The Financial Sector in Developing Economies

Question 1

Why is investment key to development for emerging economies?

Answer 1

• non-inflationary growth as both AD and LRAS increase
• beneficial for developing countries as they have really high inflation due to small productive capacity and so not able to produce which leads to supply constraints
• productive capacity increases
• low unstable inflation rates which facilitates export led growth so economic growth increases
• output increases so government collects more tax revenue
• HDI and GPI increase

Question 2

Why do developing countries face a problem of persistent lack of investment?

Answer 2

• because in developing countries people earn low incomes
• less people are saving as they have to spend on basic necessities
• banks become poorly capitalized which leads to Investments decreasing
• lower output so derive demand for labour decreases leading to further low incomes

Question 3

The Harrod-Domar Growth Model

Answer 3

• provides a mechanism for emerging economies to achieve economic development
• emphasises the crucial role of saving in stimulating economic growth

Question 4

What does the harrod domar model state?

Answer 4

The ratio of GDP is determined by the savings ratio and the capital output ratio

Question 5

Capital output ratio

Answer 5

The amount that has to be spent on capital to produce £1 worth of marginal output

Question 6

The rate of GDP growth

Answer 6

Savings ratio / Capital Output ratio

Question 7

The stages of the Harrod-Domar model

Answer 7

1. Savings
- savings are required to kickstart the model as it increases the capitalization of banks

2. Investments
- once banks are capitalized they are able to give more loans to entrepreneurs who invest in capital goods

3. Capital Account
- more capital accumulated over time of high quality as technology has improved so Investments become better quality

4. Rising Output
- more capital means more output
- workers become more productive so MRPL increases as improved capitak assissts workers

5. Rising Incomes
- the derive demand for labour increases
- more people become employed, income increases, reduce absolute poverty
- income earners can demand higher wages so their income also increases

6. Rise in Savings
- can already afford goods as increasing income so incentivised to save some disposable income

Question 8

The implications for policy makers in order to increase economic growth in the long run

Answer 8

1. To increase savings ratio
- increase interest rates, especially if it is higher than the rate of inflation as money wont depreciate as fast
- reduce the rate of income tax because RDY increases so more likely to save as they can already meet all their needs and wants

2. To decrease capital output ratio
- give firms subsidies
- invest in education and training

Question 9

Will saving lead to investment and the accumulation of capital?

Answer 9

1. Weak financial institutions
- don’t save as dont trust the bank as in developing countries there is less strict regulation regarding the money in their account
- if low levels of education people may not know about savings in developing countries
- people don’t develop the skills to build established financial institutions

2. Low marginal propensity to save
- in developing countries people live in absolute poverty so even if incomes increased people still need to meet all their needs
- people don’t save so banks don’t get liquidated and don’t become capitalized

3. Capital flight
- may save in other banks overseas as more trustworthy and stable with higher interest rates
- people capitalizing other banks so less investments
- traditionally developing countries have really low interest rates as they tend to be in larger recession periods
- also have very negative real wages due to high inflation rates so money depreciates at a faster rate so no point saving

Question 10

Will investment lead to higher output and income?

Answer 10

1. Capital Labour Substitution
- invest into capital and advanced machinery so lose their jobs and receive no income this means that they can’t save as they have to spend to afford goods and services
- they lack the transferable skills to get a new job and sO occupationally immobile
- even if there is advanced capital may not know how to use it as they don’t have the skills due to low HDI score and lack of education

2. Weak Currency
- developing countries have really weak currencies and so make it harder to even import advanced capital to use
- Central Bank may have a lack of foreign exchange reserves ascant afford
- they are investing in low quality and low valid capital which increases the capital output ratio as capital depreciates faster and have to replace a lot

Question 11

What is the importance of human capital?

Answer 11

• If investing into alot of capital it may not lead to economic growth
• MPPL for workers may be low as they don’t know what to do with capital
• due to low HDI and low mean years of schooling so future generations can’t operate with the advanced technology

Question 12

How can external sources of finance to invest prevent the harrod domar model?

Answer 12

Developing countries rely on external sources of finance

1. Developed countries may provide aid to developing
- when developed countries provide aid it may be conditioned as developed countries may ask for natural resources as a result
- doesn’t actually improve economic growth as they are being exploited
- volatile as it depends on the UK’s economic system as if they are going through a recession they would focus on domestic affairs rather than foreign aid

2. Attract MNCs
- the lack of regulation means that mncs are exploitative and would pay little wages
- mnc’s my take their money and repatriate the profits in another country as tax rates may be lower
- tax avoidance so the money doesn’t remain in the circular flow of income

3. Loans
- may set very punitive interest rates which are very exploitative
- developed countries may want to give high interest rates because they know that developing countries would end up defaulting on the loan
- would give developed countries leverage to take key domestic assets when they can’t pay back, leads to more debt

Question 13

Remittance payments

Answer 13

Money sent home by migrant workers abroad
- they are most often working in a developed country and repatriating or remitting money to the developing country they come from

Question 14

Benefits of remittances

Answer 14

1. Helps kickstart development in developing countries
- big injection into their circular flow of income which increases development
- developing countries will spend it more as they have a higher MPC so consumption increases and employment increases
- when turn pounds into foreign currencies the demand for the currency increasing causing the exchange rate to appreciate and so cheaper to import

