Harrod-Domar Growth

Model
Introduction :

The first and the simplest model of growth—the Harrod-Domar Model—is

the direct outcome of projection of the short-run Keynesian analysis into the
long-run.

This model is based on the capital factor as the crucial factor of economic
growth. It concentrates on the possibility of steady growth through
adjustment of supply of demand for capital.

It assumes substitution between capital and labour and a neutral technical

progress in the sense that technical progress is neither saving nor absorbing
of labour or capital. .

Although Harrod and Domar models differ in details, they are similar in
subsistence. Harrod and Domar assign a crucial role to capital accumulation
in the process of growth. In fact, they emphasise the dual role of capital
accumulation.

General Assumptions

The main assumptions of the Harrod-Domar models are as follows:

(i) A full-employment level of income already exists.

(ii) There is no government interference in the functioning of the economy.

(3) The model is based on the assumption of “closed economy.” In other

words, government restrictions on trade and the complications caused by
international trade are ruled out.
(iv) There are no lags in adjustment of variables i.e., the economic variables
such as savings, investment, income, expenditure adjust themselves
completely within the same period of time.

(v) The average propensity to save (APS) and marginal propensity to save
(MPS) are equal to each other. APS = MPS or written in symbols,

S/Y= ∆S/∆Y

(vi) Both propensity to save and “capital coefficient” (i.e., capital-output

ratio) are given constant. This amounts to assuming that the law of constant
returns operates in the economy because of fixity of the capita-output ratio.
(vii) Income, investment, savings are all defined in the net sense, i.e., they are
considered over and above the depreciation. Thus, depreciation rates are not
included in these variables.

(viii) Saving and investment are equal in ex-ante as well as in ex-post sense
i.e., there is accounting as well as functional equality between saving and
investment.

Significance
Although the Harrod–Domar model was initially created to
help analyse the business cycle, it was later adapted to
explain economic growth.

Its implications were that growth depends on the quantity of

labour and capital; more investment leads to capital
accumulation, which generates economic growth.

The model carries implications for less economically

developed countries, where labour is in plentiful supply in
these countries but physical capital is not, slowing down
economic progress.

LDCs do not have sufficiently high incomes to enable

sufficient rates of saving; therefore, accumulation of physical-
capital stock through investment is low.

The model implies that economic growth depends on policies

to increase investment, by increasing saving, and using that
investment more efficiently through technological advances.

The model concludes that an economy does not "naturally"

find full employment and stable growth rates.

The Harrod Domar Model suggests that economic

growth rates depend on two things:

• Level of Savings (higher savings enable higher investment)

• Capital-Output Ratio. A lower capital-output ratio means investment is

more efficient and the growth rate will be higher.
A simplified model of Harrod-Domar:

Rate of economic growth (g) = Level of savings (s) / Capital

output ratio (k)

Harrod-Domar in more detail

• Level of savings (s) = Average propensity to save (APS) –
which is the ratio of national savings to national income.

• The capital-output ratio = 1/marginal product of capital.

• The capital-output ratio is the amount of capital

needed to increase output.
 • A high capital output ratio means investment is
inefficient.

• The capital-output ratio also needs to take into

account the depreciation of existing capital
Main factors affecting economic growth

1: savings ratio
2: marginal efficiency (MEC)
3: capital depreciation

• Level of savings. Higher savings enable greater investment

in capital stock

• The marginal efficiency of capital. This refers to the

productivity of investment, e.g. if machines costing £30
million increase output by £10 million. The capital-output
ratio is 3

• Depreciation – old capital wearing out.

Warranted Growth Rate
Roy Harrod introduced a concept known as the warranted
growth rate.

• This is the growth rate at which all saving is absorbed into

investment.

• Let us assume, the saving rate is 10%. the Capital output ratio is 4. In
other words, £10bn of investment increases output by £2.5bn

• In this case, the economy’s warranted growth rate is 2.5 percent (ten
divided by four).

• This is the growth rate at which the ratio of capital to output would
stay constant at four.

The Natural Growth Rate

 • The natural growth rate is the rate of economic growth required to
maintain full employment.

• If the labour force grows at 3 percent per year, then to maintain full
employment, the economy’s annual growth rate must be 3 percent.

• This assumes no change in labour productivity which is unrealistic .

