Introduction

1. The Solow Growth Model

The Solow-Swan growth model is sometimes referred to as the neoclassical growth model because
of its reliance on the assumptions of this approach. But its distinguishing features are that the
model relies on diminishing returns to capital and an exogenously given rate of technological
progress (TP). We shall first develop the model in steps before applying it to comparative statics.
A. The Production Function and its Properties
Aggregate output or real GDP is produced by a combination of the capital stock, K, labour, L, and
technical progress also called the stock of knowledge, A, in an aggregate or economy-wide
production function specified as follows:
a
t t
a
t t t t t
L A K L A K F Y


1
) ( ) , ( ] 1 [
0 < a < 1
The combination or product AL means that knowledge is Hicksian labour augmenting and the
product is known as effective labour.
The production function is assumed to exhibit constant returns to scale (CRTS) and diminishing
returns to K and L. The assumption of CRTS enables us to re-write the production function in
intensive form or in terms of units of effective labour as:
a
t t
t a
t t
a
t
t t
a
t t
a
t
t t
t
t t
t
L A
K
L A K
L A
L A
K
L A
K
F
L A
Y

,
_

,
_

) (
) (
1 , ] 2 [
1

We can use small cases as
AL
Y
y
as intensive real GDP or output

AL
K
k
as intensive capital stock
Then (2) will be
a
t t t
k k f y ) (
This other key property is that the marginal product of intensive capital is positive but diminishing;
that is,
0 ) ( ' ' , 0 ) ( ' ) ( ] 3 [ < > k f and k f k MP
The function also satisfies the Inada (1964) conditions which state that: (i) The limit as k tends to
zero, the MP(k) tends to infinity; that is,
. ) ( ' lim
0

k f
k
This means that the slope of the f(k)
function as k = 0 tends to be vertical. (ii)
. 0 ) ( ' lim

k f
k
This means that the production
function tends to have a zero slope for sufficiently large values of k; that is, the f(k) curve tends to
be flat and therefore a negative MP(k) is ruled out. These conditions make the f(k) curve
monotonically concave and the MP(k) curve monotonically convex.
FIGURE 1
B. Growth of Inputs
The initial levels of inputs are given at K
0
, L
0
and A
0
. Labour and knowledge grow exogenously at
their respective constant growth rates as:
t g
t
nt
t
A
e A A e L L a
0 0
, ] 3 [
These can be expressed in natural logarithms as:
t g A A nt L L b
A t t
+ +
0 0
ln ln , ln ln ] 3 [
The input growth rates are defined as:
dt
A d
A
A
g
dt
L d
L
L
L
dt dL
n b
t
t
t
A
t
t
t
t
t
ln
,
ln /
] 3 [

Then effective labour grows at the rate of (n + g
A
). The capital stock is endogenously determined.
Some notes
C. Consumption, Saving and Capital Accumulation
Output produced is used either for final consumption, C, or saved, S, which is immediately turned
into capital formation or investment, I. Output is allocated to investment by a fraction s, which is
assumed to be constant and exogenously given. The C-I balance is given as:
Equation of s and S
1 / / 0 , ] 4 [ < < Y I Y S s for I sY S C Y
t t t t t
which in intensive form becomes:
add in eq
t t t t t t t
L A I k sf sy c y a / ) ( ] 4 [
The capital accumulation process is defined net of depreciation as:
1 0 , ] 5 [ < <
t t t t t
K I K sY K
dt
dK

where is the depreciation rate and K is total depreciation or capital consumption.
D. The Fundamental Solow Equation of Capital Accumulation
The Solow model is a differential equation for the rate of change of k; that is, from the quotient
t t t t
L A K k
we have to derive an expression for the differential dt dk k
t t

as a function k, or
) (
t
k k

. That is:
( )
t
t
t t
t
t
t
t t
t
t t
t
t
t t
t
t t
t
t t
t t
t t t
t
L
L
L A
K
A
A
L A
K
L A
K
dt
dL
A K
dt
dA
L K
dt
dK
L A
L A dt
L A K d
k

1
]
1

+ +
2 2
1 /
] 6 [
Note that the first term on the right is equation [5] expressed in effective terms as:
. ) (
t t t t
k k sf k sy
With substitutions for effective capital and input growth rates, the last
two terms reduce to:
. n k g k
t A t

Combining these terms results in the fundamental Solow
differential equation for capital accumulation:

0 ) ( , ) ( ) ( ) ( ] 7 [ > + + + +
A t t t A t t t
g n for k k sf k g n sy k k k


Box 1
Here is an alternative method for deriving the Solow equation in [7]. Take natural logarithm of the k-ratio as:
. ln ln ln ln L A K k Differentiate this with respect to time to get a growth equation:
. ln ln ln
L
L
A
A
K
K
L d A d K d
k
k
g
k


To get a differential equation multiply this by k = K/AL and use [5] to substitute for
K

, to get:
. k sy nk k g k sy
AL
K
L
L
AL
K
A
A
AL
K
K
K sY
k
A

This is the result in [7].
E. Equilibrium Condition, Convergence and Stability
Equilibrium in this model is defined as equality of two terms; namely, the actual investment, which
is sy = sf(k) and the investment requirement, k. Actual investment is output not consumed but
directly ploughed into capital formation per unit of effective labour. The logic of investment
requirement or break-even investment can be understood along the following lines. In order to
maintain effective capital, k, new additions to K have to be made for the following purposes: (i) to
support or gainfully employ additional workers as the labour force grows at n rate; (ii) to sustain
increased productivity of the existing labour force due to technical progress; and (iii) to replace K
in order to offset depreciation and keep the stock intact.
Equilibrium is obtained when the capital accumulation process stops, so that:
* * * * * *
) ( 0 ) ( ] 8 [ k k sf k sy k k sf k

where k* is the effective capital stock which solves the equilibrium condition. The graphical
solution of this algebraic condition is presented by the Solow diagram of Figure 2.
Figure: Stability of the Solow Equilibrium
In Panel A effective capital is measured along the horizontal axis while the vertical axis records
positive numbers. The shape of the graph for actual investment follows that of the production
function but scaled down by the saving rate. The investment requirement curve is a straight line in
k whose constant slope is measured by the constant parameter . The equilibrium condition in [8]
is satisfied at point E where the two curves intersect.
Stability of Equilibrium and Convergence: The stability of the model is examined in terms of the
dynamic behaviour of capital per unit effective labour. Point E is said to represent a stable
equilibrium if any deviation away from it creates internal adjustments that eventually take the
system back to point E. Suppose the system is to the left of point E with some effective capital
which is less than the equilibrium level or k
L
< k*. This causes disequilibrium of the sort:
L L L L
k k sf k k sf k > > ) ( 0 ) (

. This positive gap measures the excess of actual investment

over required investment as represented by the vertical distance AB. The interpretation of this
imbalance is that the excess resources available will be instantaneously invested to increase the
capital stock. The process proceeds until the growing capital stock converges to the equilibrium
level k* and the gap is cleared. Therefore to the left of k* or E capital is growing. Conversely, to
the right of E or k*, there is imbalance of
R R R R
k k sf k k sf k < < ) ( 0 ) (

, implying that
capital is declining to clear a shortage of actual investment over required investment. This
downsizing of the capital stock will continue until convergence again is obtained at k* or point E.
We have therefore proved that point E represents a stable equilibrium. To be more precise point E
represents a stable long-run equilibrium when the economy is in steady state and effective capital
is motionless.

