The Solow Growth

Model (Part One)

The steady state level of capital and

how savings affects output and
economic growth.
 Model Background

• Previous models such as the closed economy and

small open economy models provide a static view
of the economy at a given point in time. The Solow
growth model allows us a dynamic view of how
savings affects the economy over time.
 Building the Model: goods market supply

• We begin with a production function and assume constant

returns.
Y=F(K,L) so… zY=F(zK,zL)
• By setting z=1/L we create a per worker function.
Y/L=F(K/L,1)
• So, output per worker is a function of capital per worker. We
write this as,
y=f(k)
 Building the Model: goods market supply

• The slope of this function change in y

is the marginal product of y
MPK 
change in k
capital per worker. y=f(k)
MPK = f(k+1)–f(k)
• It tells us the change in Change in y

output per worker that

results when we increase Change in k
the capital per worker by
one.
k
 Building the Model:
goods market demand

• We begin with per worker consumption and investment.

(Government purchases and net exports are not included in the
Solow model). This gives us the following per worker
national income accounting identity.
y = c+I
• Given a savings rate (s) and a consumption rate
(1–s) we can generate a consumption function.
c = (1–s)y …which makes our identity,
y = (1–s)y + I …rearranging,
i = s*y …so investment per worker
equals savings per worker.
 Steady State Equilibrium

• The Solow model long run equilibrium occurs at the

point where both (y) and (k) are constant. These are
the endogenous variables in the model.
• The exogenous variable is (s).
 Steady State Equilibrium

• By substituting f(k) for (y), the investment per worker function

(i = s*y) becomes a function of capital per worker (i
= s*f(k)).
• To augment the model we define a depreciation rate (δ).
• To see the impact of investment and depreciation on capital
we develop the following (change in capital) formula,
Δk = i – δk …substituting for (i) gives us,
Δk = s*f(k) – δk
 Steady State Equilibrium
• If our initial allocation of (k)
were too high, (k) would
decrease because depreciation
exceeds investment.
s*f(k),δk δk
• If our initial allocation were too
low, k would increase because
investment exceeds
depreciation. s*f(k*)=δk* s*f(k)
• At the point where both (k) and (y)
are constant it must be the case
that, Δk = s*f(k) – δk = 0 …
or, s*f(k) = δk k
…this occurs at our equilibrium klow k* khigh
point k*.
• At k* depreciation equals
investment.
 Steady State Equilibrium (getting there)

• Suppose our initial

allocation of (k1) were too
low.

s*f(k),δk δk
k2=k1+Δk
k3=k2+Δk
k4=k3+Δk s*f(k*)=δk* s*f(k)

k5=k4+Δk
…
This process k
k1 k2 k3 k4 k5 k*
continues until we
converge to k*
K2 isKstill
3 is
K4still
too
is
K5still
is
too
still
tootoo
low low
so… low
so…low
so… so…
 A Numerical Example

• Starting with the Cobb-Douglas production

function we can arrive at our per worker
production as follows,
Y=K1/2L1/2 …dividing by L,
Y/L=(K/L)1/2 …or,
y=k1/2

• recall that (k) changes until,

Δk=s*f(k)–δk=0 ...i.e. until, s*f(k)=δk
 Changing the exogenous variable - savings

• We know that steady state s*f(k),δk δk

is at the point where s*f(k*)=δk*
s*f(k)
s*f(k)=δk
• What happens if we s*f(k*)=δk* s*f(k)
increase savings?
• This would increase the
slope of our investment k
k* k**
function and cause the
function to shift up.
• This would lead to a higher
steady state level of capital.
• Similarly a lower savings
rate leads to a lower steady
state level of capital.
 Conclusion

• The Solow Growth model is a dynamic model that allows

us to see how our endogenous variables capital per
worker and output per worker are affected by the
exogenous variable savings. We also see how parameters
such as depreciation enter the model, and finally the
effects that initial capital allocations have on the time
paths toward equilibrium.
• In the next section we augment this model to include
changes in other exogenous variables; population and
technological growth.
The Solow Growth
Model (Part Two)

The golden rule level of capital,

maximizing consumption per
worker.
 Model Background

• As mentioned in part I, the Solow growth model allows us a

dynamic view of how savings affects the economy over
time. We also learned about the steady state level of capital.

• Now, we assume policy makers can set the savings rate to

determine a steady state level of capital that maximizes
consumption per worker. This is known as the golden rule
level of capital (k*gold)
 Building the Model:
• We begin by finding the steady state
consumption per worker.
From the national income accounts
identity, y=c+i
we get c=y–i
• We want steady state “c” so we
substitute steady state values for both f(k*),δk* δk*
output (f(k*)) and investment which
equals depreciation in steady state (δk*)
giving us c*=f(k*) – δk* f(k*)

• Because, consumption per worker is the

difference between output and c*gold
investment per worker we want to
choose k* so that this distance is
maximized.
k*
• This is the golden rule level of capital k*gold
k*gold
• A condition that characterizes the Above k*gold,
golden rule level of capital is Below k*gold,
MPK = δ increasing k* increasing
increases c* k* reduces
c*
 Building the Model:

• While the economy moves

toward a steady state it is
not necessarily the golden
rule steady state. f(k*),δk* δk*
• Any increase or decrease
f(k*)
in savings would shift the
sf(k) curve and would sgoldf(k*)
result in a steady state sgoldf(k*)
with a lower level of
consumption.
k*
k*gold

To reach the The economy

golden rule needs the right
steady state… savings rate.
The Transition to the Golden Rule Steady State

