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Is Investment Engine of Growth?
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Q1: Savings - the engine of growth? (Mier, and Rauch 2000) :1
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InputDate: 7/17/2006

Reference: Meier, Gerald M. and James E. Rauch. 2000. Overview: Savings - The Engine of Growth? Leading Issues in Economic Development (seventh edition) Oxford University Press
A: Savings have been considered as the important driver for he economic growth.
Dual Economy model by Arthur Lewis
Arthur Lewis (1954) wrote, "The central problem in the theory of economic development is to understand the process by which a community which was previously saving and investing 4 or 5 percent of its national income or less, converts itself into an economy where voluntary saving is running at about 12 to 15 per cent of national income or more."

Harrod/Domar model assumes direct link between saving ratio and growth rate
In the Harrod/Domar model, where they assumed no substitution between physical capital and other factor of production, GDP growth rate was closely linked to the saving ratio through the fixed capital/output ratio. Many economists wrote that the rate of capital formation in the form of physical equipment, determines the rate of a country?fs economic growth, e.g. De Long and Summers (1991, 1992).
Neoclassical model prediscts no long-run relationship between savings and economic growth rates
On the other hand, Albert Hirschman (1958) claimed that the savings and investments follow the economic growth and not other way round.

In the neoclassical growth model, which assumed the substitution of physical capital and human capital, accumulation of physical capital through investment and savings, due to diminishing return on capital, no longer deemed as the determinant of the long-term growth rate. However, Easterly, Kremer, Pretchet and Summers (1993) stated that in the developing countries time required for the transition process to reach the steady growth path is long and , ?gif countries are far from their steady states, models in which country characteristics determine income look similar to those in which country characteristics determine growth rates.?h

Endogenous growth model revived importance of savings to economic growth
In the endogenous growth model, savings regained their importance to economic growth as savings create both physical and human capital, which in combination, produce a constant or increasing return and higher long-term economic growth.

Direction of causality is from growth to savings
Lipsey and Kravis (1987) found that the correlation of per capita growth rate with succeeding 5 year period is stronger than that with curren t or preceding 5 year period. Blomstrom, Lipsey and Zejan (1996) used the more rigorous test to find the direction of causation between per capita income growth and fixed capital formation ratio with or without country dummies and found the causation is in the direction of growth to investmment.

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Q2: Does Investment produce higher Growth? (Easterly 2001) :1.1
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InputDate: 7/16/2006

Reference: Easterly, William. 2001. The Elusive Quest for Growth, Economists Adventures and Misadventures in the Tropics. The MIT Press. p39
A: The second link in the financial gap approach is the link from investment to growth. Does investment have a quick growth payoff, as the financial gap model assumed?
No statistical corelations with investment and growth in next period
I started assuming the same short-run investment-growth relationship across all countries. I tried using four-year averages to assess the growth-investment relationship. The results with four year averages do not bode well for the financing gap approach: there is no statistical association between growth in one four-year period and investment in the previous four-year period.

Country-by-country tests: only four countries pass the tests
Let's now allow the investment-growth relationaship to vary across countries by examining the link from investment to growth individually for each country. We have 138 countries with at least ten observations on growth and investment. Again there are two tests of the investment-to-growth link. First, countries should display a positive statistical association between growth and last year's investment. Socond, the investment-growth relationship should be in the "usual" range to give reasonable "financial gaps." The four economies that pass both tests are unusual assortment: Isreal, Liberia, Reuion (a tiny French colony) and Tunisia.
Only Tunisia satisfies the tests of two links.
Remembering the few countries where the aid-to-investment link worked as expected, I can now say that the financial gap approach fits one country: Tunisia. Before Tunisians throw a national celebration, I should point out that 1 success out of 138 countries is likely to have occurred by chance even if the model made no sense, which so far the evidence say it doesn't.

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Q3: What are the empirical evidence of the impact of Investment on growth? (Blomstrom, Lipsey and Zejan 1996) :2
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InputDate: 7/16/2006

Reference: Blomstrom, Magnus, Robert E. Lipsey, and Mario Zejan. Is Fixed Investment the Key to Economic Growth? Quarterly Journal of Economics 111 (February 1996): 269-273. Reprinted in Leading Issues in Economic Development. by Gerald Meier and James Rauch.
A: The strong relationship between fixed capital formation share of GDP and growth rates since World War II has led many writers, such as De Long and Summers [1991, 1992], to conclude that the rate of capital formation in the form of equipment, determines the rate of a country's economic growth.
Causality may be reverse
Yet, the strong association between fixed investment or equipment investment and growth, particularly over spans of fifteen to twenty years, does not prove causality. The effects may very well run from growth to capital formation, so that rapid growth leads to high rate of capital formation. An earlier study by Lipsey and Kravis [1987] found that for five-year periods within the longer spans, the rate of growth was more closely related to capital formation rates in suceeding periods than to contemporary or preceding periods. That result suggested that the observed long-term relationships were due more to the effect of capital formations on growth.

