Part I

Demand-driven Growth: Harrod
Model
1 Basic Description:
It is a Keynesian model. It highlights the role of aggregate demand not only
in determination of equilibrium output in the short run, but also in explaining
the growth of this aggregate output over time. In this sense it is a dynamic
extension of Keynes.
1.1 Aggregate Demand & Actual Output:
Recall that in the static simple Keynesian model (closed economy; without
government), output is demand determined:
1
t
¹1
t
= C
t
+1
t
.
There is also a Keynesian consumption function which states that people con-
sume a …xed proportion of their income and save the rest:
C
t
= (1 :)1
t
; 0 < : < 1,
where : is the constant marginal propensity to save (determined exogenously).
This gives us the equilibrium out put in the simple Keynesian model as:
1
t
¹1
t
=
1
t
:
. (1)
Of course in the static Keynesian model investment (1) is assumed to be au-
tonomous. In this dynamic model it will change over time. How exactly? We
shall discuss that later.
1.2 Production & Aggregate Supply:
Equation (1) determines the aggregate demand and therefore the actual (or
equilibrium) output. But this is only one part of the story. There is a comple-
mentary part which comes from the production side.
Produnction is determined by an aggregate production function 1(1
t
, ·
t
),
which uses the available stock of capital (1
t
) and the existing workable popu-
lation (·
t
) as imputs to come up with certain amount of the …nal good. The
characteristics of the production function 1 are determined by the existing
technology (we shall ignore technical progress for the time being) and will be
speci…ed in a moment. But notice that aggregate supply is determined by tech-
nological conditions, while aggregate demand is determined by investment and
1
savings propoensity. So there is no apriori reason for the two to be equal (unless
by chance). What happens if the two are not equal? Typically in the macro
literature there are three types of adjustments:
(a) the price level adjusts (and to the extent that aggregate demand and
aggreagte supply respond to price level, they are eventually equalized);
(b) the adjustment takes place in terms of untended inventory accumulation
or decumulation, i.e., the producers produce at full capacity but if the produc-
tion is in excess of demand then the extra goes to the inventory stock (opposite
happens when production falls short of demand);
(c) the adjustment takes place directly in terms of less than full capacity
utilization of the existing factors, i.e, producers, anticipating excess supply, cut
back on usage of 1
t
and ·
t
(or anticipating excess demand, overstrech the use
of existing factors - assuming that is feasible).
Now, in growth models typically prices are assumed to be constant; so the
…rst channel of adjustment is ruled out. Here we shall assume that whenever
there is a mismatch between demand and supply, the adjustment
happens through the stock of inventories.
1
Thus
O
t
¹o
t
= 1(1
t
, ·
t
).
Also, inventory stock evolves over time according to the following rule:
\
t+1
= \
t
+ (O
t
1
t
). (2)
Now let us look at the speci…c production function used by Harrod. Harrod
assumed a …xed coe¢cient production technology such that
1(1
t
, ·
t
) = 'i:

1
t
c
,
·
t
,

,
where c, , 0 are technology determined parameters, representing the inverse
of capital productivity and labour productivity respectively.
The …xed coe¢cient production function has important implications for the
factor employments. Recall the the economy has certain historically given stocks
of capital and labour at the beginning of period t and given these stocks, it is
unlikely that
1
t
c
=
·
t
,
at every t. Thus one of the factors is likely to be un-
derutilized. We shall call an economy ‘capital-constrained’ (or, equivalently,
‘labour-surplus’) i¤
1
t
c
<
·
t
,
. Similarly, we shall call an economy ‘labour-
constrained’ (or, equivalently, ‘capital-surplus’) i¤
1
t
c

