Harrod –Domar Growth Model

Solow Growth Model

Endogenous Growth Model

Econ 171 -- Atanu Dey -- Lecture 5 1

Thinking About Development
Rates of growth of real per-capita income are . . . diverse,
even over sustained periods . . . I do not see how one
can look at figures like those without seeing them as
representing possibilities. . .
The consequences for human welfare involved in
[questions related to development] are simply
staggering: Once one starts thinking about them, it is
hard to think about anything else.
-- Robert Lucas

Econ 171 -- Atanu Dey -- Lecture 5 2

Link between Human Development and
Income
[A] unity of interests would exist if there were rigid links
between economic production (as measured by
income per head) and human development (reflected
by human indicators such as life expectancy or literacy,
or achievements such as self-respect, not easily
measured). But these two sets of indicators are not
very closely related.
-- Paul Streeten (1994)

Econ 171 -- Atanu Dey -- Lecture 5 3

Rate of Growth
 How long would it take for a quantity to double if it
grows at a compounded rate of growth of 7 percent?

 . . . of 10 percent?

Econ 171 -- Atanu Dey -- Lecture 5 4

Rule of 70

 Simple formula: Divide 70 by the rate of growth

 At 7 percent compounded rate of growth, the doubling

time is 10 years, and vice versa.

Econ 171 -- Atanu Dey -- Lecture 5 5

Harrod-Domar Growth Model
 Developed independently by Sir Roy Harrod in 1939
and Evsey Domar in 1946
 Explains growth in terms of the level of saving and
productivity of capital
 Production = Consumption goods + Capital goods
 Investment  Capital formation
 Saving means delaying present consumption
 Growth depends on investing savings in increasing
capital stock

Econ 171 -- Atanu Dey -- Lecture 5 6

Macroeconomic Flow
 Firms and households
 Firms produce stuff
 Firms pay wages, profits and rents to households
 Households consume stuff
 Consumption expenditure is income for firms
 Households save
 Savings are investments for firms
 Circular flow of production, consumption, saving, and
investment

Econ 171 -- Atanu Dey -- Lecture 5 7

Variables
 Y represents income
 same as output or production
 K represents capital stock
 δ depreciation rate of the capital stock
 S is savings
 s is the savings rate, and
 I is investment
 C is consumption
The Harrod-Domar model makes the following a
priori assumptions:
Econ 171 -- Atanu Dey -- Lecture 5 8
Assumptions
 Output (or income) is consumption plus savings
 Y(t) = C(t) + S(t)
 The product of the savings rate and output equals
saving, which equals investment
 sY = S = I
 The change in the capital stock equals investment less
the depreciation of the capital stock
 K(t+1) = (1 – δ)K(t) + I(t)

Econ 171 -- Atanu Dey -- Lecture 5 9

Harrod-Domar Equation
 Savings rate is s
 s = S(t)/Y(t)
 Capital-output ratio is θ
 Amount of capital required to produce one unit of
output
 θ = K(t)/Y(t)
 Rate of growth g
 g = [Y(t+1) – Y(t)]/Y(t)
 s/θ = g + δ – the Harrod-Domar Equation

Econ 171 -- Atanu Dey -- Lecture 5 10

What the H-D equation means
g = s/θ - δ

 It links growth rate g to two other rates

 The savings rate s and the capital-output ratio θ

 What’s the effect of population growth?

Econ 171 -- Atanu Dey -- Lecture 5 11

Adding population growth
 Population P grows at rate n
 P(t+1) = P(t)(1 +n)
 Per capita income is y(t)
 y(t) = Y(t)/P(t)
 Per capita income growth rate is g*
 y(t+1) = y(t)(1 + g*)
 New equation
 s/θ = (1 + g*)(1 + n) – (1 – δ)
 Combines savings ability, capital
productivity, depreciation, and population growth

Econ 171 -- Atanu Dey -- Lecture 5 12

What it means
 s/θ = (1 + g*)(1 + n) – (1 – δ)
 (1 + g*)(1 + n) = 1 + g* + n + g*n
 But g* and n small numbers, and so g*n is negligible
 So s/θ ≈ g* + n + δ
 Interpretation:
 Per capita growth rate is reduced by population growth
rate and by capital depreciation rate
 Per capita growth rate is increased by savings rate and by
more efficient use of capital

Econ 171 -- Atanu Dey -- Lecture 5 13

Are the variables exogenous?
 H-D models saving rate, capital-output ratio, and
population growth rate as constants, and not affected
by the growth of the economy
 s, n and θ are considered exogenous
 What if saving rate is a function of per capita income?
 Poor people cannot save at the same rate as those who
are rich
 Distribution of income – and not just per capita income
– affects the saving rate
 Therefore saving rate may rise with rising incomes

Econ 171 -- Atanu Dey -- Lecture 5 14

Population growth rate
 Population growth rate declines as incomes go up
 Why?
 n is endogenous
 The capital-output ratio also changes due to the law of
diminishing returns to individual factors of
production
 When capital level is low, the marginal productivity of
capital is high
 So θ is endogenous as well

Econ 171 -- Atanu Dey -- Lecture 5 15