Harrod-Domar Growth Model

JOIN KHALID AZIZ

ECONOMICS OF ICMAP, ICAP, MA-

ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.

CONTACT: 0322-3385752 0312-2302870 R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

Topics for today

In growth models, we will encounter the following terms:
Lord Harrod and Mr. Domar Keynesian based models Saving rates Capital/Output ratio or Personal Consumption Gross Savings Gross Investment Net Investment, or Capital

Capital Productivity Capital stock GDP

Accumulation Depreciation Dynamic models

What is a Keynesian Growth Model?

Keynes model and Keynesian models were

developed to explains business cycles

A short run phenomena

As such they attribute a major role to aggregate

expenditures (demand side) Regarding the supply side, they assume that there is unemployment: production responds fast to increases in aggregate demand because capital and labor is unemployed.

 Aggregate Demand, AD
AD = C + I + G + X-M C, Consumption expenditures I, Investment expenditures G, Government expenditures X-M, Foreigners Expenditures

Aggregate Supply
AS < ASfe Aggregate Supply, at full employment

Macroeconomic Equilibrium
AS = AD Or S=I

A Keynesian Model
A Keynesian growth model takes a long run

perspective.

Aggregate demand (or savings=investment) still is important, but It also includes the aggregate supply
Investment has two impacts:
On expenditures (in the short run) On capital stock (in the long run)

Trends and business cycles

Trend

Real GDP

One business cycle

Years

Main Propositions
Economic growth can be accelerated by
changing the saving rate improving technology.

Saving rates and technology can be changed

government interventions without consideration to prices

Harrod-Domar Growth Model

A Flow chart model
Depreciation Rate Saving Rate

d D

Ig

s C GDP

In

v= K/Y or Capital/Output a=Y/K Ratio or Productivity

Capital
Production function

Factors Explaining the growth rate According to Harrod-Domar model

+ Rate of Economic Growth

s
+

Saving rate

g
_

a d

Capital productivity

Capital depreciation

Explained variable

Explanatory Variables

Arithmetic specification
Without Depreciation

If we know output Y, and we know s, which is the saving rate, then we know total savings S. If we know the initial capital stock K; and we know a, (how much output increases when capital increases 1 unit) then we know what will total output Y be.

lf a tI o w n k e w o n k e ,v S s g i a n a c e w h u m o w e n i ) I ( t s v ) K d ( l a t i p c

S=Y.s

s=dS/dY

dY Y=K.a I If we know dK and a, we know growth of output dY

dK

a=dY/dK

Numerical specification
Without Depreciation

If we know output Y=1 and we know the saving rate s=.10, then we know total savings S=.10

lf a tI o w n k e e w 0 1 .v = S s g n i a n a c e w t h o k w e n i 0 1 . = I t s v ) 0 1 .t = K d ( l a i p c

Or s=.10 S=.10 dY = s.a

dY=.02=2% By approximation:

dY/Y=s.a/Y Y=1 g=s.a

.10
If we know dK=.10 and a=.20, we know growth of output dY=0.02=2%

Since Y=1

If we know the initial capital stock K=5; and we know its productivity a=.20 then we know total output Y=1

a=.20
dK=.10 K=5

Economic growth formula

According to Harrod-Domar the rate of economic growth is defined by the formula:

g = s.a d
that is, if s=10% and a=0.20 and d =1%, then g=0.10*0.20 - 0.01 = 0.02 -0.01 = 0.01 = 1% What happens if the rate of saving (s) increases to 20% ? What happens if the productivity of capital (a) increases to 0.40? What happens if the depreciation (d) rate is 2% ?

Mathematical derivation of Harrod-Domar model

.
Specification Saving function (demand side) S = s.Y where s is the average propensity to save or average saving rate. In the conventional short run Keynesian model investment (I) is given. I = Ia In equilibrium S=I Solving the model s.Y = Ia Y = 1/s.Ia = m.Ia where m is the investment multiplier Conventional Keynes Model

In this model national GDP increases because the autonomous demand (I) increases. It is assumed that aggregate supply responds as to produce what is demanded. But, what will happen if the economy was at full employment? The only way for production to increase will be an increase in the capital stock. With more capital (and labor) the economy will produce more GDP.

Mathematical derivation of HarrodDomar model (2)

Keynes Model Expanded to Consider Growth Harrod and Domar explained how the aggregate supply expands. For them, investment has two effects, one on the aggregate demand side (businesses expend more) and another in the aggregate supply side (more investment increases capital stock and thereby businesses produce more the next period). We, therefore, need to add a production function: Y = a.K production function Where a is the productivity of capital: Y/ K, which is constant Now we can determine how a change in capital changes income. Y = a.K

Mathematical derivation of HarrodDomar model (3)

What we need to know is how capital changes. It changes by businesses, and government investment:

K = Ia
We are assuming that capital doesnt ware out, i.e. there is not depreciation. Returning to the equilibrium condition (S=I) we solve the model again for the long run case

s.Y = Ia = K, but we know that K = Y/a, then s.Y = Y/a s.a = Y/Y Calling Y/Y = g : rate of GNP growth

Mathematical derivation of HarrodDomar model IV

g = s.a If we recognize that capital depreciates: g = s.a d Where d is the depreciation rate per year.

Notice that in this model the rate of growth (g) is constant. Why?

Harrods way: K = v.Y where v = 1/a g = s/v And with depreciation g = s/v - d

To growth model

Production function
K GDP2> GDP1 GDP1 GDP GDP Production function
Productivity rate

To growth model

Labor/capital proportions are fixed

K GDP2> GDP1 GDP1 GDP GDP Production function

Assumptions

Productivity rate

Saving rate is given

S

S
Saving rate

Saving function

Income = GDP

Non-existence of equilibrium
Y,S,D,I

S
In D

D K

Review
You should now be familiar with the following terms:
Technology or

capital/output ratio Saving rate

Depreciation rate Capital accumulation Growth rate

JOIN KHALID AZIZ

ECONOMICS OF ICMAP, ICAP, MA-

ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.

CONTACT: 0322-3385752 0312-2302870 R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.