NOTES
Investment and Growth
On Using the Harrod–Domar Model
Pronab Sen
The simplicity of the
Harrod–Domar model of growth,
which is at the heart of most
planning and growth models
that exist today, has enabled
a significant widening of the
range of participants in debates
surrounding the needs and
prospects of growth in developing
countries. Three of the more
obvious oversimplifications of
the Harrod–Domar model are
identified and discussed, and
reasonably simple correctives are
provided which can be applied
even by laypersons to alter their
initial assessments and arrive at
more realistic and technically
justifiable conclusions.
An earlier version of this article appeared as
a Planning Commission Working Paper with
the title: “A Note on Growth Projections for
Capital-Constrained Economies.”
Pronab Sen (pronab.sen@gmail.com) is
Country Director, International Growth
Centre, India.
Economic & Political Weekly EPW JUNE 8, 2019
T
here are many good reasons for
which most of the planning mod-
els that exist today are based on
the Harrod–Domar model.1 For most
developing economies, which are usually
capital-constrained, the supply-side issue
of creating adequate productive capacity
is of dominating concern. The Harrod–
Domar model encapsulates this concern
admirably and provides a powerful ana-
lytic tool to assess future prospects and
the requirements for growth. Over the
years, there have been many extensions
and refinements of this model, but
none have captured the imagination in
quite the same way as the original. The
Harrod–Domar model today has gone
beyond the toolkit of the professional
economist and has entered the domain
of popular discourse.
The essence of the Harrod–Domar model
lies in a simple and yet powerful formu-
lation, which links growth to the rate of
capital accumulation or investment:2
g = i/k … (1)
where g = growth rate of GDP;
i = investment rate = investment/GDP;
k = incremental capital–output ratio.
The central concept in this formula-
tion is “k”—the incremental capital–out-
put ratio or ICOR—which is a summary
expression for the technical conditions
and structural configuration of the eco-
nomy that captures the relationship be-
tween investment and additional out-
put. It is also frequently, and not entirely
justifiably, treated as a measure of the
efficiency of capital. Nonetheless, the
value of equation (1) is that, once there is
an estimate of the ICOR (k), future pro-
jections for the economy become very
simple. Whether these are done by esti-
mating the maximal growth rate that can
be achieved given the likely trajectory of
the investment rate or by computing the
vol lIV no 23
investment requirements for any target
rate of growth makes little difference
since the two are uniquely related by
equation (1). Thus, the investment re-
quirement (i*) for any target rate of
growth (g*) is given by:
i* = k.g* = i.g*/g … (2)
where i = estimated historical invest-
ment rate; g = estimated historical
growth rate
Although the ICOR is an extremely ab-
struse concept covering, as it does, an
extraordinarily complex set of relation-
ships, its apparent simplicity has made it
an integral part of the popular discourse
on economic matters. At one level, this is
undoubtedly a good thing in that debates
on growth prospects or its requirements
have become more democratised and
not just confined to the arcane world
of planners and growth theorists. At
another level, however, there has also
been a trivialisation of the concept, its
measurement and application, which
has the potential of leading to severe
errors in assessing the needs and pros-
pects of future growth.
The purpose of this article, therefore,
is to draw attention to a few critical is-
sues in the measurement of the ICOR and
the method of application of the general
growth equation (1) to mitigate the im-
pact of the more common errors that are
made in this respect. The objective is not
to go into all the details or the complexi-
ties, which can be left to the experts in
the field, but to provide relatively simple
methods by which even laypersons can
correct their initial assessments and
arrive at more realistic and technically
justifiable conclusions.
Continuous vs Discrete Time
The first point that needs to be recognised
is that the growth equation (1) has been
derived under three basic assumptions:3
(i) The economy is on a steady-state
growth path, (ii) investments instanta-
neously translate to additional capacity,
and (iii) time is continuous—that is, it is
infinitely divisible.
Each of these assumptions has a signi-
ficant bearing on how the growth equation
57
NOTES
should be applied and the modifications
that need to be made.
Consider first the third assumption
regarding continuous time. Although in
a philosophic sense this assumption is
indeed true, the data on which all esti-
mation is done are available only for dis-
crete periods, such as a quarter or a year.
Thus there is a disjunction between the
theory and the data to which it is applied.
