Prague University of Economics and Business Faculty of Informatics and Statistics
Study program: Quantitative Methods in Economics Field of study: Quantitative Economic Analysis
Regression analysis of the relationship between economic growth and foreign aid in Africa
MASTER THESIS
Study programme: Quantitative Methods in Economics Field of study: Quantitative Economic Analysis
Author: JEAN GABIN NGANGO Supervisor: Mgr. Milan Bašta, Ph.D.
Prague, May 2021
Declaration
I hereby declare that I am the sole author of the thesis entitled “Regression analysis of the relationship between economic growth and foreign aid in Africa”. I duly marked out all quotations. The used literature and sources are stated in the attached list of references.
In Prague on ………… Signature
Jean Gabin Ngango
Acknowledgment
First and foremost, I am thankful to Mgr. Milan Bašta Ph. D., my supervisor, for his invaluable guidance, unwavering encouragement, and diligence throughout my thesis and studies. His deep understanding and depth of experience have helped me in my academic journey and everyday life.
I would like to thank my family, for always being my cornerstone and biggest supporter.
Abstract
This thesis explores the impact of foreign aid on growth in Africa. It focuses on whether foreign aid has an effect on capital accumulation and GDP growth. The dataset spans five years, from 2014 to 2018 for 44 countries. According to the regression results, foreign aid has non-linear relationship with economic growth. Foreign aid has a significant impact on investment and economic growth with diminishing returns. Foreign aid has no significance impact on saving as it fails to impact incentives to when choosing between present and future consumption.
Keywords: Africa, Foreign aid, Economic growth, Ordinary least squares, null hypothesis, alternative hypothesis
Table of contents
List of figures ... 1
List of tables ... 2
List of abbreviations ... 3
Chapter I. Introduction ... 4
I.1. Objectives of the thesis ... 5
I.1.1. Specific objectives ... 5
I.1.2. Hypothesis formulation ... 5
I.2. Problem Statement ... 6
I.3. Significance and Organisation of the thesis ... 6
Chapter II. Literature Review ... 7
II.1. Theoretical Framework ... 13
II.1.1. Saving to investment gap ... 16
II.1.2. Approach to Foreign Exchange Earning-Expenditure Gap ... 17
II.1.3. Approach to Capital Absorptive Capability ... 18
II.2. Solow Growth Model ... 22
Chapter III. Data... 27
III.1. Univariate analysis... 29
III.2. Bivariate analysis ... 34
Chapter IV. Regression analysis ... 35
IV.1. Model Specification ... 35
IV.2. Foreign aid and economic growth relationship ... 37
IV.3. Foreign aid and savings relationship... 41
IV.4. Foreign aid and investment relationship ... 43
IV.5. Discussion ... 44
Chapter V. Conclusion. ... 46
References... 48
Appendix ... 53
1 List of figures
FIGURE 1:SOLOW MODEL ... 24
FIGURE 2:THE SOLOW MODEL DYNAMICS ... 24
FIGURE 3:THE SOLOW MODEL WITH AID AS CAPITAL ... 25
FIGURE 4:AID/GDP RANKING ... 30
FIGURE 5:AID/GDP ... 31
FIGURE 6:GDP GROWTH RATE RANKING ... 32
FIGURE 7:GDP GROWTH RATE ... 33
FIGURE 8:SCATTER PLOT OF AID AND GROWTH ... 34
FIGURE 9:AID INTERACTING WITH TRADE OPENNESS... 40
FIGURE 10:AID INTERACTING WITH SAVINGS ... 40
2 List of tables
TABLE 1:TOP 10 BILATERAL DONORS ... 28
TABLE 2:TOP 10 MULTILATERAL DONORS ... 29
TABLE 3:VARIABLES IN VECTOR OF SAVING AND INVESTMENT MODEL ... 35
TABLE 4:VARIABLES IN VECTOR OF AID-GROWTH MODEL ... 36
TABLE 5:DESCRIPTIVE SUMMARY ... 37
TABLE 6:FOREIGN AID EFFECTS ON ECONOMIC GROWTH ESTIMATES ... 38
TABLE 7:F TEST ON IMPACT FOREIGN AID ON ECONOMIC GROWTH ... 39
TABLE 8:FOREIGN AID EFFECTS ON SAVING ESTIMATES ... 42
TABLE 9:FOREIGN AID EFFECTS ON INVESTMENT ESTIMATES... 43
TABLE 10:F TEST ON IMPACT FOREIGN AID ON INVESTMENT ... 44
3 List of abbreviations
ODA Official Development Assistance DAC Development Assistance Committee UNICEF United Nation’s Children Fund
IFAD International Fund for Agriculture Development UNDP United Nation Development Program
IMF International Monetary Fund GDP Gross Domestic Product FDI Foreign Direct Investment
H0 Null hypothesis
H1 Alternative hypothesis RSS Residual sum of square
DF Degree of freedom
4 Chapter I. Introduction
Development assistance is a post war phenomenon. It, as such, has substantially established and given rise to a range of organizations, both bilateral and multilateral, solely employed to aid poor and developing countries. Traditionally, aid has been viewed as something temporary, something complementary of country’s resources but aid has now become a permanent occurrence. All across history, official development assistance (ODA) or foreign aid has been a significant economic growth factor, assisting countries in their development. These aids may include social and economic infrastructure, as well as utilities and production sector assistance, education, water supply, and sanitation are examples of social infrastructure in this case, all with the aim of improving human development and ultimately contributing to long-term sustainable economic growth (Addison & Tarp, 2015).
Government assistance has been the topic of lively controversy over the last five to ten years in Africa due to the underlying basis for assistance. Foreign aid is the instrument by which this very human, actively takes place across borders in modern times and should not normally be controversial, but it is, I would say very much so. Some question the long-term returns on aid because increased inflows of aid could be diverted from their intended function, allowing disbursements to be spent on inefficient economic activities.
Grinding poverty and weak institutional climate in Africa have made foreign aid initiatives an ethical necessity for developed counties. Anyways, we live in a bubble of mutual aid. There is a strong moral obligation for humanitarian organizations to be active in crisis situation.
However, is it a long-term solution? does it help to provide a secure foundation for these countries to develop sustainably? In African countries, aid has become a significant factor, making more or less entirely dependent on it. Fighting poverty in the least developed countries through support for economic growth and development has been the key aim of foreign aid.
