ECONOMICS OF GROWTH & DEVELOPMENT

CLASS NOTES

Module 1: Growth & Development

Economic Growth
 Growth is concerned with increases in the economy's output. It can be
defined as an increase in the capacity of an economy to produce goods
and services, compared from one period of time to another. It can be
measured in nominal terms, which include inflation, or in real terms,
which are adjusted for inflation.
 Measurement of Economic Growth: It is measured by the country’s GDP
in one year.
 GDP = Total amount of final goods and services produced within the
country in a year.

Economic Development
 Economic Development is concerned with structural changes in the
economy. Promoting standard of living and economic health.
 Development relates to the growth of human capital indexes, a decrease
in inequality figures, and structural changes that improve the general
population's quality of life.

Impact of Growth & Development

The development brings qualitative and quantitative changes in the economy.
Growth: Brings quantitative changes in the economy.

Relevance:
Economic development is more relevant to measuring progress and quality of
life in developing nations.
Economic growth is a more relevant metric for progress in developed countries.
But it's widely used in all countries because growth is a necessary condition for
development.
The Vicious Cycle of Poverty:
It simply means poverty begets poverty. It is a concept that illustrates how
poverty causes further poverty and traps people unless an external intervention
is applied to break the cycle.
level of income remains low, as an implication there is low savings & low
demand which leads to low level of investment.
Consumers cannot invest because of low savings and producers cannot invest
because of low demand.
Where low levels of income exist, the problem of malnutrition arises, the health
of people is adversely affected leading to low productivity levels.
Low investment leads to low productivity which again leads to low income,
hence creating a vicious cycle of poverty.
The vicious cycle of poverty can be explained with the help of the following
diagram:

Economic Growth
In a developing country (for example India), the level of income is low. Low
levels of income lead to low savings & little or poor investment in
infrastructure. This happens as less money is available to the public and they
tend to spend more on consumption rather than saving. with this, there is no
incentive to invest as there is no improvement in infrastructure, the productivity
of an economy remains low. Hence, there is no growth in the economy which
ultimately implies low levels of income and the cycle continues until external
intervention.

Economic development
With low levels of income in an economy, the taxes paid to the government are
low. With the low generation of tax collection, the government reduces its
spending or investment on public welfare such as health and education. As the
income is low, the savings decreases and the human capital is adversely
affected. This in turn discourages investors from both within and outside the
country. This hampers the productivity level & the income levels remain low
leading to a vicious cycle of poverty.
Factors affecting investment

1. Interest rates
Investment is strongly influenced by interest rates. For an investment to
be worthwhile, it needs to give a higher rate of return than the interest
rate. As interest rates rise, fewer investment projects will be profitable. If
interest rates are cut, then more investment projects will be worthwhile.

2. Economic growth
Firms invest to meet future demand. If demand is falling, then firms will
cut back on investment. If economic prospects improve, then firms will
increase investment as they expect future demand to rise. There is strong
empirical evidence that investment is cyclical. In a recession, investment
falls, and recover with economic growth.

3. Confidence
Confidence is often driven by economic growth and changes in the rate of
economic growth. It is another factor that makes investment cyclical.
Firms will only invest if they are confident about future costs, demand
and economic prospects. If there is uncertainty (e.g., political turmoil)
then firms may cut back on investment decisions.

4. Availability of Finance
Another factor that can influence investment in the long term is the level
of savings. A high level of savings enables more resources to be used for
investment. With high deposits – banks can lend more out. If the level of
savings in the economy falls, then it limits the amounts of funds that can
be channelled into investment.
5. the State of Technology
Technological advances impact a firm's investment decision, as they
affect the investment cost. They can also affect profitability due to
demand shocks. When technological advances impact future earnings, the
investment threshold increases.

The main factors affecting economic development include

 Political stability / Law and order: Political stability and the
protection private property is the most important factor for
encouraging firms to invest in developing economies. Any sign of
instability increases the economic and personal risk of investing in
developing countries.

 Macroeconomic stability: Similar to political stability,

macroeconomic stability encourages investment and development.
This involves low rates of inflation and exchange rate stability.
Rapid devaluation can cause capital flight and a decline in growth.

 Levels of infrastructure

 Natural resources: countries with higher levels of natural resources

can use this for economic development.

 Education: Levels and standards of education have a significant

influence on labour productivity. Without basic literacy and
numeracy, it is difficult for an economy to develop from manual
labour to new higher-tech industries in the service sector

 Foreign aid: Targeted aid, can help improve infrastructure and

living standards. It can be important for developing economies
with low levels of savings and capital investment.

 trade barriers: Removal of tariff barriers can lead to a rise in

exports, which contribute to economic development.
 HUMAN DEVELOPMENT INDICES

Physical Quality of Life

Economists have tried to measure social indicators of basic needs by taking two
or more indicators for constructing indexes for human development.
Physical Quality of Life Index was developed by Morris David in 1979 for 23
developing countries. He used 3 indicators to make a composite index called
P.Q.L.I.P.Q.L.I. =
LiteracyRate+ INDEXED InfanMortalty Rate + INDEXED Life Expetancy
3

 Life Expectancy Index (L.E.I.): It means the average number of years a

person is expected to live. As per the 2011 census of India, it is 66.8
years.

 Infant Mortality Rate (I.M.I.): It refers to several infants dying within one
year of their birth out of every 1000 births. As per 2011 census, it is 47
per 1000. A higher infant mortality rate is harmful to economic
development.

 Basic Literacy Rate (B.L.I.): Any person above the age of 7 who can read
and write in any one language with the ability to understand it, is
considered literate. As per the 2011 census, it is 74.04% in India.

For each of the above-given indicator, the performance of individual countries

is rated on a scale of 1 to 100 where 1 represents the worst performance and 100
represents the best performance. P.Q.L.I is then constricted by averaging these 3
indicators giving equal weight to each of them.
L. E . I .+ I . M . I .+ B . L. I .
P.Q.L.I. = 3

To measure the performance in meeting the most basic needs of the people,
PQLI shows improvement in quality of life where people enjoy the fruits of
economic progress.
1. Increase in life expectancy
2. fall in IMR
3. Rise in BLR
For indicators of LE & BLR which are positive the best performance is the max
and the worst as is minimum. However, for IMR, the best performance is shown
by the minimum and vice versa.
The achievement level is calculated for each indicator. Using the following
formulas:
For positive indicators
Actual Value−Min Value
Max Value−Min Value

For negative indicator

Max Value− Actual Value
Max Value−MinValue

According to Morris, the max and min values are deduced as

IMR BLR LE
MAX 229 100 77
MIN 9 0-pls 38
RANGE 220 100 39

Based on the above max and min values of the components, Morris represents
the data for 4 countries in the table.
COUNTRIES PQLI Avg. GNP per capita
1950 1960 1970 growth
INDIA 14 30 40 1.8
SRI LANKA 65 75 80 1.9
USA 89 91 93 2.4
ITALY 80 89 92 5.0

Morris calls India a basket case because it exhibited slow but significant
improvement in PQLI from 14 to 40 in 2 decades with low growth in GNP per
capita (1.9)

Key Findings in terms of relationships exhibited by the three indicators

1. The coefficient of correlation between LE & IMR is negative and high
2. BLR & IMR is negative and high
 3. BLR & LE is positive and high
Limitations of PQLI
1. PQLI doesn’t include employment, social security & human rights.
2. It does not consider the monetary concept which undermines the value of
the index in a comparative analysis of different countries.
Obstacles in the calculation of PQLI
some countries with high per capita GNP had very low PQLIs - even below the
average of the poorest countries. Other countries with very low per capita GNP
had PQLIs that were higher than the average for the upper-middle-income
countries.

