CHAPTER ONE

ECONOMIC GROWTH AND ECONOMIC DEVELOPMENT

INTRODUCTION፡ In recent years, there has come into existence a new branch of economics known as
the “economics of Development”. It refers to the problems of the economic development of
underdeveloped or backward countries. The main reason for the growing popularity of “Economic of
Development” as a separate branch of economic theory is the increasing tendency on the part of the newly
independent countries of Asia and Africa to resort to developmental planning as a means to eliminate their
age-old poverty and raise living standards.
Unit objectives: After successful completion of this unit, you should be able to:
 differentiate the difference between economic growth and economic development
 Define Growth and Development
 Understand the issue of growth and development
 Analyze the indicators, scope, measurement, of Economic Development economic growth
 Understand the General characteristics of LDC’ (Features of under developed economy)
 Identify the Basic requirement for (sources of) economic growth
1.1. Growth and Development
A major goal of poor countries is economic development or economic growth. The two terms are not
identical. Growth may be necessary but not sufficient for development. Economic growth refers to
increases in a country’s production or income percapita. Production is usually measured by gross national
product (GNP) or gross national income (GNI), used interchangeably, an economy’s total output of goods
and services. Economic development refers to economic growth accompanied by changes in output
distribution and economic structure.
The words “growth” & “development though used inter-changeably have an important difference.
Growth question was the oldest question in the history of humankind and in the history of economics. In
1377, the Arabian economic thinker IbnKhaldun provided one of the earliest descriptions of economic
growth in his famous Muqaddimah (known as Prolegomena in the Western world). In the early modern
period, some people in Western European nations developed the idea that economies could "grow", that
is, produce a greater economic surplus which could be expended on something other than mere
subsistence. This surplus could then be used for consumption, warfare, or civic and religious projects.
Examples early modern period of economic thought on wealth of nations.
1. Mercantilism: is an economic theory that holds the prosperity of a nation is dependent upon its
supply of capital, accumulation of gold through export. ."

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These economic assets or capital, are represented by bullion (gold, silver, and trade value) held by the
state, It is often said that a better understanding of economic history would have helped us to avoid the
worst of the recent crisis. Over the next few weeks, free exchange will consider milestones in economic
history, showing how they contributed to the development of economic thought. 
MERCANTILISM፡ is one of the great whipping boys in the history of economics. The school, which
dominated European thought between the 16th and 18th centuries, is now considered no more than a
historical artifact and no self-respecting economist would describe himself or herself as mercantilist. The
dispatching of mercantilist doctrine is one of the foundation stones of modern economics. Yet its defeat
has been less total than an introductory economics course might suggest.
2. Physiocracy: were a group of economists who believed that the wealth of nations was derived solely
from the value of land agriculture or land development. The groups of economists who developed and
subscribed to this philosophy were known as the Physiocrats. Physiocracy originated in France during the
18th century and preceded the theory of classical economics that began with Adam Smith's The Wealth of
Nations in 1776. The formation of Phsyiocracy was heavily influenced by the late medieval period where
the nobility and land lords were deemed as productive economic agents and favored over the merchant
class. Many leading physiocrats were influenced by Confucianism and the Chinese economy where the
ideology championed agrarian policies.
1.2 The issue of growth and development
In the 19th century, various growth theories and models of economic growth were elaborated/initiated.
1. The great world depression of the 1930’s has given a new impetus to the question of economic
growth.
2. Economic crisis created due to the Second World War and the need to revive the economy of
countries affected by war was another important phenomenon that initiated the issue of growth and
development.
Example: The Marshal plan to support European countries.
The establishment of the World Bank, IMF, National Development Banks and agencies of the United
Nations (UNICEF, UNESCO, WHO, UNDP, UNIDO, FAO, etc).
3. The poverty of developing countries after the independence from colonization and the recognition
of the interdependence of the world economy by developed countries also initiated the issue of
growth and development.
Example: Developing countries required technology and capital of the developed countries for their
growth. Developed countries need raw materials for their industries and markets for their output.

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 4. The recent burden of immigration from poor to developed countries also initiated the issue of
growth and development
Growth and development is essential to improve the welfare and standard of living of individuals and
generally for human development.
Some facts in the inception of the notion economic growth

1. Rate of growth varies substantially across countries (1960 – 1990’s):

USA grew at the rate of 1.4%, Japan at 5%, India and China at 2 %, Hong Kong, Singapore, South Korea
and Thailand at > 5%
African countries mostly at negative percent
An analysis of long-term trends shows the distance between the richest and poorest countries was about:
3 to 1 in 1820 , 11 to 1 in 1913 , 35 to 1 in 1950, 44 to 1 in 1973 , 72 to 1 in 1992
World gross domestic product (world population approximately 6.5 billion) in 2006 was $48.2 trillion in
2006.The world’s wealthiest countries (approximately 1 billion people) accounted for $36.6 trillion
dollars (76%). The world’s billionaires — just 497 people (approximately 0.000008% of the world’s
population) — were worth $3.5 trillion (over 7% of world GDP).
Low income countries (2.4 billion people) accounted for just $1.6 trillion of GDP (3.3%)
Middle income countries (3 billion people) made up the rest of GDP at just over $10 trillion (20.7%).
2. Growth rates are not necessary constant overtime.
India and China are growing at greater than 10% currently.
Most African countries are now growing at positive rate.
3. There is an enormous variation in Per capita income across countries.
Example:: USA per Capita is 300 times higher than Ethiopia. An Ethiopian worker has to work two
months to get what an American worker gets in a day. Botswana’s Per Capita income is 20 times higher
than Ethiopia. Tanzania’s Per Capita income 3 times higher than Ethiopia. In the 1990’s low in come
countries (earning <765 USD according to the WB) which contain 60% of the world population receive
only 6% of the world income. Middle-income countries contain 15% of the world population and receive
17% of the world income. Rich/industrialized countries (>9385 USD according to the WB) which contain
25% of world population and receive 77% of the world income.
4. A countries relative position in the world is not fixed, poor can be rich, and the rich can be poor.
For example: Argentina was one of the richest countries in the world in 1900 and now it is among the
developing countries.

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India and China were the poorest countries some 30 years back and now are moving towards the
developed countries.
5. USA has exhibited sustained steady growth for the last 100 years.
6. Growth in output and growth in the volume of international trade for a given country is positively
correlated.
7. Both unskilled and skilled labor tends to migrate from poor to rich countries.
1.3 Economic growth and Economic Development
1.3.1. Economic Growth:
Is one- dimensional in nature, measured with reference to increase in national income only?is an increase
in output (goods & services) to satisfy the material wellbeing of the society in a given nation. Increase in
output can be achieved: Through increased input or through improved efficiency (more output from the
same level of input)
Economic growth is a term used to indicate the increase of per capita gross domestic product (GDP) or
other measure of aggregate income. It is often measured as the rate of change in GDP. Economic growth
refers only to the quantity of goods and services produced. Economic growth can be either positive or
negative. Negative economic growth implies that the economy is shrinking.
Negative growth is associated with economic recession (a decline in GDP for 2 or more consecutive
quarters) and economic depression (economic downturn where real GDP declines by more than 10%)
The words “growth” & “development though used inter-changeably have an important difference. It used
to denote a quantitative change, an increase in physical appearance, increase in physical size and weight
of the body, nutritional anthropometry (Weight, Height, Head Circumference, Chest Circumference,
assessment of tissue growth (muscle mass, skin fold thickness, bone age (Radiological Assessment of
Epiphysis, dental Age and biochemical and Histological Mean.
GDP: is the value of all final goods and services produced within the country’s during a given period.in
geographical territory, irrespective of the ownership of resources. It includes value of cars manufactured,
houses constructed and so on. Total GDP divided by the population will equal per capita GDP. Income
produced through the country’s owned resources, irrespective of the place of production.
 GNP: The value of final goods and services produced within a country plus the net factor income
from abroad and sum of factor payments(in receipts from abroad)
 GDP Per Capita or GNP per Capita: Takes into account the size of the population
 Real GDP / GNP: Takes into account the adjustments for price changes and inflation

1.3.2 Economic Development

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Economic development is a process whereby an economy’s real national income as well as per capita
income increases over a long period. Here, the process implies the impact of certain forces, which operate
over a long period and embody changes in dynamic elements. It contains changes in resource supplies, in
the rate of capital formation, in demographic composition, in technology, skills and efficiency, in
institutional and organizational set-up.

Indicators of Economic development

 Improvement in literacy, Education and training levels,

 Improvements in health & nutrition of the people resulting in reduction in morbidity & mortality
& increase in longevity;
 Orderly growth without determinant to environment, optimum use of all types of resources are
indicators of development
What are the measurements of economic development?

There are various ways in which we can measure economic development, some of which are as follows:-
Economic development measured in terms of

 Human Development Index

 Gender Empowerment Measure
 Human Poverty Index
 Human Freedom Index
1. The reduction and elimination of poverty and inequality (in the sense of equal access.)
2. Human development index which takes into account:
 real GDP per capita from (100- 40,000USD)
 life expectancy of at birth (25- 85) and
 Educational achievement (adult literacy, primary, secondary territory (0- 100%)
Note that HD index is between 0 and 1 and: High HDI >0.8, Medium HDI is from 0.5 to 0.79, Low HDI
less than or equal to 0.49
3. Improvement in welfare i.e. Increases in the consumption of goods and services. This increase stands
not only for quantity of consumption but also quality.
 Social indicators such as: calorie intake per person, infant mortality rate
 percentage of population with access to safe water
 percentage of population with access to sanitation
 Number of hospital per head of population
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  Number of doctors per head of population
5. Self-esteem (sense of self-respect and independence) it is the power and influence to conduct
relations on equal terms in their foreign relations.
6. Freedom of choice (choice in every in aspect)
Economic Development Vs Economic Growth

Economic Development Economic Growth

Scope: Concerned with structural changes in the

Growth is concerned with
economy increases in the economy's
output

Growth: Development relates to growth of human Growth relates to a gradual

capital indexes, a decrease in inequality increase in one of the
figures, and structural changes that components of Gross Domestic
improve the general population's quality Product: consumption,
of life government spending,
investment, net exports

Implication: It implies changes in income, saving and It refers to an increase in the real
investment along with progressive output of goods and services in
changes in socio-economic structure of the country like increase the
country(institutional and technological income in savings, in investment
changes) etc.

Measurement: Qualitative. HDI (Human Development Quantitative. Increase in real

Index), gender- related index (GDI), GDP. Shown by PPF.
Human poverty index (HPI), infant
mortality, literacy rate etc.

