Harrod-domar Model for Development - Research Paper Example

?I. Introduction Economic growth and economic development are two interrelated economic concepts. They may differ in definitions, measurement, implication and significance to the economy but 1they are both important economic goal. (a)Economic growth is more of a quantitative concept concerned with the increases in the economy’s output (Gross Domestic Product) while economic development is qualitative because it is all about structural changes happening in an economy. (b)Economic growth is measured in the real GDP while economic development is measured in the growth of human capital indexes and decrease in inequality figures to improve the condition or quality of life of a country’s general population (Diffen Contributors 2013). Growth is a narrower concept than development. The latter implies there is an increase in the quantity or value of the goods and services as a result of the productivity of the resources available in the economy while the former implies an increase in living standards, improvement in self-esteem needs and freedom from oppression as well as a greater choice available for the people. As growth is felt and seen in the rise in GDP of a country, development happens in the living conditions of its people through the improved access to the economic needs like education, health and recreation. Economic growth is very important but not an adequate condition for an economy to have a progressive development. The increase in the real Gross Domestic Product brought about by the growth in the economy should result to a progressive change or development which can be seen in the structural changes like an increase in numbers of infrastructures in the economy. These additional infrastructures may be in form of factory buildings or facilities imply additional investments. Additional investments may also mean more economic opportunities available for the people residing near where the investment was made. If the fruits of economic growth are properly distributed, this will increase the productivity in the economy which can also upgrade the living conditions of the people. However,(c) economic growth varies for different countries and so is their development. Hence, there is a gap between the rich and the poor countries that gave rise to the developed nations over the developing ones. Economists proposed theories to explain the importance of economic growth to development and vice versa and tried to emphasize particular patterns that each economy must pursue to attain development. II. Research Problem This paper is about one of the commonly used economic theories in relating growth and development in an economy, the Harrod-Domar Growth Theory. Specifically, this paper will (a)present the development of Harrod-Domar Theory and (b)the economists behind its development. (c)Several factors that linked economic growth to economic development will also be tackled in this paper to establish the applicability of the theory. (d)Possible effects associated with the theory will also be examined to find out if it has its significance or implication to the development of an economy. III. Research Objective This paper seeks (a)to establish a deeper understanding of the Harrod-Domar Growth Theory by answering the research problem. This is important in order (b)to explain how economies may or may not develop and (c)how may the growth barriers be identified and overcome in the future. After relating the theory’s significance to the economic condition, it aims (d)to form suggestions which are believed to be appropriate in the formulation of different development policies. IV. Literature Review The theory of economic growth asks what factors determine the full- employment growth rate of output overtime. It is important to study growth theory because it both helps explain growth rates and development and why per capita income level differs among countries. This part will present a brief review of the factors significant or related to economic growth. Growth in the economy determines the change in the level of economic activity from one year to another. However, there are different ways of by which growth can be measured. One way is to look at whether the GDP is going up or not. Then the percentage change or the rate of the GDP growth has to be considered also. Because this will show how the business cycle affects growth in the economy. (a)In the economic history of US, real GDP has generally increased except during the Great Depression of 1930’s. But the economic recession experienced in 2008 indicated the worst slump since the Great Depression (Willis, 2009). Next question is what brings in growth? The answer is pointed to growth in labor and in capital and improved technical efficiency. (b)Growth in labor is a source of economic growth because according to the Organization of Economic Cooperation and Development (OECD), labor productivity is defined as GDP per hour worked (Pasquali, n.d.). Put in simple words, productivity is a measure of output from a production process, per unit of input. Therefore, labor productivity is computed as output per labor-hour. It can determine the efficiency of a given population in producing goods and services. The use of capital or investment in generating growth is presented by De long and Summers (1990) in their paper. They used the data gathered from the United Nations Comparison Project and the Penn World Table and found out that (c)machinery and equipment investment has a strong association with growth. The percentage of association found was a much stronger association than found between growth and any of the other components of investment. A variety of considerations suggest that this association is causal, that higher equipment investment drives faster growth, and that the social return to equipment investment in well-functioning market economies is on the order of 30 percent per year. (d)The improved technical efficiency or the rate of improvement of technology is also a source of growth. One of the most significant findings in the last 50 years is that a large share of economic growth—more than one-third—is driven by technological advance. This originated with a seminal 1957 paper by Robert Solow titled “Technical Change and the Aggregate Production Function” that was published in Review of Economics and Statistics. Solow