Submitted By: Samreen Hamdani

Roll No.: ECON-23-03

Department: Economics

Subject: Economics of Growth

Date: 17th June 2025

Submitted To: Dr. Javaid Khan

ASSIGNMENT/ SEMESTER: 01/04

 Dual Gap Analysis (Two-Gap
Model)
Introduction

Economic development in low- and middle-income countries requires significant

investment, access to modern technology, and broad structural transformation.
However, many developing economies are held back by two critical financial
constraints: an inadequate level of domestic savings and a shortage of foreign
exchange to import essential capital goods. To address and understand these
constraints, the Dual Gap Analysis—a theoretical framework developed in the mid-
20th century—offers valuable insights into the sources of growth limitations and the
justification for external financing through foreign aid, concessional loans, or foreign
direct investment.

The dual gap theory, most notably articulated by Hollis Chenery and Alan Strout
(1966), builds upon the Harrod-Domar growth model and has played a foundational
role in shaping the development strategies of key international institutions like the
World Bank, IMF, and UNCTAD. It identifies two main gaps that may hinder
economic growth: the savings gap, which arises when domestic savings are
insufficient to meet the required investment levels, and the foreign exchange gap,
which occurs when a country cannot generate enough foreign currency through
exports to finance necessary imports.

These gaps are not always mutually exclusive, and the dominant gap may vary based
on a country’s stage of development. In earlier development phases, a savings gap is
typically more prevalent. However, most developing countries today—excluding oil
exporters—face a dominant foreign exchange gap, reflected in persistent trade deficits
and underutilized domestic resources. Even when savings are available, these
economies often lack the capacity to import goods vital for production and growth. In
such contexts, foreign borrowing or aid becomes crucial—not only for national
development but also for sustaining the momentum of the global economy due to
interconnected trade relationships. Historically, successful developing countries
managed to convert external borrowing into productive exports, thereby repaying their
debts and transitioning to creditor status. Yet, many of today’s developing nations
struggle to achieve this due to structural challenges, such as dependence on primary
exports with low global demand elasticity.

Theoretical background and origin:

1. The Harrod-Domar Framework:

The dual gap model builds on the Harrod-Domar growth model, which relates
economic growth to savings and capital-output ratios. According to the model:
g=s/v

Where:

 g = Growth rate of GDP

 s = Savings rate
 v = Capital-output ratio

If the required savings to achieve a growth target are not met domestically, the gap
must be financed externally. However, the Harrod-Domar model assumes closed
economies. The dual gap analysis introduces external trade and capital flows.

2. Chenery-Strout Two-Gap Model

In their seminal paper “Foreign Assistance and Economic Development” (American

Economic Review, 1966), Chenery and Strout formalized the dual gap model, stating
that development is limited either by:

 A shortage of domestic savings (savings gap), or

 A shortage of foreign exchange (foreign exchange gap)

These gaps are not always mutually exclusive but identifying the binding constraint
helps in effective planning.

Components of Dual Gap Analysis

1. Savings Gap

The savings gap refers to the shortfall in domestic savings relative to the investment
required to achieve a target growth rate.

Required Investment=Target Growth×Capital-Output Ratio

Savings Gap=Required Investment−Actual Domestic Savings
Main causes: Low income, poor financial infrastructure, weak fiscal policies

Example: Sub-Saharan African nations, where gross savings are <15% of GDP
(World Bank, 2023)

2. Foreign Exchange Gap

This is the shortfall between the foreign currency needed for imports and the actual
foreign exchange earnings (mainly from exports, remittances, or aid).

Foreign Exchange Gap=Import Requirements−Export Earnings

Main causes: Dependence on primary exports, weak industrial base, terms of trade
shocks.

Example: Nepal, where a trade deficit exists despite remittances due to heavy reliance
on imports (ADB, 2022).

Dual gap analysis and foreign borrowings

Analytical Foundations of Dual Gap Analysis

In national income accounting, the gap between investment and domestic savings is
mathematically equivalent to the gap between imports and exports. This relationship
stems from the national income identity, which from the expenditure side is written as:

Income = Consumption + Investment + Exports – Imports

Since Saving = Income – Consumption, it follows that:

Saving = Investment + Exports – Imports

or
Investment – Saving = Imports – Exports

This identity implies that when a country invests more than it saves, it must import
more than it exports—financed by foreign borrowing. This foreign borrowing allows
an economy to either spend more than it produces or invest more than it saves. The
Investment-Saving (I – S) gap and the Import-Export (M – X) gap are thus
arithmetically identical in national accounts. However, they are not necessarily equal
in a planned or ex ante sense. That is, a country may plan to invest more than it saves
without planning to import more than it exports, and vice versa. This mismatch is the
starting point of the Dual Gap Analysis.
Growth and Resource Requirements

Economic growth requires investment goods, which can be sourced either

domestically or through imports. Domestic provision of these goods depends on
savings, while foreign provision requires foreign exchange.

In the Harrod-Domar growth model, the relationship between saving and growth is
expressed as:

g=s/c
or
g = sp

Where:

 g = growth rate
 s = saving rate
 c = incremental capital-output ratio (ICOR)
 p = productivity of capital (p = 1/c)

Likewise, growth can be expressed in terms of imports:

g = i × m′

Where:

 i = import ratio (imports as a share of GDP)

 m′ = marginal productivity of imports (∆Y/∆M)

Resource Constraints and Growth Limitations

If domestic resources and foreign resources are not easily substitutable, then growth
will be constrained by the more binding factor—either domestic savings or foreign
exchange availability.

