Behavioral expectation formation and the knife-edge : another look at Harrod

One of the many interesting controversies in economics concerns Harrod's "knife-edge" or Harrod's "razor’s edge". In 1939, Sir Roy Harrod published a paper in which he presented a dynamic macroeconomic model that appeared to have an unstable golden age growth path. If an external shock knocks Harrod’s model economy off this path it never returns, hence the term knife-edge. Although Harrod acknowledged that the golden age path is unstable, he objected to the concept of the knife-edge. He argued instead that the system's inherent instability leads to the trade cycle, which is an oscillation around the golden age path. In his subsequent writings, Harrod emphasized the importance of managerial expectations as an underlying cause of the trade cycle. The purpose of this chapter is to explore the implications of adding an empirically grounded, mathematically and psychologically sound, expectations structure to Harrod’s original model in a manner consistent with Harrod’s writings. The chapter’s conclusion is that Harrod’s intuition was correct and that the concept of the knife-edge is questionable.