The Solow Growth Model

ApEc 3006, Spring 2006

Michinori Uwasu

1 Introduction
Objective
How to explain economic growth has been one of the most enduring questions in macroeconomics.
When looking around the world, we …nd huge di¤erences in economic performance (particularly
GDP per capita or individual’s income). Key observations are seen in both time series data and
cross sectional data. Three examples include; 1) Sub-Saharan (no growth since 1950’s) vs. East
Asia (high growth since 1960’s) from time series data; 2) OECD (over $10,000) vs. LDCs (less $300)
from cross sectional data; and 3) Steady economic growth for the last decades for most developed
countries. (See Appendix for graphs). These observations raise the following questions:

² Why some countries grow fast while others do not?

² Why some countries are rich while others are not?

² How to explain sustained economic growth?

The objective of my lecture is to understand the basic mechanism of economic growth by learning
the Solow growth model. In particular, we learn the mechanism of capital accumulation and the
roles of population and technological progress in economic growth. Learning the basic mechanism
of economic growth may not be su¢cient, but necessary to answer these questions.

The Solow model

To know the features of the Solow model is of importance. First, the Solow model is very neoclassic
in that it focuses primarily on the supply side. The Solow model implicitly assumes that, as long as
supply of goods increases, economic growth can be attained. So, it is very di¤erent from Keynesian
models of which focus is on the demand side of an economy such as unemployment and in‡ation.
Second, the Solow model is a DYNAMIC model (not static). Economic growth by nature contains

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dynamic aspects, which makes the model complicated. Therefore, we are going to learn the model
in steps to cope with the complication. In particular, we …rst study the basic model that has only
a capital stock accumulation mechanism. After the basic model, we are going to incorporate new
factors, population growth and technology into the model and see how these factors change the
results obtained in the basic model.
The Solow model is named after an economist Robert Solow. Originally, he came up with the
model based on the observation of US data between 1950’s and 1970’s, …nding that (1) savings
rates and input factor shares were almost constant, and (2) per capita GDP growth rates were
steady. The punch line of the Solow model is thus to systematically explain the two observations
(we will soon see this). His work has been in‡uential and thus been followed by a large number of
growth models including endogenous and multi-sector models. Robert Solow won the Nobel prize
in economics in 1986 due to his contribution to growth theory. The Solow model is simple (no
complex math needed), but provides signi…cant implications for economic growth. Therefore, it is
the perfect place to start leaning economic growth.

2 An Economy
The Solow model considers an simple economy that consists of a supply side and a demand side.
This section describes a static version of the economy before introducing a dynamic aspect.

The supply side

The economy has one aggregate output and two input factors, capital stock and labor. The pro-
duction function is given by:
  =  ( )

where   = aggregate output supply,  = capital stock,  = labor. The Solow model has three
important assumptions on the production function.

² The production function is increasing in each input, and has diminishing marginal product.
 2  2 
I.e.,   0 
  0  2  0 2  0

² When zero units of input is used for either  or , then nothing is produced. I.e.,  (0 ) =
 ( 0) =  (0 0) = 0

² The production function exhibits constant returns to scale (CRS). A production function
exhibits CRS if a proportionate increase in all input factors increase in output of the same
proportion.

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 
Example 1 Suppose a production function is given by  =  05 05  Since  = 05 ¡05 05 
2  2
0 
 = 05
05 ¡05
  0  2 = ¡025
¡15 05
  0 and 2 = ¡025 05 ¡15  0, the …rst
assumption is met. Clearly, the second one is also met. To check if it is CRS, let us multiply
each input factor by   0 : ()05 ()05 =  05 05 05 05 =  05 05 =    Since a
proportionate increase in each factor increase in output of the same proportion, it is CRS.

Two reasons for having the assumptions are in order. First, there are many empirical studies
that support the assumptions. Second, it brings analytical convenience. Speci…cally, using the CRS
property, we can obtain a simple form of production function on a per worker basis:

  =  ( )
1
Multiply both sides by

 
= (  1 )
  |{z}
 
(The above line uses the CRS property)
 
=  ( ) !   = ()
 
where   = output supply per worker, and  = capital stock per worker. This implies that per
worker output supply is determined only by capital stock per worker.

