Up Learn – A Level Economics (AQA) – Emerging and Developing Economies II
Savings Gap: The Harrod Domar Model
The Harrod-Domar model explains how low savings make it difficult for firms to ever be able to invest, keeping investment low, and limiting growth.
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Emerging and Developing Economies II
We have now seen that there are two main reasons for low savings…
Low savings can occur for two reasons. First, low incomes might mean that workers have no spare money to save in banks, and second, low access to banking might make it impossible for workers to store their savings in banks anyway!
And low savings can lead to savings gaps, which occur when…
A savings gap occurs when there is a gap between the amount of money held at banks in savings, and the amount of money that firms want to borrow from banks!
Like in Bangladesh, where low incomes and low access to banking left the country with a large savings gap!
Unfortunately, Bangladesh’s savings gap meant that Mandy the Bangladeshi mango seller couldn’t borrow any money from the bank to invest in her mango-selling business – she couldn’t afford to buy a bike for delivery, a blender for mango smoothies, or a step ladder for picking mangoes!
And firms all across Bangladesh had the same problem, meaning that investment in Bangladesh stayed very low.
What effect did low levels of investment in Bangladesh have on their real GDP?
Low levels of investment, or ‘I’ in our AD formula, kept AD low, keeping our AD curve to the left, and therefore preventing Bangladesh’s real GDP from growing! But low investment also shifted Bangladesh’s LRAS curve in, keeping Bangladesh’s real GDP even lower!
And with Bangladesh’s real GDP staying low, Bangladesh remained poor, meaning incomes all across Bangladesh stayed low. And if incomes also stay low…
If incomes stay low, savings will also stay low, as people still have no spare money to save! As a result, Bangladesh’s savings gap remained large!
And with a large savings gap…
With a large savings gap, firms all across Bangladesh still couldn’t borrow any money to invest into their businesses, keeping investment low, keeping AD and LRAS shifted to the left, and limiting growth even further!
So, the savings gap caused a vicious cycle: low incomes led to low savings, which led to low investment, which led to low growth, which led back to low incomes, which led to low savings, low investment, low growth and so on! As a result, it became very difficult for firms to ever invest – Mandy the mango seller would find it difficult to ever buy her bike, blender or ladder!
This vicious cycle was first explained by two economists: Roy Harrod and Evsey Domar. As a result, it’s called the Harrod-Domar model!
So the Harrod-Domar model explains how low savings make it difficult for firms to ever be able to invest, keeping investment low, and limiting growth!
But more importantly, without ever being able to invest, Mandy won’t ever be able to expand her business and increase her profits, meaning her profits will stay low!
And low profits in Bangladesh meant that…
Low profits meant that the Bangladeshi government collected very little corporation tax – meaning they had no money to invest in development, limiting development! For instance, they couldn’t build durable highways to allow people to get around Bangladesh more easily!
So, in summary, our fifth constraint on growth and development is savings gaps, which occur when…
Savings gaps occur when there is a gap between the amount of money held at banks in savings, and the amount of money that firms want to borrow from banks!
And without being able to take loans…
Without being able to take loans, firms can’t invest in their businesses, meaning investment stays low, AD and LRAS stay low, real GDP stays low, countries stay poor, incomes stay low and so on – meaning the savings gap persists, and growth stays low!
This vicious cycle is called…
This vicious cycle is called the Harrod-Domar model!
So The Harrod-Domar model explains how low savings make it difficult for firms to ever be able to invest. And without being able to invest, firms’ profits will stay low, meaning the government can’t collect much corporation tax, and so development is constrained!