Growth and Development
Growth and Development
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PREMIUM
A country can produce more without its people living better, so economists measure the two separately.
Galvora, a country that sells copper abroad (exports copper), produces more copper this year. Real GDP (gross domestic product) is the value of the goods and services a country produces, measured at constant prices so that price rises are taken out. So Galvora's real GDP rises. Yet most village children still leave school early. Is Galvora better off?
Economic growth: an increase in real GDP over time.
Put simply, growth means the country produces more. It does not say who receives the extra output.
The second idea is about living standards, which means how well people live: what they can buy, how healthy they are, how much schooling they get, and the services they can use, such as electricity and clean water.
Economic development: an improvement in the living standards and welfare of a country's people, measured by more than income, such as health and education.
Put simply, development means most people's lives get better: they live longer, learn more and have safe water.
The key difference is quantity against quality: growth measures how much a country produces, while development measures how well its people live. Galvora's extra copper is growth, but its children still leave school early, so development has not followed.
Countries are grouped by how developed they are. The first sign is income per head: a country's income divided by its population. The second sign is where people work: in agriculture (farming), in industry (making goods in factories, mines and building work) or in services (work such as teaching, banking and selling in shops).
Developing economy: an economy with low income per head, where many people work in agriculture and many lack good health care, schooling and clean water.
Developed economy: an economy with high income per head, where most people work in industry and services and good health care and schooling are available to most people.
Emerging economy: an economy that is moving from developing to developed, with fast growth, rising income per head and a growing share of output from industry and services.
Put simply, the three differ in income per head and in where people work. In a developing economy, income per head is low and many people farm. In a developed economy, it is high and most people work in industry and services. In an emerging economy, it is rising fast as workers move into factories and offices. Galvora is a developing country that exports copper: its income per head is low, and many of its people farm.
Growth and development are linked in both directions. Growth can raise incomes and the tax revenue, the money from taxes, that a government can spend on clinics and schools. In turn, healthier and better-educated workers tend to produce more, which adds to growth.
But growth does not guarantee development. Why not? Two things decide it: who receives the extra income, and what it is spent on. A copper mine may employ few people, so its profits may go mainly to a few owners. Then real GDP rises while most families' lives barely change. The same happens if the government spends the extra tax revenue on things other than clinics and schools: real GDP rises, but health and schooling stay as they were. Development can also come before much growth. Cheap measures, such as vaccines (injections that protect against a disease) and clean wells, can make people live longer even when incomes are low.
Real Example: In the 2015 Human Development Report, Equatorial Guinea ranked 84 places higher on income per head than on the HDI, a measure of health, schooling and income. So its health and schooling ranked far below its income. Sri Lanka showed the reverse in the 2014 report: 73rd on the HDI, but only 103rd on income per head. So income alone does not show how well people live.
The HDI turns health, education and income into one score, so countries can be compared on more than income.
Two countries can have the same income per head, yet people in one live far longer. One income figure cannot show this, so the United Nations Development Programme (UNDP) combines several statistics into one number, called a composite index.
Human Development Index (HDI): a composite index that gives equal weight to three components of development: education, health and income, each ranked between 0 and 1.
Put simply, the HDI gives a country one score for how long its people live, how much schooling they get and what their income can buy, and no component counts for more than another.
GNI is the income of a country's residents, including income they earn abroad, while GDP counts only output inside the country. PPP values a dollar by what it buys there, so the same income counts for more where prices are low.
Years and dollars cannot be added. So each indicator becomes an index between two goalposts, a fixed minimum and a fixed maximum that the UNDP sets for that indicator. A country at the minimum scores 0, and a country at the maximum scores 1. The index shows how far between them the country sits. Education has two indicators, so each becomes an index, and the two are averaged into one education index.
The three indices are then combined by a geometric mean. A geometric mean multiplies the three indices together, instead of adding them, and then brings the result back to the same 0-to-1 scale. You do not have to calculate it: the UNDP publishes each country's HDI. If the three indices are equal, the HDI is that same number. If one index is low, multiplying lets it pull the HDI down further than it would pull down a simple average (the three added and divided by 3), where the high indices would balance it.
Take two other countries. Qurin scores 0.700 on all three, so its HDI is 0.700. Oveda scores 0.900 on health, 0.900 on education and 0.300 on income. Both countries have a simple average of 0.700, but Oveda's HDI is 0.624: its strong health and education indices cannot hide its weak income index.
Galvora's health index is 0.800, and its education and income indices are both 0.600. Combined by a geometric mean, the three give an HDI of 0.660.
The UNDP groups countries into four bands of human development: very high (0.800 and above), high (0.700 to 0.799), medium (0.550 to 0.699) and low (below 0.550). Galvora's 0.660 is in the medium band, so Galvora has medium human development.
The HDI shows more than income alone, but one national average can hide how differently people live.
Galvora's HDI rose from 0.640 to 0.660 in five years. Does that mean everyone in Galvora is better off? Not necessarily. The HDI is a national average, and an average can rise when some people gain a lot while others gain nothing. So Galvora's HDI can rise because the better-off live longer and earn more, while the poorest gain nothing. This problem is called inequality: income, health and schooling are shared unevenly between people.
So how useful is the HDI? It depends on the comparison. Between countries, it is more reliable for broad gaps than for narrow ones: a country near 0.9 and one near 0.4 differ in how people live. A gap of a few thousandths may not be reliable, because weak data alone could create it.
Over time, it is more reliable when the method stays the same than when the method or the goalposts change. Compare a country's score with its own past score, not its rank. Its rank is its place in the world table of countries, and it can fall when other countries improve faster, even while its own score rises.
Real Example: India's HDI is one national figure, but life expectancy, one of its three components, differs widely between its states. In 2016-20, life expectancy at birth was 75.0 years in Kerala but 69.5 years in Bihar. One average for India hides a gap of more than five years in life expectancy between two of its states.
Exam Matters: In an Examine on the HDI, tie each advantage and limitation to the comparison the question asks about, between countries or over time. Then end by saying which matters more in the case.
Single statistics, such as access to clean water, can show which part of development is weakest.
Galvora's HDI of 0.660 is in the medium band. But in villages far from a town, families have no clean water and no doctor nearby. One number cannot show which part of development is lagging.
So economists also use indicators: single statistics that each show one part of development. Some are per capita (per person), others per thousand of population (for every thousand people). The first measure counts adult male labour, men of working age, in agriculture. It counts men only, so it misses women's work on farms.
Why does a high share of men in agriculture signal low development? On small farms with simple tools, output per worker, what each worker produces, is low. In industry and services each worker usually produces more, so incomes can be higher. A high share shows that few workers have moved out of farming.
Energy consumption works in a similar way. Factories, trucks and trains burn fuel, so a rise in energy consumption per capita usually shows more industry and transport. On its own, it does not show that households live better.
Each measure is concrete and easy to compare, but each shows only one part of development: a country can have many mobile phones and few doctors. Used together, and beside the HDI, they can show where development is lagging.
Exam Matters: In an Explain on an indicator, say what a change shows about people's lives in the case, and give the reason. In an Examine, add one reason the indicator may overstate or understate development there.
