The growth theory was achieved through the works of Harrod (1939) and Domar (1946). Harrod and Domar were both interested in ascertaining the growth rate of income which was seen as necessary condition for the smooth and uninterrupted functioning of the economy. While their works were both different, both arrived at a similar conclusion. Investment was assigned a key role but greater emphasis was laid on the dual nature it possessed. One of investments characteristic was its ability to create income and the other being its capacity to increase capital stock by supplementing the productive capacity of the economy (Jhingan, 2010). The former is the ‘demand effect’ of investment and the latter the ‘supply effect’.
They postulated that to maintain a full employment equilibrium level of income in the economy, both real income and output should expand at the same rate as the productive capacity of capital stock and if there ever was a shortfall in either, there would be an excess or idle capacity forcing entrepreneurs to limit their investment expenditure. This has the tendency to truncate economic growth and a lowering of incomes in the succeeding periods moving the economy off the path of equilibrium steady growth. Therefore, if full employment is to be maintained in the long run, there should be a continuous expansion of net investment which demands continuous growth in real income at a rate sufficient enough to ensure full utilisation of the growing stock of capital. This level of growth is what Harrod-Domar termed the warranted rate of growth or “full capacity growth rate”
In advanced countries, economic growth has been linked to core economic concepts. They include the following: the savings function, autonomous and induced investments, and the productivity of capital. The Harrod-Domar models were developed to direct attention and focus to stagnation in advanced nations in the post-war periods. Their application has been extended to developing economies. According to Hirschman (Jhingan, 2010), “The Domar model, in particular, has proved to be remarkably versatile, it permits us to show not only the rate at which the economy must grow if it is to make full use of the capacity created by new investment but inversely, the required savings and the capital-output ratios if income is to attain a certain target growth rate. In such exercises, the capital-output ratio is usually assumed at some value between 2.5 and 5; sometimes several alternative projections are undertaken; with given growth rates, overall or per capita, and with given population projections, in the latter case, total capital requirements for five- to ten-year plans are then easily derived”.
In modifying his model to make it more applicable to developing countries, Sir Roy Harrod emphasised on the supply side of his fundamental equation by illuminating the role of interest rate as the determinant in the supply of savings and the demand for savings.
It expanded on the Harrod-Domar formulation by adding a second factor, labour and introducing a third variable, technology, to the growth equation. Solow‟s neoclassical growth model exhibited diminishing returns to labour and capital separately and constant returns to both factors jointly. Technological progress because the residual factor explaining long term growth, and its level was assumed by Solow and other neoclassical growth theorists to be determined exogenously, that is, independently of all other factors. According to traditional neoclassical growth theory, output growth results from one or more of three factors; increase in labor quantity and quality (through population growth and education), increase in capital (through and investment), and improvements in technology. Closed economies with lower saving rates (other things being equal) grow more slowly in short run than those with high savings rates and tend to converge to lower per capita income levels. Open economies, however, experience income convergence at higher levels as capital flows from rich countries where capital-labor rations are lower and thus returns on investments are higher. Consequently, by impeding the inflow of foreign investment, the heavy-handedness of less developing countries governments, according to the neoclassical growth theory, will retard growth in the economics of the developing world. In addition, openness is said to encourage greater access to foreign production ideas that can raise the rate of technological progress.