The Phase Diagram: The dynamic adjustments just outlined are modeled in a phase diagram in
Panel B. The vertical distance as traced by line PL measures the gap between actual and required
investments of Panel A. Because of the concavity of the production function this gap will be at a
maximum such as AB where the PL line will peak and start to diminish until it vanishes where it
crosses the horizontal axis at k*. Thereafter, the gap is negative. The profile of
k

is the phase line

which traces the path of the gap defined in the Solow fundamental equation [7].
F. Solutions for Steady State Values of Endogenous Variables
In order to tractably solve for the values of the endogenous variables in steady state we shall use
the following Cobb-Douglas production function which exhibits CRTS:
1 0 , ) ( ) , ( ] 9 [
) 1 (
< <

AL K AL K F Y a
which in effective labour units becomes:

k
AL
K
AL K
AL
Y
k f y b
,
_

) ( ) ( ] 9 [
Let us first solve for the steady state intensive capital from the equilibrium condition. Substituting
[9b] for the intensive production function in [8], we have:

s
k
s
k
k
k sk k sf
) 1 *(
*
*
* * *
) (
This gives the steady-state intensive capital stock as:

,
_

,
_

1
1
*
*
] 10 [
s
L A
K
k a
t t
t
In growth economics great interest is focused on per capita aggregates. Therefore the capital per
person in steady state is solved by multiplying [10a] through by A
t
to obtain:
t g
t t t
t
t
A
e A A for
s
A k A
L
K
k b
0
1
1
*
*
*
, ] 10 [

,
_

,
_

Next we solve for the steady-state intensive income or output by plugging [10a] into [9b] to get:

,
_

1
1
1
]
1

,
_

,
_

1 1
1
* *
*
*
) ( ] 11 [
s s
k k f
L A
Y
y a
t t
t
This is solved at point F in Figure 2. The associated steady-state per capita income is given as:

,
_

,
_

1
* * *
*
*
) ( ] 11 [
s
A k A k f A y A
L
Y
Y b
t t t t
t
t
This can be expressed in terms of capital per head using the expression for steady-state intensive
capital as:

,
_

,
_

,
_

t
t
t t
t
t t
t
t
L
K
A
L A
K
A k A
L
Y
Y c
*
1
*
*
*
*
] 11 [
In order to get an expression for steady-state effective consumption, note that intensive
consumption can be solved from equation [4a] as c = C/AL = y sy = f(k) sf(k). This then gives
its steady-state value as:

,
_

,
_

1
* * * *
* * *
*
*
) 1 (
) 1 ( ) ( ) 1 ( ) ( ) (
) 1 ( ] 12 [
s
s
k s k f s k sf k f
y s sy y
L A
C
c a
t t
t
Graphically this is represented by vertical distance at k* of EF. The long-run per capita
consumption is solved as:

,
_

,
_

1
* * *
*
*
) 1 ( ) 1 ( ) 1 ( ] 12 [
s
A s k A s y A s c A
L
C
C b
t t t t
t
t
In terms of capital per head this becomes:

,
_

,
_

t
t
t t t
t
t
L
K
A s k A s c A
L
C
C c
*
1 * *
*
*
) 1 ( ) 1 ( ] 12 [
Equations [11c] and [12c] are quite powerful as they imply that in steady state a countrys
prosperity of level of development as measured by per capita income and consumption is
positively related to the countrys capital stock per head. The solutions which we have derived so
far are used variously in subsequent analyses.
G. Balanced Growth
In order to appreciate the steady state growth properties of the Solow model we first use an
alternative method of depicting its long-run equilibrium to the method illustrated in Figure 2. This
alternative approach uses the definition of the growth of intensive capital stock which is solved by
dividing k through into the fundamental equation [7] to obtain:

k
k sf
k
k
g a
k
) (
] 13 [

This system is graphically depicted in Figure 3. From equation [13a] since the parameter gamma
is a constant not related to k, it is represented by horizontal line at

. The term f(k)/k is the APK,

so that [13a] can be also written as:

MPK
s
sAPK
k
k sf
k
k
g c
k
) (
] 13 [


where we have used the relationship MPK = APK. Since under the Inada conditions f'(k) MPK
< 0, then the sAPK curve is downward sloped due to diminishing returns to capital as shown
Figure 3 by curve BEC.
The dashed curve FEG is used to measure the growth rate of intensive output, which from the
intensive production function in [2] is defined as:
k k y
g
APK
MPK
g k d y d g ln ln ] 14 [
This means that the growth rate of intensive output is a fraction of that of intensive capital by the
capital exponent which is also the elasticity of output with respect to capital as measured by the
ratio MPK/APK. This explains the smaller vertical distance for curve FEG than for BEC.
The equilibrium condition is defined for the growth rate of intensive capital as:

