Table of Contents
- How the Harrod-Domar Model works
- Harrod – Domar model assumptions
- How to read the Harrod – Domar model
- Importances of the Harrod-Domar model
- Limitations of the Harrod – Domar model
What’s it:The Harrod-Domar model is an economic growth model that uses saving and investment as growth sources. The model takes two economists, Sir Roy Harrod and Evsey Domar, who independently developed the model in 1939 and 1946.
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The Harrod-Domar model is an alternative economic model to explain economic growth besides the Solow growth model.Harrod-Domar assumesthe capital has constant marginal returns. It differs from the Solow growth model, where capital has a decreasing marginal return.
Another difference between the two is the effect of the saving rate. Solow assumes that changes in the saving rate have temporary effects. But, in the Harrod-Domar model, it had a permanent effect.
How the Harrod-Domar Model works
Harrod Domar’s model helps explain why an economy grows and how to grow it. This model shows you that the national savings rate and capital productivity are the two main variables driving economic growth.
In summary, the growth rate of output is equal to the savings rate divided by capital productivity. TheHarrod-Domar model equationis as follows:
ΔY/Y = s/k
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Where:
- ΔY/Y: economic growth rate
- s: savings rate, namely the ratio of national savings (S) to national income (Y). In other words, S = sY.
- k: capital-output ratio, measures the productivity of capital and k = 1/marginal product of capital
Assume no depreciation. If Indonesia’s national savings rate is 5%, and the output-capital ratio is 2, then the economy will grow by 2.5% per year. Conversely, when Indonesia’s national savings rate is 20%, and the output-capital ratio is 4, Indonesia’s economic growth will be around 5%.
Harrod – Domar model assumptions
The Harrod – Domar model relies on several assumptions to explain economic growth.
- The economy operates at full employment and makes full use of available capital goods.
- Productivity and savings rate are the main determinants of economic growth.
- The model assumes constant returns to scale for the capital-output ratio and the propensity to save.
- Average propensity to save (APS) is the same as the marginal propensity to save (MPS).
- Investment is net, that is, gross investment minus depreciation. Thus, the capital stock changes by net investment.
How to read the Harrod – Domar model
First, the savings rate represents the supply of loanable funds in the economy for investment. A high saving rate indicates that the economy has significant funds to increase the capital stock and productive capacity. Therefore, the savings rate correlates positively with the economic growth rate. An increase in the savings rate leads the economy towards higher growth.
Second, the capital-output ratio shows you the amount of capital needed to increase output. When the economy requires more capital to produce output (high capital-output ratio), it indicates inefficient investment. The opposite is true when the capital-output ratio is low.
Second, say, the capital-output ratio is low. It shows you the capital stock in the economy is relatively low. Therefore, the investment will increase the capital stock and encourage the economy to produce output significantly more than when the capital-output ratio is high. From the formula above, you can see, the ratio has an inverse relationship with economic growth.
Conversely, if the capital-output ratio is high, investment does not significantly increase the economy’s output. Therefore, it becomes inefficient.
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Third, the savings rate is positively correlated with capital stock. A higher saving rate allows for more significant capital investment.
Let’s take a simple explanation. The domestic savings represents savings from three macroeconomic sectors: households and businesses. It shows you the supply of loanable funds in the economy.
When there is a supply of loanable funds, the economy can use them to accumulate capital.
Take the households as an example. They save and invest money in various financial instruments such as time deposits, stocks, or bonds. When they buy corporate bonds, the issuing company can use them for capital expenditures such as buying machinery or building new factories. Thus, the higher the household savings, the higher the opportunity to accumulate capital.
Importances of the Harrod-Domar model
First, the model explains, the savings rate and the capital-output ratio affect the growth rate. Low levels of economic growth can be associated with low savings rates. This situation usually occurs in developing countries like Indonesia.
A low level of domestic savings causes a low level of investment in the economy. It results in a low supply of loanable funds for investment. As a result, the capital stock is low, as well as economic growth.
Meanwhile, a lower capital-output ratio shows you a more efficient capital investment. That results in a higher growth rate.
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Second, a low savings rate can create a vicious cycle. This results in low investment resulting in low economic growth.
Low economic growth indicates slow economic prosperity. That leads to a low level of national income. Low income causes a few people to save.
When growth is low, the economy creates relatively limited new jobs. As a result, household income and aggregate demand are also low. Likewise, facing limited demand conditions, it is also difficult for businesses to increase output and gain significantly more profits. This all ultimately results in a low savings rate.
Therefore, an option to boost the rate of economic growth is to increase savings. A higher saving rate creates a cycle of self-sustaining economic growth. The economy is less dependent on the supply of funds from the external sector (foreign investment).
However, indeed, increasing the saving rate is not an easy matter. Most people in developing countries use additional income for consumption instead of saving. They have to struggle to meet their basic needs, so they find it difficult to set aside more money to save.
