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Both assign a key role to investment in the process of economic growth. But they lay emphasis on the dual character of investment.

1)It increases income and2)It augments the productive capacity of

the economy by increasing its capital stock.

The former may be regarded as demand effect and latter the supply effect of investment.

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Hence so long as net investment is taking place, real income and output will continue to expand. However, for maintaining the full employment equilibrium level of income, it is necessary that both real income and output should expand at the same rate at which the productive capacity of the capital stock is expanding.

This further requires continuous growth in real income at a rate sufficient enough to ensure full capacity use of a growing stock of capital.

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This required rate of income growth may be called the warranted rate of growth or the full capacity growth rate.

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The Domar Model

Domar builds his model around the following questions: since investment generates income on the one hand and increases productive capacity on the other, at what rate investment should increase in order to make the increase in income equal to the increase in productive capacity , so that full employment is maintained?

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The demand side is explained by the keynesian multiplier .

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The Harrod ModelProf. Harrod tries to show in his model how

steady (i.e. equilibrium) growth may occur in the economy. Once the steady growth rate is interrupted and the economy falls into disequilibrium, cumulative forces tend to perpetuate this divergence thereby leading to either deflation or inflation.

The Harrod model is based upon three distinct rates of growth.

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1. there is the actual growth rate represented by G which is determined by the saving ratio and the capital-output ratio.

2. there is a warranted growth rate represented by Gw which is the full capacity growth rate of income of an economy.

3. lastly, there is a natural growth rate represented by Gn which is regarded as ‘the welfare optimum’ by Harrod. It may also be called the potential or the full employment rate of growth.

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For full employment growth , the actual growth rate of G must equal Gw that would give steady advance to the economy and

C=Cr i.e. C ,the actual capital goods. Cr, the required capital goods for

steady growth. If G>Gw, then C< Cr Results in insufficient

goods and insufficient equipments. Such a situation leads Inflation because actual income grows at a faster rate than that allowed by the growth in the productive capacity of the economy.

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If G<Gw, then C>Cr, such a situation leads to depression because actual income grows slowly than what is required by the productive capacity of the economy. This means that desired investment is less than saving and the aggregate demand falls short of aggregate supply. The result is fall in output, employment, and income. This will lead to chronic depression.

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The Natural Rate of GrowthIt is the rate of advance which the increase of

population and technological improvements allow. The natural rate of growth depends on the macro variables like population, technology, natural resources and capital equipment.

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Divergence of G, Gw & GnFor full lemployment equilibriumG=Gw=Gn and this is Knife edge balance.If G>Gw, investment increases faster than saving and

income rises faster than Gw. (Inflationary situation)If G<Gw, savings increases faster than investment and

income rises less than Gw. (deflationary situation)If Gw>Gn secular stagnation develop, in such a

situation Gw is also greater than G.If Gw< Gn the tendency of inflation is to developed in

the economy. In such a situation Gw is also less than G.

There is a shortage of capital goods and labour is plentiful.

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Profits are high since desired investment is greater than realised investment and the businessmen have a tendency to increase their capital stock. This will lead to secular inflation.

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sYS

KI

Savings rate s

Invest = ΔCapital

YkK Capital/Output = k

IS Closed Economy

The Harrod-Domar Model

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The Harrod-Domar Model

IKYksYS

YksY

k

s

Y

Y

Growth rate of GDP = savings rate/capital-output ratio& To increase GDP growth, increase s (or foreign S)

Harrod’s assumptionsBased on two hypotheses:

Capital and labor have to combine in a fixed proportion dictated by current technology to produce product.

The saving rate is fixed.The rate of growth of the capital stock (“the warranted rate

of growth”) is defined as the ratio of two constants: Saving and investment per unit of desired output Stock of capital per unit of output dictated by technology.

The rate of growth of labor is called the “natural rate of growth”

Society is fully utilizing the capital and labor only if the “warranted” and the “natural” rates of growth happen to be equal.

This is the “knife edge” problem. If investment is above the warranted rate, recession follows. If investment is below, inflation follows.

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Criticisms of the Harrod-Domar ModelNecessary versus sufficient conditions Is Saving necessary for growth?

Not if foreign investment or foreign aid (World Bank Loans, etc.)

Is Saving (Investment) sufficient for growth?Are there institutions to channel savings to

productive uses: a well-functioning financial system or government plan?