*
*
*
*
*
) (
0
) (
] 15 [
*
k
k sf
k
k sf
k
k
g
k

The dynamic behaviour of the model is analyzed for the growth rate of intensive capital. For a
stock such as k
0
which is lower than k*, growth is positive or 0 ) (
0
0
> k sAP g
k
by vertical
distance AB and therefore intensive capital stock will be increasing until convergence is obtained
at point E where the growth rate is zero. Conversely, for a lower stock such as k
1
the growth rate is
negative by vertical distance CD and intensive capital is decreasing until convergence to k*.
The Solow model satisfies the definition of balanced growth which is stated in Kaldors (1961)
stylized facts as follows: an economic system follows a balanced growth path if; (i) aggregate
GDP, consumption and capital grow at the common rate, n + g
A
; (ii) the labour force (population)
grows at the constant rate, n; (iii) levels of the capital per worker, GDP per worker, consumption
per worker and the real wage rate all grow at one and the same constant rate, g
A
; (iv) the capital-
output ratio is constant; (v) the rate of return on capital is constant; and (vi) the income shares of
factors of production are constant. (Sorensen and Whitta-Jacobsen, 2005, p. 54)
Starting with the growth rates of the absolute aggregates of K*, Y*, and C*, recall first that their
long-run equilibrium intensive ratios k*, y* and c* are constant as shown in equations [10a], [11a]
and [12a] and are therefore growing at zero rate; that is:
0
* * *

c y k
g g g
For these constant
ratios to have zero growth rate, it means that all their numerators, K*, Y* and C* have to grow at
the rate of growth of the effective labour, (n + g
A
); that is, the steady-state aggregate capital stock,
real GDP and aggregate consumption are all growing at the same constant rate, which satisfies
condition (i); that is
A
C Y K
g n g
C
C
g
Y
Y
g
K
K
+
* * *
*
*
*
*
*
*
] 16 [

Since K* and Y* grow at the same rate, then by (iv), the steady-state capital-output ratio, K*/Y*,
must be constant.
At what rate are the per capita terms given in [10b], [11b] and [12b] growing? In order to answer
this question let us take the case of per capita income. To obtain its growth rate in steady state,
first take the natural logarithm of equation [11b] and differentiate it with respect to time so that,
A A t t t
L Y
t t t t t
g n n g L d Y d Y d g b
and
L Y L Y Y a
+

) ( ln ln ln ] 17 [
; ln ln ) / ln( ln ] 17 [
* *
) / (
* * *
*

This means that all the per capita variables are growing at the rate of growth of technological
progress, so that condition (iii) is met; thus: A
L C L Y L K
g g g g
* * *
) / ( ) / ( ) / (
Verify that each per
capita term is a product of A
t
and its respective steady-state constant term which is motionless.
Since the latter terms are growing at zero rate, then the per capita terms must be growing at the rate
of growth of A
t
.
Economic growth without TP in the Solow model. As can be seen from [13], the growth rate of per
capita income without TP will be zero. This is because K*, Y* and C* will be growing at the
population growth rate so as to leave constant the ratios K*/L, Y*/L and C*/L. This means that in
the Solow economy there is no prosperity without TP.
H. Prices of Factors of Production
The Solow model is based on the assumptions of the perfect competitive market structure which
prevail in both the commodity and factor markets. Further, it is assumed that factors are paid at
their marginal productivity. From the production function the MPK is given by the expression:
1
1
1 1
) ( ] 18 [

,
_

k
AL
K
AL K r F MPK
K
Y
a
K

where r is the real interest rate or real return to rentiers of capital, whose value in steady state is
solved as:
) / ( ] 18 [
1
1
1
) 1
*( *
s
s s
k r b

,
_

,
_

This states that in the long run the real return on capital is constant as it is determined only by the
constant parameters of the model, which result is in accord with condition (v).
The general expression for the real wage rate is:

k A
AL
K
A L A K w F MPL a
L
) 1 ( ) 1 ( ) 1 ( ] 19 [
1

,
_

Then the steady-state real wage rate can be written in one of the following two forms. Note first
that

1
* * *
) / )( 1 ( ) 1 ( ) 1 ( ] 19 [ s A y A k A w b

Then secondly the real wage can be expressed in terms of factor shares as a residual after paying
capitalists; thus:
) ( / ) ( '
)] ( ' ) ( [ ) ( ) 1 ( ) 1 ( ] 19 [
* * *
* * * * * * * *
k f k f k
k f k k f A y y A y A k A w c

where ) ( '
* *
k f k is the payment to capitalists and is the share of capitalists income to total
income, so that (1 - ) is labours share. While the income shares are constant, the real wage rate
grows at the rate of TP, which is in accord with condition (iii) and in contrast to the real interest
rate which is constant in steady state.
I. Comparative Statics in the Solow Model
Comparative statics means comparing two equilibrium outcomes once a shock has been exerted to
the initial equilibrium. The shock or impulse involves varying the exogenous variables or
parameters of the model that were assumed to remain constant when configuring the initial
equilibrium. In the Solow model the parameters that were assumed to be constant are the savings
rate, s; the population growth rate, n; the depreciation rate, ; and the rate of technological change.
We shall perform experiments by varying one of these parameters at a time and observing the
transitional dynamics and steady state effects on the endogenous variables of the model. Next we
model effects of a change in the saving rate
FIGURE Effects of a Change in the Saving Rate on the
Solow Economy
In the Solow model the savings rate is exogenously determined probably by some policy planner.
It will be shown that a change in the savings rate: (a) causes a temporary or transitional change in
the growth rates of endogenous variables; (b) only affects their steady state levels but not their
steady state growth rates. That is, it has level effects but not growth effects.
Take a sudden and permanent increase in the saving rate say from s
0
to a higher rate s
1
, that s
1
> s
0
,
as shown in Panel A of Figure 5.
Figure: The Saving Rate Increase in the Solow model
The economy is assumed to have already obtained the old steady state position at time period t
0
and the increase in the saving rate occurs at some period t
i
, after remaining at s
0
for i periods, and
then remains at s
1
thereafter permanently. Other things being equal, the immediate effect is an
increase in actual investment at each level of k as:
) ( ) (
0 1
k f s k f s >
. In Panel A of Figure 4, this is
equivalent to upward shift of the entire actual investment curve at each level of k. (In Panel C this
is an upward shift of the saving function from s
0
APK to s
1
APK.) With reference to Figure 4 (Panel
A), it can be observed that at the initial equilibrium intensive capital stock,
*
0
k , actual equilibrium
investment rises as ) ( ) (
*
0 0
*
0 1
k f s k f s > . At the initial equilibrium point E the economy registers
disequilibrium of
0 ) (
*
0
*
0 1
> k k f s k

