UNIT 2 HARROD-DOMAR GROWTH

MODEL
Structure
2.0 Objectives
2.1 Introduction
2.2 Background to the Harrod-Domar Model
2.2.1 Essence of the Model
2.2.2 Assumption of the Model
2.3 The Harrod Model (HM)
2.3.1 Statement of the Model
2.3.2 Assumption of the Model
2.3.3 Policy Implication of the Model
2.3.4 The Harrod Model and Trade Cycles
2.3.5 Critique of the Harrod Model
2.4 The Domar Model (DM)
2.4.1 Statement of the Model
2.4.2 Assumption of the Model
2.4.3 Policy Implication of the Model
2.5 Comparison of Harrod Model and Domar Model (HDM)
2.5.1 Similarities
2.5.2 Dissimilarities
2.6 Harrod-Domar Growth Model
2.6.1 Substance of the Model
2.6.2 Limitations of the Model
2.7 Let Us Sum Up
2.8 Key Words
2..9 Some Useful Books
2.10 Answers to Check Your Progress Exercises

2.0 OBJECTIVES
After reading this unit you should be able to:
• Understand the background in which this model came to be developed by two
different economists, each working independently enters at the others, but still
reaching the same results;
• Appreciate the role of savings and investment in the growth process, as
expounded by Harrod, and the implication of this relationship;
• Express the role of savings and investment in the growth process, as expounded
by Harrod, and the implications of this relationship;
• Identity the similarities and dissimilarities between the Harrod Model and the
Domar Model; and
• Develop an integrated view of the Harrod Model and the Domar Model, and get
a clear idea of the usefulness and limitations of this integrated model.

2.1 INTRODUCTION
Economic growth, as you have been in Unit 1, refers to a process of sustained
22 increase in real national income of a country. A number of theories have tried to
 Harrod-Domar Growth
study the process of economic growth as it has unfolded in the past especially within Model
the free market framework. These theories are economic growth are also referred to
as growth models, especially when the quantitative interrelationships among the
critical variables in the process of economic growth are set out in a rigorous form. In
the remaining units of this block and the subsequent two blocks you will study in
depth about different models of economic growth as formulated by different
economists at different point of time. Each of these models emphasises upon a
different sector or a set of factors that in the opinion of their exponents is the major
factor that influenced economic growth. In this unit, we begin with an in-depth
analysis of what had come to be known as the Harrod-Domar Model (HDM) of
growth.

2.2 BACKGROUND TO THE HARROD-DOMAR

GROWTH MODEL
This model of growth was developed by two different economists, each working
independently of the other, but almost con-currently. These two economists were
R.F. Harrod and E.D. Domar. Harrod, of course, published his theory earlier than
Domar. Harrod's book Towards a Dynamic Economics was published in 1948, while
Domar's book Essays in the theory of Economic Growth was published in New York
in 1957. Harrod Model and Domar Model may 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).

HDM integrated the classical and Keynesian analysis of economic growth. In the
HDM, capital accumulation plays a crucial role in the process of economic growth.
Both the classical economists and the Keynesians had recognised the critical role of
capital accumulation in the process of economic growth. But the classical economists
considered only the capacity of the capital accumulation, and, believing that supply
created its own demand, did not pay attention to the demand side. Keynesians, on the
other hand, erred in the opposite direction. Concerned primarily with the short-
period, they considered only the adequacy of demand and neglected the problem of
increase in capacity through investment in the long run. HDM considered both the
sides of the investment process.

2.2.1 Essence of the Model

Starting from a full employment equilibrium level of income, the HDM postulated
that continuous maintenance of this equilibrium required that the volume of spending
generated by investment must be sufficient to absorb the increased output resulting
from investment. Given the marginal propensity to save, the more the capital is
accumulated and the larger the initial national income. The larger must be the
absolute volume of net investment, maintenance of full employment, therefore,
required an ever-expanding amount of net investment. This, in turn, required a
continuous growth in real national income. Capital accumulation and growth of
income must go side by side.

An increase in capital expands the productive capacity of the economy. If it is not

accompanied by an increase in income, any of the following things may happen:

• The new capital may remain untitled.

• The new capital may replace old capital depriving the latter of its labour and/or
markets.
• The new capital may be substituted for labour (and possibly other factors).

