an accumulation process was attempted by an application of the Harrod-Domar model, although this model has established in early 1950's for analysing sustainable growth of "developed" economy.

There are 4 assumptions underpinning this model:

The economy has a fixed capital : output ratio = k

Investment is defined as a change in the capital stock I=Æ¢K

Savings is a given proportion of national income S=sY

The economy is closed, where S=I

From these assumptions, the Harrod-Domar growth model has derived the following simple equation for growth.

 y = s / k

This equation implies that the growth rate of national income is directly related to the saving rate "s". Whereas, the capital-output ratio "k" is negatively related to the growth rate. Since the capital-output ratio is fixed in the assumptions, this model focuses mainly on the saving rate as only one factor in rising the growth rate. Thus, its conclusion was simple and clear; "the higher the level of saving and investment, the higher level of growth"

The importance of savings and investment has also been emphasised in Rostow's well known stages of growth, which has distinguished the process of development into 5 unique stages. These are the traditional stage, the transitional stage, the take-off stage, the mature stage, and the mass consumption stage. Among them Rostow noted, as the first condition of the transitional stage that at least 10% rise of the level of investment of whole national income is necessary to enable an economy enjoy self-sustaining growth. Besides, at the take-off stage, investment must also be raised up to the level of over 10% of national income for per capita income. (Rostow, 1960) Moreover, the importance of investment had also been emphasised by Rosenstein-Rodan's "big push" and Nurkse's "balanced growth". (Nixson, 1994)

Although the Harrod-Domar model has provided a simple model of growth and it has been largely adopted, there are some problems in practice. Since this model has assumed capital-output ratio is fixed and the hypothetical economy is closed, there is no practical suggestion leading to economic growth in reality. In particular for today's economies, it is impossible to think fixed capital-output ratio and closed economy. Moreover, the Harrod-Domar model has concluded that a rise in the saving rate raise the rate of economic growth, but it does not answer how to raise the saving rate and how to allocate such savings. With this model, it can not be answered what kind of capital must be accumulated for development in reality.

Therefore, although the Harrod Domar model can be useful as a starting-point to think about development and accumulation, its use is limited in reality. To compensate for these deficiencies, some models which has analysed the mechanism of accumulation in more detail have emerged and have argued for efficient forms of capital for development in the implications.

 

The Opened Economy Model: foreign capital and domestic capital

An unrealistic limitation of the Harrod-Domar model is that it assumes a "closed" economy. Thus, all sources for economic growth are domestic investment which are assumed equal to domestic savings. Therefore, it has attempted to a simple conclusion " the more savings, the more growth" in terms of the domestic economy. In reality, however, economy is not closed. It is impossible to analyse economic growth without considering the impact of international trade of goods and capital. Alternative investments not only from domestic savings but also through international trade have to be taken into account.

This extension has been developed by Bruton. (Bruton, 1955) By introducing foreign trade into the model, he has rewritten on the equation of growth as follows.

g=s/k + b/k where b=(imports-exports)

In this equation, imports are additional investments into a domestic economy, and these imports include various types of inputs such as foreign aid, credit, and private investment. Thus, it can be possible to add new investment from outside to fulfil a lack of domestic savings. In empirical studies, the Rostow's stage of growth has also witnessed such kind of substantial capital imports in the take-off stages of developed countries by the exchange with major exports such as grain in the North America and Russia, timber in Sweden, textiles in the United Kingdom. (Rostow, 1960) This extension has regarded aid and credit as important sources of capital especially for LDCs, which have suffered from a shortage of domestic savings.

From the same point of view, Chenery and Strout have proposed "two-gap theory". (Chenery & Strout 1966) When there is a shortage of domestic saving (saving gap), the growth must be constrained at the level of the domestic savings. On the other hand, the foreign exchange gap will hold the growth at the level of foreign exchange and there will be unused domestic resources. In the case of a saving gap, foreign exchange must be used to encourage domestic savings or productivity of domestic resources must be improved. In the case of the foreign exchange gap, unused domestic resources must be used to earn more foreign exchange, or the productivity of imports must be raised. This is especially the case in LDCs where there tends to be a saving gap, therefore, availability of foreign exchange seems to be important for growth of income.

