Harrod-Domar Model: Growth from Saving and Investment [Assumptions, Importance, Limitations]

What’s it: The Harrod-Domar model is an economic growth model that uses saving and investment as growth sources. The model takes two economists, Sir Roy Harrod and Evsey Domar, who independently developed the model in 1939 and 1946.

The Harrod-Domar model is an alternative economic model to explain economic growth besides the Solow growth model. It assumes capital has constant marginal returns, which differs from the Solow growth model, which assumes capital has a decreasing marginal return.

Another difference between the two is the effect of the saving rate. Solow assumes that changes in the saving rate have temporary effects. But, in the Harrod-Domar model, it had a permanent effect.

How the Harrod-Domar Model works

Harrod Domar’s model helps explain why an economy grows and how to grow it. This model shows us that the national savings rate and capital productivity are the two main variables driving economic growth.

In summary, the growth rate of output is equal to the savings rate divided by capital productivity. The Harrod-Domar model equation is as follows:

• ΔY/Y = s/k

Where:

• ΔY/Y: economic growth rate
• s: savings rate, namely the ratio of national savings (S) to national income (Y). In other words, S = sY.
• k: capital-output ratio, measures the productivity of capital, and k = 1/marginal product of capital

Assume no depreciation. If Indonesia’s national savings rate is 5%, and the output-capital ratio is 2, then the economy will grow by 2.5% per year. Conversely, when Indonesia’s national savings rate is 20%, and the output-capital ratio is 4, Indonesia’s economic growth will be around 5%.

Understanding the Harrod-Domar model assumptions

The Harrod-Domar model relies on several assumptions to explain economic growth, offering a simplified framework to analyze the role of saving and investment. However, it’s important to recognize these assumptions and their limitations:

Full employment: The model assumes the economy operates at full employment, meaning all available labor resources are utilized. This is a convenient starting point for analysis, but in reality, economies experience fluctuations around full employment due to business cycles.

Savings and productivity as main drivers: The Harrod-Domar model focuses on savings rate and capital productivity (capital-output ratio) as the main determinants of economic growth. While these are important factors, the model overlooks other contributors like technological advancements and improvements in labor skills.

Constant returns to scale: The model assumes constant returns to scale for both the capital-output ratio and the propensity to save. This means that increasing capital investment proportionally increases output, and the proportion of income saved remains constant regardless of income level. In reality, the marginal return on capital may diminish as more capital is added, and saving rates can vary with income levels.

Average propensity to save (APS) equals marginal propensity to save (MPS): The model simplifies saving behavior by assuming APS (the average proportion of income saved) is equal to MPS (the change in savings due to a change in income). However, this may not always hold true, as saving decisions can be influenced by various factors beyond current income levels.

Net investment: The model considers net investment, which is gross investment minus depreciation. This reflects the actual addition to the capital stock after accounting for the wear and tear of existing capital goods.

How to interpret the Harrod – Domar model

First, the savings rate represents the supply of loanable funds in the economy for investment. A high saving rate indicates that the economy has significant funds to increase the capital stock and productive capacity. Therefore, the savings rate correlates positively with the economic growth rate. An increase in the savings rate leads the economy towards higher growth.

Second, the capital-output ratio shows us the amount of capital needed to increase output. When the economy requires more capital to produce output (high capital-output ratio), it indicates inefficient investment. The opposite is true when the capital-output ratio is low.

Second, say the capital-output ratio is low. This shows that the capital stock in the economy is relatively low. Therefore, investment will increase the capital stock and encourage the economy to produce output significantly more than when the capital-output ratio is high. From the formula above, we can see that the ratio has an inverse relationship with economic growth.

Conversely, if the capital-output ratio is high, investment does not significantly increase the economy’s output. Therefore, it becomes inefficient.

Third, the savings rate is positively correlated with capital stock. A higher saving rate allows for more significant capital investment.

Let’s take a simple explanation: Domestic savings represent savings from three macroeconomic sectors: households and businesses. It shows the supply of loanable funds in the economy.

When there is a supply of loanable funds, the economy can use them to accumulate capital.

Take the households as an example. They save and invest money in various financial instruments such as time deposits, stocks, or bonds. When they buy corporate bonds, the issuing company can use them for capital expenditures such as buying machinery or building new factories. Thus, the higher the household savings, the higher the opportunity to accumulate capital.

Importance of the Harrod-Domar model

First, the model explains that the savings rate and the capital-output ratio affect the growth rate. Low levels of economic growth can be associated with low savings rates, which usually occur in developing countries like Indonesia.

A low level of domestic savings causes a low level of investment in the economy. This results in a low supply of loanable funds for investment. As a result, the capital stock is low, as well as economic growth.

Meanwhile, a lower capital-output ratio indicates a more efficient capital investment, which results in a higher growth rate.

Second, a low savings rate can create a vicious cycle. Low investment results in low economic growth.

Low economic growth indicates slow economic prosperity. That leads to a low level of national income. Low income causes a few people to save.

When growth is low, the economy creates relatively limited new jobs. As a result, household income and aggregate demand are also low. Likewise, facing limited demand conditions, it is also difficult for businesses to increase output and gain significantly more profits. This all ultimately results in a low savings rate.

Therefore, increasing savings is an option to boost economic growth. A higher saving rate creates a cycle of self-sustaining economic growth, making the economy less dependent on the supply of funds from the external sector (foreign investment).

However, increasing the saving rate is not easy. Most people in developing countries use additional income for consumption instead of saving. They struggle to meet their basic needs, so they find it difficult to set aside more money to save.

Also, the flow of savings and capital is immobile. Underdeveloped financial markets make savings funds not always available for companies to invest in capital goods. To overcome this, the government should develop its financial markets and promote financial literacy among the population.

Third, the Harrod – Domar model classifies economic growth into three categories: actual growth, natural growth rates, and warranted growth. The change in real GDP from year to year represents actual growth.

Natural growth represents the growth rate for maintaining full employment. When the labor supply (measured by the labor force) grows by 2%, then the economic growth must grow by 2%.

Warranted growth rate represents the rate of growth when saving equals investment. In other words, all savings are for investment allocation.

Limitations of the Harrod – Domar model

Criticism is mainly leveled for the assumptions in the model.

First, the model oversimplifies the sources of economic growth. It only uses capital and savings as determinants. It ignores other factors, such as labor productivity and technological advances, that can spur economic growth.

Second, the model assumes the economy is operating at full employment. That is unrealistic in the real world because the economy often fluctuates around full employment (potential output). These fluctuations produce business cycles in which real GDP rises and falls.

Third, the constant marginal return on capital is not valid. An increase in the capital stock actually causes lower returns. The Solow growth model shows us that if the capital per labor ratio is high, the effect of increasing output due to additional capital stock tends to decrease. Thus, capital has a decreasing marginal rate of return.

For example, when 10 staff members already have 10 computers, an additional 10 computers will not increase their output. Conversely, if the staff previously did not have computers, investing in 10 computers would increase their productivity and output.

Fourth, capital is immobile in the economy. Underdeveloped financial markets make savings not always available for investment. Some savings in banks are used to finance household consumption instead of for business capital expenditures.

Also, additional savings do not always result in the same amount of additional capital investment. The economy may borrow from abroad to fill the savings gap (financing gap). Therefore, additional savings are actually used to pay off foreign debt instead of domestic investment.