GROWTH ECONOMICS

and Fund-raising in international cooperation

SECS-P01, CFU 9
Economics for Development
academic year 2017-18
6. THE HARROD-DOMAR
MODEL OF GROWTH

Roberto Pasca di Magliano

Fondazione Roma Sapienza-Cooperazione Internazionale
roberto.pasca@uniroma1.it
 Harrod-Domar Model
introduction
Development and growth are natural phenomena
The modern theory of growth has been developed indipendently by two the
economist:
•Roy Harrod in his article “An Essay in Dynamic Theory” (1939),
•Evsey Domar in his article “Capital expansion, rate of growth and
employment” (1946)
Both inspired by the nascent Keynesian doctrine.
They developed what was then known as the Harrod-Domar model of
growth as dynamic extension of the Keynesian analysis of static equilibrium.
The model explain that growth rate is influenced by the level of saving and
the capital productivity.
Meanwhile, Robert Solow was developing the neoclassical model of
growth, inspired to the dominant influence of Alfred Marshall’s Principles of
Economy (1890).

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Harrod-Domar Model
Main questions
• If the  Y =>  I, which is the growth rate of Y ensuring equality
between planned I and S, so as to garantee a balance in the long term?
• Is there any certainty prevailing growth rate needs to ensure such
equality? Otherwise, what happens?
• In the static keynesian model, temporary gap between I and S are
compensated through the automatic adjustment garanteed by
multiplier. Instead, according Harrod, if overall productivity growth
rate do not increase enough, what happens?
Answers
 Warranted growth rate: the rate of growth at which the economy does
not expand indefinitely or go into recession.
 Actual growth: the real rate increase in a country's GDP per year
 Natural growth rate: the growth of an economy required to maintain
full employment.

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Harrod-Domar Model
simplified concepts
The H-D model is the easiest way to start learning about growth in the long run.
Main concepts used in the model:
1. Income, saving and consumption:
Y = C + S. as S = I -> Y = C + I
All income is either saved or consumed:
S = sY -> C = (1-s)Y
2. Capital accumulation:
K t+1 = It + K(1-d) where d -> depreciation
The model use the concept of capital-output ratio (efficiency of the production
system measured in term of capital):
cr = Kt / Yt
This to show that an economy can produce a lot of output with a little capital ( and
viceversa).
3. Rate of growth:
g = s / cr - d

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Harrod-Domar Model
Growth Rates
The three growth rates
•Actual rate of growth (g) (i.e. the real income change):
g = s / c = (Y / Y) =  Y / Y where: s -> propensity to save
I/Y c -> quantity of capital need to produce one
unity of production
g is then equal to the ratio between the propensity to save and the current capital-
output ratio
•Warranted rate of growth (gw) (i.e. the growth that leaves everyone satisfied with an
increase in production (no more, no less) needed to pursue better resource’s allocation, by
impling a necessary increase ininvestments)
gw =  Y / Y = s / cr where: s -> propensity to save
cr -> extra quantity of capital needed
gw is then equal to the ratio between planned and propensity to save and the extra
capital required per unit of product
•Natural growth rate (gn) (i.e. one that ensures growth that absorbs the available labor force
in relation to its production capacity) as:
Y = L (Y / L)

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Harrod-Domar Model
Actual rate of growth (Harrod)

g = s / c = (Y / Y) / (I /  Y) =  Y / Y

s -> propensity to save

cr -> incremental capital-output ratio, i.e. :

 K /  Y = I /  Y, provided that S = I

So, since S = I, the rate of increase of the product is:

g = (S / Y) / (I /  Y) =  Y / Y

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 Harrod-Domar Model
Warranted rate of growth (Harrod)
gw = Y / Y = S / cr
According to the static Keynesian model:
S = sY (propensity to save)
cr = Kr  /  Y = I / Y (capital-output ratio, ie, the amount of additional
capital needed to produce additional product units at a given interest rate and
given the technological conditions)

Then, the question is which I  Y ensure that the planned S is equal to I needed
to increas Y:
sY cr =  Y
Therefore:
 Y / Y = s / cr = gw
In order to obtain dynamic equilibrium, the product should grow at this rate, i.e.
consumer spending must equal the value of production.