·
t
,
. Harrod as-
sumes that the economy is ‘capital-constrained’, at least to begin with. This
1
This assumption is not critical. When could easily construct a demand driven growth
model where adjsutment is done through factor utilization. The results will be qualitatively
similar.
2
implies that production and aggregate supply in this economy is determined by
the following equation:
O
t
¹o
t
=
1
t
c
. (3)
Notice that actual employment in this ‘capital-constrained’ economy is given
by:
1
t
=
,1
t
c
< ·
t
.
Thus the economy is characterised by structural unemployment of the amount:
·
t
1
t
.
2
1.3 Population Growth:
The stock of labour force grows at a constant rate ::
·
t+1
= (1 +:)·
t
.
Harrod assumes that this rate of growth of population is exogenous - determined
by demographic factors.
1.4 Investment Function:
The most important assumption in the Harrod model is the existence of an
independent investment function, which depends on producers’ expectations.
(Typically, in other growth models, it is assumed that there is no independent
investment function and all savings are automatically invested - which makes
savings and investment identical. It also implies that both savings and invest-
ment decisions are made by the households. Harrod on the other hand was
highliting the fact that savings and investment decisions are separate: savings
decisions are taken by households, while investment decisions are made by pro-
ducers. Allowing for this dichotomy plays a very important role in the Harrod
model - as we shall soon see.)
There are several alternative formulations of a Harrodian investment func-
tion. Here we shall follow Hahn & Mathews (19640 and Sen (1970) in specifying
the following investment function:
1
t
= c

1
e
t+1
1
t

. (4)
The implicit logic behind this investment function as follows. Suppose the pro-
ducers expect that tomorrow’s output would be 1
e
t+1
. Then they have to produce
and extra output of 1
e
t+1
1
t
. Given that production of one unit of output re-
quires c units of capital (recall that in the …xed coe¢cient technology, c is the
inverse of capital productivity), meeting this extra (expected) demand tomorrow
would require c

1
e
t+1
1
t

extra units of capital. Hence the produceres invests
exactly that amount which augments tomorrow’s capital stock accordingly.
2
Structural unemployment is di¤erent from ‘Keynesian’ unemployment. The former hap-
pens purely due to technology, while the latter arises due to demand-supply mismatch.
3
The act of investment, by de…nition, augments tomorrow’s capital stock:
1
t
= 1
t+1
1
t
,
thereby in‡uencing tomorrow’s production (i.e., tomorrow’s aggregate supply).
But in this demand-driven economy, the act of investment plays another role:
it also in‡uences today’s demand and therefore today’s actual output (refer to
equation (1)). This dual role of investment is a key feature in the Harrod model
which drives its main results, which we discuss below.
2 Dynamics of Actual Output and Associated
Growth Path:
Recall that in this economy,
1
t
¹1
t
=
c

1
e
t+1
1
t

:
=
1
t+1
1
t
:
, (1a)
while
O
t
¹o
t
=
1
t
c
. (2a)
There is no reason why ¹1
t
= ¹o
t
in every period. And if ¹1
t
6= ¹o
t
, then
the stock of inventories adjust. Now we are interested in analysing the growth
path of the actual output (1
t
), under two scenarios:
Scenario I: ¹1
t
= ¹o
t
at every t (by some freak co-incidence);
Scenario II: ¹1
t
6= ¹o
t
at least at t = 0. In this latter case, we would also
like to know whether in the long run (as t !1), the AS and AD will eventually
converge to each other or whether they will be perpetually mismatched.
2.1 Scenario I:
In this case, 1
t
= O
t
for all t. Then from (1a) and (2a),
1
t+1
1
t
:
=
1
t
c
)
1
t+1
1
t
1
t
=
:
c
q

(say).
It is then easy to verify that 1
t
, O
t
, 1
t
- all will grow at the same constant
growth rate (q

) as 1
t
.Harrod called this secnario the warranted or desirable
scenario (since there is no mismatch between AD and AS). Correspndingly, q

is called the ‘warranted growth rate’.
Notice that this scenario also represents a ‘steady state’ or a ‘balanced
growth path’ because all variables in the economy grow at constant rates
(though not necessarily at equal rate).
4
2.2 Scenario II:
To analyse the rate of growth of actual output in this case, let us combine
equations (1a) and (2a), to get:
1
t
=
c

1
e
t+1
1
t

:
=
1
t+1
1
t
:
=
c[O
t+1
O
t
]
:
. (3a)
Now from the …rst two expressions of (3a),
1
t
=
c

