McKinnon (1973) proposes a model of economic growth relevant to developing countries. He criticizes the neoclassical growth model for making several assumptions that make it inadequate for analyzing developing countries, and makes adjustments on those assumptions. His main criticisms are that the neoclassical growth model assumes that capital markets operate perfectly and costlessly to equate all real and financial assets with a single interest rate, inputs and output are perfectly divisible with constant returns to scale, money plays no role in capital accumulation, real money balances are costless to produce, and fiscal policy is costless.

McKinnon’s adjustments include identifying all actors as confined to self-finance and there is no distinction between savers and investors, firms have small sizes, and the government can only choose the real interest rate. McKinnon’s model shows that investors in developing countries overinvest in capital, to the point where the real rate of return diminishes and declines due to depreciation. He demonstrates that by choosing an optimal real rate of interest on liquidity, the optimal level of investment can be reached.

However, there are problems with McKinnon’s model that not are explicitly stated in his assumptions. First, the model does not take into account risk-preferences of households and firms in the economy. While the neoclassical model also fails to take into account risk-taking (we assume savings = investment), risk preferences are much more pronounced in developing countries due to differences in economic development (life expectancy, family size, array of investment opportunities, efficient capital markets, etc.). According to McKinnon’s description of investors in the economy, we would imply that investors are risk-takers because they over-invest in capital, even though they stand to lose from the investment. This assumption is problematic because (1) it is not empirically true (Yesuf and Bloomstone 2007) and (2) it assumes high risk-taking preference uniformity across the economy, which is a big stretch.

Second, if we include analysis of the discount rate as a factor, then we begin to see the weakness of McKinnon’s model. The discount rate is the rate at which people would be willing to trade present consumption for future consumption. Developing countries, unlike developed countries, have particularly high discount rates. Estimates of discount rates in Pakistan, India, and the Philippines can be as high as 12% (Zhuang et al. 2007). Discount rates can also increase over the course of development (Lopez 2008). So if discount rates are high, then investment levels in developing countries are low, which is contradictory to McKinnon’s assumption of risk-preferences but consistent with empirical evidence. Moreover, if the government must choose a real rate of return on liquidity, the real rate of return must at least be as high as the discount rate at the present time and move higher with the course of development. Such returns are difficult to achieve, especially when financial sectors are underdeveloped.

Therefore, we see many problems with McKinnon’s growth model. When applying McKinnon’s model to reality, we would expect that real interest rates will struggle to achieve the theoretical optimal level because the rate must be at least as high as the discount rate in order to encourage liquid savings. Moreover, if discount rates change over time, it is not possible to determine if the current real return is maximizing investment over time. It would be pernicious for developing countries to adopt McKinnon’s policy solution when risk preferences and discount rates are taken into account.

Lopez, Humberto. “The Social Discount Rate: Estimates for Nine Latin American Countries.” World Bank. 2008.

McKinnon, Ronald I. Money and Capital in Economic Development. The Brookings Institution. 1973.

Yesuf, Mahmud, and Randy Bluffstone. “Risk Aversion in Low Income Countries.” International Food Policy Research Institute. 2007.

Zhuang, Juzhong, Zhihong Liang, Tun Lin, and Franklin De Guzman. “Theory and Practice in the Choice of Social Discount Rate for Cost-Benefit Analysis: A Survey.” Asian Development Bank. 2007.