ECONOMIC INTERDEPENDENCE

Economic interdependence is the state that exists when two or more individuals, people, groups,
businesses, or countries transact with each other (exchanging goods and services) to satisfy their
needs. The situation mostly points towards the trade among two or more parties to make sure
each of them has all the required goods and services.

Definition

“Economic interdependence refers to the relationship between two individuals, groups, sects,
businesses, regions, or countries where each of them is dependent over the other for the supply
of necessary goods and services.”

The concept of Economic Interdependence mostly applies where each party specializes in the
production of a specific good or the provision of a specific service. And the exchange of those
services is necessary to fulfill all the needs of both parties. This is the system by which
companies and countries are economically dependent on each other.

Example

1. One of the best and easiest examples of economic interdependence is international trade.
Trade that takes place between two or more countries is due to the lack of production
capabilities of a specific product of one country and the mastery in production of the
same product of the other country.

For example, Asian countries having mild-to-hot weather enjoy the harvest of certain regional
fruits, rice, and cotton. Other countries that might not be able to grow the same crops for
themselves due to their weather, humidity levels, or any other reason, import these crops from
Asia. Similarly, certain goods or products which cannot be manufactured in Asia are imported
from other countries. This system makes different countries economically interdependent.
 2. Another example comes from the Superstore chain system of Walmart. Walmart sells the
products of hundreds of companies. Therefore, Walmart relies upon these manufacturers
and companies for the production of goods to be sold by Walmart.

On the other hand, all these companies and businesses are dependent on Walmart for the sale of
their products. Both parties are therefore dependent upon each other for the fulfillment of their
needs.

3. The phenomenon of Economic interdependence also takes place in an advanced

economy. Talking about the USA, has most of the manufacturing companies and
production centers. Although they specialize in the production of all those goods, they
can’t produce the raw materials for all those goods by themselves. They thus, have to
import raw materials from other countries.

For example, the USA specializes in Auto Mobile manufacturing. However, it imports rubber for
tires from South Asian countries. Similarly, textile production within America depends upon the
import of high-quality cotton from different countries. Also, these products (cars and textiles) are
then exported from the USA to the entire world. This makes the USA and the rest of the
economy interdependent on each other for the fulfillment of their needs.

Understanding Economic Interdependence

Finding real-world examples of Economic Interdependence is pretty easy as it exists almost

everywhere. All businesses, organizations, companies, and countries are deeply rooted in the
whirl of economic interdependence. Every business is economically dependent on other
businesses and so are countries.

The reason for such interdependency lies in the ability of each business, nation, or country to
specialize in certain kinds of products only. Specialization results in better efficiency and higher
quality so businesses tend to produce only specific kinds of goods, while the rest of them are
either imported or outsourced.
Such a condition means that the operationality of every business can be slightly or greatly
influenced if any other entity in the economy is affected. Therefore, each business is deeply
bound to different segments of an economy and any economic change affects all businesses
within an economy drastically.

Higher the product specialization, the higher the production efficiency. However, a higher
specialization also means a higher economic interdependence. For instance, if an organization
excels at producing baby food, it must have expert Pediatricians and nutritionists on board along
with specialized working staff and equipment. However, it may not be possible for the company
to grow wheat as well. Therefore, they would have to import it from a wheat vendor.

Similarly, the wheat vendor is dependent upon such food manufacturers for the sale of his wheat
crop. In this way, every vendor, supplier, manufacturer, and business is dependent on other
businesses for the continuity of their operations.

Causes of Economic Interdependence

Several factors contribute to the creation of economic interdependence. Some of these are
discussed below.

 Industrialization

Industrialization leads to the advancement of economies which in turn triggers the in-house
manufacturing of several products. When a country specializes in the production of a certain
product, it then needs to import other products from other countries. An example is that of Asia
(Pakistan); it specializes in the manufacturing of footballs however leather and other preparatory
materials are imported from China.

