Lecture 5.

A Simple Life-cycle ModelThe

Economys Growth Path
ECON30009 Macroeconomics
Shuyun May Li
Department of Economics
The University of Melbourne
Semester 2, 2014

Outline
1. Tracking the growth path
2. Steady state
3. Effects of growth on welfare across generations
4. Persistent growth
Required reading: Chap. 2 and 3 of AK

1. Tracking the Economys Growth Path

Lets conduct a numerical exercise to illustrate the economys
growth path.
One period refers to 30 years.
Assign values to parameters: = 0.5, = 0.3, N = 100
Initial condition: K1 = 150, so k1 = K1 /N = 1.5
Exogenous time path for At : At A = 10 for all t
Time path for kt :
kt+1 = (1 )(1 )Akt = (0.5)(0.7)(10)kt0.3 = 3.5kt0.3
k1 = 1.5
k2 = (3.5)(1.5)0.3 = 3.593
k3 = (3.5)(3.593)0.3 = 5.286
...
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 Time paths for other variables

Kt = N kt = (100)kt
Yt = AKt N 1 = AN kt = (1000)kt0.3
wt = (1 )Akt = 7 kt0.3
rt = Akt1 = 3 kt0.7
cyt = wt = 3.5kt0.3
cot = (1 + rt )at = (1 + 3 kt0.7 )kt = kt + 3kt0.3
St = Yt (100)cyt (100)cot
It = Kt+1 Kt = 100(kt+1 kt )

Table 5.1 Illustrative Transition Path

Period

kt

Kt

Yt

wt

rt

cyt

cot

St

It

1.500

150.0

1129.3

7.905

2.259

3.953

4.888

245.27

245.27

3.953

395.3

1510.3

10.572

1.146

5.286

8.484

133.34

133.34

5.286

528.6

1647.9

11.536

0.935

5.768

10.230

48.17

48.17

5.768

576.8

1691.6

11.841

0.880

5.921

10.843

15.29

15.29

5.921

592.1

1704.9

11.935

0.864

5.967

11.036

4.67

4.67

5.967

596.7

1709.0

11.963

0.859

5.981

11.094

1.41

1.41

5.981

598.1

1710.2

11.971

0.858

5.986

11.112

0.42

0.42

5.986

598.6

1710.5

11.974

0.857

5.987

11.117

0.13

0.13

5.987

598.7

1710.6

11.975

0.857

5.987

11.119

0.04

0.04

10
.
..

5.987
.
..

598.7
.
..

1710.7
.
..

11.975
.
..

0.857
.
..

5.987
.
..

11.119
.
..

0.01
.
..

0.01
.
..

5.987

598.7

1710.7

11.975

0.857

5.987

11.119

0.00

0.00

Figure 5.1 Transition path of kt

Figure 5.2 Transition path of Yt

Figure 5.3 Transition paths of wt and rt

Figure 5.4 Transition paths of cyt and cot

Figure 5.5 Transition path of St and It

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 Summary
The only source of output growth is an increasing capital
stock and hence an increasing capital-labour ratio.
The economy starts out with a low k1 , so the wage in period
1 is low, so saving by the young is limited.
But even this limited amount of saving is sufficient to make
k2 higher.
This makes the wage in period 2 larger, facilitating even
more saving by the young which further leads to a higher k3 .
But as each period passes, the amount by which the wage
rises becomes smaller, due to diminishing returns to
additional capital.

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 Hence along the transition path, the growth rate of the

wage gets smaller and smaller, until eventually wage doesnt
change at all.
At that point, every generation saves the same amount when
young and brings the same amount of capital into old age.
As a result, kt (as well as all other endogenous variables)
remains a constant from one period to the next.
So in the absence of population growth or technological
change, growth is a temporary, or transitional phenomenon.
The standard of living will be constant in the long run.

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2.

The Steady State

The long-run position, or state to which the economy converges

is called the steady state. Let k denote the steady-state
capital-labour ratio.
One way to find k is as we did in the numerical exercise:
tracking the sequence of kt to see what value it converges to.
Another way is to note that in the steady state, we must have
Using the transition equation:
kt+1 = kt = k.
k = (1 )(1 )Ak ,
1

k = [(1 )(1 )A] 1 .

In the numerical example,
1

k = [(0.5)(0.7)10] 0.7 = 5.987.

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Figure 5.6 The Steady State

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 We can use the value of k to calculate the steady state values

of all the other economic variables.
Y = AN k .
= N k,
K
w
= (1 )Ak , r = Ak 1
cy = w,
co = (1 + r)k
K
= 0, S = 0.
I = K
From Lecture 4, St = N at+1 N at = N kt+1 N kt . In the
steady state, the positive saving by the young just offsets the
dissaving by the old, leaving total saving equal to zero.
Convergence to the steady state: Regardless of the initial value
k1 (as long as k1 > 0), the economy always converges to the
steady state (the s.s. is globally stable).
The further away the economy is from the steady state, the
faster it grows.
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Figure 5.7 Convergence to the Steady State

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3.

Effects of Growth on Welfare across

Generations

We see that during the transition, the wage rate rises and the
interest rate falls.
Rising wages mean more consumption in both periods of life.
Lower interest rates mean less increases in second-period
consumption relative to increases in first-period consumption.
Overall, next generation will consume more in both periods
than current generation, but the increase in consumption when
young is larger than the increase in consumption when old.
Therefore the welfare unambiguously improves from one
generation to next.

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 Example: Look at Table 5.1, generation 1 consume 3.953 when

young and 8.484 when old.
Generation 2 consume 5.286 when young and 10.230 when
old: 33.7% more when young and 20.6% more when old
than generation 1.

Generations born in the long-run steady state consume

5.987 when young and 11.119 when old: 51.5% more
consumption when young and 31.1% more when old than
generation 1.

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4.

Persistent Growth

Growth will continue in our model if we have either population

growth or continuing improvement in technology.
Population growth
In this case, there are more workers and savers in each
generation. Thus the actual size of the aggregate economy
increases each period.
However, the per capita steady-state values do not depend
on the size of the population, so they will be constants.
Therefore, in the steady state, the standard of living will be
constant.

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 Technological improvement
If we have a constant population size, but continuing
improvements in technologyAt increases over time, the
transition curve will shift up with each new generation.
An increase in technology will make capital and labour more
productive, increasing saving and capital accumulation.
If technology improves at a constant rate
(At+1 = (1 + g)At ), the economy will converge to a steady
state in which the capital-labour ratio grows at the same
rate as the technological improvement.
Thus, technological improvement will allow the standard of
living to grow in the steady state.

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Review Questions
How to track the time path of kt using given parameter values,
initial value of k1 , and the transition equation?
How to track the time paths of all other endogenous variables, using
the time path of kt ?
Explain why wage rate increases while the interest rate falls over
time?
Explain why both consumption when young and old increase over
time, but the increase in consumption when old is relatively small?
Understand the concept of steady state.
Find the steady state values of kt , rt , wt , yt Yt /N , cyt and cot in
terms of parameters.
How can the model be modified to generate persistent growth in
output in steady state, and persistent growth in standard of living?
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