Harrod–Domar Model

The Harrod-Domar model of growth seeks to explain two basic questions relating to
growth problems of developed countries. They are:
1. What are the requirements to maintain steady rate of growth of full employment
income without inflation and deflation?
2. Is long-run full employment equilibrium of a developed economy possible
without secular stagnation or secular inflation?
Thus, this model provides gainful suggestions to above stated questions. Regarding
steady rate of growth of full employment income, Harrod- Domar model conveys that
rate of investment should increase at a rate equal to the proportion between marginal
propensity to save and capital output ratio.

Therefore, ∆I/I = S/V

Where ∆I/ I is the rate of investment, S is the marginal propensity to save and V is the
capital output ratio.

As regards second question, Harrod-Domar are of the view that it is difficult to maintain
steady rate of growth of full employment in a capitalist economy. There are possibilities
of secular inflation or secular deflation in the capitalist country.

 the model was developed independently by Roy F. Harrod in 1939, and Evsey
Domar in 1946, although a similar model had been proposed by Gustav Cassel in
1924. The Harrod–Domar model was the precursor to the exogenous growth model
 is a classical Keynesian model of economic growth that is used in development
economics to explain an economy's growth rate in terms of the level of saving and
productivity of capital
 it suggests that there is no natural reason for an economy to have b alanced growth
 the growth of an economy is positively related to its savings ratio and negatively
related to the capital-output ratio. It suggests that there is no natural reason for an
economy to have balanced growth .

Assumptions of the Harrod–Domar Model

1. There is an initial full employment equilibrium level of income.
2. The model operates in closed economy i.e. there is no foreign trade.
3. The average propensity to save is equal to the marginal propensity to save i.e. S/Y =
∆S/∆Y absolute change in savings is equal to the relative change in savings.
4. There is no government interference in the functioning of the economy i.e. the policy
of laissez-faire prevails in the economy.
5. There are no lags in adjustment i.e. the economic variables such as saving,
investment, income, expenditure adjust themselves in the same period of time.
6. The marginal propensity to save and capital coefficient remains constant.
7. Intended investment and real investment are equal in the economy.
8. There is no depreciation of capital goods which are assumed to be fixed.
9. Saving and investment are equal in ex-ante as well as ex-post sense i.e. there is
accounting as well as functional equality between saving and investment i.e. S o = Io ,
Se = Ie.
10. There is fixed proportion of capital and labour in the productive process.
11. There are no changes in interest rates.
12. Fixed and circulating capitals are lumped together under capital.
13. Saving and investment relate to income of the same year.

Three Kinds of Growth according to Harrod Domar

1. Warranted growth rate
 refers to that growth rate of the economy when it is working at full capacity. It is
also known as Full-capacity growth rate.
 is the rate of growth at which the economy does not expand indefinitely or go
into recession
 this growth rate denoted by G w is interpreted as the rate of income growth
required for full utilization of a growing stock of capital, so that entrepreneurs
would be satisfied with the amount of investment actually made
 warranted growth rate (G w ) is determined by capital-output ratio and saving-
income ratio. The relationship between the warranted growth rate and its
determinants can be expressed as: G w Cr = s, where Cr shows the needed C to
maintain the warranted growth rate and s is the saving-income ratio.
2. Actual growth

 determined by the actual rate of savings and investment in the country. In other
words, it can be defined as the ratio of change in income (AT) to the total income
(Y) in the given period. If actual growth rate is denoted by G, then, G = ∆Y/Y
 the actual growth rate (G) is determined by saving-income ratio and capital-
output ratio. Both the factors have been taken as fixed in the given period.
 the relationship between the actual growth rate and its determinants was
expressed as: GC = s …(1), where G is the actual rate of growth, C represents the
capital-output ratio ∆K/∆Y and s refers to the saving-income ratio ∆S/∆Y.
 this relation stales the simple truism that saving and investment (in the ex - post
sense) are equal in equilibrium. This is clear from the following derivation.
3. Natural growth
 is the growth an economy requires to maintain full employment.
 for example, If the labor force grows at 3 percent per year, then to maintain full
employment, the economy’s annual growth rate must be 3 percent.

Mathematical Formalism
Let Y represent output, which equals income, and let K equal the capital stock. S is total
saving, s is the savings rate, and I is investment. δ stands for the rate of depreciation of
the capital stock. The Harrod–Domar model makes the following a priori assumptions:
1. Output is a function of capital stock
2. The marginal product of capital is constant; the
production function exhibits constant returns to
scale. This implies capital's marginal and average
products are equal.
3. Capital is necessary for output.
4. The product of the savings rate and output equals
saving, which equals investment
5. The change in the capital stock equals investment
less the depreciation of the capital stock

The Main Points of the Harrod-Domar Analysis

1. Investment is the central variable of Stable growth and it plays a double role; on the
one hand, it generates income and on the other, it creates productive capacity.
2. The increased capacity arising from investment can result in greater output or
greater unemployment depending on the behaviour of income.
3. Conditions concerning the behaviour of income can be expressed in terms of growth
rates i.e. G, Gw and Gn and equality between the three growth rates can ensure full
employment of labour and full-utilisation of capital stock.
4. These conditions, however, specify only a steady-state growth. The actual growth
rate may differ from the warranted growth rate. If the actual growth rate is greater
 than the warranted rate of growth, the economy will experience cumulative
inflation. If the actual growth rate is less than the warranted growth rate, the
economy will slide towards cumulative inflation. If the actual growth rate is less
than the warranted growth rate, the economy will slide towards cumulative
deflation.
5. Business cycles are viewed as deviations from the path of steady growth. These
deviations cannot go on working indefinitely. These are constrained by upper and
lower limits, the ‘full employment ceiling’ acts as an upper limit and effective
demand composed of autonomous investment and consumption acts as the lower
limit. The actual growth rate fluctuates between these two limits.

Criticisms of the Model

The main criticism of the model is the level of assumption, one being that there is no
reason for growth to be sufficient to maintain full employment; this is based on the
belief that the relative price of labour and capital is fixed, and that they are used in equal
proportions. The model explains economic boom and bust by the assumption
that investors are only influenced by output (known as the accelerator principle); this is
now believed to be correct.
In terms of development, critics claim that the model sees economic growth
and development as the same; in reality, economic growth is only a subset of
development. Another criticism is that the model implies poor countries should borrow
to finance investment in capital to trigger economic growth; however, history has
shown that this often causes repayment problems later.

 Developing countries find it difficult to increase saving. Increasing savings ratios

may be inappropriate when you are struggling to get enough food to eat.
 Harrod based his model on looking at industrialized countries post-depression
years. He later came to repudiate his model because he felt it did not provide a
model for long-term growth rates.
 The model ignores factors such as labour productivity, technological innovation
and levels of corruption. The Harrod Domar is at best an oversimplification of
complex factors which go into economic growth.
 There are examples of countries who have experienced rapid growth rates
despite a lack of savings, such as Thailand.
 The Model explains boom and bust cycles through the importance of capital.
However, in practice businesses are influenced by many things other than capital
such as expectations.
 Harrod assumed there was no reason for the actual growth to equal natural
growth and that an economy had no tendency to full employment. However, this
was based on the assumption of wages being fixed.
 The difficulty of influencing saving levels. In developing economies it can be
difficult to increase savings ratios – because of widespread poverty.