III Theoretical Determinants of Growth, Savings, and Investment

Martin Mühleisen, Dhaneshwar Ghura, Roger Nord, Michael Hadjimichael, and E. Ucer
Published Date:
June 1995
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The Solow-Swan framework, which is at the core of neoclassical growth models, has been used extensively for empirical analyses of growth in industrial and developing countries because of its simplicity and ease of application.22 In this frame-work, steady-state growth depends on technological progress and population growth, both of which are exogenous to the model; in the absence of technological progress, per capita output does not grow. Also, in this framework an increase in the savings (investment) rate can raise per capita economic growth in the short run. However, because of diminishing returns to capital, per capita output in the long run grows at the rate of exogenously given technological progress. As such, economic policies do not affect steady-state economic growth in the neoclassical framework, although they can affect the level of output or its growth rate when the economy is in transition from one steady state to another.

An important prediction of neoclassical growth models is that the output levels of countries with similar technologies converge to a given level in the steady state.23 Thus, over time, the growth rates of output of less developed economies would be expected to converge to those of advanced economies. The assumption of diminishing marginal returns in neoclassical models implies that the marginal product of capital falls with capital accumulation. As a consequence, as poor countries typically have lower capital-to-labor ratios than rich countries, the marginal productivity of capital in poor countries is expected to exceed that in rich countries. The higher returns to capital in developing nations are expected to attract capital from industrial countries, thereby making rapid growth possible. However, a number of recent papers have shown that the convergence hypothesis does not appear to be consistent with the empirical evidence.24 It is typically found that “unconditional” convergence does not hold.25 However, when account is taken of the effects on per capita growth of the rate of investment, population growth, and the economic and social policy environment, support for convergence is usually found. Indeed, advocates of neoclassical growth models have noted that these models do not predict unconditional convergence; rather, convergence is obtained after controlling for the determinants of the steady state itself.26

Prompted in part by the lack of empirical support for unconditional convergence, a number of papers have considered alternative models that can explain long-run growth, such as, for example, the “endogenous growth” model. Most of these models, without relying on exogenous technological change, have provided mechanisms through which economic and social policies can affect growth in the steady state. Some of these models are able to generate a link between policy and growth in the long run by assuming aggregate production functions that exhibit nondecreasing returns to scale. For example, in Romer’s model (Romer (1986)), technological change is made endogenous by assuming that it is a public good and that private capital investment raises the level of technology for the society at large. The positive externality associated with private investment leads to a production function with increasing returns to scale. In such a model, the steady-state growth rate increases when the investment rate rises; this implies that domestic policies that affect the investment rate also affect steady-state growth. In a similar model by Lucas (1988), externalities arise from increases in human capital because investment in human capital enhances the productivity of both the recipients of such capital and the society at large. Hence, policies that enhance public and private investment in human capital affect long-run economic growth. Endogenous growth models clearly show that macroeconomic and microeconomic policies can affect long-run economic growth through their effects on physical and human capital accumulation.27

It is now generally recognized that human capital development enhances economic growth. Recent endogenous growth models have shown that human capital accumulation can be an important source of long-term growth (e.g., Lucas (1988), and Becker, Murphy, and Tamura (1990)).28 Indeed, these models have shown that the decision of individuals to invest in human capital enhances technological progress, thus providing a link between human capital accumulation and growth of per capita output in the steady state. Therefore, policies that promote human capital development would be expected to contribute to per capita growth. Proponents of neoclassical models have shown that the contribution of human capital to growth is consistent with the predictions of the Solow-Swan framework when the latter is augmented to include such capital. For example, Mankiw, Romer, and Weil (1992) model human capital accumulation as an exogenous process and show empirically that the underlying production function exhibits diminishing returns to scale in reproducible factors of production.

