Prashanth Mohan

Topics: Economic growth, Investment, Economics Pages: 7 (2564 words) Published: March 8, 2013
Whether an increase in savings rate leads to change in economic growth and so a change in living standards can be tackled in a multitude of ways, but first a few relevant points can be made. The standards of living can be defined as “factors such as income..quality and affordability of housing..access to quality healthcare”. However, it can be argued that all these variables actually correspond to the level of growth in the economy. If economic growth rises, people will be able to pursue better healthcare, better education, more holidays etc., therefore it can be said that the standards of living have a strong correlation with the level of economic growth. Another relevant point is when an economy closed to international trade, we can assume that savings is equal to investment: S=I.

The relationship between savings-investment is fundamental in explaining economic growth. Firms produce many goods/services ie) commodities. Firms hire workers who help produce these goods and services, and are paid incomes in turn; theses incomes earned can then be spent on goods and services. However not all income that is earned is spent, instead a proportion is saved instead. Therefore when firms want to buy stocks of capital, they use the money that is deposited as savings, as the means of investment. This stimulates economic growth, “by investing firms create a demand for capital goods. These goods add to the stock of capital in the economy and expand the future capacity of production, generating economic growth.” When the level of investment is more than the level of funding necessary to replenish depreciated capital, the economy will grow. There are 2 models, which illustrate the effect of savings rate on economic growth called the Harrod-Domar and the Solow.

The Harrod domar model when expressed in terms of GNP, reads as g≡Yt+1-YtYt=sθ-δ .The numerator in the righthand expression is the savings rate s, while the denominator is the capital-output ratio θ, the “amount of capital required to produce a single unit of output: θ=KtYt”. This implies that economic growth g, has a linear relationship with savings and so therefore depends on savings. A rise in savings s, will cause the fraction sθ to rise, and so economic growth g, will rise as well. But remember that this equation represents the Harrod-domar model in terms of GNP, not per capita growth, which truly reflects the effect of savings on economic growth. When we look at the Harrod-Domar model in terms of growth per capita, we get the equation sθ=g*+n+δ and so once again it’s clear that “Per capita growth depends on: the ability to save and invest: s”. This demonstrates the positive relation between per capita growth (economic growth) and the levels of savings. As the level of savings rises, as long as we assume all the other variables θ, δ and n are held constant, growth per capita g* will rise as well. Therefore it can be argued that in terms of the Harrod-Domar model, a country can keep on growing forever as you increase savings rate, and so economic growth can be maintained in the long run. If we look back at the assumption we made in a closed economy where I=S, then according to the Harrod-Domar model, an increase in savings, which causes a proportion increase in investment means that the country could grow forever. Barro reinforces this argument, “A look at the cross-country data from 1960 to 2000 shows that the average annual growth rate of real per capita GDP for 112 countries was 1.8 percent and the average ratio of gross investment to GDP was 16 percent. However for 38 sub-Saharan African countries, the average growth rate was only 0.6, and the average investment ratio was only 10 percent.”

However it must be noted that while the model gives this interpretation, the Harrod-Domar model is hindered by 1 very big limitation. This limitation is that “the parameters that affect growth (savings ratio, capital output ratio, population growth and depreciation) are...
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