Criticism of Harrod-Domar growth model

Answer 1

Harod Domar Model of Growth and Its Limitations

The Harod Domar Model suggests that economic growth rates depend on two things:

1. Level of Savings (higher savings enable higher investment)
2. Capital Output Ratio (efficiency of investment)

Formula for Harod Domarg=s/c (1)

where

- g is the economic growth rate

- s=S/Y is the ratio of saving S to income,Y,

- c is marginal capital-output ratio

It is argued that in developing countries saving rates are often low, if left to the free market. Therefore, there is a need for governments to increase the savings rate in an economy. Alternatively, developed countries could step in and transfer capital stock to the developing countries, which would increase the productive capacity.

Warranted Growth Rate

Roy Harrod introduced a concept known as the warranted growth rate.

• This is the growth rate at which all saving is absorbed into investment. (e.g. £80bn of saving = £80bn of investment.
• Let us assume, the saving rate is 10%. the Capital output ratio is 4. In other words £10bn of investment, increases output by £2.5bn
• In this case the economy's warranted growth rate is 2.5 percent (ten divided by four).
• This is the growth rate at which the ratio of capital to output would stay constant at four.

The Natural Growth Rate

• The natural growth rate is the rate of economic growth required to maintain full employment.
• If the labor force grows at 3 percent per year, then to maintain full employment, the economy's annual growth rate must be 3 percent.
• This assumes no change in labour productivity which is unrealistic.

Criticisms of Harod Domar Model

• Developing countries find it difficult to increase saving. Increasing savings ratios may be inappropriate when you are struggling to get enough food to eat.
• Harod based his model on looking at industrialised countries post depression years. He later came to repudiate his model because he felt it did not provide a model for long term growth rates.
• The model ignores factors such as labour productivity, technological innovation and levels of corruption. The Harod Domar is at best an oversimplification of complex factors which go into economic growth.
• There are examples of countries who have experience rapid growth rates despite a lack of savings, such as Thailand.
• It assumes the existences of a reliable finance and transport system. Often the problem for developing countries is a lack of investment in these areas.
• Increasing capital stock can lead to diminishing returns. Domar was writing during the aftermath of the Great Depression where he could assume there would always be surplus labour willing to use the machines, but, in practice this is not the case.
• The Model explains boom and bust cycles through the importance of capital, (see accelerator theory) However, in practice businesses are influenced by many things other than capital such as expectations.
• He assumed there was no reason for the actual growth to equal natural growth and that an economy had no tendency to full employment. However, this was based on assumption of wages being fixed.