The existing theoretical models of private investment can be classified under a number of broad categories, such as the accelerator model, the expected profits model, the neoclassical model, and the Tobin’s Q model.29 However, the difficulties associated with testing the implications of these models in the context of developing countries are now well known. It is often noted that certain special characteristics of developing countries (such as the presence of imperfect financial markets, foreign exchange shortages, poor economic infrastructure, and limited macroeconomic stability) make it difficult to apply the theoretical models of investment to developing countries.30 In addition, the lack of data on capital stock or on its rate of return makes neoclassical models of investment difficult to estimate.31 Nonetheless, a few important elements of each of these models are quite relevant to the behavior of private capital formation in developing countries. For example, economic agents in these countries are concerned about the expected profitability of their investments. They may face more constraints, however, than their counterparts in industrial economies; thus, the optimization of their objective functions regarding profits is subject to a larger set of constraints, including those related to infrastructure, institutions, and credit. It has been argued (e.g., Sundararajan and Thakur (1980)) that although some of the basic assumptions attributed to the neoclassical theory do not hold in the context of developing countries, many of the useful insights provided by the theory are still valid in the context of these countries.

A number of studies have investigated the factors that affect savings in developing economies, although not many of them have specifically investigated the relationship between macroeconomic stability and savings.32 Some employ variants of the “life-cycle” model of the behavior of household savings, developed by Ando and Modigliani (1963). This model builds on the notion that individuals save mainly to smooth their consumption path over time in accordance with their anticipated lifetime income. Subsequent extensions of the basic life-cycle model of savings have incorporated the idea that individuals also save for bequest motives and for unexpected expenses.33 According to the general life-cycle theory, households’ savings depend crucially on lifetime income, wealth, and the expected returns on savings. In such a framework, government policies that affect these variables would be expected to affect savings also. In addition, the age structure of the population, typically measured by the ratio of population defined as dependent (under 15 years and over 64 years) to total population (dependency ratio), is another important determinant of savings. The larger the proportion of the working-age population in a country, the larger the aggregate lifetime income, and thus, the higher the aggregate savings. Also, an implication of the life-cycle hypothesis is that the rate of output growth should have a positive effect on savings. Indeed, empirical studies that have included growth in real output (GDP) in a savings function have invariably found it to have a positive effect on the rate of savings.34 In addition, countries that are at a higher level of development can devote more resources to savings.

The following subsections briefly review how macroeconomic policies and other variables influence growth, savings, and investment.

Macroeconomic Stability

Macroeconomic policies may affect economic growth either directly through their effect on the accumulation of factors of production, namely capital, or indirectly through their impact on the efficiency with which factors of production are used (including total factor productivity).35 A stable macroeconomic environment could be defined as one where inflation is low and predictable, the exchange rate is near its equilibrium level, the government budget is well managed, the deficit relative to GDP is at a reasonable level (consistent with a nonincreasing ratio of public debt to GDP), and the use of central bank credit to finance the deficit is kept at a minimal level. Macroeconomic stability sends important signals to the private sector about the direction of economic policies and the credibility of the authorities’ commitment to manage the economy efficiently. Such stability, by facilitating long-term planning and investment decisions, encourages savings and private capital accumulation. The lack of macroeconomic stability, by creating an atmosphere of uncertainty, makes it difficult for economic agents to extract the correct signals from relative prices, such as the real returns to investment in both human and physical capital, and thus leads to inefficient resource allocation.36 In empirical studies, progress toward macroeconomic stability is typically captured by the rate of inflation (and/or its standard deviation), the overall budget deficit, and deviations from the equilibrium exchange rate.37


The direction of the effects of inflation on savings, investment, and growth is ambiguous in the theoretical literature. According to the Tobin-Mundell effect, higher anticipated inflation leads to a lower real interest rate and causes portfolio adjustments away from real money balances toward real capital; hence, a higher anticipated inflation would be expected to lead to higher real investment and faster growth. However, in the case of developing countries with underdeveloped domestic capital and financial markets, the portfolio adjustments would most likely be from real money balances to real assets (e.g., land, livestock, jewels, and consumer durables), which are not usually included in private investment, or to assets denominated in foreign currency through capital flight. Thus, higher anticipated inflation in these countries would be expected to lower private investment. Also, in the context of developing countries, inflation may serve as an indicator of the credibility of the authorities’ commitment to a stable macroeconomic environment. The presence of high and variable inflation rates would be expected to lower the credibility of the authorities vis-à-vis the private sector and reduce the returns on private savings and investment. Thus, high rates of inflation would be expected to lower private investment and domestic savings.