Model - Technology
Fixed Coefficient (Leontieff) Production Function
The level of scarce input determines the output levels
Y (t) = min(K(t)/v,L(t)/α ……………. (1)
where
v : utilized capital/output ratio
α : employed labor/output rate) technology coefficients Leontieff technology isoquants
Note: Isoquants are the curves that define the set of points at which the same level of
output is produced while changing input levels.
In Leontieff, inputs are perfect complements (See the GRAPH)
To ensure full employment of both inputs:
Y (t) = min( K(t)/ v , L(t) / α ) ⇒K / L = v / α …………(1’)
No substitution between capital and labor ⇒ Critical property of Leontieff..

Model
Keynesian model: S(t) = Y (t) − C(t) (assuming C is a constant fraction of total income)
⇒ S(t) = sY (t) (2)
where s: saving rate (a constant fraction)
where 0 < s < 1
Goods Market Clearing Condition:
Y (t) = C(t) + I(t) (3)
Gross Investment Definition:
I(t) = δK(t) + K˙ (t) (4)
where δ: depreciation rate (a constant fraction) where 0 < δ < 1

Population
L˙(t) / L(t) = nL : Constant population growth rate (5)
NOTE: This is how we define the growth rate of any variable: X˙ (t)
X(t)
where dot above X represents the instantaneous change in X, i.e. the
time derivative of X:X˙ (t) = dX(t)
dt .
In discrete time ∆ is equivalent to dot: Xt+1 = (1 + nX)Xt
.
∆X = Xt+1 − Xt → ∆X/Xt = nX is the growth rate of X.
Macroeconomic equilibrium
Macroeconomic equilibrium (Drop t’s from now on to shorten
exposition):
S = I ⇒ (6)
sY = δK + K˙ (7)
Assuming full employment of K (and excess labor
supply/unemployment) implies:
Y=K/ v ……….(1’)
Then we can write (7) as ;

Macroeconomic equilibrium
Let gK = Y˙/ Y =Actual growth rate of the economy
By (1’): Y˙ / Y = K˙ / K = gK
At the equilibrium: ⇒ Y˙/ Y = K˙/ K = s/ v − δ ……………………..(8)
This is called the “Warranted rate of growth”: The growth rate at
which all saving is absorbed into investment. ⇒ If the goods market
clear through S = I such that the economy is in equilibrium, actual
growth rate of the economy, gK, would coincide with the warranted
growth rate, s/v − δ.

Results of Harrod-Domar model

Harrod emphasized the unstable nature of this equilibrium: if S=I

does not hold, the economy moves away from this equilibrium. Fornexample,
I If gK > s/v − δ, there is excess demand. ⇒ Firms have underinvested
and would invest more. ⇒ growth ↑ , requiring even further investment. Result:
explosive growth: gK continuously increases.
I If gK < s/v − δ, there is excess capacity. Multiplier works in the opposite way, gK
continuously decreases.
This property is known as Harrod’s knife-edge.

Suppose capital and labor levels are such that there is full employment in both:

For the full employment to remain intact: (DERIVE!)

K˙/K = L˙/L …………………………….(9)
(9)⇒(5)
gK = nL (10)
(10) brings another knife-edge condition
I If population grows faster, growing unemployment.
I If capital grows faster, labor becomes the scarce input.
If, by chance, nL = gK = s/v − δ, all markets are in equilibrium.
Inherent instability of the model was one of the biggest criticisms
Towards Harrod-Domar model.
Not a mistake: Harrod argued that stable growth periods are less likely to happen in a
capitalist society.
Instead, there will be alternating cycles (of long periods of unemployment and fast
growth).

Third main result (and the policy conclusion):

Increase the saving rate (or find a way to reduce the coefficient v)
and growth rate of the economy increases as well.
⇒ Deeply influenced the central planning of economics of the time: India, Soviet Union
and China.

Harrod – Domar model (Diagram)

The aggregate production function

An implicit assumption of the Harrod – Domar model is that there are no diminishing
return of capital . The otal production of capital curve (TPK) is a straight line from the
origin that means that the marginal product of capital (MPK) is constant and equal to
the average product of capital (APK). The reciprocal of the marginal product of capital
is the increment capital output ratio (ICOR).