23
 Economic Growth Models-I
Thus, increase in capital unaccompanied by an increase in income would result into
unemployment of capital and /or labour. Excessive capital accumulation may result
into overproduction and consequently into a fall in investment leading to depression.

2.2.2 Assumption of the Model

The HDM is based on the following assumption:

1) An initial full-employment level of income exists.

2) There is no government interference in the functioning of the economy.
3) The exogenous factors do not influence the growth variables, i.e., it is a closed
economy model.
4) There are no lags in adjustment, i.e., the economic variables like savings,
investment, income, expenditure adjust themselves in the same period. Any
change in saving brings about the corresponding change in investment in the
same period.
5) The average propensity to save(S/Y) and marginal propensity to save(∆S/∆Y)
are equal to each other, i.e,. the absolute change in saving is equal to the relative
change in saving.
6) Propensity to save and "capital coefficient"(capital-output ratio) are constant.
The law of constant returns operated because of the fixity of capital-out ratio.
7) Income, investment and savings are all defined in the net sense. It implies that
these variables exclude depreciation.
8) Saving and investment are equal in ex-ante and ex-post sense, i.e., accounting
and functional equality between saving and investment the equality can be
expressed as:

S0 = I0 (accounting equality)

Se = Ie (functional equality)

S0 and I0 are observed saving and investment. Se and Ie are expected saving and
investment.

All these assumptions are not necessary for the final solution of the problem;
nevertheless, they serve the purpose of simplifying the analysis.

2.3 THE HARROD MODEL (HM)

R.F. Harrod tries show in his model how steady (i.e., equilibrium) growth may occur
in an economy. Once the steady growth is interrupted and the economy falls into
disequilibrium, cumulative forces tend to perpetuate this divergence thereby leading
to either secular definition or secular inflation. In other words, Harrod's growth
model concentrated largely on the following question:

• How can steady growth-rate be achieved with fixed capital-output ratio (capital
coefficient) and fixed saving-income ratio (propensity to save)?
• How can the steady growth-rate be maintained or what are the conditions for
maintaining the stable growth?
• How do natural factors put a ceiling on the growth-rate of the economy?
The model seeks to provide answers to these questions.

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 Harrod-Domar Growth
2.3.1 Statement of the Model Model

The Harrod model is based on three growth rates. One, there is the actual growth
rate denoted by G. It is determined by the saving ratio and the capital-output ratio. It
shows short-run cyclical variation in the rate of growth. Two, there is the warranted
growth rate denoted by Gw. It is the full capacity growth rate of income in an
economy. Three, there is the natural growth rate denoted by Gn. This is regarded
as 'the welfare optimum'. It may also be called the potential or the full employment
rate of growth.

1) Actual Growth Rate (G) : The first fundamental equation in the HM is as

follows:
GC = s ........................(1)
where
G = actual rate of growth (or ∆Y/Y)
C = the marginal capital output ratio[or (I/∆Y)]
s = saving income ratio [or (S/Y)]

The eq.(1) explains the simple truth that savings and investment are equal to each
other in terms of ratio. Substituting the values of G,C and s in eq.(1) explains this
phenomenon:
GC = s
Substituting the values, we get
(∆Y/Y) × (I/∆Y) = S/Y
ΔY I S
× =
or
Y ΔY Y
I S
= =
Y Y
or I=S
The equality between saving and inves

tment (export sense) is thus a necessary condition for achieving steady growth. It is
also called the dynamic equilibrium.

2) Warranted Growth Rate (Gw) : It is the full capacity growth rate of income in
an economy. It is also known as 'full employment growth rate' or 'potential
growth rate'. The equation for warranted growth can be stated as follows:
GwCr = s ......................(2)
where,
Gw = warranted growth rate
Cr = amount of capital required to maintain the warranted growth rate
s = saving-income ratio

Eq.(2) states that if the economy is to advance at the steady rate of Gw that will fully
utilise its capacity, income must grow at the rate of s/Cr per year, i.e., Gw = s/Cr.