Furthermore, when the rate of inflation is highly variable, the extraction of the correct signals from relative price movements becomes a rather difficult task and can lead to an inefficient allocation of economic resources, including capital. It is often noted that the uncertain macroeconomic environment prevailing in Latin American countries in the late 1970s and early 1980s was at the heart of the massive capital flight from the region, and that efforts in the 1990s to stabilize the macroeconomic environment have been credited with the repatriation of capital from abroad.

A number of other transmission mechanisms could also give rise to an adverse effect of inflation on investment and growth. In the cash-in-advance models (e.g., Stockman (1981)), anticipated inflation, by raising the cost of capital, lowers capital accumulation, thereby lowering economic growth. In a recent paper, De Gregorio (1993) used two types of endogenous growth models to show that inflation can adversely affect growth in the steady state through its effect on both the rate and efficiency of investment. In the first model, an increase in inflation induces firms to economize in real money balances, thus raising transactions costs and the value of capital. The resulting increase in the price of capital goods leads to a reduction in the rate of investment, which in turn reduces capital accumulation and growth. In the second model, the productivity of capital is assumed to depend on employment. An increase in inflation raises the inflation tax and hence lowers the incentive to work; a fall in employment leads to a reduction in growth. Also, Fischer (1993, p. 487) has noted that “the inflation rate serves as an indicator of the overall ability of the government to manage the economy. Since there are no good arguments for very high rates of inflation, a government that is producing high inflation is a government that has lost control.”

Fiscal Policy

The effects of fiscal policy on economic activity are also ambiguous in the theoretical and empirical literature. In a broad sense, fiscal policy encompasses stabilization, growth, and distributional objectives and entails the following instruments: tax measures that generate increased revenues for the government as well as influence economic incentives and equity in the economy; expenditure measures that directly affect economic activity and encourage the development of the private sector through investments in physical and social infrastructure; and, finally, measures that influence the overall borrowing requirement of the government. The extent of government involvement in the economy and its ability to create an environment conducive to economic growth have received considerable attention in the development literature over the years. Indeed, this literature is quite large and controversial.38 The empirical literature has focused on the overall budget deficit as a measure of the government’s borrowing requirement. Other things being equal, a higher budget deficit will crowd out the private sector as a result of lower access to bank credit and/or higher real interest rates, and a more appreciated real exchange rate. Government investment has also been used in empirical studies as a direct proxy of the government’s contribution to capital accumulation, as well as an indicator of the adequacy of basic economic and social infrastructure. Some studies have also included government consumption to allow for the concern of supply-side theories that higher government spending creates expectations of future tax liabilities that in turn distort incentives and lower economic growth (e.g., Kormendi and Meguire (1985)).

Recent endogenous growth models have shown that fiscal policy can have significant effects on economic growth in the long run. Barro (1989 and 1990), in a model that assumes constant returns to scale with respect to government inputs and private capital combined but diminishing returns with respect to private capital alone, has shown that high levels of government taxation distort savings decisions, which in turn lower economic growth in the steady state. In addition, the way fiscal imbalances are corrected matters for private capital accumulation. On the one hand, declines in unproductive government expenditure, if viewed as permanent by the private sector, would reinforce the credibility of economic policies and would thus be expected to stimulate private investment. On the other hand, if fiscal imbalances are corrected by curtailing public investment, private investment would be reduced, given the complementarity between public and private investment.39

A rising budget deficit is likely to be associated with declining government savings. In the theoretical literature, the effects of changes in government savings on domestic savings are ambiguous. According to the simple Keynesian view, an increase in government consumption—that is, a decrease in government savings (and an increase in the budget deficit)—increases income by a “multiplier effect.” An increase in income, in turn, raises private savings. If the increase in private savings exceeds the decline in government savings, total saving increases. However, in an intertemporal environment where expectations play an important role, current government actions regarding its budgetary position are expected to affect the current and future time paths of macroeconomic variables, including private investment and savings. If the private sector expects an increase in future tax liabilities, current and future private consumption and savings would change depending on the income and substitution effects of these liabilities. The income effect of an increase in tax liabilities would lower consumption in all periods, whereas the substitution effect would encourage consumption in the current period. If the income effect were to dominate the substitution effect, consumption would fall in the current period, thus raising private savings. The opposite would be true if the income effect were dominated by the substitution effect.

