The Harrod-Domar (H-D) theory of economic growth was the first to question the amount
investment must rise to permit continuous full employment equilibrium income growth
(Harrod, The Economic Journal, 1939; Domar, Econometrica, 1946). In short, H-D developed
the equation specifying the growth rate of investment necessary to permit capital
to remain fully employed. Growth theory itself has grown with many authors following
the lead of Solow and Swan (Solow, Quarterly Journal of Economics, 1956; Swan, Economic
Record, 1956). The initial model has been criticized for several reasons. The absence
of labor market considerations and the assumption of a fixed capital-output ratio
are two examples. In spite of the criticisms, this model was the first to present
the critical dual role of investment as demand-creating and supply-creating.
Previous works (Hochstein, International Advances in Economic Research, 2006; 2017)
depicted how the initial H-D model can be illustrated on a production possibility
curve and incorporated into the investment savings liquidity preference money supply
(IS,LM) structure. Hochstein (International Advances in Economic Research, 2006) shows
that the model can be illustrated by computing the investment amount necessary to
permit a free market to jump from a point on one production possibility curve to another
point on a shifted curve. Hochstein (International Advances in Economic Research,
2017) outlines the important role of the money market, represented by the LM curve.
It is argued that if the model starts off in the liquidity trap region of the LM curve
and the investment demand curve increases, shifting the IS curve, interest rates remain
constant and the money market does not cause issues of concern. If the world begins
in the intermediate range of the LM curve, as investment shifts, income rises, interest
rates rise and crowd out some investment intentions. In the classical range, higher
interest rates completely crowd out intended investment. In this range, full employment
income growth cannot prevail. One would end up inside a shifting production possibility
curve. This note expands on the work of Hochstein (International Advances in Economic
Research, 2017) by incorporating the elasticity of the investment demand curve as
the investment curve shifts.
The H-D growth model, using modern terminology, is as follows. Assume, as the model
implicitly assumes, that interest rates are given and fixed. Begin at full employment
income where saving equals investment in a two-sector model. To generate full capacity
use of the net investment, one needs to know how much investment must rise (or the
investment curve must shift) to permit the new equilibrium income to be the appropriate
full employment one.
Consider starting at general equilibrium in the IS, LM model. Let IS shift to the
right due to an investment increase. To repeat, in the liquidity trap region of the
LM curve, interest rates are fixed and pose no problem. In the classical region, interest
rate increases completely crowd out needed investment. Growth is not possible. In
the intermediate region of the LM curve, when investment increases, the demand for
money rises, and with a fixed money supply, the money market will force interest rates
up. Higher interest rates cut investment. While the shift in the investment curve
is a necessary condition, it is not a sufficient condition to bring us to full employment
income. If the shifted investment demand curve is interest inelastic, overall investment
will not fall very much if interest rates rise. Full employment growth can still occur
in an increasing interest rate environment. However, suppose the investment demand
curve is highly interest-elastic. Higher interest rates will significantly reduce
profitable investment opportunities. In this case, it is very possible that the investment
curve may not be able to shift enough to permit the appropriate amount of actual investment
to take place. Unlike the case of the inelastic investment curve scenario, in this
case, full employment economic growth is an uncertain issue.
In summary, full employment income levels are critically dependent upon the elasticity
of investment demand, at least in the intermediate region of the LM curve. Consequently,
discussion of the factors that affect the slope and elasticity of the investment demand
curve become paramount when considering full employment economic growth. Without empirical
data, one can only speculate about this issue at the moment. This note is written
in the middle of the disastrous worldwide corona virus pandemic. If aggregate demand
remains low for a while after a slow return to work is implemented, and if interest
rates rise, there will be very few profitable investment projects on the shelf. Sadly,
the investment demand curve today is most likely to be highly interest-elastic. Full
employment growth of capital is unlikely in the current environment.