Updated presentation on aspects of factors affecting economic growth including the middle income trap. Designed as a resource for A2 macro - unit 4 Development Economics

1. Investment – Economic Growth
and the Middle Income Trap
A2 Macro – Autumn 2013
3:10:23 PM

2. Get help from fellow
students, teachers and
tutor2u on Twitter:
#econ4
@tutor2u_econ
3:10:23 PM

3. Sources of Economic Growth
Economic
growth
Capital stock
Active labour supply
Natural resources
Factor productivity
Innovation
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4. China and UK GDP Growth
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5. Global GDP: A Changing World
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2005 2006 2007 2008 2009 2010 2011
Emerging
markets
31.1 33.9 36.4 39.7 42.4 43.4 46.0
of which
China 9.8 11.1 12.7 15.2 18.3 17.7 19.9
Other EM 21.3 22.8 23.7 24.5 24.1 25.7 26.1
Western
world
68.9 66.1 63.6 60.3 57.6 56.6 54.0
of which
US 23.8 22.9 21.2 18.9 19.8 19.2 18.0
Japan 13.1 11.6 10.3 10.3 10.3 11.0 10.2
Rest of
world
32.0 31.6 32.1 31.1 27.5 26.4 25.8
Source: private data made available by IHS Global Insight; UN statistical service; other data from charts
in “The New Industrial Revolution: Consumers, Globalization and the End of Mass Production”, Peter
Marsh, Yale University Press, 2012.

6. Harrod-Domar Model
Increase
national
savings
Increase in
net
investment
Larger capital
stock
Rise in real
GDP / GNI
Increased
factor
incomes
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7. Harrod-Domar Growth Model
• Model stresses the importance of savings and investment
• Rate of growth depends on:
– Level of national saving (S)
– Productivity of capital investment (capital-output ratio)
• The Capital-Output Ratio (COR)
– For example, if £100 worth of capital equipment
produces each £10 of annual output, a capital-output
ratio of 10 to 1 exists.
– When the quality of capital resources is high, then the
capital output ratio will be lower
• Rate of growth of GDP = Savings ratio / capital output ratio
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8. 3:10:24 PM

9. Importance of Investment as a Growth Driver
Injection of demand for
capital goods industries
Multiplier effects
through supply chains
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10. Importance of Investment as a Growth Driver
Lift rural productivity / incomes
Economies of scale &
competitiveness in fledgling sectors
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11. Importance of Investment as a Growth Driver
Investment to cope with
rural-urban migration
Investment to sustain
export-led growth
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12. Importance of Investment as a Growth Driver
Injection of demand for capital
goods industries
Multiplier effects through supply
chains
Bigger capital stock can lift rural
productivity / incomes
Economies of scale &
competitiveness in fledgling
sectors
Investment to cope with rural-
urban migration
Investment to sustain export-led
growth
3:10:24 PM

13. Investment and Saving as % of GDP
Gross capital formation Gross savings
% of GDP % of GDP
2000 2011 2000 2011
Mongolia 29 63 23 31
China 35 48 37 53
Qatar 20 39
India 24 35 25 31
Vietnam 30 35 31 33
Nepal 24 33 22 34
South Korea 31 29 33 32
Australia 26 27 21 25
Sub-Saharan Africa 17 21 16 17
Brazil 18 20 14 17
Germany 22 18 20 24
Greece 25 16 14 5
United Kingdom 18 15 14 13
United States 21 15 18 12
Ireland 24 10 24 12
3:10:24 PM

14. China – Investment’s Contribution to
GDP Growth
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15. China’s Investment Driven Growth
“Economic commentators
have often expressed
concerns that economic
growth in China is
unbalanced, with an
investment-driven model
that is not sustainable in
the future unless it is
shifted toward a more
consumption-driven
model.” (FT, Sept 2013)
• As economies develop, they typically need higher capital investment
• Is China over-investing?
• An IMF report in 2012 argued that “investment in China may currently be around 10 per cent
of GDP higher than suggested by fundamentals.”
3:10:24 PM

16. Linda Yueh – China’s Growth
• Real GDP growth - 9.6% pa since 1979
• 60-70% has come from increasing
capital and labour inputs (input
accumulation)
• 30-40% has come from rising total
factor productivity growth (increasing
efficiency)
• Inputs: 50% of growth from adding capital,
10-20% from adding workers
• Increases in per capita output
(productivity)
• 11-15% gains in human capital
• 8-15% improving allocative efficiency
(moving from state-owned to private +
rural to urban)
• 16-17% from the effects of innovation
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17. 3:10:24 PM

