TYBA A

SEMESTER V

2021-22

ECONOMICS OF DEVEOPMENT

GROUP ASSIGNMENT

GROUP NUMBER 2 –

THEORIES OF DEVELOPMENT:

CLASSICAL AND CONTEMPORARY

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GROUP 2:

Sr No. Name Roll No. Sap id

1 DHRUVI GALA A011 40310190034

2 HARSHI GALA A012 40310190035

3 SAHIL GANDECHA A013 40310180008

4 DHARA GOSAR A014 40310190005

5 INSIYA JANALI A015 40310190007

6 AYUSHI JOGI A016 40310190049

7 CHIRAG KABRA A017 40310190050

8 AARYA KOTHARI A018 40310190148

9 AISHWARYA MALANDKAR A019 40310190059

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CONTRIBUTIONS:

Introduction, Assumptions, The

A015 INSIYA JANALI
Harrod Model and Nepal Case Study.

The Domar Model, Significance,

A016 AYUSHI JOGI Differences, Limitations and
Criticisms.

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 Insiya Janali
A015
The Harrod- Domar model of Growth
Introduction:
Harrod Domar model is a Keynesian model of economic growth. It explains economy’s
growth in terms of the level of savings and capital. It was developed by Roy Harrod in 1939
and Evsey Domar in 1946. Both developed the models individually later on it was combined
and was known as the Harrod Domar model. There are three types of growth in this model:

First, is the warranted growth which is represented by (Gw), in this all the resources are fully
utilized and it is also called full employment rate of growth and all the savings used are
converted in capital. Next we have is the actual growth rate, it is the real rate increase in a
country's GDP per year so to find whether the growth is taking place in the economy or not
we use actual growth rate(G). Last is the natural growth rate it is the growth an economy
requires to maintain full employment and it is denoted by (Gn).

Assumptions:

The assumptions for the model are as follows

• Full employment should exist.

• Second, economy should be a closed economy that is no trade should take place.
• The planned investment should be equal to the real investment.
• Fourth, there shouldn't be any depreciation of the capital.
• Savings and investment are equal.
• There should be no change in the interest rate.
• Absence of government interference and foreign aids.
• MPS and APS are equal.
• There are no lags in adjustment.
• The propensity to save and capital coefficient are considered constant.

The Harrod Model

G = Gw and C=Cr here,

G should be equal to Gw which means the actual growth should be equal to warranted
growth and C should be equal to CR that is capital output ratio needed to get G should be

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equal to capital ratio required to maintain Gw. But this condition is very rare in a free
enterprise economy and usually what happens is:

G>Gw and C<Cr (inflation)

G is more than Gw which means demand exceeds supply and we have the condition for
inflation or C is less than CR that is actual capital falls short of the required capital which
leads to inflation. The other thing which can happen is:

G<Gw and C>Cr (deflation)

G is less than Gw which means there is a deficiency of demand and this will lead to deflation
similarly C is more than Cr which means the actual capital is larger than the required capital
which will lead to the situation of deflation in the economy. So what happens is the slight
Deviation of G from Gw leads to further and further away from steady state growth hence it
is called as the Knife edge equilibrium.

Case study on Nepalese economy:

This is a case study of the Nepalese economy how the Harrod Domar model was relevant in
their economy is explained. Using different econometric techniques like co integration,
granger causality test etc. relevance of Harrod Domar model is examined. The growth is
measured over the period of 1974-75 to 2016 and 17. The study confirms the relationship
among the variables of economic growth, savings and fixed capital formation. So after the
study is conducted using all these econometric techniques they reached the conclusion that
growth rate of saving has a positive impact. On the other hand the incremental capital output
ratio has a negative impact which also supports the Harrod Domar model. The different

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Policy measures that can be taken are also suggested. People should increase their savings,
there should be proper development of capital market, since the capital output ratio is
increased the government should focus on increasing labor productivity to reduce capital
output ratio.

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REFRENCES:

 Adhikari, R. (n.d.). Relevancy of Harrod-Domar Model in Nepalese Economy. IOSR

Journal of Economics and Finance, 9(1), 37–44. https://doi.org/10.9790/5933-
090103744

 Harrod-Domar Model of Economic Growth. (n.d.). Retrieved September 7, 2021,

from https://www.economicsdiscussion.net/economic-growth/harrod-domar-model-
of-economic-growth/26330

 (42) Harrod-Domar Model of Growth by Vidhi Kalra - YouTube. (n.d.). Retrieved

September 7, 2021, from
https://www.youtube.com/watch?v=C6nD5ORW7jQ&t=188s

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 Ayushi Jogi

A016

The Harrod-Domar Growth Models:

The Harrod-Domar models of economic growth are based on the experiences of advanced
economies They are primarily addressed to an advanced capitalist economy and attempt to
analyse the requirements of steady growth in such economy.

