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Zsófia L. Bárány

Sciences Po

2014 February

Recap of last week

1. pre-industrial revolution - stagnation: growth in total output is

offset by population growth, constant per capita consumption

2. post-industrial revolution - sustained growth: around 1.5% to

2% growth per year sustained over 150 years

1. Malthusian model - main assumptions: population growth

depends on consumption per capita & land is available in

limited supply

2. Solow model - the topic of today’s lecture

The Solow model

accumulation - growth process

I the model has stark predictions relating to the growth facts

I main prediction: technological progress is necessary for

sustained growth in living standards

I note: not a micro-founded model, i.e. the goals and

constraints of the agents are not explicit

I the Solow model is the basis for the modern theory of

economic growth

Assumptions on Consumers/Workers

Labor supply

I there are N consumers

I who do not make a labor-leisure choice

I ⇒ each provides his one unit of labor

I ⇒ N is also the size of the labor force

I the population is growing at exogenous constant rate n

N 0 = (1 + n) · N

Consumers/Workers

I consumers are assumed to save an exogenous, constant

fraction s of their income, and consume the rest

I the total income of consumers is Y , which is equal to total

output, as there is no government

I note: we do not need to distinguish between labor income and

capital income or profits (since households own the firms and

do not make a labor supply decision)

I the consumer’s budget constraint is Y = C + S

I ⇒ total saving in a period is s · Y

I ⇒ total consumption in a period is (1 − s) · Y

Production

Production function

Y = z · F (K , N)

I Y total output

I z total factor productivity (TFP)

I K stock of capital

I N labor input

Important features:

I output depends on the quantity of labor and capital, and TFP

I no other inputs, such as land or natural resources, matter

Production function is assumed to be neoclassical

I positive, but diminishing marginal products

I Inada conditions

I constant returns to scale (CRS)

Characteristics of the neoclassical production function I.

positive, but diminishing marginal products:

I z · F (K , N) is monotone increasing in K and N

I MPK = ∂z·F∂K = z · FK > 0: if K increases by 1, z · F (K , N)

increases by MPK

I MPN = ∂z·F∂N = z · FN > 0: if N increases by 1, z · F (K , N)

increases by MPN

→ decreasing marginal product of both inputs

∂2F FK ∂2F FN

I FKK = ∂K 2 = ∂K < 0 and FNN = ∂N 2 = ∂N <0

I as K increases more and more, F (K , N) increases by less and

less

I as N increases more and more, F (K , N) increases by less and

less

Characteristics of the neoclassical production function II.

Inada conditions:

I the marginal product of an input goes to zero as that input

goes to infinity (holding all other inputs constant):

limK →∞ FK (K , N) = 0 and limN→∞ FN (K , N) = 0

I the marginal product of an input goes to infinity as that input

goes to zero (holding all other inputs constant):

limK →0 FK (K , N) = ∞ and limN→0 FN (K , N) = ∞

Characteristics of the neoclassical production function III.

constant returns to scale:

consequence of CRS:

as:

Y K

y= N = z · F(K N

N , N ) = z · F ( N , 1) = z · f (k)

| {z }

≡f (k)

K Y

I denote: k = N, capital per capita; y = N output per capita

I f inherits the properties from F : fk (k) > 0, fkk (k) < 0

Shape of the production function

Y z · F (K , N)

something like this.

Shape of the production function

Y

N

z · F(K

N , 1)

Shape of the production function

Y

y= N

z · f (k)

K

k= N

N , 1) looks

therefore something like this.

Example: the Cobb-Douglas production function

Y = z · K α N 1−α

zF (λK , λN)

= z(λK )α (λN)1−α = λα+1−α zK α N 1−α =λzK α N 1−α

=λF (K , N)

Per capita output is

y = Y /N = zk α

I positive, but diminishing marginal products, which are given

by:

MPK = αzK α−1 N 1−α

MPN = (1 − α)zK α N −α

I Inada conditions hold

The capital accumulation equation

Capital stock

I increases - due to investment

I decreases - due to depreciation, d

K 0 = (1 − d)K + I

How do we determine I ?

