Development Theories - Describe the Harrod-Domar model of growth

Peter Marshall

Development Theories

1) Describe the Harrod-Domar model of growth

The model was developed independently by RF Harrod and ED Domar in the 1930’s. The main principles of the model were that the rate of an economies growth depends upon the level of saving and the productivity of investment i.e. the capital output ratio.

For example, if £12 worth of capital equipment produces ach £1 of annual output, a capital-output ratio of 12 to 1 exits.

Using the model it is possible to describe reasons for economic growth. Economic growth depends upon the amount of labour and capital. As LDC’s often have an abundant supply of labour it is the lack of capital that stifles their growth and development. More physical capital therefore generates growth. Therefore net investment leads to more capital accumulation, which generates higher output and therefore income. This higher income will therefore in turn allow higher saving levels.

The key to economic growth is expanding investment levels (both fixed and human) capital using polices which encourage technological advances.

Diagram of Harrod-Domar Model

The above production possibility curve shows the importance of capital growth. I is the change in capital stock, K. The national income, Y, increases if consumption, C, is reduced, in the short run from Ca to Cb, to release saving, S, and resources for additional I from Ia to Ib. In the long run, the increase in the economies capacity shifts the production possibility frontier outwards to the pecked line which can allow the both higher consumption and investment.

2) With the use of economic theory, discuss the policies a government might introduce to promote economic development.

There are several polices that can be used by governments to promote economic development. Economic development according to Todaro’s three objectives involves raising standards of living, expanding the range of economic and social choices and providing a wider access to the resources required for basic needs. The UN, IMF and World Bank have extended these objectives to include gender equality, universal education and strategies for sustainable development.

The main way the UK and many other developed countries promote economic development is through fiscal policy and government intervention to reach macroeconomic targets. It is based on the Keynesian school of thought and that economic growth is linked with economic development as a country would gain extra income and hence higher standards of living and investment in vital services. In 1936 John Maynard Keynes broke from the classical tradition with the publication of the ‘General Theory of Employment, Interest and Money’. The classical view assumed that in a recession, wages and prices would decline to restore full employment. Keynes held that the opposite was true. Falling prices and wages, by depressing people’s incomes, would prevent a revival of spending. He insisted that direct government intervention was necessary to increase total spending. This theory is the reasoning behind government’s fiscal policies. When a recession threatens government’s decrease taxes and increase government spending. This will increase people’s disposable income and so will increase consumer spending. Firms will respond by producing more and employment will increase. This will cause economic growth and hence economic development should increase. Changes in monetary policy will also be able to increase economic growth. A decrease in interest rates encourages people to borrow and hence their disposable income increases causing a rise in consumer spending. As output = C + I + G + (X – M) economic growth will increase and so as a result will development. Although the Keynesian theory makes sense most governments only tend to use the policy when faced with an economic crisis e.g. a recession. This is because other targets include stable inflation rates, which often means taxes and interest rates rise, causing a stifling effect on economic growth and development. Also, importantly, economic growth does not guarantee development because extra income may not be spent on important basic needs or may be only received by the wealthier people in the country due to poor income distribution. However they are still polices which can be used to promote development if the income is used appropriately on services and investment in future services.

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Investment is the main focus of the Harrod-Domar model, which aims to increase a countries output by expanding their production possibility frontier. The model suggests that a countries economic growth is dependent upon the level of saving and the capital-output ratio. The model concludes that economic growth depends on the amount of labour and capital. As LDC’s often have an abundant supply of labour it is a lack of physical capital that holds back economic growth. Net investment leads to more capital accumulation, which generates higher output and income. Higher income allows higher savings enabling firms to produce more output. This model suggest that the government can use polices which encourage saving and/or generate technological advances which enable firms to produce more output with less capital. Increased government spending on research will therefore not only increase growth due to improvements being obtained in technology, pushing out the PPF but it will increase output in terms of government spending and higher employment and development as a consequence. The government could increase interest rates to encourage savings. This would in the short run cause a decline in growth and possibly development but according to the Harrod-Domar model the increase in savings as a result will lead to economic growth and development.

However there are problems using this model as a basis to increase development. Economic growth and economic development are not the same. Economic growth is a necessary but not sufficient condition for development. Practically it is difficult to stimulate the level of domestic savings, particularly in LDC’ where incomes are low. Borrowing from overseas to fill the gap caused by insufficient savings causes debt repayment problems later. Also the Law of diminishing returns would suggest that as investment increases the productivity of the capital will diminish and the capital to output ratio rise.

Supply side policies are a form of government intervention policy used to stimulate growth and hence the chance of development. Increasing supply shifts market equilibriums to the right and so output increases. Governments can give incentives for people to work by reducing unemployment benefits, increasing the minimum wage and revising tax thresholds for low-income groups with the object of encouraging more people to join the labour force. This increases the supply of labour, reduces waste of government spending on benefit and makes the economy produce closer to the PPF, thus increasing growth. Education and training removes skill shortages, improves productivity and helps use resources more efficiently thus increasing output. Privatisation and deregulation of companies removes red tape and increases competition. This increases efficiency and productivity to remain competitive and so output should increase. Supply side policies improve growth but therefore not necessarily development. Also often the policies are good in theory but difficult to impose and are often less effective than they are in theory.

