Harrod domar model

3.6 THE IMPORTANCE AND LIMITATIONS OF THE MODELS TO UNDERDEVELOPED COUNTRIES
The Harrod-Domar model like we have been taught was formulated to maintain the steady growth rate in developed economies of the world and not to address the problem of vicious cycle faced by the developing countries. Be that as it may, the model could still be used to aid in analyzing the growth process in less developed countries. The importance of this model to the developing countries is explained below.
The Harrods-Domar models are based on three principal concepts: the saving function, autonomous vs. induced investment, and the productivity of capital. These concepts were primarily developed in order to illuminate secular stagnation that was threatening the advanced economies in the post-war period. The models show us the rate at which the economy must grow if it is to make full use of the capacity created by new investment and it gave a projection of capital-output ratio of between 2.5 and 5, this rate can also be applied in less developed countries.
Harrod in his Second Essay on Dynamic Theory which he tagged “natural rate of interest”, tried to make his model more applicable to underdeveloped countries. He carefully elaborated the supply side of his fundamental equation by introducing the role of interest rate in determining the supply of savings and the demand for savings. He observed a significant influence between interest and growth rate of income and defined the natural rate of interest (rn) as the ratio of the natural growth rate of per capita output (Pc) and the natural growth rate of income (Gn) to the elasticity of diminishing utility of income (e). So we have: rn/e = Pc.Gn
Taking the values of Pc and Gn as given, the natural rate of interest depends on the value of e which is assumed to be less than Unity (1), meaning that rn and e are inversely related to each other. When e is small, rn is high and vice versa.
Harrod, recognising the fact that the less developed countries have low savings, high level of investment and chronic inflation, suggests the financing of large investments through the expansion of bank credit. But there are no organised capital markets in such economies, therefore, expansion of bank credit is the only way to finance investments and generate economic growth. Low savings in an underdeveloped country is responsible for the low rate of growth and the existence of mass unemployment and underemployment.
SELF ASSESSMENT EXERCISE
Is the Harrod- Domar model important to the developing countries? Give reason(s)