HARROD-DOMAR MODEL
The Harrod-Domar model developed in the 1930s suggests savings provide the funds which are borrowed for investment purposes.
In the 1940's Roy Harrod (1948) and Evsey Domar (1946) separately developed a macro-dynamic model through an extension of Keyns's theory. The model's original intent was to identify the source of instability in the growth of developed economies where effective denand is normally exceeded by supply capacity. In the 1950's and 1960's this model was applied to economic planning in developed economies.
The basic equation in the Harrod-Domar model is very simple, :
g=s/c (1)
where
- g is the growth rate of national income
- s=S/Y is the ratio of saving S to income,Y,
- c is marginal capital-output ratio
Under the assumption of constant c, g increases proportionally with s. Because s is considered to increase proportionally with income per capita, s is bound to be low and, hence, g will be low in low-income economies if savings and investment are left to private decision in the free market. The model implies, therefore, that the promotion of investment by government planning and command is needed to accelerateeconomic growth in low-income economies. Infact, the Harrod-Domar model provided a framework for economic planning in developing economies, such as India's Five Year Plan.
The Harrod-Domar model developed in the 1930s suggests savings provide the funds which are borrowed for investment purposes.
In the 1940's Roy Harrod (1948) and Evsey Domar (1946) separately developed a macro-dynamic model through an extension of Keyns's theory. The model's original intent was to identify the source of instability in the growth of developed economies where effective denand is normally exceeded by supply capacity. In the 1950's and 1960's this model was applied to economic planning in developed economies.
The basic equation in the Harrod-Domar model is very simple, :
g=s/c (1)
where
- g is the growth rate of national income
- s=S/Y is the ratio of saving S to income,Y,
- c is marginal capital-output ratio
Under the assumption of constant c, g increases proportionally with s. Because s is considered to increase proportionally with income per capita, s is bound to be low and, hence, g will be low in low-income economies if savings and investment are left to private decision in the free market. The model implies, therefore, that the promotion of investment by government planning and command is needed to accelerateeconomic growth in low-income economies. Infact, the Harrod-Domar model provided a framework for economic planning in developing economies, such as India's Five Year Plan.
The Economy's rate of Growth depends on:
- the level of saving and the savings ratio
- the productivity of investment i.e. economy's capital-output ratio
Further Analysis of the Model
The Harrod-Domar model developed in the 1930’s to analyse business cycles. it was later adapted to ‘explain’ economic growth.
- Economic growth depends on the amount of labour and capital i.e. NY = f(K,L)
- Developing countries have an abundant supply of labour. So it is a lack of physical capital that holds back economic growth hence economic development.
- More physical capital generates economic growth. (use Production Possibility Boundaries to illustrate)
- Net investment (i.e. investment over and above that needed to replace worn out capital (deprecation) leads to more producer goods (capital appreciation) which generates higher output and income. Higher income allows higher levels of saving.
- the productivity of investment i.e. economy's capital-output ratio
Further Analysis of the Model
The Harrod-Domar model developed in the 1930’s to analyse business cycles. it was later adapted to ‘explain’ economic growth.
- Economic growth depends on the amount of labour and capital i.e. NY = f(K,L)
- Developing countries have an abundant supply of labour. So it is a lack of physical capital that holds back economic growth hence economic development.
- More physical capital generates economic growth. (use Production Possibility Boundaries to illustrate)
- Net investment (i.e. investment over and above that needed to replace worn out capital (deprecation) leads to more producer goods (capital appreciation) which generates higher output and income. Higher income allows higher levels of saving.
| Implications of Harrod-Domar Model |
Economic growth requires policies that encourage saving and/or generate technological advances, which lower capital-output ratio.
| Criticisms of the Model |
According to Domer, Domar's purpose was to comment on business cycles, not to derive "an empirically meaningful rate of growth."
- It is difficult to stimulate the desired level of domestic savings
- Meeting a savings gap by borrowing form overseas causes debt repayment problems later.
- Diminishing marginal returns to capital equipment exist so each successive unit of investment is less productive and the capital to output ratio rises.
- The amount of investment is just one factor affecting development eg supply side approach (free up markets); human resource development (education and training)
- Economic growth is a necessary but not sufficient condition for development
- Sector structure of the economy important (i.e. agriculture vs. industry vs. services)
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