When one raw material earns most of a country's export revenue, the whole economy rises and falls with its world price.
Galvora, a developing country, earns $12bn a year from exports, and copper earns 60% of it. Copper is a commodity: a raw material or crop traded worldwide, such as oil or cocoa. Its price is set by world demand and supply, not by Galvora.
Commodity prices show volatility, which means large and frequent swings. Why? In the short run, demand and supply are both price inelastic: the quantity demanded and the quantity supplied change little when the price changes. A mine cannot quickly change its output, and factories cannot quickly replace copper. So a small fall in demand makes the price fall far before the quantities adjust. A rise in supply, such as large harvests in other producing countries, makes the world price fall far in the same way.
The 15% is right only if Galvora sells the same tonnes as before. If it sold fewer, earnings would fall by more. The lost earnings then spread through the economy, because the $1.8bn was income for Galvora's mining firms. The last effect is on investment, which means spending on new machines, buildings and roads.
A government that plans its spending on a high copper price may have to cut it when the price falls, because its tax revenue, the money it collects in taxes, falls too, so projects started in the boom may be left unfinished. Because it is hard to predict the next swing, a firm cannot be sure that a new mine or factory will earn enough to repay its cost. So the uncertainty may deter investment even in good years.
Real Example: Zambia's traditional exports, mostly copper, earned 74% of its export earnings in January 2026. So, like Galvora, Zambia earns most of its export earnings from copper and a few other traditional exports, and a swing in the copper price moves much of what it earns abroad.
Exam Matters: In an Analyse, use the commodity's share of exports to size the change in export earnings, then follow it in linked steps to tax revenue or investment.
Over the long run, the prices of crops and minerals tend to fall compared with the prices of factory-made goods.
What does Galvora's copper buy? Galvora sells copper abroad and uses the dollars to import machines and medicines it cannot make. Copper is a primary product: an unprocessed good from farming, mining, forestry or fishing.
Primary product dependency: relying on primary products, such as crops, minerals and fuels, for most of a country's export earnings.
Put simply, the country earns most of its dollars from a few raw materials, so its income swings with their prices. And much of the value is added abroad: a cocoa bean earns far less than the chocolate made from it.
As world incomes rise, people spend much of the extra on manufactured goods, made in factories, such as machines and phones. Demand for food and raw materials is income inelastic: it rises more slowly than income. A family that earns twice as much does not eat twice as much rice. Meanwhile the supply of primary products keeps growing, as new mines open and farms produce more. When supply grows faster than demand, the prices of primary products fall compared with the prices of manufactured goods. A country's terms of trade compare the price of its exports with the price of its imports.
Prebisch-Singer hypothesis: the view that, as world incomes rise, the prices of primary products fall relative to the prices of manufactured goods, so the terms of trade of countries that export primary products decline.
Put simply, over the long run a country that sells raw materials and buys machines may have to sell more and more raw materials to buy the same machines.
Notice the word relative. The hypothesis compares copper's price with the price of machines over decades, so a few years of rising copper prices do not disprove it.
Exam Matters: In an Explain, name the hypothesis and use a terms of trade figure: a fall from 100 to 75 shows the country must export more to buy the same imports.
Savings fund investment, so a country that saves little adds little new capital and grows slowly.
Where does the money for new factories and machines come from? From savings: income that households and firms do not spend. The savings ratio is saving as a percentage of GDP, the value of everything the country produces in a year.
Capital-output ratio: the amount of capital needed to produce one unit of output a year.
Put simply, it is the number of dollars of new capital, such as machines and buildings, needed to add one dollar of output each year. In Galvora it is 4: $4 of new capital adds $1 of output a year.
Harrod-Domar model: a model in which savings fund investment, so the rate of economic growth depends on the savings ratio and the capital-output ratio.
Put simply, a country grows faster when it saves more, or when each dollar of new capital produces more.
Galvora's output grows by 3% a year, but its population grows by 2.5%, so the extra output is shared among more people. Growth per head, the rise in output for each person, is only about 3% − 2.5% = 0.5%.
Savings gap: the difference between the savings a country needs to fund the investment its target growth rate requires and the savings it has.
Put simply, it is the extra saving needed to grow as fast as the country wants. Each 1% of growth needs new capital worth 4% of GDP, because each $4 of capital adds $1 of output. So for 6% growth, Galvora needs to save 6 × 4 = 24% of GDP. It saves 12%, so its savings gap is 24% − 12% = 12 percentage points of GDP, which means 12 out of every 100 dollars of GDP. Galvora's GDP is $50bn, so this is $6bn a year.
Why do poor countries save little? Most income goes on necessities such as food and rent, so little is left to save. If a country cannot raise enough saving at home, it can look to savings from abroad. Foreign direct investment (FDI) is money a foreign firm puts into factories, mines or other productive assets in the country. Aid is money or resources given or lent on easy terms by other governments.
The model assumes a fixed capital-output ratio and productive investment, and it counts only physical capital, not workers' skills.
Growth needs imported machines and fuel, and a country can pay for them only with other countries' money.
Galvora plans a new power station. Its turbines, the machines that turn to make electricity, are made abroad. The foreign firm that makes them needs money it can use to pay its own workers and suppliers. Galvora's currency is of little use for that, so the firm wants dollars. However much Galvora has saved, its own currency cannot pay the seller. It needs foreign currency: the money of other countries, mostly US dollars, which Galvora earns mainly by exporting.
Foreign currency gap: a shortage of foreign currency, when a country earns too little from exports and other inflows to pay for the imports and debt payments its growth needs.
Put simply, the country cannot earn enough dollars to buy what its growth plan needs from abroad.
Galvora's growth plan needs $14bn of imports a year, but its exports earn $12bn. The gap is $2bn. FDI, aid or loans from abroad can fill it, because each brings in dollars. If it is not filled, Galvora must import less, and the investment that needed those imports does not happen.
The key difference from the savings gap is the currency. The savings gap is a shortage of saving in the country's own currency. The foreign currency gap is a shortage of dollars to pay for imports. A country can close one and still face the other: Galvora could save enough to pay for the power station and still lack the dollars for its turbines.
Three things often cause the gap. Export earnings may be low, because the country sells only a few low-priced products. A rise in world oil prices makes each barrel (a standard amount of oil) of imported fuel cost more dollars. And payments on loans from abroad take dollars before any imports are bought.
Real Example: In 2022 Sri Lanka ran so short of foreign currency that it could not import enough fuel and medicines. Drivers queued for days at filling stations, and the government introduced a guaranteed weekly fuel quota. So a foreign currency gap can stop imports that an economy needs every day.
When people fear for their savings at home, they may move them abroad, where the money cannot fund investment at home.
A family in Galvora keeps its savings in a local bank. Prices are rising fast, and the family fears its currency will lose value. So it changes its savings into dollars and moves them to a bank abroad. Thousands of residents, the people and firms based in the country, do the same.
Capital flight: the movement of money out of a country by its own residents and firms, who withdraw savings that could fund investment at home in search of safer or higher returns abroad.