,
which is represented by vertical distance EJ. (In Panel C the disequilibrium is by
0 ) (
0
*
0 1
0
> EJ k AP s g
k
) This will create an adjustment process involving capital
accumulation, leading to rising k until the economy achieves a higher equilibrium intensive capital
stock,
*
1
k , which is associated with another steady state position G.
Dynamic Effects on Capital Stock
There are three observations to record in this regard. First, the disequilibrium is equivalent to a
jump by the gap EJ between the higher actual investment and the initial actual investment, which is
tantamount to the jump in
k

from zero to M along the higher phase line. This jump is shown in
Panel B of Figure 5 at time period t
i
as vertical distance M` from zero. Second, this gap gradually
vanishes to zero at the new equilibrium as the intensive capital stock converges to its higher steady
state level. Consequently, the
k

converges in a diminishing fashion to zero at some time period t

n
.
Third, as in Panel C, the growth rate of intensive capital initially jumps to a positive rate 0
0
>
k
g
diminishes (as in Panel C of Figure 4) to zero. Panel D maps the transition path of intensive
capital. Having been constant (with zero growth) in the old steady state path to point E, the capital
stock assumes a positive growth rate until it converges to its higher steady state level at point G.
Thereafter, it assumes a higher balanced growth path again at zero rate. In its transitional phase
intensive capital is growing at a rising but diminishing rate until convergence to the higher path is
obtained at point G. We see therefore that although the increase in the saving rate has raised the
short-run growth rate of k but above zero, its long-run rate still remains at zero but accompanied by
an increase in the level of long-run intensive capital stock.
The level effect indicates that there is a positive relationship between the saving rate and the level
of steady state capital stock. Note that in steady state intensive capital is a function of the
parameters as k* = k*(s, ). Therefore, from equation [10a] the partial effect on long-run intensive
capital of changes in the saving rate will be:

0
) 1 (
1
] 20 [
) 1 (
0
0
0
*
>

,
_

s
s
k
Dynamic Effect on Output
In terms of the level effect, it can be seen from Figure 4 that the increase in the saving rate is a rise
in the steady state intensive income from
*
0
y to
*
1
y , or movement FH along the PF curve. The
dynamic effects are the same as those we have mapped for intensive capital, except that both its
transition growth and path will be below those for intensive capital.
The effect, however, is a resultant of two components because y* = f(k*) and k* is itself a function
of the model parameters. Thus
0
) 1 (
) ( ' ] 21 [
) 1 (
0
0
0
* *
*
*
*
* *
>

,
_

s r
s
k
k f
s
k
dk
dy
s
y
a
We can go further to establish the elasticity of steady state intensive output with respect to the
saving rate, which is the proportionate change in this output to a unit change in the saving rate.
Express equation [10a] in logs as: ln y* = [/(1-)][ln s - ln ], and the desired expression for the
elasticity in question is:

1 ln
ln
] 21 [
*
*
*
*
s
y
y
s
s
y
b
s y
In the Cobb-Douglas function capitals income share is also the elasticity of output with respect to
capital, whose value is widely believed to be around 1/3 so that the response of y* to s is quite
inelastic with the coefficient in [21b] of 0.5.
Dynamic Effect on Per Capita Income
As pointed out above per capita income is an important single measure of the extent of prosperity
of countries which has motivated substantial interest worldwide. In order to gauge the impact of
the increase in the savings rate on per capita income note first that in steady state per capita income
level is a function: (Y*/L) = A
t
y* = A
t
f(k*) and is growing at g
A
. Although this is true when k* is
constant, k is growing in transition as we saw in Panel D of Figure 5. This will provide an
additional growth impetus for per capita income growth beyond g
A
in transition. As can be
verified in Panel E, per capita income growth initially jumps up at time t
i
above the initial g
A
before it steadily drops and finally converges back to its original g
A
.
The per capita level itself grows at g
A
along the original balanced growth path up to point A.
Thereafter, it is in transition along segment which has a steeper slope everywhere than g
A
, meaning
that per capita income grows by rates that exceed g
A
prior to convergence at point C on a higher
balanced path with growth rate g
A
. In the process the level of steady state per capita income has
risen; thus: ) / ( ) / (
0
*
0 1
*
1
L Y L Y > . It should be observed that without TP the economy would shift
from the balanced steady state BP
0
to BP
1
.
Summary
An increase in the saving rate causes the economy to grow faster in the transition phase
than in the long run. That is, a sudden and permanent rise in the saving rate results in a
temporary increase in the growth rate of per capita income.
A change in the saving rate leads to a change in per capita income or the size of an
economy but does not change its long-run growth rate. That is, it has a level effect but
not a growth effect in the long run. As a result, a change in the saving rate only shifts or
changes the long-run balanced growth path of an economy.
In the Solow economy only changes in the rate of growth of exogenous knowledge or
TP have long-run growth effect. As shown in Figure 6 an increase in TP from at point
A or C permanently shifts the economy to a higher balanced growth path.
Empirics on Level Effects of Structural Parameters
Equations [11b] and [11c] lead to two testable hypotheses between per capita income on one hand
and the structural parameters and the capita-labour ratio on the other hand. The testable functions
in this respect are:
u L K A L Y b
s A L Y a
+ +
+

+
) ln (ln ln ) / ln( ] 22 [
] ln [ln
1
ln ) / ln( ] 22 [
*
*

These hypothesized relationships can be construed either from the individual country perspective
or from the cross-country point of view. From the latters perspective, it is expected that countries
with higher saving rates (or investment ratios, I/Y) and parameters of gamma (n, g
A
and ) will
have higher (lower) levels of per capita incomes or prosperity. However, a positive association is
hypothesized for overall gamma with positive coefficient /(1-). The positive association is also
posited with respect to the capital-labour ratio.
(Empirical Evidence)

J. Convergence Hypotheses and the Speed of Convergence
We have so far mapped out the adjustment processes with which the economy responds and
adjusts given an exogenous shock or impulse (here to a rise in the savings rate) and then moves
from one steady state and eventually converges to another steady state. The objectives now are (a)
to establish the speed of adjustment to convergence; and (b) to track the dynamic path of the
endogenous variables when they are in transition; that is, to derive a transitional equation of
motion for these variables. We take these objectives in that order. We first use the case of
effective capital stock and then generalize the results to the other variables.
In order to set the stage, note that there are three distances in the phase diagram of Panel B in
Figure 3. One of these is the inter-steady state distance .
*
1
*
0
k k The second distance is ,
*
1
k k
t

which measures how far or short to convergence k is at any point in its transitional phase. The
third distance is the vertical distance represented by the Solow fundamental equation [7]. Of
interest here is to find a factor which reduces the second distance to zero; that is, to find a rate of
decay or discount which diminishes this distance in order to achieve convergence. Choosing the
parameter as the candidate, we can then write the problem of convergence as:

) ( ] 23 [
*
1
*
0
*
1
k k e k k
t
t


The task now is to define in terms of the parameters of the model and since it measures the speed
of adjustment it must be directly related to the slope of the phase line at the steady-state position at
.
*
1
k By applying the Taylor linear approximation method in the neighbourhood of
*
1
k using the
Solow equilibrium condition, we obtain:
0 , 0 ) ( ' ], [ ] )[ ( ' ] )[ ( ' ) ( ) ( ] 23 [
* * * * * * *
> < + k k for k k k k k k k k k k k k k k

