The Solow Model

Denition 1: The steady state level of capital per

unit of eective labour, k, is the level of capital per
unit of eective labour that equates break even investment and actual investment i.e., sf (k) = (n+g+)k.
Denition 2: A balanced growth path is a situation
where each variable in the model is growing at a constant
rate.

Denition 3. The golden rule level of capital per

unit of eective labour, kG, is the steady state level of
capital per unit of eective labour that would maximize
the steady state value of consumption per unit of eective
labour.

The Solow Model

Speed of convergence

here we will examine how to determine the rate at

which k approaches k

remember k(t) is a function of k(t) since

k(t) = sf (k(t)) (n + g + )k(t)

so k = k(k) and when k =

k ,

k=0

to determine the behaviour of k we will examine a

rst order Taylor series approx. of k(k) around the
point k = k(intuitively this 1st order approx. is
approximately the function around k = k by a line.

The Solow Model

The 1st order Taylor series approx. of a function
h(y) around the point x is
h(y) ' h(x) + h0(x)(y x)
then

k(k)

k(k) ' k(k ) +

(k k)

k
k=k

k(k)
(k k)
= 0+

Assume a Cobb-Douglas production function, that is

f (k) = k, then

k(k )
k

g + )

= sf 0(k) (n + g + ) = sk1 (n +

Since at k s
(n + g + )

(n+g+)k
,
k
3

then

k(k)
k

(n+g+)

= k1 k1

The Solow Model

k(k)
k

so
= ( 1)(n + g + ) subbing into the
original equation we get:

k(k(t)) ' ( 1)(n + g + )(k(t) k)

= (k(t) k)

where = (1 )(n + g + )
in the vicinity of the balanced growth path, the growth
rate of (k(t) k) is approximately constant and
equal to .
to see this note that the growth rate of (k(t) k)

k(t)

is (k(t)k) and we know from above this is approx

equal to
it follows that
(k(t) k) ' et(k(0) k)
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The Solow Model

the model also predicts that
(y(t) y ) ' et(y(0) y)
to see this formally remember y(t) = f (k(t)) so

y(t) =
we get

0
f (k(t))k(t)

then expanding around k = k

y(t) ' f (k) + f 0(k)(k(t) k)

(y(t) y ) ' f 0(k)(k(t) k)

so (y(t) y ) ' et(y(0) y )

The Solow Model

Example:
Population growth rate-2%
Growth in output per worker-2%
Depreciation rate-2%
= 1/3
then = (1 )(n + g + ) = (2/3)(6%) = 4%

k and y move 4% of the remaining distance towards

k and y each year
How long does it take to move 1/2 way to the balanced
growth path values
y(t) y
k(t) k
= 0.5 '
'
so

y(0) y
k(0) k
t = ln(0.5)
ln(0.5)
t =
' 17.33
0.04

et

The Solow Model

EVALUATION OF THE SOLOW MODEL.

Qualitative implications of the Solow model:

1. Per capita income levels are higher in economies with

higher investment (savings) rates.

2. Per capita income levels are lower in economies with

higher population growth rates.

3. Long run growth rates of per capita variables are

not aected by "policy" changes (changes in savings
rates, immigration etc.).

4. In the long run, changes in parameters have only

"level" eects.

The Solow Model

5. Economies with same saving rates, technology and
demographic parameters but dierent capital stocks
will eventually converge to the same per capita income level.

6. On the balanced growth path, income per capita

grows at a constant rate.

7. On the balanced growth path, the return of capital

is constant and the wage rate grows at a constant
rate (g).

8. On the balanced growth path, capital-output ratio is

constant.

9. On the balanced growth path, the shares of capital

and labour are constant.

The Solow Model

Quantitative implications of the Solow model:
Can the Solow model explain the "magnitude" of the
dierence in income per capita observed across countries?
Two sources of variation in income per capita:

Dierences in capital per worker across countries.

Example: y=k and = 1/3
If yRich/yP oor = 10
1000!!!

kRich 1/3
kP oor

= 10 kkRich =
P oor

This dierence in capital stocks would imply a huge difference in returns of capital:

rRich
rP oor

kRich 2/3
kP oor

1 , that is r
10002/3 = 100
P oor = 100 rRich.

The Solow Model

Dierences in capital stock across countries can account
for a small part of the dierences in income per capita
observed across countries.

Dierences in the eectiveness of productivity of labour,

A. W e can interpret A as education and skills of
labour force, the strength of property rights, the
quality of infrastructure, or a combination of all of
these forces.

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