The Review of Economic Studies, Ltd.

A Note on the Price Level and Interest Rate in a Growth Model Author(s): Robert Solow Reviewed work(s): Source: The Review of Economic Studies, Vol. 21, No. 1 (1953 - 1954), pp. 74-79 Published by: Oxford University Press Stable URL: http://www.jstor.org/stable/2296261 . Accessed: 20/01/2013 19:24
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Note Rate

on

the in
a

Price

Level

and Model

Interest

Growth

In working out a dynamical version of Professor Leontief's input-output system it is usually assumed that the production of one unit of a commodity, say the jth, requires aij units of the i'th commodity as current input and bij units of the i'th commodity in the form of (for convenience, non-depreciating)capital stock.' Thus if xj, the output of commodity j, increases by Axj, the j'th industry must acquire bij Axj units of the i'th commodity, as fixed investment. These are changes in time, but may be thought of as occurring along a capital-output schedule. If now we take a closed system, one with no autonomous final demands, a simple balancing-up of outputs with purchases leads to the equation
,n tn

xi=-

aijxj +

Axj bij

11,

,n

Now banish the thought that a and b are matrices and xt is a vector and think of these quantities as ordinary numbers. Then equation (I) looks suspiciously like Mr. Harrod's system.2 In fact, deep down, it is Mr. Harrod's system. This takes a little arguing. x is now a measure of real output or income, with the difficult index-number problem waived. The coefficient b measures the quantity of real commodities needed as capital per unit of current output ; it is an acceleration coefficient, both in the Leontief and Harrod formulations. With a we have some difficulty. In the inputoutput model a represents current input requirements per unit of output, a technological datum. In the Harrod model a would be the average propensity to consume and I - a the savings ratio. But a man from Mars observing a Harrod economy in operation, and ignorant of the social organisation underlying it, would see only that a fraction a of each period's output was always consumed. It would look to him quite as if the consumption of ax were required for the production of the remaining (i - a)x of output, perhaps as subsistence for the population. If, as Harrod assumes, consumption plans are always realised so that a constant fraction of output produced disappears into consumption, it is exactly as if we were to regard the saved-invested portion of output as being produced from consumption and the services of capital. The two interpretations of the coefficient a collapse into one.3
1 See, for instance, Leontief et al., Studies in the Structure of the American Economy, Oxford University Press, New York, I953, Chapter 3. 2 R. F. Harrod: " An Essay in Dynamic Theory," Economic Journal, March, I939, pp. 17-I8. The strong analogy between the statical Leontief and Keynesian systems has been noted by Goodwin, " The Multiplier as Matrix," Economic Journal, December, I949, p. 537. See also J. Chipman, The Theory of Intersectoral Money Flows and Income Formation, Johns Hopkins University Press, Baltimore, 195I, and R. Solow, " The Structure of Linear Models," Econometrica, January, I952, p. 29. The same kind of theoretical system was formulated quite explicitly by Evsey Domar in " Capital Expansion, Rate of Growth, and Employment," Econometrica, April, 1946, p. I37, and subsequent papers, where the treatment is even more clear-cut than Harrod's. I refer to Harrod instead only because I here follow Harrod in the use of discrete time periods. 3 I stress that we know there is no necessary identity between the " cost " of producing labour and the fraction of their income that people choose to consume. But this is a sociological fact with a rigid consumption function the national income totals will look quite as if this connection existed. To translate the social facts into the model would simply require an explicit supply-of-labour schedule.

this in matrix form, with a = (aij) and b -, (bij), thus : (I - a)xt = bAxt = b(xt - xt1) ........................

