In: Economics
Harrod-Domar model
It is a well known characteristic of the simple Harrod-Domar model that even for the long run economic system is at best balanced on a knife-edged of equilibrium growth. When the economy deviates slightly from the natural growth rate the consequence would be either growing unemployment or prolonged inflation, since the system has no built-in equilibrating force. The underlying assumption of fixed proportions in the combination of capital and labor has been the major object of criticism.
The main assumptions of the Harrod-Domar models are as follows:
(i) A full-employment level of income already exists.
(ii) There is no government interference in the functioning of the economy.
(iii) There are no lags in adjustment of variables i.e., the economic variables such as savings, investment, income, expenditure adjust themselves completely within the same period of time.
(iv) The average propensity to save (APS) and marginal propensity to save (MPS) are equal to each other. APS = MPS or written in symbols,
S/Y= ∆S/∆Y
(v) Both propensity to save and “capital coefficient” (i.e., capital-output ratio) are given constant. This amounts to assuming that the law of constant returns operates in the economy because of fixity of the capita-output ratio.
Conditions concerning the behaviour of income can be expressed in terms of growth rates i.e. G (actual growth), Gw (warranted growth) and Gn (natural growth) and equality between the three growth rates can ensure full employment of labour and full-utilisation of capital stock.
These conditions, however, specify only a steady-state growth. The actual growth rate may differ from the warranted growth rate. If the actual growth rate is greater than the warranted rate of growth, the economy will experience cumulative inflation. If the actual growth rate is less than the warranted growth rate, the economy will slide towards cumulative inflation. If the actual growth rate is less than the warranted growth rate, the economy will slide towards cumulative deflation.
Therefore, when the economy deviates slightly from the natural growth rate the consequence would be either growing unemployment or prolonged inflation, since the system has no built-in equilibrating force.
It is important to assume variable rather than fixed proportions production technology for the following reason:
Under Utilization of Fixed Factor:
In initial stage of production, fixed factors of production like land or machine, is under-utilized. More units of variable factor, like labour, are needed for its proper utilization. As a result of employment of additional units of variable factors there is proper utilization of fixed factor.
In contrast, an alternative model has been developed in which factor proportions are flexible and all rigidities are assumed away. This model is often referred to as “neo-classical” model.
1. Neoclassical growth theory explains that output is a function of growth in factor inputs, especially capital and labour, and technological progress.
2. Contribution of increase in labour to the growth in output is the most important.
3. Growth rate of output in steady-state equilibrium is equal to the growth rate of population or labour force and is exogenous of the saving rate, that is, it does not depend upon the rate of saving.