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Investment – Economic Growth and the Middle Income Trap A2 Macro – Autumn 2013 07:04:35 PM
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Growth Economics

Nov 29, 2014

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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
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Page 1: Growth Economics

05:38:51 PM

Investment – Economic Growth and the Middle Income Trap

A2 Macro – Autumn 2013

Page 2: Growth Economics

05:38:51 PM

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Page 3: Growth Economics

05:38:51 PM

Sources of Economic Growth

Economic growth

Capital stock

Active labour supply

Natural resources

Factor productivity

Innovation

Page 4: Growth Economics

05:38:51 PM

China and UK GDP GrowthGrowth rate of GDP, annual % change at constant prices

China and the UK - Growth Compared

Source: Reuters EcoWin

04 05 06 07 08 09 10 11 12 13

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

15.0

Pe

rce

nt

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

15.0

China

United Kingdom

Page 5: Growth Economics

05:38:51 PM

Global GDP: A Changing World2005 2006 2007 2008 2009 2010 2011

Emerging markets 31.1 33.9 36.4 39.7 42.4 43.4 46.0

of whichChina 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 whichUS 23.8 22.9 21.2 18.9 19.8 19.2 18.0Japan 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.

Page 6: Growth Economics

05:38:51 PM

Harrod-Domar Model

Increase national savings

Increase in net

investment

Larger capital stock

Rise in real GDP / GNI

Increased factor

incomes

Page 7: Growth Economics

05:38:51 PM

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

Page 9: Growth Economics

05:38:51 PM

Importance of Investment as a Growth Driver

Injection of demand for capital goods industries

Multiplier effects through supply chains

Page 10: Growth Economics

05:38:52 PM

Importance of Investment as a Growth Driver

Lift rural productivity / incomes Economies of scale & competitiveness in fledgling sectors

Page 11: Growth Economics

05:38:52 PM

Importance of Investment as a Growth Driver

Investment to cope with rural-urban migration

Investment to sustain export-led growth

Page 12: Growth Economics

05:38:52 PM

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

Page 13: Growth Economics

05:38:52 PM

Investment and Saving as % of GDPGross capital formation Gross savings

% of GDP % of GDP2000 2011 2000 2011

Mongolia 29 63 23 31China 35 48 37 53Qatar 20 39India 24 35 25 31Vietnam 30 35 31 33Nepal 24 33 22 34South Korea 31 29 33 32Australia 26 27 21 25Sub-Saharan Africa 17 21 16 17Brazil 18 20 14 17Germany 22 18 20 24Greece 25 16 14 5United Kingdom 18 15 14 13United States 21 15 18 12Ireland 24 10 24 12

Page 14: Growth Economics

05:38:52 PM

China – Investment’s Contribution to GDP Growth

Overall, Total, Contribution share to GDP growth, Constant Prices, %

China - Gross Capital Investment

Source: Reuters EcoWin

98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

20

30

40

50

60

70

80

90

Pe

rce

nt

20

30

40

50

60

70

80

90

Page 15: Growth Economics

05:38:52 PM

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.”

Page 16: Growth Economics

05:38:52 PM

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

Page 17: Growth Economics

05:38:52 PM

Page 18: Growth Economics

05:38:52 PM

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

Page 19: Growth Economics

05:38:52 PM

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

Page 20: Growth Economics

05:38:52 PM

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

Page 21: Growth Economics

05:38:53 PM

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

Page 22: Growth Economics

05:38:53 PM

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

Page 23: Growth Economics

05:38:53 PM

Unbalanced growth in ChinaBoth 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

Page 24: Growth Economics

05:38:53 PM

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

Page 25: Growth Economics

05:38:53 PM

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

Page 26: Growth Economics

05:38:53 PM

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

Page 27: Growth Economics

05:38:53 PM

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!

Page 28: Growth Economics

Causes of the Middle-Income TrapRising 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

Page 29: Growth Economics

Causes of the Middle-Income TrapRising 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

Page 30: Growth Economics

Causes of the Middle-Income TrapRising 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

Page 31: Growth Economics

Causes of the Middle-Income TrapRising 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

Page 32: Growth Economics

Causes of the Middle-Income TrapRising 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

Page 33: Growth Economics

Causes of the Middle-Income TrapRising 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

Page 34: Growth Economics

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

Page 35: Growth Economics

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

Page 36: Growth Economics

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

Page 37: Growth Economics

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

Page 38: Growth Economics

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

Page 39: Growth Economics

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

Page 40: Growth Economics

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

Page 41: Growth Economics

05:38:55 PM

Middle Income Trap

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.

Page 42: Growth Economics

05:38:55 PM

What else matters for growth?

Trust Trade Institutions

Dynamic Private Sector Sound Macro Policies Equity / Fairness

Page 43: Growth Economics

05:38:55 PM

What else matters for growth?

Trust Trade Institutions

Dynamic Private Sector Sound Macro Policies Equity / Fairness

Page 44: Growth Economics

05:38:55 PM

What else matters for growth?

Trust Trade Institutions

Dynamic Private Sector Sound Macro Policies Equity / Fairness

Page 45: Growth Economics

05:38:55 PM

What else matters for growth?

Trust Trade Institutions

Dynamic Private Sector Sound Macro Policies Equity / Fairness

Page 46: Growth Economics

05:38:55 PM

What else matters for growth?

Trust Trade Institutions

Dynamic Private Sector Sound Macro Policies Equity / Fairness

Page 47: Growth Economics

05:38:55 PM

What else matters for growth?

Trust Trade Institutions

Dynamic Private Sector Sound Macro Policies Equity / Fairness

Page 48: Growth Economics

05:38:55 PM

Upgrading an economyPolicies 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

Page 49: Growth Economics

05:38:55 PM

Upgrading an economyPolicies 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

Page 50: Growth Economics

Threats to Growth

05:38:56 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

Page 51: Growth Economics

05:38:56 PM

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