“Development Planning and Project Analysis I” (Econ 401)

June 2010
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Chapter One
1.1Basic Concepts in Development Planning

At the end of this chapter, students should be able to:

 Understand the meaning of development planning
 Distinguish the differences between economic growth and economic development
 Know the ways of measuring economic growth and economic development
 Identify the defects of relying on GDP as a measure of welfare
 Understand the problems we face while measuring GDP
Development planning has been practiced in various forms in many countries with
different socio-economic institutions and differing levels of economic development. As
such planning has been perceived and practiced in a variety of ways.
The concept of planning can be profiled in technical terms so as to fit in these different
situations.
Planning: - is the making of major economic decisions, such as the national income,
income distribution, the saving rate, the investment rate etc.
Planning: - is the coordination of economic activities via conscious effort. It is a
supplement to market forces. In most cases, price signals are misleading. As a result of
this there should be a certain particular apparatus that coordinates economic activities in
the economy.
Planning: - is a process of cognition and compromise. The very aim of planning is to
compromise the different conflicting interests and to understand the desire of the
economy by singling out social needs.
Planning is an institutionalized activity by or on behalf of a certain authority for:
a) The preparation of decisions and action to be taken by the central authority
b) The coordination of decisions and actions by lower echelons of the economy as
between themselves and the central authority for giving the development of the
entire economy and its constituent parts so as to achieve certain goals for the
economy.
Lewis Lorwin in his 1945 article entitled “time for planning.”clearly stated that
Planning, in general, is a conscious effort to direct human energy for the purpose of
security a rationally desired end.”
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A development plan is a general statement of economic policy. National development

plans are further disaggregated into a set of sectoral plans. A development plan or
program is therefore, a wider concept than a project. It may include one or several
projects at various times whose specific objectives are linked to the achievement of
higher level of common objective.
1.2 Differentiating between Economic Growth and Economic
Development
Each day, policy makers, economic development specialists, and business owners are
faced with a barrage of questions: should businesses be attracted to the region or should
businesses be home-grown within the region? What types of industries should be
supported the most? What efforts can be taken to support start-ups? How can young local
workers be more effectively trained for the positions that exist within the region? How
can the region‟s economy be more sustainable and less susceptible to fluctuations and
downturns?
These ubiquitous questions essentially boil down into three basic questions: What is the
economic situation in my community now? What could the economic situation in my
community be in the future? How could the current economic reality be transformed to
create the economic future of tomorrow?
The answers to these questions depend upon thorough understanding of the concepts of
economic growth and economic development. While frequently used interchangeably, in
reality these concepts are distinct and can shape how these questions are understood and
answered.
Economic growth simply refers to an expansion of current activities – or another way to
phrase it is that economic growth refers to increases: More jobs, more income, more
people, or more real estate. Economic development, on the other hand, is essentially
holistic in nature and generally includes aspects of social, economic, and environmental
change to enhance quality of life for all in a particular region.
In “Community Economics: Linking Theory and Practice”, Shaffer, Deller, and
Marcouiller explain the difference between these two concepts as follows:
“Growth means that we have changed the factors of production, but we probably have the
same type of output produced with income distributed the same way. Structural change,

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within the context of development, means such things as changes in industry mix,
product mix, occupational mix, ownership patterns, and technology. Development means
that there is a technical and institutional change in the way we increase production and its
distribution. It could be that there has been a change in technology, a change in
institutions, or a change in cultural/social framework, specifically, changes in attitudes
and values of the population. Development is long, purposeful, and permanent.”

In essence, while economic growth implies an expansion of existing activities, economic

growth is focused on transformation that is sustained through time to achieve a desired
outcome. While some bemoan development as a “too idealistic ideal” in reality economic
development is more concerned with economic equity than economic equality. In short,
this means that economic development is more concerned with ensuring that everyone
has the same chance than that everyone has the same outcome.
Returning to the questions posed at the beginning of this discussion, one can easily see
how these two concepts could influence how policy makers, economic development
specialists, and business owners answer these questions. Those who seek to promote
economic growth may be more inclined to recruit individuals and businesses from outside
the region at the expense of promoting local indigenous businesses. Those who are
focused on economic development may be focused on how various factors affect the
current economic situation and may be more inclined to look towards implementing a
strategy for future prosperity that includes environmental, economic, education, health,
and other factors.

In short, economic growth indicates a rise in GDP while economic development relates to
an increase in GDP and improvement in other ways of life such as decline in poverty,
inequality, illiteracy and betterment in the quality of life. Economic growth is only a
quantitative change whereas economic development is accompanied by both quantitative
and qualitative changes. Moreover, economic growth is necessary for economic development
to take place.
Economic growth refers to a rise in national or per capita income and product. It indicates a
rise in material standard of living. Economic development implies more, but no economic
development occurs without economic growth. In addition to a rise in per capita income,
economic development implies fundamental changes in the structure of the economy.

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Self test exercise 1

How do we measure economic growth and economic development?
What factors affect the measurement of economic growth and/or economic
development?

1.3. GDP as Measure of Welfare

• GDP is the best single measure of the economic well-being of a society.
• GDP per person tells us the income and expenditure of the average person in the
economy.
• Higher GDP per person indicates a higher standard of living.
• GDP is not a perfect measure of the happiness or quality of life, however.
• GDP is a good measure of economic well-being because people prefer higher to

lower incomes.

• It is not a perfect measure of well-being because some things, such as leisure time

and a clean environment, are not measured by GDP.

1.4. Measurement Issues of Economic Development

• Indicators of broader concepts of economic development.

• Social indicators reflecting access to basic human needs.
• Basic human
indicators
• Infant mortality rates.
• Life expectancy.
• Child malnutrition.
• Adult literacy.
• Access to doctors or safe water
• Personal computers etc

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Human Development Index (HDI)

The HDI is the best known effort to combine social indicators into an overall
indicator of development (UNDP).
The HDI combines measures of life expectancy, educational attainment and GNP
per capita

Self test exercise

What is HDI?
How do we measure HDI?

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Chapter- Two
Development Planning: Definitions, Objectives and Rationales
After successfully completing this chapter, students are expected to

 Know the meaning of economic planning

 Understand the objectives of planning
 Identify the rationales for planning
2.1. Meaning of Economic planning

There is no agreement among economists with regard to the meaning of the term
“economic planning” The term has been used very loosely is economic literature. It is
often confused with communism, socialism or economic development. Any type of state
intervention in economic affairs should not be treated as planning because the state can
interfere with out making any plan.
“Planning is neither the preparation of a list of schemes nor is it a political idealism;
it is rational, wise and scientific method for achieving certain socio-economic goals
and objectives.”
Jawahahrlal Nehru
What then is Planning?

➾ Planning is a technique, a means to an end the realization of certain pre-determined

and well –defined aims and

objectives laid down by a central planning authority. The end may be to achieve
economic, social, political, or military objectives.
Lewis has referred to six different senses is which the term planning is used in economic
literature.
1. Planning refers to the geographical zoning of factors, residential buildings,
cinemas and the like. Some times this is called town and country planning and
some times just planning.
2. Planning means only deciding what money the government will spend in the
future, if it has the money to spend.

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3. A planned economy is one in which each production unit or firm uses only the
resources of men, materials and equipment allocated to it by quota and disposes of
its product exclusively to persons or firms indicated to it by central order.
4. Planning some times means any setting of production targets by the government,
whether for private or public enterprise.
5. Targets are set for the economy as a whole, purporting to allocate all the country‟s
labor, foreign exchange, raw materials and other resources between the various
branches of the economy.
6. The word planning is sometimes used to describe the means which the
government uses to try to enforce upon private enterprise the targets which have
been previously determined.
But Ferdynanad Zweig maintains that planning is planning of the economy, not within
the economy. It is not a mere planning of towns, public works or separate section of the
national economy, but of the economy as a whole. Thus planning does not mean
piecemeal planning but overall planning of the economy.
To Hayek, planning means,” the direction of productive activity by a central authority”.
One of the most popular definitions is by Dickinson who defines planning as” the
making of major economic decisions what and how much is to be produced, how, when
and where is to be produced, to whom it is to be allocated, by the conscious decision of a
determinate authority, on the basis of comprehensive survey of the economic system as a
whole.
Although there is no unanimity of opinion on the subject, yet economic planning as
understand by the majority of economists implies deliberate control and direction of the
economy by a central authority for the purpose of achieving definite targets and
objectives within a specified period of time.
Planning is there in the household management or management of the private firms as
well. It is a process which aims at choosing most economizing means for satisfying
certain macro ends and a system under which coordination is brought about in the
economic ends of individual producers and the production and exchange process is
somewhat regulated and directed by the state, if not in its entirety.

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Now we can omit the need for having a strong central authority. There can be a planning
commission which may tell different sectors of the economy (private, cooperative, joint,
public etc) about the targets to be achieved or about the physical consistencies expected.
The work is not to be sporadic nor transient. It will not be limited to certain activities
only (town and country planning) or a sector only (agriculture or irrigation only).
Prototype planning was not planning within the economy; it was planning of the
economy. In the changed environment rigorous planning of the economy by a centralized
authority is to be excluded.
Private enterprise and free consumer choices can now determine the investment pattern;
comparative cost principle need not be discarded. Complete egalitarianism may not be
insisted upon, though eradication of poverty, generation of higher employment and
propagation of higher incomes will remain the important objectives of planning.
Rationalized economic decision and coordination will remain the hallmark. The society
cannot remain concerned with present only; “futurology” will be part of planning.
Reductions in the inter-personal and inter-regional disparities remain the objectives of
planning. Above all, the quality of life of people is to be improved.

2.2. Objectives of economic planning

In this section, you will study about some of the possible ways in which planning could
be superior to market forces.

➾ under planning there are wider opportunities of formulating objectives as compared to

those available under market. Further public oriented objectives are possible generally
under planning whereas this is not easy under market.
1. Wider opportunities:- In the market system, decisions about what and what not
to do are limited by two factors.
1 the short life-span of individuals
2 the limited amount of resources that an individual can command
To an extent that limitations are reduced by joint action on the part of individuals through
such organizations as joint-stock companies, but these are never as long-range in vision
and as large in resources as those of a community taken as a whole. As a result of these
limitations, economic units in a market economy opt for small and short-gestating

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investments, requiring small amounts of resources whose fruits can be reaped in the life
time of an individual.
Besides, there is, in general, a preference for the production of consumption goods as
they give immediate satisfaction to individuals, whereas in particular long-gestating
investments would be of use to others- the unborn individuals belonging to the distant
future. (Futurology, intergenerational resource allocation)
The above-mentioned limitations, however, just do not exist is planning, where the
resource user is the community as a whole.
This is so because of two reasons.
1. a community, unlike an individual never dies
2. the resources of a community are larger
This makes it possible for a community to visualize a longer and larger horizon, as
compared to that in the case of individuals, making the number of opportunities greater in
the case of community than of the individual.
2. Public-Oriented Goals
 Planning enables the community to use resources socially, as against individually
under a market system.
 The production of goods meant for social consumption like education, health
services, parks, etc is possible only if undertaken by public authorities. In a market
economy, such goods are not relevant.
 In a market economy, production of those goods whose demand is backed by money
offer takes place (i.e., production is profit-driven, profit incentive )
Even anti-planners concede the need and desirability of public goods by public
authorities.
The market system takes cognizance only of market- backed wants (depending largely on

the institution of private property) and totally ignores non-management howsoever

genuine and important they may be.

This point needs no further stressing except to mention the fact that in richest capitalist
countries on this earth, while luxury goods abound, hunger and poverty still stalk in those
nations.

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When it is said that planning makes resource-use social, it is implied that society decides
how much of individual wants, and how much of social wants can be satisfied with given
resources and further how much of the productive capacity should be earmarked for
future society, and how much for the present society.

3. Bigger Resources
Another decisively superior rating of planning arises from the fact that the resources
available under it are far more than the private operators can organize in the same set of
circumstances.
This point can be established with reference to the three principal ways in which larger
resources became available
A. No Wastage
Planning need not and should not involve frittering away of resources as is the case in a
market. In a market system the wastage of resources occurs in the form of existence of
idle capacity during the depression phase of business cycle, as also the misdirection of
resources on account of selling costs ( transaction cost ) under imperfect competition.

In planning there is no question of a business cycle because demand and supply are
balanced in advance. As a result of this, there is no occasion for the capacity to remain
idle. Moreover, there are no competitors but only partners in planning. Thus, there is no
question of selling costs, involving misdirection of resources in senseless advertising,
salesmanship etc Therefore, the resources which remain is actual use and in proper use,
are more than in a market economy.
B. Larger means and variety
The amount of resources available under planning is larger on account of the larger
means to tap resources. This is so because plans include all types of resources regardless
of the fact whether these are profitable in the market sense or not.
In a market system, the total quantum of resources equals the sum of individual
resources. Besides, these resources are by and large those which are available in money-
form like savings in banks, share money, Profits etc. In planning, however, the available

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resources include not only the total available with the individuals, voluntarily parted
within the form of deposits, equities, etc but also those which the government can secure
over and above these through the use of compulsory devices like taxes, deficit financing
etc.
C. Future Resources
The planning authority can enlarge the future horizon of resources by adopting a certain
type of production activity rather than another type of activity. A government can opt for
a program which makes available more resources in the future.
4. Langer Production
In a planned economy total production of goods is bound to be a bigger quantity than that
under a market economy largely for the following three major reasons:
A Larger resources

B Superior use- pattern ➾ more capital goods and less consumer goods are

produced under planning because the community is immortal whereas invertors are
myopic.
C. Higher Capital- out put ratio: - this results from the less underutilized
capacity and in case of perfect planning, no idle capacity. This occurs because demand
and supply are balanced ex-ante
5. Better Technique: - In planning, as compared to a market economy, there are
opportunities to use any technique, provided it is in social interest, say large production.
6. Faster Growth: - E.g. China experience
Planning is superior to market in bringing about a faster rate of growth. This is because of
i. Policy decision
ii. Langer saving
7. Better Distribution
a. Eliminating property incomes
b. More public consumption
c. Larger incomes
8. Responsive to Big Tasks

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Planning is responsive to big tasks during emergencies as opposed to market forces. The
operation of the free market does not address national tasks and national emergencies,
say, it can not mobilize people to the war front when a country is invaded by intruders.
E.g. National Tasks
National Emergencies which can not be foreseen
E.g. organizing a war

2.3 Need for planning

 Planning has been introduced in different countries for different reasons.
 In socialist countries, where revolutions preceded and public ownership of resources
followed, planning became an institutional need of the system
 In non-socialist countries, with private ownership, several factors have necessitated
the use of the instrument of planning.
 In underdeveloped countries, development needs have been predominant in
popularizing planning.
 Though one can describe many different factors for the adoption of planning, the
major ones are
a) Institutional
b) Technological and economic
c) Development
A) Institutional Requirement
 The use of planning in socialist countries is inherent in their situation.
 One aspect of this is the abolition of private ownership in the means of
production and its replacement by state ownership.
 Another aspect is the character of ideology that has inspired people in this
structural change of owner ship.
 For newly independent countries of Asia, Latin America, and Africa in
which national resurgence has preceded the winning of freedom, and
where, for the sake of economic independence and for enacting the break
with the past economic slavery, planning has been found to be the most
effective institutional medium.

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I. Public Ownership: - once means of production are owned by the state, as is

the case in all socialist countries, the need for planning emerges automatically.
- It is both because state as owner of resources must decide about their use, and
because the ideology, which inspiring all-out state ownership, requires it.
II. Use of resources by state. The change in the ownership pattern, from private
to public is associated with the demolition of the alternative market
mechanism for the use of resources.
III. Replacing obstructive capitalism: - according to Marxian philosophy,”
Capitalism bears the fruits of its own destruction.” Marx predicted that
capitalism is doomed to fail because of the inherent weaknesses in the system
itself.
Ideological considerations
 Apart from public ownership of the means of production, the ideology that motivates
socialist countries also requires for its practice the instrument of planning.
a) Social character: - i.e. production is social in nature. The veil of
money as a medium of exchange stops.
b) Capital:- money capital
Profit is replaced by deliberate decisions in respect of the rate and
pattern of capital formation.
National Resurgence
Planning, as an institutional means also came handy to those who sought the fulfillment
of the national aspirations of countries recently liberated from centuries of colonial rule.
Almost all such countries adopted planning right from the inception of their
independence.
I Symbol of sovereignty: - a part from the dire and urgent need for telescoping
development into a few years, newly independent countries found in planning a symbol
of asserting their liberation and sovereign status.
 Development planning enabled these countries to set their common goals and gave
them a sense of being sovereign in respect of what to do and how to do it.
II Break from the past: - These countries with backwardness hanging round
their necks like a mill-stone, wanted to stage a dramatic break from the past.

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 Achieve higher growth and industrialization and put their minds off from past misery
and the humiliation associated with it.
 With a pre-vision of a bright future outlined and even quantified in plans, they were
able to turn their back on the past.
 The vistas (hopes) of future opened up in the plans made them look to the past only to
draw lessons, and to mobilize efforts commensurate with the task ahead.

