THERE ARE TWO schools of thought in relation to financing economic development. On one side are those who hold that a policy of monetary and financial stability is incompatible with development and are resigned to the idea that inflation and disequilibrium in international payments are inevitable, if there is to be any development at all. On the other are those who assert that a policy of financial stability is the best way to attain balanced economic development.


THERE ARE TWO schools of thought in relation to financing economic development. On one side are those who hold that a policy of monetary and financial stability is incompatible with development and are resigned to the idea that inflation and disequilibrium in international payments are inevitable, if there is to be any development at all. On the other are those who assert that a policy of financial stability is the best way to attain balanced economic development.

THERE ARE TWO schools of thought in relation to financing economic development. On one side are those who hold that a policy of monetary and financial stability is incompatible with development and are resigned to the idea that inflation and disequilibrium in international payments are inevitable, if there is to be any development at all. On the other are those who assert that a policy of financial stability is the best way to attain balanced economic development.

This paper,1 in supporting the second of these views, analyzes the basic objectives of development policy without a continual rise in prices, without monetary depreciation, and without disequilibria in international payments. The analysis requires an examination, at some length, of the internal mechanics of the process of increasing production in a closed economy and of the factors that determine the equilibrium of international payments in an open economy.

Concept of economic development

Economic development may be defined as an increase in the productive capacity and production of a country at a rate higher than the increase in its population. Following customary usage, this definition might be qualified by restricting it to low income countries. However, since the mechanics of economic growth are essentially the same in low income and in high income countries, and any line of demarcation between the two is necessarily arbitrary, it is best not to insist upon this qualification, though in fact the purpose of this paper is to study the phenomenon of economic growth in countries with per capita incomes less than, say, $400 per annum.

Development in the sense defined does not include increases in real per capita income arising from an improvement in the terms of trade, for this is an accidental and reversible situation and gives no assurance of permanent progress. Nor does it include increases of real income obtained by utilizing more fully productive equipment which previously was not used at full capacity.2

The concept of development should be regarded as covering increases in production either for export or for domestic consumption. However, for several reasons attention will be concentrated in this paper mainly on the development of production for the domestic market: First, the consumption of raw materials and food in the world tends to increase at a slower rate than the consumption of industrial products and services, so that, if development were for the most part concentrated upon increased production of the raw materials and food which have been the traditional exports of underdeveloped countries, the rate of growth of these countries would be less rapid than they might reasonably expect.3 Secondly, in formulating development policies, countries should not rely too much on external factors which are quite beyond their power to control. And thirdly, it is widely believed that the risks of instability will be lessened by diminishing the present dependence of most underdeveloped countries on exports, not in the sense of decreasing their volume or absolute value, but by increasing the volume and value of production for domestic consumption and investment.

In examining the problem of development, it should be remembered that sometimes the more urgent immediate practical question is the avoidance of retrogression. In a study of the process of growth of real income, it should be kept in mind that population also increases; if income does not increase more rapidly than population, there is stagnation or decline instead of progress. No concrete studies in this field have yet been made, but there is reason to believe that in some Latin American countries, and certainly in some underdeveloped countries in other continents, the immediate problem is not one of advancement but one of preventing regression.

Mechanism of Development in a Closed Economy

The analysis that follows of the mechanism of the development process is based on ideas presented by E. D. Domar.4 The problem treated by him was that of the maintenance of full employment in industrial countries, and not of economic development in general. Nevertheless, his analysis of the process of increased production as a function of an increase of the stock of capital is a valuable instrument for clarifying the development mechanism.

Process of increase in production

Any examination of the possibility of development without a rise in the general level of prices assumes as an obvious condition that the output of goods and services increases at the same rate as monetary income. It therefore becomes necessary to examine how the increase in real production takes place; which factors and which mechanism determine it; and which factors and which mechanism determine the increase in monetary income.

The increase in real production may have a variety of origins. The first and most elementary is the use of a greater volume of all the factors of production. If a greater volume of labor, of capital, and of natural resources is applied to the productive process, production will increase. It will also increase if the volume of only one or two, instead of all, of the factors of production are increased. In fact, however, though theoretically the factors of production can be combined in an infinite variety of forms, in practice the possible combinations are more strictly limited than is generally assumed in marginal economic theory. Finally, production can also be increased by employing a more appropriate technology.

In an underdeveloped country, practically every conceivable form of increase of production requires an increase in the stock of capital. It may be claimed that production might be increased by exploiting a greater quantity of natural resources; for example, by cultivating new land. This, however, is likely to require capital outlays for communications, irrigation, drainage, etc. In the exploitation of mineral resources, the necessity for additional capital is greater and more obvious than in agriculture; and if a greater volume of labor is to be employed, it must be provided with a stock of capital at least equal to the average available for the workers previously employed, if it is not to be utilized in conditions of productivity that are lower than those previously established.

If an increase of production is sought through technological improvements, these nearly always require the application of capital in the form of machinery, equipment, fertilizers, irrigation, etc. We say “nearly always” because there are some technological improvements, especially in the agricultural sector, which require little or no additional capital. But in general it may be taken for granted that any increase in production will call for a greater endowment of capital, and that it is this increase in the basic capital facilities of the economy that makes possible an increase of productivity and production.

If the relationship between an increase in the stock of capital and the resultant increase of real production of goods and services were a constant, the rate at which production could increase might be easily calculated. Prima facie, however, this relationship would appear to be highly variable and difficult to calculate. In theory, a given increase of income might be the result of any one of an infinite number of possible combinations of capital, natural resources, and labor. And in practice, the fixed capital requirements of different industries and crops are so diverse that the average capital ratio may vary widely from year to year according to the composition of investment.

