Modern Macroeconomics.pdf

The new political macroeconomics 557and use of the Harrod–Domar growth model within the development literatureand development institutions such as the World Bank (see Easterly, 1999,2001a, and Chapter 11). In order to foster high rates of accumulation, in theabsence of substantial inflows of foreign capital, a country must generate thenecessary resources through high rates of domestic saving. It was assumedthat inequality of income would produce this result since the rich wereassumed to have a higher propensity to save than the poor (see Kaldor, 1955).This view is encapsulated in the following statement by Harry Johnson (1958):There is likely to be a conflict between rapid growth and an equitable distributionof income; and a poor country anxious to develop would be probably well advisednot to worry too much about the distribution of income.Another reason why inequality may lead to faster growth is linked to the ideaof investment indivisibilities, that is, the setting up of new industries frequentlyinvolves very large sunk costs. Meeting these costs in poorly developedcountries with inadequate financial markets requires the concentration ofwealth. Finally, it was also argued that without adequate incentives, investmentrates would remain insufficient to generate sustained growthThat there was a trade-off between growth and equity dominated early post-Second World War development thinking. In addition, the ‘Kuznets hypothesis’suggested that as countries develop, inequality will initially increase beforedeclining (see Kuznets, 1955). Hence the relationship between inequality andGDP per capita shows up in both time series and cross-sectional data as aninverted U-shaped relationship. Barro’s (2000) empirical results confirm thatthe Kuznets curve remains a ‘clear empirical regularity’.As economic development spread across the world during the latter half ofthe twentieth century it became clear that there was an increasing number ofsuccessful development stories where outstanding rates of economic growthwere achieved without those countries exhibiting high degrees of incomeinequality, namely the Asian Tigers. In addition many countries, for examplein Latin America, with high inequality had a poor record of economic growth.Hence, during the last decade there has been a change in thinking on thisissue. Several economists have begun to emphasize the potential adverseimpact of inequality on growth, an idea that had already been propounded byGunnar Myrdal (1973). Aghion et al. (1999) conclude that the old view thatinequality is necessary for capital accumulation and that redistribution damagesgrowth ‘is at odds with the empirical evidence’.Various mechanisms have been suggested as possible causes of a negativeassociation between inequality and subsequent growth performance (see Alesinaand Perotti, 1994). The credit market channel highlights the limited access tofinance that the poor have in order to invest in human capital formation. Sincein this environment most people have to rely on their own resources to finance