Since not much can be done about the
data, the theory needs reconsideration.
In such a situation, the growth equation
needs to be suitably modified to take
account of the discreteness of data availa-
bility. The starting point for such a refor-
mulation is the definition of the ICOR:
k = It/ΔYt ... (3)
where It = investment; Yt = GDP
In continuous time, dividing both the
numerator and the denominator by Yt
and rearranging terms yields the
growth equation (1). Unfortunately, the
definition of the ICOR given in equation
(3) is frequently forgotten and the con-
tinuous time formulation encapsulated
in equation (1) is used. This is in fact the
basis for the most common way to esti-
mate the value of “k,” in which the aver-
age investment rate during a particular
period is divided by the growth rate of
GDP over the same period. In what fol-
lows, the nomenclature “k” shall be
used to denote such an estimate of the
ICOR, which we shall refer to as the
measured ICOR.
In discrete time, however, such a proce-
dure is just incorrect. The correct measure
would be to define:
k* = It /Yt-1 = i(1 + g)
... (4)
ΔYt /Yt-1 g
Thus, the relevant equation for esti-
mating the investment requirement for
any growth target, or the analogue of
equation (2), is given by:
i* = i.g*.(1 + g)/g ... (5)
where again i and g respectively refer to
the estimated historical investment rate
and growth rate. This change can make
a significant difference while making
projections. Consider a situation where
the historical growth rate of an economy
(g) has been 6% per annum and the
58
average investment rate (i) 24%, yielding
a value of k of 4. The value of k* in such a
situation would be 4.24 from equation (5).
Thus, the investment requirement for
maintaining a 6% growth rate in the
future using the commonly-used contin-
uous time relationship would remain at
24% of GDP, but in the discrete time for-
mulation, it would be significantly higher
at 25.44%. As a result, if an investment
rate of 24% is targeted, the growth rate
actually experienced would probably not
be 6%, but around 5.7%. There are many
ways of correcting for this problem,4 but
the simplest may be to recognise that,
from equations (1) and (4):
k* = k(1 + g)
Hence, only a small modification is re-
quired to the standard method. A com-
parative picture of the differences to the
investment requirements arising from
the normally used continuous time for-
mulation given by equation (2) and the
discrete time formulation given by equa-
tion (5) is presented in Table 1.
Finally, it should be pointed out that
this particular modification to the Harrod–
Domar model has no economic content
at all. It is merely a mathematical correc-
tion, which is necessitated by the fact
that data are available only for discrete
periods of time. The shorter the period,
the lower will be the extent of correction
required. Nevertheless, as can be seen
from Table 1, the empirical significance
of this modification is considerable.
Gestation Lags
The second assumption, that of the in-
stantaneous transformation of investment
into productive capacity, obviously does
not apply in real life. All investments are
subject to gestation lags of some duration
or the other. Once these gestation lags
are taken into account, the “true” or tech-
nical ICOR turns out to be significantly
different from the implicit or measured
ICOR as defined earlier, and this affects
the way in which future projections
should be made.
Table 1: Investment Rates Required at Different Growth Rates in Continuous and Discrete Time
g* 5.5% 6.0%
Continuous time (eqn 2) 22.0 24.0
Discrete time (eqn 5) 23.3 25.4
Assumed parameter values are: i = 24% and g = 6%.
JUNE 8, 2019
Suppose that the average gestation
lag for investments in the economy is
“n” years, then the “true” relationship
between investment and output is given
by the following relationship:5
ΔYt = It-n/k’ ... (7)
where k’ = “true” or technical ICOR
which essentially states that the increase
in GDP in the current year is determined
not by investments made in the current
year, but by those made n years earlier.
Rearranging terms and dividing through
by Yt-1 yields:
k’ = i/g(1 + g)n-1 ... (8)
From equations (1) and (8) it can,
... (6)
therefore, be stated that
k’ = k/(1 + g)n-1 ... (9)
In other words, the “true” ICOR (k’) is
almost always lower than the measured
ICOR. To put this in perspective, consider
again the example taken earlier where
k = 4 and g = 6%. If the value of the
average gestation lag, n = 2.8 years,6
equation (9) implies that the value of k’
will be 3.6. The longer the gestation lag,
the lower will be the value of the “true”
ICOR for any given value of the meas-
ured ICOR. Furthermore, it should also
be noted that the difference between k
and k’ will be wider; the higher is the
growth rate that has been experienced
in the past.7 For instance, had the histor-
ical growth rate been 7% instead of 6%,
the value of k’ would have been 3.54.