Effect: Brings qualitative and quantitative Brings quantitative changes in

changes in the economy the economy

Calculating the Human Development Indices

The HDI (Human Development Index). A summary measure of human development
Calculating the HDI
Dimensions
 A long and healthy life

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  Being Knowledgeable
 A decent standard of living
Indicators
 Life expectancy
 Literacy & Enrolment
 GDP Per capita
Dimension Index
 Life expectancy index
 Education Index
 Income Index
HDI =the simple average of the three dimension indices

 The Education index is a weighted average of the ALR index and the GER index
 Education index = 2/3 ALR index + 1/3 GER index
 The GDP per capita is transformed to log (GDP per capita) – meaning increases of income at
lower levels have a greater impact on the income index
The indicators for the dimensions

Health: Life expectancy at birth (years) 

Knowledge:
 Adult literacy rate (%)
 Combined primary, secondary and tertiary gross enrolment ratio (%)
Standard of living:
 GDP per capita (PPP US$)
For each indicator a minimum and maximum goalposts must be defined. Each indicator must be
normalized to a value between 0 and 1, based on a country’s relative position

Actual value – Minimum Value

Index = -----------------------------------------

Maximum Value – Minimum Value

1.5Obstacles to economic development (Growth) of LDCs

1. Unfavorable weather particularly for their agriculture.
2. Rapid population growth which depletes resources and constrain savings.
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3. Substantial losses in terms of trade (since they are price takers, hence, foreign exchange is
constrained).
4. Inadequate infrastructure.
 Inadequate supplies of power and light;
 Insufficient roads and railways;
 Insufficient government services (highly bureaucratic and corrupted).
Poor communication facilities (telephone, internet etc).
5. Ethnic and religious conflicts, political instability and civil war.
6. Repressive/ oppressive regimes and lack of good governance
 Cannot win the will and minds of the population, which resulted in limited production;
 Cannot attract foreign direct investments;
 In efficient and corrupt tax management.
7. in appropriate economic policies.
8. under developed human capital formation: Leads to lack of skill, knowledge and expertise for
development.
9. Vicious circle of poverty
1.6 Basic requirement for (sources of) economic growth
All round development of mankind is unachievable without economic growth. If so, what is required for
an economic growth to be achieved? The following are the main ones.
1. Natural resources
Natural resources contain land, minerals, weather and climate, water resources, fertility of soil, forest
resources, etc. The quality of natural resources affects the level of agricultural productivity in early stage
of development. The productivity of agriculture permits the release of labor from agriculture to industry
and services which enables the accumulation of capital. Natural resource endowment eases the
development endeavor of countries.
2. Capital
Capital is broadly defined as any asset, which generates additional income to the society. Physical assets
such as factories, machineries, farm equipment, transport and communication facilities enhance economic
growth. Capital formation requires saving and this saving can be used for investments. Investment in
capital goods and hence capital accumulation helps to escape the vicious circle of poverty through
improving the low level of productivity which is the source of poverty; Technological progress is an
important factor in economic growth which brings new techniques and methods of production to increase
productivity.
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3. Human resources and entrepreneurial ability
Quantity and quality of labour is another important factor for economic growth .LDCs do not have
shortage of human resource quantity wise. Their problem is regarding quality. Human capital can be
developed in quality through a number of ways:
Formal training including vocational training could improve health conditions through expenditure on
health facilities. Institutional training such as on job training, adult education, training in farm
management, learning by doing helps to accumulate experience by workers, managers and owners. 
4. Institutional and political factors
Strong administration, political stability (peace), good governance, rule of law etc are very important
inputs to economic growth;
Social attitudes, work culture, traditional customs and social institutions (Religion, Debo, Idir, Ikubetc)
have significant role for economic growth.
1.7 Factors of Economic Growth
The important factors, which determine the economic growth of an economy
 Natural resources: Land, quality of soil, forest, rive, minerals and oil and Climate
 Capital formation: It is important economic factors with three interrelated stages.
 The existence of real saving, the existence of credit and financial institutions to mobilize savings,

to use these saving for investment፣ Technological Progress: Human Resources:

 Social Overheads: Like schools, Colleges, technical institutions, Medical Colleges, hospitals and
public health facilities. Such facilities make the working population healthy, efficient and
responsible. Transformation of Traditional Agricultural Society
8 Non -Economic Factors: Both economic and non-economic factors do play an important role in the
process of economic growth In this regard Political, socio and psychological, factors, education,
Urbanization, religious factors are also equally significant as are economic factors in economic
development of the LDCs.

CHAPTER TWO
MEANING AND CHARACTERISTICS OF MODERN ECONOMIC GROWTH
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  INTRODUCTION

The word ‘resources’ may be defined as “means of attaining given ends”. These ends may be the
satisfaction of individual wants or the attainment of social objectives. Thus, anything useful or anything
has attainment of social objectives. Thus, anything useful or anything having the attribute of utility may
be termed as a resource. Food, clothing, property or capital are, therefore, resources only because they are
useful and satisfy some human wants. However, resources include many more things. They include not
only material things like land, forests, coal, machinery, etc…, because all these things have the attribute
of utility. Similarly, water, air, sunshine, etc.., are all resources.

Course Objectives፡ After successful completion of this course, student will be able to
 Understand the meaning and characteristics of modern economic growth
 Identify characteristics of modern economic Growth
 Analyze factors Affecting Economic Growth
 Understand the contribution of Natural Resources in the development of a country
 Understand the importance of human capital for the need for resource consciousness
 Analyze the classification and Kinds of natural resources
 Understand the natural resource base of Ethiopia
2.1 Characteristics of modern economic Growth
A developed economy is the characterized by increase in capital resources, improvement in efficiency of
labor, better organization of production in all spheres. Development of means of transport and
communication, growth of banks and other financial institutions, urbanization and a rise in the level of
living, improvement in the standards of education and expectation of life, greater leisure and more
recreation facilities and the widening of the mental horizon of the people, and so on.

The main characteristics of developed countries are as follows.

1. Significance of Industrial Sector
2. High Rate of Capital Formation
3. Use of High Production Techniques and Skills
4. Low Growth of Population
1. Significance of Industrial Sector
Most of the developed countries in the world have given much importance of the development of
industrial sector. They have large capacities to utilize all resources of production, to maximize national
income and to provide employment for the jobless people. As we are quite aware that these countries
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receive the major portion of their national income from the non-agriculture sectors which include
industry, trade, transport, and communication

For instance, England generally receives nearly 50% of her national income from industrial sector, 21%
from transport and commerce, 4% from agriculture and 25% from other sectors.

The same case is with the U.S.A, Japan and other West European countries.But in India and other
developing countries agriculture contributes, say, 35 to 40 percent, to their national income.

2. High Rate of Capital Formation

Developed countries are generally very rich, as they maintain a high level of savings and investment, with
the result that they have huge amount of capital stocks. The rate of investment constitutes 20 to 25 percent
of the total national income. The rate of capital formation in these countries is also very high. Besides
this, well-developed capital market, high level of savings, broader business prospects and capable
entrepreneurship have led to a high growth of capital formation in these economies.

3. Use of High Production Techniques and Skills

High production techniques and skills have become an essential part of economic development process in
the developed countries. The new techniques have been used for the exploitation of the physical human
resources. These countries have, therefore, been giving priority to the scientific research, so as to improve
and evolve the new and technique of production.

Consequently, these countries find themselves able to produce goods and services of a better equality
comparatively at the lesser cost. It is because of the use of high production techniques and latest skills,
that the countries like Japan, Germany and Israel could have developed their economies very rapidly,
though they have limited natural resources.

4. Low Growth of Population

The developed countries, like the U.S.A., the U.K. and other western European countries have low growth
of population because they have low level of birth rate followed by low level of death rate. Good health
conditions, high degree of education and high level of consumption of the people have led to maintain low
growth of population followed by low level of birth and death rates. The life expectancy in these countries
is also very high. The high rate of capital formation on the one hand and low growth of population have
resulted in high level of per capita income and prosperity in these countries. Consequently, the people in

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these countries enjoy a higher standard of living and work together unitedly for more rapid economic and
industrial development of the nations.

2.2 Factors Affecting Economic Growth

The process of economic growth is a highly complex phenomenon and is influenced by numerous and
varied factors such as political, social and cultural factors. As such, economic analysis cab provides only a
partial explanation of this process. To repeat here the remark of prof. Ragnar nukes in this connection,
“economic development has much to do with human endowments, social attitudes, political conditions
and historical accidents. Capital is a necessary but not a sufficient condition of progress”. The supply of
natural resources, the growth of scientific and technological knowledge all these too have a strong bearing
on the process of economic growth. We shall briefly notice some of these factors one by one.

A. Economic Factors

The following are the important factors, which determine the economic growth of an economy.

2.3 Natural Resources

The principal factor affecting the development of an economy is the natural resources. Among the natural
resources, we generally include the land area and the quality of the solid, forest wealth, good river system,
minerals and oil- resources, good and bracing climate, etc. for economic growth, the existence of natural
resources in abundance is essential. A country deficient in natural resources may not be in a position to
develop rapidly. In fact, natural resources are a necessary condition for economic growth but not a
sufficient one. Japan and India are the two contradictory examples.

2.4 Need for resource consciousness

Resources are the basis of economic prosperity of various nations. Different countries are at different
levels of economic development primarily because of their resources. The USA & the west European
countries are economically prosperous because they possess vast resources- natural, human & cultural On
the other hand, in most parts of Africa & Asia, though nature has been quite generous to people, due to
their lack of knowledge and initiative, have been unable to turn the huge mass of resources to economic
development. The vast forest resources, mineral wealth, water power potential, etc still lie unutilized and
are therefore, not used in the service of man.

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2.3 Classification: Kinds of natural resources

Natural resources are of two kinds. They are:

1. Renewable inexhaustible/infinite resources and

2. Non- renewable or exhaustible resources
Renewable resources refer to those natural resources which can be renewed (i.e can be obtained & used
again & again). Examples of renewable resources are lands, water, fisheries forests, etc. Non-renewable
resources refer to those resources which cannot be renewed (i.e cannot be obtained and used again &
again). Example Mineral deposits.

2.4 Importance of natural resources

Natural resources play a very important role in the economic development of a country. Natural resources
help the economic development of a country in many ways. They are:

1. Favorable geographical location: one of the important natural resources contributes to the
agricultural, industrial and commercial development of a country.
2. Topography or surface features, such as the mountains, plains, coastlines etc, which are also
natural resources, contribute to the economic development of a country.
3. Land, which is one of the natural resources, contribute to the economic development of a country
by providing grounds for human settlement, agriculture, industries and all other human activities.
4. Fertile soil, one of the valuable gifts of nature, contributes to the economic development of a
country by encouraging agriculture.
5. Mineral resources contribute to the industrial development of a country by providing raw
materials & fuels for industries.
6. Water resources contribute to the economic development of a country by providing navigational
facilities and by supplying water for irrigation, hydro-electricity and industrial and domestic
purposes
7. Fisheries contribute to the economic development of a country by providing nutritious food for
man.
8. Wind, one of the gifts of nature, can be used for power.
9. Forest

2.5 The natural resource base of Ethiopia

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Many believe that Ethiopia has a tremendous natural endowment: Fertile soil, favorable climate, untapped
underground resources, surface and subsurface water.

The following sections try to describe the natural resource base of the country based on some of the most
reputed sources of information.

1. Geographical Location
Geographical location is a resource in its own right; climate, agriculture, trade, and access to costal
resources are all influenced by the location of a country. In spite of being land locked, it is the hinterland
for all the coastline of Eritrea on the Red Sea, and of Djibouti and Somalia on the Gulf of Adam and the
Indian Ocean. Ethiopia’s location near the equator, together with its extensive altitudinal range, has made
the country suitable for human settlement based on big range of crop production systems and pastoralist.

