Harrod-Domar model, the money market and the elasticity of the investment demand curve

The Harrod-Domar model of economic growth is the first economic model to examine the idea of the necessary conditions for economic growth. The standard Keynesian model can describe what needs to be done to get the economic system to full employment and a maximum output static position. But Keynes did not consider the important question as to what is necessary to keep us on a full employment moving path even if we are able to get to its starting position. The Harrod-Domar growth model addresses that point. It looks at the conditions that are necessary to maintain full employment of capital (assuming labour adjusts quickly and easily) over an economic time period in which production conditions change. The origin of the model is from two journal articles written by economists independently of each other: Roy Harrod (1939) "An Essay in Dynamic Theory". The Economic Journal and Evsey Domar (1946). "Capital Expansion, Rate of Growth, and Employment". Econometrica.

This paper presents the original model which describes the necessary growth rate of investment to maintain a full employment path. We show that it ignores the money market’s impact on the results. The model itself is put into an investment-saving (IS) curve framework and the money market is added via the introduction of the liquidity preference-money supply (LM) curve. It will be clear that the impact on growth depends critically on the elasticity of the investment demand curve and where in the three-stage LM curve (Keynesian, intermediate and Classical regions) the general equilibrium position starts and ends. The reason the money market is so important is because that is where interest rates are determined. And, of course, interest rates affect investment.