Harrod Domar Theory

A basic principle that has been stressed by both Harrod and Domar in their growth models and which has been incorporated in all modern growth theories is that net investment has a dual effect in that on the one hand it constitutes a demand for output and on the on the and on the order hand it increases the total productive capacity of the economy. Investment has therefore, both the demand and supply effects. For example the construction of a new railway line generates the demand for steel teak wood sleepers, steel rails, units an bolts, steel girders etc. But on its completion this new railway line increase the economy productive capacity in the sense that additional traffic can be handled by the new railway track. The net investment in the economy in any given time period has, therefore, a demand and a capacity effect. Net investment of any period adds to the aggregate demand of that period and if net investment of any period equals that period saving it has the effect of making the aggregate demand equal to the aggregate supply or output for that period. Thus far result than the actual output also become the equilibrium output for the period. Thus far the argument is simply Keynesian in which the role of investment has been recognised only from the side of demand. Keynes however neglected the supply effect of investment. The fact is that one period net investment by augmenting the economy productive capacity in that period increase the next period potential output making it necessary for the aggregate demand to increase in next time period if the expanded productive capacity of the economy is to be fully utilised. It therefore follows that if the net investment is taking place in the economy in each time period, then the aggregate demand has to keeps on increasing in each subsequent time period to ensure full utilisation of economy expanding productive capacity. Both harrod as well as Domar assume of fixed capital output ratio .i.e. rigid relationship between the capital stock and output. We will first discuss Do mar growth model and thereafter Harrod growth model.