TheSolow Growth Model

ApEc 3006, Spring 2006

Michinori Uwasu
1 I nt r oduct i on
Obj ect i ve
How t o explain economic growt h has been one of t he most enduring quest ions in macroeconomics.
When looking around t he world, we nd huge dierences in economic performance (part icularly
GDP per capit a or individuals income). Key observat ions are seen in bot h t ime series dat a and
cross sect ional dat a. Three examples include; 1) Sub-Saharan (no growt h since 1950s) vs. East
Asia (high growt h since1960s) from t imeseries dat a; 2) OECD (over $10,000) vs. LDCs (less$300)
from cross sect ional dat a; and 3) St eady economic growt h for t he last decades for most developed
count ries. (See Appendix for graphs). These observat ions raise t he following quest ions:
Why some count ries grow fast while ot hers do not ?
Why some count ries are rich while ot hers are not ?
How t o explain sust ained economic growt h?
Theobj ect iveof my lect ureist ounderst and t hebasic mechanismof economic growt h by learning
t he Solow growt h model. I n part icular, we learn t he mechanism of capit al accumulat ion and t he
roles of populat ion and t echnological progress in economic growt h. Learning t he basic mechanism
of economic growt h may not be su cient , but necessary t o answer t hese quest ions.
The Sol ow model
To know t hefeat ures of t heSolow model is of import ance. First , t heSolow model is very neoclassic
in t hat it focuses primarily on t hesupply side. TheSolow model implicit ly assumes t hat , as long as
supply of goods increases, economic growt h can beat t ained. So, it is very dierent from Keynesian
models of which focus is on t he demand side of an economy such as unemployment and inat ion.
Second, t he Solow model is a DYNAMIC model (not st at ic). Economic growt h by nat ure cont ains
1
dynamic aspect s, which makes t he model complicat ed. Therefore, we are going t o learn t he model
in st eps t o cope wit h t he complicat ion. I n part icular, we rst st udy t he basic model t hat has only
a capit al st ock accumulat ion mechanism. Aft er t he basic model, we are going t o incorporat e new
fact ors, populat ion growt h and t echnology int o t he model and see how t hese fact ors change t he
result s obt ained in t he basic model.
The Solow model is named aft er an economist Robert Solow. Originally, he came up wit h t he
model based on t he observat ion of US dat a between 1950s and 1970s, nding t hat (1) savings
rat es and input fact or shares were almost const ant , and (2) per capit a GDP growt h rat es were
st eady. The punch line of t he Solow model is t hus t o syst emat ically explain t he two observat ions
(we will soon see t his). His work has been inuent ial and t hus been followed by a large number of
growt h models including endogenous and mult i-sect or models. Robert Solow won t he Nobel prize
in economics in 1986 due t o his cont ribut ion t o growt h t heory. The Solow model is simple (no
complex mat h needed), but provides signicant implicat ions for economic growt h. Therefore, it is
t he perfect place t o st art leaning economic growt h.
2 An Economy
The Solow model considers an simple economy t hat consist s of a supply side and a demand side.
This sect ion describes a st at ic version of t he economy before int roducing a dynamic aspect .
The suppl y si de
The economy has one aggregat e out put and t wo input fact ors, capit al st ock and labor. The pro-
duct ion funct ion is given by:
1
c
= 1(1, 1)
where 1
c
= aggregat e out put supply, 1 = capit al st ock, 1 = labor. The Solow model has t hree
import ant assumpt ions on t he product ion funct ion.
The product ion funct ion is increasing in each input , and has diminishing marginal product .
I.e.,
oY
o1
0,
oY
o1
0,
o
2
Y
o1
2
< 0,
o
2
Y
o1
2
< 0.
When zero unit s of input is used for eit her 1 or 1, t hen not hing is produced. I .e., 1(0, 1) =
1(1, 0) = 1(0, 0) = 0.
The product ion funct ion exhibit s const ant ret urns t o scale (CRS). A product ion funct ion
exhibit s CRS if a proport ionat e increase in all input fact ors increase in out put of t he same
proport ion.
2
Exampl e 1 Suppose a producti on functi on i s gi ven by 1 = 1
0.5
1
0.5
. Si nce
oY
o1
= 0.51
0.5
1
0.5

