Capital formation plays a very important role in the process of development of a country. According to the Harrod-Domar model, economic growth depends on two important factors, viz., the saving ratio (i.e., the percentage of national income saved per annum) and the capital-output ratio.
Since the capital-output ratio remains constant in the short run, the rate of growth of a nation depends largely on the rate of saving. A country which has the capacity to save and invest at least 20 to 25% of its national income will be able to achieve a satisfactory growth rate of 5 to 6% per annum.
In the words of Daniel Fusfeld, “The modern economy is a gigantic mechanism for the generation of an economic surplus and the accumulation of capital. In a modern economy, the surplus is used to increase output. It is transformed into capital goods and knowledge (technology) that raise the productive potential of the economy.”
In the Harrod-Domar model the rate of growth of an economy (g) is expressed as:
g = (s/v) × 100%
where s is the saving ratio and v is the incremental capital-output ratio. If s = 10 % and v = 3⅓, g will be 3%. This implies that if 100 units of capital are required to produce 33 units of output in a country and the country can save and invest 10% of its national income per annum, it can achieve per capita income growth of 3% per annum. If s increases to 20% g will be 6%, provided v remains constant. The Harrod-Domar model may now be discussed in detail.
Saving, Investment and Growth: the Harrod-Domar Model:
The problem of aggregate supply and demand in the long run is complicated by the dual role of investment. Investment creates demand — via the multiplier, just as it creates supply — adding to society’s productive capacity. The question is: which aspect is more important if we consider a long period of time.
This problem led, in the period after Keynes’ General Theory, to a number of attempts to make that theory dynamic, i.e., to enable us to predict not only national income in a particular period but also its path of change over time. An example of this kind of approach is the celebrated Harrod-Domar model.
This theory was developed independently by Sir Roy Harrod and Evsey Domar.
The theory involves an examination of the following equation, in which Y stands for annual national income (or output), AY for a year’s increase in national income, I for annual investment and S for annual savings:
By making certain assumptions, we can use this equation to show some of the difficulties of keeping aggregate supply and demand in proper balance in a growing economy. To start with, let us suppose that the fraction of income people wish to save is some fixed number, say, one-tenth.
This is quite a realistic assumption. Although in the short run the marginal propensity to save might be expected to rise with income, something else happens in the long run, inasmuch as people have enough time to adjust their living standards to higher levels of income.
We also assume that the amount of machinery and other capital goods used to produce a given level of output remains more or less fixed.
Now, we can argue that the term AY/I, which represents the increase in income in a year divided by the increase in the stock of capital (i.e., investment) in a year, will be some pure number — say 1/3. In other words, business people who expand their plants and equipment by Rs 3 and will have the capacity for producing Re. 1 a year more output than before. Hence, 1/3 is the incremental capital-output ratio.
Now, from these first it is possible to determine a ‘rate of growth’ for this economy. In equilibrium, the amount that households desire to save will have to be equal to the amount that businesspeople wish to invest, or S = l.
Hence, growth can be expressed as:
ΔY/Y being the increase in output divided by the initial level of output, or the rate of growth of economy. In our example, it will be equal to 1/30 or 3.3%.
ΔY/Y = ΔY/I.S/Y = (1/3) (1/10) = (1/30) = 3.3% … (2)
Problem with model:
However, there is one major problem with the model. The growth rate that keeps investment and saving happily in balance (sometimes called the equilibrium or warranted rate of growth) may be quite different from the rate at which population is growing, called the natural rate of growth.
In this theory, there really is no guarantee at all that aggregate supply and aggregate demand will grow in harmony over time. On the contrary, the system is for ever poised toward runaway inflations or depressions, called knife-edge instability.
So, in this model the economy more on a razor’s edge, or misstep in either direction being fatal. However, while discussing the ‘knife-edge’ properties of steady-state growth path Harrod argued that potential accelerator and the saving rate that drove the actual growth rate back the warranted growth rate every time it deviated from it.
Usefulness of the model:
The model highlights certain important points, viz., saving leads to an increase in investment, which leads to an increase in income (through the incremental capital/output ratio), which leads to more saving, more investment and more income.
Capital accumulation, expansion of labour force and technical progress are given specific roles by Harrod in his model, but he also examined the role of expectations and possibilities of instability arising there-from. He has brought into focus the fundamental economics of growth, the necessary relations existing between dynamic elements — population change, technological progress and long-term saving — of an advancing society. He also emphasised the dual character of investment — it generates income and adds to the productive capacity of the economy.
Harrod and Domar were particularly concerned with the role of investment as capital accumulation and as a component of aggregate demand. Their model incorporated a simple accelerating investment function based on expected real income.
In summary, the Harrod-Domar model considers three basic issues:
1. Whether or not steady-state growth is possible;
2. The probability of steady-state growth at full employment;
3. The stability or otherwise of the warranted rate of growth.
The Harrod-Domar model neglected the effects of relative prices on factor proportions, implying they were in fixed ratio. So, even though they implied an aggregate production function they escaped the main criticisms of the production function incorporated into the neo-classical growth model.
Criticism of Harrod’s theory is generally targeted at his behavioural assumption that producers invest only to meet expected demand in the next time period. This assumption eliminates any long-term investment plans, or anticipation of long-term demand trends, by producers.
A related criticism is that producers are not required to respond to unanticipated demand levels only by varying their output. Price variations, of course, are another option that would be particularly useful in the short run.
The Harrod-Domar model set the scene for subsequent work on growth as their framework was sufficiently general to incorporate technical progress, money and other effects.