The simplest form for the accelerator theory is:
It = a( Y1 – Y(t-1))
It is investment in a specific year t. Y1 – Y(t-1) is the change in income during year t and a is the accelerator coefficient or capital output ratio. We will be looking in greater detail at the capital output ratio and its significance for India.
See graph for relationship.
This model has a number of limitations. First it assumes that capital will have the same level of productivity at all times. I.e. it cannot increase in quality. This is quite clearly not the case. £1000 worth of capital equipment now can produce a higher output than £1000 of equipment in the 1950’s.
Therefore if demand would increase by 10%, the increase in spending for capital equipment will be less as time goes on as the equipment gets more efficient.
Expectations have a considerable effect on investment. If buyers are pessimistic and expect a recession they will not buy as much even if growth is higher than expected.
Investment may also increase if there is an improvement in entrepreneurial skills. Entrepreneurs are more likely to buy capital equipment to exploit opportunities. Consequently net investment will increase.
Also some companies will run with excess capacity so when demand increases, they need not buy more capital equipment.
Economic growth
Economic growth is defined as an increase in the output of a countries goods and services from one year to another.
PPC’s (production possibility curves) can be used to show the effects of economic growth.
As you can see, at point A, the economy is producing right on the line. This signifies that it is producing its production potential i.e. there is an efficient allocation of resources. Economic growth will increase the economies potential, and correspondingly the line will move out. This means that more goods can (but not necessarily are) be produced than before. In this example, actual growth (B-A) matches the growth of potential. The diagram can also show inefficient use of resources. Point C is not at the edge of its production potential. It can be improved with better allocation of resources.
Methods for increasing economic growth
I will be measuring the output of goods and services in GDP at constant 1995 prices. Constant prices takes into account inflation so the wealth of a country is not unduly exaggerated by increasing prices. I will also be using GDP per capita quite a lot. This is useful as it takes into account changes in population so you this is an excellent way to measure standard of living in the country. You would use GDP to see the general wealth of a country. For example people in Switzerland at $33000 p.a. have a higher standard of living than US at $29000 p.a., but US is far richer than Switzerland.
There are 4 basic ways to increase economic growth in the long run.
1. Increase the quantity of factors of production (land, labour, capital enterprise.)
2. Increase the quality of factors of production
3. Technological progress, which makes many jobs more productive and efficient.
4. Increasing efficiency of industry
I will be concentrating on the increasing quality of capital equipment and labour, rather than land and enterprise. Land is difficult to improve compared to capital and labour and the enterprise factor comes a little into the improving of labour. However enterprise is impossible to quantify and therefore I will ignore it for this coursework.
Labour
There are many ways in which labour can be improved to increase economic growth. Quantity can be increased by natural population growth. More people working ensure higher output leading to economic growth. Some economists believe that investment in human capital (spending on education and training) is the most determinant of economic growth. Better educated people will generally produce higher output than those with less education. Therefore the economy will grow at a faster rate with a better educated workforce. Also net immigration and changes in demographics (a higher proportion of one age group from the other) will increase the number of people in the work force, thus increasing output.
Capital
Capital is often referred to as “the key to economic growth.” Many western countries have facilitated their economic growth by increasing primarily their capital stocks. The stock of capital goods increases when gross investment (total investment) exceeds capital consumption i.e. the using up of capital (depreciation.). This difference is called net investment. Assuming that the replacement machines are more productive than the old ones, net investment must increase potential output. An important point to make is that increasing capital spending in line with population is called capital widening. This results in keeping GDP per capita constant i.e. only increasing GDP by the rate of population increase. To make the ordinary person wealthier you must increase the amount of capital per worker. This is called capital deepening. This will increase the rate of GDP above population increase. Also savings ratio needs to kept comparatively high. If injections + leakages
There are also many ways of increasing the quality of capital goods. Technological progress thanks to innovation and research and development will increase the productivity of the capital equipment, increasing rate of change of output.