Example 2 Assume  =  05 05 is given. Then the per worker production function is

  05 05  05 05  05 

= = 05 05 = 05 = ( )05
     
!  = 05

Remark. In what follows, we basically look at per worker units of factors: this makes sense in
that we are interested more in individuals’ living standards (e.g., your income) than in the size of
an economy (e.g., GDP). So, please keep in mind the di¤erences between capital letters (   )
and small letters (  ).

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The demand side
The demand side of the economy assumes no disposal of income, so the output demand must be
equal to the sum of consumption and investment:

 ´  +  (identi…cation)
!   ´  +  (divided both sides by )

where   is output demand,  is consumption,  is investment,   is per worker output demand,

 is per worker consumption and  is per worker investment. Each individual is assumed to either
consume or save given his income:

 =  +  
!  =   ¡   (consumption function)

where 0 ·  · 1 is a savings rate (so,  ¤  is the amount of savings for each individual). Plugging
 into the identi…cation yields

 =   (investment function)

Equilibrium
In equilibrium, supply equals demand. So, plugging   =   =  () into the investment function
to obtain
 =  ¢  ()

This holds in equilibrium of the static economy. Figure 1 represents the static equilibrium of the
economy.

3 Capital Accumulation
We introduce a dynamic aspect into the static economy. In particular, we incorporate a capital
accumulation mechanism into the static model. Two factors involve in the capital stock accumula-
tion.

1 Investment: increases capital stock.

2 Depreciation: a certain proportion of capital stock wears out.

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 y, i
y=f(k)

c i=s*f(k)

0 k k

Figure 1: Static Equilibrium

Let  denote the depreciation rate in one time period and let  denote a capital stock level in
period . The rule of change in capital stock in one period of time can then be expressed as:


+1 ¡  = 4 =  ¡ 
! 4 =  ¢ () ¡ 
or +1 =  +  ¢ ( )

Transition of the economy and steady state

A graphical representation is the best way to show how an economy changes over time given initial
capital stock. Figure 2 represents an economy that is given the production function  = (),
savings rate , depreciation rate , and the initial capital stock 0  Using this amount of capital
stock, the economy produces 0 (units) of output and 0 (units) of investment With this amount
of investment, the economy is going to have 1 = (0 ¡ 0 ) + 0 units of capital stock in period 1.
The economy can thus produce 1 units of output and 1 units of investment in period 1 Likewise,
the economy will have the new capital stock level 2 = (1 ¡ 1 ) + 1 in period 2, by which the
economy will produce 2 units of output and 2 units of investment in period 2 (not shown in the
…gure though). Repeating this shows that the capital stock level is increasing until it reaches one
point (state) denoted by,   Once the economy gets to the state, it will not move from the state
because the amount of capital that wears out is equal to the amount of investment in the state.
We call such a state steady state. The formal de…nition is:

De…nition 1 Steady state is an equilibrium state where  ( per worker capital stock) is invariant.

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 y, i
y=f(k)

yss

y1 δ*k

y0

i=s*f(k)

i0
Δ k1
Δ k0
δ*k0

0 k0 k1=Δk0+k1 kss k

Figure 2: Steady State (Long-Term Equilibrium)

Thus in steady state no change in  occurs. Mathematically,

4 = 0
!  ¢ () ¡  = 0

We call this a steady state condition. If a speci…c functional form of  (), and values of  and
 are given, we can solve the condition for .

Example 3 Suppose  = 05 ,  = 02, and  = 005. The steady state condition implies

05 ¡  = 0 ! 0205 = 005

¡05 = 025 !  = 16

This further implies that the steady state level of per worker output is calculated as

05
 =  = 1605 = 4

Some comments

² If an initial capital stock is not zero, an economy approaches to a positive steady state. (When
 = 0, () = 0 by assumption So, when  = 0, the steady state condition is met, meaning
 = 0 is also a steady state.)

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 ² Once an economy gets to a positive steady state, it will not leave the steady state. (This
implies that the positive steady state is stable.) Thus steady state can be thought of as a
long-term equilibrium.