Hundreds of NGOs (Non-governmental organizations) are working to make Africa a better place, fighting deadly disease, providing food and water, providing instructors, etc
The extent to which foreign assistance is associated with subsequent economic growth in beneficiaries’ countries still remains unclear. The Millennial Declaration of the United Nations clearly acknowledges that international aid is an important source of funding for better development and the achievement of the development goals (Hailu & Tsukada, 2012), Africa has been falling behind other developing countries, yet it received US$ 1 trillion in the past fifty years. (Moyo, 2009).Governments relying on aid make less organizations to obtain taxes, this makes their citizens less responsible for them. For poorly controlled, vulnerable, and prone economies to outside control, there are many potential channels by which a recipient country is affected by aids. Big, though robust, cash flows into an economy can have adverse effects. . Deterioration of political institutions may lead to less employment prospects and rising levels of poverty. (Moyo, 2009).
There has been some research in recent years on how the current economic and political situation has impacted the aid management capability of African states. The conclusion seems
5 to be that there has been a steady decline in capability, which has exacerbated the dominant policy requirements common to the structural adjustment policy packages in the short to medium term. Thus, while economic and political systems are restructured and reformed, the ability of the African state to control its affairs appears to be significantly weakened. (Jerker Carlsson, 1997).
The question whether or not foreign aid amplify economic growth and effectiveness in using resources has long been questioned, but there is still no consensus among researchers and policy makers. Politically, relevant studies that indicate that aid works best when the policy climate is conducive to growth have shown that when data is extended and or new variables are introduced, it doesn’t hold. (Ann Veiderpass, 2007)
In this thesis, some of the essential question raised are: Is aid so ineffective? How much overseas aid should be provided to developing countries? Should assistance be calculated in terms of demand on the basis of the needs of poor countries? This thesis attempts to add a piece to the foreign aid analysis puzzle by presenting an empirical study of the aid-growth relationship using regression techniques. It focuses on the effect of foreign aid on capital accumulation, savings, and GDP growth, foreign aid will be stressed to assess the extent to which foreign aid boost economic growth. My empirical findings suggest a positive aid-growth relationship, which is not robust in a long-run based on the channels examined.
I.1. Objectives of the thesis
The general objective is to assess how foreign aid represented by net official development assistance relative to GDP affect economic growth in Africa.
I.1.1. Specific objectives
➢ Assess the impact of Net Official Development Assistance on savings
➢ Assess the impact of Net Official Development Assistance on investment
➢ Assess if Net Official Development Assistance significantly affect Economic growth
I.1.2. Hypothesis formulation
H1: Net Official Development Assistance has a significant impact on Economic growth H2: Net Official Development Assistance has a significant impact on Savings
H3: Net Official Development Assistance has a significant impact on Investment
H4: Excess of Net Official Development Assistance has a significant impact on Economic growth.
6 I.2. Problem statement
Since its inception, right after the second war when the United States of America released billions of monies to support Europe rebuild the latter’s economy, it was thought that international assistance specifically influences or at least affect a recipient’s economic growth (Sogge, 2002).
Although developed countries are now providing development assistance aid at a rate of 160 Billion to less developed countries (WorldBank, 2020). There is no empirical justification assessing the ramifications of this resources transfer to the economic beneficiary of recipient’s countries yet. Intuitive decisions are taken in the absence of objective quantitative analysis as to the relevance of foreign assistance vary from essential to insignificant. This paper is therefore an attempt to quantitatively examine the relevance of foreign assistance in African countries.
I.3. Significance and organisation of the thesis
The result of this thesis will contribute to the scholarly reports by providing to scientists and future researchers relevant information which will enable them to conduct further research in this field. Furthermore, I would like to recall that Africa has received relatively high levels of assistance since the era of independence. I assume that having the knowledge about the effectiveness of foreign development assistance on Economic growth may help Africa countries’ economy to increase their output.
As follow, the thesis is organized. The following chapter reviews literature and theoretical framework on foreign aid and economic growth. A general specification of the empirical model, data sources and an explanatory analysis of main variables are described in the third chapter. The data-based outcomes are discussed in the fourth chapter, and some conclusions and recommendations are drawn in the last chapter.
7 Chapter II. Literature review
Literatures on foreign aid focuses on a variety of aspects, including the economic growth impact of aid in recipient countries, and the links between aid and trade between donors and recipients. The effects of aid on economic growth have yielded mixed results in empirical studies. To answer the question of whether overseas aid works, various analytical methods have been used. At both micro and macroeconomic stage, the effect of aid has been measured, based on cross sectional countries and individual countries.
There are two opposing viewpoints in this debate, one contends that foreign aid promotes the development of recipients. The latter implies that aid encourage corruption and ease rent seeking while the former implies that it has a huge effect in countries with good economic policies. Early 1990s, there was a new kind of interest in understanding what drive economic growth across countries, with multiple studies attempting to address the foreign aid issue. Even scholars, on the other hand, are divided regarding the effect international aid towards economic growth. There are arguments that other non-economic factors may offset the benefits of foreign aid. State failures, like wars between ethnise, genocide, politicization, and activism, may have an effect on how much aid affects growth. The Political Instability Task Force (PITF) by Goldstone et al. (2009) at George Mason University developed a binary dataset that shows which countries and years these events occurred in. An ethnic conflict, according to the PITF, involves the clash of two different ethnic, religious, or nationalistic groups, as well as the fulfilment of two threshold criteria. At least 1,000 people must be mobilized for military conflict each year, with at least 1,000 people dying as a direct result of the conflict. In the literature, genocide, politicization, and revolution, and their effects on growth, receive little attention. Furthermore, as far as the efficacy of aid is concerned, there has been almost no research on the topic.
The two-gap and Harrod Domar model presented by Chenery & Strout (1966) were preceded by Neoclassical models commonly utilised by development economists since the mid-1990s to examine the relationship between foreign aid and subsequent economic growth. In transformation to the stable state, the neoclassical model indicates that poor countries should have a high return on capital and a quick growth rate
Boone (1996) was one of the first studies to analyse, using a neoclassical method, the macroeconomic effect of aid (Dalgaard & Hansen, 2001). Boone demonstrated the way aid doesn’t not substantially add to expenditure, but it augments ineffective government consumption. Using data collection of ninety-six countries spanning time frame of twenty years. Not only do Boone's results suggest that aid is inadequate in fostering growth generated by public investment, but it could contribute to high inflation rates reducing private investment.
Doucouliagos & Paldam (2009) analysis on 66 countries investigating the effects of aid on savings and investment. His results are in line with the result of Boone. Hansen & Tarp (2000) finds Boone findings somewhat odds in proportion to large variety of investment studies analysed by the two. When Bone included small countries with an incredibly large aid/GDP
8 ratio in his study, he revealed that foreign aid increases investment. He came to a conclusion that says, funding for large public infrastructure projects in small countries where aid was funded is less probable to be fungible, contributing to a greater marginal tendency to spend from foreign aid. Among Boone's critiques there is a linear treatment of the relationship of aid growth, which ignores the likelihood of diminishing aid returns. To inspire the non linearity modelling of the relationship between foreign and economic growth, limitations on absorptive power and discussions of Dutch disease issues were advanced.
