The Harrod-Domar Model [ Biz/ed Virtual Developing Country ]

The Virtual Developing Country is a case study of Zambia. There are a series of field trips available looking at different issues connected with economic development. This trip is the Copper Tour and this page looks at the Harrod-Domar model of economic growth.

Theories

Harrod-Domar Model

Next theory - The Lewis Model of Development >>

This model, developed independently by RF Harrod and ED Domar in the l930s, suggests savings provide the funds which are borrowed for investment purposes.

The model suggests that the economy's rate of growth depends on:

  • the level of saving
  • the productivity of investment i.e. the capital output ratio

For example, if $10 worth of capital equipment produces each $1 of annual output, a capital-output ratio of 10 to 1 exists. A 3 to 1 capital-output ratio indicates that only $3 of capital is required to produce each $1 of output annually.

The Harrod-Domar model was developed to help analyse the business cycle. However, it was later adapted to 'explain' economic growth. It concluded that:

  • Economic growth depends on the amount of labour and capital.
  • As LDCs often have an abundant supply of labour it is a lack of physical capital that holds back economic growth and development.
  • More physical capital generates economic growth.
  • Net investment leads to more capital accumulation, which generates higher output and income.
  • Higher income allows higher levels of saving.

Implications of the model
The key to economic growth is to expand the level of investment both in terms of fixed capital and human capital. To do this policies are needed that encourage saving and/or generate technological advances which enable firms to produce more output with less capital i.e. lower their capital output ratio.

Problems of the model

  • Economic growth and economic development are not the same. Economic growth is a necessary but not sufficient condition for development
  • Practically it is difficult to stimulate the level of domestic savings particularly in the case of LDCs where incomes are low.
  • Borrowing from overseas to fill the gap caused by insufficient savings causes debt repayment problems later.
  • The law of diminishing returns would suggest that as investment increases the productivity of the capital will diminish and the capital to output ratio rise.

Next theory - The Lewis Model of Development >>


Related Glossary Items:
Investment
Development
Economic Growth
Capital Output Ratio
Diminishing Returns

Related Issues:
Industrialisation of Zambia

Related Theories:
Fisher Clark's Theory of Structural Change
The Lewis Model of Development
Rostow's Model - the Stages of Economic Development
The Causes of Economic Growth