Domestic Savings Gap. An LDC suffers a domestic savings gap when it does not have enough domestic savings to use for investment to grow and develop.
LDCs must increase investment to grow and develop. Arthur Lewis, a famous development economist, posits that an LDC needs an investment of roughly 12% to 15% of its GDP to grow and develop. If an LDC only has domestic savings equal to 3% of its GDP then it has a domestic savings gap of at least 12%-3%=9%. LDCs have low savings and remain underdeveloped because they are stuck in or locked into a vicious poverty cycle.
An LDC remains locked into the vicious poverty cycle for many reasons:
1) Low Income. Low incomes mean low savings, low investment, low capital accumulation, low productivity per worker and again low incomes.
2) Current Consumption vs. Current Savings. To save now means current consumption must fall but LDC consumers cannot afford to lower their current consumption because they may be very close to poverty.
3) No Incentive to Invest. Because consumption is low consumers have limited buying power and firms have no incentive to invest because profits will be low so investment does not occur.
4) Kids are Savings. People in LDCs may save by having more kids (so their kids can look after them in the future). This means families have to spread their income over more people so savings falls further and investment falls.
However, the savings gap and poverty cycle may not be a major constraint on development because:
- MNC’s investment or foreign aid could be used to plug the domestic savings gap and help
LDCs to invest and develop.
- Maybe other factors are more important constraints on development.
