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Critically analyze the Solow Growth Model and show how it can explain growth only in the short run. Does the model predict that poor economies always grow faster than rich economies? Explain.

Introduction The Solow Model was developed primarily by the American Economist, Robert Solow in the 1950s. Solow attempted to develop a model that intentionally ignored traditional assumptions made by macro economists, such as short-run fluctuations in employment and savings rates, to create a model that described the long run growth of an economy. He received a Nobel prize for his work in 1987. Solows method created several advantages. Solows model is often described as an extension of the Harrod-Domar model. This is due to the fact that Rober Solow made the following additions to the Harrod-Domar Model. These additions are listed as follows: Labour is included as a factor of production. Technology is included as a third independent variable Labour and capital are substitutes. The capital to output ratio and capital to labour ratios are no longer fixed. This allows us to distinguish increases in capital intensity from technological progress. The model requires diminishing returns to labour and capital separately but constant returns when combined. The Harrod-Domar model and other previous models such as the closed economy and small open economy models provided a picture of the economy at a particular moment in time while the Solow model provided a chronological view of the economy. In the Solow model there is a self correcting mechanism which naturally brings output back to its equilibrium should it deviate from it. This equilibrium is referred to as the steady-state. The main conclusion of the Solow model is that the accumulation of physical capital cannot explain the massive growth in output per person overtime over time or the massive geographic differences in output per person [Romer]. The model also concludes that the rate of growth is determined by three things which are listed blow: The rate of capital accumulation The productivity of capital;and The population growth rate. Assumptions of the model: The Solow model focuses on four variables: output (Y), capital (K), labour (L) and knowledge or the effectiveness of labour (A). Output is a product of the combination of capital, labour and knowledge which are always present in the economy. This provides us with the following production function: Y(t) = F[K(t),A(t)L(t)]1. Where t denotes time. The production function implies that changes in output over time are dependent on changes in the inputs of production (K, and AL) over time. The production function is the first assumption of the Solow model. The second is that K and L are substitutes. The third assumption is that the law of diminishing returns holds. The law of diminishing returns states that adding more of one factor input (K, or L), while holding all others constant, will at some point yield lower returns per unit. This is illustrated by the following expression: . The fourth and most critical assumption that the model makes is that it has constant returns to scale. This means that doubling the quantities of capital and labour while A is constant will double the amount produced. This assumption implies two things. The first is that the economy is large enough that gains from specialisation have been completely depleted. If the economy were very small, then there would probably be enough possibilities for further specialisation that dou1 The production function could also be Yt = F(Kt , Lt)

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bling the amounts of capital and labour would more than double output. This can be illustrate by the following equation: F(cK, cAL) =cF(K, AL). This means that multiplying both sides by any nonnegative constant c leads to an equal change in output by the same value. For the assumption of constant returns to hold true then the economy must be sufficiently large that if capital and labour were doubled the new inputs are used in exactly the same way as the old ones. The second is that inputs other than capital, labour and knowledge are unimportant. The model ignores land and other natural resources. If land and other Natural resources were taken into consideration then doubling capital and effective labor would less than double output if land and natural resources were not themselves doubled. However, in practice the availability of natural resources is not a large constraint on growth. As a result assuming constant returns to capital and labour alone is a sensible decision. This assumption allows us to use the production function in its intensive form. If we equate our nonnegative constant c to 1/AL in F(cK, cAL) =cF(K, AL), then we get F(K/AL, 1) =1/AL[F(K, AL)]. K/AL is the amount of capital per unit of effective labour and F(K,AL)/AL is output per unit of effective labour (Y/AL). Let k= K/AL, y=Y/AL and F(k)=F(K,1). We can now rewrite F(K/AL, 1) =1/AL[F(K, AL)] as y= f(k). In essence we can write output per unit of effective labour as a function of capital per unit of effective labour. The intensive form production function is assumed to satisfy f(0) = 0 (constant returns to scale) f(k)>0,f(k)<0 (diminishing returns to scale). The intensive function also satisfies the Inada conditions which state that the marginal product of capital stock is high when the capital stock is small and that it decreases as the capital stock increases. The fifth assumption is that depreciation (), which can be defined as a decrease in an assets value is fixed. The sixth assumption is that labour grows at a constant rate, n. The seventh assumption is that Individuals save a constant fraction of their income: St = s x Yt. The remaining assumptions are related to how the stocks of labour, capial and knowledge change over time. The model uses continuous times and this means that the values of the inputs are defined at every point in time. The Working of the Solow model and how it can only explain growth in the Short run The Solow model evolves around two equations. The first is a production function (typically the Cobb-douglas production function and the second is a capital accumulation equation. Capital accumulation in any period is the change in capital stock in that period. This should be equal to the net investment. This is illustrated below: Capital accumulation equation: (Kt - Kt-1) Net investment: (It-Kt) (Kt - Kt-1) = (It-Kt) In the Solow model, output is a combination of consumption and investment. A fraction of output s is reserved for investment and this is exogenous to the model and constant. This is the main reason why the Solow model can only explain growth in the short run, because in the short run the rate of saving (s) does not change. The Solow model is a closed economy model so investment is equal to savings It = St. Thus Capital accumulation in any given time period is equal to sY(t) -K(t). However as the Solow model makes use of per capita figures, this essay will use the Cobb-Douglas function in per capita terms.