Also, the flow of savings and capital is immobile. I mean, these savings funds are not always available for companies to invest in capital goods as a result of underdeveloped financial markets. To overcome this, the government should develop its financial markets and promote financial literacy among the population.
Third, the Harrod – Domar model classifies economic growth into three categories: actual growth, natural growth rates, and warranted growth. The change in real GDP from year to year represents actual growth.
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Natural growth represents the growth rate for maintaining full employment. When the labor supply (measured by the labor force) grows 2%, then the economic growth must grow by 2%.
Warranted growth rate represents the rate of growth when saving equals investment. In other words, all savings are for investment allocation.
To explain the warranted growth rate, let’s retake the above formula.
ΔY/Y = s/k
Where
- s = S/Y, the saving rate equals national saving (S) divided by national income (Y).
- k = K/Y, the capital-output ratio. Since the model assumes constant returns to scale, k = ΔK/ΔY.
Now, if you plug s = S/Y, and ΔK/ΔY into the formula above, you get
ΔY/Y = (S/Y)/(ΔK/ΔY)
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ΔY/Y = (S/ΔK) x (ΔY/Y)
1 = S/ΔK
S = ΔK = I
S is national savings. Meanwhile, ΔK is the change in the capital stock, which is equal to net investment (I) in the economy. As I mentioned in the discussion of assumptions, net investment equals gross investment minus depreciation.
For example, if the business sector spends $12 billion to buy new machines and the depreciation of the existing machines is $2, the net investment is $10 billion. As a result, the capital stock (machines) in the economy increased by $10 billion.
For example, suppose the saving rate is 20%, and the capital-output ratio (ΔK/ΔY) is equal to 2. The warranted growth rate is 10%. Thus, net investment of $10 billion (ΔK) will increase output by $5 billion (ΔY = $10 billion/2).
Limitations of the Harrod – Domar model
Criticism is mainly leveled for the assumptions in the model.
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First, the model oversimplifies the sources of economic growth. It only uses capital and savings as determinants. It ignores other factors such as labor productivity and technological advances as factors spurring economic growth.
Second, the model assumes the economy is operating at full employment. That is unrealistic in the real world because the economy often fluctuates around full employment (potential output). These fluctuations produce business cycles in which real GDP rises and falls.
Third, the constant marginal return on capital is not valid. An increase in the capital stock actually causes lower returns. The Solow growth model shows you, if the capital per labor ratio is high, the effect of increasing output due to additional capital stock tends to decrease. Thus, capital has a decreasing marginal rate of return.
For example, when 10 staff members already have 10 computers, an additional 10 computers will not make them produce more output. Conversely, if the staff previously did not have computers, investing 10 computers would make them more productive and produce more output.
Fourth, capital is immobile in the economy. Underdeveloped financial markets make savings not always available for investment. Some savings in banks are used to finance household consumption instead of for business capital expenditures.
Also, additional savings do not always result in the same amount of additional capital investment. The economy may borrow from abroad to fill the savings gap (financing gap). Therefore, additional savings are actually used to pay off foreign debt instead of domestic investment.
FAQs
What are the key limitations of the Harrod-Domar growth model? ›
What are some of the key limitations / problems of the Harrod-Domar Growth Model? Increasing the savings ratio in lower-income countries is not easy. Many developing countries have low marginal propensities to save. Extra income gained is often spent on increased consumption rather than saved.
What are the key assumptions of the Harrod-Domar model? ›Harrod – Domar model assumptions
The model assumes constant returns to scale for the capital-output ratio and the propensity to save. Average propensity to save (APS) is the same as the marginal propensity to save (MPS). Investment is net, that is, gross investment minus depreciation.
Criticisms of Harrod-Domar Model
Developing countries find it difficult to increase saving. Increasing savings ratios may be inappropriate when you are struggling to get enough food to eat.
this can be expressed (the Harrod–Domar growth equation) as follows: the growth in total output (g) will be equal to the savings ratio (s) divided by the capital–output ratio (k); i.e., g = s/k.
What is the underlying assumption of the Harrod-Domar growth model? ›The underlying assumption of the Harrod-Domar growth model is that growth potential is affected by employment of labor input relative to capital.
What is the main difference between the assumptions of the Harrod-Domar growth model and those of the Solow growth model? ›Answer: The main difference between the Harrod-Domar (HD) model and the Solow model is that HD assumes constant marginal returns to capital, while Solow assumes decreasing marginal returns to capital.
What is the limitation of growth model? ›The Limits to Growth (LTG) is a 1972 report that discussed the possibility of exponential economic and population growth with finite supply of resources, studied by computer simulation. The study used the World3 computer model to simulate the consequence of interactions between the earth and human systems.
