Questions: The Harrod-Domar Growth Model and the Financing Gap

Question 1

In the Harrod-Domar model with no depreciation, a country saves 20% of output and has a capital-output ratio of 4. What is its growth rate?

• A. 4%
• B. 5%
• C. 16%
• D. 80%

Answer: (B)

g = s/v = 0.20 / 4 = 0.05, or 5% per year. Each year investment adds 20% of output to capital, and since output is capital divided by 4, output grows by 0.20 / 4 = 5%.

Question 2

A government targets 7% growth. The capital-output ratio is 3 and depreciation is zero. Domestic saving is 15% of GDP. In financing-gap reasoning, how large is the gap?

• A. 6% of GDP
• B. 7% of GDP
• C. 15% of GDP
• D. 21% of GDP

Answer: (A)

Required investment is s = g × v = 0.07 × 3 = 21% of GDP. Domestic saving covers 15%, leaving a gap of 6% of GDP to be filled from foreign sources under the model's assumptions.

Question 3

In the Harrod-Domar model, a permanent rise in the saving rate permanently raises the growth rate of output.

• T. True
• F. False

Answer: True

Because the capital-output ratio is fixed, growth equals s/v − δ, so a higher s raises g for good. In the Solow model, by contrast, diminishing returns mean a higher saving rate raises growth only during the transition to a new steady state.

Question 4

Give two reasons why the Harrod-Domar model is now considered a poor guide to development policy.

Model answer: First, it treats the capital-output ratio as fixed, ignoring diminishing returns and the ways technology and efficiency change how much output capital produces. Second, it treats saving and investment as sufficient for growth, ignoring institutions, human capital, and incentives that determine whether investment is productive; aid also need not become investment one for one.

William Easterly's 1999 critique of the financing-gap approach found little evidence that aid and investment predicted growth in the way the model implies.