Both Harrod and Domar are interested in discovering the rate of income growth necessary for
a smooth and uninterrupted working of the economy. Though their models differ in detail, yet
they arrive at similar conclusions.

Harrod and Domar assign a key role to investment in the process of economic growth. But
they lay emphasis on the dual character of investment. Firstly, it creates income, and
secondly, it augments the productive capacity of the economy by increasing its capital stock.
The former may be regarded as the ‘demand effect’ and the latter the ‘supply effect’ of
investment. Hence so long as net investment is taking place, real income and output will
continue to expand However, for maintaining a full employment equilibrium level of income
from year to year, 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. Otherwise, any
divergence between the two will lead to excess or idle capacity, thus forcing entrepreneurs to
curtail their investment expenditures. Ultimately, it will adversely affect the economy by
lowering incomes and employment in the subsequent periods and moving the economy off
the equilibrium path of steady growth. Thus, if full employment is to be maintained in the
long run, net investment should expand continuously. This further requires continuous
growth in real income at a rate sufficient to ensure full capacity use of a growing stock of
capital. 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 question: since investment generates income on
the one hand and increase his 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?

He answers this question by forging a link between aggregate supply and aggregate demand
through investment.

Increase in productive capacity. Domar explains the supply side like this. Let the annual rate
of investment be I, and the add world productive capacity per dollar of newly created capital
be equal on the average to s (bitter presents the ratio of increase in real income or output to an
increase in capital over the reciprocal of the accelerator or marginal capital-output ratio.)
Thus, the productive capacity of I dollar invested will be I.s dollars per year.

But some new investment will be at the expense of the old. It will therefore compete with the
latter for labour markets and other factors of production. As a result, the output of old plants
will be curtailed and the increase in the annual output (productive capacity) of the economy
will be somewhat less than I.s. This can be indicated as I σ (sigma) represents the net
potential social average productivity of investment (= ΔY/I). Accordingly, I σ is less than I.s.
I σ is the total net potential increase in output off the economy and is known as the Sigma
effect. In Domar’s words, this “is the increase in output which the economy can produce,” it
is the ‘supply side of our system.’

Required increase in aggregate demand. The demand side is explained by the Keynesian
multiplier stop let the annual increase in income be denoted by ΔY and the increase in
investment by ΔI and the propensity to save by α (alpha) (= ΔS/ΔY). Then the increase in
income will be equal to the multiplier (1/ α) times the increase in investment.

ΔY = ΔI 1/ α

Equilibrium. To maintain full employment equilibrium level of income, aggregate demand

should be equal to aggregate supply. Thus, we arrive at the fundamental equation of the
model:

ΔI 1/ α = Iα

Solving this equation by dividing both sides by I and multiplying by α we get:

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ΔI/ I = ασ

This equation shows that to maintain full employment, the growth rate of net autonomous
investment (ΔI/ I) must be equal to ασ (the MPS times of productivity of capital). This is the
rate at which investment must grow to assure the use of potential capacity in order to
maintain a steady growth rate of the economy at full employment.

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Domar gives a numerical example to explain his point:

Let σ = 25 percent per year, α = 12 percent and Y = 150 billion dollars per year. If full
employment is to be maintained, an amount equal to 150x12/100 = 18 billion dollars should
be invested.

This will raise productive capacity by the amount invested σ times, i.e., by 150 x 12/100 x
25/100 = 4.5 billion dollars, and the national income will have to rise by the same amount.
But the relative rise in income will equal the absolute increases divided by the income itself,
i.e.,

150 x (12/100 25/100) / 150 = 12/100 x 25/100 = ασ = 3 percent

Thus, in order to maintain full employment, income must grow at the rate of 3% per annum.
This is the equilibrium rate of growth fill stop any diversion from this golden path will lead to
cyclical fluctuations. When ΔI/ I is greater than ασ, the economy would experience boom and
when ΔI/ I is less than ασ, it would suffer from depression.