Producing specialized goods enhances production efficiency and therefore, most countries only
focus on their specialties, providing a narrow range of goods and services. This creates economic
interdependence among nations; the need for outsourcing or importing other products for the
fulfillment of basic needs.
  Economy advancement

As an economy develops, it focuses on establishing more industries and manufacturing more

goods within the country's premises. This can lead to the creation of raw materials and other
labor services from within the country or from neighboring economies.

Also. with advancement, an economy tends to move towards the rendering of services rather than
the production of goods. This way the local product manufacturing industry revolutionizes into
the services industry. Ultimately, these products are then imported from other countries, thus,
boosting economic interdependence among nations.

 Regional Production

One main reason for high economic interdependence among economies is the region-specific
production. Different regions observe different weather, different soil, and other conditions.
Within such circumstances, they specialize in the production of certain goods and crops only,
while other necessities are fulfilled by importing goods.

For example, China is one major exporter of Apples, it produces more than 41 million tons of
apples each year. Blessed by the perfect climate and land to harvest apples, China is an expert in
harvesting Apples. On the other hand, America exports Maize, Soybean, and Milk. Both of these
countries exchange their products with each other and are economically interdependent.

 Labor Specialization

Another main driving force of Economic interdependence is Labor Specialization. When too
many similar products are produced by one nation or a party, the production becomes specialized
and economic interdependence takes place. That party then forms trading relationships with
other parties for the supply of products and services that they cannot produce.
Pros & Cons of Economic Interdependence

To understand the concept of economic interdependence better, let us analyze how it can
positively or negatively impact an economy. Below are some pros and cons of economic
interdependence:

Pros

 Economic interdependence leads to more trading opportunities. Increased trade among

countries promotes the exchange of goods and creates more earning opportunities at the
national and international levels.
 Selling specialized goods within the same region may undergo tough competition.
However, between different regions selling can be much easier. For example, selling oil
within the Gulf countries may require much more marketing and selling tactics as
compared to when it is supplied to Asian countries (which cannot extract oil from their
homeland).
 Outsourcing all the side products and only focusing on your specialty leads to excellent
production. For example, if a company manufacture cars and every minor and major
spare part of the car itself, then it might not produce really good cars. The synergies of
the company, in this case, would be divided which can affect the product quality.

On the other hand, if a company only focuses on assembling cars and outsources all the other car
parts to specialized manufacturers, then this would bring in professionally manufactured spare
parts and quality assembling of the automobiles.
  Another significant advantage of economic interdependence is diversification. Focusing
and depending only upon the local market can expose you to an increased risk in case of
any national catastrophes i.e. political factors, economic downturns, regional natural
calamities, etc. Depending less on a single market and outsourcing different business
segments can help mitigate this risk.

Cons

 Importing the goods can sometimes bring on a greater cost due to customs and freight
charges upon imports. Also, the shipping costs can sometimes be too high. This can result
in a higher cost of the end product born by the consumer, which can ultimately affect
sales.
 Depending too much upon only one or fewer external suppliers can become too risky. In
case of any catastrophe (legal changes, economic crash, financial crunch, natural
calamities, etc.) in the region of the supplier of a principal raw material, the business
operations can observe a halt.
 In case of a change of supplier due to any foreseen or unforeseen reason, the customers
may not adapt to the change very soon. This can lead to substantial damage to brand
repute and decreased sales.
 The fluctuation of currency exchange rates may make it difficult to continue with
external supplies keeping the prices in control.

 Globalization

Globalization is a by-product of Economic Interdependence. It triggers the spread of technology,

products, labor, processes, and jobs all around the world. The cross-border flow of goods,
products, and jobs creates international opportunities.
The motives of globalization are opportunistic and ideal. The development of a global market
has advantaged many nations and businesses. On the contrary, some countries like Mexico and
the US have also undergone a severe disruption due to increased market rivalry.