4 Golden Rule of Capital Stock

Comparative Static
This section demonstrates comparative static with respect to a savings rate. What is comparative
static? As you notice, any models have variables. In the Solow model, we have;      0  And
any variables in a model can be divided into two categories; exogenous variables, and endogenous
variables. Exogenous variables are ones that are determined outside a model whereas endogenous
variables are ones that are determined in the model. Comparative static demonstrates how one
exogenous variable change a¤ects an equilibrium. In the Solow model, we have:

Exogenous variables   0
Endogenous variables   

How do we show the e¤ect of change in savings rates on steady state? First, note that since
the investment level is given by  =  ¢ () change in savings rates shifts the investment curve.
Clearly, the higher savings rate shifts the investment curve upward, and vice versa. Second, the
corresponding steady state also shifts. For example, suppose we have a production function  = 05 
By the steady state condition  ¢  05 ¡  = 0, we have steady state capital stock  = (  )2 (To
show this will be a homework question). The equation indicates, as  increases,  increases.
This can be graphically. In Figure 3, there are three levels of savings rates,      
When a savings rate is , the investment curve is  =  ¢ () and the corresponding steady state is
given by  . Similarly, when  is given the steady state capital stock is   When  is given,
the corresponding steady state capital stock is   Clearly, it shows      ; in other
words, the higher the savings rate is, the higher the steady state level of capital stock per worker is.
Figure 7-6 in Mankiw (p191) presents international evidence: countries with high investment rates
tend to have higher income per worker, which might support the prediction by the Solow model.
(Why "might"?)

Golden Rule
Suppose you were a policy maker. Suppose also that you can change a savings rate through …scal
policy or monetary policy. Then, what savings rate would you choose? One answer may be that
you want to choose the savings rate such that per worker consumption in steady state is maximized.

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 y, i y=f(k)

δk

i=sHf(k)

i=sf(k)

i=sLf(k)

0 kLss kss kHss k

Figure 3: Comparative Statc Analysis for Savings Rates

De…nition 2 The golden rule capital is the steady state capital stock level,  such that consump-
tion in steady state,  is maximized.

The immediate question is then: How do we …nd such a savings rate? We take the following
two steps.

Step 1 Find the golden rule level of capital stock.


Let  denote the golden rule level of capital stock. Recall consumption per worker is
calculated as

 =  ¡ 
= () ¡ 

 is maximized when the slope of the production function is equal to the slope of :

The slope of () =  

The slope of  = 

Thus, when   =  is satis…ed,  is maximized. We call "  = " a golden rule.

Step 2 Find the corresponding savings rate, .

8
 y.i
y=f(k)

gold
y ss

MPK=δ
e
gold
C ss δk
yss MPK≠δ c
d i=s
gold
f(k)
b Css
i=sf(k)

0 k* gold k
kss k ss

Figure 4: Golden Rule of Capital Stock


Note that  is also steady state level. Thus it also satis…es the steady state condition,
() =  which we can solve for 

Example 4 Suppose  = 05 , and  = 005. Find a savings rate that maximizes consumption in
steady state.
(Step 1) By the golden rule,

  = 05 ¡ 05 = 005 = 

! ¡05 = 01
!  = 01¡2 = 100

(Step 2) Plug  into the steady state condition and solve it for :

 
 ¢ ( ) = 
10005 = 005 ¤ 100
 = 510 = 05

Graphical representation

Di¤erent savings rates lead an economy to a unique steady state. In Figure 4, we have two

di¤erent savings rates.  leads the economy to  and   and  leads the economy to 

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and  
 in the long-term. In this example,  satis…es the golden rule   =  while  does
not. Therefore, we know that  is the golden rule level of capital and is clearly larger than  
The information of   and  can be used to evaluate the current status of an economy in the
context of the golden rule. If   =  is found, then the economy is …ne: people are enjoying the
maximal consumption level. If     is found it means that the economy has too little capital
stock. To see this, lets look at Figure 4: with any capital stock levels less than the golden rule level

of capital stock ( ), their marginal product of capital stock is greater than the depreciation rate
() So, politicians may want to increase the capital stock so that the economy has the golden rule
capital stock. In order to do so, they need to raise the savings rate. If     is found, on the
other hand, the economy has too much capital stock. In this case, politicians may want to decrease
the savings rate to lead the economy to the golden rule capital stock level that is less than the
current level.

