Question

[Harrod-Domar model]

a. What are the fundamental assumptions of the Harrod-Domar Model in terms of

labor markets;

marginal productivity of capital;

capital/output ratio;

capital markets;

Under these assumptions, formally derive the growth rate of aggregate output in the Harrod-Domar

Model.

b. According to the Harrod-Domar Model, calculate the rate at which the economys aggregate

output can grow if:

i. the saving rate is 15 percent and the capita-output ratio is 3;

ii. the saving rate is 15 percent and the capita-output ratio is 5;

2

iii. the saving rate is 30 percent and the capita-output ratio is 3;

iv. the saving rate is 30 percent and the capita-output ratio is 5.

Describe the pattern that emerges as you calculate the e¤ects of the four di¤erent sets of saving

rates and capital-output ratios. Intuitively, what does this pattern tell in terms of determinants of

growth of output?

c. Describe the policy implications that emerge from the Harrod-Domar Model of economic growth.

Specically, what does the model suggest that government policy makers could do to increase the rate

of growth of output of the economy?

Answer 1

a) The Harrod-Domar economic growth model stresses the importance of savings and investment as key determinants of growth. A model helps to explain how growth has occurred and how it may occur again in the future. Growth strategies are the things a government might introduce to replicate the outcome suggested by the model. 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 Harrod-Domar model starts from a position of full-employment equilibrium level of income. It, then, emphasizes the continuous maintenance of this equilibrium position. To ensure this, according to the model, which the volume of expenditure generated by investment must be adequate to absorb the increased output resulting from the investment.

The Harrod and Domar models are based on following assumptions.

1. There is an initial full employment equilibrium level of income.

2. The model operates in closed economy i.e. there is no foreign trade.

3. The average propensity to save is equal to the marginal propensity to save i.e. S/Y = ?S/?Y absolute change in savings is equal to the relative change in savings.

4. There is no government interference in the functioning of the economy i.e. the policy of laissez-faire prevails in the economy.

5. There are no lags in adjustment i.e. the economic variables such as saving, investment, income, expenditure adjust them in the same period of time.

6. The marginal propensity to save and capital coefficient remains constant.

7. Intended investment and real investment are equal in the economy.

8. There is no depreciation of capital goods which are assumed to be fixed.