Harrod-Domar theory
Aggregate supply and aggregate demand analysis helps economists understand output gaps, inflation and unemployment by evaluating the equilibrium aggregate demand and aggregate supply. However, this is a short run concept.
For a simple economy, where there are only two sectors, households and firms - there is no government or external trade) - the following is true.
- The injections into an economy are equal to the leakages. In this simple economy this means that savings are equal to investment, so S = I.
- The savings in an economy, S, can be expressed as a proportion of national income, Y. Let s be this proportion, the savings ratio. Then S = sY.
- Net investment, I, is the change in capital stock in an economy (i.e. investment less depreciation). This means I = ΔK.
- The capital to output ratio, k, is the amount of capital needed for a given output or the change in capital required to bring about a given change in national income. Then k = ΔK/ΔY (or k = K/Y).
These four statements can be rearranged to give s/k = ΔY/Y, where ΔY/Y is the annual change in national income - economic growth. S is the savings ratio as explained above, and k-1 is the output to capital ratio, the output from a given capital stock (or investment).
The following relationships can then be seen.
Homework
For Monday 20th September read and summarise the article "Credit for Bangladesh" by Peter Smith (published in Philip Allan Updates ISSN 0265 0290 in 1999) as a case study to illustrate the above set of relationships.
Case study on Bangladesh
Bangladesh is a very poor country. In 2003 the GNP per capita was US$400. Just give years earlier in 1999 this was US$240. Bangladesh has a very large population, in 2003 a population just under 140 million people, growing at a rate of 1.7% a year.
As Bangladesh is very poor the people have very little money spare to save, and so they have a very low savings ratio. When an individual chose to save they would rarely use any financial institution, either keeping the money safe in their house or investing it.
Whilst financial markets exist in Bangladesh and have developed within the urban areas, the large rural population could not access these services, as large financial firms did not see the market as a profitable one to enter. This meant that firms and individuals did not borrow money to invest, so did not see take off. These problems can be illustrated on a diagram showing the process required for self-sustaining growth.
Bangladesh has tried to increase investment into the economy however this has proved hard work. Exports represent only a small proportion of GDP and there was virtually no foreign direct investment. Bangladesh had borrowed heavily, $16bn, more than half the GDP of the economy, yet this had proven ineffective to stimulate the economy.
In 1976 the Grameen Bank was set up. This was set up in order to provide small loans at reasonable rates. Over US$4.4bn had been loaned by July 2004 in small amounts to groups of people to invest in goods such as sewing machines or rickshaws. This chance to borrow money and invest has helped growth and so should lead to increased savings. Whilst Bangladesh has, with the help of the Grameen Bank, started the process Bangladesh has not yet achieved take off.
These notes form a homework given in a lesson on 20/09/2004 and a homework given in that lesson.