• Suppose an economy starts

with more capital than in the
golden rule steady state.
• This causes an immediate
increase in consumption
and an equal decrease in
Output, y
investment.
• Over time, as the capital
stock falls, output, Consumption, c
consumption, and
Investment, i
investment fall.
• The new steady state has a
higher level of consumption t0 Time
than the initial steady state.
At t0, the savings
rate is reduced.
The Transition to the Golden Rule Steady State

• Suppose an economy starts

with less capital than in the
golden rule steady state.
• This causes an immediate
decrease in consumption
and an equal increase in
Output, y
investment.
• Over time, as the capital Consumption, c
stock grows, output,
consumption, and
investment increase. Investment, i
• The new steady state has a
higher level of consumption t0 Time
than the initial steady state.
At t0, the savings
rate is increased.
 Conclusion

• In this section we used our knowledge that savings

affects the steady state and chose the savings rate to
maximize consumption per worker. This is known as
the golden rule level of capital (k*gold)
• In the next section we augment this model to include
changes in other exogenous variables; population and
technological growth.
 The Solow Growth
Model (Part Three)

The augmented model that includes

population growth and technological
progress.
 Model Background

• As mentioned in parts I and II, the Solow growth

model allows us a dynamic view of how savings
affects the economy over time. We learned about
the steady state level of capital and how a golden
rule steady state level of capital can be achieved by
setting the savings rate to maximize consumption
per worker. We now augment the model to see the
effects of population growth and technological
progress.
 Steady State Equilibrium

• By expanding our model to include population growth our model

more closely resembles the sustained economic growth
observable in much of the real world.
• To see how population growth affects the steady state we need
to know how it affects the accumulation of capital per worker.
When we add population growth (n) to our model the change in
capital stock per worker becomes…
Δk = i – (δ+n)k
• As we can see population growth will have a negative effect on
capital stock accumulation. We can think of (δ+n)k as break-
even investment or the amount of investment necessary to keep
capital stock per worker constant.
• Our analysis proceeds as in the previous presentations. To see
the impact of investment, depreciation, and population growth
on capital we use the (change in capital) formula from above,
Δk = i – (δ+n)k …substituting for (i) gives us,
Δk = s*f(k) – (δ+n)k
 Steady State Equilibrium with
population growth
Like depreciation, population
growth is one reason why the
• At the point where both capital stock per worker shrinks.
(k) and (y) are constant it Investment Break-even
must be the case that, Break-even investment
Δk = s*f(k) – (δ+n)k = 0 Investment (δ+n)k
…or,
s*f(k) = (δ+n)k
…this occurs at our s*f(k*)=(δ+n)k* s*f(k)
equilibrium point k*. Investment

k
k*

At k* break-even
investment equals
investment.
 The impact of population growth

An increase
• Suppose population growth in “n”
changes from n1 to n2.
Investment
• This shifts the line Break-even
representing population (δ+n2)k (δ+n1)k
Investment
growth and depreciation
upward.
• At the new steady state k2*
capital per worker and output s*f(k)
per worker are lower
• The model predicts that
economies with higher rates
of population growth will have k
lower levels of capital per k2* k1*
worker and lower levels of
income.
…reduces k*
 The efficiency of labour

• We rewrite our production function as…

Y=F(K,L*E)
where “E” is the efficiency of labour. “L*E” is a
measure of the number of effective workers. The
growth of labour efficiency is “g”.
• Our production function y=f(k) becomes output
per effective worker since…
y=Y/(L*E) and k=K/(L*E)
• With this augmentation “δk” is needed to replace
depreciating capital, “nk” is needed to provide
capital to new workers, and “gk” is needed to
provide capital for the new effective workers
created by technological progress.
 Steady State Equilibrium with population
growth and technological progress
Like depreciation and population
growth, the labour augmenting
• At the point where both technological progress rate causes
(k) and (y) are constant it the capital stock per worker to shrink.
must be the case that,
Break-even
Δk = s*f(k) – (δ+n+g)k = 0 Investment
investment
…or, Break-even
(δ+n+g)k
Investment
s*f(k) = (δ+n)k
…this occurs at our
equilibrium point k*.
s*f(k*)=(δ+n)k* s*f(k)
Investment

At k* break-even
k
investment equals k*
investment.
 The impact of technological progress
• Suppose the worker An increase
efficiency growth rate in “g”
changes from g1 to g2.
Investment
• This shifts the line Break-even
representing population (δ+n+g2)k (δ+n+g1)k
Investment
growth, depreciation, and
worker efficiency growth
upward.
• At the new steady state k2* s*f(k)
capital per worker and
output per worker are lower.
• The model predicts that k
economies with higher rates k2* k1*
of worker efficiency growth
will have lower levels of
capital per worker and lower …reduces k*
levels of income.
Effects of technological progress on the golden rule

• With technological progress the golden rule level of capital is

defined as the steady state that maximizes consumption per
effective worker. Following our previous analysis steady
state consumption per worker is…
c* = f(k*) – (δ + n + g)k*
• To maximize this…
MPK = δ + n + g
or
MPK – δ = n + g
• That is, at the Golden Rule level of capital, the net marginal
product of capital MPK – δ, equals the rate of growth of total
output, n+g.
Steady State Growth Rates in the Solow Model with
Technological Progress

Variable Symbol Steady-State Growth

Rate
Capital per k=K/(E*L) 0
effective worker

Output per y=Y/(E*L)=f(k) 0

effective worker

Output per Y/L=y*E g

worker

Total output Y=y(E*L) n+g

 Conclusion

• In this section we added changes in two exogenous

variables (population and technological growth) to the
Solow growth model. We saw that in steady state
output per effective worker remains constant, output
per worker depends only on technological growth, and
that Total output depends on population and
technological growth.