1
e
t+1
1
t

:
=
1
q

1
e
t+1
1
t

) 1
t
=
1
e
t+1
1 +q

.
Thus the rate of growth of actual output depends crucially on the rate of growth
of expected output. In particular,
q
t

1
t+1
1
t
1
t
=
1
e
t+2
1
e
t+1
1
e
t+1
q
e
t+1
. (A)
This begs the following question: how is then q
e
t+1
determined? This will re-
quire some thoery about expectation formation. We shall discuss below some
speci…c expectation formation rules and their implications. But before that let
us examine the rate of growth of aggrerate supply under scenario II. Again from
equation (3a), combining the 2nd and the 4th expression:
c

1
e
t+1
1
t

:
=
c[O
t+1
O
t
]
:
) 1
e
t+1
1
t
= O
t+1
O
t
) (1 +q

)1
t
1
t
= O
t+1
O
t
) q

1
t
O
t
=
O
t+1
O
t
O
t
q
s
t
. (B)
Now let us consider various expectation formation rules. We start with constant
(static) expectation, such that q
e
t+1
remains constant (at some arbitrary value)
for all points of time. Then there are three possibilities.
2.2.1 Static Expectations, Case 1: q
e
t+1
= q

The rate of growth of actual output is then trivially determined from (A):
q
t
= q

.
A more interesting question is: what is hapenning to the demand-supply gap
in the long run? Notice from (B) that q
s
t
6= q

initially (since under scenario II
the economy is starting with some initial mismatch between demand and supply,
i.e.,
1
0
O
0
6= 1). But no matter what its initial value

1
0
O
0

is, does
1
t
O
t
converge
5
to unity in the long run? To answer this question, we look at the evolution of
the
1
t
O
t
ratio, or equivalently, the
O
t
1
t
ratio.
From (A): 1
t+1
= (1 +q

) 1
t
; while from (B): O
t+1
= O
t
+q

1
t
. Thus,
O
t+1
1
t+1
=

1
1 +q

O
t
1
t
+
q

1 +q

. (5)
This is a …rst order linear di¤erence equation which is autonomous. It is easy to
solve this equation and verify that the solution is stable and in the long run,
as t ! 1,
O
t
1
t
will converge to its steady state value, which is unity.
Thus indeed under Case 1, the mismatch between AD and AS will disappear in
the long run.
2.2.2 Static Expectations, Case 2: q
e
t+1
= q q

Once again, the rate of growth of actual output is then trivially determined
from (A):
q
t
= q.
But now the evolution of the
O
t
1
t
ratio is given by the following di¤erence
equation:
O
t+1
1
t+1
=

1
1 +q

O
t
1
t
+
q

1 +q
. (6)
Solving this linear automous equation analogously, again it is easy to verify that
the solution is indeed stable. But now the steady state value is given by
q

q
< 1.
Thus in the long run, as t ! 1,
O
t
1
t
will converge to a value which is
less than unity. Thus under Case 2, the mismatch between AD and AS does
not disappear in the long run. In fact in the long run there is perpetual excess
demand (irrespective of the initial situation).
2.2.3 Static Expectations, Case 3: q
e
t+1
= q < q

As before, the rate of growth of actual output is then trivially determined from
(A):
q
t
= q,
while the evolution of the
O
t
1
t
ratio is given by the following di¤erence equa-
tion:
O
t+1
1
t+1
=

1
1 +q

O
t
1
t
+
q

1 +q
. (7)
By analogous logic it can be shown that the solution is again stable, but the
steady state value is given by
q