Nevertheless, statistical and historical analysis has shown a fairly constant relationship in the past between an increase of capital stock and an increase of income. After examining the statistics of increase in national income and capital formation in the United States since the closing decades of the last century, Professor William Fellner found a certain regularity in the relationship between these two elements. Although its value changed in some years, the average was around 0.30. In other words, it was found that, historically, for each increase of 100 units of value in the stock of capital, income increased to the extent of 30 units of value.5

It goes without saying that the concept used here is quite different from that of the marginal productivity of capital. We are trying to determine not how much income would increase if one unit of capital were added, the quantity of all the other productive factors remaining constant, but rather what real increase of income would result if this additional unit of capital were combined with the required additional quantities of the other factors. We are attempting to measure the increases of income that go together—that have gone together historically—with increases of the stock of capital. In this historical analysis, equipment obsolescence is taken into consideration and only the net increase of the stock of capital is registered.

The increase in production that can be obtained by using a greater stock of capital is an average of investments of low productivity, such as dwellings, and of investments of the highest productivity, such as irrigation, agricultural machinery, and industrial plants, as well as investments of a productivity so diverse and difficult to determine as roads, and investments of a social character without immediate economic productivity, such as parks, schools, and hospitals.

By projecting this historical relationship, we can estimate the rate which development can attain by virtue of the process of capital accumulation. Assume that in period zero the existing stock of capital has a value equal to 3,333 monetary units, and that in the same period the national income is equal to 1,000 and saving and investment6 are each equal to 100. As the new investment of 100 implies that in period zero new factories, equipment, and production facilities in general are built, the stock of capital in period 1 will be 3,333 + 100, and consequently real production in this period will be greater than in the preceding period. If a coefficient of average productivity of capital of 0.30 is then applied, national income will be increased by 30 units, from 1,000 to 1,030 (Table 1).

Table 1
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As the potential increase of income is 30 per cent of the investment in the preceding period, and investment has been 10 per cent of income, the rate of increase in income has been 3 per cent. The rate of potential increase, i.e., the rate of development, is a function of the proportion of income saved and invested and of the coefficient of productivity of capital. If the rate of potential development is represented by d, the proportion of income saved (propensity to save) by s, and the coefficient of average productivity of capital by a, the rate of potential development can be expressed by the Domar formula:

d = αs

The rate of development will obviously change if either of the above-mentioned coefficients is modified. If, for example, the propensity to save was 0.15 instead of 0.10, and the average productivity of capital was 0.40 instead of 0.30, the rate of growth would be 6 per cent annually.

Process of increase in monetary income

The increase of real national product from 1,000 to 1,030, which is permitted by an increase of 100 in the stock of capital, does not necessarily determine a comparable increase of monetary income. If monetary income does not increase, there will be no effective demand for the increased volume of production at the prices prevailing in period zero. If, because investment subsequently does not increase enough, or because the propensity to save increases, money income does not increase but, for example, remains at 1,000 or falls below that figure, a deflationary situation will develop in which monetary incomes are insufficient to purchase the total volume of production at period zero prices. The level of prices will have to fall, or some part of the production will remain unsold. This will inevitably cause entrepreneurs to refrain from utilizing, in the next period, the full productive potential of the economy. Reacting to the lower profits obtained, they will reduce production, and instead of a process of development there will be stagnation and depression.

If, on the contrary, the increase of monetary income were 70 or 100 instead of 30, an inflationary situation would arise, with purchasing power in excess of the value of production at period zero prices. Production of 1,030 would not be sufficient to satisfy a demand of 1,070, and prices would rise.

Assume that monetary income during period 1 actually increases to 1,030. If the relationship between income and savings remains the same as in period zero, total savings during period 1 will rise to 103. In turn, in order to maintain stability of income, prices, and employment, it is necessary for investments to be equal to savings. Consequently, investments during period 1 would have to increase to 103. In other words, if the multiplier is equal to 10, it will be necessary for new investments to increase to 103, i.e., in the same proportion as the increase in productive capacity which is the result of the investment in period zero.

Thus, while the increase of output in a given period is a function of investment in the preceding period, the increase in monetary income is determined by the volume of current investment in the given period. If investment and potential production both increase in each period at the same rate, a rate determined by the formula αs, equilibrium will be maintained between the increases of monetary income and of real production of goods and services.

The rate of development, therefore, depends on the proportion of income that the country wishes to save and invest and on the coefficient of average productivity of capital. Since this coefficient is an average of the productivity of each of the individual investments which make up the total, productivity will be low and development slow, if the country dedicates a great part of its new capital to investments of low returns, such as dwellings or social services. This does not, of course, mean that no capital should be dedicated to these purposes. If, on the contrary, an important part of the new capital is devoted to investments of high productivity, as industrial and agricultural investments commonly are, the general average will also be high.

A preliminary examination of the statistics of growth of real income and capitalization in Colombia and Chile during the past few years (see pp. 235–36) suggests that for these countries the ratio of the increase in income to the increase in capital stock has been at least as high as that for the United States. It is obvious that, if saving were directed toward investments having the highest productivity, the coefficient might exceed 0.30, though in the present state of knowledge it is not possible to predict whether it would reach 0.40 or, perhaps, even a higher figure.

Possible rates of growth

The formula d = αs may be used as a formula not only for balanced development, but also for maximum growth in real terms. Development is not possible at a rate faster than that indicated by the formula. In order to accelerate the rate of growth, government policy or private enterprise has to increase one or the other of the two factors; there is no other way to achieve this objective. If inflation is assumed to be effective in accelerating development, it can be only by means of an increase in s, through the process of forced saving.