Human Development Index

Desai & Amartya Sen gave the HDI in the year 1990 when it was officially
cooperated into the first UN development report by UNDP.
It has 3 fundamental dimensions
1. Long and healthy life
2. being educated
3. decent standards of living
Using the following construct
1. Life expectancy at birth
2. Educational attainment: Adult literacy – 2/3 weightage, primary,
secondary and tertiary enrolment – 1/3 weightage.
3. Decent standards of living: GDP per capita purchasing power parity in
terms of dollars
INDICATORS MIN MAX
Life Expectancy 25 85
Adult Lit. Ratio % 0 100
Combined enrol. ratio % 0 100
GDP per capita is $ 40K 100K

Achievement level:
Actual Value−Min Value
Max Value−Min Value
For the calculation of GDP, the log function is used

Limitations of HDI
1. The HDI does not distinguish between countries with the same GDP PPP,
but different levels of income inequality or between countries based on
the quality of education.
2. It does not take GNP into account when income is an important aspect
3. The data for the calculation of the nutrition status of children under 5
could not be found.
4. the index is one of relative rather than absolute development so that if all
countries improve at the weighted rate, the poorest countries will not get
credit for their progress.
 Module 2: Growth Models
ADAM SMITH
Assumptions
1. Employment is determined by the amount of capital.
2. population growth depends upon the wage rate
3. current wage rate increases when labor decreases & vice versa
4. Savings and investments are determined by profits

Adam Smith believed in the Doctrine of Natural Law in economic affairs. Every
person is the best judge of his self-interest & should be left to pursue.
Furthering his self-interest, a person would also further the demand for common
foods. He termed this as “invisible hands” which is guided by market
mechanics. Since every individual is left free, they would seek to maximize
their wealth & for all the people in the economy.
The main points of the theory are as under:
Natural Law
Laissez-Faire:
The policy of laissez-faire allows the producers to produce as much they like,
earn as much income as they can and save as much, they like. Adam Smith
believed that it is safe to leave the economy to be propelled, regulated and
controlled by an invisible hand i.e., the forces of competition motivated by self-
interest be allowed to play their part in minimizing the volume of savings for
development.
Division of Labour:
The rate of economic growth is determined by the size of productive labour and
productivity of labour. The productivity of labour depends upon the
technological progress of a country and which, in turn, depends upon the
division of labour.
Division of labour increases the productivity of labour through the
specialization of tasks. When work is sub-divided into various parts and the
worker is asked to perform small parts of the whole job, his efficiency increases
as now he can focus his attention more carefully. Thus, the concept of division
of labour means the transference of a complex production process into a number
of simpler processes in order to facilitate the introduction of various methods of
production.
Adam Smith concentrated upon the social division of labour which emphasized
the cooperation of all for the satisfaction of the desires of each. It is the process
by which different types of labour that produce goods to satisfy the individual
needs of their producers are transformed into social labour which produces
goods for exchanging them for other goods.

Adam Smith in his book ‘Wealth of Nations’ pointed out three benefits of
division of labour:
1. Increase of dexterity of workers.
2. Saving time required to produce a commodity.
3. Invention of better machines and equipment.
Capital Accumulation:
It is the pivot around which the theory of economic development revolves. The
growth is functionally related to the rate of investment.
If the total wages at any time become higher than the subsistence level, the
labour force will increase, competition for employment will become keener and
the wages come down to the subsistence level. Thus, Smith believed that “under
stationary conditions, wage rate falls to the subsistence level, whereas in periods
of rapid capital accumulation, they rise above this level. The extent to which
they rise depends upon the rate of population growth”. Thus, it can be
concluded that the wage fund could be raised by increasing the rate of net
investment.
one of the most significant contributions by Adam Smith was the concept of
increasing returns due to the division of labour. He thought the division of
labour was a basic feature that other economists like Robinson Crusoe ignored
in their theories.
Adam Smith’s optimistic vision of the economic process as a self-generating
process is based on this increasing return. According to him, the natural course
of development is 1st agriculture then industry and finally services.
Criticism:
Labor is the consumer: Wage is at subsistence level, purchasing power will get
restricted/ constant.
The producer is an investor: Wants to increase consumption, maintain skilled
labor, increase better machinery (shrinkage of employment).

DAVID RICARDO
Explanation of the Theory:
David Ricardo, an English classical economist, first developed a theory in 1817
to explain the origin and nature of economic rent in “Principals of Political
Economy & taxation”
Like Smith, Ricardo’s model also rests upon capital accumulation:
 Capital accumulation is paramount
  capital accumulation depends on reinvestment of profits but the profits
earned by the capitalists largely depend upon growth and agricultural
output.
As a result, Ricardo believed due to a fall in agricultural production the prices
of wages dropped.
According to Ricardo rent arises for two main reasons:
1. Scarcity of land as a factor and
2. Differences in the fertility of the soil.

Since the Ricardian theory looks at the distribution of factor incomes, it is also
known as the theory of distribution.
The Ricardian theory of distribution discusses how rent, profit & wages are
distributed in the economy.

Assumptions
1. Rent of land arises due to the differences in the fertility or situation of the
different plots of land. It arises owing to the original and indestructible
powers of the soil

2. Ricardo looks at the supply of land from the standpoint of society as a

whole.

3. In the Ricardian theory it is assumed that land, being a gift of nature, has
no supply price and no cost of production. So rent is not a part of the cost,
and being so it does not and cannot enter into cost and price. This means
that from society’s point of view the entire return from land is a surplus
earning.
Stationary State:
When the capital accumulation rises with increase in profit, total output
increases which raises the wage fund. With the increase in the wage fund’
population increases which raises the demand for corn and its price. As
population increases, inferior grade lands are cultivated to meet increasing
demand of corn. Ricardo assumes that labourers and landlords spend all their
income on consumption and hence, save nothing.
The saving is done by the capitalist for profit earners. But as the society
progresses, the share of profit begins to decline. Fall in the rate of profit
slackens the process of capital accumulation and the development receives a set
back and at this stage, there is no further increase in capital and the economy
enters in a stationary state.
In this state, capital accumulation stops, population does not grow, the wage
rate is at subsistence level and technological progress ceases. The phenomenon
of stationary state is explained with the help of a diagram 3.
The decline in profits will continue till a stage comes when the net product
curve intersects the wage line OW at P. At this point, wages are equal to net
product and the profit is nil. So, P is the point at which economy is in a
stationary state.

Criticism
1. Ricardo considers the land as fixed in supply. But the land has alternative
uses. So, the supply of land to a particular use is not fixed (inelastic). For
example, the supply of wheatland is not absolutely fixed at any given
time.
2. The productivity of land does not depend entirely on fertility. It also
depends on such factors as position, investment and effective use of
capital.
3. Critics have pointed out that land does not possess any original and
indestructible powers, as the fertility of land gradually diminishes, unless
fertilisers are applied regularly.
4. Ricardo’s assumption of no-rent land is unrealistic as, in reality; every
plot of land earns some rent, although the amount may be small.
5. Ricardo restricted rent to land only, but modern economists have shown
that rent arises in return for any factor of production, the supply of which
is inelastic.
6. According to Ricardo, rent does not enter into the price (cost) but from
the point of view of an individual farm, rent forms a part of cost and
price.

THOMAS ROBERT MALTHUS

The theory of population was given by Malthus, who was an English economist
who largely tried to see the leakages between population growth & well- the
being of people. Given in 1798 in an essay published, titled “principle of
population” He observes that an increase in nations’ food production improved
the well-being of the people. GDP of a country rises, however, the increase in
well being was temporary because when there is an increase in population, the
growth rate which restores the economy.
Malthusian trap/spectre - Malthus asserts that people have a propensity to utilise
abundance for population growth rather than for a high standard of living.
He asserts that the population grows in geometric progression and output rate
grows in arithmetic progression.
The theory propounded by Malthus can be summed up in the following
propositions:
1. Food is necessary to the life of man and, therefore, exercises a strong
check on population. In other words, the population is necessarily limited
by the means of subsistence (i.e., food).
2. Population increases faster than food production. Whereas population
increases in geometric progression, food production increases in
arithmetic progression.
3. Population always increases when the means of subsistence increase,
unless prevented by some powerful checks.
4. There are two types of checks which can keep the population on a level
with the means of subsistence. They are preventive and a positive check.

