This simply states that the growth rate (G) of GDP is jointly determined by

the savings ratio (s) divided by the capital“output ratio (v). The higher the

savings ratio and the lower the capital“output ratio and depreciation rate, the

faster will an economy grow. In the discussion that follows we will ignore the

depreciation rate and consider the Harrod“Domar model as being represented

by the equation (11.14):

G = s/v (11.14)

Thus it is evident from (11.14) that the Harrod“Domar model ˜sanctioned the

overriding importance of capital accumulation in the quest for enhanced

growth™ (Shaw, 1992).

The Harrod“Domar model, as Bhagwati recalls, became tremendously

in¬‚uential in the development economics literature during the third quarter of

the twentieth century, and was a key component within the framework of

economic planning. ˜The implications of this popular model were dramatic

and reassuring. It suggested that the central developmental problem was

simply to increase resources devoted to investment™ (Bhagwati, 1984). For

example, if a developing country desired to achieve a growth rate of per

capita income of 2 per cent per annum (that is, living standards double every

35 years), and population is estimated to be growing at 2 per cent, then

economic planners would need to set a target rate of GDP growth (G*) equal

to 4 per cent. If v = 4, this implies that G* can only be achieved with a desired

savings ratio (s*) of 0.16, or 16 per cent of GDP. If s* > s, there is a ˜savings

gap™, and planners needed to devise policies for plugging this gap.

Since the rate of growth in the Harrod“Domar model is positively related

to the savings ratio, development economists during the 1950s concentrated

their research effort on understanding how to raise private savings ratios in

order to enable less developed economies to ˜take off™ into ˜self-sustained

growth™ (Lewis, 1954, 1955; Rostow, 1960; Easterly, 1999). Re¬‚ecting the

contemporary development ideas of the 1950s, government ¬scal policy was

also seen to have a prominent role to play since budgetary surpluses could (in

theory) substitute for private domestic savings. If domestic sources of ¬nance

The renaissance of economic growth research 601

were inadequate to achieve the desired growth target, then foreign aid could

¬ll the ˜savings gap™ (Riddell, 1987). Aid requirements (Ar) would simply be

calculated as s* “ s = Ar (Chenery and Strout, 1966). However, a major

weakness of the Harrod“Domar approach is the assumption of a ¬xed capi-

tal“output ratio. Since the inverse of v (1/v) is the productivity of investment

(φ), we can rewrite equation (11.14) as follows:

G = sφ (11.15)

Unfortunately, as Bhagwati (1993) observes, the productivity of investment is

not a given, but re¬‚ects the ef¬ciency of the policy framework and the

incentive structures within which investment decisions are taken. The weak

growth performance of India before the 1980s re¬‚ects, ˜not a disappointing

savings performance, but rather a disappointing productivity performance™

(Bhagwati, 1993). Hence the growth“investment relationship turned out to be

˜loose and unstable™ due to the multiple factors that in¬‚uence growth (East-

erly, 2001a). Furthermore, economists soon became aware of a second major

¬‚aw in the ˜aid requirements™ or ˜¬nancing gap™ model. The model assumed

that aid in¬‚ows would go into investment one to one. But it soon became

apparent that in¬‚ows of foreign aid, with the objective of closing the savings

gap, did not necessarily boost total savings. Aid does not go into investment

one to one. Indeed, in many cases in¬‚ows of aid led to a reduction of

domestic savings together with a decline in the productivity of investment

(Grif¬n, 1970; White, 1992). The research of Boone (1996) con¬rms that

in¬‚ows of foreign aid have not raised growth rates in most recipient develop-

ing countries. A further problem is that in many developing countries the

˜soft budget constraints™ operating within the public sector created a climate

for what Bhagwati calls ˜goo¬ng off™. It is therefore hardly surprising that

public sector enterprises frequently failed to generate pro¬ts intended to add

to government saving. In short, ˜capital fundamentalism™ and the ˜aid-¬-

nanced investment fetish™, which dominated development thinking for much

of the period after 1950, led economists up the wrong path in their ˜elusive

quest for growth™ (King and Levine, 1994; Easterly, 2001a, 2003; Easterly et

al., 2003; Snowdon, 2003a). Indeed, William Easterly (1999), a former World

Bank economist, argues that the Harrod“Domar model is far from dead and

still continues to exercise considerable in¬‚uence on economists working

within the major international ¬nancial institutions even if it died long ago in

the academic literature. Easterly shows that economists working at the World

Bank, International Monetary Fund, Inter-American Bank, European Bank

for Reconstruction and Development, and the International Labour Organiza-

tion still frequently employ the Harrod“Domar“Chenery“Strout methodology

to calculate the investment and aid requirements needed in order for speci¬c

602 Modern macroeconomics

countries to achieve their growth targets. However, as Easterly convincingly

demonstrates, the evidence that aid ¬‚ows into investment on a one-for-one

basis, and that there is a ¬xed linear relationship between growth and invest-

ment in the short run, is ˜soundly rejected™.

