Week 45

Chapter
The Solow
Growth Model

Prepared by Emily Marshall, Dickinson College

Copyright © 2018 W. W. Norton & Company

5.1 Introduction

n In this lecture, we learn:

q how capital accumulates over time,
q how diminishing MPK explains differences in
growth rates across countries,
q the principle of transition dynamics, and
q the limitations of capital accumulation.
n A significant part of economic growth is still unexplained.
Motivation
Production model
n Explains GDP per person differences across country
at a given time
q About 2/3 of the GDP per person differences is explained
by TFP differences and about 1/3 is explained by capital
per person differences
n The model does not provide an answer as to why
q countries have different capital stocks, it is exogenous
q GDP per person grows at different rates across
countries
q Why countries have different TFP levels,
Motivation - Levels and Growth
Rates of Per Capita GDP
Motivation
n In 1960, South Korea and the Philippines were
similar in many respects (both relatively poor
countries)
q Per capita GDP: $1,500 (less than 10 percent of the U.S.
level)
q Populations: approximately 25 million
q Similar fractions of the population worked in industry and
agriculture
q 5 percent of Koreans in their early twenties attended
college
q 13 percent of Filipinos in their early twenties attended
college
Motivation

n Between 1960 and 2014, the paths of these two

countries diverged dramatically.
q Philippines average annual growth rate: 2.4 percent
q South Korea average annual growth rate: 6 percent
n By 2014
q GDP per capita in Korea: $35,000 (more than two-
thirds the U.S. level)
q GDP per capita in Philippines $6,600
Motivation
Motivation

n How can we explain this huge difference in

economic performance between two countries
that appeared relatively similar?

n Why did Korea see such a large increase in

economic growth and not the Philippines?
Motivation

n Our starting point to answer these questions is

the Solow Growth model.
n The Solow growth model builds on the
production model.
q developed in the mid-1950s by Robert Solow of MIT.
q was the basis for the Nobel Prize he received in 1987.
Changes in the Model

n The Solow Growth model:

q Augments the production model with capital
accumulation
n Capital stock is no longer exogenous.
n Capital stock is now endogenized.

n The accumulation of capital is a possible

engine of long-run economic growth.
5.2 Model Set-up (Production)

n Begin with the previous production model.

q Add an equation for the accumulation of capital over
time.
n The production function:
q Cobb-Douglas
q Constant returns to scale in capital and labor
q Assume exponent of one-third on
n Variables are time subscripted (t)
̅ "* '+,*
!" = $ %" , '" = )% "
Model Set-up (Resources)

n Output can be used for consumption or

investment

q !": consumption
q #": investment
n This is called a resource constraint.
q Assumes no imports or exports
Capital Accumulation—1

n Goods invested for the future determine the

accumulation of capital
n Capital accumulation equation:

q : next year’s capital

q this year’s capital
q this year’s investment
q depreciation rate
n Usually,
Capital Accumulation—2

n Change in capital stock defined as:

n Thus:

n Future capital depends on investment today

Case Study: An Example of
Capital Accumulation
n Assume that the economy begins with !0
n Suppose:
q The initial amount of capital is 1,000 bushels of corn
q The depreciation rate is 0.10
Model Set-up (Labor)

n For simplicity, labor supply is not included.

n The amount of labor in the economy is given
exogenously at a constant level.
Model Set-up (Investment)

n The economy consumes a fraction of output

and invests the rest

q !": investment

n Therefore:

q Consumption is the share of output not invested

Five Equations and
Five Unknowns
Case Study: Some Questions
about the Solow Model
n Differences between the Solow model and
production model:
q Added dynamics of capital accumulation
q Omit capital and labor markets and their prices
n Why include the investment share but not the
consumption share?
q It would be redundant
q Preserve five equations and five unknowns
Variables

n Stock
q A quantity that survives from period to period
n tractor, house, factory

n Flow
q A quantity that lasts a single period
n meals consumed, withdrawal from ATM

n A change in the stock of capital is investment.

5.3 Prices and the Real Interest
Rate
n Adding the wage and rental price:
q Two more equations, two more unknowns
n w=MPL and r=MPK
q Omitting them does not change the model
n The real interest rate (in units of output):
q amount earned by saving one unit of output for a year
q cost to borrow one unit of output for a year
Saving

n Saving:
q The difference between income and consumption

n which is equal to investment

n where is saving
5.4 Solving the Solow Model

n The model needs to be solved at every point

in time, which cannot be done algebraically.
n Two ways to make progress:
q Show a graphical solution
q Solve the model in the long run
n Begin by combining equations algebraically
Solving the Solow Model

n Combine the investment allocation and

capital accumulation equation

q Substitute the fixed amount of labor into the

production function

̅ ' (*+'
!" = %&" )
The Solow Diagram
Using the Solow Diagram

n If the amount of investment > depreciation

q capital stock will increase until
n Here, the change in capital is equal to 0.
n The capital stock will stay at this value of capital forever.
n This is called the steady state.