But, in presence of an external shock -> deviation from equilibrium could

happen, i.e. deficiencies in equipment etc.. In this case the current rate can
growth beyond the guaranteed (c> cr), then surplus capital, and fall even greater
growth rate.
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Natural rate of growth
Domar’s contribution
• Domar introduces the natural rate of growth (gn)
Y = L (Y / L)
Two components, both exogenous:
– growth of the labor force (L)
–growth of labor productivity (Y / L)

• A change in the level of I, Δ demand: Δ Yd = Δ I /S and I increases if the

same offering: Δ Ys = Ip (p, capital productivity, Δ Y / I)
• In order to have Δ Yd= Δ Ys, it is necessary that:
Δ I /s = Ip or Δ I / I = sp
(i.e. I has to grow at a rate such that it matches the propensity to save and the
productivity of capital)
• The natural rate of growth is sp (equal 1/cr equilibrium Harrod)
• But, even if the growth ensures full utilization of capital, it also to ensures
full employment labor.

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 Natural rate of growth
(Domar’s contribution)
Importance of the model:
•Definyng the rate of growth of production capacity that ensures the long-term
equilibrium between S and I in order to have full employment

•Fixing the upper limit of the current rate of growth that would lead to a
useless accumulation.

•If g > gw,

– g can continue to diverge until it reaches gn when all the labour force is
absorbed
– but, g can never exceed gn as there are not enough labour force

•In the long run, the relationship between gw and gn is crucial

•Full employment of capital and labor requires:
g = gw = gn
the famous "golden age” studied by Cambridge’s economist Joan Robinson

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Natural rate of growth
(Domar’s contribution)
Deviations between gw and gn
gw > gn, excess capital and savings, tendency to depression due to lack of work (g
•

fails to stimulate growth in demand, i.e. the amount of savings that match with job)
Typical aspects of the crisis of '29 and maybe of recent financial crises
•gw < gn -> overwork, inflation (g grows more that is necessary to match savings
for labor), unemployment and lack of capital investment
Typical aspects of developing countries
example:
If Δ population (2%) and productivity Δ L (3%) -> Δ workforce in terms of
efficiency (5%) while Δ propensity saving (9%), requires a Δ K / Y (3%):
gw = 6 (gn = 5)
Consequences: Δ work efficiency> Δ capital accumulation (rising unemployment)
and Δ saving> Δ I (inflationary pressure)
Unemployment and inflation together is not a paradox, but it indicates that there are
opportunities to increase investment in order to increase capital (Δ K / Y) up to 4,
so that gw and gn can be equal in the long run

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 Natural rate of growth
(Domar’s contribution)

Vertical axis: grow rate. Horizontal axis: savings and investment

- Growth and investment are related to K / Y (cr)
- Propensity to save is independent from the growth
To seek for the balance the policies have to:
•reduce labor supply or productivity so as to reduce gn to gw
•adopt expansionary monetary or fiscal policies to move S / Y to the right or even
stimulate labor-intensive techniques, so as to raise gw gn
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 Policy contributions

• Not only interpretation but suggestions

for policy actions

• eg. if country sets target growth rate of

5% and if the ratio K / Y is 3, the needed
level of saving and investment has to be
15% of GDP

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 Theoretical debate
• Concerning automatic adjustment related to the fact that labour
productivity, savings and demand for K are determined independently
while the model itself admits that in the long run propensity savings
may vary, although it tends towards adjustment (in depression -> S
may fall, in inflation -> can grow)
– In depression (i.e. gw < gn), the profit share is reducing and this reduces
the overall propensity to save and then reduces the level of gn to gw
– In inflation (gn > gw), profit share will increase and this increases
propensity to save and then increaasing the level of gw to gn
– In both cases, there are limits: the fall in profits acceptable for businesses,
the fall in wages acceptable for workers

• Cambridge School (Robinson, Nicholas Kaldor, Richard Kahn, Luigi

Pasinetti) -> emphasizes on the functional distribution

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