CHAPTER TWO

CLASSICAL AND NEOCLASSICAL GROWTH

THEORIES
By : Zekarias M.
ECSU, Ethiopia
March, 2020

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 Chapter outline
❑ 2.1. The Harrod-Domar growth model
2.1.1. Introduction
2.1.2. The Model
2.1.3. Limitations of the Harrod-Domar growth model
2.2. The Solow-Swan growth model
2.2.1. Introduction
2.2.2. The Model
2.2.3. Limitations of the Solow-Swan growth model

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 2.1. The Harrod-Domar growth model
2.1.1. Introduction
➢It was developed by Sir Roy Harrod of England in 1939 and
Professor Evsey Domar of the United States in 1946.
➢It states that the rate of economic growth in an economy is
dependent on the level of saving(s)and the capital-output ratio (c).
✓Growth rate of gross domestic product (g) depends directly on the
national net savings rate (s) and;

✓inversely on the national capital-output ratio (c). If capital-output ratio (c)

decreases the economy will be more productive, so higher amounts of
output is generated from fewer inputs. This again, leads to higher
economic growth.

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 2.1. The Harrod-Domar growth model
2.1.2. The Model
❑Basic assumptions of the model:
✓Initial full employment equilibrium level of income,
✓Operates in a closed economy i.e. there is no foreign trade,
✓Capital is the binding constraint
✓There is no government interference in the functioning of the economy,
✓Output is a function of capital stock: y=f(k)

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 Reflection Question

❑How can we achieve growth under H-D Model?

✓Assume technical and strategic issues

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 2.1. The Harrod-Domar growth model
❑Basic Assumptions of the model……

✓Fixed technical combination between capital & labor

✓The marginal product of capital is constant,
✓The production function exhibits constant returns to scale
✓This implies capital's marginal and average products are equal.
✓The product of savings rate & output equals saving, w/c equals
investment
✓The change in the capital stock equals investment=k=l
✓See the next slides

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 2.1. The Harrod-Domar growth model
The Model…..
➢If we assume that there is some direct economic relationship
between the size of the total capital stock and total GDP, Y, it follows
that any net additions to the capital stock in the form of new
investment will bring about corresponding increases in the flow of
national output, GDP.
➢This relationship, in economics is known as the capital-output ratio
(c).
➢This ratio shows the units of capital required to produce a unit of
output over a given period of time.

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 2.1. The Harrod-Domar growth model
The Model…..
➢If we define the capital-output ratio as c and further assume that the national
savings ratio, s, is fixed proportion of national output and that total new
investment is determined by the level of total savings, we can construct the
following simple model of economic growth:
✓Saving (S) is some proportion, s, of national income (Y) such that we have the
simple equation:
S=sY (2.1.1)
✓Net investment (I) is defined as the change in the capital stock, and can be
represented by ΔK such that
I=ΔK (2.1.2)

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 2.1. The Harrod-Domar growth model
The Model…..
❖Because the total capital stock, K, bears a direct relationship to total national
income or output, Y, as expressed by the capital-output ratio, c, it follows that:
K/Y=c
or ΔK/ΔY= c
• Or finally ΔK= c ΔY (2.1.3)

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 2.1. The Harrod-Domar growth model
The Model…..
✓Finally, because net national savings, S, must equal net investment, I, we
can write these equation as
S=I (2.1.4)
✓But from equation-2.1.1 we know that S=sY and from equation 2.1.2 &
2.1.3 we know that
I=ΔK= c ΔY
✓Therefore, it follows that we can write the identity of saving equalling
investment shown by equation-2.1.4 as
S=sY= c ΔY=ΔK=I (2.1.5)
Or simply sY= c ΔY (2.1.6)

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 2.1. The Harrod-Domar growth model ….
➢Dividing both sides of the equation 2.1.6 first by Y and then by c, we obtain
the following expression:
ΔY/Y=g= s/ c (2.1.7)
Or ΔY/Y=g= s.v (2.1.8)
Where v =1/c measures output-capital ratio (Productive capacity of the economy or
capital productivity).
➢If we recognizes that capital depreciates, equation-2.1.7 and 2.1.8 can be
expressed as:
ΔY/Y=g= (s/ c) –δ = (s.v)– δ
where δ is the rate of depreciation per year
Note that the left hand side of equation 2.1.7, ΔY/Y, represents the rate of change
or the rate of growth of GDP , g.

