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economic development
chapter 4
solow growth model

economic development
chapter 4
solow growth model

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Rasheed zedan

Solow growth model

• In 1956 𝑠𝑜𝑙𝑜𝑤 introduce his model of economic growth

• Solow recognize the problem of rigid production

function in harrod-domar model

• Solow dropped the fixed coefficient production

function and replaced it by a neoclassical production

function that allows for more flexibility and

substitution b/w factors of production

• Like harrod –domar model 𝑠𝑜𝑙𝑜𝑤 model was

introduced to analyze industrialized economies

• But has been used to explore economic growth in all

countries including developing countries

Solow growth model

• Capital-output and capital-labor ratios are not fixed but

vary depending on the relative endowment of capital

and labor in the economy

• The 𝑠𝑜𝑙𝑜𝑤 model retains from hard-domar model the

assumption of constant returns to scale

• constant returns to scale : means that doubling the

amount of labor and capital leads to double the

amount of output

• In the 𝑠𝑜𝑙𝑜𝑤 model doubling the amount of capital can

be achieved by using a different combination of capital

and labor (the company can use more capital and less

labor or the opposite)

The basic equations in solow model

• The 𝑠𝑜𝑙𝑜𝑤 model can be understood by using all

key variables of per worker-term (capital per

worker, output per worker)

• We can do this by dividing both sides of equation 4-

1 by L we can get:

• Y/L=F(K/L,1) where

• Y/L= OUTPUT PER WORKER

• K/L=CAPITAL PER WORKER

• In this equation we can conclude that output per

worker is function of capital per worker

The basic equations in 𝒔𝒐𝒍𝒐𝒘 model

• Lower-case latters can represent quantities in per

worker term so

• y= output per worker = (Y/L)

• K= capital per worker=(K/L)

• So the first equation In 𝒔𝒐𝒍𝒐𝒘 model is:

• y=f(k)

• The solow model assume production function with

diminishing returns to capital

• diminishing returns to capital:with a fixed labor supply

increasing machines lead to increase output but the

addition to output from each new machine get smaller

and smaller

Figure 4-3 the production function in

𝒔𝒐𝒍𝒐𝒘 growth model

The basic equations in 𝒔𝒐𝒍𝒐𝒘 model

• In the above figure 4-3

• The slope of the curve decline as the capital stock

increase reflecting the assumption of diminishing

marginal product of capital

• The first equation of the model tells us that capital per

worker is fundamental to growth process

• In turn the second equation focuses on the

determinants of changes in capital per worker

• ∆𝒌 = 𝒔𝒚 − 𝒏 + 𝒅 𝑲

• Where:

• ∆𝒌 =change in capital per worker

• Sy =saving per worker

The basic equations in 𝒔𝒐𝒍𝒐𝒘 model

• This equation is very important because it implies that

the change in capital per worker (∆𝒌) is determined

by three things

• The ∆𝒌 is positively related to saving per worker

.because s is the saving rate and y is the income so

the term sy means saving per worker so as the saving

per worker increase investments will increase and

capital per worker k will increase

• The ∆𝒌 is negatively related to population growth

because growth in population means that labor force

will increase with no increase in investments means

that capital per worker will fall

• Depreciation erodes capital stock so each year the

amount of per worker capital fall by the amount of

depreciation

The basic equations in 𝒔𝒐𝒍𝒐𝒘 model

• Therefore saving increase capital per worker and

depreciation ,population growth decrease it

• If the saving per worker (𝒔𝒚) is greater than the

amount of capital needed to compensate labor and

depreciation (𝒏 + 𝒅)𝒌 then ∆𝒌 is positive number

meaning that capital per worker will increase this

situation is called capital deepening.

• capital deepening: economies in which workers have

access to more machines , computers and other

equipment these economies can produce more output

per worker

• If the amount of saving per worker is exactly equal to

the amount of capital needed to compensate labor and

depreciation this situation is called capital widening

The basic equations in 𝒔𝒐𝒍𝒐𝒘 model

• Capital widening: economies in which the widening of

saving is exactly equal to the expansion of labor force

and depreciation(this situation leads to no change in

capital per worker)

• Note :a country with a high saving rates can deepen

its capital and rapidly expand its capital per worker

providing the base for growth in output

• In hard-domar model saving play a central role in the

growth process

• In 𝑠𝑜𝑙𝑜𝑤 model relation b/w saving and growth is not

linear because of diminishing returns to capital in the

production function

• In addition 𝑠𝑜𝑙𝑜𝑤 model introduce the role of

population growth rate and allows for substitutions

b/w the factors of production

The 𝒔𝒐𝒍𝒐𝒘 diagram

The 𝒔𝒐𝒍𝒐𝒘 diagram

• The 𝑠𝑜𝑙𝑜𝑤 diagram consist of 3 curves

• The first is the production function y=f(k)

