Population Ageing and Economic Growth

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Sandra Gruescu
Population Ageing
and Economic Growth
Education Policy and Family Policy
in a Model of Endogenous Growth
With 7 Figures and 32 Tables
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Martina Bihn
Author
Dr. Sandra Gruescu
sandra_gruescu@yahoo.de
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(DRV Bund) Berlin, Germany
Dissertation, TU Darmstadt, D 17
ISSN 1431-1933
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Acknowledgements
My sincerest thanks to Bert Riirup for supervising my thesis and for teaching
me a lot about being an economist. I am grateful to Bernard Casey for guiding
me through many details in my thesis and to Werner Sesselmeier for help when
needed most. Financial support from the 'Forschungsnetzwerk Alterssicherung
(DRV Bund)' is gratefully acknowledged as this allowed me to spend most of
my studying time at the British Library, a great and inspiring place for writing
a thesis. Both the Fortune Park Early Years Excellence Centre and my family
provided excellent child care. I am particularly grateful to my mother-in-law,
Alexandra Gruescu, for extensive help every time I needed it. Many thanks to
everyone who helped with the language, especially John Chambers and Isobel
Montgomery and to Udo Kreickemeier for help with editing the final text. Of
course, all remaining errors are mine. My gratitude to my husband knows no
bounds.
London, July 2006
Sandra Gruescu
Contents
Part I Population in models of economic growth

1
Introduction
1.1 Motivation and main question of this research
,.
1.2 Organization of the research
1.3 The ageing population: Trends in Germany, United Kingdom
and the USA
The size and the growth rate of population
and economic growth
2.1 General literature on ageing population, declining population

size and declining population growth rate
2.2 Population in economic growth theory with exogenous
technological progress
2.3 Population in economic growth theory with endogenous
technological progress
2.3.1 Models with scale effects
2.3.2 Models without scale effects
2.3.3 Scale effects and policy intervention to increase
economic growth
Effects of a declining population in a model of economic
growth
3.1 Introduction to a model of economic growth - The Solow
(1956) model without technological progress
3.1.1 The real growth rate
3.1.2 The steady state
3.1.3 Transitional dynamics
3.1.4 Golden consumption
3.1.5 Speed of convergence
3
3
5
6
13
13
16
19
20
25
28
31
32
. 32
37
41
42
44
Contents
3.1.6
Conclusions on population and economic growth in

the Solow model
3.2 The Solow (1956) model with technological progress
3.2.6 Conclusions on population and economic growth in
the Solow model with technological progress
3.3 A model of economic growth with human capital - Mankiw,
Romer and Weil (1992)
the Mankiw, Romer, Weil model
3.4 A model of economic growth with human capital and age
structure - Lindh and Malmberg (1999)
the Lindh-Malmberg model
4
46
48
48
50
51
52
54
55
57
57
58
59
60
61
62
62
63
63
64
65
65
66
Effects of a declining population in a model of economic

grow^th with endogenous human capital - Lucas (1988)
4.1 The problem of dynamic optimization
and its solution
4.1.1 The problem of dynamic optimization with multiple
control and state variables
4.2 A model of economic growth with human capital - Lucas (1988)
4.2.1 The real growth rate .
4.2.2 The household
4.2.3 The Hamiltonian approach
the Lucas model
.
4.3 A note on the Lucas model
81
82
Conclusions of Part I
89
67
67
70
72
73
74
75
79
Contents
XI
Part II Models of economic growth with an ageing population

6
Models of "Silver Growth"
,....,..,,.,..,...
95
Models with exogenous population

,.
97
7.1 Model 1: The Solow (1956) model with an ageing population. , 97
98
99
102
7.1.4 Silver consumption
103
105
7.2 Model 2: The Lucas (1988) model with an ageing population . . 108
7.2.1 The real growth rate.
108
112
7.2.3 Comparison of Model 2 and Lucas (1988)
115
Models with quasi-endogenous population

119
8.1 Model 3: The Lucas model with the new time allocation and
quasi-endogenous population growth
121
123
129
. 131
8.1.4 A quantitative solution of Model 3
132
8.2 Model 4: A model of silver growth with the new time
allocation, quasi-endogenous population growth and an
ageing population
134
136
. 142
8.2.3 Comparative statics
145
8.2.4 Comparison of Model 3 and Model 4
148
Models with endogenous population

9.1 Model 5: The Lucas model with the new time allocation and
endogenous population growth
9.1.3 Comparative statics and transitional dynamics . . . . . . . .
9.2 Model 6: A model of silver growth with the new time
allocation, endogenous population growth and an ageing
population
9.2.2 The steady state .
9.2.3 Comparative statics and transitional dynamics
151
151
154
157
160
163
164
168
171
XII
Contents
10 Conclusions
.
,
10.1 Conclusions for economic growth theory
10.2 Conclusions for economic policy
177
178
185
11 Appendix
11.1 Derivations
11.1.1 Lucas (1988), section 4.2
11.1.2 Model 4, section 8.2.
11.1.4 Model 6, section 9.2
189
189
189
190
190
191
List of variables
193
References
195
Part I
Population in models of economic growth
Introduction
1.1 Motivation and main question of this research

A modern society faces two alternatives with regards to its population trend.
It can either grow or age. A population which chooses not to grow any more (or
which chooses to shrink) will necessarily age. And because of the impossibility
of all populations in all countries growing forever, it is likely that every country
will face this ageing process at some point in time. Because of this and the
importance of economic growth for the well-being of a society, the relationship
between an ageing population and economic growth will be relevant for each
country. It is already an important and much discussed matter for many.
Although population ageing is faced by virtually all industrialised countries,
the time frame and the intensity of the process vary.
The substantial changes forecasted for the demographic structure of many
countries over coming decades have led to substantial research activity aiming
to analyse and quantify the effects of these changes on a nation's economic
performance.^ A change in population size and population growth rate can affect both the demand and supply side of an economy. The extent of the effects,
however, is not clear.^ The structure of a population (for example, regarding
distribution of age or gender) may also influence the economic performance
of a society. The reason why age structure should be taken into account when
analysing economic issues is aligned with the fact (or in some fields conjecture)
that certain behaviours relating to consumption, employment, productivity,
etc. depend on a person's age. For example, if an older individual is less productive than a younger person, one could assume that, on an aggregate level,
the more older individuals a society possesses, the less productive it is. In
addition, even a constant population size does not necessarily mean that the
size of the workforce remains constant if the structure of the population is
subject to changes. For example, a change in age structure towards an older
^ For example, see OECD (2005, 2003, 1998a), IMF (2004) and Disney (1996).
2 Gromling (2004), Riirup (2000).
1 Introduction
population may decrease the size of labour supply because older age-groups
t e n d t o have lower labour force participation rates t h a n younger ones. Moreover, t h e d e m a n d side can be affected if a higher share of older people in a
population cause different consumption patterns. Problems with regard t o t h e
demand side of t h e economy are not analysed in this thesis, based as it is on
t h e works of t h e so-called neoclassical growth theory initiated by Solow (1956)
and Swan (1956).^ T h e neoclassical theory is focused on t h e supply side of
an economy, i.e. it is concerned with t h e growth potential of an economy.^
Another seminal paper in growth theory employed in this thesis is t h e work
by Ramsey (1928) on t h e household and its utility maximization over time.
This thesis is further motivated by t h e fact t h a t t h e question "How does
an ageing population affect economic growth?" has not been analysed in economic growth models with an infinite planning horizon. T h e current common
approach of analysing t h e effect of an ageing a n d / o r declining population on
economic growth is to run simulations based on equilibrium overlapping generations models.^ In this thesis the focus is on economic growth theory with
an infinite planning horizon aiming t o determine t h e factors which affect economic growth. T h e Solow (1956) and Lucas (1988) economic growth models
are widely accepted and employed in b o t h growth theory and growth empirics.
This thesis t h u s augments these two models making t h e m more appropriate
for dealing with an ageing population and t h u s with t h e effects of an ageing
population on economic growth.
We review some of t h e well-known growth models covering t h e relationship
between population growth and economic growth. In these models, demography is incorporated by focusing exclusively on one demographic variable, t h e
positive and constant growth rate of the population. Neither population decline, i.e. a negative growth rate of t h e population, nor a shift in t h e age
structure is assumed in these models. We demonstrate t h a t t h e current economic growth theory fails to provide a description of t h e demographic change
called population ageing and therefore neglects its potential influence on economic growth. T h e present thesis aims to expand economic growth theory in
this area and t h u s focuses on t h e age structure and size of a population and
their influence on economic growth. Growth theory aims t o find an answer t o
t h e question "When is an economy capable of steady growth at a constant
rate?"^ In this thesis we ask this question in economic growth theory in a
Other early works include Meade (1961) and Phelps (1961).
The Post-Keynesian growth theory (Harrod (1939), Domar (1946)) analyses economic growth with regards to the demand side. This theory assumes that investment will create capacities - the main question is then if demand is high enough
to use all of the capacities. This strand of literature was criticized as it does not
explain what determines economic growth - and therefore for many is not part of
economic growth theories.
For example, see Borsch-Supan et al. (2004), Futagami and Nakajima (2001),
Miles (1999), Kosai et al. (1998) and Jahnke (1990).
Solow (2000), p. ix.
1.2 Organization of the research
slightly different way: "In an ageing society, when is an economy capable of

steady growth at a constant rate?"
1.2 Organization of t h e research

Chapter 2 gives an overview of the literature focusing on the influence of
demographic variables on economic growth. It begins with a short overview
of findings in the general economic literature starting at the beginning of
the last century. This general literature is not based on economic growth
theory. Next the literature in economic growth theory based on models with
exogenous technological progress and models with endogenous technological
progress or endogenous human capital is reviewed. In analysing these models,
the focus is on the influence of demographic variables on economic growth and
also on scale effects. 'Scale' is usually measured as the size of the population.
Chapter 2 concludes with an assessment of the possibilities of economic growth
enhancing policies based on these models as scale effects determine the scope
for policy interventions. Chapter 3 gives an in-depth analysis of the seminal
economic growth model with exogenous technical progress by Solow (1956),
focusing on the effect of a declining population on economic growth. Two
empirical studies of the Solow model by Mankiw, Romer and Weil (1992)
and Lindh and Malmberg (1999) are also analysed. Chapter 4 analyses Lucas'
(1988) economic growth model with endogenous human capital. The analysis
focuses on the predictions the model makes about how the size and growth
rate of a population affect economic growth.
As the Solow (1956) and Lucas (1988) models do not differentiate between
the population and the workforce (and their respective growth rates), the
models cannot say anything about a change in the ratio of the workforce to
the non-working population. A change in this ratio is usually a consequence of
population ageing. Thus, analysing these models, we have to concentrate on a
declining population, i.e. a negative population growth rate. We will look at
these models in the same way. Initially we describe the findings about the relationship between population growth, in these models assumed to be positive
and constant, and economic growth. Then we assume a declining population
in the context of the models. We analyse if and how this 'new' environment,
namely the declining population, does change the real growth rate, the steady
state equilibrium and the transitional dynamics of the model. We explain how
the values for the endogenous variables output Y and physical capital K will
change because of a change in the exogenous variables, population (or workforce) growth rate n and the size of the population (or workforce) L, due
to a population decline. Employing these models within the framework of a
declining population, we demonstrate that it is not always possible to reach a
steady state solution. We then consider optimal growth and its related 'golden
consumption'. We will demonstrate whether the level of golden consumption
is changed in a model which includes a declining population. Where possi-
1 Introduction
ble, we will analyse the speed of convergence, i.e. the speed of the transition
dynamics in the model towards its steady state equilibrium (if it exists). We
analyse whether the speed of convergence predicted by the model will change
due to the demographic trend. Chapter 5 summarizes the model analysis and
highlights the shortcomings of the models while identifying areas for further
research.
As a result, in Part II of the thesis (chapters 6ff.), we develop new models
aimed at eliminating some of the identified shortcomings. First, we develop
two simple "models of silver growth" where one is based on Solow (1956) and
the other on Lucas (1988) (chapter 7). We call these "models of silver growth"
as they include a variable D to account for the ageing population, i.e. a shift
in its ratio between non-working individuals (the elderly) and working individuals (the workforce). Hereby "silver growth" refers to economic growth in
a society nicknamed a 'silver society' as it possesses a relatively large share
of elderly individuals.^ A more sophisticated model with endogenous fertility
based on Lucas (1988) is developed in section 8.1. Into this amended model
the variable for ageing is introduced in section 8.2. As this introduction of
the variable D allows us to differentiate between the workforce and the population we will employ one function to generate the growth of the workforce
and another function to generate population growth. We derive a steady state
solution for the endogenous population growth rate and the endogenous workforce growth rate. It is not possible mathematically to derive a solution for
these growth rates in their transition phase when the economy is in disequilibrium. For this reason we call the models in chapter 8 "Models with quasiendogenous population" as we know the solution for endogenous population
growth and workforce growth in the steady state but not when the economy
is in transition. In chapter 9 we develop the model further and derive a fully
endogenous population growth rate and a fully endogenous workforce growth
rate, i.e. they can be solved for the transition period and the steady state.
In this model economy we employ two policies, education policy and family
policy, and analyse their effect on economic growth and population growth.
Chapter 10 concludes by answering the main question stated in the introduction. It highlights mechanisms necessary to achieve positive economic growth
in an ageing society based on the results of our "silver growth models". The
chapter concludes with implications for both economic growth policy in terms
of family policy and education policy and economic growth theory.
1.3 The ageing population: Trends in Germany, United

Kingdom and the USA
Generally speaking an ageing population is a population which is confronted
by an increasing share of elderly and a decreasing share of young people.
^ Another common nickname is "grey society" or "grey population".
1.3 The ageing population: Trends
This is now occurring t o an extent not experienced in t h e past. T h e United

Nations classifies population on t h e basis of the percentage of people aged 65
and over. In a young population 4 per cent or less are aged 65 or over. In a
m a t u r e population t h e number is between 4 and 7 per cent, and in an aged
population t h e number of people aged 65 or over is over 7 per cent. Many
industrialised countries fall into t h e category of an aged population.^
Several indicators are available t o describe t h e age structure of a population.^
(a) T h e ageing index is calculated as t h e number of people aged 60 years
or over, per 100 persons under t h e age of 15 years. For Germany t h e figures
are 63.0 (1950), 94.9 (1975), 149.7 (2000), 271.9 (2025) and 307.5 (2050). T h e
higher t h e ageing index, t h e more pressure is p u t on a society t o change its
p a t t e r n s of redistribution, e.g. fewer schools b u t more long-term care facilities.
In t h e United Kingdom (UK) t h e figures are 69.5 (1950), 84.1 (1975), 108.7
(2000), 194.0 (2025) and 226.7 (2050). Although t h e ageing index in t h e UK
was higher in 1950 t h a n in Germany, t h e projections show a lower ageing
index in 2050, due to t h e higher fertility rate in t h e UK. T h e United States of
America (USA) has an even higher fertility rate and therefore a lower ageing
index. T h e figures for t h e USA are 46.3 (1950), 58.8 (1975), 74.4 (2000), 133.8
(2025) and 144.9 (2050). T h e current and future ageing index in t h e USA is
about half of Germany's index.
(b) T h e median age is t h e age which divides a population into two equal
groups of t h e same size. In Germany t h e median age rises from 40.1 (2000)
t o 48.5 (2025) and to 50.9 (2050). In the UK t h e median age rises from 37.7
(2000) t o 44.5 (2025) and t o 47.4 (2050). In t h e USA t h e rise is less pronounced
with a change from 35.5 (2000) to 39.3 (2025) and t o 40.7 (2050).
(c) T h e old-age dependency ratio is defined as t h e ratio of people aged
65 and over per 100 persons aged 15 t o 64.^^ This ratio defines t h e financial
burden the ageing population p u t s on Social Security systems and in particular
pay-as-you-go financed pension systems. In Germany t h e old-age dependency
ratio is predicted to rise from 24.1 (2000) to 39.0 (2020) to 54.7 (2050). In t h e
UK t h e figures are 24.1 (2000), 34.8 (2020) and 47.3 (2050). In t h e USA t h e
dependency ratio is projected t o remain considerably lower with 18.6 (2000),
29.3 (2025) and 34.9 (2050).
(d) T h e total fertility rate (TFR) is defined as t h e average number of children a woman would bear over t h e course of her lifetime if current age-specific
fertility rates remained constant throughout her reproductive age (normally
15 to 49). If t h e total fertility r a t e is 2.1, t h e fertility is at replacement level.
^ United Nations (1956). For example, in Germany the number of people aged 65
or over is 16.4 percent (in 2000), see United Nations (2002), 244.
^ The following figures are taken from the United Nations (2002), 244-245 (Germany), 458-459 (United Kingdom of Great Britain and Northern Ireland), 462-463
(United States of America), unless stated otherwise.
^ The old-age dependency ratio is sometimes defined in terms of people aged 60 (or
65) and over and per 100 persons aged 20 to 59 (or 64).
1 Introduction
In the year 2005 the TFR is 1.3 in Germany, 1.6 in the UK and 1.9 in the
USA.
(e) Life expectancy at a specific age is defined as the average number of
additional years a person of that age could expect to live if current mortality
levels observed for people above that age were to continue for the rest of that
person's life. The life expectancy at the age of 65 determines the retirement
period. In Germany this life expectancy is 17.6, in the UK 17.5 and in the
USA 18.0 years. As the figures for life expectancy at the age of 65 are roughly
the same it becomes clear that the diff'erence in the indicators described in
(a)-(c) are mainly caused by the differences in the fertility rate.
(f) Broad age groups can be used to show the shift in the age structure of
a population. The following three tables 1.1, 1.2 and 1.3 show that the age
group of persons 0 to 14 will shrink whereas the group of persons 60 and older
will increase to more than a third of the population (Germany, UK) or to a
quarter of the population (USA).
Table 1.1. Broad age groups, Germany
Age
1950 1975 2000 2025 2045
0-14 23.2 21.5 15.5 12.2 12.4

15-59 62.2 58.1 61.2 54.6 49.5
60+ 14.6 20.4 23.2 33.2 38.1
Table 1.2. Broad age groups, UK

Age
1950 1975 2000 2025 2045
0-14 22.3 23.3 19.0 15.2 15.0

15-59 62.1 57.0 60.4 55.4 51.1
60+ 15.5 19.6 20.6 29.4 34.0
Table 1.3. Broad age groups, USA

Age
1950 1975 2000 2025 2045
0-14 27.0 25.2 21.7 18.5 18.5

15-59 60.5 60.0 62.1 56.6 54.6
60+ 12.5 14.8 16.1 24.8 26.9
(g) The population growth rate is defined as the increase or decrease in the
number of persons in the population over a given period of time, expressed
as a percentage of t h e population at t h e beginning of t h e time period. T h e

growth rates of t h e t o t a l population and t h e older population are likely to
differ. T h e following tables 1.4, 1.5 and 1.6 give t h e figures for Germany, UK
and t h e USA.
Table 1.4. Growth rate of the total population and of specific age-groups, Germany,
in per cent
Total pop.
60+
65+
80+
1950-1955 1975-1980 2000-2005 2025-2030 2045-2050

0.6
-0.1
0.0
-0.3
-0.5
2.1
-1.2
1.2
1.4
-0.2
2.6
2.0
-0.4
2.5
0.9
3.3
0.1
5.6
4.8
1.7
Table 1.5. Growth rate of the total population and of specific age-groups, UK, in
per cent
Total pop.
60+
65+
80+
1950-1955 1975-1980 2000-2005 2025-2030 2045-2050

0.2
0.0
0.2
0.0
-0.3
1.1
1.5
0.6
0.9
0.1
2.1
1.2
1.6
0.6
-0.1
2.2
3.6
2.8
3.1
1.6
Table 1.6. Growth rate of the total population and of specific age-groups, USA, in
per cent
Total pop.
60+
65+
80+
1950-1955 1975-1980 2000-2005 2025-2030 2045-2050

1.6
0.9
0.9
0.7
0.5
1.5
0.7
2.6
2.0
1.6
2.4
0.6
2.9
2.3
0.9
4.2
2.5
4.5
3.0
0.5
T h e projections for t h e future show t h a t the growth rates for t h e 6 0 +

always exceed t h e growth rates of t h e t o t a l population. In the case of a decline
of t h e total population, t h e older age groups are either still growing or are
shrinking less t h a n t h e t o t a l population. For example, projections show t h a t
in 2045-2050 in Germany (UK) t h e age group 8 0 + grows by 1.7 (1.8) per cent
in this period while t h e t o t a l population falls by 0.5 (0.3) per cent.
An ageing population stems either from below-replacement fertility levels
which result in a long-term declining population, or from declining mortality levels among t h e elderly (i.e. rising life expectancy), or a combination of
10
1 Introduction
both.^^ In t h e earlier stages of t h e 'demographic transition'-^^, t h e decHne in

fertihty was t h e main determinant of population ageing. An important feature
of fertility decline is the self-reinforcing speed of decline. Not only is t h e size
of t h e younger generation supposed to support t h e older generation reduced,
b u t t h e next generation (produced by t h e young generation of reduced size
today) will be of even smaller size, even if fertility p a t t e r n s remain constant.
However, a rise in life expectancy among older age groups has increasingly
become t h e more important factor in shaping t h e relative size of t h e oldest
age groups. Combining t h e total fertility r a t e (below, at, or above replacement
level) and life expectancy (rising or constant) results in the following effects
on population as shown in Table 1.7.
Table 1.7. Effects on the population age-structure and population size as a result
of different levels of TFR and life expectancy
rising life expectancy
TFR < 2.1 (1) ageing + declining
TFR = 2.1 (2) ageing + constant size
TFR > 2.1 (3) ageing + increasing
constant life expectancy

(4) ageing + declining
(5) constant age structure + constant size
(6) rejuvenating + increasing
We differentiate between the following cases:

(1) An ageing and declining population. T h e population growth rate may
be positive in t h e beginning because of t h e growing number of elderly. But
when t h e below-replacement fertility rate sets in, t h e population declines
(rapidly). B o t h t h e old-age dependency ratio and the median age rise. T h e
demographic variables imply an age-structure and a population size effect.
(2) W i t h a constant population size t h e population still ages because of
a rising longevity but to a much lesser extent t h a n in (1). B o t h t h e old-age
dependency ratio and t h e median age rise but to a lesser extent t h a n in (1).
T h e demographic variables imply an age-structure effect but no size effect in
t h e long run.
(3) W i t h rising life expectancy and a positive population growth r a t e t h e
population is still likely t o age. T h e rising life expectancy pushes t h e old age
dependency ratio upwards.
(4) An ageing and declining population. T h e population growth r a t e is
negative. T h e demographic variables imply an age-structure effect and a size
effect. T h e size effect is stronger t h a n in (1). Both t h e old-age dependency
ratio and t h e median age rise but t o a lesser extent t h a n in (1).
^^ The impact of migration on the age structure of the population will not be discussed here. Throughout the thesis we assume a closed population, i.e. one which
is not affected by migration. For the effect of migration on population, see e.g.
United Nations (2000).
^^ For a description on the demographic transition, see United Nations (2002), 5.
11
(5) W i t h a constant population size and a constant mortality of t h e elderly,

t h e age structure remains unchanged. If there is a change in t h e age structure
(and thus a change in t h e old-age dependency ratio and t h e median age) it is
due t o different cohort sizes, e.g. the baby boom generation is getting older.
In the long-run, a population t h a t keeps its size and mortality rate constant
also has a constant age structure.
(6) A constant life expectancy and a t o t a l fertility rate above replacement
level gives a positive population growth rate. T h e old-age ratio and t h e median
age declines. T h e population rejuvenates and increases.
In general, t h e ageing process implies a size effect (i.e. a declining population) and a structure effect (i.e. an ageing population). These two effects
are interrelated as a change in t h e population size usually implies a shift in
t h e age structure. In m a n y developed countries t h e demographic development
is as described in case (1) with a size and a structure effect. As pointed out
in the introduction a population can either grow or age. A population which
chooses not to grow any more will age. Because for many countries an ageing
population is inevitable, a situation where t h e T F R is at replacement level
(case (2)) could be seen as a target case for policy makers. In this case t h e
age structure represents a younger population t h a n in case (1). But t h e fact is
t h a t population ageing is likely to continue into t h e future as mortality among
t h e elderly is declining. ^^ J u s t as increasing life expectancy is a desirable outcome of modern societies, a low fertility r a t e is seen as less desirable in t h e
industrialised countries.
T h e population size, t h e population growth r a t e and t h e age structure
of t h e population are t h r e e demographic variables which are likely t o have
an influence on economic growth. How and t o w h a t extent they effect t h e
economy depends on t h e economy's ability to adjust t o a new population
size or population structure. In particular, if t h e pace of changes in t h e age
structure is high, adjustments of social and economic institutions may be even
more difficult. For example, t h e fertility rate dramatically dropped by half in
former East Germany after re-unification of West a n d E a s t Germany. This
caused a significant shift in t h e age structure of t h e population.-^^ T h e numbers
and projections in this chapter show t h a t Germany in particular faces a significant ageing process which also includes a decline in population size. How
this change in population size and population age structure affects economic
growth and t h e scope for economic policy is t h e topic for t h e remainder of
this thesis.
^^ OECD (2005), 7.
^^ The total fertility rate dropped from 1.56 (1989) to 0.83 (1992) to 0.77 (1994) in
former East Germany See BMFSFJ (2003), 71, table 13.
The size and the growth rate of population

and economic growth
2.1 General literature on ageing population, declining

population size and declining population growth rate
This review s t a r t s with t h e h t e r a t u r e which arose following t h e low(er) fertility in countries such as t h e United Kingdom, t h e USA, France and Germany.-^
At t h e beginning of t h e world-wide ageing process, t h e fertility decline was
t h e primary determinant of population ageing. For this reason, with a few
exceptions, most of t h e literature on population and economic growth in t h e
first decades of t h e 20th century is concerned with t h e causes and consequences of this fertility decline. Specifically, t h e literature focuses on a decline
in population size and its effect on t h e growth rate of national income. T h e
decline in fertility was t h e variable which was most important in determining
t h e demographic change. T h e influence of declining mortality rates at older
ages in particular on t h e age structure of a population was (and still is) more
important in t h e later stages of t h e 'demographic transition' and is therefore
covered widely in t h e literature following t h e middle of last century. For this
reason, t h e focus of t h e literature has shifted somewhat t o a concern with an
ageing population instead of a declining population.
In Germany, t h e literature with regards t o falling fertility rates in t h e 1920s
and 1930s focused on t h e change of t h e population size. This fact was taken
as a very serious t h r e a t for t h e German people. Danzer (1937) in his booklet
Geburtenkrieg ("The Birth War") asked t h e question "What poses a greater
1
For an early discussion of the declining population in Germany see e.g. Buttler
(1979) and Dettling W. (ed.) (1978). On France: see Spengler (1938). Three early
works on population and economic growth are not discussed here as they focus
on a growing population: Malthus (1798) and Ricardo (1817) stress the limitation
of natural resources and the danger of an increasing population. In the line with
Smith (1776), population growth is both a cause and a consequence of economic
growth. See for a review of Malthus, Ricardo and Smith: Ehrlich and Lui (1997),
Hansen and Prescott (1998) and Galor and Weil (1999).
14
2 The size and the growth rate of population and economic growth
threat to the Fatherland? War or a declining birth rate?"^ He suggested that

the latter was a far more dangerous threat, calling it a "disease" (p.46). More
children and a bigger family size means more consumers (and also more soldiers) and thus he concludes "Growing people - growing economy, Shrinking
people - shrinking economy!".^
Miihlner (1934) in the book Land ohne Kinder - Land ohne Zukunft!,
Wirtschaftskrisis und Geburtenriickgang ("Land without children - Land without a future!. Economy Crisis and Birth Decline") comments on the effect of
a falling birth rate on the supply side, i.e. labour supply. Human beings are
needed in the production process and also to support the growing number of
older people (p.37). Nevertheless human beings are even more important on
the demand side. A falling birthrate will reduce consumption which in turn
will result in a "severe disruption of the economic equilibrium" .^
Following the decline in the population growth rate in the USA and Great
Britain, Keynes (1937) writes in his article Some consequences of a declining
population "that in an era of declining population...demand tends to be below
what was expected" (p. 125). Demand depends on population size as it implies
the number of consumers. In addition, demand also depends on the standard
of living. In this context "declining" means a slower population growth albeit
still positive. With a lower population growth rate and therefore a smaller than
expected population size and without "any significant technical lengthening of
the period of production" (p. 127) demand can be driven only by an increase
in the standard of living or a fall in the rate of interest.
Ritzema (1937) finds, in his analysis of the population development in
Great Britain A national peril: Our declining population, A momentous problem, that "the large and continuous decline in the growth rate of our population must at no distant date end in catastrophe unless means to avert it can
be found" (p.3). This is underlined by some projections (disregarding migration) stating that "if fertility and mortality rates continue to fall as indicated
by recent experience, the population of England and Wales, which, as enumerated at the census of 1931, was 39.952.377, will decline to 20.440.000 by
1995 and 4.426.000 by 2035" (p.4).^ For the author it is clear that "as soon as
people realize that we are a declining nation, all confidence in our future will
be gone." (p.7). In addition "we would sink to the position of a fourth-rate
power in a comparatively short time" (p.4). The effect of a declining fertility
rate on population size has considerable consequences with regards to military
In the original, "...wodurch ist das Vaterland mehr gefahrdet? Durch den Krieg
oder den Geburtenriickgang?" (p.75).
"Wachsendes Volk - Wachsende Wirtschaft, Schrumpfendes Volk - Schrumpfende
Wirtschaft!" (p.30)
In the original "...schwere Erschiitterungen des wirtschaftlichen Gleichgewichts"
(p.38).
Ritzema was proved wrong. In 1995, the population in England and Wales was
51,272,000. See National Statistics UK (2005), table 1.2 of Population Trends
120.
2.1 General literature
15
power (understandably, with reference to Germany). Economic consequences

are neglected in his analysis.
Following Davies' article Our ageing population (1938) the "reading public
has suddenly become population-conscious and is vaguely aware that at some
future time we shall be faced with a declining population" (p.l). The author
instead wants to draw attention to the "increasing average age of the community" (p.l). He projects a shift in demand because "the increasing average
age is already stimulating the demand for all things making for better health"
(p.7) He suggests an increasing average working age and a later retirement
(p. 10). In addition he is concerned with the military position of the British
Empire because "the present white population of the entire Empire is roughly
70 millions (...) against 77 millions in the German Reich" (p. 10). In addition
he analyses social and cultural effects, sport and recreation, health services
and national debt. The author comes to the conclusion that the effect of the
demographic change "will be far-reaching, and will involve great social disturbances unless preceded, or at least accompanied, by a drastic redistribution
of income and a reorganization of society" (p. 14).
In Keynes (1937) and Ritzema (1937), the change in age structure inevitably accompanying a change in population size caused by a falling birth
rate, is not mentioned. Reddaway (1939) takes the analysis further - similar
to Davies (1938) - in The economics of a declining population. Immediately
in the book's preface he makes clear that "the words declining population
in the title have been used to cover all the coming changes in its size and
age-composition" (p.8). In line with the author's comments, a changing age
structure of the workforce "has had little effect one way or the other in the
past, and is not likely to do so in the relatively near future" (p. 144). In contrast to Ritzema (1937) and Davies (1938), after analysing the effect of a
declining population on income, unemployment, public finances and trade, he
concludes that "the economic outlook must be regarded as at least potentially favourable" (p.229) but he admits dealing only with the comparatively
near future. However, he does conclude that this outlook is favourable only
if society tackles unemployment as this risk will be considerably greater in a
declining population in the future.^
Hansen (1939) addresses the decline in the population growth rate in the
presidential address delivered at the annual meeting of the American Economic Association Economic progress and Declining Population Growth. He
analyses the eflPect of population growth on physical capital formation. Physical capital formation can occur in the form of capital deepening (more capital
per unit of output) and capital widening (an increase in output but the same
amount of capital per unit of output). The latter is partly caused by an increase in population and partly caused by an increase in productivity per
capita. According to Hansen a stationary or even declining population with
a higher share of older people has two effects. First, it changes the composiReddaway (1939), 231.
16
tion of consumer demand as older people may demand more personal services
whereas a younger and larger population demands more investment such as
new residential buildings. Second, this change in consumer pattern implies
- because personal services need less investment expenditures than building
construction - that overall investment expenditure is likely to fall. Thus, the
ratio of physical capital to output (and therefore the capital widening process)
will decline/
This analysis of the general literature on population and economic growth
generally indicates that a declining population size has a negative effect on
the economy (not necessarily defined in terms of economic growth). The evidence of the effect of an ageing population, i.e. a change in the population age
structure, on the economy is mixed. However, the literature reviewed so far
does not contain a conclusive theory on economic growth. Economic growth
theory, as it is currently known and employed in research, started with Solow
(1956) and Swan's (1956) neo-classical growth theory with exogenous technological progress. In the next chapter, the sparse literature on demographic
variables in this "exogenous growth theory" will be reviewed.
2.2 Population in economic growth t h e o r y with

exogenous technological progress
Pitchford (1974) analyses the role demographic variables play in economic
growth models in his book Population in Economic Growth.^ Many properties of the neoclassical model associated with Solow (1956) and Swan (1956)
are dependent on the assumption that the rate of growth of population is constant and positive. Assuming that population always grows at a constant and
positive rate, the ratio between the workforce and older and younger dependants can be regarded as a constant. Thus, a change in the age structure of
the population (or rather a change in the ratio of the non-working elderly to
the working young) does not occur in the model. In the model's equilibrium
solution the growth rates of physical capital K and output Y are the same as
the population growth rate n, which means that physical capital per head of
the population k = ^ and output per head of the population ^ = ^ do not
grow at all. The higher the population growth rate, the higher the economic
growth, in terms of growth of national income. However, the growth rate of
income per head is zero in the equilibrium. If exogenous technological progress
QA is included in the model, the growth rate of national income gy equals the
sum of the population growth rate and the rate of technological progress, i.e.
gy = n -\- gA' The growth rate of income per head of the population equals
the rate of technological progress gAThe results of the model are determined by the growth of the population
but not by its size. Any population size can be the starting point of the
^ Hansen (1939), 7.
^ Pitchford (1974), chapter 4. See also Pitchford (1972).
2.2 Population in exogenous growth models
17
economy. In the steady state the growth rate of national income always equals
the sum of the population growth rate and the rate of technological progress.
The growth rate of income per head equals technological progress QA- In other
words, scale effects from the size of population are absent with regards to the
outcome of the steady state. Assuming a non-negative population growth rate,
in each period the highest output per head is achieved when the population
is stationary, i.e. n = 0. In such a period, the national income grows with the
rate of technological progress QA while the population remains constant. In
the following period(s), the population remains constant while the national
income increases, increasing in turn the cut per head. The fact that scale
has no consequence leads to the result that the equilibrium level of output
per head is the same, whatever the size of the population, as long as the
population is stationary. The absolute size of population plays no essential
part in determining the steady state growth rate and the steady state levels
of the model.
In the article Wirtschaftswachstum bei stagnierender und schrumpfender
Bevolkerung ("Economic Growth with a Stationary and Declining Population") its author Kurz (1982) analyses economic growth theory as a tool for
dealing with economic growth in an economy with a shrinking population.
The author surveys the Solow (1956) model, assuming a non-positive population growth rate n < 0. In the analysis, he neglects depreciation of physical
capital.^ In the case of a stationary population (n = 0), the model predicts
the same results as the model with a positive population growth rate. National income F , capital stock K and income per head of the population y
grow with the same rate as technological progress QA- In case of the rate of
technological progress exceeding the amount of negative population growth
rate {gA > \ n |), there is positive and steady state growth.^^ In the case of
the rate of technological progress equaling the amount of population growth
rate, [gA =\ n |), the economy experiences stagnation. The positive effect
on economic growth due to technological progress is exactly offset by the
negative effect of the declining population. The same outcome results in a
situation where n = 0 and gA = 0. Both k and y grow towards infinity, but
with a decreasing rate. Finally, in the case of a declining population and a
rate of technological progress which falls short of the amount of the negative
population growth rate {gA <\ n |), the economy declines. With a decrease
in Y the capital stock K declines towards zero. The income from which the
savings are taken also goes towards zero. Income per head increases because
national income declines slower than the population. While the living standard rises, the economy does not reach a steady state and declines indefinitely.
^ This is done without explanation. In the analysis of the Solow model in chapter
3 we will show that excluding/including the depreciation rate can change the
results of the model considerably when assuming a negative population growth
rate.
^ Kurz (1982), 238.
18
Kurz (1982) comes to t h e conclusion t h a t t h e neoclassical growth theory is

not appropriate making predictions about t h e effect of a declining population
on economic growth and should not be used as a basis for economic policies.-^^
T h e main reasons are: no age-structure is included in t h e model; there is a
time-lag between t h e declining birth rate and a declining growth r a t e of t h e
working population of about 20 years on average; t h e shrinking process is
self-reenforcing, a fact which cannot be modelled since t h e population growth
rate is a constant.-^^
In his article Demographische
Variablen in der okonomischen
Wachstumstheorie ("Demographic variables in economic growth theory") Schmitt-Rink
(1986) examines t h e case where technological progress QA falls short of t h e
amount of t h e negative population growth rate {QA <\ n \) in more detail. As
in Kurz's (1982) analysis, depreciation of physical capital is neglected without
an explanation. Schmitt-Rink (1986) describes t h e existence of a 'shrinking
equilibrium' (p. 69). A 'shrinking equilibrium' is a situation in which all relevant variables decline with constant rates. Assuming t h a t t h e number of workers declines with t h e (negative) population growth rate n, with QA <\ n |,
an equilibrium growth would imply t h a t t h e number of jobs declines also with
n (otherwise it would not be equilibrium growth). Furthermore, as t h e capital
stock declines with gx = '^ + 9A < 0, t h e net investment ratio must be negative. ^^ T h e decline in capital stock with n -^ gA < 0 and t h e decline in t h e
number of jobs with n imply an increase in capital per worker k with t h e rate
of technological progress gA
T h e author shows t h a t t h e equilibrium is no longer stable if the growth
r a t e of t h e workforce is negative (p. 70-71). In this shrinking equilibrium t h e
decline of t h e number of jobs and of t h e number of workers at t h e same
r a t e implies certain levels of /;;* and y* (and therefore capital productivity
Y/K).
To make sure t h a t firms choose this production process with these
levels of A:* and ?/*, a particular wage and interest level is relevant. Assuming
t h a t t h e wage level is too high (too low) t h e firms choose a k t h a t is t o o
high (too low), t h e n t h e economy is not in its equilibrium. In this situation,
t h e number of jobs declines with a smaller (bigger) rate t h a n t h e number
of workers. This is because the actual rate of decline of t h e capital stock,
i.e. t h e product of t h e (given) savings rate and capital productivity, has a
lower (higher) amount t h a n t h e necessary rate of decline because of t h e toolow (high) capital productivity. A too-high (low) wage level implies a decline
in t h e capital stock and in the number of jobs with a too-low (high) rate.
The same result is concluded by Jackson (1991).
Kurz (1982), 244.
In a closed economy this implies a negative saving ratio. In an open economy
the coexistence of a negative investment ratio and positive savings ratio may
be possible. The difference is the capital export ratio (> 0). A declining capital
stock can be the result of 1) non-replacement of used factors, 2) consumption
of production factors, 3) destruction of production factors and 4) in an open
economy, export of production factors. See Schmitt-Rink (1986).
2.3 Population in endogenous growth models
19
During this process there is a growing excess supply of jobs (workers) which
leads t o a rise (decline) in t h e wage level and a decline (rise) in t h e interest
leveL In contrast t o t h e growth model with positive population growth, in t h e
neoclassical model with population decline a too-high (low) wage level does
not trigger wage decline (wage increase). Instead it triggers further increases
(declines) in the wage level, due t o a growing excess of workplaces (workers).
In conclusion, t h e assumption of a negative growth rate of workforce and
population leads to t h e instability of t h e equilibrium.^^ As a consequence, a
reasonable analysis is no longer possible. In addition, even if the population
growth rate is assumed to be positive, neither t h e effect of t h e (changing) age
structure of t h e population nor t h e implications of t h e size of t h e population
on economic growth can be analysed in this theory.
As t h e literature on demographic variables and economic growth in "exogenous growth theory" reviewed in t h e current chapter is thin, we provide
a much more detailed analysis of Solow (1956) and other models with regards t o population and economic growth in chapter 3. First, we review t h e
"endogenous growth theory" in t h e following section.
2.3 Population in economic growth theory with

endogenous technological progress
T h e models of economic growth analysed in t h e current chapter contain m a n y
insights with regards to t h e engines of endogenous growth. However, as t h e
present thesis is concerned with t h e effects of demographic variables on economic growth, we focus here on t h e relationship between t h e workforce (or
population) size L and its growth r a t e n and t h e level of income per head y
and its growth rate Qy^^ First, we analyse wether n and L have any effect at
all on Qy and y. If there are effects, we show wether they are positive, negative
or neutral (i.e. two eflPects t h a t cancel each other out), and explain why t h e
effect goes in a certain direction. As shown in section 2.2, economic growth
theory with exogenous technological progress predicts t h a t population decline
has a positive effect on t h e equilibrium level of income per head (under t h e
assumption t h a t t h e steady state exists). Positive population growth has a
^^ Schmitt-Rink (1986), 71. This result was also obtained by Cigno (1981, 1984).
Ritschl (1986) shows that a steady state is possible with any population growth
rate assuming a certain saving function. This was already proposed by Solow
(1956), 80-82. In the case of a savings function where savings are proportional to
the difference between the actual profit income and its zero investment level (see
Ritschl (1986), 165) the stability of the steady state is no longer affected by the
sign of n. The only restriction is that n does not fall short of the depreciation
rate.
^^ Note that in these models population size and workforce can be used interchangeably, i.e. L = N,
20
negative effect, i.e. the level of income per head of the population in equilibrium is lower if population growth is high. The population size L has no effect
on the steady state solution, i.e. scale effects are absent.
In economic growth theory with endogenous technological progress, i.e.
growth theory with an endogenous explanation for technological progress, the
growth rate of the population and the size of the population have an effect
on economic growth different from the one in the "exogenous growth theory"
analysed in section 2.2. This is caused by the scale effects. For this reason
we first analyse the models with scale effects in 2.3.1 and then the models
without scale effects in 2.3.2. The findings are summarized in table 2.1 and
table 2.2 below.
2.3.1 Models with scale effects
In Romer (1990a), technological progress consists of inventing new varieties
of capital, i.e. intermediate goods. The model assumes a constant population
and a constant supply of labour. It emphasizes human capital as part of the
research process. Human capital is a specific ability which is embodied in a
human being. The total stock of human capital H is fixed in the population. It
is divided between the production sector {Hy) and the research sector {HA) SO
that H HY+ HA- Human capital can flow freely between the two sectors.
Wage differences between the two sectors are incentives for human capital
to change to the other sector. Thus in equilibrium the wage levels in the two
sectors have to be the same and they are both constant. Technological progress
A, i.e. the rate of growth of the varieties of capital goods, is proportional to
the amount of human capital allocated to research activities HA- In addition,
it depends on the existing stock of knowledge A which is available to a person
employed in research. Then technological progress takes the form oi A =
SHAA with J as a productivity parameter. The key assumption is that A is
linear in A.^^ In equilibrium the growth rate of technological progress Â = ^^
of aggregate output gy^ of aggregate consumption gc and of the stock of
physical capital gx is the same, i.e. g = gA = 9Y = gc = 9K =" SHA (P- S92).
Because the population and workforce is taken as constant the per capita
growth rate is also gy = 5HA- The conclusion with regards to population size
and its growth rate is, that the stock of human capital devoted to research
rather than population size determines the growth rate gy. A large population
is not sufficient to generate growth since growth depends on the stock of
human capital in this population.
Should the population size change, for example the population (and thus
the workforce) increases, then the growth rate gy rises if HA, the amount of
Under the assumption A = SHAA^ , for ^ = 1 the relationship is linear. If instead,
0 < ^ < l,the growth rate of Y falls to zero. For 9 > 1, outcome Y grows without
bound. The model works only under the assumption that 0=1. See Solow (2001),
152.
21
h u m a n capital devoted to research, rises. In this situation, aggregate o u t p u t

grows with gy = 5HA and t h e income per head of t h e population grows with
Qy = 5HA ^ . A S a result, t h e growth rate of income per head of t h e population is higher only if a larger population leads t o a higher share of h u m a n
capital t o be employed in t h e research sector. But does this happen with a
larger L? An increase in t h e size of t h e workforce L increases t h e demand faced
by each firm selling a durable good. An increase in L increases t h e return to
b o t h varieties of h u m a n capital: to h u m a n capital employed in the production sector and t o h u m a n capital employed in the research sector. As these
two effects cancel each other out, t h e allocation of h u m a n capital between t h e
two sectors does not change when t h e workforce size L changes.^'' As Romer
(1990a) writes, this result is not robust as this exact cancellation depends on
t h e functional forms used. For slightly different functions an increase in L can
either increase or reduce t h e amount of h u m a n capital in t h e research sector. ^^
In Grossman and Helpman (1991a) a model with repeated product quality improvements is analysed.-^^ Economic growth describes an increase in
t h e average quality of available goods in t h e economy. T h e increase in quality requires research and development (R&D) activities. These are undertaken by profit-seeking entrepreneurs. Each new product generation provides
A > 1 units of t h e product generation before. Consumers maximize their utility which is represented in a common intertemporal utility function. Utility
depends on t h e consumption of products, with each product having a particular quality level. T h e consumer spends his expenditure on the various product
lines and chooses - in each line - t h e good which offers t h e lowest price per
unit of quality. On t h e production side, t h e economy is endowed with one
input factor, labour L. One unit of labour is needed t o produce one unit of
any good, regardless of its quality. T h e aggregate production function has
t h e form Y = Y{AL,LUI^LO2,
-"^CON) with cui as a quality-adjusted intermediate a n d / o r consumer good. T h e entrepreneur invests labour to achieve a
particular R & D intensity L. T O achieve t he must invest a units of labour (per
unit of time). T h e success of research activities aiming at product improvements are uncertain b u t t h e higher t h e research intensity t = i{L), i.e. t h e
more units of labour are invested, t h e more likely is a success. Since there are
constant returns t o scale in research efforts (Grossman and Helpman (1991b,
92) an entrepreneur's probability of successful research activities is strictly
proportional t o its input of units of labour in R & D .
^'^ Romer (1990a), S93.