We have used the following reasoning. First, that the phase line crosses the k axis in steady state
when 0 ) (
*
k k

, and second that the slope of the phase line is negative at

*
k . Differentiating the
phase line with respect to k using the Solow equilibrium condition in [8] we get:
) ( ' ] ) ( ' [ ) ( ' ] 24 [
* * *
k sf k sf k k a

Solving for the equilibrium savings rate from [8] we have: ) ( /
* *
k f k s . Substituting for s in
(a) we obtain the desired result:

) 1 (
) (
) ( '
] 24 [
*
* *

k f
k f k
b
where is the capitalists income share or the elasticity of income with respect to capital stock.
The convergence speed is greater the larger the size of . We can therefore state precisely that
economic convergence to long-run equilibrium will be faster (slower) for smaller (larger) values of
and for larger (smaller) values of . This is as intuitively deduced from the structure of the
model.
Evolution of the Economy
The evolution or trajectory of k can be precisely monitored during its motion to its steady state
level. This can be achieved with the help of the Cobb-Douglas production function and the steady-
state formula for k. We can then state the equation of motion for k as follows:
( ) ( )
1
]
1

+
+

1
1
1 0
) 1 (
1
1
1
*
0
) 1 ( *
/ /
] ( ] 25 [
s k e s
k k e k k
t
T
t
T t

The time path for the other endogenous variables, y and c, can be similarly derived if k is
unknown. Otherwise the steady-state formulas may be used to generate equilibrium values for y
and c from k.
We have taken the index n as the period of the next equilibrium and 0 for any initial capital stock.
In the specific case of an increase in the saving rate discussed above,
*
0 0
k k and it should be
computed using the initial saving rate s
0
, while
*
1
*
k k
T
which should be computed using the higher
rate s
1
.
The Effect of Changes in the Population Growth Rate
The Effect of Changes in the Growth Rate of Technological Progress
Simulation Exercises
K. Applications of the Solow Model
L. Violations of the Assumptions of the Solow Model
The Effect of a Decrease in the Population Growth Rate
A sudden and permanent decrease in the population growth rate from n0 to n1 or n1 n0 < 0, for constant
s, gA and depreciation rate, will rotate the investment requirement line clockwise to 1(n1) (Panel A,
Figure 10).
Figure: Effects of increase in population
At point F the economy is in disequilibrium as ,
, 0 ) (
*
1
*
.
>
o o o o
k k f s FA k

which means that the
effective capital stock is growing. In Panel B this is tantamount to downward vertical shift of the
gamma line and at point F1 effective capital stock jumps to a positive rate by 0
1
1
>
o o k
APK s g .
This is shown in Panel C as growth of effective output also jumps by a fraction. In the transition phase
the diminishing returns catch up and the growth of effective capital and income slows down until
convergence is obtained at points C and C1. In the process per capita income in Panel D rises and
eventually converges to a higher balanced growth path. Therefore, as in the case of a change in the
saving rate, although it affects the growth temporarily, a change in the population growth rate has level
effects but not growth effects in the long run. This result also holds in the case of a change in the
depreciation rate.
The Effect of an Exogenous Rise in the Growth Rate of Technological Progress
A rise in growth rate of TP from to means that from time t0 thereafter, some A1 is greater than A0 and
growing faster. With constant s, n and depreciation rate the required investment line rotates anti-
clockwise (Panel A of Figure 11), the steady-state position shifts from point A to point C along the
stationary actual investment curve.
Figure: Increase in Technological Progress Growth
Rate
In the process, and seemingly puzzling, the rise in TP leads to reductions in steady-state effective
capital and income. This means that the denominator for these variables has moved faster than the
numerators with the acceleration of TP. As can be observed from Panels B and C, the rise in gamma
induces a negative growth rate for intensive capital. However, note that K* and Y* are growing at a
higher rate with higher rate of TP; that is,

0 0 0 1 1
.
1
* * * *
Y k
A o A o
Y k
g g g n g n g g + > +
. Further, their
per capita steady-state levels are also growing at the higher growth rate of TP. As shown in Panel D,
per capita income overshoots the higher balanced path for in transition. For example, in the case of an
increase in the saving rate or a decrease in the population growth rate per capita income would
converge at point B on a higher but parallel balanced path. But with the increase in TP growth rate per
capita income converges to a higher path BP1 with an even greater steady-state growth rate. This leads
to an important conclusion that a change in gA has both steady-state level and growth effects.
Summary
An increase in the saving rate (population growth or depreciation rate) causes the economy to
grow faster in the transition phase than in the long run. That is, a sudden and permanent rise in
the saving rate (decrease in n or ) results in a temporary increase in the growth rate of per
capita income.
A change in the saving rate (n or ) leads to a change in the long-run level per capita income or
the size of an economy but does not change its long-run growth rate. That is, it has a level
effect but not a growth effect in the long run. As a result, a change in the saving rate (n or )
only shifts or changes the long-run balanced growth path of an economy without affecting its
slope.
In the Solow economy only changes in the rate of growth of exogenous stock of knowledge or
TP have both long-run level and growth effects. As shown in Figure 7, an increase in TP at
point A or C permanently shifts the economy to a higher balanced growth path and increased
steady-state growth rate.
M. Testing the Solow Model: The Role of Human Capital
The Solow model has been tested in terms of two broad hypotheses; namely: first, that the steady-state
level of per capita income (as in [15b]) is determined by the parameters of the model; more specifically
that it is directly proportional to the saving rate but inversely related to the parameters of gamma.
Second, that when economies 55
are outside their steady state (s), they grow in transition and converge to their steady-state per capita
levels and thereafter follow the balanced growth path. The basic hypothesis here is that there is a
negative relationship between the transition growth rate and the initial level of per capita income. The
focus has been on the coefficient for the speed to convergence. In both cases empirical tests have
followed two strategies. First, the tests have aimed to verify the statistical significance of the signs of
the coefficients. In the second and more fundamentalist strategy, the aim has been to verify whether the
sizes of the hypothetical coefficients as predicted by the Solow model are significantly equal to the
empirical coefficients. This latter research programme was ingeniously designed by Mankiw, Romer
and Weil (1992) [or MRW] in the form of introducing human capital into the model. The purpose was
to reconcile the inconsistence by which the model tended to understate the size of the coefficients in
the steady-state tests but to overstate the size of the speed of convergence in the convergence-growth
tests. These issues are explained below. We first, however, introduce human capital in the model in a
summary fashion. Trends in Human Capital Accumulation Human capital accumulation is an
important input in economic development and it is a key ingredient in the monitoring of poverty
reduction as MDGs 2, 3 and 6 which are explicitly on education and health. Progress in human
development is measured by either the inputs or investments committed to these sectors or by
participation by people through consumption of or access to the services. The UNDP s Human
Development Index (HDI) and other related indexes attempt to measure developments in the quality of
human development. Figure 12: Primary School Net Enrollment
Human Capital in the Solow Model The inclusion of human capital in the basic Solow model and
derivation of its solutions start with the re-specification of the production function and then going
through the steps we followed in the derivation of the steady-state values from the basic model of
the endogenous variables. The Cobb-Douglas production function with CRTS is re-specified with
physical capital (K) and human capital (H) as follows:
[ ] a 23

