Economic Growth Models: Harrod-Domar Growth Model

There are many theories and models to explain the process of economic growth. These theories are also called growth models. Growth models set out the quantitative relationship among the critical variables in a rigorous form. Harrod, Domar and Harrod-Domar models are some of them which might be relevant for general understanding:

Harrod Model (HM)

R.F. Harrod showed through his model that steady growth rate may be achieved with fixed capital output ratio and fixed propensity to save. He also explained the conditions that need to be fulfilled to maintain this steady growth rate. He further elaborated how natural resources put a ceiling on the growth rate of the economy.

Statement of the Model

It is based on three growth rates:

• Actual Growth Rate (G)- It is the real rate increase in a country’s GDP per year.
• Warranted Growth Rate (Gw)- It is the growth rate which is attainable at full employment level.
• Natural Growth Rate(Gn)- It is the maximum growth rate that can be attained by an economy, given the natural resources. It is determined by macro variables like population technology, natural resources etc.

Policy Implications of the Model

It is advisable to make such policy instruments that help to decrease the savings, if Gn < Gw , it will increase Aggregate Demand. But if Gn > Gw , then decrease in savings will lead to inflation and hence it should be increased.

The Harrod Model and Trade Cycles

(a) When Gw > Gn at full employment level, there will be recession in the economy.

(b) When Gw < Gn at full employment level, there are two probabilities.

• There is a strong probability that in the long run it will ride above Gn and if so happens there will be vicious spiral of depression after attainment of full employment level.
• If Gw does not overtake Gn in the long run, there will be inflation in the economy.

Critique of the Harrod Model

In real scenario, there is no evidence of the existence of fixity of production function, saving ratio, growth rate of labour force as assumed by Harrod. There are many other factors leading to economic growth like improvement in technology which Harrod model does not discuss.

The Domar Model (DM)

The Domar model has tried to explain that what should be the growth rate to maintain full employment equilibrium in the economy? Domar Model has explained the conditions which need to be satisfied to attain the given goal.

Assumption of the Model

The assumptions of the Domar Model are as follows:

• Employment is a function of utilization ratio i.e. the ratio between actual output and productive capacity.
• Productive capacity can be increased by a given ratio via past and present investment.

Policy Implication of the Model

Sufficient investment is required to attain dual objective:

• To utilize the resources of the economy fully.
• To ensure that economy will be able to produce more in the future according to increased demand.

Harrod-Domar Growth Model

Harrod Model and Domar Model differ in details, but the ideas contained in both of the models are so similar that the two models have got integrated and more generally are presented as a single united model, known as the Harrod-Domar Model (HDM).

Essence of the Model

• Unless and until capital formation and increase in real national income go side by side, growth will not sustain for long.
• HDM considered demand as well as supply side of the investment process and thus, integrated the classical and Keynesian analysis.

Substance of the Model

In HDM, Investment in the economy plays a dual role. It affects Aggregate Demand as well as Aggregate Supply because on the one hand, investments increases productive capacity, and at the same time it generates income through multiplier effect.

With the increase in capacity the economy can produce greater output and greater employment, depending on the level of MPS.

There are three growth rates: Actual Warranted and Natural; the equality amongst the three ensures full employment of labour and capital stock.

The theory also explains trade cycles. When there is G > Gn, then there will be unemployed resources in the economy, hence, the economy will be in the recovery phase.

• When G = Gn, there will be full employment of resources.
• When G < Gn, there will be slump in the economy.

Limitations of the HDM Model

Following are limitations of the HDM model:

• Assumption of constant propensity to save and capital-output ratio is questioned by many economists. If these parameters change, there would be change in requirements of steady growth.
• It is well known aspect that as an economy grows, there is change in the relative importance of the three sectors, namely, primary, secondary and territory.
• HDM assumes the requirements of capital and labour per unit of output are constant i.e. capital-output ratio and labour-output ratios are constant. Actually, different factors of productions are not perfect substitutes but can be substituted for each other to a limited extent.
• The HDM is worried about steady growth but is neglecting the rate of growth. However, the aim of developing countries is to increase rate of growth.

HDM model is no where incorporating the role of government in influencing the growth process in the economy as it is based on laissez-faire policy. Hence, it is not relevant for developing economies particularly those in which government is playing a dominating role like India and China. HDM is constructed on basis of aggregates and can not show the inter-relations between the sectors and hence does not demonstrate structural changes.