Table 2, which is based on purely hypothetical figures, is intended to illustrate quantitatively, within reasonable limits, certain possible rates of growth. The figures in the table show that in a country with a propensity to save of 0.05, which directs its savings to investments of relatively low productivity, such as those with a coefficient of 0.20, the rate of growth will be 0.01, which is lower than the rate of population growth of almost all the Latin American countries. Even if savings were directed toward investments with a coefficient of 0.30, the rate of growth of the national product would still hardly exceed the rate of population growth. On the other hand, if the propensity to save were 0.15 and savings were directed toward investments having a coefficient of 0.40, growth would be at the very satisfactory rate of 6 per cent. As the coefficient of mean productivity of capital in Chile and Colombia is probably near to 0.40, these countries could develop an annual rate of growth of 6 per cent if their savings amounted to 15 per cent of national income.

Table 2.

Possible Theoretical Rates of Growth

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Capitalization in Chile, Colombia, and Cuba

The available estimates of the gross and net coefficients of capitalization in Chile, Colombia, and Cuba for the last seven years are summarized in Table 3. These figures are not strictly comparable because of the different estimating procedures that have been adopted and the great margins of error to which the capitalization estimates are always subject. They should be interpreted only as indicating orders of magnitude. Examined in that light, they show an index of capitalization in Chile markedly lower than that for Colombia or Cuba, with a sharp decreasing tendency. Since Chile has “forced” savings through inflation, while Colombia has had a more moderate type of inflation and in Cuba savings have been altogether spontaneous, the figures seem to suggest that “forced savings” do not force, but instead weaken, capital formation: the volume of spontaneous savings discouraged is greater than the volume of savings forced.

Table 3.

Capitalization as Percentage of Gross National Product1

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Based on data from the following sources: Chile, Corporación de Fomento de la Producción; Colombia, International Bank for Reconstruction and Development, Basis of a Development Program for Colombia (Washington, 1950); Cuba, National Bank of Cuba.

Even though the coefficient of savings in a given country depends on many factors, and the differences between countries may be due to differences in the distribution of income among social classes, or to the nature and habits of the population, and not to monetary factors, the figures examined tend, all the same, to show that inflation has a negative influence on capitalization; instead of accelerating capitalization, as is maintained by those who favor inflation, inflation sharply retards it. It may be that, in the first stages, inflation may have the positive effects ascribed to it, but once the country becomes accustomed to inflation, consumption tends to increase at a greater rate than monetary income, and capital formation decreases.

According to the estimates of the Corporación de Fomento de la Producción, Chile’s national income increased, at constant prices, 25 per cent between 1940 and 1949, i.e., at an average annual rate of 2.8 per cent. Since during these years the average coefficient of capitalization was 7.12 per cent of income, the average productivity of capital seems to have been 0.39.7 According to the estimates of a Mission of the International Bank for Reconstruction and Development, Colombia’s national income increased, at constant prices, 5.14 per cent per annum between 1939 and 1947. During the same period, the coefficient of capitalization averaged around 10.28 per cent. The relationship between these figures gives an average productivity of 0.50.

During the period for which these calculations have been made, the figures of average productivity of capital must have been strongly influenced by income variations due to improvements in the terms of trade and to a more intensive utilization of the productive equipment, as a consequence of the war and the postwar period. Both for this reason, and because of the wide margin of error inevitable in such calculations, the figures should be taken only as an indication that for Chile and Colombia the alpha coefficient had an order of magnitude comparable to that found by Fellner for the United States.

As far as is known, no studies on capital formation have been made for the smaller Latin American countries, where there is a lower per capita income. It would be of great interest to determine whether the savings coefficient of these countries allows, or will allow in future, income to increase more rapidly than population. It is to be feared that the answer would be negative in many cases, and that there are some countries which, instead of gaining, are losing ground.

Place of saving in development policy

The policies adopted by highly developed countries to combat unemployment during the depression contrast sharply with the policies that are appropriate for rapid development. These policies sought to reduce to a minimum the two development factors we have been analyzing, that is, to curtail savings through a fiscal system which taxed in a specially severe manner the savings classes, and to diminish the average productivity of capital by directing savings toward investments which would improve the amenities of life or would otherwise serve social ends. These policies may be justified in highly developed countries, at times when the objective of policy is not the growth of the national product but its stabilization at the highest possible level of employment. The policies to be followed by less developed countries require, on the contrary, increased savings, either through spontaneous and private means, or through the fiscal mechanism, or, even better, through both. These countries must also try to increase the productivity of the economy, dedicating new investment to the greatest possible extent to the development of industry and agriculture.

The extent to which a government should tax consumption in order to increase capitalization, and the extent to which it should direct public capital formation toward investments having high productivity—thus sacrificing investments of an aesthetic and social nature, such as urban improvements, schools, hospitals, and popular housing—are matters that cannot be evaluated in the light of purely economic criteria. From an economic point of view, the development process will be much more rapid, the greater the decrease in consumption and the smaller the proportion of capital devoted to social welfare. From an ethical point of view, it is difficult to evaluate the extent to which the present generation should sacrifice its consumption and social welfare in order to increase, more than proportionately, the consumption and welfare of the next generation. From a political point of view, a program of austerity undertaken to accelerate development would not, in all probability, be very popular.

It has recently been suggested that “it might be possible to increase savings by holding consumption constant while production increases or, at least, by allowing it to rise only in lesser proportion”.8 In this way, the development process might be accelerated without decreasing consumption. In principle, the suggestion seems reasonable, but a simplified case, which illustrates the hypothesis in an extreme form, shows that it has serious practical limitations. In constructing Table 4, it has been assumed that the mean productivity of capital is 0.40, the annual increase in consumption and in population is 2 per cent, and the rate of capitalization is sufficient to absorb the remainder of the increment of national income.

