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      Question

      In the Harrod-Domar model, which scenario correctly

      characterises the instability (knife-edge) principle?
      A If G > Gw, entrepreneurs find inventories depleting — they increase investment, pushing G further above Gw — a self-reinforcing boom; if G < Gw, the reverse — a self-reinforcing recession Correct Answer Incorrect Answer
      B If Gw > Gn, the economy automatically adjusts through flexible factor prices until G = Gw = Gn Correct Answer Incorrect Answer
      C If G > Gw, excess capacity builds up, discouraging investment and pulling G back toward Gw — the model is self-stabilising Correct Answer Incorrect Answer
      D The knife-edge problem disappears in the long run because the saving rate s adjusts to close the gap between Gw and Gn Correct Answer Incorrect Answer

      Solution

      If G > Gw: demand exceeded expectations → inventories deplete → entrepreneurs increase investment → income and demand rise further → G diverges even further above Gw. The system is inherently UNSTABLE (self-reinforcing deviation). This is the knife-edge. • (C) describes the OPPOSITE (incorrect) adjustment direction. • (D) describes a Solovian fix that Harrod-Domar explicitly lacks (saving rate is fixed exogenously).

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