Module 5: Economic Growth
Harrod-Domar model and Solow one sector
growth models; golden rule; dynamic
efficiency, technological progress and
elements of endogenous growth theory.
Harrod-Domar model
It suggests that there is no natural reason for an
economy to have balanced growth.
• The Harrod-Domar models of economic
growth are based on the experiences of
advanced capitalist economies to analyse the
requirements of steady growth in such
economy.
• The Harrod-Domar economic growth model
stresses the importance of savings and
investment as key determinants of growth..
• The model emphases on the dual character of
investment:
• 1. It creates income which is regarded as the
‘demand effect’.
• 2. It augments the productive capacity of the
economy by increasing its capital stock which
is regarded as the ‘supply effect’ of investment
The main assumptions of the Harrod-Domar
models are as follows:
1. A full-employment level of income already
exists.
2. There is no government interference.
3. The model is based on the assumption of
closed economy.
4. There are no lags in adjustment of variables.
5. The average propensity to save (APS) and marginal
propensity to save (MPS) are equal to each other.
Symbollically, S/Y= ∆S/∆Y
6. Both propensity to save and “capital coefficient”
(i.e., capital-output ratio) are given constant.
7. Income, investment, savings are all defined in the
net sense and hence they are considered over and
above the depreciation.
8. Saving and investment are equal in ex-ante as well
as in ex-post sense
The Harrod Model:
• The Harrod Model is based upon three distinct
rates of growth as below:
• 1. The actual growth rate (G)
• 2. The warranted growth rate (Gw)
• 3. The natural growth rate (Gn)
• The actual growth rate (G):
• It is defined as the ratio of change in income
(∆Y) to the total income (Y) in the given
period.
• G = ∆Y/Y
• The warranted growth rate (Gw): Warranted
growth Rate also known as Full-capacity
growth rate refers to that growth rate of the
economy when it is working at full capacity.
• The natural growth rate (Gn): The natural
growth rate also known as the potential or the
full employment rate of growth is the rate of
economic growth required to maintain full
employment.
The Harrod- Domar growth Model
• Diagram:
• Consumption goods: produced for satisfying
human wants and preference
• Capital goods: good that are produced for
producing the commodities.
• But if the households consume on
consumption goods how are capital goods
produced?
• Households save
• savings = investment (Macroeconomic balance)
• Y(T)=C(T) + S (T)
• T= 0,1,2,3,------
• Y= Total Output
• Y = consumption
• S= savings
• If S(t) =I(t)
• Therefore : Y(t)=C(t) + I(t)
THE SOLOW MODEL
• Law of diminishing returns to individuals
factors of production
• According to Solow O ie .capital output rate is
endegeneous.
• O might depend on economy wide relative
endowments of capital and labour.
• K(t+i) K(t) +sy(t)
• (explained)
• Production function –technical knowlledge
• Production function with diminishing returns
to per capita capital.
• As per capita capital increases ,the output
capital ratio falls because of relative shortage
of labour.
Convergence
• Economies with lower per capita income grow
faster than richer economies and the gap in the
per capita income between two economies
reduces—catching up– convergence
• Convergence arises due to diminishing returns
to capital.
• Convergence rate is increasing fast of
depreciation rate and an increasing function of
the population growth rate.
Types of convergence
• Absolute convergence : occurs when in
economies with the same rates of
investment ,population growth and levels of
technology, the one with a smaller per capita
income grows temporarily faster than one
with an initially higher per capita income .
• Conditional convergence: Economies converge
to their steady state. Conditional convergence
refers to the convergence of economies after
we control for or condition on differences in
steady state.
Poverty trap
• Solow assumes constant population growth.
• As PCI increases ,Population growth rate n
increases first and then declines.
• N = n(k)
• Y
----- declines with k. due to diminishing returns
• k
• Human capital is acquired by devoting resources
to invest in its acquisition.
• Human capital acquisition --- learning by doing
• Romer –knowledge creation is by product of
investment.
• A firm that accumulates physical capital also
learns how to use it
• ie how to produce more efficiently
• ie learning by doing
• Learning by doing occurs through each firms
investment –an increase in firms capital stock
leads to a parallel increase in knowledge.
• Each firms knowledge is a public good that
other firms can access at zero cost.
• Even though knowledge about technology
trickles out slowly but we assume that all this
becomes common knowledge.
• Now ways of production can be easily
duplicated by other firms because some
workers leave one firm to another.
• When firms in the economy invest more or
accumulate more capital per worker ,the skills
of workers go up proportionately as workers
improve their performance of specific tasks.
• Each firm benefits from the average level of
human capital in the economy as knowledge
spillover increase in the level of skills at firms.
• Endogeneous growth:
• Savings and capital accumulation ,population
growth and exogeneously driven productivity
growth are not a satisfactory way to explain
economic growth.
• Human capital –acquisition of skills—education-
improves the labour force
• Individuals move out of the low paid jobs to
better paying jobs.
• Education--------skills
• Skill acquisition also occurs as workers learn a
new technology
• Acquisition of skills- acquisition of human
capital.
• According to endogenous growth theory the
accumulation of human capital is responsible
for the growth in per capita income.
• The determination of long run growth is
within the model itself rather than through
some exogeneous growth variables like
technological progress.