^^ Romer (1990a), S94. Romer (1990b) shows how an increase in L can result in
a reduction of research activities and therefore reduce economic growth. Romer
(1987) shows that an increase in L would increase the rate of economic growth.
In Romer (1986), "population growth is not necessary for unbounded growth in
per capita income" (p. 1019).
^^ See also Grossman and Helpman (1991b), chapter 4. For a model with an expansion in the range of goods, see Grossman and Helpman (1991b), chapter 3.
22
The growth rate g can be defined as the growth rate of the utihty level and
as the growth rate of final output (with cu treated as intermediate goods).^ In
equilibrium the growth rate equals g = i^ log A. t* is the equilibrium research
intensity, A is the size of the 'improvement steps' with regards to the good's
quality. In equilibrium the intensity of research equals ^* =
I
f .^^
The equilibrium research intensity ^* increases with the size of the workforce
L. The conclusion is that a "larger resource base implies faster growth" (p.
51), i.e. an economy with a large workforce L will grow faster than a small
99
economy.
The size of L is also important when comparing the equilibrium growth
rate and the optimal growth rate of research intensity. The optimal research
intensity, derived by maximizing a lifetime utility function, is given as L^'^^ =
^ i^-j'^^ The divergence of the equilibrium growth rate and the optimal
growth rate is due to some market distortions in form of externalities. A
successful innovator generates a positive externality for the consumer (they
receive a product of higher quality for the same price as before), a negative
externality for producers (the innovator 'destroys' the profits of the firm it
displaces) and a further positive externality (a knowledge spillover because all
innovations can be build on a product that is of higher quality than without
the innovation). The combined present value of the two positive externalities
is equal to -^y- whereas the present value of the negative externality equals
(A !)/(/. + p).^^ The difference between the optimal and the equilibrium
growth rate is^^
^"^'-^* = ( ( + 1 - ^ )
(2.1)
X pa
log A
In principle the relationship L^'P^ > i.* holds if the steps in the quality ladder
A are of intermediate size and L^^^ < L* if X is either small (i.e. near one)
or large. In the latter case the negative externality outweighs the positive
externalities for consumers which means that research intensity is too large
in the equilibrium. It is clear from (2.1) that the term in parentheses is more
likely to be positive if L is large. The larger the size of the workforce the more
likely the relationship t^^* > ^* holds. As a result, larger economies have a
higher research intensity which translates into higher economic growth.
Grossman and Helpman (1991a, 55ff.) also study an augmentation of the
quality-based innovation model with one manufacturing sector. They add a
production sector whose output is a homogenous good of fixed quality Z. As
a result, an individual's utility depends on consumption of the homogenous
Grossman and Helpman (1991a), 50.
^^ Grossman and Helpman (1991a), 50.
^^ More details on this "scale effect" are given in subsection 2.3.3.
2^ Grossman and Helpman (1991a), 51 and (1991b), lOlff.
^^ Grossman and Helpman (1991b), 111.
^^ Grossman and Helpman (1991b), 51, equation (16).
23
good Z and on consumption of goods X = {x\^X2^...) where each is of a certain quality level (as in the model analysed before). Thus, consumers spend
a fraction s of their income on the quality differentiated products X and a
fraction (1 s) on the homogenous good. In addition, Grossman and Helpman (1991a) introduce the two input factors unskilled labour L and skilled
labour H. The assumption is that skilled labour H is used in R&D and in the
production of X, and that both L and R are used in the production of the
homogenous good Z. Unskilled labour L is neither employed in R&D nor in
the production of X. The production sector of Z employs the entire unskilled
workforce and also a share of the skilled workforce. An increase in the total
stock of skilled labour leads - all other things being equal - to a new equilibrium with a higher research intensity, which translates into higher economic
growth.
The result of an increase in unskilled labour is more complex. A higher
L increases the production of Z, the good with a fixed quality. Thus, on the
one hand, this sector needs more B. which is drawn away from the other
two sectors, the production of X and R&D. On the other hand, this sector
releases skilled labour as the wage of H rises, due to a substitution effect. With
an elasticity of substitution between both forms of labour in the production
of Z being larger than 1, the share of unskilled labour in the production
sector of Z rises and the share of skilled labour in the same sector falls.
Thus more skilled labour is employed in R&D in the new equilibrium and
a higher research intensity leads to higher growth.^^ Assuming an elasticity
of substition between skilled labour R and unskilled labour L smaller than
1, an increase in L leads to a higher reward of iJ. As a consequence, more
skilled labour is employed in the production sector of Z. As a result, research
intensity declines which leads to less innovation and less economic growth.
The elasticity of substition between skilled and unskilled labour determines
if a larger economy grows faster than a smaller economy. If the elasticity of
substition between these two factors is high, large economies grow faster than
small ones.^^
In Aghion and Howitt (1992) the workforce falls into three categories of
labour. Unskilled labour M, which is fixed and can only be used in the manufacturing sector, specialised labour R which can only be used in the research
sector and skilled labour N which can be used either in research or in the
intermediate sector, i.e. the sector which produces the intermediate goods.
The intermediate goods are produced with skilled labour A^. The consumption good is produced in the manufacturing sector with unskilled labour M
and the intermediate good. The only decision which has to be made is the
allocation of the skilled workforce between the research and the intermediate
sector. The equilibrium research level I is determined, among other variables.
^^ Grossman and Helpman (1991a), 57.

^^ Grossman and Helpman (1991b), 137.
24
by t h e size of t h e market for skilled labour.^^ T h e larger t h e endowment of

skilled labour, t h e higher is t h e marginal benefit and t h e lower t h e marginal
cost of research. T h e lower marginal cost of research is t h e result of reducing t h e wage level of skilled labour. As in Grossman and Helpman (1991a), a
higher research intensity (which can be caused by a larger N) means higher
economic growth. As in Romer (1990a) and Grossman and Helpman (1991a),
a scale effect of t h e population affects t h e results.
Table 2.1. The effect of the population size L and its growth rate n on the growth
rate gy, on the steady state growth rate g* and on the level of steady state research
intensity ^*.
n > 0 on gy
Effect of
L on g*
Romer
depends on functional form
(1986,1987,1990a,b)
Grossman and
positive
positive (basic model)
Helpman (1991a)
negative
negative (advanced model), if cr < 1
positive
positive (advanced model), if cr > 1
Aghion and
positive
positive, {N is decisive variable)
Howitt (1992)
Solow (1956)
negative on y* no effect
L on L*
positive
negative
positive
positive
n.a.
In t h e models reviewed above t h e size of t h e population has an influence

on t h e growth rate of income per capita. Positive population growth means
higher growth of income per capita as t h e positive population growth entails positive growth of scientific knowledge. T h e discovery of new ideas and
their subsequent transition into technological progress is t h e engine of economic growth in m a n y models of endogenous growth theory. Because ideas
are nonrivalrous t h e scientific knowledge in a society shows increasing
returns
to scale. As there is a scale effect from t h e size of population it is linked to
t h e growth of 'scientific knowledge'. An increase in t h e size of the population
raises t h e number of researchers (all other things being equal) and therefore
leads to an increase in per capita income growth. According t o these models,
a low or even negative growth of income per head of t h e population seems
t o be inevitable when population declines. ^^ In Romer (1990), Grossman and
Helpman (1991a) and Aghion and Howitt (1992) t h e scale effect of population
shows up in t h e economy's growth rate as gy = f{L). Therefore gy can only
be a constant (which it is in an equilibrium) if t h e population growth r a t e is
zero, leaving L unchanged. If there is positive population growth t h e growth
^^ Aghion and Howitt (1992), 334.
2^ Jones (1999), 139.
25
rate Qy itself (not t h e level of y!) grows at t h e same rate as t h e population.

This prediction finds no empirical support.^^
Consequently, with a negative population growth rate, t h e growth rate Qy
declines at t h e same rate as t h e population. This result is at odds with t h e
results of t h e models in economic growth theory with exogenous technological
progress. Solow (1956) predicts t h a t in an economy in transition towards its
steady state t h e growth r a t e of income per capita is affected negatively by a
positive population growth r a t e via its influence on t h e capital accumulation
mechanism. In equilibrium an increase in t h e size of t h e population leads t o
a decrease in per capita income level whereas t h e growth rate of per capita
income is not affected by t h e size of t h e population.
According to t h e models with scale effects summarized in table 2.1, an
economy does not reach a steady state with a constant growth rate of income
per head of the population if t h e population grows or declines. B u t t h e prediction t h a t an expansion of t h e workforce raises t h e per capita growth rate
cannot be supported empirically. T h e general view is t h a t t h e scale effect is
counterfactual.^^ As a result, economists modify t h e framework to eliminate
t h e predicted scale effect. These models are discussed in 2.3.2.
2 . 3 . 2 M o d e l s w i t h o u t s c a l e effects
Peretto (1998) proposes a model in which t h e scale effects present in t h e
models analysed in 2.3.1 are absent. He analyses t h e relationship between t h e
population growth rate and t h e rate of technological progress. T h e workforce
is divided into three different subgroups: Lx produces t h e consumption goods,
i.e. o u t p u t X; Lz is employed in t h e R&D sector and LN is employed by t h e
firms t h a t want to enter t h e market. There are two different kinds of firms,
the incumbents and t h e entrants. T h e incumbents produce the consumption
goods, i.e. t h e o u t p u t X with t h e share Lx of t h e t o t a l workforce L. Production costs depend on t h e firm's stock of knowledge Z. Knowledge Z grows
with t h e share of t h e workforce Lz employed in R&D and its productivity.
This productivity is determined by t h e stock of public knowledge K (and an
exogenous parameter a > 0). T h e innovation of one firm t o improve its own
production process also generates (public) knowledge available for t h e other
firms. Thus a firm's productivity of R&D is a combination of its own productivity and all other firms's productivity as t h e latter generates t h e stock of
public knowledge. T h e entrants take t h e public knowledge K as an input in
their own R & D activities. T h e other input factor labour is L^v, i.e. t h e share
of t h e workforce employed by t h e start-ups. T h e higher LN, t h e higher is t h e
number of new firms N. O n entry t h e new firms develop b o t h a product and
production process innovation.
In this model economic growth is defined in t h e following way. Since there
is a variety of goods, t h e households might consume more of each good ( = r a t e
^ Dinopoulos and Thompson (1999), Jones (1995a).
^^ Barro and Sala-i-Martin (2004), 297.
26
of growth of consumption of each variety) as the firms engage in cost-reducing

R&D. The other possibihty is for consumers to consume a greater variety of
goods (= rate of expansion of the variety of consumption goods) as the firms
also engage in product-creating R&D. The various goods can be interpreted
as consumption goods, or as intermediate goods, producing the final output.
In the latter case, economic growth is growth of consumption of this final good
C. In the former case a price index Pc is needed to transform consumption
expenditure E into a measure of real consumption. This consumption index
C = E/Pc takes into account that households' utilities are influenced by the
available variety of goods. In both cases the growth rate of the consumption
index gc is the proper measure of the growth rate of real income per capita.
In the steady state, consumption growth is given as^^
9c =^-^^~n+ g
(2.2)
with the population growth rate n, the productivity growth rate in the
manufacturing of each consumption good g = 6Z/Z^ and the elasticity of substitution between products, > 1. Then, economic growth entails consumption growth and productivity growth. Productivity growth does not depend
on the population growth rate. This is because an increase in population size
L induces two effects on productivity growth which cancel each other out.
On one hand, a larger L implies that since the resource base of the economy is larger R&D activities increase. This increase in R&D is also predicted
in Romer (1990a), Grossman and Helpman (1991a) and Aghion and Howitt
(1992) where it leads to higher economic growth. On the other hand, a second
effect of an increase in population - the 'dispersion effect'^^ - offsets the initial
increase in R&D in Peretto's model. A larger L implies that the number of
firms is increasing as a higher amount of L^ can be devoted to starting up
new firms.
Productivity growth g is decreasing in the number of firms as productivity
growth depends on the scale of the R&D program of the individual firm. This
scale becomes smaller as the number of firms increase and in turn creates an
offsetting effect. Thus, the steady state growth of income per head does not
depend on the size of the population. As a result, growth is possible even in
the absence of population growth. Thus, Peretto (1998) eliminates the scale
effect which is present in endogenous growth theory. However, if there is
population growth, it does affect per capita growth. As seen in equation (2.2)
the first term on the right-hand side increases if the population growth rate n
increases. As a result a permanent reduction in the rate of population growth
results in a lower growth rate of consumption (and income per capita)."^^
A small strand of literature, namely Jones (1995b), Kortum (1997),
Segerstrom (1998) and Young (1998) point out the influence of the scale effect
^2 Peretto (1998), 289.
^^ Peretto (1998), 292.
^"^ Peretto (1998), 296f.
27
on the model's outcome. As empirically there is no evidence of a scale effect,^^

they propose a theory of "semi-endogenous growth". Instead of assuming constant returns to scale as in the endogenous growth models reviewed above, this
theory assumes diminishing returns to scientific knowledge. In this framework
an ever-increasing number of researchers allocated to the R&D sector is necessary to achieve a constant growth rate of knowledge. Thus, the scale effect
on the long-run growth rate Qy is avoided. However, the level of income per
head of the population is increasing in the size of population, i.e. y = f{L).
The scale effect becomes apparent in the level of per capita income, not in its
growth rate ^y. As a consequence of this level scale effect, population growth
is necessary for economic growth. Because of the assumption of diminishing
returns to scientific knowledge the growth rate of income per head of the
population depends on the population growth rate Qy = f{n).
Starting from the implication of innovation-based growth theories that the
declining population will lead to a slowdown in productivity growth Dalgaard
and Kreiner (2001) set out to "challenge this pessimistic view". Dalgaard and
Kreiner (2001) criticize the literature and develop a theory of scale-invariant
endogenous growth. According to Dalgaard and Kreiner the scale effect of
the population hinges on one assumption, the fixed and exogenously given
individual stock of human capital (p. 188). By allowing for endogenous human
capital in a research driven growth model, population growth is not necessary
for economic growth. Not the size of the population, but the quality of the skill
level of the average individual in the population matters for the level of income
per capita. The reason for this result is that human capital is interpreted as
rival knowledge embodied in human beings. Scientific knowledge, on the other
hand, is non-rival knowledge. The 'idea-based' growth theory analysed in 2.3.1
focuses on non-rival scientific knowledge. If population increases, more people
are able to use this non-rival knowledge and work in R&D. The Dalgaard and
Kreiner (2001) model is scale-invariant, implying that "population growth is
neither necessary nor conductive for economic growth".
In Dalgaard and Kreiner (2001) an increase in population means a crowdingout effect with regards to the skills of the average individual, i.e. its human
capital.^^ The number of agents rises, but their average individual skill level
declines. In Dalgaard and Kreiner (2001), this human capital decline on the individual level offsets the scale effect of a larger population. Economic growth
happens because human capital and scientific knowledge complement each
other. New scientific knowledge enhances human capital which in turn makes
it more likely to increase scientific knowledge. This virtuous circle drives ecoEmpirically, the prediction Qy f{L), i.e. an expansion of the workforce raises
the per capita growth rate, cannot be supported. A cross-country comparison
indicates that the growth rate of GDP per head bears little relation to the country's level of population. See Barro and Sala-i-Martin (2004), 219. Kremer (1993)
indicates that the correct scale variable is the world population and shows that
world population is positively related to productivity growth.
For further discussion, see also Dalgaard and Kreiner (2003).
28
nomic growth without any influence of population growth. Table 2.2 summarizes the findings in this section.
Table 2.2. The effect of the population size L and its growth rate n on the growth
rate Qy and on the level of income per head ?/* in the steady state.
72 > 0 on *
9y
Jones (1995b)
Kortum (1997)
Peretto (1998)
Segerstrom (1998)
Young (1998)
D algaar d/ Kr einer (2001)
Solow (1956)
Effect of
L on gl
L on ?/*
no effect
positive
positive
positive
no effect
positive
neutral
no effect
positive
no effect
positive
positive
positive
neutral, for (3 = 1 positive
neutral
no effect
no effect
no effect
negative on y''' no effect
The analysis of the economic growth models shows that how and to what
extent economic growth is influenced by the size of the population and its
growth rate depends heavily on the underlying assumptions about returns to
scale. Within these limits, the models are suitable to analyse the effect of a
declining population on economic growth. With a positive population growth
rate, the models predict a higher y"". With a declining population, most of
these models predict a lower steady state growth of income per head of the
population. However, an analysis of the implicit change in the age structure
of the population is not possible.
In the following section, the relevance of scale effects for economic policy
is analysed.
2.3.3 Scale effects and policy intervention to increase economic
growth
As the analyses in 2.3.1 and 2.3.2. show, scale effects are likely to have some
kind of effect on the long-run growth rate or on the level of income per head
of the population (compare findings in tables 2.1 and 2.2). Thus, a policy
which affects the size of the population affects economic growth. In general,
the debate about scale effects implies that the size and the growth rate of
population are two key features which might constrain economic growth given
a too low growth rate or a too small size of the population. So far innovationbased growth theories imply, as a consequence of scale effects from the size
of population, that the aforementioned demographic changes will lead to a
slowdown in productivity growth in countries with a declining population.
29
We analyse t h e scope for economic growth policy which has an effect on

population in t h e models reviewed above. T h e following table 2.3 organizes t h e
growth models according to their relationship between demography (in terms
of population size L and population growth r a t e n) and economic growth (in
terms of income per head y and its growth rate Qy).^^
Table 2.3. The relationship between demography and economic growth.

Group A: gy = f{L)
Group B: Qy = f(n)
Grossman/Helpman (1991a), (+, -) Jones (1995b), (+)
Aghion/Howitt (1992), (+)
Kortum (1997), (+)
Peretto (1998), (+)
Young (1998), (+)
Lucas (1988), (+)
Grossman/Helpman (1991a), (+)
Aghion/Howitt (1992), (+)
Group C:y = f(L)
Group B: y = f{n)
Jones (1995b), (+)
Solow (1956), (-)
Kortum (1997), (+)
Dalgaard/Kreiner (2001), (-)
Segerstrom (1998), (+)
Young (1998), (+)
In Group A, a population policy measure boosting economic growth is to

increase t h e size of t h e population, i.e. a temporary boost of t h e birth rate
or higher migration is sufficient t o promote economic growth. T h e effect is
positive following Aghion/Howitt (1992). According to G r o s s m a n / H e l p m a n
(1991a) t h e direction of t h e effect depends t h e functional form employed.
These two models are also part of Group B, where an increase in t h e population growth rate n leads t o a permanent increase in t h e economic growth rate.
In Group C, an increase in population size means an increase in income per
head of t h e population, i.e. in a large economy, income per head is higher t h a n
in a small economy. In Group D t h e level of income per head is negatively
related to t h e population growth rate. A permanent lower population growth
rate implies a higher level of income.
We compare these possibilities for economic growth policy with t h e Solow
(1956) model. In t h e Solow model t h e highest o u t p u t is achieved when t h e
population is stationary, i.e. n = 0 (even higher if n < 0). T h e fact t h a t
scale does not m a t t e r in t h e system leads t o t h e result t h a t , whatever t h e
size of the population, when its growth rate is zero, t h e equilibrium level of
o u t p u t per head is t h e same. T h e absolute size of population plays no part
in determining t h e result of t h e model. This implies t h a t two economies with
^^ The sign in brackets indicates the direction of the influences, for example, in Jones
(1995b), the population growth rate n has a positive influence on economic growth
Qy. In Grossman and Helpman (1991a), the influence depends on the functional
form. Lucas (1988) is analysed in chapter 4.
30
the same characteristics except population size have the same level of output
per head in equilibrium, regardless wether being a small or a large economy.
The Solow (1956) model is analysed in much greater detail in the following
chapter.
Effects of a declining population in a model of

economic growth
Solow (1956) begins his seminal paper A contribution to the theory of economic
growth with the following statement:
"All theory depends on assumptions which are not quite true. That is
what it makes a theorj^. The art of successful theorizing is to make the inevitable simplifying assumptions in such a way that the final results are not
very sensitive. A 'crucial' assumption is one on which the conclusions do depend sensitively, and it is important that crucial assumptions be reasonably
realistic. When the results of a theory seem to flow specifically from a special
crucial assumption, then if the assumption is dubious, the results are suspect."
(Solow 1956, p. 65)
Following the advice of Solow, in this thesis we challenge two assumptions
which are generally employed in economic growth theory. We suggest that
these could be 'crucial' assumptions in the sense of Solow. These assumptions
are:
(a) The growth rate of the population is constant and positive.
(b) The labour force participation rate is constant, i.e. the growth rate of
the population and the growth rate of the workforce are the same.
Many economies will face both an ageing and shrinking population and
workforce in the future. To simplify the economy in a way Solow and many
others did is important for analysing the determinants of economic growth.
But to analyse and understand the determinants of economic growth in an
economy with an ageing and/or declining population, we have to go a step
further and change the assumptions (a) and (b). We regard the assumption of
a constant and positive population growth as an oversimplification which may
deter results. To justify such a statement we will show that some conclusions
of the standard models in growth theory literature do not hold when the
population growth rate n is negative. From the analysis in 2.2 we know that the
steady state can be either unstable or non-existent if the population growth
rate n is negative. This will be analysed in more detail in section 3.1. In the
remainder of chapter 3 we analyse several models of economic growth under
32
3 Effects of a declining population
the assumption that the population declines^ i.e. we change assumption (a). By
introducing a measure for the ratio between the population and the workforce
we are able to change assumption (b) as this allows the population and the
workforce growth rate to differ. This will be done in Part II of the thesis in
chapter 7.
3.1 Introduction t o a model of economic growth - T h e

Solow (1956) model without technological progress
Solow (1956) works on the assumption that the growth rate of the population
Upop and the growth rate of the workforce n^jork cire the same, i.e. n = Upop =
^work' This assumption, combined with the assumption that the population
and the workforce will decline (or increase) implies a population size effect
The size of the population will be smaller in the next period if the population
growth rate is negative. Inevitably the size effect will lead to an population
age structure effect but the latter cannot be explicitly incorporated into the
model. For example, with n < 0 the population declines and is likely to age.
However, the shifting age structure is not explicitly embodied in the model. In
Solow (1956) we can analyse the effect of a declining population on economic
growth but not the effect of an ageing population. The growth rate n is taken
as an exogenous constant. Before we analyse the model's steady state we show
the real growth rate of income, i.e. the growth of income if the economy is not
in its steady state.
The starting point is the general form of the neoclassical production function
where the output is produced with two input factors. The output Y is determined by capital K and labour L. The input factor labour, i.e. the workforce,
and population are used interchangeably in this model. The output and the
input factors vary with time t. The production function
Yit) = F[Kit),L{t)]
(3.1)
is called "neoclassical" if it has the following three characteristics:
positive and falling marginal productivities for all K > 0 and for all L > 0;
constant returns to scale and
the Inada-conditions are fullfilled.^
Barro and Sala-i-Martin (1998), 20, Inada (1963).
3.1 Solow (1956) without technological progress
33
Differentiating t h e production function (3.1) with respect to time t we get

t h e growth rate of t h e national income^ gy
QY
= a ' QK -^ P n
(3.2)
with t h e growth rates gy = y, 9K = % and n = j ^ . ^ a and /3 are t h e

partial production elasticities of capital and labour, respectively. Economic
growth, i.e. growth of Y is determined by t h e growth of one or both of t h e
input factors K and L (and no overcompensating decline of t h e other factor).
First, we concentrate on t h e effect of /? n on economic growth. It is obvious
from (3.2) t h a t a declining workforce, i.e. n < 0, has a negative impact on economic growth. T h e value of t h e production elasticity /3 is important because
it transfers t h e change in t h e workforce into t h e output change. Empirical
studies for Germany estimate /? at 0.61 0.7.^ Then, a change in t h e size
of t h e workforce by 1 per cent transfers into an o u t p u t change by 0.61 0.7
per cent. T h e size of t h e effect of a change in t h e workforce size on economic
growth is assumed t o be t h e same for a growing or a declining workforce.
T h e other factor which determines economic growth is t h e growth rate
of capital gK multiplied with its production elasticity a. Empirical studies
estimate a at 0.3 0.4.^ W h a t determines t h e growth rate of K? P a r t s of
t h e produced o u t p u t Y are consumed and other p a r t s are saved and invested.
T h e amount of capital which is accumulated is determined by t h e savings rate
s. T h e higher s, the more is saved and invested. Saving and consumption is
assumed to be age-neutral and be constant with 0 < s < 1. T h e change in
t h e capital stock over time is determined by gross investment sY minus t h e
amount of capital depreciation 5K t h a t occurs during t h e production process:
^
=K= SY-6K.
at
T h e growth rate of t h e capital stock is then given by
9K = ^ - S .
(3.3)
(3.4)
To analyse t h e effect of a change in t h e workforce growth r a t e on t h e growth

rate of capital we analyse t h e growth rate of physical capital (3.4) per worker.
Output and national income are two different ways to describe the same. Output
(measured as the gross domestic product) megisures the size of the production
of goods and services. National income is the sum of income of the national
population. Output describes what is produced and national income describes
what can be distributed in an economy.
A dot above the variable denotes the derivative with respect to time t.
Barro and Sala-i-Martin (2003), 439. Schroer and Stahlecker (1996) estimate a =
0.353 and jS = 0.666 for Germany Similar Smolny (2000).
When employing the Cobb-Douglas production function, a and P add up to one.
See Duffy and Papageorgiou (2000) who favour the CES function and reject the
Cobb-Douglas function as suitable for growth theory in an empirical study.
34
Because
function
k = ^ k
in terms
of t h e assumption on
we can insert equation
nk Sk.^ This gives
of physical capital per
constant returns to scale in t h e production

(3.3) into t h e relationship | = ^ ~ x ^ ^ ^ ^^
t h e dynamic equation for capital accumulation
worker:
k = sy-{n-^S)k .
(3.5)
T h e change in capital per worker is determined by three factors: two of

t h e m are analogous t o t h e capital accumulation equation as given in (3.3): investment per worker sy increases k and depreciation per worker 5k decreases
k. T h e new t e r m n reduces capital per worker. If workforce growth is positive
there are new workers around in each period. Assuming there is no depreciation and no new investment, i.e. sy 0, capital per worker declines by
nk.
T h e coefficient (n + S) is t h e effective depreciation rate for k. Capital
accumulation takes place to meet capital depreciation and t h e equipment of
t h e workforce. More depreciation erodes t h e numerator of t h e capital/labour
ratio k and more growth of the workforce accelerates t h e denominator. If t h e
workforce grows, investment is necessary t o maintain t h e capital/labour ratio.
As L increases with n, physical capital per worker declines with n. T h e less
t h e workforce grows, t h e less declines k as there is more capital per worker
available.
We now assume a declining workforce, i.e. n < 0. T h e n t h e analysis is less
straightforward. For simplicity we assume there is no investment, i.e. sy = 0,
but depreciation, i.e. 6 > 0. W i t h | n | < 5, t h e change in k over time is
negative. In each period there are less workers in t h e economy and even less
capital. Investment sy > {n -^ 5)k is needed t o maintain (or raise) t h e level
of k. B u t with I n | > (5, t h e effect of (n + 5)k in (3.5) on k is positive. T h e
workforce declines t o a higher extent t h a n capital depreciates. This results in a
higher capital/lab our ratio k^ even without investment syJ W i t h investment
t h e capital/labour ratio is even higher. However, this case where | n | > ^ is a
theoretical possibility but (so far) rather unrealistic. Empirically, t h e figures
for capital depreciation are higher t h a n t h e figures for t h e declining workforce.
However, because of this possibility depreciation of physical capital should be
taken into account when analysing t h e model.^
To derive t h e growth rate of income per worker gy we first divide t h e
equation of motion k as given in (3.5) by k and get t h e growth rate of capital
per worker gk
^ Taking logs of k = jL; , ê get logk = \ogK logL. Taking derivatives with
7
respect to time we get Tfc ~=

^
K ~ L
We examine this result in more detail in 3.1.3, the section on "transitional dynamics" .
Depreciation was left out in the analyses of Solow (1956) by Kurz (1982) and
Schmitt-Rink (1986) (see section 2.2).

gk = s^-{n + 5).
35
(3.6)
T h e relationship between Qy and gk is the following',9
_y
k f (fc)
,k-nk)
We insert gk from (3.6) into (3.7) and get

9v = snk)-['^^^]{n
+ S).
(3.8)
T h e relationship between gy and gk is more clear if we use the well-known

Cobb-Douglas production function
y ^K^-L^-^ .
(3.9)
This function written per worker is

2/ = A:^ .
(3.10)
T h e t e r m [ '/.A ^] in (3.8) is equivalent to a and (3.8) can be written as

gy = a{s ' k^~^ (n + (5)) which is
9y^cx-9k'
(3.11)
We have shown t h a t a declining workforce has a negative effect on t h e

growth rate of national income gy (see (3.2)) as fewer workers produce less
aggregate o u t p u t . There is a positive effect on t h e growth rate of income per
worker gy (see (3.8)). T h e r e are fewer workers in t h e economy. As there is more
physical capital for every worker available, each worker produces more. T h e
Solow (1956) model is based on t h e assumption t h a t , for example, 100 units
of physical capital allocated t o 10 workers have t h e same effect on economic
growth in terms of income per head y as 1000 units of physical capital allocated
to 100 workers. In other words, t h e level of income per worker y and the level
of physical capital per worker k is t h e same in a small and a large economy
measured in t h e size of t h e workforce. Thus, there are no scale effects in Solow
(1956).10
A note on returns t o scale
As Solow has pointed out t h e neoclassical model works fine without constant
returns t o scale. ^^ Usually, constant returns t o scale are assumed because of
t h e convenient mathematical features t h a t come aloncr with it. To examine
^ See Barro and Sala-i-Martin (1998), 28.
"^ See section 2.3 on scale effects.
^^ Solow (1994), 48.
36
the importance of the assumption about returns to scale in the Solow model
in more detail we analyse the growth rate of income per worker gy.
The growth rate of an aggregate variable equals the growth rate of the
correspondent variable per worker plus the growth rate of the workforce n,
for example gy = gy + n and gx = 9k + n. We analyse this relation for the
growth rate of physical capital. We differentiate fc = -j- with respect to time:
,.
k-L-KL
X2
TIK~TL
K L~
L L'
This is
which can be written (with k = j^^ ^ = gx and ^ = n) as
k
With g^ = gj^ n and gy gy ~ ^ ^^ can write the growth rate of income
per head given in (3.2) as
gy = a'gk-^n{a-^P-l)
(3.12)
and in terms of national income as

gy = cX'gk^n{a-{-
(3) .
(3.13)
Assuming constant returns to scale, i.e. a-\-/3 1, in (3.12), the population

growth rate n has no direct influence on gy via the second term on the righthand side (there is indirect influence via gk)- The following two tables 3.1
and 3.2 summarize the possible effects on economic growth depending on the
assumption on returns to scale.
With n < 0 and increasing returns to scale, i.e. a -h f3 > 1, the growth
rate gy will be lower than with constant returns to scale. With n < 0 and
decreasing returns to scale, i.e. a ~\- f3 < 1, the growth rate gy will be higher
than with constant returns to scale. So with a change in one assumption the
implications of negative population growth rate for the growth rate gy can be
reversed.
37
Table 3.1. Effect of the population growth rate n on the growth rate Qy = ex - gk +
n(a -\- p 1) for different values of a + /3.
n > 0
a + /3 = 1 no effect on Qy
a-\- P > 1 positive effect on Qy
a + /? < 1 negative effect on Qy
n < 0
no effect on Qy
negative effect on Qy
positive effect on Qy
Table 3.2. Effect of the population growth rate n on the growth rate gy = c^- gk-\n ( a + /3) for different values of a + /3.
n > 0
n < 0
a + /3 = 1 gY^= PC' gk + n gvi = a - gk-^ n
a + p>
1 gY2 >gvi
a-\- p <1 gvs < gvi
gY2 <gvi
gvs > gvi
3.1.2 T h e steady state

A steady state situation is defined as a s t a t e in which different variables grow
at a constant rate. In Solow (1956) these are t h e variables y , K and L (and
their counterparts per worker). One reason why growth theorists are interested
in t h e steady s t a t e of an economy is t h a t it gives a "good capsule description
of actual facts".^^ These facts were summarized by Nicholas Kaldor as t h e
so-called "stylized facts".^^ Three of t h e six stylized facts describe t h e steady
state situation: (1) Real o u t p u t per worker (or per working hour) grows at
a positive and constant r a t e over a long period of time. (2) Physical capital
per worker grows at a constant rate over a long period of time. (3) T h e rates
of growth of real o u t p u t and t h e stock of capital goods tend to be about t h e
same, so t h a t t h e ratio of capital to o u t p u t shows no systematic trend, i.e. is
nearly constant.
T h e other reason why a steady state is so interesting when analysing Solow
(1956) is the fact t h a t t h e model has an unique steady state solution and all
equilibrium p a t h s converge to this solution. In t h e Solow model t h e unique
steady state situation is t h e situation where k = 0. In this state t h e capital
per worker remains constant. In any other situation t h e growth rate gk would
not be constant. W i t h A: = 0, we can write t h e dynamic equation for capital
accumulation per worker as it is given in (3.5) as
s / ( r ) = (n + ^ ) r
(3.14)
where /c* denotes t h e steady state value of k. W i t h t h e assumption t h a t

s, n and S are all constant we know t h a t gx is a constant only if f{k)/k
is
^2 Solow (2000), 110.
^^ Kaldor (1961), 178f.
38
a constant.^^ This is fulfilled if the growth rate of output and capital are the
same, gy = QK- We insert this condition into the equation for the real growth
rate of national income (3.2). Assuming constant returns to scale, a = 1 ~ p,
we get QY = QK = n.lii the steady state, capital and labour both grow with
the population (or workforce) growth rate n. Therefore output grows with the
rate n. Then a decline of the workforce implies economic decline. Because of
QY = n and QY = Qy -^ n ê know that Qy is zero in the steady state.
To analyse the condition for the steady state in more detail we rewrite
(3.14) with the Cobb-Douglas production function in per capita terms y = k^
and solve for fc*. The steady state value of capital per worker is given as
r = ( ^ ) T ^
(3.15)
Substituting the steady state value of the capital into the production function we get the steady state value of output per worker
y* = ( - ^ ) I T ^ .
(3.16)
We do comparative statics: If an ageing population means a decline in the

(still positive) population growth rate n we can assume the workforce growth
rate is reduced from Uhigh to the new level niow The new depreciation factor
for capital is thus {niow + S)k < {uhigh + <^)^- The amount of investment
per worker sy* is bigger than the amount needed to keep capital per worker
constant. A smaller part of the savings must be used to meet the requirements
of the workforce (and capital depreciation), so more can be used to increase
the amount of capital per worker ("capital deepening"). Because labour is
substituted for capital the interest rate will decrease and the wage rate will
increase, k increases (and gk declines) until the rate of labour and capital
correspond again. A decline in n is therefore followed by an increase in k and
- because k and y develop proportionally - an increase in income per worker.
A change in the workforce growth rate n has an influence on the equilibrium
level of k* and y* (see (3.15) and (3.16)) but no influence on its equilibrium
growth rate ^* = g"^ (which is zero).
Achieving a steady state requires the growth rate n to be positive or - if
negative - the relation \ n \< S has to hold. For negative values of the denominator in (3.15) and (3.16) the per capita values of capital and income would
be negative. In an economy with a shrinking population and a depreciation
rate of capital which is "too low", a steady state solution in this model is
not possible. ^^ This result can also be derived analytically from the condition
for a steady state solution. The production function y = f{k) has to satisfy
/(O) = 0 and
m> ^
^^ gK is a constant if gk is a constant because gK = gk + n (and n is a constant).
^^ For a further discussion, see 3.1.3 on "transitional dynamics", case b.
39
and
s
for some A: > 0 to have a steady state solution. This is clearly not the case
if I n |< 5.
The workforce growth rate is negatively correlated with the equilibrium
output per worker. The lower the workforce growth the better equipped are
the workers. It does not imply that the workforce itself should be minimized.
But it implies that the growth rate of the workforce should be minimized to
reach a stable workforce, i.e. n = 0 (or n-^5 > 0^^) at best. Nevertheless, it
is obvious that a higher rate of workforce growth lowers the steady state level
of capital and output per worker.
The main prediction of the Solow model is that the economy converges to
a steady state in which the economy - measured in income per worker - does
not grow at all once the equilibrium is established. If we would know that
an older population means a higher or lower savings rate, we could conclude
more from the Solow model. An increase (decrease) in the investment rate,
i.e. in the savings rate s leads to higher (lower) values of A:* and y*. But even
with this assumption, the model would not predict a higher growth rate Qk
and py, only a higher level of A:* and y* in the equilibrium.
We analyse the transitional dynamics of the model in subsection 3.1.3 and
consider the impact of the savings rate on economic growth in subsection
3.1.4.
A note on population growth and the stability of the steady state
In a brief subsection Solow (1956) analyses the effect of endogenous population
in the model. ^^ Assuming that population growth is a function of the level of
per capita income and because oi y = f{k) the function is given as n = n(/c).
As a general result (the specific result depends on the specification of n =
n{k)) the economy can have more than one equilibrium. In the example given
in Solow (1956) there are two equilibriums: one is stable and one is unstable.
In case the economy departs from the unstable equilibrium a situation can
arise where the economy experiences a self-sustaining process of increasing
per capita income, i.e. Qy > 0. With exogenous population growth, the steady
state of the economy is unique and stable. With endogenous population growth
there is the possibility for several steady states. These steady states can be
stable or unstable. An example with one stable steady state and one unstable
steady state is presented in figure 3.1.
In chapter 8 and chapter 9 in Part II of the thesis we develop a model
of economic growth with an ageing population where population growth and
^^ With n + (5 > 0, a rather high value of n is possible which would mean a
disappearing workforce in the long-run.
^^ Solow (1956), 90.
40
Fig. 3.1. Stable equilibrium A;(l) and unstable equilibrium k{2) with endogenous
population growth rate n, Solow (1956)
decline is endogenous. We show that the assumption of exogenous or endogenous population growth determines whether steady state growth in an
economy with an ageing population is possible.
A note on returns to scale in the steady state
In the steady state the growth rate gy is
9Y = ag^j,-h f3n
(3.17)
which is, for /3 = 1 ce and because of gy = g^

gY = n.
We consider the case where l3 ^ 1 a. Then we can write (3.17) as
(3.18)
1-a
Under the realistic assumption that a < p the relationship between n and
gy is as given in table 3.3.
The assumption on returns to scale employed in this model determines the
size of the effect of the population growth rate n on economic growth.
9Y
41
Table 3.3. Relationship between the population growth rate n and the growth rate
QY for different values of a + /?.
n > 0
n < 0
a + P = l QY = n gp = n
a-\- P > 1 QY > n gp <n
a + P< 1 gp <n gY > n
Solow (1956) without technological progress predicts a convergence from any
value of k to its equilibrium value k"^. We review the transitional dynamics in
the model leading to the equilibrium analysed in 3.1.2. To show the dynamics
of the transition period we employ the Cobb-Douglas production function
(3.9) instead of the general production function (3.2) (the dynamics are the
same no matter which of the two functions is used). With the Cobb-Douglas
production per worker as in (3.10) the growth rate of k in (3.6) can be written
as
gk ^^sk"^-^ - ( n + (J) .
(3.19)
The transitional dynamics as in (3.19) show how income per worker converges towards its equilibrium value. If the gross investment differs from the
'combined' depreciation {n-\-S)^ we have either a situation with sk^"^ > n + J ,
which means gk is positive or a situation with sk^~^ < n + ^, in which case
gk is negative. In both cases the economy is not in an equilibrium.
If the amount of investment per worker sy = sk^~^ is bigger than the
amount needed to keep capital per worker constant, gk is positive and therefore k increases. After equipping all (old and new) labour and replace the
depreciated capital there is still surplus per worker left. And since all the
investment has to be absorbed somewhere, the capital per worker must rise.
But the higher the level of capital per worker, the lower the average product
of capital | because of diminishing returns to capital. Therefore, over time
growth will slow down and eventually stop once the equilibrium is reached.
If instead the economy would start with a capital stock per worker where
the investment sy is less the amount needed to keep the capital per worker
constant (i.e. less than n + (5), then we get a negative growth rate, i.e. k declines until the equilibrium is reached. In equilibrium, the capital per worker
remains constant, i.e. where k = 0.
Assuming that the workforce declines with n < 0 we differentiate two
cases:
(a) With \ n \< 5 the impact of the combined depreciation on gk is negative.
In this case the same transitional dynamics as above apply. But there is one
difference: during the transition period the growth of k is higher than in
the case with a positive n. The same mechanism brings the economy to its
42
equilibrium but on a higher level. Therefore a declining population has a

positive impact on k.
(b) With I n |> (5 the impact of the combined depreciation on gk is positive,
i.e. In this case a positive growth rate gk declines as above but will always stay
positive (at least as high as | n{)-{-S{-\-) |). The system will always start with
a level of k which implies a positive growth rate of k above | n() + ^ ( + ) | .
The model predicts that the workers will become richer and richer while the
economy shrinks and approaches its end.
So far we were concerned with investment and output in an economy with a
declining workforce (and population). To get an idea about the welfare effect
of investment and economic growth we look at consumption which is a decisive
variable for welfare. For example, reaching the highest possible consumption
in steady state growth (called "golden consumption"^^) would be a desirable
welfare goal. Therefore we have to ask which is the optimal savings rate with
a given growth rate of the workforce.
The steady state value of k as given in (3.14) can be reached with different
combination of s and k/f{k) given a constant n and S, For every value of s
we have a unique value fc*. As said above a change in s does not affect the
steady state growth rate (which is zero) but the steady state level of k and y
respectively. The question is which of the possible values is the optimal one.
Saving means deferred consumption. Saving today is rational if it increases
future consumption to a higher extent than the "loss" of consumption due to
saving today. As long as the utility gained from future consumption can be
increased to this extent, saving is rational. The optimal savings rate is therefore defined as the rate where the loss today and the gain tomorrow balance
out. In this context "optimal growth" means maximization of consumption
both today and tomorrow.
Output Y can either be consumed or saved. The same holds for per capita
income y, i.e. y c^- sy. The function for consumption per head is
c = y-sy
= {l-s)y
= {l-
s)f{k)
(3.20)
We insert the condition for the steady state value of k from (3.14) into
(3.20) to obtain the steady state value of per capita consumption
c * - / ( r ) - ( n + (5)r .
(3.21)
Which value of s maximizes steady state consumption c*? We differentiate

