1

Chapter 2
Capital Accumulation in Economic
Development
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Overview on growth and development theory

 How to study growth?

 Observations on growth
 Questions asked in growth theories
 Basic concepts in growth models
 Short history of modern growth theories
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Models …..

 are developed to explain & understand the US &

European historical experience, but describe some
principles in a growing economy more generally
• how do developing countries differ, & what do
we conclude from those differences?
 tools for intuition & thinking only!!!
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Models …..

 Why do we talk about robot-models that focus on

capital & investment when in developing countries
much production takes place within the household?
 What do you suggest?
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3.1 Stylized Facts of Economic Growth

► According to Jones (2002), following are observations on
growth & development where a growth model was supposed
to explain:
1. GDP PC varies a lot from country to country
2. Growth rates vary substantially across countries
3. Growth rates are not necessarily constant overtime
4. Country’s relative position in world distribution of PCIs
can change
5. Over past 100 years in US no trend in the income share of
capital & labor and in the real return to capital
6. Growth in output & growth in volume of international
trade are closely related
7. Both skilled & unskilled workers tend to migrate from
poor to rich countries/regions
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1. GDP PC varies a lot from country to country

 About 50% of world population live in countries

with GDP PC <10% of that of richest countries
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2. Growth rates vary substantially across countries

 but no huge difference b/n average growth rates of
developing & developed countries
 Average per capita growth rate in 16 today's DCs
(Europe, USA, Canada, Australia)
Periods Growth rate (% per year)
1870-1890 1.2
1890-1910 1.5
1910-1930 1.3
1930-1950 1.4
1950-1970 3.7
1970-1990 2.2
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 Average per capita growth rate in 15 LDCs in Asia &

South America

Periods Growth rate (% per year)

1900-1913 1.2
1913-1950 0.4
1950-1973 2.6
1973-1987 2.4

Source: Barro, Sala-i-Martin (1995): Economic Growth, p.6.

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Fig 3.1: Distribution of growth rates, 1960-2000
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3. Growth rates are not necessarily constant overtime

 For the world as a whole, close to zero over most of
the history but increased sharply in 20th C
 For individual countries, change overtime
• rapid growth rates observed in East Asia
• modest growth rates of about 2% per year throughout
industrialized world
 Examples:
 India: 1960-97 average growth rate was 2.3%, but
• 1960-80: 1.3%
• 1980-97: 3.5%
 China:
• 1960-78: 1.9%
• 1978-97: 5%
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Rule of thumb for doubling PCI

 used to interpret these growth rates is that a
country growing at ‘g’ percent per year will
double its PCI every ‘70/g’ years
70
Doubling time (in years) 
g
 e.g., imagine a country with PCI of $20,000 today.
If it had been growing 2% a year forever, what
would be its PCI 250 years ago?
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Solution:
 about $150 (about 50 cents/day)
 Doubling time (d)
d = 70/g = 70/2 = 35 years
 How many doubling times (df) do we have over 250 years? It
would be:
df = n/d = 250/35 = 7.143 where, n = given period
 PCI 250 years ago (PCIt-250) would be
PCI t 20,000
PCI t 250  df  7.143  $150 where, n = given period
2 2
 Percentage growth figures look like small numbers, but
overtime, small differences in growth rates can lead to
large differences in PCIs
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4. Country’s relative position in the world

distribution of PCIs can change
 Countries can move from being ‘poor’ to being ‘rich’
• Korea, Taiwan, Singapore, Japan & Hong Kong
• e.g., Korean PC GDP 7.4 times higher in 1990
than in 1960 (880  6,580 US $ in 1985 prices)

 Or from being ‘rich’ to being ‘poor’

• e.g., Iraq PC GDP fell from 3,300 to 1,780 US $
(from 1960 to 1990 in 1985 prices)
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5. Over the past 100 years in the US:

 no trend in the real return to capital (denoted by r)

• rate of return to capital is roughly constant
 no trend in the income share of capital (rK/Y) & labor
(wL/Y )
• concerns payments to factors of production (K & L)
 average per capita output growth has been positive &
relatively stable overtime
• US exhibits steady, sustained PCI growth
► These observations are the background when growth
models are designed
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Fig 3.2: GDP per capita in the United States, 1870-2000

g = 1.9%

Source: Heston, Summers, and Aten (2002).

