HarrodDomar model The HarrodDomar model is used in development economics to explain an economy's growth rate in terms of the level

of saving and productivity of capital. It suggests that there is no natural reason for an economy to have balanced growth. The model was developed independently by Sir Roy F. Harrod in 1939 and Evsey Domar in 1946. The HarrodDomar model was the precursor to the exogenous growth model. Mathematical formalism Let Y represent output, which equals income, and let K equal the capital stock. S is total saving, s is the savings rate, and I is investment. stands for the rate of depreciation of the capital stock. The HarrodDomar model makes the following a priori assumptions: 1: Output is a function of capital stock 2: The marginal product of capital is constant; the production function exhibits constant returns to scale. This implies capital's marginal and average products are equal. 3: Capital is necessary for output. 4: The product of the savings rate and output equals saving, which equals investment 5: The change in the capital stock equals investment less the depreciation of the capital stock Derivation of output growth rate:

An alternative (and, perhaps, simpler) derivation is as follows, with dots (for example, ) denoting percentage growth rates. First, assumptions (1)(3) imply that output and capital are linearly related (for readers with an economics background, this proportionality implies a capitalelasticity of output equal to unity). These assumptions thus generate equal growth rates between the two variables. That is,

Since the marginal product of capital, c, is a constant, we have

Next, with assumptions (4) and (5), we can find capital's growth rate as,

In summation, the savings rate times the marginal product of capital minus the depreciation rate equals the output growth rate. Increasing the savings rate, increasing the marginal product of capital, or decreasing the depreciation rate will increase the growth rate of output; these are the means to achieve growth in the HarrodDomar model. Although the HarrodDomar model was initially created to help analyze the business cycle, it was later adapted to explain economic growth. Its implications were that growth depends on the quantity of labor and capital; more investment leads to capital accumulation, which generates economic growth. The model also had implications for less economically developed countries; labor is in plentiful supply in these countries but physical capital is not, slowing economic progress. LEDCs do not have sufficient average incomes to enable high rates of saving, and therefore accumulation of the capital stock through investment is low. The model implies that economic growth depends on policies to increase investment, by increasing saving, and using that investment more efficiently through technological advances. The model concludes that an economy does not find full employment and stable growth rates naturally, similar to the Keynesian beliefs. Criticisms of the model The main criticism of the model is the level of assumption, one being that there is no reason for growth to be sufficient to maintain full employment; this is based on the belief that the relative price of labor and capital is fixed, and that they are used in equal proportions. The model explains economic boom and bust by the assumption that investors are only influenced by output (known as the accelerator principle); this is now widely believed to be false. In terms of development, critics claim that the model sees economic growth and development as the same; in reality, economic growth is only a subset of development. Another criticism is that the model implies poor countries should borrow to finance investment in capital to trigger economic growth; however, history has shown that this often causes repayment problems later. The endogenity of savings: Perhaps the most important parameter in the HarrodDomar model is the rate of savings. Can it be treated as a parameter that can be manipulated easily by policy? That depends on how much control the policy maker has over the economy. In fact, there are several reasons to believe that the rate of savings may itself be influenced by the overall level of per capita income in the society, not to mention the distribution of that income among the population.

Exogenous growth model The exogenous growth model, also known as the neo-classical growth model or SolowSwan growth model is a term used to sum up the contributions of various authors to a model of long-run economic growth within the framework of neoclassical economics. Development of the model The neo-classical model was an extension to the 1946 HarrodDomar model that included a new term: productivity growth. Important contributions to the model came from the work done by Robert Solow;[1] in 1956, Solow and T.W. Swan developed a relatively simple growth model which fit available data on US economic growth with some success.[2] In 1987, Solow received the Nobel Prize in Economics for his work. Solow was also the first economist to develop a growth model which distinguished between vintages of capital.[3] In Solow's model, new capital is more valuable than old (vintage) capital becausesince capital is produced based on known technology, and technology improves with timenew capital will be more productive than old capital.[3] Both Paul Romer and Robert Lucas, Jr. subsequently developed alternatives to Solow's neo-classical growth model.[3] Today, economists use Solow's sources-of-growth accounting to estimate the separate effects on economic growth of technological change, capital, and labor. Extension to the HarrodDomar model Solow extended the HarrodDomar model by: Adding labor as a factor of production; Requiring diminishing returns to labor and capital separately, and constant returns to scale for both factors combined; Introducing a time-varying technology variable distinct from capital and labor.