0,
oY
o1
= 0.51
0.5
1
0.5
0,
o
2
Y
o1
2
= 0.251
1.5
1
0.5
< 0, and
o
2
Y
o1
2
= 0.251
0.5
1
1.5
< 0, the rst
assumpti on i s met. Clearly, the second one i s also met. To check if i t i s CRS, let us multi ply
each i nput factor by c 0 : (1c)
0.5
(1c)
0.5
= 1
0.5
1
0.5
c
0.5
c
0.5
= c1
0.5
1
0.5
= c1
c
. Si nce a
propor ti onate i ncrease i n each factor i ncrease i n output of the same proporti on, i t is CRS.
Two reasons for having t he assumpt ions are in order. First , t here are many empirical st udies
t hat support t heassumpt ions. Second, it brings analyt ical convenience. Specically, using t heCRS
propert y, we can obt ain a simple form of product ion funct ion on a per worker basis:
1
c
= 1(1, 1)
Mult iply bot h sides by
1
1
1
c
1
= 1(
1
1
, 1
| { z}
)iaco
)
(The above line uses t he CRS propert y)
1
c
1
= 1(
1
1
) ! j
c
= )(/)
where j
c
= out put supply per worker, and / = capit al st ock per worker. This implies t hat per
worker out put supply is det ermined only by capit al st ock per worker.
Exampl e 2 Assume 1 = 1
0.5
1
0.5
i s gi ven. Then the per worker producti on functi on i s
1
1
=
1
0.5
1
0.5
1
=
1
0.5
1
0.5
1
0.5
1
0.5
=
1
0.5
1
0.5
= (
1
1
)
0.5
! j = /
0.5
Remark. I n what follows, we basically look at per worker unit s of fact ors: t his makes sense in
t hat we are int erest ed more in individuals living st andards (e.g., your income) t han in t he size of
an economy (e.g., GDP). So, please keep in mind t he dierences between capit al let t ers (1, 1, 1, 1)
and small let t ers (j, /, i).
3
The demand si de
The demand side of t he economy assumes no disposal of income, so t he out put demand must be
equal t o t he sum of consumpt ion and invest ment :
1
o
C + 1 (ident icat ion)
! j
o
c + i (divided bot h sides by 1)
where 1
o
is out put demand, C is consumpt ion, 1 is invest ment , j
o
is per worker out put demand,
c is per wor ker consumpti on and i is per worker i nvestment. Each individual is assumed t o eit her
consume or save given his income:
j
o
= c + :j
o
! c = j
o
:j
o
(consumpt ion funct ion)
where 0 : 1 is a savings rat e (so, : jd is t he amount of savings for each individual). Plugging
c int o t he ident icat ion yields
i = :j
o
(invest ment funct ion)
Equi l i br i um
In equilibrium, supply equals demand. So, plugging j
o
= j
c
= )(/) int o t he invest ment funct ion
t o obt ain
i = : )(/)
This holds in equilibrium of t he st at ic economy. Figure 1 represent s t he st at ic equilibrium of t he
economy.
3 Capi t al Accumul at i on
We int roduce a dynamic aspect int o t he st at ic economy. I n part icular, we incorporat e a capit al
accumulat ion mechanism int o t he st at ic model. Two fact ors involve in t he capit al st ock accumula-
t ion.
1 Invest ment : increases capit al st ock.
2 Depreciat ion: a cert ain proport ion of capit al st ock wears out .
4
k
y=f(k)
i=s*f(k) c
i
y
k 0
y, i
Figure 1: St at ic Equilibrium
Let c denot e t he depreciat ion rat e in one t ime period and let /
t
denot e a capit al st ock level in
period t. The rule of change in capit al st ock in one period of t ime can t hen be expressed as:
/
t+ 1
/
t
oc)
= 4 /
t
= i
t
c/
t
! 4 /
t
= : )(/
t
) c/
t
or /
t+ 1
= /
t
+ : )(/
t
)
Tr ansi t i on of t he economy and st eady st at e
A graphical represent at ion is t he best way t o show how an economy changes over t ime given init ial
capit al st ock. Figure 2 represent s an economy t hat is given t he product ion funct ion j = )(/),
savings rat e :, depreciat ion rat e c, and t he init ial capit al st ock /
0
. Using t his amount of capit al
st ock, t he economy produces j
0
(unit s) of out put and i
0
(unit s) of invest ment . Wit h t his amount
of invest ment , t he economy is going t o have /
1
= (i
0
c/
0
) + /
0
unit s of capit al st ock in period 1.
The economy can t hus produce j
1
unit s of out put and i
1
unit s of invest ment in period 1. Likewise,
t he economy will have t he new capit al st ock level /
2
= (i
1
c/
1
) + /
1
in period 2, by which t he
economy will produce j
2
unit s of out put and i
2
unit s of invest ment in period 2 (not shown in t he
