Harrod-Domar Model of Growth

Dual Effect of Investment: Income Effect and Capacity Effect

• Keynes’s General Theory focused on the determination of income and employment in the short run; he argued that in developed capitalist economies aggregate demand is often deficient relative to aggregate supply, causing equilibrium to be established at a less-than-full-employment level.

• Since the propensity to consume (and save) is assumed to remain constant in the short run, if investment—determined by the expected rate of profit and market rate of interest—is insufficient to match saving at the full-employment level of income, the economy settles at an equilibrium level of output and employment below full capacity.

• Keynes did not analyse the long-run growth process and largely overlooked the effect of investment on expanding the economy’s productive capacity.

• Investment has a dual effect:

  • It increases aggregate demand and income through the multiplier process (income/demand effect).

  • It increases the economy’s productive capacity by adding to the stock of capital (capacity effect).

  • While Keynes emphasised the demand effect, he largely ignored the capacity effect.

• Harrod and Domar extended Keynesian analysis to the long-run problem of economic growth by incorporating both the income effect and the capacity effect of investment.

• The Harrod-Domar growth models sought to explain the rate at which investment must grow to ensure steady economic growth in advanced capitalist economies, assigning a central role to capital accumulation in the growth process.

• In the late 1940s and early 1950s, advanced economies faced the challenge of avoiding both secular stagnation and secular inflation; the pioneering work of Harrod and Domar initiated systematic analysis of how steady growth could be maintained over time.

• The central objective of the Harrod-Domar models is to determine the unique rate of growth of investment and income required to maintain full employment equilibrium and achieve equilibrium growth over the long run.

• Although Harrod and Domar developed their theories independently and differed in details, both shared the same fundamental idea:

  • Capital accumulation is crucial for economic development.

  • Investment simultaneously generates demand and expands productive capacity.

  • Sustainable growth requires balancing these two effects.

• Their approach differed from earlier schools of thought:

  • Classical economists focused mainly on the capacity-creating role of investment.

  • Early Keynesians concentrated primarily on the demand-generating role of investment.

  • Harrod and Domar integrated both the demand and capacity aspects of investment into a single growth framework.

• The models begin with an economy at full-employment equilibrium and argue that the demand generated by investment must be sufficient to absorb the additional output created by the same investment.

• For steady growth with full employment, both the absolute amount of net investment and real national income must continuously increase over time.

• If investment continues to add to the capital stock but demand and income do not rise correspondingly:

  • Newly created productive capacity remains underutilised.

  • The growing labour force cannot be fully employed.

  • Unemployment of both capital and labour resources emerges.

• Therefore, continuous growth of investment, income and demand is essential to absorb expanding productive capacity, maintain full employment, and ensure steady long-run economic growth.

Domar’s Growth Model

Capacity Effect of Investment

• In the Harrod-Domar model, the supply side (capacity effect) of investment explains how investment increases the productive capacity of the economy and thereby raises national output or income.

• The increase in national income (ΔY) during a period depends on:

  • The increase in the stock of capital (ΔK).

  • The output-capital ratio or productivity of capital.

• The output-capital ratio is measured as:

  \(\frac{\Delta Y}{\Delta K}\)

  where ΔY represents the increase in national income/output and ΔK represents the increase in the stock of capital.

• If ₹4 of additional capital is required to produce ₹1 of additional output, the marginal output-capital ratio equals:

  \(\frac{1}{4}=0.25\)

• The increase in national income is obtained by multiplying the increase in capital stock by the output produced per unit of capital; therefore:

  \(\Delta Y=\Delta K\left(\frac{\Delta Y}{\Delta K}\right)\)

• Since an increase in capital stock (ΔK) is equivalent to investment (I), Harrod and Domar replace ΔK with I. Assuming the output-capital ratio remains constant and is equal to the average output-capital ratio, it is denoted by σ (sigma).

• Accordingly, the growth of capacity output is expressed as:

  \(\Delta Y=I\sigma\)

• The output-capital ratio (σ) is the reciprocal of the capital-output ratio, i.e.:

  \(\sigma=\frac{\Delta Y}{\Delta K}=\frac{Y}{K}\)

  Therefore, a lower capital-output ratio implies a higher output-capital ratio and greater productivity of capital.

• Example:

  • If annual investment = ₹500 crore.

  • Capital-output ratio = 4.

  • Therefore, output-capital ratio = 1/4.

  • Increase in output:

  \(\Delta Y=500\times\frac{1}{4}=125\)

  Hence, an investment of ₹500 crore generates an increase in annual output of ₹125 crore.

• Thus, according to the capacity side of the Harrod-Domar model, growth in output depends directly on the volume of investment and the productivity of capital (output-capital ratio); higher investment or a higher output-capital ratio leads to greater expansion of productive capacity and national income.