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Yt = Ct + St (11.5)
It = St (11.6)
Yt = Ct + It (11.7)
Kt +1 = (1 − δ ) Kt + It (11.8)
St = sYt (11.9)
Here [Yt + 1 – Yt]/Yt is the growth rate of GDP. Letting G = [Yt + 1 – Yt]/Yt, we
can write the Harrod–Domar growth equation as (11.13):
G = s/v − δ (11.13)
This simply states that the growth rate (G) of GDP is jointly determined by
the savings ratio (s) divided by the capital–output ratio (v). The higher the
savings ratio and the lower the capital–output ratio and depreciation rate, the
faster will an economy grow. In the discussion that follows we will ignore the
depreciation rate and consider the Harrod–Domar model as being represented
by the equation (11.14):
G = s/v (11.14)
Thus it is evident from (11.14) that the Harrod–Domar model ‘sanctioned the
overriding importance of capital accumulation in the quest for enhanced
growth’ (Shaw, 1992).
The Harrod–Domar model, as Bhagwati recalls, became tremendously
influential in the development economics literature during the third quarter of
the twentieth century, and was a key component within the framework of
economic planning. ‘The implications of this popular model were dramatic
and reassuring. It suggested that the central developmental problem was
simply to increase resources devoted to investment’ (Bhagwati, 1984). For
example, if a developing country desired to achieve a growth rate of per
capita income of 2 per cent per annum (that is, living standards double every
35 years), and population is estimated to be growing at 2 per cent, then
economic planners would need to set a target rate of GDP growth (G*) equal
to 4 per cent. If v = 4, this implies that G* can only be achieved with a desired
savings ratio (s*) of 0.16, or 16 per cent of GDP. If s* > s, there is a ‘savings
gap’, and planners needed to devise policies for plugging this gap.
Since the rate of growth in the Harrod–Domar model is positively related
to the savings ratio, development economists during the 1950s concentrated
their research effort on understanding how to raise private savings ratios in
order to enable less developed economies to ‘take off’ into ‘self-sustained
growth’ (Lewis, 1954, 1955; Rostow, 1960; Easterly, 1999). Reflecting the
contemporary development ideas of the 1950s, government fiscal policy was
also seen to have a prominent role to play since budgetary surpluses could (in
theory) substitute for private domestic savings. If domestic sources of finance
The renaissance of economic growth research 601
were inadequate to achieve the desired growth target, then foreign aid could
fill the ‘savings gap’ (Riddell, 1987). Aid requirements (Ar) would simply be
calculated as s* – s = Ar (Chenery and Strout, 1966). However, a major
weakness of the Harrod–Domar approach is the assumption of a fixed capi-
tal–output ratio. Since the inverse of v (1/v) is the productivity of investment
(φ), we can rewrite equation (11.14) as follows:
G = sφ (11.15)
Following the seminal contributions of Solow (1956, 1957) and Swan (1956),
the neoclassical model became the dominant approach to the analysis of
growth, at least within academia. Between 1956 and 1970 economists refined
‘old growth theory’, better known as the Solow neoclassical model of eco-
nomic growth (Solow, 2000, 2002). Building on a neoclassical production
function framework, the Solow model highlights the impact on growth of
saving, population growth and technolgical progress in a closed economy