These two characteristics of the rela-
tionship between k and k’ given by equa-
tion (9) point to the dangers of making
simple-minded comparisons between
countries from their implicit ICORs. To
illustrate the point, consider the case of
India and China, both of which have
recorded measured ICORs of around 4
during the 1990s and early 2000s. On
this basis, it may be tempting to infer
that the two countries are roughly com-
parable in terms of the efficiency of capital
utilisation. Such an inference would
not be correct. Over the period concerned,
(% of GDP)
6.5% 7.0% 7.5% 8.0% 8.5% 9.0%
26.0 28.0 30.0 32.0 34.0 36.0
27.6 29.7 31.8 33.9 36.0 38.2
vol lIV no 23 EPW Economic & Political Weekly
 NOTES

India has recorded an average growth
rate of 6.6%, whereas China has achieved
about 9%, which are also reflected in
their respective investment rates of 26.5%
and 37%. Moreover, the estimated gesta-
tion lag for India is 2.8 years and for
China it is almost four years. The differ-
ence in the gestation lags arises primarily
out of sectoral differences in the struc-
ture of growth in the two countries. In
India, the fastest-growing sector during
the period concerned has been services,
which has very short gestation lags,
whereas in China it has been manufac-
turing. Using equation (9) to correct for
these differences in parameters yields a
“true” ICOR for India of 3.57 and for Chi-
na of 3.09—which is indicative of a fair-
ly significant difference.8
In projecting future growth require-
ments, however, it is important to realise
that the “true” ICOR (k’) cannot directly
be plugged into the growth equations (1)
or (4). It needs to be reiterated that, with
gestation lags, future growth is deter-
mined by the investment made “n” periods
earlier. Thus, the relationship between
investment and a target GDP level in the
future is determined by:
ΔYt+n = It/k’
Rearranging terms and dividing by Yt:
It/Yt = k’.ΔYt+n/Yt
Therefore, the investment rate required
(i*) to attain a future target growth rate
(g*) is given by the expression:
i* = k’.g*.(1 + g*)n-1
Substituting for k’ from equation (9)
where i = historical investment rate
g = historical growth rate
As may be seen, if no acceleration in
the growth rate is being targeted, that is,
g* = g, then the investment requirement
remains at the historical rate (i). How-
ever, as the target growth rate is increased,
the difference between the two widens.
In order to appreciate the magnitudes
involved, the extent of differences that
arise from recognition of gestation lags at
different growth targets is given in Table 2.
In the table, it has been assumed that
the gestation lag remains invariant at
2.8 years regardless of the targeted rate
of growth. This is not realistic since it
implicitly assumes that the growth rates
of all constituent sectors of the economy
increase proportionately with the in-
crease in the target growth rate of the
GDP. The manner in which these propor-
tions will change, and thereby affect
the average gestation lag, cannot be
generalised and will depend upon a
number of factors, not the least of which
is the sufficiency of infrastructural facil-
ities in the country. Since infrastructural
investments typically have the longest
gestation lags, developing economies,
which need to build up infrastructure
... (10)
rapidly, tend to exhibit longer average
lags than more developed economies and
also tend to experience an increase in
... (11)
the lag length as the pace of growth is
sought to be accelerated.
On the other hand, gestation lags also
reflect policy, procedural and institu-
tional rigidities which affect the pace of
... (12)
implementation of investment activities
in the country. It is, therefore, entirely
possibilities, it becomes desirable to
examine the numerical implications of
changes in the lag length. This involves
respecifying equation (13) as:
i* = i.g*.(1 + g*)n*-1
... (14)
g.(1 + g)n-1
where n* = expected gestation lag in the
future
The results of such an exercise are
presented in Table 3.
As may be seen, differences in gesta-
tion lags can have a significant impact
on the investment requirements of an
economy, and the impact increases as
higher growth rates are targeted. This
characteristic arises from one basic dif-
ference between the two growth equa-
tions (2) and (13), which needs to be
noted. Equation (2) relates g* and i* in a
linear manner, whereas equation (13) is
inherently non-linear. Nevertheless, both
the curves pass through the origin, which
implies that in both cases a zero growth
rate is associated with zero investment.
