ASSIGNMENT: GROUP 5

MIB/MIT
2010/2011
 Question
• Explain and give critic to the Harrod Domar
model in relation to economic growth in
Africa.
 Introduction
• Economic growth is an increment of attribute
characterized the economy of a given nation,
custom territory regional or global eg. GDP,
GNP, Employment/unemployment rate and
Balance of payment.
 Introduction cont..
• Or, a positive change in the level of
production of goods and services by a country
over a certain period of time. Nominal growth
is defined as economic growth including
inflation, while real growth is nominal growth
minus inflation. Economic growth is usually
brought about by technological innovation
and positive external forces.
 Introduction Cont…
• Economic growth is central problem of almost
all nations and capital accumulation is at the
center of economic growth - especially in less
developed countries. Although the
importance of capital accumulation was
recognized long time ago (see Harrod, 1939;
Domar, 1946; Lewis, 1954.
 Introduction Cont…
• Less developed countries have generally failed
to finance the desired level of investment out
of their own resources (savings). This
condition called for foreign aid as an optimal
means to break the ‘vicious circle of poverty’
experienced by these poor countries and
fasten the transformation process.
 Introduction Cont…
• Early ‘structural’ development models such as
Harrod-Domar growth model and two-gap
model of Chenery and Strout (1966) showed
how foreign aid would enable developing
countries to transform their economies.
 Harrod-Domar Growth Model
• This model is named after two famous
economists: Sir Roy Harrod of England and
Professor Evesey Domar of the US who
independently formulated the model during
the 1940s.
 Harrod-Domar Growth Model
• They developed an economic growth model
based on a fixed-coefficient, constant returns
to scale function (this function assumes that
capital and labor are used in a constant ratio
to each other to determine total output – see
graph). Outputs in this graph are isoquants
(combinations of labor and capital that
produce output).
 Assumptions of Model
• The model assumes that labor and capital are
always used in a fixed proportion to produce
out equal amounts of output. The model’s
equation is Y = K/v where v is a constant found
by dividing capital (K) by investment (Y) – v is
the capital-output ratio. This ratio is primarily
a measure of the productivity of capital or
investment.
 Assumptions cont…..
• 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.
 Assumptions cont…..
• 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
.
Graphical representation of Harrod-
Domar Model
 How the Model works
• The model focuses on two critical aspects of
the growth process: saving and the efficiency
with which capital is used in investment. This
model can provide accurate short term
predictions of growth and has been used
extensively in developing countries to
determine the “required” investment rate or
“financing gap” to be covered in order to
achieve a target growth rate.
 How the Model works
• The basic model assumes that it is a closed
economy and that there is no government, no
depreciation of existing capital so that all
investment is net investment, and that all
investment (I) comes from savings (S).
• Assume that there is a relationship between
the total capital stock, K, and total GDP, Y.
 How the Model works
• For example, if Tshs 3 of capital is always
necessary to produce Tshs 1 of GDP, it follows
that any net additions to the capital stock in
the form of new investment will bring about a
corresponding increase in national output,
GDP.
 How the Model works
• Now suppose that this ratio, known as the capital-
output ratio, is 3 to 1, and we define this as v.

• Assume that the national saving ratio, s, is a fixed

proportion of national output.
 
• Assume that total new investment is determined by
the level of total savings.
 
 How the Model works
Therefore:
Savings, S, is some proportion, s, of national
income, Y, such that

S = s (Y)

Investment, I, is defined as the change in capital

stock, K, such that:

I = ∆K
 How the Model works
• Total capital stock, K, bears a direct relationship
to total national output (or income), Y, as
expressed by the capital-output ratio, v, (new
investment as a percentage of GDP) then:

K = vY or K/Y = v or
 
∆K/∆Y = v or
 
∆K = v (∆Y)
 How the Model works
• The Harrod-Domar Equation of economic
development that states that:
The rate of growth of GDP (∆Y/Y) is determined
jointly by the national saving ratio (usually
expressed as a percentage), s, and the
national capital-output ratio (expressed as an
integer), v.
 How the Model works
• Therefore:
1.The growth rate of national income is directly
(positively) related to the savings ratio, i.e.,
the more an economy is able to save – and
therefore invest – out of a given GDP, the
greater will be the growth of that GDP.
 How the Model works
2. The growth rate of national income is
indirectly (negatively) related to the economy’s
capital-output ratio, i.e., the higher is k, the
lower will be the rate of GDP growth.

In order to grow, economies must save and

invest a certain portion of their GDP.
 How the Model works
• How can we use this formula?
• Assume that the national capital-output ratio of an LDC
is 3 and that the aggregate savings ratio is 6% of GDP,
then it follows that this country can grow at a rate of
2% per year.
 