In such an intertemporal framework, the “Ricardian equivalence” theory (Barro (1974)) suggests that in anticipation of an increase in future tax liabilities following a decrease in contemporaneous government savings (an increase in government expenditures), private savings increase by an equivalent amount so that national savings remain unaffected.40 Thus, according to this view, changes in government deficits would not be expected to affect national savings. In fact, the Ricardian equivalence theory maintains that for a given higher level of public expenditure, a temporary switch from tax finance to bonds finance will not alter real variables (such as the real interest rate, output volume, and real investment) in the economy. This is because forward-looking economic agents, having full knowledge of the government’s budget constraint and using the same discount rate as the government, know that at some future time taxes will have to be increased. Hence, as economic agents are assumed to be concerned about the well-being of their heirs, they raise their savings to leave as bequests, so that the welfare of these heirs is not reduced when taxes actually increase at some point in the future. However, in the context of developing economies, the strict conditions required for the Ricardian equivalence theory to hold (such as the existence of perfect capital markets, the absence of liquidity constraints, the lack of uncertainty about the future course of fiscal policy, and the equality between public and private discount rates) are unlikely to be met. Thus, contrary to the Ricardian equivalence hypothesis, private savings would most probably not fully offset an increase in fiscal deficits. The empirical evidence to date tends to reject this hypothesis in the context of developing economies (e.g., Corbo and Schmidt-Hebbel (1991), Haque and Montiel (1989), Raut and Virmani (1989), and Rossi (1988)). In the context of industrial countries, many of the early studies tended to reject Ricardian equivalence. However, Seater (1993) notes that many of these studies have major weaknesses, such as misspecified equations, simultaneity bias, measurement problems, and spurious correlations owing to the use of nonstationary series. Most of the recent studies of industrial countries, using more appropriate econometric techniques and better data, tend to support “approximate” Ricardian equivalence (see Seater (1993)).

Exchange Rate Policy

Given that the exchange rate is an important relative price influencing the external competitiveness of domestically produced exportable goods, exchange rate policy has received a significant amount of attention in adjustment efforts in developing economies. An overvalued exchange rate acts as an implicit tax on exports and a subsidy on imports and thus leads to a trade deficit. An objective of a devaluation is to correct an overvaluation, thereby improving external competitiveness by inducing a real depreciation.41,42 Although devaluations are expected to be beneficial to the trade balance and to economic growth, some observers have noted two characteristics of sub-Saharan African economies that would weaken the effectiveness of nominal exchange rate changes. First, given the region’s high dependence on imports, including imported capital goods and other factors of production, devaluations would be inflationary. Thus, if the rise in marginal costs of production following a devaluation were to exceed the increase in output price, the production incentives would be undermined. Second, the production of agricultural exports, which constitute the main source of exports of sub-Saharan African countries, is claimed to be inelastic with respect to relative price changes. Therefore, a devaluation would not be effective in stimulating agricultural output, even if it were successful at inducing a real depreciation.

Recent evidence, however, suggests that total and agricultural exports of African countries are quite responsive to price incentives. Bond (1983) reports an average long-run elasticity of 0.21 for the major export crops. Also, Jaeger (1991) obtained price elasticities ranging from 0.1 to 0.3 for aggregate agricultural export supply. In addition, Ghura and Grennes (1994) report price elasticities of 0.65 and 0.68 for total exports and primary product exports, respectively, for a group of 33 sub-Saharan African countries. In general, these studies tend to indicate that total and agricultural exports of African countries do in fact respond to price incentives and that this response is stronger in the long run than in the short run.

The theoretical literature is equally ambiguous about the direction of the effect of real exchange rate changes on the rate of investment. On the one hand, a real depreciation raises the cost of imported capital goods, and since a large component of investment goods is imported in developing countries, domestic investment would be expected to fall with a real depreciation. On the other hand, an appreciating real exchange rate would be expected to lower the profitability of exportable goods and thus export volumes. The resulting decline in export earnings might induce the authorities to impose exchange restrictions on imports, including imports of capital goods, in order to economize foreign exchange reserves. In addition, movements in the real effective exchange rate would be expected to capture the effects of outward-oriented trade strategies. A real depreciation, by raising the profitability of activity in the tradable goods sector, would be expected to stimulate private investment in this sector.