For a moment (and only for a moment, the reader may be assured) let me write
(I)

74

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A NOTE ON THE PRICE LEVEL

75

There is another important aspect of this identification of the Leontief and Harrod dynamic models. Both trace out moving equilibriumpaths, describe what must be the course of events if equilibrium is to be maintained. Neither model has anything to say about the actual time-path that will be followed by any economic system starting from arbitrary initial conditions. Neither model contemplates in any detail the possibility or consequences of a disequilibrium situation.1 And both models define equilibrium in essentially the same way, by the ex-postjustification of investment plans or, put differently, by the perpetual appropriateness of the existing capital stock to the currentlevel of output. Thus the simple version of the Harrod model is to be regarded as a special case of the Leontief dynamic system. In fact, the following remarks on the price and interest rate implications of the Harrod model arose out of an attempt to construct an appropriateprice theory for the dynamical input-output system (i). In the course of simplifying this work for exposition to students I found that even when limited to two commodities the arithmetic rapidly became forbiddingwithout matrix methods. After taking the further desperate step to a one-commodity economy, I soon realised that what was left was nothing but the Harrodmodel thinly disguised. Inevitably, in the passage from a many-commodity to a one-commodity world considerable analytic richness is lost, and many interesting varieties of price and output behaviour disappear. To mention just one example, no considerationof the role of relative prices is possible. But the analogy remains strong.2 II The Harrod equilibriumcondition, a one-commodity version of (i), is thus3
(i - a)xt = sxt = b(xtxt-1) ....................................
(2)

If this is to hold for every period of time, it must be that: t S / l b t + b s) xo .......................(3) Xt (b s) x0= That is, starting from any initial value, real output must grow like compound interest at the rate b-- per period. This is Harrod's warranted rate of growth.4 So far the discussion is entirely in terms of real quantities. Prices and the general price level play no part. Mr. Alexander is the only author who pays much attention to prices,
1 Harrod is, of course, quite interested in the consequences of departure from equilibrium growth, and in the instability of the latter. But he provides no explicit causal dynamics. 2 The above-mentioned treatment of prices and interest in the full dynamical input-output model will appear subsequently in a publication of Professor Leontief's Harvard Economic Research Project. 3 There is an objectionable simultaneity about this equation. The causal significance would be made clearer by a change in the timing to make the right-hand side of (2) read: b (xt+i - Xt). Fortunately this would make essentially no difference in the equilibrium growth pattern or in any of the results to be developed. 4 In order that this equilibrium path be actually maintainable certain rather specific assumptions about entrepreneurial behaviour must be made. This has been elucidated by Messrs. Alexander, Baumol, Harrod and others in the Economic Journal. Incidentally, miuch of this literature gives the distinct impression that there is something especially holy about compdund interest growth, or constant proportional growth. But these modes of behaviour are a simple consequence of the fact that the authors choose to make their savings and induced investment relations linear. Non-linear difference equations would lead to quite different equilibrium patterns of increase. The usual justification for the use of linear structural relations is that almost any old function can be approximated locally by a straight line. This is fine when the discussion turns on minor deviations from equilibrium in a dynamically stable system. But it is no justification at all in terms of models of long-run one-way growth. I might mention here that balanced growth of all outputs at a constant proportional rate is only one of various kinds of equilibrium motion for the Leontief system (I).

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76

THE REVIEW OF ECONOMIC STUDIES

and he is interested in the possibility of taking out part of an excessively large rate of real growth in price increases, rather than in the intrinsic logic of prices in this kind of system. One misses a price theory especially in the frequent discussions of resource ceilings and the consequences of approaching them. It is exactly in situations like this that prices matter. The present paper will only sketch the kind of long-runtheory of price that might go along with the Harrod system. Let pt represent the general price level in period t, the price of the composite commodity we have agreed to call output, and let rt be the money rate of interest in period t. Suppose perfect competition rules in the markets for output and capital. And finally, suppose that people are endowed with perfect foresight as to the future of prices, output, and interest rate. This is always a hard assumption to swallow, and it turns up often in economics. In the present context it is perhaps not so bad. For one thing we are not interested in deducing the implications of any particular method of forming expectations about the future ; we might just as well assume the future to be known. Secondly, we are concerned with a long-run equilibrium situation, which is hardly compatible with consistently false expectations. By assumption, b units of output are required as capital to produce one unit of output per period, every period, for the indefinite future. And of the gross output a fraction i - s is consumed, as input, leaving s as net return. In period t these b units of output are worth bpt. But in equilibriumthis collection of output must sell for the present value of the stream of net income it will throw off in the future. Were this not so an arbitrage process would be set in motion. If we think of this determination as taking place at the beginning of the period, the income stream begins with s units of net output worth spt in the currentperiod ; s units of net output worth spt + 1 in the next period, and with a present value of Ipt+ 1; followed by a net income in rt
t+ , and so forth. We have then: period t + 2 with present value (I +2 r (i + Yt) (i + rt + 1

sPt4-3. (4) ^spt2 + (i+rt) (I+rt+) (I+rt) (I+rt+) (I+rt+2) + ....(4) bPt=sPti+ +rt (Nothing essentially different happens if entrepreneurialhorizons are taken as finite.) Write the same equation for t - i, and subtract from (4):
bpt-