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 2.1. The Harrod-Domar growth model
Summary
➢The Harrod-Domar model of economic growth stated simply that the rate of
growth of GDP (g) is determined jointly by the national savings ratio, s, and the
national capital-output ratio, c. …..g=s.c
➢It says that ‘g’ will be directly related to the savings ratio , s and inversely related
to the economies capital-output ratio , c.
➢The inverse of capital-output ratio, l/c (output-capital), measures how much
additional output can be had from an additional unit of investment. Therefore
multiplying the rate of new investment, s=I/Y, by its productivity, l/c, will give the
rate by which national income or GDP will increase.
➢The economic logic of the H-D model is that in order to grow, economies must
save and invest a certain proportion of their GDP. The more they can save and
invest, the faster they can grow.

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 2.1. The Harrod-Domar growth model
❑Numerical Example-2.1.1: Assuming the saving rate is 10% and the
Capital output ratio is 4, calculate economic growth rate?
❖ ΔY/Y=g= s/ c = 10%/4= 2.5%.
➢ Therefore, the economy would grow at 2.5% per year.
❑Numerical Example-2.1.2: If the savings rate is 10% and the capital
output ratio is 2, then a country would grow at 5% per year.
❖ΔY/Y =g=s/c==g=10%/2=5%

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 Example : The Capital-Output Ratio (COR)
1. If $100 worth of capital equipment produces each $10 of annual output,
a capital-output ratio of 10 to 1 exists. Similarly, a 3 to 1 capital-output
ratio indicates that only $30 of capital is required to produce each $10
of output per year.
2. 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.
❑Key point: When the quality of capital resources is high, then the capital
output ratio will be lower.
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 Summary : Harrod-Domar growth model
✓The H-D Growth model is a growth model and not a growth strategy!
✓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.
❑In H-D growth model the rate of growth is increased in one of two ways:
✓Increased level of savings(s) in the economy (gross national savings as a % of GDP)
✓Reducing the capital output ratio (i.e. rising quality / productivity of capital inputs)
➢ g= c s* c

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 2.1. The Harrod-Domar growth model

2.1.3. Limitations of the Harrod-Domar model

➢The model is too aggregative & does not provide the basis for a detailed quantitative
study, nor does it highlight the structural and regional problems
➢The assumption of a fixed coefficient of production can be questioned as it is equally
possible to doubt the assumption about the absence of trade….e.g. L and k
➢All savings may not be transformed into investment, due to market distortions
➢Saving & hence investment is only a necessary factor but not a sufficient condition
for growth
➢Estimating capital output ratio is difficult& even ratio is hardly reliable for LDCs.
➢It assumes only physical capital but not other form of capital like human capital

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 2.2. The Solow-Swan growth model
2.2.1. Introduction
➢The American economist Robert Solow and Australian Economist
Trevor Swan, constructed the Solow–Swan model in 1956.
➢It is an exogenous growth model which attempts to explain long-run
economic growth focusing on capital accumulation, labor or population
growth, and technological progress.
➢The key modification from the Harrod-Domar growth model is that the
Solow–Swan model allows for substitution between capital and labor.
➢The aggregate production function, Y = F(K, L) is assumed characterized
by constant returns to scale.

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 2.2. The Solow-Swan growth model
2.2.2.The Model
➢This model is designed to show how growth in the capital stock, growth in
the labor force, and advances in technology affect a nation’s total output.
➢It postulates that growth of per-capita output is the result of capital
accumulation and/or technological progress.
➢But the model also predicts that an increase in growth cannot last indefinitely.
In the long run, the country’s growth rate will revert to the rate of
technological progress (exogenous).
➢Underlying this pessimistic long-run result is the principle of diminishing
marginal productivity.

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 2.2. The Solow-Swan growth model
❑ Basic assumptions of the model:
✓One composite output is produced and the economy is closed
✓Constant returns to scale with diminishing returns to an individual input.
✓Two factors of production (L &K) are paid based on marginal physical productivities
✓Prices,p and wages,w are flexible
✓There is full employment of labor,L and stock of capital,L
✓Labour and capital are substitutable for each other
✓There is no technical progress
✓The saving ratio is constant and saving equals investment(s=i)
✓Capital depreciates at the constant rate, δ.
✓Population grows at a constant rate, n.

