Udviklingsøkonomi grundfag
Lecture 23: Foreign assistance and development
Based on Thirlwall ch 15
1
International capital to developing countries
International capital flows are
• Short term portfolio investment
• Bank lending
• Other commercial lending
• Foreign direct investment (FDI)
• Aid – including official development assistance (ODA)
2
Two-gap analysis - introduction
What are the factors constraining growth? How can (foreign) capital help
growth?
Gap analysis
1. Savings-investment gap
2. Foreign exchange gap
–
–
•
Expost: they are the same
Exante: they differ
Other gaps:
–
–
–
Skills
Fiscal resources
etc
3
The two-gap model (i)
4
Y  C  I   X  M
National accounts identity
S Y C
Savings:
I S  M  X  F
Savings gap
Foreign financing
Foreign exchange gap
The two-gap model
Y I t 1


(from HarrodYt
Yt k
Domar)
2. Savings function
It
or
Y 
k
St  s  Yt
3. Financing of investment
I t  St  Ft
4. Import function
Mt  m  Yt often Mt  mi  I t  mc  Ct
5. Financing of imports
Mt  X t  Ft
6. Consumption (residually)
Ct  Yt  I t  Ft
1. Supply side
g
The two-gap model (ii)
We now have two possibilities for
causality:
A: Yt from growth target St from (2)  It
from (3)
But if this It is insufficient to realize
the growth target according to (1)
 the savings gap is binding
5
Two-gap model:
1. Yt  Yt 1 
2. St  s  Yt
3. I t  S t  Ft
4. M t  m t  Yt
5. M t  X t  Ft
6. C t
B: Yt from growth target  Mt from (4)
But if this Mt cannot be finansed from (5)
the growth target cannot be met
 the foreign exchange gap is binding
It
k
 Yt  I t  Ft
The two-gap model, example (iii)
ASSUME: k = 4, s = 16%, m = 18%, Y = 1000.
Without foreign financing growth would be:
Y I t 1 s  Yt 1 160 1
g
  
 
  0.04 4%
Yt Yt k
Yt k 1000 4
The country has a growth target of 5%
Investment will then have to be:
I t  g  Yt  k  0.05  1000  4  200
If F = 30 og X = 160:
If F = 50 og X = 100:
(3) I  160  30  190
(3) I  160  50  210
.  1000  180
(4) M  018
.  1000  180
(4) M  018
(5) M  160  30  190
(5) M  100  50  150
The savings gap binds
The foreign exchange gap binds
6
The two-gap model and aid
When is aid most “effective”?
ASSUME: k = 4, s = 16%, m = 18%, Y = 1000, F = 0:
g
160 1
  0.04   4% 
1000 4
The country now receives aid= 100.
Possible growth becomes:
Savings gap binds
Foreign exchange gap binds
 I can increase by 100
 M can increase 100
s  Yt  Ft 1
g

Yt
k
160  100 1

1000
4
 0.065   6.5% 

Y M t 1  M t  / m t
g

Y
Y
100 / 0.18

1000
 0.556 55.6% 
7
The two-gap model – Discussion
Advantages of the two gap model (and versions of it)
• Rapid identification of fundamental inkonsistencies that will need to
be corrected
• Simple, central variables available from data
• Disaggregation is possible
• Policy relevance
Critique of the two gap model
 Capital and foreign exchange not the only constraints for growth
 Marginal and average k not the same
 How about the absorptive capacity of the economy
 Uncertain and unstable projections
 Neoclassical critique: substitution and relative prices omitted
 Substitution in production - k is not a constant
(recall critique of Harrod-Domar)
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Aid- Important concepts
•
Bilateral - Multilateral
•
Project aid - Programme aid
•
Concessional flows - Nonconcessional flows
•
•
Benefit of aid = grant element
Define grant element
•
Tied Aid - Untied aid
•
Value of aid = benefit - cost of tying
•
Return to assistance is its impact on growth (like the return to any
investment)
•
•
UN aid targets
Fungibility
9
Motives for aid
• Moral – humanitarian
– Relief from absolute poverty
• Political, military, historical
• Economic interests
• Distribution of aid depends on the motive
– Should we give where return is highest?
– Or where need is highest?
• Does aid help?
– Still underdevelopment
– Support to right governments / policies?
• Aid fatigue (=reluctant donor countries)
• How to increase aid flows?
• How to make aid more effective?
10