(3.21) with respect to s. With A:* = k*{s) we have
= O i . e . r ( r ) - ( n + <5)=0.
See Phelps (1961).
43
Because ^ - > 0 the expression f^{k*) {nôrk + ^) must be zero. This

gives the condition for maximum consumption
f{k^^^d) = n + 5
(3.22)
with fc* = k^^^^ as the steady state value of k which maximizes consumption. (3.22) is known as the "golden rule" of capital accumulation.^^ The
marginal productivity of capital f\k^^^^) equals the growth rate of the workforce plus the depreciation rate of the capital stock. As (3.22) determines k^^^^
we can write (3.21) as the "golden" consumption:
As an example with the Cobb-Douglas production function y k^ and

the steady state values of fe* and ?/*(3.16) and (3.15) this can be written as
c* = ( - ^ ) T T ^ - ( n + 5 ) . ( ^ ) ^
which is
c* =s("1^(71 4-(5)^^ - s O ^ ( n H - ( 5 ) ^ ^ .
(3.24)
Differentiating (3.24) with respect to s gives

ds
{I-a)
s(i)
(n4-5)-i V ' /
(l-a)
5(1) (n + (5)1 = 0 .
a.
As (n + (5) =-i > 0, the expression (1-a)

T J T ^ ^s (i-=)
zero. This gives
5 ( l - c . ) r - i-" =
(1 -a)
-- TXZ^
(l-a) ' ^^ ^^"""^ must be
. 5(l-)
(1 - a)
Solving for s gives the 'golden rule' of capital accumulation

sa .
In the optimum the savings rate equals the share of physical capital in
income a. Inserting this result into the steady state levels of physical capital
per worker we get
j^gold ^ (_^___)XTho .
^n + 5^
Then (3.23) can be written as
^'"^ = (^TTA)^^ - (" + '5)(rT7)'^

Phelps (1961), (1965).
44

This gives the level of golden consumption
^goid ^ / , ^ _ ^J^^
.(^_)T^ ,
(3.25)
Because of ^^ < 0, the golden consumption per worker is ceteris paribus

higher the lower the growth of the workforce (if n > 0). If the growth rate of
the workforce is negative c^^^^ is even higher.^^. The model predicts a higher
"golden consumption" in an economy with a declining workforce.
The economy in disequilibrium will reach its steady state at some point in
time. But how fast will this steady state be reached, i.e. what is the speed of
the transitional dynamics? As in Solow (1956) per capita growth of physical
capital and of income is only possible when the economy is not in an equilibrium, the speed of convergence determines the time period for the economy
in which growth is possible. If the transition period from disequilibrium to
equilibrium takes a very long time (e.g. 20 years), a measure to increase the
investment rate (i.e. a rise in the savings rate) could be a sensible measure to
promote economic growth over this time period. The growth patterns of the
economy would be dominated by the transitional dynamics. If the transition
period lasts only a few years the same measure would not be successful. If the
speed of convergence is fast, the growth patterns would be dominated by the
steady state. That is why it is important to know if the speed of convergence
is relatively high or low. To derive the speed of convergence we use a CobbDouglas production function as before and take the growth rate of capital
per worker gk from (3.6).^^ With the production function in terms per worker
y = k^ we write (3.6) as
gj^ = S'k''-^
-(nH-(5) .
(3.26)
In the steady state (where gk = 0 ) we have
r =(
)(-!).
s
We need to know the change of k/k* over time
^ = ^ - ( ^ ) ' ^ -
(3.27)
a 1
We write k k^-^ and take logs of (3.27)

^ The relation | n |< ^ has to hold; otherwise there would be no steady state and
the solution of (3.25) is not defined
2^ This follows Frenkel and Hemmer (1999), 171-172.

k
log
k"" J
log
UCK~1
45
(3.28)
n +J
We can rewrite (3.26) as

9k
+ 1 =
n + 5
nand write (3.28) as

1
log
a - 1
loe
9k
n + 5
(3.29)
+ 1
For an approximation of (3.29)^^ we get

log
k
I02:
9k
(3.30)
n +S
Solving (3.30) for g^ we get

9k
-(1
a){n + 5)Aog(^-^^
(3.31)
The term
{l-a){n^S)=f3c
(3.32)
is t h e coefficient t h a t determines t h e speed of convergence, pc depends

exclusively on exogenous variables b u t not on t h e savings rate (in t h e CobbDouglas case^^). a is t h e production elasticity of capital and (1 a ) is t h e
production elasticity of labour respectively. T h e lower t h e value of Pc t h e
slower is t h e speed and t h e longer is t h e transition period. A positive value of
/3c, for example, /3c = 0.05 means a convergence of k towards its steady state
value k* at a yearly rate of 5 per cent, i.e. each year t h e gap between k and
k* is reduced by 5 percent. A negative pc would mean a divergence of t h e two
values. As long as t h e inequality \ n \< 5 holds (with n < 0), it is possible to
solve for a positive pc If ^ = O7 i-^- t h e workforce is constant, then we have
/3e = (1 - a)<5.24
T h e growth r a t e of o u t p u t per worker is ^^ a- g^- We insert (3.31) into
t h e relationship log ( - ^ ) = a- log ( ^ ) and get an expression for t h e growth
rate of o u t p u t per worker^^
^2 The Taylor-Series for log{x + 1) is log{x + l) = x-V\

+ \ + .... For x -^ 0 we
get the right-hand side of (3.30).
2^ See Barro and Sala-i-Martin (1998), 44.
^^ A value of n < 0 with \ n \> 8 would give a negative pc and because of (3.31) a
positive gk- In this case the system does not reach a steady state.
^^ Barro and Sala-i-Martin (1998), 44.
46

gy =-{1-a)in
+ S)-log (j;^
(3.33)
The coefficient f3c is the same for y and k. If the speed of convergence is
high, the economy moves rather quickly towards its equilibrium which implies
that gy as in (3.33) is rather low (assuming that y < ?/*). The population
growth rate n has the same effect as depreciation of physical capital 5. We
have shown above that with high population growth (or a high depreciation)
the growth rate gy = a{s - k^~~^ ~ (n + (5)) is lower than in an economy with
low population growth (or low depreciation), as the economy is closer to its
steady state.
A declining workforce slows down the speed of convergence (assuming that
\ n \< S), An economy in which the workforce declines tends to experience a
longer transition period than an economy in which the workforce is constant
or grows. This implies a higher growth rate gy during the transition phase.
The reason is that a low population growth rate means a higher steady state
level of fc* (and y*). For a given value of k < k*^ the distance between k and
A:* is larger if n is small.
3.1.6 Conclusions on population and economic growth in the
SoloAv model
Conclusions from "The real growth rate"
With the assumption n < 0, the model predicts:
(1) A declining workforce has a negative effect on the growth rate of Y.
(2) A declining workforce has a positive effect on the growth rate of y.
(3) If there is neither investment nor depreciation the capital per worker
would decline with nk (because of k = sy {n -\- S)k). The less the workforce
grows the less would k decline. This holds as long as the growth rate of the
workforce n is positive. With a negative n the picture looks different. With
the assumption that there is no investment but depreciation and with | n |<
(5, the change in k over time is negative. If | n |> (5, the change in k over time
is positive. Then it is no longer possible to solve for a steady state.
A change in the ratio of the overall population and the workforce is not
incorporated in the model. The size of the size of the workforce L is assumed
to be the size of the population N. Therefore cases where Uwork 7^ '^pop cannot
be analysed. In the Solow model it is only possible to analyse the size effect
of a demographic change, i.e. a declining population. An analysis of an age
structure effect on economic growth, i.e. an ageing population is not possible.
Conclusions from "The steady state"
With n < 0, achieving a steady state requires that the relation \ n \< 5 holds.
In that case the steady state levels of k and y are higher than in an economy with a positive population growth rate. There is a negative correlation
47
between the workforce growth rate and level of income per worker because a
lower workforce growth rate raises the capital intensity k and hence labour
productivity. In an economy with a declining workforce with n < 0 and | n | >
5, a steady state solution of the model is not possible.
Conclusions from "The transitional dynamics"
With n < 0 and assuming \ n \< 5, the same transitional dynamics as in the
original Solow model apply. The difference is that the economy will reach a
higher steady state level of k. With n < 0 and \ n \> 5 from every starting
level fco the positive growth g^ slows down as the level of k rises. The growth
rate will always stay positive (at least as high as | n() + (5(+) |). This implies
that in an economy with a shrinking population the growth rate of k and
therefore the growth rate of y will always be positive.
The problem is that the number of workers L declines steadily. Because
the growth rate of L is exogenous the model cannot predict if and how the
decline of the workforce may stop. Similar the growth models with exogenous
population growth do not say if, how and when the positive population growth
will stop. But if L declines without bound one day the model economy experiences a situation where L = 0. While the workers become richer and richer
the whole economy drives towards its end. The growth rate of the workforce
has to be endogenised to get a more realistic and satisfying result.
Conclusions from "Golden consumption"
o
gold
Because of ^^ < 0, the golden per capita consumption would be ceteris

paribus higher the lower the growth of the working population (if n > 0). If
the growth rate of the working population is negative c^^^^ is even higher.
The model predicts a higher "golden consumption" in an economy with a
declining population.
Conclusions from "The speed of convergence"
The lower the value of pc the slower is the speed and the longer is the transition
period. A shrinking population slows down the speed of convergence, i.e. the
transition period towards the steady state is longer. In such an environment
to boost the savings rate is more likely to be a sensible measure compared to
an environment with a growing population.
To summarize, in Solow (1956) a decline in the workforce has a positive
effect on growth rates of income per worker and on consumption per worker.
A steady state solution of the model is not possible if the value of the negative
growth of the population of working age is higher than the depreciation rate
of capital. Regarding the analysis of an ageing population and its effects on
economic growth the main disadvantage of the Solow (1956) model is that we
48
can only analyse a size effect: the declining size of the population. We have
to use 'declining' as a synonym for 'ageing'. An analysis of the age structure
effects of demographic change are not possible. We develop a solution for this
problem in Part II of this thesis.
In the following sections we analyse Solow (1956) with technological
progress and two papers based on Solow (1956): Mankiw, Romer and Weil
(1992) in 3.3 and Lindh and Malmberg (1999) in 3.4.
3.2 T h e Solow (1956) model with technological progress

In the Solow model analysed in 3.1, the growth rate of income per head is zero
in equilibrium. As in many countries the income per head has grown in the
past, there must be a factor which stops the growth rate from reaching zero:
this comes in the form of technological progress. With technological progress
growth of income per head can be maintained despite the diminishing returns
to capital per worker. Solow (1956) adds a Hicks-neutral technological change
to his model and shows that this is not compatible with the existence of an
equilibrium.^^ An equilibrium is only possible if technological progress takes
the form of Harrod-neutral technological change. ^^ This implies a production
function with lab our-augmenting technological progress. The only reason to
embody technological progress in the labour-augmenting form (and not in any
other form) is because it is compatible with a steady state solution.^^
The general production function is
Y = F[K{t),LA{t)]
(3.34)
with A{t) as an index of the technology level and A>0. The technology
level A{t) grows at a constant rate QA = ^' This rate is given exogenously.
Output Y rises with capital accumulation, the stock of labour and/or technological progress. The production function (3.34) is similar to the production
function in the basic Solow model in (3.1), except the inclusion of labouraugmenting technological progress. Differentiating (3.34) with respect to time
t gives the growth rate of the national income
gY=a-gK+p-n-A-\r-fgA-L
(3.35)
^^ Solow (1956), 85. Following Hicks (1932) a technological change is neutral if the
ratio of marginal products remains unchanged for a given capital/labour ratio.
^^ Following Harrod (1942) a technological change is neutral if the relative input
shares remain unchanged for a given capital/output ratio.
2^ See Barro and Sala-i-Martin (1998), 63.
3.2 Solow (1956) with technological progress
49
with the growth rates gYi9K^9A and n. a, p and 7 denote the partial
production elasticities of capital, labour and technology level, respectively.
The growth rate (3.35) differs in the second and third term on the right hand
side from the one in the basic Solow model without technological progress,
QY = a ' gx -h f^ ' n (see (3.2)).
In the Solow model with technological progress gy in (3.35) is affected
by a declining workforce when n < 0. In this model this negative effect on
gy is higher than in the Solow model without technological progress as it is
multiplied with the technology level A> 1, A compensating effect could come
from the third term on the right side of (3.35): j-gA'L
has to be high enough
to (over)compensate the negative impact of p-n-A, With a labour-augmenting
technological progress, the higher the level of technology in the economy, the
more detrimental to economic growth is a declining workforce. A declining
workforce means that in the next period fewer workers employ the current
technology level. If the technology level is high, the effect of the 'missing'
workers is higher than with a low technology level. Thus, in an economy with
a rather low technology level A (e.g. the developing countries) the effect of a
declining workforce on economic growth is less pronounced than in an economy
with a high technology level (e.g. the industrialised countries). For an economy
like Germany, where the technology level is high, the model predicts a rather
high negative effect of a declining workforce on the growth rate gy. This is
a straightforward consequence of the implementation of labour-augmenting
technological progress in the production function. This form of technological
progress raises output in the same way as an increase in the stock of labour.
In this analysis it is important to differentiate between level effects A and L
and their growth effects gA and n.
An economy with a declining workforce experiences lower economic growth
if the growth rate of the technology level is low and the size of the workforce
is small. Here, we have a scale effect: two economies which are identical except
the size of the workforce L experience different growth rates gy. The economy which started with a large workforce experiences higher growth than
the economy with the small workforce. In Solow (1956) without technological
progress the growth rate is gy = n, i.e. economic growth is determined by
the growth rate of the workforce whereas in Solow (1956) with technological
progress economic growth is also determined by the size of the workforce as
in (3.35).
The change in the capital stock and its growth rate is derived in the same
way as in the basic model. The formula for Y differs with Y = F[K^ LA{t)].
The equation of motion for the capital per worker (see (3.5)) is
k = sF[k, A{t)] - (n + S)k
(3.36)
with F[kÂ{t)] = y. Output per head depends on k and technology level

A. Dividing (3.36) by k gives the growth rate
50

^fc = y - ( n + ^ ) .
(3.37)
As the growth rate in the basic model given in (3.6), the growth rate of k
is the difference between the product of the savings rate and the average product of capital (first term on the right-hand side of (3.37)) and the combined
depreciation rate (second term). As in the basic model without technological
progress we can see from (3.37) that a declining workforce has a positive effect
on the growth rate gk- In the case of | n |> J there is no steady state and the
growth rate gk is not only positive but also will remain positive.
With a Cobb-Douglas function the technology level can be written as
labour- or capital-augmenting.^^ The production function (3.34) can be written in Cobb-Douglas form as
y = i^(i:^)(i-^).
(3.38)
Using (3.38) in terms per worker y = kÂ^~^

output per worker as ^
we write the growth rate of
gy-â-gkîl-a)'
gA-
(3.39)
or, using (3.37)

gy = a'[s'
A:^-^^^-^ - (n + 5)] + (1 - a) Â
(3.40)
Because of technological progress (3.39) differs from (3.11) because of the

second term. In (3.39) y is also growing with technological progress. The effect
of a shrinking working population as in (3.40) is the same as in the basic model
in (3.11) - a positive effect on the growth rate of income per worker gy (see
(3.8)).
To derive the steady state we need to define a variable which is constant in
the steady state. In equation (3.36) the first term on the right side increases
over time because of the growth in technology level A{t), Therefore physical
capital k increases over time. Because the variable k is no longer constant in
the steady state {k and A both grow at the same rate in the steady state),
new variables k = ^ and y = ^ are defined to analyse the steady state.
The variables k and y are constant in the steady state. The Cobb-Douglas
production function per worker is now y = k^.
In the steady state we have k= 0. The condition for the steady state is
2^ Bretschger (1999), 38.
^^ Equation (3.35) can be transformed into (3.39) for constant returns to scale (a +
(3=1) and L = 1. This equation can be written as Qy^gA = Oi{gk gA) which is
9y = OLg~^ with y = ^ a n d k =
^.
s / ( r ) = (n + (5 + Â)^*.
51
(3.41)
With the Cobb-Douglas production function y = k^ we write the steady

state solution for capital per effective worker k* and income per worker y*
analogous to (3.15) and (3.16) in the basic Solow model^^
r
= (
)(^^
(3.42)
and
r = (^^.^^ ) ^ ^ .
(3.43)
n-ho ^ QA
Assuming n < 0, the necessary condition for a steady state is | n |< ^ + ^^
instead of | n |< J as given in (3.16) in the basic model. With technological
progress the growth rate of the workforce can be even more negative as in
the basic model and a steady state solution is still possible. We calculate the
steady state growth rate for income per worker y = ^ . Writing (3.42) as
k"^ = A' (î/_|. )^^^ into the growth rate for income per worker as given in
(3.40) gives
g;=a-
[A^-' . (n + ^ +
Â)
A^-^ - (n + 5)] + (1 - a) Â
We get
In the steady state the growth rate of income per head is determined by
the growth rate of technological progress. The growth rate is independent of
a demographic variable whereas the steady state level of y* is influenced by
the population growth rate n.
The dynamic equation for capital accumulation per effective worker can be
derived analogous to (3.5) as
k = sy-{n
+ 5-h9A)k .
(3.44)
The change in capital per effective worker is determined by the investment

sy and the combined depreciation {n + S-\-gA)k. If there is neither investment
nor depreciation nor technological progress the capital per effective worker
would decline with nk. The less the workforce grows, the less k declines.
^^ The technology A can be interpreted as a measure of efficiency. A L is the
effective workforce. One unit of this workforce is the effective worker. See Barro
and Sala-i-Martin (1998), 41.
52
We divide (3.44) by k and get the growth rate of capital per effective
worker
9k = s ^ - { n
+ d + gA).
(3.45)
k
Capital growth per effective worker is negatively correlated with the
growth rate of the workforce n. The lower n, the higher is gk^ The same conclusions with regards to the growth rate of the workforce as in Solow (1956)
without technological progress hold. The difference between the two dynamic
equations for k (3.45) and (3.6) is the parameter QA and a slightly different
definition of k. If the economy starts at a level of k that is too low (i.e. below
its steady state level), k rises over time because the amount of investment exceeds the amount needed to keep k constant, k rises until s^-j^ = {n-j-S^gA}The effective depreciation rate fov k is n + S+ gA' Without savings, k declines
due to the depreciation of K and due to the growth of the "effective amount
of labour" ^^ AL. If n is positive but low, ^^ is relatively high; if n is negative,
g^ is even higher. Assuming n < 0, we differentiate two cases:
(a) The impact of the combined depreciation on gk is negative, i.e. | n |<
S -\- gA- In this case the same transitional dynamics as above apply. The difference is a higher level of k in the equilibrium.
(b) The impact of the combined depreciation on g^ is positive, i.e. \ n \>
S^gA' In this case a positive growth rate gk declines as above but will always
stay positive (at least as high as | n{)-{-5{-{-) |). The system will always start
with a level of k which implies a positive growth rate of k above | n()+(5(+) | .
This implies that in an economy with a shrinking workforce the growth rate of
k and therefore the growth rate of y will always be positive. It is not possible
to reach an equilibrium.
The golden consumption can be derived in the same way as in the basic model.
As y can be either consumed or saved we get the consumption per head as
c={l-
s)fCk) .
(3.46)
We insert the condition for the steady state value of k from (3.41) into
(3.46) to get the steady state value of consumption per head:
c * = / ( r ) - ( ( ^ + n + Â)^*.
(3.47)
We solve for the value of s which maximizes steady state consumption c*.
We differentiate (3.47) with respect to s. With k* = k*{s) we have
See Barro and Sala-i-Martin (1995), 35.
53
5J = ,,/(r).f-(* + + ..)f = 0.
Because ^ - > 0, the expression /'(^*) {S -\- n + QA) must be zero. This
gives the condition for maximum consumption
f{k3oid^=5^n
+ gA
(3.48)
with ^* = kôid g^g ^YiQ steady state value of k which maximizes consumption. As (3.48) determines k^^^^ we can write (3.47) as
^gold _ f(^^9old^ _ (5 + ^ + g^)k3^^d
Calculating the golden consumption for the Cobb-Douglas production function y k^ and inserting the steady state values for fc*(3.42) and y*(3.43)
into (3.47) we get
g*-(,^'
, ) ^ - i S + n-^gA){^_^'^
) ^
n + d-hgA
n-Vd-^QA
which can be rewritten as
c* = s T i ^ ( n + ^ + p ^ ) ^ ^ - s^{n-\-5^gA)'^^
Differentiating (3.50) with respect to s, i.e. ^
(3.49)
(3.50)
= 0 gives
sa .
In the optimum, the savings rate has to equal a, the capital's share in national
income. We rewrite (3.47) as the golden consumption:
^gold _ J.gold{oc) _ (^ ^ ^ ^ ^ A ) ^ ^ ^ ^ ' ^
(3.51)
Inserting s = a into (3.49) gives

g ^ ^ ^ " - ( e ^ J",^, )^-i^^^^9A){,^^_^^
d + n + ^r^
which can be rewritten as
c9old = ( ^ T ^ _ ^ T ^ ) . f
) ^
(3.52)
d + n + Â
)T^ ^
(3,53)
To compare (3.53) with the golden consumption in Solow (1956) without

technological progress, we write (3.53) as
4"^^ - A . ( a ^ - a^)
. (^
)i^ .
(3.54)
^
^
^ ^(5 + n + Â^ .
^ ^
The golden consumption in the Solow model without technological progress
is (see 3.1.4)
54
c9old _ / , : ^ _ ^J^^
r_J_^J^
(3 55)
0+ n
As an example, for a = 0.03, n = 0.1,(5 = 0,035 and QA = 0.03 golden
consumption in the Solow model with technological progress is c^^ = A 1.268. Golden consumption in the Solow model without technological progress
is c^^^^ = 1.578. The level of technology A determines which consumption level
is higher. The relationship \ n \ < 5 -^ QA has to hold for the model to have
a steady state. If this condition does not hold, the solution of (3.54) is not
defined.
To derive the speed of convergence we employ the Cobb-Douglas production
function y = A- k^ and write (3.45) as
9j, = S'A-
^^^-1) - (n + (5 + Â) .
(3.56)
We derive a log-linear approximation of (3.56) close to the steady state

(as in 3.1.5) and get
9~k = - ( 1 - ^ ) ( ^ ^S + gA)' log (-^\
(3.57)
The term
{l-a){n
+ S + gA)=Pc
(3.58)
is the coefficient that determines the speed of convergence for k and hence
also for y. As in the basic model, (3c depends solely on exogenous variables
but not on the savings rate. The only difference between (3.58) and (3.32) is
the growth rate of technology QA > ^- Therefore the model with technological progress predicts a higher speed of convergence and a relatively shorter
transition period towards its steady state.
Because of the contribution of ^^, a declining workforce is more likely to
be compensated than in the basic model. Pc is more likely to be positive,
i.e. the economy converges towards its equilibrium (with /^c)- The speed of
convergence is faster with technological progress than without. This makes
the economy more likely to be dominated by a steady state. In the following
tables 3.4 and 3.5 we compare the speed of convergence in a model without
and with technological progress with varying positive and negative population growth rates. We assume 1 a = 0.8 and S = 0.05. Comparing the
numbers, we see that with technological progress the speed of convergence
is higher and therefore an equilibrium is reached faster. Hence, the effects
of a declining workforce (i.e. slowing down the speed of convergence) can be
(over)compensated with technological progress.
Comparing two economies which are identical except their pattern of workforce growth it is clear that different workforce growth patterns have different
55
Table 3.4. Speed of convergence /^c = (1 c^){n + S) in Solow (1956) without

technological progress.
Q.Ql
0.00
-0.01
-0.02
-0.03
-0.04
-0.05
0.048
0.040
0.032
0.024
0.016
0.008
0.000
Table 3.5. Speed of convergence pc = {1 a){n + S + QA) in Solow (1956) with

technological progress.
0.01
0.00
-0.01
-0.02
-0.03
-0.04
-0.05
9A
0.03
0.03
0.03
0.03
0.03
0.03
0.03
Pc
0.072
0.064
0.056
0.048
0.040
0.032
0.024
effects. Analysing an economy A with n > 0 and an economy B with n < 0 we

know from /3c as given in (3.58) t h a t economy B is relatively more dominated
by a transition period towards a steady state t h a n economy A. In economy B
a policy which boosts investment could therefore be a sensible measure t o promote growth whereas t h e same measure would be less successful in economy
A. This is due to t h e different workforce growth p a t t e r n . If the population
growth in an economy is n = 0, which gives /3c = (1 a){5 -f QA)^ the speed
of convergence is between t h e speeds of convergence in economies A and B.
3 . 2 . 6 C o n c l u s i o n s o n p o p u l a t i o n a n d e c o n o m i c g r o w t h in t h e
Solow model with technological progress
In principle, t h e same conclusions about t h e relation between t h e workforce
growth and economic growth as derived in t h e basic model hold. This is not
surprising because t h e addition of technology does not change t h e basic structure of t h e model. T h e main difference is t h e possibility of a bigger leeway for
a steady state solution for physical capital and income per worker.
56
Conclusions from "The real growth rate"

With n < 0 and labour-augmenting technology, the higher the level of technology, the higher the negative effect of the 'missing' units of labour on the
real growth rate. In an economy with a rather low technology level A the
negative effect of a shrinking workforce can be more easily compensated, if
there is (fast) technological progress gA with a rather large workforce L. This
is a straightforward consequence of the implementation of labour-augmenting
technological progress in the production function. This form of technological
progress raises output in the same way as an increase in the stock of labour.
If the stock of labour is about to decline, the technology level has to rise to
avoid a slowing down of the rate of economic growth.
Conclusions from "Transitional dynamics"
With n < 0 and | n \< S -{- QA the same transitional dynamics as in Solow
(1956) without technological progress apply. With n < 0 and | n \> S -h QA
the growth rate g^ will always stay positive (at least as high as | n() + 5{-\-)
-\-gA I). This implies that in an economy with a shrinking workforce the growth
rates of k and y remain positive.
Conclusions from "The steady state"
With n < 0 the relation | n \< S + gA has to hold. In this case, the steady
state levels of k and y are higher than in an economy with a positive workforce
growth rate. In an economy with a shrinking workforce, with n < 0 and \ n \>
S -\- gAi a steady state solution of the model is not possible.
Conclusions from "Golden consumption"
The model predicts a higher golden consumption in an economy with a declining workforce. The technology level A determines the level of the golden
consumption.
Conclusions from "Speed of convergence"
With a declining workforce, the transition period towards an equilibrium is
longer. But technological progress influences the speed of convergence positively so that the demographic influence on the speed of convergence can be
(over) compensated.
3.3 A model of economic growth - Mankiw, Romer, Weil (1992)
57
3.3 A model of economic growth with h u m a n capital Mankiw, R o m e r and Weil (1992)
Mankiw, Romer and Weil (1992) test the growth model of Solow (1956) on its
ability to describe cross-country data. They found that the model performed
well but could be improved by including human capital H in the model.
The paper employs the following Cobb-Douglas production function
Y{t) = K{tYH(tf{A{t)L{t)f-''-^
(3.59)
with the variables national income F, stock of physical capital K and technology A. The production elasticities a and [3 are constants, with 0 < a + /? < 1.
Human capital H is skilled labour, L is regarded as unskilled labour. The
production function is first-degree homogenous in physical capital, human
capital and labour. Writing the production function with lab our-augmenting
technological change and human capital in a general form as
Y{t) = F[K{t),H{t),
A{t)L{t)]
(3.60)
and differentiating with respect to time t we get the real growth rate
gYâ-gK^-p'n'A^-f'gA'Lê'gH
(3.61)
witha = | ^ f , / 3 = ^^,7=:: | 5 ^ a n d = l ^ f . G r o w t h ofFdependsamong the production elasticities a, y^, 7 and e - on the growth rates of physical
capital gx^ of the workforce n, of technological progress gA and of human
capital gH' As in Solow (1956) a negative workforce growth rate has a negative
impact on gy. This negative impact is multiplied by the level of technology
A (see conclusions of the Solow model with technological progress) .^^ We
show whether the declining workforce has a negative effect on the growth rate
of human capital and in turn on economic growth. With the 'quantitative'
component L declining because of n < 0, the 'qualitative' component /z, i.e.
human capital per worker has to increase for the growth rate of the stock of
human capital gn to be positive. But in the production function (3.60) output
depends only on the stock of human capital but not on the way it is embodied.
In Mankiw et al. (1992) H is not a function of L. This is a very strong
assumption. Therefore, in this model a relation between the stock of human
capital and the number of workers and their the growth rates respectively
can not be analysed. It is more realistic to assume that gn depends on L (as
^^ This is only the case if technological progress is modelled as labour-augmenting
(and the only reason technological progress is modelled as labour-augmenting is
that then a steady state solution is possible).
58
H h- L) and therefore on n because human capital is necessarily embodied

in human beings.^"^
In the model it is assumed that physical and human capital follow the same
production function and depreciate in the same way with the depreciation
rate 5. With SK and SH as the savings rates for physical and human capital
respectively, the change in the stock of physical capital is given by
K^
IK-SK^SK'
F[K,H,AL]
5K
and a change in the stock of human capital is given by

H=
IH-SH^SH'
F[K,H,AL]
- SH .
Dividing by K and H respectively gives the growth rates of the stocks of

physical and human capital
The stock of human capital rises with the savings rate of human capital
SH' The savings rate is given exogenously.
With k = - ^ , / i = - ^ and y ^
as physical capital, human capital and
income per effective worker we write the production function (3.59) as
y=
K-H^jAiy-'^-^ ^ ~~^ _
'-j^
= k^h''
(3.62)
Inserting y = k^h^ into (3.68) and (3.69), see below, and solving for the
steady state (i.e. A: = 0 and h 0) gives the following solution
- (^
^* ^ /
LJk
^)(i--/^),
(3.63)
) (1-^-/5) .
If we compare the per capita level in the equilibrium of (3.63) with the
equilibrium in Solow (1956) with technological progress (see (3.42)) we see
^^ Lucas (1988) provides a model where H is a. function of L as H = h - L. See
chapter 4.
59
that the investment in human capital Sh has a positive impact on the level of
^*, i.e. fc* in (3.63)> k* in (3.42).
We insert the values of (3.63) in the production function in per capita
terms and get
r = {spl)^^''^^ . (-1-)r^^
^ ^
n-\-
QA^
(3.64)
and
P
y^ = A{t) . {sts^^)TT^^^ . {
Q+/3
ê)^^^^
(3.65)
To compare the solution of the Solow (1956) model with technological

progress and the Mankiw et al. (1992) model we take logs of (3.43) and (3.65).
The solution of the Solow (1956) model is
In 2/* (t) = In A(t) -h - ^ - Ins- -^ ln(n
1a
1 a
and the solution of Mankiw et al. (1992) is
^QA^S)
ln2/*(t) = l n A ( t ) + -liiSk^^-Insh-y^^^Hn^gA+S)
1a p
1 ~ a /J
1 a p
(3.66)
(3.67)
The presence of human capital accumulation increases the impact of physical capital, i.e. the impact of the savings rate Sk on income as the term
is larger than (i^^\ in Solow (1956) with technological progress 35
With k = -^^h = ^ and y = ^
as physical capital, human capital and
income per effective worker, QA as the growth rate of the technology level, s^
as the fraction of income per effective worker invested in physical capital and
s^ as the fraction of income per effective worker invested in human capital,
the dynamic equations for the accumulation of physical and human capital
k = s~^y~{n-^gA-h5)k
(3.68)
h = s~^y-{n^gA
(3.69)
+ S)h.
From the analysis of the Solow model we know that k rises if the workforce declines (and vice versa). With fewer workers more capital per worker
is available. In (3.69) the same can be said about human capital /i. Under
2^ Mankiw et al. (1992), 417.
60
the assumption that n > 0, a growing workforce in each period implies the
stock of human capital (which is still the same) is "distributed" among more
workers. Therefore the amount of human capital per workers declines. And
vice versa with n < 0 (and assuming g^ = 0 and (5 = 0 for now) the amount
of human capital per worker rises. The logic of this assumption is doubtful
(to say the least). Of course, it is possible in a declining workforce that workers are better qualified than the generation before. But this does not happen
automatically but with better education which comes at a cost of time and
money.
Dividing (3.68) and (3.69) by k and h respectively gives the growth rates
9~k and g~^
9j, = ^
^ + 9A^S),
(3.70)
a
We obtain the growth rate of y by inserting (3.70) into the relationship
g~=a''-B+f3^^-{a
+ (3){n + gA^5).
(3.71)
k
h
The growth rate of y is ceteris paribus higher, the less the population
grows. If n < 0 and | n |> ^^ + ^ the growth rate of y is positive and remains
positive. In this case a steady state solution is not possible.
Now we can derive the steady state growth rate for income per efficient
worker. Inserting ^* and /i* from (3.63) and i/* from (3.64) into (3.71) gives
the steady state growth rate
As we have gy gy gA we can write the steady state growth rate of
income per worker as
9l=9A'
In the steady state income per head grows with the rate of technological
progress.
We analyse the condition for the "golden consumption" which is not derived
in Mankiw et al. (1992). Y and y respectively can be either consumed or
saved and invested in physical and human capital. With c ^ ; ^ we write the
consumption per effective worker as

c = (1 - s^ - s-^)y .
61
(3.72)
We rewrite (3.68) with the steady state condition k = 0 and insert t h e

values for S0 and s^y into (3.72) to obtain t h e steady state value of per capita
consumption
c* = (1 - s^ - s~^)r =r-{n
+ 9A^
SW
+ hn
which is
c*{s- Sf^) = f{k*,h*)
-in
+ gA+ S)Ck* + h*) .
We analyse which value of s = Sh-\-Sk maximizes steady state consumption

c*. W i t h ^* ^î^k) and /i* = h*{sj:^) we equate t h e first derivative with zero
Br*
~
Bk*
8h*
= O a n d [ / ' ( r , r ) - ( n + <7^ + 5 ) ] ( + ) = 0 .
Because | | ^ > 0 and ^
> 0 t h e expression / ' ( ^ * , /i*) (n + Â + ^) must
be zero.^^ This gives t h e condition for m a x i m u m consumption
with k* = kôld g^^^ ^* ^ J^goid ^g ^Yie steady s t a t e values of k and h which

maximize consumption. T h e golden consumption is t h e n
^goid ^ f{k9oid^ ^gold^^ _ (^ _!_ ^ ^ + (^)(F^^^ + /i^^^^) .
(3.74)
Because of ^ ^ < 0, t h e golden per capita consumption would be ceteris

paribus higher t h e lower t h e growth of t h e working population (if n > 0). If
t h e growth r a t e of t h e working population is negative, cP^^^ is even higher.^^
T h e Mankiw et al. (1992) model which is based on Solow (1956) shows t h e
same result with regards t o consumption and declining workforce. It predicts
a higher 'golden' consumption in an economy with a declining workforce.
3 . 3 . 5 S p e e d of c o n v e r g e n c e
In Solow (1956) with technological progress in equation (3.58) t h e speed of
convergence is
In Mankiw et al. (1992)^^ t h e speed of convergence is

- / ' ( r , Z^') stands for f l - f + f i - f .
^^ The relation | n |< (5 -\-gA has to hold; otherwise there would be no steady state.
^^ Mankiw et al. (1992), 422.
62
0CMRW = (1 - a - /5)(n + (5 + Â) .
(3.75)
The Solow model which excludes human capital (i.e /? = 0) implies a faster
speed of convergence than the Mankiw et al. (1992) model. Excluding human
capital from the model overestimates the speed and time until the economy
reaches its equilibrium. A model which includes human capital predicts that
the economy is more likely to be dominated by transition dynamics. If the
economy is dominated by transition dynamics (i.e. it is in disequilibrium for
a very long time) economic policy to boost economic growth by increasing
investment is more successful. However, the effect of (a change of) the population growth n on the coefficient of the speed of convergence is the same
in both models. If, for example, with a 0.3, /? = 0.4, S = 0.035 and the
coefficients pc and PCMRW ^^^ calculated with n = 0,01 instead of n = 0,01
both coefficients are reduced by 4.49 per cent.
Mankiw, Romer, Weil model
Human capital is an important determinant of economic growth.^^ In Mankiw
et al. (1992) human capital is exogenous and given as a 'stock'. It is not
relevant how the aggregate stock of human capital H available in the economy
is embodied in human beings. Thus, an economy with a declining workforce
experiences a higher growth of human capital per worker as the existing stock
of human capital is allocated to a smaller number of workers. This is the same
mechanism as in Solow (1956) where the physical capital per worker increases
with a declining workforce. Mankiw et al. (1992) employ the same investment
formula for human capital than Solow (1956) employed for physical capital. In
Mankiw et al. (1992) the stock of human capital available in the economy H is
not a function of the size of the workforce L. This is a very strong assumption.
Therefore, in this model a relation between the stock of human capital and
the number of workers and their the growth rates respectively can not be
analysed. We suggest that it is more realistic to assume that gn depends on L
and therefore on n because human capital is necessarily embodied in human
beings. Lucas (1988) provides a model where iJ is a function oi L a^s H = h-L.
This model is analysed in chapter 4.
3.4 A model of economic growth with human capital and

age structure - Lindh and Malmberg (1999)
Lindh and Malmberg (1999) develop an empirical approach based on Solow
(1956) and Mankiw et al. (1992). The main difference to Mankiw et al. (1992)
^^ See e.g. Barro and Sala-i-Martin (2004), chapter 5 and Institut der deutschen
Wirtschaft Koln (2005), QTff.
3.4 A model of economic growth - Lindh, Malmberg (1999)
63
is that the age structure of the population is incorporated in the model. Lindh
and Malmberg assume that age is a requirement for experience and that experience plays an important role in human capital formation. They employ
the following Cobb-Douglas-Index N of the age structure
N = l[nr
(3.76)
where n^ is the population share of age group i and a^ denotes dependent

age-groups, with a^ > 0 and âi 1. According to Lindh and Malmberg
the index N covers an experience effect on human capital and other effects
which capture the age structure. The variable a^ allows for the fact that the
actual supply of human capital to the market may vary with the dependency
burden of the household, e.g. with young or old people to care for. The authors
find that the "hypothesis of age structure effects on economic growth is not
rejected by the data"^^. The results show that "the two younger age-groups
do not have a significant positive effect on growth. Instead, it is only the
middle-age share which is significantly positively related with growth".^^
Y
^F{K,AL,EN)
which is given as a Cobb-Douglas function:
The production function in terms per worker is

y = Ak'îhNf
with 0 < a < l , 0 < ; 5 < l a n d O < a + / 3 < l
(3.77)
with y ^ j ; output per worker, k = j^ physical capital per worker, h = ^

human capital per worker and A, the technology level.
The steady state is characterized by technology A*, physical capital fc* and
human capital h*. The steady state values of physical and human capital are
given by^^
^ Lindh and Malmberg (1999), 437.
^^ Lindh and Malmberg (1999), 437.
^2 Lindh and Malmberg (1999), 434.
64

r = ((_i^)i-/5(^^^)/5^*iV/^)Tî^
(3.78)
h* = ((^)^(-^^)l-Â*Ar/3)I^:i:::F .
(3.79)
and
A* is exogenously given.
With the assumptions 5 = 5k = Sh and s = Sk = Sh (in Mankiw et al. we
have s = Sk -^ Sh) the steady state stocks of physical and human capital are
equal as in
r = ( - ^ A * i V ^ ) T ^ ^ ^ = /i* .
(3.80)
Inserting (3.80) into the production function per worker (3.77) gives the
steady state value
Achieving a steady state requires the relation \ n \< 6 to hold.