Significance:

Although the Harrod–Domar model was initially created to help analyse the business cycle, it
was later adapted to explain economic growth. Its implications were that growth depends on
the quantity of labour and capital; more investment leads to capital accumulation, which
generates economic growth. The model carries implications for less economically developed
countries, where labour is in plentiful supply in these countries but physical capital is not,
slowing down economic progress. LDCs do not have sufficiently high incomes to enable
sufficient rates of saving; therefore, accumulation of physical-capital stock through
investment is low.

The model implies that economic growth depends on policies to increase investment, by
increasing saving, and using that investment more efficiently through technological advances.

The model concludes that an economy does not "naturally" find full employment and stable
growth rates.

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Differences:

1. Domar assists a key role to investment in the process of growth and emphasises on its
dual character, But Harrod regards the level of income as the most important factor in the
growth process Whereas Domar forges a link between demand and supply of investment
Harrod on the other hand, equates demand and supply of saving.
2. The Domar model is based on one growth rate r=ae But Harrod uses three distinct rates of
growth the actual rate (G), the warranted rate (Gb) and the natural rate (G/i).
3. Domar gives expression to the multiplier, but Harrod uses the accelerator about which
Domar appears to say nothing.
4. For Harrod the business cycle is an integral part of the path of growth and for Domar it is
not so but is accommodated in his model by allowing e (average productivity of
investment) to fluctuate.
5. While Domar demonstrates the technological relationship between capital accumulation
and subsequent full capacity growth in output, Harrod shows m addition a behavioural
relationship between rise in demand and hence in current output on the one hand, and
capital accumulation on the other In other words, the former does not suggest any
behaviour pattern for entrepreneurs and the proper change in investment comes
exogenously, whereas the latter assumes a behaviour pattern for entrepreneurs that
induces the proper change in investment.

Limitations and Criticisms:

1. The propensity to save (α or s) and the capital-output ratio (σ) are assumed to be
constant. In actuality, they are likely to change in the long run and thus modify the
requirements for steady growth. A steady growth rate can, however, can be
maintained without this assumption. As Domar himself writes, “This assumption is
not necessary for the argument and that the whole problem can be easily reworked
with variable α and σ.”
2. The assumption that labour and capital are used in fixed proportions is untenable.
Generally, labour can be substituted for capital and the economy can move more
smoothly towards a path of growth. Infact, unlike Harrod’s model, this path is not so
unstable that the economy should experience chronic inflation or unemployment if G
does not coincide with Gw.

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3. The two models fail to consider changes in the general price level. Price changes
always occur over time and may stabilize otherwise unstable situations. According to
Meier and Baldwin, “If allowance is made for price changes and variable proportions
in productions, then the system any have much stronger stability than the Harrod
model suggests.”
4. The assumption that there are no changes in the interest rates is irrelevant to the
analysis. Interest rates change and affect investment. A reduction in interest rates
during periods of overproduction can make capital-intensive processes more
profitable by increasing the demand for capital and thereby reduce excess supplies of
goods.
5. The Harrod-Domar models ignore the effect of government programmes on economic
growth. If, for instance, the government undertakes a programme of development, the
Harrod-Domar analysis does not provide us with casual (functional) relationship.
6. It also neglects the entrepreneurial behaviour which actually determines the warranted
growth rate in economy. This makes the concept of the warranted growth rate
unrealistic.
7. The model has many unrealistic assumptions, and it ignores labour productivity,
technical innovations and advancement and structural changes.
8. The model also assures existence of reliable finance and transport system and
developing countries lack in it leading to a lack in investment and it is also difficult to
influence saving levels in developing countries because of the widespread poverty.
REFERENCES:
1. https://archive.org/stream/in.ernet.dli.2015.137008/2015.137008.The-Economics-
Of-Development-And-Planning_djvu.txt
2. https://penpoin.com/harrod-domar-model/
3. https://www.macroeconomicsnotes.com/the-harrod-domar-model/the-harrod-
domar-model-economic-growth-macroeconomics/14138
4. https://www.youtube.com/watch?v=-KllBsEjFBo
5. https://www.youtube.com/watch?v=C6nD5ORW7jQ
6. https://www.tutor2u.net/economics/reference/economic-growth-harrod-domar-
model
7. https://www.economicsdiscussion.net/harrod-domar-model/harrod-and-domar-
model-similarities-and-dissimilarities/13017

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