Table 4
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On the stated assumption, the increasing capitalization would greatly accelerate the process of development, and income would rise by 168 per cent in the course of a ten-year period. It is, however, very doubtful whether any model of this kind could be used as a guide for development policy. It would presuppose the initiation of the development process by a large-scale expansion of heavy industry, which is precisely the most difficult to develop. The model is, of course, a reductio ad absurdum of the hypothesis of financing development through the capitalization of income increases, but it serves to emphasize the difficulties of such a system. From a technical point of view, the question also arises whether it is possible to expand productive plant at a much faster rate than the output of consumption goods. From an economic and financial point of view, it seems doubtful whether an attractive rate of profit could be maintained for investments in the face of stationary consumption.9

Need for planning

A development process requires the institution of measures, and the solution of problems, on the economic, technical, administrative, educational, and social levels, as well as on the financial level. When it is stated that saving and investing 10 per cent of national income may increase the latter by 3, 4, or 6 per cent a year, it is implicitly assumed that all the other problems have been solved, and that private entrepreneurs, with the aid and advice of the government, or the government with the cooperation of entrepreneurs, have directed investments toward the production of goods which will find a market, either because of the increase in monetary income itself, or because the goods produced are substituted for other products which were previously imported, and that the new plants have been efficiently designed and constructed and will be efficiently operated.

In real life, these things cannot, of course, be taken for granted. A development program requires that productive resources and possibilities should be carefully, intensively, and continuously studied, and that large-scale educational plans should be made for the training of technicians, administrative personnel, and skilled labor; it necessitates the coordination of adequate fiscal, social, foreign trade, and public works policies with the program of expanding production. Summing up, it necessitates planning, not the type of planning that has for its end the control of production or of distribution, but planning designed to coordinate all efforts, both public and private, toward common goals and goals supplementary to each other; planning designed to direct public and private investment (the latter stimulated through credit facilities, technical aid, and tax incentives) toward those lines of production whose development is likely to be most beneficial.

Investment budget

In particular, a development program requires the preparation, from time to time, of an investment budget, in which estimates are included of the probable volume of private investment and provision is made for a sufficient amount of public investment so that aggregate investment will reach the level necessary to raise monetary income at the same rate as the increase in production, in accordance with the criteria and policy goals discussed. Naturally, the public investment budget should be flexible, so that it can be revised upward or downward throughout the year, to the extent that private investment falls short of, or exceeds, planned estimates.

If such a program could actually be implemented and if it were effectively to promote the uniform and continuous expansion of national income at a yearly rate of 3, 4, or 5 per cent, thus instilling in private entrepreneurs confidence that income would not fall but would continue to grow at a similar rate, the process of development would be made much easier, because entrepreneurs would plan their investments in accordance with the expected rate of growth and without having to fear that a sudden fall in income might contract the demand for their products, thus threatening the loss of their investment.

Need for external stability

The problem of lack of confidence in the future on the part of private entrepreneurs and the consequences of this lack of confidence in development are of special importance in an open economy, which is highly dependent on international markets, as are most of the Latin American countries. Such dependence makes it highly unlikely that the symmetrical scheme of continuous development outlined above can ever be fully realized. One of the greatest contributions that highly developed countries could make to the growth of their underdeveloped neighbors would be to ensure more stable markets for raw materials and food products. It would, however, exceed the reasonable limits of this paper to attempt to summarize or evaluate the issues involved in this problem.

Equilibrium of the Foreign Balance

Let us now turn from an examination of the conditions necessary for the uniform and balanced development of a closed economy to an analysis of some of the factors that determine the equilibrium of international payments.

Dependence of external on internal equilibrium

It is well known that Income equals Consumption plus Internal Investment plus Exports minus Imports. On the other hand, Income is also equal to Consumption plus Savings. Savings must therefore be equal to Internal Investment plus Exports minus Imports, so that the foreign balance, i.e., Exports minus Imports, is equal to the difference between savings and investment, exports and imports in this context covering all debits and credits on current account.10

These identities tell us that the balance on current account in the balance of payments is not something accidental or independent of the process of internal expenditures, and its distribution between investment and consumption, but it is intimately and directly related to it. They tell us further that a deficit in the balance of payments on current account is the result of spending for consumption and investment more than the country produces. Consequently, in order to have equilibrium in international payments it is necessary that there should also be internal equilibrium; total expenditures for consumption and investment should not exceed the real income of the country unless the excess is compensated or financed by the importation of foreign capital.

These statements should not be construed to mean that investment in excess of savings, which causes a deficit in the balance of payments, is necessarily voluntary investment. Let us assume a decline in exports, without any similar change in production for export. If exportable production equals 100 units, but on account of an unforeseen contraction in foreign demand only 80 units can be sold, 20 units will necessarily accumulate, as an increase of inventories. Since an increase in inventories is an investment, internal investment will have been involuntarily increased by 20 units. If imports have been maintained at a rate of 100, there would be a deficit of 20 in the balance of payments, equal to the involuntary increase in investments.

The operation of the identity between the foreign balance and the difference between savings and investments may be further examined in a slightly more complex example. If Y stands for national income, X for exports, I for investments, M for imports, S for savings, m for the marginal propensity to consume imported goods, and s for the marginal propensity to save, the formulae for the joint multiplier for exports and investments are as follows:


Let us assume a marginal propensity to consume imported goods (m) equal to 0.30, and a marginal propensity to save (s) equal to 0.10. Let us further assume a position of equilibrium with exports amounting to 300 and investments to 100, succeeded by two alternative positions of disequilibrium: one in which investments fall to 60 and another one in which they rise to 112. The positions corresponding to these hypotheses are summarized in Table 5.

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First hypothesis.

Second hypothesis.

When investments fall, income falls, imports decrease, and a positive balance is produced in the international account, which is equal to the excess of savings over investment. When investments rise, income rises, imports increase, and, exports having remained at the same level, there is a deficit in the balance of payments.

