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Harrod-Domar growth model

The Harrod-Domar model is unsurprisingly named after two economists, RF Harrod and ED Domar, who were working in the l930s. The model suggests that the economy's rate of growth depends on:

  • The level of saving
  • The productivity of investment, i.e. the capital output ratio

They therefore placed considerable emphasis on investment, savings and technology as the main agents of economic growth. Increased investment would, in turn, force the production possibility curve outwards and create more wealth. The impact of this increased investment on the production possibility frontier is shown in Figure 1 below.

Figure 1 Increased investment shifting the production possibility frontier

The model concludes that:

  • Increasing the savings ratio, or the amount of investment or the rate of technological progress are vital for the growth process
  • Economic growth depends on the amount of labour and capital.
  • As developing countries often have an abundant supply of labour it is a lack of physical capital that holds back economic growth and development.
  • More physical capital generates economic growth.
  • Net investment leads to more capital accumulation, which generates higher output and income.
  • Higher income allows higher levels of saving.

The key to economic growth is therefore to expand the level of investment both in terms of fixed capital and human capital. To do this, policies are needed that encourage saving and/or generate technological advances which enable firms to produce more output with less capital, i.e. lower their capital output ratio.

However, the model has a range of problems as it tends to focus heavily on economic growth. The problems may be:

  • Economic growth and economic development are not the same. Economic growth is a necessary but not sufficient condition for development
  • Savings and investment are a necessary but not sufficient condition for development
  • On a practical level, it is difficult to stimulate the level of domestic savings, particularly in the case of developing countries where incomes are low.
  • Borrowing from overseas to fill the gap caused by insufficient savings causes debt repayment problems later.
  • The law of diminishing returns would suggest that as investment increases the productivity of capital will diminish and the capital to output ratio will therefore rise.