Accumulation of physical and human capital is governed by the familiar dynamic equations
k = Sky-{n
+ 5)k,
(3.82)
h = shy-{n
+ 5)h.
(3.83)
The transitional dynamics are the same as in Solow (1956), see 3.2.3. They
are not repeated here. Accumulation of physical capital k and human capital
h are not affected by the introduction of the Cobb-Douglas-Index TV.
From (3.82) and 3.83) with k = 0 and h = 0 the conditions for the steady
state are
Sky"" = (n + (5)A;*
(3.84)
and
5/,2/* = (n + (5)/i* .
(3.85)
The technology level is assumed to converge to an exogenous world technology level^^

A = 7(A* - A)
with 7 as an adjustment rate.
3.4 A model of economic growth - Lindh, Malmberg (1999)
65

The golden consumption can be derived in the same way as in the Solow
(1956) model. We have
c={l-ShSk)y .
(3.86)
We insert the condition for the steady state value of k and h from (3.84)
and (3.85) into (3.86) to obtain the steady state value of consumption per
head
c* = ^ * - ( n + ( 5 ) - ( r + / i * ) .
(3.87)
We solve for the value of s which maximizes steady state consumption c*.
We differentiate (3.87) with respect to s. With ^* = k*{s) and h* = /i*(s) we
have
Because ^ > 0 and ^ > 0, the expression {^ -^ ^ ) - {S + n) must

be zero. This gives the condition for maximum consumption
f(k9oid^l^9oid^^^g^^^
(3.88)
with A:* = fc^^^^, /i* = h^^^^ as the steady state values of k and h which
maximize consumption and | | ^ + ffr = f^k^""^^, /i^^^^). As (3.88) determines
^goid ^ g ^^^ rewrite (3.87) as the golden consumption
^gold _ ^gold{cy) _ ^^ _^ n ) F ^ ^ ^ .
(3.89)
With the production function given in (3.77) we write (3.87) as
c* = r"(/i*Ar)/^-8/,y*"Sfey*.
Inserting A:*,/i* and i/* from (3.78), (3.79) and (3.81) and differentiating
with respect to s gives
s-= Sh = Sk = - ( a + /3) .
In the optimum the savings rates for physical and human capital respectively are half of the sum of the capital's shares in income.
The speed of convergence from any start value y to the steady state y* is
given by
/3e = ( l - a - / 5 ) 7 ( ( ^ + n)
with 7 as an 'adjustment rate' to a higher technology level.^^ The population growth rate n has the same effect on the coefficient as in Solow (1956)
and Mankiw et al. (1992).
66

Lindh-Malmberg model
In Lindh and Malmberg (1999) an economy with a declining workforce experiences a higher growth of human capital per worker as the existing stock of
human capital is allocated to a smaller number of workers. This is the same
mechanism as in Solow (1956) and in Mankiw et al (1992) where the physical
capital per worker increases with a declining workforce. In addition the LindhMalmberg model includes an index N for the age structure of the population.
In the production function this index is multiplied with human capital H as
it is assumed that age is a requirement for experience. Experience in turn has
a positive effect on human capital. The index also includes dependent agegroups: if a dependent age-group for a specific non-dependent age-group is
high, the supply of human capital of the non-dependent age-group is affected
as there are dependent individuals to care for.
The Solow model without technological progress offers no explanation of
growth of income per capita. This explanation is left to technological progress.
This rate determines the rate of growth of income per capita. As this rate of
technological progress is exogenous the model was criticized for not delivering
a satisfactory explanation. However, empirical tests of the Solow model prove
satisfactory under certain conditions. Two papers which test the Solow model
were analysed above. The model by Mankiw, Romer and Weil (1992) augments the Solow model with human capital and conclude that Solow (1956)
augmented with human capital performs well. Lindh and Malmberg (1999) include an age structure in the model and test it empirically. The result shows
age structure effects on economic growth.
Two different groups of growth models endogenise determinants of economic growth. One group endogenise technological progress (this branch of
research started with the seminal paper by Romer (1986)), the other group
looks for another explanation for economic growth and focuses on human
capital. The latter branch of research was encouraged by the seminal paper
of Lucas (1988). As the majority of Part II of this thesis is based on Lucas
(1988), this model is described in detail in the next chapter.
Effects of a declining population in a model of

economic growth with endogenous human
capital - Lucas (1988)
Intertemporal optimization is usually analysed employing a Hamiltonian function. The Hamiltonian function is the dynamic equivalent of the Lagrange
function. It is employed to find the values of the variables that maximize or
minimize a specific objective function. In a dynamic model, the problem involves the time path of the variables. The Hamiltonian function represents the
present value utility over an infinite horizon with respect to a state variable,
a control variable and a costate variable. Before analysing the Lucas (1988)
model we describe the problem of dynamic optimization the Lucas model
involves and how it can be solved.
4.1 The problem of dynamic optimization

and its solution
A problem of dynamic optimization asks for the optimal magnitude of a choice
(or control) variable at each time in a given time interval.^ The relevant time
interval can be either finite (with a terminal point T) or infinite (to oo).
The solution of the dynamic optimization problem is the optimal time path
for the control variable. In case there is more than one control variable, the
solution consists of the optimal time path for each variable. The problem
takes the following form: the individual chooses a number of control variables
to maximize the value of his or her utility function V. There may be only one
control variable, for example, consumption c or more than one, for example,
consumption c and the number of children the individual chooses. The state
of the economy is represented by the state variables^ for example, physical
^ See Chiang (1992) for a detailed description of problems of dynamic optimization.
An introduction to dynamic optimization in continuous time and how it can be
used in economic growth theory is given by Barro and Sala-i-Martin (2004), 604f.
The behaviour of the household which maximizes its utility over time is based on
Ramsey (1928).
68
capital per capita k and human capital per capita h. These are the constraints
the individuals face when choosing the control variables. The constraints are
dynamic as they involve a change of the variables over time. The choice of
the control variables translates into a particular pattern of movement for the
state variables, i.e. the choice variables 'drive' the state variables over time.
These state variables describe the development of the economy over time.
With one control variable (consumption c) and one state variable (physical
capital A:), an example for a dynamic constraint is given by the following
equation of motion for k
k{t) = g[k{t),c{t),t] = mt),t]
- c{t) - 5k{t)
(4.1)
with 5, the depreciation rate of physical capital. The equation of motion

for k in the Solow model, for example, is given in (3.5) in section 3.1. Equation (4.1) is a differential equation in k{t) and defines that the increase in
the capital stock per capita equals savings (which equals output minus consumption) minus depreciation. The pattern and extent of the increase in the
capital stock is thus determined by the choice of a particular c. Thus (4.1)
describes the path the variable k takes over time. It is possible to construct
the optimal state-variable path A:*(t), once the optimal control-variable path
c* {t) is found.
For the equation of motion a given initial point is assumed as given by
A:(0) := A;o > 0 .
(4.2)
This condition simply says that the state variable k{t) begins at a given
value ko. As many admissible paths are possible from the starting point ko
we also need a statement concerning the terminal point of the path. This
terminal point is either given (for example, the capital stock has to be zero
or has to have a positive value) or in case of a variable-terminal-point problem (i.e. the terminal point is not given) we have to employ the so-called
transversality condition. The transversality condition is a terminal condition
that can distinguish the optimal path for k from the other admissible paths.
The transversality condition describes how the optimal path transverse, i.e.
crosses, the terminal line.^ The transversality condition depends on the nature
of the time horizon of the problem: the horizon can be either finite or infinite, the terminal state (e.g. the value of the capital stock k(T)) can be either
fixed or free. As the growth models in Part II of this thesis (and most growth
models in the literature) deal with problems with an infinite horizon we state
only the transversality condition in case of an infinite planning horizon and a
free terminal state:^
lim e-^^^^-* . k{t) > 0 .
t>CXD
2 See Chiang (1992), 12.

^ See Chiang (1992), 261, Solow (2000), 129.
(4.3)
4.1 The problem of dynamic optimization and its solution
69
Condition (4.3) defines that the value of the state variable must be nonnegative at the end of the planning horizon k{t)^ discounted at the rate f(t).
The factor f(t) is the average discount factor for the time period between the
points in time zero and t^
In dynamic optimization the so-called maximum principle allows us to
deal with problems where the admissible values of the control variable are
confined to some closed, bounded convex set U, for example a set U in the
closed interval [0,1], i.e. 0 < c < 1.^ To summarize, the problem to be solved
is given by
max V =
v[k{t),c{t),t]-dt
(4.4)
Jo
under the constraints given in (4.1), (4.2) and (4.3) and the direct constraint on the choice variable c{t)
c{t)
c e [0,1].
V is the present value of the utility function, k is the state variable, c is the
control variable. At the initial point in time, the values of fc(0) = ko and t = 0
are given. One argument, the choice variable c, has to be chosen.
The problem given in (4.4) is solved with the tool of the maximum principle, the Hamiltonian function. This solution process involves the time variable
t, the state variable(s) and the control variable(s) and an additional variable,
the costate variable. The cost ate variable, denoted by /i(t) can be compared
to the Lagrange multiplier and is therefore also called the "shadow price" of
the associated state variable.^
For the problem of dynamic optimization with one control and one state
variable the solution can be determined using the following 'recipe'^
(1) Construct the Hamiltonian function H by multiplying the the Lagrange
multiplier /x with the right-hand side of the equation of motion for k (4.1) and
add this product to the utility function V
H = v{k, c, t) + /i(t) g{k, c, t) .
(4.5)
(2) Take the derivative of the Hamiltonian function with respect to the
control variable (here: c) and equate with zero
dH
dv
do
,, ^,
^ In infinite horizon problems the transversality condition needed to provide a

boundary condition is typically replaced by the assumption that the optimal
solution approaches a steady state; see Kamien and Schwartz (1991), 174.
^ Chiang (1992), 19.
^ See Chiang (1992), 167.
70
(3) Take the derivative of the Hamiltonian function with respect to the
state variable (here: k) and equate to the negative of the derivative of the
Langrange multiplier /x with respect to time:
dH
dv
da
, ^ ^.
(4) There are three possible cases with regards to the transversality condition.
Case 1: In case the horizon is finite, the product of the shadow price and
the capital stock at the end of the planning horizon is equated to zero
/i(r) . k{T) = 0 .
(4.8)
Either /i(T) or k{T) has to be zero to fulfill (4.8)

Case 2: In case the horizon is infinite (with discounting) the condition is
lim Mt) k(t)] = 0 .
(4.9)
tôo
Case 3: In case the horizon is infinite (without discounting) the condition

IS"
lim [H{t)] = 0 .
too
(4.10)
The equations (4.1) and (4.7) form a system of ordinary differential equations in which /i and k depend on fj,^k and c. Equation (4.6) relates /i to c so
that /i (or c) can be eliminated. Using (4.6) and (4.7) leads to an expression
for the growth rate of consumption c. From this growth rate the equilibrium
values of k and c can be derived. This recipe is applied in section 4.2, when
solving the Lucas (1988) model.
4.1.1 The problem of dynamic optimization with multiple control
and state variables
The optimization problem can include multiple control and state variables.
Then the dynamic problem with n control variables and m state variables is
given by^
poo
max
t/(0)= /
u[kiit),...,k^{t),ci{t),...,Cn{t),t]-dt
subject to
ki{t)
=g^[ki{t),...,km{t),ci{t),...,Cn{t),t]
^ See Michel (1982).

^ Barro and Sala-Martin (2003), 617.
(4.11)
4.1 The problem of dynamic optimization and its solution
71
k2{t) = 9^[kl{t), ..., km{t), Ci(t), ..., Cn{t),t]
km{t) =
g'^[ki{t),...,km{t),Ci{t),...,Cn{t),t]
ki{0)>0,,..,km{0)
> 0 given
ki{t) >0,..,,km{t)
> 0 free
and
0 < Q < 1 for all i = 1, 2,..., n .
In the case of multiple variables the solution path is similar to the problem
with one state and control variable. The Hamiltonian function is given as
i J = : w[A:i(t),...,A:^(t),ci(t),...,Cn(t),t]
m
~]-^/2i'g'[ki{t),...,km{t),Ci{t),...,Cn{t),t]
i=l
T h e first-order conditions which are necessary for a maximum are

dH
dci{t)
0,
i = 1, . . . , n
and
dH
dki{t)
.
-î,
. 1
2= l,...,m.
T h e transversality conditions are

lii{T)'ki{T)
= 0, for a l H .
T h e equations form a system of ordinary differential equations in which

fii and ki depend on /i^, ki and Q .
T h e Lucas (1988) model analysed in t h e following section involves a problem of dynamic optimization with two control variables (consumption c and
time spent in t h e production sector u) a n d two state variables (physical capital
k and human capital h).
72
4.2 A model of economic growth with h u m a n capital Lucas (1988)

In t h e Solow (1956) model analysed in chapter 3 t h e production factors are
physical capital K and labour L. H u m a n capital, i.e. t h e skills and knowledge embodied in h u m a n beings, is not included in t h e production function.
Mankiw et al. (1992) include human capital and assume t h e same production
function for physical and h u m a n capital (see section 3.3). Lucas (1988) chooses
a different way t o include h u m a n capital in a model of economic growth. ^^
There are two sectors. Lucas assumes t h a t individuals spend a fraction of time
(u) in t h e production sector and some time {1 u) in t h e education sector
accumulating new skills. In the production sector o u t p u t is produced with
t h e input factors physical capital and labour, enhanced by its level of h u m a n
capital. T h e o u t p u t can be consumed a n d / o r invested in physical capital. In
t h e education sector t h e input factor h u m a n capital generates new h u m a n
capital. T h e accumulation of individual h u m a n capital h follows t h e function
h = E'{l-u)'h-5'h
(4.12)
with E t h e "education technology" (or productivity) and S t h e depreciation of h u m a n capital.-^^ This function relates t h e change in t h e h u m a n capital
level to t h e level already attained and to the time spend acquiring more skills
{1 u). An increase in human capital h requires the same effort, no m a t t e r
what level of h has already been attained.^"^ There have t o be constant ret u r n s t o h u m a n capital otherwise h u m a n capital could not serve as an engine
of endogenous economic growth.^^ T h e change in t h e stock of h u m a n capital
H = hL is
H = E{1-
u)hL - 5hL = E{1 - u)H - 5H
and t h e growth rate is

gH = E{l-u)-6
= gh.
(4.13)
^ In the literature, the model is called "Uzawa-Lucas" model as Lucas (1988) is

based on Uzawa (1965). Lucas (1988) includes several models. In this thesis,
Lucas (1988) refers to chapter 4 of his paper.
^^ The production of human capital involves no physical capital. Rebelo (1991)
applies a Cobb-Douglas function which employs both human and physical capital
in the production function.
^2 Lucas (1988), 19.
^^ If the accumulation of human capital would follow a rule such as h = E{1 u)h^
and C < 1 there are diminishing returns to human capital accumulation. This
means that the growth rate of human capital is ^ < E(l)h^~^ so that ^ goes to
zero as h grows (see Lucas (1988), 18). See Solow's criticism of (4.12) in Solow
(2000), 126.
4.2 A model with human capital - Lucas (1988)
73
The growth rates QH and gh are identical under the assumption that all
workers are identical. The time spent in production u is constant in equilibrium, i.e. the growth rate of u is zero. If the growth rate QU is positive, u
grows towards 1 and then exceed 1. This is not a possible solution. If the
growth rate QU is negative, u declines towards zero. Then no time is spent in
the production sector and all time is spent in the education sector. This is not
a sensible solution for an economy in equilibrium. With Qu = ^ and 0 < u < 1
there is a constant time share {1 u) in education which means a constant
growth rate of human capital.
In the general production function the input factor labour is substituted by
human capital:
Yit) =
F[K{t),He{t)]
where He stands for effective labour, i.e. He uH uhL. Not all human
capital available in the economy can be used for the production of goods; a
fraction of it {1 u) is always needed in the education sector to produce new
human capital. The growth rate of Y is
gy = (^-gK + P'gHe
(4.14)
with a and f3 the production elasticities of K and He respectively. This is

analogous to the real growth rate of the original Solow model in equation (3.2).
Instead of the quantitative variable population growth n, we have now the
growth rate of the 'combined' variable He which consists of two quantitative
components {u and L) and the qualitative component (h).
Lucas assumes a constant and positive population growth rate (population
is equivalent to the workforce). A restrictive assumption for the stock of human
capital H in the economy is employed: only the combination of h and L is
important, h and L are perfect substitutes: a worker with human capital h is
the productive equivalent of two workers with the level ^h each or a half-time
worker with 2h.^^ If the number of workers declines, He can still grow if the
workers accumulate more human capital on their individual levels. The tradeoff is the more time individuals spend acquiring new skills (off-the-job) (and
hence increase human capital) the less time they spend in production (and
hence decrease production in the present period). Hence the overall effect on
output is ambiguous. The more time is spent acquiring new skills in period 1,
the higher is the human capital which can be used in the goods production
sector in period 2.
^^ Lucas (1988), 17. See criticism by Nerlove and Raut (1997), 1140, "... so 10 men
who can read are better than 100 who cannot no matter what the size of the
labour force?"
74
For the analysis of the model we write the Cobb-Douglas production function as
Y = K''{uhLy~'^
(4.15)
in which technology level A for reasons of simplicity is omitted as it is

exogenous. ^^ L is the supply of unskilled labour and h is human capital per
worker.
An equilibrium on the goods market is assumed. We apply the relation
Y = C -\- K -\- 5K and write the production function as
K'îuhL)^-''
=cL + k + SK .
(4.16)
Solving (4.16) for ^ , the growth rate of the stock of physical capital is given
by
The growth of human capital is given by (4.13). For the analysis of the
steady state we need the growth rate of the ratio of physical and human
capital. This growth rate is zero in the steady state, and is
9^=9K-
{9h + QL) = uî--) ( - ^ ) - ( ^ - - ) ^^Ê{l-~u)~n.
(4.18)
4.2.2 The household

The preferences of the representative individual are given in the following
function of constant elasticity of substitution (CES function) as in
u(c,) = ^ ^ ^ ^ ^
(4.19)
with the utility w, the consumption per head c and cr > 0. (1/cr) is the
intertemporal elasticity of substitution. If this elasticity is small, i.e. a > 1
the individual regards consumption at different times as poor substitutes for
one another and therefore tends to smoothen consumption. If the elasticity is
larger than one, i.e. 0 < cr < 1, consumption at different times can be more
easily substituted with one another and therefore consumption tends to be
less smooth. It is assumed that u'{c) > 0 and u'{c) < 0. In case of a = 1 the
function (4.19) is reduced to the logarithmic utility function, logc.
^^ In Lucas (1988) the production function is Y - ^ K'^(uhLf~'^hl with technology level A. The term hZ captures the external effects of human capital. As
we are not concerned with externalities of human capital, we can simplify the
function to (4.15), i.e. we set 7 = 0. In addition we neglect the technology A as
it is exogenous in this model.
75
The individual (or a household) maximizes its intertemporal utility function by choosing c and thus maximizes the integral over all future time of
discounted instantaneous utilities
U{ct) = /
^^
Jo
e-^'dt
(4.20)
1 -^
with the discount rate p. The discounted sum of the instantaneous utilities
u{c) represents the welfare. In (4.20) the population growth rate n ^ 0 is not
accounted for. Population can be thought of as many identical families with
its sizes changing over time. An alternative to (4.20) is then the so-called
Benthamite welfare function where the number of family members in the
household is accounted for. Then (4.19) is multiplied with the population size
As Lucas (1988) does not differentiate between population N and workforce I/, we have Nt = NQ - e^^ = LQ e'^^ = Lf and write the Benthamite
function as:^^
^_
/
Jo
W
-Lo'e''''e-P'dt
1 -^
(4.21)
or, setting LQ = 1,
U=
r ' ' ^ ^ ^ ' " " " ^ . e-^P-^'^'dt .

(4.22)
Jo
1 -^
Taking population growth into account is equivalent to reducing the rate
of time preference to p n. A larger size of the family (and thus population)
in the future increases the weight given to the utility of the representative
individual in a later generation.-^^
4.2.3 The Hamiltonian approach
The solution path of the Lucas (1988) model is given here in detail with focus
on the demographic variables workforce (or population) L and workforce (or
population) growth rate n. This is the difference to the solution paths given
in the textbooks^^ where the problem and its solution is presented as one
being independent of population and workforce growth respectively. In the
textbooks, population size is taken as constant, i.e. n = 0. Then, the stock of
human capital in the economy is H = h-L where L const. As a consequence
the effect of the size of the population and its growth rate on growth rates of
consumption and income cannot be analysed.
Lucas (1988) takes population growth as a positive and fixed constant. In
his model the stock of human capital is H = h-L where L is growing at rate n.
^^ Chiang (1992), 255.
^^ Blanchard and Fischer (1989), 38.
^^ For example, Barro and Sala-i-Martin (1995), chapter 5.
76
As the solution in his model is kept very brief (as it is a journal article) and the
influence of the size of the population and its growth rate is not highlighted
in other literature this will be done in this section. Both the original model
and thus the textbook presentations of the model have in common that h and
L are perfect substitutes: a worker with human capital h is the productive
equivalent of two workers with the level ^h each or a half-time worker with
The maximization of the intertemporal utility function (4.22) is subject
to two dynamic constraints: the equations of motion for (individual) human
capital h and the stock of physical capital K. The maximization problem is
maxt7(c) = / " ""^^^'"^ ~ ^ e-^^~^^'dt
Jo
1 -<^
subject to
k = Y -cL-5K = K'îuhiy-'' -cL-5K
(4.23)
and
h = E{l- u)h - 5h,
(4.24)
with
K{0)
=Ko>0
h{0) = /lo > 0 .
The transversality conditions are
lim e-^^-^^Vi(0^(0 = 0
t-ôo
lim e-^''-"^*H2{t)hit) = 0 .
If the transversality conditions do not hold there would be a tendency to
postpone consumption forever.^^ The standard technique to solve a maximization problem with dynamic constraints is to form the Hamiltonian function J
(see section 4.1):
J = U{c) e^* e-^^dt -h iui{k) + fi2{h)
where /xi and /i2 are the costate variables (shadow prices). Inserting the
equations of motions for K (4.23) and h (4.24) we get the Hamiltonian function
^^ Lucas (1988), 17.

20 Solow (2000), 129.

J = -^
e"* e-P*dt + iJ,iiK'{uhL)^-'
77
- cL - SK)
1 (J
^jj.2{E{l-u)h-5h)
(4.25)
The Hamiltonian function includes the utility function (4.22) where LQ =

1. The control variables are consumption c and time spent in production u.
Differentiating (4.25) with respect to consumption c and time spent in the
production sector w, we get the following first-order conditions
- u^c) . e^* e-^* - /,iL = 0 ^ c"^ = fuL e"^* e^' = /ii - e^* (4.26)
and
87
= /ii(l - a)irî6-^(/iL)^-^ - /i2^/^ = 0
^ /ii(l - a)Kî/-^(/iL)^-^ = /i2^/i .
(4.27)
The first-order condition (4.26) guarantees that the marginal utility of consumption (at each instant) equals the marginal utility of net investment which
is the shadow price /ii. The economic meaning of this first-order condition is
that, since output can be allocated either to consumption or to investment,
in the optimum the marginal utilities of both have to be equal. Taking logs of
c~^ fii ' e^* (4.26) and differentiating with respect to time we get
-a log c = log /ii + pt log e,
which is
-a ' - =
c
\- p
/ii
and a relationship for the growth rate of consumption gc
The first-order condition (4.27) guarantees that the value of the marginal
unit of studying time {ii2Eh) equals the value of the marginal unit of production time. Equation (4.27) can be written as
Differentiating the Hamiltonian function (4.25) with respect to the capital

stock K and equating with the negative derivative of pi with respect to time,
gives
78
BT
-^1
and
/ -^ \a l
Al
/ii
1 a I r
(4.30)
hL
Inserting (4.30) into (4.28) gives the growth rate of consumption per capita
g, = -{a-
( ^ ) - ( i - " ) u(i-") -5-p).
(4.31)
Differentiating the Hamiltonian function (4.25) with respect to the capital

stock h and equating with the negative derivative of /i2 with respect to time,
gives
87
and
^
. K^(t/L)i-^(1 - a)/i-^ + {E{1
-u)-5)
(4.32)
M2
M2
Inserting the inverse of (4.29) into (4.32) leads to

( 5 - ^ :
A2
(4.33)
M2
To get an expression for the growth rate of u we differentiate the first-order

condition (4.29) with respect to time
/i2/ii - /^2/ii _ (1 -o^)
^ \
'9
a-l
dt
(1-a)
^hL'
dL
"
dt
and
hL
(4.34)
Multiplying the left-hand side of (4.34) with ^ and the right-hand side
with i^{-^)~'u'L''^
(which is the equivalent, see (4.29)) gives
^- =a' QK-a-gu-^gL
112
111
79
(4.35)
^^
Lastly, inserting (4.30) and (4.33) into (4.35) and solving for g^ gives
gu = E{--l)Êu-^^
n{- - 1) .
(4.36)
a
K
a
As explained in section 4.1, the only sensible growth rate of u is zero. If
the growth rate g^ is positive the time spent in the production sector would
increase and exceed 1 at some point in time. This is not possible as we have
0 < u < 1. Assuming a negative growth rate gu < 0, the time spent in the
production sector is zero at some point in time. This implies that nobody
works in the production sector. This cannot be a sensible solution.
The growth rate of ^ follows from (4.17) and (4.31)
9^=9c + 9L-9K = ( ^ ^ ) (^)-(^-") u^'-"^

+^-(-)-[^(l-^)+P]+n-
(4.37)
The growth rate of ^ is given in (4.18) as
4.2.4 The s t e a d y s t a t e
The steady state variables can be found by setting the three growth rates in
(4.36), (4.37) and (4.18) to zero. From ^f^ = 0 we have
K
h a
and
^=E{--l)+Eu^
K
a
From OcL = 0 we have
n[~ - 1) .
a
= i ( 5 ( i _ ^) + p) _ n - ( ^ ^ ) . ( ^ ) - ( ^ - " ) u^'-'
(4.39)
(4.40)
and from gjK_ = 0 we have

hL
i^)
= (+E{l-u)+n)^-u.
Inserting (4.39) into (4.41) gives
(4.41)
80
= [bE + n)]^-u.
riL
a
Inserting (4.42) into (4.40) gives the steady state value for
(4.42)
^
A * = - ( 5 ( 1 - a) + p- (E + n)) - n + -{E + n} .
A
cr
a
We insert (4.43) into (4.38) to get the steady state value of u
1
(4.43)
77
^*^^__(l + ^) + l
(4.44)
with Lp = - ^ ( ^ ( 1 cr) + p). In the steady state, the lower the population
growth rate n, the higher the time spent in production u*. In case of a stable
population with n = 0 equation (4.44) can be written as
w* = (^
hi.
a
(^)* = [l(^ + n ) ] - b + i ( . - l - | ) ] .
(4.45)
Lastly, we can solve for the steady state growth rates. Inserting ( ^ ) * from
(4.45), ( ^ ) * from (4.43) and w*from (4.44) into QC in (4.31), gn in (4.13) and
QK in (4.17) we get the steady state growth rates for consumption, physical
capital and human capital
g;=gl
= îE-S-p
+ n)
= 1{E-S-P
(4.46)
and
9K -9*CL=91L
n(l + a)) .
(4.47)
The impact of the value of n on u* (the lower n, the higher is iz*) is reflected
in the steady state growth rate of human capital (4.46): the lower n, the lower
is the growth rate g^ (as more time is spent in the goods production sector
and less time is spent in the education sector). For a given population growth
rate n, policies aimed at enhancing economic growth must therefore increase
the productivity E of the education sector. We take logs of the production
function (4.15) and differentiate with respect to time to get the growth rate
of output in the steady state
9Y=O^'9K
+ {^-
o^){9l +9h+ 9L) = 91L
and thus
^^ = -{E - (5 - p + n(l + cr))
(J
(4.48)
81
and t h e growth rate of income per capita

g; = -{E-5-p
+ n).
(4.49)
4 . 2 . 5 C o n c l u s i o n s o n p o p u l a t i o n a n d e c o n o m i c g r o w t h in t h e
Lucas m o d e l
T h e impact of t h e variable n on t h e steady state value of t h e time devoted
to t h e production sector u* can be seen in (4.44). More time is spent in t h e
production sector if population growth is low or even negative. If population
growth is high, more time is spent in t h e education sector accumulating new
h u m a n capital.
Table 4.1. Steady state values for u* and Qy as in (4.44) for different population
growth rates n.
n 0.03 0.01 0.0 -0.01 -0.03
n* 0.55 0.58 0.60 0.62 0.65
gl 0.054 0.048 0.045 0.041 0.034
Source: own calculations, with
E = 0.2,5 = 0.035, p = 0.033, a = 3.
For example, if t h e population grows at n = 1 per cent, t h e individuals

spend 58 per cent of their time in production, and 42 per cent in education,
generating a growth rate oi Qy = 4 . 8 per cent.
As a result (see table 4.1), an economy with a declining population increases goods production. Current consumption outweighs t h e loss of future
consumption as t h e growth r a t e of h u m a n capital is lower because of n < 0
(see (4.46).21
In t h e Lucas model t h e growth rate of consumption per head and income
per head depends positively on t h e population growth rate n and t h e productivity of t h e education sector E. National income Y grows also in E and in n
but with t h e higher factor n ( l + (j) t h a n income per head.
Table 4.2. The steady state growth rates in Solow (1956) and Lucas (1988).
Solow (1956)
~^^ n = s- f(k)/k
g; = S'f(k)/k-6-n
21
-S
Lucas (1988)
g1^ = l(E-S-p
+ nil + a))
= 0 gl ^ j;{E - 8 - p +n)
This result is also derived by Robertson (2002) who analyses demographic shocks
in the Lucas (1988) model, augmented by unskilled labour.
82
Table 4.2 shows that in the Solow model the population growth rate n does
not affect the steady state growth rate of income per head (as this is zero).
But the steady state level of y is inversely related to n (see sections 3.1. and
3.2). In the Lucas model, the growth rate of income per capita is positive as
long disE 5 p-{-n>0. With positive population growth this implies that
E-^n > S-\-p. In case of negative population growth, we have E > 5-\-p-\- \ n \.
With a constant S -\- p, the productivity of the education sector E is the
factor to promote economic growth in the case of a declining population.
The model does not suggest that individuals should invest more time in their
education (i.e. study longer) as u is not a variable affecting g* directly. Rather
it suggests that it is necessary to improve the education productivity to sustain
positive growth of income per capita. Improving education productivity will
in turn affect the time spent in production and education. A policy to promote
economic growth would therefore include enhancing the productivity E of the
education sector.
The lower the population growth rate the more time individuals spend in
the production sector. If population declines at a constant rate of e.g. n = 1
per cent (see table 4.1) the model predicts that individual spend 62 per cent
of their time in the production sector and 38 per cent in the education sector.
That would generate a growth rate of income per head of ^r* = 4.1 per cent.
To promote economic growth (per head) one could either increase the population growth rate (i.e. the birth rate on the assumption that the mortality
rate is given as an exogenous constant) or increase education productivity E,
Increasing E becomes even more important for economic growth when the
population is declining.
4.3 A note on t h e Lucas model

To explore the structure of the Lucas (1988) model in more detail, we alter the
original model. Lucas (1988) employed human capital H instead of labour L
in his seminal growth model. We keep the basic structure of the Lucas (1988)
model but reverse the replacement and take population L instead of H as
an input factor in the production process. In Lucas (1988), the time spent in
the production sector u is determined in the model and u in turn determines
the growth rate of human capital gh- The Lucas Model is a model with endogenous economic growth and exogenous population. With the replacement
reversed, we expect a model with exogenous economic growth and endogenous
population.
There are two sectors: the production sector (as before) where output Y
is produced and the "domestic sector" where the individuals "produce" and
bring up children. We have the following production function
Y = K'^{uLy-''
(4.50)
83
u is, as before, the time spent in the production process. The production
function (4.50) has the same input factors K and L as the production function
in the Solow model in (3.9). Accumulation of physical capital follows the usual
equation of motion K = Y C 5K. Here, the difference to the Solow model is
that the input factor L can be employed either in the production process (i.e.
spending time u) or at home bringing up children (i.e. spending time 1 u).
Instead of accumulation of human capital as in the Lucas model we have now
"accumulation" of children, i.e. the future workforce in the domestic sector,
i.e.
L = 7(1 - u)L - dL .
(4.51)
7 is a parameter which can be interpreted as the home productivity, i.e.

it translates the time spent at home into the fertility rate (= 7 (1 u)). The
higher the parameter 7, the higher the fertility rate for a given time {1 u).
The workforce grows with the home productivity 7, the time spent at home
rearing children {1 u) and declines with the death rate d. The growth rate
of the workforce is
gL=j{l-u)-d.
(4.52)
The death rate d is assumed to be constant. The individual maximizes his

or her utility function t/(c),
/7(c)
c(t)i-^ - 1
1
The Hamiltonian function is

J = U{c)e-P^ + iJ.i{K'{uLf-'
-C-5K)Jr
^2(7(1 - u)L - dL)
(4.53)
and the first-order conditions are

dJ
dJ
^ dJ
. dJ
-d-c = d^=''-^dK=-^'-^dL=-^'The first-order condition ^
.^ ^^,
^''')
= 0 gives
U\c) = /iie^*
(4.55)
which states that, in the optimum, the marginal utility of per-capita consumption is equal to the (discounted) shadow price of capital (/xi). The firstorder condition | ^ = 0 gives
/ii(l - o^K^r
^ - " = M2 i^ 7
(4.56)
Condition (4.56) states that in the optimum the value of the marginal unit
of time spent in the production sector must equal the value of the marginal
unit of time spent in the domestic sector.
84

Condition ^
= Ai gives
- / i i = / i i ( a . wî-^) ( ^ ) - ( i - ^ ) _ J) .
(4.57)
Equation (4.57) states t h e rate of decrease of t h e shadow price over time (or
t h e depreciation of t h e shadow price) to be equal to t h e marginal contribution
of capital t o t h e enhancement of t h e utility. T h e m a x i m u m principle requires
t h a t t h e shadow price of capital depreciates at t h e rate at which capital is
contributing t o t h e future utility level of t h e household.^^
^ = - a . 1/(1"-) . ( ^ ) - ( i - ) -f S .
/ii
L
(4.58)
T h e condition f^ = A2 gives
^
/^2
- - ^
. (1 - a ) . ^ ( 1 - - ) . ( ^ ) - -j{l-u)^d.
M2
(4.59)

^
= d~ 1.
(4.60)
M2
From t h e condition (4.55) we get (with t h e utility function U{c)

1-cr
- o - c = /xie^* .
(4.61)
Taking logs of (4.61) and differentiate with respect to t i m e gives^^
^ = i(-fl-.).
(4.62)
Inserting (4.57) gives the growth r a t e for consumption per head

(7e = - = - ( a u ( i - " ) ( ^ ) - ( ^ - " ) -5-p).
c
a
L
T h e growth rate of t h e stock of physical capital is
<;^ = I =(!-). ( | ) - a - ) - ^ - < 5 .
(4.63)
(4.64)
We have two possibilities t o write t h e rate of growth of t h e shadow price

^ . From (4.62) we have
22 Chiang (1992), 208.

^^ Taking logs gives In 1 Inc = In/ii + ptlne. Differentiating with respect to time
gives (4.62)

Ml
= -(J 'QcMl
85
From (4.58) we have

^^_a.Ji-).(:^)-(i-a)+^.
Ml
L
Equahzing b o t h equations we get
-a . u^^-^^ . ( _ ) - ( i - )
^â.g^-p-8
which is
H ( I - ) . ( : ^ ) - ( i - ) = 1 ( ^ . ^^ + p + ^) .
(4.65)
L
a
We see in (4.65) t h a t t h e right-hand side is a constant because a, cr, p
and 5 are constant parameters and t h e r a t e of growth of consumption QC is
constant in t h e steady state. Because t h e expression on t h e right-hand side
is a constant, t h e expression on t h e left-hand side of (4.65) is a constant.
Because t h e left-hand side is a constant we can differentiate it logarithmically
and equate t h e derivative with zero.
We get
(1 - a) logu - (1 - a ) logiiT + (1 - a ) l o g L = 0
which is
(1 - a ) . p x = (1 - a ) . ^^ -f (1 - a ) ^L .
(4.66)
Dividing (4.66) by (1 a ) and taking into account t h a t in t h e steady state

Qu = 0, we get t h e following relationship for t h e steady state
9K=9l-
(4-67)
In t h e steady state t h e stock of physical capital grows at t h e same rate as

t h e workforce. To show if this relationship is compatible with positive growth
of consumption per head of t h e workforce QC we derive t h e growth rate of
physical capital in relation to g^ We know t h a t in a closed economy t h e
aggregate consumption C = c - L plus net investment K equals t h e quantity
produced Y, i.e.
which is
k = K'îuL)^-'^
-C'L
Dividing (4.68) by K and using (4.65) we get
(4.68)
86
4 EfTects of a declining population
9K = -{(T-9c
+ P + 5)-%^
(4.69)
We see from (4.69) t h a t t h e ratio ^ has to be a constant. T h e first t e r m

on t h e right-hand side is a constant and QK is a constant in t h e steady state.
Because ^ is a constant in t h e steady state we have
9*0+91=
9K-
(4-70)
As shown in (4.67), t h e stock of physical capital grows with t h e growth

rate of t h e workforce. As a consequence from (4.70), t h e steady state growth
rate of consumption per head of t h e workforce has to be zero. This shows
t h a t there is no (endogenous) growth in t h e model. This is also confirmed
when deriving t h e rate of growth of national income Y. Taking logs of t h e
production function (4.50) and differentiating with respect to time we get
, ,u L,
y
K
,,
y = - ^ + ( i --^^û^j)
(4.71)
From (4.71) follows

9Y=9L
As a consequence t h e steady state rate of growth of income per head of

t h e workforce y = ^ is
9;^9*Y-9l
= 0.
Replacing human capital in t h e original Lucas (1988) model with h u m a n

beings reduces t h e result of t h e model t o one which we are already familiar
with from t h e discussion of t h e Solow model (see section 3.1): o u t p u t grows
with t h e same rate as population which means t h a t ^^ = 0. T h e difference
t o Solow is t h a t population does not grow with some exogenous r a t e n but
depending on t h e time (1 '^) spent in t h e domestic sector determined within
t h e model. As o u t p u t and population grow at t h e same r a t e we arrive at t h e
result t h a t o u t p u t per head and consumption per head does not grow at all
in t h e steady state. Introducing exogenous technological progress would give
t h e same result as in t h e Solow model with technological progress (see section
3.2): in t h e steady state output per head and consumption per head grow with
t h e rate of exogenously given technological progress. In terms of a model of
endogenous growth of income and consumption per head of t h e workforce t h e
slightly modified Lucas (1988) model does not provide a solution.^^
^^ Solow (2000, 133) modifies the Lucas (1988) model by introducing leisure time.
Then the Lucas model is reduced to the standard Solow model. See also Hahn
(1990). See Rebelo (1991) for a model where time is divided between leisure, work
and education.
87
The function to model endogenous fertility and thus endogenous population growth as employed in the current section in (4.51) and (4.52) is applied
in a similar form in Part II of this thesis.
Conclusions of Part I
The analysis of the general literature on population and economic growth in

section 2.1 generally indicates that a declining population size has a negative
effect on a country's economic performance. However, in the general literature
economic performance is not necessarily defined in terms of economic growth.
The evidence of the effect of an ageing population, i.e. a change in the population age structure, on the economy is mixed. The literature reviewed in section 2.1 does not contain a conclusive theory on economic growth. Economic
growth theory, as it is currently known and employed in research, started
with Solow (1956) and Swan's (1956) neo-classical growth theory with exogenous technological progress. The literature on demography in neo-classical
theory reviewed in section 2.2 is sparse and mainly concludes that neo-classical
growth theory is not a tool to analyse demographical issues with regards to
economic growth. When reviewing endogenous and semi-endogenous growth
theory in section 2.3. we distinguished between models with and without scale
effects. A model with a scale effect from population predicts that it does not
reach a steady state with a constant growth rate of income per head if the population growth rate is at a positive or negative rate. However, the prediction
that an expansion of the workforce raises the per capita growth rate cannot
be supported empirically.-'^ The general view is that the scale effect is counterfactual.^ As a consequence, economists modify the framework to eliminate
the predicted scale effect. Nevertheless, when analysing the relation between
population and economic growth, scale effects are an important issue as they
also determine the scope for policy intervention. In the semi-endogenous models reviewed in 2.3.2. the steady state growth rates are pinned down to the
exogenous population growth rate which is regarded as largely independent
of population measures.^
1 Jones (1995a), (1999).