No evidence that capital formation preceeds growth
Using more formal methods of studying the direction of causation, informal and formal tests using only fixed investment ratios as independent variables give evidence that economic growth preceeds capital formation, but no evidence that capital formation preceeds growth. Thus, the causality seems to run in only one direction, from economic growth to capital formation.
Granger-Sims causality test; Investment to growth
A more formal way of examining the direction of causality is to apply tests in the Granger-Sims causality framework (Gronger 1969; Sims 1972). We first estimate the equations (1) and (2) in the Table I.

(1) RGDPC = f(RGDPC1, RGDPC2)
(2) RGDPC = f(RGDPC1, RGDPC2, INV1)

where RGDPC is growth in real income per capita, and INV is the ratio of fixed capital formation to GDP. and 1 and 2 after the variable name is the value of the variables in one or two year before. We interpret investment to be Granger-causing growth when a prediction of growth on the basis of its past history can be improved by further taking into account the past period's investment. Estimation (1) and (2) gives the attached results (click Related Statistics). Thus we cannt reject the null hypothesis that capital formation in the preceeding period has no explanator power with respect to growth in the current period, given the past history of growth in the country. The past history of growth is a poor predictor of current growth, but lagged investment does not improve the prediction.

Granger-Sims causality test; Growth to investment
We can then reverse the question to ask whether past growth has an effect on current capital formation rates, given the history of capital formation rates. The results are as in (3) and (4) in the attached Table I.

The significant t-statistics on RGDPC1 suggests that past growth has a significant effect on current capital formation even after past capital formation is taken into account. Even though the past history of capital formation rates predicts current rates well, past growth rates improves the prediction.

In sum, informal and formal tests using only fixed investment ratio as independent variables give evidence that economic growth preceedes capital formation, but no evidence that capital formation preceeds growth. Thus causality seeds to run in only direction, from economic growth to capital formation.

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Q4: What are the roles of Investment and Saving in economic growth? (Hayami, 2001) :2.1
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InputDate: 7/18/2006

Reference: Hayami, Yujiro. 2001. Development Economics, From the Poverty to the Wealth of Nations, Second Edition, Oxford University Press
A: High positive correlation between the growth rates of per capita GNP and per capita investment (see Statistics). Indeed their correlation coefficient is as high as 0.9.
Causalities work both ways
However, it cannot be concluded from this correlation that growth ininvestment is a major determinant of GNP growth. There is a little doubt that a causal relationship works for investment growth to contribute positively to GNP growth. At the same time, however, a reverse causality of high-income growth that results in high investment is likely to operate, since expected return to investment are usualy so high in high-growing economies that much of the incremental income above the 'permanent income' in the Friedman sense would turn into saving.

two-way causality produces vicious and virtuous circle
These two-way causal relationaships have reinforced each other to create a virtuous circle in Asia, while they seem to have a vicious circle in Africa. Indeed, the hypothesis that a high rate of income growth promotes the rate of saving is supported by the ratios of gross domestic savings to GDP compared with the percapita GNP growth rates.
Growth pessimism for low-income countries
A conventional view is that the saving rate increases according to increases in per capita income. This view has underline development economists' pessimism of low-income economies escaping from the low-equilibrium trap characterized by poverty and stagnation. however, the saving rates in East Asian economies were not only higher than those in low-income economies in South Asia and Africa, but were also higher than those in the middle-income economies in Latin America and even higher than those in OECD members.

Asian economies enjoyed higher saving rates than higher income countries
Moreover, the rates of growth in savings from 1965 to 1995 were also distinctly higher in East Asia than in other regions. These findings seem to suggest that even very poor economies such as those in Sub-Saharan Africa, will be able to invest sufficiently large domestic savings to achieve high economic growth once these economies are set on the track of high growth.

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Q5: What was the effectiveness of the Financial Gap approach? (Easterly 2001) :3
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InputDate: 7/16/2006

Reference: Easterley, William. 2001. The Elusive Quest for Growth, Economists Adventures and Misadventures in the Tropics. The MIT Press. p37-38
A: When we financing gap user calculatedaid requirements as the excess of "required" investment over actual saving, our presumption was that aid would go one for one into investment. Moreover, aid givers talked about conditions that would require countries to increase their rate of national saving at the same time, which some like Rostow thought would even happen naturally. So aid conbined with savings conditions should increase investment by even more than one for one. Let's see what actually happened.
Only seventeen of eighty-eight countries show a positive statistical association between aid and investment
We have eighty-eight countries on which data are available spanning the peeriod 1965 to 1995. The aid to investment link has to pass two tests for us to take it seriously. First, there should be a positive statistical association between aid and investment. Second, aid should pass into investment at least one for one: an additional 1 percent of GDP in aid should cause an increase of 1percent of GDP in investment. How did the aid to investment do on these tests? On the first test, only seventeen of eighty-eight countries show a positive statistical association between aid and investment.

