Economy

1. The Harrod-Domar growth model shows that investment and innovation generate both aggregate demand increases and aggregate supply increases, but because but the uncertainty of investment and innovation mean that growth in productive capacity is unlikely to generate its own demand. When investment falls, monetary policy may be necessary to spur new investment, and if excess capacity is so great that zero interest rates do not spur investment, expansionary fiscal policy is needed to substitute government demand for the missing investment demand for output. Harrod and Domar hypothesized that investment demand was a function of recent growth in the aggregate demand for output, YD = C + I = (1 − σ)YS + b(ΔYD). The economy is in equilibrium when desired investment equals actual savings, or when: ΔYD/YS = σ/b. However, that it is difficult to maintain this equilibrium. Because dynamically the growth of aggregate demand is equal to the growth of aggregate supply only if: ΔYD/YD = σ/b = ΔYS/YS = σ/γ. Thus, the economy continues on a given growth path only as as long as b = γ. This equality is unlikely to hold, however. As discussed above, in the real world γ is not a constant, and the parameter b is dependent on the volatile state of investor confidence, or what Keynes called animal spirits. If intended investment, ID, declines, say because something happens to undermine confidence in the future, then b effectively falls and intended investment falls below the savings available for investors: ID = b(ΔYD) < σYS . On the other hand, if for some reason a bout of optimism raises b so that b(ΔYD) > σYS, an upward spiraling economic boom develops. If full employment is reached, then an inflationary spiral could result. This instability of the dynamic economy is often referred to as the knife’s edge of the Harrod-Domar model. Anything that drives the economy out of equilibrium causes a continuous output spiral away from equilibrium. It takes active policy...