If income grows at the warranted rate, the capital stock of the economy will be fully
utilised; the entrepreneurs will be willing to continue to invest the amount of saving
generated at full potential income. Gw is therefore, a self-sustaining rate of growth
and if the economy continues to grow at this rate, it will follow the equilibrium path
shown in 25
 Economic Growth Models-I

I
I2
I1

S3

SAVING & INVESTMENT

S2

S1

S1

INCOME
Fig. 2.1

In Fig.2.1, income is measured along the horizontal axis, and saving and investment
are measured along the vertical axis. It would be seen that the change in income from
Y1 toY2 induced investment would be to equal savings S1 at A(Y2). This investment,
in turn, raised income to Y3 and Y3 induced I2 to equal S2 at B(Y3). I2 in turn raised
income to Y4 and Y4 induced I3 to equal S3 at C(Y4 income). In this way, the
economy moves on the growth path.

The point of intersection of the investment line and the line running parallel to the Y-
axis indicated the required investment that is forthcoming.

The greater proportion of savings, the greater must be the rate of increase in output to
induce sufficient investment to maintain equilibrium if we assume no change in the
investment co-efficient.

In brief, the warranted growth rate equation in the model implies that actual
investment (ex-post investment) must be equal to expected investment (ex-ante
investment), if an economy is to achieve stable growth. In such a situation, the
following equalities will obtain:

G = Gw, and

C = Cr

The economy would be in equilibrium.

If these equalities do not obtain, the economy will be pushed into a state of
disequilibrium if either of the following situations obtain.

a) G > Gw
or
C < Cr
b) G < Gw
or
C > Cr
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 Harrod-Domar Growth
a) State if disequilibrium when G > Gw Model

Under this situation, growth rate of income is higher than the growth rate of output.
It means that the demand for output(because of higher lever of income) would
exceed the supply of output (because of lower level of output). The economy would
experience inflation.

Stated another way, if C<Cr, the actual amount of capital falls short of the required
amount of capital. This will lead to the deficiency of capital. This, in turn, would
adversely affect the goods to be produced. Fall in output would affect the goods to
be produced. Fall in output would affect the goods to be produced. Fall in output
would result in scarcity of goods, and hence inflation.

Either of the two ways lead to inflation. And growth under inflationary situation is
not stable.

b) State of disequilibrium when G < Gw

In this situation, the growth rate of income is less than the growth rate of output.
There would be more goods for sale but the income would be insufficient to purchase
these goods. There would be deficiency of demand and the economy would face the
problem of over production.

Similarly, when C>Cr, actual amount of capital would be larger than the required
amount of capital for investment. The larger amount of capital available for
investment. The larger amount of capital available for investment would lower the
marginal efficiency of capital in the long-period. Secular decline in the marginal
efficiency of capital would lead to depression and unemployment.

Economic growth under the situation of depression cannot be stable.

Harrod stated that once g departs from Gw, it will further depart away from
equilibrium. He writed: “Around that line of advance which it adhered to would
alone give satisfaction, centrifugal forced are at work, causing the system to depart
further and further form the required line of advance.” Thus, equilibrium between G
and Gw is a knife-edge equilibrium. It follows that one of the major tasks of public
policy is to bring G and Gw together in order to mainatain long-run stability.

For this purpose, Harrod introduces his third concept of natural rate of growth.

3) Natural Growth-rate (Gn): It is the maximum growth rate that an economy can
achieve with its available natural resources. The equation for the natural growth
rate can be state as follows:

Gn Cr = or ≠ s ................(3)

It stated that the natural growth rate is determined by macro variables like
population, technology, natural resources and capital equipment. These factors,
place a ceiling beyond which expansion of output is not possible.

Interaction between G, Gw and Gn

Comparing Gw and Gn, it may be concluded that Gn may or may not be equal to Gw.
In case Gn happen to be equal to Gw, the condition of steady growth would prevail.
But such a possibility is remote one because a variety of factors (influencing Gn and
Gw) come into play and make balance between these two growth-rated difficult.
There exists a greater probability of inequality between Gn and Gw. It may take two
terms:

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 Economic Growth Models-I
a) Gw>Gn

b) Gn>Gw

a) Gw>Gn: It Gw exceeds Gn, G would lie below Gn for most of the time.

