Question

Give a simple explanation of the mechanism of the Harrod-Domar growth model.

Short answer

The Harrod-Domar growth model is a simplified economic model that explains long-term economic growth based on savings, investment, and output. It determines the growth rate needed for full employment and stable prices using the equation: Growth Rate (g) = \( \frac {S} {k} \), where S is the total savings and k is the Incremental Capital Output Ratio (ICOR). The model states that changes in savings or ICOR can impact economic growth - higher savings and investments or a lower ICOR can lead to increased economic growth. However, the model has limitations as it doesn't account for factors such as technology, human capital, and productivity, which are crucial in explaining modern economic growth.

Step-by-step solution

(Introduction to the Harrod-Domar Model)

The Harrod-Domar growth model is an economic model that was developed independently by Roy Harrod and Evsey Domar in the 1930s. It was one of the first models that attempted to explain long-term economic growth by focusing on the roles of investment, savings, and capital output. The primary purpose of the model is to determine the growth rate of an economy that is necessary to maintain full employment and a stable price level.

(Key Components)

There are three main components of the Harrod-Domar model: 1. Savings, denoted as S: This refers to the total amount of income that is saved, rather than consumed, in an economy. 2. The Marginal Propensity to Save (MPS), denoted as s: This is the proportion of each additional unit of income that is saved, rather than consumed. 3. Incremental Capital Output Ratio (ICOR), denoted as k: This is the additional amount of capital required to produce one additional unit of output or income.

(The Harrod-Domar Equation)

The Harrod-Domar model is expressed using the following equation: Growth Rate (g) = \( \frac {S} {k} \) Where: - Growth Rate (g) is the rate of economic growth needed to maintain full employment and stable prices. - Savings (S) represents the total amount of income saved in the economy. - Incremental Capital Output Ratio (ICOR), (k) is the additional capital needed to produce one more unit of output.

(Explanation of the Mechanism)

The Harrod-Domar model simplifies the complex process of economic growth into the relationship between savings, investment, and output. According to the model, an increase in savings leads to higher investment, which in turn increases capital stock and thus contributes to economic growth. The growth rate of an economy (g) is determined by two factors: the marginal propensity to save (s) and the incremental capital-output ratio (k). If any of these two factors change, it affects the overall growth rate. For example, if the marginal propensity to save increases, this means that people are saving more money and therefore, investment in the economy can increase. This leads to higher capital accumulation, which can ultimately lead to higher economic growth. Similarly, if the incremental capital-output ratio decreases, it means that the economy becomes more efficient in using capital to produce output. This will also result in higher economic growth as less capital investment is required to achieve the same increase in output. While the Harrod-Domar model simplifies the economic growth process, it has its limitations. The model does not consider factors such as technology, human capital, and productivity that play significant roles in explaining modern economic growth. However, the model has been an important starting point for the development of more advanced economic growth theories.

Key concepts

Economic Growth

At the heart of the Harrod-Domar growth model lies the concept of economic growth. Economic growth is defined as the increase in the production of goods and services in an economy over a period of time. In this model, growth is quantified by the growth rate (g), representing how fast a country's economic output, often measured as GDP, is increasing.
This model simplifies economic growth by emphasizing key economic variables: savings, investment, and the capital output ratio. It suggests that the rate of economic growth needed for full employment and price stability can be determined by how much of an economy's income is saved and how efficiently that capital is translated into output.

• Growth Rate (g): An essential part of the model, calculated by dividing the total savings by the capital output ratio, illustrating the direct impact of these factors on the economy’s growth.

While economic growth is crucial for improving living standards, it is influenced by a multitude of factors beyond those outlined by Harrod and Domar. These include not just the quantity of investment but also its quality, technological advancements, and improvements in labor productivity.

Savings

In the framework of the Harrod-Domar growth model, savings play a pivotal role in fueling economic growth. Savings refer to the portion of income that is not consumed but set aside for future investment. In essence, it's the seed money for investment, which is directly linked to growth.
The model views savings as critical because they provide the funds needed for investment in capital goods. This investment subsequently increases the capital stock, which is necessary for production.

• Marginal Propensity to Save (MPS): This is a measure of how much of additional income households save, rather than spend on consumption. A higher marginal propensity to save indicates a greater potential for investment and, thus, growth.

The Harrod-Domar model assumes a direct relationship between savings and investment: more savings ideally lead to more investment. This investment in new capital goods increases the economy's productive capacity, helping to drive growth. However, it's worth noting that in real economies, savings do not always translate perfectly into investment due to various real-world constraints.

Investment

Investment is a fundamental driver of economic growth in the Harrod-Domar model. It involves the purchase of capital goods that are used to produce future goods and services. The model assumes that this investment originates from savings, which are set aside for productive purposes.
Through investment, an economy can enhance its capital stock, which entails factories, machinery, and equipment. An increase in capital stock raises an economy's output capacity and efficiency.

• The Investment Process: Savings fuel investment, which in turn, enriches the economy’s capital stock. This is crucial for creating jobs and enhancing productivity.

Yet, investment effects are not automatic. The efficiency with which investment translates into economic outcome depends on factors like the policy environment, the stability of financial institutions, and technological advancements. Despite the straightforward relationship proposed in the model, real-world investments face risks and uncertainties that can affect their efficacy in spurring growth.

Capital Output Ratio

A key metric in the Harrod-Domar model is the capital output ratio, often called the Incremental Capital Output Ratio (ICOR). This ratio indicates the amount of capital required to produce one additional unit of output. It's a reflection of how efficiently an economy uses its capital.
Lower capital output ratios suggest that less capital is needed for new production, indicating a high level of efficiency in capital use. Conversely, higher ratios imply greater capital is required, pointing to lower efficiency.

• ICOR (k): This is a vital component of the model, representing the efficiency of investment in translating into economic growth. Lower ICOR values are desirable as they imply better investment efficiency.

The capital output ratio is a powerful tool in understanding an economy's productivity. For sustainable economic growth, improving the efficiency of capital use is crucial. This can often be achieved through technological innovation, better management practices, and workforce skill development. While the Harrod-Domar model focuses on this ratio simplistically, real-world factors like technology and institutional quality greatly impact capital efficiency.