Malthus pointed out that there were two possible checks which could limit the
growth of the population: (a) Preventive checks, and (b) Positive checks.

Preventive Checks:
Preventive checks exercise their influence on the growth of the population by
bringing down the birth rate. Preventive checks are those checks which are
applied by men. Preventive checks arise from man’s fore-sight which enables
him to see distant consequences He sees the distress which frequently visits
those who have large families.
Positive Checks:
Positive checks exercise their influence on the growth of the population by
increasing the death rate. They are applied by nature.
The unwholesome occupations, hard labour, exposure to the seasons, extreme
poverty, bad nursing of children, common diseases, wars, plagues and famines
are some of the examples of positive checks. They all shorten human life and
increase the death rate.
Malthus recommended the use of preventive checks if mankind was to escape
from the impending misery. If preventive checks were not effectively used,
positive checks like diseases, wars and famines would come into operation. As a
result, the population would be reduced to the level which can be sustained by
the available quantity of food supply.s
CRITICISM OF MALTHUSIAN THEORY:
1. It is pointed out that Malthus’s pessimistic conclusions have not been
borne out by the history of Western European countries. Gloomy forecast
made by Malthus about the economic conditions of future generations of
mankind has been falsified in the Western world. Population has not
increased as rapidly as predicted by Malthus; on the other hand,
production has increased tremendously because of the rapid advances in
technology. As a result, living standards of the people have risen instead
of falling as was predicted by Malthus.

2. Malthus compared the population growth with the increase in food

production alone. Malthus held that because land was available in limited
quantity, food production could not rise faster than population. But he
should have considered all types of production in considering the
question of optimum size of population.

3. Malthus compared the population growth with the increase in food

production alone. Malthus held that because land was available in limited
quantity, food production could not rise faster than population. But he
should have considered all types of production in considering the
question of optimum size of population.

4. Malthus held that the increase in the means of subsistence or food

supplies would cause population to grow rapidly so that ultimately means
of subsistence or food supply would be in level with population, and
everyone would get only bare minimum subsistence. In other words,
according to Malthus, living standards of the people cannot rise in the
long run above the level of minimum subsistence.
 KARL MARX
He explained the determination of the wage rate at the minimum subsistence
level. According to Marx, the forces at work in a capitalist economic system
bring about an increase in the rate of exploitation of labour. The basic force at
work is the competition among the capitalists to increase the rate of surplus-
value which Marx called the rate of exploitation and thereby enlarge their
profits share relative to wages share. In Marx’s analysis, it is the prevailing
excess of labour supply over the demand for labour that prevents the wages
from rising above the minimum subsistence level.
Assumptions of the Theory:
1. There are two principal classes in society.
 Bourgeoisie (upper class)
 Proletariat (working class)
2. Wages of the workers are determined at the subsistence level of living.
3. Labour theory of value holds good. Thus, labour is the main source of
value generation.
4. Factors of production are owned by the capitalists.
5. Capital is of two types: constant capital and variable capital.
6. Capitalists exploit the workers.
7. Labour is homogenous and perfectly mobile.
8. Perfect competition in the economy.
9. National income is distributed in terms of wages and profits

He puts forward the concept of surplus-value.

surplus-value is defined as the excess of value over the cost of wearable capital,
where wearable capital is the labour force. According to Marx, the surplus value
or profits which are created by labour over and above the value of their
subsistence requirements are unjustifiably expropriated by the capitalist class. In
other words, the surplus value or profits extracted from labour by the capitalists
represents the exploitation of labour.
M – C – M”
money – commodity – money
M’>M
M’ – M = surplus-value
Absolute surplus-value =
increase in working days
relative surplus-value =
decrease labour hours by enhancing their productivity
surplus-value = value of output – value of labour
rate of surplus-value = change in surplus-value / change in wearable capital
= S/V

CRITICISM OF THE THEORY

1. Marx had predicted that relative share of wages in the national income
would fall and the economic conditions of the workers would deteriorate.
Empirical research has found that share of wages in the national income
has remained constant in the Western capitalist countries instead of
falling as predicted by Marx. The workers have obtained a due share from
the increases in physical productivities brought about by the technical
progress and capital accumulation in the capitalist countries.

2. Further, there is a great theoretical flaw in Marx’s contention of falling

rate of profit with the increase in organic composition of capital. Several
authors have pointed out that law of the falling rate of profit cannot really
be derived from the law of the increasing organic composition of capital.
Since Marx believes that the real wages of the workers remain fixed at
the subsistence level, then as a result of increase in organic composition
of capital due to capital accumulation and technical progress, the output
per head will greatly increase and given the real wages constant at the
subsistence level, the surplus value (i.e., the profits) earned by the
capitalists will greatly increase and will secure a rising rate of profit.

3. , Marx’s theory of income distribution under capitalism is based upon the

labour theory of value which is not acceptable to the modern economists.
Marx’s analysis of surplus value or exploitation of labour is directly
based upon his contention that all value is created by labour and capital
merely transfers his own value to the value of the commodity.

4. A shortcoming of Marx’s model is that he neglected the possibility of

food shortage or lack of wage goods leading to the increase in cost of
 living of the people causing rise in wage rate. At the higher wage rate
demand for labour will decline.

WW ROSTOW
Has sought a historical approach to the process of economic development which
is divided into 5 key stages.
1. Traditional Society
2. Preconditions for Take-Off
3. Take off stage
4. Drive to Maturity
5. High Mass Consumption

1. Traditional Society
“Traditional Society is defined as one whose structure is developed within
limited production function based on pre-Newtonian science & technology and
attributed towards the physical world”
Rostow asserted that a ceiling existed on a level of attainable output per head
due to a lack of tools & outlook towards the physical world even though
innovation & inventiveness were present in the economy. The social structure in
the traditional society was hierarchal, family played a dominant role &
agriculture was the main source of income.
2. Pre-Conditions to Take Off
The stage where the foundation of sustained growth takes place.
These are encouraged by 4 initiators
1. The new learnings – New methods of production
2. New Monarchy – new forms of governance
3. New world – changes in people around one
4. New Religion – introduction of new beliefs
These forces create reasoning among people in place of faith & authority. It
brought a decline in feudalism & lead to the rise in the spirit of the invention
will result in new discoveries ultimately creating a mercantile class. (Mercantile
class  traders).
Thus these 4 initiators were instrumental in bringing changes in social attitudes,
expectations, structures & values in society. The process of creating
preconditions follow along these lines:
 The ideas spread that economic progress is possible
 Education for some at least broadens & changes to suit the needs of
modern activity.
 Banks mobilise savings
 investments increase notably in transport communications & in raw
materials in which other nations may have an economic interest.
Based on these preconditions, sustained industrialisation requires radical
changes in 3 non-industrial sectors –
1. Build up social overhead capital especially in transport in order to expand
the market & exploit resources & help the state to rule effectively.
2. Technological revolution to increase agricultural productivity. to meet the
requirements of the population.
 3. Expansion of imports including capital imports financed by efficient
production & marketing of natural resources for exports.

3. Take-Off Stage
“The essence of transformation can be described legitimately as a rise in the
rate of investment to a level which regularly, substantially & perceptibly
which outstrips population growth”
Rostow defines the take off as an industrial revolution tied directly to radical
changes in the methods of production having their consequences over a
relatively short period of time.
The take-off years for countries according to Rostow are given:
Britain 1783 – 1802
United States 1843 – 1860
Japan 1878 – 1900
Sweden 1868 – 1890
India Around 1952
China Around 1952

Necessary conditions to be fulfilled by every economy to start to take off:

1. Rise in rate of productive investment to over 10% of national income or
NNP.
2. Development of one or more substantial manufacturing sectors with a
high rate of growth.
3. Existence of quick emergence of political, social & institutional
framework which exploits the impulses to expansion in the modern sector
& gives to growth & outgoing character.