gure t hough). Repeat ing t his shows t hat t he capit al st ock level is increasing unt il it reaches one
point (st at e) denot ed by, /
cc
. Once t he economy get s t o t he st at e, it will not move from t he st at e
because t he amount of capit al t hat wears out is equal t o t he amount of invest ment in t he st at e.
We call such a st at e steady state. The formal denit ion is:
Deni t i on 1 Steady state i s an equi li bri um state where / ( per wor ker capital stock) i s i nvari ant.
5
*k
y
ss
k
ss
k
0
y
0
k0
i
0
*k0
k
1
=k
0
+k
1
y
1
k
1
y=f(k)
i=s*f(k)
k 0
y, i
Figure 2: St eady St at e (Long-Term Equilibrium)
Thus in st eady st at e no change in / occurs. Mat hemat ically,
4 / = 0
! : )(/) c/ = 0
We call t his a steady state condi ti on. If a specic funct ional form of )(/), and values of : and
c are given, we can solve t he condit ion for /.
Exampl e 3 Suppose j = /
0.5
, : = 0.2, and c = 0.05. The steady state condi ti on i mpli es
:/
0.5
c/ = 0 ! 0.2/
0.5
= 0.05/
/
0.5
= 0.25 ! /
cc
= 16
Thi s further i mpli es that the steady state level of per worker output i s calculated as
j
cc
= /
0.5
cc
= 16
0.5
= 4.
Some comment s
If an init ial capit al st ock isnot zero, an economy approachest o a posit ivest eady st at e. (When
/ = 0, )(/) = 0 by assumpt ion. So, when / = 0, t he st eady st at e condit ion is met , meaning
/ = 0 is also a st eady st at e.)
6
Once an economy get s t o a posit ive st eady st at e, it will not leave t he st eady st at e. (This
implies t hat t he posit ive st eady st at e is stable.) Thus st eady st at e can be t hought of as a
long-t erm equilibrium.
4 Gol den Rul e of Capi t al St ock
Compar at i ve St at i c
This sect ion demonst rat es comparat ive st at ic wit h respect t o a savings rat e. What is comparat ive
st at ic? As you not ice, any models have variables. In t he Solow model, we have; /, j, i, :, c, /
0
. And
any variables in a model can be divided int o t wo cat egories; exogenous variables, and endogenous
variables. Exogenous variables are ones t hat are det ermined out side a model whereas endogenous
variables are ones t hat are det ermined in t he model. Comparat ive st at ic demonst rat es how one
exogenous variable change aect s an equilibrium. I n t he Solow model, we have:
Exogenous variables :, c, /
0
Endogenous variables /, j, i
How do we show t he eect of change in savings rat es on st eady st at e? First , not e t hat since
t he invest ment level is given by i = : )(/), change in savings rat es shift s t he invest ment curve.
Clearly, t he higher savings rat e shift s t he invest ment curve upward, and vice versa. Second, t he
correspondingst eady st at ealsoshift s. For example, supposewehaveaproduct ion funct ion j = /
0.5
.
By t he st eady st at e condit ion : /
0.5
c/ = 0, we have st eady st at e capit al st ock /
cc
= (
c
c
)
2
(To
show t his will be a homework quest ion). The equat ion indicat es, as : increases, /
cc
increases.
This can be graphically. In Figure 3, t here are t hree levels of savings rat es, :
1
< : < :
1
.
When a savings rat e is :, t he invest ment curve is i = : )(/) and t he corresponding st eady st at e is
given by /
cc
. Similarly, when :
1
is given t he st eady st at e capit al st ock is /
1cc
. When :
1
is given,
t he corresponding st eady st at e capit al st ock is /
1cc
. Clearly, it shows /
1cc
< /
cc
< /
1cc
; in ot her
words, t hehigher t hesavings rat eis, t hehigher t hest eady st at elevel of capit al st ock per worker is.
Figure 7-6 in Mankiw (p191) present s int ernat ional evidence: count ries wit h high invest ment rat es
t end t o have higher income per worker, which might support t he predict ion by t he Solow model.
(Why " might " ?)
Gol den Rul e
Suppose you were a policy maker. Suppose also t hat you can change a savings rat e t hrough scal
policy or monet ary policy. Then, what savings rat e would you choose? One answer may be t hat
you want t o chooset hesavings rat esuch t hat per worker consumpt ion in st eady st at eis maximized.
7
y=f(k)
k
i=s
L
f(k)
i=s
H
f(k)
i=sf(k)
k
Lss
