Chapter-II

Exogenous growth Models

2.1. The Harrod-Domar growth model

2.1.1. Introduction
2.1.2. The Model
2.1.3. Limitations of the Harrod-Domar growth model
2.2. The Solow-Swan growth model
2.2.1. 2.2.2. The Model
2.2.3. Limitations of the Solow-Swan growth model

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 Learning objectives

Having completed this chapter, and the essential

reading and activities, the students will be able to:
Explain the characteristics of Harrod-Domar growth model
Understand the characteristics of Solow-Swan growth model
Differentiate Harrod-Domar growth model from the Solow-
Swan growth model.
Understand the main drawbacks of each model.

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 2.1. The Harrod-Domar growth model

2.1.1. Introduction
It was developed by Sir Roy Harrod of England in 1939 and
Professor Evsey Domar of the United States in 1946.
It states that the rate of economic growth in an economy is
dependent on the level of saving and the capital-output
ratio (c).
 Growth rate of gross domestic product (g) depends directly on the
national net savings rate (s) and

 inversely on the national capital-output ratio (c). If capital-output ratio

(c) decreases the economy will be more productive, so higher amounts
of output is generated from fewer inputs. This again, leads to higher
economic growth.

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 2.1. The Harrod-Domar growth model

2.1.2. The Model

Basic assumptions of the model:
There is an initial full employment equilibrium level of income.
The model operates in closed economy i.e. there is no foreign
trade.
Capital is the binding constraint: Output is a function of capital
stock:
There is no government interference in the functioning of the
economy.
Capital and labor are used in a fixed technical or behavioral
relationship. The factors of production are used in fixed
proportions, as there is no substitutability between factors.
The marginal product of capital is constant;

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 2.1. The Harrod-Domar gro….

The production function exhibits constant returns to scale.

This implies capital's marginal and average products are
equal.
The product of the savings rate and output equals saving,
which equals investment.
The change in the capital stock equals investment.

• AK model because it is based on a linear production

function with output given by the capital stock K times a
constant, often labeled A.

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 2.1. The Harrod-Domar growth model

The Model…..cont’d
If we assume that there is some direct economic
relationship between the size of the total capital stock
and total GDP, Y, it follows that any net additions to the
capital stock in the form of new investment will bring
about corresponding increases in the flow of national
output, GDP.
This relationship, in economics is known as the capital-
output ratio (c).
This ratio shows the units of capital required to produce
a unit of output over a given period of time.

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 2.1. The Harrod-Domar growth model

The Model…..contd
If we define the capital-output ratio as c and assume
further that the national savings ratio, s, is fixed
proportion of national output and that total new
investment is determined by the level of total savings,
we can construct the following simple model of
economic growth:
Saving (S) is some proportion, s, of national income (Y)
such that we have the simple equation
S=sY (2.1.1)

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 2.1. The Harrod-Domar growth model

The Model…..contd
Net investment (I) is defined as the change in the capital
stock, and can be represented by ΔK such that
I=ΔK (2.1.2)
But because the total capital stock, K, bears a direct
relationship to total national income or output, Y, as
expressed by the capital-output ratio, c, it follows that
K/Y=c
or ΔK/ΔY= c
• Or finally ΔK= c ΔY (2.1.3)

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 2.1. The Harrod-Domar growth model

The Model…..cont’d
Finally, because net national savings, S, must equal net
investment, I, we can write these equation as
S=I (2.1.4)
But from equation-2.1.1 we know that S=sY and from
equation 2.1.2 & 2.1.3 we know that
I=ΔK= c ΔY
It therefore follows that we can write the identity of saving
equaling investment shown by equation-2.1.4 as
S=sY= c ΔY=ΔK=I (2.1.5)

Or simply sY= c ΔY (2.1.6)

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 2.1. The Harrod-Domar growth model

The Model…..contd
Dividing both sides of the equation 6 first by Y and then by
c, we obtain the following expression:
ΔY/Y=g= s/ c (2.1.7)
Or ΔY/Y=g= s.v (2.1.8)
Where v =1/c measures output-capital ratio (Productive capacity
of the economy or capital productivity)
If we recognize that capital depreciates, equation-2.1.7 and
2.1.8 can be expressed as:

