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Study Notes

4.3.2 Economics of the savings gap and the Harrod-Domar model (Edexcel)


Last updated 6 Oct 2023

This Edexcel study note covers the economics of the savings gap and the Harrod-Domar model as it applies to developing countries.

The Savings Gap is a concept in economics that relates to the difference between the amount of savings needed to finance a country's desired level of investment and the actual level of domestic savings available. This concept is particularly relevant to developing countries, where achieving high rates of economic growth and development is a priority. The Harrod-Domar model is a theoretical framework used to understand and analyze the Savings Gap in developing countries.

Key Components of the Harrod-Domar Model:

  1. Desired Investment (I): This represents the level of investment that an economy needs to achieve a specific rate of economic growth. It includes spending on capital goods, infrastructure, factories, and other productive assets.
  2. Domestic Savings (S): This refers to the portion of a country's income that households, businesses, and the government save rather than consume.
  3. Savings Gap (SG): The Savings Gap is the difference between Desired Investment (I) and Domestic Savings (S). Mathematically, it can be expressed as SG = I - S.
  4. Multiplier Effect (k): The Harrod-Domar model assumes that there is a positive relationship between investment and income. An increase in investment leads to a larger increase in income due to the multiplier effect. The multiplier (k) represents how much an initial increase in investment will ultimately boost national income.

Explanation of the Savings Gap in Developing Countries:

In developing countries, achieving high rates of economic growth is crucial for reducing poverty and improving living standards. However, these countries often face a Savings Gap because their domestic savings are insufficient to finance the level of investment needed to achieve the desired growth rate.

Factors Contributing to the Savings Gap:

  1. Low Domestic Savings Rate: Developing countries often have low levels of domestic savings due to low income levels, limited access to banking services, and high consumption rates.
  2. Limited Access to Foreign Capital: Many developing countries also struggle to attract foreign investment or secure loans from international financial markets. This limits their ability to bridge the Savings Gap through external financing.
  3. Political and Economic Instability: Political instability and economic uncertainty can deter both domestic and foreign investment, exacerbating the Savings Gap.

Implications of the Savings Gap:

  • When the Savings Gap is not closed, it can result in slower economic growth, inadequate infrastructure development, and reduced job creation in developing countries. These factors can perpetuate poverty and hinder overall development.

Role of Government and Policies:

  • Governments in developing countries often play a critical role in addressing the Savings Gap. They can implement policies to encourage higher domestic savings, attract foreign investment, and create a conducive environment for economic growth.
  • Policies may include tax incentives for savings, financial sector development to promote access to credit and banking services, efforts to improve political stability and reduce corruption, and initiatives to attract foreign direct investment (FDI).

In summary, the Savings Gap in developing countries, as analyzed through the Harrod-Domar model, highlights the challenge of mobilizing sufficient resources to finance the desired level of investment needed for economic growth. Closing this gap is essential for achieving sustainable development and improving the well-being of populations in these countries.

Remittances and the savings gap

Remittances, which are funds sent by migrant workers to their home countries, can play a significant role in helping to close the savings gap for a developing country. These inflows of money can boost domestic savings, provide a stable source of foreign exchange, and contribute to economic development. Here's how remittances help close the savings gap, along with real-world examples:

1. Increased Savings and Investment:

  • Remittances are often used for savings and investment purposes. Families receiving remittances may save a portion of the money in banks or financial institutions, which in turn can be channeled into investment activities such as starting small businesses, buying land, or investing in education.

Real-World Example: In the Philippines, a significant recipient of remittances, many families use remittance income to invest in small enterprises, such as sari-sari stores (small neighborhood convenience stores) or agricultural projects. These investments contribute to local economic development and job creation.

2. Reduced Dependency on Foreign Borrowing:

  • Remittances can reduce a country's reliance on external borrowing, which is often used to finance development projects. When a country receives substantial remittances, it can reduce its debt burden and allocate more resources to productive investments.

Real-World Example: In Bangladesh, remittances from overseas workers have played a crucial role in funding development projects. The country has been able to reduce its dependency on foreign loans for infrastructure development due to the inflow of remittances.

3. Enhanced Financial Inclusion:

  • Remittance recipients who open bank accounts or use formal financial services may become part of the formal financial system. This can lead to greater financial inclusion and increased opportunities for savings and investment.

Real-World Example: In Mexico, the government and financial institutions have encouraged remittance recipients to open bank accounts. This has not only improved financial inclusion but also facilitated access to credit and financial services, allowing individuals to invest in income-generating activities.

4. Stability in Balance of Payments:

  • Remittances provide a stable source of foreign exchange earnings for developing countries. They can help offset trade deficits and contribute to a stable balance of payments, reducing the risk of external financial crises.

Real-World Example: In India, remittances have been a consistent and significant source of foreign exchange. They have helped stabilize the country's balance of payments, contributing to macroeconomic stability.

5. Poverty Alleviation:

  • Remittances can directly improve the well-being of recipient families by covering basic needs like food, housing, and healthcare. This, in turn, can free up other income for savings and investment.

Real-World Example: In Guatemala, remittances from the United States have been vital in reducing poverty levels. Families receiving remittances have been able to improve their living conditions and allocate resources to education and healthcare, indirectly contributing to savings and investments in human capital.

While remittances offer significant benefits, it's important to note that they may also have some drawbacks, such as dependency on external income sources and potential exchange rate risks. Nonetheless, when managed effectively, remittances can help developing countries bridge their savings gap and promote economic development.

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