Conceptual & Analytical Framework – Finance, Investment & Growth

There is a sizable theoretical and empirical literature on the link between finance, investment and growth. All growth models have come to accept that the rate of growth of an economy is determined by the accumulation of physical and human technology (World Bank, Chenery, 1961). In turn, finance is postulated as an important determinant of investment and therefore of growth. It is argued that the liberalization of financial markets lead to greater investment efficiency and mobilization of greater financial resources to finance investment.

Determinants of Finance

Finance is very critical to investment (McKinnon, 1973, Shaw, 1973). In general, finance is a process of channeling funds in the form of credit, loans or invested capital to those economic entities that most need them or can put them to most productive use (New Encyclopedia Britannica, Vol.4, London 2003).Thus finance facilitates investment and so for growth to take place, financial institutions must pool savings and direct them to viable investments (Copeland Weston 1980). This so-called supply leading theory of finance. First, finance is determined by the level of available savings which in turn is determined by income. Generally, it is postulated that the higher level of income, the higher the savings rate, other things being equal. Thus, with a constant marginal propensity to consume, increases in income translate to increases in savings. However, where poverty is widespread and severe, savings is likely to be low. Secondly, saving is affected by limited financial intermediation. For instance, where only a handful of institutions provide the service, especially where the environment is not competitive, the amount of saving is likely to be low (IMF, 1999). In other words, underdeveloped financial sector, poor monetary policies, including administrative credit allocation, interest rate control and inadequate accounting practices constrain the amount of savings. Generally, savers will substantially augment their real cash balance holdings only if their real interest yield is adequate. Indeed, a significantly high yield on long-term deposits (after adjusting for ongoing inflation) may encourage a spurt in financial saving. But where depositors receive a negative interest rate, they will tend to limit their saving to short-term forms, thus giving rise to financial repression in the economy (Gerald M. Meier, 1984). A repressed financial system leads to emergency of an informal financial sector where rent-seeking intermediators offer high rates to depositors and lend such funds at higher rates than prevailing sectors. Secondly, lenders in the organized market may be stimulated to lend indirectly to the unorganized market. A burgeoning theoretical literature suggests that the functioning of equity markets affects liquidity, risk diversification, information acquisition about firms, corporate control and saving mobilization. Under this condition, the stock exchange provides an alternative avenue for investors to raise long-term capital. The level of capital market development is thus, an important determinant of finance, efficiency of investment and ultimately, the rate of economic growth.

Thirdly, macroeconomic stability typified by a low inflation rate affects the level of available finance. Economic agents would postpone present consumption I they were sure that inflation would be reasonably low and predictable. This position is strengthened by the existence of positive real deposit rates given that savings is itself an inter-temporal choice. Moreover, firms plough back their internal funds especially during low inflation regimes as the opportunity costs of such funds are low.

Generally, credit is the link through which resources are transferred for capital formation. Indeed, the financial sector affects not only the quality of investment but also the efficiency of its allocation (Lynch, 1995). Accordingly, the desire to achieve high and sustainable rate of economic growth requires the mobilization of savings that can be channeled into investment. Such finance could come from either domestic or external sources. Most investments in developing countries are financed domestically because they have difficulties in accessing external savings.

Domestic finance takes the form of bank loan, retained profit, and equity finance. However, the bulk of finance available in Nigeria has been of the short term nature which hardly supports long-term investment (Odoko, 2002). New issues of Federal Government Development Stock ceased in 1986 but resumed in 2003. It is also for the insufficiency of savings for investment that several developing countries set up development finance institutions and in the past, pursued the policy of low interest rate and directed credit (Babalola and Odoko 1995). Evidence supports the hypothesis that credit flows have a positive and statistically significant effect on private investment. Interest rate ceiling is an important tool of monetary policy for many developing countries, and so the quantity rather than the price of credit was considered a relevant variable for investment decision. Tighter monetary policy or a change in the composition of credit that favors the public sector reduces private investment. When bank loans are the main source of financing, which is often the case, lower government borrowing releases resources for private investment.