Does such kind of foreign capital have same function as domestic capital so far? Although the open economy model has assumed perfect substitution of imports for domestic saving, the equation contains a contradiction. In the equation, when quantities of imports and exports are equal to each other, it can be said that there is no economic growth, whether both of the quantities have increased or decreased. To respond to this contradiction, it has to be said that there are some un-substitutable kinds of imports in any countries, where their ratio of imports to national income may not decrease as much as the income increases. In addition to this, there must be "un-tradable goods" which can not be substituted for overseas goods. Then, it concludes theoretically that there is no perfect substitution of imports for domestic goods and savings.

 

Concerning international aid and credit for LDCs in reality, over reliance on foreign aid and credit has resulted in a serious deficit problem, in which the most of recent LDCs face with gigantic amount of deficit. Furthermore, such aid and credit have frequently been tied-up with obligation of purchasing foreign goods and services by inadequate price. Therefore, accumulating foreign capital can not be a effective solution especially for LDCs which have relatively poor conditions of economy.

This is because of that to use foreign capital requires a certain ability, which must be a domestic endowment of each country. From this point of view, the open economy model and two-gap theory are too optimistic to be applied as a solution of real problems of LDCs which suffer from a shortage not only of domestic saving but also of domestic endowments such as physical and human resources, and technology. (Such domestic factors will be mentioned in this essay later.) As Bruton admitted, "foreign capital , even if available, cannot solve the technological problem; this must be a purely domestic achievement of the underdeveloped country". (Bruton, 1955) This is serious limitation of the open economy model.

The Mahalanobis model and the Lewis model: multi-sectoral approaches

Another unrealistic assumption of the Harrod-Domar model is fixed capital-output ratio "k". In reality, the capital-output ratio is changeable depending on sectors, which have various economic characteristics from agriculture to industry. Since the levels of capital-output ratio are different among sectors, the effects of saving and investment must be different among them. Thus, sectoral approach is necessary when thinking effective accumulation in the development process. This multi-sector approach has been coped by the Mahalanobis model. (Mahalanobis, 1955) Besides, from a structural approach, the Lewis model has also considered the development process with a sectoral approach. This section mentions them in turn.

The Mahalanobis model has introduced a sectoral concept into the Harrod-Domar model. This model has assumed two sectors; an investment (or capital) goods sector and consumption goods sector. For example, if there are two machines and one of them can produce a new machine while another machine is used for consumption, the former machine is defined as an investment good and the latter is defined as a consumption good.

In the two sectors model, since all consumption goods are produced by investment goods, the growth rate can be stated a function of the share of new investment in the investment goods sector. Besides, savings needed for the new investment can be attained by expense of the consumption goods sector, because the consumer demand will be decreased correspondingly by raising marginal rate of savings. Therefore, Mahalanobis's dual sector model has emphasised the new investment in the investment goods sector as a key factor in achieving economic growth effectively, so the domestic saving rate has to rise for the new investment.

On the other hand, although the Lewis model also assumes two sectors, this model has intended that the structure will be changed by shifting from one sector to another. The Lewis model has consisted of two sector; one is a traditional, overpopulated rural subsistence sector whose marginal labour productivity is zero and where there is abundant surplus labour, another is a high-productivity modern urban industrial sector which has enjoyed higher income and technology and where profits are saved and reinvested.

With this situation in mind, the Lewis model has constructed the structural transformation. Since the traditional sector is overpopulated and is characterised by low productivity while the modern sector has ensured higher wage, surplus labour in the traditional sector will shift to the modern sector where high productivity and more employment are enjoyed. This growth of the modern sector does not stop here, because there will be certain reinvestment from profits, which enable this sector to receive more labour from the traditional sector. Since there is an unlimited supply of labour from the traditional sector, "capital-saving technology" must be chosen for employing more labour. In this cycle, the modern industrial sector will take over the traditional agricultural sector. Finally, the Lewis model has implied self-sustaining growth of the modern sector which seems to be the key factor in the development process.

Both of dual sectoral models have emphasised the importance of an advanced sector (an investment goods sector in the Mahalanobis model and a modern industrialised sector in the Lewis model). In both of the models, capital in the advanced sector has been significantly focused in the development process, therefore, they seem to suggest that the investment must be enforced in the advanced sector for effective accumulation.

However, the Mahalanobis model and the Lewis model have some theoretical and practical problems. Firstly, the models have over emphasised the importance of the advanced sector. In the Mahalanobis model, since it has focused on an investment goods sector, the demand of the consumer goods sector which seems to be related directly to people, tends to be left out of the analysis. Similarly, the Lewis model has ignored the key role of an agriculture sector which must be considered as food supply and balance of payments problems.