Technological and economic factors

Technologies of modern times are of such nature, and involve so much expense that their
fuller utilization requires that they be used in a planned way. Equally important are the
economic factors, associated mostly with the inadequacy and malfunction of market
economies, which necessitate the use of planning techniques to overcome these
deficiencies.

A. Technological Reasons
Modern technologies, because of certain characteristics, can be put to proper use if there
is planning on a national scale.
Characteristics of modern technologies
- Indivisibility
- Adjustability
- Product changes
- Mass production
Economic Reasoning
 The need to overcome the deficient functioning of the market system
 Recent knowledge of economics and the perfection of planning techniques.
 separation of management
 Integration of economies
 Market deficiencies
 Market inadequacy
 Economic knowledge
Pre-requisite for Development
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For many countries development has been the major reason for the adoption of planning.
Planning is an essential tool for a comprehensive and integrated development of
economies that require coordinated effort.

Self test exercise

Discuss what economic planning is all about.
Why do we need economic planning? Justify.

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Chapter Three
Types of Development Planning
After thoroughly reading this chapter, you should be able to:
 Decipher the various types of development planning
 Distinguish the distinctions that exist among the different types of planning
3.1. Introduction
In theory there can be varieties of planning. In practice too, planning has taken on various
forms, resulting from differences in :
 Time period
 Geographical area
 Institutions affected
 Media of planning
 Extent of activities covered
 Mode of executing plans etc.
Among the many types, the important ones are
 Long-term, medium-term and short-term planning
 Fixed and Rolling plans
 Regional, national and International planning
 Sectoral and area planning
 Structural and Functional planning
 Indicative and Imperative planning
Long-term, medium-term, and short term planning
 This classification of plans is based on the division of time into long, medium
and short periods
 Long-term covers 10, 15, 20 and even more years.
 Medium term extends over 3 to 5 years and even up to 7 to 10 years.
 Short-term plans relate to as short a period as one year.
Long-term plans
 Long-term planning is becoming quite popular these days to take a longish
view of the future of the economy.

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 The statistical techniques now available make it possible to forecast

reasonably well the course of events for such a long period of time.
Examples
- Demography long-term projections can accommodate the
- Health implications for development in these fields.
- Education
Characteristics of long term planning

1. Greater freedom of choice:- the number and intensity of constraints on

choices are much less in long-tem planning
2. Broadened scope: - It is possible to over-reach the narrow frame of purely
economic considerations and to explore social and human implication of
economic development .Besides; it may be feasible to overcome the narrow
boundaries of national planning and plan in the international context.
 The resource availability over a longer period is much greater and more
flexible than in a short period.
 Over a longer period one can include, besides the resources that will pile
up over the years, new resources that will be made available only in the
future. Such a comprehension of resource availability makes for greater
freedom of choice in respect of planned activities as compared to medium-
term and short-term planning periods.
Purpose of long term planning
Long-term planning in the first place provides a vista vision of the future. This period is
long enough to allow for structural changes to take place and to work themselves out.
Changes which are associated with civilization, societies and modern science and
technology can be taken account of in this length of time. Such a long –range frame of
time thus enables one to encompass economic and non-economic movements.
This helps in presenting a total view of the future.
In the context of this future vision, planners perceive objectives and availabilities of
means for a society in the light of its philosophy or ideology which inspires the lifestyles
of that particular society.
Merits of long-term planning
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Besides the important purpose which long-term planning serves, it has certain merits,
among these; one may mention three principal beneficial implications.
A. Educative: - long term planning provides an opportunity of informing and
explaining to the public the major problems that are posed by the future society,
the available choices and the limitations which surround these choices,
 It helps in preparing more realistic medium and short-term plans
 There is a better understanding of the processes of economic development
which is of particular relevance to developing economies.
B Explanatory: - A long-term perspective is helpful in enlightening the decision
makers and those who are to implement the plans. The information made available under
this type of planning ensures integration of short-term plans into a longer-term
framework. This enables the planning authority to make adequate preparation for the
solution of problems that may arise in the future. Besides, perspective plans make it
possible to assess the long-term implications of medium term and short-term decisions.
C. Stimulant: - Long-term plans by making obvious future choices and by reducing
uncertainties enable decision-makers to act boldly in respect of decisions for shorter term
plans. Public opinion too gets adequately stimulated because perspective plans open up
prospects for progress and reduce incomprehension of the implications of the present.
Such knowledge on the part of the public reduces hesitations in respect of short-term
plans.
Limitations of long term planning
 The future is uncertain
 In case this type of planning is confined to prognostic forecasting (foretelling), no
firm thinking on the subject will be possible.
Medium-term plans
 They extend from three to ten years.
 They fall between the long-period and short-period plans.
 They have a two-fold significance.
 First, they act as link between the long period and the short-period plans, and thereby
connect the chain of time.

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Second, these plans draw upon the horizon chalked out in the long-term perspective plan,
and at the same time present a framework for drawing up short period plans.
Rationale
 The period coincides with the business cycle which is around seven years.
 Development activities like road building, training man power, raising of saving as
percentage of national income fall under this type of planning
 The period is enough for planners to remedy mistakes in the early years of planning.
Political reason
 It helps in securing peoples‟ co-operation in the implementation of plans.
 Helps to bring forth the better enthusiasm for sacrifices to achieve the plan objectives.
Psychological reason
 Under this planning period, adults can well see the results of their efforts.
Indicative
Medium-term plans are generally indicative in nature, and provide the framework for the
action to be embodied in short-term plans. In other words, these plans are not operational.
Though indicative, many if not all, of the plan objectives are quantified. In fact, the
performance during annual plans is evaluated more in terms of the criteria of medium-
term plans, and less in terms of long-term plans.
Short-term plans
 Short-term plans are also annual plans because the action for the period of one year is
linked with the budgets of government, usually presented after every one year.
Controlling plans:- these plans are also called controlling plans mainly for two
reasons.
Namely
1) Government gets authority from parliament to spend money, which is usually for
one year.
2) It is during this one-year period that resources are actually matched to
requirements or targets. Thus the actual operation of any plan is controlled in the
one-year document.
Framework

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Annual plans are governed by medium-and long term plans, both in respect of the goals
to be pursued and the methods by which these are to be achieved. In the words of Jan
Tinbergen “the main function of both 5-year (i.e. Medium term) and perspective plans is
to specify the government intentions. One year plans, on the other hand, have the task of
setting out how the government‟s policy should be carried in to effect.”
Summary
 Long-term plans specify (clarify) the perspective and vision of a society
 Medium term plans concretize aspirations, many of them in quantitative terms, for
a shorter-period.
 Short-term plans provide for action.
Fixed and Rolling Plans
Fixed planning
 It refers to the unchanging period of time for which a plan is prepared.
 For example, a plan for a period of five years, 1975-80, will be a plan for this period
alone. The plan for this period will run its full course of five years. After this will
begin another plan of five years, spanning the next period from 1980 to 1985. And so
on and so forth.
 While the fixity of period is the basis of this type of planning, there is more that goes
with it than the given length of time. Fixity implies that the targets that have been
formulated /quantified are equally fixed. So are the means that have been designed for
the purpose. The plan thus is unchangeable for the period of five years. Fixity on both
the time period and the targets is the hallmark of fixed plans.
 A fixed plan is thus a plan that remains fixed (given) for a specified time period.
 Sometimes important changes can be incorporated in fixed plans. This may happen
for many reasons.
a. Resources may fall far short of needs,
b. International development may upset calculations in respect of foreign resources
etc.
A Fixed plan lays down definite aims and objectives which are required to be
achieved during the plan period. For this purpose, physical targets are fixed along
with the total outlay.

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- Physical targets and financial outlays are seldom changed except under
emergencies.
Merits
 It makes for boldness in planning i.e. under such a planning one can design for
higher objectives with larger resources, with little fear of their being scuttled
down.
 It ensures effective implementation: - because this type of planning presupposes
commitment to the plan.
 It provides for stability in the economy: - because it imparts certainty to the
functioning of the system.
 Fixed plans act as performance-test to check on the efforts made, their adequacy
or inadequacy and success/ failure to locate the points that deserve approbation/
disapproval as also to draw lessons there from.
 There is a “checking” mechanism built into the planning system. Every one will
there fore be subjected to scrutiny.
 There is bound to be disciplined thinking and action in respect of the formulation
of policies and their execution.
Pitfalls (shortcomings )
 Weaknesses arise from the inflexibility of such plans. Plan targets are rigidly
fixed. Changes can not be easily made.
 Wastage of resources prevails if the plan gets out of tune with the reality.
Rolling plans
As the name implies, it involves the rolling of a plan at intervals, usually one year, so that
it continues to be a plan of certain number of years.
To illustrate a rolling plan let us take a hypothetical plan for the five year period, 1980 –
1985.
 After the first year is over in 1980, another year 1986 is added, so that it
becomes a five year plan for 1981-1986.
 In 1982, one year, namely 1981, gets dropped, and 1987 added. As a result in
1982 there is again a five-year plan of 1982-1987. And so on and so forth.

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 Thus as the first year is over, the fifth year is stretched into the next year. The
time-span of such plans roll, shedding the initial one year, and adding one as the
terminal year. Thus, every year the time-horizon is kept for the five-year period.
Features of rolling plans
 They are based on unfixed dates
 Revisions and adjustments are part and parcel of the technique of rolling
planning
 Provision for change: - rolling plans always beep open the door for changes.
Merits
Flexibility: - this methodology enables planners to keep their options open and make
necessary changes if and when circumstances require. The rigidities of fixed planning are
tackled here.
Realism: - this type of planning is a realistic exercise. The targets and the provisions
for them remain feasible propositions in view of the revisions and adjustments that are
made as per changes in the circumstances surrounding the plan.
 Being flexible a rolling plan is more realistic than a fixed plan. It takes into
consideration such unforeseen natural and economic changes.
Demerits It creates uncertainty: - one serious drawback is that it causes uncertainty,
something that knocks the very bottom out of the planning itself. Because of the recurring
changes, both the private sector and the government remain unsure of each other‟s
responses.
 It lacks boldness:- rolling plans make planners timid, as a result less than
possible or desirable is attempted.
 Since these plans are prone to revisions, these exercises become a cover for not
making difficult decisions or taking courageous measures.
 Every time a difficult situation arises, there will be the temptation of adopting
the easier course of revising downward the targets of plans. Such a planning
would amount to doing what can be done without planning. It is contended that
the rational of planning lies in achieving more than what can be done in a
market or non-planning situation.
 Lacks commitment: - rolling plans preclude any commitment to planning.

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 Weak discipline: - there are no fixed goals and means nor enough will to
back it up. There is little basis for expecting any disciplined thinking and action
in respect of the formulation of policies and their execution.
 Inadequate test: - they do not provide any test to check the performance of
the economy. In the absence of established provisions, it is impossible to judge
whether and to what extent implementation has taken place. Besides, there will
be no urge or need to assess the magnitude of deviation from the original plan.
Regional, National and International planning
 These types of planning largely rest on the basis of spatial(geographical)
differences.
 Within a nation, planning for separate regions is described as regional planning.
 National planning includes the whole of a country whose geographical area is
determined politically.
 International planning refers to the planning of countries at the world level.

Regional planning

 This type of planning is carried out within the framework of national scheme to
better meet the special needs of a region and the wants of its population.
 Regional planning has a two-fold dimension
a. It is part of the national plan
b. It is a plan on its own merit.
Some scholars view regional planning as a one-dimensional scheme. According to this
view, regional planning is planning for a region and the national economy comes into the
picture only to be controlled for the purposes of executing a regional plan. Example
Tennessee Valley Authority
Rationale
 Special needs: - there are special needs of regions which require separate
treatment because they are not properly or fully dealt within national plans.
 National plans do not necessarily fulfill all the needs which are peculiar to
regions.

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Special capabilities: - certain regions are endowed with special capabilities like the
availability of certain types of labor, or skill or certain natural factors like proximity to
shortest sea routes to other countries, etc.
Regional Differences:- Regional difference in terms of levels of economic
development, natural resources, culture and language, etc are so large that it becomes
necessary to have regional plans to accommodate regional peculiarities and aspirations
into the national plan.
National planning
 National planning has two essential features which make it possible to identify it
from the other two types of planning Namely:-
a) It is conterminous with the political boundaries of a nation.
b) There is one political regime that has a full control over the
entire area.
Rationale
 National planning is the only sort that must exist before one can even legitimately
speak of regional or international planning. Further, the other two types of
planning draw off from national plans in the sense that both, at the present level of
consciousness when internationalism is still not mature, cater to the needs of and
are subservient to national plans.
 The resources of a country are effectively utilized in the sense that politically it
becomes possible to make full use of national resources.
 The resources of a country are effectively utilized in the sense that politically it
becomes possible to make full use of national resources.
 Centralized control which national planning permits makes for a rational use of
resources.
 National planning becomes useful when combined with the other two types, in
respect of full use of a nation‟s resources and for a healthy growth of
international trade and the efficient economic structure of the countries.
International planning
 International planning concerns countries at the world level.

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 If all the countries plan the use of their resources through a single agency with
political authority, it can be cherished. “World planning”. Short of that, any
planning effort among countries may be called “international planning”. The
sphere of activities planned depends upon the extent to which the participant
countries agree.
Activities covered: - The scope of international planning differs with differences in
the activities covered and the number of countries involved.
From the angle of activities covered, one can distinguish two distinct patterns in extreme
forms with so many falling in between the two.
In an extreme pattern, one may conceive of countries merging into one another, giving
rise to a new politico-economic unit. This amounts to pooling of all resources, leading to
full-scale planning as if it is national planning.
At the other extreme can be another form, under which the participant countries retain
their individuality in terms of economic policies in respect of trade and exchange, but
join hands in planning one or a few activities.
Example:-1 COMECON (the council) for mutual Economic Association of the
communist or socialist countries.
Example2:-Coffee Board
Number of countries: - the number of countries, depending upon the size of the
participating countries, fixes the area falling under international planning. In other words,
it determines the scope of planning horizontally or geographically.
Example
I. Food and Agricultural Organization
II. COMECON:- related to a limited number of countries
III. Colombo plan: - association of south and South East Asia counties.
Cooperation and mutual Assistance: - In actual practice, international planning
has been in most cases confined to two forms.
In one form there are groups of countries, each group planning for its members in respect
of activities they have agreed upon or for mutual assistance.
Example COMECON, Colombo plan etc

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The other form is wherein certain activities are planned at the world level, largely
through UN agencies. Planning is confined to those activities agreed upon. Execution is
mostly left to member countries of the UN or that of the group dealing with those
activities.
International planning is thus mostly in the nature of cooperation and mutual assistance
among member countries.
Conditions necessary for the success of international planning
I. Limited objectives: - It is extremely difficult to cover all the activities of
nations. Because of the differences in the levels of development, economic,
cultural and historical conditions, each county can not develop fully by delegating
all the powers of planning to a single international agency.
II. Thus, international planning should begin with limited objectives; increase its
scope slowly alongside the reduction in economic levels of member countries.
III. International apparatus: - an apparatus for the preparation of world plans
should be instituted in consultation will potential member countries.
Sectoral and Area planning
Sectoral planning
Meaning: - It refers to planning in terms of the sectors of an economy.
These sectors can broadly be divided into
2. Primary
3. Secondary
4. Tertiary
- Primary sector, Eg. Agricultural crops like food grains and some plantation crops
- Secondary sector, Manufacturing industrial like steel industry, cotton textiles etc
- Tertiary sector, service sector
 Sectoral planning can also be divided into consumer goods and capital goods
producing sectors.
 The basis of sectoral planning is the division of the economy into sectors of economic
significance in respect of production and consumption
 Planning for these sectors is not bounded by geographical limits, except that of
national boundaries.

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Rational
- Planning in terms of sectors is the only way to comprehend the totality of
economic life
- Changes in the economy can be incorporated in plans by providing for adequate
inputs, institutional reforms, and policy prescriptions.
- Economic activities are conceived in terms of the sectors of the economy.
- Sectoral planning supplements area planning.
Area Planning
Meaning: - It is planning in geographical terms. In the plan the schemes included are
bounded by the limits of space. That space may be conterminous with the boundaries of a
village or a cluster of villages, or a district, or a region etc. The programs are location or
area specific.
- The area plans focus on the economy of the block. For this reason, it is called area
planning.
- This is to be distinguished from the sectoral plans which are in essence
technological divisions of an economy into sectors.
- The area plans are smaller unit plans, linked with larger unit plans.
- Sectoral plans are not bounded by areas within a country.
Rationale
- Area planning is of immense significance to a large-sized country of the
continental dimensions. Because such a country is likely to have regions with
varying climatic and resource difference.
- There is again the likelihood of such a country inhabited by people of different
tastes, living patterns etc
Example, Ethiopia, India
- Area planning allows the fuller exploitation of the potentials of the areas fixed for
micro-plans.
- Area planning makes planning viable not only at the small area level, but also
imparts strength and substance to the bigger area/national plans.
- Area planning is necessary for the achievement of certain specific objectives.
Examples of Area planning

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i) Drought prone area program

ii) Hill area Development program
iii) Integrated rural area development program
 Area planning is an indispensable tool for the achievement of particular objectives
Decentralized and concretized planning
Decentralized choices (also known as market forces) and centralized choices (or planning
office)
Decentralized planning
This is associated with capitalist economies. However, even in mixed economies with a
significant proportion of public sector enterprises, decentralized planning prevails.
Market-dominance: - the predominant characteristic of decentralized planning is the
dominance of the market in decision making.
Problems and Difficulties of decentralized planning
1. Incompatibility /between what the plan requires and what the market does.
2. Adjustment difficulty: it is not possible to know in advance the reactions of the
market. This makes adjustments difficult.
3. Non-planning:- imbalance between demand and supply
Central Choices
Under centralized planning, the main decisions are made by the central planning office.
Main decisions could vary with time and circumstances. However, the predominant ones
include:-
- Prices
- Volume & investment
- Amount of wages etc
Problems and difficulties of centralized planning
 Difficulties of calculation
 Inadequate control and information
 Rigidity and bureaucracy
Structural and functional planning
This classification of planning is done in terms of whether it is associated with
institutional changes or not.

