Farwa

Title of Course: - Economic Growth

Assignment:-
Submitted By: - Farwa Baneen
Harrod-Domer Model
Keynesian model was developed to explain business cycles (a short run
phenomenon). It attributes major role to aggregate expenditure (i.e., aggregate
demand)
AD  Y  C  I  G  ( X  M )

There are 3 approaches to measure GDP.

1) Expenditure or outlay approach

Y  C  I  G  (X  M )

2) Income approach

Y  wL  iK  rT  E Y=wL+iK+rT+E

3) Productivity approach / Market Value

n
Y   P1Q1
i 1

Where Y=GDP=Gross domestic product=National income

C=Consumption expenditure (by household)

I=Investment (by household)

G=Government expenditure

X-M=Net exports (foreigner’s expenditure)

AD=Aggregate demand

Harrod-Domer model assume that if unemployment exist (production respond will

be fast to increase in AD as K and L are not fully utilized). E.g. GDP growth rate
for Japan, UK, USA, is small as compared to India, Pakistan. According to Harrod-
Domer model aggregate supply is less then equilibrium aggregate supply

AS<AS*

Where AS AS* at full employment level. Here actual aggregate supply is

less than potential aggregate supply. So macro-economic equilibrium in the
economy exist at point where AD=AS and finally Harrod-Domer gets I=S i.e.
investment is equal to saving. Keynesian model’s take long run perspective (more
than 10 years). (Where as business cycle phenomenon is short run phenomena)

Harrod-Domer model Long run phenomena AD=AS and hence I=S

Where investment (I) affect the economy through 2 channels

1) In short run investment (I) affect the economy through expenditure

 AD  Y  C  I  G  ( X  M ) 

I Exp Y

2) In long run investment (I) affect the economy through capital stock
 I capital accumulation Y

Main preposition of Harrod –Domer model:-

1) Economic growth can be accelerated through change in saving rate.

2) Improvement in technology. Where improvement in technology and increase in

saving rate can be achieved through government intervention i.e. (without change
in P).

Flow chart of Harrod-Domer model:-

S=I

D=depreciation Ig=gross S=saving C=consumption

investment
s mpc

In=net GDP=Y=f (k)

investment
Y=C+S

K/Y(capital over output ratio)

Capital (K)

Factors affecting economic growth according to Harrod-Domer model are

1) s=saving rate

2) a=capital productivity (where a=1/v) d=capital depreciation

All these three things contribute to g i.e. economic growth rate.

Harrod-Domer growth model:-

Factor explaining growth rate is Harrod-Domer model.

Explained variable

g = rate of economic growth

 s=saving rate

g a=capital production (v=Y/K) where a=K/Y, a=1/v

d=capital depreciation value

Arithmetic specification of Harrod-Domer model: - (without depreciation)

S=sY S=I (without depreciation)

Y (dy)

a=dY/dK

K(dK)

Numerical specification (without depreciation)

Example showing relationship between different variables

1) If you know Y and if you know (saving rate) you can compute total saving in an
economy through relationship

S=sY
Example:-

Y=$100 s=0.10

Then total saving in economy=S=sY

= (0.10)*(100) = $10

2) If you know initial capital (K) and you know productivity of capital that compute
growth rate of output (Y).

Example:-

K = $ 100 a=0.20

Y= aK = 0.20*100 = $20

3) If you know dK and a then you can compute growth rate of output (dY).

Example:-

dK =0.10 a =20

dY = Y0 = a*dK = (0.20)*(0.10) = 0.02 = 2%

dY = s*a

Divide both sides by Y

dY/Y = (s*a)/Y (1)

Where dY/Y = g i.e. economic growth rate

g = s*a/Y (2) Lets Y=$1

Then g = s*a it gives us relationship between saving rate and economic growth rate
without considering the depreciation rate. Now equation (2) with depreciation
becomes g = s*a - d

Example (1):-

If saving rate is 10% = s = 0.10

Productivity of capital is 20%= a = K/Y = 0.20, Depreciation rate is 1%= a =0.01

Then economic growth rate is

g = s*a –d= (0.10) (0.20) – 0.01 = 0.020 – 0.10 = 0.01 = 1%

Example (2):-

If saving rate is equal to 20% that is equal to s=0.20

Productivity of capital = 20%= a = K/Y =0.20, Depreciation rate = 1% = d= 0.01

Then economic growth is

g = s*a –d = (0.20) (0.20) -0.01 = 0.04 -0.10 = 0.03 = 3%

If saving rate doubles from 10% to 20% then economic growth rate increases from
1% to 3%

Example (3):-

If saving rate =20% = s = 0.20

Productivity of capital = 40% =a = K/Y= 0.40, depreciation rate =1% = d= 0.01

Then economic growth is

g= s*a –d= (0.20) (0.40) -0.01= 0.08 -0.01= 0.07= 7%

Conclusion:-

If capital productivity doubles from 20% to 40% then economic growth rate
increases from 1% to 7%

Example (4):-

If saving rate = 10% = s = 0.10

Productivity of capital = 20% = a = K/Y =0.20, depreciation rate d= 2% = 0.02

Then economic growth is

g= s*a –d = (0.10) (0.20) -0.02 =0.020-0.02 = 0.02-0.02 = 0

Conclusion:-
If depreciation rate doubles from 1% to 2% then decline in economic growth rate
exist.