n If depreciation is greater than investment

q the economy converges to the same steady state
as above.
Model Dynamics
n When not in the steady state,
q the economy exhibits a change in capital toward
the steady state.
n As K moves to its steady state,
q output will also move to its steady state.
n At the rest point of the economy,
q all endogenous variables are steady.
n Transition dynamics
q take the economy from its initial level of capital to
the steady state.
The Solow Diagram with Output
Solving Mathematically for the
Steady State
n In the steady state, investment equals
depreciation.

n Substitute into the production function:

̅ $∗ = '̅(#
"# ̅ $∗) +*,-)
Solving for the Steady State—1

n Solve for K*
q ̅ $∗ = '̅(#
"# ̅ $∗) +*,-)
̅ 1∗23*452
.̅/0
∗
q #$ = divide by "̅
6*
∗,-) .̅/̅ 3*452
q #$ = divide by #$∗)
6*
4
∗ .̅/̅ 3*452 452 ,
q #$ = raise to the power of
6* ,-)
4
.̅/̅ 452
q #$∗ = +* collect the exponents of +*
6*
Solving for the Steady State—2
n Solve for K*

n The steady state level of capital is:

q Positively related to the
n investment rate
n the size of the workforce
n the productivity of the economy
q Negatively correlated with
n the depreciation rate
Solving for the Steady State—3

n Plug K* into the production function to get Y*

!"∗ ̅ ∗( )+,(
= &'" *
n Plug in our solved value of K*
(
+ -̅ +,(
!"∗
= &̅+,( *)
.̅
n Higher steady state production
q caused by higher productivity and investment rate
n Lower steady state production
q caused by faster depreciation
Solving for the Steady State—4

n Divide both sides by labor to get output per

person in the steady state:
,
∗
$%
* -̅ *+,
!∗ = = )̅*+,
'& .̅
n Note the exponent on productivity is different
here than in the production model.
q Higher productivity has additional effects in the
Solow model by leading the economy to
accumulate more capital.
5.5 Looking at Data through the
Lens of the Solow Model
n Recall the steady state:

n The capital to output ratio is the ratio of the

investment rate to the depreciation rate:

n Investment rates vary across countries

n It is assumed that the depreciation rate is
relatively constant
Explaining Capital in the Solow
Model
Differences in Y/L

n The Solow model shows TFP is more

important in explaining per capita output
q Can be used to understand differences in y
n Take the ratio of y* for five richest and five
poorest countries, depreciation rate is the
same:

From Chapter 4 See figure 5.3 (previous slide) slide)

Differences in Y/L

n Production model from last lecture

n Take the ratio of y* five richest and five

poorest countries
5.6 Understanding the Steady
State
n The economy reaches a steady state because:
q investment has diminishing returns
q the rate at which production and investment rise is
smaller as the capital stock is larger
n Also, a constant fraction of the capital stock
depreciates every period.
q Depreciation is not diminishing as capital increases.
n Eventually, net investment is zero.
q The economy rests in steady state.
5.7 Economic Growth in the
Solow Model
n Important result:
q There is no long-run growth in the Solow model.
n In the steady state, growth stops, and
q output,
q capital,
q output per person, and
q consumption per person
are constant.
Economic Growth in the Solow
Model
n Empirically, however, economies appear to
continue to grow over time.
q Thus, we see a drawback of the model.
n According to the model:
q Capital accumulation is not the engine of long-run
economic growth.
q After we reach the steady state, there is no long-run
growth in output.
q Saving and investment
n are beneficial in the short run
n do not sustain long-run growth due to diminishing returns
Case Study: Population Growth
in the Solow Model
n Can growth in the labor force lead to
overall economic growth?
q It can in the aggregate
q It cannot in output per person
n Diminishing returns lead ! and " to approach
the steady state.
q This occurs even with more workers.
5.8 Some Economic
Experiments
n The Solow model:
q Does not explain long-run economic growth
q Does help explain some differences across
countries
n Economists can experiment with the model
by changing parameter values.
An Increase in the Investment
Rate—1
n Suppose the investment rate increases permanently
for exogenous reasons.
q The investment curve rotates upward.

q The depreciation curve remains unchanged.