18. Harrod-Domar Model - Constraints
Persistent savings gap in some
countries
Small scale financial
institutions
Weaknesses in human capital
to adapt to investment
Risks from unbalanced growth
(C v I)
Investment and natural
resource depletion
3:10:24 PM

19. Harrod-Domar Model - Constraints
Persistent savings gap
in some countries
In many smaller low-income
countries, high levels of
extreme poverty make it
almost impossible to
generate sufficient savings
to provide the funds needed
to fund investment projects.
This increases reliance on
tied aid
Some countries borrow
heavily to fund capital
investment projects – this
can lead to a high level of
external debt
3:10:24 PM

20. Harrod-Domar Model - Constraints
Small scale financial
institutions
Financial markets help to
channel domestic savings into
funding for investment projects
Many of the least developed
countries have limited financial
markets such as banking,
money and credit systems,
insurance markets and stock
markets
3:10:24 PM

21. Harrod-Domar Model - Constraints
Weaknesses in human capital
to adapt to investment
Investment increases the size
of the capital stock and helps
to achieve “capital
deepening” (capital per
worker) but the skills and
experience to make best use
of new technology
In many countries there are
acute shortages of human
capital
Some countries lose some of
its limited skilled workforce to
other countries through a
brain drain
3:10:24 PM

22. Harrod-Domar Model - Constraints
Risks from unbalanced
growth (C v I)
1. High levels of capital investment
might un-balance the economy
2. Depressing short-term living
standards
3. Low quality investment projects
given the go-ahead
4. Risks of investment bubbles e.g.
in new house-building
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23. Unbalanced growth in China
Both China and Japan have adopted the so-called “Asian growth model”.
This involves generating breakneck economic growth with very high levels
of investment and export expansion. Manufacturers are subsidised with
cheap capital, while exports are boosted by an artificially depressed
exchange rate. National savings are encouraged, at the expense of
domestic consumption. Low interest rates reduce the return on
household savings, while a cheap currency makes imports more
expensive.
This set of mercantilist policies delivers economic miracles during the
boom years, but it tends to culminate in excess investment, lacklustre
domestic demand, credit and real estate bubbles, and the widespread
misallocation of capital. The macroeconomic imbalances produced by
China are on an epic scale. Household consumption, at an astonishingly
low 35 per cent of GDP, is just over half the global average.
Source: Edward Chancellor, FT, August 2013
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24. Harrod-Domar Model - Constraints
Investment and natural
resource depletion
• Natural resources provide a source
of wealth for many lower-income
countries
• When world prices are high, there
is an incentive to increase
investment and extraction rates to
boost short-term export earnings
• This can damage growth potential
3:10:24 PM

25. Ideas, Institutions and Innovation
The growth that lifts a country from being lower-income to
middle income is not necessarily the same type of growth
needed to move from middle to higher income status.
Input driven growth can only take countries so far along
development paths
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26. The Middle Income Trap
“The concept
defines the fast-
growing economies
that face a possible
dilemma of being
caught between
poverty and
prosperity”
Source: World Bank
Development Blog
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27. The Middle Income Trap
According to the
OECD, only 17
countries have
joined ranks of rich
nations in the post
war period by
breaking out of the
middle income trap
- this includes
Greece and
Portugal!
3:10:24 PM

28. Causes of the Middle-Income Trap
Rising wages / unit labour costs
Productivity slowdown
Challenges of moving up the
product value chain
Institutional Weaknesses
Challenge of maintaining macro-
economic stability
2:32:17 PM

29. Causes of the Middle-Income Trap
Rising wages / unit labour costs
Productivity slowdown
Challenges of moving up the
product value chain
Institutional Weaknesses
Challenge of maintaining macro-
economic stability
2:32:17 PM
Rapid wage inflation in
China

30. Causes of the Middle-Income Trap
Rising wages / unit labour costs
Productivity slowdown
Challenges of moving up the
product value chain
Institutional Weaknesses
Challenge of maintaining macro-
economic stability
2:32:17 PM
Rapid wage inflation in
China
Requires better capital
and more innovation

31. Causes of the Middle-Income Trap
Rising wages / unit labour costs
Productivity slowdown
Challenges of moving up the
product value chain
Institutional Weaknesses
Challenge of maintaining macro-
economic stability
2:32:17 PM
Rapid wage inflation in
China
Requires better capital
and more innovation
Moving away from low
value manufacturing

32. Causes of the Middle-Income Trap
Rising wages / unit labour costs
Productivity slowdown
Challenges of moving up the
product value chain
Institutional Weaknesses
Challenge of maintaining macro-
economic stability
2:32:17 PM
Rapid wage inflation in
China
Requires better capital
and more innovation
Moving away from low
value manufacturing
Underdeveloped finance
& legal markets