Chenery and Bruno, 1962, argued that investment to GDP ratio consistently exceeded the savings gap ratio, implying that domestic saving was insufficient to fund the required investment. This is the Saving-Gap model and it points the need for external finance to supplement domestic resources. Similarly, the Foreign Exchange-Gap model stressed the availability of foreign exchange as a constraining factor vis-à-vis the difficulty of financing import needs by means of exports. This is the so-called two gap-models of the domestic saving and foreign exchange constraints to growth, which guided external aid and lending agencies in estimating the external resources that developing countries would need to finance imports and investment. External finance is a means of filing these two gaps. It consists of the total official and private flows and takes the form of bilateral, multilateral and even direct investment and official development assistance. It is available at a cost and has to be repaid mostly in foreign exchange. Whereas, initially, inflow of foreign repayment and the servicing of the loans given the unproductive nature of most public investment (Papanek; World Bank, 1990). Official development assistance provides external resources for investment and finances projects that could not be undertaken with commercial credit because of debt overhang or a long project gestation period. External finance can in principle; help an economy out of a low growth trap by enabling it take off despite structural limitation to increased domestic savings.


Determinants of Investment

Investment can be broadly defined as the acquisition of an asset with the aim of receiving a return (Stiglitz, 1993). It could also mean the production of capital goods; goods which are not consumed but instead used in future production.  Examples include building a railroad, or a factory, clearing land, or putting oneself through college.

There are several motives for investment. As has been referred to above, the basic motive is profit/return. According to Keynes’ theory, this motive depends on the expected marginal efficiency of capital (MEC) in relation to the expected rate of interest. The difference between the realized marginal efficiency of capital and the rate of interest is the opportunity cost of investment. The theory assumes that the expected return on investment is intrinsically volatile in view of the uncertainty that accompanies the main determinant of investment returns. But this is especially as far as private investment is concerned. In the context, the accelerator principle suggests that increases in output leads to increases in investment. This principle relates investment to GDP. It follows from the fact that the demand for machineries and factories is a derived one. Thus, if they demand for the goods that capital equipment produces risings, and the existing industry capacity cannot meet this demand, if production were to be increased, then new plant and equipment would be required. While new capital equipment is being built and installed, investment expenditure has taken place. If the desired stock of capital goods increases, there will be an investment pool which will translate to increase GDP in that economy. This makes investment depend on changes in final demand, and hence changes in GDP. In this vein, the accelerator explains why a slowdown in growth of GDP can lead to negative growth in subsequent periods through a fall in investment spending.

As a result of the restrictive assumptions of the accelerator model, Jorgenson (1967) and Hall and Jorgenson (1971), formulated a neoclassical approach. In this theory the desired or optimal level of investment stock depends on the level of output and on the user cost of capital which in turn depends on the price of capital growth, the real rate of interest and the depreciation rate. The difference between the current and desired capital stock lags in decision making and delivery, giving rise to the change in capital stock. The deficiencies in this theory relates to the inconsistency of the assumptions of perfect competition and exogenously determined output. The assumption of static expectations about future prices, output and interest rate, has also been found inappropriate. This necessitated the formulation of an alternative theory by Tobin (1969). The theory, referred as Tobin’s Q theory emphasis the relationship between the increase in the value of the firm due to installation of additional capital and its replacement cost. Investment, therefore, is a function of difference between market value of the additional unit of capital and its replacement cost. This ratio (known as marginal Q) may differ from unity due to delivery lags, adjustment and installation costs. On account of measurement problems, marginal Q is proxied by the ratio of the market value of the entire market value to its replacement cost (the average Q ratio). Tobin’s Q theory has been criticized on the following grounds:

The marginal and average Q will systematically differ if firms enjoy economies of scale or market or market power or are unable to sell all they want;
The assumption of increasing installation cost is unrealistic;
The cost of addition to an individual firm’s capital stock is likely to be proportional or even less than proportional to the volume of investment, because of the indivisibility of many investment projects.
Disinvestment is more costly than positive investment as capital ggods are often firm specific and so have little resale value.
To deal this point, Arrow (1968) suggests that investment can be considered irreversible in an extreme situation. This implies that investment decisions can be viewed from perspectives of reversibility and irreversibility. While under conditions off certainty, irreversibility creates a wedge between the cost of capital and its marginal contribution to profit, under uncertainty (where irreversibility has important implications for investment decisions) irreversible investment can be adversely affected by risk factors (Bernanke 1983; McDonald and Siegel 1986; Bertola and Cabelloro 1990). This means that under uncertainty, firms acquiring additional capital presently stand the risk of being stuck with excess capacity in the future that cannot be costlessly eliminated. This notion amplifies the importance of uncertainty in investment decision making. The problem of uncertainty is more severe in developing countries where transformations inherent in development such as the establishment of new firms and new industries and the absorption of new technologies heighten uncertainty (World Bank 1993).

The disequilibrium approach (Malinvaud 1980, 1982; Sneessens 1987) views investment as a function of both profitability and demand for output. This approach suggests that investment decisions have two stages viz:

The decision tp expand the level of productive capacity; and
The decision about the capital intensity of the additional capacity (Malinvaud 1982). The first stage depends on the expected degree of capacity utilization in the economy which provides an indicator of demand conditions; while the second stage depends on relative prices such as the cost of capital and labour. The implication of this dichotomy is that while factor proportions are assumed variable before the investment, and fixed after it, investment decisions take place under conditions in which firms may be facing current and expected future sales constraints.
The disequilibrium model, however, has been criticized for the simplicity of its assumptions regarding expectations and inability to explain price rigidities.

The coordination failure states that total investment depends on the inability of individual economies system. Coordination problems derive principally from shortcomings in markets for information and risk sharing. Both types of problems exist in all economies but the consequences to be worse in developing economies. For example, in developing economies, information problem such as poor accounting standards; and a dearth of banks and other institutions to monitor corporate performance mean that bond and equity markets are often weak or entirely absent. Also, limited market mechanisms for sharing risk (firms often cannot buy insurance for the most serious risk they face) as a result of lower wealth levels in developing economies make households and firms more vulnerable. Monolithic competition and increasing returns to scale also common causes of coordination failure.

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Against this background, the return on investment depends on the overall level of economic activities which in turn is positively affected by the volume of aggregate investment.

Financial constraints on investment are gaining prominence in the literature. Stglitz and Weiss (1981) suggests that at micro level, firms may face binding financial constraints in domestic capital markets because interest rates are controlled or subjected to endogenous credit rationing. Restrictive monetary and credit policies affect investment in two ways. They increase the real cost of bank credit and by raising interest rates, increase the opportunity cost of retained earnings. Both mechanism raise the user cost of capital and lead to a reduction in investment. Asymmetric information, adverse selection and incentive effects may make interest rate charges an inefficient device to distinguish good from bad borrowers. Asymmetric information relates to a situation in which parties to a transaction do not have the same information. Thus, agreements are reached to the advantage of the party with more information. The acquisition of information therefore, becomes critical to investment. Similarly, the adverse principle says that those who are most desperate to buy insurance for example are those most at risk, so charging high   price for insurance will discourage those at less risk from buying insurance at all. In the case of credit, if interest rates reflect high demand for loans, marginal demand would be priced out. This is a distortion to the market which has to discriminate in the market. Under these conditions, creditors prefer credit rationing and quantitative constraints to reliance on the most of them are unable to manage their risks due to inadequate information or the effects of adverse selection.


Economic growth refers to the increase in the value of goods and services produced by an economy. It is conventionally measured as the rate of increase in GDP. Growth is usually calculated in real terms (netting out the effect of inflation on the price of the goods and services produced). It can be studied in two time paths: short run and long run paths.

The short run variation of economic growth is known as business cycle, and all economies experience periodic recession. The long run path of economic growth is one of the central questions of economics: over long periods of time, even seemingly small rates of growth, through compounding, can have large effect.

