Determinants of Economic Development

Determinants of Economic Development

"Innovation is an inexhaustible engine for Economic Development"

Determinants of Economic Development - The determinants of economic development are broadly categorised in two different groups -

1. Economic factors
2. Non-Economic factors

Economic Factors - Economic factors include -

• Capital formation
• Economic system
• Economic policy
• Structure of an economy (share of agriculture, industry & service sector in economy)
• Level of specialisation
• Global factors (including foreign trade & investment)
• Natural resources, etc.

Non-Economic Factors - Non-economic factors include -

• Socio-cultural factors
• Political factors
• Psychological factors
• Religious factors
• Demographic factors, etc.

Capital formation - (Investment) It refers to the process of increase in the fiscal stock of capital like machinery, equipment, factories, etc.

It is the most important determinants of economic growth. It increases productivity, production as well as future productivity capacity of an economy.

Harrod Domar Model - on which the 1st Five year plan was made, defines Economic growth as the ratio of Investment to incremental capital output ratio (ICOR).

i.e., Economic growth = Investment/ICOR

COR (Capital output ratio) is the ratio of capital to the output whereas ICOR (Incremental capital output ratio) is the ratio of increase in capital to the increase in output.

i.e., COR = Capital/Output &

ICOR = Increase in capital/Increase in output

COR shows how much money is invested to produce an output of 1 unit.

ICOR (Incremental Capital Output Ratio) - It means the number of units of capital that are required to produce an additional rate (unit) of output.

Higher ICOR shows lower efficiency and vice-versa.

ICOR of India after independence -

• 1970s - >5
• 1980s - 4.5
• 1990s - 4.3
• 2000s - 4.2

It shows that the efficiency is improving, since ICOR is reducing.

India shows a paradox of high saving despite low income 

Reason for that are -

1. Cultural reason 
• Society is not extravagant
• Dowry, etc.
2. Lack of social security
3. Inequalities (higher the inequality, higher the saving will be)
4. Tax rebate (on Fixed deposit, Provident funds, etc.)
5. High interest rate
6. Diversified financial system, etc.

Stages in Capital formation 

1. Saving 
2. Finance
3. Investment

Saving which equals to the difference between disposable income and consumption.

Finance which is mobilisation of saving of household for investment by firms through financial institutions like Banks, NBFCs, Insurance companies, etc.

Investment which is the expenditure on capital goods.

Saving - Gross domestic saving in India is about 32.3% of GDP in which -

• Household accounts for - 70 to 75% of total saving
• Private Corporates accounts for - 20%
• and rest 5% by Public Sector

Investment - Gross domestic capital formation is about 33.3% of GDP which includes -

• 85% by Private sector &
• 15% by Public sector

Difference between Closed Economy and Open Economy 

Closed economy

• It is an economy which does not have any economic relation with the rest of the world.
• Here, Investment = Saving

Open economy

• It is an economy which have economic relation with the rest of the world.
• Here, Investment = Saving + Net foreign capital inflow (such as FDI, Borrowing from abroad, etc.)

Determinants of Investment 

1. Profitability expectation
2. Business environment
3. Ease of doing business
4. Availability of Skilled labours
5. Tax rates
6. Infrastructure
7. Demand in market, etc.

Paradox of thrift - In developed countries, increase in saving results in decrease in demand which eventually results into decrease in economic growth or Recession. This paradox of increase in saving accompanied by recession is known as paradox of thrift.

i.e., ↑ Saving → ↓ Demand → ↓ Economic Growth → Recession

Whereas in Developing countries increase in saving results in increase in investment which leads to economic growth (here demand will not fall because of increase in saving because in developing countries there is no deficiency of demand because of high population, budgetary deficit for developmental expenditure, etc.)

i.e., ↑ Saving → ↑ Investment → ↑ Economic Growth

Economic growth is accompanied by inflation, but China shows parody of High economic growth and low inflation because of the reason that China invested 45 to 60% of his saving and there is always export surplus in favour of China.

Vicious circle of Poverty 

• It was given by Prof. Ragnar Nurkse.
• It is a circular constellation of forces tending to act and react upon another in such a way as to keep a poor country in a state of poor.
• i.e., poor country is poor and remains poor because it is poor.

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Note - This is my Vision IAS Notes (Vision IAS Class Notes) and Ashutosh Pandey Sir's Public Administration Class notes. I've also added some of the information on my own. 

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