In growth and development policy, investment ratio is an important policy instrument. However, there is no well-defined framework to determine what should be the investment ratio for a given growth target. This paper explains the potential of Solow (1956) and Solow (1957) to explain the relationship between the target growth rate and investment ratio. Hypothetical data are used for illustration in the study.
A legacy of the Harrod-Domar growth models for growth and development policy is that, to
increase the growth rate, the ratio of investment to output (investment ratio) should be
increased. In contrast, the neoclassical growth model of Solow (1956) and his Growth
Accounting Framework (GAF), based on Solow (1957), imply that the key to permanently raise
the growth rate is to raise Total Factor Productivity (TFP). An increase in the investment ratio
only increases the growth rate during the transition of the economy from one steady state to
another steady state. However, it is well known that the East Asian countries, especially
Singapore, have achieved high growth rates for several years in spite of modest increases in
TFP and mainly through high investment ratios. Therefore, it would be interesting to understand
the relationship growth and investment ratio. We first use the simpler GAF and then the more
informative Growth Model Framework (GMF) of Solow (1956). We show that the simple GAF
gives good approximate empirical results and for the medium term of five to ten periods/years,
the investment ratio improves the growth rate.
The main driving force in the economy, moving it towards its steady state, is the fall in the
marginal productivity of capital as capital stock increases. Such effects are taken into account in
the neoclassical growth model of Solow (1956). However, it is not obvious from its familiar
textbook versions as how long the relationship between growth rate and investment ratio will
be significantly above the new steady state growth implied by TFP or TFP and factor
accumulation when the behavior of the level of output is of interest. |