2 Barro and Sala-i-Martin (2004), 297.
^ Christiaans (2004).
90
5 Conclusions of Part I
We have shown in chapter 3 that neo-classical growth theory as in Solow

(1956) and two other models (Mankiw et al. (1992) and Lindh and Malmberg
(1999)) which are based on Solow (1956) have several shortcomings in respect
to an ageing and declining population in a model of economic growth. As the
literature based on Solow (1956) is extensive, most of these models share the
same shortcomings with regard to demography and economic growth. Most
importantly, the models assume that the population growth rate n is a positive
constant or that n is zero. A declining population, experienced or expected
in many countries, is not analysed in these models. However, defining the
population growth rate n as a negative constant and applying n < 0 to these
models, has three problematic implications:
1) Depending on the size of the other parameters (depreciation rate S and
technological progress QA) ^ steady state solution may not be possible.'^
2) Neo-classical growth theory predicts that population decline (or low
population growth) has a positive effect on the economy. The more the population declines, the more physical capital per worker is achieved. The steady
state value of physical capital and of income per head is higher the lower the
population growth rate n is. The equilibrium values are even higher if the
population growth rate is negative, assuming a steady state is still possible.
As a result, a constant low population growth or constant population decline
leads to a more favourable economic situation. This result is at odds with the
projections on declining population and economic growth.^
3) The third problematic implication is that with an exogenous n < 0, the
population perpetually declines. Individuals become richer and richer, but the
economy as a whole declines.
The first implication affects growth theory focusing on steady state economic growth, the second and third implication affect growth policy as neoclassical growth theory predicts that zero population growth or even population decline has a positive impact on the steady state levels of income and
consumption per head.
Other than in Solow (1956) et al.^, the Lucas (1988) model predicts a
growth rate of income per head of the population which is positively related
to population growth. As shown in chapter 4 this depends heavily on the form
of the utility function employed in the model. In Lucas (1988) population
decline has a negative effect on economic growth in the steady state, whereas
in Solow (1956) et al., population decline has a positive effect on economic
growth in the transition to a steady state and a positive effect on the level of
income per head of the population in the steady state.
Besides these conflicting predictions about the effect of population growth
on economic growth in Solow (1956) and Lucas (1988), the two models share
^ We have shown this in 3.1.2 and 3.1.3.
^ See projections from OECD (2005) and OECD (2003).
^ Solow (1956) et al. stands for Solow (1956), Mankiw, Romer, Weil (1992) and
Lindh and Malmberg (1999).
91
a problematic feature. When analysing demographic change and economic

growth in these two models it is not possible to differentiate between age
groups. There is only one population size and it does not distinguish between
older and younger age groups. In these models the terms 'population' and
'workforce' are employed interchangeable. Thus it is not possible to differentiate between those who work ('the young') and those who do not work ('the
elderly').
Several models of economic growth can act as a starting point for further
research in order to address the problems specified above and for analysing
the effect of an ageing population on economic growth. The choice of model
depends on the specific question that one would like answered. To analyse
not only the effect of population size on economic growth but also the effect
of its population age structure on economic growth, one starting point is to
introduce a variable which accounts for the age structure of the population.
This is done in chapter 7 employing Solow (1956) and Lucas (1988). We show
the extent to which the introduction of a new variable alters the growth rates
and the steady state in these models. As human capital is a determinant
of economic growth, the effect of an ageing population on the accumulation
of human capital is an important question. A starting point is the Lucas
(1988) model, where individuals decide on the amount of time they spend in
education and in production. Whether and how this decision is affected by
introducing the variable for age structure into the model is shown in section
7.2.
In the literature reviewed in Part I of the thesis, population growth is
assumed to be exogenous. In Part II of the thesis, the Lucas (1988) model is
altered by introducing a third option of time allocation for the individuals,
namely to spend time at home bringing up children. This allows us to analyse
endogenous fertility and, keeping mortality exogenous, endogenous population
growth and workforce growth (or decline). This is done in chapter 8.
In addition to human capital, technology and technological progress are
important engines of growth. An analysis of the impact of the ageing workforce on innovations and technology and thus on economic growth could be
undertaken in a model of endogenous economic growth as in Romer (1990a),
Grossman and Helpman (1991a) or Aghion and Howitt (1992). We reviewed
these models in section 2.3.1.'^ To analyse the effect of an ageing workforce
on economic growth^ with a model of exogenous economic growth, once could
also employ a "capital-vintage" model by Solow (1959). In the way that Solow
(1959) distinguishes between capital equipment of different dates of construction (or vintages), it is possible to assume that "old" and "new" labour (the
^ There are two surveys on age and innovations, Brasche and Wieland (2000) and
Skirbekk (2003). The two papers can be a starting point to formulate a theory
of age and innovation. See also Canton et al. (2002) on technology adaption of
older workers and Jones (2005) on age and invention.
^ See OECD (1998b) and Johnson and Zimmermann (1993) on workforce ageing.
92
workforce) have different characteristics. A reasonable assumption is, for example, to attribute a higher level of human capital to "new" labour as those
individuals have enjoyed a better education. The remainder of the thesis does
not analyse the effect of an ageing workforce on technology, innovation and
economic growth but focuses on an ageing population and a shift in the age
structure of the total population rather than an ageing workforce. We suggest
this area for further research.
To summarize, the existing models of economic growth are not appropriate
for analysing the effects of an ageing population on economic growth. The
analysis of the effects of a declining population on economic growth is possible,
within limits, with endogenous growth theory. The limits are set by the scale
effect of the population which is present in many models of endogenous growth
theory but cannot be empirically supported. For these reasons, a new model
is developed in Part II of this thesis. This model is then employed to analyse
the effects of education policy and family policy on economic growth.
Part II
Models of economic growth

with an ageing population
6
Models of "Silver Growth"
In the following chapters we amend the economic growth model by Solow

(1956) and the model by Lucas (1988) analysed in detail in chapters 3 and 4.
Both models assume
exogenous population growth;

the growth rate of the population and the workforce to be equal, g^ = QL]
the size of the population equals the size of the workforce, N L.
In chapters 7 and 8 we amend the two models by changing these assumptions. In a first step, we amend the Solow and the Lucas model by including
a variable for an ageing population D = ^ ~ ^ . This variable D allows the
population and the workforce to have different sizes and growth rates (see
sections 7.1, Model 1 and 7.2, Model 2). We are then able to analyse the impact of an ageing population on economic growth. However, for this exercise,
the growth rates gjsf and QL^ albeit different, remain exogenous constants. The
population is ageing if the ratio of the "dependent" (older) population to the
workforce increases. We will call models which incorporate this variable D for
an ageing population "models of silver growth" to describe the fact that the
models deal with growth in an economy with an ageing population (as the
elderly are sometimes called the 'silver generation').
In a second step, we incorporate a function to generate endogenous population growth (section 8.1, Model 3) in the Lucas (1988) model. In the Lucas
model, individuals spend their time in education and in production. We will
add a third alternative. The individual can choose to spend time at home to
bring up children. In addition, we insert the dependency ratio D into this
amended model (section 8.2, Model 4). As this allows us to differentiate between the workforce L and the total population N we get one function to
generate the growth of the workforce and another function to generate population growth. We derive a steady state solution for the endogenous population
growth rate and the endogenous workforce growth rate. As it is analytically
not possible to derive a solution for these growth rates in their transition
96
6 Models of "Silver Growth"
phase, i.e. the economy is in disequilibrium, we call these models "models

with quasi-endogenous population". "Quasi-endogenous" describes the fact
that we know the solution for endogenous population growth and endogenous workforce growth in the steady state, but that we do not know how the
population develops when the economy is in transition.
In chapter 9 we alter the functions for population growth and workforce
growth slightly and then derive the population and the workforce growth rate
which are fully endogenous. We derive both the steady state and the transitional dynamics for endogenous population growth and endogenous workforce
growth (section 9.1, Model 5). As we can determine the dynamics of the system in its transition towards a steady state, we also analyse the stability of the
equilibrium. In section 9.1 in Model 5 the steady state is not stable. We show
in section 9.2 in Model 6 that adding the variable D makes the steady state
in our model economy stable. In addition to analysing the 'complete' Model
6 with endogenous fertility and an ageing population, education policy and
family policy are analysed with regard to their growth-enhancing possibilities.
Models with exogenous population
7.1 Model 1: T h e Solow (1956) model with an ageing

population
The detailed analysis of the Solow (1956) model in chapter 3 has shown that
the model's conclusions do not hold, under the assumption that the population growth rate is negative. A steady state solution is not possible under
certain conditions. Furthermore, different growth rates of the total population gjsi and the workforce QL are not possible within this framework. Also,
the characteristic of the Solow (1956) model is that the size of population N
and the size of workforce L does not differ. But we know that the growth
rates and the sizes do differ. Therefore, we show in the current chapter how
to differentiate between these variables. To address this, we introduce a new
variable in the model, the ratio
This variable describes the ratio between the non-working population which
equals the total population minus the workforce N L and the working population L. As the nominator N L is sometimes called the "dependent population", the ratio D is interpreted as the dependency ratio. This variable
becomes an index for an ageing population if we assume a fertility rate below
replacement level. Furthermore, we assume exogenous and constant mortality. As a result, population decline is the cause for the ageing process of the
population. When the workforce L declines more than the total population
iV, the dependency ratio D rises.
The output of the economy is determined by the input factors capital K
and labour L, the latter augmented by the technology level A. Thus, A appears
as the so-called labour-augmenting technology.^ As labour is a function of the
98
7 Models with exogenous population
population it can be written as L = j r ^ - T h e general production function

Y = F{K^ AL) written in Cobb-Douglas form is t h e n
Y = K'ÂL^-'^
= K'^{A ' ^ ) ^ - ^
(7.1)
T h e production function per head of t h e population is

y = ^
= A:^ A ^ - ^ . (1 + i ^ ) - ( i - ^ ) .
(7.2)
To derive t h e growth rate of t h e dependency ratio we take logarithms of

D = ^2^ ^^<^ differentiate with respect t o time. We get
P(i+D) =9N - 9L '
(7.3)
By rearranging t h e equation we arrive at t h e growth rate of t h e workforce

9L=
9N - 9{i+D) '
(7.4)
T h e growth rate of t h e population and t h e growth rate of t h e workforce

are exogenous and given as constants. If t h e case where QL = 9N t h e growth
rate ^ ( I + D ) is zero which implies t h a t D is a constant. If QL < 9N-> t h e growth
rate 5'(I+D) is positive which implies t h a t D is rising, i.e. t h e population is
ageing.
7.1.1 T h e real grow^th r a t e
Taking logs of t h e production function (7.1) a n d differentiating with respect
t o time gives t h e real growth rate of national income
9Y =oi-gK-^{l--
cy){9A -^9N - 9(I+D))
(7.5)
T h e growth rate of t h e national income is determined by t h e growth rates

9K,
9N, ^'ând
9{I-^D)-
T h e stock of physical capital develops as in t h e basic Solow model. We

have
k = sK'^{ALf~'^
-5K
(7.6)
and get t h e growth rate of physical capital

QK = SK''-\ALY~''-
(7.7)
which, when substituting L = j ^ , is

QK = s i ^ ^ ~ ^ A ^ ~ ^ i V i ~ ^ ( l + L>)-î-^) - 5 .
(7.8)
From (7.8) we see t h a t t h e growth r a t e of t h e physical capital declines in
(l + D).
7.1 Model 1: The Solow (1956) model with an ageing population
99
The change of the physical capital per head of the population k = ^ is

then
k={9K-
9N)k = [sK"''A'-N'-^{l
+ D ) - ( i - " ) - S - gr,] ^
(7.9)
which is equivalent to
k^sk''-
A^-"" (1 + D)-î-^) - ((5 + gN)k .
(7,10)
The growth rate of physical capital per head is

gk = sk^-'
A i - " (1 + i ) ) - ( i - " ) -{5 + gr,) .
(7.11)
With the income per head as in (7.2) we can write the growth rate of the
income per head as
9y = a'gk-{l-
Q^)P(i+D) + (1 - cy)gA
(7.12)
which is
9y
aisk'^-^ A^-^ . (1 4- i ) ) - ( i - ^ ) - ((5 + QN))
(T.13)
- ( 1 - Ot)g(îJ^D) -h (1 ~ Oi)gA .
In (7.13) the dependency ratio D has an effect on the growth rate Qy via
two channels. The size of D has a negative effect on g^ (and therefore on
gy) and its growth rate has a negative effect on gy (through the last term on
the right hand side). Even if the population is not ageing, i.e. ^ ( I + D ) = 0, a
high D which indicates a high percentage of elderly people in the population
translates into a low growth rate gy.
To analyse the steady state we choose variables that are constant in the steady
state, these are k -^ and y = -^-'^ With A: = 0 we can write (7.10) as
ik^ = {5-^gN+gA)-k^{l-^
I))^^-")
(7.14)
which is the condition for the steady state. Solving (7.14) for k gives the
steady state value
Figure 7.1 compares the steady state solution for physical capital in Solow
(1956) and Model 1. The comparison shows that the steady state level of
100
> ^ sk'^(a-1
)
(5+g(N)+g(A))(1+Dr(1-a)
5+g(N)+g(A)
(1956)
k* (Model 1)
k* (Solow)
Fig. 7.1. The steady state k* in Model 1 and in Solow (1956)

physical capital per head in Model 1 is always lower than the level in Solow
(1956).
Inserting (7.15) into the production function per head y* = k*^ gives the
steady state value for income per head of the effective population
r = (- gN
-y
+ 9A
(1+^)
(7.16)
The level of k* and y* respectively are lower by the factor (il]j\ than the
steady state level predicted by the Solow (1956) model. In the original Solow
model, the steady state values y* and k* are determined by the population
growth rate n.^ The size of a demographic variable (population N) is not a
relevant variable in the steady state. Here, the steady state levels are influenced by the growth rate of a demographic variable (population) - as in the
Solow (1956) model - and the size of another demographic variable (ratio D).
The Solow model predicts the same equilibrium values y* and k* for two
economies which are identical except their population sizes, i.e. one economy
is small and the other economy is large. If we substitute 7x+^ ^^ C^-^^) ^^^
^ We call A N the 'effective population' following the term 'effective labour' in
subsection 3.2.2.
^ Here and in the following chapters we use the notation QN for the population
growth rate.
101
(7.16) with (iljy\ = ^ we see that the steady state values depend on the
difference between L and N:
r = (
)T^ .
^ "^S + QN^gA^'^
'N'
If the economy has a population N that includes a high number of nonworking people and a relatively small workforce, then the income per head
of the population is relatively low. The larger the difference between L and
iV, the lower the income per head of the population. Model 1 predicts the
same steady state values for a small and a large economy only if they have
the same ratio of workforce to total population. An economy with a higher
share of elderly people has a lower income per head.
We need one further assumption to guarantee that (7.15) and (7.16) are
indeed the steady state values: TJITDT ^^^ ^^ ^^ constant. This is only the
case if the growth rate of the dependency rate is zero, gfi_^,) = 0- In other
words, for the model to have a steady state we have to assume that the two
exogenous growth rates g^ and g^ are equal and constant. With the steady
state value of k*, we derive the steady state growth rate g^
which is
9l=si^-^^)-{l
+ Dy-''-il
+ D)-'-'--^.A-^'-''^-A'---{6
+ gN+gA).
(7.17)
Then we get the rate of growth of physical capital per head
9l=9A The steady state growth rate of income per head is

9y=^-9k-i^-
^)9ii+D) + (1 - ^)9A
which is
g;=g^-{l-
a)gl^ô) .
(7.18)
We have shown in this section that achieving the steady state levels k*
and 1/* requires a constant age structure, i.e. ^^ , >) = 0. If this is the case,
income per head grows with the rate of technological progress. If the population is ageing however, i.e. ^ ( I + D ) > 0, the economy is not in equilibrium and
economic growth is only possible if p ^ > (1 Q^j^'ci+D)-
102

The growth rate of the physical capital per head of the population as in (7.11)
can be written in terms of the variable k = -^, the capital per head of the
effective population
^^ = sfc^-^l + D)-î-") -{5 + 9N + 9A) .
(7.19)
If the economy is not in an equilibrium we have a situation where either
sk^-\l
+ D ) - ( i - ) >{S +
sk^-\l
+ i^)-(i)
9N+gA)^9k>^
or
<[8^9N+9A)-^9k<^'
If the amount of investment per head sy = sk^~^{l + D)-(^~^) is bigger

than the amount needed to keep capital per head constant, 9^^ is positive and
therefore k increases. After allocating capital to the population and replacing
the depreciated capital, there is still surplus per head left. And since all the
investment has to be absorbed, the capital per head of the population must
rise. But the higher the level of capital per head, the lower the average product
of capital | because of diminishing returns to capital. Therefore, over time
growth will slow down and eventually stop once the equilibrium is reached.
Because of the dependency ratio -D, the difference between sk^~^{l-^D)~^^~^^
and {5-\-9N -^9A) is smaller for a certain level of k (and therefore 5^^ is) than in
the Solow (1956) model. Model 1 not only predicts a lower income per head
once the economy is in equilibrium but also a lower growth rate when the
economy is in disequilibrium. We will show in section 7.1.5. however, that the
growth rates in both models are the same if the distance between k and k* in
Model 1 is the same as the distance between k and k* in Solow (1956).
In addition to the assumption of an exogenous and constant population
growth 9N made in Solow (1956) we assume that D is constant in the steady
state, i.e. ^n_^^) = 0- As shown in subsection 7.1.2., this assumption is necessary to derive steady state levels for y and k. We show in figure 7.2 that
reaching this steady state is not possible, if D is not a constant.
To explain this further, we refer to figure 7.2 and assume an ageing population, i.e. 9{iJ^D) > 0- If the economy starts at a level of A: < ^*, the physical
capital per head of the population will rise over the next period(s). At the same
time, the 'combined' depreciation {5 -\- 9N ^ 9A){^ + DY^~^^ (pictured in the
straight line in figure 7.2) will take on a higher level in the next period(s). A
'preliminary' steady state may be reached at fc*(t = 1). But, because D is still
increasing in the next period, k will be too high and has to decline. Even if the
economy reaches a new steady state in one period, {5 + 9^ + 9A){^ + D)^^~^^
will keep on moving. To be able to reach a steady state for y and k we have
to assume gfi^m 0.
103
^s.k"(a-1)
(6+g(N)+g(A))(1+Dr(1-a)
i^---v^
t
t
(5+g(N)+g(A))(1+Dr(1-a)
^ ^ ~ ~
Fig. 7.2. Model 1 with an ageing population

In the next subsection, we analyse if the optimal consumption differs from
Solow (1956). We call the maximum consumption possible in Model 1 "silver
consumption". In the following subsection and in the remainder of this thesis,
we will use the terms "silver consumption" and "silver growth" to express
two things. First, the term "silver consumption" is coined because maximum
consumption in Model 1 is lower than in Solow (1956), i.e. silver consumption
is lower than golden consumption. Second, we refer to a model of "silver
growth" when referring to a model with includes the dependency ratio D, i.e.
when analysing a model with an ageing population (referring to the "grey" or
"silver" generation)."^
7.1.4 Silver consumption
As the steady state values y* and ^* are lower by j ; ^ in Model 1 it is very
likely that the "golden consumption" is lower as well. In this section we show
if and to what extent the optimal consumption in Model 1 differs from the
golden consumption in Solow (1956).^
National income Y can either be consumed or saved. The same holds for
income per head of the effective population y = -^. We can write
^ This label should not be confused with the golden or platinum age of growth as
it is defined in Robinson (1963)
^ The golden consumption in Solow (1956) was analysed in subsection 3.2.4.
104
This is
c = y-sy = {l-s)y
= {l'- s)k'^{l + D^-"^ .
(7.20)
We insert the condition for the steady state value k* from (7.15) into (7.20)
to get the steady state value of consumption per head
c* = r " ( l + i ) ) - ( i - ) -{5 + gM+ 9A)k* .
(7.21)
We solve for the value of s that maximizes steady-state consumption c*.

We equate the first derivative of (7.21) with zero. With A:* = k*{s) we have
f = 0 U. i.-4(1+ !-<-)-(. + ,+.)f = 0 .

Because ^ > 0, the expression a^*^~^(l + i:))-(i-Q=) - (^s ^ g^ -^ g^)
must be zero. This gives the condition for maximum consumption
with ^* = ^^^^^^^ as the steady state value of k which maximizes consumption. As (7.22) determinesfc^'^^^^^we get
We rewrite (7.21) as the "silver consumption":

^^silver _
j^silver{a)^-^ ^ ]jy{l-o.)
_ (J 4. ^ ^ _^ y^)P^^^^^ .
(7.24)
^^sUver ^
0 ^ QN ^ 9A
)T^ . { - ^ ^
l^ D
/c-
\/
- ( ^ + ^7v)(7-
<^
(1 + D)-^'-^
x^
(7.25)
^ )'
which is
c^'-'- = ( a T ^ - a i ^ ) . (
/
) ^( - ^ ) .
(7.26)
0 +gN + QA
1 + -U
By comparing (7.26) with the "golden consumption" in Solow (1956) (see
3.2.4),
c9w = ( a i ^ - a i ^ ) (^
)T^
^S + gM+9A^
105
we show that the consumption in Model 1, a model of "silver growth" is indeed

lower than in Solow (1956) as j ^ is always lower than 1. Specifically, the
higher the dependency ratio D^ the lower is the level of consumption in this
'Silver Growth Model'.
In this section we analyse the speed of convergence, i.e. the speed that the
economy adapts to move towards its steady state. The steady state was derived
in 7.1.2. The speed of the transitional dynamics implies the time span for the
economy in which economic growth is possible. The growth of capital and
income per head respectively is only possible when the economy is not in an
equilibrium, neglecting hereby the possibility of growth through technological
progress. If the transition period from disequilibrium to equilibrium takes a
very long time (e.g. 20 years), a measure to increase the investment rate (i.e.
a rise in the saving rate) could be a sensible measure to promote economic
growth per head over this time period. The growth patterns of the economy
would be dominated by the transitional dynamics. If the transition period
lasts only a few years the same measure would not be successful. If the speed
of convergence is fast, the growth patterns would be dominated by the steady
state. That is why it is important to know if the speed of convergence is
relatively high or low. This is particularly important in an ageing population,
because, as shown in 7.1.2, in an economy where the ratio D is high, the
steady state value of ^* tends to be low.
To derive the speed of convergence we use the same approach as in 3.1.5.
From (7.19) we have
g-, = sk^-\l
+ D ) - ( i - " ) -i5 + gN+ QA)
(7.27)
In the steady state (where gk = 0) the physical capital per head is (see (7.15))
k* = ()T^ ^-^r .
^S + gN+gA'
(l + D)
We derive the change of k/k* over time:
^
= fc . ( -
) ( ^ (1 + D) .
(7.28)
^ ^
(7.29)
We write k = k^^-^ and take logs of (7.29) and get
ua-l
\k* J
a-1
We can rewrite (7.27) as
''
-9N
^9A
/I I
n\a-l
{l^DY
(7.30)
106

9k
, 1_
s^^""-'^ -{l + D) a-1
(7.31)
and insert the left-hand side of (7.31) into (7,30). We get

log
1
a-1
A:*
9k
log
S-^9N
+gA
(7.32)
+1
For an approximation of (7.32) we get'

1
log ( 77 ) ~ r
k*J
a-1
Solving (7.33) for p^ gives
9,
9k
log I c ,
[o^gN-^gA
(7.33)
-{1 ~ a){5 + QN + gA) ' ôg ( p
(7.34)
The term
(7.35)
(1 - a){5 + QN -h gA) = Pc
is the coefficient that determines the speed of convergence. The speed of

convergence of k is the same as in the Solow (1956) model. The lower the value
of /3c, the slower is the speed of convergence and the longer is the transition
period. For example, a positive l3c of 0.05 means a yearly convergence of 5 per
cent. We show whether the speed of convergence of y also is the same as the
one in Solow (1956).
With y = ^^(1 + ))~(i-^) the growth rate of income per head of the
population is
= a'gj^~{l-
(7.36)
a)g(î^D)
This can be written as

1 , (l-a)
9k=gy'
g{i+D)
We know from (7.34) that

gk = - ( 1 - ^)(^ + ^'iv + gA)' log
We take logs of (7.36) and get
log
a ' log
- (1 - a) . log(
l-VD
(7.37)
The Taylor-Series for log{x + 1) is log{x + l) = x + ^ + %- + .... For a; ^ 0 we

get the right-hand side of (7.33).

We solve (7.37) for log (^j
107
and get
Inserting (7.38) into QJ^ from (7.34) we get
ffS = - ( 1 - a)(5 + 5iv + 5^) ^ log ( I ) + ^ i ^ l o g ( ^ i ^ ) . (7.39)

Inserting (7.39) into Qy from (7.36) we get
gy = -{1-a){5^gN^gA)'log
( ^ ^ ) + (1 - a)log(^^^+^^ J
(7.40)
We see that the speed of convergence in (7.40) differs from the speed of
convergence of k. The dependency ratio has an effect on this speed.
The rate of growth in Solow (1956) with technological progress is given as
gy = - ( 1 - a){S + ^ ^ + gA) log (^)
(7.41)
Equations (7.40) and (7.41) are only the same if g(i-\-D) = 0 and the level of
(1 + i)) is at its steady state value. As D depends on the exogenous variables
population N and workforce L, here it is not possible to specify the steady
state value oi {I -\- D)*.
To summarize the findings in Model 1, the level of (1 H- D) has a negative
effect on the level of t/* and ^* (see figure 7.1). The economy in Model 1
can reach its levels t/* and k* where the variables do not change only if the
population is not ageing, i.e. g(i^D) = 0- However, constant economic growth
is possible if the population age structure changes with g(i-^D) 7^ 0 = const.
Economic growth is positive as long as the growth rate of technology A is
higher than the growth rate gî^D)*- Model 1 predicts lower growth rates for
Y and y than the original model if g(iJ{-D) > 0 (see table 7.1).
Table 7.1. The level of income per head y* and its growth rate gy* in Solow (1956)
with technological progress and in Model 1.
9y =
Solow (1956) a gk
Model 1
OL- gk -- ( 1 - - oc)' g(i+D)
gy* =
gA
gA-
y^ =
^S + QM''
{l--o^)'9(i+Dr
(jT^)^^
'
1
1+D
108
7.2 Model 2: T h e Lucas (1988) model with an ageing

population
In this chapter we introduce the dependency ratio D into Lucas (1988). We
insert D into the general production function Y = F[K^ w, /i, L) from Lucas
(1988)
Y = K'îuhLf-'^ = K'^{uh-^^f-'^
(7.42)
with L j ^ . The production per head of the population y = ^ is
y^k^.
(^/,_2_)i- .
(7.43)
As in Model 1 (see equation (7.3)), the growth rates for the dependency
ratio and for the workforce are
9{i+D) =9N -9L
(7.44)
and
9L = 9N- 9(I+D)
(7.45)
If QL = 9N^ the growth rate ^ ( I + D ) is zero. In this case, the dependency

ratio D is constant. gL and g^ are given exogenously.
The growth rate of physical capital is
gK = K'^-\uh^f-
- ^ - S
(7.46)
and the growth rate of human capital is the same as in the original model
gh = E{l~u)-~S.
(7.47)

Taking logs of the production function (7.42) and differentiating with respect
to time, we get the real growth rate for Y :
9Y = CX9K + (1 - c^){9u +9h+9N
~ 9{i+D))
(7.48)
The growth rate of the national income depends on the rates of growth
of physical capital gx-, of the population gjsf^ of the dependency rate gîô):
of human capital gh and of the time spent in production gw The growth
rates are known from above, except the growth rate for u. To determine the
growth rate gu we set up the Hamiltonian function. As in the Lucas (1988)
model individuals maximize their utility function under the constraints of the
development of physical capital and human capital.
7.2 Model 2: The Lucas (1988) model with an ageing population
109
The Hamiltonian function J for the Lucas model, augmented with the
dependency ratio J9, is
J = -^-^-
e^* e-P'^dt + fiiiK'îuh
- ) ^ - ^ -cN-
5K) (7.49)
^lJi2{E{l-u)h-5h) .
The function (7.49) is almost the same Hamiltonian function as in the
original Lucas model (see section 4.2, equation (4.25)). The only difference is
the replacement of L with j ^ .
The first-order conditions are
dJ
dJ
^ dJ
dJ
Differentiating the Hamiltonian function (7.49) with respect to consumption c and with respect to time spent in the production sector u we get the
following first-order conditions:
ri J
^ - u\c) . e^^ e-P^ -i^^N = 0^ c'^ = f^N e"^* e^' - /ii e^' (7.50)
ac
and
1 ^ = 0 ^ ^ i ( l - a ) i ^ " - " / i i - " ( ^ - ^ ) i - " = i^2Eh .
(7.51)
The first-order condition (7.50) guarantees that the marginal utility of consumption equals the marginal utility of net investment, which is the shadow
price /ii (e^* is the discount factor). Taking logs of c~^ = /ii e^* and differentiating with respect to time, we get
-a
- =
\- p
/ii
and a relationship for the growth rate of consumption QC

9c = - = -{-^-p).
C
(7
(7.52)
jJ^l
The other first-order condition (7.51) guarantees that the value of the
marginal unit of studying time {ii2Eh) equals the value of the marginal unit
of production time. Condition (7.51) can be written as
/i2 _ {I-a)
fjLi
^^
^_^ ^_^ ^Jl_)i-c.
(7 53)
\ ^ D
Differentiating the Hamiltonian function J in (7.49) with respect to the

physical capital stock K and equating with the negative of the derivative of
/ii with respect to time we get
110
1 ^ = -Ml ^ yii{aK--\uh,^f--
-5) = -/ii
and
^
= -aK''-\uh^-)^-'' + S ,
(7.54)
Inserting (7.54) into (7.52) we get the growth rate of consumption per
capita
g, = ^(aK^-\uh-^y-"-5-p).
(7.55)
Differentiating the Hamiltonian function in (7.49) with respect to the human capital stock h and equating with the negative of the derivative of /i2
with respect to time we get
and
Ml
1-^(1 - a ) / i - ^ + (^(1 - ^) - (5) = - ^ .
M2
(7.56)
M2
Inserting the inverse of (7.53) into (7.56) leads to

S-E=^
(7.57)
M2
Equation (7.57) is the growth rate for the shadow price /i2. It is the same
as in the original Lucas model. To derive an expression for the growth rate of
u^ we differentiate (7.53) with respect to time:
A2M1 - /^2Al _ (1 - ) [^ . ^ - l (dK\ ^ _ _ ^ - a ( ^ ) l - a
(MI)2
E
'
\dtj
"^l + D
+ i ^ " - " / i - " (1 - a) A^-'" ^

at
(1 + ))-(!-")
+ii:" U-" / i - " Ari-"(a - 1) (1 + ) ) - ( i - " ) - i . ^^^ + -^^ .

This can be simplified to

A2 _ /X2/ii ^ O - o )
[C^{9K -9U-
^,
^_
^, ^ (-^)^"--
111
(7.58)
9h) H- (1 - Q^)(5'iv - ^(i+D))]
Multiplying the left-hand side of (7.58) with ^ and the right-hand side
with i3î^"^w^/i^( i:^)"^^"""^ (which is the equivalent of ^ , see (7.53)) we
get
= OL{gK -9u-
9h) + (1 - oi){gN - 9{I+D)) -
(7.59)
Inserting (7.54) and (7.57) into (7.59) and solving for QU gives
1
g^ = E{--l)
+ Eu-
cN
1
^ {QM - P(i+D))(- " 1)
(7.60)
In the original Lucas model, the growth rate for u was
g^ = E{--l)Êu-^^
a
n{- - 1) .
a
In (7.60) the growth rate of the time spent in the production sector gu
depends on the population growth rate g^ (as in Lucas (1988) with the population growth rate n) and on the growth rate of the dependency rate g(i-^D)'
As in the original Lucas model, the only sensible growth rate of u is zero, i.e.
gu = 0. The other two growth rates which are zero in the steady state are gcN
and g K . This is shown below. From (7.54) and (7.52), we know that
^ = -ag, -p= -aK^-\uh-^y-"

111
i- -r JJ
+5
which can be written as

a
1 -{- D
The parameters cr, p, S and a are constant, gc is constant in the steady
state. Therefore, the left-hand side of (7.61) is constant. Inserting the lefthand side of (7.61) into the growth rate of physical capital (7.46) gives
agc^p
+S
cN
TF~^ '
^^'^^^
a
K
Because gx is a constant in the steady state and all other parameters in
(7.62) are constant, ^ has to be constant. This is only the case iigc-\-gN = 9K
which means that QCN = 0 . We now show that a K = 0. We know that
9K =
9K, ÎS
are constant in the steady state. The term (^ ^
growth rate of physical capital (from (7.46))
^ a - i ^ i - a ^^ ^j^^
112

_ ^ . . _ i
i _ . cN
has to be constant. We know that in the steady state t^ is a constant.

Then ^ ^ has to be constant in the steady state. This is only the case if
9K Qh^QN 9{i+D)' We know that the growth rate of human capital g^ is
constant in the steady state, QL and QN are exogenously given as constants.
Then also g{iJ^D) = 9N 9L is a constant. To summarize, the following three
growth rates are zero in the steady state:
The growth rate of ^ which is (inserting (7.55) and (7.46))
9^=9c+9N-9K = {^^^){K-\uh-^)^'-''^)
1
(7.63)
cN
-{-)'m-<T)^p]^9N^^.
the growth rate of
9 ^
= 9K-{9h^9N-9{i+D))
which is (inserting (7.46) and (7.47))

K
cN
= (^Tiy-)''"^^^^"''^:^-E{l-~u)-gN-^9{i+D)
(7.64)
and the growth rate of u (see (7.60))

1
a
cN
K
gu = E{- -l)-i-Eu---\-{gN-
1
a
5 ' ( I + D ) ) ( - - 1)
The steady state of the model is derived in the next section.

As the three growth rates gu-,gcN_ and g K are zero in the steady state, we
can equate (7.60), (7.63) and (7.64) with zero. From ^r-^ = 0 in (7.60) we get
and
cN
I
1
= E ( - - 1) + ^tz + ( - - 1)(^^ - ^(1+,,)) .
K
a
a
(7.66)
From gaN_ = 0 in (7.63) we get
= C-^^){K"-\uh-î^-'^^)
- 5iv + -m
- a) + p] .
(7.67)
113
From g K = 0 in (7.64) we get

K
cN
- - = [--Ê{l-u)^gN^4D
'^
1
9{i+D)]~ ' u .
(7.68)
We use the four equations (7.65), (7.66), (7.67) and (7.68) to derive the
steady state values of the model. We insert the expression for ^K (7.66) into
equation (7.68) and get
- ^
= [^ . 1 + (5^ - 5(,^^)) -U^^-u.
(7.69)
'^ l+D
Equation (7.69) is inserted into (7.67). We get the value for ( ^ ) * in the
steady state:
C-^r
= ( ^ - \){E + 9N- 9ii+D)) -9N + 1(5(1 -a)+p).
(7.70)
Inserting (7.70) into (7.65) gives the steady state value u*
u* = (1 _ i ) _ l ^ d + o ) - 1 . 1 ( 5 ^ - 3 ( 1 + ^ ) ) + 1 . 1 ( 5 ( 1 _ a ) + p ) . (7.71)
E a'""'' ''''^^>' ' E
To get the steady state value for ^ ^ , we insert the expression for u-^
'^ l1+_i_Dn
from (7.71) into (7.69) and get
( _ ^ ) * =. [^ . i + (^^ _ ^(^^^)). i ] ^ . [(1 _ 1 ) _ i ^ ^ , ^ ^ ) (7.72)

1 1
1 1
Now we insert (7.70), (7.71) and (7.72) into the equations for the growth
rates QK^ Qh and QC to get the growth rates for physical capital, human capital
and consumption when the economy is in equilibrium. The growth rates are
g*K = (T^r'^''-'^-n<'-'^-(^r-5=UE-5-p)
+ hgN-g^,+o))+9N
(7.73)
gj, = ^ ( 1 -u'')-S
and
= ^{E-5-p)^^{gN-
gî+D)) +
^(I+D)
(7.74)
114
(7.75)
In t h e steady state, t h e following equations have to be verified (because
we have set g K and gcN_ to zero)
9h-^9N-
9(i+D) = 9K
i^-^^)
and
9C^9N
=9K
'
We see from t h e three growth rates (7.73), (7.74) and (7.75) t h a t these
two relations hold.
Lastly, we can derive t h e steady state growth rates for national income Y
and income per head of t h e population y. T h e growth rate for national income
was given as (see (7.48))
9Y = ex ' 9K ^ {I - (y){9u +9h^9N
- 9{i+D))
Inserting g'^ and g^ and considering t h a t ^* = 0, t h e steady state growth

rate is
9Y = -{E
- S - p-^ gN{l + cr))
g(i+D)
T h e steady state growth rate of physical capital per head of t h e population

is
9K-9N=9k
= -(^
- S - p-hgN-
9(i+D))
T h e steady s t a t e growth rate of h u m a n capital per head of t h e population

is (see (7.76))
9h=9k+
9{i+D) = -{E-5-
p^gN)+
9(1+0)
(!--)
We insert t h e steady state values g^, gf^ and ^f* = 0 into t h e growth rate
of income per head of t h e population
9y = 0i'gk + {l-a)'{gu-hgh-
9(I+D))
and get t h e steady state t h e growth rate of income per head of t h e population
9y
=9k
which is
9l = -{E-5-p
+ gN-9(i+D))-
(7.77)
115
In the steady state, income per head of the population and physical capital
per head of the population grow with the same rate. This growth rate is given
in (7.77). This formula for ^* includes the effect of an ageing population for
9{i+D) > 0- The effect of an ageing population on economic growth was not
describable in the original Lucas model. A comparison of Lucas (1988) and
Model 2 is given in the following section.
The following table compares the values for u and i^* in the original Lucas
(1988) model and in the augmented model, Model 2.
Table 7.2. Comparison of the time spent in the production sector in the Lucas
(1988) model and in Model 2.
Lucas (1988) ^ = ^ ^ - (^ - 1) - -1(^ - l)n
Model 2
u = l ^ ^ - (^ - 1) - ^ ( 1 - l){gN - P(i+r)
Lucas (1988) u* = (1 - ^) - ^ ^n + i^(<^(l - cr) + p)
Model 2
^* ^ (1 - I) - I . Ip^ + 1^(^(1 - ^) + P) - i^(*i+D)(l - i)
In the Lucas (1988) model, the higher the growth rate of the population n,
the greater the time (1 u*) spent in the education sector and the lower the
time spent in the production sector. The same is true in Model 2. The higher
the rate of population growth, the more individuals are willing to invest time
in the education sector to increase their future consumption. This result is
determined by the form of the utility function as in (7.49). Taking population
growth into account is equivalent to reducing the rate of time preference to
p n. The lower the time preference rate p (and in this case p n) is, the less
important present consumption for individuals is and the more important future consumption is. If the population growth rate is high the time preference
is low, i.e. future consumption is more important. If population declines the
time preference is high, i.e. present consumption is more important. Excluding population growth from the utility function we get the following result
in Model 2:
^* = (1 - ^) + 1^(^(1 - ^) + P) - |^(i+D)(l - I) '
(7.T8)
In Lucas (1988), under the same assumption that population growth is

excluded from the utility function we get the steady state value of time spent
in the production sector
u* = {l-^)
+ ^li5il-a)+p).
(7.79)
116
In (7.79) no demographic variable is present. In comparison with Lucas

(1988) in Model 2 we have a (second) 'demographic effect' on t h e time spent
in production and education in equilibrium.'^ This demographic effect exists
because Model 2 includes t h e dependency r a t e {1 -}- D) and its growth rate:
dn+D) ^^^ ^^ effect on i/* through t h e t e r m ^gfi^mi'^
^ ) - If dh+D) ^ ^'
t h e individuals spend less time in t h e production sector and more time in t h e
education sector. T h e economic explanation is t h a t individuals anticipate t h e
dampening effect of the ageing of t h e population on economic growth and
therefore spend more time in education to increase future income and consumption t o counteract t h e negative effect of population ageing. Education,
i.e. accumulation of human capital can compensate for t h e negative effect of
t h e ageing population on economic growth. In t h e opposite case, gfi^jj) < 0,
t h e t i m e spent in education is lower. If e.g. gp^=0
and g^ = 0.01 t h e n
dn+D) ~ O-Ol- This means t h a t t h e t e r m ^gh^mi^
^ ) is positive which
implies t h a t t h e time spent in t h e production sector is higher. Individuals
anticipate t h a t there is no negative effect of an ageing population on economic growth and therefore spend more time in production and less time in
education.^ To summarize, in an economy where t h e population is ageing in
t h e steady state with g7i_^]j\ > 0, comparing Lucas (1988) and Model 2, t h e
time spent in production is '?^ModeZ2 ^ ^lucas- ^^^ dh+D) ^ ^' ^^^ result is
^Model2
^Lucas'
T h e following table compares t h e growth rates of national income and t h e

growth rates of income per head of t h e population in t h e Lucas (1988) model
and in Model 2, in t h e transition phase and in t h e equilibrium.
T a b l e 7 . 3 . C o m p a r i s o n of t h e Lucas (1988) m o d e l a n d M o d e l 2
Lucas (1988) gv =--a-QK + 0L -a)(gu

+gh + 9L)
Model 2
9Y =-- o-- 9K + {'\
L - OL){9U + 9h+ 9N -
9{i+D))
Lucas (1988) 9y = a- gk + (1 - a){gu + gh)