Competitive equilibrium

Two options:

i.e. the goods market is in equilibrium

Y =C +I

combine this with the consumer’s budget constraint: Y = C + S

⇒ gives us market clearing on the capital market:

S =I

2. Capital market is in equilibrium

total saving = total investment

S =I

combine this with the consumer’s budget constraint: Y = C + S

⇒ gives us the income-expenditure identity:

Y =C +I

Equilibrium dynamics of capital per worker/per capita

The equilibrium dynamics of capital is then:

K0 F (K , N) K

=s ·z · + (1 − d)

N N N

Equilibrium dynamics of capital per worker/per capita

The equilibrium dynamics of capital is then:

K0 F (K , N) K

=s ·z · + (1 − d)

N N N

N0 K 0 F (K , N) K

0

=s ·z · + (1 − d)

N N

|{z} N N

=1

Equilibrium dynamics of capital per worker/per capita

The equilibrium dynamics of capital is then:

K0 F (K , N) K

=s ·z · + (1 − d)

N N N

N0 K 0 F (K , N) K

0

=s ·z · + (1 − d)

N N

|{z} N N

=1

(1 + n)N K 0 F (K , N) K

=s · z · + (1 − d)

N N0 N N

Equilibrium dynamics of capital per worker/per capita

The equilibrium dynamics of capital is then:

K0 F (K , N) K

=s ·z · + (1 − d)

N N N

N0 K 0 F (K , N) K

0

=s ·z · + (1 − d)

N N

|{z} N N

=1

(1 + n)N K 0 F (K , N) K

=s · z · + (1 − d)

N N0 N N

the key equation of the Solow model

s · z · f (k) (1 − d)k

k0 = +

1+n 1+n

→ determines capital per worker in the next period as a function

of capital per worker today

I investment in the current period

I plus whatever is left of capital after depreciation

I adjusting for the fact that the population is higher in the next

period

Finding the steady state

I if k < k ∗ ⇒ k 0 > k

I if k > k ∗ ⇒ k 0 < k

The steady state

Equation determining the steady state of the economy:

k∗ = k0 = k

s · z · f (k ∗ ) (1 − d)k ∗

k∗ = +

1+n 1+n

(1 + n)k = s · z · f (k ) + (1 − d)k ∗

∗ ∗

(n + d)k ∗ = s · z · f (k ∗ )

| {z } | {z }

break-even investment actual investment

I the amount of actual investment is exactly such that

I it compensates for depreciation and the growth in population,

i.e. for the break-even investment

⇒ the level of capital per worker stays constant

A useful graphical representation:

The ‘savings curve’ (actual investment) and the ‘effective

depreciation line’ (break-even investment)

break-even investment

actual investment

break-even investment =

= actual investment

This graph is very useful for studying the effects of n, s and z

Three important questions about the Solow model:

1. does the steady state exist?

k ∗ from any initial k0 ?

Three important questions about the Solow model:

1. does the steady state exist?

YES, if the two curves cross

k ∗ from any initial k0 ?

Three important questions about the Solow model:

1. does the steady state exist?

YES, if the two curves cross

YES, if the two curves only cross once

k ∗ from any initial k0 ?

Three important questions about the Solow model:

1. does the steady state exist?

YES, if the two curves cross

YES, if the two curves only cross once

k ∗ from any initial k0 ?

YES, if the actual investment curve is above the break-even

investment curve for k < k ∗ , and if the actual investment

curve is below the break-even investment curve when k > k ∗

Three important questions about the Solow model:

1. does the steady state exist?

YES, if the two curves cross

YES, if the two curves only cross once

k ∗ from any initial k0 ?

YES, if the actual investment curve is above the break-even

investment curve for k < k ∗ , and if the actual investment

curve is below the break-even investment curve when k > k ∗

This is due to the neoclassical production function.

Example 1.

i

(d + n)k

k

Example 1.

i

(d + n)k

szf (k)

violated?

Example 1.

i szf (k)

(d + n)k

violated?

Example 2.

i

(d + n)k

szf (k)

violated?

Example 3.

i szf (k)

(d + n)k

violated?