The shapes of these two relationships
are presented graphically in Figure 1:
Figure 1: Growth–Investment Relations with
and without Lags
n = 2.8
i* n = 2.1
Without lag
24%
0 6% g*

yields: possible that the average gestation lag of

an economy can be reduced through a Depreciation of Capital Stock
i* = k.g*.(1+g*)n-1 = i.g*.(1+g*)n-1
... (13) streamlining of policies and procedures Possibly the most critical weakness of
(1+g)n-1 g.(1+g)n-1 and with better governance. Given these the commonly used Harrod–Domar
formulation, is that it does not explicitly
Table 2: Investment Rates Required at Different Growth Rates with and without Gestation Lags
(% of GDP) take into account the fact that the pro-
g* 5.5% 6.0% 6.5% 7.0% 7.5% 8.0% 8.5% 9.0% ductive capital stock of an economy does
Without lags (eqn 2) 22.0 24.0 26.0 28.0 30.0 32.0 34.0 36.0 not have an infinite life. All capital as-
With lags (eqn 13) 21.8 24.0 26.2 28.5 30.8 33.1 35.5 37.9 sets have a finite life, which is deter-
Assumed parameter values are: i = 24%; g = 6% and n = 2.8 years.
mined partly by wear and tear and partly
Table 3: Investment Rates Required at Different Growth Rates with Alternative Gestation Lags by obsolescence. In the data normally
(% of GDP)
available from the National Accounts,
g* 6.0% 6.5% 7.0% 7.5% 8.0% 8.5% 9.0%
this is sought to be captured by the concept
Lag length n = 3.5 25.0 27.4 29.9 32.4 34.9 37.5 40.2
Lag length n = 2.8 24.0 26.2 28.5 30.8 33.1 35.5 37.9
of “consumption of fixed capital,” where-
Lag length n = 2.1 23.0 25.1 27.2 29.2 31.4 33.5 35.6 by a particular fraction of the existing
Assumed parameter values are: i = 24% and g = 6%. capital stock is assumed to drop out of
Economic & Political Weekly EPW JUNE 8, 2019 vol lIV no 23 59
NOTES
the production processes in each time
period. However, it should be noted that
depreciation was explicitly taken into
account in the original Harrod–Domar
model, but under a steady-state assump-
tion, and with a constant depreciation
rate, it can be shown that the deprecia-
tion term cancels out and the growth
equation (1) gets re-established. Thus,
under the specific assumptions of the
Harrod–Domar model, ignoring the pos-
sibility of depreciation is perfectly valid.
Nevertheless, when making projections
for the future or estimating the require-
ments of accelerated growth, not taking
into account the real-life fact of depreci-
ation can lead to serious errors.
In order to accommodate the process
of consumption of fixed capital stock or
depreciation, the basic model used so far
has to be modified quite significantly. As
a starting point, it is necessary to define
the concept of net investment, which is
the difference between the gross invest-
ment made in a particular period and
the depreciation of the existing capital
stock during the same period. Thus:
NIt = It - Dt ... (15)
where NIt = net investment in time
period t
It = gross investment in time period t
Dt = “depreciation” of existing capital
stock in time t
Equation (15) essentially states that
the gross investment (I) made during
any particular period can be conceptu-
ally split into two components—one
component (D) is basically for replace-
ment of the capacities which have gone
out from the production structure, and
the other (NI) for the creation of addi-
tional capacities. Clearly, the additional
output produced during the given time
period (ΔYt) should depend only upon
the additional capacity created (NIt) and
not upon the replacement investment,
which merely restores the productive ca-
pacity to its pre-existing level. Thus, it
becomes necessary to redefine the rela-
tionship between investment and output
growth by introducing the concept of
the net ICOR:
v = NIt/ΔYt = (It – Dt)/ΔYt ... (16)
where v = net ICOR
60
It may be noticed that equation (16) is
an analogue of equation (3) and can be
rewritten in the form:
v = k – Dt/ΔYt
In order to operationalise this con-
cept, it becomes necessary to add some
more structure to the second term in the
right-hand side of equation (17). For sim-
plicity it is assumed that a constant frac-
tion “d” of the capital stock existing at
the end of the previous time period goes
out of the production process during the
current period:
Dt = d.Kt-1
where Kt-1 = capital stock at the end of
period t-1
Furthermore, the relationship between
the capital stock existing at a particular
point in time and the level of output is
given by the concept of the average
ACOR, which is defined as:
a = Kt/Yt
In a steady-state path, the ACOR (a) is
a constant, and can be estimated directly
from the data on GDP and capital stock
routinely found in the National Accounts.