Model 2
+ 9h ~ 9(i+D))
9y = a- gk + (1 -a){9u
Lucas (1988) 9Y =-HE-S- p + Piv(l + o-))
Model 2
p-J-gNJl + cr))- ^g{i+D)
9Y =îiE^SLucas (1988) *
gy* =
Model 2
9y =
HE-SiiE-S-
P + 9N) =- 9h= 9c
P + 9N ~ ^(l+D)) = 9h-
9a+D) = 9c
The population growth rate is the other demographic effect if the model employs
a utility function that includes population growth.
If the model includes population growth in the utility function, u* is as given in
table 7.2. Then the effect of the two demographic variables gN and g(î^)) do not
only depend on their sizes but also on the difference between them (or rather the
difference between g^ and ^ L ) .
117
In Model 2 the economy reaches an equilibrium with steady state growth,

i.e. the relevant variables grow at constant rates. This is expected as QL^ an
exogenous constant in the original model, was replaced by two exogenous and
constant growth rates QN and gî-ô)- In Lucas (1988), the steady state growth
rate of income per head is equal to the steady state growth rate of human
capital g*=gl = ^{E-S-p-h
QN)-
In Model 2, the steady state growth rate of income per head is equal to
the steady state growth rate of human capital minus the growth rate of the
dependency rate, g* = g^-gl^j^jj^ = ^{E-5-p-^gN-gî-^D))Compared to
Lucas (1988), Model 2 predicts lower economic growth in an economy if the
population is ageing, i.e. ^ ( I + D ) > 0. In Model 2 it is possible to present the
effect of population ageing on economic growth whereas in Lucas (1988) it is
not. We know from the analysis of Lucas (1988) in chapter 4 that education
policy in terms of raising the education productivity E in turn raises the
steady state growth rate of income per head ^* ^ Moreover, increasing the
population growth rate has a positive effect on ^* The same is true in Model
2. In addition to the conclusions from Lucas (1988), in Model 2 a decline in
the growth rate of the dependency rate g{iJ^D) contributes to higher economic
growth. In Model 2, the growth rates of the demographic variables gNt gh and
9{i+D) are assumed to be exogenous. Education, either in terms of time spent
in the education sector {lu) or in terms of the productivity of the education
sector E^ has no effect on the level of these growth rates. This assumption is
abolished in chapters 8 and 9 where population growth and workforce growth
is endogenised.
See also appendix, subsection 11.1.1.
8
Models with quasi-endogenous population
In the models analysed so far the population growth rate is an exogenous

variable. In the current chapter population growth is endogenised. In section
8.1 in Model 3 we derive a steady state solution for the endogenous population growth rate. Model 3 augments the Lucas (1988) model with a third
sector, the domestic sector. In section 8.2 in Model 4 we derive the endogenous
population growth rate and the endogenous workforce growth rate. Model 4
combines Model 2, where the dependency ratio was introduced into the Lucas
(1988) model and Model 3. As it is anal3îcally not possible to derive a solution for population and workforce growth rates in their transition phase when
the economy is in disequilibrium, we call these models 'models with quasiendogenous population'. The term 'quasi-endogenous' describes the fact that
we know the solution for endogenous population growth and endogenous workforce growth in the steady state, but that we do not know how the population
develops when the economy is in transition. In the current chapter the fertility
rate is the endogenous determinant for changes in population size as the mortality rate is an exogenous constant. A model is developed aiming to explain
the fertility rate, i.e. the population growth rate. Population growth can be
defined with the rate of natural increase when it is exclusively determined
by births and deaths and excludes migration. The rate of natural increase is
expressed by the number of births per 1000 inhabitants minus the number of
death per 1000 inhabitants, e.g. QN = j ^ YO ~ 0.01. If gN = 0.01,
the population declines by 1 per cent. Assuming the number of deaths to
be exogenous, the population growth rate g^ is determined by the number
of births. The number of births can be expressed in terms of the fertility
rate.^ Economic explanations of fertility patterns can be found in the modern micro-economic theory of the family, pioneered by Gary Becker (1960).^
^ Fertility rate is expressed as the number of children per woman. The number of
birth is expressed as per 1000 inhabitants.
^ Economic theories of fertility have been around for over two hundred years, for
example, see Malthus (1798).
120
8 Models with quasi-endogenous population
T h e modern economic theories of fertility (as part of t h e micro-economic theory of t h e family) are built on rational individuals deciding on t h e number
of children t h e y want, by taking into account their own and their children's
utility, their income, the cost of commodities and t h e cost of bringing up children. T h e number of children is a control variable, i.e. individuals decide how
many children they would like t o have under t h e given budget constraint,^
T h e demand for children would depend on t h e relative price of children. T h e
question analysed in this theory is, how changes in income and cost affect t h e
t h e number of children.^ Childlessness is possible as an outcome, b u t only as
a corner solution. This solution is neglected as t h e theory focuses on "having
more or fewer children".
Another common approach to explain fertility p a t t e r n is t h e analysis of
a trade-off between quantity and quality of children. One outcome of t h e
quantity-quality
approach is t h a t parents tend to have fewer children if they
are concerned with t h e level of their children's education (i.e. their h u m a n
capital).^ As a consequence of the interaction between quantity and quality,
it can make sense t o have only one child (low quantity) and invest a lot in
its education (high quality). In this theory b o t h fertility and child quality
are non-zero.^ Remaining childless cannot be a possible outcome as there is
no child in which t h e individual invests. Childlessness cannot be explained in
this framework when parents face a trade-off between quantity and quality of
children.
In our model, we are focusing on t h e decisions which determine t h e likelihood of having children at all. For example, a high level of h u m a n capital
can imply a lower likelihood to have children.^ As childlessness is a possible
outcome in our model we take an approach t o model fertility t h a t is different
from t h e quantity-quality approach and t h e "demand for children" approach
in t h e micro-economic theory of t h e family. T h e decision is not about having
two or more children as opposed t o having only one. T h e decision is about
having children at all or remaining childless. In our model introduced below
in section 8.1, individuals maximize their utility via controlling their consumption c and how they spend their time in t h e production sector producing
goods, in t h e education sector accumulating h u m a n capital and in t h e domestic sector, bringing u p children. T h e three main differences t o t h e models in
t h e micro-economic theory of t h e family are:
^ The individual can choose the values of the control variable. The control variable
is the variable that controls the law of motion for the constraints (see section 4.1
on the problem of dynamic optimization).
^ Becker (1991), 138.
^ Becker and Lewis (1973) and Becker (1991).
^ Ermisch (2003), 113.
^ For Germany, see Wirth and Diimmler (2004). Data shows that better educated
women are more likely to remain childless than women with average education.
8.1 Model 3: The Lucas model with a new time allocation
121
the variable number of children does not form a part of the individuals'
utility function, i.e. the number of children does not increase the utility;
the variable number of children is not a control variable, i.e. the individual
does not decide (ex ante) on the number of children they have;
in addition to consumption c, the control variables are the time spent in
production u and the time spent in education b.
As before, the individual's utility depends on the consumption level. The

number of children per se has no effect on the utility. This assumption allows
us to model the outcome "having children" as a result of the time-allocation
decision and not as a result of an analysis of the quantity and quality of children. However, we show in the following models that the decision to have
children or to remain childless does have an affect on income and thus consumption. As a consequence it indirectly affects utility as this utility depends
on the consumption level. The result of an individual having children (or not
having children) is modelled as a by-product of their decision to spend time
in the education sector and production sector. This approach is based on the
empirical fact that most people decide how much time they want to spend
in the education sector and in the production sector. The decision to have
(or not to have) children is then taken in line with the decision on the timeallocation between education and production. Individuals with a high level of
human capital face larger opportunity costs on spending time in the domestic
sector than individuals with a low level of human capital. Thus, we expect
individuals who have accumulated a rather high level of human capital to
spend more time in production rather than in the domestic sector.
In section 8.1 we develop a model and show that childlessness can be a
possible outcome of the individuals' decision (Model 3). Moreover, remaining
childless is not only a possible outcome it is also the optimal outcome. We
will show that this hinges on the exclusion of the dependency ratio D in the
model. Subsequently in section 8.2, the dependency ratio D is included. As
a result, individuals are concerned about an unfavourable development of the
population, i.e. a progressive ageing of the population which has a negative
effect on economic growth. Thus, in this model (Model 4) individuals choose
to have children.
8.1 Model 3: The Lucas model with the new time

allocation and quasi-endogenous population growth
In the original Lucas (1988) model the individual spend time in the production
and the education sector. In this chapter we introduce a third option: spending
time at home bringing up children. The individual decides on
the amount of time spent in the production sector u and

the amount of time spent in the education sector 6; these determine
122

the amount of time spent in the domestic sector {1 u b).
Whereas in the Lucas (1988) model population growth was exogenous, in

this model we offer an endogenous explanation: population growth depends
on the time devoted to bringing up children. The more time is spent in the
domestic sector, i.e. the higher {1 u b) is, the more children are born.
At first glance, this seems to be an unrealistic assumption, as for example in
Germany the birth rate is low, although the time spent at home is high. In
Sweden, on the other hand, mothers go back to work sooner, i.e. they spend
more time in production than in Germany and the birth rate is high.
The causal relationship between 'time spent at home' and birth rate can
go two ways:
1) The individual has a child. The individual then decides whether to spend
time at home and how much time to spend at home bringing up children. This
decision might be constraint by the availability of child-care and suitable jobs
with family-friendly working hours.^
2) The individual decides to have a child and decides to spend time at
home to bring up that child. There is no constraint upon how much time is
spent on bringing up the child.
The causal relationship described in 2) is employed in the following models.
As it is sensible to assume that children will turn into members of the
workforce at some point, the change in the size of the workforce is determined
by the number of births which in turn is determined by the time spent at
home. The change in the size of the workforce is as follows
L = j'{l~u-b)L-d'L
(8.1)
where d is the mortality rate. 7 is a "conversion coefficient" with 0 < 7 < 1

that translates the time spent at home bringing up children into the fertility
rate. 7 can be interpreted as the productivity of the domestic sector. At this
stage, we employ the same assumption as Lucas (1988): the population N
and the workforce L are the same. We will change this assumption in the next
chapter when we insert the dependency ratio D into the model. To highlight
the changes in the model caused by the new time allocation we will introduce
the dependency ratio only in the next chapter.
The growth rate of the workforce or population is then given as
gL^j=7'{l-u-b)-d.
(8.2)
As the mortality rate d is an exogenous constant the population growth

rate is determined by the fertility rate j - {1 u b). The less time is spent
In Germany (old Lander) the majority of non-working mothers of children under

12 would like to work but are not able to do so as both child care and working
hours are inadequate. See Riirup and Gruescu (2005), 21.
123
working and studying the more time is devoted to raising children which in
turn increases the population growth rate.
The general production function is F = F{K,H) = F{K,uhL). In CobbDouglas form it is
Y = K''{uhLy-''
(8.3)
The production function per head is
The change in the stock of physical capital is

k = K'^{uhLf-'^
-C -5 .
(8.4)
The growth rate of physical capital is

9K='^=K'^'\uhLY-'--^-5.
(8.5)
Aggregate consumption is C = c L with c as consumption per head. With

E as the 'education productivity' and h the time spent in the education sector
the change in the individuals' human capital is
h = E'b'h-5h
(8.6)
which gives the respective growth rate

5;, = ^ = 6 - ,5.
(8.7)
In Lucas (1988) the time spent in education is (1 u). In our model the
time spent in education is called b.
to time we get the real growth rate for Y :
gy = a'gK-^{l-
Oi){gu -{-Qh^ 9L) -
The growth rate of output depends on QK^QL, 9h and QU The first three
growth rates are given above in (8.2), (8.5) and (8.7). The growth rate for
u has to be determined. The utility function is given as before. Under the
constraints of the development of physical capital K (8.4), of human capital
h (8.6) and of the workforce L (8.1) the individuals decide on the allocation
of their time in the production sector u, in the education sector b and in the
domestic sector {1 u b) to maximize their utility function which depends
on consumption c.
124

T h e present value Hamiltonian function for this maximization problem is^
J = ( ^ - ^ ^ ) e-P' + fii{K^{uhLy~^ -C-5K)
(8.8)
1 <T
4-/i2(^ 'b'h-5h)+
with C = cL.
i^sh {l-u-b)L-
dL)
T h e usual first-order conditions can be derived by applying

dJ
dJ
dJ
dc
du
db
and
dJ
dJ
dJ _
Maximizing t h e Hamiltonian function with respect to consumption c gives

t h e familiar condition
c " ^ = IJ.lL ' eP^ .
(8.9)
Taking logs of (8.9) and differentiating with respect to time, we get t h e

growth rate of consumption per head QC '<7 log c = log /ii H- log L -^ pt log e
c
c
1,/ii
a 111
L
L
Pc = - ( - - - ^ L - p ) .
(8.10)
a
Hi
Maximizing t h e Hamiltonian function with respect to working time u we
get t h e following condition
/ i i ( l - a)K'^{hLf-'û-'^
= ii3'l-L
(8.11)

^ Lucas (1988) employs the Benthamite utility function which takes the size of
future generations into account. In Model 3 and all following models a widely
used utility function without taking account of n is applied. One reason for this
is purely technical. Applying a Benthamite utility function would complicate the
solution of the model considerably as the first-order condition f^ = As (see
(8.21)) would result in an equation which cannot be solved with the Hamiltonian
approach. The other reason is that this way we are able to concentrate on the
effects of an ageing population (see also Model 2 and Model 4) by introducing the
dependency ratio D, rather than the effects of a declining or increasing population.
Aî
125
unit of time spent in the production sector must equal the value of the
marginal unit of time spent in the domestic sector bringing up children.
Maximizing the Hamiltonian function with respect to studying time b gives
1^2'E'h
= 1^3-1'L,
(8.13)
This first-order condition (8.13) guarantees that the value of the marginal
unit of time devoted to studying must equal the value of the marginal unit of
time spent at home, bringing up children. The third margin is automatically
taken care of, i.e. from (8.11) and (8.13) we know that the value of the marginal
unit of working time equals the value of the marginal unit of studying time
as in
//i(l - a)K^(/iL)^-û-^ = iJ.2Eh .
(8.14)
Equation (8.14) can be written as

;^ =
We have three more conditions for an optimum ^

dJ _
(^-^'^
= Ai^f^ ~ ~^'^ ^^^
= - A i => î{aK^-\uhL)'-~^
- 5K) = ~fii .
(8.16)
From (8.16) we have

-aK'^-ûhiy-''
-^SK =
(8.17)
Ml
which we insert into (8.10) to get the growth rate for consumption
gc = -{aK^-\uhLY-''
- 5K - 9L - p)
(8.18)
(7
The next condition gives

= -/i2 =^ /xii^"(uL)i-"(l - a)/i- + î2{Eh - 5h) = -/i2
which is
- ^ i ^ " ( w L ) i - " ( l - a ) / i - " - {Eh -5h) = .
M2
/"2
(8.19)
126

Using (8.15) we can write (8.19) as
5h-E{u + b) = ^
(8.20)
In the Lucas (1988) model this condition is Sh E = ^, diS b = 1 u.

The last condition gives^^
= -/is ^ lî{K''{uh)'-"{l-a)L-")+i^3{j-{l-u-b)-d)
= -A3 (8.21)
which is
- ^ ( i r ^ ( ^ / i ) ^ - ^ ( l - a ) L - ^ ) -{j'{l~u-b)-d)
/^3
=^
(8.22)
/is
Using (8.12) equation (8.22) can be written as

j-{b-l)
+ d=^ .
(8.23)
Ms
There are two possibilities to derive the growth rate of u: we can differentiate (8.15) or (8.12) with respect to time. We take both approaches to
demonstrate their consistency. First, we differentiate (8.15) with respect to
time. This follows the same procedure of deriving QU in the original Lucas
model in subsection 4.2.1 and in Model 2 in section 7.2. Therefore we present
the derivation in an abridged form. Differentiating (8.15) with respect to time
gives
III
= Ê;
111 111
E
( T T ) -U "^ L'{a'gK~a'gu
hL
hL
+ 9L)
Multiplying the left-hand side with ^ and the right-hand side with the
equivalent j ^ K-^L-(^-^)/i^tt^ gives
- =a'9J<-a-gu+9L^
II2
/ii
(8.24)
'^^
Inserting (8.17) into ^,(8.20) into ^ , (8.2) into QL and applying g_E_
c_
K^-\uhLY~^ -.c_^^_j^j^^Sh-9L.
we get
K
9K-9h-9L=
9u = - ' U - ^ + Eb{- - 1) + gL{- - 1) .

(8.25)
a
K
a
a
In the Lucas (1988) model the workforce growth rate n is exogenous but in
our model (here named p^) this variable is endogenous. The workforce growth
We assume C = const., i.e. if L changes, c changes in the opposite direction so
that C = cL remains constant. This allows us to write | ^ = 0 instead of | ^ = c.
127
rate QL is also determined by the size of u. With gi = j ^ {1 u b) d we

can write (8.25) as
<? = - - u - - ^ + E 6 ( i - 1 ) + [ 7 - ( l - - 6 ) - d ]
a
K
a
(--!)
a
which is
g,=u-{-
{E - j) + j) - ^+
K
{b. {E-j)+J-d)
{--!).
a
(8.26)
Equation (8.26) can be simplified if the productivity of the education sector

E equals the productivity of the domestic sector 7. We demonstrate that this
is the case in this model. We take logs from the first-order condition (8.13)
and differentiate with respect to time. We get
log /i2 + log E + log h = log /i3 + log 7 4- log L
and
Inserting (8.20) for ^ and (8.23) for ^ gives

-E{u + 6) + E6 = 7 (5 - 1) + 7 (1 - u - 6)
Eu = ju
which means that E = ^ has to hold.
Then we can write (8.26) as
gu=u-^-^+^-{--l)-d-{]--l).
(8.27)
K
a
a
In the Lucas model the growth rate of u is (excluding workforce growth
rate from the utility function)
gu = E-u-%+E{--l).
(8.28)
K
a
Comparing equation (8.27) with the one in the Lucas model (see (8.28))
we see that the difference is in the last term on the right side. In Model 3 the
growth rate of u is declining in the mortality rate. Ceteris paribus in Model
3 Qu is lower than in Lucas (1988) by the term d- (^ 1).
Is is also possible to derive the growth rate of u from (8.12) in the same
way. We differentiate (8.12) with respect to time which (following the same
procedure as above) gives
128

gu=7-u-^
+ {b-iE-^)+^){--l)-d-{--l).
(8.29)
K
a
a
The equations (8.26) and (8.29) have to be equal. This is only the case if
E = J. We have already shown that this condition holds. Then (8.29) can be
written as
gu=^7-u-^
+ j-{--l)-d-{--l).
(8.30)
K
a
a
We employ (8.30) to derive the steady state solution where Qu = ^'
We look at the other growth rates which are constant in the steady state.
First, we show that the growth rates gcL and gjK_ are zero in the steady
state.^^ We know from (8.17) and (8.10) that
Ai
111
and
-(^9c - P~
9L =
Ml
Therefore we have
K^-\uhL)^-^
= -{ag, + p -f 5 + ^^) .
(8.31)
a
As the right-hand side of (8.31) is a constant {gc and gL are constant
in the steady state, cr, a , p and SK are constant parameters), the left-hand
side has to be a constant too. As in the economy the aggregate output Y is
equal to the aggregate consumption C plus (net) investment K^ we have Y
= K'îuhL)^-'^ = cL + k, Dividing by K gives
K^-\uhL)'-^
= ^+gK.
(8.32)
Inserting (8.31) into (8.32) we get

-{age -^P + S-^gL)-gK
=^ -PT '
(8.33)
a
K
As on the left-hand side all parameters and growth rates are constant, the
right-hand side has to be constant too. This is only the case if gc^ 9L = 9KWe differentiate (8.31) logarithmically and equate the derivative with zero
because the right-hand side of (8.31) is constant. We get
( a - l ) l o g i ^ + (l -a){logu-{-logh-^logL)
=0
which is
log i^ - log IX + log /H- log L .
See Solow (2000), 125.
(8.34)
129
Differentiating (8.34) with respect to time we get the growth rates

gu^gh-^9L=
9K '
Because we know that ^^^ = 0 in the steady state we see that ^

constant. Also, from g^ = gc-\- QL we have
gh-^9L=
gc + 9L '
is a
(8.35)
We see from (8.35) that the growth rate of human capital and the growth
rate of consumption per head are the same.
To summarize, the three growth rates which are zero in the steady state
are
9^=9c+9L-9K
^
= i^^){^r-'u'-^--[5+9L+p]+9L
a
riL
+ ^+S
(8.36)
and
9^=9K-9h-9L
= {^r-'u'-''-^-Eb~j-{l-u-b)+d
(8.37)
and
C
I
Pu = 7 ^ - T7 + 7 (
K
a
1
1) - ^ (
a
1) "
Both b and u have to be constant in the steady state. If they grew, they
would exceed 1 at some point. This is not possible as we have 0 < b < 1 and
0 < u < 1, U they declined, work and education would decline towards zero
and all time is spent bringing up children. While this might be possible in
individual cases, under the given assumption that all individuals are the same
this would imply that nobody works and/or studies. This is not a sensible
solution for an equilibrium.
For gu = 0 equation (8.27) can be written as
u=l^-{^-l)
+ ^.{^-l).
(8.38)
From (8.38) we get

=7-ii4-7-(--l)-^(--l).
(8.39)
K
a
a
We equate (8.36) and (8.37) with zero. From 9c_ = 0 and gj_ = 0 and
K
considering that E = j we have
hL
130
^ = ( ^ ^ ) ( ; ^ r - V - " + 5 ( l - l ) + [ 7 ( l - u - & ) - d ] ( - - l ) + ip(8.40)

A
a
tiL
a
a
(J
and
(^) = [J+7-(l-)-rf]^-.
(8.41)
We insert (8.39) into (8.41) and get
(^) = [ 1 ( , - . ) ] ^ . .
(8.42)
which in turn is inserted into (8.40) to get
1?
iv = ( ^ -(J^ ) â( ^ - '^) + '^((J- 1) + [^(1 - - & ) - d\{-a - 1) +a- P (8.43)
We insert (8.38) into (8.43) and get the steady state value for ^
{%r
= {-- 1)(7 -d)+5{--l)+p-
7K1 - ^)
(8.44)
Inserting (8.44) into (8.38) gives the steady state value for u
w* = {5{l -a)+p)--h{l-a)
.
7
Inserting (8.45) into (8.42) gives the steady state value for ^
ÎI)*
^ [^^^ - d ) ] ^ mi -a) + p ) l - 6(1 ~ a)] .
(8.45)
(8.46)
rates QK^QL^ 9h and QC to get the growth rates for physical capital, for the size
of the population, for human capital and consumption when the economy is
in an equilibrium.
The steady state growth rates are
9*K = ( ^ ) * " - V i - " - ( ^ ) * - < 5 = {^-d)-5{l-a)-p+^h{l-a)-5
gl=-y.{l-u*
-h)-d={'-i-d)-5{l-a)gl = E-b-d = -yb-5
g* = i ( a ( - ^ ) * " - i u * i - " --^.(i-u*-b)+d-p)=jb-5.

(7 nL
p-'^ba
(8.47)
(8.48)
(8.49)
(8.50)
131
The growth rate for physical capital per head of the population is
9*K-9l
= 9l =
Eb-S.
Therefore
9l = 9:=9l=Eb-5.
(8.51)
With the production function per head of the population as in y =

k^{uh)^~^ we get the steady state growth rate
9l =OLgl-^{l-a){gl^gl)
Inserting the steady state growth rates which is ^^ = g"^ and ^* = 0 we

get
gl=Eh-5,
In the steady state, income, human capital, consumption and physical capital per head of the population grow with the same rate. This rate depends on
education productivity E, depreciation rate 5 and the time spent in education
h. The variable h is still undetermined.
The following table compares the steady state values of u and of the growth
rate of income per head of the population in Lucas (1988) and Model 3.
Table 8.1. Steady state in Lucas (1988) and in Model 3.
u*
Lucas (1988) u* = (<5(1 --^) + P ) i ^ - i ( l +
Model 3
u* = ((5(1 -- a ) + p ) ^ - 6 ( l - a )
9l
^) 9l-Ê{l-u'')-6-QI--Êh-5
= 9h
= gl
In the Lucas (1988) model the steady state growth rate ^* declines in u*.
9y = 9h depends positively on the time spent in the education sector (1 u*).
The growth rate ^* rises with the time spent in the education sector. Model
3 predicts a different result: the growth rate g* rises in u*. This is because
g* rises in b and u* in turn is higher the higher b is. In the steady state 'U*
depends positively on b as in (8.45). Because a higher b implies a higher u
(for (J > 1), the growth rate g* = Eb S rises in u. The individual is likely to
spend more time in the production sector the more it has studied. In the Lucas
(1988) model the individual faces a trade-off between studying and producing
goods. In the steady state, the more time individuals study, the less time they
132
spend in production. Thus, the Lucas (1988) predicts that an individual who
has accumulated a high level of human capital spends relatively little time in
the production sector. This is not a sensible outcome as one can rather expect
a well-educated individual to spend a long time in the labour market, i.e. the
production sector.
In Model 3, the trade-off has shifted to another alternative. By adding
a third option of 'time spending', the trade-off is between time spent in the
production sector, in the education sector and at home bringing up children.
Model 3 pictures the observable pattern that individuals who spend more time
in the education sector and accumulate more human capital also spend more
time in the labour market (i.e. in production) instead of spending time in the
home sector bringing up children.
8.1.4 A quantitative solution of Model 3
As IX is a positive function of b and g* is a positive function of 6, the optimal
solution for the individual would be to spend as much time in the education
and the production sector, i.e. b -\- u* 1, to achieve the highest growth
rate. With this solution no time is spent at home, i.e. (1 w* 6) = 0 . In
this situation the growth rate of income per head is the highest possible (the
growth rate of national income gy is then the lowest possible).
In this case we can derive a specific solution for b which was until now
unspecified. We insert the steady state value for u^ f{b) as in (8.45) into
the relationship 1 = it* + 6. Because E = j , we get
1 = {6{1 - (j) + p ) 4 -b{l~a)^b.
(8.52)
Solving (8.52) for b results in

b* = l-l.liS{l-a)+p).
(8.53)
Inserting (8.53) into (8.45) we get the solution for i^* :

u* = l-l
+ ^-m-<T)+p).
(8.54)
Both 6* and i^* now depend solely on exogenous parameters. Inserting

(8.53) and (8.54) into the growth rates given in (8.47) - (8.50) we get
gl =
^{E-5-p)-d
9l = -d
gl =
^{E-5-p)
gl =
133
l{E-5-p).
For assumed standard values^^ of cr = 3, (5 = 0.035 and p = 0.033 and

setting ^ = 0.1^^ the solution is
6* = 0.455
u" = 0.545
Individuals spend 45.5 per cent of their time in the education sector and
54.5 per cent in the production sector. This results in a growth rate of income
per head of the population of 1.1 per cent.
If the economy is in the steady state, we are able to analyse the effect of
an exogenous 'shock'. It is standard routine to analyse what happens if one
parameter in the model is changed. The new steady state can be compared
with the old steady state. A possible 'shock' is, for example, a policy intervention which changes E. We analyse the possible effect on the growth rate of
income per head if education policy raises the productivity of the education
sector E.
From (8.53) we have
if(5(l (j) + p < 0 which is the case for a > 1 and reasonable values of 3 and
PFrom (8.54) we have
As a result, we have f^ < 0 and ^ > 0. Therefore If is lower and u""

higher in the new equilibrium situation. With a higher E^ individuals have to
spend less time in the education sector to achieve the desired level of human
capital.
How does this affect the steady state growth rate of ^*? The growth rate
in the steady state is
gl=Eh''-5
= -{E-5-p).
(8.55)
^^ For example, see Barro and Sala-i-Martin (1998).

^^ We assume that one extra year spent in education translates into a 10 percent
rise in human capital, see e.g. OECD (2002), 16.
134
Although b* is lower in the new steady state, we see from the term on the
right-hand side of (8.55) that g* in the new steady state is higher as -^
^ > 0. A one-off increase in the level of education productivity E^ is a policy
measure which boosts the growth rate of income per head permanently. In this
Model 3, where the ageing of the population is not (yet) included, the growth
rate of income and consumption per head is independent of any population
(or workforce) growth rate. In Lucas (1988) the growth rate of income per
head gy = ^{E 5 p + n) rises with positive population growth and declines
(or rises less) with negative population growth. The effect of n on gy is based
on the composition of the utility function: Lucas uses the Benthamite utility
function that takes n into account. In Model 3 and in all following models, a
widely used utility function without taking account of n, is applied. Applying
a Benthamite utility function would alter the outcome of Model 3 and of
the following models in a way that the individuals take population growth
into account when maximizing their utility. They would spend time having
children. Because the effect of population ageing instead of population decline
is analysed here, we use the utility function where individuals do not care
about the size of the future generation when taking decisions. This will allow
us, in particular in Model 4 and Model 6 (see sections 8.2 and 9.2) where the
dependency ratio D is relevant, to focus on the effect of age structure of the
population instead of the effect of the size of the population.
The behaviour of individuals in the steady state solution in Model 3 is the
same as in the Lucas model: they spend time in the production sector and in
the education sector. In the Lucas model no other alternative was given but
in Model 3 this is the result of maximizing behaviour. In other words, we get
the result that having no children is the rational decision. As a consequence,
population declines with the mortality rate d.
In section 8.2 we analyse if this result changes if the model is augmented
one step further by introducing the dependency ratio D into the model. We
will show that this will change the individual's decision and therefore the
outcome of the model.
8.2 Model 4: A model of silver growth with t h e new

t i m e allocation, quasi-endogenous population growth
a n d an ageing population
In this chapter we combine the steps undertaken in Model 2 and Model 3.
We augment the Lucas model both with the new time allocation which allows
us to endogenise population growth and with the dependency ratio D which
allows us to analyse the age structure of the population. The combination of
the two allows us to derive endogenous population growth and endogenous
workforce growth. As a consequence we are able to model changes in the
population's age structure in the economy.
8.2 Model 4: A model of silver growth with the new time allocation
135

Y = F{K, H) = F{K, uhL) = F{K,
N
uh--)
with y, K and L = j ^ as before. Time can either be spent in the production sector (w), in education (b) or in the domestic sector bringing up children
(l-u-b).
The production function in Cobb-Douglas form is
Y = K''{uh-^y-''
(8.56)
and the income per head of the population is

y = A:"(ft^-^)i-".
(8.57)
The change in the stock of physical capital is given as

k = K ^ ( u / i ^ ) ^ - ^ -C-5K
(8.58)
Aggregate consumption is C = c- N with c as consumption per head. As

in Model 3, the change in the individual human capital is given as
h-=E'b-h-5h
(8.60)

gh = E'b-5.
(8.61)
As in Model 3, endogenous population growth depends on the time devoted

to bringing up children. In addition, in Model 4 we differentiate between the
population N and the workforce L. The more time is spent at home, i.e. the
higher (1 w 6), the more children are born. The change in the size of the
population N is given as
N = -i-{l-u-b)L-d'N
(8.62)
with d the mortality rate and 7 the conversion coefficient that translates
the time and effort spent in raising children into the fertility rate. 7 can
be interpreted as the productivity of the domestic sector. The population
size changes with the number of children born to the group of the workforce
^'{lub)L. This approach is different from the existing literature. In current
growth theory it is standard to employ the following definition of a change in
136
the population size: N = bN dN = nN^ with the birth rate 6, the death rate
d and the population growth rate n. Whereas it is sensible to assume that the
population declines with the mortality rate d of the whole population iV^^, the
multiplication of n with N is not very realistic as children and elderly people,
who form a large part of the population, do not have children. In Model 4
the fertility rate 7 (1 u 6) is multiplied with the size of the workforce
1/ as a closer approximation to reality. Despite including women above the
childbearing age, L is a better approximation than N. As a consequence, the
size of L is decisive for the growth rate of N. For example, a development
where N is growing because the mortality rate at old age declines and people
are getting older but L is in decline, implies a lower growth rate of both L and
N as in future periods the number of L and thus the number of prospective
parents is in decline. Using the definition N = j - {1 u b)N d - N^ a higher
N would ceteris paribus imply a higher growth rate g^ in the next period(s).
This is an unrealistic development assuming that N is increasing because of
a decline in mortality at old age and L is declining at the same time.
The growth rate of the population is therefore given as
5iv = ^ = 7 - ( l - t x - 6 ) ^ - d = 7 - ( l - t x - & ) 3 ^
- d.
(8.63)
Assuming that the children turn into members of the workforce, the change
in the size of the workforce is
L = j'{l-u-b)L-dLL
(8.64)
where dL is the retirement rate.

The growth rate of the workforce is given as
9L = ~=7'{l-u-b)-dL.
(8.65)
The fertility rate j (l u b) minus the retirement rate dL is the growth

rate of the workforce. The less time is spent working and studying the more
time is devoted to bringing up children. This increases both the growth rate
of the workforce and the growth rate of the population.
The growth rate of the dependency rate D is given as
9{i-{-D) = 9 N - QL
(8.66)

to time gives the real growth rate for Y :
^^ Although the mortality rates among different age groups differ significantly.
8,2 Model 4: A model of silver growth with the new time allocation
9Y = oi gx -}- {I - a){gu -^9h^9N
- 9{i+D)) -
137
(8-67)
The growth rate of national income depends on p ^ , p/^, g^^ 9ii+D) and gw
The first four growth rates are given in (8.59), (8.61), (8.63) and (8.66). The
growth rate for u has to be determined. The utility function is given as before.
The individual maximizes their utility under the constraints of the development of physical capital K (8.58), human capital h (8.60) and population N
(8.62). Another constraint, which has to be taken into account, is the development of the workforce L. This constraint does not have to be included in
the Hamiltonian function if for now we make one further assumption: L = N.
This is the case if
j'{l-u-b)L-dLL==j'{l-u-b)L-dN
diL = dN
(8.68)
d.^dj-.
The present value Hamiltonian function for this maximization problem is
J = C~
-) e-"' + ^,{K''{uh-^f-"
-C-5-K)
(8.69)
N
+ /i3(7 (1 " ^ - ^) Y : ^ - dN) .
+/i2(^ 'h'h-5'h)
The usual first-order conditions can be derived by applying

dJ
dc
dJ
du
dJ
db
and
dJ
dJ
9J _
Maximizing the Hamiltonian function with respect to consumption per

head c gives the familiar condition
c"^ = /ii A^ e^* .
(8.70)
Taking logs of (8.70) and differentiating with respect to time gives the
growth rate of consumption per head gc :
^^ For example, dL is double the size of d under the assumption of a population of
80m and a workforce of 40m.
138

G log c = log /ii + log N ^ pt log e
c
1 ,Lii
9c = -{---9N-p)^
cr 111
(8.71)
Maximizing the Hamiltonian function with respect to working time u gives

the following condition
/xi(l - a ) i r " ( / i ^ ) i - " u - " = ^ 3 . 7 . ^
(8.72)

M3 _ ( ^ - Q ' ) / ^ ^ l - a ( ^ .-a -a _ (1 - ) . J^ l^/^l-^^-c^ ^g 73)
Ml"
7
^1 + ^ ^
"
7 \T^)^
^^ ^
unit of time spent in the production sector must equal the value of the
marginal unit of time spent in the domestic sector bringing up children. It
becomes clear in the first-order conditions that the dependency ratio affects
individual behaviour with j x ^ .
Maximizing the Hamiltonian function with respect to studying time h gives
/i2 ; /i = /X3 7 Y ^
(8.74)
This condition (8.74) guarantees that the value of the marginal unit of
time devoted to studying must equal the value of the marginal unit of time
spent bringing up children. The third margin is automatically taken care of,
i.e. from (8.72) and (8.74) we know that the value of the marginal unit of
working time equals the value of the marginal unit of studying time as in
Mi(l ~ a ) i ^ - ( / i Y ^ ) i - u = îÊh
(8.75)

/^2 _ (1 - a) ^ j^.^Nî-.^-.^-.
/ii
E
'1 + D'
(g 7g)
We have three more conditions for an optimum which are | ^ = /ii, ^

dJ
-A2 and 1^
= -/is :
dN
1 ^ = -;î =^ ^ , ( ^ i ^ - i ( ^ / , _ Z _ ) i - _ 5K) = -/ii .
(8.77)
8.2 Model 4: A model of silver growth with the new time allocation 139
From (8.77) we have
-aK^-\uh-^f-^ -^5K = ^
I -t V
(8.78)
111
which we insert into (8.71) to get the growth rate for consumption
5c = -{aK'^-ûh-^y-'^
a
-SK-9N-P).
(8.79)
1 -f- JJ
which is
- ^ " ( ^ T ^ ) ' " " ( l - c^)^"" - (Eb -6h) = ^^
/i2
1 + i^
(8.80)
M2

6h-E{u^b)
= ^ .
(8.81)
/^2
This is the same condition as in Model 3. The change of the shadow price
/JJ2 over time (with /i2 being the price or value of an additional unit human
capital) is not affected by the introduction of the dependency ratio D, In the
Lucas (1988) model this condition was Sh E = ~ , as there b = 1 u.
The last condition gives
BT
= -/i3 ^ liiK-{uh)'-^{l
~ a)N-^{l
+/i3(7 (1 - ^ - b){l + D)-'
+ i^)-(i-)
-d)
= -As
so that
-^K'îuhy-îl
-{j.{lû-b){l
- a)N-^{l
+ L>)-(i-^)
+ D)-^-d)
(8.82)
= ^ .

c/ + 7 - ( & - l ) ( l + ^ ) ~ ' = .
(8.83)
Ms
In Model 3 this condition was d -\- j - {b 1) = . The change of the
shadow price /X3 over time (with /is being the value of an additional human
being) is affected by the introduction of the dependency ratio D. The change
140
over time is lower by (1 + D)~^. To get the growth rate of u^ we differentiate

(8.73) with respect to time. This and further multiplying with ^ and the
equivalent j ^ ^ - ^ / ^ ^ - ^ ^ ^ ( Y ^ ) ^ gives
~ = -otgK ^9u-^-{oi~
l)gh + agN - agiîô)) -
(8-84)
Inserting (8.78) in ^ and (8.83) in ^ and employing the growth rates

gx^gh and g^ from (8.59), (8.61) and (8.63) and solving for gu we get
(? = 7(1 + D)-^ -^-^ + {--l)[Eh

K
a
+ 7(1 - h){l + D)-' - d\ .
(8.85)
We take logs of (8.74) and differentiate with respect to time. This gives
A2 ,
As ,
\ - g E + gh^ yg^^gNM2
g(i+D) -
Ms
As E and 7 are assumed constant we have gs ~ g-r 0- Inserting (8.81)

and (8.83) gives
-Eu = d- -fu{l + D)-^ - g{i+D)
which is
^ = 7(1 + D)-^ - - + -9{i^D) .
(8.86)
u
u ^
As a consequence E no longer equals 7 as was the case in Model 3 in section
8.1. We apply equation (8.85) to derive the steady state solution where ^f^ = 0
in the next section. We now look at the growth rates which are constant in
the steady state.
We know from (8.78) and (8.71) that
-aK^-\uh-^f-^
1 + 1/
^5K = ^
fjji
and
-age - p- gN =" .
Ml
Therefore we have
K'^'Huh-^)'-''
= -{age
+ P + SK+9N).
(8.87)
As the right-hand side of (8.87) is a constant {gc and gN are constant

in the steady state, cr,a,p and 5K are constant parameters), the left-hand
side has to be a constant, too. As in the economy the aggregate output Y is
141
equal to the aggregate consumption C plus (net) investment K we have Y

= Kîuhj^y-"^
=^cL^k, Dividing by K gives
Inserting (8.87) we get

1
cN
-{(JQc ^P + SKi-9L)-gK
= ~rr '
(8.88)
a
K
As on the left-hand side all parameters and growth rates are constant, the
right-hand side has to be constant too. This is the case if gc+ 9N QKWe differentiate (8.87) logarithmically and equate the derivative with zero
as this is constant. We get
(a - 1) logir + (1 - a)(log w + log /i + log A^ - log^(i+i))) = 0
which is
logK = \ogu^\ogh
+ logN - loggî+D) -
(8.89)
Differentiating (8.89) with respect to time we get

9K = gu+ 9h + gN - g(i+D)
Because in the steady state p^^ = 0, the ratio
is a constant. Also,
from gx = gc^ gn we have

gh^gw
= gc-\-gN -
(8.90)
We see from (8.90) that the growth rate of human capital and the growth
rate of consumption per head are the same. Therefore we analyse the growth
rates of the ratios of ^ and ^ ^ . These are
+g^{l-^)
The growth rate of ^ ^
g-ji^
=gK-gh-
+ ^-^[Sji{l-a)
+ p].
(8.91)
is
{gN - g{i+D)) =
^'^~î^^Tl~TO^~'^
cN
--Eb-gN+gii+D)-
(8.92)
142

As explained when solving the Lucas (1988) model, the only possible growth
rate for u is zero (see section 4.2). The derivation of the steady state follows
the same pattern as employed in Model 2 and Model 3. Therefore most details
are omitted. Then, for gu = 0, equation (8.85) can be solved for u :
u = 1 ^ ( 1 -^D)~{-7 K
a
1)[-6(1 ^D)~~{l^D)-b^l].
J
7
(8.93)
From (8.93) we have

^
= 7 ^ 1 + D)-^ + ( - - l)[Eb -d~{h-
1)7(1 + D)-^] .
(8.94)
We equate (8.91) and (8.92) with zero. From gcN_ = 0 and g K = 0 and
considering that in this model E j^ j we have
? = (^)(r^)""''~"(l - b^ + ^^ + (^ - IM
Î+D
(J
(8.95)
and
K
cN
(-rw:)
= l-^^^^-^9N-gii^D)]~
'U.
(8.96)

We insert{T^)
(8.97) for
-r-^ into +
(8.95)
and get
= [^{Eb-d
^{l-b){l^D)-')]^û.
A
cr
(8.97)
1 + JJ
+(1 - - ) 7 u ( l + D)-^ + -(,5(1 - a) + p) .

(J

cN
1
( ) * = Eb{a - 1) + Eb{- - 1) + 5(1 - a) + p
K
a
+(i-l)[7(l-6)(l + D)-i-d].
a
Inserting (8.99) into (8.93) we get the steady state value
(8.99)
. 1
u- = - ( 1 + D)[{Eb - S){a ~ 1) + /9] .

77
Inserting (8.100) into (8.97) gives the steady state value
( ^ 4 - ) * = [-(^^ - c/ + 7(1 - ^)(1 + D)-')]^
143
(8.100)
. u^ .
(8.101)
rates gK^9L,9N,gh and QC to get the growth rates for physical capital, for the
workforce and for the population, for human capital and consumption when
the economy is in equilibrium.
The growth rates are
9K = ir^r-'
n*'-- - (^)*
g]^=^-{l-u*-b*){l
- S
+ D)-'-d
gl=j-{l-u*-b*)-dL
(8.102)
(8.103)
(8.104)
gl = E-h* -5
9l = - ( a ( - ^ ) * " - ^ * ^ - " -5-g*r,-p).
(8.105)
(8.106)
The steady state b* still has to be determined.