1. Reinvestment of 5-10% NNP

 One of the essentials for take-off is the increase in per capita
should outstrip the growth in population in order to maintain a high
level of per capita in the country.
 For this condition to hold Rostow says a minimum of 5-10% of
NNP needs to be reinvested into capital formation.

2. Development of leading sectors

  Primary Growth sectors – Sectors that help identify key
development, where possibilities of innovation or exploiting new
or unexplored resources leads to high rates of growth.
For example, in England, the primary growth sector that was
identified was cotton textile industry.
 Supplementary Sectors – Basic metals (iron, coal & steel) required
for capital formation where rapid growth takes place as a
consequence of development of primary sector.
For example, Railways in a primary growth sector & expansion of
iron, coal & steel industry.
 Derived Growth Sectors – Where growth takes place in some fairly
steady relation to the growth in income.
example: health, housing, availability of nutritious food &
education, better infrastructure & hospitals.

Leading Sectors

Primary Supplementary Derived

Transport,
Agricultural Oil, coal etc. communication,
housing, etc.
Identifying the sector’s
sectoral growth depends on:
1. Increase in effective demand which is brought by a sharp rise in the
actual real income.
2. New production functions along with the expansion of capacity should be
introduced into these sectors
Q = f(L)  Q = f (L, K, T)
There must be sufficient initial capital investment profits for the take-off
in these leading sectors.
 Lastly, these leading sectors must introduce the expansion of output to
other sectors through the technological transition.

4. Drive to Maturity
According to Rostow, drive to maturity is defined as a period when the society
is effectively able to apply the bulk of its technology to its resources.
It’s a period of long & sustained economic growth, extending to somewhere
around 4 decades.
New leading sectors are created in the economy.
The rate of Interest is way high above 10% & the economy is able to withstand
unexpected shocks.
The technological maturity given by Rostow follows the following the schedule
Countries Year of Tech. Maturity
Great Britain The 1850s
USA The 1900s
Germany & France The 1910s
Sweden The 1930s
Japan The 1940s
Russia & Canada The 1950s

Three conditions are needed:

1. Characteristics of the working force change, it primarily becomes skilled.
People prefer to live in the urban areas & real wages start to increase &
the workers organize themselves to have more social & economic
security.
2. The characteristics of an entrepreneur also changes (the rigid
hardworking master give way to polished, polite & efficient managers)
3. society feels bored of the miracles or industrialization & wants something
new leading to further change.
Example; Landlines  cellphones  Smartphones.

5. Age of High Mass consumption

According to Rostow, this stage has been categorized by migration.
Extensive automobiles, durable consumer goods & household gadgets are also
extensively brought.
In this stage, the focus shifts from supply to demand (focus on what people
want)
Problems of production are replaced by problems of consumption & social
welfare.
Three forms are needed to increase welfare, post maturity stage:
1. A national policy to enhance power & influence beyond national
frontiers.
2. To have a welfare state which focuses on social welfare through equitable
distribution of income
3. A decision to create a new commercial Centre & leading sectors like
cheap housing, electricity, water & automobiles

Criticisms of Rostow’s model:

Traditional society is not a pre-requisite qualification for development.
Countries like the USA, Canada, Australia, and New Zealand were not
‘traditional’ when they were born.
The drive to maturity is confusing. The stage contains all the features of the
take-off, e.g., net investment over 10 per cent of national income, development
of latest production techniques etc. Therefore, the need for a separate stage
where growth is self-sustained is no longer required. In reality, no growth is
absolutely self-sustaining or self-limiting.
Chronological order is not maintained in the stage of high mass consumption.
Some countries like Canada and Australia entered this stage even before
attaining maturity.
 precondition for take-off and take-off may overlap with one another

JOSEPH SCHUMPETER’S VIEW OF THE SYSTEM

It was introduced by Joseph A Schumpeter in 1934 in his book “the theory of
economic development: an inquiry into profits, capital, credit, interest, & the
business cycle”.
The Schumpeter model of economic growth moves round the inventions and
innovations.
1. Circular flow/ stationary state: Schumpeter starts his analysis of
development process with the concept of circular flow. It implies a condition
where economic activity produces itself continuously at constant rate
through time.
a. All economic activities are essentially repetitive & follow a familiar
routine course.
b. All the producers know the aggregate demand for goods & adjust the
supply of output accordingly. This means demand & supply are in
equilibrium at each point of time.
c. The economic system has the optimum level of output & its maximum
use & there is no possibility of wastage of resources.
d. The firms working in a system are in a state of competitive equilibrium
2. Role of Innovation: Innovation may be defined as a change in existing
production system to be introduced by the entrepreneur with a view to make
profits and reduce costs. The innovation is closely linked with
Schumpeterian concept of development. He defined development as
a “Spontaneous and discontinuous change in the channels of flow,
disturbance of equilibrium which forever alters and displaces the equilibrium
state previously existing”. When changes take place in the economy, circular
flow is disturbed, and the development process starts. He assumed that
change is the basic element of dynamic process, and those changes come in
the form of innovations.
Any innovation may consist of:
a) The introduction of a new product
b) The introduction of a new method of production
c) The opening up of a new market
d) The conquest of a new source of supply of raw materials or semi
manufactured goods.
e) The carrying out of the new organisation of any industry.

3. Technological change & development:

Schumpeter has visualised broadly two types of technological changes. Some of
the new technologies develop from prevailing technologies. In his opinion,
technological changes are as a rule carried out in new firms which generally do
not arise out of the old ones. The act of introducing new technologies is often
called as “enterprise” or “innovation” & the individuals who perform this task
are known as “entrepreneurs”.
4. Role of Entrepreneur/Innovator:
In Schumpeter’s system, entrepreneur has been assigned a strategic role. The
entrepreneur is the person who carries out innovations & thereby seizes an
opportunity for economic development. Schumpeter calls “social climate’’ is a
complex phenomenon reflecting the social, political & socio – psychological
environment within which entrepreneurial activity takes place. He firmly
believes that entrepreneurship thrives only when uncontrolled capitalism
guarantees complete freedom to the spirit of individual rationalism.

Cyclical Process
Schumpeter’s approach to business cycle or crisis is historical, statistical &
analytical. He believes that business cycle is not merely the result of economic
factors but also of non- economic factors. Bank credit is an essential element of
Schumpeter’s model. According to Schumpeter, the creation of bank credit is
assumed to accelerate money incomes and prices in the economy.
Schumpeter concludes that crisis is the “process by which economic life adapts
itself to the new economic conditions”.

Breaking of the circular flow

The society progresses through trade cycles, in order to break the circular flow,
the innovating entrepreneurs are financed by bank credit expansion.
Once the innovations become successful & profitable, other entrepreneurs
follow it in “swarm like clusters”.
The credit inflation starts with the entrance of new entrepreneurs in the field of
production, which superimposes on the primary wave of innovations. This may
be called boom or prosperity period. In this stage, the economic activities reach
their maximum heights, and the idle or unemployed resources are minimised.
During the boom period, the new products start appearing in the market with the
entrance of new entrepreneurs. These products displace the old ones and thus
decrease their demand in the market. Consequently, the prices of old products
fall. With a view to liquidating their stocks, the old firms start selling their
goods at a low price and hence most of the firms incur losses and some firms
are even forced to run into loss.
A wave of pessimism sweeps the entire economy, and the boom period ends
with the appearance of the phase of depression. Schumpeter believes in the
existence of the long wave of upswings (or boom) and downswings (or
depression). Once the upswing ends, the long wave of downswing begins and
the painful process of readjustment to the “point of previous neighbourhood of
equilibrium” starts.
The economic forces of recovery come into operation and ultimately bring
about a revival. Once again, the economy comes across the equilibrium, and the
new boom period starts with a new set of innovations. This process of capitalist
development may be regarded as “creative destruction” wherein the old
economic structures of society after destruction are ultimately replaced by the
new economic structures.

