NPTEL- History of Modern Economic Thought
Module 5
Growth Theories
(Lectures 33, 34, 35 & 36)
Topics
5.1 Growth Theory I
5.1.1 HarrodDomar Model
5.2 Growth Theory II
5.2.1 Solow Model
5.3 Growth Theory III
5.3.1 Endogenous Growth Models
5.4 Growth Theory IV
5.4.1 Neo-Schumpeterian Growth Models IV
Dept. of Humanities and Social Sciences, Indian Institute Of Technology, Kanpur
NPTEL- History of Modern Economic Thought
Module 5
Lecture 33
Topics
5.1 Growth Theory I
5.1.1 HarrodDomar Model
5.1 Growth Theory I
The discussion on the Keynes-Classics debate centered around the cyclical
fluctuation in the economy and the ways to correct it.
This is just one part of macroeconomics, the other part being the growth theories
which discuss the long run trend of national income.
The development of growth theories has three distinct phases:
1. Harrod-Domer model of growth (1947-48)
2. Neo-classical growth Models pioneered by Solow and Swan (1956)
3. Endogenous growth models (1962-)
5.1.1 HarrodDomar Model
Even though economists are talking about economic growth for ages, the first
formal growth model was worked out only in 1947-48, right after the Second
World War
The remarkable growth story of Soviet Union through forced savings triggered
interests in growth. It was specially because after the second World War Soviet
Union emerged as one of the super power.
Moreover, after the WW II, World Bank was established with the announced goal
of reconstructing the world economies. Hence, understanding the process of
growth became essential.
Rostow's stages of growth can be seen as the precursor of the Harrod-Domer
model. According to Rostow's theory there are five stages of development which
are:
Dept. of Humanities and Social Sciences, Indian Institute Of Technology, Kanpur
NPTEL- History of Modern Economic Thought
1. The traditional society
2. Preconditions for takeoff
3. Takeoff
4. The drive to maturity
5. The age of high mass-consumption
It is the take off stage where Rostow predicted that the rate of savings and
investment would rise from 5% of the national income to 10%. Hence, this is the
stage an economy will take off to the path of high growth. But Rostow did not
have a proper theory identifying the path leading to take off.
The growth theories which Harrod and Domar independently arrived at had a
simple view of the economy. In this model production function is the fixed
coefficient production function meaning that the capital-output ratio is a constant.
(1)
Because is constant, we can also write
(2)
From the relationships that and we canderive
(3)
This means that the rate of growth of output is exactly equal to the rate of growth
of capital.
Net change in capital stock is given by
(4)
Where represents investment and is the rate of depreciation.
Putting the saving investment equality (and assuming that savings is a constant
fraction of income) in the last equation we get
Dept. of Humanities and Social Sciences, Indian Institute Of Technology, Kanpur
NPTEL- History of Modern Economic Thought
(5)
Hence, the growth rate can be represented as
(6)
This means that higher the savings rate higher is the growth rate.
This formula can be written as
(9)
Assuming this is simply
Then per capita income grows at the rate
(10)
Where is the rate of population growth rate. In steady state, where all variables
such as labor, capital and income grow at the same rate it must be the case that
However, Harrod assumed that s, v and δ from equation (9) are technologically
or institutionally determined. Hence, there is no guarantee that the actual growth
rate will be equal to the warranted growth rate given by s/v. This leads to the
famous Knife Edge instability of Harrod model. If actual growth is slower than
the warranted rate, it implies excess capacity i.e. the growth of a country’s
productive capacity is outstripping its effective demand.
Similarly, in the steady state, there is no guarantee that will hold true.
If population is growing at a higher rate than that of capital. There will be
continuously rising unemployment.
If capital and income will grow at the rate . After that growth will be
constrained by labor force.
Dept. of Humanities and Social Sciences, Indian Institute Of Technology, Kanpur
NPTEL- History of Modern Economic Thought
Hence, steady state can only happen if .
Hence, Harrod-Domar theory characterizes an economy with fundamental
instability. In this model there is no guarantee that the system, once perturbed
will come back to the equilibrium. This property implies an inherent instability in
the capitalist system.
Robert Solow however found the reason behind getting such a result. It was an
implication of the assumption of the fixed coefficient production function. Solow in
his model assumed the standard neo-classical production function and the result
changed radically. We shall see this in the next lecture.
Dept. of Humanities and Social Sciences, Indian Institute Of Technology, Kanpur