2. Soil
Soil erosion is the most visible form of land degradation affecting nearly half of the agricultural land and
resulting in soil loss of 1.5 to 2 billion tons annually, equivalent to 35 tons per hectares and monetary
value of US$1 to 2 billion per year (Ethiopian Soil Science Society, 1998; Ethiopian Highland
Reclamation Study (EHRS) 1985, Hurni, 1992; NFIA, 1998, UNEP/GRID). Similarly, a recent study has
highlighted the catastrophic impact of soil erosion, estimated at US$1 billion per year, on the country’s
economy, requiring urgent steps to arrest it (Sonneveld, 2002).

3. Mineral Resources
In Ethiopia, the contribution of minerals was less than 1 percent to both GDP and exports in 1993.

There are, however, many areas in the country with favorable conditions for the exploitation of minerals:
metallic mineral deposits in Precambrian rocks, and oil and gas in sedimentary rocks. So far, activity has
been concentrated in the Adola area where gold mining has been going on.

Extensive areas of alluvial gold have recently been discovered in Tigray. There is a soda ash project at
Lake Abijata in the Rift Valley, which will be used for the manufacturing of caustic soda, textiles, tyres,
detergents and soaps. Oil and gas exploration has focused on the Ogaden where promising discoveries of
natural gas have been made, and plans for exploitation are advancing.

4. Rivers
Ethiopia is often considered as the “water tower’ of North-eastern Africa. The country has more than
seven large rivers with an annual runoff amounting 111 billion cubic meters. It is disappointing to see that
less than 5% of the irrigation and less than 2% of the power generation potentials have been utilized so
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far. There are several factors that hindered use of the water resources in Ethiopia and had neither the time
nor the wealth to harness the Nile waters due to:

 Concerned with maintaining its territorial integrity and political independence

 For several decades the country was also wrecked by civil war
 Suffered of drought and famine for several time
5. Lakes
Ethiopia is endowed with lakes that could be for several purposes including fishing and irrigation.The
total surface of the 18 natural and artificial Lakes in Ethiopia is about 7,500km 2Lakes Shala and Abyata
have concentrations of chemicals for the production of soda ash.The maximum sustainable annual yield of
fish is about 60,300 tons although present average annual production is only 4000 tons. The Rift valley
lakes basin has over 25 fish species and accounts for about 50 percent of the total island fish production.

6. Groundwater resources
In Ethiopia, the groundwater potential is not known with any certainty.A preliminary water resources
master plan study of the various basins estimates it to be 2.9 billion cubic meters.So far, only a small
fraction of this resource is in use, mainly for local water supply purposes.

7. Livestock Resources
Ethiopia has one of the largest livestock populations in Africa. This consists of 30 million cattle and over
42 million heads of sheep and goats, 7 million equines and over 53 million chickens. Cattle provide
traction power for 95 percent of grain production and also provide milk, meat, manure, cash income and
serve as a hedge in times of drought and risks. A shift towards more intensive feeding systems

o Emphasis on cut and carry feeding

o Gradual shift away from uncontrolled grazing, particular on uplands and slopping areas.
o
8. Flora and fauna
Ethiopia has an important place in its richness and diversity (heterogeneous) of its flora and fauna and
endemic plants (TweldeBerhane, 1991). It is an important centre for crop genetic diversity since it is the
sole or the most significant source of genetic diversity for some crops such as arabica coffee, teff, ensete,
noug, and Ethiopian rape. It is estimated to contain between 6500 and 7000 species of higher plant, of
which about 12 percent are endemic. .
Forest
9. Non-renewable Energy Resources
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In Ethiopia the exploration for non- renewable underground energy resources has been stepped- up in
recent years with some promising results. Coal and Oil shale occurrences have been confirmed in a
number of regions. Natural gas deposits of over 25 billion cubic meters have been discovered in the
Somalia Region.

 Geothermal energy resources’ totaling 700 MW have been found

 Concrete measures have now been taken to explore and extract petroleum resources.
o Example: the Ethiopian government has signed an agreement with Malaysia’s national
Petroleum Corporation for exploration of petroleum at the Gambela basin.
10. Renewable Energy Resources
Ethiopia is endowed with solar energy yThe average daily radiation reaching the ground varies from a
high of 5.55 KWh/m2 in February and March to a low of 4.55 KWh/m 2 in July with a mean of 5.20
KWh/m2.The annual variation is thus small, allowing for a very efficient use of solar energy facilities.The
potential for wind energy is estimated to be some 4.3 million year, of which 5 % is deemed exploitable.

A significant amount (49.8%) of this exploitable potential is located in two regions. Hararge (29.9 %) and
Bale (20%)

CHAPTER THREE
THEORIES OF ECONOMIC DEVELOPMENT
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Introduction
This chapter discusses a few of the major theories of economic development. The first two theories with
some application to LDCs today – those of the English classical economists, and of their foremost critic,
Karl Marx – were developed in the 19th century during the early capitalist development in Western
Europe and the United States.
The theories of economic development point out the nature of economic development and the causes
contributing to economic development. We shall review the economic thought of classical economists,
notably Adam Smith, Ricardo and Malthus in respect of economic development and stagnation. The
period of classical economists was related with the process of rapid economic progress, particularly in
European countries. Their economic ideas in relation to economic development are obviously of great
importance for us, as they had thrown light on the factors responsible for economic development and
those that retarded it at that time.
Unit objectives: After successful completion of this unit, you should be able to:

 analyze the theories of economic development

 explain classical theory economic growth and development
 understand rostow’s stages of economic growth and others
 Identify the keynesian economic theory.
2.1 Classical Theory Development
The classical school of economic thought was formalized by Adam Smith,he was the father of economics.
Malthus, Ricardo, J. s. Mill and J.B fully developed the classical theory. Adam Smith was a professor of
“Moral Science”. Ricardo was a banker, Malthus was a clergyman & Mill was a greater thinker of
different subjects..
Adam Smith (1723–1790) was a Scottish philosopher and economist who is renowned as the author of
The Wealth Of Nations (1776), one of the most influential books on market economics ever written.
Adam Smith was born in 1723 on an unknown date. He studied moral philosophy at the University of
Glasgow and Balliol College, but eventually left the latter and made a name for himself as a traveling
lecturer. He later became a professor of logic, ethics, rhetoric, jurisprudence and political economy.
Adam Smith has not received as much recognition for his theory of growth as he has for his theory of
value and rent, but the fact still remains that he does provide a consistent dynamic model.
Adam Smith identified three major sources of growth:
 Growth in the labour force and stock of capital

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  Improvement in the efficiency with which capital is used in labour through greater division of
labour and technological progress
 Promotion of foreign trade that widens the market and reinforces the other two sources of growth

David Ricardo (1772–1823) was one of the greatest theoretical economists of all time. Ricardo attended
school in London and Amsterdam and at the age of fourteen entered his father's business. Initially Ricardo
following his dad’s business line, set up independently as a broker on the London Stock Exchange. Soon
Ricardo became interested in economics in 1799 after reading the works of Adam Smith (the Wealth of
Nations). He, after some initial struggle published his own book, The Principles of Political Economy and
Taxation, in 1817. Two of Ricardo's most important contributions were the theory of rent and the concept
of comparative advantage.

Thomas Malthus (1766–1834) was an economist who was most famous for his doctrine, which stated that
"population increases in a geometric ratio, while the means of subsistence increases in an arithmetic ratio
which basically means that the population of mankind will eventually outstrip man's ability to supply
himself with the necessities of life. Dubbed the "prophets of gloom and doom," his theories became
associated with turning economic thought into a dismal science. He became renowned for his pessimistic
predictions regarding the future of humanity. His major contribution to economic thought came in the
form of six editions to An Essay on the Principle of Population, published from 1798 to 1826.

The fundamentals of the classical supply side growth model presented as follows:

1. Economic growth is the function of increasing real output.

A nation becomes rich only in figurative sense with high component of income from services. True
economic development is the increasing function of real/material output. Growth depends upon:

 Rich natural resources

 Increasing net contribution of labour by way of material productivity over what it consumes and
receives in wages.
 Increasing rate of capital accumulation, and
 Increasing production due to better organization (Rising output due to better technology).
Natural resources are inert/static and need discovery. Capital, the engine of economic growth, is however,
a “produced means of production” which actually depends upon the labour/human-beings saving at high
rate.

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  Nature is the “mother”,
 Labour is the “father” and
 Capital the “child” of the interaction of the two.
Labour has the most important place in the growth process provided.
(i) Its demographic consumption is not a big leakage and its physical productivity is higher than the
wages.
(ii) The life time consumption of labour should be less than the life time production.
Economic growth is the function of natural hierarchy of economic activities. Agriculture comes first
because “there is multiplication in it”, while there is only “addition in industry.”
2. Maximum real output would require that prices be set by market clearing paradigm.
Economy is to be guided by the “invisible hand”. i. e by prices, set by free play of demand and supply. If
price go down, there is no need for support. Falling price will reduce excess supply and/or increase
demand. Similarly, rising price should not lead to government controls; rising prices will increase supply
responses and/or reduce demand. J.B say argued, “Supply creates its own demand.”
If supply creates its own demand, then demand will create its own supplies also. Whatever is demanded
will be produced as the rising prices send appropriate signals to producers. Falling prices also send signals
to producers for adjustment as also to those who demand. Whenever something is produced its price
equivalent is always distributed to five factors of production in the form of: Rent, wages, interest,
salaries and profits.
3. Rate of capital accumulation/ investment depends upon high rate of profits.

If capital is the “engine” of growth (leading the economy), profit are “Carrots” (providing all the
incentives to move for forward movement) of growth. Thus K= f (P)

Both Smith and Ricardo viewed savings to be a function of parsimonious/economical conduct or frugal
behavior. They regarded prodigals /wasteful as public enemy and frugal persons as the greatest public
benefactors/supporter. Capital accumulation is necessary at increasing rate and should in all cases exceed
the growth of population. Extended division of labour of specialization (which increases dexterity/skill
and brings all sorts of economics) increases production and benefit. Capital is “stored up labour” in the
classical model. Savings are Y- C (income minus consumption) and the rich have greater propensity to
save. [Out of two loaves of bread I save one, but out of four loves I save three, so wrote Recardo]. Hence
the ‘capitalists’ (entrepreneurs) not the poor should be helped to reap high profits.
4. High profits are functions of neutral, fiscal and monetary policies
a. Fiscal policy:
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Fiscal policy is budget police which a decision made by government about taxing, spending.
It is the use of government expenditure and revenue collection (taxation) to influence the economy. The
two main instruments of fiscal policy are government expenditure and taxation. It is budget/resource
allocation on different sectors, and Deficit/Shortage levels that is tolerated by the government (the gap
between expenditure and revenue.)
b. Monetary policy:
Monetary policy is the process by which the monetary authority of a country controls the supply of
money, often targeting a rate of interest for the purpose of promoting economic growth and stability.
Monetary policy is referred to as either being expansionary, or a contractionary, where an expansionary
policy increases the total supply of money in the economy more rapidly than usual, and a contractionary
policy expands the money supply more slowly than usual or even shrinks it.
Monetary policy is a decision made by governments with regard to the supply of money (how much
money is going to circulate in the economy and Interest rate.
The classical model assumes (and recommends) that the government fiscal policies will be neutral and
will involve small amounts. All taxes are bad; only those taxes are good which involve small amounts.
No government should tax at a high rate or spend big amounts or incur high debts. Debts were to be taken
in bad times and returned in good times. The classical economists were of the view that ‘non-action’ is
the only action required on the part of the government about the growth. “That government is the best
which governs the least.” It should function silently like stomach”. The classical economists did not
consider it appropriate that the government should tax the rich and provide benefits of public expenditure
to the poor. Fiscal policy has to be neutral.
5. High rates of profits are function of freer international trade as well, which should be on the base of
‘comparative advantage’. Smith wrote that one should never produce at home what can be purchased
cheaper from outside (except for defense goods).
This is true of international commerce also. Recardo demonstrated that international trade will not and
should not take place unless the absolute advantage in costs is comparative also.
The maxims/proverbs of trade will have to be
Specialize in the production of that commodity in the production of which comparative advantage is the
highest and this is the commodity of specialization and exports and
(B) to further this specialization import other commodities from abroad in which other countries have
specialization provided the loss is the least.
6. Money is not very important in the theory of economic growth.