Schumpeter’s cyclical process of economic development has been illustrated in

the above diagram where the secondary wave is superimposed on the primary
wave of innovation. In the prosperity period, as the above figure reveals, the
economic development proceeds more rapidly due to over optimism and
speculation.
The business cycle continues to fall below the level of equilibrium with the
beginning of the recession and ultimately reaches the point of depression. In the
end, the retake of economic activities leads to revival of the economy.
 BIG PUSH THEORY
The theory of ‘big push’ first put forward by P.N. Rosenstein-Rodan is actually
a stringent variant of the theory of ‘balanced growth’. The crux of this theory is
that the obstacles of development are formidable and pervasive. The
development process by its very nature is not a smooth and uninterrupted
process. It involves a series of discontinuous ‘jumps. The factors affecting
economic growth, though functionally related with each other, are marked by a
number of ‘discontinuities and ‘hump’.

MODULE 3: NEO-CLASSICAL GROWTH MODELS

BALANCED & UNBALANCED GROWTH
BALANCED
It is propagated by ROSENSTEIN RODAN, RAGNAR NURKSE & ARTHUR
LEWIS
The doctrine of balanced growth has several authors who introduced in their
own way to some, it means investing in land sectors, sectors in which they are
lagging behind to bring them forward in other sectors. For others, it implies that
investment takes place simultaneously in all sectors or industries at once and
lastly, balanced growth implies development of man industry & agriculture
simultaneously
there should be balanced growth in all sectors
Therefore, balances growth requires balance between different consumer goods
industries & a balance between consumer & capital goods industries
the theory of balanced growth states that there should be simultaneous and
harmonious development of different sectors of the economy so that all the
sectors grow uniformly within & across sectors
the concept as per Rodan’s and Nurkse’s formulation is given below
The theory was propagated in 1943 under the article titled problems of
industrialization of eastern & southeastern Europe
his main contention revolves around the difference between SMP & PMP
where SMP = SOCIAL MARGINAL PRODUCT
PMP = PRIVATE MARGINAL PRODUCT
SMP depicts the growth in industry keeping in view its social implications
while private marginal product depicts growth for the entrepreneur or the firms
on the basis of market/ profit principles
social marginal product is greater than private marginal product (overlooked)
also known as a social marginal cost which is not accounted for by the firms.
Rodan’s main contention is that “often social marginal product of an investment
is different (greater) from its private marginal product & that when a group of
industries are brought together in accordance to their social marginal product
the rate of development of the economy is greater than it otherwise would be”
this is because the individual entrepreneur is only interested in the private
marginal product of investment and is not likely to have an accurate estimate of
its social marginal product, in support of its argument RR gives a number of
examples where the social marginal product of an investment is greater than its
private marginal product.
he gives an example of a shoe factory suppose a large shoe factory is started in a
region where 20k unemployed workers are employed if these workers spent all
of their income on shoes, a market for shoes will be created however this is
unlikely to happen because workers will not spend all their wages on shoes if
instead a whole series of industries was started on which workers would have
spent all their income, the industry would expand by a multiplier process,
therefore, planned creation of a system of industries would reduce the risk of
not being able to sell their products and would lead to large scale
industrialisation
this principle propounded by RR under balanced growth theory was further
elaborated by NURKSE in his thesis.
firms have to work in totality
when we make decisions from the perspective of the social marginal product
then the implication on the development of the economy will be greater & the
economy will develop in a much-balanced manner – 19730s perspective when
globalisation began.

NURKSE’S INTERPRETATION
He was concerned with the path of development & the pattern of investment
According to him, VCP is operational among UDCs which affects economic
development
if the VCP can be broken, economic development will follow.
Two perspectives supply & demand side
Supply
He believed that there is a small capacity to save resulting from low real income
because of low productivity which in turn is due to a deficit of capital. Vicious
circle of poverty affects the supply side of capital formation. In the
underdeveloped countries, poverty exists because the per capita income of the
people is low. Due to low per capita income, the level of saving is low. Since
investment depends on savings, so investment would be low due to which
capital formation would be low. Low capital formation would lead to low
productivity which would result in poverty. This is how vicious circle from
supply side completes.
Low-Income → Low Savings → Low Investment → Low Capital
→ Formation → Low Productivity → Low Income

Vicious Circle of Poverty: Supply Side:

The underdeveloped countries can resort to capital formation and accelerate the
pace of economic development only by breaking the vicious circle of poverty.
Once the vicious circle of poverty is broken, the economy would be on the rails
to development. Now the question is how to break the vicious circle of poverty.

Demand
people’s investment is low, due to low levels of real income which means
people continue to remain poor
therefore, limited by the size of the market (capital market) curtails the level of
investment as a result the capacity to produce and hence grow and dev becomes
marginalised.
(a) Demand Side:
Vicious circle of poverty affects the demand side of capital formation. The
underdeveloped countries are poor because their level of income is low. Due to
low level of income, their demand for low-income goods is low.

Vicious circle of poverty: On Demand Side:

In UDCs the size of the market is limited. As a result, private investors do not
get opportunities for more investment. This reduces investment and capita.
Hence productivity of capital would fall.

Low-Income → Low Size of Market → Low Investment → Low

Productivity → Low Income.

This according to Nurkse is a VCP that keeps the economies underdeveloped.

How does the circle break?
the important factor is for the role of the state to become prominent
according to Rodan & Nurkse, an individual’s investment alone cannot solve
this problem
for example: if we look at the shoe factory example if in the rest of the economy
nothing is done to increase product and purchasing power the market for
additional shoes is likely to be a deficit.
People engaged in the industry will not like to spend all their income on shoes
similarly, people outside the shoe industry will follow similar patterns
therefore, the new industry that gets set up is most likely to fail due to the
inadequacy of the markets.

How the Market can be enlarged:

1. Government Intervention:
Nurkse is of the view that the government must intervene in productive
activities through economic planning. He is of the view that when government
participates in productive activities, it will help in breaking the vicious circle of
poverty. Nurkse opines that if entrepreneurs are available in underdeveloped
countries, then they can be induced to make investment. But in underdeveloped
countries, private entrepreneurs cannot come forward with so much heavy
investment. This can easily be carried by the government only. Thus, vicious
circle of poverty can be broken only by the intervention of the government.
2. External Economies:
Balanced growth also leads to external economies. External economies are
those which accrue because of the setting up of new industries and expansion of
the existing industries. The accruing of external economies leads to the law of
increasing returns to scale. It leads to a fall in the cost of production and hence
the price level. A fall in the price leads to the increase in demand which is
useful for economic development.
3. Economic Growth:
Balanced growth helps in accelerating the pace of economic growth. According
to Nurkse, increase in investment in different branches of production can
enlarge the total market. This can break the bonds of the stationery equilibrium
of underdevelopment.
The market size can be enlarged by monetary expansion, salesmanship and
advertisement, removing trade restrictions and expanding social over heads i.e.,
infrastructures. It can be widened either by a reduction in prices or by an
increase in money while keeping constant prices.
Criticism
 1. Rise in cost: As the cost of production increases, the output decreases
which in turn affects investment in an economy. The rise in costs cannot
be same for different sectors.
2. Fails as a theory of development: According to Hirschman, as the
development brings about structural change from one sector to another, in
the doctrine of balanced growth, there is no change to something new but
only a dualistic pattern of development is seen.
3. No attention to reducing costs: Nurkse fails to look into reducing costs
among existing industries which would automatically enhance investment
and therefore development. He asserts that the theory fails to look within
the domestic economy & existing industries and instead focuses on
starting new industries altogether.