In this situation, there would be a tendency for cumulative recession. A downward

trend would set in, resulting in unemployment and depression. However, downward
trend cannot continue indefinitely. The reason is that lower limit to depression is set
by the minimum consumption level. The consumption cannot fall below a minimum
level. The minimum consumption requirements can be made possible by reducing
the working capital. The entrepreneurs may not reduce fixed capital in the hope that
future might entail bright prospects for investment. These two factors would
gradually set the wheels of recovery in motion. The economy would experience
upward trend.

b) Gn>Gw: In this situation, G would also exceed Gw for most of the time,

There would be a tendency for cumulative boom and full employment. Such a
situation will create inflationary trend. To check this trend, savings should be
encouraged, as these would ensure a high level of employment without inflationary
pressures.

2.3.2 Assumptions of the Model

• The HM is based on the following assumptions:
• The level of ex-ante aggregate saving is a constant proportion of aggregate
income. It means propensity to save is assumed to be constant.
• Technical progress has been assumed to be labour argumenting or 'neutral'. This
implies that neutral technical progress is the basis of the model.
• The requirements of capital and labour per unit of output are constant, i.e.,
capital-output and labour-output ratios are assumed constant.
• Constant returned to scale operate. This implies that output increased at a
constant rate.

2.3.3 Policy Implications of the Model

The policy implications of the model are simple and straight forward. These can be
briefly summarised as follows:

Saving is a virtue in any inflationary gap economy and a vice in a deflationary gap
economy. In an advanced economy the saving coefficient, s, has to be moved up or
down as the situation demanded.

2.3.4 The Harrod Model and Trade Cycles

Harrod has used his model to explain trade cycles. In the recovery phase, because of
the existence of unemployed resources, G>Gn. When full employment is reached
G=Gn. If Gw exceeds Gn at the full employment, slump is inevitable. Since G had to
fall below Gw, it will, for the time being, be driven progressively downwards.
Further, G itself fluctuated during the course of the business cycle. Savings as a
fraction of income, though fairly steady in the long run, fluctuate in the short run. In
the short run, savings tend to be residual between the earning and normal
consumption. Companies, also, are likely to save a large portion of their short-period
increased in net receipts. Thus, even it Gw is normally below Gn, it is likely to ride
above Gn in the later stages of advance, and, if it so happens, a vicious spiral of
depression is inevitable when full employment is reached. If Gw does not ride above
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 Harrod-Domar Growth
Gn in the course of advance, there would be continued pressure to advance when full Model
employment is reached; this would lead to inflation and consequently, sooner or
later, to a rise of Gw above Gn, resulting ultimately into a vicious spiral of depression.
Actually, G may be reduced before the employment is reached because of
immobilities, frictions, and bottlenecks and, if it so happens, depression may come
before full employment is reached. If Gw is far above Gn, G may never rise far above
Gw during the revival and the depression may result long before full employment is
reached.

2.3.5 Critique of the Harrod Model

The instability in Harrod's model is due to the rigidity of its basic assumptions, viz.
fixed production function, a fixed saving ratio, and a fixed growth rate of labour
force. Economists have attempted to relieve this rigidity by permitting capital and
labour substitution in the production function, by making the saving ratio a function
of the profit rate and the growth rate of labour force as a variable in the growth
process.

Check Your Progress 1

1) Why is the model discussed in this unit known as the Harrod-Domar Model?

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2) State in brief the basic formulations of the Harrod model of growth.

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3) How does the Harrod model explain the occurrence of trade cycles?

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 Economic Growth Models-I
2.4 THE DOMAR MODEL (DM)
The fundamental question around which E.D. Domar builds his model can be stated
as follows:

Investment leading to an increase in productive capacity and income, what should be

the rate of increase in investment which would equalise the increase in income and
the increase in productive capacity, so that full employment is maintained?

Domar answers this question by forging a link between aggregate supply and
aggregate demand through investment.

2.4.1 Statement of the Model

Domar model is based on the dual character of investment: one, investment increases
productive capacity, and two, investment generated income. The two sides of
investment provide solution for steady growth. The following symbols are used in
DM.
Yd = Level of national income or level of effective demand at full employment
(demand side)
Ys = Level of productive capacity or supply at full employment level (supply
side)
K = real capital
I = net investment, which implies change in stock of real capital, i.e. ∆K
d = marginal propensity to save, which is the reciprocal of multiplier i.e.,
(mp λ =1/multiplier)
σ = productivity of capital

We can make use of these notations to frame a set of equations that help formulate
the DM.