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 2.2. The Solow-Swan growth model
2.2.2.The Model…contd.
➢Given these assumptions, let us build this model by steps.
Y = F (K, L) (2.2.1)
Where, Y is income or output, K is capital and L is labor.
➢The aggregate production function, Y = F(K, L) is assumed
characterized by constant returns to scale:
F(γK , γL) = γF(K, L) for all γ, K, L>0 (2.2.2)
➢With constant returns to scale, output per person y = Y/L will depend on
the capital stock per person k= K/L. That is, equation (2.2.2) implies that:
Y/L = F (K, L)/L= F (K/L, 1) (2.2.3)
where γ = 1/L
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 2.2. The Solow-Swan growth model
2.2.2.The Model…
➢Or equation (2.2.2) can be expressed as y = ƒ (k)
Where, y = Y/L is output or income per worker, k = K/L is the capital-labor
ratio, f is the per capita production function.
➢Here the y = ƒ (k) indicates what each person can produce using his
or her share of the aggregate capital stock.
➢The concave shape of ƒ(k)—that is, increasing at a decreasing
rate—reflects diminishing returns to capital per worker.

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 2.2. The Solow-Swan growth model
2.2.2.The Model….
➢If the production function is Cobb-Douglas production function :
=(

Where, Y is gross domestic product, K is the stock of capital (which may include human
capital as well as physical capital), L is labor, and A(t) represents the productivity of labor,
which grows over time at an exogenous rate.
➢We can specify the per capita production function as:
y=f(k)=A (2.2.4)
➢Equation (2.2.4) states that output per worker depends on the amount of
capital per worker.
✓The more capital with w/c each worker has to work, the more output that worker can
produce.

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 2.2. The Solow-Swan growth model
The Steady State
✓Equation-2.2.5 shows that the growth of k depends on savings sf(k), after
allowing for the amount of capital required to service depreciation, δk, and
after providing the existing amount of capital per worker to net new
workers joining the labor force, nk.
Δk=sf(k)–(δ+n)k (2.2.5)

✓The process through which the economy increases the amount of capital
per worker, k, is called capital deepening.
❑What is likely drawback of capital deepening w.r.t. growth?

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 2.2. The Solow-Swan growth model
The Steady State…
➢An increase in the capital stock that just keeps pace with the
expanding labor force and depreciation is called capital widening (i.e.
‘widening’ of both the total amount of capital & the size of workforce).
➢Capital widening occurs when sf(k) is exactly equal to (δ + n)k), implying
no change in k.
➢Therefore, investment required to maintain capital per worker would be:
(nk + δ k) = (n + δ) k (2.2.6)
Where, δk is the investment needed to replace worn-out capital and nk is the
investment per worker to maintain capital-labor ratio for the growing
population.

24
 2.2. The Solow-Swan growth model
The Steady State…
❑ Is there any drawback of capital widening w.r.t. growth? Mention!

❖Assuming that A remains constant, there will be a state in w/c output

& capital per worker are no longer changing, known as steady state.

❖To find this steady state, set Δk = 0. This is the fundamental equation
for the Solow-Swan mode. The economy reaches a steady-state when
sƒ(k*) = (δ + n)k* (2.2.7)

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 2.2. The Solow-Swan growth model
The Steady State…
sƒ(k*) = (δ + n)k* (2.2.7)
❖The Solow-Swan model is explained in Fig. 2.1 below.

➢The notation k* means the level

of capital per worker when the
economy is in its steady state.
➢If k is higher or lower than k*,
the economy will return to it; thus
k* is a stable equilibrium.

Fig. 2.1: The Steady State in the Solow-Swan model

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 2.2. The Solow-Swan growth model
The Steady State….
✓The sf (k) curve represents saving per worker.
✓The (n + d) k is the investment requirement line from the origin with a
positive slope equal to (n+d).
✓The steady state level of capital, is determined where the sf (k) curve
intersects the (n+d)k line at point E.
✓The steady state income is y* with output per worker k*P, as measured
by point P on the production function y = f (k).

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 2.2. The Solow-Swan growth model
The Steady State…
❖Since f(k)= Akα , we can rewrite equation(2.2.5) as:

Δk = sAkα – (δ + n)k (2.2.8)

❖Finding the steady-state entails finding a value of capital, k*, for which equation
(2.2.8) is equal to zero.

0 = sAkα – (δ + n) k* which implies that

sAkα = (δ + n) k*

❖To solve for k*, first divide both sides by (k*) and by (δ+n). Then raise both sides
to the power 1/(1-α).

k* (2.2.9)
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 2.2. The Solow-Swan growth model
The Steady State…
➢Plugging equation (2.2.9) in to the production function y= Akα , we
get an expression of the steady state level of output per worker, y*.

y* (2.2.10)

➢This equation confirms that, ceteris paribus, raising the rate of

investment, s, will raise the steady-state level of output per worker.
➢Similarly, raising the rate of depreciation or rate of population
growth will lower the steady-state level of output per worker.

