Theories of Development 2: Harrod Domar Model

Harrod-Domar model is named after Sir Roy Harrod & Evsey Domar, who developed it in 1930s

This model suggests that economy’s growth rate depends on:

(1) Savings. The higher the level of savings, the greater will be the amount of funds available for investment purposes. Investment here include onto fixed capital & human capital

(2) Investment & the productivity of investment. Productivity of investment is also known as capital-output ratio. The lower the ratio the better. To illustrate, say £20 worth of capital equipment produces each £1 of annual output, then a capital-output ratio of 20 to 1 exist. A 10 to 1 capital-output ratio suggest that only £10 of capital is required to produce each £1 of output annually

Economic growth is often associated with amount of labour & capital. In LDCs (less developed countries), it is often the lack of physical capital that hinders economic growth. Meanwhile supply of labour is abundant. When there is economic growth, there will be higher income. As such this allow higher level of savings (cycle repeat itself)

Problems

(1) Economic growth vs. economic development. Both are not the same. Economic growth is necessary but not sufficient condition for development

(2) Difficult to enforce savings. In LDCs, incomes are generally low. Therefore it is difficult for people to save. The bulk of earnings will be spent on necessities

(3) Increased in savings, not necessary lead to economic growth. For a start, there must be people who are willing to take the risk to invest. Also it depends on whether they can access the funds at a reasonable interest rates

(4) Borrowing to finance growth. Borrowing from developed foreign countries, international organisations such as IMF & World Bank to finance investment, will only push the recipients to deeper poverty & having problems of debt repayment. This is because most of the aids are conditional & often the borrower will be forced to some austerity measures that will aggravate the cycle of poverty

(5) Law of diminishing return. This suggest that, as investment increases, the productivity of the physical capital will diminish, causing the capital to output ratio to increase. In other word, as more & more labour is being added to a production process, later these workers will get into each other’s way, causing a disruption e.g. waiting for turn to use an equipment. This will cause an increase in production costs