k
Hss
k
ss
y, i
k 0
Figure 3: Comparat ive St at c Analysis for Savings Rat es
Deni t i on 2 The golden rule capi tal i s the steady state capi tal stock level, /
cc
such that consump-
ti on i n steady state, c
cc
i s maxi mi zed.
The immediat e quest ion is t hen: How do we nd such a savings rat e? We t ake t he following
two st eps.
St ep 1 Find t he golden rule level of capit al st ock.
Let /
jc|o
cc
denot e t he golden rule level of capit al st ock. Recall consumpt ion per worker is
calculat ed as
c = j c/
= )(/) c/
c is maximized when t he slope of t he product ion funct ion is equal t o t he slope of c/:
The slope of )(/) = '11
The slope of c/ = c
Thus, when '11 = c is sat ised, c is maximized. We call " '11 = c" a golden rule.
St ep 2 Find t he corresponding savings rat e, :.
8
y.i
y=f(k)
MPK=
k
y
gold
ss
k
gold
ss
i=s
gold
f(k)
k
C
gold
ss
Css
i=sf(k)
MPK
kss
yss
a
b
c
0 k*
e
d
Figure 4: Golden Rule of Capit al St ock
Not e t hat /
jc|o
cc
is also st eady st at e level. Thus it also sat ises t he st eady st at e condit ion,
:)(/) = c/ which we can solve for :.
Exampl e 4 Suppose j = /
0.5
, and c = 0.05. Fi nd a savi ngs rate that maxi mi zes consumpti on in
steady state.
(Step 1) By the golden rule,
'11 = 0.5/ 0.5 = 0.05 = c
! /
0.5
= 0.1
! /
jc|o
= 0.1
2
= 100.
(Step 2) Plug /
jc|o
i nto the steady state condi ti on and solve i t for ::
: )(/
jc|o
cc
) = c/
jc|o
cc
:100
0.5
= 0.05100
: = 5,10 = 0.5.
Gr aphi cal r epr esent at i on
Dierent savings rat es lead an economy t o a unique st eady st at e. In Figure 4, we have t wo
dierent savings rat es. : leads t he economy t o /
cc
and c
cc
, and :
jc|o
leads t he economy t o /
jc|o
cc
9
and c
jc|o
cc
in t he long-t erm. I n t his example, /
jc|o
cc
sat ises t he golden rule '11 = c while /
cc
does
not . Therefore, we know t hat c
jc|o
is t he golden rule level of capit al and is clearly larger t han c
cc
.
Theinformat ion of '11 and c can beused t o evaluat et hecurrent st at us of an economy in t he
cont ext of t he golden rule. If '11 = c is found, t hen t heeconomy is ne: peopleareenj oying t he
maximal consumpt ion level. If '11 < c is found, it means t hat t heeconomy has t oo lit t lecapit al
st ock. To seet his, let s look at Figure 4: wit h any capit al st ock levels less t han t hegolden rule level
of capit al st ock (/
jc|o
cc
), t heir marginal product of capit al st ock is great er t han t hedepreciat ion rat e
(c). So, polit icians may want t o increase t he capit al st ock so t hat t he economy has t he golden rule
capit al st ock. In order t o do so, t hey need t o raise t he savings rat e. If '11 c is found, on t he
ot her hand, t he economy has t oo much capit al st ock. In t his case, polit icians may want t o decrease
t he savings rat e t o lead t he economy t o t he golden rule capit al st ock level t hat is less t han t he
current level.
Sit uat ion Diagnoses Policy I mplicat ions
'11 c in ss ! t oo lit t le capit al st ock ! increase t he savings rat e
'11 = c in ss ! golden rule of capit al st ock ! keep t he savings rat e
'11 < c in ss ! t oo much capit al st ock ! decrease t he savings rat e
A t r ansi t i on pat h of consumpt i on when : i s i ncr eased Supposet he current economy is
in st eady st at e of /
cc
as in Figure 4. The golden rule of capit al st ock implies, t he current economy
is not maximizing peoples consumpt ion level and raising t he savings rat e from : t o :
jc|o
will lead
t he economy t o t he golden rule level of capit al st ock; t hus at t aining opt imal consumpt ion i n the
long-term. In t he short -t erm, however, t he economy will experience lower consumpt ion levels due
t o t he increase in :. Too see t his, we again look at Figure 4. I n t he original st eady st at e, t he
consumpt ion level was given by a c (c
cc
). When we increase t he savings rat e from : t o :
jc|o
, t he
immediat econsumpt ion level becomes / c t hat is clearly lower t han a c. As t imegoes by, capit al
st ock is accumulat ing, so t hat consumpt ion st art s increasing. Not e t hat when t he capit al st ock
level get s t o /