Maintenance of external equilibrium

The dependence of external on internal equilibrium having been more than sufficiently stressed, the question then arises of how to maintain external equilibrium on the assumption that investment and income increase, exports remaining constant. In most cases, for the reasons already stated, economic development presupposes an increase in production greater than the increase in exports. On this assumption it is obvious that, if external equilibrium is to be maintained, imports must not be allowed to increase; the marginal propensity to import has to be reduced to zero and the whole increment in income spent on domestic goods.

In the hypothetical case where investment was increased from 100 units to 112, the increment of 30 units in monetary income was distributed in the following manner: 3 units were saved, 18 were devoted to increased consumption of goods produced by industries already established, which had raised their production by that amount, and 9 were allocated to increased consumption of import goods. In order to maintain equilibrium in international payments, these 9 units of income should have been used to purchase domestically produced goods, and domestic industries, instead of having increased production of consumption goods by 18 units only, should have increased it by 27.

The distribution of the increment of 30 units in real production might also be described as involving the allocation of 12 units to capital goods (increase of investments from 100 to 112) and of 18 to consumption goods. Since for the reasons already stated real production could increase by only 30 units from one period to another, it would have been necessary, in order to increase the production of consumption goods by 9 units, to reduce the production of capital goods by the same amount, that is to say, investments should have been reduced from 112 to 103. This would have required, of course, that the investments made during period zero should have been used to construct the equipment required to increase production of consumption goods by 27 units and not by 18, and that installations for increasing capitalization should have been expanded to a lesser degree. If these adjustments had been made, a situation of equilibrium would have been attained, as indicated in Table 6. The figures in Table 6 have been derived from those in Table 5 by a linked modification that changes this model to a position of external and internal equilibrium, and they correspond exactly to the multiplier formula discussed above. If in the first of these formulae we should let Δ X equal zero and m equal zero, we would have the formula for the investment multiplier in the closed economy:

Table 6
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which explains the increment in income of 30 units, as a result of an increment of 3 in investment and a marginal propensity to save of 0.10.

The same figures could also serve as a model of uniform development in an open economy were it not for the fact that, normally, development requires increased imports of capital goods, such as motors, machinery, rolling stock, precision instruments, steel, etc. Even though it would be theoretically possible to begin development with heavy industry—and it is advisable that underdeveloped countries should not neglect this phase of industrialization as far as it may be possible and economically reasonable for them to embark upon it—development would, normally, during its first stages, be much more intense in light industry and, consequently, there would be a substantial increase in imports of equipment. If exports do not increase, in order to maintain equilibrium in international payments it is necessary that imports of consumption goods should decrease, to make room for the increment in imports of capital equipment.

Four theoretical models

For a further study of this new factor, a series of theoretical models may be constructed in which total imports are subdivided into consumption goods imports and capital goods imports (Table 7). The former vary as a function of consumption, and the latter as a function of changes in the total amount of investment. Therefore, in relation to investment operations a distinction may be made between payments made for domestic goods and services and payments made for imported equipment. In all these models it is assumed that out of every 100 dollars of total investment 60 are used within the country and 40 are sent out to pay for imported equipment.

Table 7
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Col. 1 + 2 + 6, or Col. 8 + 9.

Col. 3 + 7.

COL. 1 – 10.

The first line of each model, which is the same for all, shows a situation of equilibrium, in which savings are equal to investment and exports to imports. In each model, monetary income and real income then increase in a subsequent period by 30 units, from 1,000 to 1,030. Monetary income is increased by the maximum allowed by the increase in productive capacity which has been made possible by the capitalization that took place in the initial period. Therefore, there is neither a rise nor a fall in prices in any of these models; there is neither inflation nor deflation. The reason for the increase in monetary income by 30 units differs for each model. In the first model there is a small increase in investment, strengthened in its multiplying effect by a decrease in imports of consumption goods. In the second model there is a greater increase in investment, neutralized by a rise in imports which increase in proportion to income, the marginal propensity to import remaining constant. In the third model, it is assumed that investments are doubled, imports increasing considerably. In the fourth and last model, a considerable increase in investment (even greater than in model 3) is also assumed, but for the purpose of compensating a fall in exports. In the first three models exports remain constant; in the fourth they fall substantially. In all these models the propensity to save remains constant.

In model 1 equilibrium is maintained in the balance of payments. Since exports have not risen and imports of equipment have risen from 40 to 41.2, imports of consumption goods must fall by 1.2. This fall in imports has a multiplying effect similar to that of a rise in exports or in internal investments, which, for this reason, are able to rise very little if it is desired to avoid an expansion of income greater than 30. Internal investments rise by 1.8, which, added to the fall of 1.2 in imports of consumption goods, gives a multiplicand of 3, which is the correct one if, with a multiplier of 10, the desired increase in income is to be obtained.

If the propensity to import had remained constant, imports of consumption goods would have increased to 309. Since, in fact, they have fallen to 298.8, new domestic production has filled a demand of 10.2 that would normally have been covered by foreign goods. With an increase in income of 3 per cent, the additional demand for goods produced by domestic industry has increased by 18. Therefore, the increase of 30 units in domestic production has been distributed as follows: 1.8 in capital goods, 18 in lines already produced in the country, and 10.2 in goods that up to the previous period were purchased abroad.

To establish the ideal equilibrium contemplated in this model, the following conditions must be satisfied: (1) imports must be reduced either by protective measures or, more naturally, because of the quality and low cost of new domestic production; (2) in the previous period investments must have been properly directed, partly to create industries to produce goods to substitute for imports, partly to satisfy additional demand for goods already produced in the country and, also, in part, to place the economy in a position from which investments can be still further expanded; and (3) investments in the second period must increase only by a moderate amount (in view of the expansive effect of the substitution of imports).

At first sight, it seems impossible to achieve these requisites without very detailed and strict planning and control. If, however, the increase in investments is kept within cautious limits and the new domestic goods to substitute for imports are produced on a competitive basis, we may rely upon the price system in the long run to achieve a reasonable degree of equilibrium, provided that the stock of gold and exchange reserves is adequate to take care of short-term fluctuations in the balance of payments.