Growth in output can be divided into two major categories: growth through increased input and that through improvement in productivity. Given that labour and capital inputs cannot be increased indefinitely without encountering diminishing marginal returns, technological progress is needed to increase the standard of living in the long run.

Generally, finance and investment aid growth and development in an economy. This is relevant from the link between growth of output, investment and savings, which is well documented in the literature. Levine and Renelt (1992) explored the empirical relationship between investment and economic growth concluded that the rate of physical investment to GDP was the most important of the factors.

Arrow (1962) pioneered a work that considered the impact of human capital on the growth and concluded that the variation in investment performance and growth rates across countries accounted for either explicitly or implicitly by the variations in the accumulation of human capital. Recent studies have also established a relationship between investment and saving. Feldstein and Horioka (1980) explained that the long term, gross national saving and domestic investment rates show a strong positive correlation. Schimdt-Hebbel et al (1996) argued that available international evidence on the long term patterns of growth appears to support the increasing disparities of investment and growth on the difference on saving rates over the past thirty years. Thus, several authors have attempted to explain the mechanism for the transmission of savings and investment to growth. These mechanism include the relationship of interest rates on savings and investment, the close link between investment and growth and the budget constraint, and the role of foreign finance on investment profile and growth.

The foregoing, therefore, corroborates the view of the traditional growth models that state that output can only through increased factor accumulation and/or through technical progress. It often happens, however, that especially in public investment, it is difficult to reconcile particular units of growth with units of investment. In some cases, while rates of growth in investment is growing, that of growth is declining and vice versa. This scenario is not completely absent even in private investment as there are cases of investment failures in that component, leading to no growth at all or even negative growth. There are, therefore, instances where it would appear that growth can take place without investment or investment can result in no growth. These cam occur due to the following factor:-

Under-utilization of Capital:
Growth can occur without immediate investment if the economy or industry is harboring excess capacity or even inventory. Thus, as demand increases, excess capacity is utilized to satisfy the growing demand.

Long gestation periods of capital projects:as a result of long gestation periods of capital projects, the investment/growth nexus in an economy may be eclipsed especially statisticians assemble data on monthly, yearly or quarterly basis.
Manpower Constraints:
Manpower constraints can cause viable projects to become unproductive. This is applicable in situations where a viable project is managed by an unqualified person. Managerial ability and hence human capital is, therefore, an important variable in the investment function, especially in developing countries where critical skills are limited in supply. In this regard therefore, mention has to be made of the attitude to work of the manager. If the attitude of the manager spurs him to work harder, he would perform better than another manager of the same qualification whose attitude to work is poor.

Notwithstanding these problems, the development of growth models started during the industrial revolution in Europe. The classical economists and Karl Marx loved through the period of take-off into sustained growth. Their observation regarding the nature and causes of economic growth are of considerable interest which in later years gave rise to the rise to the development of more modern growth models such as the Harrod-Domar model, the Solow neoclassical model, the Two-Gap or Dual-Gap model, the Endogenous Growth model, the Three-Gap model among others. In what follows, we shall examine a few of the growth models:-

The Cobb Douglas Production Function

Charles Cobb and Paul Douglas pioneered research in the areas of applied economic growth in the 1920s and 1930s and came out with a production function tagged the Cobb-Douglas production function. The function may be written as:

Ot =Tt Ka t Lβ t ……………………………. (1)

Where Ot is real output at time time, Tt is an index of technology, or “total” productivity, Kt is an index of capital stock, or capital services, or constant prices, Lt is an index of labour input with respect (preferably man-hours). á is the partial elasticity (responsiveness) of output with respect to capital (holding labour constant), and β is the partial elasticity of output with respect to labour (holding capital constant).

The theory assumes that changes in technology are endogenous and independent of changes in factor inputs and that the effect of technical progress is natural on the factor intensity of production. The most critical assumption of this theory is the perfectly competitive one that states if production is subject to constant returns are paid the value of their marginal products, the factor shares will reflect the elasticity of output with respect to each factor. The elasticity of output with respect to capital, ń, for example is:

ń = (dO/O)/(dK/K) = (dO.K)/(dK/O)

Now if capital is paid its marginal product, then dO/dK = r, where r is the rental on capital. Hence ń = rK/O, where rK/O is capital’s share of total ouput.