The demand side of investment can be represented by an equation as follows:

Yd = I/d

This equation explains two things as follows:

i) The level of effective demand (Yd) is directly related to the level of

investment(I). An increase in investment will result in an increase in effective
demand, and vice versa.

ii) The effective demand is inversely related to the marginal propensity to save (d).
An increase in marginal propensity to save will decrease the level of effective
demand and vice-versa.

Eq.(1) represents the demand side of investment.

The supply side of investment can be represented by an equation as follows:

Y = σk ....................(2)

Eq.(2) explains that supply of output(Ys) at full employment depends upon two
factors, ie.., productive capacity of capital( σ ) and the amount of real capital(K). A
change in the supply of any of these will result in a corresponding change in the
supply of output. For example, an increase in the productivity of capital will result
30
 Harrod-Domar Growth
in an increase in output, and vice-versa. Likewise, an increase in the amount of real Model
capital will lead to an increase in output, and vice-versa.

Equilibrium: In equilibrium, the demand and supply should balance. Therefore,

Yd = Ys

or I/d = σ K

By cross multiplication,

I = dσ K ..........................(3)

Eq.(3) explains the condition for steady growth.

Steady growth is possible when:

Investment equals the product of saving-income ratio, capital productivity and

capital stock.

From this the condition for maintaining the steady growth can be explained. For this
we have to give increment to the demand and supply conditions presented above.

The demand equation in its incremental form can be stated as follows:

∆Yd = ∆I/d ........................(4)

Increments have been shown in the level of effective demand and investment
because they are variables, but increment has not been shown in d because it is
constant in terms of the assumptions employed.

The supply equation it its incremental form can be stated as follows:

∆Ys = σ ∆K ........................(5)

Eq.(5) explains that change in the supply of output (∆Ys) would be equal to the
product of change in real capital (∆K), and the productivity of capital ( σ ). The
change in real capital is expressed as net investment. Therefore, ∆K represented
investment(I). Substituting I in place of ∆K in eq.(5), we get.

∆Ys = σ I ........................(6)

The equilibrium between eq.(4) and eq.(6) provides us the condition for maintaining
the steady growth. In equilibrium

∆Yd = ∆Ys

or ∆I/d = σ I

cross-multiplying , we get,

∆I/I = σ d .......................(7)

Eq.(7) explains that the growth-rate of net investment ∆I/I should be equal to the
product if marginal propensity to save (d) and productivity of capital ( σ ). This
equality must be maintained to ensure stable and steady growth.

Donar gives a numerical example to explain this condition of maintaining steady

growth.
31
 Economic Growth Models-I
Let σ = 25% per year

d = 12%

Y = $150billion a year

12
If full employment is to be maintained, an amount equal to 150 × =$18 billion
100
should be invested. This will raise productive capacity by the amount invested σ
12 25
times i.e., by 150 × × =$4.5 billion, and the national income will have to rise
100 100
by the same amount. But the relative rise in income will equal the absolute increase
divided by the amount itself, i.e.,

12 25
×
150 × 100 100 = 12 × 25 = 3%
150 100 100

Thus in order to maintain full employment, income must grow at a rate of 3% per
annum. This is the equilibrium rate of growth. Any divergence from this "golden
path" will lead to cyclical fluctuation when ∆I/I greater than σ d the economy would
experience boom. The economy would suffer from depression, it ∆I/I is less than σ d.

2.4.2 Assumption of the Model

The Domar model is based on the following assumption.

1) Income is determined by investment through multiplier. For the sake of

simplicity, saving-income ratio is assumed constant.

2) Productive capacity is created by investment according to the potential social

average investment productivity. For the sake of simplicity this is also assumed
to be constant.

3) Investment is induced by output growth together with entrepreneur confidence.

4) Employment depends upon the 'utilisation ratio' expressed as the ratio between
actual output and productive capacity.

5) Past and present investment can greater productive capacity at a given ratio.

2.4.3 Policy Implication of the Model

An economy always faced a serious dilemma if sufficient investment is not
forthcoming today, unemployment will occur today; but if enough in invested today,
still more will be needed tomorrow in order to increase demand so that the expanded
capacity can be utilised and excessive capital accumulation avoided tomorrow;
otherwise the excessive accumulation will cause a fall in investment leading to a
depression day after tomorrow. To stay at the same place, therefore, the economy
must move faster and the economy must move faster and faster, otherwise it will slip
downward.