Trade Policy

Outward-oriented trade strategies include policies to maintain the exchange rate close to its equilibrium level, lower import protection, and remove trade barriers. According to the theoretical literature, the main channels of transmission from openness to growth are through the effects of increased competition and access to trade opportunities on the efficiency of resource allocation, and through the positive externalities resulting from access to improved technology. Khan (1987, p. 28) notes that “tariffs, quotas, and other restrictions on trade and payments reduce the amount of trade and specialization and tend to foster import-substituting industries that lack the efficiency and flexibility of firms continuously exposed to international competition.” In the endogenous growth models developed by Grossman and Helpman (1989a and 1989b), openness to international trade accelerates technological advancement from access to goods and services with embodied technology; technological advancement, in turn, is beneficial for economic growth. Lucas (1988) has considered a growth model where access to essential production inputs from abroad accelerates the positive externalities stemming from learning-by-doing. Romer (1986 and 1990) has noted that increased openness promotes growth because of the increased availability of technologies and the accompanying knowledge spillovers. Also, Krueger (1974) and Grossman and Helpman (1989b) have argued that the existence of import quotas diverts productive resources to rent-seeking activities and hence hinders growth.43

Structural Policies

Although macroeconomic stability is a necessary condition for sustained economic growth, it must be supplemented by structural and institutional reforms. Such reforms are necessary to enhance economic incentives and improve the efficiency of resource allocation, as well as to remove the impediments to private sector development. Structural policies can be classified into two broad categories: policies that improve the efficiency of resource allocation, and policies that expand the productive capacity of the economy (Khan (1987)). Improving the efficiency of economic resources involves measures to reduce the wedges between prices and marginal costs, which typically arise from price controls (including on interest rates, exchange rates, and agricultural prices), imperfect competition, subsidies and tax exemptions, distortive taxes, and exchange and trade restrictions. Policies to expand capacity include those aimed at raising savings and investment. Although, in principle, structural reforms make it possible to raise output for a given level of economic resources without reducing consumption, in practice, the rewards from such policies may be felt with a lag. A primary reason for this is that it takes time for factors of production to move from one sector (or activity) to another. In addition, special interest groups that benefit from the rent opportunities provided by existing price distortions may stand in the way of the implementation of these policies.44

Other structural reforms include liberalization of administrative procedures for private sector activity and legal reforms. A common characteristic of countries with limited political rights and civil liberties is a lack of well-defined property rights and market-friendly legal institutions. The absence of these rights and institutions lowers the security for life and property and, as a consequence, reduces the rate of accumulation and the efficiency of factors of production, including human and physical capital. The lack of political freedom, therefore, is expected to lower economic growth.45

Financial Intermediation

McKinnon (1973) and Shaw (1973) emphasized the crucial role played by financial deepening in increasing the rate of domestic saving, and thus in lowering the cost of borrowing and stimulating investment. In addition, if financial deepening contributes to an increase in the expected profitability of capital, it would also be expected to encourage investment. Recently, the endogenous growth literature has been extended to investigate the effects on growth of financial deepening and intermediation.46 This literature has emphasized the important role that financial intermediation plays in improving the efficiency of investment and thus in stimulating economic growth.47

Efforts toward financial liberalization include lifting the ceilings on deposit and lending rates and making them more responsive to market conditions.48 The theoretical literature is ambiguous about the effect of a change in interest rates on saving and consumption because the income and substitution effects of such a change work in opposite directions. An increase in the returns to savings raises the stream of future income and wealth and thus is expected to raise current consumption. At the same time, the higher returns on savings are expected to encourage economic agents to raise savings because postponing current consumption would imply the possibility of larger future consumption out of current income. If the substitution effect of a rise in the returns to savings dominates the income effect, then an increase in interest rates would be expected to raise savings.