ΔY/Y=g= (s/ c) –δ = (s.v)– δ

where δ is the rate of depreciation per year
Note that the left hand side of equation 2.1.7, ΔY/Y, represents
the rate of change or the rate of growth of GDP , g.
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 2.1. The Harrod-Domar growth model

Summary
The Harrod-Domar model of economic growth stated simply that the
rate of growth of GDP (g) is determined jointly by the national
savings ratio, s, and the national capital-output ratio, c.
It says that ‘g’ will be directly related to the savings ratio , s and
inversely related to the economies capital-output ratio , c.
The inverse of capital-output ratio, l/c (output-capital), measures
how much additional output can be had from an additional unit of
investment. Therefore multiplying the rate of new investment, s=I/Y,
by its productivity, l/c, will give the rate by which national income or
GDP will increase.
The economic logic of the H-D model is that in order to grow,
economies must save and invest a certain proportion of their GDP.
The more they can save and invest, the faster they can grow.

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Summary…..cont’d
• The H-D model suggests that in order to grow, economies must save
and invest a certain proportion of their GNP. The more they can save
and invest (increasing capital accumulation and there by increasing
capital-labor ratio), the faster they can grow (e.g., The Marshall Plan
for Europeans in the post WW II).
 2.1. The Harrod-Domar growth model

Numerical Example-2.1.1: Assuming the saving rate is

10% and the Capital output ratio is 4, calculate economic
growth rate?

ΔY/Y=g= s/ c = 10%/4= 2.5%.

Therefore the economy would grow at 2.5% per
year.

Numerical Example-2.1.2: If the savings rate is 10%

and the capital output ratio is 2, then a country would
grow at 5% per year.

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 2.1. The Harrod-Domar growth model

2.1.3. Limitations of the Harrod-Domar model

The model is too aggregative and hence does not provide the basis for a detailed
quantitative study, nor does it highlight the structural and regional problems.
Saving and Investment are necessary but not sufficient condition for accelerated
economic growth.
The assumption of a fixed coefficient of production may also be questioned just
as it is equally possible to doubt the assumption about the absence of trade.
All savings may not be transformed into investment.
Saving and hence investment is only a necessary factor for growth but not a
sufficient condition.
Overall, the task of estimating capital output ratio is difficult anywhere. Even if
the data or the information is available in LDCs you can’t estimate such a ratio
reliably.
In the H-D model capital refers only physical capital but not other form of capital
like human capital.
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 2.2. The Solow-Swan growth model
2.2.1. Introduction
The American economist Robert Solow and the Australian
Economist Trevor Swan, constructed the Solow–Swan model
in 1956.
It is an exogenous growth model which attempts to explain
long-run economic growth by looking at capital accumulation,
labor or population growth, and technological progress.
The key modification from the Harrod-Domar growth model
is that the Solow–Swan model allows for substitution between
capital and labor.
The aggregate production function, Y = F(K, L) is assumed
characterized by constant returns to scale.

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 2.2. The Solow-Swan growth model
2.2.2.The Model
This model is designed to show how growth in the capital
stock, growth in the labor force, and advances in
technology affect a nation’s total output.
It postulates that growth of per-capita output is the result of
capital accumulation and/or technological progress.
The model predicts that an increase in growth cannot last
indefinitely. In the long run, the country’s growth rate will
revert to the rate of technological progress (exogenous).
Underlying this pessimistic long-run result is the principle
of diminishing marginal productivity of capital.

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 2.2. The Solow-Swan growth model
 Basic assumptions of the model:
One composite output is produced and the economy is closed.
There are constant returns to scale with diminishing returns to an
individual input.
The two factors of production (L &K) are paid according to their
marginal physical productivities.
Prices and wages are flexible and there is full employment of labor.
There is also full employment of the available stock of capital.
Labour and capital are substitutable for each other.
There is no technical progress.
The saving ratio is constant and saving equals investment.
Capital depreciates at the constant rate, d.
Population grows at a constant rate, n.

