The Harrod-Domar Model vs the Neo-Classical Growth Model
Author(s): Ryuzo Sato
Source: The Economic Journal, Vol. 74, No. 294 (Jun., 1964), pp. 380-387
Published by: Wiley on behalf of the Royal Economic Society
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THE HARROD-DOMAR MODEL vs THE NEO-
CLASSICAL GROWTH MODEL'
IT is a well-knowncharacteristicof the simple Harrod-Domarmodel
that even for the long run the economicsystemis at best balancedon a
knife-edgeof equilibriumgrowth. Whenthe economydeviatesslightlyfrom
the naturalgrowthratethe consequencewouldbe eithergrowingunemploy-
ment or prolongedinflation,since the systemhas no built-inequilibrating
force. The shortcomingsof this simplemodelhave now been discussedfor
some time.2 The underlyingassumptionof fixed proportionsin the com-
binationof capital and labourhas been the main object of criticism. In
contrast,an alternativemodel has been developedin which factorpropor-
tions are flexibleand all rigiditiesare assumedaway. This model is often
referredto as the " neo-classical" model.
The basicconclusionof the neo-classicalgrowthmodelis that, in certain
circumstances,when productiontakes place under the usual neo-classical
conditionsof variableproportionsand constantreturnsto scale no conflict
betweenthe naturaland the warrantedratesof growthin the Harrod-Domar
modelis possible; that is, the extremeinstabilityof long-rungrowthequili-
briumis unlikelyand,givensufficienttime,the actualgrowthratecan adjust
to any given initial condition,achievingbalancedgrowthin the long run.
However,practicalimplicationsof the neo-classicalgrowthmodelhinge
heavilyon how rapidlyadjustmentwill proceedwhenthe systemmovesfrom
one equilibriumto another. If the adjustmentperiodis shortdisequilibrium
in the economicsystemis easilyeliminatedand balancedgrowthis promptly
achieved. Butif the adjustmentperiodis long or if factorsubstitutiontakes
place at a slowrate disequilibrium, suchas unemploymentor inflation,may
last for a considerablelengthof time. If adjustmentproceedsat a slowrate
proportionsin the combinationof capitaland labourmay virtuallybe con-
sideredas fixed.
Thispaperproposesto measurethe approximatelengthof the adjustment
periodandto showwhatpracticalimportancethe neo-classicalgrowthmodel
has comparedwith the Harrod-Domarmodel. Somenumericalresultsare
given to demonstratethe approximatelengthof the adjustmenttime.
1 The author wishes especially to acknowledge criticism and encouragement from ProfessorR. A.
Musgrave of Princeton University and Professors Edwin S. Mills and Carl F. Christ of the Johns
Hopkins University. He has also benefited from comments and suggestions by Professor Robert M.
Solow of the MassachuisettsInstitute of Technology.
2 Undoubtedly the most important paper is R. M. Solow's " A Contribution to the Theory of
Economic Growth," QuarterlqJournalof Economics,Vol. 70 (February 1956). See also T. W. Swan,
" Economic Growth and Capital Accumulation," EconomicRecord,Vol. 32 (1956), and F. Hahn,
" The Stability of Growth Equilibrium," QuarterlyJournalof Economics,Vol. 74 (1960).
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MOULDVSNEO-CLASSICAL
JUNE 1964]HARROD-DOMAR GROWTHMODEL 381
I. THE NEO-CLASSICAL
GROWrHMODEL
Assumean economy with one product (Y(t))and two factorsof production,
capital and labour, K(t) and L(t) respectively, capital being an accumulated
stock of Y. Assume neutral technological progressat a constant rate p. We
assume further that Y(t)is subject to a linear homogeneous production func-
tion, that is, constant returns to scale. Thus,
Y(t) =A(t)F(K(t).,];(t)). . . . . . (1
where A(t) is the neutral technological improvement factor and equals
Aoept.