Hadjimichael et al. (1995), Durbarry et al. (1998) used an aid square variable, have identified a positive effect on the aid on growth relationship but which is negative past the criterion of a level aid to GDP. Hadjimichael et al. (1995) inferred that the threshold to be twenty-five per cent of Gross Domestic Product. On the other hand, Durbarry et al. (1998) inferred that the criterion is forty-two per cent of Gross Domestic Product. In addition to the findings that aid affects growth through investment, Hansen & Tarp (2001) revealed that there exist diminishing returns to foreign aid.
A seminar paper of Burnside & Dollar (2000) adding an aid-policy interaction concept, they capture the non-linearity in the aid-growth relationship. Within the paper, they elaborated that foreign aid could have a positive effect on growth of the economy only when there are stable macroeconomic policies. For them, the perfect indicators macroeconomic policy were the budget surplus in relation to Gross Domestic Production, inflation, trade openness and openness to trade. The measure of openness of Sachs and Warner is a categorical variable where the value of zero represents the economy that has been closed due to any of the following reason: An overall rate of tariff beyond 40%, on average, more than 40% of imports were covered by its non-tariff barriers. (Rodrigues & Rodrik, 2000).
A weighted average of all these 3 variables and a policy index was developed. They concluded based on panel data set of fifty-six countries over a six four-years’ time period, that foreign aid has in fact a positive impact on economic growth among developing countries where there is good economic, trade and monetary policies, but there is a very little effect on the existence of bad policies. There findings have influenced aid commitments, leading to more “selective”
aid from multilateral development banks and donor governments and allocating a big part to countries with well-structured institutions and sound policies. Although intuitively probable, the declaration that aid functions in a “sound” context, it does not clearly describe what good policy implies. If a country suffers from persistent balance of payments and debt issues, high tariff or non-tariff import barriers may be an acceptable strategy for a country to follow.
Following the same approach in Burnside and Dollar, Easterly (2003) used alternate openness metrics and other macroeconomic stability indices in order to create many policy indexes. With these alternate policy indices and aid experiences, he reran the Burnside and Dollar regressions and observed that not a single interactive term is statistically different from zero. Aid in just any good policy setting does not fuel growth. They demonstrated two implications of the neoclassical model on the aid-growth relationship. They first proposed that there is a positive relationship between aid and growth as long as the recipient's GDP is less than the amount
9 corresponding to its peak transitional growth rate. Second, they claimed that there was a negative correlation between distortion taxes and growth. Aid and policy, even if conditional on initial income, would not be sufficient to explain cross-sectional variance in growth.Taking the distortion economy without aid as a benchmark, with a growth rate of about 0.2 percent. In this case, better policy will result in a 0.15 percentage point boost in the growth rate, bringing it to 0.35 percent. Aid will result in a 0.6 percentage point increase in the growth rate in the absence of policy improvements. Aid combined with policy improvements, on the other hand, would lift the growth rate by more than the total of these effects: the rise would be about 1.15 percentage points rather than 0.75.
Dalgaard & Hansen (2001) used the same dataset as Burnside & Dollar (2000) argued that an advance optimistic effect of foreign aid on economic growth in a sound policy atmosphere is not a dependable outcome. It is based on few influential observations.
Results by Hadjimichael et al. (1995) shows that foreign aid boost economic growth with returns that are decreasing. In contrast to aid's positive effect on development, national savings and investment, they have been found to be both adversely affected by flows of foreign aid with a positive effect on government investment. The positive relationship between aid and growth in Sub-Saharan African countries during the period of 1986-1992 is demostrated by the amount of aid that financed expenditure of government on investment. Gillivray et al. (2006) shows how aid to African countries not only boosts development but also lowers poverty levels.
Furthermore, the author emphasizes the critical fact that persistently rising poverty, especially in Sub-Saharan African countries, jeopardizes the MDGs' (Millennium Development Goal) main goal of halving the percentage of people living in extreme poverty by 2015, which was set in 1990. His research examines empirical time series data from 1968 to 1999 using econometric methods. The paper concludes that each country's policy regimes, such as inflation and trade openness, have an effect on the amount of aid earned. From 1960 to 2002, Addison et al. (2005) look at trends in official aid to Africa. They focused on the dramatic reduction in aid over the last decade, which will have an effect on Africans living in poverty as well as the African economy as a whole. They elaborated that MDGs would as a result of the aid shortfall.
Gomanee, et al. (2005) look at the mechanisms through which aid affects growth. The authors found that foreign aid has a substantial positive impact on economic growth. They also described investment as the most important mode of transmission. According to their study, a one-percentage-point rise in the aid/GNP ratio contributes one-quarter of a percentage-point increase in the growth rate. As a result, factors other than inadequate assistance must be blamed for Africa's poor growth performance. Quartey (2005) study focuses on novel ways to make financial aid successful in Ghana rather than using a wide pool of data from a variety of developing countries. He came to the conclusion that primarily multi-donor budgetary support could be fruitful, but only if the Ghanaian government and its partners prepare and organize their efforts better. Furthermore, the government must strive to reduce its debt burden so that aid inflows are not used to service its debt. The MDBS (multi-donor budgetary support), according to the author, will not be completely effective until it is fully integrated with other
10 types of project aid and inflows become more predictable. Ram (2004) examines the problem of poverty and economic growth from the perspective of recipient country policies, which he believes play a critical role in the efficacy of foreign aid. Despite this, he disagreed with the commonly held belief that targeting assistance to countries with better policies leads to higher economic growth and lower poverty rates. As a result of his study, he concluded that there is insufficient evidence to support the widely held view that directing foreign aid to countries with sound policies can boost development and reduce poverty in developing countries.
Karras (2006) uses annual data from 1960 to 1997 for a sample of 71 aid-receiving developing countries to investigate the relationship between foreign aid and per capita GDP growth. His paper concludes that the aid has both strong and long-term statistically important impact on economic growth. More precisely, a permanent increase of $20 per citizen in foreign assistance results in a 0.16 percent increase in the growth rate of real GDP per capita. These findings are obtained without taking policy effects into account.
Clemens, et al. (2004) assessed usefulness of the aid directed to support commitments government and the balance of payments, aid directed to investment in infrastructure, aid directed in agriculture and industry.The authors argued that, in the short run, aid allocated to these sectors is likely to have a discernible impact on growth. They note that aid to foster democracy, the environment, health, and education only affects growth, if at all, in the long run. Hadjimichael et al. (1995) results are consistent with Clemens et al. (2004) of a favourable effect of aid on growth
Foreign aid and income from natural resources share another link in literature. Political establishments a negative impact. Inflow of aid may reduce the need for collecting taxes by governments which result in a reduction of controls and balances within the country.
