Harrod-Domar Growth Model

Professor Carlos A. Benito

Department of Economics
Sonoma State University

ECON 403
Topics for today
In growth models, we will encounter the
following terms:
◆ Lord Harrod and Mr. Domar
◆ Keynesian based models
◆ Saving rates
◆ Capital/Output ratio or
Capital Productivity
◆ Capital stock
◆ GDP
◆ Personal Consumption
◆ Gross Savings
◆ Gross Investment
◆ Net Investment, or Capital
Accumulation
◆ Depreciation
◆ Dynamic models
What is a Keynesian Growth Model?
◆ Keynes’ model and Keynesian models were
developed to explains business cycles
» A short run phenomena
◆ As such they attribute a major role to aggregate
expenditures (demand side)
◆ Regarding the supply side, they assume that there is
unemployment: production responds fast to
increases in aggregate demand because capital and
labor is unemployed.
◆ Aggregate Demand, AD
– AD = C + I + G + X-M
– C, Consumption expenditures
– I, Investment expenditures
– G, Government expenditures
– X-M, Foreigners’ Expenditures
◆ Aggregate Supply
– AS < ASfe
– Aggregate Supply, at full employment
◆ Macroeconomic Equilibrium
– AS = AD
– Or
– S=I
A Keynesian Model
◆ A Keynesian growth model takes a long run
perspective.
– Aggregate demand (or savings=investment)
still is important, but
– It also includes the aggregate supply
» Investment has two impacts:
◆ On expenditures (in the short run)
◆ On capital stock (in the long run)
Trends and business cycles

Trend
Real GDP

One business cycle

Years
Main Propositions
◆ Economic growth can be accelerated by
– changing the saving rate
– improving technology.
◆ Saving rates and technology can be changed
– government interventions without consideration
to prices
 Harrod-Domar Growth Model
A Flow chart model
Depreciation Saving Rate
Rate
Ig S s
d
C
D
GDP

v= K/Y or Capital/Output
In a=Y/K Ratio or Productivity

Capital
Production function
 Factors Explaining the growth rate
According to Harrod-Domar model

+ s Saving rate

Rate of +
Economic g a Capital productivity
Growth

_
d Capital depreciation

Explained variable Explanatory Variables

 If we know output Y,
Arithmetic specification and we know s, which is
the saving rate, then we
Without Depreciation
know total savings S.

latow
nkefI If we know the initial
S=Y.s s=dS/dY capital stock K; and we
w
onke,S
sgiva
nacew
hum
o know a, (how much
w
eni)I(tsv output increases when
)K
d(latipc capital increases 1 unit)
dY Y=K.a then we know what will
total output Y be.

I
If we know dK and
a, we know growth dK a=dY/dK
of output dY
K
 If we know output Y=1
Numerical specification and we know the saving
rate s=.10, then we know
Without Depreciation
total savings S=.10

latow
nkefI Or …
ew
01.=Ssgniva S=.10 dY = s.as=.10
nacewthok If we know the initial
w
eni0.1=
Itsv dY=.02=2%
By approximation: capital stock K=5; and
)01.=
K
d(latipc we know its productivity
dY/Y=s.a/Y
Y=1 a=.20 then we know
g=s.a
total output Y=1
Since Y=1
.10

dK=.10 a=.20
If we know dK=.10
and a=.20, we know K=5
growth of output
dY=0.02=2%
Economic growth formula
According to Harrod-Domar the rate of economic growth
is defined by the formula:

g = s.a – d

that is, if s=10% and a=0.20 and d =1%, then

g=0.10*0.20 - 0.01 = 0.02 -0.01 = 0.01 = 1%

What happens if the rate of saving (s) increases to 20% ?

What happens if the productivity of capital (a) increases to 0.40?
What happens if the depreciation (d) rate is 2% ?
Mathematical derivation of Harrod-Domar model
.
Conventional Keynes’ Model

Specification

Saving function (demand side)

S = s.Y where s is the average propensity to save or average saving
rate.

In the conventional short run Keynesian model investment (I) is given.

I = Ia

In equilibrium
S=I

Solving the model

s.Y = Ia
Y = 1/s.Ia = m.Ia where m is the investment multiplier
In this model national GDP increases because the autonomous demand
(I)
increases. It is assumed that aggregate supply responds as to produce
what is demanded. But, what will happen if the economy was at full
employment? The only way for production to increase will be an increase
in the capital stock. With more capital (and labor) the economy will
produce more GDP.
Mathematical derivation of Harrod-Domar model (2)
Keynes’ Model Expanded to Consider Growth
Harrod and Domar explained how the aggregate supply expands.
For them, investment has two effects, one on the aggregate demand
side (businesses expend more) and another in the aggregate supply
side (more investment increases capital stock and thereby
businesses produce more the next period).
We, therefore, need to add a production function:
Y = a.K production function
Where a is the productivity of capital: ∆ Y/ ∆ K, which is constant
Now we can determine how a change in capital changes income.
∆ Y = a.∆ K
Mathematical derivation of Harrod-Domar model (3)
What we need to know is how capital changes. It changes by
businesses, and government investment:

∆ K = Ia
We are assuming that capital doesn’t ware out, i.e. there is not
depreciation.
Returning to the equilibrium condition (S=I) we solve the model again
for the long run case

s.Y = Ia = ∆ K, but we know that ∆ K = ∆ Y/a, then

s.Y = ∆ Y/a
s.a = ∆ Y/Y
Calling ∆ Y/Y = g : rate of GNP growth
Mathematical derivation of Harrod-Domar model IV

g = s.a
If we recognize that capital depreciates:

g = s.a – d
Where d is the depreciation rate per year.

Notice that in this model the rate of

growth (g) is constant. Why?
Harrod’s way:
K = v.Y where v = 1/a
g = s/v
And with depreciation
g = s/v - d
 To growth model

Production function

K GDP Production
GDP
function
GDP2> GDP1
GDP1 Productivity rate
N
K
 To growth model

Assumptions
– Labor/capital proportions are fixed

K GDP Production
GDP function
GDP2> GDP1
GDP1 Productivity rate
N
K
– Saving rate is given
S
Saving
S function

Saving rate

Income = GDP
Non-existence of equilibrium
Y,S,D,I Y

In
D
D

K
Review

You should now be familiar with the following

terms:

◆ Technology or ◆ Depreciation rate

capital/output ratio ◆ Capital accumulation
◆ Saving rate ◆ Growth rate