4.3.2 Factors influencing growth and development

Contents

The impact of economic factors

Primary product dependency

• Primary products include commodities like oil and rare earth metals, as well as agricultural products.
• Some countries are very dependent on primary product exports. For example, for the Democratic Republic of Congo (DRC), 90% of exports are extracted commodities, such as copper, tin and gold.
• Having natural resources can be a “resource curse” for a country:
  • A particular type of “resource curse” can occur through currency markets.
  • Suppose one country exports oil as its primary product and increases oil exports.
  • This boosts demand for its currency, as people need its currency to buy the oil. So the value of the currency increases.
  • This appreciation makes exports dearer, reducing the competitiveness of other exports. So, other exports see a fall in demand.
  • In other words, the country cannot diversify easily into other exports because of its dependency on oil.
• Prebisch-Singer hypothesis
  • The Prebisch-Singer hypothesis states that the price of primary commodities falls over time, relative to the price of manufactured goods.
  • This means poorer countries, that rely on primary commodities, will see reduced net exports over time, preventing growth and development.
  • One explanation is primary commodities are usually necessities, with an income elasticity of demand (YED) near zero.
  • But manufactured goods have a higher YED. The YED for services is even higher still.
  • So as global incomes rise, demand for manufactured goods and services rises significantly. But demand for primary commodities only rises a little.
• Volatility of commodity prices
  • Commodities have price inelastic demand, as they are often necessities. They also have price inelastic supply, as it can take time to discover new resources.
  • So, for any given shift in demand or supply, price fluctuations are much larger.
  • This price volatility makes revenues less certain. This reduces the extent to which producers can plan for the future.
  • Indeed producers are likely to reduce investment as they cannot predict future prices.

Savings gap: Harrod-Domar model

• The Harrod-Domar model predicts that low savings lead to low economic growth.
• This is because low savings mean reduced funds for investment.
• Reduced investment means capital may depreciate if investment does not now cover capital depreciation costs.
• This reduces productivity, so this shifts LRAS left, reducing real GDP. Lower investment also means reduced aggregate demand (AD=C+I+G+X-M), so AD shifts left, further reducing the economic growth rate.

Foreign currency gap

• Some developing countries have a shortage of foreign currency.
• This could be caused by low export revenues.
• As a result of a foreign currency shortage, households and firms do not have the foreign currency necessary to buy imports.
• This reduces imports of essentials such as food and energy, required for households to survive and for firms to use as inputs to increase production.
• Foreign currency shortages also make it more difficult for governments to repay debt owed to other countries in foreign currency. This may lead governments to stop making debt repayments, reducing their creditworthiness, which limits access to financial markets in the future.

Capital flight

• Money may flow out of a country abroad.
• This could be because of political instability or because of the risk of expropriation (government confiscating property).
• As a result of capital flight, there is less investment in the country.

Demographic factors

• Some countries have ageing populations, which may lead to a shrinking labour force. This reduces tax revenue from income tax while increasing government spending on pensions and healthcare as a percentage of GDP (which has an opportunity cost).
• Conversely, high population growth increases demand for water, food, housing and healthcare. Governments may find it difficult to provide sufficient infrastructure and education to support the new population.

Debt

• Some developing economies may have high government debt, for example because of conflict, natural disasters or corruption.
• This saddles the government with high debt interest repayments, leaving less funds to spend on infrastructure or public education.
• This holds back productive capacity of the economy, slowing the economic growth rate.
• High household debt levels may reduce consumer spending and make households more vulnerable to economic shocks.
• Household debt can leave people in a cycle of poverty, as debt repayments make it harder to save to escape poverty.

Access to credit and banking

• It may be difficult to access loans in developing economies.
• Potential borrowers are less likely to have a credit record, less likely to have collateral (assets the lender can take if the borrower fails to repay) and are likely harder to track down if not repaying loans.
• Because of this higher risk of lending, there will be a reduced supply of loanable funds and any supply of loans is likely to come with a higher interest rate, to incentivise lenders to take this extra risk. That reduces demand for loans.
• So lending falls, reducing the amount of borrowing to fund consumption and investment.
• This shifts aggregate demand left, as C and I are components of AD (AD=C+I+G+X-M).
• Lower investment also means reduced productivity growth as capital is more likely to wear off, so LRAS shifts left. Altogether this means reduced real GDP.
• Example: 35% of adults have an account at a financial institution, such as a bank, in Ethiopia.