, t he economy brings d c unit s of consumpt ion t o each worker t hat is t he same

as t he original consumpt ion level a c. So, unt il t his point , t he economy has lower consumpt ion
levels, but t hereaft er t he economy can enjoy higher consumpt ion levels t han t he original one and
when it get s t o t hest eady st at e, it can have t heopt imal consumpt ion level. Theconsumpt ion pat h
of consumpt ion discussed here is drawn in Figure 5.
10
c
ss
c
gold
ss
time
c
Increase s capital stock = k* capital stock = k
gold
ss
Figure 5: Consumpt ion pat h when changing a savings rat e from : t o :
jc|o
5 Popul at i on Gr owt h
Thus far we havexed t henumber of labor (= populat ion) in t he model. TheSolow model assumes
t hat labor force is growing over t ime at a rat e of :. This means t hat populat ion growt h rat e in t he
model is exogenous. So, we can demonst rat e a comparat ive st at ic wit h respect t o :. Before going
int o it , weneed gureout how populat ion aect s t he economy. Populat ion growt h spreads t hecap-
it al st ock moret hinly t o larger populat ion, so it has a negat iveeect on capit al st ock accumulat ion.
In part icular, t he accumulat ion rule for t he economy wit h populat ion growt h becomes:
/
t+ 1
= i
t
(c + :)/
t
+ /
t
or 4 / = /
t+ 1
/
t
= i
t
(c + :)/
t
where (c + :)/
t
is called a break-even i nvestment curve because it is t he amount of invest ment
necessary t o keep capit al st ock const ant . See Appendix for t he derivat ion of t he equat ion.
St eady St at e St eady st at eof t heeconomy can be obt ained in t hesameway. I n st eady st at e,
capit al st ock per worker will be invariant , so we have
4 / = i (c + :)/ = 0.
Given a specic funct ional form of a product ion funct ion and paramet er values, wecan nd a st eady
st at e of a part icular economy (t his will be a homework quest ion).
Now, we are ready t o demonst rat e how populat ion aect s st eady st at e of t he economy. A
11
y, i
k
y=f(k)
i=sf(k)
(+n
H
)k
(+n
L
)k
k
Lss
k
Hss
y
Lss
y
Hss
0
Figure 6: Comparat ive St at ic Analysis for Populat ion Growt h
graphical present at ion is t he best way t o do it . The implicat ions of Figure 6 is as follows. 1)
Populat ion growt h rat e shift s t he break-even curve. Given :
1
< :
1
, (c + :
1
)/ has a at t er
slope t han (c + :
1
)/. 2) Thus t he corresponding st eady st at e also shift s. When :
1
leads t he
economy t o t he st eady st at e /
1cc
, whereas :
1
leads t he economy t o t he st eady st at e /
1cc
. Clearly,
/
1cc
< /
1cc
. Figure 7-7 in Mankiw (p203) present s int ernat ional evidence: high populat ion growt h
rat es are negat ively associat ed wit h income per worker, which might support t he predict ion by t he
Solow model. (Again why " might " ?)
Gol den Rul e Given t he accumulat ion rule, t he golden rule is:
'11 = : + c.
So, using t his rule and t he st eady st at e condit ion, we can nd a savings rat e t hat maximizes
consumpt ion in st eady st at e.
Summar y 1
The st eady st at e is a long-t erm equilibrium. The Solow model shows how an economy is
changing over t ime unt il it get s t o st eady st at e.
Savings rat es det ermine t he level of per worker capit al st ock in st eady st at e. Higher t he
savings rat e, t he higher t he level of per worker capit al st ock.