Structural Change Model – Migration Model - LEWIS

It operates on the principle of a dual economy.
 Agriculture Industry
Agriculture
 Synonym for rural population/countryside
 income is bare minimum
 production for self-sustaining & a natural economy.
 This makes the agricultural sector work at a very low level of
productivity & output.
Lewis also says that there is a manufacturing sector which is largely found in
towns that are also urban settlements.
The standard of living is much higher.
In early sectors according to Lewis, starts with agriculture.
A large amount of surplus labour is present in the agricultural sector which
results in extremely low productivity & leads to disguised unemployment
Marginal Productivity  low / zero / negative
wage rate: “subsistence wage rate”
Therefore, people migrate & when this happens
1. marginal productivity rises & wage rate stabilises.
2. Industrial sector blooms due to availability of surplus labour.
3. The ones who are left behind, see higher productivity as the
overcrowding reduces.
How does growth happen?
1. Enhanced agriculture provides raw materials & food security caters to
increased demand of raw materials.
2. Industrial growth provides more job opportunity for people enhancing
standard of living. It acts as an incentive for the agricultural sector.
Criticism
1. Harris & Todaro pointed out that Lewis fails to explain why will there be
rural – urban migration in the presence of unemployment in the urban
areas.
It is the expectation due to which people migrate, expected wage difference
is adjusted to the level of unemployment.

UNBALANCED GROWTH MODELS

The theory of the unbalanced growth model is opposite to the doctrine of
balanced growth. According to this concept, investments should be made in
selected sectors rather than all sectors of the economy. This notion suggests that
no underdeveloped country possesses either capital or resources to go for
investments in all sectors. Therefore, investments should be made in only those
sectors or industries that in the economy can result in high levels of
development. Economists like Singer Streeton and Kindle Berger have laid out
their views to favour the unbalanced growth doctrine & Hirschman is the key
economist who propounded the theory systematically.

HIRSCHMAN CONCEPT
Hirschman has laid down two assumptions for the thesis of unbalanced
growth as stated below:
(i) SOC and DPA should not be increased at the same time.
(ii) That path should be followed which maximizes private investment
The concept of unbalanced growth according to Hirschman implies
“Investments in strategically selected industries or sectors which leads to new
investment opportunities thereby propagating high levels of development” if a
country has to keep moving, Hirschman asserts the task of development policy
is to maintain tensions, disproportions & equilibria. This “sea-saw” advance is
induced by one disequilibrium which in turn leads to a new disequilibrium &
the process keeps going. According to Hirschman, new projects are started, they
create external economies that can be exploited by subsequent once there are
some appropriate more external economies than they create which he calls
“CONVERGENT SERIES OF INVESTMENT”.
According to him, there are other projects which are known as “DIVERGENT
SERIES OF INVESTMENT”
Hirschman believed that there should be disequilibrium as, under steady
conditions, sectors tend to get comfortable & not work more towards
development/policymaking.

In practise, development policy should aim at

1. The prevention of convergent series of investment which appropriate
more external economies than they create.
2. The promotion of divergent series of investments in which less
appropriate external economies than they create.

Development can only take place by unbalancing the economy. This is possible
by either investing in social overhead capital or directly productive activities
(DPA). The former creates external economies while the latter appropriate
external economies.
Unbalancing the economy with social overhead capital
SOC has been defined as “The basic services without which primary, secondary
& tertiary production activities cannot function”.
These include investments in education, transportation, public health, public
activities like water, gas, electricity, drainage & communication.
A large investment in SOC will encourage large private investment.
For ex: Cheaper supply of electric power will encourage the establishment of
small-scale industries. SOC investments indirectly subsidise agriculture industry
& commerce (any kind of business) by cheapening various inputs which they
can use at reduced costs. Therefore, Hirschman asserts that until & unless SOC
investments in an economy which provide for cheap & improved services, DPA
investments will not happen. Therefore, SOC approach believes in unbalancing
he economy such that without investing in SOCs, investments in DPA become a
distant dream.
Which is likely to raise the production costs substantially, in the course of time,
political pressures might stimulate investments in SOC
Investment sequence are generated by profit expectations & political pressure.
profit expectations generate sequence from SOC to DPA which is contrary to
pol press sequence which is from DPA to SOC. As a result, an imbalance can be
created in the growth trajectory

SOLOW (GOLDEN RULE OF ACCUMULATION)/ EXOGENOUS

GROWTH MODEL
The neo classical exogenous growth model was put forward by Solow, to
explain how long run economic growth happens in an economy. He looks at
four crucial factors:
1. Productivity
2. Capital Accumulation (savings)
3. Population Growth Rate
4. Technical Progress
The common prediction of this model was that the economy will always
converge towards a steady state of growth which depends upon the above four
factors. Empirically the model has been successful in some countries like East
Asian miracles where the countries have converged towards a steady state
growth rate, however traces have been found within countries where southern
states for example have converged towards northern states.
Ex: USA
Assumptions
a. Solow builds the model around the following key assumptions
b. only one commodity is produced
c. output is always net output that is depreciation of capital
d. constant returns to scales are applicable
 e. there are only two factors of production (labour & capital)
f. The factors of production are paid according to their productivity.
g. Prices & wages are flexible
h. There is always full employment.
i. Labour & capital are substitutable
j. Saving ratio is constant (MPS is constant)
Theory
With these assumption, Solow in his model shows that with wearable technical
coefficient. with this, there would be a tendency for the K/L to adjust itself such
that it moves the economy towards the equilibrium ratio or steady state growth
path.
For example: if the initial K/L is more then, output & capital will grow slow vis
a vis than growth of labour or vice versa.
Solow analyses this with the help of the following mathematical model:
Y = F (K, L)
Y = Output
K = Capital Stock
L = Supply of labour force

s: part of income which is saved.

K(t) = capital formation / change in stock of capital
s. Y(t) = rate of savings

K or dk/dt: change in capital

K dot = SY ---- (i)
Y = f (L, K) ---- (ii)
replacing (ii) in (i)
K dot = s.f (L, K)
when L is at full employment
Given that full employment is labour, the population according to Solow grows
exogenously, which ult increases the labour force at a constant rate which is
nt
given as L(t) = L0 e ¿ ¿---(iv)
where n = change in population from 0 to t
replacing (iv) in (iii)

k dot = s. f (L0 e nt , K) – golden rule of accumulation

This determines the time path or capital accumulation of k star/ dot.

(n+d) f (k)

Q = f (L,K)

S.Y
T0

Initial Condition
In the above diagram,
Q is the production function which is a function of labour and capital.
S.Y is the savings function & is below the output or production function
because part of the income is consumed.
(n+d)f(k) is a 45 Degree line from O which is the summation of population
growth rate (n) & level of depreciation (d)
Reflecting overall capital needed for capital formation.
Initial equilibrium is at T0 where savings = (n+d)f(k)
Which gives us K* as capital per head & Y* as output per head.
T0 is the equilibrium capital labour ratio.

There are 3 cases:

1. When savings increase
2. When population increases
3. When technology innovates

1. When savings increases

 explain initial condition

 When savings increase, the savings function shifts upwards from S.Y to
S1.Y. This upwards shift in the savings gives us a new equilibrium capital
ratio at T1 which reflects higher capital per head (from K* to K**) & higher
output per head (Y* to Y**)

2. When population increases

 explain initial condition

 The output per head declines with an increase in population. Rise in

population deaccelerates growth as the output decreases, to correct this,
savings will have to be induced. Therefore, the role of govt will be to induce
savings in order to stabilise the de-stabilised economy. When this happens,
investment takes place and the economy slowly starts getting stabilised.

3. When technology innovates

 explain initial condition

 An increase in technological innovation signifies that the saving &

productivity increases which shifts the savings & production curve upwards
depicting that equilibrium level shifts from T0 to T1 resulting a much higher
level of increase in capital & output therefore, enhancing productivity
simultaneously.
 HARROD – DOMAR MODEL
The HD model of economic growth discusses how developing economies
today can develop on the basis / experience of already developed countries.
Both Harrod & Domar are interested in discovering the rate at which income
grows for a smooth & uninterrupted working of an economy.

H-D assigned a key role to investment (I) in the process of economic growth.
1. Role of Investment:
a. investment generates income
AD= C+I  K – formation  AS
b. It augments the productive capacity of the economy by increasing its
capital stock.
Hence, according to HD, so long as net investment takes place, real income &
output will continue to expand.
However, maintain a full employment equilibrium level, it is necessary that
both real income & output should expand at the same rate at which the
productive capacity of the capital stock is expanding.
Any divergence between the two will lead to excess or idle capacity, thus
fording firms to curtail their investment expenditure. Ultimately, it will
adversely affect the economy by lowering income increasing unemployment &
will move the economy off the equilibrium path of steady growth. Therefore,
net investment should expand continuously.
The required rate of income growth is called the warranted rate of growth or
full capacity growth rate.