Using equations (18) and (19), the defini-
tion of net ICOR given by equation (17)
can be modified as follows:
v = k – a.d.Yt-1/ΔYt = k – a.d/g
Substituting for k from equation (1)
yields:
v = (i – a.d)/g
While making future projections, it
needs to be recalled that the gross in-
vestment made at any point in time not
only has to provide the additional capac-
ities necessary for the target growth
path, but also replacement for capacities
which have been lost due to “deprecia-
tion.” Therefore, the analogue of equa-
tion (2) in this case becomes:
i* = v.g* + a.d
where the first term on the right hand side
of equation (22) represents the investment
Table 4: Investment Rates Required at Different Growth Rates by the Gross Investment and
Net Investment Approaches
g* 5.5%
Gross investment (eqn 2) 22.0
Net investment (eqn 23) 22.9
Assumed parameter values are: i = 24%; g = 6%; a = 2.72 and d = 4%.
going into creating new capacity and
the second term represents replacement
investment. Substituting from equation
(21) and collecting terms then yields the
... (17)
final expression for estimating the in-
vestment requirement for any future
target rate of growth:
i* = i.(g*/g) – a.d.(g* - g)/g ... (23)
where as earlier, “i” and “g” represent
the historical investment and growth
rates respectively, and “a” and “d” the
measured values of the ACOR and the
average annual depreciation rate.
The first point to be noted from equa-
... (18)
tion (23) is that if the economy is in a
steady state or no significant change
is expected in the growth rate in the
future, the second term on the right
hand side becomes zero or negligible,
and the standard growth equation (2),
or the gross investment approach, gets
re-established. If, however, the target
growth rate (g*) is aimed to be signifi-
... (19)
cantly different from the historical ex-
perience (g), the investment require-
ments arising from the net investment
approach given by equation (23) will be
very different from that arising from
the gross investment approach, with
the difference increasing as the diver-
gence between the two growth rates
widens. Moreover, it should also be
... (20)
noted that, for whatever reason, if the
future growth rate is expected to be
lower than the historical, the net invest-
ment approach will require a higher in-
... (21)
vestment rate than the gross investment
approach. A numerical example, using
parameters which approximate recent
Indian experience, may help to clarify
these points, and is presented in Table 4.
As may be seen, the investment re-
quirements arising from the net invest-
ment approach are significantly differ-
ent from those given by the gross
investment, or Harrod–Domar approach,
except in a steady state (represented by
... (22) the historical growth rate of 6%). The
above results can be interpreted in the
following manner.
(% of GDP)
6.0% 6.5% 7.0% 7.5% 8.0% 8.5% 9.0%
24.0 26.0 28.0 30.0 32.0 34.0 36.0
24.0 25.1 26.2 27.3 28.4 29.5 30.6
JUNE 8, 2019 vol lIV no 23 EPW Economic & Political Weekly

Of the total investment made in the
country in a particular year, an invest-
ment amounting to 10.88% of GDP has
to be applied towards replenishing the
capital stock and thereby leaving the
over-all productive capacity unchanged.
Thus, this magnitude of investment has
to be made simply to keep the economy
at its current level of production with no
growth at all. Any investment in excess
of this level leads to an increase in the
production capacity, and hence to GDP. It
requires about 2.19 percentage points of
GDP of such additional investment to
produce each percentage point of addi-
tional GDP growth—that is, a net ICOR of
2.19. In contrast, the gross investment
approach implies that every percentage
point of GDP growth requires an invest-
ment rate of 4 percentage points. This
difference can best be understood
graphically by plotting equations (2) and
(23), as is shown in Figure 2.
