StudySpace: Economics in Development, 6th Edition

Worked Example: Investment and Growth

Countries A and B start in 1995 with GDP = Y = 1,000 and I = 150. Two alternative values are explored for this variable. For present purposes, the “low” rate of g(I ) = 5.0 percent per annum is used. With this growth rate, investment expands from I = 150 in 1995 to

I = 150(1.05) = 157.5 in 1996,
I = 150(1.05)² = 165.4 in 1997,
I = 150(1.05)³ = 173.6 in 1998,

and so on. At this growth rate, investment in 2005 would be I = 150(1.05)¹⁰ = 244.3. The Harrod-Domar model from Chapter 4 can be written in the form Yt+1 = Yt

+ (It/ICOR). So if we know the values of Y, I, and the ICOR for any one year, we can compute the value of GDP for the subsequent year and then iterate for each succeeding year. At the moment we know I for each year. Following the textbook, let ICOR = 4 for country A and ICOR = 3 for Country B. We know Y(1995) for each country. So we can compute Y(1996):

For A: Y(1996) = 1,000 + (150/4) = 1,037.5.
For B: Y(1996) = 1,000 + (150/3) = 1,050.0.

And knowing Y(1996), we can calculate Y(1997):

For A: Y(1997) = 1,037.5 + (157.5/4) = 1,076.9
For B: Y(1997) = 1,050 + (157.5/3) = 1,102.5

And so on, giving the values shown in the text table and beyond. For example, Table 11–1 below shows the results for country A out to 2005.

Click here for Table 11-1

Over the decade, GDP increases by just under 50 percent in country A. Similar calculations for country B (see Exercise 1) show that with ICOR = 3 and identical investment levels, GDP would increase by more than 60 percent over the same time period.

Suppose the population in each country grows by 3 percent per year, or 34 percent for the decade [(1.03)¹⁰ = 1.34]. What is the increase in per capita income for the decade? In country A, GDP increases by a factor of 1.47, while population increases by a factor of 1.34. Hence, GDP/POP will increase by a factor of 1.47/1.34 = 1.10, or 10 percent. In Exercise 1 you will compute the corresponding figure for country B and see that per capita income in B increases more than twice as much as in A. This difference is due wholly to the difference in ICOR values. If, realistically, investment also grows more quickly in B due to the higher level of income, then the disparity would be even more dramatic.

Exercises

1. Now it is your turn to investigate the relationship between investment and growth. Table 11–2 is set up for you to project country B’s economic growth over the period 2000 to 2005. Country B’s ICOR equals 3.0. The investment growth rate (5 percent per year) is identical to that of country A in the Worked Exercise. Country B’s GDP for 2000 is taken from the example in the textbook.

a. Complete Table 11–2 by finding GDP for the years 2000 to 2005.

Click here for Table 11-2

b.

(i) In 1995 country B had GDP = 1,000. Over the decade 1995 to 2005, GDP is projected to grow by a factor of . (ii) Suppose the population grows by 3 percent per annum. Then, the population will increase by a factor of over the decade. (iii) Per capita income (GDP/POP) in country B will rise by percent. Compare this to the rise in per capita income of 10 percent in country A. What explains the difference?

c. As the level of income in country B increases relative to the level of income in country A, one may assume that country B could afford more rapid investment growth as well. After 2000, let g(I ) = 10 percent in country B. On the basis of this assumption, fill in the row in Table 11–3 showing the level of I for 2001 to 2004. Then complete the table by finding GDP for the years 2001 through 2005.

Click here for Table 11-3

d.

(i) Assuming g(I ) = 10 percent per year after 2000, GDP in country B increases by a factor of over the decade 1995 to 2005 (starting from GDP = 1,000 in 1995).

(ii) Still assuming 3 percent per year population growth, per capita GDP will increase by percent for the decade.

e. The textbook points out that a country with less-efficient investment would need a higher investment ratio in order to match the growth performance of a country where the ICOR is lower.