q
1. Thus in the long run, as t ! 1,
O
t
1
t
6
will converge to a value which is greater than unity. Thus under Case
3, once again the mismatch between AD and AS does not disappear in the long
run. But now in the long run there will be perpetual excess supply (irrespective
of the initial situation).
2.2.4 Other Typs of Expectations:
Of course there is no reason why expectations will be constant (static). What
happens if we allow for other types of expectations? In particular, if we bring
in other kinds of expectation formation stories, will that change the conclusions
that we have derived above?
First, let us consider rational expectations. It turns out that bringing
in rational expectations would not change any of these results. This is
because in this model, at every point of time, q
t
= q
e
t+1
(by construction). Thus
on each of these constant expactation growth paths (such that q
e
t
= q
e
t+1
=
some constant), expectations are always ful…lled. Or equivalently, any arbitrary
constant q
e
t+1
will be consistent with a rational expecation growth path.
Next consider an adaptive expectation rule such that starting form any
arbitrary intial expectation, q
e
0
, the expected growth rate evloves according to
the following equation: q
e
t+1
= q
e
t
+c [q
t
q
e
t
] ; 0 < c < 1. However, as we have
just notes, in this model the actual growth rate itself depends on tomorrow’s
expected growth rate. Thus plugging in the information that q
t
= q
e
t+1
in the
adaptive expectation rule implies that
q
e
t+1
= q
e
t
+c

q
e
t+1
q
e
t

) (1 c)q
e
t+1
= (1 c)q
e
t
) q
e
t+1
= q
e
t
.
Thus the only adaptive expectation rule that is consistent with the model is
that of constant expectations.Hence bringing in adaptive expectation does
not change any of the results either.
Finally, let us assume that producers adjust their expectation by looking at
the economic conditions, in particular, by looking at the changes in the stock of
inventories. If in any period, they …nd that there is unintended accumulation
of inventories, they feel that they expected too much and cut down on next
period’s expected growth rate; on the other hand if in any period, they …nd that
there is unintended decumulation of inventories, they feel that they expected
too little and jack up next period’s expected growth rate.
3
Thus, starting with
any arbitrary initial expectation q
e
0
, the expected growth rate evloves according
to the following equation: q
e
t+1
= q
e
t
+ ) (\
t+1
\
t
) , such that )(0) = 0 and
)
0
(.) < 0. However, recall that inventory stocks adjusts in accordance with the
mismatch between AS and AD, such that \
t+1
\
t
= O
t
1
t
(refer to equation
(2)). Thus the above expectation function can be written as:
q
e
t+1
= q
e
t
+) (O
t
1
t
) ; )(0) = 0, )
0
(.) < 0,
3
Harrod did not specify any particular expectation adjustment function, but many people
argue that this is that mechanism that he was hinting at.
7
or, equivalently,
q
e
t+1
= q
e
t
+/

O
t
1
t
1

; /(0) = 0, /
0
(.) < 0. (8)
Now let us get back to the dynamic equation which determines the evolution of
the ratio
O
t
1
t
. As before, we have (from (A)):
1
t
=
1
e
t+1
1 +q

)q
t
= q
e
t+1
) 1
t+1
= (1 +q
e
t+1
)1
t
.
On the other hand, from (B):
O
t+1
= O
t
+q

1
t
.
Thus,
O
t+1
1
t+1
=
1
1 +q
e
t+1

O
t
1
t
+q

)
O
t+1
1
t+1
=
1
1 +q
e
t
+/

Ot
Yt
1

O
t
1
t
+q

; /(0) = 0, /
0
(.) < 0, q
e
t
given. (9)
This is non-linear di¤erence equation in
O
t
1
t
which (usually) cannot be solved
explicitly.
4
Nonetheless we can say something about the nature of the steady
state provided we have some more information about the /(.) function. It is
easy to construct many di¤erent /(.) functions which satisfy the basic criteria
that /(0) = 0, /
0
(.) < 0 and for which qualitatively similar results will follow.
[An Illustration: Suppose /(.) is a linear function: /

Ot
Yt
1

= ,.