Efficiency
This is an often overlooked but extremely important factor of economic growth. First you should make the right decisions about how to use the equipment. The argument is that the quantity of investment is not important but its direction .For example Concorde in its early days wasn’t profitable. Some economists argue that the government aren’t the best people to judge where best to invest. There are usually too many external political pressures for a government to make a rational decision based on likely return of investment. Usually the risk taker is the person best able to make an informed decision about where to invest. Investment in the wrong place is often useless, witness the Labour governments investment in the failing shipping industry in the 70’s and the Indian government’s obsession with heavy industry in the early ‘50’s. Economic planning from the State is generally a recipe for disaster because of the lack of innovation and incentives for the workers.
Another important factor is being open to foreign trade. Governments are prone to putting up barriers and tariffs in order to protect domestic industries. This will generally lead to inefficiency in the industry, as there is less competition. There is reduced incentive to innovate as the companies are guaranteed a market. Also export laws prevents people buying capital equipment from abroad so that the better equipment of foreign countries can’t be used to reduce costs and increase productivity. It also prevents foreign firms from setting up factories and bringing in money in the country.
The Harrod Domar model of economic growth
This model argues that savings ratio, investment, and technological change are key variables in determining economic growth.
It is expressed as
Rate of Growth = S/k
where S is saving ratio and K is ratio of capital:output. The implications of this model are clear. To stimulate growth, saving has to be increased which increases investment (see before.), or technological improvement which will lower k and increase output. I will be using this frequently in my analysis of the data. However this is a very simple model. It assumes a closed economy. IT may not be savings that restricts investment but a lack of opportunities
Lewis Model
W Arthur Lewis believed that it was possible for LDC’s to grow rapidly by the process of people switching from a largely low productive rural jobs to high output urban jobs. He argued that initially due to the people flooding in from the farms the wages of the relatively high paid city jobs could stay constant thus reducing costs and increasing productivity.
Figures Used
I will be using GDP figures for both countries. Also net investment figures and education expenditure figures expressed as a percentage of GDP. Also we will be looking at productivity of capital (capital output ratio.)
Education figures. These numbers are the total government spending on education expressed as a percentage of GDP.
Saving Ratio this is the ratio of saving in the economy to the total GDP. It is expressed as a percentage.
Analysis
The growth of India’s economy pre 1990 has, whilst not been at 7% year on year, was reasonable. The average trend rate of growth from independence in 1947 to 1990 was 3.5% (see GDP graph 1) This “normal” growth figure for post war countries means that India is placed below the other Asian “tiger” economies in terms of size of growth. However it means that India is relatively well placed to record its ‘big push’ experienced by Japan in the ‘60’s and ‘70’s and South Korea and Indonesia in the ‘80’s.
There are many reasons why India’s growth has been stuck at 3.5% for so long.
A Quick History Lesson (Bullet Point this)
When India gained independence from the Britain in 1948 Jawarharlal Nehru became the first Prime Minister of the Congress Party. He became impressed (as many others were at the time) with the mobilisation of resources by the Soviet Union. Nehru then embarked on a policy of Fabian socialism, with a lot of barriers to entry to protect India’s fledgling heavy industries. He also made use of Soviet style 5 Year Plans, which gave targets for all the major industries to fulfil. He also stopped international companies like Coke and Ford from selling their products in India. Sheltered behind protective walls and used to a policy of planning, Indian industry became increasingly less productive and useless. Thanks to the lack of trade foreign machinery wasn’t used, so when the investment rate was high it was being used to buy Indian goods, which thanks to the lack of competition at home and abroad wasn’t up to scratch. There was a definite problem with productivity of machinery. There were also some definite problems with the substantial public sector. It went well beyond the conventional confines of public utilities and infrastructure like health, transport, police and the army. This just became inefficient, due to no incentive to innovate and a lack of productivity and efficiency in the enterprises.
We therefore have 3 main reasons why India’s economy has underperformed in the last 50 years.
1. Over licensing and too much bureaucratic control over investment, production and trade
2. Foreign investment policies geared towards protectionism
3. A substantial public sector, far bigger than any western country in scale and breadth.
We will now look at all 3 and see how the Indian government has tried to combat all 3 which led to such success during the 1990’s
Over licensing
The controls of trade and industry in India are truly vast.