0.5 Perspectives on the role of capital in development: physical  (Page 8/10)

(1)

• 
• K = Physical capital stock, not considering Human Capital
• Y = Annual Output (Income)
• V = a constant, the capital output ratio . Where
• • 
  • Note that Harrod-Domar assumes that output is a linear function of capital and capital only .

The capital output ratio was thought to be range from 3-6 in poor countries.

-V=5 means that it takes an initial $25 million investment in capital to produce, annually, $5 million worth of product.

A high V means Capital intensive production.

A low V indicates labor intensive production.

Note: V can be high in very poor countries if capital is underpriced , and therefore used inefficiently, as it often has been owing to interest rate controls; especially controls that keep interest rates below the rate of inflation (see Chapter___).

From this simple formulation, the economics profession moved on to the ICOR:

• The Incremental Capital Output Ratio
• The ICOR reflects the productivity of additional capital that is the amount of new capital required to get an increment of output
• Armed with an ICOR, we can now determine a growth relationship, showing changes in annual output resulting from changes in capital investment.

(2)

• 
• Dividing through both sides of (2) by income (Y) yields a growth rate g.

(3)

• 
• This is the H-D Model focuses on grow investment, not net investment. Thus it ignores depreciation of capital.

The H-D Model was not a bad way to begin organizing your thinking about development. But the undue focus on capital in the model required economists and policymakers, in rich and poor countries, to channel almost all attention to the need for additional Physical capital, to make economics grow faster. The weaknesses of the H-D approach are apparent.

It is worth noting that in sixties and seventies version of the H-D Model ended up being the basis of the strongest arguments for Foreign Aid and Central Planning. In fact, the H-D model was widely used as a basis for central economic planning in many nations, especially India before 1982. All the planners needed to do was:

1. calculate ICORS for all sectors of the economy,
2. allocate capital to each sector according to plan priorities, and
3. sit back and watch the economy grow at rates determined by the increment in capital in each sector.

Clearly if the key for growth was to sharply increase investment, then the next issue was: where to find the ital in the model required economists and policymakers, in rich and poor countries, to channel almost all attention to the need for additional savings to finance investment.

• Recall, in the simplest formulation in national income accounts:
• Y= C+ I +G and
• I = I _g +I _p + I _F
• and Expost, I must equal S.
• Investment must be financed by savings, so we have:
• S = S _p + S _G + S _F
• [Note= S _G = T-G _C ]

INVESTMENT

I _G = Government Investment I _P = Private Investment I _F = Foreign Investment

SAVINGS

S _P = Private Domestic S _G = Government S _F = Foreign

CONSUMPTION

Includes private consumption and government consumption

If, as in many poor nations, especially in the fifties, S _p is near zero (because of both low incomes and poor tax collection) then under these conditions how does a nation finance investment. The usual answer in the sixties and seventies was to rely on foreign savings (S _F ).