Globalization is a social, political, legal, and cultural phenomenon and it lends well to the
economy of every country. Here is why globalization is important,

 Socially, Globalization triggers much interaction among different countries and nations
which promotes the relationship between countries. Also, between businesses, it creates a
reason to support each other as the collapse of any business would affect all other
businesses too.
 Through the cross-border flow of products, jobs, and processes, the culture, traditions,
and values of nations also flow which strengthens the inter-relations among different
nations.
 Politically, globalization keeps international organizations like the UNO and WTO on
the hook which is better for peaceful trade.
 On legal grounds, the promotion of globalization has led to the creation and enforcement
of international laws that oversee the contracting party's rights.

Conclusion

 Economic interdependence is the situation where two or more parties (individuals,

businesses, companies, countries, etc.) depend upon each other for the exchange of goods
and the fulfillment of their necessities.
 Economic interdependence takes place between businesses when they rely on external
suppliers for their business needs. Also, the international trade between countries triggers
economic interdependence between them when one country specializes in the production
of certain goods and relies on imports for their other needs.
 Many factors lead to the creation of economic interdependence such as industrialization,
economic advancement, labor specialization, regional production, etc.
  Economic Interdependence also leads to Globalization which triggers international
relations and an efficient trading system among economies.
 Advantages of Economic interdependence include the growth of international trade and
earning opportunities, efficiency in production due to outsourced supplies, lesser risk due
to diversification, etc.
 Disadvantages of Economic interdependence include the exchange rate fluctuations,
higher import costs, risks associated with depending upon a sole supplier, etc
1. What is economic interdependence?

Economic interdependence is the situation where two or more parties (individuals, businesses,
companies, countries, etc.) depend upon each other for the exchange of goods and the fulfillment
of their necessities.
2. What are the main characteristics of economic interdependence?

The main characteristics of economic interdependence are the dependence of businesses on

external suppliers for their goods and services, and the dependence of countries on other
countries for the production of certain goods.
3. How does economic interdependence affect the world?

Economic interdependence creates a global market where goods, products, and jobs can flow
freely across borders. This increased cross-border interaction promotes international relations
and an efficient trading system among economies.
4. How do you measure economic interdependence?

Economic interdependence can be measured by the amount of trade that takes place between two
countries. This can be done by looking at the value of exports and imports between the two
countries.
5. How can economic interdependence benefit economies?

There are many advantages to economic interdependence, including the growth of international
trade and earning opportunities, efficiency in production due to outsourced supplies, lesser risk
due to diversification, etc.
The Essence of Internal and External Equilibrium

The problems of macroeconomic equilibrium is in the Centre of economic theory since the Great
Depression of 1929-1933. John Maynard Keynes determined the achieving of "full
employment)) by the means of aggregate demand regulation as a priority of the economic policy.
Monetarists determined the economic growth without inflation as a main goal of the economic
policy and proposed the monetary rule as a means of achieving it . Proponents of the theory of
rational expectations believed that the lack of confidence in the government is the main obstacle
for achieving the potential level of output together with the lowest level of inflation.

Maintaining internal and external balance still remains a major challenge for macroeconomic
regulation. The solution of this task requires proper attention to the correlation between the main
macroeconomic variables that characterize the internal state of the economy and are mediated by
external processes. At the same time, the economic variables that reflect the external sector state
is under the influence on influence on internal variables. All this makes it more difficult to carry
out macroeconomic policy, which requires the increasing number of factors to be taken into
account.

In various models of an open economy there are different interpretations of the internal and
external balance, but the meaning remains the same. In a broad sense, the internal equilibrium is
the equilibrium of the national income, and the external equilibrium is the equilibrium of
balance of payments.

The internal equilibrium require the balance of supply and demand together with full
employment and absence of inflation (or its stable low level). In the short term, this problem can
be solved by regulation of aggregate demand through fiscal and monetary policy. According to
the approach of the classical school, the internal equilibrium means a stable state of income (Yn)
on a certain "natural" level that indicates indicates the availability of capital and labor resources.
In the Keynesian theory the "natural" level of income is understood as the non-inflationary rate
of unemployment.

