Uses of Harrod-Domar Model in underdeveloped countries
Growth theory in advanced economies has been associated with three principal concepts: the saving function, autonomous vs. induced investment, and the productivity of capital.
The Harrods-Domar models are based on these concepts and were primarily developed in order to illuminate secular stagnation that was threatening the advanced economies in the post-war period.
The application of these models has now been extended to the development problems of underdeveloped economies.
As Hirschman writes: “The Domar model, in particular, has proved to be remarkably versatile, it permits us to show not only the rate at which the economy must grow if it is to make full use of the capacity created by new investment but inversely, the required savings and the capital-output ratios if income is to attain a certain target growth rate.
In such exercises, the capital-output ratio is usually assumed at some value between 2.5 and 5; sometimes several alternative projections are undertaken; with given growth rates, overall or per capita, and with given population projections, in the latter case, total capital requirements for five- or ten-year plans are then easily derived.” Let us see how these models can be used for planning in underdeveloped countries.
Suppose the capital-output ratio is assumed to be 4:1 and the full capacity growth rate or the warranted growth rate is estimated at 3 per cent per annum for the economy. By applying either the Harrod or the Domar formula, the planners can find out the saving- income ratio required to sustain the growth rate of 3 f per cent per annum.
Thus, if the capital-output ratio is assumed as 4:1 in an economy, the community will have to save 12 per cent of its annual income, if its annual growth rate of output is to be 3 per cent. Let us work it out in practice. Given the saving ratio and the capital-output ratio, the Harrod formula for calculating the growth rate.
Sir Roy Harrod in the Second Essay on Dynamic Theory has tried to make his model more applicable to underdeveloped countries. He has elaborated the supply side of his fundamental equation by introducing the role of interest rate in determining the supply of savings and the demand for savings.
The natural rate of interest rn is defined as the ratio of the natural growth rate of per capita output Pc and the natural growth rate of income Gn to the elasticity of diminishing utility of income e.
Taking the values of Pc and Gn as given, the natural rate of interest depends on the value of e which is assumed to be less than unity; rn and e are inversely related to each other. When e is small, rn is high and vice versa.
The capital requirements, Cr, depend on the rate of interest, Cr =firm). Rather, Cr is a decreasing function of rn. The higher the rate of interest, the lower the capital requirements, and vice versa.
The savings requirements Sr, like Cr, are also of much importance in underdeveloped countries. But the average propensity to save s is not necessarily equal to social requirements of savings, Sr.
This will lead to depression in the economy. On the contrary, if S < Sr, then Gw < Gn. It implies that actual savings being less than the required savings in the community, there would be fall in investment.
In the long run, it would lead to a fall in the warranted growth rate below the actual growth rate, i.e., Gw < G and the level of investment would increase. Ultimately there will be chronic inflation.
Since low savings, high level of investment and chronic inflation are some of the features of underdeveloped countries, Harrod suggests the financing of large investments through the expansion of bank credit and automatic investment of inflationary profits in the capital markets.
But there are no organised capital markets in such economies, therefore, expansion of bank credit is the only way to finance investments and generate economic growth. Low savings in an underdeveloped country are responsible for its low rate of growth and the existence of mass unemployment and underemployment.
Thus the actual level of saving should be raised to the level of required rate of savings by a compulsory levy or a surplus budget to that S = Sr Besides, Harrod also emphasises the need for changes in social and institutional factors in such economies.
For social and institutional obstacles may be the cause of a low growth rate rather than the lack of savings in underdeveloped countries. Under the circumstances, Sr will also be low and S may approximate to it.