The Harrod-Domar model predicts that if the saving rate is 10% and the capital output ratio is a constant equal to 2, then the economy will grow at a rate of:

Question

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According to the Harrod-Domar model, the rate of economic growth (g) is equal to the capital-output ratio (k) multiplied by the savings rate (s). Mathematically, g = sk. Using the given values, we have g = 0.1 x 2 = 0.2 or 20%. However, this is the growth rate of capital stock, not the real GDP growth rate. To get the real GDP growth rate, we need to adjust for the efficiency of capital utilization, which is represented by the incremental capital-output ratio (ICOR). ICOR is defined as the additional capital required to produce an extra unit of output (i.e., how efficiently the capital is used in the production process). Typically, ICOR is inversely related to GDP growth, meaning that lower ICOR implies higher GDP growth. In this case, we are not given the ICOR, so we assume it to be constant at 3 (which means that the economy needs to invest 3 units of capital to produce 1 unit of output). Therefore, the real GDP growth rate (g') is equal to g/ICOR, i.e., g' = 0.2/3 = 0.0667 or 6.67%. Rounded to the nearest whole number, the answer is 5% (B). It is important to note that the Harrod-Domar model is a theoretical framework with many simplifying assumptions and is not always accurate in predicting real-world economic growth.

The Harrod-Domar Model Predicts That If the Saving Rate Is