In each of the other three models a deficit develops in the balance of payments. In the second model the propensity to import is kept constant and, since exports do not increase, monetary reserves fall, unless there are investments of foreign capital to cover the deficit. A constant propensity to import being given, internal investments may be allowed to increase (in fact they increase by 12 units), without producing inflationary pressures. An increase in internal investments being given, purchases of equipment abroad also increase (by 8 units), and the deficit rises to 17 units (8 due to increases in purchases of equipment, plus 9 due to the 3 per cent increase in consumption imports). In this model the increase in production of 30 units is subdivided into 18 units for the increment in consumption of goods already produced in the country and 12 units devoted to capitalization goods or services. There is no substitution of domestic production for imports. It is evident that this type of development cannot be maintained for a period of time longer than that permitted by previously accumulated reserves or by the importation of foreign capital (or by a combination of both factors).

The third model is similar to the second, except that all the changes are assumed to be on a larger scale, with the larger imports of capital goods being financed by an inflow of foreign capital or a sharp loss in reserves, or by a combination of both. Even though this model has only theoretical interest, it has been constructed to show what may happen in any economy if there is a very large increment of capitalization. It may be seen how consumption of goods of domestic origin has decreased in comparison with the initial period. This is due to the fact that such a substantial increase in domestic investment necessarily takes resources away from activities dedicated to the production of consumption goods. Logically, the doubling of domestic investment assumed in this model would require a remarkable increase in the number of persons employed in the production of capital goods, and this amount of labor would have to be taken away from consumption activities. The expansion of investment could also result in a transfer of equipment from one activity to another; for example, the use of railway freight cars to transport cement and stone instead of using them for transporting wheat and other consumption goods. Since the transferability of resources from one use to another is limited, especially in an underdeveloped country, it does not seem possible that a very large increase in investment could take place without causing severe disturbances. In this connection it is interesting to note that, even where national resources could be substantially supplemented by foreign loans, an increase in investment exceeding certain limits may have inflationary effects.

In the fourth model a sharp decline in exports, from 340 to 240, is assumed. How could this fall in exports be compensated in order to keep monetary income at the level it would have reached if exports had not declined? There are four methods of doing this. The first would be to keep export industries at the old level of activity and stockpile or destroy the surplus. From a political and social point of view this would be the most expeditious way, because it is not easy to transfer employees and workers, many of them with specialized training, to other industries and locations. If the government purchases the export surplus, this working force is kept at its habitual tasks and monetary income at its original level. But if the foreign market does not recover, this method involves a total loss for the economy, that is, a loss of labor devoted to useless production and of the raw materials and fuel utilized in maintaining such production. Moreover, the country loses monetary reserves in maintaining its imports at their old level in spite of the fact that sales abroad have declined.

Another way to cushion the effects of the decline in exports would be to establish unemployment insurance that would allow the continuation of salary and wage payments to the personnel of export industries, even though this working force were actually not working. This solution too means, but to a lesser extent than in the previous case, a wasting of resources and a loss of exchange.

A third solution would be to let activity decline in export industries, but to transfer the personnel to other occupations, such as public works of easy construction not requiring additional importing of equipment. The country would benefit from the works executed, but it would go on losing reserves indefinitely.

The last possibility would be to transfer labor from export activities to other new activities in which productivity is as high as in the export industries. This would necessitate an extraordinary importation of equipment. The deficit in the balance of payments resulting from the decline in exports would thus be made worse by larger imports of equipment. This is the case described by the fourth model.

In the fourth model there is a great drain on the country’s reserves, but investment of 269.5 would give, during the following period, an increase in income of about 80, that is to say, only 20 per cent less than the decline in exports. The solution given to the problem in this model naturally presupposes that in previous periods the country had accumulated a large reserve of exchange, or else that it is able to obtain substantial loans from abroad to face the emergency arising from the fall in exports. Moreover, the model assumes a rate of industrialization impossible to reach in practice because of the lack of personnel, technical knowledge, organization, etc.; it presents a situation, however, that is highly interesting as a goal to be pursued.

It is relevant to add that in none of these development schemes, not even in the one in which we sought equilibrium, does the industrialization of the imaginary country depicted in the model provoke any decline in international trade. What really happens is a change in the composition of imports, consumption goods from light industry being replaced in part by capital goods and in part by more valuable consumption goods whose importation is made possible by the higher income level. This means that tariff increases in such countries would not necessarily restrict international trade, or export unemployment, or hurt highly developed countries, although they would harm some individual industries, compensation therefore being effected through an increase in purchases made from other industries in the same countries.

Pros and Cons of Inflation

So far the purpose of this paper has been to demonstrate the theoretical possibility of development without inflation or disequilibrium in international payments. So much time has been devoted to proving this theoretical possibility (and theoretical possibility by no means implies ease of application in practice) because of the conviction that inflation is not the most adequate method for promoting economic development. The analysis may appropriately be concluded by a brief presentation of the main arguments in favor of and against inflation as an instrument for development.

Arguments in favor of inflation

Inflation cannot be indicted outright, since there are some plausible arguments in its favor. The first is that by constantly raising the level of monetary income, inflation ensures a market for production and stimulates entrepreneurs to increase production because the constant increase in prices allows them to make larger profits. In general, but especially in its initial stages, inflation raises prices more rapidly than costs and increases the profits of entrepreneurs. Since inflation on the one hand ensures demand and on the other raises profits, it stimulates an increase in production. To stimulate an increase in production is tantamount to favoring development, because development is synonymous with increase in production.

