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Harod-Domar Model
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Q1: What is the implication of Harrod-Domar model on the cause of growth? :1
FAQID:637

: global,

InputDate: 7/8/2006
Reference: Hayami, Yujiro. Development Economics, From the Poverty to the Wealth of Nations, Second Edition, Oxford University Press
A: In the 1940's Roy Harrod (1948) and Evsey Domar (1946) separately developed a macro-dynamic model through an extension of Keyns's theory. The model's original intent was to identify the source of instability in the growth of developed economies where effective denand is normally exceeded by supply capacity. In the 1950's and 1960's this model was applied to economic planning in developed economies.
Basic Equation
The basic equation in the Harrod-Domar model is very simple, :

g=s/c (1)

where
- g is the growth rate of national income
- s=S/Y is the ratio of saving S to income,Y,
- c is marginal capital-output ratio

What is the implication?
Under the assumption of constant c, g increases proportionally with s. Because s is considered to increase proportionally with income per capita, s is bound to be low and, hence, g will be low in low-income economies if savings and investment are left to private decision in the free market. The model implies, therefore, that the promotion of investment by government planning and command is needed to accelerateeconomic growth in low-income economies. Infact, the Harrod-Domar model provided a framework for economic planning in developing economies, such as India's Five Year Plan.
Reference:
Domar, E. 1946. Capital Expansion, Rate of Growth, and Employment. Econometrica, 14 (Apr.): 137-47

Harrod, R. F. 1948. Toward a Dynamic Economics: Some Recent Developments of Economic Theory and Their Application to Policy (London: Macmillan)

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Q2: Why did Harrod-Domar model influenced the development aid? :2
FAQID:638

: global,

InputDate: 7/8/2006
Reference: Easterley, William. 2001. The Elusive Quest for Growth, Economists Adventures and Misadventures in the Tropics. The MIT Press.
A: The idea that aid-financed investment in dams, roads, and machines would yield growth goes back a long way. In April 1946, economics professor Evsey Domar published an article on economic growth, "Capital Expansion, Rate of Growth, and Employment," which discuss the relationship between short-term recessionns and investment in the United States.
Domar assumed that output (GDP) is propotional to machines
Domar's approach to growth became popular because it had a wonderfully simple prediction:
- GDP growth will be proportional to the share of investment spending in GDP. ,
- so the change in output will be proportional to the change in machines, that is, last year's investment.
- So GDP growth this year is just proportional to last year's investment/GDP ratio.

How did Domar get the idea that production was proportional to machines? Did not labor play some role in production? Domar was writing in the aftermath of the Great Depression, in which many people running the machines lost jobs. Domar and many other econmists expected a repeat of the depresion after World War II unless the government did something to avoid it. Domar took high unemployment as a given, so there were always people available to run any additional machines that were built. Domar's theory became known as the Harrod-Domar model. (A British economist named Roy Harrod had published in 1939. Clearly Domar's interest was the short-run business cylale in rich countries. So how did Domar's fixed ratio of production to machines make it into the analysis of poor countries' growth?

Domar disavowed his model to be applied for long-run growth
Although Domar assumed that production capacity was propotional to the stock of machinary, he admitted the assumption was unrealistic and eleven years later, in 1957, complaining of an "ever-guilty conscience," he disavowed the theory. He said his earlier purpose was to comment on an esoteric debate on business cycles, not to derive an "empirically meaningful rate of growth." He said his theory made no sense for long-run growth, and instead he endorsed the new growth theory of Robert Solow.
It was ironic that domar's growth model became the most widely applied growth model
To sum up, Domar's model was not intend as a growth model, made no sense as a growth model, and was repudiated as a growth model over forty years ago by its creator. So it was ironic that Domar's growth model became, and continued to be today, the most widely applied growth model in economic history.

Domar models was used for rationalize "finacial gap" approach
economists applied H-D model to poor countries to determine "required" investment rate for a target growth rate.
- The difference between the required investment and the country's own savings is called the "financial gap".
- donors fill the financial gap with foreign aid to attain target growth.
- This is a model that promised poor countries growth right away through aid-financed investment.

Model proved to befailing as more data became available
With the benefit of hindsight, the use od Domar's model for growth projections was a big mistake.
- The experiences we observed seemed to support a rigid link from aid to investment to growth.
- It was only as more data became available that the model's failings became ghastly apparent.
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Q3: What type of production function does Harrod-Domar model assume? :3
FAQID:639

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InputDate: 7/8/2006
Reference: Hayami, Yujiro. Development Economics, From the Poverty to the Wealth of Nations, Second Edition, Oxford University Press
A: It is important to recognize that the strategy to promote economic growth by forcing increased savings wa based on the assimption of a special production function.
Constancy in the capital-output ratio
Recall that the Harrod-Domar model assumed constancy in the capital-output ratio (c=K/Y). This assumption implies that the aggregate production function relating national product (Y) with the input of production factors take the form of

Y=AK (1)

where A=1/c is constant.

The production function assumes capital is the only factor of production
The peculiar nature of the production function is evident from the specification that only capital, but not labour, incuded as a factor contributing to production. This means that, so long as capital remains the same, output deos not increase whatever the increae in lanour. In other words, equation (1) assumes that labour and capital are not substitutable in production. Harrod's original theory dealt with the sort-run situation in which design of factors and machinary were fixed in a certain optimam combination with labour. However, in the long-run process of development, where major technical advances are expected, fixed factor proportion deos not seem to be relevant assumption.
Under the disguised unemployment, this specification may be relevent
- The specification of the production function might be relevent to developing economies if disguised unemployment exists as assumed in the theory of balaced growth.
- However, empirical evidence casts dout on the existance of surplus labour at zero marginal productivity (Schultz, 1964; Hopper, 1965)
Assumption of no technical progress
More irrelevent to long-run development analysis is the assumption of no technological aprogress implied in the constancy of A(=1/c), though it could be appropriate in dealing with the problem of short-run economic fluctuations.

Why economists assume constant capital-output ratio?
The reason why a model assuming a fixed capital-output ratio and no factor substitution was popular among planners and policy-makers in developing countries may be eaplained partly by underestimation of developing economies' capacity to carryout technological innovation, as well as over-estimation of disguised unemployment. Another reason may be based on the misunderstanding by economic theorists of the historical trend of the capital-output ratio.
Reference:
Schultz, T.W. (1964). Transforming Traditional Agriculture New Haven, Yale University Press
Hopper, D. (1965). Allocation Efficiency in Traditional Indian Agriculture, Journal of Farm Economics, 47(Aug.): 611-24.
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