The external equilibrium means a maintenance of a zero balance of payments in terms of a

certain exchange rate regime. The maintaining of external equilibrium may reflect two main
objectives: to achieve a certain state of the current account and to maintain a certain level of
foreign exchange reserves. Macroeconomic regulation is provided by monetary and fiscal policy.
The goal of the external equilibrium is complicated by capital mobility - intensity of the cross-
country mobility of capital in response to interest rate fluctuations.

In fact, the maintenance of internal and external equilibrium refers to the functioning of three
markets: goods, money and foreign exchange markets.

Tools of Economic Policy Used for Balance in Economy

The functioning of the market does not always lead to a satisfactory equilibrium (balance).
Government intervention becomes necessary to regulate the economy. The government is
developing the economic policies to achieve macroeconomic equilibrium.

An economic policy is a set of various measures taken by the government in order to achieve the
specific goals of economic development, which is a complex social mechanism. It aims to reach
the following objectives:

• economic growth, determined by the rate of GDP growth;

• full employment, defined by the level of unemployment;

• price stability, defined by the rate of inflation;

• external account balance that is reflected in the accounts of balance of payments.

There are two main types of economic policy depending on the purpose pursued by the
government:

• cyclical policy, which is used to compensate the temporary reduction in economic activity;
• structural policy, which is used to change the economic and social structure. Long-term goals
are laid down in the basis of the structural policy. It contains measures affecting employment, tax
policy, industry and agriculture, health care system, environmental policy, the system of social
protection of the population, etc., which give results only in the long term.

The economic policy is more effective when the decisions are taken by the government with a
focus on specific current conditions - production and technical potential, the state of the social
structure, the institutional order of national and local government, etc.

For the implementation of economic policy by the state, the following macro-economic
instruments are used:

• fiscal policy;

• monetary policy.

Fiscal policy represents as measures affecting public spending, taxation and the government's
budget in order to ensure full employment, an equilibrium of balance of payments and economic
growth.

Instruments of fiscal policy are the costs and revenues of the state budget: public procurement,
taxes, transfers. In this regard, there are two types of fiscal policy - facilitating and moderating
policy.

Facilitating fiscal policy (expansionary fiscal policy) aimes at overcoming the cyclical downturn
of the economy in the short term, implies an increase in government spending, tax cuts or a
combination of these measures. In the long term, such policy leads to the growth of the economic
potential of the country.

Restrictive fiscal policy in the short term is to reduce inflationary demand and slowing the
decline in production. For this purpose, measures such as: reducing government spending, tax
increases, and the combination of these measures are used.
Monetary policy represents as measures of authorities to influence on money supply, interest
rates, and through them - on investment and real GDP using direct and indirect instruments of
regulation.

The direct instruments include administrative measures such as directives of the central bank.
Credit limits and direct regulation of interest rates provide the most rapid economic effect. But
usually, in a market economy the implementation of monetary policy is provided by indirect
instruments.

The indirect instruments include such measures as changes of reserve requirements, interest rates
and open market operations.

Reserve requirements are determined as a percentage of total deposits. The central bank
manipulating the statutory reserve ratio affects the ability of commercial banks to lend .

Raising reserve rate increases the amount of required reserves that banks must hold. This tool
affects the decline in bank lending due to the loss of excess reserves, or forcing banks to reduce
deposits and thus the money supply. Decrease in reserve rate moves required reserves in excess
and increases the ability of banks to create new money by lending.

One of the traditional functions of a central bank is providing loans to commercial banks, and the
interest rate, which the loan is issued at, is called the discount rate. Changing the discount rate
affects the volume of reserves of commercial banks, reducing or increasing their ability to lend.
Thus, the increase in the discount rate leads to a decrease in reserves, thereby reducing the ability
of the bank to create money by lending.

For countries with developed stock market transactions in the open market are the most
important means of controlling the money supply by the central bank. Application of this method
is difficult in the emerging stock market. This tool involves the buying and selling of government
securities by the central bank. A purchase of securities is accomplished by transfering the
securities portfolios of commercial banks to central banks which in their turns pay for these
securities by increasing the reserves of commercial banks in the amount of the purchase. A sale
of securities is fulfilled by transfering securities from the central bank to commercial banks, that
reduces their reserves.

