Tushar Kelkar

Week 1 Macroeconomics: Solow-Swan Model

How does a permanent increase in the saving rate change the
growth rate of output per worker and the level of output per worker
in the Solow-Model?
Using the Solow model we see that an increase in the saving rate will lead to a
higher level of savings for every level of capital input this is an upwards shift of
the savings function, which is equal to the production function multiplied by the
savings rate. Because the savings rate is now closer to the value of 1, it is an
upwards shift at every point (apart from the origin). If we are assuming that there
are no changes in population or productivity, then we will see an extension along
production function as capital per worker increases, k, an extension along the
new savings function leading to higher savings per worker, and an extension
along the investment function leading to higher investment per worker. Because
of the diminishing marginal product of capital we know that the increase in
savings per worker will be smaller than the increase in investment per worker for
all increases in capital per worker if we are assuming we begin from an
equilibrium steady state, where the capital worker is at the original steady state
level. The result is that we will see a new steady state emerge in future time
periods. This will result in a higher capital-labour ratio as capital per worker has
increased. There will be a higher output per worker because capital per worker
increases leading to an extension along the production function.
The change in the rate of savings will not change the growth rate out output per
worker, however, in the long-run. It will remain at the coefficient of the
investment function (the rate of depreciation). This is because, in the
intermediate period between the two steady states, whilst the growth rate does
increase as capital increases because there is now a large gap between the
investment and savings functions when the savings rate increases, this gap
becomes smaller as capital approaches the new steady state level of capital
again, capital faces diminishing marginal returns, and the gradient of the
investment function will be higher than the gradient of the savings function.
There will be increases in growth of output per worker, as the Classical growth
theory and the Harrod-Domar model tell us, but the Solow-Swan model indicates
that these changes are temporary, and there is no change in the long run for any
per capita endogenous value once we arrive at the new steady state level of
capital.

What about a permanent increase in the level of productivity?

If total factor productivity increases this will cause an upwards shift of the
savings function, as the savings rate is being multiplied by a higher coefficient. It
will also increase the production function by a stretch in the y-axis direction of
the same factor. The effect will be that at the original steady state level of capital
the output per worker is now higher. The savings per worker will also be higher
than investment per worker. This disequilibrium will lead to the level of capital
increasing, leading to a further increase in output per worker and savings per
worker, as well as investment per worker increasing. Capital per worker will

Tushar Kelkar
increase up to the point where a new steady state is achieved, and so a higher
output per worker is achieved. Again, however, this is a short-run increase in
growth of output per worker, and we will see no change in the long run to
economic growth (other things constant this will be zero as output rises
proportionally with population at the steady state level by definition).

What about a permanent increase in the rate of productivity growth?

Productivity growth is how much productivity increases per period of time. We
saw above that an increase in productivity that is permanent will lead to a short
run effect on growth of output per capita, and increases in savings, output, and
investment per capita, however in the long run we will see no growth in output
per capita. However, because technology, or productivity is not bound, like the
savings rate is, an increase in the rate of productivity growth means that we will
constantly be shifting our production functions (and savings functions) upwards,
leading to the same process described above, and leading to growth in output
per capita through the constant short run adjusting dynamics described by the
model.

Explain the meaning of the golden-rule level of savings.

For the given exogenous values population growth, technology, and depreciation,
there is one unique (non-zero) steady state level of capital per capita. The
Golden Rule level of savings is that level of savings which produces the
maximum level of consumption per person in the long run. This is the savings
rate which produces the steady state level of capital whereby the tangent to the
production function for that level of output per capita is equal to the effective
depreciation rate. This is because at this level the distance between the
production function and the relevant savings function is maximised. Because the
production function is a concave curve, this is at the point along the x-axis where
their gradients are equal. It is the Golden Rule because it follows the principle
of doing unto others what you would want them to do to you. In other words, the
trade off between current consumption and future consumption is solved by
ensuring that consumption per worker is maximised in the long run. Any other
steady state points would lead to dynamic inefficiencies. However, this may not
be the case if households heavily discount future consumption.

What does the Solow model with and without human capital (and
other) extensions say about convergence of growth rates between
countries?
Without human capital added to the model, we would expect poorer countries to
catch up with richer countries. For example, if a group of countries had similar
production functions, savings rate, population growth, and deterioration, but
different starting capital per capita, the countries with lower starting capital per
capita levels would have higher capital growth than the countries with higher
starting capital per capita levels. All countries would converge to similar steady
state levels of capital per worker and output per worker. This tells us that poorer
countries that may have initially suffered from war, famine, drought etc. and
have low levels of output per worker initially, despite having structurally similar

Tushar Kelkar
economies, will converge with richer economies and have the same output per
capita and capital per capita this is absolute convergence. This hypothesis
appears to hold true for data that considers similar economies, for example
states within the USA after the Civil War, where Southern States were more
adversely affected than Northern States, and hence had lower starting output
per worker, and capital per worker
If we consider the extension where economies are different and therefore will
converge to different steady states, we have the conditional convergence
hypothesis, whereby the economy that is further away from its steady state
values will grow faster (or contract faster). Here, if poor countries suffer from
lower savings rates than richer countries they may in fact grow slower than rich
countries, because the rate of growth of capital per worker is not as great as in
the rich country, because the savings function is shifted much further to the left
for the poor country.
The problem arises when the empirical data applied to the current Solow model
predicts a much higher level of convergence than there is currently. The actual
level of convergence would require a much higher capital share of inputs. This is
possible if we consider both human and physical capital. Now in steady state we
will have a given level of human capital and physical capital defined. This
explains the lower level of convergence than predicted earlier: we see a much
higher share of capital within this model than before, and therefore would predict
a lower rate of convergence because richer countries have much higher amounts
of human capital than poor countries, which would continue to have low levels of
capital per worker.

What should a beneficent central bank do to the (real) interest rate,

if there is a permanent increase in the savings rate, so as to ensure
that aggregate demand is always equal to aggregate supply, and
there is no inflation or deflation, during the transition to the new
equilibrium growth path? Is the new final equilibrium growth rate the
same as that described in part (a) (i) above? What will happen to the
(real) interest rate along the path of transition to this new
equilibrium growth path?
There exists the possibility of an output gap due to i) and ii). When the savings
rate increases this will normally lead to a fall in aggregate demand in the short
run, and therefore a fall in output per worker if prices are sticky. The economy is
stuck at the original level of capital per capita, which means excess savings. The
central banks role is to reduce the interest rate to disincentivise savings and
thereby stimulate investment which would lead to a higher capital to labour
ratio, and therefore a higher output per capita level. Moreover, aggregate
demand will have been prevented from falling through increases in investment,
caused by the reduction in interest rates. This final equilibrium is very similar to
the final equilibrium described in part a) i), however the economy is operating at
a lower interest level. As the economy transitions to the new equilibrium,
demand for investment will have the same profile, because the increase is

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theoretically happening purely from the decrease in the interest rate. The central
bank has simply tried to avoid the problem of price stickiness through changing
the price of money itself, and thereby clearing the savings glut through the
interest rate channel rather than the rent channel, which is seemingly broken.