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Surprising it may seem but it is true that the classical economists consider money to be less important in
the theory of economic growth. Money is important in the theory of instability. A shortage of money will
hinder growth but a plethora/excess of it will promote it. In fact it will cause inflation. The classical
system is based on the premise that the problems of development arise because ‘price’ deviate from
‘values’.To keep this divergence to the minimum it is necessary to:
 strengthen certain institutions which have a great bearing on the growth such as a sound
administrative system, a stable government,
 well organized financial agencies,
 a legal system which has capacity of ensuring security to persons and private property,
 efficient organization of the means of production,
 A simple and well defined system of land rights and inheritance.
Points of criticism of classical economic theory

1. They considered poor to be their own cause of poverty and freed the capitalists of all
responsibilities
2. Too much of emphasize on laissez faire will completely neglect the social consequences of
economic development.
3. The problems of growth and development are so many and so grave that unless growth is
‘sponsored’ also it will not lead to development.
2.2 Marx’s model of economic development

Karl Marx was undoubtedly the greatest name of the 19th century. He was a revolutionary, a social
reformer, an economist, a social scientist, a political thinker, a historian, a maker of history, a philosopher,
etc.Karl Marx had elaborated the ‘stages of economic development’ in the Communist Manifesto, which
he wrote along with his lifelong friend Engles. There were three stages of economic development before
the onset of capitalism. They were:
1. Primitive communism
2. Slavery
3. Feudalism
The fourth and fifth stage of economic development is capitalism and imperialism.
1. Production function

The causal relationships of the economic development in capitalism are the same as expressed by the
classical economists.

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 (a) Economic development is the function of material output, which itself is the function of the
richness and use of land (natural resources), labour, capital and organization.
(b) Capital accumulation, and technology depend upon the rate of saving in the society.
But, the rate of saving in Marxian model does not depend upon income nor abstinence or parsimony (as in
the classical model) but on the quantum of exploitation. The capital is not ‘stored up labour’ (Ricardo),
but “stolen labour”, with the capitalist.
(c) Rate of capital accumulation and saving depend on
(i) Payment of low subsistence real wages and
(ii) High rate of profits.
2. Commodity relations determine human relations
Karl Marx who was a close observer of the economic relations around him, developed the law of the
‘fetishism of commodities’. Human beings produce things which have some social and economic
progressions.(For example, a cobbler produces things of hides and skins and since these commodities are
cheaper than some other commodities and their production is also distasteful or objectionable; the cobbler
gets an inferior socioeconomic status in the society. It is not the social consciousness that determines
economic relationships but economic relationships that determine the social consciousness in capitalist
order.
3. Money becomes an asset rather than a medium of exchange; it also becomes a tool of exploitation
under capitalist mode of production.
In a pre-capitalist era money was only a medium of exchange. It facilitated barter with the help of money.
There was produced commodities (C), exchanged them with money (M) and purchased other
commodities with the help of money. Under capitalism, relationship gets converted to M-C-M system. i.e
some persons got hold of money through devious/tricky means of paying less to the workers, and with
this money they purchase commodities (C) produced by others, which they sell to earn more money (M).
The aim of capitalist is to maximize exchange values and not the use value. It is not the consumer
satisfaction or economic happiness of the common people that is sought to be maximized but the gains
and profits of the capitalists.
4. Workers are not paid according to the ‘labour theory of value’, which enables the capitalist to earn
‘surplus value’, which becomes the source of accumulation.

‘Labour theory of value’ is that “value of a commodity is equal to the amount of labour hours expended in
the production of that commodity.” Karl Marx pointed out that the employers do not pay the workers the
full value of the output produced by them. If a worker works for 10 hours in a factory, he may be paid

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wages equal to say 6 hours’ worth of output. The output worth 4 hours’ work retained by the employer is
surplus value.
Marx further extended his explanation by showing how the rate “profit” (surplus value) is increased in the
following manner:
 Prolonging the working day or the working hours of surplus labor.
 By reducing the labor time required to produce the subsistence wage of the laborer (improving
technology).
 Technological improvement requires further investment which is possible due to the appropriation
of surplus value.
 By increasing the productivity of labor through enhancing the skill of labor.
From the above analysis Marx arrived at the following laws:-

Law of capitalist accumulation of capital. How?

 by increasing the rate of exploitation (surplus value)
Law of falling tendency of capitalist profit (surplus value). How?
 Competition among gigantic/huge enterprises forces them to cheapen their product (by improving
technology and increasing labour productivity)
The law of concentration and centralization of capital
 Through the fierce competition between capitalist firms those who are able to cheapen their
products will control the market and hence all wealth concentrates in their hands.
The law of increased misery /unhappiness of the working class.
 Capital accumulation and concentration leads to the substitution of labour by machine which
creates industrial reserve army.
 With unemployment all sorts of misery exacerbates leading to the capitalist crisis.
Limitations of Marxian Theory

The capitalist system focus is prices and is not of values. He argued that the aim of capitalist is to
maximizes exchange values/price and not the use value. Not all technologies replace labour instead
creates more employment through raising aggregate demand and income.

Falling tendency of profit is not correct because increase in productivity and total output raises profit. The
law of increasing misery of the working class is wrong because in developed capitalist countries real wage
of workers is rising and they are becoming more prosperous.Finally, Marx theory of surplus value and
accumulation of capital has dealt with the developed capitalist nations. It is irrelevant to LDC’S

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2.3 Keynesian economic theory.

John Maynard Keynes's most influential work, The General Theory of Employment, Interest, and Money,
was published in 1936. The book constituted a vast assault on the classical economics tradition in which
he had been raised. The era that had nurtured classical economics had been destroyed by the first world
war, and for Keynes the cataclysms since had demonstrated the tradition's inadequacies. A new synthesis
was necessary, and that is what Keynes sought to create.

In particular, he concluded that classical economics rested on a fundamental error. It assumed, mistakenly,
that the balance between supply and demand would ensure full employment. On the contrary, in Keynes's
view, the economy was chronically unstable and subject to fluctuations, and supply and demand could
well balance out at an equilibrium that did not deliver full employment. The reasons were inadequate
investment and over-saving, both rooted in the psychology of uncertainty.

The solution to this conundrum was seemingly simple: Replace the missing private investment with
public investment, financed by deliberate deficits. The government would borrow money to spend on such
things as public works; and that deficit spending, in turn, would create jobs and increase purchasing
power. Striving to balance the government's budget during a slump would make things worse, not better.
In order to make his argument, Keynes deployed a range of new tools—standardized national income
accounting (which led to the basic concept of gross national product), the concept of aggregate demand,
and the multiplier (people receiving government money for public-works jobs will spend money, which
will create new jobs). Keynes's analysis laid the basis for the field of macroeconomics, which treats the
economy as a whole and focuses on government's use of fiscal policy spending, deficits, and tax. These
tools could be used to manage aggregate demand and thus ensure full employment. As a corollary, the
government would cut back its spending during times of recovery and expansion.

With the outbreak of World War II, Keynes moved on to the questions of how to finance the war and then
how to develop a postwar currency system. He was one of the fathers of the Bretton Woods accord, which
established the World Bank and the International Monetary Fund, and which put in place a system of
fixed exchange rates.

Keynes provided both a specific rationale for government's taking a bigger role in the economy and a
more general confidence in the ability of government to intervene and manage effectively. Despite
Keynes's fascination with uncertainty and his speculative talents in the marketplace, Keynesians deemed
"government knowledge" to be superior to that of the marketplace.

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Keynesian Economic Theory 3: It was not until the 1970s that evidence began to accumulate in many
countries that Keynes's theories, at least as implemented by Keynes's advocates after his death, might not
perpetually yield the favorable outcomes Keynes himself had predicted.

Keynesian economic theory emanates from the great world depression of the 1930’s.

This great world depression was characterized by:

1. A massive drop in the production of goods andservices [EgProduction in the USA dropped by 50% in
1933 from its 1929 level.]

2. High unemployment rate exhibited. [Eg Unemployment level which was only 1.5 million in 1929
increased to 13 million in 1933 which was nearly 25%]

3. Incomes of the society dropped substantially.As a result of all these aggregate demand fell down.

• The market forces were not able to correct the market failure.

• Price and wages were more down wards so as to increase employment opportunity.

– Wages: A sum of money paid to a worker in exchange of services, especially for work
performed on an hourly, daily, or weekly basis

– Salary: is payment for non-manual work: a fixed annual sum, paid at regular intervals,
usually monthly, to an employee, especially for professionals or clerical.

John Maynard Keynes hence came up with a new economic growth theory which states that
aggregate/total demand determines the level of income and the volume of employment.

In order to raise aggregate demand Keynes suggested that tangible action by the government to raise
consumption demand and investment demand should be taken.

Government can increase public investment through deficit financing (The practice of spending more
money than is received as revenue, the difference is made up by borrowing) for capital formation
(increasing capital expenditure).

This will raise income and create employment opportunity.Attracting foreign direct investment is another
option for policy makers of LDCs.

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Generally, Keynes formulation of the principal role that government has to play in the matter of economic
growth is what is applicable to LDCs. These include:

 Government policy that aimed at raising aggregate demand

 Deficit financing (The practice of spending more money than is received as revenue, the difference
is made up by borrowing) towards public investment

 Combating/fighting disequilibrium, which is common in LDCs due to various barriers to economic

growth and market failure.

2.4 Rostow’s stages of economic Growth and others

The most influential and outspoken advocate of the stages-of-growth model of development was the
American economic historian Walt W. Rostow. According to Rostow, the transition from
underdevelopment to development can be described in terms of a series of steps or stages through which
all countries must proceed.

The advanced countries, it was argued, had all passed the stage of “takeoff into self-sustaining growth,”
and the underdeveloped countries that were still in either the traditional society or the “preconditions”
stage had only to follow a certain set of rules of development to take off in their turn into self-sustaining
economic growth. One of the principal strategies of development necessary for any takeoff was the
mobilization of domestic and foreign saving in order to generate sufficient investment to accelerate
economic growth. The economic mechanism by which more investment leads to more growth can be
described in terms of the Harrod-Domar growth model, today often referred to as the AK model because it
is based on a linear production function with output given by the capital stock K times a constant, often
labeled A. In one form or another, it has frequently been applied to policy issues facing developing
countries, such as in the two-gap model.