Monetary policy, as well as fiscal, has two types: expansionary and constractionary.

Expansionary monetary policy is called as a policy of "cheap" money. Among its tasks are
making credits cheaper, facilitating access to it, in order to increase aggregate demand and
employment. For this purpose the reduction of reserve ratio, lowering the discount rate and the
purchase of securities are used.

Restrictionary monetary policy (a policy of "expensive money") aims to reduce the money
supply in order to reduce costs and curb inflation. To maintain such a policy it is necessary to
raise the reserve requirement and the discount rate, and also sale government securities.

Most economists believe that monetary policy is an important part of the economic stabilization
policies, some of the scientific schools pay more attention to fiscal policy.

In the Keynesian model fiscal policy is seen as the most effective instrument of macroeconomic
stabilization, as government spendings has a direct impact on the value of aggregate demand and
multiplicative effect on consumer spendings. At the same time taxes are quite effective)
influence on consumption and investment. In the classical model fiscal policy plays a secondary
role in comparison with the monetary one. Moreover, fiscal measures cause crowding-out effect
and enhance the increase in the rate of inflation, that significantly reduces its incentive effect.

In the Keynesian model monetary policy is seen as a secondary towards fiscal, because the
monetary policy transmission mechanism is very complex: the change in money supply leads to
changes in GDP through the mechanism of change in investment spendings, which respond to
the dynamics of the interest rate. In the classical model it is assumed that the change in the
money supply directly affects aggregate demand and, consequently, the nominal GDP.

In the modern market economy it is taken as a rule, first of all, to consider monetary measures,
and then - fiscal. This is due to the fact that the implementation of monetary policy to a greater
extent reflects the typical balance of the market and the state origins in the economy.
In various models there are different approaches to macroeconomic equilibrium due to the
objectives and instruments. Dutch economist J. Tinbergen worked out the rule that to
achieve N goals it is necessary to use N different instruments. Thus, if there is a double set of
objectives of macroeconomic equilibrium, such as income and balance of payments, it is
necessary to use two independent instrument of economic policy.

THEORIES OF GROWTH
1. Classical Growth Theory

The Classical Growth Theory postulates that a country’s economic growth will decrease with an
increasing population and limited resources. Such a postulation is an implication of the belief of
classical growth theory economists who think that a temporary increase in real GDP per person
inevitably leads to a population explosion, which would limit a nation’s resources, consequently
lowering real GDP. As a result, the country’s economic growth will start to slow.

Structural Model

In the chart above, the y-axis represents total production, and the x-axis represents labor. Curve
OW outlines the total subsistence wages. If the level of population (labor) is ON, and the level of
output is OP, the per capita wage is represented by NR. Consequently, the surplus or profit is
RG.
Because of the surplus, the capital formation process comes into effect. Consequently, the
demand for labor increases, leading to a rise in total wages, as the curve moves to GH. If the total
population remains constant at ON, and wages exceed subsistence wages, i.e., NG > NR, then
total population or total manpower will increase as the curve moves toward OM. Because of the
increase in population, surplus can be generated.

In such a manner, the process will continue until the economy reaches point E, as depicted by the
arrow. Point E represents a stationary situation wherein wages and total output equalize, and no
surplus can be generated. However, according to classical economists, with technological
progress the production function will shift upward, as depicted by the curve TP2. Also,
according to the Classical Growth Theory, economic stagnation can be postponed, although
ultimately not avoided.

Limitations of the Classical Growth Model

Ignorance with respect to technology: The classical model of growth ignores the role efficient
technical progress could play for the smooth running of an economy. Advancements in
technology can minimize diminishing returns.

Inaccurate determination of total wages: The classical model of growth assumes that total wages
do not exceed or fall below the subsistence level. However, this is not entirely true. Changes in
the industrial structure and substantial economic development can result in total wages exceeding
or falling below the subsistence level. Moreover, the classical theory of growth does not consider
the role played by trade unions in the process of wage determination.