Only six countries passed the two tests
Just six of these seventeen countries also passed the test of investment increased at least one for one with aid. The magic six include two economies with trivial amounts of aid: Hong Kong (which got an average of 0.07 percent of GDP)and China (average of 0.2 percent of GDP). The other four - Tunisia, Morocco, Malta, and Sri Lanka - did have nontrivial amount of aid, The other eighty-two countries fail the two tests.
1994 study found no relationship between aid and investment
These county-by-county results are reminiscent of the results of a 1994 study that found no relationship between aid and investment across countries. Unlike this study, I do not intend here to make a general statement about whether foreign aid is effective. There are many problems in doing such an evaluation, most of all the possibility that both aid and investment could be responding to some third factor. It could be that in any given country there was bad luck like a drought that caused investment to fall and aid to increase. I am only asking whether investment and aid jointly evolved the way that the user of the financial gap model expected. We financial gap advocates anticipated that aid would go into investment, not into tiding countries over droughts. According to my results, investment and aid did not evolve the way we expected.

The recipient country may use aid to buy consumption goods
The financial gap approach failed badly as a panacea because it violated this book's official motto: People respond to incentives. Think of the incentives facing the recipents of foreign aid. They invest in the fututre when they get a high return to their investments. They do not invest in the future when they do not get a high return to their investments. There is no reason to think that aid given just because the recipient is poor changes the incentives to invest in the future. Aid wil not cause its recipient to increase their investment; they will use aid to buy more consumption goods. This is exactly what we found when we checked the aid-investment relationship: on balance there is no relationship.

Encourage savings so that aid can link to investment
Aid could have promoted investment instead of all going into consumption. As many aid advocates suggested, aid should have been made conditional on matching increases in a country's savings rate. That would have given the governments in poor countries incentives to increase their own savings and to promote private savings. The latter can be done by a combination of tax breaks for income that is devoted to saving and tax on consumption. The increase in saving would have kept the aid recipients out of debt troubles and would have promoted as increase in investment. Haing aid increase with country saving is the opposite of the current system, where a country with lower saving has a higher financial gap and so gets more aid.

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Q6: What are the roles of Intrastructure for growth? (Devarajan, and Kessides, 2002) :4
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InputDate: 7/16/2006

Reference: Devarajan, Shantayanan and Christine Kessides. 2002. Infrastructure and Growth: A Multicountry Panel Study, World Bank
A: The purpose of this study was to produce estimates of the effects of major kinds of physical infrastructure on GDP per capita growth and multifactor productivity. The study modeled five kinds of infrastructure separately, in a standard growth framework with total capital, human capital, and geographic variables as additional candidates for explaining growth. The estimates were produced in a full panel (152 countries) of annual data (1950?E5) and with a new multicountry database of infrastructure stocks.
The study analyzed the determinats of the infrastructure stock
The study found that among the explanations of a country's infrastructure stocks, population size and per capita income are important, but so are area and degree of urbanization. These signal the degree of density, which affects the per capita cost of supplying roads, electricity, and telecommunications.

Causality runs in both ways
On the crucial question of causation - Does infrastructure cause growth or vice versa? - The study concluded (on Granger tests and helped by cointegration in the series of infrastructure stocks and per capita income) that causality between income levels and infrastructure stocks runs in both directions, but that the long-run effect is from infrastructure to income.
Electricity generation and paved road produce equal or higher productivity gain as general capital
Measuring the long-run productivity of infrastructure capital relative to capital in general across the entire sample, the study found electricity generating capacity to have productivity about equal to that of capital in general. It found the same for transport routes (paved roads and railway track) in lower-income countries. Assuming that no infrastructure will be laid down that is not as productive as capital in general, there is no evidence in these cases, on average, of externalities associated with these kinds of infrastructure. In higher-income countries, however, transport routes have a greater impact on GDP per worker than does capital in general. Telephones also have a large impact on output, but the effect is so large as to strain credibility, at least as a supply effect; it probably reflects the chronic excess demand for telephones in many developing countries and to that extent is demand determined.