With a neoclassical production function

break-even investment

actual investment

steady state:

break-even investment=actual

investment

k∗ = k0 = k

Implications 1.

I k ∗ is constant

I y ∗ = f (k ∗ ) is constant as well

I c ∗ = (1 − s)y ∗ is constant as well

I K ∗ = N · k ∗ grows at rate n

I Y ∗ = N · y ∗ grows at rate n

I C ∗ = N · c ∗ grows at rate n

Implications 2.

production function ⇒ they have the same steady state capital

per worker, k ∗ ⇒ they converge to the same steady state

⇒ conditional convergence

(why?)

Implications 3.

sA < sB ?

I ⇒ their steady state per capita capital is different, i.e.

kA∗ 6= kB∗

I both countries converge to their own steady state, but these

are different

⇒ no absolute convergence

necessarily grow faster

Saving rate and the steady state per capita capital

i

(d + n)k

k

Saving rate and the steady state per capita capital

i

(d + n)k

sA zf (k)

k

Saving rate and the steady state per capita capital

i

(d + n)k

sA zf (k)

kA∗ k

Saving rate and the steady state per capita capital

i

(d + n)k

sB zf (k)

sA zf (k)

kA∗ k

Saving rate and the steady state per capita capital

i

(d + n)k

sB zf (k)

sA zf (k)

kA∗ kB∗ k

Saving rate and the steady state per capita capital

i

(d + n)k

sB zf (k)

sA zf (k)

kA∗ kB∗ k

The steady state capital per worker is higher, when the savings

rate is higher.

sA < sB ⇒ kA∗ < kB∗

Data: Real income per capita and the investment rate

→ per capita GDP and the investment rate are positively correlated

Income per capita and saving rate in the model

What is the implication of a higher saving rate in the Solow

model?

I intuitively, a higher saving rate implies that the saving curve,

the actual investment curve is higher

I ⇒ higher steady state k ∗ ⇒ higher y ∗

I long-run increase in the level of per capita capital

I long-run increase in the level of per capita output

I temporary increase in the growth rate of per capita capital

and per capita output

I no effect on the long-run growth rate of capital per worker

and output per worker, which are equal to zero

A change in the savings rate has a long-run level effect, but does

not have a long-run growth effect.

Saving rate and the steady state per capita capital

the steady state, k ∗ , and thus to a higher steady state per

capita income, y ∗

I ⇒ should people increase their saving rate in order to increase

output? would this be good for them?

I put another way: Does it mean that a higher saving rate is

always better?

I what is the ’best’ steady state?

Saving rate and the steady state per capita capital

the steady state, k ∗ , and thus to a higher steady state per

capita income, y ∗

I ⇒ should people increase their saving rate in order to increase

output? would this be good for them?

I put another way: Does it mean that a higher saving rate is

always better?

I what is the ’best’ steady state?

I define the ’best’ steady state as the one that maximizes

consumption per capita, c ∗

Consumption and steady state capital

c ∗ = (1 − s)zf (k ∗ ) = zf (k ∗ ) − szf (k ∗ )

i zf (k)

szf (k)

k

Consumption and steady state capital

c ∗ = (1 − s)zf (k ∗ ) = zf (k ∗ ) − szf (k ∗ )= zf (k ∗ )−(n + d)k ∗

i zf (k)

(d + n)k

szf (k)

k∗ k

Consumption and steady state capital

c ∗ = (1 − s)zf (k ∗ ) = zf (k ∗ ) − szf (k ∗ )= zf (k ∗ )−(n + d)k ∗

i zf (k)

(d + n)k

c∗

szf (k)

k∗ k

and (d + n)k.

The golden rule

I what are the effects of a higher s on c ∗ ?

I higher s ⇒ higher k ∗ ⇒ higher y ∗

c ∗ = (1 − s) y ∗

|{z} | {z } |{z}

? ↓ ↑

The golden rule

I what are the effects of a higher s on c ∗ ?

I higher s ⇒ higher k ∗ ⇒ higher y ∗

c ∗ = (1 − s) y ∗

|{z} | {z } |{z}

? ↓ ↑

The golden rule

I what are the effects of a higher s on c ∗ ?