1 , 1 , 0 , ) (
1
< + < <



AL H K Y
Dividing AL to both sides of the production function gives the intensive form:
[ ] b 23


h k y
The proportions of output set for investment in physical capital and human capital are,
respectively, s
K
and s
H
. Then the accumulation equations are:
[ ] a 24
Y Y s Y I K
k K

.
[ ] b 24
Y Y s Y I H
H H

.
where we have assumed equal depreciation rates for both types of capital. The fundamental
equations of capital accumulation in units of effective labour are:
[ ] a 25
k h k s k y s k
K k



.

[ ] b 25
h h k s h y s h
H H



.
Given diminishing to both types of capital, + < 1, there exist a steady state for
0
. .
h k
, and
the solutions for intensive capital values are:

[ ] 26
,
1
1
1
*

,
_

H K
s s
k ,
1
1
1
*

,
_

H K
s s
h
The solution for per capita income becomes:

[ ] 27

,
_

1
*
_
K
t
s
A Y

,
_

1
H
s
Steady State Tests of the Solow Model
For purposes of empirical estimation in steady state of the role of the saving rates, using cross-
section data for countries i = 1 to C, we take logs of the basic Solow per capita equation [11b] and
the augmented one as:
[28a] In pcy
i
=
0 +

I
[In s
i _
In (n
i
+ v)] +
i
[28b] In pcy
i
=
0 +

I
[In s
k
i _
In (n
i
+ v)] +
2
[In s
i
H
_
In (n
i
+ v)] + u
i
Where:
pcy = per capita income ( *);

0=

0=
In A;
I
= /(1);
I
= /(1)

2
= /(1)
The term v represents an assumed cross-country constant for depreciation rate and TP growth rate,
and and u are random error terms.
We are now in a position to explain the role of human capital to the elimination of the
inconsistency between the theoretical prediction and empirical results from empirical tests.
Applying the ordinary least squares (OLS) regression method to the basic model in [28a], yields
empirical estimate of this elasticity of around 1.47 which is statistically different from zero
(Sorensen and Whitta-Jocobsen, 2005, p.141). This empirical result therefore supports the
hypothesis that per capita income is positively determined by the savings rate and negative with
other structural parameters. It is however, widely believed that the income share of capital s
income is 1/3 for advanced economies. On this basis, the basic Solow model postulates an
elasticity of output with respect to the saving rate about 0.5. This means that the model understates
the role of the saving or investment ratio in the determination of per capita income. The
implication of this is that for this empirical coefficient of 1.47 to be sustained, capital s income
share be around 0.6, which is contrary to the stylized steady-state value of 1/3. So to the
fundamental empiricists of the Solow model, although the model fits the data quite well, the
empirical parameters are not all very satisfactory and can therefore be improved upon.
58
In order to resolve this inconsistence either the Cobb-Douglas specification together with the
assumption of CRTS are invalid or the capital input is grossly mis-measured. It is in the latter vein
that MRW proposed of including another capital input to share the 2/3 income share equally, but
which is a labour type, so that the whole labour s income share remains 0.7. This additional
capital is human capital, which is different from raw labour in that it embodies accumulated
education and skills acquired over time. Estimation of the augmented Solow model by Sorensen
and Whitta-Jocobsen (pp. 170 172) yields parameters of 0.59 for 1 and 0.97 for 2 which give
values (solved simultaneously from the expressions for 1 and 2) of 0.23 and 0.36 for and ,
respectively, thereby restoring consistency between the model s theoretical prediction and the
data. Note that although the coefficient for gamma in the basic Solow model is the same as for the
saving ratio, in the augmented model it is equal to (+)/(1- ), which then is solved as
1.564.
Country Economic Growth Convergence
The study of convergence in economics has been carried out in three disciplines. First, in
international trade the interest has been to investigate the whether involvement in trade leads to
convergence, that is, to narrowing of the gap in incomes as predicted by the factor price
equalization theorem. Second, in monetary unions there is concern as to whether stability of a
common currency or a regional fixed exchange rate system can be achieved by some convergence
criteria such as public deficits and debt relative to income and inflation rates. Then, thirdly, is the
issue at hand in the study of long-run economic growth. In this research programme, convergence
hypotheses have emerged out of empirical applications and testing the convergence property of the
Solow model. The basic idea of convergence here is whether or not countries have a shared destiny
in terms of converging to the same long-run level of development as measured by per capita
income and thereafter grow at the same balanced path. The sequence of empirical execution of the
research programme reveals two strategies. The first one involved testing, using the standard or
original Solow model, the statistical significance of convergence among (sets of) countries under
the hypotheses of absolute (unconditional) and conditional convergence. This research strategy has
not been concerned with testing the hypothetical size of the speed of convergence as predicted by
the Solow model. The work by MRW introduced another research strategy whose focus was to
reconcile the model s theoretical speed and the empirically-fitted speed by augmentation of the
conditional convergence test with human capital. We start with a review of the operationalization
of the theoretical convergence property of the Solow model into testable convergence hypotheses.
We shall then later on review the empirical evidence before presenting the role of human capital.
Derivation of the Convergence Equation
In the growth convergence literature countries are classified from rich to poor on the basis of the
level of per capita income as used interchangeably with the capital stock per worker (per person).
This is because the Solow model predicts (in equation [15b]) that the standard of living or
prosperity is directly proportional to the level of capital stock per person. Further, growth of per
capita income is directly proportional to the growth of capital per head. The Solow model then
predicts a negative relationship between the initial level of development and the subsequent
transitional growth rate of per capita income to its the long-run per capita level. This proposition
can be derived by differentiation of the Solow capital growth equation [11] with respect to k as:
[ ] [ ] [ ] 0
) (
) ( ' ) ( ) (
1
29
'
2
<
1
]
1