The complete differential of the production function with respect to t
gives us
ldY aYK ldK aYL IdL
Y dt- =ax Y R
X d-t AL Y L dt M
aYK aY L
By substituting ocand j3for the shares ofcapital and labour -aKY
and aL y and
1
letting y dY== Gy = GK and L dL A; the above equation becomes
Gy =oGK + A +P .(2)
Thus the growth rate of income GY equals the sum of the technological
improvement factor p and the weighted mean of the growth rates of capital
and labour. The weight is given to each factor by its respectiveshare in the
national income. Equation (2) can be rewritten in an alternative and, for
our purpose, a more convenient form
GY-=c#GK+ (A+. ).(3)
If planned investment equals planned saving so that the effective demand is
sufficiently large to absorb the effective supply, GK in the above equation is
the warranted, and (A + the naturalgrowth rate ofincome in the Harrod-
Domar model. This is because, at a growth rate equal to GK,neither sur-
pluses nor deficiencies of capital develop, and at a growth rate of (A + )
the maximum rate of advance is assured with a given rate of population
increase and technological improvements. Replacing GK and (A +
by GWand G. respectively, equation (3) may be written as
Gy aGw+3Gn .(4)
In other words, the actual growth rate of income is the weighted mean of the
warranted and the natural rates of growth; the weight is given by the shares
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382 THE ECONOMIC JOURNAL [JUNE,
of capital and labour. If Gwand G,, are identical, then the growth rate of
income must be equal to each of them and the economy is in long-run
growth equilibrium. But if, for instance, the warranted rate is greater than
the natural rate the actual growth rate of income will be equal to neither of
them; it lies between Gw and G.. Thus in Harrod's terms the crucial
question of balanced growth boils down to a comparison between G. and
Gn. y
Let us now investigate stability of long-run equilibrium. Let y -
K K
v = -and k = -. From equation (1) we have y = AoeptF(k, 1)
Y ~L
In equilibrium, k + kA-sy
or k= sv-l-A .(5)
where s = the saving ratio. Subtract ? from either side of equation (5), i.e.
k
P-szv--A -=Gw-G . (6)
But v =k p -(F'v) k (7)
Combining (7) and (6) gives
v (1 -F'v) (Gw- Gn) . * * * *(8)
Since (1 - F'v) equals the share of labour, f3,which is always positive, Gw
must be obviously a diminishing function of v.
Now let v* be the equilibriumvalue of v. It is found by solving Gw= Gn.
Consider H(v) (v - V*)2 .(9)
H(v) > o if v# v*. Also
dt ) 2(v v*)v. (10)
By equation (8), the above equation is always negative unless v = v*.
Hence for all initial conditions for which v(t) is bounded, v approaches v*.
But clearly v(t) is bounded for all co > v(o) > 0.1 Thus long-run equili-
brium is stable.
1 I am indebted to the referee of thisJouRNALfor his suggestion of the above proof, which is an
alternative to my original proof derived by the Liapounoff method. Obviously it is assumed that
lim a > 1, where a is the elasticity of substitution. With regard to this see my paper, " On the
Stability of Growth Equilibrium," presented at the 1963 Econometric Society Meeting in Boston,
Mass.
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1964] HARROD-DOMAR MODEL VS NEO-CLASSICALGROWTH MODEL 383
We have shown that when Gy deviates from both the natural rate of
growth G. and the warranted rate Gwit will always come back to G. by
adjustmentof supply and demand, achieving Gy G = G,Ggiven sufficient
time. Contrary to the Harrod-Domar growth model, growth equilibrium
is stable in the long run. This is the basic result of the neo-classicalgrowth
model.
I. SPEED OF THE ADJUSTMENT
PROCESS
We have seen that when production takes place under the usual neo-
classical conditions of variable proportions and constant returns to scale the
extreme instability of long-run growth equilibrium in the Harrod-Domar
model is unlikely and the actual growth rate of income can adjust to any
given initial condition, given sufficient time. Theoretically when t ap-
proaches infinity, then complete adjustment will be achieved, but as a
practical matter we are interestedin knowing how long it will take to achieve
a virtually complete adjustment, e.g., 90% of the return of the growth rate
of income towards the natural rate of growth.
Let us investigate this problem by assuming further that the production
function is the Cobb-Douglas type multiplied by the neutral technological
improvement factor.
Y-- AoePtKaLF3. (11)
The Cobb-Douglas production function is extremely useful for computa-
tional purposes because the shares of capital and labour are constant. The
savings ratio s in the basic model is replaced by the total savings ratio {,
which is the sum of the private and the public savings. Thus 6 equals
[x + s(l - x) - g(l - h)], where x = proportionate income tax rate,
s - the private savings ratio, g - government expenditures for goods and
servicesas a fraction of national income, and h = government capital forma-
tion as a fraction of government expenditures. We shall apply the model to
actual economies to find the approximate length of time for a given percen-
tage of adjustment. Since the entire movement of Gy results from changes
in the output-capital ratio, we shall use the output-capital ratio v-1 = r, the
growth rate of income Gy and the warranted rate of growth Gw.1
The tables were prepared from the following equations:
+ + A a + A)[e2 -el1)]
12 +(51-2) e- P + PlA)' a m 2 61
where rm is the value of r with m% adjustment.