Secondly, the mechanism of saving and investment is not clear or realistic. Although the saving rate which has been assumed as a key in the Mahalanobis model, there is no mechanism of change in the saving rate explained by the model (Nixson, 1994). Besides, the Lewis model assumes that all profits reinvested in the modern sector which will create new jobs, however, in reality such capitalist investment tends to be reinvested in " labour-saving technology ", not in capital-saving technology which the Lewis model has suggested. (Todaro, 1995) Moreover, some profits may be "invested" to buy luxury goods and it is very often that capitalist save the profit in overseas banks (called capital flight), such conditions reduce a function of reinvestment cycle.

Thirdly, the utilities of these models seem to be reduced by thinking of foreign trade, which segregates assumed strong sectoral interdependency. In reality, it is impossible for LDCs to live without any foreign trade, so there has already been a high level of sectoral disaggregation in LDCs. Moreover, the debt problems or capital flight, which seem to be among the most serious problems facing LDCs, can not be taken into account at all by those closed models.

Therefore, it can be concluded about the Mahalanobis model and the Lewis model that have made certain improvements by introducing sectoral concepts into a growth model, but their implication must be understood carefully because there are some limited assumptions for application to the reality. In particular, over emphasised importance on the advanced sector must be reconsidered by thinking of the ignored backward sector, which must be the target of development economics.

Other important issues

Although the growth models considered various types of capital in accumulation process, there are other crucial factors which influence the growth pattern. This section examines such important residuals in turn.

In addition to above discussed two sectoral models, it must be mentioned that there is another issue of two sectoral structure ; the public sector and the private sector. If a country doesn't have enough endowments such as skilled labour or physical resources, the country should invest in the public sector and use it's limited resources more effectively. Otherwise, the country have another possible way to introduce foreign ownership in the private sector and stimulate domestic economy by the foreign investment. While there are lots of critiques of ineffectiveness and economic failure about the public sector and many countries move to privatisation, "A large foreign-owned private sector usually creates economic and political opportunities as well as problems not found in countries where foreign investors are less prevalent" (Todaro, 1994) Therefore, a choice between the private and the public sector should not be independent itself, but must be made in conjunction with other policies.

Another important issue is a choice made between physical resources and human resources. Physical resources refers to land, minerals and other raw materials, while human resources means the population and the level of skills. Compared with the choice between the private and the public sector, it is easier to choose physical resources or human resources. If a country doesn't have enough physical resources, it must concentrate on improving its human resources through education. However, in the reality there are two problems. Firstly, education is quite expensive compared with the results. For example, while the cost-earning ratio is 6.6 to 1 for primary and 17.6 to 1 for higher education in developed countries, while LDCs have to pay respectively 11.9 and 87.9 to 1. (Todaro, 1994) Secondly it has not been clear what should be taught in the education. Since the education must be somehow effective for their future occupations, it is related the issue of a choice of appropriate technology. However, as mentioned in the previous section, even if the capital-saving technology is desirable for early stage of LDCs, the reality tends to be in the opposite direction; labour-saving technology.

Conclusion

This essay has considered the accumulation process and the various types of capital for accumulation by reviewing related growth models and other factors. It seems that all famous growth models emphasise the importance of capital accumulation through savings and investment. Theoretically, the Harrod-Domar model was a starting-point which stated simply that the rate of growth is directly dependent on the domestic savings rate. From the Harrod-Domar model which only mentioned the importance of saving rate, some extents have been made for searching the desirable type of capital for LDCs.

The open economy model opened up closed the Harrod-Domar model and then, with two gap theory, it emphasises the roles of foreign aid and credit as a substitute to fulfil a lack of domestic saving. However, it had a problem of application because the real world is not favourable to LDCs than they expected from foreign exchange. Besides two-sector models (the Mahalanobis model and the Lewis model) suggested clearly that investments must be made into an advanced sector for effective accumulation, and the Lewis model also suggested capital-saving technology. However they also had failed because they largely ignored the role of disadvantaged sector in the development process.

Although these models could be quite useful in explaining a certain situation, no growth model could reach a perfect goal of general accumulation process and the desirable capital. This is because they segregated capital into two types and judged which is good or desirable one, however all resources must co-operate each other. Thus in this essay, other important factors such as choices between "the private sector and the public sector" and "physical resources and human resources" were mentioned.

From considering those various types of capital, it can be concluded that all types must have an important role to play in the growth (accumulation) process. Where, they are not independently working but they are strongly related and influenced each other in the development process.