The empirical literature for developing countries does not clarify the ambiguity about how changes in interest rates affect the rate of savings. Fry (1978 and 1980) provides empirical evidence to support a positive (although small) relationship between the real interest rate and aggregate savings. However, subsequent work by Giovannini (1983 and 1985) found that Fry’s results were not robust because they depended crucially on Korea’s experience with financial liberalization. With a modified data set, Giovannini found that the response of aggregate savings to changes in the real interest rate was negligible. The lack of a significant and robust relationship between the real interest rate and savings in the context of developing countries may reflect more a measurement problem than a substantive one with the existing theory of the role of financial intermediation. It is well known that savings data for developing countries are not very reliable. Also, during the time period used by most existing studies, interest rates in many developing nations were controlled and thus adjusted very slowly relative to economic fundamentals. Although the empirical evidence suggests that interest rate policies have a small effect on savings rates, maintenance of negative real interest rates for prolonged periods could discourage financial savings.

External Debt

A number of transmission channels have been identified in the literature for the negative impact on private investment and savings of large ratios of external public debt to exports. Two of these channels are particularly relevant for sub-Saharan African countries. First, the resources used to service the debt crowd out public investment, which, because of the complementarity between public and private investment, discourages private investment. Second, the external debt ratio could be indicative of a “debt overhang,” whereby the presence of high debt ratios leads economic agents to anticipate future tax liabilities for its servicing (Borensztein (1990a and 1990b) and Eaton (1987)). An increasing external debt ratio could induce these agents to transfer funds abroad instead of saving domestically, thus raising the implicit domestic cost of capital.

Terms of Trade Changes

The effects of a change in the terms of trade on growth are ambiguous in the theoretical literature. On the one hand, if an improvement in the terms of trade were to reduce input prices relative to output prices, firms would have an incentive to raise quantity supplied in the short run. However, this argument may not hold for many countries in sub-Saharan Africa for two reasons. First, the manufacturing and infrastructural bases in these countries are weak, thus limiting the capacity of economic agents to respond adequately to improvements in the terms of trade in the short run. Second, many African countries rely heavily on one or two primary commodities that have long gestation cycles and whose response to price incentives in the short run is limited. On the other hand, an improvement in the terms of trade could lower growth in the short run, because it would lead to an appreciation of the equilibrium real exchange rate and thus lower the profitability of tradable goods.49 Similarly, a permanent deterioration of the terms of trade would cause a depreciation of the equilibrium real exchange rate. If the nominal exchange rate did not adjust, it would become overvalued, thus undermining the incentives for producing tradable goods.

The effects of changes in the terms of trade on savings are also ambiguous in the theoretical literature.50 In the models proposed by Harberger (1950) and Laursen and Metzler (1950), a deterioration in the terms of trade, by lowering real income, lowers savings. Subsequent authors, using intertemporal models, have challenged the Laursen-Metzler-Harberger effect. For example, in a model proposed by Obsfeld (1982), savings actually increase with a deterioration of the terms of trade. In this model, the economy has a target level of real wealth; with a fall in real wealth as the terms of trade deteriorate, savings are raised to maintain this target level of real wealth. The paper by Svensson and Razin (1983) has noted that a change in the terms of trade has ambiguous effects on savings, depending on whether the change is temporary or permanent. Persson and Svensson (1985) have also shown that the effect of a change in the terms of trade on savings is ambiguous depending on whether or not this change is anticipated and whether it is “temporary or permanent.

In the context of sub-Saharan African countries, a deterioration in the terms of trade associated with a decline in the world prices of primary commodities exported by these countries would, in the short term, lower export earnings, private disposable incomes, and, to the extent that government revenue relies heavily on export taxes, tax receipts. The impact on output growth would depend on the response of export volumes to the decline in export prices and of aggregate demand to the decline in real disposable income, as well as the response of policies to the deterioration in the terms of trade. Exchange rate depreciations and/or reductions in domestic costs could alleviate or compensate for the decline in the price of traded goods relative to nontraded goods and, over time, reverse the decline in disposable incomes. Similarly, access to higher foreign financing (including foreign assistance) could help sustain the level of aggregate demand but would have no remedial impact on the relative price of exportable goods.