demonstrated that capital and labor accounted for less than two-thirds of growth. The remainder was technology (Reikard, 2011). So, part of the improvement in the productivity of any factor is the method or means by which things are to be done. Among the economists who worked to relate the importance of economic growth to economic development were Sir Harrod of England and Prof. Domar of America. They worked independently and developed the Harrod-Domar growth theory, a model that shows the relationship between input such as capital and the output. In this theory, they argued that there is growth produced through the effects of delayed consumption or savings. (e)Sir Roy Forbes Harrod was born on February 13, 1900 in London. Harrod was educated at Oxford and at Cambridge, where he was a student of John Maynard Keynes. His career at Christ Church, Oxford (1922–67), was interrupted by World War II service (1940–42) under Frederick Lindemann (later Lord Cherwell) as adviser to Winston Churchill. He was also an adviser to the International Monetary Fund (1952–53). He was knighted in 1959 (Encyclopedia Britannica, 2012). He is credited with getting twentieth-century economists thinking about economic growth. He introduced three types of economic growth rate- warranted growth, natural growth, and actual growth (The Concise Encyclopedia of Economics, 2008). The warranted growth rate is the growth rate at which all saving is absorbed into investment. For example, if people save 10 percent of their income, and the economy’s ratio of capital to output is four, the economy’s warranted growth rate is 2.5 percent. This computed by dividing savings rate of 10 by the ratio of capital to output which is four in this case. The 2.5 percent is the growth rate at which the ratio of capital to output would stay constant at four. The natural growth rate is the rate required to maintain full employment. For instance, the labor force grows at 2 percent per year, in order to maintain full employment, the economy’s annual growth rate must be 2 percent (assuming no growth in productivity) (Pettinger, 2012). (f)Prof. Evsey David Domar was born on April 16, 1914 in Russia and was raised in Manchuria. Domar has lived in the USA since 1936. He graduated from the University of California in 1939 and received his doctoral degree in 1947. Since 1940, he has taught in American universities and institutes. Since 1957, he has been a professor of economics at Massachusetts Institute of Technology. Domar’s theories are directed at finding ways of raising the rate of the economic growth of capitalism. He is mainly concerned with the accumulation of capital. He rejects the existence of objective laws of economic development and assigns psychological factors a decisive role. His works include Essays in the Theory of Economic Growth (Farlex, 2013). V. Discussion A. Cause (a)In 1930’s the Harrod-Domar model was developed to analyze business cycles. The model suggests that savings provide the funds which are borrowed for investment purposes by firms or entrepreneurs. Thus, the economy's rate of growth (g) depends on two things. First, the level of savings (S) and the savings ratio (s=S/Y) and second, the productivity of investment i.e. economy's capital-output ratio (K/Y =?). Net investment or the increase in capital stock less capital depreciation may lead to more producer goods. The increase in producer goods means capital appreciation and this will generate higher output and income. Higher income will allow higher levels of saving. With depreciation (?=0), g= s/?. For example, if $8,000 worth of capital equipment (K) produces each $1,000 of annual output (Y), a capital output ratio of 8,000/1,000 or 8 to 1 exists. Because savings is the part of the income that is not consumed, it means that it will be later used as capital. So, there is the linked between savings rate and capital formation. The higher the savings rate the higher the capital formed that would be used for the production of goods and services to generate income. Applying business cycle concepts, it is expected that during peak phase savings rate could higher than during recessions. So, less opportunity for capital formation is available during this stage. (b)In the 1940's this macro-dynamic model was developed through an extension of Keynes's theory. Keynesians believes that government intervention can significantly improve the operation of the economy. The Harrod-Domar model's original intent was to identify the source of instability in the growth of developed economies where effective demand is normally exceeded by supply capacity. Later on, this model was adapted to explain economic growth. Because economic growth (Y) depends on the amount of labor (L) and capital (K) ceteris paribus on all other factors, it was assumed that developing countries have an abundant supply of labor (L). So it is a lack of physical capital (K) that holds back economic growth hence economic development. However, the efficiency of capital in relation to economic growth also depends on several factors. This may include values of workers, their skills or even the technology being used. These factors may determine whether capital could be productive or not. (c)In the 1950's and 1960's this model was applied to economic planning in developed economies. The relationships between flows and stocks, depreciation and investment and efficiency and growth were expressed by Harrod and Domar in a simple equation which formalized over 200 years of theorizing about economic growth. According to Harrod-Domar model, economic growth depends on just three factors. These include the saving rate which is determined by households; the capital/output ratio which reveals the way firms base their demand for capital on the amount of output they want to produce; and the depreciation rate which represents the consequence of the quality of investment decisions in the past. These factors were summarized in Harrod-Domar theory. This model was used to determine an equilibrium level of growth rate (g) for an economy. (d)GDP is denoted by Y and savings by S. Savings is a function of GDP, S = sY. The level of capital (K) needed to produce an output (Y) is a function of the capital- output ratio. In equation form it is written as K = ?Y. Investment (I) becomes a significant variable because of its roles. First, it represents an important