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 2.2. The Solow-Swan growth model
 2.2.2.The Model…contd.
Given these assumptions, let us build this model in steps.
Y = F (K, L) --AK Model--
(2.2.1)
Where Y is income or output, K is capital and L is labor.
The aggregate production function, Y = F(K, L) is assumed
characterized by constant returns to scale.
F(γK , γL) = γF(K, L) for all γ, K, L>0 (2.2.2)
With constant returns to scale, output per person y = Y/L will
depend on the capital stock per person k= K/L. That is,
equation (2.2.2) implies that
Y/L = F (K, L)/L= F (K/L, 1) (2.2.3)
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 2.2. The Solow-Swan growth model
 2.2.2.The Model…contd.
Or equation (2.2.2) can be expressed as y = ƒ (k)
Where y = Y/L is output or income per worker, k = K/L is the
capital-labor ratio, f is the per capita production function.
Here the y = ƒ (k) indicates what each person can
produce using his or her share of the aggregate capital
stock.
The concave shape of ƒ(k)—that is, increasing at a
decreasing rate—reflects diminishing returns to capital
per worker.

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 2.2. The Solow-Swan growth model
 2.2.2.The Model…contd.
If the production function is Cobb-Douglas production
function : =
=(
where Y is gross domestic product, K is the stock of capital (which
may include human capital as well as physical capital), L is labor,
and A(t) represents the productivity of labor, which grows over
time at an exogenous rate.
We can specify the per capita production function as:
y=f(k)=A (2.2.4)
Equation (2.2.4) states that output per worker depends on the
amount of capital per worker. The more capital with which
each worker has to work, the more output that worker can
produce.
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 2.2. The Solow-Swan growth model
  The Steady State.
Equation-2.2.5 shows that the growth of k depends on savings
sf(k), after allowing for the amount of capital required to service
depreciation, δk, and after providing the existing amount of capital
to net new workers joining the labor force, nk.
Δk=sf(k)–(δ+n)k (2.2.5)
The process through which the economy increases the
amount of capital per worker, k, is called capital
deepening.
Implication: Economies in which workers have access
to more machines, computers, trucks, and other
equipment have deeper capital base than economies
with less machinery, and these economies are able to
produce more output per worker.
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 2.2. The Solow-Swan growth model
 The Steady State…contd
An increase in the capital stock that just keeps pace with
the expanding labor force and depreciation is called
capital widening (refers to a ‘widening’ of both the total
amount of capital & the size of the workforce).
Capital widening occurs when sf(k) is exactly equal to
(δ + n)k), implying no change in k.
Therefore the investment required to maintain capital per
worker would be:

(nk + δ k) = (n + δ) k (2.2.6)

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 2.2. The Solow-Swan growth model
 The Steady State…contd
Where δk is the investment needed to replace worn-out capital and
nk is the investment per worker to maintain capital-labor ratio for
the growing population.

Assuming for now that A remains constant, there will be

a state in which output and capital per worker are no
longer changing, known as the steady state.

To find this steady state, set Δk = 0. This is the

fundamental equation for the Solow-Swan mode. The
economy reaches a steady-state when
sƒ(k*) = (δ + n)k* (2.2.7)
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 2.2. The Solow-Swan growth model
 The Steady State…contd
sƒ(k*) = (δ + n)k* (2.2.7)
 The Solow-Swan model is explained in Fig. 2.1 below.

The notation k*
means the level of
capital per worker
when the economy is
in its steady state.
If k is higher or
lower than k*, the
economy will return
to it; thus k* is a
Fig. 2.1: The Steady State in the Solow-Swan model stable equilibrium.
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 2.2. The Solow-Swan growth model
 The Steady State….contd
The sf (k) curve represents saving per worker.
The (n + d) k is the investment requirement line from the
origin with a positive slope equal to (n+d).
The steady state level of capital, is determined where the
sf (k) curve intersects the (n+d)k line at point E.
The steady state income is y* with output per worker
k*P, as measured by point P on the production function y
= f (k).

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 2.2. The Solow-Swan growth model
 The Steady State…contd
Since f(k)= Akα , we can rewrite equation(2.2.5) as:

Δk = sAkα – (δ + n)k (2.2.8)

Finding the steady-state entails finding a value of capital, k*, for which
equation (2.2.8) is equal to zero.