Foreign Assistance

In an accounting framework where the current account deficit of the balance of payments equals the difference between national savings and investment, the effectiveness of foreign assistance on domestic economic performance is a priori indeterminate. The increase in disposable income resulting from an inflow of foreign assistance could be either invested or consumed, depending largely on the perceived permanence of the higher level of foreign savings. Thus, uncertainty regarding the permanency of aid inflows could discourage private investment. At the same time, the large increases in public sector investment frequently associated with foreign aid, even in the form of grants, can have a negative impact on domestic savings over the medium term if the recurrent cost implications lead to a deterioration in the fiscal position. In addition, the success of foreign aid, and the absorption of higher levels of aid in particular, is likely to depend to a large extent on the capacity of governments to use the aid efficiently. It is conceivable that once the absorptive capacity of foreign assistance has been reached, additional inflows of foreign aid could become counterproductive.

A branch of the literature on the real exchange rate, building on the “Dutch disease effect,” has noted that foreign aid can have undesirable effects on economic performance.51 When a part of foreign aid is spent in the nontraded goods sector, the ensuing upward pressure on the domestic price of nontraded goods causes the equilibrium real exchange rate to appreciate, thus harming external competitiveness. But the resulting improvement in the profitability of the nontraded goods sector induces labor to move out of export-oriented activities (such as export-agriculture) into service-oriented activities. A fall in labor supply in agriculture puts upward pressure on labor costs in agriculture, thus lowering the profitability of this sector. The resulting decline in external competitiveness hurts export performance and, in turn, economic growth. In fact, as noted by van Wijnbergen (1986), aid can create a vicious circle of poor export performance and aid dependency. Despite the Dutch disease effect, an inflow of foreign assistance is not always undesirable. Foreign assistance can also have beneficial effects if it helps the development of economic and social infrastructure, thereby complementing private sector activities. The extent to which foreign aid is beneficial depends on whether the positive effects of aid inflows dominate their undesirable effects.

At the microeconomic level, foreign assistance would be expected to affect the labor-leisure choice of individuals and, therefore, domestic saving efforts. Aid makes it possible, on average, for individuals to maintain a given level of income and consumption without having to offer the same number of hours of work (effort) as before the inflow of aid. That is, aid lowers the opportunity cost of work, thereby encouraging economic agents to substitute work efforts with leisure. As work effort decreases, income out of own-labor-supply falls, thus lowering savings. This adverse effect of aid on domestic savings would be more pronounced if the inflow of foreign assistance were perceived to be permanent. However, if at the macroeconomic level aid were to help the development of the social and physical infrastructure—boosting employment and raising the productivity of the labor force and physical capital—real income would rise. Thus, by potentially raising real income, aid can boost domestic savings. Hence, while the direct effect of foreign aid on domestic savings is likely to be negative, the indirect effect could be positive.

See Solow (1956) and Swan (1956). For recent applications of the neoclassical growth framework, see Khan and Kumar (1993), Knight, Loayza, and Villanueva (1993), and Mankiw, Romer, and Weil (1992).

See Khan and Kumar (1993), and Knight, Loayza, and Villanueva (1993) for an analysis of convergence in developing countries.

See the papers by Barro (1991), Barro and Sala-i-Martin (1992), De Long (1988), Khan and Kumar (1993), and Mankiw, Romer, and Weil (1992). See also the paper by Ghura (1992) for the case of sub-Saharan Africa.

“Unconditional” convergence implies that the simple cor-relation between real per capita GDP growth and initial income would be negative in a cross-country sample.

See, for example, the paper by Mankiw, Romer, and Weil (1992).

The papers by Renelt (1991) and Easterly and others (1991) provide surveys of the theoretical and empirical issues related to the neoclassical and endogenous growth models. See also the paper by Otani and Villanueva (1989).

Tallman and Wang (1982) provide a survey of recent papers concerned with the mechanisms through which human capital development contributes to economic growth.

See Greene and Villanueva (1991) for brief descriptions of the existing theoretical models of investment.

See, for example, the paper by Rama (1994).