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6. Growth in output & growth in volume of

international trade are closely related
 Volume of trade is defined as sum of exports & imports
 For many countries, trade volume has grown faster than
GDP
• share of exports & imports in GDP has generally
increased around the world since 1960

 Trade intensity can be calculated as

Exports  imports
Trade intensity ratio 
GDP
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Trade intensity
 exceeds 150% for newly industrialized countries (NICs)
• b/s NICs import unfinished products, add value by
completing production process & then export the
result
• an increase in trade intensity plays substantial role in
the strong economic performance of NICs
 fell from around 21% in 1960 to around 18% in 1992 in
Japan despite rapid per capita growth
 increased for many SSA countries from 1960 to 1990
while economic growth weakened
• nearly all SSA countries have trade intensities higher
than Japan’s
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Fig 3.3: Relationship between economic openness & PC GDP

Source: Sachs and Warner (1995)

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7. Both skilled & unskilled workers tend to migrate

from poor to rich countries/regions
 Robert Lucas suggested the evidence for this fact can be
seen in the presence of migration restrictions in rich
countries
 the returns to both skilled & unskilled labor must be
higher in rich countries than in poor countries
• otherwise, labor would not be willing to pay high costs
of migration
 In terms of skilled labor this raises an interesting puzzle
• skilled labor is scarce in LDCs & simple theories predict
factors returns are highest where factors are scarce
• Why then doesn’t skilled labor migrate from US to
Ethiopia?
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Questions to be asked:

 Why are some countries poor & others rich?

 Why are some countries growing & others not?
 Where does growth come from?
► Such kinds of issues will be discussed in the
following theories of economic growth
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Basic concepts

 Before discussing the growth models, important to

note the following concepts:
• Production functions
• Marginal product
• Productivity
• Law of diminishing returns
• Returns to scale
• Euler's Theorem
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Production functions
 The production process in a firm or a country is usually
described as a function that links inputs to output(s),
denoted by
Y  F(X )
Where,
Y = output of the firm/country (this is GDP)
X = a vector of inputs- i.e., X = (X1,X2,…, Xn) assuming
there are n d/t inputs that are relevant
 For now, let’s consider labor (L) & capital (K) as inputs.
In this case, the PF is
Y  F ( L, K )
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Marginal product
 refers to the marginal change in output when a given
Y
input is marginally changed, MPi 
X i
 Thus,
Y
= marginal product of labor (denoted by FL)
L
Y
= marginal product of capital (denoted by FK)
K
 In general, it is assumed that both marginal products
are positive,
FL  0, FK  0
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Productivity
 refers to the average product
 productivity of labor in general refers to Y/L, though
sometimes confused with MP of labor
 Here L is at the same time labor force & population
size of a country
 Y/L  y will be output per capita of a country-i.e., on
average how much output each individual produces/
receives
• this is GDP per capita
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Law of diminishing returns

 states that if one input increases while others held
constant the rate at which the output increases will
eventually diminish
 In our model,
 2Y  2Y
FLL   0, FKK  0
LL KK
 i.e., the production function is assumed to be concave
 In general, it is also assumed that

FLK  FKL  0 [interpret]

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Returns to scale

 refers to the change in output when all inputs are

scaled up/down
 Most common case & very important for us is that of
constant returns to scale (CRS), given by condition:
 Meaning: increasing scale of production by a certain
factor (say, doubling, = 2) would produce the scaling
factor in output
 Does it seem reasonable?
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Returns to scale….
 Another case of importance is that of increasing
returns to scale (IRS)
 Y  F (  L,  K ),  ,   1 &    
 Meaning: the more you produce the more productive
you are
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Returns to scale….
 A nice property of CRS production functions is the
following
 Take  = 1/L, then Y  F (L, K )
Y K
  F (1, )  f ( k )
L L
 y  f (k ) where k = K/L (capital stock per capita),
y = Y/L (GDP per capita)
 Distinguish F (GDP) from f (GDP per capita)
 So we may be able to work with a function with
only one input (k)
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Production functions

