1. Econ 171 Economic Development
Atanu Dey
5th Meeting
Mon 27th June, 2011
2:00 PM – 3:30 PM
3 Le Conte

2. Thinking About Development
Rates of growth of real per-capita income are diverse, even over sustained periods I do not see how one can look at figures like those without seeing them as representing possibilities. . . The consequences for human welfare involved in [questions related to development] are simply staggering: Once one starts thinking about them, it is hard to think about anything else. -- Robert Lucas
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

3. Link between Human Development and Income
[A] unity of interests would exist if there were rigid links between economic production (as measured by income per head) and human development (reflected by human indicators such as life expectancy or literacy, or achievements such as self-respect, not easily measured). But these two sets of indicators are not very closely related. -- Paul Streeten (1994)
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

4. The Malthusian Trap
Short-term economic gains through technological progress lost in population growth
Majority in 1800 poorer than their remote caveman ancestors
Life expectancy and stature equal or lower than hunter-gatherers
The economic future is one of universal prosperity
Income growth is central to development
Economic life until the 1800s described by the Malthusian Trap
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

5. Malthusian Era
Rev Thomas Malthus’ essay of 1798 on The Principles of Population
Technological advance ~ 0.05 percent per year (about a 30th of present rates)
Population growth impoverishes economies
reduced population growth rates improves material living standards
They lived above the bare subsistence levels
It is possible to fall below the Malthusian subsistence levels
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

6. High Mortality, High Levels of Material Prosperity
Population levels low in pre-industrial England relative to Japan due to hygiene levels
Mankind subject to Darwinian natural selection even after the Neolithic Revolution of 8000 BCE led to settled agriculture
Economic success led to reproductive success – which meant downward mobility
Industrial Revolution due to productivity advances arising out of technological progress
Efficiency advances translated into material prosperity instead of population increase
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

7. Two Events in Europe 1760-1900 Industrial Revolution
Demographic Transition
Decline in fertility, starting at the top and gradually working downwards
Three theories to explain the two events
Changes exogenous to the system – political institutions such as democracy
External shocks that changed the equilibrium
Gradual evolution of the system – endogenous growth
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

8. Economic Growth Models
Harrod –Domar Growth Model
Solow Growth Model
Endogenous Growth Model
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

9. Economic Models Economists use models to study economic issues
A model makes simplifying assumptions about the world
It thus allows us to see the relationship among the variables which would not be evident from examining the complex real world
Example: To study international trade, a model with 2 goods, and 2 countries gives useful insights on the nature of trade
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

10. Macroeconomic Flow
Circular flow of production, consumption, saving, and investment
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

11. Macroeconomic Flow Firms and households Firms produce stuff
Firms pay wages, profits and rents to households
Households consume stuff
Consumption expenditure is income for firms
Households save
Savings are investments for firms
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

12. Harrod-Domar Growth Model
Developed independently by Sir Roy Harrod in and Evsey Domar in 1946
Explains growth  in terms of the level of saving and productivity of capital
Production = Consumption goods + Capital goods
Investment  Capital formation
Saving means delaying present consumption
Growth depends on investing savings in increasing capital stock
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

13. Variables Y represents income K represents capital stock S is savings
same as output or production
K represents capital stock
δ depreciation rate of the capital stock
S is savings
s is the savings rate, and
I is investment
C is consumption
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

14. Relationships Output (or income) is consumption plus savings at time t
Y(t) = C(t) + S(t)
The product of the savings rate and output equals saving, which equals investment
sY = S = I
The change in the capital stock equals investment less the depreciation of the capital stock
K(t+1) = (1 – δ)K(t) + I(t)
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

15. The major assumption
The Harrod-Domar model makes the following a priori assumptions:
There is a direct relationship between the capital stock K and the output Y
It is called the capital-output ratio
It is usually between 3 and 1
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

16. Harrod-Domar Equation
Savings rate is s
s = S(t)/Y(t)
Capital-output ratio is θ
Amount of capital required to produce one unit of output
θ = K(t)/Y(t)
Rate of growth g
g = [Y(t+1) – Y(t)]/Y(t)
s/θ = g + δ – the Harrod-Domar Equation
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

17. What the H-D equation means
g = s/θ - δ
It links growth rate g to two other rates
The savings rate s and the capital-output ratio θ
What’s the effect of population growth?
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

18. Adding population growth
Population P grows at rate n
P(t+1) = P(t)(1 +n)
Per capita income is y(t)
y(t) = Y(t)/P(t)
Per capita income growth rate is g*
y(t+1) = y(t)(1 + g*)
New equation
s/θ = (1 + g*)(1 + n) – (1 – δ)
Combines savings ability, capital productivity, depreciation, and population growth
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

19. What it means (1 + g*)(1 + n) = 1 + g* + n + g*n
But g* and n small numbers, and so g*n is negligible
So s/θ ≈ g* + n + δ
Interpretation:
Per capita growth rate is reduced by population growth rate and by capital depreciation rate
Per capita growth rate is increased by savings rate and by more efficient use of capital
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

20. Are the variables exogenous?
H-D models saving rate, capital-output ratio, and population growth rate as constants, and not affected by the growth of the economy
s, n and θ are considered exogenous
What if saving rate is a function of per capita income?
Poor people cannot save at the same rate as those who are rich
Distribution of income – and not just per capita income – affects the saving rate
Therefore saving rate may rise with rising incomes
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

21. Population growth rate
Population growth rate declines as incomes go up
Why?
n is endogenous
The capital-output ratio also changes due to the law of diminishing returns to individual factors of production
When capital level is low, the marginal productivity of capital is high
So θ is endogenous as well
Econ 171 Mon 27 June: Lecture#5 Atanu Dey

22. Further Reading Implications of the H-D Growth model
“The Harrod-Domar Growth Model”
Econ 171 Mon 27 June: Lecture#5 Atanu Dey