The capital-output and capital-labor ratios are not fixed as they are in the Harrod Domar model. These refinements allow increasing capital intensity to be distinguished from technological progress. Short run implications Policy measures like tax cuts or investment subsidies can affect the steady state level of output but not the long-run growth rate. Growth is affected only in the short-run as the economy converges to the new steady state output level. The rate of growth as the economy converges to the steady state is determined by the rate of capital accumulation. Capital accumulation is in turn determined by the savings rate (the proportion of output used to create more capital rather than being consumed) and the rate of capital depreciation.

Long run implications In neoclassical growth models, the long-run rate of growth is exogenously determined in other words, it is determined outside of the model. A common prediction of these models is that an economy will always converge towards a steady state rate of growth, which depends only on the rate of technological progress and the rate of labor force growth. A country with a higher saving rate will experience faster growth, e.g. Singapore had a 40% saving rate in the period 1960 to 1996 and annual GDP growth of 5-6%, compared with Kenya in the same time period which had a 15% saving rate and annual GDP growth of just 1%. This relationship was anticipated in the earlier models, and is retained in the Solow model; however, in the very long-run capital accumulation appears to be less significant than technological innovation in the Solow model. Assumptions The key assumption of the neoclassical growth model is that capital is subject to diminishing returns and in a closed economy. Given a fixed stock of labor, the impact on output of the last unit of capital accumulated will always be less than the one before. Assuming for simplicity no technological progress or labor force growth, diminishing returns implies that at some point the amount of new capital produced is only just enough to make up for the amount of existing capital lost due to depreciation. [1] At this point, because of the assumptions of no technological progress or labor force growth, the economy ceases to grow. Assuming non-zero rates of labor growth complicates matters somewhat, but the basic logic still applies[2] in the short-run the rate of growth slows as diminishing returns take effect and the economy converges to a constant "steady-state" rate of growth (that is, no economic growth per-capita). Including non-zero technological progress is very similar to the assumption of non-zero workforce growth, in terms of "effective labor": a new steady state is reached with constant output per worker-hour required for a unit of output. However, in this case, per-capita output is growing at the rate of technological progress in the "steady-state"[3] (that is, the rate of productivity growth). Empirical evidence A key prediction of neoclassical growth models is that the income levels of poor countries will tend to catch up with or converge towards the income levels of rich countries as long as they have similar characteristics for instance saving rates. Since the 1950s, the opposite empirical result has been observed on average. If the average growth rate of countries since, say, 1960 is plotted against initial GDP per

capita (i.e. GDP per capita in 1960), one observes a positive relationship. In other words, the developed world appears to have grown at a faster rate than the developing world, the opposite of what is expected according to a prediction of convergence. However, a few formerly poor countries, notably Japan, do appear to have converged with rich countries, and in the case of Japan actually exceeded other countries' productivity, some theorize that this is what has caused Japan's poor growth recently convergent growth rates are still expected, even after convergence has occurred; leading to over-optimistic investment, and actual recession. The evidence is stronger for convergence within countries. For instance the percapita income levels of the southern states of the United States have tended to converge to the levels in the Northern states. These observations have led to the adoption of the conditional convergence concept. Whether convergence occurs or not depends on the characteristics of the country or region in question, such as:

Institutional arrangements Free markets internally, and trade policy with other countries. Education policy