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If changes in socio-economic institutions are part and parcel of planning, it is called

structural planning.
In functional planning, no big changes in the socio-economic structure of society are
involved. Planning is done with in the framework of existing instructions.

Structural planning is associated with big changes in the set-up of a country, in addition
to the changes in such economic magnitudes as national income, investment etc. Under
functional planning; it is by and large the economic magnitudes which undergo changes
with the socio-economic framework of society remaining intact.

Thus, structural planning causes many and often major upset in the life of the people.
While functional planning causes no such upsets but only tiny vibrations in the lifestyle
of the people.

Indicative and impetrative planning

- The distinction between these two types of planning mainly rests on the sphere of
implementation and formulation of plans.
Indicative planning: - serves as a guide to decision making.
- This planning is to be found in capitalist economies /mixed economies
- It helps to coordinate different economic units
- Indicative planning enables to make prediction of the probable or feasible future.
Besides, it specifics a desirable future, in terms of growth rates for the economy
- It brings forth more commitment to its implementation/ execution.
Imperative planning /directive planning
In imperative planning, the implementation is provided for along with plan
formulation. In other words, once a plan is drawn up, its implementation is a matter of
enforcement. For this reason it is also called directive planning.

Planning by direction and planning by inducement

Planning by Direction
- it is an integral part of a socialist society
- it entails complete absence of laissez-faire

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- There is one central authority which plans, directs, and orders the execution of the
plan in accordance with pre-determined targets and priorities.
- It is a comprehensive planning and encompasses the entire economy
- The various ministries and enterprises are duty bound to carry out the targets and
directives of the national plan
- The state holds the “commanding posts” in its hands by taking over the entire
private industrial and agricultural sectors, and banking and transport.
Drawbacks
1. Planning by direction is associated with a bureaucratic and totalitarian regime.
There is complete absence of consumers‟ sovereignty. People are not allowed to
spend and consume according to their choice. Even the right to choose one‟s own
occupation does not exist.
2. Both the consumer and labor markets are determined by the planning authority.
Rationing and price controls are the main propositions of planning by direction
which will lead to corruption and nepotism /cronyism
Economic planning would involve directions of almost the whole of our life.
- Planning by direction is unsatisfactory because the present economic system is
exceedingly complex.
3. Planning by direction is always inflexible
4. The fulfillment of the plan targets is difficult
5. planning by direction develops the tendency to procrastinate tasks
6. planning by direction is a costly affair
Planning by inducement
- Planning by inducement is a democratic planning
- It means planning by manipulating the market
- There is no compulsion but persuasion
- There is freedom of enterprise, freedom of consumption and freedom of
production.
- But these freedoms are subject to state control and regulation
- People are induced to act in a certain way through various monetary and fiscal
measures

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- If the planning authority wishes to encourage the production of a commodity, it

can give subsidy to the firms.
- When the planning authority finds shortage of goods in the market, it can
introduce price controls and rationing.
- In order to increase the rate of capital formation, the planning authority can then
undertake public investment and/or encourage private investment. It can adopt a
suitable monetary policy and at the same time a taxation policy which encourages
investment and discourages consumption
- Planning by inducement is able to achieve the same results as those likely to be
achieved under planning by direction with less sacrifice of individual liberty.
Difficulties of planning by inducement
i) The incentives offered may not be adequate for the producers and consumers
to act the way the state desires them to behave. It may upset the government
plans.
ii) Surpluses and shortages are bound to arise because the actual working of the
plan is left to the market forces. In other words, proper adjustment between
demand and supply is difficult to achieve.
Shortages are frequent and they necessitate price control and rationing which
are the forms of direction. In such a station, planning by inducement merges
into planning by direction
iii) Monetary and fiscal measures alone are not adequate to induce planned
development of the economy by raising the rate of capital formation.
Financial and physical planning
Financial planning refers to the technique of planning in which resources are
allocated in terms of money whereas physical planning pertains to the allocation of
resources in terms of men, materials and machinery.
Financial planning
- Finance is the key to economic planning
- If sufficient finance is available, it is not difficult to achieve physical targets.
However, without the stipulated financial resources, it is not possible to carry the
plan to it s successful culmination

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- Financial planning is essential in order to remove maladjustments between

supplies and demand and for calculating costs and benefits of the various projects.
- In the case of financial planning “the outlay is fixed in terms of money and the
estimates are made on the basis of various hypotheses regarding the growth of the
national income, consumption, imports etc., to cover the outlay by taxation,
savings and the increase in the cash holding. “
- Financial planning should also establish equilibrium between
 Private investment and public investment
 Foreign payments and Foreign receipts etc
- By securing a balance between demands and supplies, financial planning should
avoid inflation and bring about economic stability.
Limitations
i) Measures to mobilize financial resources through taxation may adversely
affect the propensity to save.
ii) In an underdeveloped country there is a vast subsistence non-monetized sector
and a small organized money sector. This will lead to shortages in supplies
and to an inflationary rise in prices.
iii) Supplies can be increased through imports which will lead to balance of
payments difficulties from which under developed countries already suffer.
iv) Financial planning can create inflationary pressure in the economy.
v) Financial planning could aggravate the disparity of income distribution i.e.
worsen income inequality.
Physical planning
- This is planning in terms of factor allocations and product yields so as to
maximize incomes and employment
- The physical balance consists in a proper evaluation of the relation between
investment and output.
- Investment decisions to be made in each sector are articulated in physical
planning. Besides, the amount and kinds of various goods needed in order to
obtain an increase of output of a product are specified

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- In physical planning, an overall assessment is made of the available real

resources such as raw materials, man power etc
- Physical planning requires the fixation of physical targets with regard to:
o Agricultural and industrial production
o Socio-cultural and transportation service
o Consumption levels and employment
o Income and investment levels of the economy
- Physical planning has to be viewed as an overall long-term planning rather than a
short term piecemeal planning.
Limitations
i) Lack of statistical data and information with regard to the available physical
resources. If physical targets are fixed beyond the availability of resources on the
basis of inaccurate data, planning will end in a fiasco.
ii) Problem of balancing the different segments of the economy
It is not possible to attain internal consistency of a high order in an
underdeveloped country due to its inherent structural difficulties.
iii) Shortages in physical targets are likely to lead to inflationary pressures through an
increase in prices.
iv) Physical planning can not succeed without financial backing.

Self test exercise

Compare and contrast financial planning and physical planning

Democratic planning and totalitarian planning

Democratic planning
It implies planning within democracy.
- In democratic planning, people are associated at every step in the formulation and
implementation of the plan.

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- A democratic plan is characterized by the widest possible consultations with the

various state governments and private enterprises at the stage of preparation.
- It seeks to avoid clashes, and tries to harmonize all opinions that are for the
welfare of the people.
- Cooperation of different agencies, and voluntary groups, and associations plays a
major role in its execution.
- The plan is fully debated in the parliament and the state legislatures and in the
private forums.
- The plan prepared by the planning commission is not always accepted as it is. It
can be rejected or modified by the parliament of the country.
- Hence, the plan is not forced upon the people from above. It is planning from
below.
- Democratic planning respects the institution of private property.
Nationalization is resorted to the limited extent absolutely necessary and
reasonable compensation is paid in all cases. Price mechanism is allowed to play
its due role.
The government only seeks to influence economic and investment decisions in the
private sector through fiscal and monetary measures.
The private sector operates side by side with the public sector. There is healthy
competition between the two for the fulfillment of the plan targets. Democratic
planning aims at the removal of inequalities of income and wealth through
peaceful means by taxation and government spending on social welfare and social
security schemes. Individual freedom prevails. People enjoy social, economic and
political freedoms.
Criticism
 Critics claim that democratic planning is a myth.
 Some sort of state intervention is inevitable even in democratic planning
whereby economic freedom becomes ridiculous.
Totalitarian Planning
- This is a comprehensive planning

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- In totalitarian or authoritarian planning, there is central control and direction of all

economic activity in accordance with a single plan. There is planning by direction
where consumption, production, exchange, and distribution are all controlled by
the state.
- In authoritarian planning, the planning authority is the supreme body. It decides
about the targets, schemes, allocation, methods and procedures of implementation
of the plan. There is absolutely no opposition to the plan. People have to accept
and rigidly implement the plan.
- Economic and political powers are polarized and social life is regimented. There
is thus no democratic freedom in authoritarian planning which is extremely rigid.
Limitations
- It sacrifices peoples‟ freedom of choice. In other words, the loss of economic,
social and political freedoms is enormous.
Planning under capitalism and socialism
Planning under capitalism is not based on any central plan. In the absence of a central
plan, the means of production are owned privately. Production is also carried out by
private enterprise. It is not planned by the government. Market prices are determined by
market forces and are not set by the government.
Planning under socialism
Planning under socialism is based on a central plan. There is a central planning authority
or board which formulates a plan for the entire economy. There is complete centralization
of economic power in the central planning authority. It fixes the plan objectives, priorities
and targets. It organizes and allocates the resources of the economy by deliberate
direction and control for the purpose of achieving definite objectives and targets laid
down in the plan during a specified period of time.

The central problems of the economy- what and how much is to be produced, how, when
and where it is to be produced, and to whom it is to be allocated are exclusively decided
by the central planning authority.
The central plan has definite socio-economic objectives. These objectives may concern:
- Aggregate demand
- Full employment

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- Satisfaction of communal demand

- Allocation of factors of production
- Distribution of national income
- The amount of capital formation
- Economic development etc
To achieve these objectives, the planning authority owns and controls the means of
production and distribution.
Corrective planning and Development planning
A number of maladjustments arise in a capitalist economy. When the government plans
and adopts various fiscal, monetary and direct control measures to rectify them, this is
called corrective planning.

If the economy suffers from Inflationary pressures, the government adopts such
corrective measures as:-
- a contractionary monetary policy
- Raising tax rates
- Reducing consumption, investment and public expenditure
- Surplus budgetary policy.
In the event of a depression, corrective planning includes:-
- An expansionary monetary policy
- Reducing tax rates
- Stimulation of consumption
- Increase in private and public investment
- Deficit budgetary policy
Corrective planning can be used to reduce inequalities of income distribution and
concentration of monopoly power.
To reduce inequalities of income distribution, corrective planning requires the adoption
of such measures as:
- imposition of heavier burdens on the higher income groups through death duties,
steeply progressive income taxes, increased expenditure on public works and
social security etc

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- To control monopoly concentration, the government may encourage competitive

small business, start public enterprises, pass anti- monopoly laws etc.
Development planning
This is meant to develop the economy as a whole. It involves “the application of a
rational system of choices among feasible courses of investment and other development
actions. “ For this, it relies to a large extent on the market mechanism.
Under development planning, the government formulates a development plan for the
whole economy. It includes consideration of the most important economic aggregates
such as
- Total saving
- Investment
- Output
- Government expenditure
- Foreign transactions
Development planning also explores sectoral relationships in the overall framework of
the economy. In particular it lays down investment priorities for the public sector.
Developmental planning is primarily related to the development activities of under
developed countries.

Self test exercise

1 Suppose you are an expert in the Planning Commission of Ethiopia and
you are engaged in preparing a medium term plan for the next five years
of the national economy. Which one do you favor from fixed and rolling
types of planning? Justify your answer.

2 compare and contrast planning by direction and planning by

inducement.

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Chapter Four
The Basic Aspects of Development Planning
After thoroughly reading this chapter, you are expected to:
 Explain the main aspects of development planning
 Understand the stages of development planning
 Identify the prerequisites necessary to successfully prepare a plan
4.1. Plan formulation and requisites for Successful Planning
The formulation and success of a plan require the following:
1. Planning Commission
The first prerequisite for a plan is the setting up of a planning commission which
should be organized in a proper way. It should be divided and sub – divided into a
number of divisions and sub-divisions under such experts as economists, statisticians,
engineers, etc, dealing with the various aspects of the economy.
2. Statistical data

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A prerequisite for sound planning is a thorough survey of the existing potential

resources of a country together with its deficiencies. As Baykov puts it, “Every
act of planning, in so far as it is not mere fantastic castle building presupposes a
preliminary investigation of existing resources.”
This kind of survey is essential for the collection of statistical data and
information with regard to the total available material, capital and human
resources of the country. Data pertaining to the available and potential natural
resources along with the degree of their exploitation, agricultural and industrial
output, transport, technical and non –technical personnel etc. are essential for
fixing targets and priorities in planning.
3. Objective
Some of the objectives of an economic plan include:-
- Increasing national income.
- Expanding employment opportunities
- Reducing inequalities of income and wealth
- Increasing agricultural production
- Industrializing the economy
- Achieving balanced regional development and self –reliance and so on
4. Fixation of targets and priorities.
After objectives are laid down, targets and priorities for achieving the objectives
should be fixed. The targets should be both global and sectoral. Global targets
must be bold and cover every aspect of the economy. They include quantitative
production targets, additional training institutions and increasing national income,
saving and investment.

Sectoral targets pertain to individual industries and products in physical and value
terms both for the private and public sectors. Global and sectoral targets should be
mutually consistent in order to attain the required growth rate for an economy.
5. Mobilization of resources
A plan fixes the public sector outlay for which resources are required to be
mobilized. There are various internal and external resources for financing a plan.

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Savings, profits of public enterprises, net marketing borrowings, taxation and

deficit financing are the principal internal sources of fiancé for the public sector.
Net budgetary receipts corresponding to external assistance relate to the external
sources of financing the plan.
6. Balancing in the Plan
A plan should ensure proper balance in the economy; other wise shortages or
surpluses with arise as the plan progresses. There should be a balance between
saving and investment, between the available supply of goods and the demand for
them, between labor force requirements and their availabilities, and between the
demand for imports and the available foreign exchange.

7. Incorrupt and efficient administration

A strong, efficient and incorrupt administration is the sine qua non (main essential
feature) of successful planning. However, underdeveloped countries suffer from
lack of strong, efficient and incorrupt administration.

8. Proper development policy

The state should lay down a proper development policy for the success of a
development plan and to avoid any pitfalls that may arise in the development
process.
9. Economy in administration
Every effort should be made to effect economy in administration. The people
must feel confident that every pie that they pay to the government through
taxation and borrowings is properly spent for their welfare and development, and
not dissipated a way.
10. An education base
For a clean and efficient administration, a firm educational base is essential. If a
plan is to succeed, it must take into account the ethical and moral standards of the
people. One can not expect economy and efficiency in administration unless the
people possess high ethical and moral values. This is not possible unless a strong
educational base is built up whereas instructions are imparted both in the
academic and technical fields.

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11. A theory of consumption

Underdeveloped countries should not follow the consumption patterns of the more
developed ones. In other words, underdeveloped countries should be free from
demonstration effect. Inexpensive and durable goods are preferable in areas
inhabited by low-income earning people.
12 public cooperation
Planning requires the unstinted cooperation of the people. Public cooperation is
considered to be one of the important ingredients for the success of the plan in a
democratic country.
Economic planning should be above party politics, but at the same time, it should
have the approval of all the parties. In other words, a plan should be regarded as a
national plan when it is approved by the representatives of the people. Without
public support (popular enthusiasm) , no plan will be successful.
4.2. Stages of planning
There are four well defined stages through which an economic plan has to pass for
its successful working.

4.2.1. Plan formulation

The first stage in planning is the formulation of the general objectives of the plan
and their definition in quantitative terms. It is possible that the task of
formulation of general objectives may be attempted by the government itself,
though it may sometimes leave the task to the planning commission. The
definition of the general objectives in quantitative terms i.e. the drafting of the
plan is a task which is left to be performed by the planning commission. The
planning commission is a body of experts and specialists in different fields of
activities. The planning commission has the necessary data at its disposal. After
due deliberation and thought, the planning commission works out the economic
plan for the country and presents it to the government for final acceptance.

