“Week 1 ECO3EGS”

Group 4 - Maxine Catchlove, Sam Ridsdale, Stephanie Schott, Tim Hawley

  1. What are the main assumptions of the “Financing Gap model”?

. A country’s investment requirements for any given growth rate is proportional to the growth rate by a constant known as the Incremental Capital Output ratio (ICOR).

. The gap between investment requirements and the financing available from the sum of private financing and domestic saving, known as the “Financing Gap,” can be used as a tool to estimate aid requirements.

  1. What is the ICOR? (Note, you can look anywhere for a definition that makes sense to you)?

The Incremental Capital Output Ratio (ICOR) is the ratio of investment to growth and can be defined as:

ICOR for year t = (Investment in year t)/(Increase in value of output during the year t)

A. A. Walters - ‘Incremental Capital-Output Ratios’, The Economic Journal, Vol. 76, No. 304 (Dec., 1966), pp. 818-822

http://www.jstor.org/stable/pdf/2229085.pdf

  1. What are the testable implications of the Financing Gap model?

The testable implications of the Financing Gap Model as stated by Easterly are that;

. Aid will go into investment one for one,

. There will be a fixed linear relationship between growth and investment in the short run.

  1. How does Easterly test them?

Easterly tests the model’s predictions empirically with the following examples:

Test of the relationship between aid and investment:

Easterly first uses data from 88 aid recipient countries to test the assumption of a one-to-one relationship between aid and investment. He finds that only six countries showed a coefficient greater than or equal to one concerning the effect of a foreign aid on investment. This means that only 7% respected the one-to-one proportion.

Test of the relationship between investment and growth:

To test whether the relationship between investment and growth had some predictive power he used data from 138 countries with at least 10 observations of growth and investment. He added a “zero” constant that wasn’t present in the ICOR model. Only four economies passed the test with this constant and an ICOR between 2 and 5. In these four countries, only one (Tunisia) also passed the first test. This means that the Financing Gap Model fits only one country out of 138.

Test of the necessity of investment in the short-run:

Using different ICORs and period lengths (one and four years), he tests how often the necessary investment rate accompany one-year high growth episodes. With an optimistic ICOR of two, only 39% of the sample passed the test. With a normal ICOR of 3.5, only 9% passed and with an ICOR of 5 just 1%.

Then, he looked at how often investment increased by the required amount where growth increased. Considering four-year periods, this condition was satisfied only between 6 and 12% of the time (3 to 7% for annual averages). In conclusion, there is no evidence that investment is necessary nor sufficient for short-run growth increases.

To have a concrete vision of the inefficiency of this model, he took the example of Zambia. According to the Financing Gap Model, Zambia should be an industrialized country instead of being poor. The investment rate went down and aid increased but wasn’t followed by short-run growth. This is also the case for many countries that Easterly analysed.

  1. What does he find?

Easterly offers several theoretical reasons for the model being inconsistent with the empirical data he was able to analyse. Firstly, he identifies a moral hazard problem resulting from the fact that donors base their decisions on the recipient country’s “financing gap”. This then incentivises them to maintain or increase their “financing gap” by reducing the rate of saving.

He also assesses the relationship between growth and investment by discussing how the assumption stacks up when compared firstly to the exogenous Solow growth model and the more recent endogenous growth models. In both cases he finds that the ICOR is not a measure of investment quality, there is no causal proportional relationship between investment and growth, and the ICOR is not constant in the transition phase nor during steady state growth.

Therefore, Easterly is able to conclude that not only is there no empirical evidence for the Financing Gap model, but there is no theoretical justification for the model either. The assumption that filling a “financing gap” determined by “investment requirements” will raise investment or growth in the short run is therefore false.

Y <- rep(NA, 200)
K <- rep(NA, 200)
K[1] <- 1
alpha <- 0.4
A <- 5
delta <- 0.07
s <- 0.3
Y[1] <- A*K[1]^alpha
for (t in 2:200) {
  Y[t] <- A* K[t-1]^alpha
  K[t] <- s*Y[t] + (1-delta)*K[t-1]}

plot.ts(K)