Put simply, a country's own savers send their money away because they do not trust that it is safe at home, hoping for safer or higher returns (the income their money earns) abroad.
Capital flight widens both the savings gap and the foreign currency gap. The money that leaves is saving that local banks could have lent to firms, so the savings gap widens. It also leaves as dollars, which savers buy with local currency. These dollars come from the country's limited supply of foreign currency, and once they are moved abroad they can no longer pay for imports, so the foreign currency gap widens too.
So if the money stayed and was invested at home, Galvora would grow by 3% + 0.5% = 3.5% a year, instead of the 3% it grows with the capital flight. Capital flight can also reinforce itself. When many residents sell local currency for dollars, the currency loses value. Banks also lose deposits, the money people keep in them. Both give the savers who stayed a reason to leave too.
A ban on moving money abroad is rarely enough. What can reduce capital flight is removing the reason to leave: stable prices, property that cannot be seized (taken away by force or by the state), and honest government.
The more children and old people a country has for each person of working age, the more each worker must support.
Galvora's population grows by 2.5% a year and its output by 3%, so income per head rises by only about 0.5%. These are demographic factors: facts about a population's size and make-up.
The age distribution is the share of people in each age group. In Galvora, 45% are under 15, 50% are 15 to 64, and 5% are over 64. Children and old people are dependants: most do not work, so the output they consume has to be produced by people of working age.
Dependency ratio: the number of people aged under 15 and over 64 for every 100 people of working age (15 to 64).
Put simply, it shows how many dependants every 100 people of working age must support.
Why does a high ratio hold growth back? Each worker's income must feed more people, so less is left after food and other necessities, and households save less. With so many children, the government must also spend more of its tax revenue on schools and child health, so less is left for roads and power, which are investment too. Both mean less investment.
Now take the reverse case: an ageing economy, where the birth rate (the number of babies born each year for every 1,000 people) has fallen and people live longer. Suppose 15% are under 15, 63% are of working age and 22% are over 64. Its ratio is (15 + 22) ÷ 63 × 100, about 59. That is lower than Galvora's 100, because there are far fewer children. But as the share over 64 grows in the years that follow, the ratio rises, and each worker helps pay for more pensions, the regular payments made to retired people. China is an example: its one-child policy, which allowed most families only one child, ran from about 1980 to 2015, and its working-age share has since fallen.
A falling birth rate can also help. There are fewer children to support, so the dependency ratio falls. Then the large group of children already born grows into a large working-age group, which raises income per head if there are jobs for them. Migration, people moving between countries or from the countryside to towns, also changes a population.
Repaying a debt uses money that could have paid for food, schools or imported machines.
After a bad harvest, a farming family in Galvora borrowed from a moneylender, a person who lends privately. Now part of each month's income goes on debt service, the interest and repayments due on a loan, and cannot buy food or pay school fees. Debt comes in two kinds.
Household debt: the money that households owe, to banks and to informal lenders such as moneylenders.
Overseas debt: the money that a country's government and firms owe to lenders abroad, usually in foreign currency.
Put simply, household debt is what families owe and repay out of their own income. Overseas debt is what the country owes abroad, and it is repaid in dollars.
The key difference is who repays, in which currency, and what it takes away. A family repays in local currency and has less for food and schooling. A government collects tax revenue in local currency, but it must swap it for dollars to repay foreign lenders. So the repayment uses up tax revenue, which could have paid for clinics and schools, and it uses up dollars, which could have paid for imports.
Household debt becomes dangerous when interest rates, the price of borrowing, rise. Some families can no longer repay, so the banks that lent to them lose money. Those banks then have less to lend, so other families and firms find it harder to borrow.
The burden grows if Galvora's currency depreciates, which means that each unit of Galvora's currency buys fewer dollars than before. The debt is fixed in dollars, so each dollar repaid costs more local currency, and more tax must be raised. A country that cannot pay may default, failing to make the payments it owes, and lenders then charge it more or refuse to lend.
Borrowing is not harmful in itself. A loan that builds a port is not a burden if the port earns more each year than the interest on the loan: its earnings can then repay the loan. Debt becomes a constraint when its cost is greater than what the borrowed money produced.
Exam Matters: When a question gives debt service as a share of export earnings, use the figure: it shows how many dollars are gone before any imports are paid for.
Without banks to hold savings and lend them, small firms find it hard to borrow, and saving does not reach investment.
Bilal is a tailor in Galvora. He has orders for more shirts than one sewing machine can make, and a second machine would double his output. He has no bank account, and no title to land or a house (the legal papers that prove he owns it). He needs credit, which means borrowing, but no bank will lend to him.
Why not? A bank cannot judge whether a stranger's project will succeed. So it asks for collateral: an asset, such as land or a house, that the lender can take if the loan is not repaid. Without collateral, the bank would lose the whole loan if the project failed, so it may not lend.
A banking system does two jobs. It collects many small savings and keeps them safe. Then it lends them to people with projects, such as Bilal. Where most people have no bank account, both jobs fail. A bank may also be too far away: if the journey costs more than the interest a small deposit would earn, saving in the bank does not pay.
Families still save, but they keep their savings as cash, livestock (animals such as goats and cows) or jewellery. These earn no interest and fund no one's project. People who must borrow go to a moneylender, often at very high interest. A loan is worth taking only if the project's return, the extra income it earns, is greater than the interest. At very high interest, few projects pass that test, so Bilal's second machine may never be bought.
So much of the saving that does happen never reaches investment. The money exists, but no bank collects it and lends it, so it cannot pay for a sewing machine for Bilal. The country then invests less than its own saving could allow.
Missing roads, power and water raise firms' costs, so less is produced and invested.
A farmer in Galvora grows tomatoes far from the nearest town. In the wet season the track floods, the truck cannot reach her, and part of her crop rots.
Infrastructure: the basic physical capital an economy shares, such as roads, railways, ports, power supply, water and telecommunications.
Put simply, it is the shared equipment, from roads and power lines to phone and internet networks, that farms, firms and households rely on, and that none of them could build alone.
When infrastructure is missing or unreliable, it raises the costs of many firms. Power cuts force factories to stop work or run their own diesel generators, machines that burn fuel to make electricity. Poor roads raise transport costs and delay deliveries. Slow ports keep goods waiting, already paid for. With higher costs, each sale earns less profit. So firms produce less, and they have less reason to invest.
The farmer is hurt even when her tomatoes arrive. A trader, who buys crops to sell in town, pays her the town price minus the cost of transport. The worse the road, the higher that cost and the lower the price she receives. So each extra crate earns her less, and she may grow less.
Missing infrastructure also costs people time. Workers who cannot reach their jobs when a road floods, and children who spend hours carrying water from a distant well, lose hours that would otherwise go to work or school. It also deters FDI, because a foreign firm choosing where to build a factory often looks closely at power, ports and roads.
Why do poor countries not simply build it? Infrastructure is expensive, lasts for decades and pays back slowly, so private firms rarely build it alone. Governments are short of savings to fund it, and short of the foreign currency to import turbines, pipes and rails.