Per Worker Basis

These graphs can be put on a per worker basis by dividing the capital stock (k),
GDP (Y) and savings (s) by the number of workers (N) . The shapes of the curves
will not change if we assume that there are constant returns to scale.
Net Investment Per Worker

The blue line indicates the amount of new capital that goes to replace depreciated
capital and the amount needed to equip new workers with the same amount of capital as
the present workers.The difference between that and net capital accumulation. In this
model per workers income grows at a constant rate indefinitely and the absolute
increments to growth get bigger every year .
Calculate Growth Rate of GDP

Calculating the Growth Rate of GDP

The growth rate of GDP can be calculated very simply. The ICOR is defined as the growth in the
capital stock divided by the growth in GDP. Since Investment (I) is defined as the growth in the capital
stock, the ICOR is equal to Investment divided by the growth of GDP. Investment will be equal to
savings and Savings is equal to the APS times GDP. If we divide both sides by the ICOR and we divide
both sides of the equation by GDP we have the result that the growth rate of GDP will equal the Average
Propensity to Save (APS) by the Incremental Capital -Output Ratio (ICOR). Thus if the APS is 12% and the
ICOR is 3 the growth rate of GDP, G(Y), would be 4%.
Calculating Growth Rate of GDP/Capita

Calculating the Growth Rate of GDP Per Capita

The growth rate of GDP can be calculated very simply. The growth rate of any ratio is equal to the
growth rate of the numerator minus the growth rate of the denominator. In this case we must subtract
the growth rate of population, G(P) from the growth rate of GDP, G(Y). The growth rate of GDP, G(Y)
is equal to the APS/ICOR. Therefore the growth rate of GDP Per Capita, G(Y/P) is equal to APS/ICOR
– G(P).
The Effect of Savings Rates

The Effect of Savings Rates

An increase in the savings rate (APS) will increase the growth rate of per capita income. The size of the
increase will be inversely proportional to the size of the incremental capital output ratio (ICOR). If the
ICOR was 3, a 6% increase in the savings rate would be needed to increase the growth rate of per
capita income by 2%, assuming that both the ICOR and the rate of population growth G(P) remained
constant.
The Effect of Inefficiency

An Increase in the Incremental Capital-Output Ratio

The incremental capital-output ratio, or ICOR, is equal to 1 divided by the marginal product of capital.
The higher the ICOR, the lower the productivity of capital. The ICOR can be thought of as a measure
of the inefficiency with which capital is used. In most countries the ICOR is in the neighborhood of 3.
Increase in Population Growth Rate
The Effect of an Increase in the Population Growth Rate
The Growth Rate of GDP will equal the average propensity to save (APS) divided by the incremental
capital-output ratio, (ICOR). If the population growth rate is zero, that will also equal the growth rate of GDP
per capita since the growth rate of GDP per capita is equal to the growth rate of GDP minus the growth rate of
the population. Thus every 1% increase in the population growth rate translates into a 1% fall in the growth rate
of per capita GDP.

CRITICISM

Criticism # 1. Unrealistic Assumptions:

The main objection to these models is that they are based upon rigid, abstract
and unrealistic assumptions .These models assume many things constant,
which actually do not do so. For example, propensity to save and capital-
output ratio are assumed constant.

Criticism # 2. Aggregative Character of Models is Open to

Criticism:
These models are criticised because their excessively aggregative in
character. The variables used in the exposition of these models are macro in
character. Single sector models based on aggregates can hardly explain the
relation among different sectors of an economy. Such a model fails to explain
the structural changes taking place in the various sectors of an economy.

3. Variables Expressed Only in Real Terms:

Another point of criticism of these growth models is that the variables are
expressed in real terms. In other words, the variables are non-monetary in
character. Due to the “real” nature of the variables, the influence of monetary
factors on investment, savings and demand cannot be considered. In the
present day world, monetary and real factors cannot be separated for the
purpose of policy-making.

4. Exaggeration of Instability:
Instability of steady-growth has been exaggerated in these models. These
models conclude that once the path of steady-growth Is distributed ,the forces
of instability gather momentum ,which results in either secular inflation or
secular over production.

5. Natural Growth Rate Concept (Gn) is Open to Objection:

Prof. L.B. Yeager has raised objection against the use of the concept of
“natural growth rate” (Gn) in Harrod’s model. He is of the opinion that ceiling
limit to growth is not only determined by the available labour and natural
resources as suggested by Harrod but also by the production techniques
employed.

6. Limited Relevance to Under-developed Countries:

Harrod-Domar models have been criticised on the ground that they have little
application for underdeveloped countries. These models attempt to solve the
problem of economic instability but neglect the problems of development
which is the main concern of under-developed countries.

7. Assumption of Laissez-faire Policy is Unwarranted:

Harrod-Domar models are based on the assumption of laissez-faire. This
assumption might have been realistic and warranted in the past. Modern
governments can ill afford to sit like silent spectators in matters of economic
development.

8. Non-economic Factors Ignored:

Harrod-Domar models stress the importance of economic parameters only.
These models have not provided due place to the non- economic
parameters such as social, political, religious factors etc. Some writers say
that the non-economic determinants are more important than the economic
determinants.