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

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

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

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

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

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

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

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

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

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

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

Harrod-Domar Growth Model Developed independently by Sir Roy Harrod in 1939 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

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

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

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

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

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

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

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

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

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

Further Reading Implications of the H-D Growth model http://bit.ly/lE7ZC2 “The Harrod-Domar Growth Model” http://www.sjsu.edu/faculty/watkins/growthmodels.htm Econ 171 Mon 27 June: Lecture#5 Atanu Dey