component of the demand for the output of the economy and second, it also shows the increase in capital stock. Therefore change in capital (K) is equal to capital-output ratio as a function of change in output (Y). So, for equilibrium to be established, the supply and demand for an economy’s output should be balanced. Putting this in equation,(e) I = ?K = ??Y and I = S, so ??Y= sY. The equilibrium growth rate is when g = ?Y/Y = s/?. If there is some direct economic relationship between the size of the total capital (K) and total GDP(Y), it follows that there is corresponding increases in the flow of national output (Y). Therefore, the greater the rate of growth of GDP is the greater savings/capital ratio will be. If the capital-output ratio is defined as K and the national saving ratio, S, is fixed proportional of national output, then change in Y/Y represents the rate of change or rate of growth of GDP. Harrod-Domar theory states that the rate of growth of GDP (change in Y/Y) is determined jointly by the national savings ratio(S), and the national-output ratio (K). B. Effects The first implication of Harrod-Domar theory was (a)its difficulty to stimulate the desired level of domestic savings especially in developing countries. Because it was assumed that if households consumed less, their savings will be higher which will automatically form part of capital as business firms used it as their investment. (b)Meeting a savings gap by borrowing from overseas can cause debt repayment problems and other related issues in the future. It is argued that saving rate is difficult to increase in developing countries and so there should be government intervention to increase the capital of the economy. One option is for developed economies to transfer their capital stocks for the developing countries attain higher productivity. The problem is the lack of investment for these economies. (c)Diminishing marginal returns to capital equipment exist so each successive unit of investment is less productive and the capital to output ratio rises is another thing. Attempt to stimulate foreign direct investment (FDI) is less successful for slow-growing economies unless they possess oil and other strategic natural resources. The effect was the amount of investment is just one factor affecting development e.g. supply side approach (free up markets); human resource development (education and training). This was because the theory was developed after the Great Depression. It was assumed that there would always be surplus of labor to use the machineries and equipment, but in reality, this is not the case (Pettinger, 2012). (d)Harrod-Domar theory did not take into consideration other factors of productivity such as labor, technological advances and population growth rate. In the case of the developing countries, they lack capital for production of goods and services but have abundant supply of labor due to high rates of population growth. If labor productivity is high then it could increase the level of output in the economy. There were economies that experienced rapid growth rates even with insufficient savings rate. (e)The theory was reliable for explaining short term growth rates but not for long term growth rates because in the long run everything will be uncertain. The uncertainty for the productivity of each factor will create rough estimates about the actual and full employment level of growth. VI. Conclusion After studying and examining the Harrod-Domar Theory, it was concluded that (a) economic growth is a necessary but not sufficient condition for development. Because growth is dynamic, it is not enough that GDP has increased; there should be changes that the people in that economy are experiencing. The increased in GDP should not only make the income of the workers rise but also their lives should be improved and better in the long run. (b)Sector structure of the economy is also important. This is because the kind of sector available in the economy will also determine its kind of development. The issue of specialization comes in as each country may have a different situation as compared to others. A country with agricultural sector that has more potential to be productive than its industry sector may focus on improving agricultural products. (c)Economic growth requires policies that encourage saving and/or generate technological advances, which lower capital-output ratio. This is because in the absence of government intervention, the growth rate of national income will be directly or positively related to the savings ratio and inversely or negatively-related to the economy’s capital-output ratio. So, for an economy to grow, they must save and invest a certain proportion of their income. The higher the rate of their savings and investment, the faster they can grow. Bibliography Diffen Contributors. (2013). Economic Development vs. Economic Growth. Retrieved April 19, 2013, from www.diffen.com: http://www.diffen.com/difference/Economic_Development_vs_Economic_ Encyclopedia Britannica. (2012). Sir Roy Forbes Harrod. Chicago: Encyclopedia Britannica. Farlex. (2013). Domar, Evsey David. Retrieved April 20, 2013, from encyclopedia2.thefreedictionary.com: http://encyclopedia2.thefreedictionary.com/Evsey+Domar J. Bradford De Long, L. H. (1990, November). Equipment Investment and Economic Growth. Retrieved April 20, 2013, from The National Bureau of Economic Research: http://www.nber.org/papers/w3515 Pasquali, V. (n.d.). Labor Productivity and Growth. Retrieved April 20, 2013, from www.gfmag.com: http://www.gfmag.com/tools/global-database/economic-data/11857-labor-productivity-and-growth.html#axzz2RM7AlZyC Pettinger, T. (2012, May 7). Harrod-Domar Model of Growth and Its Limitation. Retrieved April 20, 2013, from www.economicshelp.org: http://www.economicshelp.org/blog/498/economics/harod-domar-model-of-growth-and-its-limitations/ Reikard, G. (2011, March 1). Stimulating Economic Growth Through Technological Advance. Retrieved April 20, 2013, from magazine.amstat.org: http://magazine.amstat.org/blog/2011/03/01/econgrowthmar11/ The Concise Encyclopedia of Economics. (2008). Roy F. Harrod. Retrieved April 20, 2013, from www.econlib.org: http://www.econlib.org/library/Enc/bios/Harrod.html Willis, B. (2009, August 9). U.S. Recession Worst Since Great Depression, Revised Data Show. 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