What is the E.D. Domar’s model of economic growth?

E.D. Domar’s model of economic growth

Domar builds his model around the following question: since investment generates income on the one hand and increases productive capacity on the other, at what rate investment should increase in order to make the increase in income equal to the increase in productive capacity, so that full employment is maintained?

Doar’s model satisfies this question by forging a link between aggregate supply and aggregate demand through investment.

Increase in Productive Capacity:

Domar explains the supply side like this. Let the annual rate of investment be I, and the annual productive capacity per dollar of newly created capital is equal on the average to s (which represents the ratio of increase in real income or output to an increase in capital or is the reciprocal of the accelerator or the marginal capital-output ratio).

Thus the productive capacity of dollar invested will be I.s dollars per year. But some new investment will be at the expense of the old. It will, therefore, compete with the latter for labour markets and other factors of production.

As a result, the output of old plants will be curtailed and the increase in the annual output (productive capacity) of the economy will be somewhat less than I.s. This can be indicated as la, where a (sigma) represents the net potential social average productivity of investment.

Accordingly la is less than I.s. IA is the total net potential increase in output of the economy and is known as the sigma effect. In Domar’s words this “is the increase in output which the economy can produce,” it is the “supply side of our system.”

Required Increase in Aggregate Demand. The demand side is explained by the Keynesian multiplier. Let the annual increase in income be denoted by A Y and the increase in investment by AI and the propensity to save by a (alpha) (= AS/AY). Then the increasing income will be equal to the multiplier (1/a) times* the increase in investment.

This equation shows that to maintain full employment the growth rate of net autonomous investment (A I/I) must be equal to (the MPS times the productivity of capital). This is the rate at which investment must grow to assure the use of potential capacity in order to maintain a steady growth rate of the economy at full employment.

Thus in order to maintain full employment, income must grow at a rate of 3 per cent per annum. This is the equilibrium rate of growth. Any divergence from this ‘golden path’ will lead to cyclical fluctuations. When A III is greater than, the economy would experience boom and when AHI is less than, it would suffer from depression.