I higher s ⇒ higher k ∗ ⇒ higher y ∗

c ∗ = (1 − s) y ∗

|{z} | {z } |{z}

? ↓ ↑

I due to the assumptions made on the production function

The golden rule

I what are the effects of a higher s on c ∗ ?

I higher s ⇒ higher k ∗ ⇒ higher y ∗

c ∗ = (1 − s) y ∗

|{z} | {z } |{z}

? ↓ ↑

I due to the assumptions made on the production function

I c ∗ first increases, then decreases in s

The golden rule

I what are the effects of a higher s on c ∗ ?

I higher s ⇒ higher k ∗ ⇒ higher y ∗

c ∗ = (1 − s) y ∗

|{z} | {z } |{z}

? ↓ ↑

I due to the assumptions made on the production function

I c ∗ first increases, then decreases in s

I golden rule of saving: s such that c ∗ is the highest

I how to find it? by choosing s maximize

c ∗ = (1 − s)zf (k ∗ ) = zf (k ∗ ) − szf (k ∗ )= zf (k ∗ )−(n + d)k ∗

note: the last equality makes use of the steady state condition

(szf (k ∗ ) = (n + d)k ∗ )

The golden rule

∂c ∗

→ take the derivative with respect to s, and find s where ∂s =0

where does s enter the right hand side?

The golden rule

∂c ∗

→ take the derivative with respect to s, and find s where ∂s =0

where does s enter the right hand side? only through k ∗ , as the

steady state level of per capita capital increases in s

∂c ∗ ∂f (k ∗ ) ∂k ∗ ∂k ∗ ∂k ∗

=z − (n + d) = zf 0 (k ∗ ) − (n + d)

∂s ∂s ∂s ∂s ∂s

∂k ∗

= zf 0 (k ∗ ) − (n + d)

=0

∂s

⇒ zf 0 (k ∗ ) = n + d}

| {z

| {z }

MPk effective depreciation rate

The golden rule

∂c ∗

→ take the derivative with respect to s, and find s where ∂s =0

where does s enter the right hand side? only through k ∗ , as the

steady state level of per capita capital increases in s

∂c ∗ ∂f (k ∗ ) ∂k ∗ ∂k ∗ ∂k ∗

=z − (n + d) = zf 0 (k ∗ ) − (n + d)

∂s ∂s ∂s ∂s ∂s

∂k ∗

= zf 0 (k ∗ ) − (n + d)

=0

∂s

⇒ zf 0 (k ∗ ) = n + d}

| {z

| {z }

MPk effective depreciation rate

∗

→ First find the k ∗ that maximizes c ∗ (where ∂k

∂c

∗ = 0).

∗

→ Then find the s that achieves this k using the steady state

condition szf (k ∗ ) = (n + d)k ∗ .

The golden rule

steady state to achieve the highest per capita consumption

I → we can find the saving rate that results in this specific

steady state: sgr

I if the government, central planner would prescribe this saving

rate, the economy would reach the steady state and the

maximum possible consumption

I in practice: we can estimate MPK , we know n, we can

calculate d ⇒ we can actually calculate sgr

I should the government do something, try to impose this?

1. redistribution across generations

2. consumers save optimally (given their preferences)

⇒ is there a market failure that prevents them from achieving

the correct trade-off between current consumption and

savings?

Data: Income per capita and the population growth rate

Income per capita and the population growth rate in the

model

model?

I a higher n increases the break-even investment, rotates the

effective depreciation line up

I lower steady state per capita capital and output: k ∗ , y ∗ ↓

I long-run decrease in the level of output per worker

and output per worker, which are equal to zero

Income per capita and the population growth rate in the

model

Income per capita and technology in the model

I a higher productivity, z increases actual investment in the

model

→ the savings curve pivots up

I higher steady state per capita capital and output: k ∗ , y ∗ ↑

I long-run increase in the level of output per worker

I no effect on the long-run growth rate of capital per worker

and output per worker, which are equal to zero

Income per capita and technology in the model

Income per capita and technology in the model

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