Real Example: In 2023 South Africa had planned power cuts, called load-shedding, on a record 332 days. A firm without power must stop work or pay to run its own generator. So a power supply that keeps failing can raise firms' costs across a whole economy.
Exam Matters: In an Explain, name the cost that the missing infrastructure raises and for whom, then link it to output or investment.
Workers with little schooling each produce less, so a country with few skills stays poorer.
A textile factory in Galvora imports a new weaving machine. Within a month a part breaks, and no one in the town can repair it, so the machine stands idle (unused) for weeks. The country has the capital, but not the skills to use it.
Many adults in Galvora left school after a few years. Their literacy and numeracy, the ability to read, write and use numbers, are low. Few can read a machine's manual or keep a firm's records.
Human capital: the knowledge, skills and health of workers that make them productive.
Put simply, it is what workers bring to the job: what they know, what they can do, and how healthy they are. Output per worker, also called productivity, is the output each worker produces.
Low skills also make each new machine less productive, because a machine that workers cannot run well produces less, and a broken one produces nothing. So more capital is needed for each dollar of output, so the capital-output ratio rises and the same saving gives slower growth. Better education raises human capital, so the same workers produce more. This shifts the production possibility frontier (PPF), the curve showing the most an economy can produce, outwards: the same workers and machines can now produce more.
Low skills can also keep families poor from one generation to the next. Poor households may need their children's work, so children may leave school early. As adults they earn little, so they may not be able to pay for their own children's schooling. Years in school are also not the same as skills: a child can attend for years and learn little if the teaching is poor.
Real Example: In 2022 the World Bank, an international lender to developing countries, estimated that about 70% of 10-year-olds in low- and middle-income countries could not read and understand a simple text. The estimate measures what children can do, not how long they have been in school. So in many poorer countries, basic skills can be low, and the workforce these children become may have less human capital than its years of schooling suggest.
When officials demand private payments or courts fail, investing becomes costlier and riskier, so less is invested.
In Galvora, a trader applies for a licence, official permission, to open a shop. The official in charge says it will take a year, unless she pays him privately. This private payment is a bribe. In another case, a firm's customer refuses to pay a bill, and the court takes eight years to settle the dispute. Both involve public office, a job in government such as an official or a judge, but they are different problems.
Corruption: the abuse of public office for private gain.
Poor governance: the failure of the state to provide reliable rules and services, such as courts that enforce contracts and protect property.
Put simply, corruption is an official using the job for personal gain. Poor governance is a state whose rules and services do not work, for example courts that cannot make people keep their agreements, even when nobody takes a bribe.
The key difference is private gain. The licence official gains privately, so that is corruption. The slow court may be honest but short of judges, so that is poor governance.
Both act like a tax on investment. A bribe raises the cost of a project, just as a tax would. A court that cannot enforce contracts (make people keep their agreements) adds risk, because the firm may never be paid. So does a court that cannot protect property rights, the legal right to own and use land, buildings and goods. Facing more cost and risk, a firm needs a higher expected return, the profit it expects to earn from a project, before it invests, and fewer projects offer one. Less is invested, and foreign firms may build elsewhere.
Corruption also diverts public money. If a road contract goes to an official's relative at twice the usual cost, the same budget builds half the road.
A production possibility frontier (PPF) is the curve showing the most an economy can produce with its resources. Both problems mean waste. Officials and firms spend time and effort on bribes, and projects are chosen as favours to friends, not for their returns. Resources used in these ways produce less than they could, so the economy produces at B, a point inside the frontier, instead of at A, a point on it.
War destroys the capital and workers an economy produces with, while attacks on civilians spread fear that makes people invest less.
In a town in a country at war, the bridge and the power station have been destroyed. Factories have no power, and many young people have left.
Civil war: armed conflict between organised groups within one country.
Terrorism: the use or threat of violence against civilians to create fear, for political ends.
Put simply, a civil war is fighting inside a country between armed groups. Terrorism is violence, or the threat of it, aimed at ordinary people to frighten them into a political change.
The key difference for the economy is what is lost. A war destroys capacity, the means an economy has to produce: capital, workers and schools. Terrorism usually does less physical damage. It acts through fear and through confidence, which here means how sure people feel that the future is safe.
Fighting destroys roads, factories and homes, kills workers and makes others flee, and closes schools. The government spends on its army instead of on development. With less capital and fewer workers, the production possibility frontier (PPF), the most the economy can produce with its resources, shifts inward, from PPF to PPF₁ on the diagram.
The damage outlasts the fighting. Investors also avoid the country, because new capital might be destroyed too. Rebuilding takes years, and children who missed school become adults with few skills.
An attack may destroy only one hotel or one market. Yet it changes the decisions of many people: tourists cancel their trips, people avoid markets and buses, and firms pay for guards and for higher insurance (payments that cover them against losses), which raises their costs.
Why does fear lower investment when little capital is destroyed? An investor compares the profit a project is expected to earn with the risk of losing money on it. After an attack, investors fear that another attack could damage the project or keep its customers away, so the risk of loss looks higher. The investor then needs a higher return before going ahead. Fewer projects offer that, so less is invested, even though the frontier has hardly moved.
The damage is often greatest in tourism, transport and shops, and in the regions hit, and it can last because confidence returns slowly.
Real Example: After bomb attacks on churches and hotels in Sri Lanka on Easter Sunday 2019, foreign tourist arrivals in May were about 70% lower than a year earlier. In June they were still 57% lower. So attacks on one day cut tourist arrivals sharply for at least two months.
When workers leave a country, it loses their skills, but the money they send home can help their families.
A nurse at a hospital in Galvora is offered a job abroad at much higher pay, and she takes it. Moving abroad like this is emigration; moving into a country is immigration. People move for economic reasons, such as higher pay or a job. They also move for other reasons: war, persecution (cruel treatment because of their beliefs or group), disaster, or to join their family.
For a developing country, an important cost is the emigration of skilled workers, called a brain drain. Doctors, nurses, engineers and teachers are often trained at public expense. When they leave, the country loses their skills and the money spent on training them. A hospital that loses its nurses cannot treat as many patients.
Remittances: money sent home by people working abroad.
Put simply, a worker abroad earns in a foreign currency and sends part of the pay to the family at home.
Remittances raise household incomes, and families often spend them on schooling, health care and better housing. They also arrive in foreign currency, such as dollars. Those dollars can pay for imports, so they ease the foreign currency gap. Some migrants also return with savings, skills and contacts, people abroad who can help them with trade or jobs.
Migration within a country matters too. When workers move from farms, where each produces little, to factory jobs in towns, output per worker rises.
So migration has costs and gains, and both must be weighed. Who leaves matters a great deal. A doctor who leaves a country with few doctors is a large loss, because many patients then go untreated. An unemployed worker who finds work abroad costs the country little output, because that worker was producing nothing at home, and the money sent home is a gain.
Real Example: In 2023, money sent home by Nepalis working abroad was about 26% of Nepal's GDP, by World Bank data. So in some developing countries, remittances are a large part of national income.
Removing barriers to trade lets firms sell to larger markets abroad, but it also exposes them to foreign rivals.
