Vol.1, Issue 3
May - June 2003
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Understanding Economic Dynamics
by Mohammad Mojtahedzadeh

Traditionally, economists use mathematics often in the form of difference or differential equations to develop models of dynamic processes in economics. The obscurity of mathematics has led many economists to believe that the methods of dynamic economics are difficult and accessible only to students having a reasonably advanced level of mathematical training. This column attempts to show that systems thinking tools and simulation techniques can aid in the understanding of economic dynamics without the need for advanced analytical mathematics.

Let's take a look at the Harrod-Domar model of economic growth developed in the late 1940s. The basic idea of the Harrod-Domar model is that economic prosperity and growth occurs through a reinforcing process where capital is accumulated. Given the assumptions of the model, the rate of an economy depends on two things: the propensity to save and the capital-output-ratio, a constant that turns capital into production.
About this Column

This column will be devoted to the applications of systems thinking and simulation in economic dynamics. Our objective is to show how systems thinking tools and simulation techniques facilitate learning about the complexity of economic dynamics. This month's column is devoted to the Harrod-Domar model of economic growth. Please send your feedback and, comments to mohammad@attunegroup.com.

About the Author

Mohammad Mojtahedzadeh is the managing director of Attune Group, Inc an organization aspiring to bring systems thinking capabilities into the workplace. Attune Group, Inc develops state-of-the-art analytical techniques and tools that help organizations better visualize, analyze, and communicate business strategy, operational management, and information systems. Dr Mojtahedzadeh holds a PhD in system dynamics from University at Albany and a degree in Economics from University of Tehran, Iran.

Attune Group, Inc.
Mohammad Mojtahedzadeh
mohammad@attunegroup.com
Figure 1 shows the structure of the Harrod-Domar model in iThink®/STELLA®. The diagram presents three important aspects of the model which one can easily see and recognize:
  1. It shows the stock of capital and the flows (investment and depreciation) that change the stock.
  2. The diagram reveals the reinforcing process that creates the economic growth. A higher stock of capital leads to a higher production, which leads to a higher savings that in turn leads to a higher investment, which increases the stock of capital.
  3. The diagram shows a balancing process that tends to offset the rate of economic growth. A higher stock of capital leads to higher depreciation, which decreases the stock of capital.
Although mathematical equations of the Harrod-Domar model contain all the information shown in the diagram, they, nonetheless, do not easily communicate the existence of accumulation point (stock of capital) or reveal the reinforcing and balancing processes that exist in the model.

Now the remaining question is how we learn about the implications of the Harrod-Domar model of macro-dynamic growth. What is the growth rate of production in the long run? What if propensity to save is increased (or decreased)? What would happen if a technological improvement caused the capital-output-ratio to decrease?

Do we need to engage in analytical mathematics to arrive at the robust answers to the questions posed above? My answer to this is, "not necessarily". Actually simulation can help to provide answers to a vast variety of "what-if" questions. Figure 2 depicts how the slider input device in iThink and STELLA helps the user to see and compare the time path of economic growth under different conditions.

Figure 2 show that a decrease in capital-output-ratio due to a boost in technology causes the annual growth rate to rise from 5 percent to 7.5 percent. The figure also makes the point that a sudden change in technology may create a transient high economic growth rate that is well above its equilibrium value.

The Harrod-Domar model of economic growth is simple. The analytical mathematics required to investigate the model is not so complicated after all. However, if we decide to change some of the simplistic assumptions in this model, the mathematics will very quickly become increasing sophisticated.

Having said that, we are not trying to undermine the importance of mathematics in economics and social sciences. Rather we claim that systems thinking tools and simulation techniques enable us to easily and effectively learn about the complexity of economic dynamics without the need for analytical mathematics.

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