However, the theory has some limitations. First, since only one combination of factor inputs can be observed at any one time, there is an identification problem in attempting to distinguish shifts in the function (technical progress) from movements along the function (changes in factor intensity). Secondly, the assumption that technical progress is independent of increase in factor inputs has been questioned. Thirdly, the Cobb-Douglas function cannot represent a change in the ease of substitution between capital and labour it possesses the restrictive property of constant unitary elasticity of substitution between factors whatever the factor intensity.

Harrod-Domar Model

The Harrod-Domar model is a combination of the classical anf Keynesian theories of growth and recognizes the strategies importance of investment in growth process. The model is used to estimate investment required to achieve a target rate of growth in output. In practice, emphasis is on the additional capital that is required to produce an additional unit of output. The formal Harrod-Domar growth model is specified as follows: (DY/Y =s/k) or (g = sp).

Where g = DY/Y; the growth rate of national output

s = the savings ratio;

k = capital output ratio; and

P = I/K; the reciprocal of the productivity of capital.

It thus utilizes the marginal capital output ratio. The major limitations of the model include:

The analyses of Harrod-Domar, were developed under different set of conditions and were meant to prevent an advanced economy from the possible effects of secular stagnation. It was never intended to guide industrialization programme in underdeveloped countries.
It fails to solve the problem of structural unemployment prevalent in underdeveloped countries. It can tackle the problem of “Keynesian unemployment” arising out of deficiency of effective demand or   under-utilization of capital.
The model is based on the assumption of closed economy and lack of government intervention in economic activities. These are unrealistic given the state of the underdeveloped economies vis-à-vis globalization.
The Two-Gap Model

The Two-Gap model follows from the Harrod-Domar growth model which states that the growth rate of the national output equal the saving ratio divided by the capital output ratio or the saving ratio multiplied by the reciprocal of the productivity of capital.

Considering the impact of the external sector given that most economies are open, it is important to examine the impact of foreign borrowing or grants on growth. Thus, we have:

DY/M = m

M/Y = i

g  = im

where m is the incremental output-import ratio and is the ratio of investment good imports to income.

The specification of the Two-Gap model is based on the assumption that growth requires investment goods, which may either be provided domestically or imported. The domestic provisioning requires savings while the external one requires foreign exchange. Therefore, if investment goods can only be provided from abroad, there is always a minimum amount of foreign exchange required to sustain the growth process. If this minimum amount is unavailable, then growth is constrained. A similar constraint is engendered by a short of saving in case of domestic provisioning of inputs.

The Two-Gap model is based on certain restrictive assumptions which limit its usefulness in achieving the target growth rate in LDC’s. these include the assumption that domestic savings and foreign borrowing are mutually exclusive and that there are structural rigidities in the economy. It also treats all types of capital investment as homogenous and excludes the impact of government intervention in the economy. In view of these limitations, the Two-Gap model pioneered by Chenery and Bruno (1962) and Chenery (1967) has been extended to a Three-Gap model framework.

This approach distinguished the fiscal constraint as another important impediment to economic growth. The fiscal gap analysis is normally linked to the public sector borrowing requirement (PB) expressed as a proportion of national income (Y).

Thus, we have

Ig – Sg  = PB/Y=Pu

Where Ig = government investment;

Sg  = government savings;

PB/Y = public sector borrowing requirement – actual national output ratio;

u = capacity utilization.

The model assumes that the incremental capital-output ratio (c) or ICOR and other behavioral parameters are fixed at least in the medium term. It also assumes that there is lack of substitutability between foreign and domestic resources, especially in the short run. In spite of these limitations, this model has been variously applied in empirical studies. In this study, the Three-Gap model would be used, given that it is the most appropriate model for the less developed countries.

Conceptual & Analytical Framework – Finance, Investment & Growth

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