Inserting u* from (8.100) into (8.103), the population growth rate is
(?;, = 7 (1 - b*){l + ) ) - ! -d + {Eb* - S){1 -a)-p
(8.107)
and the growth rate of the workforce is

gl=-1-{l-b*)-dL
+ {Eb* - 5){l - a){l + D) - p{l + D)] .
(8.108)
Inserting (8.101) and (8.107) into (8.106) gives the growth rate of consumption per head which equals the steady state growth rates of human capital
5* =Eb*-5
= gl.
From the production function per head of population (8.57) we get the
growth rate
144

9y = OiQk + (1 - a){gu +gh-
9{i+D))
(8.109)
We have to assume that the growth rate of the dependency rate is zero in
the steady state. Otherwise steady state growth is not possible. If gfi^D) / 0,
the economy is not in equilibrium, as some growth rates would not be constant.
A positive growth rate ^ ( I + D ) affects the population growth rate. If we assume
9{i^D) > 0? the dependency rate (1 -h D) continues to rise which changes the
population growth rate continuously. Thus the population growth rate is not
a constant. Also with g{iJ^D) > 0 the steady state level of u* as in (8.100)
rises as (1 + D) is no longer a constant. As long as g{i^D) > 0? the level of u
and the population growth rate gN cannot be constant.
Because ^^ = 0 and g(i-^D) = 0 in the steady state we can write (8.109) as
g;=gl
Eb*-d.
Now we solve for the steady state value of 6. We know that in equilibrium
9li+D) =9N-9l
= ^'
Equating g"^ from (8.103) minus g^ from (8.104) with zero, i.e. g^g}^ = 0
and solving for h we get the steady state value for the time spent in education
(d - (II) - \5il - (j) + p]D + TTXn
6* = ^
~
-^
^^^ .
E{a-l)D
^-^
(8.110)

^* = - ( 1 + D)[{Eh'' - 5){(j - 1) + p] .
(8.111)
7
With the values^^ d = 0.01, d^ = 0.02,1) - 1.2, E = 0.1,7 = 0.2,(5 =
0.035,(7 = 3,p = 0.033 we get 6* = 0.411. Inserting this into the equation
for ix* (8.111) we get a value of w* = 0.497. In the steady state individuals
spend 41.1 per cent of their time in the education sector, 49.7 percent in
the production sector and (from 1 u^ h* = 0.91) just over 9 per cent at
home bringing up children. Inserting these values into the growth rates of
consumption per head (and income per head) and the growth rates of the
population and the workforce we get
91 = 0.61% = gl
9*N=9l = -0.167% .
^ (5, a and p are the usual standard values. Setting the mortality rate at d = 0.01
implies that the retirement rate is dL = 2d 0.02. Setting ^ = 0.1 as before we
employ equation (8.86) to estimate 7 which gives 7 ^ 0.2. The dependency ratio
D is set near the actual value for Germany D = ^^ = ^^^"^^^ - 1.2 .
145
The consumption per head increases by 0.61 per cent while the population
and the workforce both decline by 0.167 per cent. As the level of D determines
the outcome we now compare steady state situations with a different level of
D. The higher D is, the older is the population, i.e. the higher is the share of
older people in the population. If D rises from Doid to Dnew as the population
is ageing the equilibrium value 6*^^ will be lower because of | ^ < 0 (see
subsection 11.1.2 for details about the derivative). In the new equilibrium
Qo.f^^nA is lower.
Table 8.2. Growth rate g* and steady state values of b and u, with different values
of D, Qy and QL = QN in per cent.
D
D
D
D
=
=
=
1
1.1
1.2
1.3
b*
0.433
0.427
0.421
0.415
^z*
0.467
0.477
0.487
0.496
9;
0.833
0.773
0.714
0.656
9L
= QN
0.00
-0.09
-0.17
-0.23
Table 8.2 shows that a higher dependency ratio lowers the growth rate of
income per head of the population. For example, if D = 1.2 the individual
spends 42.1 per cent of his time in the education sector and 48.7 per cent
in the production sector. This results in a growth rate of income per head
of 0.71 per cent with a declining workforce and population of -0.17 per cent.
The figures in table 8.2 show the direction of the changes. These correspond
well with prognoses by the OECD which forecast very low growth of income
per head if the population continues to age.^Â higher dependency ratio D
means that individuals are less willing to postpone consumption. Thus they
study less and spend more time in the production sector. This means lower
economic growth (measured in g*) in the future periods.
8.2.3 Comparative statics
If the economy is in the steady state we can analyse the effect of exogenous
'shocks' such as policy interventions. Two different policies are employed. A
change in the productivity of the domestic sector 7 (scenario 1, see figure 8.1)
and a change in the productivity of the education sector E (scenario 2, see
figure 8.2) and their effects on economic growth are analysed.
In scenario 1 a rise in domestic sector productivity 7 from "joid to jnew is
analysed. In the first period the economy experiences a higher home sector
productivity. Ceteris paribus gL increases by {"ynew-Joid) and gN by {jnew 7oZd) j : ^ - This results in a situation where gL > QN- Because of this gî+o) <
^^ OECD (1998a), (2003).
146
(u+b) for y^ (new)
Fig. 8 . 1 . Model 4: The effect of a change in 7 on tz and b
(u+b) for E(new) = (u+b) for E(old)
F i g . 8.2. Model 5: The effect of a change in E on u and b
147
0. If D declines the new, lower Dnew means that in the next period more time
is spent in education (i.e. b is higher) because of (8.110). Because bnew > ôid
we get Unew > Uoid as ti is a positive function of h and the growth rate of
the workforce will decline. The workforce declines more than the population
which means that 5'(I+D) ~^ 0- I^ the new steady state we have hnew > bold ,
Unew > Uoid and QLinew) = 9L(old) = 9N{new) = 9N{old). During the transition
the workforce is rising (also the population but to a lesser extent) and is
declining again. Because bnew > ôid in the new steady state the economy
experiences a higher growth rate of consumption (income) per head. Raising
the domestic sector productivity 7 increases the growth rate permanently. In
the example above raising 7 by 50 percent from "ôid = 0-2 to '^new = 0-3
results in a growth rate 9y(^new)
= 1.49 per cent. The following table shows
the growth rate Qy for different values of 7.
Table 8.3. Growth rate Qy (in per cent) and steady state values of b and u, with
different values of 7, g* and QL = QN in per cent.
6*
tx*
g; 9L = gN
7 == 0.2 0.421 0.487 0.714 -0.167
7 == 0.25 0.463 0.463 1.133 -0.167
7 =- 0.3 0.499 0.439 1.495 -0.167
In scenario 2 the productivity of the education sector E rises from Eoid

to Enew' Because of a higher Enew in the new steady state we have a lower
^new < Kid because f^ < 0 (see subsection 11.1.2 for details). The time
spent in production is higher with u^^^ > u*i^. The time spent at home is the
same in the new steady state, i.e. the growth rates of the workforce and the
population are unchanged. There are two effects on the growth rate Qy. The
increase in E has a positive effect on the growth rate and the corresponding
decline in b has a negative effect on economic growth. Because g* = Eb^ S the
change is -f^ =b* Ê- j ^ . The second term is negative because H < 0. The
growth rate will be on a higher level in the new steady state if 6* > | E--^ \ .In
the example above raising E by 50 per cent from Eoid = 0.1 to Enew 0.15
results in a growth rate of 9y(^^yj) 1-2 per cent. The following table 8.4
shows the growth rate Qy for diflFerent values of E,
To double the growth rate gy in this model economy the home sector
productivity 7 has to be increased by 50 percent. Doubling the growth rate
with increasing education productivity, E has to be increased by 100 percent.
Assuming that a percentage increase in 7 and in E costs the same, it is less
costly to increase 7 to boost economic growth. The reason for this result is
that a higher E has both a positive and a negative effect on economic growth.
Increasing 7 has only a positive effect. Individuals adjust their behaviour when
policy changes a parameter. Raising 7 motivates them to spend less time at
148
Table 8.4. Growth rate g* (in per cent) and steady state values of b and u, with
different values of E, g* and gL = gn in per cent.
h*
u*
g* 9L = 9N
E^ = 0.1 0.421 0.487 0.714 -0.617
E^ = 0.15 0.313 0.594 1.203 -0.617
E =- 0.2 0.249 0.658 1.494 -0.617
home and more time in education and production. Hence the population and
workforce growth rate stay the same while accumulating more human capital
which improves economic growth. Raising E motivates individuals to spend
less time in the education sector and more time in the production sector.
This has a negative effect on economic growth which is partially offset by the
increase in E. Thus the positive effect of a higher E is reduced because of the
individuals changing their behaviour. The population and workforce growth
rate remains the same, as the time spent at home is the same in the new
steady state.
8.2.4 Comparison of Model 3 and Model 4
Introducing the dependency ratio D into the model alters the resulting tradeoff in the steady state. In Model 3, in the steady state the time was divided
between the education sector and the production sector. In Model 4 some time
is also spent in the domestic sector.
Thus, in Model 4 there is
a theoretical reason why (1 u* 6*) > 0 and

an economic reason why (1 -u* 6*) > 0
whereas in Model 3 we have (1 u* ~ 6*) = 0.

The theoretical reason is that the equilibrium condition ^ ( I + D ) = 0 has to
be fulfilled. A steady state situation is only possible if the workforce and the
population grow or decline with the same rate. Assuming instead that the time
spent in the home sector is zero (as in Model 3) we have 7(1 u* 6*) = 0.
In this case the growth rate of the workforce is QL = di, and the growth rate
of the population is g^ = d. Then the population and the workforce growth
differ, i.e. g^ 7^ QN as dL ^ t/. As a consequence the population is ageing with
9{i+D) {d dL) > 0. With an ageing population the economy is not in an
equilibrium.
The economic reason is that the individuals take the dependency ratio D
into account when they make their decisions. A higher D means a lower value
of 6* and a lower growth rate of income and consumption per head. Vice versa,
a lower D means a higher value of 6* and a higher growth rate of income and
consumption per head respectively.
149
If the productivity of the domestic sector 7 is increased in Model 4, the

steady state growth rate of consumption per head of the population is higher as
a higher 7 means a higher b. Increasing the productivity of the education sector
E has also a positive effect on the steady state growth rate of consumption
per head but to a lesser extent. Increasing E lowers b and increases u. Family
policy measures which increase the productivity of the domestic sector 7 have
a more growth increasing effect than education policy measures which increase
the productivity of the education sector E. The reason for this is that the
individual responds to the different policy measures in different ways. If, on
one hand, home productivity 7 is increased, the time spent in the education
and production sector can be increased as it is optimal to spend less time at
home (see figure 8.1). The growth rate of the population and the workforce is
unchanged, but the same growth rate is achieved with less time spent at home.
If, on the other hand, education productivity E is increased, it is optimal for
the individual to spend less time in the education sector and spend more time
in the production sector (see figure 8.2). The time spent at home remains
unchanged, so that the growth rate of the population (and the workforce)
remains unchanged. This policy measure also increases the steady state growth
rate of consumption per head but to a lesser extent.
9
Models with endogenous population
In the current chapter we derive a model where the population and the workforce growth rate are fully endogenous. We derive both the steady state and
the transitional dynamics for endogenous population growth and endogenous
workforce growth. As we can determine the dynamics of the system in its
transition towards a steady state, we also analyse the stability of the equilibrium. In Model 5 we employ the original Lucas (1988) model and alter the
function for time allocation in a similar way as we have done in Model 3. This
will allow us to introduce endogenous population. Model 5 is a model without
the dependency ratio, i.e. population and workforce are the same. Model 6 is
the 'complete' model with the dependency ratio, the new time allocation and
endogenous population growth.
9.1 Model 5: The Lucas model with the new time

allocation and endogenous population growth
In this chapter we extend Model 3 (see section 8.1) by changing the function
for population (aka workforce) growth to be able to derive an endogenous and
unique b.
Y = F{K,H)
F{K,uhL)
with y, K and L as before.

r-K"(w/iL)^-^
and per head
(9.1)
152
9 Models with endogenous population
k = K''{uhLf-'' -C-5K
(9.2)
which gives t h e respective growth rate

9K = ^=K'^-\uhLY-'^-^-5.
(9.3)
Aggregate consumption is C = c L with c as consumption per head. As in

Model 3 and in Model 4 t h e change in t h e individual h u m a n capital is given
as
h = E'b'h-5h
(9.4)
with t h e productivity of t h e education sector E^ t h e time spent in education b and t h e depreciation rate of h u m a n capital 5. T h e respective growth
rate of h u m a n capital is
gh = E-b^5,
(9.5)
As before, endogenous workforce growth (which equals population growth

in this model) depends on the time devoted t o bringing up children. T i m e can
either be spent in production (u), or in education (b) or at home bringing up
children (1 u b).
Here, t h e function for workforce growth is altered slightly to allow for t h e
fact t h a t studying time b affects t h e time spent bringing u p children t o a
different degree t h a n working time u. T h e change in t h e size of t h e workforce
L is given as
L = 7 . (1 - n - b'')L - dL
(9.6)
with d t h e mortality rate and 7 t h e productivity of t h e domestic sector

t h a t translates t h e time spent bringing u p children into t h e fertility rate. T h e
effect of t h e time spent in education b on t h e t i m e spent at home depends on
t h e parameter x. If x = 1 we have the same function as employed in Model 3
and Model 4. Here we focus on two different economies where x ^1}
In economy A we have 0 < x < 1. In this economy t h e time spent studying
has a rather negative eflFect on t h e time spent bringing u p children. As 6 < 1,
we have (1 u 6^) < {l u~b)An
economy A^ t h e decision to study implies
t h a t t h e time and effort spent bringing up children is considerably smaller
^ Another possibility to alter the function for the change in the size of the workforce
is to model the change in the size of the workforce as L = ^ - (l u b)^ - L dL.
This approach is not taken here as we are interested in the effect of time spent
in the education sector on the time bringing up children. The function in (9.6)
allows us to model that better educated individuals have fewer (or no) children.
The alternative function has a different meaning: then x defines the effect of the
time spent at home bringing up children but not the time spent in eduction in
particular.
9.1 Model 5: The Lucas model with the new time allocation
153
than in an economy where x = 1. In economy B, where x > 1, the time spent

in education does not have such a large effect on the time and effort spent
bringing up children. The negative effect of b on the time spent at home is
smaller than in an economy where x = 1. The features of the two different
economies are summarized in table (9.1).
Table 9.1. Economy A and economy B with different values of x.
Economy A
Economy B
with 0 < X < 1
with X > 1
b"" <b
6^ > 6
( l - u - 6 " ) < ( l - - u - 6) (1 - n - 6^) > (1 --u-b)
e.g. Germany
e.g. Sweden
In economy A, the higher the value of x, the lower is 6^, as 0 < 6 < 1.
Examples for economy A are countries where the correlation between individual human capital and numbers of children is negative, i.e. individuals with
a higher education tend to have fewer (or no) children than individuals with
lower education. This is, for example, the case in Germany. Examples for
economy B are countries where the correlation between individual human
capital and number of children is not negative, i.e. individuals with a high
education are at least as likely to have children than individuals who study
less. This is, for example, the case in Sweden.
The growth rate of the workforce is given as
g^=j.(lû-bn-d.
(9.7)
Both 7 and x can be seen as family policy indicators. 7 determines how

'effective' the time spent at home is used, with regards to having children. The
higher 7 the higher is the fertility rate because of the time spent at home.
The 'speed premium' in Sweden is an example. Women were encouraged to
have a second child after the first in quick succession (while still being at
home after the birth of the first child). In Germany 7 is rather low, as women
spend a relatively long time at home without producing a high fertility rate.
The size of x determines the effect of the time spent in education on the
times spent at home. This in turn determines the fertility rate. This effect
on the fertility rate can be influenced by family policy measures with regard
to combining education and having children. For given values of b and w, in
economy A (where 0 < x < 1) the fertility rate is lower, the lower x is. This is
the case where a balance of family and work is rather difficult with educated
individuals tending to have fewer or no children.^
For data on Germany, see Riirup and Gruescu (2003), graph 3, 14.
154

The real growth rate for Y is calculated by taking the logs of the production
function (9.1) and differentiating with respect to time:
^y = a ^K + (1 - a){gu -^9h^
9L)
The growth rate of national income depends on gK^Qh^QL and QW The

first three growth rates are given in (9.3), (9.5) and (9.7). The growth rate for
u is to be determined. Again, the utility function is given as in Model 3 and
Model 4. The individual maximizes its utility under the constraints given in
(9.2), (9.4) and (9.6).
The present value Hamiltonian function for this maximization problem is
J = ( ^ T ^ ) e-^* -h iii^K'^ûhLY-^
1a
+fi2{E 'b'h- 5hh) + /i3(7 '{1-u-
-C-
5KK)
b'')L - dL) .
(9.8)

dJ__dJ__dJ__
dc
du db
and
dJ
. dJ
dJ

head c we get the familiar condition
c-^ - /ii L e^^ .
(9.9)
Taking logs of (9.9) and differentiating with respect to time we get the
growth rate of consumption per head QC '
9c = -{---9L-p).
(9.10)
a 111

/ii(l - a)i^^(/iL)^"^?i-^ = /is 7 X
(9.11)
Ml
7
fi2-E'h
= /^S'-f'L'X'b''-^
155
(9.13)

f:^=M3-7-X.
(9.14)
From (9.11) and (9.14) we have
/ii(l - a)K^{hL)^-"u-"
= Z.b^'-i
(9.15)

^
/i2
= ,
^ ,
(1 -
. 6^-^ . K-^L~î-^)/iû^ .
(9.16)
Oi)x
We have three more conditions for an optimum. These are ^

-/i2 and f^ = - / i s :
d7
- - / i i =^ ii^{aK^-\uhLY-^
= /ii, f^ =
-5) = -fi, .
(9.17)
From (9.17) we have

-c-l/ 7 ^
-aK^'-ûh
- )M-a
^ - ^ +, 5r = >^ 1
(9.18)
^ 1 + D^
111
^ ^
which we can insert into (9.10) to get the growth rate for consumption
gc = -{aK'^-ûhLf-^
a
~ 5 - QL - p) ^
(9.19)
= -/i2 =^ /iiK"(^/L)i-"(l - a ) / i - " + fi2{Eb -5) = -fi2

an
which is
- ^ i i r ^ ( i ^ L ) i - ^ ( l - a)h-'' -{Eb-5)^^
M2
(9.20)
/^2

--.b^-^'U-Eb
X
+ S=^
(9.21)
fl2

f) T
= -Aa ^ /iiK"(M/i)i-"(l - a ) L - " + /i3(7 (1 - M - 6^) - rf) = - / i s

which is
156
- ^ K ^ ( w / i ) ^ - ^ ( l - a ) ! . - ^ - 7 . (1 - ^z - 6^) + ^ = ^
(9.22)
Using (9.12) the equation (9.22) can be written as

7.(6^-l)+d=^.
(9.23)
In Model 3 this condition was j-{b l)+d= ^ . The size of x determines

if (9.23) is lower or higher then the change of the shadow price /is in Model
3. Now we derive the growth rate of b by differentiating (9.13) with respect
to time:
^'^'
/ ^ ^ ' = l^xiix-lW-'-'bLh-'-h-'-'kLb^-'Uh-'b--']
Ms
(9.24)
which can b e written as
^ - ^ ^ = l-x.Lh-H^-^[{x-l)-l-'^
Ij^s fis /2s E
+ ^].
L
(9.25)
Multiplying the left-hand side with ^ and the right hand side with ^
l ^ . i . 61-gives
^ - ^ = {x-l)gt-9h-^9L(9.26)
M2 Ms
Inserting (9.21), (9.23), (9.5) and (9.7) into (9.26) gives the growth rate
for b :
In the next step we derive the growth rate of u: we differentiate (9.12)

which is ^ = -rr^K-'^h-^^-'^^L'û'^
with respect to time. This follows the
same procedure of deriving QU in the original Lucas model in chapter 4 and
in Models 3 and 4 in chapter 7. Therefore most details are here omitted. The
differentiation with respect to time and further multiplying with ^ gives
= -otgK + otgu + ( a - l)gh + OIQL (9.28)

Ml Ms
Inserting (9.18) into ^ and (9.22) into ^ and inserting gx^ gn and gL
from (9.3), (9.5) and (9.7) gives
157
5 = 7 " - ^ + Ebi- - 1) - di- - 1) - 7&"(- - 1) + 7 ( - - 1)

K
a
a
a
a
(9.29)
We apply equation (9.29) to derive the steady state solution where QU = 0.

As shown in the analysis of Model 3 in chapter 8 the growth rates of the ratios
of ^ and ^ are zero in the steady state. The same applies in this model.
To summarize, the growth rates which are zero in the steady state are
g^ = 9C+9L-9K = {^^^){^r~'u'-'^--[S+9L+p]
^
(7
9M.=9K-9h-9L
riL
+ ^+S+gL
K
= ( ; ^ ) " " ' " ' " " -"-^-Eb-gL
(9.30)
(9.31)
and from (9.29)

9u=lu-^+
Eb{- - 1) - d{- - 1) - jb^- 1) + 7 ( - - 1)

a
a
a
a
and from (9.27)
The steady state is derived in the following subsection.

9.1.2 The s t e a d y s t a t e
The only possible constant growth rate in a steady state for 6 is zero. Setting
(9.27) to zero gives
^, = 0 ^ ( | - x ) i ^ = 5 * .
(9.32)
In (9.32) the unique b is solely determined by exogenously given parameters.

In the next step we show that ^ ^ E? We write (9.32) as
7 = - 6^-^ .
(9.33)
We have j = E only if x = 1 but this case was excluded in the assumptions

at the beginning of this chapter. As a consequence E does not equal 7.^
Setting Qu = 0, (9.29) can be written as
.= i f - ^ ( i - l )
+ ^(i-l)+6^(i-l)-(i-l).
^ This is also clear from the first-order condition (9.13).

^ For x = 1, see Model 3.
(9.34)
158

Solving (9.34) for ^ gives
^ = 7^ + Eb{~ - 1) - d{~ - 1) - -fb^- - 1) + 7 ( - " 1)

(9-35)
K
a
a
a
a
We equate (9.30) and (9.31) with zero. From gc_ = 0 and g_K_ = 0 and
considering that in this model E ^ j we have
cL ^ ^^_aK^_,^,_^
K
a
tiL
^ ^^1 _ ^^ ^ ^ ^ 1 _ ^^ ^ 1
a
a
a
^^^^^
and
^
= [^+E6 + 7-(l-M-6^)-d]^-.
(9.37)

- ^ = [-{Eb - d - 76^ + 7 ) ] ^ ^ .
hL
a
We insert (9.38) for ^ and (9.34) for u into (9.36) and get
= {^^^)[-{Eb-d-jb^+j)]^S{--l)^gL{--l)
(J
(9.38)
+ -p]^ (9.39)
G
Inserting (9.34) into (9.39) and solving for ^ we get
= ( i _ l ) ( ^ _ d ) _ j ( ^ _ l ) + p + ^ 6 ( a - l ) + ; 6 ( - - l ) - 7 6 ^ ( i - l ) . (9.40)
1
P/)
U=-(<5(1-(T) + P ) - ( l - a ) .
7
(9.41)
= [ l ( 6 - d - 7 6 ^ + 7 ) ] ^ [^(<5(1 - a ) + p ) - ^ ( 1 - a ) ] .
(9.42)
The last step to get the steady state values of u^ ^ and ^ is to insert
6* z= ( ^ . x)^
into (9.40), (9.41) and (9.42). This gives the following three
steady state values
A *
K
= ( - - 1)(7 -d)-5{a-l)+p
a
+E{1
x)T^{^
u* = -iS{l -a)
+ E{1 x)T^{a~l)
h
- 1) - j{l
+ p)-
159
(9.43)
x ) t ^ ( l - 1)
- ( ^ x ) T ^ ( l - a)
(9.44)
^ 1 1 /
Û^* = f ^ ^ ^ ^ i . x ) T ^ - d - 7 ( | rr)T^ + 7 ) ] ^
(9-45)
[-(<5(l-a)+p)--(l-x)T^(l-<T)].
rates QK^QLI 9h and gc to get the growth rates for physical capital, for the size
of the workforce, for human capital and consumption when the economy is in
an equilibrium.
In the steady state human capital grows according the following rule
gl = E{^-x)r^
-S.
(9.46)
The size of x is therefore decisive for the growth rate of human capital.
The stock of physical capital grows as in
g^j, = E{l-x)T^{l-a)Ê{l^x)T^-j{^^x)T^-5
(9.47)
The workforce grows as in

gl==Eil-x)T^{l-a)-j{^-x)T^+j-d
+ 5{a-l)-p.
(9.48)
= 9l'
(9.49)
The growth rate of physical capital per head is

9l=gK-9l=E{^'^)^-^
Inserting (9.44), (9.45) and (9.48) into (9.19) gives the growth rate of
consumption per head
9t=E{^-x)T^-5
The growth rate of income per head is
*
*
9y=9h'
= gl.
(9.50)
160
As an example for economy A where 0 < x < 1, with t h e s t a n d a r d values

of cr = 3 , ^ = 0.035,/? = 0.033, d = 0.01 and setting E = 0.1 (as before),
7 = 0.14 and x = 0.5 we get b* = 0.49 and u* = 0.43.^ In this economy t h e
individuals spend 49 per cent of their time in education and 43 per cent of
their time in production. This implies t h a t 8 per cent is spent in t h e domestic
sector. This translates into a growth r a t e of t h e population of ^fi, = 0.029, i.e.
t h e population declines by 2.9 per cent in each period. This implies a steady
state growth rate of income per head Qy = gf^ = 0.014, i.e. in t h e steady state
income grows with a rate of 1.4 per cent.
In t h e current model t h e steady state values for time spent in t h e education
sector and time spent in the production sector are
b* = il-x)r^
(9.51)
and
u* = 1(6(1-a)+p) - ^(l.x)T^{l-a)
.
(9.52)
7
7 i^
We analyse how t h e steady state values of 6* and u* are influenced by t h e
two parameters, t h e domestic sector productivity 7 and t h e education sector
productivity E.
T h e effect of a change in 7 can be seen in
db""
1
r-x_-n
,x._i_
dj
1-x
^
Ê^
db^
> O i f O < x < l and
dj
db^
< 0 if X > 1 .
dj
If t h e education productivity is changed, t h e steady state level of 6* is
changed as in
db*
dE
(96*
~dE
db*
dE
r_l
<OifO<x<l
l^
_1_
and
> 0 if X > 1 .
^ In Model 5 the relationship between 7 and E with 1 = ^ b^~'^ (see (9.33)) has
to be fulfilled. The parameter 7 is set at a value to fulfill this relationship with
E = 0.1. We had set J = 0.1 in Model 3, see 8.1.4. The parameter x is set at
mean value, x = 0.5.
161
Economy A is an economy where 0 < x < 1, i.e. time b spent in education

has a larger impact on t h e workforce growth rate t h a n in economy B where
X > 1. While economy A is in equilibrium, t h e individuals spend more time in
education (i.e. a higher b) when t h e productivity in t h e domestic sector 7 is
high. This translates into higher economic growth. A higher education sector
productivity E would mean a lower steady state value of b and t h u s lower
growth (see table 9.2). In economy B t h e effects of E and 7 on 6* are t h e
opposite.^ Because of Qy = Eb* S = E{^ - x)^^^ 5 t h e level of 7 or " in
equilibrium translates into the following rates of higher economic growth:
Table 9.2. The steady state growth rate Qy in economy A and B as a result of a
change in home productivity 7 and education productivity E.
Economy A
Inew > lold
Economy B
with 0 < X < 1

with X > 1
b^new JS high -^ Q* JS high bêw IS low> Q* is low
is low -^ gl is low
6* ew; is high^ g^ is high
In economy A a policy which increases t h e domestic sector productivity 7

will boost economic growth. In economy B a policy which increases 7 reduces
economic growth, i.e. t h e growth rate Qy is permanently at a lower level. In
b o t h economies increasing 7 and E together may have no or little effect on
economic growth as t h e effects on b may offset one another. To employ b o t h
policies at the same t i m e is therefore counterproductive.
We analyse t h e stability of t h e equilibrium, i.e. whether b is converging to
its steady s t a t e value 6* if 6 ^ 6*. During t h e transition towards an equilibrium
b grows with (see (9.27))
9h = 7
7T 'U(n
\x I)
6^-^) .
X
T h e conditions for a steady state in economy A and economy B are given in

table 9.3.
T h e figures 9.1 and 9.2 show t h a t t h e conditions are not fulfilled, i.e.
t h e steady state in this economy is unstable. T h a t means t h a t either t h e
economy 'jumps' to this equilibrium from t h e start or it will never reach this
equilibrium.
If, for example, in economy A, 6 is smaller t h a n 6* we can see from figure
9.1 t h a t 7 > b^~^' Because T^rjT i^ < 0 we have a negative growth rate
^^ < 0. If 6 < 6* it will decline even more and diverge from its equilibrium
value. T h e same hold vice versa for t h e case if 6 > 6* and for economy B
Here, the case where a: = 1 is not defined. For x = 1 refer to Model 3 in section
dh dh dgy
8.1. See subsection 11.1.3 for the derivatives |97
^ ,' |dE^
| , ^dj and % - .
162
Fig. 9 . 1 . Model 5: Economy A with 0 < x < 1
Fig. 9.2. Model 5: Economy B with x > 1
163
Table 9.3. Conditions for a steady state in economy A and B.

Economy A
with Q < X < 1
Economy B
with x > 1
< 6* 7 < f 6^-^ -> Pb > 0 7 > f 6'-^
^gb>0
6 > 5* 7 > I ^'"" -^ Pb < 0 7 < I ^'~"
^9b<0
(figure 9.2). As this is unsatisfactory, we need an additional condition for the

steady state to make the equilibrium stable. In Model 6, which augments
Model 5 by including the dependency ratio D and its growth rate g(i-^D)j ^he
equilibrium is stable in economy A.
9.2 Model 6: A model of silver growth with t h e new

t i m e allocation, endogenous population growth and an
ageing population
In this chapter the dependency ratio D is introduced into Model 5. This is the
most 'complete' model in this thesis and combines the different characteristics
from the previous models.
The general production function is given as in Model 4
Y = FiK,H) =
F{K,uhYf^)-

Y = Kûh^y-"
(9.53)
and production per head of the population is

y = k''(uh-
\l-a
k = K'^{uh-^^y-''
-C-5K
Aggregate consumption is C = c-N with c as consumption per head of the

population. As before, the change in the individual human capital is given as
164

h =
E'b'h-5h
which gives t h e respective growth rate

gh = E-b-5,
(9.55)
As before, endogenous population growth and workforce growth depends

on t h e time devoted t o bringing up children. Time can either be spent in
production (it), or in education (6) or bringing u p children (1 u h).
T h e change in t h e size of t h e workforce L is given as
L = j ' { l ~ u - b'')L -dL'L
(9.56)
with dL t h e retirement rate and 7 t h e productivity in t h e domestic sector

t h a t translates t h e time and effort spent bringing up children into t h e fertility
rate. T h e effect of t h e time spent in education h on t h e time spent at home
depends on the parameter x. Here we focus on t h e case x 7^ 1. As before (see
section 9.1) if x < 1, then b^ > b. In this case t h e negative effect of t h e time
spent studying on t h e time spent at home is bigger t h a n in t h e case with
X = 1. If X > 1, then b^ < b. In this case t h e negative effect of t h e time spent
studying on t h e time spent at home is smaller t h a n in t h e case with x = 1.
T h e higher t h e value of x t h e lower is 6^, as 0 < 6 < 1.
T h e growth rate of t h e workforce is t h e n given as
gL = j'il-u-b'')-dL.
(9.57)
As explained in detail in Model 4 (section 8.2) t h e population size changes

with t h e number of children born t o t h e group of t h e workforce 7 (1 u &)L.
T h e change in t h e size of t h e population A^ is t h e n
iV = 7 (1 - w - 6^)L - dN .
T h e growth rate of t h e population is then given as
gj^=^.(l_y_6-)_i__d.
(9.58)
T h e growth rate of t h e dependency ratio is

9{i-\-D) ^ 9N - 9L '
9 . 2 . 1 T h e real g r o w t h r a t e
t o time gives t h e real growth rate for Y :
9Y
= Oi' QK + { l -
a){gu
-^ 9h ^ 9N - 9{I+D))
9.2 Model 6: A model of silver growth with the new time allocation 165
The growth rate of output depends on gKi9hi9Ni 9{I+D) ^^^ dw The first
four growth rates are given above. The growth rate for u is to be determined.
The growth rate for income per head of the population is
9y = ot'gk^{l-
a){gu -\-9h - 9{i+D))
As before, consumption c is the only argument in the individuals' utility.

The utility function is given as before. Individuals are maximizing their utility
under the constraints of the development of physical capital K, human capital
h and population N. As in Model 4 another constraint that has to be taken into
account is the development of the workforce L, This constraint does not have
to be included in the following Hamiltonian function (9.59) if we make one
further assumption: L = N. This is the case if we have j'{lu b)L dLL =
7 (1 li b)L dN which can be simplified to dL dj^J
The present value Hamilton function for this maximization problem is
J = (^-
-) e-"* + ; , i ( / r " ( M / i - ^ ) i - " -cN-5-K)
i (J
(9.59)
i + i^
+M2(^ b-h-5-h)+
fisil ( ! - - ^'^) Y ^
- dN) .

9 j _ 9J _ a j _
dc
du dh
and
dJ
. dJ
dJ _

head c and taking logs and diff'erentiating with respect to time gives the
familiar formula for the growth rate of consumption per head QC :
9c = -i---9N-p)^
a
(9.60)
III

/xi(l - a ) i r " ( / i ^ ) i - " u - " = M3 7 Y ^
(9.61)

See section 8.2. For example, if population N is 80m and workforce L is 40m,
then d = hdh-
166
111
^1+D^
^ ^

^,^.Eh = î^^{,^)xh--K
(9.63)

112'E'h
irb^
, N^
= ^''^'^TTD^'
^'-'^^
From (9.61) and (9.64) we have

Mi(l - a ) i i ' " ( / i ^ ) ^ - " u - " = t^2Eh
(9.65)

= ,_ ^ , b^-^ i ^ - ( ^ ) - ( i - " ) f t " u " .
Ai2
(l-a)x
^1 + D'
(9.66)
^ ^
We have three more conditions for an optimum which are ^ = fii, ^ =

-fi2 and I f = -/is :
H
= _ / , ! =^ ^ , ( i f a - i ( / , _ ^ ) i - " _ <5) = _ ^ , .
(9.67)
From (9.67) we have

-aK''-\uh-^y-'' ^S=^
(9.68)
which we can insert into (9.60) to get the growth rate for consumption per
head of the population
gc = - ( a i ^ " - ^ ( u / i - ^ ) i - " -5-gN-p).
(9-69)

dJ
dh
.
..^. N
A2 => M l i ^ " ( ^ J ^ ) ' ~ " ( l - Ce)/l-" + li2{Eb - (5) = ~A2
which is
- ^ K ^ ( ^ ^ ) ^ - ^ ( l - a)/i-^ -{Eb-5)
=^ .
(9.70)

--b^-''-u-Eb^5=^
X
,
112
(9.71)
167

BJ
- -As ^ /iii^-(^/i)i(1 ~ a)N-^{l
+ i))-(i)
(l-a)
+/i3(7 (1 - ^ - &")(! + D)-^'~^^
-d)
= -fis
which is
-î^^(ix/i)^-^(l - a)iV-^(l + L>)-(i-^)
Ms
-7 (1 - 1^ - 6^)(1 + D)-^^-^^
(9.72)
+ d= ^ ,
/^3

7 . (6^ - 1)(1 + D)-^ + d - ^
(9.73)
Now we derive the growth rate of b: we differentiate the first-order condition given in (9.63) with respect to time and multiply the left-hand side with
^ and the right hand side with ^ = f N'^' ^b^^-''^h' (1 + D).^ This gives
M2
= {x-
l)gb -Qh^QN-
9(i+D)
(9-74)
M3
Inserting (9.71), (9.73) and the growth rates gh (9.55) and QN (9.58) into
(9.74) gives the growth rate for b :
Because we now have a formula for the growth rate g^^ Model 6 allows
us to analyse the behaviour of the economy during the transition towards its
steady state.
In the next step we derive the growth rate of u: we differentiate (9.62) with
respect to time. This follows the same procedure of deriving gu in the models
above. Therefore we will not repeat the details here. The differentiation with
respect to time and further multiplying with ^ gives
Ml
= -otgK + o/-gu + (o^ - l)gh + ocgN ~ c^g(i+D)
(9.76)
Ms
Inserting (9.68) for ^ and (9.72) for ^ and gx (9.54), gn (9.55) and gN
(9.58) gives
This is the same procedure as in Model 5 in section 9.1.
168
5 = ( - - l)Eb - ^
a
- ( 1 - l)d + ( 1 - 1)7(1 - 6-)(l + D)-'

a
(9.77)
From equation (9.77) we derive the steady state solution where Qu ~ ^

The growth rates which are zero in the steady state are given as^
g^=gc^9N-9K^
Ha{^^r-û^--
The growth rate of -r\-
9^<^=gK-9h-9N+9ii+D)
^5~-p\-{--
l)gN (9.78)
is (with ^fA^ + 9(I+D) = 9L)
= {r^r~'u'~''-^-Eb-gL.
(9.79)

The only possible constant growth rate in a steady state for b is zero. Moreover,
the growth rate of the dependency ratio 9(1+D) has to be zero in the steady
state. If ^(i+D) " O5 the growth rate of b in (9.75) is not a constant (with
the only possible constant being zero). As a consequence a steady state is not
possible. If we assume 9{I+D) > O5 the dependency rate (1 + D) continues
to rise which also changes the population growth rate continuously. Thus the
population growth rate is not a constant. In the steady state the only possible
constant growth rate for D is therefore 9(I-\-D) = 0- Setting 9{I-^D) 0 and
the growth rate for b as given in (9.75) to zero gives
5b = 0 ^ ( | ( l + D ) - i x ) T ^ = 6 * .
(9.80)
In (9.80) the unique b is solely determined by exogenous parameters. We

show that in this model we have ^ ^ E. We write (9.80) as
7 = - ( l + i:))6i-^ .
(9.81)
As a consequence E does not equal 7.^^

As in the Lucas model solution (see subsection 4.2.4), the growth rate for
u can only be zero. The growth rate 9y (9.77) can therefore be written as
^ As shown in the analysis of Model 4 in section 8.2 the growth rates of the ratios
of ^ and , ^N ^re zero in the steady state. The same applies in this model.
^ The equation (9.81) can also be derived by taking logs of (9.63) and differentiating
with respect to time.
u = 1 ^ ( 1 + D) - ^ ( i - 1)(1 + D) + ^ ( 1 - 1)(1 + D)
169
(9.82)
+6^(1-1)-(1-1).
a
Solving (9.82) for ^
gives
^ = 71.(1 + D)-^ + Eb{- - 1) - d{- ~ 1)

K
a
a
-76^(1 + D)-\- 1) + 7(1 + i ^ ) - ^ ( - - 1) .
a
a
(9.83)
We equate (9.78) and (9.79) with zero. From QCN, = 0 and gjK, = 0 and
K
hL
considering that in this model E y^ ^ we have

cN
.a~a^^
^ ^ . . _ i i _ . . .A
.. .
A
.. . 1
"W = ( V ^ ) ( 7 r ^ ) " " ' " ' " " + ^ ( ^ - 1) + 5 i v ( ^ - 1) + ^Z'
(9-84)
and
- ^
= [^+^6 +7-(l-^-n~rfL]^-^.
(9.85)

^
[-{Eb + 7(1 - 6^)(1 + D ) - i - 6 / ) ] ^ . u .
(9.86)
We insert (9.86) for 7 - ^ into (9.84) and using (9.82) we get
= {-a
l)Eb +(a-
l)Eb + {-a
1)[(1 - 6^)7(1 + D)-'
- d](9.87)
Inserting (9.87) into (9.82) gives the steady state value for the time spent
in production, for b b*
^ = 1(1 + D)[{Eb'' - (5)(a - 1) + p)] .
7
('h r ^N ) / = [^(^^
+ 7(1 - hîl + D)-' - d ) ] ^
L V
^1+D
\l^D)[{Eb-5){cj-l)^p)].
7
(9.88)
(9.89)
170
T h e last step t o derive t h e steady s t a t e values of u, - ^ a n d ^ is t o insert

6* = ( ^ . x ) ^ into (9.87), (9.88) and (9.89). T h e results are inserted into
t h e equations for t h e growth rates QKJ QN-, QL^ 9h and QC to get t h e growth
rates for physical capital, for t h e size of the population and of the workforce,
for h u m a n capital and consumption when t h e economy is in an equilibrium.
In t h e steady state human capital grows according t h e following rule
gl = Ei^x{l + D)-')T^-5.
(9.90)
In addition to E, 7, 5 and x (as in Model 5), t h e variable (l + D) is decisive

in determining t h e growth rate of h u m a n capital.
T h e stock of physical capital follows
g^j^ = Eb-S + {l- a){Eb ~ 6) + 7 ( 1 - 6^)(1 + D)'^
- d- p .
(9.91)
T h e workforce grows with

gl = 7(1 - b-) -dL + il + D)[{Eb - <5)(1 -a)~p]
(9.92)
and t h e population growth rate is

g^j^ = 7(1 - 6^)(1 + D)-^
-d + {Eh- 5){1 ~ a) ~ p .
(9.93)
T h e growth rate of physical capital per head of t h e population is

gl=9*K-9*N
= Eh-5 = E ( | ( l + D)-^x)^
- 5 .
(9.94)
T h e growth rate of consumption per head is

g;=Eb-S
= ( | ( 1 + D)-'x)T^
-5 = 9l.
(9.95)
As an example, with t h e s t a n d a r d values (as before) a = 3,6 = 0.035, p

0.033, rf = 0.01 and setting E = 0.1 (as before), 7 = ^.Ih^^D
= 1.2 and
X 0.5 we get h 0.33 and u 0.24. In this economy t h e individuals spend
33 percent of their time in education and just 24 per cent of their time in
production. This implies t h a t 43 per cent is spent in t h e home production
sector. This translates into a workforce growth rate of QJ, 0.0273, i.e. t h e
workforce grows with 2.73 per cent in this period. T h e growth r a t e of t h e
population is ^jv = 0.0115, i.e. t h e population grows with 1.15 per cent in
this period. Growth of income and h u m a n capital per head of t h e population
is Qy = Qh = 0.0027, i.e. income declines with 0.27 per cent in this period.
This situation is not a steady state (yet) as there is one more condition which
^^ In Model 5 we set 7 at 0.14. This is because in Model 5 the relationship between
7 and E with 7 = - h^~^ has to be fulfilled. In Model 6 this relationship is
7 = 1 (l + D ) - 6 i - ^
171
has to be fulfilled: the growth rate of the dependency ratio has to be zero, i.e.
we have 9% 9^ = 0- Using (9.92) and (9.93) we have
9N-9l=^^
>"(1 + D)-^ + h-E{a-l)~5{a
7(1 + D)-^
-l)^p-{d-dL)=0.
In the economy described above where 9L = 0.0273 > 9N = 0.0115 the

dependency ratio D will decline as ^ ( I + D ) < 0. AS D declines the economy
reaches the steady state when gj^ 9L' With the given values the steady state
is reached with D = 1.048 and 9N = 9L 0.0006, i.e. when the population is
stationary. In the steady state the time spent in education is 6* = 0.37 and
the time spent in production is u^ = 0.31. This translates into a growth rate
9y = 0.00225, i.e. income grows with 0.225 per cent in the steady state. In this
example, the economy experienced an economic decline when D = 1.2 (in the
initial situation), but enjoys (modest) economic growth when the dependency
ratio is lower at I^ = 1.048 (in the steady state situation).
The comparison of the two scenarios demonstrates that for higher economic
growth, the value of h has to be higher, i.e. individuals have to spend more time
in education accumulating human capital. As the value of h is determined by
the dependency ratio (1 + !)), a higher h is only possible (for given parameters
of E and 7) if D declines.
In Model 6 the steady state values for the time spent in the education sector
and the time spent in the production sector are
6* = ( 2 ( 1 4_ D)-^x)^
E
(9.96)
and
w* = i ( l + D)[5{1 -a)-^pEb%l - a)] .
(9.97)
7
We analyse how the level of the steady state 6* and 2/* is influenced by
the exogenous parameters, the home sector productivity 7 and the education
sector productivity E.
The effect of a change in 7 on 6* is
db
> O i f O < a : < l and
97
db*
< 0 if X > 1 .
172