The study by W.W. Rostow is the broadest in scope, using an essentially historical methodology.He
attempts to develop a broad picture of the development process from the earliest “Traditional” society to
the most advanced “high mass-consumption economy”

He postulated and described 5 distinct “stages” of economic development and attempts to account for the
forces inherent in each stage that provide for the transition to the next.These stages are:

 Traditional Society

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  The precondition to take off
 The take over
 The drive to maturity
 The age of high mass consumption
Stage 1: The traditional society

In the process of economic development, first or the initial stage refers to a traditional society.

It is a primitive society where no window is open for the utilization of modern science and technology. In
other words, it is a society based on primitive technology and primitive attitudes towards the physical
world. This stage may take many centuries to be ended.

Though a traditional society is considered to be a static and changeless society, yet it may be
characterized by significant changes in the level of output, pattern of trade, population and per capita
income.

Whenever a traditional society comes in contact with a little advanced society or a nation for war or any
other reason, it may change its culture, way of life and way of thinking, and may learn the new methods
of production and hope for a better life. It is in this way that the hunting stage changes into pastoral and
the pastoral into the agricultural stage.

At this stage, agriculture is the main occupation of the masses. However, some of them used to work as
the smiths, the weavers and other craftsmen. Land revenue was only the source of state's income. In
agriculture, the productivity was very low for want of modern technology and its application. There was
lack of scientific understanding of their physical environment and hence, the scientific and technological
development could not become a regular feature. The social structure of such traditional societies was
mostly hierarchical. In this regard, family and clan relations played a dominant role. The political power
was in the hands of landed aristocracy.

Since most of the savings of the nations were diverted to unproductive expenditures like wars,
monuments, temples, expensive weddings and funerals, the capital formation as an important tool of
economic development remained suspended in such traditional societies.

Stage 2: The precondition for take-off

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The second stage of growth refers to societies in the process of transition. It covers a long period of
century or more during which the preconditions for take-off are developed. In fact, the preconditions for
take-off embrace many fundamental changes in the social, political and economic fields:

1. A change in people’s attitude towards science;

2. The society realizes that economic progress is desirable and possible;
3. Propagation of education;
4. Evolution of entrepreneurship;
5. Development of financial institutions;
6. Expansion of investment, especially in transport, communications and in primary products required by
other countries;
7) Emergency of political sovereignty;
8) Development of centralized tax and financial system;
9) The construction of certain economic and social overheads like railroads, and educational institutions;
10) Encouragement of import substitutions
Stage 3: The take-off

The take-off stage is defined as an industrial revolution tied directly to radical changes in methods of
production. It is the interval during which rate of investment and real output per capita rises. The will and
capacity to develop increases. The entire institutional set-up undergoes a change for further development
and innovations.

Increase of productive investment from 5% to over 10% of national income. Development of one or more
substantial manufacturing sectors with high growth rate. The emergence of a suitable socio-political and
institutional frame work under which the growth and expansion of modern sector becomes marked.

The main features of the takeoff stage are the following

a) New possibilities for productive enterprises:-Perpetuate an initial increase in the scale of investment.
b) Entrepreneurship and capital formation
C) Foreign capital is helpful but not an essential condition (In Britain and Japan, take off occurred
without foreign capital, while in USA, USSR and Canada foreign capital played an important role)
d) Emergence of leading sectors (which have new production functions of high productivity that generate
a maximum or reinvest able surplus which can be used for another investment.
Stage 4: The drive to maturity

Take-off requires the following 3 conditions:

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Take of stage is followed by a drive to maturity stage.
During this stage all efforts are made to maintain the rising trends in the economy and investment
increases from 10% of GNP to about 20% of GNP.
 New industries expand while the old and existing ones contract.
 Emphasis is laid on import substitution.
Three significant stages take place at this stage.
1) The character of working forces changes. It primarily becomes skilled. People prefer to live in urban
areas than in rural. Real wages start to rising and the workers organize themselves in order to have greater
economic and social security.
2) The character of entrepreneurs’ changes. Strong and hardworking masters give way to genteel and
watch efficient managers.
3) The society feels fed up of the miracles of industrialization and wants something new leading to a
further change.
Stage 5: The stage of high mass consumption

It comprises the tendency of migration from villages to the cities, the extensive use of automobiles, the
durable consumer of goods and house hold instruments. In this period,” the balance of attention of the
society is shifted from supply to demand, from problems of production to problems of consumption and
of welfare in the widest sense. “The countries like the USA, UK, France, Germany, Japan etc have
attained the stage of high mass consumption. There is increasing financial security for everybody and a
continuous stage of full employment.

It is a kind of very progressive and prosperous society in which “hunger is something that one reads
about and poverty a memory.”

Criticism of Rostow’s stage of economic growth

Rostow’s work, the stage of economic growth, is in fact a remarkable contribution to the subject of
economics.On the other hand his work is criticized on the following grounds.It is not true that every
country essentially passes through the first stage of traditional society. There are countries in the world
like the USA, Canada, New Zeland& Australia which were born free of traditional society and they
attained the precondition from the UK and advanced country.

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 CHAPTER FOUR
GROWTH MODELS

 Introduction

Over the 18th, 19th, and 20thcenturies aggregate production has been more or less steadily increasing in
most countries of the world. This holds both as concerns overall output as well as concerns production per
capita. So, the per-capita gross domestic product (GDP) in the world quadrupled from1900 to the early
1990’s, corresponding to an average growth rate of about 1.5 percent per year. In Western European
countries, GDP growth was still larger with an average annual growth rate of roughly 1.9 percent, which
implies that per-capita GDP in the early 1990’s was 5.6 times larger than in 1900. Whereas the rise in
overall output does not seem to be too surprising as the population of a country increases, this does not
necessarily hold for per-capita output. Although both aspects are of importance and have been studied by
economists, it is in particular the latter question, which has especially raised the interest of economists.
Already the classical economists of the 18th and 19th century have addressed the question of which
factors generate economic growth.

Unit objectives:

After successful completion of this unit, you should be able to:

 Identify the Harrod-Domar Model

 Analyze the Lewis Model (1960’s) Theory of Development
 Understand the Big Push or Rosenstein Rodan Model
 Differentiate between the Balanced growth model and Unbalanced growth model
 Understand Neoclassical Model of economic Growth and others

4.1 Exogenous Growth Models

The Harrod-Domar growth theory is based on the work by these two authors. They developed their
models independently, but the assumptions and results are, nevertheless, basically the same. They built
their theory in the late 1930’s and mid 1940’s, when the memory of industrialized countries being
plunged into deep recessions, with a high unemployment rate and a sharp decline of gross domestic
product due to the recession in 1929 and 1930, was still present. Harrod and Domar based their theorizing
on the famous work by Keynes who offered an explanation of why markets may fail to bring about full

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employment. The early classical writers, mentioned in the Introduction, fully believed in Say’s law,
stating that supply creates its own demand.

4.2 The Harrod-Domar Model

Harrod-Domar growth model A functional economic relationship in which the growth rate of gross
domestic product (g) depends directly on the national net savings rate (s) and inversely on the national
capital-output ratio (c)

Every economy must save a certain proportion of its national income, if only to replace worn out or
impaired capital goods (buildings, equipment, and materials). However, in order to grow new investments
representing net additions to the capital stock are necessary. If we assume that there is some direct
economic relationship between the size of the total capital stock K, and total GDP, Y. For example, if $3
of capital is always necessary to produce an annual $1 stream of GDP it follows that any net additions to
the capital stock in the form of new investment will bring about corresponding increases in the flow of
national output GDP. Suppose that this relationship, known in economics as the capital-output ratio, is
roughly 3 to 1. If we define the capital-output ratio as k and assume further that the national net savings
ratio, s, is a fixed proportion of national output (e.g., 6%) and that total new investment is determined by
the level of total savings, we can construct the following simple model of economic growth:

1. Net saving (S) is some proportion, s, of national income (Y) such that we have the simple equation

2. Net investment (I) is defined as the change in the capital stock, K, and can be represented by K such
that

But because the total capital stock, K, bears a direct relationship to total national income or output, Y, as
expressed by the capital-output ratio, c,3 it follows that

3. Finally, because net national savings, S, must equal net investment, I, we can write this equality as

To grow, economies must save and invest a certain proportion of their GDP. The more they can save and
invest, the faster they can grow. However, the actual rate at which they can grow for any level of saving
and investment how much additional output can be had from an additional unit of investment can be
measured by the inverse of the capital-output ratio. It follows that multiplying the rate of new investment,
by its productivity, will give the rate by which national income or GDP will increase. In addition to
investment, two other components of economic growth are labor force growth and technological progress.
In the context of the Harrod-Domar model, labor force growth is not described explicitly. This is because
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labor is assumed to be abundant in a developing-country context and can be hired as needed in a given
proportion to capital investments (this assumption is not always valid). In a general way, technological
progress can be expressed in the Harrod-Domar context as a decrease in the required capital-output ratio,
giving more growth for a given level of investment. This is obvious when we realize that in the longer run
this ratio is not fixed but can change over time in response to the functioning of financial markets and the
policy environment. But again the focus was on the role of capital investment.

This growth model is named after English economist Roy Harrold and Polish born American economist
EvseyDomar in the 1950’s.HarrodDomar growth model postulates three kinds of growth:

a) Warranted growth: the rate of output at which firms feel they have the right level of capital and do
not wish to expand or decrease investment.

 It is the average of the growth rates desired by all entrepreneurs.

 The entrepreneurs would like to reach at this stage and if it is there, they will not desire any
change however.

 ENTREPRENUERS will be satisfied with the amount of investment actually made.

b) Natural rate of growth: Is a growth that corresponds to the growth in labour force.

Naturally, if the labour supply becomes more efficient or increases, or there is resource discovery, or
technological improvements the natural growth rate will also increases.

C) Actual growth: growth that results from changes in total output.

Harrod develops the following equations in his model

G= c, where G= Rate of growth of out- put or income.

= ▲Y

C= Ratio of increase in capital to increase in output

during the given period.

Two important behavior relations are then postulated from the equation:

i) Saving depends on the level of income and,

32
 ii) Investment depends on the rates of growth income.

This model is based on the notion that actual income determines the amount of savings, which again
determines investment and thus affect the rate of economic growth. If saving is not enough, the potential
growth rate will not be achieved. The two economists are interested in the actual growth and the factors
that derive it.Their model explained economic growth to depend on labour and capital. Observing that
LDC’s have sufficient supply of labour, the constraints to growth are lack of physical capital.

Therefore, they concluded that the rate of economic growth depends on capital that comes from
investment. The model argues that more physical capital (the tangible resources used to produce goods &
services) generates economic growth and more investment leads to more capital accumulation which
generates higher output and income.

It further states that higher income resulting from higher investment allows higher level of savings.
Hence, higher savings further enhance net investment. The implication of the model is therefore, policies
are needed to encourage savings and investment to produce more output.