33. Causes of the Middle-Income Trap
Rising wages / unit labour costs
Productivity slowdown
Challenges of moving up the
product value chain
Institutional Weaknesses
Challenge of maintaining macro-
economic stability
2:32:17 PM
Rapid wage inflation in
China
Requires better capital
and more innovation
Moving away from low
value manufacturing
Underdeveloped finance
& legal markets
Threat of high inflation
and trade deficits

34. Avoiding a Middle Income Trap
Rising domestic consumption
Human capital investment
Investment in critical infrastructure
Regional Trade Integration and New Trade Routes
Diversification of industrial base and export industries
Encouraging private sector development
Measures to support inclusive growth
2:32:17 PM

35. Avoiding a Middle Income Trap
Rising domestic consumption
Human capital investment
Investment in critical infrastructure
Regional Trade Integration and New Trade Routes
Diversification of industrial base and export industries
Encouraging private sector development
Measures to support inclusive growth
2:32:17 PM

36. Avoiding a Middle Income Trap
Rising domestic consumption
Human capital investment
Investment in critical infrastructure
Regional Trade Integration and New Trade Routes
Diversification of industrial base and export industries
Encouraging private sector development
Measures to support inclusive growth
2:32:17 PM

37. Avoiding a Middle Income Trap
Rising domestic consumption
Human capital investment
Investment in critical infrastructure
Regional Trade Integration and New Trade Routes
Diversification of industrial base and export industries
Encouraging private sector development
Measures to support inclusive growth
2:32:17 PM

38. Avoiding a Middle Income Trap
Rising domestic consumption
Human capital investment
Investment in critical infrastructure
Regional Trade Integration and New Trade Routes
Diversification of industrial base and export industries
Encouraging private sector development
Measures to support inclusive growth
2:32:17 PM

39. Avoiding a Middle Income Trap
Rising domestic consumption
Human capital investment
Investment in critical infrastructure
Regional Trade Integration and New Trade Routes
Diversification of industrial base and export industries
Encouraging private sector development
Measures to support inclusive growth
2:32:17 PM

40. Avoiding a Middle Income Trap
Rising domestic consumption
Human capital investment
Investment in critical infrastructure
Regional Trade Integration and New Trade Routes
Diversification of industrial base and export industries
Encouraging private sector development
Measures to support inclusive growth
2:32:17 PM

41. Middle Income Trap
3:10:24 PM
Danny Quah
The proposition that fast-growing
economies will slow eventually is
called “neoclassical convergence” —
when capital-deepening has run its
course and any further advance in
prosperity can come only from
technological progress, whether
through indigenous innovation or
through importing techniques from
any economies still running on
ahead. But neoclassical convergence
is an old idea.

42. What else matters for growth?
3:10:25 PM
Trust Trade Institutions
Dynamic Private
Sector
Sound Macro Policies Equity / Fairness

43. What else matters for growth?
3:10:25 PM
Trust Trade Institutions
Dynamic Private
Sector
Sound Macro Policies Equity / Fairness

44. What else matters for growth?
3:10:25 PM
Trust Trade Institutions
Dynamic Private
Sector
Sound Macro Policies Equity / Fairness

45. What else matters for growth?
3:10:25 PM
Trust Trade Institutions
Dynamic Private
Sector
Sound Macro Policies Equity / Fairness

46. What else matters for growth?
3:10:25 PM
Trust Trade Institutions
Dynamic Private
Sector
Sound Macro Policies Equity / Fairness

47. What else matters for growth?
3:10:25 PM
Trust Trade Institutions
Dynamic Private
Sector
Sound Macro Policies Equity / Fairness

48. Upgrading an economy
3:10:25 PM
Policies to support diversification and productive upgrading can help a country
escape the middle-income trap. For example, South Korea has grown it’s
capacity to benefit from trade-led growth in high connectivity and higher value-
added sectors

49. Upgrading an economy
3:10:25 PM
Policies to support diversification and productive upgrading can help a country
escape the middle-income trap. For example, South Korea has grown it’s
capacity to benefit from trade-led growth in high connectivity and higher value-
added sectors

50. Threats to Growth
3:10:25 PM
Many factors can throw a country off their projected long run growth path. Many of
the world’s least developed countries are highly vulnerable
Changes in the real exchange rate affecting competitiveness
Financial instability e.g. unsustainable credit boom and fall in savings
Volatility in world prices for essential imports and key exports
Political instability / military conflicts
Natural disasters and other external supply shocks
Disruptive technologies that threaten existing trade advantages

51. Get help from fellow
students, teachers and
tutor2u on Twitter:
#econ4
@tutor2u_econ
3:10:25 PM