Unit-II

THEORIES OF GROWTH (KR)

HARROD DOMAR'S GROWTH MODEL

The Harrod-Domar economic growth model stresses the importance of savings and investment as
key determinants of growth. The model emphases on the dual character of investment:

1. It creates income which is regarded as the ‘demand effect’.

2. It augments the productive capacity of the economy by increasing its capital stock which is
regarded as the ‘supply effect’ of investment.

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

1. A full-employment level of income already exists.

2. There is no government interference.

3. The model is based on the assumption of closed economy.

4. There are no lags in adjustment of variables.

5. The average propensity to save (APS) and marginal propensity to save (MPS) are equal to each
other. Symbolically, S/Y= ∆S/∆Y

6. Both propensities to save and “capital coefficient” (i.e., capital-output ratio) are given constant.

7. Income, investment, savings are all defined in the net sense and hence they are considered over
and above the depreciation.

8. Saving and investment are equal in ex-ante as well as in ex-post sense.

Although Harrod and Domar models differ in some aspects, they are similar in substance as both the
models stress the essential conditions of achieving and maintaining steady growth.

The Harrod Model:

An English economist, Henry Roy Forbes Harrod (13 February 1900 – 8 March 1978) tries to show in
his model how steady growth may occur in the economy. Once the steady growth rate is interrupted
and the economy falls into disequilibrium, cumulative forces tend to perpetuate this divergence
thereby leading to either secular deflation or secular inflation. The Harrod Model is based upon three
distinct rates of growth as below:

1. The actual growth rate (G)

2. The warranted growth rate (Gw)

3. The natural growth rate (Gn)

1. The actual growth rate (G):

It is defined as the ratio of change in income (∆Y) to the total income (Y) in the given period.
Mathematically; G = ∆Y/Y
The actual growth rate (G) is determined by:

(a) Saving-Income ratio (s) known as the Average Propensity to Save which is expressed as s =S/Y

(b) Capital- Output ratio (C) which is expressed as C=∆K/∆Y where ∆K denotes change in Capital
stock which equal investment (I)

The relationship between the actual growth rate and its determinants is expressed as:

GC = s ------(1)

Now;

The above equation so derived explains that the condition for achieving the steady state growth is
that ex-post (actual, realized) savings must be equal to ex-post investment.

2. The warranted growth rate (Gw):

Warranted growth Rate also known as Full-capacity growth rate refers to that growth rate of the
economy when it is working at full capacity. In other words, Gw is interpreted as the rate of income
growth required for full utilization of a growing stock of capital.

Warranted growth rate (Gw) is determined by capital-output ratio and saving- income ratio and their
relationships is expressed as:

Gw Cr = s

or Gw=s/Cr

where;

Cr denotes the amount of capital-output ratio needed to maintain the warranted

s denotes the saving-income ratio.

The above equation reflects that if the economy is to advance at the steady rate of Gw at its full
capacity, income must grow at the rate of s/Cr per year.

3. The natural growth rate (Gn):

The natural growth rate also known as the potential or the full employment rate of growth is the rate
of economic growth required to maintain full employment. The natural growth rate regarded as ‘the
welfare optimum’ by Harrod is the maximum growth rate which an economy can achieve with its
available natural resources.

The Natural growth rate is determined by natural conditions such as labor force, natural resources,
capital equipment, technical knowledge etc. The third fundamental relation in Harrod’s model
showing the determinants of natural growth rate is expressed as:

GnCr = or ≠s

Condition for the Achievement of Steady Growth:

According to Harrod, the economy can achieve steady growth when there is equality between G and
Gw at the same time between C and Cr . This condition can be expressed as:

G = Gw and C = Cr

Harrod states that a slight deviation of G from Gw will lead the economy away and further away from
the steady-state growth path. Thus, the equilibrium between G and Gw at this junction is considered
as a knife-edge equilibrium.

Interaction of G, Gw and Gn:

To achieve full employment equilibrium growth, the economy must satisfy the condition where
Gn=Gw = G. But this is a knife-edge balance. For once there is any divergence between natural,
warranted and actual rates of growth conditions of secular stagnation or inflation would be
generated in the economy. The same argument can be shown through the following diagram:

As shown in Panel-(A), if Gw>Gn, secular stagnation will develop resulting in unemployment. In such
a situation, Gw is also greater than G for most of the time because the upper limit to the actual rate
is set by the natural rate.

If Gw < Gn, secular inflation will develop in the economy. In such a situation, Gw is also less than G
for most of the time as the one shown in Panel-(B) of the above diagram.

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. Thus, in an advanced economy, s has to be moved up or down as the situation demands.