The golden rule of capit al st ock maximizes t he consumpt ion level in t he long-t erm.
12
Populat ion growt h has a negat ive impact on capit al st ock accumulat ion. The higher t he
populat ion growt h rat e, t he lower level of st eady st at e.
However, neit her fact or can explain sust ained economic growt h as observed in developed
count ries. In t he current model, capit al st ock per worker is invariant in st eady st at e.
6 Technol ogi cal Pr ogr ess
Labor augment i ng t echnol ogy
To int roduce a t echnology element int o t he model, we st art wit h a new aggregat e product ion
funct ion:
1 = 1(1, 1 1)
where 1 = out put , 1 = capit al st ock, 1 = labor (workers), and 1 is e ciency of worker. 1 1
in t he product ion funct ion is called eecti ve workers. In t he economy, e ciency of workers may be
det ermined by knowledge, experience, and skills of average workers. Becauset he e ciency variable
is at t ached t o labor input , it is called labor-augmenti ng technology: an increase in 1 can increase
out put level as if more labor input is used. In t he Solow model, 1 is growing at a const ant rat e of
q (so, q is an exogenous variable).
We assume t hat t he product ion funct ion exhibit s CRS. This means t hat we can divide bot h
sides by 1 1 t o obt ain:
j = )(/)
where j =
Y
11
is output per eecti ve worker, and / =
1
11
is capi tal stock per eecti ve wor ker .
Like populat ion growt h, t echnological progress aect s capit al accumulat ion. Theruleof capit al
accumulat ion (per eect ive worker) is now:
/
t+ 1
= i
t
(c + : + q)/
t
+ /
t
or 4 / = /
t+ 1
/
t
= i
t
(c + : + q)/
t
where (c + : + q)/ is called a break-even i nvestment curve because it is t he amount of invest ment
necessary t o keep capit al st ock const ant . Appendix shows how t his equat ion is derived.
St eady st at e
Deni t i on 3 Steady state i n the economy wi th technologi cal progress i s an equi li bri um state where
/ (capi tal stock per eecti ve worker) i s invari ant.
13
y, i
k
y=f(k)
i=sf(k)
(+n+g)k
k
ss
y
ss
0
Figure 7: An Economy wit h Technological Progress and Populat ion Growt h
Thus t he st eady st at e condit ion is
4 / = i (c + : + q)/ = 0
To obt ain a st eady st at e, we need solving t he condit ion for /. Figure 7 present s t he st eady st at e of
an economy wit h t echnological progress.
So, is t here any dierence? The answer is yes. Too see t his recall t he denit ion of each variable
is given by (see Table 2):
Table 2: St eady St at e Growt h Rat es wit h Technological Progress
Vars St eady St at e Growt h Rat e
/ (capit al st ock per eect ive worker) 0
j (out put per eect ive worker) 0
1 (labor/ populat ion) :
1 (e ciency of worker) q
1
1
= / 1 (capit al st ock per worker) q
Y
1
= j 1 (out put per worker) q
1 = / 1 1 (capit al st ock) : + q
1 = j 1 1 (out put ) : + q
The implicat ion of t he informat ion is as follows. In an economy wit h t echnological progress,
capit al st ock per eect ive worker is not growing in st eady st at e. However, capit al st ock per worker
14
is growing at a rat e of q (a rat e of t echnological progress) even in st eady st at e. Why? This is
because 1 is growing at q in all periods by assumpt ion and because
1
1
is dened by / 1. So,
even if / is not growing in st eady st at e,
1
1
is growing at q. Moreover, t his means t hat
