Harrod-Domar Model: Formula, 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. Harrod-Domar assumes the capital has constant marginal returns. It differs from the Solow growth model, where 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 you 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%.

Harrod – Domar model assumptions

The Harrod – Domar model relies on several assumptions to explain economic growth.

• The economy operates at full employment and makes full use of available capital goods.
• Productivity and savings rate are the main determinants of economic growth.
• The model assumes constant returns to scale for the capital-output ratio and the propensity to save.
• Average propensity to save (APS) is the same as the marginal propensity to save (MPS).
• Investment is net, that is, gross investment minus depreciation. Thus, the capital stock changes by net investment.

How to read 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 you 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. It shows you the capital stock in the economy is relatively low. Therefore, the 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, you can see, 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. The domestic savings represents savings from three macroeconomic sectors: households and businesses. It shows you 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.

Importances of the Harrod-Domar model

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

A low level of domestic savings causes a low level of investment in the economy. It 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 shows you a more efficient capital investment. That results in a higher growth rate.

Second, a low savings rate can create a vicious cycle. This results in low investment resulting 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, an option to boost the rate of economic growth is to increase savings. A higher saving rate creates a cycle of self-sustaining economic growth. The economy is less dependent on the supply of funds from the external sector (foreign investment).

However, indeed, increasing the saving rate is not an easy matter. Most people in developing countries use additional income for consumption instead of saving. They have to 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. I mean, these savings funds are not always available for companies to invest in capital goods as a result of underdeveloped financial markets. 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 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 as factors spurring 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 you, 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 make them produce more output. Conversely, if the staff previously did not have computers, investing 10 computers would make them more productive and produce more 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.