Democratic establishments can become less responsible and less inclusive when the government centralize the political process to receive sufficient flows of aid from outside.
On panel dataset for 108 countries, including forty-three countries from Africa, Djankov et al.
(2008) found that aid is negatively correlated with institutions when it comes to diminished checks, balances, and lack of democracy. The argument isn’t validated with an empirical proof through. Only few examples of several channelling which aid may negatively impact political establishments. Trustworthy data on governance body for Africa are limited.
International aid, according to Gong & Zou (2001), lowered capital accumulation and labour supply. They said that international aid would increase citizens' spending, as well as citizens' leisure time, decreasing labour supply. Nonetheless, Mallik (2008) found that international aid had a long-term negative effect on economic growth. As a result, foreign aid has a "long-term detrimental impact on living conditions." Mitra & Hossain (2013) found that a 1% rise in foreign assistance resulted in a 0.51 percent decrease in economic growth in the Philippines.
For 13 Asian economies, Mitra, et al. (2015) discovered a negative relationship between
11 foreign aid and economic growth in the short and long run. They found that a 1% rise in foreign assistance resulted in a 0.18 percent drop in economic growth in Asian economies.
It's worth noting that aid to developing countries has increased significantly in recent years, despite the fact that other forms of flows, such as foreign direct investment and other private flows, have decreased. Other researchers discovered that there is no connection among aid and economic growth. According to Mosley et al. (1987), aid had little effect on economic growth.
The findings of Boone's (1996) research were similar to those of Mosley et al. (1987).
According to Lensink & Morrissey (2000), there is no impact that link economic growth and international assistance. Between 1985 and 2010. Liew et al. (2012) used pooled ordinary least squares, random effect, and fixed effect models to investigate the effects of foreign aid on economic growth in East African countries, they discovered that international aid and economic development have a negative relationship.
While the neoclassical model helped Burnside & Dollar (2000) develop some intuition for the relationships between aid and development, other factors may complicate the scenario.
Assume, instead, that some portion of aid is tied to the recipient's income level, and that as the recipient's income level rises, the amount of aid decreases. In this situation, the donor's aid rules will serve as a charge on the recipient country's capital accumulation. Overall capital accumulation would increase as long as the direct impact of contributed capital outweighed the indirect tax effect, but the aid would have a smaller impact than in the lump-sum situation.
Assume the presence of a good social manager, ideal markets in the recipient country, or some other mechanism that ensures results are in line with a social optimum. There are a variety of explanations why this isn't the case. In practice, governments act as intermediaries, and governments are not often viewed as benevolent social planners. The rewards that politicians face is not quite the same as those that a social planner face. As a result, it's likely that aid would have little to no effect on the recipient country's overall economic growth.
Mosley & Hudson (1996) have demonstrated that when the donor-recipient interaction is modeled as a non cooperative game, moral hazard issues will result in help having little effect on the problems it is intended to solve. Aid could well simply relieve the recipient government's budget constraints without having much more of an impact on the amount of money spent on capital acquisition. Additionally, the donor nation may be involved in this game for reasons other than benevolence. Donor interest can lead to less-than-optimal aid usage, reducing any positive effect. While these and other considerations indicate that the positive effect of aid is likely to be less than what neoclassical model predicts, the thesis' priors on the effect of aid are still based on that example. This thesis will therefore concentrate on how growth determinants are influenced by foreign inflows.
Countries with bad institutions or with stagnant income or with exchange rate that is overvalued may receive aid. In this scenario, aid is considered as endogenous of aid-growth relationship, it means calculated in association with the response variable (growth). The OLS criteria are biased and inconsistent if aid is endogenous. There can be a negative association between aid and the response variable, but causality isn’t expressed in this situation. A problem
12 well known in the literature is the simultaneity bias due to the consideration that aid is endogenous in the aid-growth relationship. Instrumentation for aid and the use of 2SLS to approximate aid’s influence holding other factors constant on the dependent variable. The problem in the use of 2 Stage Least Square is what instruments should be used since they must be uncorrelated with the structural equation's error term and at least partly correlated with aid.
In the literature, there is no agreement on how to provide the right instruments. Weak instruments allow the estimators of the 2 Stage Least Square to be far worse compared to Ordinary Least Square estimators (Burnside & Dollar, 2000).
In estimates on effect of aid and sound government policies on the economic growth, Burnside
& Dollar (2000) use both Ordinary Least Square and 2 Stage Least Square. The Ordinary Least Square estimators do not deviate significantly from the 2 Stage Least Square estimators.
13 II.1. Theoretical framework
There has been a lot of discussion about foreign aid in the globally as a dialogue on development and international affairs. Some of the most fascinating, critical, and difficult fields of modern social science are the mechanism of economic growth and the causes of disparities in economic performance across nations. Economic growth is described as an increase in output/income over time (i.e., an increase in the production of goods and services over time), typically a year. This results in disparities in global living conditions in terms of nutrition, life expectancy, literacy, child mortality, and other direct indicators of well-being.
Classical economists such as Adam Smith, Thomas Malthus, David Ricardo, and Karl Marx all studied the mechanism of economic growth. The importance of the “invisible hand” (the power of supply/demand in a competitive market, specialization/division of labour, accumulation of physical capital/investment, and technological advancement, according to Smith (1776), are the most determinants of long-term economic growth and thus the prosperity of nations. In terms of a chronological perspective, Ramsey (1928) is regarded as the starting point for modern growth theory. Neoclassical theory, formulated primarily by Solow and Swan in the second half of the twentieth century, clarified economic growth theory, during this period, the neoclassical growth theory was used to examine the disparities in living standards between countries.
Foreign aid theory and experience suggest that it can be effective for underdeveloped and developing countries in the first steps. In addition, aid-growth model and dependency on aid face significant political and economic hazards. Foreign assistance should therefore be beneficial for countries in development path.
Foreign aid has been a very important component of the global debate on sustainability in the post-second world war era and the international economic order. It made a major contribution underdeveloped countries’ development; it made the centre of North-South ties bigger until in eighties. Its credibility as an instrument of promotion of underdeveloped countries’ economic growth derives from Harrold-Domar growth model, which recognizes capital as the important growth instrument. For these nations, aid is often preferred as it minimize their three main shortcomings, namely funds, countries’ foreign exchange, and technological expertise as their internal frameworks for the economy are not able to encourage international trade or draw foreign direct investment. (Pankaj, 2005)
Foreign aid theories are not acknowledged as independent theory in development economics, they are part of the general theory of growth. Foreign aid theories are not treated separately like most of other theories that are used today. Therefore, critiques of foreign aid theories is a criticism of one other economic theory in one way or another, therefore, it would be useful in understanding the foundation of economic growth theories.