APK MPK
k
s
k
k f
k f
k
s
k sf k k sf
k k
g
k
This negative relationship is governed by diminishing returns to capital and the Inada conditions,
so that under CRTS the inequality MPK < APK holds.
Then according to the hypothesis of absolute (unconditional) convergence the per capita incomes
of all countries converge to the same long-run per capita level and the same BGP and that countries
which are poorer and start in some initial period with lower per capita income will subsequently
grow faster in order to catch up with richer countries which start with higher per capita income and
converge to the same BGP. Suppose, as shown in Figure 14, there are only two countries in the
world, namely, B and C that share a steady-state intensive capital stock of *Pk. Since country B is
poorer it will have a lower capital base, kB < kC, and will therefore be further away from the long-
run equilibrium intensive capital stock than the richer country C. Further, country B will start with
a higher growth rate than country C,
,
1 1
c
k k
g CC BB g >

so that Further, it will have to growth faster subsequently in order to catch
up with C and converge to the same balanced growth path after reaching *

,
*
p
k
(at point P). The test equation for absolute convergence hypothesis relates the average growth
between end-point per capita income and the initial the initial per capita level against the latter. In
anticipation of our presentations, we shall state the test design in its general form. Thus in a cross-
country situation of countries i = 1 to C and between initial period t = 0 and final period t = n, this
may be formulated in the followingform:

[ ] + + + + ) ( ) ( 30
0 0 0 ,
i
k k
i
j j G G
i i i
n
i
o n
Z z B DUM Iny Iny Iny g

i
The test is on the statistical significance of coefficient and the negative sign. It turns out that the
ACH [without (B), DUM and (C)] has been massively rejected. In fact Barro and Sala-i-Martin
(1995, p. 27; Sorensen and Whitta-Jacosen, 2005, pp. 45; Romer, 2001, pp. 33-34), instead of
finding a negative coefficient from a sample of 118 countries report a positive coefficient,
indicating that rich countries grow faster than poor countries. The verdict is that ACH does not
seem to hold. Under the ACH countries differ only in terms of where their per capita income
initially is relative to the shared balanced growth path. It does not bring into consideration initial
differences in other features. In the real world countries do differ in terms of characteristics and
only selective groups of countries may have approximately similar structural characteristics of
saving culture, population homogeneity, technological progress, human capital, openness in trade
and finance, legal, social and political institutions, geography and historical experiences. This has
led to the conditional convergence hypothesis, which can be stated in terms of various sub-
hypotheses as we present them next.
One of these is the selective country group convergence, which states that countries converge to
the same long-run per capita income and BGP if they have similar characteristics. Poorer countries
among them will grow faster than richer ones in order to catch up to the common BGP. When a
number of groups can be identified as having different cross-group characteristics and GBPs, then
this would be the case of club convergence. For instance, in Figure 14 we have two groups of
countries, one consisting of rich countries X and Y that share a steady-state outcome at point R,
and the poor countries B and C with shared steady state at point P.
Figure : Convergence Among Countries

The groups of countries are assumed to differ only in saving or investment ratios; that is, countries
in the rich group have a higher ratio than countries in the poor group. Consequently, rich countries
will have a higher steady-state intensive capital than the poor group,
* *
p R
k k >
. In this respect, the
poorer among the rich (the poor) will have to grow faster in order to catch up with the richer of the
rich (the poor) in order to convergence to their respective BGPs. In this case, countries in the poor
club will never catch up with countries in the rich club.
In a seminal article, Baumol (1986) investigated convergence for the period 1870-1979 for 16
developed countries of the OECD (Australia, Austria, Belgium, Canada, Denmark, Finland,
France, Germany, Italy, Netherland, Norway, Japan, Sweden, Switzerland, United Kingdom and
United States of America [USA]). Using the data in Madison (1982), he applied OLS on the
absolute component of convergence equation in [30] and found a statistically significant
coefficient of -0.995, indicating almost perfect convergence. Baumol s work was criticized by De
Long (1988) on account that the results suffered from the sample selection bias problem, meaning
that countries were selected with a bias in support of the hypothesis. However, this type of
convergence has been confirmed also in the cases of the different states of the USA and Canada.
Weak Conditional Convergence. The weak version of conditional convergence hypothesis
recognizes cross-country diversity in structural characteristics and that each country converges to
its own BGP. When these country-specific factors are controlled for then there will be a negative
relationship between initial per capita income and subsequent growth. However, countries need not
converge to the same long-run per capita income and BGP. But when a country starts far below its
long-run per capita income, it will have to grow faster in order to converge to its BGP. This
hypothesis takes as conditioning factors the parameters of the basic Solow model contained in the
Zj vector, without DUM and part (C), and specified by Mankiw, Romer and Weil (1992) as:
[ ] ( ) [ ] v n In Ins Iny g
i i i i
o n
+

1
31
0 0 ,

+
i
Empirical estimates have found the size of convergence coefficient around 0.02 or 2% (MRW;
Sorensen and) for the Whitta-Jacobsen, p. 144) for OECD countries and much less (about 0.007 by
Sorensen and Whitta-Jacobsen, pp. 146 145) when other countries are included in the sample. We
therefore see that the Solow model performs quite well in its conditional forms in confirming the
off steady-state prediction of conditional convergence.
Testing the Magnitude of the Speed of Convergence with Human Capital
The fundamentalist test of convergence seeks to ensure that the theoretical size corroborates with
the empirical size of the speed of convergence, thereby going beyond the preceding tests of
convergence which are insensitive to this distinction. Unlike in the case of tests for steady-state
levels where we showed that the theoretical prediction understates the empirical coefficient, the
theoretical speed overstates the empirical one in tests of convergence. The problem is explained as
follows. From the basic Solow model, the predicted size for stylized facts for the OECD countries
has been found to be between 0.04 and 0.05 (for = 1/3, n = 0.01, gA = 0.03 and = 0.03).
However, the actual coefficient from testing the basic Solow model is 0.02, which is far less than
the theoretical prediction. However, if the Solow model is augmented with human capital, then the
theoretical speed becomes
( 1)(10.3-0.3)(0.06)=0.4*0.6=0.024
Depending on the variations of the realistic sizes of the parameters, the theoretical speed sizes are
around 1.6-2.4. Mankiw, Romer and Weil (1992), therefore tested the following human-capital
augmented model:
[ ] ( ) [ ] [ ] + +