Setting r = rm we obtain
=1+ mte(1-
o 2(I - M)
No. 294.-VOL. LXXIV. cc
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384 THE ECONOMIC JOURNAL [JUNE
ExampleI
In Example I we consider five cases.'
Case| p _ _ A x s g h e=[x+s(1-x)-g(1-kh)
1 1.3% 65% 1.5% 17% 12% 18% 15% 11266%
II ,, ,, ,, ~~18% ,, , ,12-54%
III ,, ,, ,, 20% ,. ,, ,, 14.30%
IV | , ,, ,, 17% | 19% , 10.81%
Assuming that the system is in long-run equilibrium under Case I,
Gy Gn= G. and the economy grows at 3-5% a year. Now suddenly x
is raised from 17 to 18% (Case II), thus the total savings ratio is increased
from 11*66to 12.54%. As a result, r starts decreasingfrom its original value
of 0300171 to its new equilibrium value of Case II, orV0279106. Table I
TABLE I
TimeLengthof Adjustment
(From Case I to Case II)
r t__ r. Gw,%. Gy,%. m%.
0-300171 3 5000 3 5000
0 0.300171 3-7641 3-5925 0
1 0.299657 3-7577 3-5902 2 44
2 0*299145 3*7513 3-5879 4-87
3 0*298762 3*7465 3*5863 6-67
4 0*298151 3-7388 3-5836 9.59
5 0.297694 3-7331 3-5816 11*76
6 0.297265 3-7277 3-5797 13*80
7 0.296811 3-7220 3-5777 15*95
8 0.296359 3'7163 3.5757 18*10
9 0.296008 3-7119 3-5742 19*76
10 0*295683 3.7079 3-5728 21*31
20 0.292080 3 6627 3 5569 38*41
30 0.289351 3*6285 3 5450 51*36
40 0.287238 3*6020 3-5357 61*40
50 0.285527 3-5805 3*5282 69*52
60 0*284137 3-5631 3-5221 76-21
70 0*283148 3-5507 3-5177 80*81
80 0.282326 3-5404 3-5141 84-71
90 0.281667 3-5321 3*5112 87X84
100 0.281210 3*5264 3*5092 90*01
oo 0.279106 3.5000 3.5000 100-00
shows how r changes as time goes on, to complete the adjustment from the
initial position of Case I to the new equilibrium of Case II. The correspond-
ing changes in Gy and Gware also shown.
Now let m be the percentage of the initial difference between G. and Gy.
1 These values may be very close to actual values in the American economy estimated by several
people, including Solow, and Kendrich and Sato. See R. Solow, " Technical Change and the
Aggregate Production Function," Review of Economicsand Statistics, Vol. 39 (August 1957), and
J. W. Kendrick and R. Sato, " Factor Prices, Productivity, and Economic Growth," American
EconomicReview,Dec. 1963.
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1964] HARROD-DOMAR MODEL VS NEO-CLASSICALGROWTH MODEL 385
After the first ten years m = 21-31%. After 50 years m 69-52% and so -
forth. For m to reach 90 % almost 100 years must pass. Thus when the
system deviates from the natural rate it will take almost a century to achieve
balanced growth. The values of change in G. and Gy in our illustration are
very small. Initially Gy jumps from G. = 3-5% to 3-5925%, and it
gradually comes back to the original value of 3.5%. But after the first ten
years Gy still stands at 3-5728%.
If, instead, x is raised from 17 to 20% (Case III) we find that the time
required for m to reach 90% is shortened (93-4 years) compared to Case I
(98-4 years). It, therefore,is clear that a sharp rise in the savings ratio will
shorten the time length of the adjustment. Conversely, as shown in Table
II, a sharp decrease in the savings ratio will slow the adjustment. In
TABLE II
Comparison
of TimeLengthof Adjustment
in VariousCases
t years.
Case II. Case III. Case IV. Case V.
10 4*3 3*9 5.1 5.9
20 9.2 8*4 103 12-3
30 14-9 13.2 16-7 19-3
40 21*5 19.1 23*7 27.2
50 28*8 26.2 32.1 36-3
60 38*5 35*6 42-4 47*3
70 50-8 46*8 55-6 61-1
80 68.2 63-7 73.4 79-6
90 98*4 93.4 104*4 111.0
100 00 oo oo 00
Case IV for m to reach 90 % it take 104-4 years, but in Case V it takes 111
years. The actual growth rate of income and the values of r for different
values of m are summarisedin Table III.
TABLE III
Comparison
of GrowthRatefor VariousCases
Case II. Case III. Case IV. Case V.
m%.
r. Gy, %. r. Gy, %. r. Gy, %. r. Gy, %.