Some of the defects of the second argument in favor of inflation have already been discussed. Inflation, it is maintained, accelerates, or may accelerate, the rate of capital formation. This presupposes that capital formation is achieved directly and immediately through the investments financed with the newly created money and, indirectly, through the decline in consumption on the part of most of the population which is caused by the rise in prices. Consumption may indeed decline in this way during the initial stages of inflation. But the decline will cease when important social classes, having become accustomed to inflation and foreseen its course, defend themselves by forcing an increase in their monetary income in line with, or in advance of, the price increase. When the rate of rise in prices is no greater than the rise in income of specific social classes, especially of wage earners, the process of acceleration of capital formation through inflation becomes largely, if not completely, ineffective. On the other hand, insofar as it discourages spontaneous savings and stimulates capital exports, inflation may, and in fact often does, reduce the rate of capital formation. It is difficult to give precise statistical evidence for this statement, but the capitalization estimates for Chile, Colombia, and Cuba quoted above seem to indicate clearly that, instead of intensifying capital formation, Chilean inflation has kept capital formation down to a rate lower than that observed in Colombia and Cuba.

The third argument in favor of inflation, which is not generally given publicity although many industrialists and economists understand it perfectly, is that inflation necessitates (and warrants) exchange control that may be used as additional protection for domestic industry vis-à-vis foreign competition. At a time when, in the commercial as well as in the monetary field, international agreements are directed toward a liberalization of world trade, the situation of disequilibrium in international payments created by inflation has been widely recognized as a reason for protecting domestic industry from foreign competition, either openly or covertly but just as effectively, without the risk of objection by the pertinent international organizations insofar as these measures are only of the magnitude necessary to equilibrate the balance of payments.

Arguments against inflation

The first argument against inflation is of a social nature: inflation reduces the real income of the poorer classes and increases that of the wealthy. To the extent that it actually accelerates capital formation through a reduction in the consumption of most of the population, inflation works in a direction opposite to the democratic ideal of social justice. To the extent that wage earners are able to defend themselves and obtain salary increases at the same, or a higher, rate than the rate of rise in prices, the social argument loses strength, but at the same time the economic argument in favor of inflation is correspondingly weakened.

The second argument against inflation, which is economic in character, is that inflation tends to direct productive resources toward luxury consumption and profit-yielding investments which, economically speaking, are of low productivity. Resources are not directed toward the most productive activities, but toward those which produce more profit. Such is the case of the great apartment houses, office buildings, sumptuous residences, accumulation of inventories, etc. The general validity of this argument is, however, open to question. The International Monetary Fund Mission’s report on Chile recognizes that the proportion of capital devoted to housing in that country is not excessively high; in fact, it is not higher than in other countries without inflation. To determine whether, or how far, there is, in practice, a justification for this objection to inflation would require a more systematic investigation than is possible here, both of the facts and of their interpretation, because the diversion of resources to low productivity activities might be a consequence of inadequate planning rather than of inflation.

The third objection to inflation is that it fosters the export of savings by those who wish to keep their resources liquid, not in domestic currency which is subject to a continuous decline in value, but in gold or a foreign currency of stable value.

The fourth objection, which has already been mentioned in the discussion of forced savings, is that inflation discourages spontaneous savings. In view of the difficulty of maintaining the value of liquid savings or of savings invested in fixed-interest securities, it provides a strong inducement for savers who do not wish to run the risks inherent in investments in common stocks to place their funds in real estate or to withdraw them from the country. These operations involve inconvenience and difficulty, so that savings are discouraged.

A fifth objection to inflation is that it makes difficult, well-nigh impossible, any long-term financing at fixed interest rates, a form of financing that is essential for development. The supply of capital for fixed-interest loans is considerably reduced and, insofar as there is any such supply, it is available only at high interest rates that attempt to compensate for the depreciation of the principal. Not only private credit is made difficult, but also and especially, public credit. Inflation makes it impossible to direct private savings toward government obligations. Once inflation has started and confidence in the future stability of the internal and external purchasing power of the currency is lost, government obligations have little attraction for investors. On the other hand, the government is not willing to pay the rate of interest that would stimulate the saver to acquire its obligations because this would substantially increase the service of the public debt. The process of inflation tends to be self-perpetuating, in the sense that governments, unable to finance themselves from current savings, draw directly from the central bank, thereby increasing the quantity of money in circulation and the commercial banks’ reserve base on which the commercial banks can expand the money supply even further.

The effect of inflation on public securities is extremely important, because both economic development and the maintenance of monetary and financial equilibrium require that the savings generated should be reinvested in the capitalization activities that are most productive for the country, and the nature of some of these activities necessarily requires that they should be carried out by the government. When the channeling of current savings toward the government is hindered, the opportunity is lost of using part of the country’s spontaneous savings for essential ends. Thus, only fiscal savings, i.e., the savings of social insurance institutions and savings obtained through taxation, are available for government investments.

The sixth argument against inflation is the exact opposite of one of the arguments mentioned earlier in favor of it. Inflation, by fostering internal and external disequilibria, seems to necessitate the adoption of controls that serve to protect domestic industry from foreign competition. These controls are, however, two-edged instruments, even from the viewpoint of the protected industries, for they create obstacles, delays, frictions, and inconveniences of all kinds, which more than neutralize the benefits derived from the protection they are intended to afford.

The last general argument against inflation is that it tends to become cumulative and its indefinite continuance can then not be avoided. It becomes a sort of second nature to the economy of the country; it enters into the expectations of entrepreneurs, of labor, and of government; the country as a whole accustoms itself to the ways of inflation. To stop it without causing great disturbances in the economy is extremely difficult.

The strongest argument in favor of inflation is that it keeps up a high level of demand. However, if a gradual and steady increment in monetary income can be maintained, in line with the increase in productivity, and entrepreneurs become convinced that the rate of growth of monetary income and of demand will be maintained without serious fluctuations, the same advantages that can be obtained in part from inflation will be assured.

