The Solow growth model

Macroeconomic Theory I

ECON222

Fall 2017

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Questions

How are capital accumulation and economic growth interrelated?

What key factors determine a nations long-run standard of living?

What determines the dynamics of economic growth?

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Assumptions
CRS aggregate production function:

Y = AF (K , N )

Zero productivity growth (in basic model)

Change in the capital stock

K = I dK

,! constant rate of physical depreciation: d

The workforce grows at a constant rate n:

N
=n
N
,! workforce is proportional to population
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Assumptions (continued)

The economy is closed and there is no government

,! goods market equilibrium =)

I =S

Aggregate saving is given by

S = sY

,! constant savings rate, s =) consumption is

C = (1 s )Y

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Production in per-worker terms

The relationship between output per worker and capital per worker
can be written as
y = Af (k )
where y = Y /N and k = K /N.

Output per worker increases with capital per worker

The slope of the function declines with k due to diminishing MPK.

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 y

y = Af(k)

Decreasing
output-capital ratio

k
Figure: Per worker production function

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Example: Cobb-Douglas

Suppose the production function is:

1 1
Y = AK 2 N 2

In per worker terms this becomes:

1
Y K 2
=A
N N

Which we can express as

1
y = Ak 2

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The dynamics of capital per worker
Growth in capital per worker:
k K N
=
k K N
But K = I dK and so
k I dK
= n
k K
Since I = S = sY ,
k sY
= d n
k K
Multiply through by k = K /N:
sY
k = (d + n )k
N

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The dynamics of capital per worker

Since Y /N = y = Af (k ) we have the dynamic equation

k = sAf (k ) (d + n )k
| {z } | {z }
actual steady-state
investment investment
per worker per worker

This equation describes how the capital stock per worker changes
from one period to the next given any inital capital stock per worker
,! it shows how these dynamics depend on key features of the economy
(s, A, d and n)

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 Investment
per worker
Af(k)
Consumption

sAf(k)

k
Figure: Actual investment per worker

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The steady state (long run)
A steady state is a situation in which y , c and k are constant, do not
change over time

If k = 0, then the capital stock per worker, k , must satisfy

sAf (k ) = (d + n)k
,! k is the value of k at which the saving curve and the steady-state
investment line cross

Steady state output is then

y = Af (k )
Steady state consumption per worker is
c = (1 s )Af (k )
= Af (k ) (d + n)k

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 Figure: The Steady State

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Steady state consumption per worker

The higher is the steady-state capital-labour ratio:

,! the greater is output per worker, Af (k )
,! the greater is the amount of output per worker that must be devoted
to investment, (n + d )k

The Golden Rule level of the capital stock, k GR , maximizes

consumption per worker in the steady state

We will focus on situations where k < k GR

,! increases in k result in higher c

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 Figure: The Golden Rule
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Reaching the steady state

From the diagram, we can see that if k < k it must be that

sAf (k ) > (n + d )k

It follows that
k > 0 if k < k
,! as k grows, actual investment per worker rises, but the gap between it
and its steady state level falls

Similarly
k < 0 if k > k
,! in this case capital per worker falls until we reach the steady state

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 Figure: Dynamics of the Solow model

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 Figure: Dynamics of the Solow model

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 Figure: Dynamics of the Solow model

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 Figure: Convergence to the Steady State

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Determinants of the Long-run standard of living

Long-run well-being is measured here by the steady-state level of

consumption per worker

Its determinants are

,! the saving rate, s
,! the population growth rate, n
,! total factor productivity, A

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The saving rate

A higher s implies a higher living standard, provided k < k GR

,! a steady-state with higher y and c is attained in the long run

An increase in s has a cost a fall in current consumption

) a trade-o between current current and future consumption

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 Figure: Increase in the savings rate

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Population growth

Increased n tends to lower living standards

When n is high, a large part of current output must be devoted to

just providing capital for the new workers to use
,! less output left over for new investment and consumption

In reality, too low a rate of population growth may also be a problem

,! high dependency ratio aging population

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 Figure: Increased population growth

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Productivity growth

Increased productivity will improve living standards

A one-time productivity improvement shifts the economy only from

one steady state to a higher one

Only continuing increases in productivity can perpetually improve

living standards
,! the saving rate cant exceed 1
,! population growth rates have generally been positive

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 Figure: Increased TFP

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Income convergence

Do poor countries grow faster that rich ones?

,! for OECD (i.e. rich) economies this is roughly true
,! for a larger sample of rich and poor countries no convergence

Not really a fair test of the model: s, n and A vary across countries

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Conditional convergence

Should evaluate model, controlling for variation in s, n and A across

countries

Requires a more sophisticated statistical analysis

There is evidence of conditional convergence

,! how can this be?

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 Per Capita High s, low n
Income

Low s, high n

Time

Figure: Conditional Convergence

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Limitations of the Solow model

Does not explain why productivity, saving and population growth

varies across countries
,! really just puts the question to a deeper level

Does not explain long run dierences in growth rates

,! need a model of endogenous growth

While some countries have caught up, why havent others?

,! geography, history and political/legal institutions

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