Model Answer
0 min readIntroduction
The Harrod-Domar model, a cornerstone of post-Keynesian growth theory developed in the 1940s, posits that economic growth is determined by the rate of savings and capital output ratio. Within this framework, three growth rates are crucial: the warranted growth rate (the rate consistent with full capacity utilization), the actual growth rate (the rate actually achieved), and the expected growth rate (the rate entrepreneurs anticipate). When the expected growth rate surpasses the warranted growth rate, the economy faces a dynamic situation with implications for future growth and stability. This answer will explore the relationship between these rates and the resulting impact on the actual growth rate.
Understanding the Growth Rates
Before delving into the scenario, it’s essential to define the key terms:
- Warranted Growth Rate (Gw): This is the rate of growth that ensures that planned investment equals planned savings, maintaining equilibrium. It is determined by the savings rate (s) and the capital-output ratio (v): Gw = s/v.
- Actual Growth Rate (Ga): This is the rate at which the economy is actually growing, determined by the increase in output.
- Expected Growth Rate (Ge): This is the rate of growth that entrepreneurs expect to occur, influencing their investment decisions.
The Scenario: Ge > Gw
When the expected growth rate (Ge) exceeds the warranted growth rate (Gw), entrepreneurs anticipate higher future demand and, consequently, increase their investment. This increase in investment is driven by the accelerator principle, which states that a rise in output requires a proportional increase in capital stock. The multiplier effect then amplifies this initial investment increase, leading to a further rise in income and demand.
Impact on the Actual Growth Rate
The relationship between the actual and expected growth rates depends on the initial conditions:
- If Ga < Gw initially: The increase in investment, fueled by the higher Ge, will push the actual growth rate (Ga) *towards* the expected growth rate (Ge). The economy experiences accelerating growth. This is because the initial gap between actual and warranted growth provides room for investment to expand without causing inflationary pressures.
- If Ga > Gw initially: The higher Ge will further accelerate the actual growth rate (Ga), potentially leading to an unsustainable boom. This can result in inflationary pressures, resource constraints, and ultimately, a downturn when expectations are revised downwards.
- If Ga = Gw initially: The economy will move towards a new, higher equilibrium growth rate, driven by the increased investment. However, this new equilibrium is contingent on the sustained validity of the higher expectations.
The Role of the Multiplier and Accelerator
The multiplier (k = 1/(1-MPC)) amplifies the initial investment increase, while the accelerator (a = I/ΔY) links investment to changes in output. When Ge > Gw, the accelerator effect leads to increased investment, which is then magnified by the multiplier, resulting in a larger increase in output and a higher Ga. However, this process is inherently unstable. If Ge proves to be overly optimistic, a correction will occur, potentially leading to a recession.
Limitations of the Model
It’s important to note that the Harrod-Domar model is a simplified representation of reality. It assumes a fixed capital-output ratio and doesn't account for technological progress, changes in relative prices, or the role of government intervention. These factors can significantly influence the actual growth path of an economy.
Conclusion
In conclusion, when the expected growth rate exceeds the warranted growth rate in Harrod’s model, the actual growth rate will initially move towards the expected rate, potentially leading to accelerating growth. However, this dynamic is inherently unstable and dependent on the accuracy of expectations. Sustained high growth requires a continuous alignment between expected, warranted, and actual growth rates, a challenging feat in a complex economic environment. The model highlights the crucial role of investment and expectations in driving economic growth, but also underscores the potential for instability if these factors are not carefully managed.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.