4.2.2 Plan adoption

The adoption of the plan is the function of either the parliament or the
government. In principle, the parliament or the government can make any changes

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they like in the plan. But these bodies usually do not introduce any drastic or far-
reaching changes in the draft of the plan. The reason is that the plan is a
comprehensive, coherent and well-knit document. Any substantial or far-reaching
changes effected anywhere in this document will upset the entire plan and
necessitate its reformulation by the planning commission. In light of this, the
parliament or the government makes only minor changes at the time of plan
adoption.
As soon as the plan is adopted by the parliament or the government, it becomes a
law. It then becomes the statutory obligation of the government to execute the
plan.
The position regarding the formal status of plans differs from country to country.
Generally, speaking, the national development plans of all socialist countries are
approved by their legislatures other authorities and have the force of a law. The
plan targets are mandatory on all executing agencies. Sanctions are provided in
the laws for non – execution of plan targets. Several countries with mixed
economies also provide for the enactment of their plans as laws even through they
are generally binding only on the enterprises under the direct control of the central
government.
There are two clear advantages in giving the plans a legal status.
Firstly, the enactment of a plan into law raises its status in the eyes of political
leaders, government officials and the general public thereby increasing the
chances for its fulfillment.
Secondly, it ensures continuity in the plan. This is advantageous in a country
where governments change frequently. Succeeding governments are more likely
to implement the plan if it has been enacted into a law than if it has only been
approved by an earlier government as an expression of its economic policy.
As against this, there are two disadvantages in putting a development plan on the
statute book. Firstly, if the plan in enacted into a law, it will lack the desired
flexibility which is an essential feature of a good plan. Secondly, if the plan is
submitted to the legislature for approval, amendments may be introduced to it
which disrupts the internal balance and consistency of the plan.

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4.2.3. Plan implementation

As pointed out above, the planning commission is only an advisory body. It has
no power to implement or execute the plan. The execution of the plan is the
responsibility of the government. The various government departments and
agencies take the necessary measures to execute the plan. These departments and
agencies maintain continuous liaison with the planning commission which is the
final authority as far as the interpretation of the provisions of the plan is
concerned.
Every plan, however, well – drawn it may be, has to be constantly changed during
its execution to adapt it to new requirements and new situations. In the words of
A. Lewis “Implementation of a plan is more difficult than making it. “ Making a
plan is an exercise of imagination, while implementation is a struggle with reality.
Before crossing the Atlantic, the pilot of an aircraft plots his course in relation to
expected weather and winds. Once aloft, reality is found to differ from
expectation. The plan must be modified continually to cope with changing facts.”
4.2.4. Plan evaluation
The supervision of the fulfillment of the plans is one of the fundamental
prerequisites of planning. Planning can not be considered as good unless it takes
in to account the course of the fulfillment of the plan. If the plan is not bound up
with plan fulfillment, it becomes a mere scrap of papers.

The supervision of the plan, however, calls for an independent body of experts
and technical accountants unconnected either with plan formulation or plan
execution. This body should evaluate plan fulfillment in a strictly impartial
manner. It should boldly bring to the notice of the government the failures and
drawbacks which it detects in the course of its evaluation.

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Self test exercise

There are four well-defined stages through which an economic plan has to pass
for its successful working. Discuss those stages.

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Chapter Five
Financiering A plan
After thoroughly going through this chapter, you should be able to:
 know how to finance a development plan
 identify the sources of finance for the attainment of plan
objectives
 define foreign investment and sort out its merits and demerits
 understand the pros and cons of foreign aid
5.1. International resource mobilization

Resource mobilization refers to the scheme of collecting funds for financing a plan. It
involves the study of various internal and external sources of finance for the execution of
the plan.

Finance is the instrument for resource mobilization. It is essential for the purpose of
removing maladjustments between supplies and demands of goods and services in order
to avoid inflation and balance of payment difficulties.
If sufficient funds are not available, the achievement of plan targets becomes an
impossibility. The importance of resource mobilization in an underdeveloped country lies
in curtailing consumption and augmenting savings for an accelerated investment in the
community.
Methods of resource mobilization
There are mainly three items of resource mobilization to finance the public sector.
i) Domestic budgetary resources which include
- Balance from revenues – contributions of public enterprises like railways,
posts, telegraphs , retained profit of the national bank , taxation
- State provident fund
- Net market borrowings and borrowings by financial institutions etc.
ii) Deficit financing
iii) Net budgetary receipts corresponding to external assistance. These are also
called internal sources.
Internal resources

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The principal items of internal resources are

a) current revenue balance:- current expenditure of the government.
b) Surpluses of public enterprises
c) Loans from public or public borrowings
The increasing reliance on borrowings for financing plan outlays in each year is not a
healthy sign for the economy. For it would lead to an increase in non – plan
expenditures in the form of interest payments on loans which are continuously rising
every year.
d) Taxation and domestic deficit financing are also other ways of internal resource
mobilization for financing a plan.
External Assistance
 External assistance is another source of financing a plan. It is a means to bridge
the gap between internal sources and plan outlay.
 Efforts to mobilize domestic resources through taxation, public borrowings and
deficit financing may not be adequate which necessitate the inflow of external
assistance.
Besides supplementing domestic resources, foreign aid helps in industrialization, in
building up economic overhead capital, and in creating larger employment
opportunities. It not only brings money and machines but also technical knowhow.
It opens up inaccessible areas and exploits untapped and new resources. It removes
the balance of payments problem and minimizes the inflationary pressures. Further
foreign aid helps in modernizing the backward society and strengthens both the
private and public sectors.

However, external assistance does not flow smoothly into the country. It is a very
uncertain source of income and involves many problems. It leads to dependency
because the donors insist on aid – tying to the purchase of goods and services at
costs much higher than the Competitive world prices, and on monetary, fiscal and
export – import policies detrimental to the national interest of the recipient country
For instance the recipient country may be required to keep on overvalued exchange
rate, low interest rate etc. Then there is the problem of debt servicing which, if not

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managed properly and in time, may lead the country to “debt trap” where by the
entire aid is utilized in debt servicing.

Deficit financing as an instrument of economic Development

The phrase deficit financing is used to mean any public expenditure that is in excess
of current public revenues.

In advanced countries, deficit financing is used “to describe the financing of a

deliberately created gap between public revenue and public expenditure or a
budgetary deficient. The method of financing being borrowing of a type that results
in a net addition to national outlay or aggregate expenditure.”
Role of deficit financing
Deficit financing is the most useful method of promoting economic development in
LDcs. The nature of an LDC is such that sufficient private investment is not forth-
coming due to various, social, economic and institutional factors. Therefore, the
responsibility of augmenting the rate of net investment in the economy devolves on
the government. On account of the lack of sufficient resources to finance public
investment, governments have to resort to the method of deficit financing.

Deficit financing may be used for the development of economic and social
overheads such as construction of roads, railways, power projects, schools, hospital
etc. By providing socially useful capital, deficient financing is able to break bottle
necks and structural rigidities and thereby increases productivity.

Deficit financing may also augment community savings by increasing money

incomes.

The rationale for deficit financing is that it tends to raise the income of the
entrepreneurial class which has a high propensity to save. Deficit financing is
always expansionary in its effects.
Adverse effects of deficit financing
 It has inflationary potential.
A continuing rise in prices is a dangerous way of promoting economic
development. Inflation is not only economically but also socially undesirable as a

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method of financing development. That is why; it is the most dreaded method of

accelerating the rate of economic growth.

Inflation as a method of forced savings gives rise to considerable social costs.

Inflation, no doubt, helps to reduce consumption and increases savings yet from the
social view point; it is a wasteful method of forcing savings.
Inflation may retard economic development. With the rise in the price level, the cost
of development projects also rises resulting in larger doses of deficit financing on
the part of the government. If not checked in the earlier stages, the rise in prices
becomes cumulative. The vicious circle of more money chasing fewer goods
develops which ultimately brings a total collapse of the monetary system.
Severe inflation also leads to balance of payments difficulties because imports
increase further as domestic prices rise.
Inflation encourages the speculative and unessential transactions which are major
obstacles to economic development: discourages domestic savings as well as
foreign investment; disrupts foreign trade relations, and lowers the general
efficiency of productions.
Thus, there is little positive relation between deficit financing and economic
development.

Safe limits of deficit financing

1) Growth rate of the economy
2) Growth of the monetized sector
3) Increase in loans and taxes
4) Control over wages and prices
5) Creation of import surplus
6) Increase in supply of goods
7) Increase in equity capital, undistributed profits and budgetary surpluses.
8) Spirit of sacrifice .
5.2. Foreign investment
Foreign capital can enter into a country in the form of private capital and /or public
capital. Private foreign capital may take the form of direct and indirect investments.
Direct investment
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This means that the concerns of the investing country exercise defacto or de jure
control over the assets created in the capital importing country by means of that
investment.

Direct investments may take many forms

- The formation in the capital importing country of a subsidiary of a company of
the investing country.
- The formation of a concern in which a company of the investing country has a
majority holding
- The formation in the capital importing country of a company financed
exclusively by the present concern situated in the investing country.
- Setting up a corporation in the investing country for the specific purpose of
operating in the other concerns or
- The creation of fixed assets in the other country by the nationals of the investing
country. Such companies or concerns are known as transnational corporations
(TNCS) or multinational corporation ( MNCx).
Direct private investment (DPI) has been concentrated mainly in the extraction of raw
materials like:
- iron
- crude oil
- manganese
- bauxite
- copper
- Electric energy etc.

Only a small percentage of DFI has gone to manufacturing and distribution.

Merits of private Foreign Investment ( PFI)

1. PFI provides finance, managerial, administrative and technical personnel, new
technology, research and innovations in products and techniques of production which
are in short supply in LDCs.
2. It encourages local enterprises to invest in collaboration with foreign enterprises.
3. FDI helps in filling the savings gap and the foreign exchange gap in order to achieve
the goal of national economic development in LDCs.
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4. A part of the profits from PFI is generally reinvested into the expansion,
modernization or development of related industries.
5. PFI adds more value added to output in the recipient country than the return on
capital from foreign investment. In this sense, the social returns are greater than the
private returns on foreign investment.
6. PFI also brings revenue to the government of an LDC when it taxes profits of foreign
firms or gets royalties from concession agreements.
7. PFI helps in raising productivity and hence the real wages of local labor.
8. It helps to reduce the balance of payments problem by encouraging the production of
manufactured articles, for both domestic market and foreign markets.
9. PFI encourages its local entrepreneurs to invest in other LDcs.

Demerits of Private foreign investment

1. the recipient country may be required to provide basic facilities like land, power, and
other public utilities, concessions in the form of tax holiday, development rebate,
rebate on undistributed profits, additional depreciation allowance, subsidized inputs
etc. such facilities and concessions involve cost in absorping an LDc‟s resources that
could be utilized elsewhere by the government
2. To attract PFI, LDCs have to provide sufficient facitlites for transferring profits,
dividends, interest and principal. If these payments lead to a net capital outflow, they
create serious balance of payment which eventually leads to Debt servicing.
3. PFI increases investment, employment, income and savings in LDCs. However, it
adversely affects income distribution when it competes with home investment.
Capital and other resources may flow to foreign enterprises in preference to domestic
enterprises. This may reduce profits in the latter, thereby discouraging local
enterprise.
4. Most (PFIs) reserve key executive posts for their nationals and pay them very high
salaries with many perks (fringe benefits) which are a huge drain on the resources of
the recipient country.
5. PFI brings in highly capital intensive technologies which do not fit in the factor
proportions of LDCs. Most of the time obsolete and outdated machines and

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techniques are imported which involve high social costs in terms of replacement after
a few years.
6. PFI involves costs in the form of a loss of domestic autonomy when foreign firms
interfere in policy making decisions of the government of an LDC which favors the
foreign enterprises. Such interference is usually resorted to by the multinational
corporations.

Self test exercise

Explain the pros and cons of foreign direct investment and foreign aid
to economic growth.
Elaborate the difference between’ tied aid’ and ‘untied aid’

Describe the boons and banes of Multinational Corporations(MNCs)

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Chapter Six
Crucial Economic policies Attached with Development planning

After studying this chapter, you are expected to:

 Identify the role of fiscal policy to economic development
 The contribution of monetary, commercial and price policy for macroeconomic
stability.
6.1. Fiscal policy
Fiscal policy means the use of taxation, public borrowing, and public expenditures by
government for purposes of „stabilization or development‟.
The use of fiscal policy for the purpose of promoting economic development is of recent
origin. The Keynesian analysis of fiscal policy is applicable to advanced economies. The
role of fiscal policy in advanced economies is to stabilize the rate of growth. In the
context of an underdeveloped economy, the role of fiscal policy is to accelerate the rate
of capital formation. It is designed as an instrument of economic development. In the
Keynesian analysis, fiscal measures are used to reduce savings and raise the propensity to
consume. But in underdeveloped economies, the propensity to save is extremely low and
the propensity to consume is very high.

Fiscal policy plays a dynamic role in underdeveloped countries. In fact, an extensive use
of fiscal policy is indispensable for economic development.
Fiscal policy, in the words of Nurkse, “assumes a new significance in the face of the
problem of capital formation in underdeveloped countries.” The few rich indulge in
conspicuous consumption. A considerable portion of savings is dissipated in un
productive channels such as in real estates, hoardings, jewellery, gold, speculation etc.
Fiscal policy diverts all these into productive channels.
Taxation is a useful instrument of forced savings because the flow of voluntary savings is
meager in underdeveloped economics

Taxation effectively curtails conspicuous consumption and other wasteful expenditure of

the richer classes.

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Taxation is an important and useful fiscal instrument for reducing private consumption
and transferring idle resources for capital formation by the government.

In underdeveloped country where monetary policy alone is ineffective due to the

existence of underdeveloped money and capital markets, fiscal policy can be used as an
important adjunct to monetary policy in accelerating the rate of capital formation.
Objectives of Fiscal policy
1. Increase the rate of investment
2. Encourage socially optimal investment
3. increase employment opportunities
4. promote economic stability in the face of international instability
5. counteract inflation
6.2. Monetary policy
Monetary policy refers to the policy of the monetary authority of a country with regard
to monetary matters. It may be defined as that policy which deals with
a. the controls of financial institutions.
b. Active purchases and sales of paper assets by the monetary authority as a deliberate
attempt to effect changes in money conditions : and
c. Passive purchases and sales for paper assets resulting from the maintenance of a
particular interest rates structure, the stability of security prices , or meeting other
obligations and commitments.
Objectives of monetary policy
 monetary targeting
 inflation targeting
 interest – rate targeting
 exchange – rate targeting
 increasing employment, output
 Price stability.
Main Features of monetary policy
Monetary policy can be taken to function in the following directions
i) To have a suitable interest rate structure

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ii) To achieve a correct balance between the demand for and supply of
money.
iii) The provision of proper credit facilities for a growing economy and
stopping its undue expansion
iv) The creation, working and expansion of financial institutions.
v) Debt management
6.3. Commercial policy
Commercial policy may accelerate the rate of economic development:
a) by enabling the underdeveloped country to have a larger share of the gains from
trade.
b) By augmenting the rate of capital formation
c) By promoting industrialization and
d) By maintaining equilibrium in the balance of payments.
6.4. Price policy
Rise in prices is inherent in the development process. Imbalance between demand
and supply of commodities and factors is inevitable under development planning. The
demand for goods and services rises as a result of stepping up investments on a large
scale and the consequent creation of money income. Ever mounting administration,
non – developmental and defence expenses and population pressures give a further
pull to demand.
On the other hand, supply fails to meet the increased demand as investments in
underdeveloped countries are made on such projects that take a long – time to mature.
Backward technology, low skills, market imperfection and various other bottlenecks,
restrict the supply of consumer goods. The gap between demand and supply leads to a
rise in prices.
Objective of price policy
Price policy is not merely concerned with holding the price hike or keeping prices
sable at any given level, but it is equally concerned with the movements of general as
well as relative prices of goods and services. Price policy is intended to attain the
following objectives:
1. to establish equilibrium between demand and supply of goods and services

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2. to bring flexibility in prices

3. To stabilize prices of consumer goods
4. Micro and macro aspects of price policy
5. Agricultural price policy
6. price policy for consumer goods
7. Price policy for industrial raw materials
8. Price policy in relation to enterprises.
9. Relation between price and wage policy

Self test exercise

Discuss the ways by which commercial policy helps achieve the
development aspiration of underdeveloped countries. In your
discussion, include the partial and general equilibrium analysis of
imosing tariff on imports.

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Chapter Seven
Techniques of Development planning
7.1. Harrod – Domar Model
The Harrod – Domar model is used in development Economics to explain an economy‟s
growth rate in terms of the level of saving and productivity of capital. It suggests that
there is no natural reason for an economy to have balanced growth. The model was
developed independently by Sir Roy F. Harrod in 1939 and Evsey Domar in 1946. The
Harrod – Domar (HD) model was the precursor to the exogenous growth model.
In its simplest terms, economic growth is the result of abstention from current
consumption.
 Functional form of F(K,L) is the key in the HD model. Different assumptions about F
will lead to different models and different conclusions.
 HD is the first and basic model of capital accumulation and growth.
Assumption
1. Assume unemployed labor, so there is no constraint on the supply of labor
2. Production is proportional to the stock of machinery.
Fixed coefficients
Capital ( K) and labor ( L) are used in a fixed amount to produce a certain amount of out
put.

