Economic Growth I

Economics 331
J. F. OConnor

"A world where some live in

comfort and plenty, while half of
the human race lives on less than
$2 a day, is neither just, nor
stable."
Quote of the Day, NYT of
Wednesday, July 18, 2001

Output per Capita, 0-1995

6000

5000

GDP per capita

4000

3000

2000

1000

200

400

600

800

1000
Year

1200

1400

1600

1800

2000

Output per Capita, 0-1995

Logarithmic scale
9

GDP per capita in logs

4
0

200

400

600

800

1000
Year

1200

1400

1600

1800

2000

Output per Capita by Major Region

1820-2000
30000
25000
20000
15000
10000
5000
0
1820

1840

1860

1880
W. Eur
Lat. Amer

1900
E. Eur
Japan

1920

1940
W. Offshoot
Asia (ex. Japan)

1960

1980

2000

Model of Capital Accumulation

Y = F(K, L) where F displays constant
returns to scale and diminishing marginal
products
Y=C+I
C = (1-s)Y where s is the saving rate
is the change in the capital
stock and is the depreciation rate of
capital

Per Unit of Labor Version

Y/L = F(K/L,1) = f(k)
Y/L = C/L + I/L
C/L = (1-s)Y/L
LLL

y = f(k)
y= c+i
c = (1-s)y
k i - k

Note:
y-c=i
y - c = sy =sf(k)

sf(k) = i
k sf(k) - k

Key Relationship
k sf(k) - k
The change in capital per worker, k=K/L, is
equal to saving (investment) per worker less
depreciation of capital per worker. Capital
per worker increases if saving per worker is
greater than the depreciation in capital per
worker, and vice versa.

Growth and the Steady State

From above, the equation governing the
growth in capital per worker is:
k i - k = sf(k) - k
In the steady state equilibrium, the change
in the capital per worker is zero, k =0.
Investment = depreciation.

The Steady State Equilibrium

Given the equilibrium capital-labor ratio,
k*, we can find output, f(k*) and
consumption per capita, (1-s)f(k*).
Note that the economy converges in the
long run to a steady state, where there is no
growth! It arrives at a stationary state and
stays there.

Saving and Growth

Note experience of Germany and Japan
after WWII
See how a change in the saving rate affects
growth. It causes the capital to grow
towards a new steady state. But once that is
reached, there is no more growth.
So, what does a high rate of saving and
investment do for you? It gives you a higher
per capita income in the steady state.

Prediction:
Higher s higher k*.
And since y = f(k) ,
higher k* higher y* .
Thus, the Solow model predicts that countries
with higher rates of saving and investment
will have higher levels of capital and income
per worker in the long run.

International Evidence on Investment

Rates and Income per Person

Inc ome per

person in 1992
(logarithmic sc ale)
100,000

Canada
Denmark Germany
U.S.

10,000

Mexico

Egypt

Pakistan
Ivory
Coast

Finland
U.K. Singapore
Israel
FranceItaly

Peru
Indonesia

1,000

Zimbabwe
Kenya

India
Chad

100
0

Brazil

Japan

Uganda

Cameroon

10

15

20

25

30

35

40

Investment as perc entage of ou

(average 1960
1992)

A numerical example
Production function (aggregate):

Y F (K , L) K L K

1/ 2 1/ 2

To derive the per-worker production

function, divide through by L:
1/ 2
1/ 2 1/ 2
Y K L
K

L
L
L
Then substitute y = Y/L and k = K/L to
1/ 2
get

y f (k ) k

A numerical example, cont.

Assume:
s = 0.3
= 0.1
initial value of k = 4.0

Approaching the Steady State:

A Numerical Example
Assumptions:

k;

Year
Year
11
22
33

cc
1.400
1.400
1.435
1.435
1.467
1.467

ii
0.600
0.600
0.615
0.615
0.629
0.629

kk
4.000
4.000
4.200
4.200
4.395
4.395

yy
2.000
2.000
2.049
2.049
2.096
2.096

s 0.3;
kk
0.400
0.400
0.420
0.420
0.440
0.440

kk
0.200
0.200
0.195
0.195
0.189
0.189

Exercise: solve for the steady state

Continue to assume
s = 0.3, = 0.1, and y = k 1/2

Use the equation of motion

k = s f(k) k
to solve for the steady-state
values of k, y, and c.

Solution to exercise:
k 0
s f (k *) k *
0.3 k * 0.1k *

k*
k*

def. of steady state

eq'n of motion with k 0
using assumed values

k*

Solve to get: k * 9 and y * k * 3

Finally, c * (1 s )y * 0.7 3 2.1

Population Growth
Assume that the population--and labor force-- grow
at rate n. (n is exogenous)

L
n
L
EX: Suppose L = 1000 in year 1 and the
population is growing at 2%/year (n = 0.02).
Then L = n L = 0.02 1000 = 20,
so L = 1020 in year 2.

Introducing Population Growth

Recall that k = K/L and therefore,
% k = % K - % L
k/k = K/K - L/L

= ( I - K )/K - n
where n is the rate of population growth
Multiply both sides by k = K/L to get

k = I/L - k - nk

where I/L = i

Growth and the Steady State

From above, the equation governing the
growth in capital per worker is now :
k i - k - nk = sf(k) - (n)k
In the steady state equilibrium, the change
in the capital stock is zero, k =0.
Investment per capita = the depreciation
rate + population growth rate.

Break-even investment
( + n)k = break-even investment,
the amount of investment necessary
to keep k constant.
Break-even investment includes:

k to replace capital as it wears out

n k to equip new workers with capital
(otherwise, k would fall as the existing capital stock
would be spread more thinly over a larger population
of workers)

The equation of motion for k

With population growth, the equation of
motion for k is

k = s f(k) ( + n) k

actual
investme
nt

breakeven
investme

The Solow Model diagram

Investment,
break-even
investment

k = s f(k) (
+n)k
( + n ) k
sf(k)

k*

Capital per
worker, k

The impact of population growth

Investment,
break-even
investment

( +n2) k
( +n1) k

An increase in n
causes an
increase in breakeven investment,
leading to a lower
steady-state level
of k.

sf(k)

k2*

k1* Capital per

worker, k

Prediction:
Higher n lower k*.
And since y = f(k) ,
lower k* lower y* .
Thus, the Solow model predicts that countries
with higher population growth rates will have
lower levels of capital and income per worker
in the long run.

International Evidence on Population

Inc ome per
Growth and Income per Person
person in 1992
(logarithmic sc ale)
100,000
Germany
U.S.
Denmark
Canada

10,000

U.K.
Italy

Japan
Finland France

Mexico

Singapore

Egypt

Israel

Brazil
Pakistan
Peru

Indonesia

1,000

Cameroon

India

Ivory
Coast
Kenya

Zimbabwe
Chad

100
0

Uganda

3
4
Population growth (perc ent per ye
(average 1960
1992)

Chapter Summary
1. The Solow growth model shows that, in the long
run, a countrys standard of living depends
positively on its saving rate.
negatively on its population growth rate.

2. An increase in the saving rate leads to

higher output in the long run
faster growth temporarily
but not faster steady state growth.