Limitations of the model

The model addresses economic growth but not economic development. In reality, economic growth is
only a subset of development

It is very difficult to stimulate the level of domestic savings for LDC’s where incomes is low

4.3 Lewis Model (1960’s) Theory of Development

Basic Model One of the best-known early theoretical models of development that focused on the
structural transformation of a primarily subsistence economy was that formulated by Nobel laureate W.
Arthur Lewis in the mid-1950s and later modified, formalized, and extended by John Fei and Gustav
Ranis. Lewis model is named after the black economist born in St. Lucia and educated in London. Arthur
Lewis who won a Nobel Prize for his contribution to economic growth theory. His model is a dual sector
model. Namely,

a) The traditional agricultural sector

b) Modern industrial sector

33
The Lewis two-sector model became the general theory of the development process in surplus labor
developing nations during most of the 1960s and early 1970s, and it is sometimes still applied,
particularly to study the recent growth experience in China and labor markets in other developing
countries. In the Lewis model, the underdeveloped economy consists of two sectors: a traditional,
overpopulated rural subsistence sector characterized by zero marginal labor productivity. a situation that
permits Lewis to classify this as surplus labor in the sense that it can be withdrawn from the traditional
agricultural sector without any loss of output and a high-productivity modern urban industrial sector into
which labor from the subsistence sector is gradually transferred.

The primary focus of the model is on both the process of labor transfer and the growth of output and
employment in the modern sector. (The modern sector could include modern agriculture, but we will call
the sector “industrial” as a shorthand). Both labor transfer and modern sector employment growth are
brought about by output expansion in that sector. The speed with which this expansion occurs is
determined by the rate of industrial investment and capital accumulation in the modern sector. Such
investment is made possible by the excess of modern sector profits over wages on the assumption that
capitalists reinvest all their profits. Finally, Lewis assumed that the level of wages in the urban industrial
sector was constant, determined as a given premium over a fixed average subsistence level of wages in the
traditional agricultural sector. At the constant urban wage, the supply curve of rural labor to the modern
sector is considered to be perfectly elastic.

Moreover: The traditional agricultural sector is a subsistence economy, where there is abundant surplus
labour, with low or zero marginal/ insignificant product of labour, due to huge unemployment? This
traditional sector is characterized by low productivity, low income & low savings.

The modern industrial sector is technologically advanced with high levels of investment, higher wages
(incomes) and high output. Assessing the two sectors Lewis argues that the surplus labour in the
traditional sector has to be transferred to the modern sector to achieve economic growth.

This transfer benefits both sectors.

The modern sector will get labour required for the production at lower wages (since they are unskilled and
additional labour supply lowers wage rate).The unskilled labour in due time, acquire the skill to increase
his productivity, hence output and profit increases.

The traditional sector gets relief from the burden of unemployment which it feeds. The transfer would
have no effect on agricultural productivity since the marginal/insignificant productivity of labour is zero.

34
More food will be available for the rural area which might generate surplus that could generate additional
income to the rural. The surplus labour transferred from rural to urban will earn increased income which
leads to higher quality of life and more savings.

The combined outcome of this transfer of surplus labour is:

 Increase in output in both sectors;

 Increased profit for the modern sector;
 Increased income for the surplus labour as well as to the rural peasants;
 Due to increased income increased demand for goods and services;
 Increased savings and investment from increased income and profit respectively.Hence labour
transfer offers self-generating growth.
The model is viewed as applicable in countries like China, India, Bangladesh, Latin America and some
sub-Saharan Africa.

Criticisms of the Lewis Model

Although the Lewis two-sector development model is simple and roughly reflects the historical
experience of economic growth in the West, four of its key assumptions do not fit the institutional and
economic realities of most contemporary developing countries. First, the model implicitly assumes that
the rate of labor transfer and employment creation in the modern sector is proportional to the rate of
modern- sector capital accumulation. The faster the rate of capital accumulation, the higher the growth
rate of the modern sector and the faster the rate of new job creation. But what if capitalist profits are
reinvested in more sophisticated laborsaving capital equipment rather than just duplicating the existing
capital, as is implicitly assumed in the Lewis model? (We are, of course, here accepting the debatable
assumption that capitalist profits are in fact reinvested in the local economy and not sent abroad as a form
of “capital flight” to be added to the deposits of Western banks.)

Increased industrial profit may lead to investment in labour saving capital. But in LDC’s the urban sector
is not that much developed to absorb and provide jobs for rural migrants (immediate employment is not
guaranteed).

4.4The Big Push or Rosenstein Rodan Model

Professor Paul N. Rosenstein-Rodan’s theory states growth in underdeveloped economy can be achieved
if there is a big push i.e a minimum level of investment in every sector.Investment in all sectors will
35
create external economies (the benefit that others obtain).He emphasized investment of at least 30 to 40
percent the total investment in sector like power, transport and communication which is a requirement for
other productive investment that solve the problem of supply.
In order to solve the problem of market in less developed economy he recommended investment in all
sectors, agriculture, industry, service etcRegarding the capital required for investment he argued that the
increase in investment in all sectors will create additional in come so that marginal saving will increase.
Critics to the model
He recommended investment in all sectors simultaneously, however, LDC’s lack capital required for such
an investment. Therefore, his model does not address the source of fund for investment.

4.5 Balanced growth model

The concept of balanced growth has been interpreted differently by different economists.To some it
means investment in a sector of economy which is lagging behind, say, agriculture or industry so that it
can be brought on par with other sectors. To others it implies simultaneous investment in all sectors of the
economy like agriculture, industry and transport and in every industry such as capital goods and consumer
goods industries. The reason for advocating this doctrine is that when all sectors and all industries
develop, they employ a large number of people; thereby creating demand for one other’s goods. The
various sectors and industries will complement one another’s activities and bring about a simultaneous
balanced growth of the economy.
Criticism
Lack of resources: The application of the balanced growth theory requires huge amounts of resources like
capital, entrepreneurial ability etc.
4.6 Unbalanced growth model
It is the opposite of balanced growth model. The main proponent of this model was Hirschman.
It implies that, instead of developing all sectors of the economy, there should be concentration of
investment in some selected sectors. The argument for unbalanced growth was based on the principle of
economizing the limited resources that LDC’s have. Since LDC’s lack resources and entrepreneurs,
investing in all sectors is not possible; Hence priority should be made for a certain investment.
Critics: Lacks diversification (it is like putting all eggs in one basket. Shifting resources from one sector
to another is difficult and creates resistance. The development of Eastern Europe and the previous USSR
is an example of this balanced growth.

36
 CHAPTER FIVE

DOMESTIC MEASURES/ACTIONS FOR ECONOMIC DEVELOPMENT

 Introduction

The economic development of underdeveloped countries is taking place against the background of the
world consisting of countries having close economic relationship with one another. Underdeveloped
countries are depending on the import of capital goods for achieving rapid economic development.
Foreign capital and foreign trade are regarded as the ‘Engine of growth’. The object of this chapter is to
analyses the relationship between foreign trade and economic development and balance of payment and
economic development.

Unit objectives: After successful completion of this unit, you should be able to:
 Understand the sources of Capital Formation and its Importance in economic development
 Identify the domestic Resources:
 Analyze the benefit of external/Foreign resource for economic development
 Understand the role of Capital Formation in Economic Growth of a Country
 Analyze the Monetary Policies& Fiscal Policies for Economic Growth and Development
 Define the Role of the Financial System in Economic Development
 Define The Role of Central Banks and Alternative Arrangements
 Understand the benefit of Deficit financing
4.1 Sources of Capital Formation and Importance
The stock of capital goods can be built up and increased through two main sources:
(1) Domestic Resources
(2)External Resources
4.1.1 Domestic Resources:
Domestic resources play an important part in promoting development activities in the country. These
sources in brief are:
(i) Voluntary Savings. There are two main sources of voluntary savings
(a) Households
(b) Business sector
As regards the volume of personal savings of the households, it depends upon various factors such as the
income per capita, distribution of wealth, availability of banking facilities, value system of the society,
37
etc. In the under-developed countries, the saving potential of the people is lows a greater number of them
suffer from absolute poverty. As far as the rich section of the, society is concerned, they mostly spend
their wealth on the purchase of real estates. Luxury goods, or take it abroad to safe keeping. There is,
therefore very little saving forthcoming from the high-income group.
4.1.2 External/Foreign resource for economic development
Developing countries face three types of gaps in their economic development endeavor. These are;-
 Investment saving gaps;
 Import export gaps or foreign exchange gap;
 Fiscal gap (expenditure-revenue gap)
External resources have the following types:
(i) Foreign Economic Assistance

There is a controversy over the impact of inflow of capital for the development of a country. It is argued
that capital is one of the variable in the growth process. If the government of a country is ineffective and
people are not receptive to social changes, the inflow of capital resources and technical assistance would
go waste. In case, the developing nations needing foreign capital and technical assistance have the will to
absorb capital and technical knowledge and the social and political barriers are overcome; capital then
becomes the touchstone of economic development. The main benefits of the foreign economic assistance,
however, in brief are as under:

(a) Foreign loans bridge saving gap.

(b) Close the trade gap: the export earnings are persistently falling short of import requirements. The
foreign, exchange gap caused by excess of import/export is being filled up with inflow of capital.
(c) Provides greater employment opportunities
The financing of various projects with the help of foreign assistance provides greater employment
opportunities in a country.
(d) Increase in productivity of various economic sectors. The inflow of capital and technical know-how
increases the productive capital of various sectors of the economy.
(e) Increase in real wages. The foreign resources help in increasing marginal productivity of labor in the
recipient country. The real wages of the workers are thus increased with the help of foreign assistance.
(f) Provision of higher products
The foreign capital helps in the establishment of industries in the country. The inflow of technical
knowledge improves the quantity and quality of manufactured goods and makes them available at lower
prices to the domestic consumers.
38
(g) Increase in tax revenue.
The profits earned on foreign investment are taxes by the government; the revenue of the state is thus
increased.
(h) External economies፡ The inflow of foreign capital and advanced technology stimulates domestic
enterprises. The firm avails of the benefits of external economies like that of training of labor,
introduction of new technology, new machinery, etc.
(ii) Donor Country and the Economic Assistance:
Here a question can be asked .as to why the developed nations are kind in giving aid to the developing
countries. According to the rich nations, the foreign aid is given for a combination of humanitarian and
self-interest reasons:
(a) Humanitarian ground፡ If a country is faced with famine, drought, epidemic, diseases, earthquake etc.
It is obligatory for the developed nations to help that country financially purely on humanitarian grounds.
The rich countries are extending economic assistance in the form of grants to the poor nations of the
world.
(b) Self-interest reasons፡ Foreign economic assistance is also provided on the following self-interest
reasons by the donor countries.
(a) The foreign aid may be given to protect the developing country from the influence of-other camp
countries.
(b) The donor country may have surplus products.
In order to check the fall in the prices of products in the domestic market and to maintain level of
production, the surplus goods are exported to the needy countries on loan.
(c) Economic assistance is also provided by the. Donor countries to remove the economic disparities
among the nations of the world.(d) Some advanced nations particularly the socialist countries provide
financial and technical help for the propagation of political ideology in the capitalist developing countries.
4.2 Capital formation & economic development
4.2.1 Role of Capital Formation in Economic Growth of a Country
Capital plays a vital role in the modern productive system. Production without capital is hard for us even
to imagine. Nature cannot furnish goods and materials to operate unless he has the tools and machinery
for mining, farming, forestry, fishing, etc.
Therefore, accumulation of capital goods every year greatly increases the national product or income.
Capital accumulation is necessary to provide people with tools and implements of production. If the
population goes on increasing and no net capital accumulation takes place, then the growing population

39
would not be able to get necessary tools, instruments, machines and other means of production with the
result that their capacity to produce would be seriously affected.
Capital formation: is the addition to the physical and human capital stock. Capital (both physical and
human) is one of the determinants of economic growth. Capital formation is required for:
 Expanding the scale of production;
 Enhancing productivity;
 Constructing infrastructure;
 Engaging in research & development;
 Fuller utilization of resources;
 Increase in output, income & employment.
 Though capital formation is so important for economic growth, LDC’s have low rate of capital
formation mainly because of low saving (due to low income).
 The question is how can LDC’s with low income and low saving create capital from domestic
sources?
 This can be achieved through various means:-
i) Improving efficiency (producing more goods & services without using more resources) and reducing
resource wastage to increase production which is a means for an increased income;
ii) Increase awareness towards saving for various purposes such as saving for investment, saving for
unforeseen opportunity, saving for emergencies.
iii) Establish financial institutions that can mobilize saving at the grassroots level and direct this savings
towards investment;
iv) Protect resources/capital running away/missing;
v) Improve tax collection methods and expand tax base;
vi). Support and expand the export sector.
4.3. Monetary & Fiscal Policies for Economic Growth
4.3.1The Role of the Financial System in Economic Development
1. Providing payment services
It is inconvenient, inefficient, and risky to carry around enough cash to pay for purchased goods and
services. Financial institutions provide an efficient alternative. The most obvious examples are personal
and commercial checking, check clearing, and credit and debit card services; each is growing in
importance, in the modern sectors at least, even in low-income countries.