Eg. Perfect complements

Q=min (ak,bc)
L-shaped isoquants
K
C 1Q3  If aK>bL, then only
B 1Q2
 
b .L of the capital is
a
A 1Q1 used and the rest is
unemployed
 If aK<bL, then only
0 L  
a .k of the labor is
b
used and the rest is
unemployed.

Optimal production takes place at the vertices

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There is no substitutability / between labor and capital

- K and L are used in a constant proportion ratio to each other to produce Y.
- No substitution between K and L
- IF more workers (L) are added without investing in more capital ( k) , output
will not rise.
Constant Returns to scale
- In order to double output Y, you need to double both capital and labor.
- If K and L double then Y doubles.\
1 1
Example 1. Y  k 2 L 2

2. Y  5k  10L
- Generally, if you want to multiply production by a number, you will need to
multiply K and L by that same number.
K L
Because of constant returns to scale (CRS) and ratios are constant.
Y Y
Example of fixed coefficient in the Harrod – Domar model
1. Assume that Moha Soft Drinks produces Mirinda with a fixed coefficient
 
1 1 
technology, Y  min  k , L  . Currently, Moha has 90 units of K and 100
4 2 
 
units of labor
a) what is the feasible output?
Solution
1 1 
Y  min  .80, .100 ,
4 2 
Y  min 20,50
 20

b) what is the optimal employment level ?

solution
1
a  
emp   .k   4 .80  40
b  1 
2
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Algebraic Representaion / Mathematical Formalism

Let t denote time periods, t = 1,2,3,4,…….
Y(t) denotes the total income at date t.
C(t) denotes the consumption at date t and
S(t) denotes total savings ( net of borrowing for current consumption ).then,
Y t   C t   S t 1
The other side of the coin is the value of produced output, also equal to Y must be
matched by goods produced for consumption plus those needed by investors; that is,
Y t   C t   I t 2
Where I denotes investment .
If we put these two equations ( 1 and 2) together, we get the famous
macroeconomic balance equation that savings equals investment.
S (t )  I (t _ 3
We can use equation ( 3) to complete our basic argument. Investment augments the
national capital stock K and replaces that part of it that is wearing out. Suppose that
a fraction  of the capital stock depreciates. Then of course, the capital
accumulation equation overtime can be written as
K t  1  1   K t   I t 4
Equation (4) tells us how the capital stock changes over time.
S t 
Now let us introduce two concepts. The savings rate which is just s  . assume
Y t 
that it is constant.
K t 
The capital – output ratio, . which we also assume is constant and represented
Y t 
by  .
Combine equations ( 3 ) and ( 4) to obtain K t  1  1   K t   S t 5
And since S t   sY t  as well as the fact that the capital – output ratio is constant,

i.e k t   Y t  we get,
Y t  1  1   Y t   sY t 6
Dividing the whole expression by Y t  yields

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Y t  1 s
1 
Y t  
Which when rearranged is the Harrod – Domar model

Y t  1 s
1   
Y t  

Y t  1  Y t  s
g    7
Y t  
The left hand side is simply the rate of growth of income, output, or GDP which we
denote as g.
Policy implication for growth
- Save more ( s  ) , make more productive investment  , and lower

 
depreciation rate  , will result in a higher growth rate g  .
-  represents the incremental capital –output ratio ( ICOR)
change in k
ICOR 
change in y
The equation is formulaic or has the air of the recipe. It seems all we have to do is
increase our savings rate or lower the capital – output ratio to increase our growth
rates. There is no limit to how much growth can be had!

In summation, the savings rate times the marginal product of capital minus the
depreciation rate equals the output growth rate. Increasing the savings rate,
increasing the marginal product of capital, or decreasing the depreciation rate will
increase the growth rate of output; these are the means to achieve growth in the
Harrod- Domar model.
Conclusion
Although the Harrod- Domar model was initially created to help analyze the
business cycle, it was later adapted to explain economic growth. Its implications
were that growth depends on the quantity of labor and capital; more investment

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leads to capital accumulation, which generates economic growth. The model also
had implication for less economically developed countries; labor is in plentiful
supply in these countries but physical capital is not, slowing economic progress.
LDCS do not have sufficient average incomes to enable high rates of saving, and
therefore accumulation of the capital stock through investment is low.
Revisit Harrod – Domar Model ( with population)
Harrod – Domar gave us
Y t  1  Y t  s
g  
Y t  
Which tells us that the growth rate “g” of total income, Y, is simply a function of
the savings rate, s and the capital –output ratio,  , less the depreciation of capital
.
From this, we could conclude that there are no limits to growth, and that if I
increased the savings rate or lowered the capital – output ratio, I would have higher
growth rates in perpetuity! However, this statement contradicts with the law of
diminishing marginal returns.
How would population change the Harrod – Domar equation?
Start with equation (6) from the preceding discussion
Y t  1  1   Y t   sY t 6 and let per – capita income at time t be y(t)
Y t 
such that y t  
p t 
Dividing (6) by population, p(t) yields
Y t  1 Y t  sY t 
 1    
pt  pt  pt 
Y t  1
 1   y t   syt 
pt 
Multiply and divide the left hand side with pt  1 to get,
Y t  1  pt  1
.  1   y t   syt 
pt  1 pt 
pt  1
yt  1.  1   yt   syt 
pt 

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Now divide by yt  to get,

yt  1 pt  1
 1    
s
.
yt  pt  
pt  1
Recognizing that  1  n , and that
pt 
yt  1
 1  g * , so
yt 

1  9 1  n  1     s
*

0
1  n  9*  9 * n  1    
s


s
g   n   ------------------------(8)


g* = growth rate of per capita income

Alternative Derivation of the Growth Rate of GDP
We want to determine the growth rate of GDP which is defined as:

G Y  
change in Y  where Y  GDP
Y
To do this, we estimate the incremental capital-output ratio ( ICOR) , which is a
measure of capital efficiency.
charage in K K
ICOR   where K= capital stock ……..(1).
ch arg e in Y Y

 A higher ICOR implies a high increase in capital stock relative to the

increase in GDP. Thus, the higher the ICOR, the lower the productivity of
capital.
 Since capital is assumed to be the binding production constraint, investment
(I) in the Harrid – Domar model is defined as the growth in capital stock.
I  (change in K )
But investment is also equal to savings (S) , which is equal to the average
propensity to save ( APS) times GDP(Y)

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Denote APS = s
I = S = APS Y= sY
sY
So ICOR =
change in Y
change in K
From (1) change in Y= and change in K=sY
ICOR
change in Y s
Rearranging terms G(Y) = 
Y ICOR
The above equation states that the growth rate of GDP is equal to the ratio of
saving (Marginal Propensity to Save, MPS) to ICOR.

out

Student activity
Now suppose that you live in a country where the savings rate is 20%
and the capital output ratio is 4. Assume a depreciation rate of 2% and
population growth is 1%. What is the approximate growth rate of per –
capita income?

Suppose the population of Ethiopia is expected to grow at 3% and the

planners would like to achieve a steady 4% rise in per capita income.
Furthermore, it is given that the aggregate capital-output ratio for the
eeconomy is 3. What should be the required saving rate to achieve the
given per capita growth target. Use the Harrod-Domar model.
Problems and their solutions
1. From 1980 to 1990, real GDP in India grew by 5.8 percent per annum, while
investment averaged 23.1 percent of GDP. What was the ICOR for India
between 1980 and 1990?
Answer:- the annual growth rate (g) and investment rate are give as 5.8% and
23.1% , respectively. The Harrod – Domar model assumes that the investment
rate equals the savings rate (s), so the saving rate equal 23.1%. To calculate the

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ICOR   , use the Harrod – Domar equation, g 

s
, which can be rewritten as

s 23.1% 0.231
 , so     3.98  4.0
g 5.8% 0.058
Thus, the ICOR was about 4.0
2. In Indonesia during the 1970s the incremental capital –output ratio (ICOR)
average 2.50.
a) Using the Harrod – Domar growth equation, what saving rate would have
been required for Indonesia to achieve an aggregate growth rate of 8
percent per annum?
b) With the same ICOR, what growth target could be achieved with a saving
rate of 27 percent?
c) If there is a large increase in the saving rate, and therefore a large increase
in the amount of new capital formation, is the ICOR likely to rise, fall or
remain the same? Explain
Answer a) Given that the ICOR   equals 2.50 and the targeted annual growth rate is
8% (g), the Harrod – Domer equation can be rewritten s  g in order to solve for the
required saving rate (s) . Thus, s =(0.08) (2.50)=0.20=20%.

Thus, in order to achieve an 8% growth rate, Indonesia would have to have a saving rate
of 20%.
b) Given the ICOR   equals 2.5 and the saving rate (s) equals 27%, the Harrod
– Domar equation can be used to determine the expected annual growth rate (g) :

. substituting in the given values for s and   : g 

s 0.27
g  0.108  10.8%. If
 2.5
the saving rate were 27%, the growth rate would be 10.8% Per year.
The Harrod – Domar model assumes the ICOR to remain constat. Thus, according
to the Harrod – Domar model, an increase in the saving rate has no effct on the
ICOR. One might conjecture, however, that the model‟s assumption is wrong and
that a large increase in savings might result in some decline in the productivity of
capital, hence higher ICOR.

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3. The government of a poor country fears that a political upheaval will occur
unless the growth rate is at least 4 percent per annum. The ICOR and the
saving rate are projected to be   5.0 and s  14 percent, respectively.
a) Show that 4 percent growth can not be achieved under these
circumstances.
b) With the saving rate as given, what ICOR would be required to achieve
the 4 percent growth target?
Answer a) If the saving rate is 14%, and the ICOR is 5.0, then the growth rate can be
s 0.14
expected to be g    0.028  2.8%. This falls short of the desived 4% growth
 5.0
rate.
b)If the targeted growth rate is 4% and the saving rate is 14%, then the ICOR
s 14% 0.14
must be equal to      3.5 Note that if the ICOR were lower
g 4% 0.04
than 3.5, growth would be greater than 4% per year ( assuming the saving rate
remains 14%).
7.2 The Mahalanobis model
P.C. Mahalanobis was an Indian statistician and was an economic advisor to Jawahrlal
Nehru( the then prime minister of India )
Some econnomists refer to the Mahalanobis model as Feldman – Mahalanobis model
Feldman was a Russian economist whose model was published in GOSPLAN ( a plan of
the Russian Economy) in 1928.

In 1953, Mahalanobis developed a two sector model where the entire net output of the
economy was supposed to be produced in only two sectors.
Namely:- the investment goods sector and the consumer goods sector.
In 1955 he developed the four –sector model.
A Two sector model
The two – sector model was the basis / foundation for the formulation of the four –sector
model.
The Mahalanobis two –sector model was based on the following assumptions:

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a. It is related to a closed economy where there is no foreign trade

b. The economy consists of two sectors: the consumer goods sector and the capital
goods sector. There is no intermediate sector. The industries producing
intermediate goods are grouped together with the consumer goods and the capital
goods which they help to produce.
c. There is total non – shiftability of capital equipment once installed in any of the
sectors. But products of the capital goods sector can be used as inputs in the two
sectors.
d. There is full capacity production in the consumer goods sector as well as in the
capital goods sector.
e. Investment is determined by the supply of capital goods.
f. There are no changes in prices
Givn these assumptions, Mahalanobis divided the economy into two parts
k , The proportion of net investment used in the capital goods sector.
c , The proportion of net investment used in the consumer goods sector.
k  c  11
Besides, net investment (I) can be divided into two parts at any point of time ( t) .
these are :
k I t :  This is used to increase the productive capacity of the capital goods sector.
c I t  This is utilized to increase the productive capacity the consumer goods sector.
Hence , I t  k I t  c I t 2

Taking Bk and  c as the output – capital ratios of the capital goods sector and the

consumer goods sector respectively and  as the total productivity coefficient,

 k  k   c c
 But 2  c  1
 k  c
Thus,    k k   c c 3
The income identity equation for the entire economy is
Yt  Ct  I t 4

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When national income (Y) changes, investment (I) and consumption ( C) also
change.The change in investment depends upon previous year‟s investment I t 1  and

so does consumption on previous year‟s consumption Ct 1  . So the increase in

investment in period t, is I t  I t  I t 1 and the increase in consumption

is Ct  Ct  Ct 1 . The increase in the two sectors is related to the linking up of

productive capacity of investment and the output capital ratio.
The investment growth path is determined by the productive capacity of investment in
 
the capital goods sector k I t and its output – capital ratio  k 
So that
I t  I t 1  k  k I t 1

I t  I t 1  k  k I t 1

I t  1  k  k I t 1 5 or

Putting different values for t t  1,2,3 the solutions of the equation (5) are
I1  1  k  k I 0
I 2  1  k  k I1

I2  1  k  k 1  k  k I o because I1  (1  k k ) I 0

I 2  1  k  k  I o
2

In the same manner by putting the value of t in equation (5) , we get.

I t  I o 1  k  k 
t

I t  I 0  I 0 1  k  k   I 0 subtractin g I 0 from both sides

t


I t  I 0  I 0 1  k  k   1 6
t

Similarly, by putting the values of t ( t=1,2,3,……..) in the consumption growth path.
Ct  Ct  Ct 1  c  c I t 1, we get

C1  C 0  c  c I o
C 2  C1  c  c I 1

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And finally Ct  C0  c  c I 0  I1  I 2  I 3    I t  by substituting the value of

I1 , I 2 , I 3 , I t in equation (6) and its related equations, the above equation can be
solved as

Ct  C0  c  c I 0  1  k  k I 0  1  k  k  I 0    1  k  k  I 0
2 t


 c  c I 0 1  1  k  k   1  k  k     1  k  k 
2

t *

 1  k  k t  1
 c  c I 0  
 1  k  k   1 

 1  k  k t  1
or Ct  C0  c  c I 0    7
 k  k 
Now the growth path of income for the whole economy on the basis of equation (4) is
Yt  I t  Ct or Yt  Yo  I t  I 0   Ct  C0 
By substituting the values of equations (6) and (7) in the above equation , we get
 1  k  k t  1

Yt  Yo  I 0 1  k  k 
t

 1  c  c I 0 
k  k

 

 
  
 I 0 1  k  k   1 1  c c 
t

 k  k 

 
    c  c 
 I 0 1  k  k   1  k k
t

k  k 
 
Supposing I 0  oYo and substituting it in the above equation we have


Yt  Yo  oYo 1  k  k   1  k k
t

    c  c 

 k  k 


Yt  0Y0 1  k  k   1  k k
t

    c  c 
  Y0
 k  k 

    c  c
Yt  Y0 1  0 k k
k  k
 
1  k k t  1  8 
 
Where
Yt= Gross domestic national income in year t.
 0  The share of investment in the base year

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k  The share of net investment used in the capital goods sector.

c  1  k  The share of net investment going to the consumer goods sector.
 k  Incremental output – capital ratio in the capital goods sector.
 k  Incremental output- capital ratio in the consumer goods sector
 c  Incremental output – capital ratio in the consumer goods sector.
Implications of the model for economic growth
4. Four sector model
The Mahalanobis model is not a growth model in the real sense, rather it is an allocation
model. The Mahalanobis model takes a four – sector economy consisting of:
a) the investment goods sector (k)
b) the factory produced consumer goods sector (C1)
c) the small household produced ( including agricultural products) consumer goods
sector (C2) and,
d) Services (health, education , etc) producing sector (C3)
For each of these four sectors a set of three parameters is introduced:  ' s (beta) i.e.
 k , 1 ,  2 ,  3  the ratios of net income generated to investment or output – capital
ratios
 ' s .(theta),i.e..  k ,1 , 2 , 3, - the net investment required per engaged person or
capital – labor ratios.
 ' s (lambda), i.e. k , 1 , 2 , 3 , - the proportion of investment allocated to each sector
or allocation ratios.
Further, A stands for the total amount of investment to be made for the plan period E
represents total increase in income and N denotes the total increase in employment
over the plan period.
Given these parametric ratios  ' s, ' s,  ' s  and the total amount to be invested (A),
an estimate of total income (E) and employment (N) to be generated during the plan
period can be manipulated on the basis of the system of equations as follows.
The equations of the model are:

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E  E k  E1  E 2  E3  1
N   k  1   2   3  2
A  k A  1 A  2 A  3 A 3
 is the Greek letter eta
Now the increase in employment (N) in each sector is
k A
k  or  k  k  k A 4
k
A
1  1 or 11  1 A 5
1
 A
 2  2 or  2 2  2 A 6
2
 A
 3  3 or  3 3  3 A 7 
3
Substituting the value of k A, 1 A, 2 A and 3 A in equation (3), the total investment
equation becomes
A   k k  11   2 2   3 3
Similarly, the increase in income (E) generated in each sector can be estimated as
follows:

E k  k A. k  8

E1  1 . A.1  9
E 2  2 . A. 2  10
E3  3 . A. 3  11

Also E   k k  k  11 1  3 3  2   3 3  3 because k A  kk and so on.