Infrastructure

• Poor quality infrastructure can mean poor quality roads, public transport or internet connectivity. This is the case in the DRC, where road and rail networks have become disused. Only 1.8% of roads have a tar surface.
• Poor quality roads for example means it takes longer to get to work, leaving workers with less leisure time and thus reducing quality of life.
• It also means workers are more geographically immobile – there are fewer jobs they can reach. This means there is a worse match between workers and the jobs that suit their skills, reducing overall productivity.
• So the LRAS shifts left if infrastructure worsens, reducing the degree of economic growth.
• Aggregate demand is lower due to low government spending on infrastructure (AD=C+I+G+X-M). This further reduces growth.
• Note the effects of all the above on wages. Reducing worker productivity lowers the marginal revenue product of labour. This lowers wages. That is likely to result in lower consumption. So people may be less likely to be able to afford necessities.

Education and skills

• Low levels of education mean the human capital level of workers remains low, keeping labour productivity low.
• So the LRAS does not shift right, reducing the extent of economic growth.
• Lower education levels mean workers have a lower marginal revenue product of labour. So they are paid less, increasing poverty.
• Example:
  • Ethiopia ‘s literacy rate for 15-24 year olds is 72.8%.
  • Government spending on health and education is 5.8% of GDP, half of the rate required to achieve Ethiopia’s Sustainable Development Goals.

Absence of property rights

• A lack of property rights means land, business assets, property or intellectual property may not be protected from theft.
• This reduces the rate of return from investments, as there is a greater chance that the entrepreneur’s rewards or assets may get stolen without repercussions.
• This reduces the amount of investment including lower foreign direct investment. As explained with the access to credit point made above, this shifts AD left and LRAS left, reducing the rate of economic growth.

Note these factors influence both economic growth and development.

Economic growth and development are linked.

For example, a fall in economic growth (caused by low savings for example) reduces the tax revenue available to spend on healthcare and education projects.

This lowers the level of development.

The impact of non-economic factors

Corruption

• Corruption also means often rich businessmen influence policies in their favour. For example making the tax regime less progressive. This may increase income inequality.
• Corruption may lead to misallocation of government spending. For example too much government spending may be wasted on projects with low returns.
• Wasted government spending may raise government borrowing, increasing the amount of debt interest paid. This means higher taxes may be needed in future to pay off debt interest. Higher taxes are likely to reduce aggregate demand and long-run aggregate supply, reducing future growth and real incomes.
• Alternatively if the government continues to borrow, there could be a debt crisis if interest payments cannot be met. The government would default on its debt, which would significantly harm its future ability to borrow and attract funds from abroad.

Conflict and natural disasters

• Conflict and natural disasters worsen the quality of life. Such events directly lower well-being and cause injury and deaths. It can also worsen the other development barriers, such as worsening infrastructure or healthcare provision.
• These events also reduce the rate of return to any investment, as there is a risk of machinery or output (E.g. housing) being destroyed. This is likely to reduce investment.
• If a country is missing a generation of workers as a result, that will also reduce productive potential.
• Example:
  • Ethiopia has faced civil war in the northern Tigray region. The civil war has displaced 5 million people as of 2021 and Tigray faces difficulties accessing clean water and medical aid. In November 2022 there was agreement to cease hostilities. 
  • Ethiopia is prone to droughts. 12 million people are estimated to suffer from food insecurity in the most drought-affected areas of the country.

Other non-economic barrier could include geographical barriers such as whether a country is landlocked. A landlocked country is surrounded by land borders with no borders with the sea. This makes it costlier to export, as shipping is harder, which may reduce AD and economic growth.

How to evaluate barriers to growth and development

The extent to which the points above are barriers to growth and development depends on:

• For primary product dependency, whether the country has a fixed exchange rate regime. If the exchange rate is fixed, then higher exports of natural resources cannot lead to an appreciation and reduce demand for other exports. This prevents the “resource curse”.
• For poor education, healthcare and infrastructure, the extent of aid and NGO help (NGO = non-governmental organisation). Aid may help fund these issues, rendering them less of a barrier.
• Regarding access to credit, the influence of microfinance matters. In countries where there is widespread use of microfinance, this may make access to credit easier.
• More generally, the more development policy solutions in place, the more likely economies can overcome barriers to development.

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