What is the Harrod-Domar Model?
The Harrod-Domar economic growth model stresses the importance of savings and investment as key determinants of growth
The Harrod Domar Growth model is a growth model and not a growth strategy!
A model helps to explain how growth has occurred and how it may occur again in the future. Growth strategies are the things a government might introduce to replicate the outcome suggested by the model.
Basically, the model suggests that the economy's rate of growth depends on:
- The level of national saving (S)
- The productivity of capital investment (this is known as the capital-output ratio)
The Capital-Output Ratio (COR)
- For example, if £100 worth of capital equipment produces each £10 of annual output, a capital-output ratio of 10 to 1 exists. A 3 to 1 capital-output ratio indicates that only £30 of capital is required to produce each £10 of output annually.
- If the capital-output ratio is low, an economy can produce a lot of output from a little capital. If the capital-output ratio is high then it needs a lot of capital for production, and it will not get as much value of output for the same amount of capital.
Key point: When the quality capital resources is high, then the capital output ratio will be lower
Basic Harrod-Domar model says:
Rate of growth of GDP = Savings ratio / capital output ratio
- If the savings rate is 10% and the capital output ratio is 2, then a country would grow at 5% per year.
- If the savings rate is 20% and the capital output ratio is 1.5, then a country would grow at 13.3% per year.
- If the savings rate is 8% and the capital output ratio is 4, then the country would grow at 2% per year.
Based on the model therefore the rate of growth in an economy can be increased in one of two ways:
- Increased level of savings in the economy (i.e. gross national savings as a % of GDP)
- Reducing the capital output ratio (i.e. increasing the quality / productivity of capital inputs)
LDCs often have an abundant supply of labour it is a lack of physical capital that holds back economic growth and development. Boosting investment generates economic growth which leads to a higher level of national income. Higher incomes allow more people to save.
What are some of the key limitations / problems of the Harrod-Domar Growth Model?
- Increasing the savings ratio in lower-income countries is not easy. Many developing countries have low marginal propensities to save. Extra income gained is often spent on increased consumption rather than saved. Many countries suffer from a persistent domestic savings gap.
- Many developing countries lack a sound financial system. Increased saving by households does not necessarily mean there will be greater funds available for firms to borrow to invest.
- Efficiency gains that reduce the capital/output ratio are difficult to achieve in developing countries due to weaknesses in human capital, causing capital to be used inefficiently
- Research and development (R&D) needed to improve the capital/output ratio is often under-funded - this is a cause of market failure
- Borrowing from overseas to fill the savings gap causes external debt repayment problems later.
- The accumulation of capital will increase if the economy starts growing dynamically – a rise in capital spending is not necessarily a pre-condition for economic growth and development – as a country gets richer, incomes rise, so too does saving, and the higher income fuels rising demand which itself prompts a rise in capital investment spending.
Exam tip: The mathematical derivation of the Harrod-Domar model is not required at A level.