ASSUMPTIONS OF THE MODEL

1. There is initial full employment equilibrium level of income
2. There is no govt interference
3. It is a closed economy model
4. There are no lags in adjustments between Investment & creation of
productive capacity
5. MPS is constant
6. Ratio of capital stock to income is assumed to be fixed.
7. Capital goods are assumed to have infinite life.
8. Savings & Investment relate to income of the same year.
9. General price levels are constant
10.There are no changes in interest rate.
11.There is only one type of product.

DOMAR MODEL
Domar builds his model around the following question:
Since investment generates income on one hand & increases productive
capacity on the other, at what rate the Investment should increase to make the
increase in income equal to the increase in productive capacity so that full
employment is maintained?
Domar explains this from 2 perspectives:
DEMAND & SUPPLY
1. increase in productive capacity (supply side)
2. Required increase in aggregate demand (demand side)

1. Increase in productive capacity (supply side)

Let annual rate of investment be (I)

Annual productive capacity per $ of newly created capital on an average

be equal to (s)

Thus, the productive capacity on total investment of Investment $ will be

(I,s) $ per year.
But somehow, the new investment will be at the expense of the old. It
will therefore, compete with the latter for labour markets & the increase
will be soon lower. Iσ < Is
where, σ depicts net potential average productivity of investment.
The relationship exists because net is lesser than actual.
This is also known as sigma effect.
I σ = ΔY/I ---- productive capacity of investment.
 Supply side equation 

2. Required increase in aggregate demand (demand side)

Demand side is explained by the Keynesian concept of multiplier.
K= ΔY/ΔI

ΔY = K X ΔI

K= 1/MPS
= 1/ 1- MPC
Let the annual increase in income be denoted ΔY & increase in
investment by ΔI.
Given propensity to save is α
MPS= ΔS/ΔY

Then increase in income should be equal to multiplier K= (1/ α) * ΔI

ΔY = ΔI* (1/ α)
Equilibrium
To maintain full employment equilibrium level of income,
AD=AS
Thus, we arrive at the fundamental Domar Eqn.
Iσ= ΔY/I ---i
ΔY= ΔI* (1/ α) --- ii
ΔI* (1/ α) = Iσ
Dividing both sides by I & multiplying α we get,
ΔI/I = α σ*
This Eqn. shows that to maintain full employment of growth rate, the net
autonomous investment (ΔI/I) must be equal to α σ*
where, α is MPS & σ* is productive capacity of capital.
This is the rate at which investment must grow to ensure steady growth rate of
the economy at full employment.

Q. Let σ= 25% α= 12% Y=150$ Billion per year.

If full employment is to be maintained then
an amount equal to (150*12/100) = 18B$ should be invested.
This will raise the productive capacity by the amount invested σ times
18*25/100 = 4.5$B & the national income will have to rise by the same amount
but the relative rise in income will be equal to
ABSOLUTE INCREASE / INCOME ITSELF
= (150 X 0.12 X 0.25)/ 150
= 3%
Thus, in order to maintain full employment, income must grow at 3% per
annum. Any divergence from this golden path will lead to cyclical fluctuations.
ΔI/I > α σ*  boom
ΔI/I < α σ*  slowdown
 HARROD MODEL
Professor RF Harrod tries to show in his model how steady growth may occur in
an economy.
once the steady growth rate is interrupted and the economy falls into
disequilibrium. Cumulative forces tend to perpetuate its divergence, thereby,
leading to either secular deflation or inflation. The Harrod model is based upon
3 distinct rates of growth.
1. Actual Growth Rate(G) – this is determined by the saving ratio and
the capital output ratio & it shows the short run cyclical variations in
the growth.
2. Warranted Growth Rate (Gw) – This is the full capacity growth rate
of income of an economy.
3. Natural Growth Rate (Gn) – It is regarded as the welfare optimum
or the potential or full employment rate of growth.

1. Actual Growth Rate

In the Harrod Model the first fundamental equation is GC = s
Where G = rate of growth of output in a given period of time and can be
expressed by ΔY/Y
C is net addition to capital & is defined as the ratio of investment to increase in
income. It can be denoted by I/ ΔY
s is the average propensity to save = S/Y
substituting these ratios in the above formula we get
ΔY/Y* I/ ΔY = S/Y
I=S
The Eqn. is simply a restatement of the fact that savings should be equal to
investment. The Eqn. is disclosed by the behaviour of income where S depends
on Y & I depends on ΔY. The latter is nothing but the acceleration principle.

2. Warranted Growth Rate

According to Harrod, it is the rate of growth “at which the producers will be
at content with what they are doing”. It is the entrepreneurial income “it is
the line of advance which if achieved will satisfy profit takers that they have
done the right thing”. Thus, this income is therefore related to the behaviour
of businessmen. At the warranted rate of growth, the demand is high enough
for businessmen to sell what they produce and they will continue to produce
at the same percentage of growth. Thus, it is the path on which the supply &
demand of goods & services will remain in equilibrium given the propensity
to save.
The Eqn. for warranted rate of growth is Gw*Cr = s
Where Gw = is the warranted growth rate or full capacity growth rate of
income which will fully utilise the growing stock of capital that will satisfy
the entrepreneurs with the amount of investment actually made. It is the
value of ΔY/Y

Cr is the capital requirements which is the amount of capital needed to

maintain the warranted growth rate. It is I/ ΔY

s is APS = S/Y

The equilibrium states that if the economy has to advance at a steady growth
rate of Gw that will fully utilise its capacity then income will grow by
s/Cr per year.
Gw= s/Cr

If income grows at the warranted rate, the capital stock of the economy will
be fully utilised, the entrepreneurs will be willing to continue to invest.
Therefore, according to Harrod Gw is self-sustaining rate of growth. If the
economy continues to grow at this rate, it will follow the equilibrium path.
 However, if G & Gw are not equal, then the economy will be at
disequilibrium.

a. G>Gw
C will be less than Cr. As a result, there is shortage in the economy &
insufficient goods in the economy due to insufficient equipment (C< Cr).
such a situation leads to secular inflation, because actual demand grows at
a faster rate than the productive capacity of the economy. This further
leads to a deficiency of capital goods which results in Chronic Inflation.

b. G<Gw
C>Cr such a situation leads to secular depression because actual income
grows slowly than what is required by the productive capacity of the
economy leading to excess of capital goods. As a result, aggregate
demand falls short of aggregate supply and markets do not clear. This
results in Chronic Depression. Harrod states that once G departs from
Gw, it will continue to depart further and further away from equilibrium.
As a result, the equilibrium between G & Gw is a knife-edge
equilibrium, for once it is disturbed it is not self-correcting. Hence, the
major task of the public policy is to bring G & Gw together in order to
maintain long run stability and for this purpose Harrod introduces his 3 rd
concept of Natural Rate of Growth.

3. Natural Rate of Growth

According to Harrod, the natural rate of growth “is the rate of advancement
at which the increase in population & technological improvements allow”
It depends upon macro variables like population, technology, natural
resources etc. It determines the rate of increase in output & employment
which is determined by growth of population & technological innovation.
The Eqn. for the natural rate of growth is
Gn*Cr = or ≠ s

Here Gn stands for natural rate of growth or full employment rate of growth.
Maintaining the equilibrium between G = Gw = Gn is the Knife Edge
equilibrium.
The full employment equilibrium growth rate given by the above
relationship
is a critical knife edge balance & any divergence away from this equilibrium
creates depression or inflation.