What is the conclusion of Harrod-Domar model? ›The Harrod-Domar model also derived a conclusion that differs from the static Keynesian model: instead of a stable unemployment equilibrium, in the dynamic Harrod-Domar model the economy's equilibrium is unstable.
What are the limitations of classical theory of growth? ›Limitations of the Classical Growth Model
Ignorance with respect to technology: The classical model of growth ignores the role efficient technical progress could play for the smooth running of an economy. Advancements in technology can minimize diminishing returns.
The main prediction of the Harrod-Domar model is that “GDP growth is proportional to the ratio of investment over GDP”.
What are the causes of instability in Harrod-Domar model? ›
The instability in Harrod's model is due to the rigidity of its basic assumptions such a fixed production function, a fixed saving ratio, and a fixed growth rate of labor force. The policy implications of the model are that saving is a virtue in any inflationary gap economy and vice in a deflationary gap economy.
What is the underlying assumption of the Harrod-Domar growth model quizlet? ›According to the theory of structural patterns of development, which of the following tends to occur as a country develops? The underlying assumption of the Harrod-Domar growth model is that: A the incremental capital-output ratio is given by c = Y/K.
Is Harrod-Domar model relevant for developing countries? ›Harrod-Domar model was very popular with the planners of under-developed countries. This model was used for the calculation of income, saving and investment targets which were vital in the planning of under-developed economy.
What is Harrod-Domar growth model with depreciation? ›Under the Harrod-Domar model, growth rates depend on the savings rate and the capital-output ratio, given the depreciation rate of capital. The model shows that growth rate is increased by savings rate and by more efficient use of capital.
What does the Harrod growth needed suggest about growth? ›directly related to savings and inversely related to the capital/output ratio.
Which among the following is based on the Harrod-Domar model? ›...
Detailed Solution.
| Five Year Plan | Period | Salient Features |
|---|---|---|
| Fourth Five Year Plan | 1969-74 | The main objectives was to achieve sustainable growth with self-reliance. |
The key assumption of the Solow–Swan growth model is that capital is subject to diminishing returns in a closed economy. Given a fixed stock of labor, the impact on output of the last unit of capital accumulated will always be less than the one before.
What are the 2 key assumptions that we make about the production function in the Solow model? ›Solow builds his model around the following assumptions:
(1) One composite commodity is produced. (2) Output is regarded as net output after making allowance for the depreciation of capital.
- Model Calibration. The mathematical parameters in models that describe a certain process can be adjusted to obtain better agreement between model output and observations. ...
- Model Validation. ...
- Model Sensitivity.
Limitations of the Two-Stage Dividend Discount Model
A shorter first stage will cause the valuation to be undervalued. While a longer first stage could lead to overvaluation in case of a high growth assumption in the first stage.
What are the common limitations of models? ›
Details—Models cannot include all the details of the objects that they represent. For example, maps cannot include all the details of the features of the earth such as mountains, valleys, etc. Approximations—Most models include some approximations as a convenient way to describe something that happens in nature.
What are three growth concepts Harrod introduced? ›Harrod introduced the concepts of warranted growth, natural growth, and actual growth. The warranted growth rate is the growth rate at which all saving is absorbed into investment.
How does the Harrod model explain the occurrence of trade cycle? ›The theory also explains trade cycles. When there is G > Gn, then there will be unemployed resources in the economy, hence, the economy will be in the recovery phase. When G = Gn, there will be full employment of resources. When G < Gn, there will be slump in the economy.
What are the two limitations of classical theory? ›Following were the common drawbacks in the classical theory of management: Classical theory doesn't talk about creativity and innovation. Classical theory focus on individual performance than team performance. Classical theory creates disputes and frustration among the employees.
What is the criticism of growth theory? ›One of the biggest criticisms aimed at the endogenous growth theory is that it is impossible to validate with empirical evidence. The theory has been accused of being based on assumptions that cannot be accurately measured.
What are the limitations of the classical theory of economics? ›Abstract: Commons criticized three limitations of the classical theory of value, namely the elimination of scarcity, ownership and money, and attempted to construct new concepts and theories to overcome these limitations.
What is the condition of equilibrium in Harrod-Domar model? ›Harrod lays down equilibrium condition for steady growth by saying that the actual rate of growth must be equal to the warranted rate of growth, i.e., the rate of increase in output or income should be just so much as to keep the entrepreneurs satisfied with the actual investment they have made.
What are the conditions necessary for steady state in Harrod-Domar model? ›The Harrod-Domar model is not a steady state growth model where Gw (= s/v) = Gn (=n + m). It is one of knife-edge balance between cumulative inflation and cumulative deflation. It is only when the warranted growth rate s/v equals the natural rate of growth n+m, that there will be steady state growth.