 If saving is the binding constraint, growth will be savings-limited, and some

foreign exchange will remain unused.
 If foreign exchange is the constraint, growth will be foreign exchange-limited,
and some domestic savings will go unutilized.

Most developing countries today fall in the latter category, where despite having idle
domestic resources, growth is restricted due to insufficient foreign exchange to
finance essential imports. Conversely, some oil-exporting countries with ample
foreign reserves may face saving constraints.

Calculating the Gaps

Suppose a country sets a target growth rate (r). Based on growth equations:

 Required saving ratio: s = r / p*

 Required import ratio: i = r / m′*

If actual saving (s) falls short of s*, the investment-savings gap is:

It – St = (r/p) × γt – s × γt

Similarly, if export earnings cannot cover the required imports, the foreign exchange
gap is:

Mt – Xt = (r/m′) × γt – i × γt

Where:

 γt = output at time t
 It, St, Mt, Xt = investment, saving, imports, and exports at time t

Foreign capital flows must fill the larger of the two gaps to achieve the growth target.
The gaps are not additive:

 If the foreign exchange gap is larger, foreign capital will automatically cover
the smaller savings gap.
 If the savings gap is larger, foreign borrowing will also suffice to meet the
lower foreign exchange requirement.

Policy Implications and Theoretical Contribution

The dual gap analysis contributes a valuable perspective to development theory by

emphasizing that foreign assistance serves a dual role:

1. Supplementing domestic savings

2. Financing essential imports

This duality integrates traditional views (foreign aid as a savings supplement) with
modern realities (aid as necessary for acquiring imported goods that domestic
economies cannot produce). The theory underscores that if foreign exchange is the
binding constraint, trade liberalization alone may not ensure optimal resource use. In
such cases, protectionism or import substitution may be justified to avoid
underutilization of domestic resources.
Thus, dual gap analysis also provides a more realistic theory of trade for developing
nations, recognizing that internal and external equilibrium cannot always be achieved
simultaneously under free trade, especially when foreign exchange constraints
dominate.

Assumptions of Dual-Gap Analysis

1. No Easy Substitution: The model assumes that foreign exchange and domestic
savings are not easily substitutable, especially in the short run.
2. Savings vs. Foreign Exchange: If a country lacks foreign exchange, it cannot
simply use domestic resources to fund imports. Conversely, it’s often easier to
use foreign exchange to overcome a savings gap.
3. Real-World Application: Oil-rich countries (like Gulf nations) may have
enough foreign exchange but lack skilled labor, leading to investment-saving
gaps rather than foreign exchange gaps.
4. Development Pattern: Countries usually face a savings gap in the early stage of
development and a foreign exchange gap during the take-off stage due to
increased import needs.
5. Post-Oil Shock Impact: After the oil shocks of 1973 and 1979, most non-oil-
producing countries started facing chronic foreign exchange gaps.

Critical Appraisal of the Dual Gap Model

While the Dual Gap Analysis has been influential in development planning, it faces
several criticisms:

1. Absorptive Capacity Overlooked: The model ignores whether the recipient

country has the capacity to effectively utilize foreign aid, such as institutional
strength and project management capability.
2. Overly Aggregative: It treats all investments as uniform, overlooking that
developing countries often need targeted investments in specific sectors like
health, infrastructure, or education.
3. Mechanistic and Static Assumptions: The model assumes fixed values for
parameters like the capital-output ratio and saving rates, which can vary over
time. It also unrealistically assumes that foreign aid can always fill gaps
predictably.
4. Crude Estimation of Aid Needs: It provides only an approximate calculation of
aid requirements, with uncertainty in estimating import needs and project
feasibility, leading to potentially misleading figures.

Implications of Cost-Benefit Analysis in Aid

The cost-benefit analysis of aid leads to important policy insights:

 Tied vs. Non-Tied Aid: Non-tied aid (aid not restricted to spending on donor-
country goods) is more costly for the donor but more beneficial for the
 recipient. In contrast, tied aid lowers the donor’s real cost but reduces the
recipient’s real benefit and increases their repayment burden.
 Policy Recommendation for Donors: Developed countries should aim to ease
the terms of aid. The goal should be to increase the grant equivalent (real value
or generosity) of each unit of aid, not reduce it.
 Grants Over Loans: Since there’s always a risk of default by the recipient, aid
should preferably be given in the form of grants rather than loans to avoid debt
stress and ensure effective support for development.

Conclusion

The dual-gap analysis offers a valuable framework for understanding the constraints
on economic growth in developing countries, particularly the limitations posed by
inadequate domestic savings and foreign exchange shortages. It emphasizes that
external assistance is often necessary to bridge the larger of these two gaps. By
highlighting the limited substitutability between domestic and foreign resources—
especially in the short run—it underscores the need for targeted foreign aid to unlock
growth potential. The approach also brings attention to the quality of aid, advocating
for more generous, non-tied assistance and the refinement of methods like the grant
equivalent to better assess the true value and impact of aid flows. Ultimately, the
model underlines that strategic and equitable resource transfers from developed to
developing nations are essential not just for national progress but also for sustaining
global economic stability.