Conditions
a. If G>Gw
Investments increase faster than savings & income rises faster than Gw

b. If G<Gw
Savings increase faster than investment & rise in income is less than Gw

c. Gw>Gn
C>Cr & there will be excess of capital goods due to shortage of labour. The
shortage of labour keeps the rate of increase in output to a level less than
Gw. Machine becomes idle or they are under-utilised & there is excess
capacity in the economy. This further dampens investment, output,
employment & income. As a result, the economy is gripped by Chronic
Depression.

d. Gw<Gn
There is a tendency of the economy to experience secular inflation, this is
because when Gw<Gn, C<Cr. There is a shortage of capital goods & labour
is plentiful. Profits are high since desired investments are greater & the
capitalists for the firms are willing to invest in capital stock. However,
labour combined with higher capital induces aggregate demand, beyond the
productive capacity inducing inflationary pressures.
The policy implication of the model, therefore, lies in correcting inflationary
or deflationary gap that may arise in the economy. And the effective tool to
correct this gap is savings. The savings needs to move either move up or
down which would alter investment demand, thereby pushing the economy
towards equilibrium.

CRITCISMS
 1. The concept of Laissez – Faire is unwarranted
In the present era of development planning, the policy of Laissez-Faire is
not suitable for solving the problems of economic growth. So these
models can hardly fit in the frame-work of planned development
following the assumption of Laissez-Faire.

2. Interest Rates are not constant

Another serious drawback of Harrod-Domar Model is that it considers
rate of interest as constant which is absolutely irrelevant in the changing
environment of the economy. Although investment, yet it is true that
during the phase of over-production, downward direction of interest rate
will certainly induce the demand for capital and thereby provides a
solution to the problem of excess supplies of goods.

3. No Study of General Price Level:

Another point of criticism against these two models is that they fail to
consider the changes in general price level. Price changes always occur
over time and may stabilize otherwise unstable situation.

4. Study of Technical Change Ignored:

Harrod-Domar models ignored the study of technical change which in the
present economic world is a must. In fact, technological changes are
taking place at a fast rate in the modern economic world. Without the
study of technological change, it loses relevancy.

KALDOR’S MODEL OF DISTRIBUTION

Harrod – Domar model is based on a restrictive assumption of fixed saving to
income ratio, the Kaldor model is an attempt to make this saving to income
wearable in the growth process. It is based on the classical savings function
which implies that saving equals the ratio of profits to national income.

ASSUMPTIONS
Kaldor builds his model on the following assumptions
1. There is a state of full employment which implies that national output or
income (Y) is given.
2. National income consists of wages & profits only (2 – sector – model)
 3. W comprises both manual labor & salaries while P includes income of
property owners & of entrepreneurs
4. MPC of workers> MPC of capitalists, whereby MPS of workers< MPS of
capitalists. Therefore, Sw<Sp
5. The investment output ratio (I/Y) is independent
6. Elements of imperfect competition exists.
Given these assumptions the Kaldor model is derived as under
Equation:
Wages – w
Profits – p
Y=w+p
w = Y – p --- (i)
At eq. I = S --- (ii)
S = Sw + Sp
S = Sw.w + Sp.p
Replacing value of “S” from eq. (i)
I = Sp.p + Sw (Y-p)
I = Sp.p + Sw.Y – Sw.p
I = Sp.p – Sw.p + Sw.Y
Dividing this eq. by Y
I ( Sp−Sw) Sw
=p + .Y
Y Y Y
I ( Sp−Sw)
=p +Sw
Y Y
I ( Sp−Sw)
−Sw= P
Y Y
P I I Sw
= . −
Y (Sp−Sw) Y Sp−Sw

Thus, given the MPS’ of wage earners & capitalists then the ratio of profits to
national income depends on ratio of investment in total output.
MPS of workers  Sw
MPS of capitalists  Sp
If, there is an increase in investment income ratio, it will result in increase in
share of profits national income given Sp> Sw is a crucial condition.
Sp>  stable condition

If Sp< Sw a full in prices will cause a fall in demand which would ultimately
bring fall in cumulative prices this will result in economic slowdown or
depression in economy & vice versa.
If Sp< Sw < inflation, deflation.
Further the degree of stability depends upon the difference between marginal
properties to save i.e. (1/Sp. Sw) which Kaldor defines as coefficient of
sensitivity of income distribution.
P/Y = (1/Sp. Sw) (I/Y) – (Sw/Sp-Sw)
If there is a small difference between two marginal propensities the coefficient
1/Sp. Sw will be large & small changes in investment output ratio will bring
about relatively larger changes in profit income ratios & vice versa.
Incase the MPS of labor is zero (Sw=0)
When MPS (Sw) is zero, the number of profits is equal to the sum of
investments & capitalists’ consumption.
P/Y = (1/Sp. Sw) (I/Y) – (Sw/Sp. Sw)
when Sw=0
P/Y = (1/Sp) (I/Y) – 0
P = (1/Sp) I
It is also termed as widow’s curse, where the rise in consumption of
entrepreneurs increases the profits.
If however, I/Y & Sp are assumed to be constant over time, the share of wages
will also be constant. In other words, as output per man increases real wages
will rise automatically. In case MPS out of wages (Sw>0) the total profits will
fall by Sw i.e., number of workers savings.
 JOAN ROBINSON
Mrs. Joan Robinson in her book “Accumulation of capital” builds a simple
model of economic growth based on the “capitalist rules of the gain”.
o This theory is based on the following three assumptions:
o There is a Laissez Faire closed economy model
o labour & capital are the two factors of production
o in order to produce a given output, capital & labour are employed in
fixed proportions.
o There is neutral technical progress.
o There is no shortage of labour & the entrepreneurs or the firms can
employ as much labour as they want
o There are only two classes – the workers & the entrepreneurs.
o National income is divided between the two classes – Wages + Profits
o Entrepreneurs consume nothing but save their entire income (profits)
for capital formation.
o If they have no profits, the entrepreneurs cannot accumulate.
o There are no changes in the price level

given the above assumptions, the Robinson model gives Net national as under:
Y= w*N+ p*k
where Y is net national income
w is the real wage rate
N is the no of workers employed
p is the rate of profit
K is the amount of capital
p = Y-wN/K
Dividing the numerator & denominator by N
p = (Y/N – w)/K/N
Putting Y/N as l
K/N as theta

According to Robinson, is it the ratio of productivity (l) – real wage rate (w) to
the amount of capital utilised per unit of labour. In other words, profit rate
depends upon income, labour productivity, real wage rate & capital to labour
ratio.
On the expenditure side net national income(Y) = Consumption Expenditure (c)
& investment expenditure (I)
Since Joanne Robinson assumes zero savings out of wages but attributes
savings to entrepreneurs’ profits are meant for investment only which gives us
the entire savings S = I
This saving investment relationship may be shown as
S = p*K
I = ΔK
Since S = I
ΔK = p*K = ΔK/K = (l-w)/ Q
THE GOLDEN AGE
According to Joanne the growth rate of population also affects the economic
growth of a country.
When the growth of population equals the growth rate of capital, it is the full
employment equilibrium.
ΔN/N = ΔK/K
Joanne Robinson categorises this as the Golden Age, to describe the smooth
steady growth with full employment.
When technical progress is neutral and proceeds steadily the population should
grow fast enough to absorb the aggregate supply which is enhanced due to rise
in productive capacity.

The above diagram describes the condition of Golden Age.

The capital labour ratio (K/N) or theta is measured along the horizontal axis &
per capita output which is Y/N is measured upon the vertical axis. The growth
rate of labour is taken upon the origin to the left along the horizontal Y axis.
OP is the production function, every point on this curve shows the ratio of
capital to labour needed to produce the output. In order to find out the capital
labour ratio and the wage profit relation we draw the tangent line NT which
touches the production function OP at point G. The point G cuts the vertical
axis at point W & the point of tangency G depicts the capital ratio needed for
the golden age which is measured by OK.
In this case, OA is the per capita output and WA or EG are the profits on the
capital employed. This figure also proves that growth rate of capital EG/EW is
equal to the growth rate of labour (ΔN/N)
Using Tan α = Tan β
6 marks – derivation & theory
8 marks – assumptions & theory
10 marks – assumptions, theory & derivation
Lewis – case study of India