Check Your Progress 2

1) Discuss the principal features of the Domar Model of growth.

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 Harrod-Domar Growth
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2) State the conditions necessary for steady growth.

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3) State the conditions necessary for maintaining for maintaining steady growth.

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2.5 COMPARISON OF HARROD MODEL AND

DOMAR MODEL
Harrod model and Domer model show both similarities and dissimilarities with each
other. Let us have a look at these.

2.5.1 Similarities
The two models are similar in substance. Harrod's is domar's d. Harrod's warranted
rate of growth (Gw) is Domar's full employment rate of growth (d σ ). Harrod's
Gw=s/Cr≡Domar's d σ ).

To prove it

S
d= or S=dY ................(1)
Y

ΔY
σ = or Δ Y = I σ ................(2)
I

Since S=I, and substituting S for I in eq.(2), we have

Δ Y = dY σ [∵ S=dY]

ΔY
or = dσ ................(3)
Y 33
 Economic Growth Models-I
ΔY
∴ Gw = d σ (since Gw = )
Y

In other words, Harrod's Gw is the same as Domar's d σ , but in reality, Domar's rate
of growth r=ds ¬ 's Harrod's Gw, and Domar's r = d σ is Harrod's natural growth
rate. In Domar's model s is the annual productive capacity of newly created capital
which is greater than σ which is the net potential social average productivity of
investment. It is the lack of labour and other factors of production which reduced
Domar's growth rate from r=ds to r d σ . Since labour is involved in σ therefore
Domar's potential growth rate resembled Harrod's natural rate. We may also say that
the excess of s over σ in Domar's model expresses the excess of Gw over Gn in
Harrod's model.

2.5.2 Dissimilarities
Both the models, no doubt, are based on similar assumptions, yet there are
differences in the two models. These dissimilarities can be presented as below:
Dissimilarities between the Domar Model and Harrod Model.

Parameter Domar Harrod

1. Long-run difficulty "Under-investment Labour shortage
sapping growth" deflecting growth

2. Position of labour Shortage of certain Determinant of

input labour may trigger natural rate of
scrapping and the growth: key element
inhibition of investment;
optional element

3. Centrifugal force Continuously undermined Unstable adjustment

from equilibrium investment incentives process

4. Reason for fixed Assumed for inconvenience Due to fixed interest

capital output ratio rate, low
substitutability, etc.

5. State of economy Idle capacity prevalent Labour unemployment

common place
Further differences between the two models are revealed when we discuss their
policy implications. Domar's model explains the technological relationship between
the capital accumulation and full employment growth rate of output. Harrod model
shows the behavioral or psychological relationships between the capital
accumulation and full capacity growth rate of output. Domar's analysis is based on
the principle of multiplier, whereas Harrod's analysis is based upon the principle of
acceleration. Domar's model suggests the role of planned investment in the
economic development, while Harrod's model stresses on induced investment.

2.6 HARROD-DOMAR GROWTH MODEL

You have read about the Harrod Model (HM) and the Domar Model (DM)
separately. By now, you would have understood that the two models are similar in
substance, although they may differ in details as also in policy implications. Now we
have reached a stage in our study where we can integrate these two models in the
form of what has come to be known as the Harrod-Domar Growth Model (HDM).

2.6.1 Substance of the Model

The main points of the HDM can be summarised as follows:
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 Harrod-Domar Growth
1) Investment is the central theme of the HDM. It plays a dual role. ON the one Model
hand it generates income and on the other it creates productive capacity.
2) The increased capacity results in greater output and greater employment,
depending on the behaviour of the income.
3) Condition regarding the behaviour of income can be expressed in terms of
growth-rates, i.e., G Gw and Gn. The equality between these growth rates would
ensure full employment of labour and full utilisation of capital stock.
4) These conditions, however, designate only a steady-line of growth. The actual
growth rate may differ iron the warranted growth rate. If the actual growth rate
is higher than the warranted rate of growth, the economy will experience
cumulative inflation. If the actual growth-rate is lower than the warranted
growth-rate, the economy will hurtle towards cumulative deflation.
5) The business-cycles are viewed as the deviations from the path of steady growth.
These deviations cannot go on indefinitely. There are constraints on upper and
lower limits. The "full employment ceiling" acts as an upper limit and
autonomous investment and consumption act as a lower limit. The actual
growth-rate fluctuates between these two limits.

