439HARROD DOMAR GROWTH MODEL (1).pptx

macroeconomics

1. Growth Theories

2. Endogenous and Exogenous Growth Endogenous Growth Theory Emerged in early 1980s Romer (1986, 1990); Lucas (1988) Endogenous growth theory is an economic theory which focuses that economic prosperity is generated from within a system as a direct result of internal processes. More particularly, investment in human capital within the system will lead to economic growth of a nation. Rich country may follow an ever increasing growth path while poor economy grows at much slower path leading to divergence to the world economy It is found that similar rate of investment and growth of technology may not result in similar pattern of growth among economies. Technological progess --------------------------Economic growth Technological progess takes place through innovation in the form of new product, market and places. It consider technical progress as endogenous factor. 2

3. Endogenous Growth Theory Endogenous growth theory takes two important points First, It views technological progress as a product of economic activity. Second, knowledge and technology are characterized by increasing returns, and these increasing returns drive the process of growth. The endogeneous growth theory attempts to explain the sources of technological progress. Three important candidates for the source of such progress are Ideas (Profit-seeking research) International openness Human capital formation So, crucial point of this theory is that knowledge drives growth. New knowledge or technology Increasing return 3

4. Exogenous growth model Developed by Solow Technology is exogenous factor that contribute to economic growth Capita accumulation and labor force improvement as sources of growth The three central assumptions Constant return to scale Perfect competition Exogenous technological change Growth is determined by accumulation of capital and labour along with technical change Technology can be discovered outside the nation and can be transferred into the nation. 4

5. Harrod Growth Model This model is based on the capital factor as the crucial factor of economic growth. Harrod and Domar assign a crucial role to capital accumulation in the process of growth. In fact, they emphasize the dual role of capital accumulation. On the one hand, new investment generates income ,on the other hand, it increases productive capacity (through productivity effect) of the economy by expanding its capital stock

6. Assumptions The main assumptions of the Harrod-Domar models are as follows: ( i ) A full-employment level of income already exists. (ii) There is no government interference in the functioning of the economy. (iii) The model is based on the assumption of “closed economy (iv) The average propensity to save (APS) and marginal propensity to save (MPS) are equal to each other. S/Y= ∆S/∆Y (v) Both propensity to save and “capital coefficient” (i.e., capital-output ratio) are given constant. (vii) Income, investment, savings are all defined in the net sense, i.e., they are considered over and above the depreciation. (viii) Saving and investment are equal.

7. Harrod’s growth model raised three issues: ( i ) How can steady growth be achieved for an economy with a fixed (capital- output ratio) (capital-coefficient) and a fixed saving-income ratio? (ii) How can the steady growth rate be maintained? Or what are the conditions for maintaining steady uninterrupted growth? (iii) How do the natural factors put a ceiling on the growth rate of the economy? 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 .

8. The Actual Growth Rate The Actual Growth Rate is the growth rate determined by the actual rate of savings and investment in the country. In other words, it can be defined as the ratio of change in income (AT) to the total income (Y) in the given period. If actual growth rate is denoted by G, then G = ∆Y/Y The actual growth rate (G) is determined by saving-income ratio and capital- output ratio. Both the factors have been taken as fixed in the given period. The relationship between the actual growth rate and its determinants is expressed as: GC = s …(1)

9. Warranted growth “Warranted growth” refers to that growth rate of the economy when it is working at full capacity. It is also known as Full-capacity growth rate. This growth rate denoted by G w is interpreted as the rate of income growth required for full utilisation of a growing stock of capital, so that entrepreneurs would be satisfied with the amount of investment actually made. Warranted growth rate ( G w ) is determined by capital-output ratio and saving- income ratio. The relationship between the warranted growth rate and its determinants can be expressed as G w C r = s where C r shows the needed C to maintain the warranted growth rate and s is the saving-income ratio. Let us now discuss the issue: how to achieve steady growth? According to Harrod , the economy can achieve steady growth when G = G w and C = C r

10. Instability of Growth If G > G w then C < C r and If G < G w then C > C r it can be concluded that steady growth implies a balance between G and G w . Natural Growth rate Thus, the natural growth rate is the maximum growth rate which an economy can achieve with its available natural resources. The third fundamental relation in Harrod’s model showing the determinants of natural growth rate is

11. The Domar Model: The aggregate model assumes that net increase in capital stock (new investment ) would generate dual effect in the economy. 1) It would help increase in outcome 2) it enhances the productive capacity of the economy which is instrumental for future production.

12. Assumptions and Calculation The basic Harrod-Domar model assumes that National output is proportional to the capital stock of the economy. i.e Y= σK ------------------1 where Y=national output σ= outut -capital ratio (Y/K), constant K=total capital stock and any change in K would lead to change in Y by σ times change in K. ∆Y=σ∆ K or, ∆Y= σI , where I=∆ K= new investment in equilibrium Saving=Investment S=I

13. or, ∆Y= σS As, saving is S= sY or, ∆Y= σsY Dividing both side by Y, or, ∆Y/Y= σsY /Y or, ∆Y/Y= σs ---------------(3) which implies that growth rate of national income depends on output-capital ratio (σ) and marginal propensity to save.

14. Disequilibrium If ∆Y/Y> σs Under the first situation, long-term inflation would appear in the economy because the higher growth rate of income will provide greater purchasing power to the people and the productive capacity ( σs ) would not be able to cope with the increased level of income. The first situation of disequilibrium will, therefore, create inflation in the economy

15. If ∆Y/Y< σs The second situation, under which growth rate of income or investment is lagging behind the productive capacity, will result in over production. The reduced growth rate of income will put a constraint on the purchasing power of the people, thereby reducing the level of demand and resulting in over-production