A garment maker in Galvora has always sold only at home. Now Galvora and its neighbours agree to end their tariffs, the taxes each country charges on imports from the others. A quota, a limit on the quantity imported, is the other main barrier to trade. The garment maker can now sell abroad without a tax added to its price.
This is a market-orientated strategy: one that works through markets, prices and private firms, rather than through the state.
Trade liberalisation: the reduction or removal of barriers to trade, such as tariffs and quotas.
Put simply, firms can buy from and sell to other countries with fewer taxes and limits in the way.
Why might this promote growth? Firms reach much larger markets, so each firm can make more of one product and sell it to more buyers. Galvora can then specialise in the goods it makes at a lower opportunity cost than other countries do, and buy the rest from them. Opportunity cost is what is given up to make something. Imported machinery and fabric also become cheaper once the tariff is gone. Machinery and fabric are inputs, the things a firm buys to make its own goods. Cheaper inputs lower an exporter's costs, so it can charge less abroad and win more orders. More exports earn more foreign currency, which narrows the foreign currency gap: the shortfall of foreign currency to pay for imports.
There are costs too. Infant industries (new industries whose costs are high while they are still small) may close before they can compete with established foreign rivals. A country that exports mainly crops or minerals may become even more dependent on them, because cheaper imported manufactured goods can close its own factories. The government loses the revenue, the money it collects, from tariffs. And workers in industries that shrink may lose their jobs, while workers in exporting firms may gain.
So the impact depends on what the country can export. A country with factories that can grow gains new markets. A country that sells one crop may gain little beyond cheaper imports, and it loses its tariff revenue.
Real Example: Vietnam became the 150th member of the World Trade Organization in January 2007. Its exports rose from about $48.5 billion in 2007 to about $264 billion in 2019, with garments and phones among the largest. Its exports grew strongly, which fits the point that an economy with factories able to expand can gain from wider markets.
A foreign firm's factory adds to a country's investment, but part of the profit it earns leaves the country.
A phone maker that runs factories in many countries is choosing where to build its next one. It compares two developing countries on costs, roads and rules.
Foreign direct investment (FDI): investment by a firm in productive assets in another country, such as a factory or a mine, that gives it control of them.
Put simply, FDI is a foreign firm building or buying something that produces, and running it.
A firm that produces in many countries is called a transnational company (TNC). Governments compete for TNCs with tax breaks (lower taxes for a set time), with special economic zones (areas with good roads, power and ports, and simpler rules), and by allowing more foreign ownership of local firms.
In the Harrod-Domar model, foreign savings add to investment just as a country's own savings do.
FDI is foreign saving put to use in Galvora, so it helps to close the savings gap. It also arrives in foreign currency, which helps with the foreign currency gap, and it brings technology that local firms can learn.
There are costs. The TNC owns the factory, so it owns the profit. Profits it sends to its parent company, the head firm in its home country, are called repatriated profits. That income leaves Galvora, so the income of Galvora's residents, its national income, rises by less than the factory's output. Tax breaks mean the government collects less tax, and the TNC may offer local people only low-skilled jobs.
The gain depends on what the factory does locally. If it buys parts from local suppliers and trains local managers, more of the benefit stays in Galvora.
Exam Matters: In a Calculate question, add the FDI to domestic saving before you divide by the capital-output ratio, and show each step.
Ending subsidies and selling state firms can free public money, but each change has losers the government must plan for.
A government spends a fifth of its budget keeping fuel cheap. It pays a subsidy, a payment from the government to producers that lowers the price buyers pay. Petrol stations sell below the cost of supplying fuel, and the government pays the difference.
Who gains from cheap fuel? Most of all those who use the most: car owners and firms with generators, rarely the poorest. So the subsidy is costly and badly targeted: most of the money does not reach the people who need it most.
Removal of subsidies means ending these payments. Sellers again need to receive the full cost of each unit, so the supply curve shifts back up. The price buyers pay rises, and the quantity bought falls. The money saved can pay for clinics, schools and roads, and the price now shows what fuel really costs.
The losers are households who bought the subsidised good. Dearer fuel raises bus fares, and it raises food prices because food is carried to market by truck. Protests can follow. So many governments remove a subsidy in steps and give part of the saving to poor households as cash.
Governments also own firms, such as electricity companies. A firm owned by the government is a state-owned enterprise. It is in the public sector, the part of the economy owned and run by the state. Other firms are in the private sector, the part owned by individuals and companies.
Privatisation: the transfer of a firm or industry from the public sector to the private sector.
Put simply, the government sells a firm it owns to private buyers, who run it for profit.
Why might this raise efficiency? A private owner keeps the profit, so it has a reason to cut waste and invest. The sale also raises revenue, and the government stops paying for the firm's losses.
But ownership alone does not force efficiency. The pressure comes from competition: a firm with rivals loses buyers if its prices are high. A power grid is a natural monopoly: one firm can supply the whole market more cheaply than several. Selling it turns a state monopoly into a private one, which may raise prices because buyers cannot switch. A regulator, a public body that limits prices and sets quality standards, can prevent this. Other risks are job cuts, and sales at low prices to people with close links to the government.
Real Example: In May 2023 Nigeria's new president ended the petrol subsidy. Within days the pump price rose from about 185 naira a litre to around 500, and by July it was 617. This shows what can happen when a subsidy is removed in one step: the whole price rise reaches buyers at once.
When a currency floats, a fall in demand for it lowers its value, and the cheaper exports that follow may narrow the gap between import spending and export earnings.
Galvora's exchange rate, the price of its currency in dollars, is $0.50. For years its central bank, the bank that manages the country's money, has held it there by spending dollars to buy its own currency. When copper earnings fall, it cannot keep spending dollars it no longer earns, so Galvora lets its currency float.
Floating exchange rate system: a system in which the value of a currency is set by the demand for and supply of the currency, with no target defended by the central bank.
Put simply, the currency's price moves like the price of any good, and the central bank stops spending its reserves (the foreign currency it holds) to protect a chosen value.
Copper buyers pay in dollars, and Galvora's mining firms swap those dollars for local currency to pay wages. When copper earnings fall, they swap fewer dollars, so demand for Galvora's currency falls. With no target to defend, its price falls from $0.50 to $0.40. On the diagram, the demand curve for Galvora's currency shifts left from D to D₁, and the price falls along the supply curve S. This fall in value is a depreciation.
Over the following months, the quantity of Galvora's exports demanded abroad rises and the quantity of imports Galvorans demand falls. If the quantity of exports demanded responds enough to the lower price, the gap between import spending and export earnings narrows, and no reserves are spent.
There are costs. A floating rate can swing sharply, which makes it hard for firms to plan. Imported fuel, food and machinery cost more in local currency, which adds to inflation (a rise in the general price level). And a debt owed in dollars now takes more local currency to repay.
Real Example: Egypt's central bank held the pound at 8.8 to the dollar while it rationed dollars. In November 2016 it let the pound float. The pound fell from 8.8 to about 13 to the dollar, so each pound was worth about a third less in dollars. This shows what can happen when a rate held too high is released: the market sets a much lower value.
Very small loans, guaranteed by a group of borrowers, let poor people start or grow tiny businesses.