Finally

E  Y0 1     1
t

E  Y 1     112
t
0

A numerical example of the Mahalnobis Four – sector model

Suppose the planning commission in Ethiopia has planned a 5% increase in national
income. The maximum available fund or net investment for the coming 5 years is

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approximated to be Birr 5,600 million and the objective in this 5 years period is to
create an additional employment of 11 million. In addition, with the current
technological conditions output- capital ratio for investment goods sector (K). factory
produced consumer goods ( C1) , small household industries (C2) and services (C3)
are 0.20, 0.35, 1.25 and 0.45 respectively.
Capital – labor ratios for the same sectors are 2000, 875, 250 and 375 respectively
Further, the experts in the planning commission have decided the proportion of
investment allocated to each sector to be 33% for investment goods, 17% for factory
produced consumer goods, 21% for small household industries and 29% for services.

Given the above data, calculate the amount of investment, the increase in income, the
increase in employment in each sector of the economy as a result of the investment.
Solution
Given Atotal investment   5,600 million

N total employment   11 million

Proportion of investment for the four –sector  ' s 
k  33%  0.33  investment goods
1  17%  0.17  factory produced consumer goods
2  21%  0.21  0.21  small household industries
3  29%  0.29  services
Out put capital ratio  ' s 
 k  0.2  2  1.25
1  0.35  3  0.45
Out put capital ratio  ' s 
 k  2000  2  250
1  875  3  375
On the basis of the above data
1.a) Investment goods sector  k A  0.335,600 million 

 1848 million

b) Factory produced consumer goods  1 A  0.175,600 million 

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 952 million

c) Small households sector  2 A  0.215,600 million 

 1176 million

service  3 A  0.295600 million 

 1614 million

2. the increase in income in each sector

a)  investment goods sector  k Ak  1848million 0.2

 369.6 million

b)  factory produced consumer goods  1 A1  952million 0.35

 333.2 million

c)  small household industries  2 A2  1176million 1.25

 1470 million

d)  service sector 3 A3  1614million 0.45

 726.3 million

3. the increase in employment of each sector

k A 1848 million
a) Investment goods sector 
k 2000

 0.924 million

1 A 952 million
b) Factory produced consumer goods  
1 875

 1.088 million

2 A 1176 million
c) Small house hold industries  
2 250

 4.704 million

3 A 1614 million
d) Service sector 
3 375

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 4.304 million

Evaluating the Mahalanobis model (criticisms of the Mahalanobis model)

1. The model is confined to a closed economy
The model assumes there will be no imports and exports of investment goods. Thus,
the absence of the role of foreign trade is regarded as very unsatisfactory part of the
model. Because for developing countries capital goods can be imported with low cost
instead of being produced at home at a high cost and the welfare of the economy
would be maximized.
2. The model assumes an arbitrary value for  k . It does not give any reason for this.
Thus the planners may not arrive at correct solution for the optimum allocation of
investments of the different sectors of the economy.
3. In the model, the problem of unemployment has not received due emphasis. The
choice of more capital – intensive methods of production usually increases the
problem of unemployment, particularly in a labor surplus economy.
4. The model assumes a constant technique of production during the plan period.
But there is technological change during the process of development.
5. An estimation for the values of  ' s and  ' s is not easy in developing countries
where reliable data are not available in a complete way.
6. The model assumes an infinitely elastic supply of labor, which goes with the
available capital. But skilled labor is always a problem in developing countries.
7. the model has also a limitation in that it ignores the pattern of factor prices (i.e.
factor prices are assumed to be constant) while fixing targets on the basis of the
model.

Self test exercise

Elaborate the basic essences/notions and limitations of the
Mahalanobis model.

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7.3 The Solow Model

7.3.1 The Basic Solow Model
The Solow model is built around two equations, a production function and a capital
accumulation equation. The production function describes how inputs are combined to
produce output. To simplify the model, we group these inputs into two categories, capital,
K, and labour, L, and denote output as Y. The production function is assumed to have the
Cobb-Douglas form and is given by
[1] Y = F(K, L) = KαL1-α,
where α is some number between 0 and 1. Notice that this production function exhibits
constant returns to scale: if all of the inputs are doubled, output will exactly double- i.e. a
production function has constant returns to scale if
zY = F(zK, zL) for any positive number z. That is, if we multiply both
capital and labour by z, we also multiply the amount of output by z.
In line with the above stylised facts, we are interested in explaining output per worker or
per capita output. With this interest in mind, we can rewrite the production function in
equation [1] in terms of output per worker, y ≡ Y/L, and capital per worker, k ≡ K/L - i.e.
setting z = 1/L
Y/L = F(K/L, 1)
y=f(k) where f(k) = F(k, 1)
Equation [1] can, thus, be written as
[2] y = kα
This production function is graphed below. With more capital per worker, firms produce more output per
worker. However, there are diminishing returns to capital per worker: each additional unit of capital we give
to a single worker increases the output of that worker by less and less.
Figure 1

y =kα

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The second key equation of the Solow model is an equation that describes how capital accumulates. The
capital accumulation equation is given by
.
[3] K  sY  dK
. dK
K =
dt
.
According to this equation, the change in the capital stock, K , is equal to the amount of
gross investment, sY, less the amount of depreciation that occurs during the production
process, dK.
The term on the left-hand side of equation [3] is the continuous time version of Kt+1 – Kt,
that is, the change in the capital stock per "period". We use the 'dot' notation to denote a
derivative with respect to time.
The second tem of equation [3] represents gross investment. Following Solow, we
assume that consumers save a constant fraction, s, of their combined wage and rental
income, Y = wL + rK. The economy is closed, so that saving equals investment, and the
only use of investment in this economy is to accumulate capital.

The third term of equation [3] reflects the depreciation of the capital stock that occurs
during production. The standard functional form used here implies that a constant
fraction, d, of the capital stock depreciates every period.

To study the evolution of output per person in this economy, we rewrite the capital
accumulation equation in terms of capital per person.

K
Recall that k
L
ln k  ln K  ln L
d ln k d ln K d ln L
[4]  
dt dt dt
. . .
k K L
 -
k K L
Note that the derivative of logarithm of a variable with respect to time gives its growth
rate.

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From the capital accumulation equation of [3], the growth in capital stock is given
.
K Y
as  s  d . Substituting this expression into [4],
K K
. .
k Y L
 s  d  n , where n is the growth in labour force ( )
k K L

.
Y
k
s L d n
k K
L
y
s d n
k
.
[5] k  sy - (d  n)k
This equation says that the change in capital per worker each period is determined by
three terms. Two of the terms are analogous to the original capital accumulation equation.
Investment per worker, sy, increases k while depreciation per worker, dk, reduces k. the
term that is new in this equation is a reduction in k because of population growth, the nk
term. Each period, there are nL new workers around who were not there during the last
period. If there were no new investment and no depreciation, capital per worker would
decline because of the increase in the labour force.
.
α
Having the two basic Solow equations -.i.e. y = k and k  sy - (d  n)k , we can ask

fundamental questions of our model. for example, an economy starts out with a given
stock of capital per worker, k0, and a given population growth rate, depreciation rate, and
investment rate. How does output per worker evolve over time in this economy- i.e. how
does the economy grow? How does output per worker compare in the long run between
two economies that have different investment rates?
These questions are most easily analysed in a Solow diagram as shown below.

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Figure 2 (n+d)k

sy = skα

K
*
k0 k
The Solow diagram consists of two curves, plotted as functions of the capital-labour
ratio, k. the first curve is the amount of investment per person, sy = skα. This curve has
the same shape as the production function shown above, but it is translated down by the
factor s. the second curve is the line (n + d)k, which represents the amount of new
investment per person required to keep the amount of capital per worker constant- both
depreciation and the growing workforce tend to reduce the amount of capital per person
in the economy. The difference between these two curves is the change in the amount of
capital per worker. When this change is positive and the economy is increasing its capital
per worker, we say that capital deepening is occurring. When this per worker change is
zero but the actual capital stock K is growing (because of population growth), we say that
only capital widening is occurring.
To consider a specific example, suppose an economy has capital equal to the amount k0
today, as shown in the above figure. What happens over time? At k0, the amount of
investment per worker exceeds the amount needed to keep capital per worker constant, so
that capital deepening occurs- that is, k increases over time. This capital deepening will
.
continue until k=k*, at which point sy = (n +d)k, so that k = 0. at this point, the amount
of capital per worker remains constant, and we call such a point a steady state.

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What would happen if instead the economy began with a capital stock per worker larger
than k* ? At point to the right of k* in the above figure, the amount of investment per
worker provided by the economy is less than the amount needed to keep the capital-
.
labour ratio constant. The term k is negative, and therefore the amount of capital per
worker begins to decline in this economy. This decline occurs until the amount of capital
per worker falls to k*.
Notice that the Solow diagram determines the steady-state value of capital per worker.
The production function of equation [2] then determines the steady-state value of output
per worker, y*, as a function of k*.

Figure 3

y* y
(n+d)k
Consumption sy
sy*

k* k

Figure 3 combines the Solow diagram with the production function. The steady state
consumption per worker is given by the difference between steady state output per
worker, y*, and steady state investment per worker, sy*.

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Comparative Statics
Shocks: increase in the investment rate, s, and an increase in the population growth rate,
n.
An increase in the investment rate
Figure 4
(n + d)k

s'y

sy

k* k** k

The increase in the investment rate shifts the sy curve upward to s'y. At the current value
of the capital stock, k*, investment per worker now exceeds the amount required to keep
capital per worker constant, and therefore the economy begins capital deepening again.
This capital deepening continues until s'y = (n +d)k and the capital stock per worker
reaches a higher value, indicated by the point k**. From the production function, we know
that this higher level of capital per worker will be associated with higher per capita
output; the economy is now richer than it was before.
Increase in the population growth rate : from n to n'
Figure 5
(n' + d)k
(n + d)k

sy

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k
** *
k k

The (n + d)k curve rotates up and to the left to the new curve (n' + d)k. at the current
value of the capital stock, k*, investment per worker is now no longer higher enough to
keep the capital-labour ratio constant in the face of the rising population. Therefore the
capital-labour ratio begins to fall. It continues to fall until the point at which sy = (n' +
d)k indicated by k** in figure 5. At this point, the economy has less capital per worker
than it began with and is therefore poorer: per capita output is ultimately lower after the
increase in population growth.

Properties of the steady state

By definition, the steady-state quantity of capital per worker is determined by the

.
condition that k =0. Equation 2 and 5 allow us to use this condition to solve for the
steady state quantities of capital per worker and output per worker.

Substituting from [2] into [5].

.
k =skα – (n + d)k,
and setting this equation equal to zero yields

sk   (n  d )k
sk 
k
(n  d )
1
 s  1
k *   
 nd 
[6]

Substituting this into the production function reveals the steady-state quantity of output
per worker, y*:

 s  1
y *   
 nd 
This equation reveals the Solow model's answer to the question "Why are we so rich and they so poor?"
countries that have high saving/investment rates will tend to be richer, ceteris paribus. Such countries
accumulate more capital per worker, and countries with more capital per worker have more output per

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worker. Countries that have high population growth rates, in contrast, will tend to be poorer, according to the
Solow model. A higher fraction of savings in these economies must go simply to keep the capital-labour ratio
constant in the face of a growing population. This capital widening requirement makes capital deepening more
difficult, and these economies tend to accumulate less capital per worker.

Empirical Example
Economic Growth in the Simple Model
What does economic growth look like in the steady state of this simple version of the
Solow model? The answer is that there is no per capita growth in this version of the
model! Output per worker (and therefore per person, since we've assumed the labour
force participation rate is constant) is constant in the steady state. Output itself, Y, is
growing, of course, but only at the rate of population growth. This can be shown as
Y
y
L
ln y  ln Y  ln L
d ln y d ln Y d ln L
 
dt dt dt
Since the growth in per capita output is zero at the steady state
d ln Y d ln L
0 
dt dt
d ln Y d ln L

dt dt

This model fails to predict a very important stylised fact: that economies exhibit
sustained per capita income growth. In this model, economies may grow for a while, but
not forever. For example, an economy that begins with a stock of capital per worker
below its steady-state value will experience growth in k and y along the transitional path
to the steady state. Over time, however, growth slows down as the economy approaches
its steady state, and eventually growth stops altogether.

To see that growth slows down along the transition path, notice two things. First, from
the capital accumulation equation [5]
.
k  sy - (d  n)k

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.
k k
s  ( d  n)
k k
.
k
[7]  sk   1  (d  n)
k
.
k s
 1  (d  n)
k k
Because α is less than one, as k rises, the growth rate of k gradually declines. Second, the
growth rate of y is proportional to the growth rate of k, so that the same statement holds
true for output per worker- i.e.
y = kα
lny = αlnk
d ln y d ln k

dt dt
. .
y k

y k
This indicates that when the growth rate of k is zero at the steady state, output growth
would also be zero. Thus, in this model doesn't explain growth at the steady state.
Figure 6
Transition Dynamics

.
k
k

n+d

sy/k = skα-1

k*

The transitional dynamics implied by equation [7] are plotted in figure 6. The first term
on the right-hand side of the equation is skα-1, which is equal to sk/y. The higher the level
of capital per worker, the lower the average product of capital, y/k, because of

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diminishing returns to capital accumulation (α is less than one). Therefore, this curve
slopes downward. The second term on the right-hand side of equation [7] is n + d, which
doesn't depend on k, so it is plotted as a horizontal line. The difference between the two
.
k
lines in figure 6 is the growth rate of the capital stock, or . Thus, the figure clearly
k
indicates that the further an economy is below its steady-state value of k, the faster the
economy grows. Also, the further an economy is above its steady-state value of k, the
faster k declines.

Technology and the Solow Model

To generate sustained growth in per capita income in this model, we need to introduce
technological progress to the model. This is accomplished by adding a technology
variable, A, to the production function:

[8] Y = F (K, AL) = Kα (AL) 1-α.

Entered this way, the technology variable A is said to be "labour-augmenting" or
"Harrod-neutral". Technological progress occurs when A increases over time – a unit of
labour, for example, is more productive when the level of technology is higher.

An important assumption of the Solow model is that technological progress is

exogenous: in a common phrase, technology is like "manna from heaven," in that it
descends upon the economy automatically and regardless of whatever else is going on in
the economy. Instead of modelling carefully where technology comes from, we simply
recognize for that there is technological progress and make the assumption that A is
growing at a constant rate:
.
A
 g  A  A0 e gt
A
where g is a parameter representing the growth rate of technology.

The capital accumulation equation in this model is the same as before- i.e.
.
K  sY dK
[9] .
K Y
s d
K K
To see the growth implication of this model, first rewrite the production function [8] in
terms of output per worker:
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Y = F (K, AL) = Kα (AL) 1-α

Y
 K  A1 L
L

K
y    A1
L
y  k  A1
Taking the logs and differentiating the above expression:

lny   lnk  (1-  )ln A

dlny d ln k d ln A
[10]   (1   )
dt dt dt
. . .
y k A
   (1   )
y k A
Notice from the capital accumulation equation [9] that the growth rate of K will be
constant if and only if Y/K is constant. Furthermore, if Y/K is constant, y/k is also
Y
constant (i.e. Y/K = L  y ) and most important, y and k will be growing at the same
K k
L
rate. A situation in which capital, output, consumption and population are growing at
constant rates is called a balanced growth path.

Let's use the notation gx to denote the growth rate of some variable x along a balanced
growth path. Then, along a balanced growth path, gy = gk. Substituting this relationship
into equation [10]
g y g k  (1   ) g
.
A
Recall that  g
A
Since gy = gk along the balanced growth path

g y  g y  (1   ) g
g y (1   )  (1   ) g
g y  gk  g
That is, along the balanced growth path in the Solow model, output per worker and
capital per worker both grow at the rate of exogenous technological change, g. Notice
that in the simple model, there was no technological progress, and therefore there was no

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long-run growth in output per worker or capital per worker; gy = gk = g = 0. The model
with technology reveals that technological progress is the source of sustained per capita
growth.

The Solow Diagram with Technology

In the case where we introduce technology in the Solow model, the only important
difference is that the variable k is no longer constant in the long run. So we have to write
our differential equation in terms of another variable. The new state variable will be
~
kK . Notice that this is equivalent to k and is obviously constant along the
AL A
~
balanced growth path because gk = gA = g. The variable k therefore represents the ratio
of capital per worker to technology. We will refer to this as the "capital-technology" ratio
(recall that the numerator is capital per worker).
~
Re-writing the production function in terms of k , we get
Y  K  ( AL )1

 K 
Y 
AL  AL 
~ ~
yk ,
~ ~ K k
Where y = Y = y and k = = .
AL A AL A
~
Following the terminology above we will refer to y as the "output-technology ratio" and
sometimes called output per effective labour.

~ K
Recall that: k =
AL
~
ln k  lnK - lnA - lnL
~
dlnk dlnK dlnA dlnL
  
dt dt dt dt
.
~ . . .
k K A L
~
  
k K A L
From the capital accumulation equation, we know that

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.
K Y
s d
K K
Substituting this into the above expression
.
~
k Y
~
s d  g n
k K
Y
s AL  (d  g  n)
K
= AL
~
y
s ~  (n  g  d )
k
.
~ ~ ~
[11] k  s y  (n  g  d ) k

Equation [11] would give the Solow diagram with technology as given below.