2.6.2 Limitations of the Model

HDM throws light on the important determinants (and policy implications) of
economic development, yet they are not free from criticism. The HDM has been
criticised on the following grounds:
1) The HDM assumes key parameters, like the propensity to save and the capital-
output ratio, to be constant. In reality, these are likely to change over the long
run. Changes in these parameters would change the requirements of steady
growth.
2) The HDM includes only aggregates as variables. A model constructed on the
basis of such aggregates cannot show the inter-relations between the sectors and
as such is not meant for demonstrating the structural changes which constitute a
basic aspect of the economic development of a developing economy.
Harmonious growth of different sectors of the economy is very important for
steady growth. Deviations from steady growth may be caused by a lack of
harmony between the growth of different sectors even when aggregative
requirements for stability are fulfilled.
3) The HDM assumes the production function to be fixed and therefore there is no
scope for substitution between different factors. Actually different factors of
production, at least to a limited extent, can be substituted for each other.
Substitutability between different factors increases the flexibility of the economy
and thereby decreases the possibilities of cumulative deviations from the path of
steady growth.
4) The HDM pays attention only to the requirements of steady growth and neglect
the rate of growth. It is more useful for developed countries whose main aim is
stability and not the rate of growth. In contrast, developing countries are
interested more in the rate of growth. They would not mind following policies,
which create fluctuations if these considerably raise the rate of growth.
5) The HDM is purely laizzez-faire only based on the assumption of fiscal
neutrality and designed to indicate the conditions of progressive equilibrium for
a developed economy. The policy implications, therefore, are not very relevant
to the developing economies.

Despite these limitations, the HDM is an important model because it represented a

stimulating attempt to dynamise and secularise Keynes' static short-run saving and
investment theory.
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 Economic Growth Models-I
Check Your Progress 3

1) State the similarities between the Harrod Model and the Domar Model.

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2) State the differences between the Harrod Model and the Domar Model.

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3) What are the basic features of the Harrod-Domar Model of growth? Also state
the limitations of this model.

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2.7 LET US SUM UP

The Harrod-Domar growth model was developed separately, but concurrently, by
two economists. Both the Harrod Model and the Domar Model brought out the
importance of saving and investment in the process of economic growth. Both the
models sought to lay out the conditions for steady growth; the non-fulfilment of
these conditions would lead to disequilibrium, resulting in inflationary and
deflationary gap. Although both the models differed in details, they were the same in
substance. Therefore, both the models stand out integrated, and are known as the
Harrod-Domar Model of Growth. The model was developed in the context of
advanced market economies. But it has been widely used in formulating plan models
in developing economies.

2.8 KEY WORDS

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 Harrod-Domar Growth
Capital-Output Ratio: The number of units of capital required to produce a unit of Model
output.

Investment: That part of national income which is spent on the acquisition of capital
goods.

Natural Growth Rate: Refers to the maximum growth rate which an economy can
achieve with its available natural resources.

Savings: That part of national income which is not spent on the purchase of
consumer goods.

Warranted Growth Rate: Refers to that growth-rate of the economy when it is

working at full capacity and making optimum use of machine and manpower.

2.9 SOME USEFUL BOOKS

Meier, Gerald M. and Rauch, James E (eds.) (2000). Leading Issues in Economic
Development (7th edition). Oxford University Press, Oxford.

Solow, Robert M. (2000), Growth Theory: An Exposition (2nd edition). Oxford

University Press, Oxford and New York.

Surrey, M.J.C. (ed.) (1976). Macroeconomic Themes. Oxford University Press,

Oxford.

2.10 ANSWERS TO CHECK YOUR PROGRESS

EXERCISES
Check Your Progress 1

1) See Section 2.2

2) See Sub-section 2.3.1
3) See Sub-section 2.3.4
4) See Section 2.2
5) See Sub-section 2.3.1
6) See Sub-section 2.3.4
Check Your Progress 2
1) See Sub-section 2.4.1
2) See Section 2.4.1
3) See Sub-section 2.4.1
Check Your Progress 3
1) See Sub-section 2.5.1
2) See Sub-section 2.5.2
3) See Sub-section 2.6.1 and 2.6.2

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