ECO 402

Prof. Erdin

Fall 2013

Economic Growth
The Solow Model

The Neoclassical Growth model

Solow (1956) and Swan (1956)

Simple dynamic general equilibrium model of

growth

Neoclassical Production Function

Output produced using aggregate production
function Y = F (K , L ), satisfying:
A1. positive, but diminishing returns
FK >0, FKK<0 and FL>0, FLL<0
A2. constant returns to scale (CRS)

F (K , L) F ( K , L), for all 0

Production Function in Intensive Form

Under CRS, can write production function
K
Y F ( K , L) Y L.F ( ,1)
L
Alternatively, can write in intensive form:
y = f(k)
- where per capita y = Y/L and k = K/L
Exercise: Given that Y=L f(k), show:
FK = f(k) and FKK= f(k)/L .

Competitive Economy
Representative firm maximises profits and take price
as given (perfect competition)
Inputs paid by their marginal products:
r = FK and w = FL
inputs (factor payments) exhaust all output:
wL + rK = Y
general property of CRS functions (Eulers THM)

A3: The Production Function F(K,L)

satisfies the Inada Conditions
lim K 0 FK ( K , L) and lim K FK ( K , L) 0
lim L0 FL ( K , L) and lim L FL ( K , L) 0

Note: As f(k)=FK have that

lim k 0 f ' (k ) and lim k f ' (k ) 0

Production Functions satisfying A1, A2 and A3

often called Neo-Classical Production Functions

Technological Progress
= change in the production function Ft

Yt Ft ( K , L)
1. Ft ( K , L) Bt F ( K , L)

Hicks-Neutral T.P.

2. Ft ( K , L) F ( K , ( At L))

Labour augmenting
(Harrod-Neutral) T.P.

3. Ft ( K , L) F ((Ct K ), L)

Capital augmenting
(Solow-Neutral) T.P.

A4: Technical progress is labour augmenting

Ft ( K , L) F ( K , ( At L))
and
At A0 e

gt

Note: For Cobb-Douglas case three forms of

technical progress equivalent:

Ft ( K , L) Bt K L(1 ) K ( At L) (1 ) ( Dt K ) L(1 )
when Bt At

(1 )

Dt

Under CRS, can rewrite production function in

intensive form in terms of effective labour units

y f (k )
Y
K
where y
and k
AL
AL
-note: drop time subscript to for notational ease
- Exercise: Show that

f ' (k ) FK and f ' ' (k ) AL FKK

Model Dynamics
A5: Labour force grows at a constant rate n

Lt L0e

nt

A6: Dynamics of capital stock:

dK
K I K
dt
net investment = gross investment - depreciation
capital depreciates at constant rate

 closing the model

National Income Identity
Y = C + I + G + NX
Assume no government (G = 0) and closed
economy (NX = 0)
Simplifying assumption: households save constant
fraction of income with savings rate 0 s 1
I = S = sY
Substitute in equation of motion of capital:

K sY K sF ( K , AL) K

Fundamental Equation of
Solow-Swan model
dk
k sy (n g )k
dt
K
Proof : k
ln k ln K ln A ln L
AL
d ln k d ln K d ln A d ln L

dt
dt
dt
dt

k K
sY
sy
g n
(n g ) (n g )
k K
K
k

Steady State
Definition: Variables of interest grow at
constant rate (balanced growth path or BGP)

k 0 y c 0
at steady state:

sf k (n g )k 0
*

Solow Diagram: Steady State

ibreak even n g k

y , i, sy

sk * n g k *

y k

ss

k*

sy sk

Existence of Steady State

From

previous diagram, existence of a (nonzero) steady state can only be guaranteed for all
values of n,g and if

lim k 0 f ' (k ) and lim k f ' (k ) 0

- satisfied from Inada Conditions (A3).

Transitional Dynamics
If k k * , then savings/investment exceeds
depreciation, thus k 0 g k 0
k
*
If k k , then savings/investment lower than
depreciation, thus k 0 g k 0
k
By continuity, concavity, and given that f(k)
satisfies the INADA conditions, there must
*
*
*
k
such
that
sf
(
k
)

(
n

g
)
k
exists an unique

Properties of Steady State

1. In steady state, per capita variables
grow at the rate g, and aggregate
variables grow at rate (g + n) Proof:
K
as k
AL
d log K d log A d log L d log k
gK

g n gk
dt
dt
dt
dt
d log k d log K d log A d log L
gk

dt
dt
dt
dt
0 in Steady State

2. Changes in s, n, or will affect the

levels of y* and k*, but not the growth
rates of these variables.
- Specifically, y* and k* will increase as s
increases, and decrease as either n or increase
Prediction: In Steady State, GDP per worker will
be higher in countries where the rate of investment
is high and where the population growth rate is low
- but neither factor should explain differences in
the growth rate of GDP per worker.

Policies to Promote Growth

1. Are we saving enough? Too much or too
little?
2. What policies may change the savings rate?
3. How should we allocate savings between
physical and human capital?
4. What policies could generate faster
technological progress?

Golden Rule
Definition: (Golden Rule) It is the saving rate that
maximises consumption in the steady-state.
We can use the rule to evaluate if we are saving
too much, too little or about right.
max c* (1 s ) f (k * ) f (k * ) (n g )k *
s

c* f (k * ) k *
k *
*

(
n

f
'
(
k
GR ) ( n g )
*
s
k s
s
*
k
Given GR ,we can use

to find sGR .

*
*
sf (kGR
) (n g )kGR

Golden Rule and Dynamic

Inefficiency
If our savings rate is given by sGR then our savings
rate is optimal and
f ' (k * ) (n g )
GR

If
If

*
f ' (kGR
) (n g ) then we must be under-saving
*
f ' (kGR
) (n g ) then we must be over-saving

Check why this is the case!

Is Golden Rule attained in the

US? Is it Dynamically Efficient?
Let us check: Three Facts about the US Economy
a) k 2.5 y
The capital stock is about 2.5 times the GDP
b) k 0.1 y
About 10% of GDP is used to replace depreciating capital
'
MP
.
k
f
(k ).k
'
c) f (k ).k 0.3 y
k

0.3
OR
y
f (k )
Capital income is 30% of GDP: Note alpha also measures
the elasticity of output with respect to capital!

Is Golden Rule attained in the

US? Is it Dynamically Efficient?
Since

k 0.1y

0.04
k 2.5 y
MPk .k 0.3 y

MPk 0.12
k
2.5 y

US real GDP grows on average at 3% per year, i.e. n g 0.03

Hence, US economy is under-saving because
MPk (n g )

Changes in the savings rate

Suppose that initially the economy is in the
steady state: sf (k1* ) (n g )k1*

*
*
If s increases, then sf (k1 ) (n g )k1 k 0
Capital stock per efficiency unit of labour
grows until it reaches a new steady-state
Along the transition growth in output per
capita is higher than g.