1

Both assign a key role to investment in the

process of economic growth. But they lay

emphasis on the dual character of
investment.
1)It increases income and
2)It augments the productive capacity of the
economy by increasing its capital stock.
The former may be regarded as demand
effect and latter the supply effect of
investment.

Hence so long as net investment is taking

place, real income and output will continue
to expand. However, for maintaining the
full employment equilibrium level of
income, it is necessary that both real
income and output should expand at the
same rate at which the productive capacity
of the capital stock is expanding.
This further requires continuous growth in
real income at a rate sufficient enough to
ensure full capacity use of a growing stock
of capital.
4

This required rate of income growth

may be called the warranted rate of growth

or the full capacity growth rate.

The Domar Model

Domar builds his model around the

following questions: since investment

generates income on the one hand and
increases productive capacity on the other,
at what rate investment should increase in
order to make the increase in income equal
to the increase in productive capacity , so
that full employment is maintained?
6

The demand side is explained by the

keynesian multiplier .

The Harrod Model

Prof. Harrod tries to show in his model how

steady (i.e. equilibrium) growth may occur in

the economy. Once the steady growth rate is
interrupted and the economy falls into
disequilibrium, cumulative forces tend to
perpetuate this divergence thereby leading to
either deflation or inflation.
The Harrod model is based upon three distinct

rates of growth.
8

1. there is the actual growth rate represented by

G which is determined by the saving ratio and

the capital-output ratio.
2. there is a warranted growth rate represented
by Gw which is the full capacity growth rate of
income of an economy.
3. lastly, there is a natural growth rate
represented by Gn which is regarded as the
welfare optimum by Harrod. It may also be
called the potential or the full employment rate
of growth.
9

For full employment growth , the actual

growth rate of G must equal Gw that would

give steady advance to the economy and
C=Cr i.e. C ,the actual capital goods.
Cr, the required capital goods for
steady growth.
If G>Gw, then C< Cr Results in insufficient
goods and insufficient equipments. Such a
situation leads Inflation because actual
income grows at a faster rate than that
allowed by the growth in the productive
capacity of the economy.
10

If G<Gw, then C>Cr, such a situation leads to

depression because actual income grows

slowly than what is required by the productive
capacity of the economy. This means that
desired investment is less than saving and the
aggregate demand falls short of aggregate
supply. The result is fall in output,
employment, and income. This will lead to
chronic depression.

11

The Natural Rate of

Growth
It is the rate of advance which the increase of
population and technological improvements
allow. The natural rate of growth depends on
the macro variables like population,
technology, natural resources and capital
equipment.

12

Divergence of G, Gw &
For full lemployment equilibrium
Gn
G=Gw=Gn and this is Knife edge balance.
If G>Gw, investment increases faster than saving and
income rises faster than Gw. (Inflationary situation)
If G<Gw, savings increases faster than investment and
income rises less than Gw. (deflationary situation)
If Gw>Gn secular stagnation develop, in such a situation
Gw is also greater than G.
If Gw< Gn the tendency of inflation is to developed in
the economy. In such a situation Gw is also less than G.
There is a shortage of capital goods and labour is
plentiful.

13

Profits are high since desired investment is

greater than realised investment and the

businessmen have a tendency to increase
their capital stock. This will lead to secular
inflation.

14

The Harrod-Domar Model

S sY

Savings rate s

I K

Invest = Capital

K kY

Capital/Output = k

SI

Closed Economy

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3-15

The Harrod-Domar
Model
S sY kY K I

sY kY
Y s

Y
k
Growth rate of GDP = savings rate/capital-output ratio
& To increase GDP growth, increase s (or foreign S)
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3-16

Harrods assumptions
Based on two hypotheses:
Capital and labor have to combine in a fixed proportion
dictated by current technology to produce product.
The saving rate is fixed.
The rate of growth of the capital stock (the warranted rate of

growth) is defined as the ratio of two constants:

Saving and investment per unit of desired output

Stock of capital per unit of output dictated by technology.

The rate of growth of labor is called the natural rate of growth

Society is fully utilizing the capital and labor only if the

warranted and the natural rates of growth happen to be

equal.
This is the knife edge problem. If investment is above the
warranted rate, recession follows. If investment is below,
inflation follows.

17

Criticisms of the Harrod-Domar

Model

Necessary versus sufficient conditions

Is Saving necessary for growth?

Not if foreign investment or foreign aid (World

Bank Loans, etc.)

Is Saving (Investment) sufficient for growth?

Are there institutions to channel savings to
productive uses: a well-functioning financial
system or government plan?

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