What are the important limitations of the Harrod-Domar model?

Important limitations of the Harrod-Domar model

The essence of Harrod-Domar analysis is as follows:

Capital accumulation has a dual character that is on the one hand it generates income, and on the other it increases the capacity of the economy. This duality in the character of capital accumulation puts at the centre of the problem of steady growth.

The increased capacity may result in larger output and may thus contribute to prosperity. Alternatively it may result in unemployment and thus may become a cause of poverty and sufferings. What actually happen will depend on the behaviour of income.

Both Harrod and Domar state conditions for the behaviour of income under which full employment will be maintained over time. These conditions specify a certain rate of growth of full employment income which will leave neither any portion of the full employment savings unabsorbed, nor any part of capital stock unutilised.

This equilibrium rate of growth (same as Harrod’s warranted rate of growth) ends on the incremental capital-output ratio and the size of the multiplier. Therefore, if full employment is maintained over time, then income must increase at compound interest rate.

These conditions state only the path of steady growth. However, the actual rate of growth may differ from it. If the actual rate of growth is higher than the equilibrium rate of growth, the economy will be caught in a chronic inflationary gap.

Conversely, if the actual rate of growth is lower than the equilibrium rate of growth, the economy will be caught in a chronic deflationary gap.

The business cycle has been considered as a deviation from the path of steady growth. Deviations are not self-righting but self-aggravating. Though self-aggravating in nature, their upper limit is set by the employment ceiling, and the lower limit is determined by floor of autonomous spending.

Both Harrod and Domar have tackled the problem of growth in a similar manner. It is for this reason that in most discussions their models are lumped together. However, in matter of details these models differ from each other.

If we first consider how these models are similar. Both Harrod and Domar have studied the requirements of steady growth in a developed economy. They make more or less the same assumptions on account of which their models are easily distinguishable from other growth models. Further, in both models capital is at the centre of the problem of economic growth.

To be specific, according to both Domar and Harrod, given the capital-output ratio so long as the average propensity to save remains equal to the marginal propensity to save the equality of saving and investment satisfies the condition of equilibrium rate of growth. How this condition is implicit in their models can be followed from a careful study of these models presented below:

Domar’s Model their investment expenditures. Ultimately, it will adversely affect the economy by lowering incomes and employment in the subsequent periods and moving the economy off the equilibrium path of steady growth. Thus, if full employment is to be maintained in the long run, net investment should expand continuously.

This further requires continuous we may write growth in real income at a rate sufficient enough to ensure full capacity use of a growing stock of capital. This required rate of income growth may be called the warranted rate of growth or “the full capacity growth rate.”

There are, however, important differences in the two models:

Domar assigns a key role to investment in the process of growth and emphasises on its dual character. But Harrod regards the level of income as the most important factor in the growth process. Whereas Domar forges a link between demand and supply of investment, Harrod, on the other hand, equates demand and supply of saving.

The Domar model is based on one growth rate r = oca. But Harrod uses three distinct rates of growth: the actual rate (G), the warranted rate (Gw) and the natural rate (Gn).

Domar uses the reciprocal of marginal capital- output ratio, while Harrod uses the marginal capital- output ratio. In this sense Domar’s a = 1 /C_r of Harrod.

Domar gives expression to the multiplier but Harrod uses the accelerator about which Domar appears to say nothing.

The formal identity of Harrod’s Gw equation and Domar’s equation Hs maintained by Domar’s assumption that AI/I = AY/Y. But Harrod does not make such assumptions. In Harrod’s equilibrium equation Gw, there is neither any explicit or implicit reference to AI or I. It is, however, in his basic equation G = s/C that there is an implicit reference to I, since C is defined as I/AY. But there is no explicit or implicit reference to AI.

We have noted that Domar’s a is the same as Harrod’s s, and Domar’s a is reciprocal of Harrod’s C_r Thus Domar’s condition turns out to be the same Harrod’s.

Both Harrod and Domar are interested in discovering the rate of income growth necessary for a smooth and uninterrupted working of the economy. Though their models differ in details, yet they arrive at similar conclusions.’

Harrod and Domar assign a key role to investment in the process of economic growth. But they lay emphasis on the dual character of investment. Firstly, it creates income, and secondly, it augments the productive capacity of the economy by increasing its capital stock. The former may be regarded as the ‘demand effect’ and the latter the ‘supply effect’ of investment.

Hence so long as net investment is taking place, real income and output will continue to expand.

However, for maintaining a full employment equilibrium level of income from year to year, it is necessary that both real income and output should expand at the same rate at which the productive capacity of the capital stock is expanding.

Otherwise, any divergence between the two will lead to excess or idle capacity, thus forcing entrepreneurs to curtail

For Harrod the business cycle is an integral part of the path of growth and for Domar it is not so, but is accommodated in his model by allowing a (average productivity of investment) to fluctuate.

While Domar demonstrates the technological relationship between capital accumulation and Subsequent full capacity growth in output, Harrod shows in addition a behavioural relationship between rise in demand and hence in current output on the one hand, and capital accumulation on the other.