~
Figure 2 (n+g +d) k
~
sy

~ ~
k* k
If the economy begins with a capital-technology ratio that is below its steady-state level,
the capital-technology ratio will rise gradually over time because the amount of
investment being undertaken exceeds the amount needed to keep the capital-technology
ratio constant.

Solving for the Steady State

The steady-state output-technology ratio is determined by the production function and the
.
~ ~
steady-state condition – i.e. k =0. Solving for k *, we find

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~ ~
0  s y  (n  g  d ) k
~ ~
s y  (n  g  d ) k
~ ~
s k  (n  g  d ) k
~
k s

~ (n  g  d )
k
~ 1 s
k 
(n  g  d )
1
~  s  1
k*   
 (n  g  d ) 
~
Substituting the steady state k * in to the production function, we get

~  s  1
y*   
 (n  g  d ) 

To see what this expression implies about output per worker, rewrite the equation as

~
y = Y = y
A(t ) L A(t )
~
y yA
~
y * (t )  y A(t)

 s  (1 )
y * (t )  A(t )  
n  g  d 

Equation [12] shows that both y and A depends on time. From this equation, we clearly
see that output per worker along the balanced growth path is determined by technology,
the investment rate, and the population growth rate.
An interesting result from equation [12] is that changes in the investment rate or the
population growth rate affect the long-run level of output per worker but do not
affect the long-run growth rate of output per worker.

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Figure 8

~
s' y
~
sy

~ ~ ~
k* k ** k

The Equations are not complete

Suppose an economy begins in steady state with investment rate s and then permanently
increases its investment rate to s'. The Solow diagram (figure 8) shows that at the initial
~
capital-technology ratio k *, investment exceeds the amount needed to keep the capital-
~
technology ratio constant, so k begins to rise.

To see the effects on growth, from the capital accumulation equation [11] we have the
transitional dynamics implied by this equation is drawn as figure 9. The sk is drawn as a
negatively sloped curve since α is less than one and hence an increase in k would lead to
a lower value of sk .
.
~ ~
Figure 9 k k

n +g +d
~  1
s' k

~  1
sk
~ ~ ~
k* k ** k

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Figure 10

.
y y

t* Time

Figure 11

Log y

Level Effect

t* Time
Figure 9 shows the transitional dynamics implied by equation 13. As the diagram shows,
the increase in the investment rate to s' raises the growth rate temporarily as the economy
~ ~
transits to the new steady state, k **. Since g is constant, faster growth in k along the
transition path implies that output per worker increases more rapidly than technology:
.
y y > g. The behaviour of the growth rate of output per worker over time is displayed in
figure 10.

Figure 11 cumulates the effects on growth to show what happens to the log level of
output per worker over time. Prior to the policy change, output per worker is growing at
the constant rate g, so that the log of output per worker rises linearly. At the time of the

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policy change t*, output per worker begins to grow more rapidly. This more rapid growth
continues temporarily until the output-technology ratio reaches its new steady state. At
this point, growth has returned to its long-run level of g.

We can draw two important points from the above illustration. First, policy changes in
the Solow model increase growth rates, but only temporarily along the transition to the
new steady state. That is, policy changes have no long-run growth effect. Second, policy
changes can have level effects – i.e. a permanent policy change can permanently raise (or
lower) the level of per capita output.
The Solow Model: Evaluation
How does the Solow model answer the key questions of growth and development? First,
the Solow model appeals to differences in investment rates and population growth rates
and (perhaps) to exogenous differences in technology to explain differences in per capita
incomes. Why some countries are so rich and others so poor? According to the Solow
model, it is because the rich countries invest more and have lower population growth
rates, both of which allow the rich countries to accumulate more capital per worker and
thus increase labour productivity. This hypothesis is supported by data across the
countries of the world.
Second, why do economies exhibit sustained growth in the Solow model? The answer is
technological progress. Without technological progress, per capita growth will eventually
cease as diminishing returns to capital set in. Technological progress, however, can offset
the tendency for the marginal product of capital to fall, and in the long run, countries
exhibit per capita growth rate of technological progress.
How, then, does the Solow model account for differences in growth rates across
countries? At this juncture, the Solow model appeals to the transitional dynamics. An
economy with a capital-technology ratio below its long-run level will grow rapidly until
the capital-technology ratio reaches its steady-state level. This reasoning may help
explain why some countries such as Japan and Germany, which had their capital stocks
wiped out by World War II, have grown more rapidly than the United States over the last
fifty years. Or it may explain why an economy that increases its investment rate will
grow rapidly as it makes the transition to a higher output-technology ratio. This

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explanation may work well for countries such as South Korea, Singapore, and Taiwan
which increased their investment rates dramatically since 1950.

7.4. Input –Output Models

The Leontief input –output model in economics may be characterized as a description of
an economy in which input equals output, or consumption equals production, i.e. the
model assumes that what is production, i.e. the model assumes that whtatever is produced
is always consumed. Say’s law, “supply creates its own demand”
Wassily W. Leontief, a Russian Economist, won a Nobel Prize in 1972 in Economics for
his contribution to the Input-Output model.
Input –output models are of two types.
1. Closed input –output model:- assumes that the entire production is
consumed by those participating in the production. The objective here is to find
the relative income of each participant in the system.
2. Open input – output model :- it is an input –output model in which some
of the production is consumed by those participating in the production and the rest
of production is consumed by external bodies such as households, governments
and so on. In this model, we seek the amount of production needed to achieve a
forecasted demand, when the amount of production needed to achieve a current
demand is known.
Assumptions of the input –output Analysis
1. An economy is decomposed in to n sectors (or industries) and each of these
produces only one kind of product, each of the sectors uses an input, the output of
the other sectors.
2. The output of any industry becomes either the input of another industry or the
final demand (or the final consumption).
3. In any productive process all inputs are used in fixed proportions and increase in
input is in proportion with the level of output. Production takes place through
processes with constant technical coefficients. The technical coefficient shows the
number of units of any industry‟s output needed to produce one unit of another

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industry‟s output. In other words, it shows the amount of raw materials needed by
an industry from any other industry to produce a certain product.
4. All transactions may be considered in terms of money values.
5. The economy is assumed to be in state of dynamic equilibrium, i.e. there are
neither shortages nor surpluses of the products under consideration. In other
words, gross product of each sector is sufficient to meet the final demands as well
as demands of other sectors.
The Input-Output table displayed below describes the interdependence of industries
during some time period.
Sectors of destination Intermediate use sectors Financial Total
consumer sector (inputs) (on industries) demand output

Producers sector (outputs) 
sectors of origin sectors 
 1 2 3 n
F1 x1
1 x11 x12 x13  x1n
F2 x2
2 x21 x22 x23  x2 n
F3 x3
3 x31 x32 x33  x3n
 
    
Fn xn
n xn 1 xn 2 xn 3  xnn

Primary input (labor )

1  2 3  n

The Sector of destination are also known as purchasing sectors or input purchasers and
are shown on the columns.

 the rows show the sales, called output that each industry makes to the others.
 The columns show the purchases called inputs that each industry makes from the
others.

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Intermediate use x 
ij Final demand Total

Total final Output

Selling sector Input to Input to Input to Total intermediate Household Government
(out put
sector )
agriculture manufacturing service demand consumption consumption
Investment Export demand
D
x 
j

Agirculture 50 150 0 0 30 40 20 10 100 300

Manufacturing 100 100 50 50 50 80 80 40 250 500
Service 0 150 50 50 25 45 25 5 100 300

Total intermediate purchase

150 400 100 100 105 165 125 55 450 1100

Imports 15 20 0 0 0 0 0 0 0 35

Government (taxes) 10 15 30 30 0 0 0 0 0 55

Labor 75 15 110 110 50 0 0 0 50 250

Capital 20 30 25 25 0 0 0 0 0 75

Land 30 20 35 35 0 0 0 0 0 85

Value added 135 80 200 200 50 0 0 0 50 465

Total input x 
j 150 100 200 200 155 165 125 55 500 1600

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The elements in each row show the distribution of output to various sectors and uses
while the data in a column indicate the sources of inputs needed for production. For
example, reading across the first row, altogether the agricultural output is valued at Birr
300 per year, of this total, birr 100 worth of goods go to final consumption (household,
and government consumption , investment and export) the remaining output from
agriculture goes as inputs 50 to itself, 150 to manufacturing The sum of total intermediate
and total final demand yields a gross output for agricultural production of Birr 300
worth. Similarly, the manufacturing sector produces a total output of value Birr 500, of
which Birr 250 worth of goods is sold to other sectors and used by itself as an
intermediate input, the rest birr 250 worth of the output of this sector is used for final
consumption, 50 for household, 80 for government, 80 for investment and 40 for export
demand. The disposition of the total outputs of the other three sectors can be read off the
table in the same manner.

The elements in each column show the input or cost structure of the sectors. For instance,
reading down in the first column we see that in order to produce its total output of Birr
300 worth of goods , agriculture uses 50 of its own output , 100 from manufacturing.
Thus, total intermediate purchase of the agricultural sector equals 150. The remaining
150 Birr worth of total inputs purchased consists of the importation of 15 Birr worth of
foreign goods and the creation of 135 Birr worth of value added in the form of payments
of Birr 10 to the government as taxes, 75 to households as wages, 20 for the use of capital
in the form of interest, and 30 birr for the use of land in the form of rent. Thus the value
of the total output of agriculture is equal to the total value of all inputs purchased i.e. the
sum of intermediate inputs purchased and the primary inputs used. The same procedure
can be followed for other sectors.
The input requirements per unit worth of output for each industry can be obtained by
setting:
xij Birr value of the product of industry i used by industry j
aij  
xj Birr vale of the total product of industry j

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In other words, xij  aij x j . This amounts to saying that sales of i th industry to j th industry

are a constant proportion a ij of the output of j th industry. To put it differently,

xij  aij x j represents the Birr value of the product of i th industry used by j th industry.

The Coefficient matrix also referred to as input - output coefficient matrix or Technology
matrix is given as follows:

 a11 a12  a1n 

a a22  a2 n 
A  21 
    
 
an1 an 2  ann 

 d1 
d 
Final demand vector D   2 

 
d n 

 x1 
x 
Gross output vector x   2 

 
 xn 
The balance equations under the condition of no surpluses and no shortages:

Internal consumption + consumer demand = Total output

Or alternatively
Intermediate input requirement(use)+final demand=total output

Here the terms internal consumption and intermediate input requirement are used
synonymously. Besides, the consumer demand can alternatively be called as final
demand. The total output given in this model is gross total output.

This leads to the system of equation known as balancing equations:

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a11 x1  a12 x 2    a1n x n  d1  x1

a 21 x1  a 22 x 2    a 2 n x n  d 2  x 2
 
a n1 x1  a n 2 x 2    a nn x n  d n  xn

 x1   a11 a12  a1n   x1   d1 

 x  a a  a 2 n   x2   d 2 
Matrix form  2    21 22   
      
      
 xn  an1 an 2 ann   xn  d n 
  A  D
or

I  A  D

Premultiplying both sides by inverse of (I-A) i.e. (I-A)-1

yields
I  A1 I  A  I  A1 D
You recall that a matrix multiplied by its inverse gives us an identity matrix.
I  I  A D
1
Hence,

You know that any matrix multiplied by an identity matrix gives the original matrix
itself. Thus,
adjI  A adjI  A
  I  A1 D or   .D because ( I  A) 1 =
IA IA

The I-A matrix is called the Leontief matrix

Where I  A is the determinant of the Leontief matrix and adj(I-A)= adjoint of the

Leontief matrix and is obtained by transposing the cofactor matrix

X1  X11  X12    X1n  D1

X 2  X 21  X 22    X 2n  D2


X n  X n1  X n 2    X nn  Dn

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X ij
aij 
Xj

X ij  aij X j

X 1  a11 X 1  a12 X 2    a1n X n  D1

X 2  a21 X 1  a22 X 2    a2 n X n  D2
 
X n  an1 X 1  an 2 X 2    ann X n  Dn

X 1  a11 X 1  a12 X 2    a1n X n  D1

 a 21 X 1   X 2  a 22 X 2     a 2 n X n  D2
  
 a n1 X 1  a n 2 X 2     X n  a nn X n   Dn

1  a11 X 1  a12 X 2    a1n X n  D1

 a 21 X 1  1  a 22 X 2    a 2 a X n  D2
  
 a n1 X 1  a n 2 X 2    1  a nn X n  Dn

I  A  D

Or in matrix form

(1  a11 )  a12  a1n   X 1   D1 

 a 1  a22   a2 n   X 2   D2 
 21     
        
     
  a n1  an 2 (1  ann )  X n   Dn 

I  A  D
Premultiplying both sides by I  A
1
as was given earlier gives us

I  A1 I  A  I  A1 D

I  I  A D
1

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  I  A1 D

I  A1  1
adj I  A
IA

adj I  A  the transpose of the cofactor matrix I  A

* cofactor is a minor with a sign

Cij   1 M ij
i j

Where C = cofactor
M= minor
Since the industries of the model are all distinct (I-A) is non-singular i.e. its determinant
is different from zero. Thus, the vector:   I  A D gives the gross production level,
1

which is just sufficient to meet the final demand as well as the demand of all the
industries themselves.
The transaction matrix: the matrix I  A which provides a constant multiplier
1

is known as transaction matrix. It may be noted that for different projected demand
vectors, a simple multiplication would yield the gross output X.
Hawkins – Simon conditions of viability of the system

1  a11   a12   a1n 

 a 1  a22   a2 n 
The matrix I  A  
21

    

  an1  an 2 1  ann 
Should be that

i. the determinant of Leontief matrix (I-A) must always be positive and

ii. the diagonal elements 1  a11 , 1  a22 ,1  ann  should all be positive or in

other words a11.a22 ,, ann should all be less than one.

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A hypothetical example of the Input-Output table

Sectors Purchasing sector

Input to Input to Input Total Final Gross
agriculture manufacturing to immediate demand output
service input xj
Agriculture 50 150 0 200 100 300
Manufacturing 100 100 50 250 250 500
Selling sector

Service 0 150 50 200 100 300

Total
intermediate 150 400 100 650 450 1100
purchase
Household
150 100 200 450 50 500
(primary inputs)
Gross in put (xj) 300 500 300 1100 500 1600

Because of the assumption of fixed proportions, to produce a birr worth of

agricultural output requires:-
50 300  0.17 worth of agricultur al goods
100 300  0.33 worth of manufactur ingl goods
0 300  0.00 worth of service goods
The same analysis applies to the other sectors i. e manufacturing and services
The intersectoral technical matrix A= aij for our hypothetical example is
0.17 0.30 0.00
A= 0.33 0.20 0.17
 
0.00 0.30 0.17

Let Xi=total output of sector i.

Xij= the amount of the product of industry i used as an intermediate input by
industry j.
Di= the amount of output of sector i produced to satisfy final demand

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The set of equations for the three sectors therefore can be put in linear form:

Suppose the planned target settled by the planer for the next year as final demand in our
hypothetical example is birr 150 worth of goods for agriculture, 300 for manufacturing
and 150 for service sector. What level of output should be produced to meet the target?
0.17 0.30 0.00 150 
A  0.33 0.20 0.17 D  300
   
0.00 0.30 0.17 150 

1 0 0 0.17 0.30 0.00

A  0 1 0  0.33 0.20 0.17
   
0 0 1 0.00 0.30 0.17

 0.83  0.30 0.00 

  0.33 0.80  0.17
 
 0.00  0.30 0.83 
0.80  0.17  0.33  0.17
I  A  0.83  0.30
 0.30 0.83 0.00 0.83
= 0.427
0.613 0.274 0.099
Cofactor C  0.249 0.688 0.249
 0.051 0.141 0.565

Cofactor transposed C  adj I  A

0.613 0.249 0.051

 0.274 0.688 0.141
0.099 0.249 0.565

0.613 0.249 0.051

1 
 I  A adj I  A  0.274 0.688 0.141
1 1

IA 0.427  
0.099 0.249 0.565

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1.436 0.583 0.119

 I  A   0.641 1.613 0.330 X i  I  A D
1 1
 
0.232 0.583 1.323
 X 1  1.436 0.583 0.119 150 
 X    0.641 1.613 0.30  300
 2    
 X 3  0.232 0.583 1.323  150 

X1=1.436(150)+0.583(300)+0.119(150)
= 408.15
X2=0.641(150)+1.613(300)+0.33(150)
= 629.55
X3=0.232(150)+0.583(300)+1.323(150)
= 408.15
Exercise

1 Obtain the input –out put coefficients for the following input-output table of a

certain economy in a given year (figures in million of Birr ).

Total
Inter
Consumer demand
Total (input) sectoral
From(output) demand or total
demand
output
Agriculture Industry Services
1 2 3 4 5 6

Agriculture 80 100 100 280 40 320

Industry 80 200 60 340 60 400

Services 80 100 100 280 20 300

i. Interpret the table clearly.

ii. Obtain the gross outputs of the three sectors to meet the final demand.

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iii. Determine the output if the final demand changes to 60 for agriculture, 40 for
industry and 20 for services.

