Question

Formulate the key equation of harrod domar model and describe the dynamics of economic growth that follow from this model.

Answer 1

The Harrod-Domar Model is the direct outcome of projection of the short-run Keynesian analysis into the long-run. This model is based on the capital factor as the crucial factor of economic growth. It concentrates on the possibility of steady growth through adjustment of supply of demand for capital.

The Harrod-Domar model adds the concept of a capital-output ratio. This is basically the efficiency of production for an economy, measured in terms of capital. If the capital-output ratio is low, then the economy can produce a lot of output from a little capital. If the capital-output ratio is high then it needs a lot of capital for production, and it will not get as much value of output for the same amount of capital. The capital-output ratio can take into account things like the ‘quality’ of capital, if a country has high quality capital that is very productive then it will have a low capital-output ratio.

Basically, the model suggests that the economy's rate of growth depends on:

• The level of national saving (S)
• The productivity of capital investment (this is known as the capital-output ratio)

The Capital-Output Ratio (COR):- For example, if £100 worth of capital equipment produces each £10 of annual output, a capital-output ratio of 10 to 1 exists. A 3 to 1 capital-output ratio indicates that only £30 of capital is required to produce each £10 of output annually. If the capital-output ratio is low, an economy can produce a lot of output from a little capital. If the capital-output ratio is high then it needs a lot of capital for production, and it will not get as much value of output for the same amount of capital.