Yara sells vegetables at a market stall. She needs $150 to buy more stock, but she owns no land or house. A bank asks for collateral, something the borrower gives up if the loan is not repaid. She has none, so the bank will not lend to her.
Microfinance: providing very poor people with small loans (microcredit), and other financial services, to help them start productive activities or grow their small businesses.
Put simply, microfinance is banking for people that banks will not serve: loans of a few hundred dollars or less, and a safe place to save.
It answers the lack of credit in a different way. Instead of collateral, it often uses group lending: loans to a small group of borrowers who each guarantee the others' repayment.
Why do members repay? If one member does not pay, the others must pay for her, and none of them can borrow again. So each member checks that the others' businesses are sound, which means likely to earn enough to repay. Loans are repaid weekly in small amounts, which fits incomes that arrive a little each day. With a loan, Yara can buy more stock, sell more and earn more, and a family with more income can spend more on food, schooling and health.
Microfinance is a market-orientated strategy, because most lenders aim to cover their costs from the interest they charge (the price of borrowing, paid in addition to the loan) rather than rely on gifts.
It has limits. Most loans fund very small businesses that stay very small. Interest rates are often high, because lending many tiny sums is costly to run. Some borrowers use loans to buy food, then struggle to repay, because food earns no income to repay with. And careful studies have found only modest effects on average incomes. The effect depends on whether borrowers can sell what they make: if many borrowers start the same kind of stall in the same market, each may sell less.
Real Example: Bangladesh's Grameen Bank, founded by Muhammad Yunus, lends without collateral through groups of borrowers, and most of its loans go to women. In 2015, six careful studies in six countries described microcredit's effects as "modestly positive, but not transformative". So the careful studies found that microcredit helps a little on average, not enough to transform the lives of borrowers.
Spending on schools and health makes workers more productive, but the gain comes years after the money is spent.
Galvora's government is deciding whether to make secondary school free. The fees are small, but many poor families cannot pay them, so many teenagers leave school early.
Making school free is an interventionist strategy: the state acts where markets provide too little. Why too little here? A poor family cannot borrow against the higher wage its child may earn later. And much of the benefit goes to others: healthy children spread less disease to the people around them, and educated workers share what they know with those they work with.
Education and health build human capital, the skills, knowledge and health that make workers productive. More human capital raises output per worker, which adds to growth. The state's tools include free schools, training courses, vaccination and clinics. Each also counts as development in itself, because schooling and health are two of the three parts of the Human Development Index (HDI), the UN's measure that combines income, education and health.
The payoff comes late. A pupil who starts secondary school this year starts work several years later, and the extra output comes only then. But the spending happens now. So a government short of money may cut it first, because the cost is clear today and the gain is not.
Two conditions decide the result. Quality matters as much as enrolment, the number of pupils signed up: a crowded class with no textbooks adds little skill. And the economy must be able to employ the skills it creates; otherwise trained doctors and engineers may emigrate, and their skills then raise output abroad, not at home.
Exam Matters: In an Explain question on a schooling policy, use the figures in the question, then follow one chain from more schooling to output per worker to growth.
A new industry may need shelter from imports while its costs fall, but shelter can also keep it inefficient.
A new tyre factory opens in Galvora. Each tyre costs it far more to make than a foreign rival's, because it is small and its workers are still learning. If imports stay free, buyers choose the cheaper foreign tyres and the factory closes.
Protectionism: restricting imports to protect domestic producers from foreign competition.
Put simply, the government makes imports harder or dearer to sell, with a tariff (a tax on imports) or a quota (a limit on the quantity imported), so home firms sell more.
Infant industry: a new industry whose costs are high until it grows large enough to compete with established foreign firms.
Put simply, an infant industry is not yet efficient (able to make each unit at a low cost), but it could become efficient if it survives long enough.
Why would its costs fall? As output grows, the cost of its machines is spread over more tyres. Its workers also learn by doing, so they waste less. Protection gives the industry time for both to happen. A wider version is import substitution: making at home goods the country used to import, which saves foreign currency and builds industry.
The risks are serious. Buyers pay more for protected goods, including firms that buy machinery. A sheltered firm may never become efficient, because no rival forces it to cut costs, and protection meant to be temporary can become permanent. Trading partners may retaliate, taxing the country's exports in return. And a firm that sells only at home has few buyers in a small market, so its output, and the fall in its costs, may stay small.
So protection is more likely to work when it is temporary, targeted at a few industries, and tied to firms starting to export. An export target exposes the firm to foreign rivals, so it must become efficient to meet it.
Exam Matters: In an Analyse question, apply the infant industry argument to the firm in the question, then show how the same protection raises costs for its buyers.
A central bank can steer its currency's value by buying and selling it, but only while it can afford to.
Suppose Galvora had chosen to defend its currency instead of letting it float, and the currency is falling fast. Its central bank sells dollars from its reserves, the foreign currency it holds, and uses them to buy its own currency. Why does this hold the value up? Buying its own currency raises demand for it, and higher demand supports its price.
Managed exchange rate system: a system in which the market sets the value of a currency, but the central bank buys and sells the currency, or changes interest rates, to keep its value within a range.
Put simply, the market moves the currency's price, but the central bank keeps that price inside a range it chooses.
As a strategy, a managed rate has two possible aims. The first is stability. Exporters, importers and investors can plan when the rate does not swing, and import prices stay steadier. The second is a deliberately low rate. The central bank sells its own currency to keep its value down. More of the currency is then on offer, so its price falls, exports stay cheap abroad, and export industries grow.
Each aim has a cost. To hold the currency down, the central bank creates local money to sell, which adds to the money supply and can cause inflation (a rise in the general price level). To hold it up, it needs reserves that a poor country may not have. A central bank short of reserves can raise interest rates instead: foreign savers then earn more by holding the currency, so they buy it, and demand for it rises. Speculators are traders who buy or sell currencies to profit from expected changes. When reserves run low, they may bet that the rate will fall. Their selling makes the rate harder to defend. A rate held too high for too long also makes exports too dear to sell well abroad. It encourages capital flight too: savers move their money abroad before the rate falls.
So a managed rate suits a country with large reserves, or with an export surplus (exports worth more than imports, which keeps foreign currency coming in), better than one with a foreign currency gap.
Roads and power lines lower firms' costs, but only if the state can pay for them, chooses them well and keeps them maintained.
Galvora's government can afford one large project this year: a new international airport, or power lines to its villages.
Infrastructure means the roads, power lines, ports and water pipes that all firms use. Missing infrastructure raises firms' costs: without roads and power, trucks are slow and firms must run their own generators. Private firms build too little of it, because it is costly, pays back slowly, and helps many people who do not pay. So the state builds it, and the questions are how to pay, what to build and how to keep it working.
The money comes from taxes, overseas loans, or grants from richer countries (money that does not need to be repaid). Overseas loans are repaid in foreign currency, so a project that earns no exports adds to the debt burden.
Projects can be chosen for prestige, to make the government look important, or for the profits of builders with close links to the government, rather than for their use. An airport that few airlines use costs as much as a busy one. Power lines to villages let workshops replace diesel generators and let farmers keep crops cool, so costs fall where many poor people work.
