Now we can think about the change in capital stock,. It tells us how the economy can grow such that the growth in the capacity of the economy to produce is matched by the demand for the economy's output. This situation can also be explained when C is greater than C r. We would have an equation like this: When we have an open economy which does engage with the rest of the world then we allow for some other forms of funding the investment — as well as which is the saving from domestic savers, we can borrow from foreign savers, or, if we are a developing country, we can get aid to finance investment. Conditions concerning the behaviour of income can be expressed in terms of growth rates i. Domar's 1961 paper is cited as the source of , a set of rules and processes for combining industry growth data together to get aggregate industry sector or national growth. With slight modifications and reinterpretations, it can be made to furnish suitable guidelines even for the developing economies.
If we were in a closed economy, ie an economy which does not trade and has no involvement with the rest of the world, then this investment, I, would entirely be financed by domestic savings, ie the proportion of income that households were not spending and were instead putting in banks or other financial intermediaries that the firms go to to borrow funds to invest. To understand the implications of Domar model, one should get familiar with the relations listed below: 1. So the higher the proportion of household income that is used for current consumption, the less is being saved, and when there is not as much being saved, there are not as many funds available for firms to borrow to invest in capital goods. The level of income Y 0 is determined by the intersection of saving line S Y and the investment line I 0I 0. Note also that the is present in Domar's model: unless the actual investment growth rate r is equal to s s, the system is unstable.
This, under this situation the economy will find itself in the quagmire of inflation. Investment on the one side increases productive capacity and on the other generates income. Economic growth is basically the proportionate change in output. Such a situation will create an inflationary trend. The demand side of the long-term effect of investment can be summarised through the following relation.
This would lead to deficiency of capital, which would, in turn, adversely affect the volume of goods to be produced. Thus, s is the potential output-capital ratio. Long run growth is key to raising living standards, reducing poverty and promoting economic development. The last part of that equation gives you the amount of capital that has been depreciated. For simplicity, this is also assumed to be constant.
But we must made sure there is adequate aggregate demand next year to absorb the production of 1100. Warranted growth rate G w is determined by capital-output ratio and saving- income ratio. The slope of this line tangent α measures the average and marginal propensity to save. The increased capacity arising from investment can result in greater output or greater unemployment depending on the behaviour of income 3. General Assumptions : The main assumptions of the Harrod-Domar models are as follows: i A full-employment level of income already exists.
Thus, depreciation rates are not included in these variables. For simplicity saving-income ratio s is assumed constant. This model is based on the capital factor as the crucial factor of economic growth. This process of rise in income, saving and investment shows the acceleration effect on the growth of output. The increase in capital stock has come as a result of firms investing in new capital.
If the economy deviates from it in either direction there will be an economy calamity. In order to discuss these issues, Harrod had adopted three different concepts of growth rates: i the actual growth rate, G, ii the warranted growth rate, G w iii the natural growth rate, G n. Secondly, the capital-output ratio needed to achieve G must be equal to the required capital-output ratio in order to maintain G w, given the saving co-efficient s. Instability of Growth: We have stated above that the steady-state growth of the economy requires an equality between G and G w on the one hand and C and C r on the other. A richer country with hi tech equipment, fast railways, high speed internet connections, large scale production plants and so on, is going to be able to produce more because it has a high capital stock. If we define this as g, then we get a simple Harrod-Domar equation for growth:. If the actual growth rate is greater than the warranted rate of growth, the economy will experience cumulative inflation.
Income is determined by investment through multiplier. Lets try an example of this. Many African countries were very poor in 1960 and some have had negative growth of output per person since then, eg Madagascar has been falling back 1. The extent of the income increase depends upon the productivity of capital, which is measured by the slope of the line Y 0P 0 α. He was raised and educated in Russian , then emigrated to the in 1936. But due to managerial miscalculation, the new investment projects will cause untimely demise of old project and plants.
Among his students was the economic historian , who was awarded the in 1993. It assumes that there are constant returns to factor, ie the capital-output ratio stays constant and the more of the factor capital that you add, the more growth you will get, so if you add more and more capital then your growth rate will go up and up. At that level of income the consumer demand is 0. The couple had two daughters. I 0I 0, I 1I 1 and I 2I 2 are the various levels of investment. On the other hand, suppose the investment demand fell short of 300, say 250. From the above analysis, it can be concluded that steady growth implies a balance between G and G w.