Evidence for conditional convergence comes from multivariate, cross-country regressions. If productivity were associated with high technology then the introduction of information technology should have led to a noticeable productivity acceleration over the past twenty years; but it has not: see: Solow computer paradox. Econometric analysis on Singapore and the other "East Asian Tigers" has produced the surprising result that although output per worker has been rising, almost none of their rapid growth had been due to rising per-capita productivity (they have a low "Solow residual").[5] Criticisms of the model Empirical evidence offers mixed support for the model. Limitations of the model include its failure to take account of entrepreneurship (which may be a catalyst behind economic growth) and strength of institutions (which facilitate economic growth). In addition, it does not explain how or why technological progress occurs. This failing has led to the development of endogenous growth theory, which endogenizes technological progress and/or knowledge accumulation.

Graphical representation of the model

The model starts with a neoclassical production function Y/L = F(K/L), rearranged to y = f(k), which is the red curve on the graph. From the production function; output per worker is a function of capital per worker. The production function assumes diminishing returns to capital in this model, as denoted by the slope of the production function. n = k = y = L s = saving rate population = capital output/income growth per per rate depreciation worker worker force

labor

Capital per worker change is determined by three variables: Investment (saving) per worker Population growth, increasing population decreases the level of capital per worker.

Depreciation capital stock declines as it depreciates.

When sy > (n + )k, in other words, when the savings rate is greater than the population growth rate plus the depreciation rate, when the green line is above the black line on the graph, then capital (k) per worker is increasing, this is known as capital deepening. Where capital is increasing at a rate only enough to keep pace with population increase and depreciation it is known as capital widening. The curves intersect at point A, the "steady state". At the steady state, output per worker is constant. However total output is growing at the rate of n, the rate of population growth. The optimal savings rate is called the golden rule savings rate and is derived below. In a typical CobbDouglas production function the golden rule savings rate is alpha. Left of point A, point k1 for example, the saving per worker is greater than the amount needed to maintain a steady level of capital, so capital per worker increases. There is capital deepening from y1 to y0, and thus output per worker increases. Right of point A where sy < (n + )k, point k2 for example, capital per worker is falling, as investment is not enough to combat population growth and depreciation. Therefore output per worker falls from y2 to y0. The model and changes in the saving rate

The graph is very similar to the above, however, it now has a second savings function s1y, the blue curve. It demonstrates that an increase in the saving rate shifts the function up. Saving per worker is now greater than population growth plus depreciation, so capital accumulation increases, shifting the steady state from point A to B. As can be seen on the graph, output per worker correspondingly moves from y0 to y1. Initially the economy expands faster, but eventually goes back to the steady state rate of growth which equals n. There is now permanently higher capital and productivity per worker, but economic growth is the same as before the savings increase. [edit] The model and changes in population

This graph is again very similar to the first one, however, the population growth rate has now increased from n to n1, this introduces a new capital widening line (n1 + ) Mathematical framework The Solow growth model can be described by the interaction of five basic macroeconomic equations:

Macro-production function GDP equation Savings function Change in capital

Change in workforce

Macro-production function

This is a CobbDouglas function where Y represents the total production in an economy. A represents multifactor productivity (often generalized as technology), K is capital and L is labor. An important relation in the macro-production function:

which is the macro-production function divided by L to give total production per capita y and the capital intensity 'k. Savings function

This function depicts savings, I as a portion s of the total production Y. Change in capital

The d is depreciation. Change in workforce

'n' is the rate of growth. e.g. n=0.02 would mean or a 2% rise in References

1. ^ Solow, Robert M. (1956). "A Contribution to the Theory

of Economic Growth". Quarterly Journal of Economics (The MIT Press) 70 (1): 6594. doi:10.2307/1884513. JSTOR 1884513. 2. ^ Solow, Robert M. (1957). "Technical Change and the Aggregate Production Function". Review of Economics and Statistics (The MIT Press) 3 (3): 312320. doi:10.2307/1926047. JSTOR 1926047.

3. ^

Haines, Joel D. (January 1, 2006) Competitiveness Review A framework for managing the sophistication of the components of technology for global competition. Volume 16; Issue 2; Page 106.