Economists have invariably defined capital in the classical tradition as a main drive for growth and development, they value of other variables such as trade, land, labour, and specialization have also been recognized simultaneously. Specialization, commerce, capital accumulation and
14 increased production by technological means were significant factors in development for Adam Smith. But he emphasizes capital’s position and writes:” Consequently, the rise or decrease of a nation’s capital, raise or decreases of its annual output, any capital rise or decline tends to decrease or increase the actual quantity of industries, the amount of usable land and the wages of all its inhabitants” (Smith, 1961)
Capital accumulation is the secret to rising, but accumulation for David Ricardo also has a depressive effect. Profits begin to drop as inflation speeds up due to a spike in incomes stemming from rising costs as a result of a rising population, lack cultivable plots and consequently the law of declining returns surface. Economic growth then undergoes decrease of capital accumulation. Stressing the need for savings and spending, Malthus proposed a notion of maximum saving tendency and demonstrated that saving is profitable up to a certain level. However, if savings exceeds that certain level, consumer demand becomes limited to a degree where consumption is therefore hindered. He appears, therefore, to propose an optimal amount of savings in order to keep the economy rising gradually (Ricardo & Malthus, 1966).
The Magnum Opus Das Capital of Karl Marx, he elaborated the principles of capitalism’s growth and collapse, its actions, intrinsic inconstancies, and the implications of the so-called inexorable capitalism’s rules of workings. Marxian economics key is a surplus value. (Marx, 1971).
The general theory of work, interest and money by John Keynes had a seminal influence on the economics of growth since the second world war. His central contribution to the philosophy of development lies in defining both savings as well as spending as the important variables for growth. Savings and gross capital formation are the major factors of boosting the national economy. According to Keynes, Income =Consumption + Investment where Saving = Income – Consumption. Consequently, Saving = Investment. The amount of saving, he writes is the result of the aggregate actions of entrepreneurs. Savings and investment are equally necessarily because they are both equal to the surplus of demand relative to profits.
Income = Output value = Consumption + Investment. (Keynes, n.d.) (1)
In the time following the second world war, the economics of development developed a distinct form and a fundamentally perspective towards the emphasis moved from the general idea of development to particular models of growth that stressed one or other variables. The first econometric model was developed by Harrod and Domar which defined capital as an important variable in influencing the economic growth. In modern aid theory, their model had a useful implementation.
Harrod-Domar model suggests that the economy’s rate of growth depends on the level of national saving and the productivity of capital investment known as the capital-output ratio. If the capital-output ratio is low, an economy can produce a lot of output from a little capital. On the other hand, if the capital-output ratio is high, it needs a lot of capital for production, and it will not get as much value of output for the same amount of capital.
15 Rate of growth of GDP = 𝑆𝑎𝑣𝑖𝑛𝑔𝑠 𝑟𝑎𝑡𝑖𝑜
𝐶𝑎𝑝𝑖𝑡𝑎𝑙−𝑜𝑢𝑡𝑝𝑢𝑡 𝑟𝑎𝑡𝑖𝑜 (2)
Gr= 𝑠𝑟
𝑐𝑜 Gr stands for the growth rate of economy sr stands for the saving relative to income Co stands for the capital relative to output
Therefore, if an economy invests 9% from its national income and the marginal capital-output ratio is 3%, the growth rate would be 3%. If the country receives an external assistance flow equivalent to 3% of national income, there will be a rise at a rate of 4%. Therefore, with the assistance of external stimuli to broaden the whole economy opportunities of mobilization resources from sources inside the country, international aid is justified. (Rostow, 1961).
Ragnar Nurkse also supports large investment in capital in underdeveloped nations to crack the hunger vicious cycle. They are stuck in a cycle spiral of poverty, insufficient wages, lack of savings, minimal consumption, low rate of growth, he explains. As a result, a great drive of strong capital spending will crack this loop. In delivering the big drive, international aid would be beneficial (Nurske, 1953). Arthur Lewis has suggested a theory that calls for the manufacturing sector to be drained out of excess agricultural labour. This cannot be done, though, unless the manufacturing sector expands appropriately. However, since poor countries experience issue of lack of savings and low capital investment, for this cause the internal financial resources are inadequate (Lewis, 1954).
External dimensions were applied by Raul Prebisch and Hans Singer to the theory of development by defining international trade and imports of capital as the key growth’s determinants. In their research on underdevelopment in Latin America, Prebisch demonstrated the primary causative factors are a mixture of external factors, such as export volumes, trade terms and net capital imports. He promotes a policy of growth in which primary focus is paid to external influences (Prebisch & Singer, 1950).
Theories of economic growth indicate that from the classical period, capital formation in economics has held a dominant role in the debate of growth until now. Growth and development have been characterized by classical economists as a never-ending battle between population increase and technological advancement. The latter, however, depends on the creation of capital in turn. Capital, according to neo-classists, is at the heart of the growth mechanism, but still paying attention to non-economic factors. Socio-cultural economic growth models were introduced between 1960s and 1970s, and even later (Higgins, 1990).
Nevertheless, in development economics, the capital-centric growth paradigm has remained dominant. Invariably, there are capital deficits. Because international assistance is viewed as a way of accumulating wealth, the protagonists argue that underdeveloped countries, which are
16 invariably the capital deficit, are a source of growth and development. Rodan, Chenery, Strout, Hans Singer, Raul Prebisch, Max F. Millikan, J.K. Galbraith, W.W. Rostow, P.N. Rosenstein Rodan, Chenery, Strout, Hans Singer, Raul Prebisch a major transition of wealth from developing countries to underdeveloped countries (Chenery & Strout, 1966) (Hawkins, 1970) (Galbraith, 1961) (Healey, 1971) (Mikesell, 1968). They also argued that the low level of capital accumulation was a major restriction on these countries achieving a high rate of growth.
However, these countries may still proceed in the path of rapid growth with the assistance of international funding.
To bolster their case, they used a method of three-model to establish a positive connection between international aid and the growth of the economy. They used three fundamental methods to support the proposition that foreign aid has a significant effect on the recipient country's growth and development. There is a savings-to-investment imbalance method, expenditure on foreign currency trade earnings gap method, lastly approach to absorptive capital power.
II.1.1. Saving to investment gap
Chenery & Strout (1966), Mikesell (1968) and Galbraith (1961) are famous representatives of this technique. They clarified that weak savings and investment rates and the failure to raise them in the short run due to institutional and non-institutional bottlenecks that hold their growth rate at a low level are the key constraints on the development of the less developed countries.
