Model Answer
0 min readIntroduction
Economic growth models attempt to explain the factors that drive long-run increases in a nation’s standard of living. The Harrod-Domar model, developed in the post-World War II era, was among the first attempts to formalize the relationship between savings, investment, and economic growth. However, it faced criticisms due to its rigid assumptions. Robert Solow’s growth model, introduced in 1956, built upon the Harrod-Domar framework but incorporated crucial elements like diminishing returns to capital and technological progress, offering a more nuanced and realistic explanation of sustained economic growth. This answer will explore the similarities between Harrod’s warranted rate and Domar’s required rate, and then detail Solow’s improvements upon the Harrod-Domar framework.
Harrod-Domar and the Concept of Growth Rates
Both Harrod (1939) and Domar (1946) independently developed models emphasizing the crucial role of savings and investment in driving economic growth. Their models are often considered together due to their strong similarities.
- Harrod’s Warranted Rate of Growth (Gw): This is the rate of growth of the economy that allows firms to maintain a constant capital-output ratio. It’s determined by the savings ratio (s) and the capital-output ratio (v): Gw = s/v. If the actual growth rate (Ga) is equal to Gw, the economy is in a ‘golden age’ of steady growth.
- Domar’s Required Rate of Growth (Gr): Domar focused on the investment needed to prevent rising unemployment. His required rate of growth is the rate at which investment must grow to maintain full employment. It is also calculated as Gr = s/v.
The core similarity lies in the formula: both models suggest that the growth rate is directly proportional to the savings rate and inversely proportional to the capital-output ratio. A higher savings rate, or a lower capital-output ratio, leads to a higher growth rate. Both models assume a fixed capital-output ratio, meaning that the amount of capital required to produce one unit of output remains constant.
Limitations of the Harrod-Domar Model
Despite their initial influence, the Harrod-Domar models faced several criticisms:
- Fixed Coefficients: The assumption of a fixed capital-output ratio is unrealistic. In reality, as an economy develops, technological advancements and changes in production techniques can alter the capital-output ratio.
- Knife-Edge Problem: The models are highly sensitive to the initial conditions. If the actual growth rate deviates even slightly from the warranted rate, the economy can either fall into stagnation or experience accelerating growth, a situation termed the ‘knife-edge’ problem.
- No Role for Technological Progress: The models do not explicitly account for technological progress, a key driver of long-run economic growth.
Solow’s Improvements: The Solow-Swan Model
Robert Solow’s growth model (1956), independently developed by Trevor Swan, addressed the limitations of the Harrod-Domar model by introducing several key modifications:
- Diminishing Returns to Capital: Solow assumed diminishing returns to capital. This means that as capital stock increases, the additional output generated from each additional unit of capital decreases. This eliminates the ‘knife-edge’ problem by providing a natural stabilizing mechanism.
- Labor as a Factor of Production: Solow incorporated labor as a crucial factor of production, alongside capital. This allowed for a more realistic representation of the production process.
- Technological Progress: Solow explicitly included technological progress as an exogenous factor driving long-run growth. Technological progress shifts the production function upwards, allowing for sustained growth even in the face of diminishing returns to capital.
- Steady State: Solow’s model predicts that the economy will converge to a ‘steady state’ where capital per worker and output per worker are constant. This steady state is determined by the savings rate, the depreciation rate, the population growth rate, and the rate of technological progress.
Comparing the Models
| Feature | Harrod-Domar | Solow-Swan |
|---|---|---|
| Capital-Output Ratio | Fixed | Variable (Diminishing Returns) |
| Role of Labor | Implicit | Explicit |
| Technological Progress | Absent | Included (Exogenous) |
| Stability | Unstable (Knife-Edge) | Stable (Steady State) |
| Long-Run Growth | Dependent on Savings Rate | Dependent on Technological Progress |
Solow’s model demonstrated that sustained economic growth is ultimately driven by exogenous technological progress, while the Harrod-Domar model focused solely on the role of savings and investment. Solow’s inclusion of diminishing returns to capital also provided a more realistic and stable framework for analyzing economic growth.
Conclusion
In conclusion, while both Harrod’s warranted rate and Domar’s required rate of growth highlight the importance of savings and investment, they suffer from unrealistic assumptions. Solow’s model significantly improved upon the Harrod-Domar framework by incorporating diminishing returns to capital, labor as a factor of production, and, crucially, technological progress. This allowed for a more stable and realistic explanation of long-run economic growth, establishing a cornerstone of modern growth theory. The Solow model, however, is not without its limitations, particularly the exogenous nature of technological progress, which has spurred further research into endogenous growth models.
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.