Given these limitations, empirical studies of investment in developing countries have tended to investigate the correlations between a number of policy variables and the rate of investment while controlling for the effects of other variables. See, for example, the paper by Greene and Villanueva (1991).

See the studies by Aghevli and others (1990), and Schmidt-Hebbel, Webb, and Corsetti (1992) and the studies cited in them.

See, for example, the paper by Blanchard and Fischer (1989).

See, for example, Collins (1989), Fry (1978, 1980, 1986, and 1989), Giovannini (1983 and 1985), and Mason (1988), among others.

The discussion of the theoretical effects of policy variables on economic growth can be motivated by a production function of the form:

Yt = F(At, a(..) Kt, b(..) Lt, c(..) Ht),

where Y is aggregate output; At represents an economywide efficiency factor, including the level of technology, and the state of macroeconomic and institutional environment; K is the quantity of physical capital; L is the labor force; H is the level of human capital; a(..), b(..) and c(..) are efficiency parameters; and t is a time index. In empirical work, the estimated regressions are usually based on the time-difference version of this production function, augmented with variables to account for the effects of macroeconomic policies on efficiency.

See the papers by Barro (1976 and 1980) for a theoretical analysis of this issue.

See, for example, Fischer (1991 and 1993).

See the paper by Lindauer and Velenchik (1992) for a survey of the issues involved in the context of developing countries. The paper by Easterly and Rebelo (1993) discusses the effects of fiscal policy on economic growth.

In the current study, an attempt is made to isolate the empirical effect of the information content of the budget deficit ratio by including the government investment ratio in the empirical investment equation as a separate regressor.

Seater (1993) provides a detailed survey of the issues related to Ricardian equivalence.

Many sub-Saharan countries have by now adopted more flexible exchange rate arrangements. The term “devaluation” here is used to refer to the array of policies, including exchange rate policies, that aim at maintaining the actual real exchange rate close to its equilibrium rate.

For a detailed review of exchange rate policies in developing countries, see Aghevli and others (1990).

Roubini and Sala-i-Martin (1991) survey the links between trade orientation and economic growth. Their main message is that existing theoretical models predict ambiguous effects of openness on growth. However, the authors note that the bulk of empirical studies show a positive link (e.g., World Bank (1987)).

Given the complex nature of structural reforms, it is not possible to have a variable that accounts for them explicitly in empirical work. In the empirical section of the current study, an attempt is made to capture the effects of these reforms by the use of dummy variables for selected country groups. The sustained adjusters are considered to have made relatively more progress in the area of structural reforms than the countries with protracted macroeconomic imbalances during the period under review.

Some empirical studies have attempted to capture the effects of the political and institutional environment on growth performance. See, for example, the papers by Barro (1991), Fosu (1992), and Kormendi and Meguire (1985).

See, for example, the studies by Bencivenga and Smith (1991) and Greenwood and Jovanovic (1990). King and Levine (1993) provide a survey of studies investigating the empirical links between financial indicators (including the ratio of money to GDP) and economic growth.

A number of empirical studies have found a positive relationship between the real interest rate and economic growth (e.g., World Bank (1989b), Gelb (1989), and Roubini and Salai-Martin (1992)). See also the papers by King and Levine (1993), and De Gregorio and Guidotti (1992) on the beneficial effects of financial intermediation on growth.

For a detailed review of interest rate policies in developing countries, see International Monetary Fund (1983).

It must be noted that the effect of a change in the terms of trade on the real exchange rate is ambiguous because it depends on substitution versus income effects (see Edwards (1989), and Khan and Ostry (1991)). If the income effect dominates the substitution effect, an improvement in the terms of trade will lead to an appreciation in the real exchange rate. Empirical evidence for sub-Saharan Africa suggests that improvements in terms of trade lead to appreciations in the real exchange rate, indicating that the income effect of changes in the terms of trade dominates the substitution effect (Ghura and Grennes (1993 and 1994)). Edwards (1989) provides similar empirical evidence for developing countries in general.

See the papers by Persson and Svensson (1985) and Svensson and Razin (1983) for a summary of the issues related to the effects on savings of changes in the terms of trade.

See van Wijnbergen (1986) for a theoretical exposition and empirical confirmation.

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