| Harrod-Domar model | growth model used in development economics that
states an economy’s growth rate is dependent on the level of saving and the capital-output ratio. Explains growth in terms of the level of savings and productivity of capital. This model of economic growth has been applied to the problems of economic development.
This model also explains three types of growth: warranted growth, actual growth rate, and natural growth. |
| The Harrod-Domar model was developed independently by | Sir Roy Harrod in 1939 and Evsey Domar in 1946. |
| The capital output ratio measures the | productivity of the investment that takes place. If the capital-output ratio decreases the economy will be more productive, so higher amounts of output are generated from fewer inputs. This again leads to higher economic growth. |
| TYPES OF GROWTH | • Warranted Growth
• Actual Growth Rate
• Natural Growth Rate |
| Warranted Growth | All resources are fully utilized. The warranted growth rate of growth where all savings are converted or used as capital. it is a rate of growth at which the economy does not expand indefinitely or goes into recession. the growth the rate at which all saving is absorbed into investment. |
| Actual Growth Rate | - Measures economic growth as expressed by gross domestic product (GDP) per year. Actual/Real economic Growth Rate reveals changes in the value of all goods and services produced by an economy - the economic output of a country - while accounting for price fluctuations. |
| Natural Growth Rate | It is the rate required to maintain full employment. Natural growth rate. For example, if the labor force grows at three percent per year, the
economy's annual growth rate must also increase at 3% to maintain full
employment |
| FACTORS AFFECTING ECONOMIC GROWTH | • Savings
• Marginal Efficiency of Capital
• Depreciation |
| Savings – | – Higher savings enable greater investment in capital stock. It is the
proportion of national income that is saved. |
| Marginal Efficiency of Capital | This refers to the productivity of investment, e.g.,
if machines costing £30 million increase output by £10 million. The capital-output
the ratio is 3.
?(Economic Growth) =
?(Savings Ratio)/
? (Capital Output Ratio) |
| Depreciation | – old capital wearing out. It refers to the decline in value of a capital
asset |
| Harod-Domar Model | Increased savings> Increased investment> Higher capital stock> Higher economic growth |
| Savings | – represents the supply of loanable funds in the economy for investment. A high saving rate indicates that the economy has significant funds to increase capital stock and productive capacity. An increase in the savings rate leads the economy towards higher growth. |
| Investment | it is the production of goods that will be used to produce other goods. The
action or process of investing money for profit or material result. |
| Capital stock | the savings rate is positively correlated with capital stock. A higher saving
rate allows for more significant capital investment. |
| GENERAL ASSUMPTIONS | • A full-employment level of income already exists.
• 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.
• The model assumes constant returns to scale for the capital-output ratio and the
propensity to save.
• Investment is net, that is, gross investment minus depreciation. Thus, the capital
stock changes by net investment. |
| LIMITATIONS | • 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.
• 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.
• The constant marginal return on capital is not valid. An increase in 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 |