~bpt + P+ + ^ spt

bp-

= - spt-1 + (i = spt-+ (i rt--

-)

( st + ) bpt.

r +

Therefore:
Pt
(I

+ rt- ) b

Pt-,

......................................

(5)

This equation for the equilibrium price level could be obtained more simply by noting that the holder of b units of output has the option of selling at once or of producing s units of net output this period and selling the capital assets next period, and
in equilibrium the present value of these options must be equal. But the longer route taken here is perhaps more fundamental. The price equation (5) contains the rate of interest as an unknown function, but in terms of the latter it can be solved to give: Pt (I +
rO)

(I + r) . . . (I + rt-)

b)

Po

................

(6)

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A NOTE ON THE PRICE LEVEL

77

The equilibrium price path (6) differs from the equilibrium output path (3) in two ways. Note that the growth factor is turned upside down in the price solution. As equilibrium output grows, equilibrium price would decay away toward zeroexcept for the second difference, the factor (i + ro) (i + rl) . . . in (6). This is an accumulationfunction; it is the value at the beginning of period t of one dollar invested at the beginning of period 0 and reinvested every period since. The equilibriumpattern of prices depends on the course of the interest rate over time. Before pursuing this trail any further, there are a few interesting observations we can make which do not depend on the particular history of the rate of interest. If we multiply correspondingmembers of (3) and (6), we find:
Ptxt=
(I + ro) (I + ) * .

(I + rt-1)

POX0..........................(7)

This asserts that if the money value of output at any time is discounted back to some earlier period, the discounted value will just equal the money value of output at the earlier period. In other words, the money value of output at any period, if invested and reinvested at the going rate of interest, will always just suffice to buy back the current output at current prices.' The logic of this result is that in an equilibrium system with perfect foresight the future is implicit in the present, a seed literally is its own future stream of net outputs of fruit, and must be worth the present value of its own future. If we multiply both sides of (7) by s we get the same kind of relation for net outputs, and if we multiply instead by b we find that the money value of the capital stock at any point of time, if discounted back to some common point, is always the same. From (7) it also follows that
Ptxt txt-=1Xt - 1t-l *ve**v.. r(8 ............................................... pt Pt-,1 Xt-, (8)

At every moment of time the rate of interest is equal to the relative rate of change of the money value of output, and trivially also equal to the relative rate of change of the money value of net output, and of the money value of the capital stock. Evidently, freed of all its allocative functions by our rigid assumptions, the price level acts, with the interest rate, as an intertemporal exchange ratio. It measures the future goods value of present goods, and in this light, and rememberingthe growth of equilibrium output according to (3), the price pattern (6) and its consequences seem reasonable characteristicsof equilibrium. III There remains the interest rate rt. As with this whole circle of ideas we want to know not what determines the rate of interest, but what determines the equilibrium rate of interest. One additional equilibriumcondition is needed to close up the system. There are undoubtedly several ways of doing this, each correspondingto a different set of assumptions about the banking system or the capital market. I propose to mention just one, which has interesting consequences. The net return to the owners of industry, after allowance for consumption is sptxt. In equilibrium this net return is exactly equal to what could be earned, at the
'All such propositions describe the equilibrium or warranted time paths of output, price, and interest, not necessarily any observed or observable path.

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78

THE REVIEW OF ECONOMIC STUDIES

going rate of interest, on the capital committed to production.' The value of this capital is not, as might at first seem, bptxt. Owing to the peculiar timing of the original Harrod equation (2), which makes investment depend on the output of which it is itself a part, we make all our valuations at the beginning of the period. Thus the amount of capital on which interest would be earned in period t is what is left over from the previous period valued at the new prices, bptxt-1. The interest earnable on this amount is rtbptxt-1. If we put this equal to the net return from production sptxt we find, using (2):
sptxt 'bpbbb. S

bptxt-,

b b - s=

s b- s

...............................