Y
1
, out put
per worker (equivalent t o individual income) is also growing at q even in st eady st at e. Likewise,
capit al st ock and t ot al out put in t he economy are growing at : + q. The bot t om line of t he Solow
model is: t echnological progress explains sust ained economic growt h in t he cont ext of individual
living st andards.
The r ol e of t he gover nment Researchers have found what fact ors det ermine t he e ciency
of workers in an economy. Thosefact ors include; educat ion, healt h, infrast ruct ure(road, highways,
airport , port , ut ilit ies, t o name a few), law&order, and security (police, re ght ing, milit ary
services). Not e t hat many of t he fact ors t hat aect e ciency of an economy involve public goods
element s, and it iswell known in economicst hat market st hemselvescannot provideenough amount s
of public goods. Usually, government saret heonly agent t hat havean abilit y t oprovidet hesu cient
amount of public goods, which implies t hat t he role of t he government is import ant in (sust ained)
economic growt h.
Gol den Rul e Wit h t he accumulat ion rule, t he golden rule is given by:
'11 = : + c + q.
Using t his rule and t he st eady st at econdit ion, wecan nd a savings rat et hat maximizes consump-
t ion in st eady st at e.
Summar y 2
The Solow model shows how capit al st ock accumulat es over t ime, det ermines t he long-t erm
equilibrium, and shows how savings, populat ion growt h, and t echnology aect s an economy
in t he long-t erm.
Savings and populat ion growt h det ermine t he st eady st at e level; however, neit her variable
explains sust ained economic growt h.
Technological progress can explain economic growt h in st eady st at e. In st eady st at e, out put
per worker is growing at a rat e of t echnological progress.
15
Government s can play a key role in improving e ciency of workers. Good educat ion/ healt h
services, good infrast ruct ure, st rict law&order syst ems, and security improve t he e ciency of
an economy and t hus support sust ained economic growt h.
The rat e of t echnological progress is exogenous in t he Solow model. Thus t he Solow model
it self does not det ermine sust ained economic growt h.
Appendi x
1. Dat a Alt hough it is very import ant t o t ake a close look at real dat a in st udying economic
growt h, we have no t ime t o do so. However, a large number of useful dat a sources for int ernat ional
economies are readily available. If you are int erest ed, t ry t he following:
Summers-Hest on Penn World Dat a (Universit y of Pennsylvania): Very useful. Cont ainsmany
key variables such as GDP, invest ment , labor force for most economies from 1950. Dat a can
be downloaded via ht t p:/ / pwt .econ.upenn.edu/
World Development I ndicat ors(World Bank): Availablein Wait elibrary, or visit ht t p:/ / www.worldbank.o
Human Development Report (Unit ed Nat ions): Est imat es unique variables for human devel-
opment . Available in Wait e library or visit ht t p:/ / hdr.undp.org/ .
The Penn World Dat a are used t o const ruct t he gure and t able below.
2. Exampl es
.
0
2 0 0 0
4 0 0 0
6 0 0 0
8 0 0 0
10 0 0 0
12 0 0 0
14 0 0 0
16 0 0 0
1
9
6
0
1
9
6
3
1
9
6
6
1
9
6
9
1
9
7
2
1
9
7
5
1
9
7
8
1
9
8
1
1
9
8
4
1
9
8
7
1
9
9
0
1
9
9
3
1
9
9
6
Ye a r
G
D
P