0 = sA(k*)α – (δ + n) k* which implies that

sA(k*)α = (δ + n)k*

To solve for k*, first divide both sides by (k*)α and by (δ+n). Then raise
both sides to the power 1/(1-α).

k* (2.2.9)
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 2.2. The Solow-Swan growth model
 The Steady State…contd
Plugging equation (2.2.9) in to the production function
y= Akα , we get an expression of the steady state level of
output per worker, y*.

y* (2.2.10)

This equation confirms that, ceteris paribus, raising the

rate of investment, s, will raise the steady-state level of
output per worker. On the other hand, raising the rate of
depreciation or rate of population growth will lower the
steady-state level of output per worker.
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 2.2. The Solow-Swan growth model
2.2.2.1. Effect of raising saving rate on the Steady State
Higher saving leads to faster growth in the Solow-Swan
model, but only temporarily. An increase in the rate of
saving raises growth only until the economy reaches the
new steady state.
If the economy maintains a high saving rate, it will
maintain a large capital stock and a high level of output,
but it will not maintain a high rate of growth forever.
The following graph (Fig. 2.2) shows the effect of
saving rate on the steady-state.

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 2.2. The Solow-Swan growth model
2.2.2.1. Effect of raising saving rate on the Steady State
An increase in the saving
rate from s to s1 shifts the
saving curve sf(k) upward to
s1f(k). The new steady state
point is E1.

As saving increases, the

capital per worker will
continue to rise to k1*, which
will raise output per worker to
y1*and so will the growth rate
of output increase. But this
process continues at a
diminishing rate in the
transition period.
Fig. 2.2: The effect of saving rate on the steady-state
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 2.2. The Solow-Swan growth model
2.2.2.2. Population growth and the steady state.
population growth reduces
Capital per worker ( f(k) the accumulation of capital
y)
y* (n1 + δ)k per worker much the way
y1*
(n + δ)k depreciation does.
 Depreciation reduces k by
sf(k)
wearing out the capital stock,
whereas population growth
reduces k by spreading the
capital stock more thinly
among a larger population of
K1* k* Capital per worker ( k) workers.
Fig. 2.3: The effect of population growth on the steady-state

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 2.2. The Solow-Swan growth model
2.2.2.2. Population growth and the steady state…contd
An increase in the rate of population growth from n to
n1 shifts the line representing population growth and
depreciation upward.
The new steady state K1* has a lower level of capital
per worker than the initial steady state k*.
Thus, the Solow-Swan model predicts that economies
with higher rates of population growth will have lower
levels of capital per worker and therefore lower incomes.

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 Discussion Questions
Discussion Question-2.1: Explain the Golden Rule
Level of Capital.
Discussion Question-2.2: Explain the effect of
Technological Progress in the Solow Model.

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 2.2. The Solow-Swan growth model
2.2.2.4. The Solow-Swan model as a theory of income
difference
According to the Solow-Swan model, If a country has a
higher rate of investment, it will have a higher steady-state
level of output per worker. Thus we may think of the Solow-
Swan model as a theory of income difference.
Assuming the same level of productivity, A, and the same
rate of depreciation, δ and population growth, n, we can
expresses the ratio of income per worker in country i to
income per worker in country j as follows:

(yi*)/(yj* )= ( 2.2.13)

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 2.2. The Solow-Swan growth model
• Numerical Example 2.2.1: Suppose that country i has
an investment rate of 20% and country j has an
investment rate of 5% . We use the value of = 1/2 .

Substituting the value of investment rates in to equation

(2.2.13).
(yi*)/(yj* )= = =2
 
Thus the Solow-Swan model predicts that the level of
income per worker in country i would be twice the level
of country j.

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 2.2. The Solow-Swan growth model
2.2.3. Conditional Convergence and the Solow-Swan
model.
• The Solow-Swan model predicts the following basic
conditional convergences.
If two countries have the same level of investment but
different level of income, the country with lower income will
have higher growth.  
If two countries have the same level of income but different
rate of investment, the country with a higher rate of
investment will have higher growth.

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 2.2. The Solow-Swan growth model
2.2.4. Limitations of Solow-Swan model
First, the model assumes that countries having no type of
interrelation. However, it is unrealistic to assume
countries having no interrelation.
The equilibrium rates of growth of the relevant variables
depend on the rate of technological progress, an
exogenous factor and furthermore, the individuals in the
Solow–Swan model have no motivation to invent new
goods.

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 2.2. The Solow-Swan growth model
2.2.4. Limitations of Solow-Swan model…contd
It assumes that the only source of difference in income
per worker across countries is difference in their per
worker capital stock, ignoring differences in other factors
of production or in the production function by which
these factors are combined.
The model argues that difference in investment rates are
important but does not say anything about the sources of
these differences in investment rate.
Etc.

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