2. Can import better quality and advanced capital due to appreciation
- import capital for cheaper and initiate the harrod domar cycle
- allows them to produce and sell higher value goods and services so strengthen their terms of trade
- better quality capital also depreciate slower which means the capital output ratio decreases as don’t have to keep spending on capital to increase output

3. Better human capital
- People who have left their home country to go to a developed country may return back with better quality skills that are transferable and so productivity and output increases
- if more people in the home country consumption increases and so kickstart economic growth

4. People gain more skills abroad and may start up firms in their home country
- can lead to a trickle down effect as there is more job opportunities
- when become entrepreneurs they could help improve education as can pass on their skills which improves HDI
- quality and quantity of labor increases so productive capacity increases LRAS shifts or inflation decreases

Question 15

Drawbacks of remittances

Answer 15

1. Human capital flights
- high skilled workers will leave the country until output decreases
- only left with low quality labour so productive capacity decreases
- also decreases HDI as doctors may leave to come to developed country so life expectancy may decrease

2. Lower tax revenue
- Lower skilled workers left and tend to work in agriculture or primary sector so only receive cash in hand so can’t be taxed
- high skilled workers have higher income and so if they leave income tax decreases

3. Depends on the economic cycle
- , if in a recession can’t send money back home and immigrants don’t receive benefits so if they lose their jobs they cannot send money back home

4. Exports more expensive
- when the exchange rate appreciate exports are more expensive so slows down export lead growth and negative multiplier effect

5. Money sent back may not be used
- money may not be spent instead saved at home, so won’t enter the circular flow of income and the harrod domar model is not activated
- the money may be spent on servicing debt instead of on goods as developing countries tend to be heavily in debted

Question 16

What is market failure caused by in areas where lending might take place?

Answer 16

1. A lack of information
- a lack of information of documentation such as workers earnings as people in developing countries earn cash in hand
- they may not have a bank account or employment history so can’t calculate their credit score so less likely to get a loan

2. A lack of property rights
- legal documents that show you own a house
- makes it harder to take out loans as these people don’t have collateral and don’t have documents of wealth so they are seen as more risky and cannot be backed up
- government unintentionally have weak property rights so that if there was any defiance the gov can just take their assets back (expropriation)

3. A Lack of trust
- weak financial institutions and lack of compensation if money is lost
- banks may not be capitalized enough so firms can’t take out loans

Question 17

What is the result of this market failure?

Answer 17

people in rural areas are often forced to depend upon in formal markets for credit and borrow from local money lenders at often punitive interest rates

Question 18

Micro-Finance

Answer 18

A scheme that provides loans for small scale projects in developing countries

Question 19

What is the aim of microfinance?

Answer 19

Reducing poverty
- provide credit without the need for collateral
- reduce the burden and anxiety of paying back a debt
- leads to more entrepreneurship as more funds for investments

Question 20

What does microfinance provide a mechanism to?

Answer 20

To stimulate entrpreneurship
- non-inflationary growth as ad and lraas increase simultaneously
- this is because when a business is set up need to employ people and invest in capital
- when output increases, absolute poverty decreases as there is a trickle-down effect and people can afford their basic needs
- there is more private sector entrepreneurship so more efficient and productive
- HDI and GPI increases so tax revenue also increases

Question 21

Why has a key feature of micro finance been the targeting of women?

Answer 21

In developing countries, girls cannot go to school and have an education as they don’t gain skills due to marriage and looking after children
- women don’t have any assets in the first place as tend to live with their parents and when they get married they live with their husvbands instead

Question 22

What are the problems that have arisen as a result of microfinance?

Answer 22

1. Poor regulation
- low income households can still be exploited due to loans being given out due to punitive interest rates
- if the whole community can’t pay back loans they all lose their assets

2. A lot of competition in the market
- markets become oversaturated which leads to irresponsible lending
- to attract consumers a lot of lenders will lend away above and individual’s capacity meaning people are more likely to default and lenders can take their assets

3. Should put in place specific education and training
- if poor education they won’t know how to take out loans and start upper business

4. Can just give grants instead
- a grant may be better as there is no pressure to pay it back and enables them to be more creative

Question 23

HIPC

Answer 23

Heavily indebted poor country

Question 24

The conditions for debt cancelation

Answer 24

1. implementation of free market growth strategies
2. diversify export portfolios so less susceptible to demand side shocks
3. a clear poverty reduction strategy
4. boost private sector enterprise as more efficient

Question 25

What are the three areas that need to be focused on for development to be effective?

Answer 25

1. Improvements in physical infrastructure
- allows private sector enterprise to flourish and make microfinance more effective
- improves geographical mobility so lots of people can go to work and productivity increases

2. Human capital levels (high levels of education and skills)
- enables people to work in the tertiary sector and have more transferable skills

3. Access to credit (loans)
- there needs to be a clear improvement to financial institutions so that firms can take out credit to set up

Question 26

What is this the most difficult to achieve?

Answer 26

Due to the lack of trust as governments are corrupt
- In some developed countries there is a lack of legislation and oversight

Question 27

Why did emerging economies grow?

Answer 27

Because of globalisation
- helps facilitate exported growth
- opened a gap in the world
- social infrastructure (education and healthcare)