The Ghost of Financing Gap: Testing the Growth Model Used in the International Financial Institutions

Published in Journal of Development Economics v60, n2: 423-38.

The Harrod-Domar growth model supposedly died long ago. But still today, economists in the International Financial Institutions apply the Harrod-Domar model to calculate short-run investment requirements for a target growth rate. They then calculate a "Financing Gap" between the required investment and available resources and often fill the "Financing Gap" with foreign aid. The Financing Gap Model has two simple predictions: (1) aid will go into investment one for one, and (2) there will be a fixed linear relationship between growth and investment in the short run. The data soundly reject these two predictions of the Financing Gap model.