Factors affecting economic growth in developing countries
There are some economic facts of life that underpin all macroeconomic explanations of growth. Perhaps the most important is that in order for capital goods to be accumulated to produce greater quantities of consumer goods in the future, consumer goods have to be given up in the present. For example, if workers are building a textile factory they cannot simultaneously be making textiles these will only appear in the future as a result of the sacrifices of the present.
Increases in the amount of capital goods are called investment. For growth to occur the level of investment has to be greater than the amount of depreciation, i.e. the amount by which machines wear out or become obsolete during the year. The higher the level of investment above depreciation the greater the potential output of the economy in the future.
Unfortunately, the resources to enable investment have to come from somewhere. The only way that workers can be freed from making cars to build car factories is by an increase in savings by households i.e. by the postponement of any decision to buy goods today in favour of future consumption. Look now at the investment figures for your six case study countries and think about the differences between them, particularly those between Asian and Latin American countries. Notice also the very marked regional differences in investment and savings rates. The analysis above gives the traditional PPF model of economic growth. In the diagram below, a country starting with high levels of current consumption will have few resources available for investment. Its PPF will increase only slowly, if at all. A country succeeding in restricting consumption today will have an expanded PPF in the future, and can move to a point of higher consumption.
It may be the case that governments are not well enough informed to make investment decisions which reflect market circumstances. However, some kinds of investment are subject to market failure and government provision may therefore be necessary. For example, the provision of infrastructure is difficult to achieve in a free market it has too much of a public good aspect to be provided effectively by private companies.
General macroeconomic conditions are very important in terms of the general climate under which investment decisions are made. So economic growth will depend to some extent upon the stability of the economy e.g. fiscal balance, and reasonably predictable levels of inflation. Macroeconomic stability reduces the risks of investment and might therefore be seen as a necessary condition for growth. Fiscal balance ensures that there is less risk of inflation, because there will be less risk of governments printing money. This may also stabilise the exchange rate and allow interest rates to be set at a reasonably low level - so further encouraging investment.
Stability is also an important factor in the amount of foreign direct investment a country may be able to attract. For developing countries this may be the only realistic source of investment funds.
Trade Liberalisation, Capital Mobility and Exchange Rate Policy
The abolition of trade restrictions (tariffs and quotas) is often seen as a necessary condition for growth. The idea is to widen markets and thus allow economies of scale in exporting industries.
It is often argued that exchange rates need to be adjusted downwards at the same time, to ensure that potential exporters can compete on world markets. To encourage direct foreign investment restrictions on international capital flows may need to be reduced. These policies have often been introduced to satisfy the conditions of IMF loans this is discussed in more detail under structural adjustment policies. However, such policies are extremely controversial. Free trade did not seem to be a necessary condition for European growth. Certainly, exposure to foreign competition may increase the productivity of companies that survive but the side-effects for what are likely to be some of the poorest people in developing countries are likely to be severe.
Savings and Investment
There are some economic facts of life that underpin all macroeconomic explanations of growth. Perhaps the most important is that in order for capital goods to be accumulated to produce greater quantities of consumer goods in the future, consumer goods have to be given up in the present. For example, if workers are building a textile factory they cannot simultaneously be making textiles these will only appear in the future as a result of the sacrifices of the present.
Increases in the amount of capital goods are called investment. For growth to occur the level of investment has to be greater than the amount of depreciation, i.e. the amount by which machines wear out or become obsolete during the year. The higher the level of investment above depreciation the greater the potential output of the economy in the future.
Unfortunately, the resources to enable investment have to come from somewhere. The only way that workers can be freed from making cars to build car factories is by an increase in savings by households i.e. by the postponement of any decision to buy goods today in favour of future consumption. Look now at the investment figures for your six case study countries and think about the differences between them, particularly those between Asian and Latin American countries. Notice also the very marked regional differences in investment and savings rates. The analysis above gives the traditional PPF model of economic growth. In the diagram below, a country starting with high levels of current consumption will have few resources available for investment. Its PPF will increase only slowly, if at all. A country succeeding in restricting consumption today will have an expanded PPF in the future, and can move to a point of higher consumption.
Government-Financed Investment
It may be the case that governments are not well enough informed to make investment decisions which reflect market circumstances. However, some kinds of investment are subject to market failure and government provision may therefore be necessary. For example, the provision of infrastructure is difficult to achieve in a free market it has too much of a public good aspect to be provided effectively by private companies.
Macroeconomic Stability
General macroeconomic conditions are very important in terms of the general climate under which investment decisions are made. So economic growth will depend to some extent upon the stability of the economy e.g. fiscal balance, and reasonably predictable levels of inflation. Macroeconomic stability reduces the risks of investment and might therefore be seen as a necessary condition for growth. Fiscal balance ensures that there is less risk of inflation, because there will be less risk of governments printing money. This may also stabilise the exchange rate and allow interest rates to be set at a reasonably low level - so further encouraging investment.
Stability is also an important factor in the amount of foreign direct investment a country may be able to attract. For developing countries this may be the only realistic source of investment funds.
Trade Liberalisation, Capital Mobility and Exchange Rate Policy
The abolition of trade restrictions (tariffs and quotas) is often seen as a necessary condition for growth. The idea is to widen markets and thus allow economies of scale in exporting industries.
It is often argued that exchange rates need to be adjusted downwards at the same time, to ensure that potential exporters can compete on world markets. To encourage direct foreign investment restrictions on international capital flows may need to be reduced. These policies have often been introduced to satisfy the conditions of IMF loans this is discussed in more detail under structural adjustment policies. However, such policies are extremely controversial. Free trade did not seem to be a necessary condition for European growth. Certainly, exposure to foreign competition may increase the productivity of companies that survive but the side-effects for what are likely to be some of the poorest people in developing countries are likely to be severe.
