Harrod – Domar Model - Development Model.pptx

Harrod – Domar Model
Prof. Nithin Kumar S
Assistant Professor
Department of Economics
J.S.S Banashankari Arts, Commerce and
Shantikumar Gubbi Science College
Vidyagiri, Dharwad - 580004

Sir Henry Roy Forbes Harrod
(13 February 1900 – 8 March 1978)
Evsey David Domar
(April 16, 1914 – April 1, 1997)
Prof. Nithin Kumar S 2

Introduction
• All economic and non-economic factors which are visible in the
process of development are in the purview of this model.
• Economists R.F. Harrod and E. Domar have been credited with
developing a more acceptable economic model by way of cause
and effect analysis of various factors which are part and parcel in
attainment of long- run development and helpful in maintenance of
economic stability.

• Study of conditions necessary for growth of national income in a
country without any obstacles has been the subject matter of
Harrod-Domar model.
• Harrod and Domar strongly feel that capital formation and
investment of capital play a decisive role in economic
development.
• They have assigned a crucial role for accumulation of capital in the
process of growth in the same way as classical economists.
• According to Harrod and Domar, investment has two
characteristics. They are:

I. Firstly, it generates income. That is, investment
promotes effective demand by way of multiplier.
II. Secondly, investment raises productive capacity
in the economy through expansion of capital
accumulation.

• Harrod and Domar have propounded a development model
helpful to determine economic growth, i.e., rise in national
income by way of combining capital-output ratio with
investment ratio.
• These economists have developed their analysis by using
macro factors in the same way as Keynes.
• Harrod-Domar model is influenced by "Income Theory"
that had emerged from Keynesian economics. In this sense,
it may be aptly considered to be a post Keynesian economic
model.

Assumptions
1. Full employment level income will be in existence
in the economy.
2. Marginal propensity to save and capital-output
ratio remain constant.
3. Average propensity to save will be equal to
marginal propensity to save.

4. Interest rates do not undergo any change.
5. Stability prevails in the price level.
6. Capital goods will be usable for infinite
period.

7. Income, investment and savings are taken into
consideration in net terms. That is, depreciation cost is
not included in these variables.
8. Savings and investment will be equal.
9. Time lag does not exist between investment and
generation of productive capacity.
10. There is absence of governmental interference in
economic activities.

11. Closed economy will be in existence. In other words, there
will be no net foreign trade and external aid.
12. Actual investment will be equal to proposed investment in
the economy.
13. 'Capital' includes both fixed capital and variable capital.
14. Savings and investment are related to the income of the
same year.

R.F. Harrod in his model has brought three issues
to the forefront. They are:
I. The method of achieving steady growth in the
fixed capital output situation.
II. The method of maintaining steady i.e., stable
economic growth.
III. The way in which natural factors limit the rate
of growth in the economy.

• In the process of analyzing these issues,
Harrod has introduced the following three
distinct concepts as regards growth rate.
I. Actual rate of growth,
II. Warranted rate of growth, and
III.Natural rate of growth.

Actual Rate of Growth
• Actual rate of growth is that rate of growth determined by savings and
supply of capital ratio.
• In Harrods model, actual rate of growth is shown by the letter ‘G’
• Actual rate of growth is determined by the sums of savings available in the
country and actual investment.
• It shows the ratio of change in income in the total income in a given period.
• This is expressed with the help of the following equation.

• G=
Δ𝒀
𝒀
• Y= Total income
• ΔY = Ratio of change in income.

• Actual rate of growth gets determined by the
two factors of savings-income ratio and
capital-output ratio.
• The relationship between actual growth and its
determinants in expressed through the
following equation.

• GC=S
• Where,
• G= Actual rate of growth
• C= Capital-output ratio [
𝜟𝑲
𝜟𝒀
]
• S= Savings-income ratio [
𝑺
𝒀
]

• Therefore:
• G=
𝜟𝒀
𝒀
• Y denotes total output (Income) and ΔY denotes
increased output (income).
• C indicates increase in capital. It expresses the
amount of capital in the increased output in a
given period.