But subject to rapid diminishing returns
Estimating a translog function, the study found that electricity capacity and paved roads are each subject to rapidly diminishing returns. Building much of such infrastructure on the chance of demand is therefore risky. It also found that electricity capacity and paved roads are complements to both physical and human capital. This signifies that the effectiveness of each increases with stocks of general capital and therefore (with everything measured in per worker terms) with capital deepening across the economy, that is, with industrialization.

Rate of return of electricity is higher in low income countries
Across the entire sample, the study found much heterogeneity in the rates of return to paved roads and electricity capacity relative to that to capital in general. In a number of cases infrastructure has the lower rate. Disaggregating by per capita income, however, the study found that middle-income developing countries show rates of return to paved roads well above those to capital in general, indicating undersupply and, possibly, pronounced externalities to paved roads associated with middle income. For electricity capacity, however, the highest relative rates were found in the low-income group, while the return in the middle-income group is close to that to capital in general.

Reference:
Canning, David, and Esra Bennathan. 2000. "The Social Rate of Return on Infrastructure Investments." Policy Research Working Paper 2390. World Bank, Development Research Group, Washington, D.C.

Canning, David. 1999. "Infrastructurefs Contribution to Aggregate Output." Policy Research Working Paper 2246. World Bank, Development Research Group, Washington, D.C.

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Q7: What is the recent trend of correlation between savings and growth? (Kusakabe, 2005) :5
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InputDate: 7/17/2006

Reference: Kusakabe, Motoo. 2005. ICT and National Innovation System: Is ICT Engine of Growth? Presentation at International Workshop on Workforce Development For Knowledge Economy, 7-13 September 2005, Seoul, Korea
A: In the figure above, I calculated the correlation coefficients between the gross domestic savings ratio and the per capita GDP growth rates (constant 2000 US$) for the two income groups.
Negative correlation between saving ratio in previous decades and growth of per capita GDP
In all periods and income groups, the correlations are negative and significatly negative for higher income countries, except for the final period (correlation between savings in 90s and growth in 2000s). In the final period, the correlations are not statistically significant level.
Growth has a positive impact on savings in succeeding decades
If the correlations are calculated between the per capita GDP growth rates and savings ration in the succeeding decade, correlations become all positive, except for the higher income countries in the final period (1990's savings and 2000s economic growth)

Direction of causality goes from growth to savings
From these two observations, we can conclude that the correlation between saving ratio and growth in the preceding period is stronger than that with the succeeding period all income groups and almost all period.

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Q8: How about the recent trends in correlations between Investment and Growth? (Kusakabe, 2005) :5.1
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InputDate: 7/17/2006

Reference: Kusakabe, Motoo. 2005. ICT and National Innovation System: Is ICT Engine of Growth? Presentation at International Workshop on Workforce Development For Knowledge Economy, 7-13 September 2005, Seoul, Korea
A: The same conclusion can be made for the correlations between investment and growth.
Investment has negligible correlation with growth after 70s
This figure shows the correlation coefficients between gross fixed capital formation (per cent of GDP) and the per capita GDP growth rates in the succeeding decades. We can observe that there was a significantly high correlation in higher income countries between the investment in 1960s and growth rates in 1970s, but otherwise there is no statistically significant correlations.
Rather growth causes higher investment in the succeeding decades
This figure shows that there is a significantly high correlations between the growth rates and gross fixed capital formation in the succeeding decades. We can safely conclude that the fixed investments are not the driver of the economic growth, and rather higher investment is the consequence of the high economic growth.

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Q9: Savings & Investment - What are the policy implications? (Kusakabe, 2005) :5.2
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InputDate: 7/17/2006

Reference: Kusakabe, Motoo. 2005. ICT and National Innovation System: Is ICT Engine of Growth? Presentation at International Workshop on Workforce Development For Knowledge Economy, 7-13 September 2005, Seoul, Korea
A:
Higher saving does not bring about higher growth
Increase in savings & investment does not automatically bring about higher growth of per capita income. Higher savings may induce higher investment only if there is a strong incentive and capacity of the people to invest profitably in the business.

Higher investment does not necessarily bring about higher growth
More often, higher investment in inefficient projects financed through external borrowing at high market rate of interest caused problems in the later years. Investment brings about a positive effect only if business people has a sound investment decision and financial sector finance these investment efficiently.
Higher economic growth will increase the savings & investment
On the other hand, higher growth almost always followed by higher savings and higher investment. This implies that if the government wants to accelerate the growth, forcing people to save and promote investment is not a good option in most of the cases in developing countries. Rather they create a effective demand in the domestic market and make their industry competitive in export market to create higher demand-led growth. Then savings and investment will follow and there will be a virtual cycle starts, as in many of the Asian NIEs.

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