In economy A where 0 < x < 1, 6* increases in 7. In economy B, 6*
declines in 7. Comparing ^ (from Model 6) with ^ = j^J^'^

( f )^^^
(from Model 5), we find that the change in 6* following a change in 7 is smaller
in Model 6 because of (1 + D)~-^. This implies that the impact of a policy that
aims to increase economic growth by increasing the time spent in education b
will be lower, the higher the dependency ratio D.
As u* is a function of 6* the time spent in production will also change. A
change in b and in u will change the time spent at home bringing up children
and thus the fertility rate. We have^^
-;-- > O i f O < a : < l and

oj
5^<0ifx>l.
For economy A where 0 < x < 1, we have ^ > 0 and ^ ^ > 0. In this
economy a rather high level of the home sector productivity 7 motivates the
individuals to study and work more and to spend less time at home. The
positive effect of a rise in 7 on the population and workforce growth rate
is compensated by the fact that the individuals study and work more and
spend less time in the home sector, the latter having a negative effect on the
population and workforce growth rate. As a result, increasing 7, assuming
that ever3rthing else remains the same, does not lead to a higher population
and/or workforce growth rate.
However, a change in 7 has an effect on the growth rate of b. From (9.75)
we have
In the steady state, where gt = 0 and g{i-\-D) = 0^ ^ê term in the square
brackets in (9.98) is zero. A rise in 7 means that that term becomes positive.
Then p^ < 0, because of x < 1. As the growth rate of b is now negative, b
declines. As b declines, so does u. A lower b means that the time spent in the
domestic sector rises (and the term in the square brackets above increases even
more, i.e. g^ decreases further). Then we have a situation where gL > gn^ i-^
the growth rate of the dependency ratio is negative, ^ ( I + D ) < 0. This causes
the growth rate of b to rise (it becomes less negative)."^^ As b rises, so does u.
Because u and b rise, the time spent in the home sector declines. As u and b
rise the system comes back to the original starting point (where 6* = 5*^^ and
The details of the derivative oi u* with respect to 7 can be found in subsection
11.1.4.
^^ See the growth rate of b in (9.75). Inserting g{i-^D) < 0 into (9.75), the last term
on the right-hand side becomes positive as (a: 1) < 0.
173
tx* = uî^ and p(i+D) = 0)- But now we have a situation (with the same levels
of u and b) where 5'(I+D) is still negative. This means the growth rate of b is
still positive. For this reason b continues to rise (so does u) until QL = QN and
gb = 9u = 0.
Throughout the transition phase we have g(i-^D) < 0. As the dependency

ratio declines the population growth rate is ceteris paribus higher in the
next period. That means in the new steady state we have a situation where
9L{new)
= 9N{new)
> 9L(old) =
9N{old)-
To summarize, an increase in the home sector productivity 7 leads to a

new steady state where
the individuals spend more time in the education sector;

the individuals spend more time in the production sector;
the dependency ratio Z) is on a lower level and
the population growth rate and workforce growth rate are on a higher
level.
In economy B where x > 1, we have ^ < 0 and ^ ^ < 0. In this economy

a rather high level of the home sector productivity motivates the individuals
to study and work less. The positive effect of a rise in 7 on the population
and workforce growth rate is enhanced by the fact that the individuals study
and work less and spend more time in the home sector, the latter having
another positive effect on the population and workforce growth rate. As a
result, increasing 7, leads to a higher population and workforce growth rate.
The change in 7 also has an effect on the growth rate of b. From (9.75) we
have
In the steady state, where 9h ^ and ^ ( I + D ) = O5 the term in the square

brackets is zero. A rise in 7 means that the term becomes positive. Then
Qh > 0, because of x > 1. As the growth rate of b is now positive, b rises.
As b rises, so does u. A higher b means that the time spent in the domestic
sector declines. As a consequence the term in the square brackets in (9.99)
increases further and so does g^. We then have a situation where 9N > 9L^
i.e the growth rate of the dependency ratio is ^ ( I + D ) > 0- This causes the
growth rate of b to rise even more.^^ As b rises, so does u. Because u and b
rise, the time spent in the home sector declines, b increases and diverges from
the steady state. As a result, in economy B the steady state is unstable. A
change in the parameter 7 brings b off the equilibrium path.
We now analyse the effect of a change in the education sector productivity
E on 6* in economy A and in economy B. The derivatives are
^^ See the growth rate of b in (9.75). Inserting 5^(1+0) < 0 into (9.75), the last term
on the right-hand side becomes positive as (x 1) < 0.
174
< O i f O < x < l and

dE
db*
>Oifx>l.
As li* is a function of 6* and E, the time spent in production will also
change. ^^
< O i f O < x < l and
oE
-7 > 0 if X > 1 .
dE
In economy A where 0 < x < 1, we have ^ < 0 and ^ - < 0. In this
economy a rather high level of the education sector productivity motivates
the individuals to study and work less. A change in E has no effect on the
growth rates of the population and the workforce. To work out the transitional
dynamics we start with the growth rate of b
In the steady state, where ^6 = 0 and P ( I + D ) = 0, the term in the square

brackets is zero. A rise in E means that the term becomes negative. Then
Qb > 0, because of x < 1. As the growth rate of b is now positive, b increases.
As b increases so does u. This translates into higher economic growth in the
short-term. ^^ A higher b (in the next period) means that the time spent in the
home sector declines (and the term in the square brackets above becomes even
more negative, i.e. gi, becomes even more positive). Then we have a situation
where QN > 9L, i-e the growth rate of the dependency ratio is 5'(I+D) > 0This causes the growth rate of b to decline (becomes less positive and then
negative as g(i-^D) is still positive). Then b declines and so does u. Because u
and b decline, the time spent in the home sector rises. As u and b decline and
{1 u b) rises, the growth rate g{i^D) declines (but is still positive). The
system comes to a halt where 5'(I+D) = 0 and g^ g^ =0.
Throughout the whole transition phase we have g{iJ^D) > 0. As the dependency ratio rises, the population growth rate is ceteris paribus lower in the
next period. That means in the new steady state, we have a situation where
9L{new)
= 9N{new)
< 9L(old) =
9N(old)'
To summarize, a higher level of the education sector productivity E leads

to a new steady state where
^^ The details of the derivative of 6* and tx* with respect to E can be found in
subsection 11.1.4.
^^ In the long-term when the new steady state is reached the effect of an increase
in E on economic growth will be negative.
175
the individuals spend less time in the education sector;

the individuals spend less time in the production sector;
the dependency ratio D is on a higher level which causes
the population growth rate and workforce growth rate are on a lower level
in the steady state.
In economy B where x > 1, we have f^ > 0 and ^ > 0. In this economy a

rather high level of the education sector productivity motivates the individuals
to study and work more. A change in E has no effect on the growth rates of
the population and the workforce. To show if the economy will reach its new
steady state after the increase of the education productivity E^ we work out
the transitional dynamics. We start with the growth rate of b
In the steady state, where gt = 0 and g(i-\-D) = 0^ the term in the square
brackets is zero. A rise in E means that the term becomes negative. Then
Qt < 0, because of x > 1. As the growth rate of h is now negative, b declines.
As b declines, so does u. A lower b (in the next period) means that the time
spent in the home sector declines (and the term in the square brackets above
becomes even more negative and so does g^). Then we have a situation where
gL > gN-! i-e the growth rate of the dependency ratio is ^(I+L>) < 0. This
causes the growth rate of b to decline even more. Because u and b decline, the
time spent in the home sector rises. The dependency ratio keeps on declining,
but at the same time b declines. That is, b diverges from the (new) steady
state. A change in the parameter E brings b off the equilibrium path.
As the equilibrium in economy B is unstable unlike in economy A, we
focus now exclusively on economy A where the equilibrium is stable. If b (and
u) diverge from the equilibrium path, for example, because of a change in a
parameter, the economy will reach a (new) steady state.
During the transition b grows with (see (9.75))
The last term on the right-hand side of (9.100) is crucial for the stability of
the equilibrium. We have seen in Model 5 that the equilibrium was unstable,
i.e. the economy was either in the steady state right from the start or it
never reached the steady state. In Model 6 the steady state exists and is also
stable in economy A. This is caused by the additional variable D (compared
to Model 5) and its growth rate ^ ( I + D ) - In a situation where b is not in the
steady state the dynamics of the economy are the following: In case 6 < 6* the
time spent at home is higher and the workforce grows at a higher rate than
the population, i.e. gi > gN- This causes the dependency ratio D to decline
with g(i-^D) < 0. A lower D increases the growth rate of b as given in (9.100).
As D falls, gb rises less and less in each period, b increases (and D declines)
176
until the steady state b* is reached. Similar transitional dynamics apply for
the case h > h*.
We have shown how the economy is affected by a rise in 7 or in ^ . In economy A the individual studies more when 7 is increased and studies less when
E is increased. To summarize, because Qy = Eb 6 E{^{l-\-D)~^x)^^^
5
the results of an increase in 7 or E is as follows in economy A with 0 < x < 1 :
7 is higher^ 6* is higher > g* is higher

^ is higher^ 6* is lower -^ ^* is lower
Furthermore, Model 6 suggests that the impact of policies to increase

economic growth is smaller than suggested by Model 5. This is because of the
inclusion of the dependency ratio D in the model. The higher the dependency
ratio D the less successful is the policy measure to rise 7 (in economy A) to
increase b and thus economic growth. Rising E is even more detrimental to
economic growth when the dependency ratio D is high.
As can be seen in the formula for the steady state value of the time spent
in education (9.96) 6* is lower for higher values of D. This indicates that in
a population where the ratio of the dependent to the working is rather high,
economic growth is lower in the steady state, as the individuals spend less
time in the education sector accumulating human capital (and more time at
home and in production). With regards to population growth, a high level of
D means a lower value of 6* which implies that the individuals spend more
time at home. This has a positive effect on QL and QNIn economy B, because the equilibrium is unstable, we are not able to
analyse the impact of policies on economic growth. However, in economy A
there a two possibilities for economic policy to increase the growth rate of
income per head of the population on a permanent basis. First, the home
section productivity 7 can be increased, as this causes individuals to study
and work more. Second, the size of x can be increased (in the limit 0 < x < 1).
The higher x the less pronounced is the negative effect of studying time b on
the time spent at home bringing up children. As a result in the steady state
the time spent in education and in production is higher.
10
Conclusions
This research expands our understanding of economic growth in an economy

with an ageing population. Specifically, this research expands the current economic theory relating to an economy with an ageing population. Drawing
conclusions for economic policy, it is important to bear in mind that, as with
all economic models, the models developed and presented in this thesis are a
simplified picture of the real world. This means that any policy implications
and, more importantly, any recommendations for policy that may be derived
run the risk of being simplistic.
We analyse economic growth as a result of an endogenous time allocation
decision. In Lucas (1988), the decision to spend time in the education sector
and in the production sector determines the long-run growth rate. Here, in
addition to Lucas (1988), we allow individuals to decide on a third option,
spending time at home bringing up children. This decision affects the endogenous growth of the population and the workforce. This in turn determines if
and to what extent the population is ageing (i.e. D is increasing). This ageing process has an effect on economic growth. Adding endogenous population
growth allows us to employ different policies which affect population growth.
The effect of these policies on economic growth in an economy with an ageing
population can be analysed (see section 10.2). We perform comparative statics, analysing the steady state levels of time spent in production and education
when employing different levels of education policies and family policies. The
comparative statics show how economic growth in terms of growth in income
per head is affected by different policies.
It is important to mention that this research does not analyse the effect
of demand on economic growth. Similar to most economic growth literature,
we assume that the economy always reaches its (full) production potential.
Put differently, all existing models reviewed here, as well as the new models
developed in this paper deal exclusively with the supply side of the economy. This can be explained by the main focus of our research, which is the
178
10 Conclusions
production potential, not the output gap.^ Also, the effects of a smaller and
older workforce on innovation and economic growth is not the topic of this
thesis. The 'innovation-based' endogenous growth theory^ could function as
a starting point for analysing the ageing population and ageing workforce in
the context of innovation and economic growth. This is a topic for further
research.
The following table gives an overview of the models developed in this
thesis. The models that include the dependency ratio D are also referred to
as "Silver Growth Models" as they include a variable for the (changing) age
structure of the population.
Table 10.1. List of models in Part Two.
Model
(Chapter)
1 (7.1)
2 (7.2)
3 (8.1)
4 (8.2)
5 (9.1)
6 (9.2)
Augmentation
Solow (1956) with
Lucas (1988) with
Lucas (1988) with
Lucas (1988) with
Lucas (1988) with
Lucas (1988) with
dependency ratio D
dependency ratio D
a new time allocation
a new time allocation and D
a new time allocation
a new time allocation and D
Population
N y^ L, exogen
N y^ L, exogen
N = L, quasi-endogen
N ^ L^ quasi-endogen
N = L, endogen
N y^ L, endogen
10.1 Conclusions for economic growth t h e o r y

In Part I of this thesis we have analysed two widely accepted standard models
of economic growth theory, Solow (1956) and Lucas (1988), and their approach
to demography and economic growth. The relevant variables in these models
are
the size of the population and

the growth rate of the population.
In both models, population refers interchangeably to the workforce. In

Part II of the thesis we differentiate between population N and workforce L
by introducing the dependency ratio D = ^^^ to reflect the impact of the
ageing population, i.e. the population age structure and its ageing process on
economic growth. In the "Models of Silver Growth" we differentiate between
the growth rate of the population and the growth rate of the workforce, as
^ See Solow (2000), 184. A simulation of the ageing population on demand can be
found in OECD (2005).
^ For example, Romer (1990a), Grossman and Helpman (1991a) and Aghion and
Howitt (1992), see chapter 2 for a review of these models.
179
these models allow the size of the population N and the size of the workforce
L to be different.
In these Silver Growth Models the new variable, the dependency ratio D^
is a simple presentation of the age structure as it divides the population in
the elderly, non-working population and the young, working population. As it
allows us to distinguish between the workforce and the non-working population, it is a first step towards making Solow (1956) and Lucas (1988) accessible
for questions regarding an ageing population and economic growth. By introducing the dependency ratio D and the possibility of differentiating between
the workforce and the population, the Silver Growth Models incorporate more
demographic variables than Solow (1956) and Lucas (1988). These augmented
models allow for a more realistic presentation of the demographic change in
an economy. The relevant demographic variables in these augmented models
are
the
the
the
the
size of the population,

growth rate of the population,
size of the workforce,
growth rate of the workforce.
This allows us to analyse
the ratio between the population and the workforce (a "dependency ratio")
and
the growth rate of this ratio.^
This enables us to reach more realistic results regarding economic growth

as the age structure of the population is taken into account. Specifically, the
Silver Growth Models predict a decline in both the national income and income per head if the dependency ratio D rises. This is more realistic than the
result in numerous growth models based on Solow (1956), where a declining
working population has a positive effect on per capita growth. Including the
dependency ratio D in Solow (1956) illustrates the negative effect of a large
dependency ratio on the level of income per head in the steady state. This
negative effect exists in the steady state situation as well as during the economy's transition towards equilibrium. An ageing population, i.e. a rise in D^
has a negative effect on the growth rate Qy in the augmented Solow model.
This has been shown in Model 1 in section 7.1. The augmented Lucas model
also predicts a negative effect of the ageing population on economic growth.
This has been shown in Model 2 in section 7.2.
In Model 1, the augmented Solow (1956) model, the economy converges to
its steady state. However, the familiar steady state solution of the Solow (1956)
model is no longer possible to achieve if an ageing population is included in
the model. In Model 1 the additional variable D means that an additional
condition for the steady state is necessary. In the steady state, the growth
If this ratio is growing, the population is ageing.
180
10 Conclusions
rate P ( I + D ) has to be zero, i.e. QN = QL- It is not possible to derive a steady

state of the income per head with gfi_^m > 0. In other words, an economy
with a constantly ageing population will not converge to a situation where
the variable y* = -^ is a constant. Nevertheless and the more important
result with regards to demography and economic growth. Model 1 predicts
steady state growth, i.e. the relevant variables grow at constant rates. Based
on the Silver Growth Model 1, we conclude that an economy with an ageing
population is capable of steady state growth as long as the rate of technological
progress QA is large enough.
In Model 2, the augmented Lucas (1988) model, the relevant variables
grow with constant rates when the economy is in equilibrium. In Model 2
the additional condition for steady state growth is that QÎ^D) is a constant.
As a result of this Silver Growth Model 2 the economy experiences growth
of income per head as long as the education sector productivity E (minus
depreciation rate and time preference rate) is larger than the growth rate of
the dependency ratio, i.e. {E 5 p) > p(i+/)). The more the population is
ageing, the higher must be productivity E to guarantee growth of income per
head.
This gives an answer to the questions posed in the introduction: "In an
ageing society when is an economy capable of steady growth at a constant
rate?^\ Based on the Silver Growth Model 1, we conclude that with an ageing
population an economy is capable of steady state growth as long as the rate of
technological progress is large enough. Based on the Silver Growth Model 2,
we conclude that with an ageing population an economy is capable of steady
growth at a constant rate as long as the education productivity is large enough.
The Silver Growth Models, Model 1 and Model 2, are simple 'finger exercises' to show the relevance of including a variable for the age structure of the
population into a model of economic growth. They show the negative effect of
an ageing population on economic growth. Assuming that the population is
not ageing any longer, the negative effect of an aged population on the steady
state levels of income and capital per head of the population becomes clear.
The population growth rate and workforce growth rate in these two model
are taken as exogenous constants. There is no explanation to what extent the
population is ageing and why.^
To develop a more sophisticated model of economic growth in an economy
where steady state growth is possible with an ageing population, we have
focused in this thesis on the Lucas (1988) model. There are three reasons
for this. First, with a negative population growth rate all models based on
Solow (1956) share the same problems. Anal3rtically a solution might not
be possible with a negative population growth rate n. Although this is only
a relevant case in theory, as in empirics the depreciation rate of physical
capital plus the rate of technological progress is higher than the value of the
^ We have offered an explanation in the models developed in chapters 8 and 9,
Models 3 to 6, where the ageing process in endogenous.
181
negative population growth rate,^ the problematic economic interpretation

of the model however, remains. The lower the population growth rate, the
richer the country (in per capita terms). A zero or even negative population
growth rate improves the level of income even further. This unrealistic feature
is not present in the Lucas (1988) model. The second reason to employ Lucas
(1988) in this research is that Lucas (1988) is a model in which economic
growth appears as a result of a time-allocation decision by individuals who
maximize their utility. This allows us to introduce endogenous population (or
rather, endogenous fertility) as a result of the individuals' behaviour. The third
reason is that in this thesis we are interested in human capital and education
as engines of growth. The literature reviewed focuses either on human capital
or technological progress as growth determinants. Because we are interested in
how education influences fertility and both education and fertility influences
economic growth we have taken the Lucas (1988) model as a starting-point,
augmenting it with endogenous population growth. If one wanted to focus
instead on technological progress one could have chosen the 'technology and
innovation based growth models' based on Romer (1986, 1990) and others.
In Model 3 endogenous population growth is introduced into the Lucas
(1988) model as a result of a time-allocation decision. The time-allocation
decision itself is endogenous in Model 3, i.e. the time spent in the production sector, in the education sector and in the domestic sector is a result
of the individual's utility maximization. We define fertility as a function of
the individual's willingness to spend time at home bringing up children. As
a result, fertility is the outcome of the individual's decision to allocate time
to the domestic sector. Fertility as the outcome of a time-allocation decision
in an economic growth model with infinite horizon is new in the literature.
This approach is different from the existing literature which features endogenous population growth or endogenous fertility, where individuals maximize
their utility function by choosing consumption and the number of children.^
In these models the number of children are a result of the quantity-quality
approach. As parents are interested in their children's education (their quality) they might choose to have fewer children but educate each child better.
One drawback of this approach is that childlessness is not a possible outcome
in these models. As a result, the population growth rate in existing literature
is determined by the number of children and by the mortality rate (the latter
assumed to be exogenous and constant^).
The key variable determining population growth in our models is not the
number of children per individual but the individual's time-allocation for the
domestic sector. This mirrors the empirical fact that better-educated women,
and men and individuals who are self-employed and face a heavy workload,
^ See chapter 3.
^ See, for example, Blackburn and Cipriani (2002), Kremer and Chen (1999), Becker
et al. (1990), Becker and Barro (1988).
^ Our analysis makes the same assumption regarding the mortality rate.
182
10 Conclusions
spend more time in production and education and are less likely to have
children at all.^ For example, a quantitative solution of Model 3 in section
8.1.4, featuring our approach to model endogenous fertility, shows that it is
rational for individuals not to have children. The steady state is a situation
where {1 ~ u b) 0^ i.e. no time is spent at home bringing up children.
The individuals allocate their time between the education and production
sector. Childlessness is a possible outcome in this model. Thus this approach
more appropriately explains childlessness compared with the current quantityquality approach in the literature.
Another augmentation of current models of economic growth is that in
the Silver Growth Models endogenous population growth depends on the age
structure, as modelled in section 8.2. and applied in Model 4 and Model 6.
This allows more realistic representation of population growth, as population growth depends on the share of young people of reproduction age in a
population.
Adding the possibility of spending time at home alters the result of the
original Lucas (1988) model considerably. In Lucas (1988), the greater the
time spent in education 6 = (1 tt), the higher the steady state growth rate
of human capital gh and the growth rate of income and consumption per
head. As the time spent in education b and the time spent in production u
always add up to one, this implies that the more time individuals spend in
production, the lower the economic growth. This is an unrealistic result as it
implies an optimum where all individuals study 100 per cent of their time and
spend no time in the production sector. A benevolent planner would set the
exogenous parameters in a way to achieve just that, as this would result in
the maximum growth possible. This is because in Lucas (1988) there is only
one growth engine, the time spent in education which determines the amount
of human capital.
In Model 3 and in the following models there are two growth engines.
The growth engines are both time spent in education b and time spent in
production u. The result shows that w is a positive function of b. The higher
b and u are, the higher the economic growth gy. As b and u are positively
related, compared to Lucas (1988) where they are negatively related, there
is a 'natural' limit to the amount of time which can be spent in education.
In Lucas (1988) this limit for b is not given, except the limit that b cannot
exceed 1. Also, Lucas (1988) predicts - as 6 and u are negatively related that an individual who has accumulated a high level of human capital spends
relatively little time in the production sector. This is not a sensible outcome
as one can expect a well-educated individual to spend a long time in the
labour market, i.e. the production sector. Model 3, however, predicts that an
The database with regards to men and children or childlessness is, so far, very
thin. For some data on Germany, see Riirup and Gruescu (2003), 15f. and Schmitt
(2004).
183
individual spends more time in the production sector the more it has studied,
i.e. the more time it has spent in the education sector.
In Models 3 to 6 developed in this thesis, the time spent in production
and education determines the time spent in the domestic sector bringing up
children. The time spent bringing up children in turn determines the population growth rate. In Model 4 we combine the time-allocation decision with
the variable for an ageing population, the dependency ratio D (which was
introduced into Lucas (1988) in section 7.2, Model 2). It is then possible to
distinguish endogenous population growth and endogenous workforce growth.
Now we have g{i+D) " 0 which allows us to picture the endogenous ageing
process of the population. Model 4 shows how the inclusion of the dependency
ratio D affects the result of Model 3 (i.e. individuals choose not to have children at all). The inclusion of the variable D has a negative effect on economic
growth. But, because of D, individuals decide to spend time at home to have
and bring up children. The individuals know that a high D^ which is caused
by a low fertility rate, has a detrimental effect on their economic situation.
This knowledge influences their decision about time allocation.
Model 3 and Model 4 are both limited because it is only anal3îcally
possible to derive endogenous population growth and workforce growth in
the steady state. When the economy is in disequilibrium we do not know
these two growth rates. Hence, we have called these two models "Models with
quasi-endogenous population".
Model 5 and Model 6 are further developments of Model 3 and Model
4 respectively. In Model 3 and 4, the time spent in the production sector
and the time spent in the education sector had the same effect on the time
spent in the domestic sector, for example, if 40 percent of the time is spent
in eduction, the time spent at home was reduced by these 40 percent. In
Model 5 this assumption has been altered by the introduction of a factor
X which varies the effect of the time spent in education on the time spent
bringing up children (as in 6^). With this factor we can model an economy in
which time spent in education (hence becoming better qualified) has a strong,
detrimental effect on having children {x < 1). In the examples in chapter 9
this happened in economy A. Thus, the better individuals are educated, the
less likely they are to have and bring up children. Germany and Italy are
examples of this. The other model economy was economy B where spending
time in education and thus being better educated had only a small effect on
having and bringing up children [x > 1). Sweden and Norway are examples
of this economy. Analytically, the introduction of the factor x is essential
in determining a fully endogenous growth rate for the population and the
workforce. In Model 5 and Model 6 we have determined endogenous population
growth and workforce growth in equilibrium and in disequilibrium. These two
models advance Model 3 and Model 4 in this respect.
In Models 5 and 6 steady state growth is not possible if the dependency
ratio D continues to grow, thus changing in absolute level (1 + J9). This
affects the relevant growth rates and their levels in the economy. The growth
184
10 Conclusions
rate g(i-^D) > 0 affects the steady state level of income per head. If t h e age
structure is constant, i.e. g{i-^D) = 0^ steady state growth in t h e economy
is possible. In other words, to achieve steady s t a t e growth, t h e economy has
t o fulfill t h e condition t h a t t h e workforce growth rate equals t h e population
growth rate, i.e. gi = gn- We have found t h e following answer to t h e questions
posed in t h e introduction: "/n an ageing society when is an economy capable
of steady growth at a constant rate?^\ As a result of Model 3, 4, 5 and 6
steady state economic growth is not possible in an economy with an ageing
population. T h e reason is t h a t these models include endogenous population
and workforce growth. This in t u r n determines D which affects the growth
rates of t h e relevant variables as they are functions of (1 -\- D), This was not
t h e case in Model 1 and Model 2 where steady state growth in an economy
with an ageing population was possible as long as ^(i+p) = const. Table 10.2
shows why t h e results differ.
Table 10.2. Growth rate Qy as a function of D.
Model Qy is a function of
1,2
Qy = f{g{i+D)),
3,4,5,6 Qy
(-)
= f{l + D),{-)
In Model 1 and Model 2 the growth r a t e of income per head is a function

of t h e growth rate of t h e dependency ratio g(i-^D)i i-^- gii+D) has a negative
effect on gy. As long as t h e growth r a t e gîô) is a constant steady state
growth of gy is possible. T h e introduction of endogenous population in Models
3 t o 6 alters this result. In these four models t h e growth r a t e of income per
head is a function of t h e dependency rate itself, b u t not of its growth rate.
This can be compared to t h e scale effect of t h e population size (see Models
of Group A, where gy = f{L), table 2.3 in subsection 2.3.3) which could not
be supported empirically. Here we have a scale effect given by t h e size of t h e
dependency ratio. We still have a scale effect, b u t t h e i m p o r t a n t difference is
t h a t this scale effect is supported empirically.^ We suggest t h a t t h e relevant
scale is not population but t h e ratio between non-working population and
working population. As a result, steady state growth of income per head is
not possible if D is not a constant. An economy would not reach a steady
state with a constant growth rate of income per head of t h e population if
t h e r a t e of growth gîJ^n) is at a positive (or negative) rate. This also has
implications for economic policy. In Model 1 and Model 2, t h e growth rate
of t h e dependency ratio 5'(I+D) = gN gL must decline in order to boost
economic growth (see table 10.2). This is possible with a fertility rate t h a t is
permanently on a higher level (then g^ is higher). In Models 3 t o 6 the ratio
See, for example, OECD (1998a), (2002).
185
(1 + D) = ^ has to decline. This is possible with a one-oflF increase in fertility,

i.e. L increases. Another possibility would be to increase the retirement age.
Growth theory had and still has a tendency to analyse steady states. The
finding, that steady state growth is not possible in an economy with an ageing
population (based on the models with endogenous population developed in
this thesis), suggests that future growth theory should focus more on growth
paths that are off the equilibrium path. As the calculations of growth paths
which are not an equilibrium are far more costly, the wider use of computer
and simulation programmes for growth theorists will be inevitable.^^
The models developed in this thesis are regarded as a first step towards
making economic growth theory more usable for questions with regard to an
ageing and declining population and their effect on economic growth. Regardless of the economy, a population cannot grow or decline forever. In addition,
this growth and decline determines the ageing process. It is important to know
what exactly determines the population growth rate. Therefore the endogeniety of population growth is here regarded as a feature of utmost importance.
We have endogenised the fertility by defining it as a function of the individual's decision to spend time in the domestic sector. The other determinant of
population growth, the mortality rate, is regarded as exogenous and constant
in these models. This assumption was employed to focus on the relevance of
fertility on the ageing process and economic growth. Nevertheless, the determinants of the mortality rate are important for the ageing process in an
economy and therefore relevant for economic growth. Exploring the determinants of mortality and their effects on economic growth (and vice versa) via
the ageing process of the population is a question for further research.
The main result for economic growth theory is that, in an economy, where
the population is ageing, steady state economic growth is not possible. A
steady state growth is only possible, if the age structure of the population is
constant. Economic growth in an economy where the population is ageing, i.e.
the age structure is not constant, is only possible during the transition of this
economy towards its steady state.

The ageing of the population has a negative effect on economic growth as
shown in Part II of this thesis. This result has been demonstrated before
in numerous simulations and models with overlapping generations but not
in neoclassical growth theory with infinite horizon. Economic policy which
favours and improves the conditions for economic growth is even more important in a economy with an ageing population. Two policies which are regularly
discussed to improve economic growth are family policy (to ease the coordination of work and family life, aiming at a higher birth rate) and education
^ Jones (2004), 2, suggests the main question in growth theory is "Why is there
growth at all?" instead of focusing on the question of steady state growth.
186
10 Conclusions
policy. ^^ Although t h e quintessence of the on-going discussion is "a bit of b o t h

is best", one strand of t h e literature states t h a t education policy which leads
t o more h u m a n capital accumulation has a relatively more positive effect on
economic growth, pointing out t h a t a higher birth rate means a higher youth
dependency ratio and no improvement in terms of income per head of t h e
population.-^^ Another strand states t h a t a higher fertility r a t e is necessary to
lessen t h e effects of an ageing and declining population on economic growth. ^^
This thesis leans towards family policy over education policy as a growth
enhancing policy. Here, policy measures are seen in t h e context of t h e individuals' time-allocation decision. Policy measures influence this decision. Hum a n capital is - as in the original Lucas (1988) model - one engine of economic
growth. However, t h e age structure has a negative impact. T h e amount of
accumulated human capital is t h e result of an individual's time-allocation decision, and so is t h e age structure. This decision is t h e reason why family
policy can act as a policy which enhances h u m a n capital and t h u s growth.
As family policy has a positive influence on t h e fertility rate, this means t h a t
time spent at home is more productive. As a result individuals are t h e n able
t o devote more time to education. This means t h a t individuals spend more
time in production as this in t u r n is positively related t o t h e amount of time
spent in education. As shown in chapter 9, family policy does lead to a permanently higher steady state growth rate. It also lifts the fertility r a t e onto
a permanently higher level which has a positive effect on t h e age structure of
t h e population. To summarize this first conclusion, we suggests family policy
as economic growth policy.
T h e second conclusion is t h a t for an economy with an ageing population
t o guarantee economic growth, it is more i m p o r t a n t t o increase t h e time spent
in education t h a n it would be for an economy with a 'young' population. In
an 'old' economy, i.e. where t h e dependency ratio D is high, t h e time spent
in education is rather low and t h e time spent in production rather high.^^
As t h e time spent in education is crucial for economic growth, with an ageing population, economic policy has t o increase this time. This can b e done
through t h e family policy measures, i.e increasing t h e domestic sector productivity (7 t ) a n d / o r decreasing t h e effect of education time on t h e fertility r a t e
{x t ) . As a result, individuals spend more time in education and production.
T h e following tables show the growth rate Qy (in per cent) with ^ = 0.1, for
different values of x and D.
In this thesis, family policy is represented in terms of increasing the productivity of the domestic sector and improving the co-ordination of family and
work/education. Education policy is represented in terms of increasing the productivity of the education sector.
See, for example, Borsch-Supan et al. (2004).
See Prognos (2003), (2005) and Riirup and Gruescu (2003).
The time spent in production is still positively related to the time spent in education. If (the rather low) h rises, so does (the rather high) u.
187
Table 10.3. The growth rate of income per head g* in per cent, with 7 = 0.25, for
different x and D.
X
0.4
0.5
0.6
0.7
0.8
D = 1.2
-0.813
-0.272
0.339
1.164
2.709
D = 1.4
-1.176
-0.787
-0.412
-0.011
0.519
Table 10.4. The growth rate of income per head g* in per cent, with 7 = 0.27, for
different x and D.
X D = 1.2 D = 1.4
0.4 -0.445 -0.857
0.5 0.265 -0.336
0.6 1.153
0.243
0.7 2.527
1.010
0.8 5.623
2.405
T h e tables show t h a t t h e highest growth of income per head is possible

with a high x (in t h e limit 0 < x < 1) and a high(er) 7. A high x implies t h a t
co-ordination of education with bringing up children is easier t o fulfill. A high
7 means t h a t t h e total time spent at home is more productive in terms of t h e
fertility rate. These policy parameters are less effective if D is higher.
T h e third conclusion for economic policy is very different from t h e Lucas (1988) model. T h e Lucas (1988) model suggests education policy as an
economic growth policy. In Lucas (1988), increasing t h e productivity of t h e
education sector E has a positive effect on b}^ As a result, t h e growth rate
of income and h u m a n capital per head is higher with a higher level of ^. In
our models t h e effect of an increase in E on t h e time spent in education b is
positive only in t h e short-term during t h e transition phase. ^^ Over t h e longterm, i.e. once t h e economy has reached its steady state, t h e effect is negative
because individuals spend less time in education t h a n before. T h e following
table 10.5 compares t h e effect of an increase in E on t h e time spent in t h e
education and production sector.
There are two reasons for this result which suggests t h a t education policy, i.e. increasing E is detrimental t o economic growth in t h e long-term.^^
First, individuals adjust their behaviour in a different way if t h e parameter
^^ In Lucas (1988), {1 - u) = b
^^ See chapter 9.
17
Education policy is detrimental when comparing two steady states: one steady
state before productivity E is increased and one steady state after the increase
188
10 Conclusions
Table 10.5. The effect of an increase in E on the steady state in Lucas (1988) and
in Models 5 and 6.
Lucas (1988) Models 5, 6
Sb*
8E
6u*
>0
<0
<0
<0
E changes. This is because there is the third option how to spend the time
which alters the trade-off the individual is facing. Second, the inclusion of the
dependency ratio D and its growth rate P ( I + D ) triggers a different transition
path towards the new steady state. As the models developed in the second
part of this thesis deliver more realistic results regarding the engines of economic growth (i.e. b and u), the conclusions for economic policy are seen as
reasonable.
Up until now, endogenous growth theory has implied that education policy
increases economic growth as shown in Lucas (1988). As demonstrated in
this thesis, including endogenous population and workforce growth in the
Lucas (1988) model leads to new policy implications. In other words, family
policy as modelled here (raising 7 or x) increases economic growth. This is the
result of modelling population growth and workforce growth as endogenous
variables. The introduction of the dependency ratio D into the models also
has implications for economic policy. The higher D is, the less successful
the policies. Obviously, because economic growth has several determinants,
an effective growth policy must embrace several areas, labour market policy,
pension policy and innovation policy among others.^^ Family policy is part of
this mix. Family policy, as defined above, functions as a policy which increases
the individual's time spent accumulating human capital. As a result, family
policy as modelled in this thesis not only has a positive effect on the fertility
rate, but also on the growth rate of human capital. Therefore we have shown
here that family policy, via its influence on human capital accumulation and
on the fertility rate, acts as an economic growth policy.
18
in E. The new steady state is lower than the initial one, as individuals spent less
time in education.
For an analysis of how a policy mix can boost economic growth in Germany, see
Deutsche Bundesbank (2004), Deutsche Bank Research (2003), OECD (2002).
n
Appendix
11.1 Derivations
The following derivations were calculated with the software Mathematica 5.1.
In case the sign of the formula was not obvious, the formula was calculated
with the parameters used throughout the thesis. The parameters were set at
the standard values cr = 3, p = 0.033, (^ = 0.035, d = 0.01. The parameters
which were varied to guarantee that the sign does not change when the underlying parameter changed, were ^ , 7 , D and x. On average the values were
E = 0.1, 7 = 0.2, D = 1.2 and x = 0.5.
11.1.1 Lucas (1988), section 4.2.
dv^ _
1
~dE ~ ~E-a
du*
dn
"^
E - n - p
< 0 forn < 0,n > 0.
E'^ -a
1
< 0 for n > 0
E 'a
du* _ 1
> 0 forn < 0
dn
E 'a
dE
dn
190
11 Appendix

db* ^
, du*
> 0 and < 0
db*
, du*
^
<Oand > 0
db*
, du*
-<Oand > 0
dgl
i<
Economy A^ with 0 < x < 1.
9&*
d-f
1-x
5x
97
7^
( 1
1^
, X ,
Ê^
= __.^(^-.).(,,)^<0
^;^
^(l-x)-x
(l-a;)2^
7 (1 x)
9u* _ (1 - g) X ( f ) - ^ + T ^
a^
;-(i-x)
7^
(1 - g) ( f
7
) ^
11.1 Derivations
9u*_
^(l--)-(f)^-((Tr^ + i ^ ;
dx
dE
E-{l-x)
Ê'
Ê'
dj
dx
1 X
^ E'
l-x
191
>0
Ê'
>0
^{l-x)-x^
{l-xY'

Economy A, with 0 < x < 1.
d-j
9x
9u* _
97
{1 +
D)-E-{1-X)
db*
dE
^x
iTTTnVEy'^^
(l + D ) - 2 . ( i _ 3 ; ) <
db* _
IX
dD
{l +
^(l + ) ) - ^
{j^^^^)-^+^
DY-E-{l-x)
^(l-ar)-x
<0
(1 - x)2
(l + D ) 2 . ( l - a ) . x - ( ( ^ + ^ ) - ^ " ) - ^ + T ^
7 (1 x)
72
> 0
du*
a^
(1 + i>)(^^^"^-^^l!-l^=S^^^^
_ ^(1 _ .); ^(n|fe)x^
;(i-x)
^ _ ^
^
7
192
11 Appendix
du*
( l + I ^ ) - ^ - ( l - a ) - ( M t e ) ^ - ( n(l-a)-a^
rki +
^ ? , l f ^ ^ ).
^ " '(1-x)^
dx
du* _
(1 + D)-{1-
(T) a , . ( a + ^ ) - T ^ ) - i + T ^
ai?
dE
1-x
{l + D)-E-{l-x)
fl*
r-(
'^dy _ -^
d-r
'^
{l + D)-E
"i-i+ii?
\(I+D)-E)
{i +
D)ii-x)
>0
M - 2^:iawir^<o
ar*
(1 + r')2 (1 - x)
^ Q
List of variables
Y national income, aggregate output {y income per head)

K stock of physical capital {k physical capital per head)
H stock of human capital (h human capital per head)
N size of the population
L size of the workforce
A technology level
Qi growth rate of variable i = Y,K,H,..,
n population growth rate
D dependency ratio, D = ^ ~ ^
a production elasticity of physical capital
(3 production elasticity of labour
s savings rate
C aggregate consumption (c consumption per head)
5 depreciation rate
p discount rate
a elasticity of marginal utility of consumption
J Hamiltonian function
E productivity of the education sector, index for education policy
7 productivity of the domestic sector, index for family policy
/i shadow price
u time spent in the production sector
b time spent in the education sector
X factor that determines effect of studying time b on time spent in the
domestic sector (1 u b^) in Model 5 and 6
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Population Ageing

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Russel Cooper/Gary Madden (Eds.)

With 7 Figures and 32 Tables

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Dedicated to Berta Dittrich and Aurora Gruescu

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Part I Population in models of economic growth

2.1 General literature on ageing population, declining population

Conclusions on population and economic growth in

Effects of a declining population in a model of economic

Part II Models of economic growth with an ageing population

Models of "Silver Growth"

Models with exogenous population

Models with quasi-endogenous population

Models with endogenous population

Population in models of economic growth

1.1 Motivation and main question of this research

1.2 Organization of the research

slightly different way: "In an ageing society, when is an economy capable of

1.2 Organization of t h e research

1.3 The ageing population: Trends in Germany, United

1.3 The ageing population: Trends

This is now occurring t o an extent not experienced in t h e past. T h e United

1950 1975 2000 2025 2045

0-14 23.2 21.5 15.5 12.2 12.4

Table 1.2. Broad age groups, UK

1950 1975 2000 2025 2045

0-14 22.3 23.3 19.0 15.2 15.0

Table 1.3. Broad age groups, USA

1950 1975 2000 2025 2045

0-14 27.0 25.2 21.7 18.5 18.5

1.3 The ageing population: Trends

as a percentage of t h e population at t h e beginning of t h e time period. T h e

1950-1955 1975-1980 2000-2005 2025-2030 2045-2050

1950-1955 1975-1980 2000-2005 2025-2030 2045-2050

1950-1955 1975-1980 2000-2005 2025-2030 2045-2050

T h e projections for t h e future show t h a t the growth rates for t h e 6 0 +

both.^^ In t h e earlier stages of t h e 'demographic transition'-^^, t h e decHne in

constant life expectancy

We differentiate between the following cases:

1.3 The ageing population: Trends

(5) W i t h a constant population size and a constant mortality of t h e elderly,

The size and the growth rate of population

2.1 General literature on ageing population, declining

threat to the Fatherland? War or a declining birth rate?"^ He suggested that

2.1 General literature

power (understandably, with reference to Germany). Economic consequences

2.2 Population in economic growth t h e o r y with

2.2 Population in exogenous growth models

Kurz (1982) comes to t h e conclusion t h a t t h e neoclassical growth theory is

2.3 Population in endogenous growth models

2.3 Population in economic growth theory with

2.3 Population in endogenous growth models

h u m a n capital devoted to research, rises. In this situation, aggregate o u t p u t

^'^ Romer (1990a), S93.

2.3 Population in endogenous growth models

^^ Grossman and Helpman (1991a), 57.

by t h e size of t h e market for skilled labour.^^ T h e larger t h e endowment of

In t h e models reviewed above t h e size of t h e population has an influence

2.3 Population in endogenous growth models

rate Qy itself (not t h e level of y!) grows at t h e same rate as t h e population.