q The capital stock

n increases by transition dynamics to reach the new

steady state
n this happens because investment exceeds depreciation
q The new steady state
n is located to the right
n investment exceeds depreciation
An Increase in the Investment
Rate—2
An Increase in the Investment
Rate—3
n What happens to output in response to this
increase in the investment rate?
q The rise in investment leads capital to accumulate
over time.
q This higher capital causes output to rise as well.
q Output increases from its initial steady state level
Y* to the new steady state Y**.
The Behavior of Output after an
Increase in "!
A Rise in the Depreciation Rate—1

n Suppose the depreciation rate is exogenously

shocked to a higher rate.
q The depreciation curve rotates upward.
q The investment curve remains unchanged.
q The capital stock
n declines by transition dynamics until it reaches the new
steady state
n this happens because depreciation exceeds investment
q The new steady state
n is located to the left
A Rise in the Depreciation Rate—2
A Rise in the Depreciation Rate—3

n What happens to output in response to this

increase in the depreciation rate?
q The decline in capital reduces output.
q Output declines rapidly at first, and then gradually
settles down at its new, lower steady state level
Y**.
Behavior of Output after an
!
Increase in "
Experiments on Your Own

n Try experimenting with all the parameters in

the model:
q Figure out which curve (if either) shifts
q Follow the transition dynamics of the Solow model
q Analyze steady state values of:
n capital (K*)
n output (Y*)
n output per person (y*)
5.9 The Principle of Transition
Dynamics
n If an economy is below steady state
q It will grow
n If an economy is above steady state
q Its growth rate will be negative
n When graphing this, a ratio scale is used.
q Output changes more rapidly if we are further
from the steady state.
q As the steady state is approached, growth shrinks
to zero.
The Principle of Transition
Dynamics
n The farther below its steady state an
economy is, (in percentage terms)
q the faster the economy will grow.
n The closer to its steady state,
q the slower the economy will grow.
n Allows us to understand why
economies grow at different rates
Understanding Differences in
Growth Rates
n Empirically, for OECD countries, transition
dynamics holds:
q Countries that were poor in 1960 grew quickly
q Countries that were relatively rich grew slower
n For the world as a whole, on average, rich and
poor countries grow at the same rate.
q Two implications of this:
n most countries (rich and poor) have already reached their
steady states
n countries are poor not because of a bad shock, but because
they have parameters that yield a lower steady state
(determinants of the steady state invest rates and A)
Growth Rates in the OECD,
1960–2014
Growth Rates around the World,
1960–2014
Case Study: South Korea and
the Philippines—1
n South Korea
q 6 percent per year
q Increased from 10 percent of U.S. income to 75
percent
n Philippines
q 2.4 percent per year
q Stayed around 10 percent of U.S. income
n Transition dynamics predicts
q South Korea was far below its steady state.
q Philippines is already at steady state.
Case Study: South Korea and
the Philippines—2
n Assuming equal depreciation rates

n The long-run ratio of per capita incomes

depends on:
q The ratio of productivities (TFP levels)
q The ratio of investment rates
Investment in South Korea and
the Philippines, 1950–2014
5.10 Strengths and Weaknesses
of the Solow Model
n The strengths of the Solow Model:
q It provides a theory that determines how rich a
country is in the long run.
n long run = steady state
q The principle of transition dynamics
n allows for an understanding of differences in growth
rates across countries
n a country further from the steady state will grow faster
Strengths and Weaknesses of
the Solow Model
n The weaknesses of the Solow Model:
q It focuses on investment and capital
n the much more important factor of TFP is still
unexplained
q It does not explain why different countries have
different investment and productivity rates.
n a more complicated model could endogenize the
investment rate
q The model does not provide a theory of sustained
long-run economic growth.
Additional Figures for Worked
Exercises—1
Additional Figures for Worked
Exercises—2
Additional Solow Graph
Examples
n Slides 56-60 include additional Solow graph
examples.
 The Solow Diagram graphs these two
pieces together, with Kt on the x axis:

Investment,
Depreciation

At this point,
dKt = sYt, so

Capital, Kt
Suppose the economy starts at this K0:
•We see that the red line is above
Investment, the green at K0
Depreciation •Saving = investment is greater
than depreciation
•So ∆Kt > 0 because

•Then since ∆Kt > 0,

Kt increases from K0 to K1 > K0

Capital, Kt
K0 K1
Now imagine if we start at a K0 here:

Investment,
•At K0, the green line is above the
Depreciation red line
•Saving = investment is now less
than depreciation
•So ∆Kt < 0 because

•Then since ∆Kt < 0,

Kt decreases from K0 to K1 < K0

Capital, Kt
K1 K0
We call this the process of transition dynamics:
Transitioning from any Kt toward the economy’s
steady state K*, where ∆Kt = 0

Investment,
Depreciation

No matter where we start,

we’ll transition to K*!

At this value of K,
dKt = sYt, so

Capital, Kt
K*
We can see what happens to output, Y, and
thus to growth if we rescale the vertical
axis:
Investment, • Saving = investment and
Depreciation, Income depreciation now appear
here

Y* • Now output can be

graphed in the space
above in the graph
• We still have transition
dynamics toward K*
• So we also have
dynamics toward a
steady state level of
income, Y*

Capital, Kt
K*