In the Harrod-Domar (H-D) model of economic-growth investors
or producers track and compare actual-growth-rate and warranted-growth-rate to
arrive at investment decisions. Actual growth is what the economy achieves and
warranted growth rate is what the official data projects.
In the model, the economy is on the knife-edge… means when
the actual growth rate diverges from the warranted growth rate; the real
effects of the disturbances are cumulative in nature.
When actual growth rate is less than the warranted growth
rate investors expect less aggregate demand (A-D) and they invest less and
every time they invest less (actual) growth rate falls and the economy falls in
a downward spiral, less demand and less growth… On the other hand, if actual
growth rate exceeds the warranted growth rate, they (investors) expect more and
more demand, and the economy booms…
Nevertheless, this trend is observable to an extent, but
with a difference… It is true that an economy takes several rounds of
exuberance during booms and busts and it takes few rounds before people realize
that they were wrong… It happens every time… Every economy goes through
credit-boom and trade-cycles…
The indicator (actual growth rate) which the investors
accept as a signal of the aggregate demand has now become old and now the
investors take prices as the right signal of aggregate-demand. If they expect
higher prices they supply more…
Same like the Cobb-Douglas-Production-Function in case of
agricultural products. Prices in the past period are the right signal of the
aggregate demand… Supply is positively related to the prices. And, high
inflation means high demand…
In our H-D model which is considered to be a long run model
authors have totally ignored price changes and especially the price of capital,
interest rate, assumed constant, but interest-rates change in the long run,
which is a great cursor for investment, and more especially (ceteris paribus),
real-interest rate (real interest rate = nominal/money interest rate minus
inflation), according to Fisher, who gave us the Quantity-Theory-of-Money …
If we try to see this model in the context of the Indian economy
where actual growth rate was less than the warranted growth rate (projections)
for the past three years, there had been a negative sentiment as far as growth
rate of the economy is concerned and the economy is going through the bottom
because we expect interest rates to go up, if supply side constraints are not
removed and inflation comes down…
So if, investors expect the growth rate of Indian economy to
go up they will invest more and moreover the real interest rate in the Indian
Economy is also near zero which are great signals for investment and
production… The argument is simple, if inflation goes up it reduces the value
of money and, therefore, of the debt goes down. The income distribution will
move in favor of the debtor, but the central banks job is to keep the value of
money stable so that it does not add to income inequality…
However, the knife-edge problem remains unsolved even in case of real interest rate…
Because, in the Indian economy inflation is high and real
interest rate is near zero and if the investors and producers view it as a
trigger for investment he will invest more and it will generate more inflation
in the face of supply side bottlenecks and real interest will fall more and
people will invest more…
Economy is on the knife-edge…
Over-supply is normal after booms…
Our economists are still without a demand equation which can
be solved to arrive at supply decisions…
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