IEcoS (Economic Services) Economics Paper2: Questions 1 of 82
» Theory of Employment, Output, Inflation, Money and Finance » The Classical Theory of Employment and Output and Neo Classical Approaches
Describe in Detail
Explain the Harrod Domar model and bring out the differences between the two versions.
Explanation
Harrod Domar model was developed as a reaction to Keynes’ analysis in 1950s. Harrod and Domar models differ in details but basically, they are similar in substance. Both the models highlight the essential conditions for achieving and maintaining steady growth.

Ideas of Keynesian analysis, which were incorporated in the model Emphasis on full employment break from marginalism Utilisation of macro analysis to the highest degree.

Harrod argued that Keynes neglected the role of savings, while domar opined that Keynes ignored the immediate effect of investment (accumulation of physical capital).

The model focuses on the dual role of investment: productivity effect (classical) and multiplier effect (Keynesian).

General assumptions of the model:

An Initial full employment level of income

Laissezfaire policy – no government interference in the functioning of the economy

Based on the principle of closed economy – no role of foreign trade and aid

No lags in adjustment – any change in savings brings the corresponding changes in investment in the same period
APS () = MPS ()

Propensity to save and capital output ratio are constant.

Income, investment and savings are all defined in the net sense variables exclude depreciation

Savings and investment are equal in exante and expost sense.

Harrod model

Assumptions

The level of exante aggregate saving is a constant proportion of aggregate income.

Neutral technical progress (labour augmenting) is assumed

Capital output and labour output ratios are assumed constant

Constant returns to scale operate


Concentrates largely on the following questions

How can steady growth rate be achieved with fixed capital –output ratio and fixed saving –income ratio?

How can steady growth rate be maintained?

How do natural factors put a ceiling on growth rate of the economy?


To answer the above questions, Harrod explained three growth rates

Actual growth rate (G)

Warranted growth rate (G_{w })

Natural growth rate (G_{n})

Actual growth rate (G)
Determined by the actual amount of savings and investment available in the economy.
Where,
ΔY: change in income
Y: income
The relation between the actual growth rate and its determinants can be expressed as –
GC = s
G: actual growth rate
C: marginal capitaloutput ratio ()
s: savingincome ratio ()
Substituting the values, we get –
I = S (dynamic equilibrium): Necessary condition for achieving steady growth
Warranted growth rate (G_{w}): also known as full capacity growth rate
Growth rate of the economy when it is working at full capacity and making optimum use of machine and manpower.
The relation can be written as:
Instability of growth:
1.
2.
rate of palnned I is increased
G increas (inflationary situation)
rate of palnned I is increased
G decrea (depression)
Thus, the stability between actual growth rate (G) and warranted growth rate () is termed as knifeedge equilibrium.
Natural growth rate (G_{n}):
Made up of two components
Growth of labour force (L) and growth rate of productivity (q’=Y/L)
Importance of natural growth rate
Defines long run full employment equilibrium growth rate and sets upper limit to the actual growth rate, which brings cumulative expansion in the Harrod model to a sticky end.
Relation between G, G_{W} and G_{n}:
The only situation in the Harrods’s model where there is full employment of both capital and labor under equilibrium is when
The equilibrium is unstable and any diversion from this growth path will result in further aggravation of the gap between actual and warranted growth rate. This is so improbable a situation that Mrs. Joan Robinson has termed it ‘Golden Age”.
Domar model:
Evsey Domar published his work on “Capital Expansion and Growth” in 1946, seven years later than a very similar work by Roy Harrod.
National Income (output) is determined by investment through the multiplier as per the following relation:
Where s (assumed to be constant) is the marginal propensity to save.
Productive capacity () of an economy (or capital stock) is defined by Domar as its output when the entire labour force is fully employed.
Where, α is marginal capital output ratio
Investment is induced by output growth together with entrepreneurial confidence.
The latter is adversely affected by junking – untimely loss of capital value due to unprofitable operations of existing capital
For equilibrium:
_{: }Level of effective demand at full employment
: Supply at full employment
K: real capital
I: net investment
(Demand side) k (Supply side)
Path of disequilibrium
When
(situation of inflation)
(over production)
The two models are similar in the following ways:
For both the economists, the starting point is to make the Keynesian framework dynamic.
Both have assumed, to some extent, constancy of capitaloutput ratio (CC) in case of Harrod and its inverse, the related outputcapital ratio () in case of Domar.
Both obtain constant growth paths.
Both assume that output follows demand thereby implying that output can fall below potential level leading to entrepreneurial reaction of change in rate of investment.
Both conclude a grimmer future if ever the economy diverges from its unstable equilibrium path.
Differences in the model:
Issue  Domar  Harrod 
1. Key Concept  Rate of growth, which equate output to productive capacity, ensuring full employment of labour but if junking is present, it is possible with less than full employment of capital.  Equilibrium rate of growth for entrepreneurs, which requires full employment of capital but is compatible with less than full employment of labour. 
2. Long run problem  Junking of capital decreasing the rate of investment below the warranted.  Labour shortage not allowing economy to reach warranted rate of growth. 
3. Feature of Economy  Unused capacity  Less than full employment of labour 
4. Role of labour  Shortages lead to junking of capital and thus negatively affects rate of investment.  Determines the natural rate of growth which is a cap on the rate of growth an economy can achieve 
5. Cause of instability  Continuously decreasing investment incentive due to increasing unused capacity.  The process of adjustment which results in expected rate of growth diverge further from the warranted rate of growth. 