2. Neoclassical Growth Model

The Neoclassical Growth Theory is an economic model of growth that outlines how a steady
economic growth rate results when three economic forces come into play: labor, capital, and
technology. The simplest and most popular version of the Neoclassical Growth Model is
the Solow-Swan Growth Model.
The theory postulates that short-term economic equilibrium is a result of varying amounts of
labor and capital that play a vital role in the production process. The theory argues that
technological change significantly influences the overall functioning of an economy.
Neoclassical growth theory outlines the three factors necessary for a growing economy.
However, the theory puts emphasis on its claim that temporary, or short-term equilibrium, is
different from long-term equilibrium and does not require any of the three factors.

Production Function in the Neoclassical Growth Model

The Neoclassical Growth Model claims that capital accumulation in an economy, and how
people make use of it, is important for determining economic growth.

It further claims that the relationship between capital and labor in an economy determines its
total output. Finally, the theory states that technology augments labor productivity, increasing the
total output through increased efficiency of labor. Therefore, the production function of the
neoclassical growth model is used to measure the economic growth and equilibrium of an
economy. The general production function in the neoclassical growth model takes the following
form:

Y = AF (K, L)
Where:
Y – Income, or the economy’s Gross Domestic Product (GDP)
K – Capital
L – Amount of unskilled labor in the economy
A – Determinant level of technology
Also, because of the dynamic relationship between labor and technology, an economy’s
production function is often re-stated as Y = F (K, AL). This states that technology is labor
augmenting and that workers’ productivity depends on the level of technology.

Assumptions of the Neoclassical Growth Model

Capital subject to diminishing returns: An important assumption of the neoclassical growth

model is that capital (K) is subject to diminishing returns provided the economy is a closed
economy.
Impact on total output: Provided that labor is fixed or constant, the impact on the total output of
the last unit of the capital accumulated will always be less than the one before.

Steady state of the economy: In the short term, the rate of growth slows down as diminishing
returns take effect, and the economy converts into a “steady-state” economy, where the economy
is steady, or in other words, in a relatively constant state.

Key Conclusions of the Neoclassical Model of Growth

Output as a function of growth: The neoclassical growth model explicates that total output is a
function of economic growth in factor inputs, capital, labor, and technological progress.

Growth rate of output in a steady-state equilibrium: The growth rate of total output in a steady-
state equilibrium is equal to the growth rate of the population or labor force and is never
influenced by the rate of savings.

Increased steady-state per capita income level: While the rate of savings does not influence the
steady-state economy growth rate of total output, it does result in an increase in the steady-state
level of per capita income and, therefore, total income as well, as it raises the total capital per
head.

Long-term growth rate: The long-term growth rate of an economy is solely determined by
technological progress or regress.

3. Endogenous Growth Theory

The Endogenous Growth Theory states that economic growth is generated internally in the
economy, i.e., through endogenous forces, and not through exogenous ones. The theory contrasts
with the neoclassical growth model, which claims that external factors such as technological
progress, etc. are the main sources of economic growth.

Key Policy Implications of Endogenous Growth Theory

Governmental policies can raise an economy’s growth rate if the policies are directed toward
enforcing more market competition and helping stimulate innovation in products and processes.

There are increasing returns to scale from capital investment in the “knowledge industries” of
education, health, and telecommunications.
Private sector investment in R&D is a vital source of technological progress for the economy.

STRUCTURAL CHANGE THEORY

Focuses on the mechanism by which under developed economies transforms their domestic
economic structures from a heavy emphasis on traditional subsistence agriculture to a more
modern, more urbanized, and more industrially diverse manufacturing and service economy. It
employs tools of neoclassical price and allocation of resources theory and modern econometrics
to describe how this transformation process takes place.

THE HAROD – DOMAR GROWTH MODEL

The model explains the relationship between capital accumulation rate and the rate of economic
growth. According to this model, for an economy to grow, the following assumptions are
important.