What are two major causes of economic instability? ›Causes of economic instability include stock market fluctuations, fluctuations in the prices of houses and other assets, black swan events (unexpected disasters that impact the economy), and changes in interest rates.
How do Harrod and Domar model of economic growth compare? ›Domar relates investment forward to the increase in income but Harrod is concerned with the way the investment is traced back to the rate of income. 4. Harrod uses three distinct rates of growth i.e. actual rate (G), warranted rate (Gw) and natural rate (Gn) while Domar uses one growth rate.
What is the knife edge instability in Harrod model? ›
Harrod's “knife-edge” reconsidered: An application of the hopf bifurcation theorem and numerical simulations* Harrod (1939) concluded that the warranted rate of growth is a unique moving equilibrium, but a “highly unstable” one. This is named Harrod's knife-edge instability or the Instability Principle.
How can economic development be measured which method is better and why? ›The most common way to measure the economy is real gross domestic product, or real GDP. GDP is the total value of everything - goods and services - produced in our economy. The word "real" means that the total has been adjusted to remove the effects of inflation.
What is the five year plan on Harrod-Domar model? ›Notes: India's first five-year plan which started in 1951 is known as the Harrod-Domar model. It focussed on agriculture and irrigation. The plan was a success, with the economy growing at an annualized 3.6%, beating the target of 2.1%.
What is depreciation in Solow growth model? ›Starting at the initial level of capital, K1, depreciation now exceeds investment. This means the capital stock starts to decline, and continues until capital falls to its new equilibrium level of K2. The increase in the depreciation rate leads to a decline in the capital stock and in the level of output.
What is the dual character of investment in Harrod-Domar model? ›Domar model is based on the dual character of investment: one, investment increases productive capacity, and two, investment generates income.
What is the formula for warranted growth rate? ›sY = ν(dY/dt). This implies that the growth rate of Y must beThis is the only rate at which equilibrium growth is possible, so long as the saving ratio s and the capital–output ratio v are taken as fixed.
What is the importance of assumptions in an economic model? ›Assumptions provide a way for economists to simplify economic processes and make them easier to study and understand. An assumption allows an economist to break down a complex process in order to develop a theory and realm of understanding.
What is the most important assumption in economics? ›The key assumption of economics (especially microeconomics) is that “individuals allocate their scarce resources so as to make themselves as well off as possible.” This assumption is central to economics; there is an “economic way of thinking” that is different and distinct from the methods of other social sciences.
What is the most important assumption for creating models in economics? ›The scarcity or abundance of resources is important in determining the choices that participants make in an economy.
What are the assumptions of Harrod Domar model? ›The Domar model is based on the following assumption. 1) Income is determined by investment through multiplier. For the sake of simplicity, saving-income ratio is assumed constant. 2) Productive capacity is created by investment according to the potential social average investment productivity.
What is 2 the underlying assumption of the Harrod Domar growth model? ›
The basic idea of the Harrod-Domar model is that economic growth depends on the amount of capital that is available for investment, and that the rate of capital accumulation is proportional to the rate of savings.
What are the main limitations of Solow growth model? ›Limitations of the Solow Growth Model: Even though the Solow model is supposed to be a growth model - it cannot really explain long run growth: The per capita income does not grow at all in the long run; The aggregate income grows at an exogenously given rate n, which the model does not attempt to explain.
What is the knife-edge instability in Harrod model? ›Harrod's “knife-edge” reconsidered: An application of the hopf bifurcation theorem and numerical simulations* Harrod (1939) concluded that the warranted rate of growth is a unique moving equilibrium, but a “highly unstable” one. This is named Harrod's knife-edge instability or the Instability Principle.
What are three limitations of measuring economic growth? ›- The exclusion of non-market transactions.
- The failure to account for or represent the degree of income inequality in society.
- The failure to indicate whether the nation's rate of growth is sustainable or not.
Key Takeaways
A few Solow growth model assumptions are- the manufacture of a single blended product, deduction of depreciation, variable costs, sufficient & endless labor employment, sufficiently employed capital, homogenous technical progress, and unchanged saving ratio.
The Harrod-Domar models of economic growth are based on the experiences of advanced capitalist economies to analyse the requirements of steady growth in such economy. The Harrod-Domar economic growth model stresses the importance of savings and investment as key determinants of growth.
What is the knife edge equilibrium in Harrod model an equality between? ›Knife-edge equilibrium in the Harrod model
Sir Roy Harrod advocated that steady growth requires equality between the actual growth rate (G) and the warranted growth rate (Gw), and, between the actual capital-output ratio (C) and the capital required to maintain the warranted growth rate (Cr).
A knife-edge condition is a condition imposed on parameter values such that the set of values satisfying this condition has an empty interior in the space of all possible values […].
What are knife edge situations? ›To be on a knife-edge means to be in a situation in which nobody knows what is going to happen next, or in which one thing is just as likely to happen as another.