If foreign aid is pumped into these countries though, they can reach a higher rate of growth than their own savings and expenditure rates warrant. In addition, due to their potentially high savings rate, they would be able to achieve a high growth as the Keynesian hypothesis assumes the saving marginal propensity is higher than the average saver's proclivity. In comparison, it is asserted because of the lack of money, these countries' economies run at less than optimum levels. But they can benefit from the optimum level of activities with the aid of international resources, and they can harvest large-scale economies relative to the highest possible degree of output. A condensed version of this as follows:
Growth rate = 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡−𝑅𝑎𝑡𝑖𝑜 𝑜𝑓 𝑂𝑢𝑡𝑝𝑢𝑡 (3)
Economy (X) with a savings rate of 12 percent, for example, will gain 4 percent if ICOR (The Incremental Capital Output Ratio which defines the association between the degree of economic activity and the consequent growth in GDP.) were (assumed) 3 percent, the cent growth rate.
Growth rate = 15
5 = 3% (4)
Nevertheless, if an economy earns foreign aid of 5 percent as a percentage to saving, as per the above formula, the growth rate would move to 4 percent.
17 Growth rate =15+5
5 = 4% (5)
The economy is likely to attain a 1 percent greater growth rate as a result in terms of international assistance inflow amounting to 4% of savings rate, holding incremental capital output ratio constant. The solution to the savings-investment gap appears. However it will be founded on the following assumptions:
o o The Harrod-Domar growth model and Cobb-Douglas output function.
o Countries in the developing world are marked by such a low capital rate creation as well as rapid growth rates are a significant constraint.
o There is a great substitute for domestic and international capital.
o The marginal tendency to save (MPS>APS, a Keynesian assumption) is higher than the average propensity to save.
o The low levels of capital formation give acquisition results in the under-use of capital, domestic skill, and properties.
II.1.2. Approach of earnings-to-expenditure ratio in foreign exchange
Chenery & Strout (1966), Mckinnon (1964)) and Prebisch & Singer (1950) suggested that when international aid is allocated in funding purchases of products and services which aren’t locally generated but bring a certain strategic value for the economic growth of the country, it could have a greater beneficial effect on the growth and development of underdeveloped countries. This is all the more important because, as a result of the scarcity of these goods and services economies of these nations are unable to function at the optimal level and government reserves are inadequate to purchase them. Because of a long-term contraction in exchange in main gods and services. Prebisch & Singer (1950) added an inelastic supply inside the country situation, where countries suffer from systemic restrictions to raise foreign exchange earnings.
Prebisch has also proposed that these countries should switch out of primary commodities, also with the assistance of foreign aid, development and massive import substitution are followed such the economic situation gradually progresses to the point of self-sufficiency of growth.The main assumptions of the earning-expenditure difference in foreign exchange approaches include:
o Many products and services are of vital significance to development and growth are not domestically generated at the early stage of development and it is essential and must be imported.
o The unavailability of certain goods and services has an effect on the optimal output standard and results in the avoiding the usage of domestic capital.
o Both international capital substitutivity and inadequate domestic.
o Secular drop in the trade of countries exporting primary commodities
18 II.1.3. Approach to capital absorptive capability
Such approach promotes a non-economic model for foreign aid. This method is supported by analysts and policies-makers who may not limit oneself to an investment-saving model as well as the approach based on expenditure- earnings gap of foreign exchange in assessment of existence and the number of foreign currency assistance. Absorbent ability of capital is described as a quasi-absolute limitation mostly on sum allocated to resources, internal or external, that could be used constructively inside the context of having net income above depletion” (Vinding, 2006). According to one theory, there is a low level of capital absorption potential in underdeveloped countries, which influences the efficient use of local and foreign funds. However, the impact of foreign assistance, primarily aimed at initiatives such as capacity growth, the creation of human resources, the development of specific areas, establishment of technical institutions and administrative and business preparation under-developed countries' technical workers will increase their growth rate.
Millikan et al. (1957) applied a mixture of approach to financial investment as well as savings absorption estimation ability of the needs for foreign aid in developed countries, their approach depends on the following assumptions:
1. Non-economic causes, primarily bottlenecks of cultural-institutional origin, lack of growth and development of these economies, entrepreneurship, structural impediments to technical improvements and advances, low levels of schooling, quick growth of population and fixed drivers of production are some main constraints. In exchange, these conditions produce a lack of qualified employees, administrators, and technical staff, significantly restricting the amount of productive investment that can be prepared, coordinated, and carried out.
2. Most of these countries face a shortage in the early growth process. Executive, professional, and other trained employees who do not encourage the investment amount to become as large as their national rate of savings might have permitted. When putting money into scientific as well as educational institutions, professional workers may be produced both in research and production. As underdeveloped countries are facing capital scarcity, they have a very weak resource base for investing in these industries.
In comparison, skilled generation is a long-term process, and a high gestation time characterizes it. However, if international aid is imported directly targeted at the generation of skills in terms of a program or mission, the least developed countries will be able to address this shortcoming.
Bauer (1959), Shenoy (1974), Byres (1972), and Lipton & Toye (1990) are some of the writers are well-known opponents in terms of development strategy, leading to foreign aid. They discarded the theory that international assistance can influence economic growth or development. They contend there is a major distinction in between inland capital and foreign aid funds. In addition, the growth and prosperity of underdeveloped/less-developed countries is not assured by foreign aid. Instead, there are some economic and political risks that need to be known with dependency on foreign assistance. Theoretical ideas as well as realistic
19 knowledge for assistance recipient countries. Their argument is against a foreign aid driven development policy. First, they contend that development models led by foreign aid are skewed against the strategy for capital-intensive expansion. As the institutional requirements of all these countries are not the same, the universal use of these models is not without limitations.
Capital formation is therefore not the only challenge that these countries face. They undoubtedly suffer from the formation of low capital. Yet these countries' issues go beyond either savings constraints or constraints on foreign exchange. Problems such as socio-cultural impediments to growth and development, systemic rigidities, low technological levels, entire banking institutions that are underperforming, bad government initiatives, as well as an overburdened primary sector. The adaptability to the least developed nations, which are invariably labour surpluses, is another issue with this capital-oriented development policy, and their key reason for worry is not only the raise of growth rate, but the expand the economy's job prospects.
Significant assumptions of the savings-investment gap method have been criticized by opponents. Initially, it is said that the production function of Cobb Douglas does not contain a variety of important growth determinants, such as technical development, the quantity and nature of natural capital and the cultural as well as social features as critical growth variables in an economy (Mikesell, 1968). In comparison, along with opposed to reliance in terms of capital, Solow stresses technological advances and compares them to the pace of production (Solow, 1956).