 As we will use graphs a lot through the course, it is

good for you familiarizing with them …
 e.g., Fig 3.4 below plots a typical neoclassical
production function in per capita terms
 shows a function with positive MP & that satisfies
law of diminishing returns (it’s concave)
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.
Fig 3.4 Neoclassical production function
f (k )

df ( k )
dk
f (k )

k
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Euler's theorem
 A nice feature of CRS production functions is that you
can apply Euler's Theorem to show that

 In neoclassical theory of factor payment, it’s assumed all

factors of production are paid accordingly to their MP
• i.e., w = F/L & r = F/K
• where w = wage rate & r = return to capital
 Euler's theorem implies total product in an economy (Y)
is exactly equal to sum of factors remuneration
 This also refers to macroeconomic idea that
National product = National income
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Theories of economic growth

 Understanding the basic concepts, let’s discuss
briefly the following 5 theories of economic growth:
1. Rostow’s stages of economic growth
2. Balanced vs unbalanced growth models
3. Harrod-Domar growth model
4. Solow model
5. Endogenous growth theory
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3.2 Rostow’s Stages of Economic Growth

 According to this theory, transition from underdevelopment

to development can be described in terms of 5 stages of
economic growth through which all countries must proceed
1. Traditional society
2. Pre-conditions for take-off
3. Take-off
4. Drive to maturity
5. Age of high mass consumption
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3.2 Rostow’s Stages…..

 This theory argues:
• DCs had passed stage of ‘takeoff’ into self-sustaining
growth
• LDCs were still in either traditional society or pre-
conditions stage that they 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 tricks of development necessary for
any takeoff was mobilization of domestic & foreign
saving in order to generate sufficient investment to
accelerate economic growth
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Rostow’s traditional society

 Pre-Newtonian or 18th century
 Lumps past economies, DCs 19th century, & LDCs today
together
 Neglects dualism of many low-income countries today
 It is basic stage of economic development.
 It is society where production is limited.
 The level of per capita income is so low.
 The labour force depends upon agriculture
 The methods of production are old. There is less mobility
of factors of production.
 There is unequal distribution of wealth in the country.
 36

Rostow’s preconditions stage

 Increased transport investment– enlarge market & specialization
 Agricultural revolution to feed urban population
 Expansion of imports (especially capital), perhaps financed by
exporting natural resources
• In this stage people look to economic progress as a healthy sign.
• They show the desire and willingness to participate the
productive activity.
• The stagnation in various sectors is broken.
• People begin to apply new techniques of production in various
sectors.
• People accept the importance of education. Banking system
always begins to develop.
• The domestic and foreign trade increases.
• In this stage savings, income, investment, production and
purchasing power increases.
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Rostow’s central stage, takeoff
 Decisive expansion 2-3 decades;
 Radically transforms economy & society
 Late-18th century Britain, pre-civil war US, late-19th century
Germany, post-Meiji (1868) Japan, pre-1917 Russia, post-
independence India & post-1949 China;
• In third stage, all the obstacles are controlled, the rate of economic
development increases.
• New markets are found.
• Discoveries and inventions take place.
• New industries are stabilized.. Rate of employment increases (20 to
30) years
 This stage has three important characteristics;
i. The rate of saving and investment increases from 12 to 15 percent
of GNP
ii. The growth of one and more than one sector increases more swiftly.
iii. There is a resolution in the social, political and economic structure.
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Rostow’s 3 conditions for takeoff