• Therefore:
• C=
𝜟𝑲
𝜟𝒀
=
𝟏
𝜟𝒀
• ΔY denotes rise in output and I represents increase
in capital. S stands for propensity to save.
• Therefore: S=
𝑺
𝒀
• Y shows total income and S denotes total savings.

• Harrod held the view that steady economic growth
(Growth with stability) occurs in a situation where
expost savings are equal to expost investment.
• This is expressed through an equation as follows:
•
𝚫𝒀
𝐘
X
𝟏
𝚫𝒀
=
𝑺
𝒀
OR
•
𝟏
𝒀
=
𝑺
𝒀

• This equation denotes equality between savings and
investment.
• In Harrod's opinion, amount of money supplied out of
sayings constitutes supply of capital.
• Propensity to save is the factor determining supply of
capital.
• To find out total investment, G is to be multiplied with
capital-output ratio.
• Harrod believed that steady economic growth is possible
when investment in equal to savings.

Warranted Rate of Growth
• Warranted rate of growth is shown with the
help of letters GW.
• The following equation illustrates warranted
rate of growth.
• Gw Cr = S

• 'Gw' represents warranted rate of growth. Harrod
defined warranted rate of growth as the one which
could be attained by effectively utilizing the available
resources in the prevailing situations.
• Attainment of this rate of growth makes the
entrepreneurs be satisfied with a feeling that they were
able to increase their income and profits by adopting
efficient methods of production.

• This concept indicates that the investment executed has
created adequate volume of output and income without
being wasted.
• Functioning of the economy at the maximum level by
utilizing the machineries and manpower to the fullest
extent is revealed by this concept.
• Gw is determined by the factors of capital-output ratio
and savings income ratio.

• Cr denotes demand for capital.
• It is the size of capital needed to maintain
warranted rate of capital.
• Total amount of capital needed is known by
multiplying Gw with Cr.

• S denotes propensity to save and shows the supply of
capital.
• Requirement of total amount of capital is known by
multiplying Gw with Cr.
• S stands for propensity to save and represents supply of
capital.
• Attainment of stable economic growth on the part of
the economy needs equality between G and Gw and
between C and Cr (G=Gw and C=Cr)

• Thus, this equation elucidates the following points
1. Actual rate of growth should be equal to warranted rate of
growth.
2. When saving coefficient (S) is of a given extent, capital
output ratio needed to attain actual rate of growth should
be equal to capital-output ratio required to maintain
warranted rate of growth. The implication of this is,
actual investment being equal to expected investment is
the most essential factor for attainment of stable
economic growth.

Natural Rate of Growth
• Harrod has defined that "Natural rate of growth is
the trend in production with full employment and
non-inflation. It is the rate of advance which the
increase in population and technological
improvements allow.“
• Natural rate of growth is expressed with the help
of the following equation

• G=Gw=Gn
• In the above equation, G stands for 'actual rate of
growth'.
• This is determined by the volume of savings and
investment in the economy.
• In other words, it indicates the ratio of changed income
out of the total income.
• G represents the rate of growth actually experienced by
the economy.

• Gn represents 'natural rate of growth'.
• It is determined by a long range of variables
such as population, technology, capital and
natural resources.

• In Harrod's view, equilibrium situation among G, Gw and
Gn is a necessary factor.
• If this equilibrium is disturbed, the economy will be in utter
chaos as a result of inflation and secular stagnation.
• Desired savings exceed the level of desired investment
when Gw is more than G.
• Growth is regarded as a result of utilization of these savings
for unnecessary expenditure.

• On the other hand, when G exceeds Gw, investment rises
above the level of savings and peak in economic activities
and output occurs as a result of massive amount of income.
• This process continues to take place till the economy
reaches the Gn level.
• Accomplishment of economic growth is not possible
beyond the level of Gn.
• For, natural resources and labour become scarce after this
level.