As advocated by the foreign assistance protagonists, Richard Nelson protested against the single factor growth paradigm, which defines only savings, foreign exchange, and ability as just a significant restriction of success as well as the advancement of these nations. He has emphasized it exists a strong degree for inter - dependence between different development drivers. In different foreign aid models, this factorial interdependence has been neglected since they have traced large a part of enhanced growth to resource input, foreign currency, and skills (Nelson, 1964).
Burton (1981) has questioned the development paradigm for foreign aid focused on the plan for the Earnings-to-expenditure difference in foreign exchange. He has split the earnings from foreign exchange into two pieces, the unpaid foreign exchange earnings, as well as foreign earnings. It retains, based on the preceding identification, that the simple flow of non-earned foreign exchange isn’t useful in driving the rate of growth. The point he explains is that foreign exchange is an oversea inflow in terms of remittances from nationals serving in another country.
The idea of receiving foreign aid has been dismissed by Bauer, a major opponent of foreign aid, on basis of international assistance, self-sustained development. He defined people's views are influenced by a variety of factors, economic characteristics and behaviours, their principles and ambitions, as well as their political and social beliefs that are not favoured influenced by international aid inflows. Furthermore, he considers that natural capital and foreign business prospects are two other significant factors, and the latter is more important than the former
20 from the point of view of production. Bauer illustrates Japan, Belgium, and Netherlands in defence of his case. The Netherlands is lacking in mineral wealth, however nonetheless made substantial strides economically growth by leveraging the prospects of the external market. In comparison, historical precedent exists for countries that have made significant material development without a sufficient amount of foreign aid, and for countries that, despite an immense complete sum of international assistance, have struggled to achieve a growth rate that is self-sustaining. In the first category there are several examples from Japan, Hong Kong, and other Western countries, while India fell into the second type (Ward, et al., 1968).
Another significant critique of foreign aid is the destruction of the learning process. Whenever resources are developed locally, the nation involved has the potential to study and improve the method of processing, fresh capability, and technologies. Although where resources are only imported from abroad, which is the case for international assistance, the process of gaining information and expertise is often lost. This lack of incentive in terms of the production process strengthens the reliance of the receiving country on external suppliers. Foreign aid also appears to help export lethargy in the receiving country when it is more often than not oriented towards meeting foreign exchange shortages. But the issue is how the receiving country uses this scarcity as an alibi to get more international assistance rather than relying on export promotional efforts, the simple alternative of collecting foreign assistance is used. However, this cultivates a system of export laziness, but it often maintains indiscipline throughout the payment balance role. Foreign assistance has other consequences for the nation providing aid.
Invariably, it has been observed that recipient countries continue to participate in ambitious plans on the grounds of external donors' assurance that does not mobilize the necessary domestic capital needed. In comparison, domestic inability to harness municipal capital is being tackled by a conspicuous use of deficit financing. International assistance also has unfavourable consequences for government policy since. It contributes in relation to centralization of authority in the recipient country of aid as a donor. Countries grant aid directly to government resultingin improved the central financial powers of the government. On the basis of international assistance, the government is committed to the rapid growth of the public sector without considering their economic feasibility. The role of government policy is a vital part in fostering development and growth (Moyo, 2009).
Foreign assistance also causes detrimental cultural impacts on the recipient country of aid.
Bauer blamed foreign assistance for fostering a pauperization culture. Defines the pauper as someone that depends on income that isn’t unearned and thus signifies propagation as well as adoption of notion that undeserved contributions are the key component in livelihoods. He further states that the likelihood of suffering arising from lobbying and inflow of assistance is exacerbated by persistence certain behaviours and customs are prevalent in many developing countries, in particular the recognised beggar and lack of social shame in recognition of the indiscriminate charitable giving evident in most under-developed countries (Ward, et al., 1968).
21 Aside from the theoretical justification, there has been empiric proof demonstrating the usefulness of international assistance as an example catalyst of development and economic growth. The USA's Marshall Plan is most frequently cited as a case in point, with foreign aid proponents often pointing to this plan as a case in point. The Marshall Plan was a major economic aid initiative initiated in 19 European countries experiencing issues of down the production and sluggish development in the period after world War II. This policy has been underway for a decade and has resulted in a rapid rebound from economic crisis in these countries. Chenery and Strout offered Greece, Israel, Taiwan, and the Philippines are some examples, and wrote in the sense:
“Opportunities to ensure fast and long-term growth by usage of international aid effectively has been seen to be striking in the last decade for countries like Israel, Taiwan and the Philippines. In either scenario, a considerable rise in investment funded mainly by foreign loans and grants has led to a gradual growth of the GNP, accompanied by a gradual decline in the dependence on external financing. Not only has growth increased by foreign aid, but the capacity of each economy to support further growth on its own resources have been dramatically improved” (Chenery & Strout, 1966).
The underdevelopment hypotheses, hegemony and reliance describe foreign assistance as a phenomenon viewpoint of recipient nations. And these are detailed hypotheses assessing the issue of underdevelopment as well as the dependence of least developing country on their western powers, they haven’t concentrated exclusively on international assistance. Instead, they analysed the North-South relations in depth, and international assistance is part of the study. Imperialism's ideology treats international assistance as a tool for neo-imperialism.
However, the viewpoint of progressive’s thinkers a student at this school is fundamentally different from the Marxists' point of view Hobson, Kautsky, and Schumpeter. adhere to the liberal outlook. Their core point is the insufficient intake on the local market of the developing nations is the origin of the movement of capital to the exterior world and thus of colonialism.
(Chilkote, 1994). They elaborated their opinion that, the higher local demand, There will be no excess to spend in international markets as well as thus the pattern of funds transfer to countries in development way would automatically cease.Marxist school has found that the accumulation of capital will ultimately contribute to imperialism, because imperialism is a manifestation of the increasing capitalism that is demanded because of the inconsistencies of the capitalist methods of production, they suggested the fact that imperialism is capitalism level.
Andre Gunder Frank pointed out that this was the main explanation for lack of progress of periphery countries rely on the accumulation by the capitalist core of their surplus, and capitalist meters are making gains at detriment of reliant periphery countries. He suggests, thus, that the ties of interdependence between the imperialist metro and the underdeveloped periphery that arose in the post-World War II period are a kind of neo-imperialism in which capitalist resources evolve at the cost of the underdevelopment of the peripheral countries, this
22 pattern has been defined by Andre Gunder Frank as the growth of the developing world (Frank, 1967).