Diagram Representation of Domar Model:

Domar Model can also be explained with the help of the following diagram as below:

As shown in the above figure, the line S(Y) passing through the origin indicates the level of saving
corresponding to different levels of income. I0I0, I1I1 and I2I2 are the various levels of investment. Y0P0
and Y1P1 measure the productivity of capital corresponding to different levels of investment. The
lines Y0P0 and Y1P1 are drawn parallel so as to show that productivity of capital remains unchanged.
The level of income Y0 is determined by the intersection of saving line S(Y) and the investment line
I0I0. At the level of income Y0, the saving is Y0S0. When the saving Y0S0 is invested, it will increase the
income level from OY0 to OY1. The productive capacity will also rise correspondingly. The extent of
the income increase depends upon the productivity of capital, which is measured by the slope of the
line Y0P0 (α). Higher is the level of income higher the productive capacity. Similarly, when the level of
income is OY1 the level of saving is S1Y1. With investment of S1Y1 income will further rise to the level
Y2. This increase in income means expansion of purchasing power of the economy.

COMPARISON OF HARROD MODEL AND DOMAR MODEL

Similarities:

(i) The models are based on similar assumptions. It is for this reason that the names of Harrod
and Domar are clubbed in any discussion of growth models.
(ii) Both the models employ Keynesian saving-investment equality as a condition for steady
growth.
(iii) Both these models stress the “Knife-edge equilibrium”.
(iv) Both the models have been built in the context of advanced economies where capital is
found in abundance.
(v) As against Keynes’ macro-static theory, Harrod and Domar hold that a dynamic approach to
growth should be introduced in the long run.

Dissimilarities:

(1) Domar assigns a key role to investment in the process of growth while Harrod regards the level of
income as the most important factor in the growth process.

(2) Domar forges a link between demand and supply of investment while Harrod equates demand
and supply of saving.

(3) The Domar model is based on one growth rate αϬ. But Harrod uses three distinct rates of growth:
the actual rate (G), the warranted rate (Gw) and the natural rate (Gn).

(4) Domar gives expression to the multiplier but Harrod uses the accelerator about which Domar
appears to say nothing.

(5) Domar’s assumption that ∆I/I = ∆Y/Y. But Harrod does not make such assumptions.

SOLOW'S GROWTH MODEL

The Solow Growth Model is an exogenous model of economic growth that analyzes changes in the
level of output in an economy over time as a result of changes in the population growth rate, the
savings rate, and the rate of technological progress.

Solow’s model of growth is based on the following assumptions:

1. Only one single composite commodity, national output, is produced.

2. The production takes place according to the linear homogeneous production function of first
degree of the form, i. e., there are constant return to scale.

3. There is full employment in the economy.

4. There are two factors of production -capital and labour.

5. Labour and capital are substitutable for each other.

6. Technical progress does not influence the productivity and efficiency of labour.
7. There is flexible system of price-wage interest.

Following these above assumptions, Prof. Solow tries to show that with variable technical co-
efficient, capital labour ratio will tend to adjust itself through time towards the direction of
equilibrium ratio. If the initial ratio of capital labour ratio is more, capital and output will grow more
slowly than labour force and vice-versa. To achieve sustained growth, it is necessary that the
investment should increase at such a rate that capital and labour grow proportionately i.e. capital
labour ratio is maintained

The graph represents the output-per-effective-worker, on the Y-axis, for an economy over a specific
period. For simplicity, it assumes the absence of the government sector, zero population growth, and
constant labour productivity.

The graph represents a steady-state at the point where the line (n+d)k intersects with the sY curve.
The economy will always end up in a steady state. Steady-state is the key to understanding the Solow
model.

The depreciation curve, i.e., the straight line, is proportional to the amount of capital. With the
capital increase, depreciation also increases. Capital and labor also observe proportional growth.
Prof. Solow assumes constant returns to scale, so real output grows at the same rate (n), and output
per head of worker remains constant.

Extra investment increases the output. So, the output per worker increases with an increase in
capital per worker. However, the production function line, i.e., Y = f(K), shows that output per worker
increases at a diminishing rate as K (capital) increases due to the law of diminishing returns.

The saving rates (assumed fixed) are equal to actual investment, i.e., sY. So firms multiply their
investments by savings.

So one can observe that initially, Investment > Depreciation, i.e., capital grows.

In the next phase, Investment < Depreciation. It means the capital shrinks.