• The second curve is the saving function which can

be driven directly by multiplying both side of the

production function by the saving rate we get

sy=s× 𝒇 𝒌 because saving is assumed to be a fixed

fraction of income

• the third curve is the line (n+d)k which is a straight

line through the origin with the slope (n+d). This

line represent the amount if capital needed to

compensate the growth of labor force and

depreciation to keep capital per worker (k) constant

The 𝒔𝒐𝒍𝒐𝒘 diagram

• Note that: the second and third curves are

representation of the two right-hand terms of

equation }4-14{

• The second and third curves intersect at point A

where 𝒌 = 𝒌𝒐 at point A 𝒔𝒚 is exactly equal to (𝒏

The 𝒔𝒐𝒍𝒐𝒘 diagram

• Note: to the left of point A (𝒌 = 𝒌𝟏) the amount of saving

is greater than the amount needed to compensate the

labor force and depreciation (capital deepening) and the

economy continue to shift to the right until it reaches the

steady state point (A) in terms of production function

shifting to the right represent an increase in output per

worker from 𝒚𝟐 𝒕𝒐 𝒚𝒐

• To the right of point A. 𝒌 = 𝒌𝟐 the amount of saving 𝒔𝒚 is

smaller than the amount needed to compensate the

growth in labor force and depreciation 𝒏 + 𝒅 the

economy continue to shift to the left until it reaches the

equilibrium at point A . this shift to the left caused output

per worker to decline from 𝒚𝟐 𝒕𝒐 𝒚𝟎

The 𝒔𝒐𝒍𝒐𝒘 diagram

• Point A is the only place in which the amount of

saving 𝒔𝒚 is equal to the amount needed by the

labor force and depreciation 𝒏 + 𝒅 𝒌 so that the

amount of capital per worker 𝒌 remain constant

• Point A is called the steady state in 𝑠𝑜𝑙𝑜𝑤 model

• Output per worker at the steady state (𝒚𝒐) is

mentioned as the steady state, long run, potential

level of output per worker

• It should be noted that all values that remains

constant are expressed in per worker term

• However output per worker is constant the total

output grow at rate 𝒏

Changes in the saving rate and population

growth rate in the 𝒔𝒐𝒍𝒐𝒘 model

• Both harrod-domar and 𝑠𝑜𝑙𝑜𝑤 models put saving at

the core of the growth process

• In the harrod-domar model an increase in the

amount of saving leads directly to an increase in

aggregate output

• As shown in figure 4-5 increasing saving from 𝒔‘𝒕𝒐 𝒔

increasing saving means that saving per worker

increase and the saving function shift from 𝒔𝒚 to be

𝒔‘𝒚 so the amount of saving per worker is greater

than the amount needed to compensate labor and

depreciation (𝒏 + 𝒅)𝒌 so k increase from 𝒌𝒐 𝒕𝒐 𝒌𝟑

Figure 4.5 an increase in saving rate

Changes in the saving rate and population

growth rate in the 𝒔𝒐𝒍𝒐𝒘 model

• And the output per worker increase from 𝒚𝒐 𝒕𝒐 𝒚𝟑 and

the economy shift to a new long run equilibrium at

point B

• Therefore increasing the saving rate means that

investment will increase which will lead to increase per

worker capital

• The 𝑠𝑜𝑙𝑜𝑤 model predicts economies that save more

have higher living standard than those saving less

• The increase in per capita income however is smaller

than for a similar increase in 𝒔 in the harrod-domar

model because the 𝑠𝑜𝑙𝑜𝑤 model has diminishing to

returns in production

Changes in the saving rate and population growth

rate in the 𝒔𝒐𝒍𝒐𝒘 model

• Higher saving also lead to a temporary increase in

the economic growth rate as the steady state shifts

from A to B

• However the increase in the saving rate does not

lead to a permanent increase in the long run rate of

output growth rate which remain at n

• The solow diagram also can be used to evaluate the

impacts of a change in the population growth rate

• An increase in the population growth rate from

𝒏 𝒕𝒐 𝒏‘ rotates the capital widening line to shift

from (𝒏 + 𝒅)𝒌 to (𝒏‘ + 𝒅)𝒌 as shown in fig.4-6

Fig. 4.6: The effect of Population Growth

in the Solow Model

Changes in the saving rate and population growth

rate in the 𝒔𝒐𝒍𝒐𝒘 model

• As a result of increasing the population growth rate

the labor force increase and saving per worker

decline so the capital per worker falls from

𝒌𝒐 𝒕𝒐 𝒌𝟒 and the economy shift to a new steady

state C saving per worker falls from 𝒔𝒚𝒐 𝒕𝒐 𝒔𝒚𝟒

,output per worker also falls from 𝒚𝒐 𝒕𝒐 𝒚𝟒

• Thus an increase in the population growth rate

leads to lower average income in the 𝒔𝒐𝒍𝒐𝒘 model

• With a higher population growth rate ,Y need to

grow faster to keep y constant

Changes in the saving rate and population growth rate in

the 𝒔𝒐𝒍𝒐𝒘 model

• The 𝑠𝑜𝑙𝑜𝑤 growth model suggests that growth

rates differ across countries for two main reasons:

• Two countries with the same current level of

income may experience different growth rates if

one has a higher steady state level of income than

the other

• Two countries with the same long run steady state

level of income may have different growth rates if

they are In a different points in transition to the

steady state

Technological changes in the 𝒔𝒐𝒍𝒐𝒘

model

• The 𝑠𝑜𝑙𝑜𝑤 model is a powerful tool for analyzing

the inter-relationships b/w saving, investment,

population growth, and economic growth

• The technological progress allows output per

worker to continue to grow

• The technological progress is a key driver but not

the only driver of productivity growth

• The technological progress play a central role of

explaining productivity growth

Technological changes in the 𝒔𝒐𝒍𝒐𝒘 model

• To incorporate economy’s ability to produce more

output with the same amount of capital and labor we

modify the original production function by adding new

variable T to represent technological progress as

follows:

• 𝒀 = 𝑭(𝑲, 𝑻 × 𝑳)

• Technology is introduced in such a way that directly

enhance the input of labor as shown T is multiplied by L

this type of Technological changes is referred to as

a labor augmenting

• As the technology increase the efficiency and

productivity of labor increase because the same

amount labor are now able to produce more

output

Technological changes in the 𝒔𝒐𝒍𝒐𝒘 model

• Increase in T can result from improvements In

technology or in term of human capital such as

improvements in health, education, or skills of the

work force

• The combined term 𝑻 × 𝑳 Is sometimes referred to

as the amount of effective units of labor

• The expression 𝑻 × 𝑳 measures both the amount

of labor and its efficiency in the production process

• An increase in either T or L lead to an increase in

the amount of effective labor and aggregate output

Technological changes in the 𝒔𝒐𝒍𝒐𝒘 model

• An increase in T differ from an increase in L

however , because the rise in income from new

technology does not need to be shared with

additional worker

• Technological changes and productivity growth

allows output per worker to increase

• The usual assumption that technology grow at fixed

∆𝑻

rate denoted by 𝜽 so that = 𝜽

𝑻

• if technology grows at 1 percent per year , then

each worker will be1 percent more productive each

year

Technological changes in the 𝒔𝒐𝒍𝒐𝒘 model

• With the work force growing at n , growth in the

effective supply of labor is equal to 𝒏 + 𝜽

• If the work force grows by 2 percent per year and

the technology grows by 1 percent per year the

effective supply of labor increase by 3 percent

• To show technological change in the 𝑠𝑜𝑙𝑜𝑤 diagram

we need to modify our notations

• Previously we express y and k as output per worker

and capital per worker

• we need now to express these variable in terms of

output and capital per effective worker

Technological changes in the 𝒔𝒐𝒍𝒐𝒘 model

• So instead of dividing Y and K by L as previously (to

obtain y and k)we will now divide them by (𝑻 × 𝑳)

• Output per effective worker (𝒚𝒆)=Y/(T× 𝑳)

• Capital per effective worker (𝒌𝒆)=K/(T× 𝑳)

• With these changes the production function can be

written as follows: 𝒚𝒆 = 𝒇(𝒌𝒆)

• Saving per effective worker: 𝒔𝒚𝒆

• Effective labor now growing at the rate (𝒏 + 𝜽)

• The capital accumulation equation can be written

as: ∆𝒌𝒆 = 𝒔𝒚𝒆 − 𝒏 + 𝒅 + 𝜽 𝒌𝒆

Technological changes in the 𝒔𝒐𝒍𝒐𝒘 model

• The new term 𝒏 + 𝒅 + 𝜽 𝒌𝒆 is greater than the

original one 𝒏 + 𝒅 𝒌𝒆.indicating that more

capital is needed to keep capital per effective

worker constant

Strengths and weaknesses of the 𝒔𝒐𝒍𝒐𝒘

model

• Strengths:

• It is more powerful tool for understanding the

growth process

• Provide more reasonable flexibility of factors

proportions in the production process.as it replace

the fixed coefficient production function with a

neoclassical one

• It emphasize the important role of factor

accumulation and saving

• Does much better job of describing real world

outcomes than harrod-domar model

Strengths and weaknesses of the 𝒔𝒐𝒍𝒐𝒘 model

• Provide the role of technological changes and

productivity growth in the growth process

• Provide powerful insights in the relationship b/w

saving, investment , population growth and

technological change on the steady-state level output

per worker

Strengths and weaknesses of the 𝒔𝒐𝒍𝒐𝒘 model

• Weaknesses:

• Specifying productivity growth exogenous it do not

spell out exactly how it takes place or how the

growth process itself might affect it

• The model helps focus attention on the more

fundamental influences on the steady state and the

growth rate but it does not provide a full

understanding of the precise pathway through

which these factors influence output and growth

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