• Excess of Gw over Gn leads to abundance in the availability of capital
goods and deficiency of labour.
• Capital goods remain stagnant in such a situation leading to decline in
investment, output, income and the level of employment.
• Deflation catches momentum leading to economic recession and fall in the
rate of economic growth.
• Instead, more of Gn than Gw results in surplus of labour and scarcity of
capital goods. Desired level of investment will be very high and rising
profits will be the trend. Over production and inflation will emerge out of
this situation. Unemployment reaches intolerable extent gradually.

• The foregoing analysis brings us to the
conclusion that equilibrium among actual rate
of growth, warranted rate of growth and
natural rate of growth is an essential condition
to maintain economic stability and to keep the
economy out of any problems.

Introduction
• In his model, Prof. Domar has assigned greater role to investment of
capital.
• He has stated that net investment has the ability to create capacity in
the economy.
• Domar argued that investment, on the one hand, creates income, and
on the other rises productive capacity.
• His analysis focuses on the level of warranted rate of investment to
increase income to be equivalent to productive capacity in order to
maintain the level of full employment.

• Domar emphasizes that "the economy will be said to
be in equilibrium when its productive capacity
equals to its national income (N)."
• Determination of the rate of growth of income for full
employment to prevail in the economy at all times has
been discussed in Domar's model.

• Domar's model has been evolved as a strong reaction to John Maynard Keynes'
theory.
• Two factors are notable in this context.
1. In Domar's view, investment has the effect of raising the productivity in the same
way as it has the effect of creating income. It can increase productivity by way of
the capacity to generate output.
2. Domar's another criticism has been that, Keynes has taken into account only
unemployment of natural resources and has neglected the unemployment of
capital. When capital assets are not involved in production and they lie idle,
volume of investment will be restricted and income declines. Fall in income leads
to deficiency of demand and rise in the extent of unemployment.

• In a broader way, Domar's model may be
described with the help of two equations.
• Yd=
𝟏
ɑ
• Yd= the level of national income or effective
demand at full employment level.
• I= Net investment which results in increase in real
capital.
• ɑ= Marginal propensity to save.

• This equation explains the demand side of
investment.
• The equation shows that the level of national
income is directly proportional to net investment.
• Rise in the level of investment causes an upward
movement in national income, whereas decline in
investment results in fall in the size of national
income.

• Effective demand will be inversely proportional
to marginal propensity to save.
• That is, in the size of national income.
• Effective demand will be inversely proportional
to marginal propensity to save.
• That is, with increase in propensity to save, the
amount of disposable income declines and
effective demand comes down.

• Ys=σK
• Ys= Supply of output at full-employment level
• σ= Productivity of capital or net investment
• K= Amount of real capital.
 This equation represents supply side of investment.
 The equation tells that supply of output at the full-employment level
(Ys) is dependent upon productive capacity of capital (σ) and the
amount of real capital (K).
 Rise in these factors leads to elevation in the supply of output and
vice-versa.

• Equality between the demand side and the
supply side is an essential factor for
equilibrium to be established in the economy.
• Yd=Ys That is,
•
𝟏
ɑ
=Σk or
• Ι=ασκ

Similarities in Harrod and Domar
Models
1. Both the models are based on the same type of assumptions such as
closed economy, no time lag, and lack of government interference,
equality of marginal and average savings and attainment of full
employment.
2. Both the models are of the view that in order to maintain full
employment, desired savings resulting from full- employment level
income should be equal to the amount of desired investment.
3. Both the models exhibit the characteristic of being applicable to only
advanced economies.

4. Both the models are macro dynamics in scope.
5. Equilibrium path has been recognized in both the models.
6. Both Harrod and Domar believed that economic tragedy was
sure to occur if the economy diverts from the equilibrium path.
7. Both Harrod and Domar have argued for introduction of
dynamic element for attainment of steady economic growth.
8. In both the models, rise in investment is the initial point and
attainment of full-employment is the last one.