Then the project must be maintained. Why does an unmaintained road add debt but not output? The loan must still be repaid, but potholes slow the trucks, so each trip takes almost as long as it did before the road was built. So the repayments continue while the time firms saved, and the cost they saved with it, is lost.
Building also creates jobs and incomes for a few years. The test is whether the extra output a project enables over its life is larger than its full cost, including maintenance and interest.
If a foreign firm must share ownership with a local partner, more of its profit and know-how stays in the country.
A foreign car maker wants to build a plant in Galvora to sell to its growing market. The car maker is a TNC (it produces in many countries), and the government agrees on one condition: the plant must be part-owned by a local firm.
Joint venture: a business that two or more organisations own and run together, sharing its costs, profits and decisions.
Put simply, two owners share one business: each pays part of the cost and takes part of the profit.
Promoting joint ventures is interventionist. With ordinary foreign direct investment, the TNC owns the plant and keeps the profit. Here the government shapes the terms, so that more of the gain stays in the country.
Why does shared ownership keep more of the profit? If the local partner owns half the plant, half the profit belongs to it. Only the TNC's half can be repatriated, sent home to the parent company. Local engineers and managers also work alongside the foreign staff and learn their methods, and that know-how stays after the venture ends. The local partner may also know local suppliers, so more parts may be bought at home.
There are risks. Some TNCs will not invest on these terms and build elsewhere. Partners chosen for their close links to people in government, not their skills, may add little. And two owners may disagree, which slows decisions.
The strategy works when the country has something the TNC needs, such as a large market or a valuable resource. Then the TNC would lose more by leaving than by sharing, so it is more likely to accept the terms.
Real Example: Botswana's diamonds are mined by Debswana, a company set up in 1969 and owned 50:50 by the government and the diamond firm De Beers. Botswana's government therefore owns half of the venture and shares in its profit. This fits the idea that a country with a valuable resource, such as diamonds, may be able to set such terms.
An agency buys a crop when a big harvest pushes its price down, and sells when a small harvest pushes it up.
Coffee farmers in Galvora earn very different incomes from year to year, because a big harvest pushes the price down and a poor one pushes it up. Coffee is a commodity, a raw material or crop traded in large amounts. Galvora's national coffee scheme, run by a state agency, sets a floor price, the lowest price it allows, and a ceiling price, the highest it allows: $2.00 and $2.40 a kilogram.
Buffer stock scheme: a scheme that sets a floor price and a ceiling price for a commodity, buying and storing it when the price would fall below the floor and selling from the store when the price would rise above the ceiling.
Put simply, the agency stores coffee in good years and sells it in poor years, so the price stays inside the band.
Supply is the quantity sellers offer at each price. Once picked, the harvest is fixed until next year, so the same quantity is offered at every price, and this season's supply is a vertical line at the harvest. The price settles where the quantity demanded equals the harvest. On the diagram, D is the demand curve for coffee: it shows the quantity demanded at each price.
Why exactly 80? If the agency bought less, some coffee would be unsold at $2.00, and sellers would cut the price below the floor. Buying the whole surplus holds the price at $2.00. The agency pays the floor price for each tonne it buys, so its cost is the quantity it buys multiplied by the floor price.
The scheme has limits. Storage and transport cost money. A floor set above the price the market would settle at over time means buying year after year until the money runs out, while a run of poor harvests empties the store. Crops that rot cannot be stored for long, and an international scheme needs most producing countries to join.
Real Example: The International Tin Council ran a buffer stock for tin. When demand for tin fell in the early 1980s, it kept buying tin to hold up the price. In October 1985 it ran out of money, and tin trading in London was suspended. This shows what can happen when a floor is held above what the market will pay for years.
Exam Matters: In a Calculate question, find the gap between the harvest and the quantity demanded at the floor, then multiply that quantity by the floor price to find the cost.
Moving workers from farms, where they add little, to factories, where they add much, can raise output without raising wages, for a time.
A family farm in Galvora has more hands than its harvest needs: if two workers leave, the harvest barely falls.
Industrialisation means a growing share of output from industry, such as manufacturing in factories. Economists split the economy into two sectors, or parts. The traditional sector is mostly small farms in the countryside, where output per worker is low. The modern sector is industry in the towns, where workers have more machines and output per worker is much higher.
Lewis dual-sector model: a model of development in which workers move from a low-productivity traditional sector, mostly farming in the countryside, to a high-productivity modern sector of industry in the towns, attracted by higher wages.
Put simply, an economy develops as workers leave farms for factories, where each of them produces more.
Surplus labour: workers in the traditional sector who add almost nothing to its output, so they can leave without output falling.
Put simply, these workers are not unemployed: they work on the family farm, but their extra output there is close to zero.
Why does the wage stay at $3 while jobs grow? While surplus workers remain on the farms, each new job attracts another worker at $3, because $3 is more than the $2 the farm gives. Farm output does not fall when they leave, and so many workers want the jobs that factories have no need to pay more. At 5 million jobs the surplus is used up. Each remaining farm worker now adds to the farm's output, so a farm family would lose income if a worker left, and a worker will leave only for a higher wage. Factories must now pay more to attract workers: $3.75 a day in Galvora. This point is called the Lewis turning point. On the diagram, S is the supply of workers to the modern sector, flat at $3 up to 5 million and rising after that. D₁, D₂ and D₃ are the demand for workers, which shifts right as profits are reinvested, and D₄ is the demand after the turning point.
The model has been criticised. In many emerging economies, countries growing fast from low incomes, migrants arrive in cities faster than factory jobs appear, so urban unemployment, the number of people in towns without work, rises. Factories may buy labour-saving machines, which do work that people did before, so reinvested profit creates fewer jobs. And profits may be sent abroad rather than reinvested.
Tourists bring foreign currency and jobs, but only the spending that stays in the country adds to its income.
A beach resort in Galvora is owned by a foreign hotel chain. Each visitor pays for a room, meals, trips and a flight. How much of that spending becomes income for people in Galvora?
Tourism is an export of services: a visitor spending money in Galvora earns foreign currency, just as copper does. That helps to close the foreign currency gap. Tourism is also labour-intensive, meaning it needs many workers for each dollar of capital: cooks, guides, drivers and cleaners. And hotels buy food and crafts from local firms.
But not all the spending stays. A leakage is spending that goes abroad, such as the foreign chain's profit, imported wine or a foreign airline's fare. Only the spending that stays, as local wages, local purchases and taxes, becomes income for Galvora's people. A foreign owner sends its profit home, and a hotel that buys imports pays foreign firms. So the gain depends on who owns the hotels and where they buy.
Many tourism jobs are seasonal and low-paid. Visitors may stop coming after an attack, a disease outbreak or a recession (a period when output falls) in their own countries. So tourism earnings can swing, as the earnings from a commodity such as coffee do. Tourism also creates negative externalities, costs to people outside the deal that no one pays for: hotels use clean water that villages need, airports add pollution, and farmland is built over.