Anticyclical policy

Except in one model, it has been assumed throughout this study that exports were kept constant. This assumption cannot be maintained, however, for economies highly dependent on exports whose demand and value are likely to fluctuate widely. Since this is the position of most underdeveloped countries, where therefore the maintenance of a constant increment in national income becomes much more difficult, any study of the financial problems of development would be incomplete if it did not examine, even briefly, the need for anticyclical policies, both on a national and on an international scale.

The coordination of development policy with anticyclical policy requires the accumulation of gold and exchange reserves during periods of high exports. At first sight, this seems to be contrary to the requirements of development, because the accumulation of exchange means giving up the immediate utilization of part of the country’s potential capacity for development. It means maintaining a rate of investment lower than the one which would bring imports up to the level of exports. Gold bars or dollar balances are stored away instead of being used to acquire equipment, or even consumption goods to increase the consumption of the labor employed in the capitalization works.

If, however, the maintenance of a constant rate of growth is essential to give private entrepreneurs confidence that their current investments will not suffer a partial or complete loss when the national income falls as a consequence of a contraction in exports, we are able to understand why it is advisable not to utilize all the financial and real resources of the country to raise the rate of development to a maximum; it is, rather, better to keep part of these resources for use when exports decline and it becomes necessary to cushion the contraction of monetary and real income, so as to keep machinery imports at the same level. In this sense, anticyclical and development policies are not incompatible, but complementary.

Stabilization policy could be more effective in the international than in the national sphere, because in the latter it is limited by the amount of reserves that each country may accumulate. Internationally, all possible efforts should be made to maintain stability in exports from underdeveloped countries through the maintenance of an effective policy for the stabilization of employment, income, and consumption in the highly developed countries. This would constitute a valuable contribution to the development of the Latin American countries. When these countries need no longer fear a violent contraction in their exports, they will have done away with a fundamental obstacle to their development.

Alternative approaches to international stabilization that have been widely discussed include the creation of buffer stocks, setting up therefor international organizations with funds to purchase surpluses, and compensatory capital movements that would involve increased international lending during periods of decline in the exports of debtor countries. If the latter policy were to have genuine stabilizing effects, it would have to be publicized adequately beforehand and assurances given to the underdeveloped countries that a crisis in their exports would not be permitted to stop the process of their development.

Summary and Conclusions

The basic objectives of a financial policy for development may be summarized in the following terms:

1. Uniform and gradual expansion of monetary income in line with any increase in production capacity;

2. Increased domestic savings;

3. The channeling of savings toward investments which within the general plan of development are likely to have the maximum productivity;

4. Price equilibrium and exchange equilibrium.

The purpose of the analysis of this paper has been to demonstrate that the achievement of these objectives is not impossible. It will not be easy, but every effort should be made to approximate them as closely as possible. Economic development is a complex and difficult task, but it is not impossible. From a technical point of view, it is a task involving national education, necessitating a rapid and intensive incorporation of the technical knowledge of other countries. From an economic point of view, it means adequate planning, overcoming inertia, stimulating the initiative of the private entrepreneur, and setting up industries that may substitute for imports of foreign goods without too much harm to the domestic consumer. From the financial point of view, it means a gradual growth in investment, in the money supply, and in monetary income in line with the increase in productivity. This, we repeat, is a difficult, but not an impossible, task. The sacrifice of 10 to 15 per cent in present consumption and an adequate channeling of investment could promote a relatively satisfactory rate of growth, substantially greater than is now being attained in underdeveloped countries. With the help of foreign capital, this rate could be accelerated still further.


Mr. Pazos, who is a graduate of the University of Havana, has served as Commercial Attaché at the Cuban Embassy in Washington, and as Chief of the Latin American Division and Advisor to the Managing Director of the International. Monetary Fund. He was the first President of the National Bank of Cuba, and is now Advisor to the Economic Staff of the International Bank for Reconstruction and Development.


This paper is a revised translation of a paper presented to the Third Meeting of Experts of the Central Banks of the American Continent, held in Havana in February 1952.


The definition of development proposed above is not significantly different from that proposed by Dr. Ahumada: “Any increment of net production per manhour, taking place under conditions of full employment” (“Desarrollo Económico y Estabilidad”, El Trimestre Económico, Vol. XVIII, No. 3, July-September 1951). It is more convenient, however, not to associate the concepts of development and full employment in the way suggested by Dr. Ahumada’s definition, as the notion of full employment, in its application to underdeveloped countries, itself requires further definition.


This point has been further elaborated in Economic Survey of Latin America, 1949 (prepared by the Secretariat of the Economic Commission for Latin America, United Nations, Department of Economic Affairs, New York, 1951),


“Expansion and Employment” American Economic Review, March 1947, and “The Problem of Capital Accumulation”, American Economic Review, December 1948. The present paper was written before the author had had an opportunity to read R. F. Harrod, Towards a Dynamic Economics (London, 1951).


W. Fellner, “The Capital-Output Ratio in Dynamic Economics”, in Money, Trade, and Economic Growth (volume in honor of John Henry Williams, New York, 1951).


Saving and investment are used here in their broader conceptual sense, including private and governmental capital formation.


Since d=αs,α=d8=0.02780.0712=0.39.


Measures for the Economic Development of Under-Developed Countries (Report by a Group of Experts appointed by the Secretary-General of the United Nations, New York, May 1951), p. 39.


In the analysis of this concept the author has benefited greatly from collaboration with Mr. Julián Alienes of the National Bank of Cuba.


Although this identity is a basic concept in contemporary economic thinking, it is frequently overlooked in analyzing the balance of payments effects of economic development. Effective use of the concept in relation to development has been made, however, by Juan Noyola, in his Desequilibrio Fundamental y Fomento Económico en México (México, D.F., 1949).