Dissimilarities
1. Harrod's model is based on the principle of acceleration, whereas
Domar has developed his theory on the basis of the principle of
multiplier.
2. Acceleration co-efficient is psychological in Harrod's model, while
it is technological in Domar's model.
3. In Harrod's model, certain behavior pattern is assumed on the part
of the entrepreneur which induces him to undertake investment.
No such behavior pattern is assumed in Domar's model.

4. In Harrod's model, business cycle is an integral part of the path of growth,
while business cycle is not a major factor in Domar's model.
5. Harrod analyses three distinct rate of growth such as actual rate,
warranted rate and natural rate, but Domar uses only one concept as far as
growth rate is concerned.
6. Harrod has indicated the marginal propensity to save with the help of ɑ
(Alpha) a Greek word but it is represented by letter 'S' in Domar's model.
7. In Domar's model, productivity of capital, i.e., output- capital ratio, is
shown by the Greek letter σ (Sigma). In Harrod's model capital-output
ratio is indicated by the letter 'C'.

Criticisms on Harrod-Domar Model
1. Unrealistic assumption of constancy of propensity to save and capital-output ratio
2. Macro factors
3. Consideration of factors in real terms
4. No consideration of changes in price
5. Neglect of the role of government
6. Unrealistic assumption about the rate of interest
7. Lack of clear explanation of warranted rate of growth
8. Unrealistic assumption of closed economy
9. Neglect of non-economic factors
10. Not consistent with the conditions of underdeveloped countries

1. Unrealistic assumption of constancy of
propensity to save and capital-output ratio
• This model has been evolved based on the assumption of constancy of
marginal propensity to save and capital-output ratio.
• In fact, this assumption in unrealistic.
• For, they undergo change in the long run.
• Fluctuation in these factors gives a different turn to the development
process.
• Validity of Harrod-Domar model has taken a beating as a result of its
assumption of constancy of propensity to save and capital-output ratio.

2. Macro factors
• The variables introduced in this model
are macro in nature, and hence they are
incapable of explaining mutual
relationship among different sectors.

3. Consideration of factors in real
terms
• Another drawback of this theory is that variables
introduced in it are analyzed in real terms.
• As a result, the study of the effect of monetary
and price factors on savings, investment and
demand has become a difficult task.

4. No consideration of changes in
price
• This model has failed to take into
consideration the role of price changes in the
development process.
• This has rendered this model to be irrelevant.

5. Neglect of the role of government
• Harrod-Domar model is incomplete since it has
ignored the role of government in the
development process.
• It is a known fact that government is involved in
implementation of a large number of programmes
to attain development.

6. Unrealistic assumption about the
rate of interest
• The model is based on the unrealistic
assumption of constancy of rate of interest.
• However, rate of interest is subject to
fluctuations, and the changing rate of interest
has a very deep effect on investment and
growth process.

7. Lack of clear explanation of
warranted rate of growth
• Harrod has failed to give a lucid
description of the concept of
warranted rate of growth.

8. Unrealistic assumption of closed
economy
• The assumption of the existence of closed
economy and absence of net foreign trade and
aid in questionable.

9. Neglect of non-economic factors
• Another major defect of this theory is its failure to take
political, social and cultural factors into cognisance.
• In fact, these factors play a dominant role in the process
of economic development.

10. Not consistent with the conditions of
underdeveloped countries
• Harrod-Domar model does not fit into the conditions of
underdeveloped countries.
• The model is applicable only to capitalist as well as
developed countries since it concentrates to analyze the
process of maintenance of economic stability.
• The fundamental problem of underdeveloped countries is
not maintenance of economic stability, but attainment of
development.

Conclusion
• Validity and importance of Harrod-Domar model cannot be
overruled in spite of these drawbacks.
• It has succeeded in providing basic tools to analyze the
process of economic growth of developed countries.
• Many economists have been of the opinion that the model
has its validity even to the conditions of underdeveloped
countries with certain modification.

• The model is a great success in providing a
knowledge of factors essential for attainment
of steady growth.
• Influence of Harrod-Domar model is extra
ordinary in the post-Keynesian economic
thinking and building up of economic model.

Harrod – Domar Model - Development Model.pptx

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