Two-gap model

3 key takeaways

• The two-gap model identifies two primary constraints on economic growth in developing countries: the savings-investment gap and the foreign exchange gap.
• The savings-investment gap occurs when domestic savings are insufficient to finance the desired level of investment.
• The foreign exchange gap arises when a country does not have enough foreign currency to import the goods and services needed for development.

What is the two-gap model?

The two-gap model is a theoretical framework in development economics that highlights the dual constraints of insufficient domestic savings and inadequate foreign exchange on a developing country’s economic growth. It was developed to understand the limitations faced by developing countries and to design policies and strategies to overcome these barriers.

Components of the two-gap model

The two-gap model comprises two main components:

• Savings-investment gap: This gap occurs when a country’s domestic savings are not sufficient to fund the level of investment required for economic growth. Investment is crucial for building infrastructure, developing industries, and enhancing productivity, but low savings rates limit the available capital for these purposes.
• Foreign exchange gap: This gap arises when a country lacks the foreign currency needed to purchase necessary imports such as machinery, technology, and raw materials. Developing countries often rely on imports for development projects, but limited foreign exchange reserves can constrain their ability to procure these essential goods and services.

Implications of the two-gap model

The two-gap model has several important implications for economic development:

• Role of foreign aid: Foreign aid and external financing can play a crucial role in bridging both the savings-investment gap and the foreign exchange gap. Aid can provide the necessary capital for investment and the foreign currency required for imports.
• Policy focus: Policymakers in developing countries need to focus on strategies to increase domestic savings and attract foreign investment. Improving financial institutions, creating a favorable investment climate, and promoting export-oriented industries can help address these gaps.
• Balanced development: The model emphasizes the need for balanced development strategies that simultaneously address both gaps. Focusing solely on increasing domestic savings without ensuring adequate foreign exchange availability, or vice versa, may not lead to sustained economic growth.

Examples of the two-gap model in practice

Real-world examples illustrate the principles of the two-gap model:

• Post-war reconstruction: After World War II, many European countries faced significant savings-investment and foreign exchange gaps. The Marshall Plan, which provided substantial foreign aid, helped bridge these gaps and facilitated rapid economic recovery and growth.
• Developing countries: Many developing countries in Africa, Asia, and Latin America face persistent savings-investment and foreign exchange gaps. International aid, foreign direct investment (FDI), and trade policies are often designed to address these gaps and support development.

Understanding the two-gap model is crucial for analyzing the constraints on economic growth in developing countries and designing effective development policies. For further exploration, topics such as development finance, foreign aid effectiveness, and strategies for increasing domestic savings provide deeper insights into overcoming the challenges identified by the two-gap model.