Figure 2: Growth–Investment Relations by
the Gross and Net Investment Approaches
i* Gross investment
Net investment
24%
10.9%
0 6%
In brief, therefore, the net investment
approach suggests a higher investment
requirement than the gross investment
(or Harrod–Domar) approach for growth
rates lower than the historical experi-
ence and vice versa for higher growth
rates. Hence, savings (or investible re-
sources, in general) may not be as insu-
perable a constraint to accelerating
growth as is commonly made out to be.
However, if external or exogenous con-
ditions dictate a slowdown, then care
has to be taken to ensure that invest-
ments do not fall excessively.9
An Integrated Model
In the preceding sections, three separate
modifications to the standard Harrod–
Domar formulation have been proposed.
Of these, two—discrete time and gesta-
tion lags—operate towards increasing
Economic & Political Weekly EPW JUNE 8, 2019
the investment requirement for any ac-
celeration in the growth rate as com-
pared to that given by the Harrod–
Domar model. The third—consumption
of capital or depreciation—works in
exactly the opposite direction. Since all
three influences are likely to obtain in
real life, it appears desirable to integrate
them into one single model, so that the
combined or net effect of the three can
be estimated. The starting point for such
an integration is the definition of the
“true” or technical net ICOR in the pres-
ence of gestation lags, which involves
combining equations (7) and (16):
v’ = NIt-n/ΔYt = (It-n – Dt-n)/ΔYt
where v’ = net ICOR with gestation lag
From equations (18) and (19), this may
be rewritten as:
v’ = (It-n – a.d.Yt-n-1)/ΔYt
Dividing through by Yt-1 yields:
i.(1 + g) – a.d
v’ =
g.(1 + g)n
As earlier, when projecting forward,
the investment rate required (i*) to at-
tain a target growth rate (g*) with a ges-
tation lag of n* is given by:
i* = v’.g*.(1 + g*)n*-1 + a.d
Substituting for v’ from equation (26)
and arranging terms yields the final ex-
g* pression for the integrated model:
i*= i.g*.(1+g*)n*-1 – a.d.|g*.(1+g*)n*-1 - 1|
... (28)
g.(1+g)n-1 | g.(1+g)n |
where all the symbols bear the defini-
tions mentioned earlier. Although equa-
tion (28) appears extremely complex, it
can be easily evaluated in numerical
terms. The results of this exercise are
presented in Table 5.
As can be seen, the net investment ef-
fect arising out of a recognition of depre-
ciation dominates the other two effects
at the assumed parameter values. As a
consequence, the investment require-
ments for accelerating the growth rate
Table 5: Investment Rates Required at Different Growth Rates by the Harrod–Domar and
the Revised Models
g* 5.5%
Harrod–Domar (eqn 2) 22.0
Revised (n*=2.8) (eqn 28) 23.4
Revised (n*=2.1) (eqn 28) 22.9
Assumed parameter values are: i = 24%; g = 6%; a = 2.72; d = 4% and n = 2.8 years.
vol lIV no 23
NOTES
of the economy for a country like India is
likely to be significantly lower than that
indicated by a simple-minded applica-
tion of the Harrod–Domar model. The
situation could well be different at other
combinations of parameter values, and
hence no generalisations should be made.
Conclusions
The purpose of this article is to contrib-
ute to the wider debate on growth pros-
pects and requirements in developing
economies, particularly in India, by pro-
viding fairly simple correctives for the
more obvious oversimplifications that
are embodied in the manner in which
... (24)
the Harrod–Domar model is usually ap-
plied. In attempting to do so, it has been
necessary to indulge in a fair amount of
algebra. Although much of this may
appear intimidating, it was felt essential
... (25)
that the rigorous derivations be provided
in order for discerning readers to verify
the validity of the results. Nevertheless,
... (26)
the reformulations of the growth–invest-
ment relationship proposed in this article
—given by equations (5), (14), (23) and
(28)—can be numerically evaluated us-
ing only a pocket calculator, provided
that the parametric values are available.
Of the five basic parameters that have
... (27)
been used—namely the investment rate
(i), the growth rate (g), the ACOR (a), the
“depreciation” rate (d) and the average
gestation lag (n)—the first three are also
amenable to fairly straightforward cal-
culation by laypersons themselves from
data readily available in the National
Accounts. The other two, however, are a
little more complex. As far as the “depre-
ciation” rate is concerned, the National
Accounts do provide an estimate of
“consumption of fixed capital,” which is
an aggregation of asset-wise depreciation
rates based on a priori specifications of
the operational life of each form of asset.
