The Harrod-Domar Economic Growth Model (With Assumptions)

Introduction to the Harrod-Domar Economic Growth Model:

Ever since the end of the Second World War, interest in the problems of economic

growth has led economists to formulate growth models of different types.

These models deal with and lay emphasis on the various aspects of growth of the

developed economies. They constitute in a way alternative stylized pictures of an

expanding economy.

A feature common to them all is that they are based on the Keynesian saving-

investment analysis. 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. Then there is Mrs. Joan Robinson’s model which considers

technical progress also, along with capital formation, as a source of economic growth.

The third type of growth model is built on neo classical lines.

It assumes substitution between capital and labor and a neutral technical progress in

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

Both the factors are used in the same proportion even when neutral technical takes

place. We deal with the prominent growth models here.

Although Harrod and Domar models differ in details, they are similar in substance. One

may call Harrod’s model the English version of Domar’s model. Both these models

stress the essential conditions of achieving and maintaining steady growth. Harrod and
Domar assign a crucial role to capital accumulation in the process of growth. In fact,

they emphasize the dual role of capital accumulation.

On the one hand, new investment generates income (through multiplier effect); on the

other hand, it increases productive capacity (through productivity effect) of the economy

by expanding its capital stock. It is pertinent to note here that classical economists

emphasised the productivity aspect of the investment and took for granted the income

aspect. Keynes had given due attention to the problem of income generation but

neglected the problem of productive capacity creation. Harrod and Domar took special

care to deal with both the problems generated by investment in their models.

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.

(iii) 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 capital - 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.

These assumptions were meant to simplify the task of growth analysis; these could be

relaxed later.

Harrod’s growth model raised three issues:

(i) How can steady growth be achieved for an economy with a fixed (capital- output

ratio) (capital-coefficient) and a fixed saving-income ratio?

(ii) How can the steady growth rate be maintained? Or what are the conditions for

maintaining steady uninterrupted growth?

(iii) How do the natural factors put a ceiling on the growth rate of the economy?

In order to discuss these issues, Harrod had adopted three different concepts of growth

rates: (i) the actual growth rate, G, (ii) the warranted growth rate, Gw (iii) the natural

growth rate, Gn.

The Actual Growth Rate is the growth rate 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 steals the simple truism that

saving and investment (in the ex- post sense) are equal in equilibrium. This is clear from

the following derivation.

This relation explains that the condition for achieving the steady state growth is that ex-

post savings must be equal to ex-post investment.

“Warranted growth” refers to that growth rate of the economy when it is working at full

capacity. It is also known as Full-capacity growth rate. This growth rate denoted by Gw

is interpreted as the rate of income growth required for full utilisation of a growing stock

of capital, so that entrepreneurs would be satisfied with the amount of investment

actually made.
Warranted growth rate (Gw) is determined by capital-output ratio and saving- income

ratio. The relationship between the warranted growth rate and its determinants can be

expressed as

Gw Cr = s

where Cr shows the needed C to maintain the warranted growth rate and s is the

saving-income ratio.

Let us now discuss the issue: how to achieve steady growth? According to Harrod, the

economy can achieve steady growth when

G = Gw and C = Cr

This condition states, firstly, that actual growth rate must be equal to the warranted

growth rate. Secondly, the capital-output ratio needed to achieve G must be equal to the

required capital-output ratio in order to maintain Gw, given the saving co-efficient (s).

This amounts to saying that actual investment must be equal to the expected

investment at the given saving rate.

Instability of Growth:

We have stated above that the steady-state growth of the economy requires an equality

between G and Gw on the one hand and C and Cr on the other. In a free-enterprise

economy, these equilibrium conditions would be satisfied only rarely, if at all. Therefore,

Harrod analysed the situations when these conditions are not satisfied.

We analyse the situation where G is greater than Gw. Under this situation, the growth

rate of income being greater than the growth rate of output, the demand for output

(because of the higher level of income) would exceed the supply of output (because of
the lower level of output) and the economy would experience inflation. This can be

explained in another way too when C < Cr Under this situation, the actual amount of

capital falls short of the required amount of capital.

When this happens it would lead to deficiency of capital, which would, in turn, adversely

affect the volume of goods to be produced. Fall in the level of output would result in

scarcity of goods and hence inflation. Under this situation the economy will find itself in

the quagmire of inflation.

On the other hand, when G is less than Gw, the growth rate of income would be less

than the growth rate of output. In this situation, there would be excessive goods for sale,

but the income would not be sufficient to purchase those goods. In Keynesian

terminology, there would be deficiency of demand and consequently the economy

would face the problem of deflation. This situation can also be explained when C is

greater than Cr.

Here the actual amount of capital would be larger than the required amount of capital for

investment. The larger amount of capital available for investment would dampen the

marginal efficiency of capital in the long period. Secular decline in the marginal

efficiency of capital would lead to chronic depression and unemployment. This is the

state of secular stagnation.

From the above analysis, it can be concluded that steady growth implies a balance

between G and Gw. In a free-enterprise economy, it is difficult to strike a balance

between G and Gw as the two are determined by altogether different sets of factors.
Since a slight deviation of G from Gw leads the economy away and further away from

the steady-state growth path, it is called ‘knife-edge’ equilibrium.

Gn the Natural growth rate is determined by natural conditions such as labour force,

natural resources, capital equipment, technical knowledge etc. These factors place a

limit beyond which expansion of output is not feasible. This limit is called Full-

Employment Ceiling. This upper limit may change as the production factors grow, or as

technological progress takes place. Thus, the natural growth rate is the maximum

growth rate which an economy can achieve with its available natural resources. The

third fundamental relation in Harrod’s model showing the determinants of natural growth

rate is

GnCr is either = or ≠s

Interaction of G, Gw and Gn:

Comparing the second and the third relations about the warranted growth rate and the

natural growth rate which have been given above, we may conclude that Gn may or

may not be equal to Gw. In case G„ happens to be equal to Gw, the conditions of

steady growth with full employment would be satisfied. But such a possibility is remote
because of the variety of hindrances are likely to intervene and make the balance

among all these factors difficult. As such there is a definite possibility of inequality

between Gn and Gw. If G„ exceeds Gw, G would also exceed Gw for most of the time

as is shown in Figure 17.1, and there would be a tendency in the economy for

cumulative boom and full employment.

Such a situation will create an inflationary trend. To check this trend, savings become

desirable because these would enable the economy to have a high level of employment

without inflationary pressures. If on the other hand Gw exceeds G„, G must be below G„

for most of the time and there would be a tendency for cumulative recession resulting in

unemployment (Figure 17.2).