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 2.2. The Solow-Swan growth model
2.2.2.1. Effect of raising saving rate on the Steady State
➢Higher saving leads to faster growth in the Solow model, but only
temporarily.
➢An increase in the rate of saving raises growth only until the
economy reaches the new steady state.
➢If an economy maintains a high saving rate, it will maintain a large
capital stock & a high level of output, but it will not maintain a
high rate of growth forever.
➢ The following graph (Fig. 2.2) shows the effect of saving rate on
the steady-state.

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 2.2. The Solow-Swan growth model
2.2.2.1. Effect of raising saving rate on the Steady State

➢An increase in the saving rate

from s to s1 shifts the saving curve
sf(k) upward to s1f(k). The new
steady state point is E1.

➢As saving increases, the capital

per worker will continue to rise to
k1*, which will raise output per
worker to y1*and so will the growth
rate of output increase. But, this
process continues at a diminishing
rate in the transition period.

Fig. 2.2: The effect of saving rate on the steady-state

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 2.2. The Solow-Swan growth model
2.2.2.2. Population growth and the steady state.
Capital per worker ( y) f(k)
➢Population growth reduces the
y* (n1 + δ)k
y1*
accumulation of capital per worker
(n + δ)k
much the way depreciation does.

sf(k)
➢ Depreciation reduces k by wearing
out the capital stock, whereas
population growth reduces k by
spreading the capital stock more
thinly among a larger population of
workers.
K1* k* Capital per worker ( k)

Fig. 2.3: The effect of population growth on the steady-state

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 2.2. The Solow-Swan growth model
2.2.2.2. Population growth and the steady state…
➢An increase in the rate of population growth from n to n1 shifts
the line representing population growth and depreciation upward.
➢The new steady state K1* has a lower level of capital per worker
than the initial steady state k*.
➢Thus, the Solow-Swan model predicts that economies with higher
rates of population growth will have lower levels of capital per
worker and therefore lower incomes.

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 Discussion Questions
❖Discussion Question-2.1:
❑ Explain the Golden Rule Level of Capital.
❖Discussion Question-2.2:
❑Explain the effect of Technological Progress in the Solow
Model.

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 2.2. The Solow-Swan growth model
2.2.2.4. The Solow-Swan model as a theory of income difference
➢According to the Solow-Swan model, If a country has a higher rate of
investment, it will have a higher steady-state level of output per worker.
➢ Thus, we think of the Solow-Swan model as a theory of income difference.
➢Assuming the same level of productivity, A, and the same rate of
depreciation, δ and population growth, n, we can expresses the ratio of
income per worker in country i to income per worker in country j as follows:

(yi*)/(yj* )= ( 2.2.13)

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 2.2. The Solow-Swan growth model
❑Example 2.2.1: Suppose that country i has an investment rate of 20% &
country j has an inv’t rate of 5% . We use the value of =1/3 .
✓Substituting the value of investment rates in to equation (2.2.13).
(yi*)/(yj* )= = =2

✓Thus, the Solow-Swan model predicts that the level of income per worker
in country i would be twice the level of country j.

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 2.2. The Solow-Swan growth model
2.2.3. Conditional Convergence and the Solow-Swan model.
✓The Solow-Swan model predicts three basic conditional convergences.
✓If two countries have the same level of investment but different level of income,
the country with lower income will have higher growth.
✓If two countries have the same level of income but different rate of investment,
the country with a higher rate of investment will have higher growth.
✓A country that raises its level of investment will experience an increase in its
rate of income growth.

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 2.2. The Solow-Swan growth model
2.2.4. Limitations of Solow-Swan model
✓First, the model assumes that countries having no type of interrelation.
However, it is unrealistic to assume countries having no interrelation.
✓Second, The implicit share of income that comes from capital (obtained
from the estimates of the model) does not match the national
accounting information.
✓Third, the equilibrium rates of growth of the relevant variables depend on
the rate of technological progress, an exogenous factor and furthermore,
the individuals in the Solow –Swan model have no motivation to invent
new goods.

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 2.2. The Solow-Swan growth model
2.2.4. Limitations of Solow-Swan model…
✓Fourth, it assumes that the only source of difference in income per
worker across countries is difference in their per worker capital stock,
ignoring differences in other factors of production or in the production
function by which these factors are combined.
✓Fifth, the model argues that difference in investment rates are
important but does not say anything about the sources of these
differences in investment rate.
✓Six, it does not model long-run growth, because in the steady state of
the model, countries do not grow at all.
✓Others???

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 Chapter Summary
Questions ?
Suggestion?
Thank You?

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