0-300171 3 5000 0-300171 3*5000 0-300171 3*5000 0300171 3 5000
0 0-300171 3-5925 0-300171 3-7774 0.300171 3-4107 0300171 3*2321
10 0*298064 3-5832 0*294629 3-7496 0302531 3-4196 0*308573 3.2589
20 0*295957 3*5740 0289087 3-7219 0*304891 3*4286 0-316975 3*2857
30 0.293850 3-5647 0.283545 3*6940 0*307251 3.4375 0-325377 3-3125
40 0.291743 3.5555 0.278003 3-6664 0-309611 3-4464 0 333779 3.3393
50 0.289636 3*5462 0.272461 3-6387 0*311971 3.4553 0.342181 3-3660
60 0-287529 3*5370 0.266919 3-6109 0-314331 3*4643 0.350583 3.3928
70 0*285422 3-5277 0*261377 3-5832 0*316691 3-4732 0-358985 3-4196
80 0283315 3-5185 0.255835 3.5555 0-319051 3-4821 0-367387 3-4464
90 0*281208 3-5092 0.250293 3-5277 0-321411 3*4911 0-375789 3-4732
100 0*279106 3 5000 0.244755 3*5000 0-323774 3*5000 0-384193 3 5000
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386 THE ECONOMIC JOURNAL [JUNE
ExampleII
In ExampleI we assumeda ratherlow value of p and a high value of A. In
this example we put p = 1*7% instead of 1.3% (Solow's estimate is between
1 and 2%) and A -10% instead of 1.5%, and repeat the same changes in x
and g. Table IV illustrates the time length necessary for adjustment in
TABLE IV
of TimeLengthof Adjustment
Comparison
t (years).
m%. _ _ __
Case II'. Case III'. Case IV'. Case V'.
10 4-2 3s8 4.9 5*7
20 8-9 8-1 10-0 11.9
30 14-4 12-8 16*2 18*7
40 20-8 18-5 23*0 26*3
50 27.9 25*3 31*1 35*1
60 37-3 34.4 41*1 45.7
70 49-2 45-3 53-7 59.1
80 66-0 617 71*1 77*0
90 95-2 90*4 101-1 107*5
100 00 00 00 00
various cases. Again four cases are compared. The difference from
Example I is that for each case the time required to achieve a given level of
adjustment becomes 1P222 times 137%+ 1.5%x 65%/o 1-221978
shorter than in Example I.
ExampleIII
In this example, we do not stick to the values of parametersapplied to the
United States economy, but we will take different possible cases. One case
TABLE V
TimeLengthof 90% Adjustment
$, initial 2,, new Years to
P, %- A, %.
f3,,%- total savings total savings Gr,
%- achieve 90%
ratio, %. ratio, %. of change.
0 2 75 5 10 2 114
10 5 ,, 194
8 10 ,140
10 11 ,, 148
14 16 ,, 146
10 15 ,,130
65 10 15 , 150
1 ,, ,, ~~~~~~1
0 15 3.5 85
2 , 75 14 16 437 62
I) )1 ~~~~5 10 2Y49
3 15 65 12 15 6'1 52
4 10 18 7-7 36
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1964] HARROD-DOMAR MODEL VS NEO-CLASSICAL GROWTH MODEL 387
may apply to under-developed economies, and the others may apply to fast-
growing economies. Table V summarisesthe time length required for m to
reach 90%.
III. CoNCuLsIoN
We have shown that the adjustmentprocessin the neo-classicalsystem of
variable proportionstakes place only at an extremely slow rate.' When the
system deviates from the natural rate of growth it will always come back to
the original equilibrium position. But this is only valid in the truelong run.
Thus the neo-classicalgrowth model may lose its basic foundation unless the
time span is extremely long. For most practical purposes the neo-classical
system of variable proportions by no means rules out the use of fixed pro-
portions in the combination of capital and labour which is a characteristicof
the Harrod-Domar growth model. The adjustmentprocessin the dynamic
model is so slow that fixed proportions may be a realistic assumption for
practical purposes. The insight of the Harrod-Domar model may still serve
as a guiding landmark in theoretical growth analysis, provided that the
production side is accounted for in a manner similar to the neo-classical
growth model.
RYuzo SATO
Universityof Hawaii.
1 The basic relationshipsbetweenthe adjustmentperiod and values of parametersare investi-
gated in my paper, " Fiscal Policy in a Neo-Classical Growth Model: An Analysis of Time
Requiredfor EquilibratingAdjustment,"Reviewof Economic Studies,February1963.
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