2. Matching savers and investors

40
Although many people save, such as for retirement, and many have investment projects, such as building
a factory or expanding the inventory carried by a family microenterprise, it would be only by the wildest
of coincidences that each investor saved exactly as much as needed to finance a given project. Therefore,
it is important that savers and investors somehow meet and agree on terms for loans or other forms of
finance. This can occur without financial institutions; even in highly developed markets, many new
entrepreneurs obtain a significant fraction of their initial funds from family and friends. However, the
presence of banks, and later venture capital or stock markets, can greatly facilitate matching in an efficient
manner. Small savers simply deposit their savings and let the bank decide where to invest them.

3. Generating and distributing information

From a society wide viewpoint, one of the most important functions of the financial system is to generate
and distribute information. Stock and bond prices in the daily newspapers of developing countries (and
increasingly on the Internet as well) are a familiar example; these prices represent the average judgment
of thousands, if not millions, of investors, based on the information they have available about these and all
other investments. Banks also collect information about the firms that borrow from them; the resulting
information is one of the most important components of the “capital” of a bank, although it is often
unrecognized as such. In these regards, it has been said that financial markets rep- resent the “brain” of
the economic system.
4. Allocating credit efficiently
Channeling investment funds to uses yielding the highest rate of return allows increases in specialization
and the division of labor, which have been recognized since the time of Adam Smith as a key to the
wealth of nations.
5. Pricing, pooling, and trading risks
Insurance markets provide protection against risk, but so does the diversification possible in stock
markets or in banks’ loan syndications.
6. Increasing asset liquidity
Some investments are very long-lived; in some cases—a hydroelectric plant, for example—such
investments may last a century or more. Eventually, investors in such plants are likely to want to sell
them. In some cases, it can be quite difficult to find a buyer at the time one wishes to sellat retirement, for
instance. Financial development increases liquidity by making it easier to sell, for example, on the stock
market or to a syndicate of banks or insurance companies.
4.3.2. Monetary policy

41
For an economic growth to be achieved there must be a monetary policy that encourages savings.This can
be achieved:
 Expansion of financial intermediaries which encourage productive surplus to be saved
 Commercial banks;
 Insurance companies;
 Development banks;
 Construction banks;
 Saving & credit associations etc
ii) Weakening, control or curb unorganized money market;
iii) Ensuring efficient allocation of capital between competing financial institutions (interest rate
discrimination);
iv).Monetary expansion to meet increased demand for money per unit of output and to facilitate trade
v) Credit creation by commercial banks:
 All forms of taxation;
 Public borrowing from banks, which raise prices to surplus consumption;
 Schemes for compulsory lending to the government (this may divert private investment towards
public investment).
 Import restriction policies (tariffs, quotas, import duties etc), it reduces consumption of imported
goods and releases fund for investment;

4.3.3 The Role of Central Banks and Alternative Arrangements

Functions of a Full-Fledged Central Bank In developed nations, central banks, such as the Federal
Reserve Board in the United States, conduct a wide range of banking, regulatory, and supervisory
functions. They have substantial public responsibilities and a broad array of executive powers. Their
major activities can be grouped into five general functions.
1. Issuer of currency and manager of foreign reserves
Central banks print money, distribute notes and coins, intervene in foreign-exchange markets to regulate
the national currency’s rate of exchange with other currencies, and manage foreign- asset reserves to
maintain the external value of the national currency.
2. Banker to the government
Central banks provide bank deposit and borrowing facilities to the government while simultaneously
acting as the government’s fiscal agent and underwriter.
42
3. Banker to domestic commercial banks
Central banks also provide bank de- posit and borrowing facilities to commercial banks and act as a
lender of last resort to financially troubled commercial banks.
4. Regulator of domestic financial institutions
Central banks ensure that commercial banks and other financial institutions conduct their business
prudent land in accordance with relevant laws and regulations. They also monitor re- serve ratio
requirements and supervise the conduct of local and regional banks.
5. Operator of monetary and credit policy
Central banks attempt to manipulate monetary and credit policy instruments (the domestic money supply,
the discount rate, the foreign-exchange rate, commercial bank reserve ratio requirements, etc.) to achieve
major macroeconomic objectives such as controlling inflation, promoting investment, or regulating
international currency movements. Sometimes separate regulatory bodies handle these functions.

4.3.4 Fiscal Policy for Development

Fiscal policies that stimulate economic growth:

1. Fiscal concessions such as:

 Duty free import of capital goods;
 Tax holidays (exemption from profit tax for certain years);
 Tax exemption for reinvested profit
2. Macro stability and Resource Mobilization

Financial policy deals with money, interest, and credit allocation; fiscal policy focuses on government
taxation and expenditures. Together they represent the bulk of public-sector activities. Most stabilization
attempts have concentrated on cutting government expenditures to achieve budgetary balance.
Nevertheless, the burden of resource mobilization to finance essential public developmental efforts must
come from the revenue side. Public domestic and foreign borrowing can fill some savings gaps. In the
long run, it is the efficient and equitable collection of taxes on which governments must base their
development aspirations.32 In the absence of well-organized and locally controlled money markets, most
developing countries have had to rely primarily on fiscal measures to stabilize the economy and to
mobilize domestic resources.

3. Taxation: Direct and Indirect

43
Nevertheless, to the degree those government resources are spent wisely, such as on human capital and
needed infrastructure investments, some of the causality may run the other way as well. Typically, direct
taxes—those levied on private individuals, corporations, and property—make up 20% to 40% of total tax
revenue for most developing economies.
Indirect taxes, such as import and export duties, value added taxes (VATs), excise taxes, and sales taxes,
constitute the primary source of fiscal revenue for most developing countries. As can be seen in Table
15.3, developed OECD countries generally rely more strongly on direct taxes, but this pattern is much less
pronounced in Europe, where reliance on indirect taxes is almost as great as on direct taxes. It is not clear
whether direct or indirect taxation is better for economic development because their impact on critically
important human capital accumulation is so complex.
1. The level of per capita real income
2. The degree of inequality in the distribution of that income
3. The industrial structure of the economy and the importance of different types of economic activity (e.g.
the importance of foreign trade, the significance of the modern sector. The extent of foreign participation
in private enterprises, the degree to which the agricultural sector is commercialized as opposed to
subsistence-oriented. The social, political, and institutional setting and the relative power of different
groups (e.g., landlords as opposed to manufacturers, trade unions, village or district community
organizations)
5. The administrative competence, honesty, and integrity of the tax-gathering branches of government
We now examine the principal sources of direct and indirect public tax revenues. We can then consider
how the tax system might be used to promote a more equitable and sustainable pattern of economic
growth.
4.3.5Deficit financing
Deficit financing is usually from domestic and foreign borrowing. Public borrowing is fruitful if it is
successful in mobilizing surplus money. Public expenditure on capital projects also, in the text below will
be look into the correlation between budget and trade deficit - “twin deficits”, reviewed through the
exchange rate intermediary effect.
As discussed above deficit financing is one of the mechanism through which low level of LDC’s private
investment is augmented by public investment. Deficit financing occurs when government expenditure is
in excess of its revenue due to increased expenditure or lowered taxes deliberately. The sources of deficit
financing are-
 Domestic borrowing;
44
  Foreign borrowing;
 Drawing down of government reserve;
 Printing money
In the past as today, the deficit budget policy is famous instrument of fiscal policy used to increase the
rate of economic growth of the country. That way of financing was establish after the two world wars, oil
crises and current financial and economic crises. There are three ways to finance the deficit – taxes,
borrowing and monetization (inflation tax). The most popular model of deficit finance is borrowing,
which is usually done by issue of government bonds. When the government is over indebted tends
through national bank to buy government bonds which increases the money flow and reduces the interest
rate pressure.
However, it diminishes the real value of money and makes the future unpredictable for the economic
actors. Therefore, it is positive to conclude the debt deficit finance effects and implications that will be
separately reviewed in the paper. It is known that nowadays the current public debt growth is larger than
the growth rate of the economy for most of the industrial countries. It is expected that the growing public
debt will cause problems in perspective related to its service. The channels for public debt effect on the
economy are the following:
1) Direct effect on the interest rates accompanied with the necessity to sell larger supply of bonds. As the
supply of bonds intended for sale increases, their prices tend to fall, and the market interest rates go up;
except if credit offer is timelessly elastic and the private borrowing is reduced. The interest rate increase
can be temporary limited from the capital inflows.
2) Interest rate component of the public expenditure will tend to rise, and consequently raise future fiscal
deficits.
3) Correlated with the previous two effects, the effect on the investment and expenditure and thus on the
perspective economic performance.
4) Exchange rate effect and therefore trade flows and capital movement;
5) High risk of something that may go wrong
This risk tends to rise when the total need for government borrowing caught substantial part of the total
financial transactions. In that case the psychological element will have immense impact on the financial
market and further on the financial stability.

45
 CHAPTER SIX

INTERNATIONAL MEASURES FOR ECONOMIC DEVELOPMENT

 Introduction

There was complete lack of monetary co-operation amongst the countries of the world after the First
World War. In fact, there was an acute commercial rivalry amongst the majority of the countries of the
world at that time. Every country was trying to maximize its exports and to minimize its imports. To
achieve this objective, several countries resorted to competitive currency devaluation. Thus, there was a
sort of economic war going on amongst the majority of the countries resorted to competitive currency
devaluation, thus, there was a sort of economic war going on amongst the majority of the countries of the
world.
Unit objectives: ፡ after successful completion of this unit, you should be able to:
 Identfy the international measures for economic development
 Analize Forms of foreign resource flows to LDc’s
 Understand foreign Aid which is the Development Assistance Debate
 Define Types of foreign sources
 Understand the Private Foreign Investment andd private Portfolio Investment: Benefits and Risks
6.1 Forms of foreign resource flows to LDc’s
6.1 1 Loan: In an open economy, foreign lending and borrowing is a natural phenomenon and play a
significant role in the economic development of countries. It is particularly important for LDC’s without
which their economy faces problem to progress. Loans are of two types
6.1.2 Hard loan፡ hard loan is loan given at commercial interest rate and its repayment period is short. A
foreign loan that must be paid in the currency of a nation has stability and a reputation abroad for
economic strength and hard currency. For example, hard loan in breaking down agreement between a
Brazilian company and an Argentinean company where the debt is to be paid in U.S. dollars. This
contrasts with a hard loan, which has to be paid back in an agreed hard currency, usually of a country with
a stable robust economy.