Real Example: Bhutan charges foreign tourists a daily Sustainable Development Fee as part of a "high value, low volume" tourism policy. It raised the fee to $200 a night in 2022, then cut it to $100 in 2023 to attract more visitors. This shows a government weighing the number of visitors against the money each visitor pays.
Developing farming and mining can earn foreign currency and raise rural incomes, but it keeps a country exposed to swinging prices.
Galvora mines copper ore and ships it abroad. It is deciding whether to build a refinery beside the mine, so it can export pure copper instead. Mining is one of the primary industries: those that take resources from nature, such as farming, mining, forestry and fishing.
Many of the poorest people farm, so better seeds, irrigation and storage raise their incomes. Mines can raise tax revenue for schools and roads, and exports earn foreign currency. Many developing countries have a comparative advantage here: they produce these goods at a lower opportunity cost, what is given up to make them, than other countries do.
Value added is the difference between what a firm sells its output for and what it paid for its inputs, the materials it buys. Refined copper sells for more than the ore it is made from, so a refinery adds value, and it needs workers to run it. If the refining happens abroad, that extra value, with its jobs and profits, goes abroad too. So processing at home keeps more of the value in the country.
The risks are ones that any primary exporter faces. Commodity prices swing, so export earnings swing with them. According to the Prebisch-Singer hypothesis, demand for primary products is income inelastic (it grows more slowly than incomes). As incomes rise, buyers spend a smaller share on them, so their prices tend to fall relative to the prices of manufactures (factory-made goods). The terms of trade (export prices relative to import prices) may then worsen for a country that exports primary products. Mines create few jobs for each dollar of capital, and large resource revenues, the money earned from minerals or oil, can invite corruption: officials taking public money for themselves.
So the strategy works best when the revenue is invested in other industries, such as factories that make goods whose demand grows faster as incomes rise. The country then depends less on primary products.
Help from abroad can add new resources or cancel old debts, but either helps only if the money is used well.
Some developing countries spend more each year on their overseas debt than on health. They also lack the savings to invest. Help from abroad can come in two forms: new resources, such as gifts of money, cheap loans, food or expertise, or relief from old debts.
Aid: the transfer of resources to a developing country on better terms than the market offers, such as grants, soft loans, food or expertise.
Debt relief: the cancellation or reduction of a country's debts, or of the interest due on them.
Put simply, aid gives a country something new, while debt relief lowers what it must pay on loans it already has.
Tied aid must be spent on goods from the donor country, so the receiving country may pay more than it would elsewhere. In the Harrod-Domar model, aid that is invested adds to investment just as savings do.
Aid has critics. It can be spent on poor projects or taken by corrupt officials. A government that relies on it may raise less tax of its own, which creates dependency.
Many poor countries borrowed in dollars. When interest rates rose, their repayments grew faster than their export earnings, and some could no longer pay: a debt crisis.
Why does relief free foreign currency? Debt service, the interest and repayments due each year, is paid in dollars. The government raises local money from taxes and swaps it for dollars, the foreign currency that exporters earn. Galvora pays $1.2bn a year. If relief halves it to $0.6bn, $0.6bn a year is freed: dollars that can pay for imports, and the tax money that would have bought them, which can pay for clinics and schools.
Relief often comes with conditions, such as a plan to reduce poverty. Critics argue that it may reward governments that borrowed too much and encourage others to do the same. And it helps only if the freed money is used well.
Real Example: Under the Heavily Indebted Poor Countries (HIPC) initiative, poor countries had their debts cut once they showed a record of reform and a plan to reduce poverty. By 2023, 36 of the 39 eligible countries had received full relief. By 2016 the relief was worth $76 billion over time. This shows relief tied to conditions: countries received it only after they made reforms.
Two international lenders do different jobs: one funds long-term development, the other lends in short-term crises.
Two requests arrive from a developing country. One is for a 30-year loan to build a dam. The other is for an emergency loan to pay for this month's fuel imports, because the country has run out of dollars. A country that cannot pay for its imports or its debts has a balance of payments problem. Each request goes to a different international institution, an organisation that many governments own and run together. One of them looks after the international monetary system, the arrangements that let countries exchange currencies and pay each other for trade.
World Bank: an international institution, owned by its member governments, that lends to and gives grants to developing countries for long-term development projects.
International Monetary Fund (IMF): an international institution that works to keep the international monetary system stable, watches its members' economies and lends to members with balance of payments problems.
Put simply, the World Bank pays for things a country will use for decades, such as dams, roads and schools. The IMF lends in emergencies, so a country short of foreign currency can keep paying for imports while it fixes the cause.
The key difference is time and purpose: the World Bank funds long-term development projects, while the IMF restores short-term stability. So the dam goes to the World Bank, and the fuel loan to the IMF.
IMF loans usually come with conditions, called conditionality: changes the borrower agrees to make. Why attach them? The loan is needed because something went wrong, such as a large budget deficit (government spending well above its revenue) or a currency held too high. If the cause is not fixed, the country may run short again and be unable to repay. Common conditions are cutting the budget deficit, removing subsidies, raising interest rates and letting the currency fall.
Supporters argue that conditions fix the cause of the crisis and restore confidence: private lenders and investors expect to be repaid again, so they return. Critics argue that spending cuts fall on health and education when the poor most need them, that they can deepen a recession, and that one set of conditions may not suit very different economies.
Real Example: In March 2023 the IMF approved a loan of about $3 billion to Sri Lanka, paid in stages over four years. Each stage depends on a review of the agreed reforms, and one condition is electricity prices that cover the cost of supply. This is conditionality at work: the money arrives only as the agreed changes are made.
Charities and community groups can reach the poorest villages directly, but they work on a small scale.
A health worker from a charity walks two hours to a village that no road reaches. She vaccinates its children and trains a local woman to treat common illnesses. No government clinic has reached the village yet.
Non-government organisation (NGO): any non-profit, voluntary citizens' group that is organised on a local, national or international level.
Put simply, an NGO is not run by a government and does not aim to make a profit. It depends on donations and grants to do its work.
NGOs play several roles in development. They bring emergency relief after disasters. They run schools, clinics, clean-water and microfinance projects, and they train farmers. Some campaign, for example for debt relief.
Why can they target the poorest well? Their staff work inside communities, so they know which households are poorest and what each village lacks. Their projects are small, so they can be shaped to local needs. They are often cheaper to run than state programmes, so the same money can reach more poor households.
They also have limits. Most work on a small scale compared with governments. Their funding depends on donors, the people and governments that give them money, so it is uncertain and can follow donors' priorities rather than local needs. Many projects stop when the NGO leaves, and services run beside the state's may weaken it: people turn to the NGO, so the state has less reason to build its own. So NGOs work alongside governments, the World Bank and the IMF; they rarely have the money to build national roads, and they cannot hold a currency's value steady, as a central bank or the IMF can.
Real Example: BRAC was set up in Bangladesh in 1972, after the war of 1971. By number of staff it has been called the largest non-government development organisation in the world. It shows that an NGO can grow very large, though few do.
A country can produce more without its people living better, so economists measure the two separately.
The HDI turns health, education and income into one score, so countries can be compared on more than income.