(i) Beginning in the year 2000 with Y = 1,207.3, what annual rate of GDP growth would country A require over the ensuing five years to match the 1995 level of GDP achieved by country B in Table 11–3?

g(Y) = % per year.

[Hint: The question implies a particular target level of GDP for 2005 and you know GDP for the year 2000; work backward from the target GDP to find g(Y).]

(ii) With ICOR = 4, find the investment ratio that country A requires to achieve the growth rate that you just calculated. Remember that s = I/Y in the Harrod-Domar model.

I/Y = %

(iii) For comparison, you can see from Table 11–3 that country B achieves the same level of income in the year 2005 with an investment ratio (for that year) of

I/Y = %.

2a. Table 11–6 contains information on net foreign direct investment (FDI) in 1992 for the same countries. Most FDI is directed toward other wealthy countries and a handful of the more successful developing countries (see Chapter 14 for a detailed discussion).

Click here for Table 11-6

(i) Are these figures consistent with this generalization? Does there appear to be a positive correlation between FDI and per capita income? Explain.

(ii) China stands out as getting a large inflow of FDI despite a low level of per capita income. What does this observation suggest about a possible link between net FDI and population size? From the data provided, does this link appear generally to hold? Explain.

(iii) Korea stands out as not getting a large inflow of FDI despite quite a high level of per capita income. In fact, the FDI figure for Korea is negative. What exactly does this mean?

 

b. The text explains that many developing countries underwent large macroeconomic adjustments when net resource flows moved adversely after the debt crisis. Let’s see how foreign savings flows changed between 1980 and 1990 for three African countries with above-average debt burdens. Table 11–7 presents data on foreign savings flows for Kenya, Senegal, and Zambia.

Click here for Table 11-7

(i ) The net resource transfer represents financing to support the excess of imports over exports of goods and nonfactor services. The 1980 figure for Kenya, $839.1 million, is provided on line 2. Fill in the remaining entries on this line.

(ii) The net resource flow represents financing to support the excess of imports over exports inclusive of payments for factor services. The 1980 figure for net resource flows to Kenya, $1,033.4 million, is shown on line 4. Fill in the remaining entries on this line.

(iii) The net resource flow is commonly used as a measure of foreign savings. For these three countries, was there a large decline in the net inflow of foreign savings between 1980 and 1990? Explain.

(iv) To put this in perspective, one can restate the net resource flows on a per capita basis. The 1980 per capita figure for Kenya, $61.9, is shown on line 6. Fill in the remaining entries on this line.

(v) In per capita terms, did these countries suffer a large decline in the net inflow of foreign savings between 1980 and 1990? Explain.

(vi) A more meaningful evaluation would take into account the decline in the value of the dollar between 1980 and 1990. During this period the U.S. price level rose by 58.5 percent. You can multiply the 1980 figures by 1.585 to get a constant-price comparison with the figures for 1990. How does this affect your assessment of the change in net resource flows per capita for each country?

c. Several other points can be drawn from Table 11–7.

(i ) What percentage of the 1990 net resource flow for each country was needed to cover net income payments, as indicated by the algebraic sum of lines 3a and 3b?

%

It is useful to know that this net outflow of income payments consists largely of interest payments on foreign debt.

(ii) One often hears about the huge burden of debt service borne by poor African countries. Did Kenya, Senegal, and Zambia bear large debt-service burdens in 1980? In 1990?

(iii) Each of these countries benefited from a large net inflow of foreign savings—enough to meet debt-service payments and still have finance to cover an excess of imports over export earnings. What is the most likely source of the foreign savings: foreign aid, direct foreign investment, or foreign commercial borrowing? Explain.

(iv) Finally, what can you infer about the gap between domestic savings and investment in these three countries in 1980?

In 1990?

Obviously one cannot generalize about all of Africa from three examples, but at least one can learn how to analyze the foreign savings flows.

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