The type of economic growth (balanced v unbalanced) also affects government policy. Economists argue that balanced growth leads to industrialisation and hence rapid growth but often at great risks of high debts, for LDC’s, due to vast amounts of money being spent on several sectors of the economy. Often unbalanced is more practicable for LDC’s but would low the market to reveal bottlenecks and hence inducing investment from both the private and public sector. Also they can concentrate on industries with significant inter-industry linkages.

According to the Lewis Model LDC’s could increase development by transferring labour to the modern industrial sector. It was based on the assumption that many LDCs had dual economies with both a traditional agricultural sector and a modern industrial sector. The traditional agricultural sector was assumed to be of a subsistence nature characterised by low productivity, low incomes, low savings and considerable underemployment. The industrial sector was assumed to be technologically advanced with high levels of investment operating in an urban environment.

Lewis suggested that the modern industrial sector would attract workers from the rural areas. Industrial firms, whether private or publicly owned could offer wages that would guarantee a higher quality of life than remaining in the rural areas could provide. Furthermore, as the level of labour productivity was so low in traditional agricultural areas people leaving the rural areas would have virtually no impact on output. Indeed, the amount of food available to the remaining villagers would increase as the same amount of food could be shared amongst fewer people. This might generate a surplus which could them be sold generating income. Those people that moved away from the villages to the towns would earn increased incomes and this crucially according to Lewis generates more savings. The lack of development was due to a lack of savings and investment. The key to development was to increase savings and investment. Lewis saw the existence of the modern industrial sector as essential if this was to happen. Urban migration from the poor rural areas to the relatively richer industrial urban areas gave workers the opportunities to earn higher incomes and crucially save more providing funds for entrepreneurs to investment. A growing industrial sector requiring labour provided the incomes that could be spent and saved. This would in itself generate demand and also provide funds for investment. Income generated by the industrial sector was trickling down throughout the economy.

Governments can therefore increase development by encouraging people to leave the agricultural way of life and move and work in modern industrial areas. Offering cash incentives, providing cheap affordable housing, training for new skills and improved education, can do this.

There are many problems to this theory though. The idea that the productivity of labour in rural areas is almost zero may be true for certain times of the year however during planting and harvesting the need for labour is critical to the needs of the village. The assumption of a constant demand for labour from the industrial sector is questionable. Increasing technology may be labour saving reducing the need for labour. In addition if the industry concerned declines again the demand for labour will fall. The idea of trickle down has been criticised. Will higher incomes earned in the industrial sector be saved? If the entrepreneurs and labour spend their newfound gains rather than save it, funds for investment and growth will not be made available. The rural urban migration has for many LDCs been far larger that the industrial sector can provide jobs for. Urban poverty has replaced rural poverty as a result.

Rostow’s Model shows the different stages if development. It is based on development being in 5 stages. Stage 1 (Traditional society) is when the economy is dominated by subsistence. Resource allocation is determined very much by traditional methods of production and so output is low and so is development. In contrast stage 5 (high mass consumption) is when the consumer durable industry flourishes and the service sector is increasingly dominant. As a result output is high and so is the level of development. Therefore output must be closely linked with development and so measures taken to increase economic growth will increase development. This could involve improving the quantity and quality of land resources, improving quantity and quality of human resources and improving the quantity and quality of land resources. Also by increasing the quantity and quality of enterprise will increase growth.

The level of economic growth may be slowed down if there is a lack of entrepreneurial and risk taking managers. For growth to take place inventions and innovations must be encouraged. Again the role of education is seen as being essential here. Multinational enterprises also can provide training in management skills. In countries like Zambia where for many years the government has taken a considerable role in production through parastatals, there might be a lack of enterprise culture. In addition, where traditional agriculture has been communally organised then the move towards a private sector profit-making culture is likely to be slow.

According to Rostow development requires substantial investment in capital. For the economies of LDCs to grow the right conditions for such investment would have to be created. If aid is given or foreign direct investment occurs at stage 3 the economy needs to have reached stage 2. If the stage 2 has been reached then injections of investment may lead to rapid growth.

However many development economists argue that Rostow’s model was developed with Western cultures in mind and not applicable to LDCs. It addition its generalised nature makes it somewhat limited. It does not set down the detailed nature of the pre-conditions for growth. In reality policy makers are unable to clearly identify stages as they merge together. Thus as a predictive model it is not very helpful. Perhaps its main use is to highlight the need for investment. Like many of the other models of economic developments it is essentially a growth model and does not address the issue of development in the wider context.

These economic theories show that there are several ways governments can try to increase development. However many of these are hard to employ effectively and are based on the fact that they improve economic growth which is only a condition of development. Development is a broader process that includes raising living standards and poverty reduction. Economic growth may result in an improvement in the standard of living of a relatively small proportion of the population whilst the majority of the population remain poor. It is how the economic growth is distributed amongst the population that determines the level of development. Some economists argue that economic growth will eventually lead to a general improvement of peoples' living standards as trickle down occurs. Trickle down as its name suggests is the process whereby part of the population experiencing an increase in their income spend money on the domestic economy thus setting in motion the multiplier effect, which generates income for the poorer sections of the population. However there is considerable evidence from a number of countries that this process does not make any meaningful improvement to the lives of the poor. It is thus possible to have economic growth with no or little development.