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used to sum up the contributions of various authors to a model of long-run economic growth within the framework of neoclassical economics. Contents: 1. Development of the model 2. Empirical evidence 3. Criticisms of the model 4. Graphical representation of the model 5. Mathematical framework 6. The model's solution 7. See also 8. References 9. External links

**1. Development of the model
**

The neo-classical model was an extension to the 1946 Harrod-Domar model that included a new term, productivity growth. The most important contribution was probably the work done by Robert Solow; [1] in 1956, Solow and T.W. Swan developed a relatively simple growth model which fit available data on US economic growth with some success. [2] Solow received the 1987 Nobel Prize in Economics for his work on the model. Solow also was the first to develop a growth model with different vintages of capital. [3] The idea behind Solow's vintage capital growth model is that new capital is more valuable than old (vintage) capital because capital is produced based on known technology and because technology is improving. [3] Both Paul Romer and Robert Lucas, Jr. subsequently developed alternatives to Solow's neo-classical growth model. [3] Today, economists use Solow's sources-of-growth accounting to estimate the separate effects on economic growth of technological change, capital, and labor. [3]

**1. 1. Extension to the Harrod-Domar model
**

Solow extended the Harrod-Domar model by:

• • •

Adding labor as a factor of production; Requiring diminishing returns to labor and capital separately, and constant returns to scale for both factors combined; Introducing a time-varying technology variable distinct from capital and labor.

The capital-output and capital-labor ratios are not fixed as they are in the Harrod-Domar model. These refinements allow increasing capital intensity to be distinguished from technological progress.

1. 2. Short run implications

no economic growth per-capita). Including non-zero technological progress is very similar to the assumption of non-zero workforce growth. This relationship was anticipated in the earlier models.• • • • Policy measures like tax cuts or investment subsidies can affect the steady state level of output but not the long-run growth rate. 3. in the very long-run capital accumulation appears to be less significant than technological innovation in the Solow model. At this point. because of the assumptions of no technological progress or labor force growth.g. e. percapita output is growing at the rate of technological progress in the "steady-state" (that is. the long-run rate of growth is exogenously determined in other words. Capital accumulation is in turn determined by the savings rate (the proportion of output used to create more capital rather than being consumed) and the rate of capital depreciation. in this case. Assuming for simplicity no technological progress or labor force growth. Assuming non-zero rates of labor growth complicates matters somewhat. Given a fixed stock of labor. but the basic logic still applies . it is determined outside of the model. 1. Growth is affected only in the short-run as the economy converges to the new steady state output level. The rate of growth as the economy converges to the steady state is determined by the rate of capital accumulation. compared with Kenya in the same time period which had a 15% saving rate and annual GDP growth of just 1%. the economy ceases to grow. . Singapore had a 40% saving rate in the period 1960 to 1996 and annual GDP growth of 5-6%. 4. A common prediction of these models is that an economy will always converge towards a steady state rate of growth. 1. diminishing returns implies that at some point the amount of new capital produced is only just enough to make up for the amount of existing capital lost due to depreciation. the rate of productivity growth).in the short-run the rate of growth slows as diminishing returns take effect and the economy converges to a constant "steady-state" rate of growth (that is. A country with a higher saving rate will experience faster growth. Assumptions The key assumption of the neoclassical growth model is that capital is subject to diminishing returns. However. however. and is retained in the Solow model. which depends only on the rate of technological progress and the rate of labor force growth. the impact on output of the last unit of capital accumulated will always be less than the one before. Long run implications In neoclassical growth models. in terms of "effective labor": a new steady state is reached with constant output per worker-hour required for a unit of output.

a few formerly poor countries. leading to over-optimistic investment. one observes a positive relationship. and trade policy with other countries. or different measurement metrics: • • Average Labor Productivity (ALP) is economic output per labor hour. say. but Robert J.. Variations in productivity's effects Within the Solow growth model. In a growing economy. not ALP. such as: • • Institutional arrangements Free markets internally. In other words. MFP is measured by the "Solow residual". Gordon says the weight to labor is more commonly assumed to be 75%. 5. so the denominator in the growth function under the MFP calculation is growing faster than in the ALP calculation. measuring in ALP terms increases the apparent capital deepening effect. 2. .like for instance saving rates. If the average growth rate of countries since. do appear to have converged with rich countries. Multifactor productivity (MFP) is output divided by a weighted average of capital and labor inputs. the opposite empirical result has been observed on average. MFP growth is almost always lower than ALP growth and growth. and actual recession. (Therefore. The model can be reformulated in slightly different ways using different productivity assumptions.1. capital is accumulated faster than people are born. even after convergence has occurred. GDP per capita in 1960). Hence.e. the Solow residual or total factor productivity is an often used measure of technological progress. the opposite of what is expected according to a prediction of convergence. Empirical evidence A key prediction of neoclassical growth models is that the income levels of poor countries will tend to catch up with or converge towards the income levels of rich countries as long as they have similar characteristics . The evidence is stronger for convergence within countries. and in the case of Japan actually exceeded other countries' productivity. 1960 is plotted against initial GDP per capita (i. Whether convergence occurs or not depends on the characteristics of the country or region in question. notably Japan.) Technically. some theorize that this is what has caused Japan's poor growth recently convergent growth rates are still expected. Since the 1950s.[citation needed] However. These observations have led to the adoption of the conditional convergence concept. For instance the per-capita income levels of the southern states of the United States have tended to converge to the levels in the Northern states. The weights used are usually based on the aggregate input shares either factor earns. This ratio is often quoted as: 33% return to capital and 66% return to labor (in Western nations). the developed world appears to have grown at a faster rate than the developing world.