 NNP increases sharply, say 5 to 10%
 Leading manufacturing sector stimulates growth through
linkages
 Political, social & institutional framework to exploit
modern expansion: entrepreneurship, retained earnings,
banks & capital markets, foreign investment
• In this stage more refined technology is used in the
economy.
• The rate of investment increases from 12 percent to 20
percent of the national income.
• The substitutes of imports are produced inside the country.
• Exports quantity increases and balance of payment
improves.
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Rostow’s drive to maturity

• Growth regular, expected & self-sustained
• Urban, skilled, less individualistic, more bureaucratic
labor force
• State provides more economic security
• In this stage more refined technology is used in the
economy.
• The rate of investment increases from 12 percent to 20
percent of the national income.
• The substitutes of imports are produced inside the
country.
• Exports quantity increases and balance of payment
improves.
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Age of high mass consumption

• Alternative: welfare state, military power
• US 1920s, Western Europe 1950s
• Autos, suburbs, innumerable durable consumer goods &
gadgets
• In this stage of economic growth, prosperity is being found in
the country.
• The per capita income is very high and people can save easily
after meeting the basic necessities.
• Rural population moves to urban areas.
• Durable goods like cars and machines are produced in the
country. Government prepares the social welfare plans.
• Colleges and universities are available in large numbers.
• College education is within the reach of more than half of the
population.
• Russia is struggling hard to achieve this stage of economic
growth.
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Critique of Rostow
 Lack of empirical evidence (increase investment
rates)
 No historical evidence of abruptness
 Difficult to test
 Stages define not explain
 Stages not unique
 Dualism (not just pre-science & technology)
 How does an economy move to next stage?
 Does self-sustained growth imply effortlessness? Are
obstacles to growth removed?
 Is this Western (or US) model in disguise?
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3.3 Harrod-Domar Growth Model

 HD model is economic growth factor in Keynesian

macroeconomic models
 Its name comes from two pioneering articles:
• Harrod, R.F. (1939) An essay in dynamic theory.
Economic Journal 49:14-33.
• Domar, E. (1946) Capital expansion, rate of growth
and employment. Econometrica 14:137-147.
Yt  C t  I t 43

Dynamics in a Keynesian model

 Consider the main Keynesian equations for determining a
macroeconomic equilibrium in simple economy
Yt  C t  St (1 )
Yt  C t  I t (2)
Where Yt = Real GDP (NI or output) in period t
 In eq.1 (aggregate income or demand),
Ct = Purchase of consumption goods in period t
St = Household saving in period t
 In eq.2 (aggregate output or supply),
Ct = Production of consumption goods in period t
It = Production of new capital goods = Gross investment
in period t
Yt  C t  I t 44

In equilibrium,
 Aggregate income = Aggregate output

Ct  St  Ct  It

 It  St ( 3)
 Eq.3 is the macroeconomic equilibrium, which
translates into savings equal investment
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 The income generated from production of all goods is

spent on both consumer goods & capital goods
 Typically households buy consumer goods,
 firms buy capital goods to expand their production
and/or to replace worn-out machinery
 This generalization immediately raises a question:
 If all income is paid out to households & households
spend their income on consumption goods, where
does the market for capital goods come from? How
does it all add up?
• the answer is deceptively: households’ savings
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 Saving rate (s)- share of income that can be allocated

to investment to increase growth rate, expressed as:
St
s
Yt
 S t  sYt ( 4)
 Substituting eq.4 into eq.3
I t  sYt (5)
 How capital stock (K) & investment flow (I) related?
 Production next year depends on capital stock
available in next year
► Dynamics of the model is capital stock available in
next year
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Introducing dynamics in HD model

 Dynamics of model given by capital accumulation (CA)
 Consider the CA equation:

K t 1  (1  d ) K t  I t ( 6)
 Important definitions:
K= capital stock
d= depreciation rate (fraction of capital stock that
depreciates each period)
s= St/Yt: savings rate (what fraction of income is saved)
c= 1-s = Ct/Yt: propensity to consume in Keynesian
models
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 It = Addition to existing capital stock (investment

flow) in period t
• can be defined as difference in capital stock
(It=ΔK)
K t 1  K t  I t  dK t  K  dK t  I t
• i.e., investment augments national capital stock
(K) & replaces stock depreciates
► tells how the capital stock must change overtime
 Capital-output ratio ()- units of capital required to
produce one unit of output
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GDP rate of growth

 Could you derive GDP growth rate from CA equation?

