Harrod-Domar model
The Harrod-Domar model is used in economics to explain an economy's growth rate in terms of the level of saving and productivity of capital. It suggests there is no natural reason for an economy to have balanced growth. It was the precursor to the Exogenous growth model.
The model was developed independently by Sir Roy F. Harrod in 1939 and Evsey Domar soon afterwards.
According to the model there are three concepts of growth;
- Warranted growth – the rate of output growth at which firms believe they have the correct amount of capital and therefore do not increase or decrease investment, given expectations of future demand.
- Natural rate of growth – The rate at which the labour force expands, a larger labour force generally means a larger aggregate output.
- Actual growth – The actual aggregate output change.
Two problems are seen in an economy according to the model; Firstly, the relationship between actual and natural growth rate, as factors that determine actual growth are separate from those that determine natural growth. Factors such as birth control, culture and general tastes determine the natural rate. Whereas other effects such as propensity to save influence actual output. There is no guarantee an economy will achieve output large enough to sustain full employment.
The Second problem identified in the model is the relationship between actual and warranted growth. If it is expected that output will grow, investment will increase to meet the extra demand. The problem arises when actual growth either exceeds or fails to meet warranted growth expectations. A vicious cycle can be created; where the difference is exaggerated by attempts meet the actual demand, causing economic instability.
Findings
Although the Harrod-Domar model was initially created to help analyse the business cycle it was adapted to help explain economic growth. Its implications were that growth depends on the quantity of labour and capital, more investment leading to more capital accumulation, increasing economic growth. It also had implications for less economically developed countries; labour is in plentiful supply, however physical capital is not, and slows economic progress. LEDC’s do not have high enough average incomes to allow saving, and therefore accumulation of capital stock.
The model has been used to imply that economic growth depends on policies to increase saving (investment), and using that investment more efficiently through technological advances.
The model concludes that an economy does not find full employment and stable growth rates naturally, similar to the Keynesian beliefs.
Criticisms of the model
The main criticism of the model is the level of assumption, one being that there is no reason for growth to be enough to maintain full employment, this is based on the belief that the relative price of labour and capital is fixed, and that they are used in equal proportions. The model explains economics boom and bust by the assumption that investors are only influenced by output (known as the accelerator principle), this is now widely believed to be false.
In terms of development, criticisms are that the model sees economic growth and development as the same, in reality, economic growth is only a part of development. Another criticism is that the model implies poor countries should borrow to finance investment in capital to trigger economic growth, however, history has shown that this often causes repayment problems later.