+ +

+ ) (
1 1
32
0 0 ,
v n In Ins v n In Ins Iny g
i i
H
i i
K
i i
o n

i
On the basis of this test strategy by MRW the size of the empirical speed of convergence to 1.4%
1.8% (to 1.4% by Sorensen and Whitta-Jacobsen, p.180) even when poor countries are included in
the sample. This strategy therefore reconciles the discrepancy between the theoretical prediction
and reality. The results also mean that although countries differ in characteristics, they will in
steady state have their per capita income grow at the same rate but along parallel BGPs. (For
critique of MRW s work see Dowrick and Rogers, 2002)
Sources of Growth and Total Factor Productivity Growth Parallel to the theoretical and testing
theories of growth researchers have developed methods, one, for measuring the contribution of
factors of production to economic growth in what is known as sources of growth or accounting for
growth; and, two, for gauging the contribution of technological progress in what is known as total
factor productivity growth. We shall review these approaches in that sequence.
Sources of Growth: Accounting for Growth
The methodology used to estimate the contribution of factors of production to growth is based on
getting a growth equation from a production function. Depending on the level of aggregation this
could be at a firm, industry or country level. In most studies time series approach has been used,
although panel analysis approach has also applied depending on the motivations of the researches.
Common to the sources of growth studies is postulation of a production function, which in general
form of:
[ ]
L H K
L H A L H K A F Y

) , , , ( 25
The first step is to derive the rate of change of output by differentiating the function totally and
with respect to time as:
[ ]
. . . .
.
26
L MP H MP K MP A MP
dt
dL
PM
dt
dH
MP
dt
dK
MP
dt
dA
MP
dt
dY
Y a
L H K A
L H K A
+ + +
+ + +
Note that MPi is the marginal product of input i. In order to obtain the growth equation divide all
terms of the equation by Y and multiply and divide terms on the right by their respective levels of
input, so that:
[ ]
[ ]
[ ]
L L H H K K A A
L
L
H
H
K
K
A
A
L H K K
Y
g g g g d
g
Y
L v
g
Y
H v
g
Y
K v
g
Y
A v
c
L
L
Y
L MP
H
H
Y
H MP
K
K MP
A
A
Y
A MP
Y
Y
g b
+ + +
+ + +
+ + +
26
26
26
. . . .
The sources of growth approach is sensitive to assumptions about market structures in product
markets input and product markets. The formulation in [26b] and [26d] are market neutral if we
only concentrate on the MPi in [26b] or interpret the parameter i as the elasticity of output with
respect to factor i. In this respect the contribution of each input to growth is the product of its MP
or elasticity coefficient and its growth rate; meaning that not only should this input grow but also
that its should be highly productive or that output should be highly responsive to it. The reference
to elasticity suggests that there could be structural rigidities in an economy or in certain factor
markets which may constrain the production or supply in responding as desired to input utilization.
These rigidities may arise from imperfect markets such as monopolies, trade unions, bureaucratic
interferences, etc. At the policy level the thrust has been to liberalize markets in order to enhance
efficiencies, thereby increasing the responsiveness of output to inputs and enhancing their
productivity. The structural adjustment and reform programmes are intended to perform these
functions. If we let each input be paid its MP, MPi = vi, then we invoke the perfect competitive
market structure and the assumption of CRTS; that is, 0 < i < 1 and ii = 1. In this regard the
contribution of each input to growth is its growth weighted by its income share. The model is
flexible in that the inputs can be unbundled beyond our inclusion of human capital. For instance,
physical capital can be further disaggregated into machinery, infrastructure, et cet. As pointed out
the model can be applied to various sectors of the economy; e.g agriculture, natural resources,
mining, manufacturing, services, the role of the environment, social sectors, et. cet.
Total Factor Productivity Growth
In the accounting for growth the contribution of TP is modeled by the term for A in [26b] [26d].
Solow and others have proposed an indirect method for estimating the role of TP by estimatingit as
a Solow residual or total factor productivity (TFP) in:
L H K
L H K
Y
A

which in growth terms is transformed as:

[ ]

+ +
i
i i Y L L H H K K Y A growth
g g g g g g g TFP
0
Note that a direct subtraction in [26d] yields a residual as TFP AgA. However comprehensively
inputs i s may be accounted for, there will always be a residual measuring the combined or joint
contribution of the identified inputs in addition to their separate and accounted for contributions.
According to Romer (1989, p. 55), it a stylized fact that the growth of factors of production is not
sufficiently large to explain the rate of growth of output; meaning that accounting for growth will
always find a Solow residual. A pragmatic way of estimating TFP is to assume a CRTS production
function and then proceed to estimate the income shares of the inputs identified.
TFP under Imperfect Markets
The assumption of CRTS is incompatible with imperfect market structures and the computation of TFP
growth has to be modified as we demonstrate next. In the simplest model with only inputs K and L TFP
growth equation reduces to:
[ ] ( ) [ ]
1
]
1

+
,
_

+ +
L K Y
L L K L Y L L K L Y A growth
g
Y
wL
g
Y
wL
g
g g g g g g g TFP
1
1
0

We know that under perfect competition labour is paid the value of MPL or W = VMPL = P.LMPL =
P.LAPL = PL (Y/L). The real wage rate is w = W/P = MPL = L(Y/L). Under imperfectly competitive
markets firms earn a mark up factors are and paid their marginal revenue product; that is W =
MR.MPL, so that the real wage rate becomes: w = W/P = (MR/P)L(Y/L). Under monopolistic
competition the firms monopoly rents are contested to zero and the optimal pricing is set as MR = MC
and P = AC, which leads to the definition of returns to scale coefficient as MR/P = MC/AC = 1/( K +
L). With substitutions the real wage rate now becomes: w = L/( K + L) (Y/L). Using this term for w
in the TFP equation we obtain:
[ ]
L L K K
L K
Y
L
L K
L
K
L K
L
y growth
g g g
g g g TFP

+
+

1
]
1

+
+

,
_

+

1
1
1
Concluding Remarks on the Solow Model
These remarks are based on extensions of the model, which have included the following:
(i) To explain the case of poverty traps. This occurs when the fundamental equation behaves perversely
and/or there are increasing returns to capital.
(ii) To incorporate other determinants of prosperity and transitional growth such as: the role of
government in terms of taxation and spending; the role of the ROW in terms of trade in commodities,
services and of finance foreign direct investment and foreign aid. These extensions are performed at
various stages of our work.
(iii) What are the policy implications to be drawn from the Solow model?