Ot
Yt
1

,
where , is a positive constant. Derive the system of di¤erence equations in this
case and …nd out the corresponding steady state values. Is AS=AD at this
steady state? Show that this steady state is a saddle point such that for any
initial value of
Ot
Yt
, there exists a only a unique initial expectation (q
e
0
) which will
take the economy to the steady state and any other expectation will necessarily
move the economy away from the steady state. Do this as an exercise.]
3 Economic Implications of Harrod Model:
Thus we see that under the Harrod model, the best possible scenario is when
q
e
t+1
= q

.In this case the economy grows steadily at the rate q

and there is
no demand-supply mismatch in the long run. For any other scenario, there is
perpetual excess supply or perpetual excess demand.
4
In fact, equation (8) and equation (9) constitute a 2X2 nonlinear system of di¤erence
equations of …rst order.
8
Is the best possible scenario sustainable? This is where the population
growth rate comes into play. This best possible scenario is sustainable if and
only if q

= : and this can only happen by pure chance.
If q

:, then output and therefore employment is increasing at a rate faster
than population growth rate. Thus even though the economy started with some
slack labour (remember, the economy was capital-constrained to begin with),
this slack labour will be mopped up quickly and the economy will then reach
a point where labour becomes the binding constraint. In other words, at that
point the economy will get rnsformed from a capital-constrained to a labour-
constarined economy. What happens thereafter is somewhat uncertain. One
possibility is that producers cease to invest (since adding to capital stock does
not make sense any more; there is no labour to equip those capital stocks),
investment drops to zero and so thus aggregate demand. Thus the economy
suddenly plungs into a crisis. Alternatively the producers could anticipate the
impending labour constarint and invest only so much which will keep the labour
stock fully employed. In the latter case the economy will grow at the rate :.
(According to Harrod, the latter is unlikely because population growth rate
is determined by demographic factors and it is not easy for the producers to
anticipate that).
If q

< :, then output and therefore employment is increasing at a rate
slower than population growth rate. As a consequence, (a) the rate of growth
of per capital income will negative, which means that people will experience
falling living standards, and (b) at the same time, there will be growing volume
of unemployment.
Thus the conclusions of the Harrod model is rather dark: it paints a rather
sombre picture of a leissez faire economy, which will either plung into a crisis
from a steady growth path, or will exhibit perpeputal misery and unemploye-
ment. The solution to this, according to Harrod, lies in government intervention.
Analogous to Keynes, Harrod also argued for an active role of the government
which can save the economy by boosting aggregate demand through government
expenditure.
4 Di¤erence between Harrod & Domar:
Domar constructed a model around the same time as Harrod, which is almost
identical to Harrod in every respect, except one: Domar did not incorporate a
separate investment function. For Domar, all savings are automatically invested
(which implicitly assumes that savers and investors are the same set of people
(the households), while Harrod assumed that savings decisions are undertaken
by households, but investment decisions are undertaken by …rms). Notice that
the moment one assumed that all savings are automatically invested, the output
is no longer demand driven. (In other words, equation (1) loses its signi…cance
and is tautologically true). Thus unlike Harrod, Domar is a supply side model,
even though it otherwise looks exactly similar to the Harrod model.
9
Indeed, if actual output is determined by aggregate supply, then
1
t
= O
t
=
1
t
c
.
Again all saving being automatically invest means,
1
t
= o
t
= :1
t
) 1
t+1
1
t
= :1
t
= :
1
t
c
)
1
t+1
1
t
1
t
=
:
c
q

.
Thus output, employment, capital stock - everything will always grow at the
rate q

. Producers’ expectations cease to play any role here and there is never
any mismatch between AS and AD.
To be sure, to the extent that q

6= :, the other problems mentioned by
Harrod would still persist. In particular, if q

< :, the economy would still be
characterized by falling living standards and growing unemployment. But when
q

= :, there is no longer any crisis. Investment does not fall to zero even when
the economy hits the full employment barrier. Recall that all savings are auto-
matically invested (irrespective of whether the economy is labour constrained or
capital constrained) and the economy switches from q

to : the moment labour
becomes the binding factor rather than capital.
NOTE: The mechanics of the Harrod model described here is slightly dif-
ferent from the prescribed reference (A.Sen: Growth Economics, Introduction).
The purpose of the present exercise is to show that the basic Harrodian results
are robust to various kinds of expectation formation, including rational expec-
tations. (In contrast, Sen’s formulation depends heavily on adaptive expecation
and would fall ‡at if producers have rational expecations). It is advised that you
go through for the formulations to get a complete understanding of the issues
involved.
10

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