it does not explain how or why technological progress occurs. but it has not: see: Solow computer paradox. as denoted by the slope of the production function. Limitations of the model include its failure to take account of entrepreneurship (which may be catalyst behind economic growth) and strength of institutions (which facilitate economic growth). almost none of their rapid growth had been due to rising per-capita productivity (they have a low "Solow residual"). n = population growth rate d = depreciation k = capital per worker y = output/income per worker L = labor force s = saving rate . From the production function. 4. output per worker is a function of capital per worker. If productivity were associated with high technology then the introduction of information technology should have led to a noticeable productivity acceleration over the past twenty years. Graphical representation of the model The model starts with a neoclassical production function Y/L = F(K/L). Econometric analysis on Singapore and the other "East Asian Tigers" has produced the surprising result that although output per worker has been rising. cross-country regressions. The production function assumes diminishing returns to capital in this model. 3. In addition. Some critics[who?][citation needed] suggest that Schumpeter’s 1939 Theory of Business Cycles.• Education policy Evidence for conditional convergence comes from multivariate. which is the orange curve on the graph. which endogenizes technological progress and/or knowledge accumulation. Criticisms of the model Empirical evidence offers mixed support for the model. rearranged to y = f(k). This failing has led to the development of endogenous growth theory. modern Institutionalism and Austrian economics offer an even better prospect of explaining how long run economic growth occur than the later Lucas/Romer models.

In a typical Cobb-Douglas production function the golden rule savings rate is alpha. so capital per worker increases. Right of point A where sy < (n + d)k. and thus output per worker increases. however. .Capital per worker change is determined by three variables: • • • Investment (saving) per worker Population growth. but eventually goes back to the steady state rate of growth which equals n. so capital accumulation increases. Therefore output per worker falls from y2 to y0. Where capital is increasing at a rate only enough to keep pace with population increase and depreciation it is known as capital widening. this is known as capital deepening. Initially the economy expands faster. There is now permanently higher capital and productivity per worker. the rate of population growth. it now has a second savings function s1y.capital stock declines as it depreciates. output per worker is constant. point y2 for example. increasing population decreases the level of capital per worker. The curves intersect at point A. as investment is not enough to combat population growth and depreciation. the saving per worker is greater than the amount needed to maintain a steady level of capital. in other words. When sy > (n + d)k. The model and changes in the saving rate The graph is very similar to the above. Saving per worker is now greater than population growth plus depreciation. capital per worker is falling. At the steady state. However total output is growing at the rate of n. output per worker correspondingly moves from y0 to y1. As can be seen on the graph. the "steady state". the blue curve. when the savings rate is greater than the population growth rate plus the depreciation rate. Left of point A. 4. The optimal savings rate is called the golden rule savings rate and is derived below. 1. Depreciation . It demonstrates that an increase in the saving rate shifts the function up. but economic growth is the same as before the savings increase. There is capital deepening from y1 to y0. then capital (k) per worker is increasing. shifting the steady state from point A to B. point k1 for example. when the green line is above the black line on the graph.

the population growth rate has now increased from n to n1. 3. Macro-production function This is a Cobb-Douglas function where Y represents the total production in an economy. I as a portion s of the total production Y. Savings function This function depicts savings. 5. this introduces a new capital widening line (n1 + d) 5. however. 1. An important relation in the macro-production function: which is the macro-production function divided by L to give total production per capita y and the capital intensity 'k. 2. A represents multifactor productivity (often generalized as technology). 2.4. 5. Change in capital . Mathematical framework The Solow growth model can be described by the interaction of five basic macroeconomic equations: • • • • • Macro-production function GDP equation Savings function Change in capital Change in workforce 5. The model and changes in population This graph is again very similar to the first one. K is capital and L is labor.

Growth in capital 2. 4. 6. 1. 5.The is the rate of depreciation. as it allows the following calculations: When there is no growth in A then we can assume the following based on the first calculation: Moving on: Divide the fraction by L and you will see that . Growth in the GDP 3. 1. The model's solution First we'll need to define some growth functions. Growth function for capital intensity 6. Solution assuming no multifactor productivity growth This simplification makes the solution's derivation more comprehensible. Change in workforce gL is the growth function for L.

By subtracting gL from gK we end up with: If k is known in the year t then this formula can be used to calculate k in any given year. Furthermore we know that . Differentiating we obtain: which is we know that is the population growth rate over time denoted by n. In the first segment on the right side of the equation we see that Deriving the Steady-state equation: where k = K/L and k denotes capital per worker.

where is the depreciation rate of capital. The same can be done if technological progress is included. The steady state consumption will then be: . In the steady state the change in must be 0. Hence we obtain: which is the fundamental Solow equation.

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