 Yes
• to do so, use a term () that relates capital stock
(K) & output (Y)

Kt
   K t  Yt
Yt
 K t 1   Y t  1 (7)
 50

GDP rate of growth…..

 Substituting eq.5 & 7 into eq.6, you will get
 Yt 1  (1  d ) K t  sY t (8 )
 Dividing eq.8 by Yt, you will get:
 Y t 1
 (1  d )  s (9)
Yt
 With little algebra, eq.9 can be rewritten as:
s
g d (10)

where g is output (GDP) rate of growth
 This is an example of ‘Endogenous Growth’ where g is
determined ‘within the model’
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 Eq.10 is an initial HD equation

• firmly links growth rate of the economy into
two fundamental variables:
• ability of the economy to save
• capital-output ratio
 52

GDP rate of growth …..

 Possible to accelerate the rate of growth, by:

• pushing up the rate of saving
• increasing the rate at which capital produces
output (or achieving lower capital-output ratio)
 Central planning in countries like India & former
Soviet Union was deeply influenced by HD-equation
 A small amendment to HD model allows us to
incorporate effects of population growth
 In order to talk about per capita growth we must net
out effects of population growth
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HD equation can be used

 to calculate the need for aid for investment
purposes
• for the desired growth rate, you can calculate the
investment need
 Soviet planning: How to finance a 5 year plan
 HD eq. becomes a theory of growth when we
assume investment is determined by savings through
a smooth functioning financial intermediation
 Note: implicit assumption of no limit on labor
 54

GDP per capita rate of growth

 You can convert GDP (Yt) into GDP PC (yt) as follows:
 Take equation (8) & divide it by Lt (or Pt), with little
algebra, to obtain
g * n  g*  s  ( n  d ) (11)

 Since g* (GDP PC growth rate) & n is usually b/n 1 & 5% (if
g* =0.02 & n= 0.05, g*n= 0.020.05 = 0.0001), their
product is very small relative to other terms
 in view of this we ignore the term g*n
 Hence,
g*  s  n  d (12)

 Eq.12 is the final equation of HD
 55

• All variables (s, , n & d) in HD model are exogenous

(whose values are determined outside the model)
• s depends on behavior of people’s saving &
government policy
•  depends on technology
• n depends on different factors
• d depends on type of capital & technology
• In free market economy, all these parameters are
determined by people’s tastes & technology
• In socialist (centrally planned) economy, government
enforces to increase saving (s) & decrease population
growth (n)
• e.g., Bolshevik revolution in 1917 in Soviet Union
 56

Exercise 3.3
1. Consider the following information about a country
Year GDP Savings Machinery
1990 1000 400 4000
1991 1050 __a__ 4100
1992 __b__ __c___ __d___
• Assuming that this country behaves as in HD model
a. What is the saving rate? Ans. 0.4 (or 40%)
b. What is the depreciation rate? Ans. 0.075 (or 7.5%)
c. Complete the table above
Ans. a=420, b=1076.25, c=430.5, d=4212.5
d. What should the savings rate be in order to achieve a 1%
growth in GDP PC when the population is growing at 3%?
Ans. s = 0.46 (or 46%)
 57

Exercise 3.3 ….
2. In Indonesia during the 1970s the capital-output ratio
averaged 2.50 while the depreciation rate was 1%.
a. Using the HD growth equation, what saving rate
would have been required for Indonesia to achieve
an aggregate growth rate of 8% per annum?
Ans. s = 0.225 (or 22.5%)
b. With the same capital-output ratio & depreciation
rate, what growth target could be achieved with a
savings rate of 27%? Ans. g = 9.8%
 58

Will continue next------