This, however, is an inadequate measure
of the rate of attrition of capital stock,
which has to include not only the physical
deterioration of assets but also the
(% of GDP)
6.0% 6.5% 7.0% 7.5% 8.0% 8.5% 9.0%
24.0 26.0 28.0 30.0 32.0 34.0 36.0
24.6 25.9 27.2 28.5 29.8 31.2 32.5
24.1 25.2 26.4 27.6 28.8 30.0 31.3
61
NOTES
scrapping of assets on grounds of eco-
nomic non-viability or technological
obsolescence. Measurement of the more
complete concept is extremely difficult
to do, and it may be more practical to
simply settle for the limited version for
which data readily exists.10
Estimating the average gestation lag
in the economy, however, presents a
much more intractable problem. There
are no readily available estimates that
are routinely published, nor a universally
accepted methodology that can be ap-
plied to available data. There are a num-
ber of econometric methods available,
but most of these are fairly complex and
not easily usable by non-experts.11 How-
ever, as shown in this article, given the
substantial difference that this factor
makes to future assessments, it would not
be proper to ignore it altogether either.
In the interest of generating wide-spread
debate on growth prospects and require-
ments of the economy, it may, therefore,
not be a bad idea to standardise a meth-
odology for obtaining gestation lags and
insist that the statistical system publish
such estimates on a regular basis.
62
Notes
1 The so-called Harrod–Domar model was inde-
pendently developed by Roy F Harrod (1939)
and Evsey Domar (1946).
2 This particular formulation is not in either of
the original papers, but is the most popular
form in usage today. The original versions
were strictly classical in terms of investments
being determined by savings. This assumption
led to the “razor’s edge” characteristic of the
Harrod–Domar model, which spawned an
entire literature. We abstract from the razor’s
edge problem in this article to focus on issues
which we believe are more germane to the
current discourse.
3 There are of course many other assumptions,
such as continuous full capacity utilisation and
full employment, unchanging sectoral struc-
ture of the economy, etc, but these need not
concern us at present.
4 A procedure that is commonly used is to com-
pute the average investment rate with a one-
period lag. Another procedure, which is true to
the definition of the ICOR given in equation (3),
involves calculating
It = Kt – K0 ,
where K is the capital stock at a given point
in time
ΔYt = Yt – Y0
and dividing one by the other.
5 Gestation lags usually imply that the invest-
ment necessary to create new capacity are
spread over a number of time periods, and
hence should be specified in the form of dis-
tributed lags rather than as a one-time invest-
ment leading to capacity after “n” periods as
has been done in equation (7). While this is
certainly true, the assumption of a steady state
permits this kind of a simplification in the
specification.
JUNE 8, 2019
6 The average gestation lag of 2.8 years has been
taken from the Indian experience on the basis
of estimates made by the author.
7 The first partial derivatives of k’ with respect to
both n and g are negative.
8 It should be further noted that structural dif-
ferences in growth patterns affect not only the
average gestation lag, but also the aggregate
ICOR, which is a weighted average of sectoral
ICORs. Thus, if the ICOR for manufacturing is
higher than that for services, the “true” secto-
ral ICORs for China would be even lower than
those for India.
9 Economic slowdown arising from external or
exogenous factors, such as a slowdown in the
world economy, oil price shocks or agricultural
failure, can easily translate into recession if the
domestic investment activity falls sharply. This
is a real possibility since private investment re-
acts adversely to decreasing capacity utilisa-
tion, thereby setting off a downward spiral. In
such situations, public investment has to be
stepped up to ensure that the aggregate invest-
ment rate does not fall below the level war-
ranted by the estimates given above.
10 In fact, in this article also, the value of the
“depreciation” rate has been taken from the
National Accounts.
11 The estimate of the average gestation lag for India
(and also for China) used in this article is derived
from some very sophisticated exercises that were
carried out in the Planning Commission during
the formulation of the Ninth Five Year Plan.
REFERENCES
Domar, E (1946): “Capital Expansion, Rate of
Growth, and Employment,” Econometrica, 14(2),
pp 137–47.
Harrod, R F (1939): “An Essay in Dynamic Theory,”
The Economic Journal, 49(193), pp 14–33.
vol lIV no 23 EPW Economic & Political Weekly