At the steady-state, Investment = Depreciation. At this point, all the investment is used to maintain
the depreciation.
Equation

Here is the Solow growth model equation-

For the sake of simplicity, analysts and economic researchers assume that the economy is a closed
economy without any external trade influence or government role. The most common equation used
in this growth model is-

Y = Af (K, L)

where Y= real GDP

 A = Measure of productivity

 K= Capita Share (measured in physical units or in $ value)

 L= Labor

For other equations of the Solow neoclassical growth model formula, one will be using the following
terminologies:

 Gw = Per worker GDP (Gross Domestic Product) and is also the capital’s square root

 Kw = Per worker capital

 Rd = Depreciation rate

 Rs = Rate of saving

For isolated economy, per worker GDP, G = Cw + Iw where Cw = per worker consumption & Iw =
investment per worker

Applying the above terminologies, the major equations of the Solow growth model steady state are:

1. Production function, Gw = function (per worker capital, K) = f(kW)

2. Investment, I= saving rate (per worker capital, Y) = Rs (Gw)

3. Consumption, C= (1-Rs) Gw

4. Variation in capita concerning labor ratio, Vcl = Iw-d Kw

5. If the Vcl becomes zero for an economy, it has achieved the steady-state. As a result, the per
worker investment gets equal to that of the product of the depreciation rate and per worker
capital. So, Iw = Rd* Kw

Implications of the Solow Growth Model

There is no growth in the long term. If countries have the same g (population growth rate), s (savings
rate), and d (capital depreciation rate), then they have the same steady state, so they will converge,
i.e., the Solow Growth Model predicts conditional convergence. Along this convergence path, a
poorer country grows faster.
Countries with different saving rates have different steady states, and they will not converge, i.e. the
Solow Growth Model does not predict absolute convergence. When saving rates are different,
growth is not always higher in a country with a lower initial capital stock.

THEORIES OF ENDOGENOUS GROWTH WITH SPECIAL REFERENCE TO ROMERS MODEL

The endogenous growth model states that the economic growth of any nation is an outcome of
internal factors like human capital, knowledge, and innovation. This principle stresses internal factors
and not exogenous forces.

This school of thought believes that governments and private sector enterprises should work on
endogenous elements contributing to research and development. This will lead to technological
advancement and a rise in productivity in the long run.

The origin of endogenous growth theory can be traced back to the 1980s. Economists back then
opposed Solow Swan's neo-classical growth model. The neo-classical model disregarded the impact
of exogenous forces on economic development. The exogenous growth model highlighted the role of
physical capital investments and infrastructure (exogenous factors) in causing a gap between
developed nations and under-developed nations.

But Paul Romer stated that investments made in R&D foster innovation and technological change
over a period and thus are a key influence behind economic growth.

Assumptions

The endogenous growth principle makes the following assumptions:

1. The government and private sector can ramp up technical progress by investing in research
and development programs.
2. The government should mold entrepreneurship to support innovation, capital investment,
and job creation.
3. Considerable investments should be made in learning and training programs—to enhance
productivity and human capital. Such an investment offers a return to scale.
4. Return to scale refers to a scenario where an increase in inputs is less, but the increase in
production output is considerably more.
5. Investing in technological advancement (optimization of the manufacturing process)
increases productivity.
6. Entrepreneurs and businesses that opt for R&D get incentives in the form of intellectual
property rights—copyrights and patents.

The endogenous theory has proposed various growth models, as discussed below:

Arrow Model

The arrow model, or AK model, was first developed in 1962 by Arrow and Frankel. This economic
model recognizes technology and innovation as key forces that drive the economic growth of a
nation. This theory emphasizes the practice of ‘learning by doing’ to enhance human capital,
productivity, and innovation. It is denoted by:

Y = AK
Here,

A is a constant positive value.

K is the aggregate capital stock.

Y is proportional to K.

Uzawa–Lucas Model

In 1965, Uzawa proposed an endogenous growth model that narrowed down on human capital
investments—causing long-term growth in an economy. Further, in 1988, Lucas contributed to the
idea that investing in education is necessary for increasing the productivity of human capital. Lucas
proposed internal training of workers (to improve production).

The Uzawa-Lucas Model is presented as follows:

Yi = A(Ki) x (Hi) x He

Here,

A resembles the technical coefficient.

Ki is the physical capital.

Hi is the human capital.

He denotes the economy's average level of human capital.

Romer Model

In 1990, Paul Romer introduced Endogenous Technological Change in the Journal of Political
Economy. Romer stated long-run growth results from the contribution of entrepreneurs and
researchers in the form of innovation and technological advancement. He, too, stressed the
importance of new ideas, learning, and knowledge in economic growth. Further, he believed that the
government should support and play a crucial role in appreciating innovative ideas.

The technological production function given by Romer is as follows:

∆A = F (KA, HA, A)

Here,

∆A is the increasing technology.

F is the production function for technology.

KA denotes the capital investment in developing the new technology.

HA is the human capital used for research and the development of new ideas.

A is the current technology.

Limitations

1. Due to the lack of empirical evidence favouring the endogenous growth theory, it cannot be
considered a proven model.
2. Also, this theory depends upon various assumptions; the assumptions often seem vague or
inaccurate for real-world applications.
3. It considers physical and human capital as two different factors: one is external, and the
other is internal. However, some critics believe there is no difference between these two
forces.