Harrod-Domar Model of Economic Growth

‘Crude but Flexible’

Lecture #3 of Eco 3317

Harrod-Domar Model as a Neo-Classical Model

• This model is older and cruder than Solow Model• This model links Income Growth(output) with

Capital(input): dK leads to dY in two ways-

- Quantity of Capital through Savings = Investment

- Effectiveness and Efficiency of Capital

- Different Institutions can make a difference

in effectiveness and efficiency of capital

• It explain some Asian Economic Development to

some extent.

1. Derivation of Harrod-Domar equation

dY/Y = dY/dK x dK/Y

As S = I = dK , and thus

= dY/dK x S/Y = S/Y x dY/dK

Income Growth Rate = Saving Rate x Efficiency of Capital

= Savings Ratio x Marginal Product(ivity) of Capital

Alternatively we can say

Growth Rate = S/Y

dK/dY

= Average Propensity to Save Average Propensity to Save Incremetal Capital Output Requirement (ICOR)

= Quantity of K / In-Efficiency or Capital Requirement of K for one more unit of Y.

2. Key Concepts

“The higher MPK, the lower ICOR,

the more efficiently is capital being used.”

“The more effectively capital is raised and the more efficiently it is used, the higher the rate

of economic growth will be”

3. Implications of the H-D model

i)The key to economic growth is to expand the level of investment: capital accumulation or ‘Mobilization of capital’

ii)Equally important is the productivity or efficiency of use of capital: the higher the marginal product of capital,(MPk) the better, or the lower the required incremental capital-output ratio(ICOR), the higher the economic growth rate will be.

iii) In general, eventually, the more amount of capital, the Marginal Productivity of capital decreases – “Convergence”Recall: In the latter part of the S curve, the MP of capital is a decreasing function of capital –“Decreasing Marginal Returns” or “Law of Diminishing Marginal Return”

This happens as the size of capital grows in the natural course of economic growth.

• It is a formidable task to keep the weighted average Marginal Product of Capital constant or even Increasing for the entire economy.

• Technical Innovations may keep it high

4. This leaves a room for An Endogeneity:

What makes differences in effectiveness of raising capital and efficiency of using capitalacross countries?

It may be their ‘Different Institutions’

or ‘Different Economic Organizations’ that maymake a difference.

• Different ‘Institutions’ or ‘Organizations’ leads to Different Effectiveness of raising Capital and

Different efficiency of using Capital

• What are institutions? covers visible Direct Government Policy or Indirect Policy Environment

Business Operating System;

invisible Value System(ethics,religion)

5. Applied to East Asian Economic Growth

There must be unique ‘institutions’ that help effectively mobilize capital and enhance efficiency of capital

Theory: The studies of economic growth is to find out what institutions they are.

Practice: The strategy of economic growth is first to foster such ‘institutions’

* Case Studies

1) Japan

Kozo Yamamura’s or Kazuo Sato’s paper reports that during the take-off stage of economic growth of Japan, 1) there was a big increase in capital due to high savings rates, and 2) the ICOR as well as average capital-output ratio fell significantly.

In turn, these two factors were due to favorable Government policies, business organizations, and institutions.

Specifically, what are they?; how did they work?

For detailed explanation

• Read Kozo Yamamura’s paper and

• Kazuo Sato’s paper

• Government’s

Economic Development Planning(Progressive Stages)

Industrial Policies• Institutions

No social welfare system

Bonus System

Minimum Investment on Housing

(max. investment on production facilities)

Lifetime Employment System

Conglomerate System

2) Korea

An Exact replica of the Japanese economic growth model

3) Some failures

Some countries have succeeded in mobilization of capital, but failed in the efficient use of capital.

Stalinist Economy

North Korea

Great Leap Movement in China

4) Chinese economic growth

A bit of mystery?

• Effectiveness of Raising Capital

. A high savings ratio for the entire society: 50%

• Efficiency of Capital Use

“Where does efficiency come from or not?”

The Chinese ICOR is twice as large as the Japanese ICOR in heyday as shown next:

Chinese economic growth has happened in spite of many things:

1)Chinese government figures overstate

investment;

2) China may not be a capital poor country in that it has really no reason for conserving capital.

3) China needs massive investment on Social

Overhead Capital(SOC) or Infra structure.

4) Capital requirement for the same Manufacturing has changed since the 1960s.

6. Shortcomings of the Harrod-Domar Model

• Over time, naturally, efficiency of capital use falls: - The law of diminishing returns suggests that as capital

increases, the marginal productivity of the capital will diminish, and ICOR will rise: The model predicts that in the long-run, economic growth rate will fall- convergence. Empirically it is always the case. And we attribute this to Technical Innovation.

• What does this mean? MP =f (K) only in H-D model.

• It may be true in short-run.

• However, in the long-run, MP = f(K, ?)