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- 1. DOMAR’S GROWTH MODEL Prof. Prabha Panth, Osmania University
- 2. Domar’s Growth Model (1946) • Objective: to find that rate of growth of NY which full employment requires – i.e. Full employment, steady growth. • Domar was interested in analysing: How an economy that has reached full employment, can grow at a constant rate in the future. • His model analyses long term growth of capitalist economies. • Post Keynesian model, • I =→ S, investment equals savings, and importantly determines savings. 26-Sep-13 2
- 3. Features of Steady Growth • Steady growth: the rate of growth should remain constant over time. • NY of an economy should grow at a constant rate; e.g. if NY is growing at 3%, it should always increase at 3%. • If it keeps fluctuating then there is unsteady growth. • Steady growth is also called ‘Equilibrium growth.’ • In steady growth, aggregate supply = aggregate demand while the economy is growing. 26-Sep-13 3
- 4. In Steady growth all the following grow at the same rate: the rate of Investment (I/I), = the rate of growth of capital stock (K/K), or capital accumulation, = the rate of growth of income or output (∆O/O) = the rate of growth of employment (N/N) As such the following remain constant in steady growth: • aggregate capital output ratio (K/O), • the aggregate savings ratio (S/Y), • the capital intensity (K/L) 26-Sep-13 4
- 5. Assumptions of the model 1. Aggregate model: aggregate Y, C, I, and S. 2. No changes in price level, 3. Net investment = ∆K (K accumulation), durable K. 4. O/K ratio () is constant, given by technology, 5. Keynesian framework, I → ∆Y → ∆C and ∆S, i.e. I =  S. 6. S/Y = ∆S / ∆Y and both are constant, 7. Full employment and full capacity utilisation, 26-Sep-13 5
- 6. Steady Growth Equation 1) Supply side: Y = I × , where  = ∆O/ ∆K, the incremental output-capital ratio. 2) Demand side: ∆Y = 1/s × ∆I, where 1/s = multiplier. Steady growth requires S = D, or (Y = I × ) = (∆Y = 1/s × ∆I) ∆Y/Y = (I ×  = 1/s × ∆I), or Or ∆Y/Y = ∆I/I = G = s ×  This is Domar’s equation of Steady growth: G = s ×  The exponential growth equation: It = I0 e(s)t Example if s = 0.2, and  = 0.4, then G = 0.08 = 8% growth 26-Sep-13 6
- 7. Twin Effects of Investment • Following Keynes, Domar showed that I = → S. • After full employment is reached, Investment has two simultaneous effects: 1) It leads to increase in National Income via the multiplier, thus increasing Aggregate Demand. Keynes, short term analysis. 2) But investment also leads to increase in the productive capacity of the economy, i.e. increase in the stock of capital, Domar: long term growth. 26-Sep-13 7
- 8. • DUAL nature of investment: (a) Investment  leads to increase in Y and increase in C, i.e. Aggregate Demand . (b)Investment  leads to increase in K, and productive capacity . Aggregate Supply  It is not necessary that these two will exactly match, i.e. Increase in D  increase in S. Also there is a time gap between the two. Only if these two are equal, then there will be steady growth. There is only one unique rate of growth that can equate them. 26-Sep-13 8
- 9. Asymmetrical effects of Investment • I  ∆Y at a constant rate, and is determined by the multiplier (∆Y = I × 1/mps). • Aggregate D increases at a constant rate. • But I  ∆ K, more and more addition to capacity or to capital each year with Investment . • Aggregate S increases at a faster rate. • Therefore growth in Y has to be faster to keep up with growth in capacity. • Otherwise there will be unused capacity in the economy. 26-Sep-13 9
- 10. Example of asymmetrical effects of Investment Let s = 0.2,  = 0.5, initial capacity = 100 Year 1 2 3 4 ∆I 200 200 200 200 Y = ∆I .1/s =200 × 1/0.2 1000 1000 1000 1000 Capacity= 1000 + ∆I .  = 1000 + (200 × 0.5) 1100 1200 1300 1400 26-Sep-13 10 Increase in Y is constant. But capacity increases each year, so there is a gap between S and D
- 11. How to achieve steady growth • In the above example, ∆I is constant each year. • Domar points out that ∆I should increase each year for D to catch up with S. • The steady growth of this investment should be equal to: G = ∆I/I = s ×  • ∆I should increase at a steady rate every year. • In this example = s ×  = 1/5 × ½ = 1/10 = 10%. • If this economy grows at 10%, then it is possible for demand to catch up with supply, – There is steady growth. – But it takes place after one year’s time lag. 26-Sep-13 11
- 12. Steady Growth Taking s = 0.2,  = 0.5, initial capacity = 100, G = 10% Year 1 2 3 4 ∆I 200 220 242 266.2 ∆Y = ∆I .1/s 1000 1100 1210 1331 Capacity = ∆I .  1100↗ 1210↗ 1331↗ 1464↗ 26-Sep-13 12 By increasing Investment by 10% each year, it is possible to increase effective demand ∆Y, and make it equal to increase in capacity or Supply. This ensures steady growth, but after a time lag.
- 13. Junking • Domar showed that if the economy is not having steady growth, it leads to junking of extra capital. • Hundreds of entrepreneurs invest independently. • So actual capital stock > required capital stock for steady growth. • Therefore the extra capital will be “junked” • It may also lead to fall in investment, and to disequilibrium situation again (recession). 26-Sep-13 13
- 14. Criticism 1) Domar does not have an Investment function, on what factors does investment depend? 2) O/K or  is constant, no technical progress. 3) Full employment is not discussed, but assumed. 4) Aggregate analysis, 5) Does not show how to make G = s ×  if the system is not in steady growth. 6) Does not discuss inflationary situation, only over production and recession. 26-Sep-13 14

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