2. Given the input matrix and the final demand vector

0.05 0.25 0.34 1800
A  0.33 0.10 0.72 d   200 
   
0.19 0.38 0.00  900 

i. Explain the economic meaning of the elements 0.33, 0.00 and 200.
ii. Explain the economic meaning (if any) of the third column sum.
iii. Explain the economic meaning (if any) of the third row sum.

3. Consider an economy consisting of three sectors, agriculture, manufactures and

services. The hypothetical flow of goods and services in physical units is summarized in
the following table.
Final
Agricultur e Manufactur es Services
Demand
Agricultur e 60 180 0 120
Manufactur es 30 60 30 180
Serices 0 40 10 100
If the demand changes to [ 150, 160, 180], what will be the new output?
Solution
The matrix of input –output coefficients is given by

60 360 180 300 0 150   1 6 3 5 0 

A  30 360 60 300 30 150  1 12 1 5 1 5 
  
 0 360 40 300 10 150   0 2 15 1 15

 x1  150
Let X   x 2  denote the new output and D  160
 
 x3  180

Denote the demand vector

The A  D      I  A D
1

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1 0 0  1 6 3 5 0   56 3 5 0 
    
Now I  A  0 1 0  1 12 1 5 1 5   1 12 45 1 5
     
0 0 1  0 2 15 1 15  0  2 15 14 15

5  56 2  3  14 
There fore I  A        0
6  75 75  5  180 
83
 0
150
18 14 1 
 25 25 25 
I  A1 
1
adj I  A 
150 7
 7 1
6 
IA 83  90 9
1 1 37 
 90 9 60

 x1  18 14 1 
150
 25 25 25 
  I  A1 D   x 2   160
150 7
 7 1 
 
83  90 9 6 
 x3  1
 90 1 37 180
9 60
396.14
300.13
 
235.75

4. For a three sector economy, input-output coefficients, aij‟s are given below:
a11  0.5 a12  0.1 a13  0.1
a 21  0.2 a 22  0.6 a 23  0.2
a31  0.1 a32  0.2 a33  0.6

i. Using Hawkins- Simon condition test whether the system is viable

ii. Determine the gross output for the three sectors when the final
demand values for the three sectors are 21,000,42,000 and 63,000
units respectively.
iii. Determine the new level of output if the final demand increases by:
1500,3,000and 4,500 units respectively.
Solution
Let A denote the input –output coefficient matrix. Then

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0.5 0.1 0.1 1 0 0 0.5 0.1 0.1

i, A  0.2 0.6 0.2 and I  A  0 1 0  0.2 0.6 0.2
 
 0.1 0.2 0.6 0 0 1  0.1 0.2 0.6

 0.5  0.1  0.1

  0.2 0.4  0.2
  0.1  0.2 0.4 

 Now /I –A / =0.042.since / I – A/ is positive and all the elements on the main

diagonal of A are less than1, Hawkins Simon conditions are satisfied and the
system is viable.
 x1   21,000 
Let    x 2  be the gross output required to meet the final demand D  42,000
 
 x3  63,000 

Then   I  A D. It can be verified that / I –A / =0.042  0

1

Thus, ( I –A ) -1 exists and is given by

I  A1  1
adj I  A
IA

0.12 0.06 0.06

1 
I  A 0.10 0.19 0.12
1

0.042  
0.08 0.11 0.18

Therefore
0.12 0.06 0.06  21,000 210,000
1 
  I  A 0.10 0.19 0.12 42,000  420,000
1
D
0.042     
0.08 0.11 0.18  63,000 630,000

iii. If the demand increases by 1,500, 3,000 and 4,500 units respectively, the new level of
output is   I  A DN where DN= the new final demand
1

 N  I  A1 DN XN=the new gross output

0.12 0.06 0.06 22,500 225,000

1 
  0.10 0.19 0.12 45,000  450,000
   
0.042
0.08 0.11 0.18 67,500 450,000

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5. A company has two interacting branches, B1 and B2 . Branch 1 consumes $0.5 of its

own output and $0.2of B2 output for every $1 it produces. Branch  2 consumes $0.6 of B1
out put and $0.4 of its own output per $1 of output.
The company wants to know how much each branch should produce per month in order
to meet exactly a monthly external demand of $50,000 for B1 product and $40,000 for
B2 product.
a. Set up (without solving) a linear system of equations whose solution will
represent the required production schedule.
b. Find a production schedule for the above external demand
c. Determine whether or not every non negative external demand could be satisfied
by a nonnegative production schedule.(Hawkin-Simon condition).
Solution
Let X1and X2 be the birr values of outputs of branch B1 and B2 respectively

x  50,000
Let X   1  be the production vector, and D    be the demand vector.
 x2  40,000

Consumption matrix is
 
C  0.5 0.6
0.2 0.4

We know that I  C X  D so X  I  C  D
1

 1 0 0.5 0.6   x1  50,000

 
 0 1  0.2 0.4   x   40,000
      2   
Then,
 0.5  0.6  x1  50,000
 0.2 0.6   x   40,000
   2  
So
0.5 x1  0.6 x 2  50,000
 0.2 x1  0.6 x 2  40,000

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b. we know that   I  C  D
1

so, we need to find I  C 

1

I  C 1  1
adj I  C 
I  C 
Then
0.6 0.6
I  C 1  1
0.3  0.12 0.2 0.5

1 0.6 0.6 6018 6018

  
0.18 0.2 0.5 20 15 
 18 18 
10 10 
I  C 1  10 3 3
 25 
 9 9

x 
   1   I  C 1 D
 x2 

10 10  50,000
  3 3
 
10 25  40,000
 9 9

 300,000 
 500,000 
=
 3 

Hence, the production schedule is $300,000 of outputs of branch1 and $166.666.67 of

outputs of branch 2.
c. Since all entries of (I –C)-1 are non negative, then a non-negative production vector can
be found for any given non-negative demand.
In this case, the economy (and the consumption matrix C ) is said to be productive.
Remark: in the consumption matrix, if a column sums to less than 1, then the
corresponding industry consumes less than $1, in order to produce $1 of output.
In this case, the industry (or the sector ) is said to be profitable.
* If all the industries are profitable, then the economy is productive.
* If all row sums are less than 1, then the economy can output $1 of each industry while
internally using less. So the economy will be productive
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Example
0.5 0.4 1 0.5 0.4 0.9
0.7 0.1 1  0.7 0.1  0.8
      
The above economy has 2 sectors.
* while each having $1 value of product, the first sector spends $ 0.9 and the second
sector spends $0.8
Example
Let the consumption matrix of an economy be
 A M L

 0.3 0 0.2 A
C  0.2 0.6 0.3 M
 
0.4 0.2 0  L
 
Since each column is less than 1, each industry is profitable, so, the economy is
productive.
Examples let the consumption matrix of an economy be

 A M L

 0.4 0 0.2 A
C   0.1 0.5 0.3 M
 
0.6 0.2 0  L
 
* the first column sum is 1.1. so the industry is not profitable. The second and the third
industries are profitable. Since each row sum is less than 1, the economy can output $1 of
each industry while internally using less. So, the economy is productive.
Determination of employment level
We can use the input-output model to see the impact of any change in final demand or
total output on the level of total industrial employment in the economy.
The labor coefficient (  i ) required to produce a birr worth of output in sector I is given
by
Li
i 
i
Li   i  i

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The level of employment in each industry is uniquely related to the amount of total
output produced by that industry. Thus, to find the amount of labor employed in industry
i, we merely multiply the corresponding labor coefficient  i by the total output of Xi of
that sector . By summing the products of labor coefficients and total outputs of all
industries throughout the economy, we can derive the total industrial employment i.e.
LT    i X i

  1 x1   2 x2   3 x3     n xn where LT= total industrial employment

Similarity the change in employment as a result of a change in total output can be
expressed as:
n
LT    i xi
i 1

Using matrix algebra we can represent the equation LT    i xi for our three sector

economy as:
 x1 
LT   1 ,  2 ,  3  x 
 2
 x3 

In simple way
LT  1
Where 1= a matrix of labor coefficient
X= a matrix of total output.
Balance of Payments Analysis
The input output model can be used in the area of international trade to examine the
approximate impact of any predicted or planned change in final demand or total output on
the balance of payments position of the given economy.

Exports are assumed to be determined exogenously, but imports are endogenous. The
change in the import requirements of sectors (intermediate imports) may be calculated by
multiplying the required change in each sector‟s output by the sector‟s import coefficient.
Mi
mi 
Xi
M i  mi X i

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Where Mi= the value of intermediate imports of sector i.

m = a matrix of import coefficient
X = a matrix of total output
n
M T   mi X i
i 1

i.e.
 X1 
M T  m1 , m2 , m3  X 
 2
 X 3 

The change in import requirement as a result of change in the final demand can be given
as
n
M T   mi X i
i 1

7.5. Social Accounting Matrices (SAM)

This section sets out the framework of a social accounting matrix (SAM) and shows how
it can be used to construct SAM-based multipliers to analyse the effects of
macroeconomic policies on distribution and poverty. Estimates provided by a social
accounting matrix (SAM) can be useful even essential -for calibrating a much broader
class of models to do with monitoring poverty and income distribution. To put it
differently, Social Accounting Matrix (SAM) represents flows of all economic
transactions that take place within an economy (regional or national). It is at the core, a
matrix representation of the National Accounts for a given country, but can be extended
to include non-national accounting flows, and created for whole regions or area. SAMs
refer to a single year providing a static picture of the economy.
What is a SAM? A SAM is a particular representation of the macro and meso economic
accounts of a socio-economic system, which capture the transactions and transfers
between all economic agents in the system. In common with other economic accounting
systems it records transactions taking place during an accounting period, usually one
year. The main features of a SAM are threefold.

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First, the accounts are represented as a square matrix; where the incomings and outgoings
for each account are shown as a corresponding row and column of the matrix. The
transactions are shown in the cells, so the matrix displays the interconnections between
agents in an explicit way.

Second, it is comprehensive, in the sense that it portrays all the economic activities of the
system (consumption, production, accumulation and distribution), although not
necessarily in equivalent detail.

Thirdly, the SAM is flexible, in that, although it is usually set up in a standard, basic
framework there is a large measure of flexibility both in the degree of disaggregation and
in the emphasis placed on different parts of the economic system. As it is an accounting
framework not only is the SAM square but also the corresponding row and column totals
must be equal. Clearly, at one extreme, any set of macroeconomic aggregates can be set
out in a matrix format. But this would not be a „social‟ accounting matrix in the sense in
which the term is usually used.

An overriding feature of a SAM is that households and household groups are at the heart
of the framework; only if there exists some detail on the distributional features of the
household sector can the framework truly earn the label „social‟ accounting matrix. Also,
a SAM typically shows much more detail about the circular flow of income, including
transactions between different institutions (including different household groups) and
between production activities, and in particular recording the interactions between both
these sets of agents via the factor and product markets.

Three principal motivations underlie the development of SAMs. First, the construction
of a SAM helps to bring together data from many disparate sources that help to describe

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the structural characteristics of an economy. A SAM can also be used to good effect in
helping to improve the range and quality of estimates, by highlighting data needs and
identifying key gaps.

Secondly, SAMs are a very good way of displaying information; the structural
interdependence in an economy at both the macro and meso levels are shown in a SAM
in a simple and illuminating way. A SAM shows clearly the linkage between income
distribution and economic structure and, of course, this is especially important in the
context of this volume.

Thirdly, they represent a useful analytical framework for modelling;that is, they provide a
direct input into a range of models, including fixed-price multiplier models and are also
an integral part of the benchmark data set required to calibrate computable general
equilibrium (CGE) models

In summary, a suitably-designed and disaggregated SAM shows a great deal about the
structural features and interdependencies of an economy. It represents a snapshot of the
transactions (flows) taking place in a given year.

The SAM is a meso-level framework: it serves as a useful bridge between a macro

framework and a more detailed description of markets and institutions. Of course the
detail in the SAM might not be limited to the real economy, and there are some notable
examples of SAMs and SAM-based models that incorporate the financial sectors and the
flow of funds.

Clearly the economic structure of the SAM may change as the economy changes and
responds to shocks. A more formal modelling approach should therefore include
structural or behavioural specifications for the various groups of transactions. This is
especially true for example if the structure changes as a result of changes in relative
prices. However, often as a first-cut ex ante analysis, a SAM has frequently been used to
examine the partial equilibrium consequences of real shocks, using a multiplier model

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that treats the circular flow of income endogenously. The circular flow captures the
generation of income by activities in producing commodities, the mapping of these
income payments to factors of production of various kinds, the distribution of factor and
non-factor income to households, and the subsequent spending of income by households
on commodities. These patterns of payments are manifested in the structure of the SAM,
and are modelled analogously to the input structure of activities in an input-output model
based only on interindustry transactions. However, it is important to stress that the results
differ from input-output by virtue of the fact that input-output multipliers are augmented
by additional multiplier effects induced by the circular flow of income between activities,
factors and households. A main outcome of SAM-based multiplier analysis is to examine
the effects of real shocks on the economy on the distribution of income across socio-
economic groups of households. One other important feature of SAM-based multiplier
analysis is that it lends itself easily to decomposition, thereby adding an extra degree of
transparency in understanding the nature of linkage in an economy and the effects of
exogenous shocks on distribution and poverty.

SAMs are square (columns equal rows) in the sense that all institutional agents
(Firms,Households, Government and 'Rest of Economy' sector) are both buyers and
sellers. Columns represent buyers (expenditures) and rows represent sellers (receipts).
SAM's were created to identify all monetary flows from sources to recipients, within a
disaggregated national account. The SAM is read from column to row, so each entry in
the matrix comes from its column heading, going to the row heading. Finally columns
and rows are added up, to ensure accounting consistency, and each column is added up to
equal each corresponding row. In the illustration below for a basic open economy, the
item C (consumption) comes from Households and is paid to Firms.

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Illustrative example: an open economy SAM.

Rest of Net Total

Firm Household Government
Economy Investment (Received)

C+GF+(X-
Firm C GF (X-M)K I
M)K+I

W+GH+(X-
Household W GH (X-M)C
M)C

Government TF TH TF+TH

(X-
Rest of
(X-M)K (X-M)C M)K+(X-
Economy
M)C

Net
SH SG SH+SG
Investment

(X-
Total W+TF+(X- C+TH+(X-
GF+GH+SG M)C+(X- I
(Expended) M)K M)C+SH
M)K

Abbreviations: Capital letters: Taxes, Wages, Imports, Exports, Savings, Investment, Consumption, Government Transfer Subscripts:
Firms, Households, Government, Consumption Goods, K: Capital Goods

SAMs can be easily extended to include other flows in the economy, simply by adding
more columns and rows, once the standard national account (SNA) flows have been set
up. Often rows for „capital‟ and „labor‟ are included, and the economy can be
disaggregated into any number of sectors. Each extra disaggregated source of funds must
have an equal and opposite recipient. So the SAM simplifies the design of the economy
being modeled. SAMs are currently in widespread use, and many statistical bureaus,

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particularly in OECD countries, create both a national account and this matrix
counterpart.

SAMs form the backbone of Computable general equilibrium (CGE) Models and various
types of empirical multiplier models and Input-output model

7.6. Computable general equilibrium (CGE) Models

7.6.1 Introduction to CGE Models

Besides various theoretical refinements of general equilibrium modeling, the

development of computable general equilibrium models has had a long tradition in
empirical economics.
While especially in the 1970s theoretical propositions on the existence, uniqueness,
optimality and stability of solutions to general equilibrium models were explored and
further developed, the first full-fledged computable general equilibrium
(CGE) model was that of Johansen which dates back to 19601. Since then CGE models
have been used as a powerful technique for quantitative analysis of a great variety of
questions. These include analyzing the effects on - for instance - industries, regions, the
labor market, income and welfare induced by changes in, e.g., government policies
including taxes, trade restrictions, and/or technology. More recently also dynamic CGE
models have been put forth, enabling researchers to address also multi-period (dynamic)
problems by means of numerical general equilibrium analysis.
In recent years, improvements in model specification, data availability, and computer
technology have improved the payoffs and reduced the costs of policy analysis based on
CGE models, paving the way for their widespread use by policy analysts throughout the
world.
At this point it seems useful to define what is meant by computable general equilibrium
models. The term "general equilibrium" refers to an analytical approach where the
economy is regarded as a complete system of interdependent components (different
markets, industries, households, etc.) and all decisions are taken according to fully
optimizing behavior. Economic shocks affecting any one of theses components may
produce repercussions throughout the whole system. Assessing the effects of the shocks

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can be done by means of simulation, i.e. by measuring the repercussions that are
triggered by shocking the system in various ways. The models are called "computable" in
the sense that they should produce numerical results that are applicable to particular
situations in particular countries. To do so, the coefficients and parameters (elasticities)
of the model have to be estimated by making use of real world data.

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8. References

A.N.Agrawal (1980), Economic Planning; Principles, Techniques and Practice. 2nd ed.

Vikas Publishing House Pvt. Ltd.

M.L. Jhingan (1988), The Economics of Development and Planning. 21st revised ed.

Konark Publishers Pvt.Ltd.

O.S. Shrivastava (1996), Economics of Growth, Development and Planning. Vikas

Publishing House Pvt. Ltd.

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