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k*= s x Akta - (n + )kt Where k* represents the change in capital per capita. This formula illustrates that capital per capita is the difference between actual investment per capita and break even investment per capita. When the actual investment per capita is greater than the break even investment or required investment per capita there is new capital accumulation in that time period and we would have an increase in total capital stock per capita. However when the break-even investment per capita exceeds the actual investment per capita in a time period, there is a decrease in the total capital stock. Break even investment is the amount of investment that must be done to keep capital per capita at its existing level. This is primarily because of two reasons. The first is that capital depriciates at a rate , therefore some investment is required to replace the capital lost. The second is that the population grows at a rate of n, therefore the capital per capita needs to grow at an identical rate to keep the capital per capita at its existing level . The point where the actual investment per capita and the break even investment per capita is known as the steady state. At this point, capital per capita stops growing.

This is further explained by the diagram above. When actual investment exceeds break-even investment then there will be an increase in the total capital stock per capita from K2 to K*. If break-even investment exceeds required investment then there will be a decrease in the capital stock per capita from K1 to K*. If the actual investment is equal to the break even investment then capital per capita remains constant as we have reached the steady state. The model explains economic growth in the short run because temporary shocks in the economy like an increase in savings or technological progress lead to immediate increases in the growth rate, however the growth rate will decline over time until it returns to zero. However when it does so the steady state capital-labour ratio becomes higher. As shown in the diagram below. There is an increase in the steady state from k*OLD to k*NEW. However there is no lasting effect on growth. Furthermore if the temporary shock is removed after a while then there is no effect in the long run. If the shock is a permanent one then there is no lasting effect on growth, but there is a permanent effect on the steady state. If the shock is a positive one then there will be a permanent increase in the steady state.

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However in my opinion this analysis is not entirely true. This is because if a country should continually improve its technology then the country will experience repeated increases in short term growth and this could go on infinitely. The has not been a period in living memory when technological improvements stopped. As a result of this several countries around the world have enjoyed positive growth rates for long periods of time. These countries have never reached their steady state. As a result the economy enjoys positive growth instead of zero growth. If this trend has continued for a very long period of time can we not define this as the long run? So in this case I believe the model offers some explanation for long run growth. However this prediction does not necessarily hold true when compared to the real world. For example the model does not explain the sustained growth of the Asian Tiger economies between 1950 and the year 2000 where large increases in investment as a percentage of GDP contributed to growth rates of over 5% during the period.

The Solow model is grossly simplified in a large number of ways. These are outlined below: There is only a single good There is no government Fluctuations in employment are neglected Production is explained by a total with only three inputs. It has also been said that Solows explanation of the effectiveness of labour is very incomplete. This is because the model does not explicitly define the effectiveness of labour. It appears to be a basket for factors apart from labour and capital that could affect output.

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ConverThe latter part of the question refers to the idea of convergence. Convergence refers to the idea that poorer countries will catch up to richer in terms of income curs the poorer is illustrated by below.

gence:

countries per capita, and that until this occountries will grow faster than the rich. This the diagram

In the diagram s x Aka-1 represents the rate of growth. The diagram shows that the growth rate of poor countries is in fact greater than that of rich countries, and that as poor countries grow and approach their rich fellows their growth rate slows. In the world today this is generally true. Poorer countries tend to have higher growth rates than richer ones. The Solow model predicts that countries tend to move toward their balanced growth paths. As a result of this one would expect that differences in output per capita are caused by countries being at different points of their growth paths. So we would expect poor countries to catch up to the richer countries. Furthermore the model implies that the rate of return on capital is lower in countries with greater capital per worker. Hence, it seems likely that there will be a flow of capital from richer countries to poorer countries to take advantage of the higher rate of return. This will lead to convergence. It is also important to note that differences in economic size between rich countries and poor countries are likely to be reduced over time as poor countries are yet to acquire the new technologies. When they do, convergence will be expected. This is illustrated by the diagrams on the left, which is a regression run by Baumol. The diagram shows almost perfect convergence. However these findings have been thought to be fraudulent because of the sample selection and the lack of data. The countries that were poor a century ago were only included if they grew rapidly over the century, and the countries that were rich a century ago are included even if their growth was moderate. As a result of this we are likely to see poorer countries growing faster and converging with richer countries. A second regression was run by De Long to remove the bias of the first. He added seven more countries, which included Argentina, Chile, Ireland, East Germany, Portugal, New Zea-

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land, and Spain; and removed Japan. The inclusion of these countries ruined the case for convergence as seen on the left. While the model does predict that poor countries grow faster than rich countries the model does not predict that this is always the case. The model also predicts conditional convergence where countries with better economic structures converge to a higher steady state and countries with similar economic structures converge to a similar steady state. The countries with dissimilar economic structures will be expected to grow faster the further away they are from their steady state. This means that that the hypothesis could could be true if it depends on the economic structures of the economies. Bibliography David Romer (1996), Advanced MacroEconomics, ebook. Lecture slides.