Lecture 4
THEORY OF ECONOMIC GROWTH: THE HARROD-DOMAR MODEL

1. Assumptions

• Fixed capital-output ratio (v)

• Production function:     Y = (1/v) K

• Saving equals fixed proportion of output:
      S = sY     (What is s?)

2. Model

• Saving equals investment:
  S = I

• Investment leads to addition to capital stock:
  I(t) = K(t+1) - K(t)

• Growth rate of output is the rate of change in output over time:
  g = [Y(t+1)-Y(t)]/Y(t)

3. Results

• Growth rate of output = Saving ratio/Capital-output ratio:
  g = s/v

• Higher the saving ratio, faster is economic growth

• A country can attain any desired level of growth (g) by choosing the appropriate saving ratio (s)

• "Saving gap" could be filled by attracting foreign saving

4. Criticism

• Model ignores institutional framework
  
  • Infrastructure, financial markets, bureacracy

• Knife-edge instability
  • In steady state, output per capita is constant:
        n = s/v
  • But n, s and v are all independent parameters; thus, why should n be equal to s/v?

• Problems with estimating a country's capital stock
  • Difficult to obtain the value of v