• ∆Y/Y = s/v
 
• % growth of GDP = 6%/3
 
• % growth in GDP = 2%
 How the Model works
• Now, if national savings rate can be increased
from 6% to 15%, then GDP Growth can be
increased from 2% to 5% as seen below.
• ∆Y/Y = s/v

• % growth of GDP = 15%/3

• % growth in GDP = 5%
 How the Model works
• The ‘tricks’ of economic growth, according to
this model, are simply a matter of increasing
savings and investment.
• The main obstacle to or constraint on
development then is the relatively low level of
new capital formation or investment in most
LDCs.
 How the Model works
• Therefore, the ‘savings gap’ or what is later
referred to as the ‘Financing Gap’ can be
filled either through foreign aid or private
foreign direct investment.
 Application of the Model in Africa
• The Harrod-Domar model is still applied today
to calculate short-run investment
requirements for a target growth rate.
Development economists calculate a
‘Financing Gap’ between the required
investment and available resources and often
fill the ‘Financing Gap’ with foreign aid.
 Application of the Model in Africa
• ‘Financing Gap’ equals difference between the
required investment and the LDC’s savings

• This model promised LDCs growth in the

short-run through aid and investment.
 Application of the Model in Africa
• Majority of African countries and other Less
Developed Countries have used this model to
foster for economic growth and development.
• This model is said to be the mostly widely
used among economic theories and models.
 Application of the Model in Africa
• Foreign aid and borrowing have been used by
African countries since the years of
independence.
• African countries have been obtaining
between 40% to 70% of their budgets from
foreign aids and foreign loans.
 Criticism of the model
• It is not possible to state that development is
simply a matter of removing obstacles and
supplying various ‘missing components’ like
capital, foreign exchange, skills and
management – a task in which DCs could
theoretically play a major role.
 Criticism of the model
• Besides physical capital which is the definition
of capital in the Harrod-Domar model, there is
human capital, organizational capital and
technological knowledge which all come into
play in economic growth and development.
 Criticism of the model
• Another problem with the Harrod-Domar
model is that more labor is a factor in
increasing total GDP, but only Investment in
capital (machines) is taken into account.
 Criticism of the model
• Taking Tanzania as an example of a
developing country in Africa the main criticism
of the Harrod – Domar 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.
 Criticism of the model
• 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 Tanzania investors are
influenced by a number of factors which
include political stability, technological
advancement, capital, labour and market.
 Criticism of the model
• 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. This can vividly been seen in
Tanzania where by the economic growth has
been growing at the 7% average in the past
ten years but the life of most Tanzanian does
not reflect this growth as object poverty is still
very severe, especially in rural areas.
 Criticism of the model
• 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.
 Conclusion
• It is difficult to conclude the usefulness of
Harrod-Domar Model as empirical studies
came up with mixed results. Some argued that
aid has positive impact when used in good
policy environment (see Durbarry et al., 1998;
Ali et al., 1998;Khan, 2003; Burnside and
Dollar, 2000) while others argued that aid, at
best, has no demonstrable effect (Griffin and
Enos, 1970; Weisskoff, 1972; Dowling and
Hiement, 1983; Mosley et al.,1987).
 Conclusion
• But our quick observation suggests that
borrowing has caused big repayment
problems to LDCs, such that instead of putting
much effort in their citizens, significant
resources of these poor countries are used to
repay loans.
 Conclusion
• According to A research paper by Conchesta
Nestory Kabete (2008) “Foreign Aid and
Economic Growth: The Case of Tanzania”, the
main findings are that foreign aid and total
debt service have a negative impact on GDP
growth.
 Conclusion
• On the other hand, export growth and net
national savings have shown a positive impact
on GDP growth as it was expected because
they increase the country’s capacity to invest.
Both government’s development and
recurrent expenditures of foreign aid
resources have shown a negative impact on
GDP growth.
 Conclusion
• This implies that the development
expenditures undertaken were not enough or
not productive enough to impact on GDP
growth positively. The overall aid and aid for
development expenditures have shown to
have more negative impact in the 1990s than
in the early 2000s.
 Conclusion
• In the case of Botswana, one of the fastest
developing countries in Africa, the countries
development has proved to be not resulting
from borrowing or foreign aid, but rather
institutions of private property are what made
this country different from other countries of
Africa.
 Conclusion
• In Botswana a broad cross section of people
have effective property rights ie Rule of law,
Sanctity of contract, and minimal state or
private predation; relatively efficient,
business-friendly bureaucracy and
conservative fiscal policy.