Answer to Question #317760 in Macroeconomics for Ash

Question

What constitutes the knife-edge instability problem in the Harrod model? Give a formal 

proof and illustrate with an example.

Answer 1

Harrod's model implies unstable growth given that the warranted rate of growth is a unique moving equilibrium, but a highly instable one, and this property is known as the knife-edge instability problem. If firms adjusted investment according to their anticipations about future demand, and anticipated demand was forthcoming, warranted growth would equal actual growth. However, if the actual demand was more than anticipated demand, an underinvestment would have occurred, and the firms would respond by investing further. The result would be explosive growth. Vice versa, if actual demand fell behind anticipated demand, a deceleration of growth would result. For instance, if a company projects future demand and adjusts accordingly, but actual demand exceeds the projected demand, then the company has underinvested and will most likely invest some more, leading to explosive growth.