A further weakness of the Harrod“Domar framework is the assumption of

zero substitutability between capital and labour (that is, a ¬xed factor propor-

tions production function). This is a ˜crucial™ but inappropriate assumption

for a model concerned with long-run growth. This assumption of the Harrod“

Domar model also leads to the renowned instability property that ˜even for

the long run an economic system is at best balanced on a knife-edge equilib-

rium growth™ (Solow, 1956). In Harrod™s model the possibility of achieving

steady growth with full employment was remote. Only in very special cir-

cumstances will an economy remain in equilibrium with full employment of

both labour and capital. As Solow (1988) noted in his Nobel Memorial

lecture, to achieve steady growth in a Harrod“Domar world would be ˜a

miraculous stroke of luck™. The problem arises from the assumption of a

production function with an in¬‚exible technology. In the Harrod“Domar

model the capital“output ratio (K/Y) and the capital“labour ratio (K/L) are

assumed constant. In a growth setting this means that K and Y must always

grow at the same rate to maintain equilibrium. However, because the model

also assumes a constant capital“labour ratio (K/L), K and L must also grow at

the same rate. Therefore, if we assume that the labour force (L) grows at the

same rate as the rate of growth of population (n), then we can conclude that

the only way that equilibrium can be maintained in the model is for n = G =

s/v. It would only be by pure coincidence that n = G. If n > G, the result will

be continually rising unemployment. If G > n, the capital stock will become

increasingly idle and the growth rate of output will slow down to G = n.

Thus, whenever K and L do not grow at the same rate, the economy falls off

its equilibrium ˜knife-edge™ growth path. However, the evidence is over-

whelming that this property does not ¬t well with the actual experience of

growth (for a more detailed discussion of the Harrod“Domar model see Hahn

and Matthews, 1964; H. Jones, 1975).

11.10 The Solow Neoclassical Growth Model

Following the seminal contributions of Solow (1956, 1957) and Swan (1956),

the neoclassical model became the dominant approach to the analysis of

growth, at least within academia. Between 1956 and 1970 economists re¬ned

˜old growth theory™, better known as the Solow neoclassical model of eco-

nomic growth (Solow, 2000, 2002). Building on a neoclassical production

function framework, the Solow model highlights the impact on growth of

saving, population growth and technolgical progress in a closed economy

The renaissance of economic growth research 603

setting without a government sector. Despite recent developments in endog-

enous growth theory, the Solow model remains the essential starting point to

any discussion of economic growth. As Mankiw (1995, 2003) notes, when-

ever practical macroeconomists have to answer questions about long-run

growth they usually begin with a simple neoclassical growth model (see also

Abel and Bernanke, 2001; Jones, 2001a; Barro and Sala-i-Martin, 2003).

The key assumptions of the Solow model are: (i) for simplicity it is as-

sumed that the economy consists of one sector producing one type of

commodity that can be used for either investment or consumption purposes;

(ii) the economy is closed to international transactions and the government

sector is ignored; (iii) all output that is saved is invested; that is, in the Solow

model the absence of a separate investment function implies that Keynesian

dif¬culties are eliminated since ex ante saving and ex ante investment are

always equivalent; (iv) since the model is concerned with the long run there

are no Keynesian stability problems; that is, the assumptions of full price

¬‚exibility and monetary neutrality apply and the economy is always produc-

ing its potential (natural) level of total output; (v) Solow abandons the

Harrod“Domar assumptions of a ¬xed capital“output ratio (K/Y) and ¬xed

capital“labour ratio (K/L); (vi) the rate of technological progress, population

growth and the depreciation rate of the capital stock are all determined

exogenously.

Given these assumptions we can concentrate on developing the three key

relationships in the Solow model, namely, the production function, the con-

sumption function and the capital accumulation process.