p
e
r

c
a
p
i
t
a
Chad
South Korea
Why some count ries grow fast while ot hers do not ? Chad and Sout h Korea 1960-1998 (Not e: 1996 prices)
16
Why some count ries are rich while ot hers are not ?
The Living St andards in 12 most populous count ries 1998
Count ry GDP per Capit a Populat ion Count ry GDP per Capit a Populat ion
Unit ed St at es 31,049 275,675 Indonesia 3,521 203,678
Japan 23,345 126,410 China 3,203 1,238,599
Germany 21,724 82,047 India 2,464 978,672
Mexico 8,060 95,846 Pakist an 2,053 131,582
Russia 6,948 146,909 Bangladesh 1,655 125,629
Brazil 7,130 165,874 Nigeria 1,025 120,827
Not e: GDP per Capit a (in US dollars), Populat ion (in t housand).
3. M at hemat i cal Not es 3-1. Derive 4 / = i (c + :)/.
Not ing t hat
4 1 =
d1
dt
= 1 c1
d1,dt
1
= :,
we have
/
t+ 1
/
t
= 4 /
t

d/
dt
=
d(1,1)
dt
=
d1
dt

1
1

1
1
2

d1,dt
1
=
1 c1
1

1
1
d1,dt
1
= i c/ /:
! 4 / = i (c + :)/.
3-2. Derive 4 / = i (c + : + q)/.
Not ing t hat
d1,dt
1
= :
d1,dt
1
= q
d(11),dt
11
=
o1ot
1
1 +
o1ot
1
1
11
= : + q,
17
we have
/
t+ 1
/
t
= 4 /
t

d/
dt
=
d(1,11)
dt
=
d1
dt

1
11

1
(11)
2
(
d1
dt
1 +
d1
dt
1)
=
1 c1
11

1
11
(
d1,dt
11
1 +
d1,dt
11
1)
= i c/ /(: + q)
! 4 / = i (c + : + q)/.
3-3 We show t hat shares of each input fact or is equal t o t he elast icit y of each input . Assume
t he aggregat e product ion funct ion is given by:
1 = 1(1, 1)
Let r denot e a rent al rat e of capit al, and let n denot e a wage rat e. We want t o show t hat
'11 = r
1
Y
and '11 1 = n
1
Y
. The economy maximizes it s prot :
max = 1 n1 r1 = 1(1, 1) n1 r1
The rst order condit ions are:
d
d1
!
d1
d1
= n
d
d1
!
d1
d1
= r
Mult iply bot h sides in t he rst equat ion by 1 and divide t hem by 1 yields
d1
d1
1
1
= n
1
1
! '11
1
1
| { z }
el ast i ci t y of labor
= n
1
1
| { z}
labor share
18
For capit al st ock,
d1
d1
1
1
= r
1
1
! '11
1
1
| { z }
el ast i ci t y of capi t al st ock
= r
1
1
| { z}
capit al st ock share
Cobb-Dougl as Pr oduct i on funct i on A Cobb-Douglas product ion funct ion is t he most
commonly used CRS product ion funct ion:
1 = 1
c
1
1 c
The elast icit ies of each input s for Cobb-Douglas are given by:
'11
1
1
= c
'11
1
1
= 1 c.
So, t he fact or shares for capit al st ock and labor are given by c and 1 c, respect ively. This is
very convenient in pract ice because you need no calculat ion t o nd capit al share once you have a
product ion funct ion.
19