In other words, the former does not suggest any behaviour pattern for entrepreneurs and the proper change in investment comes exogenously, whereas the latter assumes a behaviour pattern for entrepreneurs that induce the proper change in investment.

Harrod and Domar are being remembered even now on account of the pioneer work they did in the field of growth theory. However, their models suffer from a number of weaknesses which emanate from their simplifying assumptions. Further, these models are derived from an examination of developed economies at a particular point in the cycle.

Hence they are of limited value even for the advanced economies. We shall first examine the limitations of these models in general and then see if they have any relevance for the developing economies.

Simple models invariably sacrifice realism. This is true of the growth models built up by Harrod and Domar also. The two models particularly suffer from the following limitations:

Harrod-Domar models rely greatly on a capital theory of value. While labour can be introduced into the system, the two factors, viz., capital and labour, should always remain in fixed proportion. This is a highly unrealistic assumption.

If labour and capital grow at different rates, then under the model one of the two factors must remain less than fully utilised. Further, the assumption of non- substitutability of labour and capital is not congruent with the real world.

If it is conceded, as it has been done in neoclassical growth model, that appropriate substitutions between the two factors of production are made in the real life, then the economy can advance along the path of steady growth more smoothly.

Assumptions with regard to the constancy of propensity to save and capital-output ratio are at variance with the reality. In the long run both propensity to save and capital-output ratio are likely to change. Domar himself has admitted that these assumptions are not necessary for the argument and the problem can be worked out with variable a and a.

The general price level has been assumed to be constant in models of Harrod and Domar. In reality prices do change over time. Had these models made some allowance for price flexibility, the system would have had greater stability than these models suggest.

The assumption of the constancy of interest rates is both unrealistic and unnecessary. Although interest rate may not be a major factor in investment decisions, yet it has to be admitted that a downward flexibility in rate of interest during periods of over production will induce the demand for capital and thereby provide a solution to the problem of excess supplies of goods.

Growth models of Harrod and Domar have at least one thing common with the Ricardian and Malthusian models. Models of these classical economists had no provision for the effects of technological change.

Interestingly both Harrod and Domar also did not provide for the effects of technological change though in the present-day world technological changes are taking place at a very fast rate.

Herrick and Kindleberger pointing out the 1 imitations of the Harrod-Domar model on empirical grounds. They write, “The model also has shortcomings on narrower empirical grounds.

Observed growth has been faster than can be accounted for by the rate of physical capital formation and a fixed capital-output ratio. The theory could be ‘saved’ by allowing capital-output ratio to change, but then it ceases to be a theory and lapses into the category of tautology.”

These shortcomings apart, growth models of Harrod and Domar are important, because they have raised basic questions to the problem of economic growth. True, these models are concerned with the growth process in advanced capitalist economies.

But this is as truer of the theories of Marx, Ricardo, Adam Smith and Malthus. Kurihara argues that Harrod- Domar models are important “because they represent a stimulating attempt to dynamise and secularise Keynes’ static short-run saving and investment theory.”

Some of the conclusions depend on the crucial assumptions made by Harrod and Domar which make these models unrealistic:

The propensity to save (oc or 5) and the capital- output ratio (ct) are assumed to be constant. In actuality, they are likely to change in the long run and thus modify the requirements for steady growth. A steady rate of growth can, however, is maintained without this assumption. As Domar himself writes, “This assumption is not necessary for the argument and that the whole problem can be easily reworked with variable <x and a.”

The assumption that labour and capital are used in fixed proportions is untenable. Generally, labour can be substituted for capital and the economy can move more smoothly towards a path of steady growth. In fact, unlike Harrod’s model, this path is not so unstable that the economy should experience chronic inflation or unemployment if G does not coincide with Gw.

The two models also fail to consider changes in the general price level. Price changes always occur over time and may stabilise otherwise unstable situations. According to Meier and Baldwin, “If allowance is made for price changes and variable proportions in production, then the system may have much stronger stability than the Harrod model suggests.”

The assumption that there are no changes in interest rates is irrelevant to the analysis. Interest rates change and affect investment. A reduction in interest rates during periods of overproduction can make capital-intensive processes more portable by increasing the demand for capital and thereby reduce excess supplies of goods.

The Harrod-Domar models ignore the effect of government programmes on economic growth. If, for instance, the government undertakes a programme of development, the Harrod-Domar analysis does not provide us with causal (functional) relationship.

It also neglects the entrepreneurial behaviour which actually determines the warranted growth rate in the economy. This makes the concept of the warranted growth rate unrealistic.

The Harrod-Domar models have been criticised for then: failure to draw a distinction between capital goods and consumer goods.

According to Professor Rose, the primary source of instability in Harrod’s system lies in the effect of excess demand of supply on production decisions and not in the effect of growing capital shortage or redundancy on investment decisions.

Despite these limitations, “Harrod-Domar growth models are purely laissez-faire ones based on the assumption of fiscal neutrality and designed to indicate conditions of progressive equilibrium for an advanced economy.”

They are important “because they represent a stimulating attempt to dynamise and secularise Keynes’ static short-run saving and investment theory.”