Let us make an in-depth study of the meaning, basic requirement and assumption of the Harrod-Domar model of growth.
Meaning of Harrod-Domar Model:
The Harrod-Domar model of growth seeks to explain two basic questions relating to growth problems of developed countries.
(i) What are the requirements to maintain steady rate of growth of full employment income without inflation and deflation?
(ii) Is long-run full employment equilibrium of a developed economy possible without secular stagnation or secular inflation?
Thus, this model provides gainful suggestions to above stated questions. Regarding steady rate of growth of full employment income, Harrod- Domar model conveys that rate of investment should increase at a rate equal to the proportion between marginal propensity to save and capital output ratio. Therefore,
∆I/I = S/V
Where ∆I/ I is the rate of investment, S is the marginal propensity to save and V is the capital output ratio.
As regards second question, Harrod-Domar are of the view that it is difficult to maintain steady rate of growth of full employment in a capitalist economy. There are possibilities of secular inflation or secular deflation in the capitalist country.
Basic Requirement of Harrod-Domar Model:
The Harrod-Domar model confines itself to a study of the conditions required for the smooth and uninterrupted growth of national income in a country. The basic idea of this model is capital accumulation. It plays a crucial role in the process of economic growth. An important feature of this model is that it takes into account both the sides of the investment process, namely, the supply side and as the demand side.
The old classical economists considered only the supply side of capital accumulation (i.e., saving side) without giving any thought to the demand side and neglected the demand side (or, investment side) of capital accumulation. J.M. Keynes, on the other hand, considered the demand side of capital accumulation and failed to give any thought to the supply side.
The superiority of the Harrod-Domar model lies in the fact that it considers both the sides of capital accumulation. It represents an integration of the classical and the Keynesian analyses of economic growth.
The Harrod-Domar model starts from a position of full-employment equilibrium level of income. It, then, emphasizes the continuous maintenance of this equilibrium position. To ensure this, according to the model, that the volume of expenditure generated by investment must be adequate to absorb the increased output resulting from the investment.
Investment not only generates spending; it expands the productive capacity of the economy. There must exist a balance between the volume of spending generated by investment and the productive capacity created by it. In other words, capital accumulation (investment) and growth of income must go side by side. An increase in capital accumulation expands the productive capacity of the economy.
This must, therefore, be accompanied by an adequate increase in the income of the community to absorb the increased output.
If the increased productive capacity is not accompanied by an adequate increase in income, any of the following three things may occur:
(i) The new productive capacity may remain unutilized,
(ii) The new capital assets may replace the old capital assets, and
(iii) The new capital may be substituted for labour and other factors, leading to unemployment in the economy.
In short, an increase in capital accumulation (investment) unaccompanied by an adequate increase in income would result in an imbalance in the economy, leading to unemployment. Thus, Harrod-Domar model points out that excessive accumulation of capital unaccompanied by an adequate increase of income would lead to over-production, unemployment and depression in the economy.
The Harrod and Domar models are based on following assumptions.
1. There is an initial full employment equilibrium level of income.
2. The model operates in closed economy i.e. there is no foreign trade.
3. The average propensity to save is equal to the marginal propensity to save i.e. S/Y = ∆S/∆Y absolute change in savings is equal to the relative change in savings.
4. There is no government interference in the functioning of the economy i.e. the policy of laissez-faire prevails in the economy.
5. There are no lags in adjustment i.e. the economic variables such as saving, investment, income, expenditure adjust themselves in the same period of time.
6. The marginal propensity to save and capital coefficient remains constant.
7. Intended investment and real investment are equal in the economy.
8. There is no depreciation of capital goods which are assumed to be fixed.
9. Saving and investment are equal in ex-ante as well as ex-post sense i.e. there is accounting as well as functional equality between saving and investment i.e. So = Io , Se = Ie.
10. There is fixed proportion of capital and labour in the productive process.
11. There are no changes in interest rates.
12. Fixed and circulating capitals are lumped together under capital.
13. Saving and investment relate to income of the same year.
Commenting on the importance of Harrod- Domar, Prof. K.K. Kurihara has rightly observed, The Harrod-Domar models are important not only because they represent a stimulating attempt to dynamise and secularise. Keyner static short-run saving investment theory but also because they are capable of being modified so as to introduce fiscal policy parameters as explicit variables in economic growth of an under-developed country.
In the light of these views importance of Harrod-Domar model has been summarised below:
1. The main objective of stead growth model is investment as it generates income on one head and creates productive capacity on the other hand.
2. Harrod- Domar model shows that the behaviour of income as expressed in terms of growth rates i.e. G, Gw and Gn. The equality between these growth rates can ensure full-employment of labour and full utilization of capital stock.
3. These models explain that the increased capacity results in greater output or greater unemployment depending upon the behaviour of the income.
4. Harrod-Domar model focuses that the actual growth rate may differ from the warranted growth rate. If the actual growth rate is greater than warranted growth, the economy will experience cumulative inflation, if the actual growth rate is less than the warranted growth rate, the economy will slide towards cumulative deflation.
5. Apart from above, the business cycles are viewed as the deviations from the path of steady growth. These deviations cannot go indefinitely. These are upper and lower limits. The full-employment ceiling acts as an upper limit and autonomous investment and consumption act as lower limit, and the actual growth rate moves between these two limits.