(9

(9)

We conclude that if the rate of interest functions to maintain the kind of equilibrium in the capital market described,above, the interest rate will remain constant and (compare (3)) equal to the equilibrium or warranted rate of growth of output. Moreover,insert (9) into (6) and it develops that ....... (IO) b s b Po= &-b Po = Po ..... If the rate of interest begins and stays at its equilibrium value, then the equilibrium price level is constant at its arbitrary initial value. This is not remarkable. With the interest rate equal to the rate of growth of output the single important structural fact about the equilibrium motion is already fully expressed. The intertemporal terms of trade are managed by the interest rate alone. The price level has no functions to perform and hence stays where it is put. 2 What is implied here is that on the real side either the price time-series or the interest time-series is redundant. The price level can be arbitrarilyset, given any time shape and the interest rate maintains allocational equilibrium according to (5). Or the interest rate can be strait-jacketed and the burden of adjustment placed on the price-level accordingto (6). In the case of many commodities this connection between price theory and capital theory is even more interesting ; we can choose as our variables either the prices themselves or the own-interest rates. The two sets of variables are connected by relations which generalise (5). Once things get this complicated it would probably be an aid to clear thinking to be explicit about factor supplies so that the rate of saving and the rate at which inputs can be transformed into net product are not confounded as they are in our notation. The arbitrarinesswhich appears to be introduced by the interchangeability of prices and own-rates of interest is used up when we introduce monetary or capital-market considerations.
pt =

IV There is something missing in all this, or rather a number of related things. In the first place, what happens if the interest rate and the price level are not at their equilibrium values ? It would not be excessively difficult to formulate a set of more or less reasonableassumptionswhich would enable us to conclude either that deviations from the path (6) will be eliminated over time, or grow larger over time : either that
1 It turns out that this automatically entails that each period's interest earnings are just equal to the same period's net investment outlays in current prices. That this should be so is an alternative equilibrium condition. Owners of capital cannot have a less-than-unit propensity to invest, since directly or indirectly capital stock is the only earning asset available. 2 These results can also be obtained by the methods of E. Malinvaud's fine paper " Capital Accumulation and Efficient Allocation of Resources," Econometrica, April, 1953, p. 251. Since I introduce the interest rate explicitly my prices are what he calls " normalised." Thus (g) could be deduced from (Io), which says that the normalised price level is constant. Other normalisation rules yield other price behaviour.

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A NOTE ON 'THE PRICE LEVEL

79

the equilibriumprice-interest path is stable or unstable. This is Mr. Harrod'sprocedure with respect to output. One can't help wishing, however, for a more complete causal dynamics of-the kind uslial in business cycle theory. In these terms questions beginning "What would happen if " would have exact answers. But what is really remarkableis that Harrod'sdiscovery of an equilibriumgrowth of output required no formal consideration of prices, and the development of a priceinterest equilibrium in Sections II and III above could have proceeded without reference to the equilibrium output path. Equations (2) and (5) are quite independent of each other. The equilibrium conditions for price and output are uncoupled. Economic of intuition says that this is all wrong. The equilibnrum output ought not to be main.tainable when prices are out of line, and vice versa. From another angle, the equations do not reflect the fact that one could affect output by operating on prices.' This would appear naturally in an attempt to build up a causal dynamics. A mechanical first step in this direction could be made by letting the choice between consumption and investment depend on the interest rate and price level in some arbitrary but simple way. I do not carry this out here, although the formal execution would be fairly easy, because I am not convinced that this obvious line of approachis necessarily the best one. Another possibility would be to think of investors as Ramsey-type utility maximisers over time. A certain amount of depth could be added by assuming the existence of two goods differentiated with respect to their utility in consumption and in investment. But this goes beyond the simple Harrod model and past the bounds of simple arithmetic. Cambridge,Mass.
ROBERT SOLOW.

1 Even more so in a many-commodity system when inter-commodity substitution possibilities are available as well as intertemporaL

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