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.”

 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

 Easterly beings by talking about the Volta river project in Ghana in ◦ 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

 According to Domar (1946), what was the critical assumption of the Harrod- Domar Model?  Why was this assumption not very realistic?  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”

 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 for economic growth  Set a target savings rate!

 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.  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.

 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?  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

 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?  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.