1. The economy must save a certain proportion of national income and income should be
invested in capital goods in order to replace worn out capital and increase its capital stock.

Capital accumulation has two vital roles.

(i) To expand the productive capacity of the economy ie. Supply side.

(ii) To raise incomes i.e. on the demand side

Change in capital stock (K) = Net new investment ie. I = ΔK Note that; Net new investment =
growth investment less depreciation

2. There is a direct economic relationship between capital stock (K)and Total output or GDP (Y)
ie capital is released to increase output through the capital-out put ratio K,Y; k = K/Y

3. The national savings ratio (S) is a fixed proportion of national income such that total savings is
(S) is a function of national income s=f (Y) or S=sY small s is certain proportion of Y saved.

4. Total new investment (I) is a function of national savings (S) I = S from the above
assumptions the model can be constructed as follows. Total national savings (S) is proportion of
income (Y) S= sY…………. ………………..(i)
That investment (I) is defined as change in capital stock I =ΔK …………….. (ii)

From assumption 2 above

We have k= K/Y which implies that suppose there is Δ k = K/Y

ΔK = k ΔY If ΔR what happens is ΔK = kΔY………………. (iii)

We also know that at equilibrium for a simple economy

Total national savings must be equal total invest ie I = S From equations (i) (ii) and (iii)

S = sY = kΔY = ΔK =I

sY = kΔY ………………. iv

Suppose we divide both sides by sY =kΔY/ kY kY

k ∆Y
sY = then divide by kY both sides of the equation
kYkY

❑
❑

s = ΔY but Δ Y = Economic growth k Y Y

Therefore, according to Harrod – Domar G = s/k ………………… (v)

k Where g is economic growth rate of the national economy s is national savings ratio k capital
output ratio. Therefore, the rate of growth of GDP (g) is determined jointly by national savings
ratio (s) and national output ratio (k specifically g is positively related to s and inversely related
❑❑
to k. ❑ ❑

SIGNIFICANCE OF THE MODEL

1. It emphasizes the importance of savings and investment (K-accumulation in economic

development. That for an economy to attain a given rate of economic growth it must achieve a
certain level of savings and investment given that domestic savings are sufficient to achieve the
rate of economic growth of the economy. Therefore, the model is important in explaining low
levels of growth in an economy like Uganda where level of savings as a proportion of GDP is
low.

2. The model also suggests that for economic growth to take place, it is important to improve
efficiency and productivity i.e. capital output ration must be low such that the efficiency and of
capital output ratio must be high i.e the LDCs tend to have high capital output ratio of about 4
which is twice as much as that of advanced countries. This is mainly due to lack of co-operant
factors and use of poor technology.

3. For economic growth to take place investment should be done in investment assets ie capital
goods like machinery and buildings etc.

LIMITATIONS OF MODEL

1. It is misleading to assume that any increase in output is due to capital accumulation but a
combination of other factors acts jointly to increase output. e.g. Political, economic stability,
good infrastructures, entrepreneur class and good must work hand in hand for development to
take place.

2. The model only considers physical capital and ignores human capital as a form of investment

3. There is need to distinguish between the average and marginal or incremental capital output
ratio. This model is based on incremental capital out put the ratio and not the average output
ratio. However due to limitations of data most theories consider the average capital output ratio.

4. The model is based on weaker assumptions that for any economy the level of investment = to
its savings. However, given the present nature of capital mobility and international investment a
country can invest far in excess of its savings.

5. The model is developed in the context of developed economies which have already achieved
growth. It therefore seeks to find out by how much income would have to increase to induce
sufficient investment to sustain this rate of growth, rather than answering the poor nation’s
fundamental problems of how to initiate the higher rate of growth in the 1st place.
6. The model assumes that other co-operant factors exist and increase at the same rate as the
increase capital. However, the problems of developing countries include lack of other factors
such as skilled labour technology, political and economic stability etc.

7. The model has been criticized for its failures to draw a clear difference between capital goods
and consumer goods.