"Harrod-Domar Model"

The Harrod-Domar 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 Harrod-Domar model was the precursor to the Exogenous growth model.

Overview
According to the model there are three concepts of growth:

Warranted growth – the rate of output growth at which firms believe they have the correct amount of capital and therefore do not increase or decrease investment, given expectations of future demand.
Natural rate of growth – The rate at which the labour force expands, a larger labour force generally means a larger aggregate output.
Actual growth – The actual aggregate output change.
Two possible problems are observed in an economy according to the Harrod-Domar model. First, the relationship between the actual and natural (population) growth rates can cause disparities between the two, as factors that determine actual growth are separate from those that determine natural growth. Factors such as birth control, culture, and general tastes determine the natural growth rate. However, other effects such as the marginal propensities to save and consume influence actual output. There is no guarantee that an economy will achieve sufficient output growth to sustain full employment in a context of population growth.

The second problem identified in the model is the relationship between actual and warranted growth. If it is expected that output will grow, investment will increase to meet the extra demand. The problem arises when actual growth either exceeds or fails to meet warranted growth expectations. A vicious cycle can be created where the difference is exaggerated by attempts to meet the actual demand, causing economic instability.

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 labour 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.