46
Soft loan is a loan provided for longer period (up to 50 years) at a very low interest rate. A soft loan is a
loan with a below-market rate of interest. This is also known as soft financing. Sometimes soft loans
provide other concessions to borrowers, such as long repayment periods or interest holidays.
Governments to projects they think are worthwhile usually provide soft loans. The World Bank and other
development institutions provide soft loans to developing countries.

6.1 2 Foreign Aid: The Development Assistance Debate

To start with, it is better to have a clear understanding of the notion “foreign aid”. Any transfers of capital
from one country to another cannot be treated as foreign aid. In the strict sense, all governmental resource
transfers from one country to another is to be called foreign aid. In addition, resource transfers by private
foreign investors need not to be confused with aid. According to economists, any flow of capital is
included within the ambit of foreign aid to LDCs if it satisfies three criteria.

Aid helps which is given to countries in the event of humanitarian crisis or for longer term sustainable
economic growth, with string or restrictions attached to it. Such type of assistance has two types of string:

A) Where to expend the aid, to buy goods and services from the donor country or a group of
countries. (This restricts purchase from cheapest countries)

B) How it should be used, usually for a selected purpose or project. The purpose of project
may not be the priority area of the recipient country.

(1) Its objective should be non- commercial from the point of view of the donor, and

(2) It should be characterized by concessional terms; that is, the interest rate and repayment period for
borrowed capital should be softer (less stringent) than commercial terms. Even this definition can be
inappropriate, for it could include military aid, which is both noncommercial and concessional. Normally,
however, military aid is excluded from international economic measurements of foreign-aid flows.

2. Motives and Objectives of Foreign Aid

The economic objectives of foreign aid are to alleviate poverty and increase savings, investment and rate
of growth of GNP in developing countries. However, development assistance has not always succeeded in
achieving these objectives because in many cases donor motives for giving aid and recipient motives for
accepting it conflict with the economic objectives of foreign aid. There is no historical evidence that over

47
large periods of time donor country assist others without expecting some corresponding benefits (political,
economic, military) in return.

3. Donor Motives for Giving Foreign Aid

There are several motives, which inspire financial assistance from public bodies on concessionary terms,
such as humanitarian, political, commercial, military and economic. The direction of U.S. aid shows that
it is obvious that aid does not always go to the poor84. Some development assistance may be motivated
by moral and humanitarian desires to assist the less fortunate, but there is no significant evidence to
suggest that over longer periods of time donor countries assist others without expecting some
corresponding benefits. The official aid reports generally point out the humanitarian aspect of foreign aid
with its usefulness in promoting social stability in the recipient countries. However, the development
motifs of foreign aid still take large part in official reports of donor governments and the OECD
Development Assistance Committee (DAC)85. Moreover, many donor countries consider their national
economic interest, political and strategic interest as well.

3.1.: Moral and Humanitarian Motives:

The objectives of most donors have an ingredient of moral obligation stressing that social welfare should
be promoted in the LDCs so as to decrease the disparity between the two groups.Donor provide aid for
moral and humanitarian reasons to assist the poor, like emergency food relief programmes. Others feel
obliged to compensate LDC’s for past exploitation and colonization. National boundaries are quite
artificial constructions; therefore, developing countries accept assistance not only from national
governments as a part of their regular aid program, but also from many voluntary and charitable
organizations, and from emergency and disaster relief funds

3.2: Political, Commercial and Military Motives:

The donor's primary motives for giving aid are political rather than moral and humanitarian. Indeed
countries like Turkey, Egypt, Greek and Israel are of geopolitical significance to the United States and
thus receive more aid than the normal. The political purposes have been to obtain strategic advantages and
to cultivate the aspirations of the donor such as democracy and communism, among others. The
termination of World War II witnessed the gradual emergence of liberated nations who required
assistance for progress.

Bilateral assistances are also often reflects political and military objectives (Thirlwall, 1989). Therefore, it
can be said that especially the decision to grant aid to the another country is fundamentally a political
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decision. In other words, Economic aid from the powerful to the powerless countries is an instrument of
power politics.

3.3: Economic Motives:

Apart from political and military motivations, there are also some commercial motives for giving aid as
they procure economic benefits as a result of their aid programmes. This is apparent as donors are
increasingly tending towards providing loans instead of grants. It is indicated that interest bearing loans
now constitutes over 80% of all aid compared to less than 40% in early periods. Here, "tied aid" either by
source (i.e. loans or grants have to be spent on the purchase of donor country's goods and services) or by
project (funds can only be used for specific projects) can be an example of commercial motives89. As it is
stated by Thirlwall (1989), "there are some economic motives for developed countries investing in
developing countries, not only to raise the growth rate of the developing countries, but also in their own-
self-interest to raise their own welfare" (Thirlwall, 1990, p.320). In this case, international aid can be
mutually profitable.
3.4: Recipient Motives for Receiving Foreign Aid:
It is well known that LDCs, at least until recently, have been very eager to accept foreign aid, even in its
most stringent and restrictive forms. It has been given much attention to receiving foreign aid. A primary
motive for receiving aid is political as foreign aid provides greater political leverage to the existing
leadership to maintain its power and suppress opposition. Another major reason is clearly economic in
concept and practice. According to Todaro (1989), developing countries have often tended to accept
uncritically the proposition that foreign aid is a crucial and essential ingredient in the development
process. There are some successful cases such as Israel, Taiwan and South Korea. Hence, foreign aid
supplements the scarce domestic resources of developing countries; it contributes towards the economy
transforming structurally. It is also contributes to the achievement of developing countries' take-offs into
self-sustaining economic growth.
5.1.3. Foreign direct investment (FDI)
There are two types of foreign private equity capital flows:
1) Portfolio investment (an investor holds shares in firms in a developing country but is not involved in its
management)
2) Foreign direct investment (investment where the investorparticipates in the management of the firm in
which he owns shares.
In sum, enormous size confers substantial economic (and sometimes political) power on MNCs vis-à-vis
the countries in which they operate. This power is greatly strengthened by their predominantly
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oligopolistic market positions, that is, by the fact that they tend to operate in worldwide product markets
dominated by a few sellers. This situation gives them the ability to manipulate prices and profits, to
collude with other firms in determining areas of control, and generally to restrict the entry of potential
competitors by dominating new technologies, special skills, and, through product differentiation and
advertising, consumer tastes. Although a majority of MNC investments are still directed to other
developed countries, most developing countries, given their small economies, feel the presence of
multinational corporations more acutely than the developed countries do.

v) Commercial bank loans

• Foreign commercial banks can provide loan to companies provided the loan receiving company
country approve the loan.

6.2 Types of foreign sources

Bilateral source
Foreign resource can be gained from a single country such as one of the developed countries. Bilateral
donors usually seek political influence, tied up strings and control over the debtor country. The recipient
countries are not comfortable with it because they do not want to be dictated and hate the feeling of
dependency that arise with it.
ii) Multilateral sources
These are international or regional institutions such as the World Bank, European Union, IMF, ADB
(African Development Bank) and the like.These organizations themselves receive the money from a
group of countries contributions. From among multilateral sources, the World Bank is the main foreign
source of fund for LDC’s.The world bank since its establishment to the 1960’s, it was financing
infrastructure such as:
 Power generation;
 Transportation;
 Port construction;
 Telecommunication;
 Irrigation etc.
In the 1970’s it began to include agriculture and urban rural poor. Currently its emphasis is on poverty
reduction. The World Bank support economic growth of LDC’s through its two partners:
International Development Association (IDA) which usually provide soft loan; International Finance
Corporation (IFC) concentrates on private enterprises development in LDC’s by making equity

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investment. Multilateral sources provide better bargaining opportunity, if not free from tying strings.
However, their criterion is less political. They are not free from tying string, because the officials of these
institutions are selected by the fund donating countries. If they do not serve the interest of these donor
countries they will lose their credibility.
 LDC’s have problem of skilled man power to;
 Negotiate;
 Identify source of fund;
 International bidding;
 Utilization of fund obtained
6.2.1 The International Flow of Financial Resources
Portfolio investment: financial investments by private individuals, corporations, pension funds, and
mutual funds in stocks, bonds, certificates of deposit, and notes issued by private companies and the
public agencies.
We explained that a country’s international financial situation as reflected in its balance of payments and
its level of monetary reserves depends not only on its current account balance (its commodity trade) but
also on its balance on capital account (its net inflow or outflow of private and public financial resources).
Because a majority of non-oil-exporting developing nations have historically incurred deficits on their
current account balance, a continuous net inflow of foreign financial resources represents an important
ingredient in their long-run development strategies. These recurrent requirements are amplified by the
need for targeted resources for investments in key sectors and for carrying out poverty reduction
strategies. In this chapter, we examine the international flow of financial resources, which takes three
main forms:
(1) Private foreign direct and portfolio investment, consisting of
 foreign “direct” investment by large multinational (or transnational) corporations, usually with
headquarters in the developed nations, and foreign portfolio investment (e.g., stocks, bonds and
notes) in developing countries’ credit and equity markets by private institutions (banks, mutual
funds, corporations) and individuals;

(2) Remittances of earnings by international migrants;

(3) Public and private development assistance (foreign aid), from
 individual national governments and multinational donor agencies and, increasingly
 Private nongovernmental organizations (NGOs), most working directly with developing nations at
the local level

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6.2.2. Private Foreign Direct Investment and the Multinational Corporation

Few developments have played as critical a role in the extraordinary growth of international trade and
capital flows during the past few decades as the rise of the multinational corporation (MNC). An MNC is
most simply defined as a corporation or enterprise that conducts and controls productive activities in more
than one country. These huge firms are mostly based in North America, Europe, and Japan; but a growing
number are based in newly high-income economies such as South Korea and Taiwan. In recent years a
much smaller but growing number of MNCs have emerged from upper middle-income countries such as
Brazil and even some fast-growing lower-middle income countries, most notably China. MNCs and the
resources they bring present a unique opportunity but may pose serious problems for the many developing
countries in which they operate.

6.2.3 Private Foreign Investment፡ Few areas in the economics of development arouse so much
controversy and are subject to such varying interpretations as the issue of the benefits and costs of
private foreign investment. If we look closely at this controversy, however, we will see that the
disagreement is not so much about the influence of MNCs on traditional economic aggregates such
as GDP, investment, savings, manufacturing growth rates though these disagreements do indeed
exist as about the fundamental economic and social meaning of development as it relates to the
diverse activities of MNCs. In other words, the controversy over the role and impact of foreign
private investment often has as its basis a fundamental disagreement about the nature, style, and
character of a desirable development process.

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