Harrod Domar Growth Model Equation
Harrod Domar Growth Model
The Harrod-Domar model, developed independently by Sir Roy Harrod in 1939 and Evsey Domar in 1946, is a 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.
The Harrod Domar Growth Model suggests that the rate of economic growth depends on two factors, namely:
- Level of National Savings
- The productivity of capital investment (Capital-Output Ratio)
The Harrod-Domar model posits that when there are high levels of savings and a low capital-output ratio because more investment will occur to generate economic growth at a steady pace. When savings rates decrease or the capital-output ratio increases, however, economic growth will be less stable.
Saving in a country can lead to an increase in borrowing for firms, which helps them invest more. This investment leads to higher production levels and economic growth.
The capital-output ratio measures the productivity of investment. If this ratio is low, then more input is needed to produce a certain amount of output.
Harrod Domar Growth Model Equation
To get the Harrod Domar Growth Model equation, assume that Y be GDP and S be savings. The level of savings is a function of the level of GDP, say S = sY. The level of capital K needed to produce an output Y is given by the equation K = σY, where σ is called the capital-output ratio. Investment is a very important variable for the economy because Investment has a dual role.
The investment I represent an important component of the demand for the output of an economy and the increase in capital stock. Thus ΔK = σΔY. For equilibrium, there must be a balance between supply and demand for a nation’s output. In simple case, this equilibrium condition reduces to I = S. Thus,
I = ΔK = σΔY
and I = S
σΔY = sY.
Therefore the equilibrium rate of growth g is given by
g = ΔY/Y = s/σ
In other words, the equilibrium growth rate of output is equal to the ratio of the marginal propensity to save and the capital-output ratio. This is a very significant result. It tells us how the economy can grow such that the growth in the capacity of the economy to produce is matched by the demand for the economy’s output.
When an economy moves too far from the Harrod-Domar equilibrium, it risks falling into a recession or depression.
Importance of Harrod Domar Growth Model
Although the Harrod-Domar model was created to help analyze the business cycle, it later revealed its true potential in explaining economic growth. It achieved this by recognizing that growth relies on two factors: labor and capital. More investment leads to more accumulation of capital which then creates economic growth.
In the Harrod–Domar model, economic growth is dependent on policies to increase investment in order to increase saving and using that investment more efficiently through technological advances.
Harrod Domar Growth Model Criticism
- The Harrod-Domar model has been criticized for being a closed system of equations, and it does not take into account the presence of foreign trade. In addition, it is unable to explain why some economies
- The Harrod-Domar models ignore the effect of government programs on economic growth. But if the government undertakes development programs, there is no causal (functional) relationship between them and economic growth according to Harrod-Domar models.
- The Harrod-Domar model is an oversimplified analysis of complex factors that go into economic growth.
- There are examples of countries who have experienced rapid growth rates despite a lack of savings, such as Thailand as argued by the Harrod-Domar model
- The story of Harrod and the great recession is not just about economics, but also about society. The model that he created is based on assumptions that are no longer true in today’s world. One man was a key figure in shaping economic theory who believed marginal productivity would lead wages to increase as employers grew more desperate for workers; the other argued there was no reason for actual growth to equal natural growth and that economies had no tendency to full employment- this assumption was based on wage being fixed. However, these beliefs are now challenged by many economists – it has
- Economic growth is necessary but not sufficient for economic development. This means that an economy needs to grow before it can develop, and economies with high rates of growth are more likely than the average to achieve higher levels of development in a shorter period of time.