II.2. Solow growth model
The classical economists of the 18th and 19th centuries, who studies are strongly discussed in conjunction with the transition to neoclassical growth model, are responsible for a school of thought and theories on economic growth. Robert Solow (1956) and Trevor Swan were the first to establish the basic concept of neoclassical growth models. The overall production of the economy, according to this neo-classical model, it is determined by the quality and amount of physical capital employed, the amount of labour employed, and the aggregate level of ability of the labour force at any given time. However, after the economy has reached full equilibrium, additional growth in the stock of capital per worker will occur only if productivity improves, either through increased capital stock or improved labour force efficiency. Constant returns to scale, decreasing capital marginal output, exogenously determined technological development, and substitutability between capital and labour are among the basic assumptions of the Solow model. And his key concern was, "What are the main determinants of long-term economic growth?"
The model of Solow on economic illustrate the evolution of earnings and consumption per employee in the long run, which is influenced by saving rates, spending or population growth.
(Sørensen & Whitta-Jacobsen, 2010).
The foundation of Solow’s model of growth is constructed on two functions. A function of output and a function of accumulation of capital. The output function is presumed to take Cobb Douglas form as described below:
𝑦 = 𝐵(𝑘𝑡)𝛼 (𝐿𝑡)1−𝛼 𝐵 > 0; 0 < 𝛼 < 1 (6)
Y represents output and both k and L represent inputs of capital and labour. Parameters are represented by B and α. B catches within these innovations the effect of all influences driving production, rather than those directly present in the production function. This production feature shows continuous returns. Let’s consider that all the inputs are doubled, the output is doubled as well. Per capita GDP decides a nation's prosperity.
The equation of Solow model is expressed as production and capital per employee . y = Y/L
k = K/L
𝑦𝑡 = 𝐵(𝑘𝑡)𝛼 (7)
Any increase of production per employee can only be derived from an increase in capital, assuming that B remains constant. Capital returns, however, are decreasing, this implies that each increase in unit of capital given to an employee raises their production by less and less.
Assuming that employees or consumers save a constant rate of their earnings and the economy
23 doesn’t operate with the outside world, in order for savings equate investment and the only way to use investment in such economy is the acquisition of capital/funds. The adjustment of capital stock every year is equal to the amount of gross investment minus the amount of depreciation that happens during the manufacturing process.
The Solow growth model assumes that the rate of growth of labour equates to growth rate of population defined in parameter n.
𝐿𝑡=(1 + 𝑛)𝐿𝑡 𝑛 > 0 (8)
When the amount of savings is larger than what disappears due to depreciation and population growth, the rule of motion in Solow model tells us that capital can rise per worker. The capital per worker reduces as the amount of savings is less than the amount required for substitution.
△ 𝑘 = 𝑠𝑦
𝑡− (𝑛 + 𝛿)𝑘
𝑡(9)
Where △ 𝑘 denotes change of capital, s denotes saving rate, y denotes income, n denotes population growth and 𝛿 denotes depreciation.
In case
𝑠𝑦
𝑡> (𝑛 + 𝛿)𝑘
𝑡△ 𝑘 > 0
Saves replacement capital is rising
In case
𝑠𝑦
𝑡< (𝑛 + 𝛿)𝑘
𝑡△ 𝑘 < 0
Saves replacement capital decreases
The output function of the country (y=f(k)) is plotted in blue in figure 1. The number of the savings are expressed by a green line, while the sum required for replacement is represented by a red line. Point A reflects the balance of the economy at that point, the volume saved is exactly equal to the quantity required to be substituted, so that capital per worker remains constant.
24 Figure 1: Solow model
Source: (Charles, 2008)
What if a country begins with a low per capita capital? Say a country begins with the K1. At K1, we find that the green curve is above the red line. This means that the savings are higher than the substitution. As a result, capital per worker will rise, and we will shift to the right of the x-axis to hit k2. At k2, savings are still higher than the amount required for substitution, as Figure 2: The Solow model dynamics
Source: (Ray, 1998)
No matter what capital per person we start with, income will always converge to the balance calculated by savings and depreciations. What happens to the Solow model when a country gets foreign assistance in the form of extra capital? As seen in the graph below, income per
25 employer will rise momentarily, but inevitably, dynamics are such that resources per worker would converge back to the amount of income per person y ̽.
Figure 3: The Solow model with aid as capital
Source: (Sørensen & Whitta-Jacobsen, 2010)
It is bound to be poor in countries where the majority of people live on the margin of subsistence savings. Considering that capital is circulating, as it is often believed to be.
Successful investment ventures aren’t pursued because of a lack of local savings (Boone, 1996).Development efforts have to depend on different accumulation of resources like foreign aid for example. In the neo-classical model, inflow of aid from outside promotes development by means of capital formation by providing countries with financing required to balance capital formation opportunities as an addition to supplying foreign exchange to fund the required imports of the funds and intermediate commodities and make it easier for governments to direct their other funds in physical or social infrastructure and ease fiscal restrictions.
The figure 3 demonstrates how the higher savings generated by aid impact income. Considering the capital stock level at k* spending per employee surpasses needed sum for retaining constant capital per employee. The economy starts to deepen capital all over which will proceed till 𝑠𝑦𝑡 = (𝑛 + 𝛿)𝑘𝑡 Inciting a transition to the steady state, (kaid). Such higher level of capital per employee is related to a high production per employee.
The simple Solow model predicts that GDP growth per worker can no longer happen until a nation hits its steady state. This is in contrast to the long-term rise in per capita Gross Domestic
26 Product witnessed in the majority of developing countries especially Africa and Asia. From the model, the growth will stop in the long term because of a decrease in capital marginal returns. This means that the growth will collapse as the capital gradually increase. As a result, temporary GDP growth per worker is on the road to a stable state, but there is no steady state growth. However, temporary acceleration is taking place over decades with a reasonable valuation for the parameters. In a general overview, three main predictions are made by the model. First, growing capital compared to labour leads to economic growth because more capital allows people to be more productive. Second, poor countries with lower per capita capital develop faster because each capital investment yields a higher return than rich countries with sufficient capital. Third, economies gradually hit a point where any rise in capital no longer generates economic growth, that is also regarded as steady state, as a result of declining returns to capital.
In order to help understand long-term GDP growth rates, the Solow model can be improved by technological development, which balances the decreasing of capital accumulation return and allows a long run sustainable growth path. Technology is known to be exogenous and extremely unplausible. Human capital, which is considered as technical advancement, isn’t affected by the marginal returns’ falling in the new addition to the Solow model (Sørensen &
Whitta-Jacobsen, 2010). Other drawbacks include the inability of understand why rate of economic growth and income vary widely around the world with no evidence of confluence.
(Clunies-Ross, et al., 2009).