Situation Diagnoses Policy Implications

    in ss ! too little capital stock ! increase the savings rate
  =  in ss ! golden rule of capital stock ! keep the savings rate
    in ss ! too much capital stock ! decrease the savings rate

A transition path of consumption when  is increased Suppose the current economy is

in steady state of  as in Figure 4. The golden rule of capital stock implies, the current economy
is not maximizing people’s consumption level and raising the savings rate from  to  will lead
the economy to the golden rule level of capital stock; thus attaining optimal consumption in the
long-term. In the short-term, however, the economy will experience lower consumption levels due
to the increase in . Too see this, we again look at Figure 4. In the original steady state, the
consumption level was given by  ¡  ( ). When we increase the savings rate from  to  , the
immediate consumption level becomes  ¡  that is clearly lower than  ¡  As time goes by, capital
stock is accumulating, so that consumption starts increasing. Note that when the capital stock
level gets to  ¤  the economy brings  ¡  units of consumption to each worker that is the same
as the original consumption level  ¡ . So, until this point, the economy has lower consumption
levels, but thereafter the economy can enjoy higher consumption levels than the original one and
when it gets to the steady state, it can have the optimal consumption level. The consumption path
of consumption discussed here is drawn in Figure 5.

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 c

gold
c ss

css

time
gold
Increase s capital stock = k* capital stock = k ss

Figure 5: Consumption path when changing a savings rate from  to 

5 Population Growth
Thus far we have …xed the number of labor (=population) in the model. The Solow model assumes
that labor force is growing over time at a rate of . This means that population growth rate in the
model is exogenous. So, we can demonstrate a comparative static with respect to . Before going
into it, we need …gure out how population a¤ects the economy. Population growth spreads the cap-
ital stock more thinly to larger population, so it has a negative e¤ect on capital stock accumulation.
In particular, the accumulation rule for the economy with population growth becomes:

+1 =  ¡ ( + ) + 
or 4 = +1 ¡  =  ¡ ( + )

where ( + ) is called a break-even investment curve because it is the amount of investment
necessary to keep capital stock constant. See Appendix for the derivation of the equation.

Steady State Steady state of the economy can be obtained in the same way. In steady state,
capital stock per worker will be invariant, so we have

4 =  ¡ ( + ) = 0

Given a speci…c functional form of a production function and parameter values, we can …nd a steady
state of a particular economy (this will be a homework question).
Now, we are ready to demonstrate how population a¤ects steady state of the economy. A

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 y, i y=f(k)
yHss
yLss (δ+nH)k

(δ+nL)k

i=sf(k)

0 kLss kHss k

Figure 6: Comparative Static Analysis for Population Growth

graphical presentation is the best way to do it. The implications of Figure 6 is as follows. 1)
Population growth rate shifts the break-even curve. Given    , ( +  ) has a ‡atter
slope than ( +  ). 2) Thus the corresponding steady state also shifts. When  leads the
economy to the steady state   whereas  leads the economy to the steady state   Clearly,
    Figure 7-7 in Mankiw (p203) presents international evidence: high population growth
rates are negatively associated with income per worker, which might support the prediction by the
Solow model. (Again why "might"?)

Golden Rule Given the accumulation rule, the golden rule is:

  =  + 

So, using this rule and the steady state condition, we can …nd a savings rate that maximizes
consumption in steady state.

Summary 1

² The steady state is a long-term equilibrium. The Solow model shows how an economy is
changing over time until it gets to steady state.

² Savings rates determine the level of per worker capital stock in steady state. Higher the
savings rate, the higher the level of per worker capital stock.

² The golden rule of capital stock maximizes the consumption level in the long-term.

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 ² Population growth has a negative impact on capital stock accumulation. The higher the
population growth rate, the lower level of steady state.

² However, neither factor can explain sustained economic growth as observed in developed
countries. In the current model, capital stock per worker is invariant in steady state.

6 Technological Progress
Labor augmenting technology
To introduce a technology element into the model, we start with a new aggregate production
function:
 =  (  £ )

where  = output,  = capital stock,  = labor (workers), and  is e¢ciency of worker.  £ 

in the production function is called e¤ective workers. In the economy, e¢ciency of workers may be
determined by knowledge, experience, and skills of average workers. Because the e¢ciency variable
is attached to labor input, it is called labor-augmenting technology: an increase in  can increase
output level as if more labor input is used. In the Solow model,  is growing at a constant rate of
 (so,  is an exogenous variable).
We assume that the production function exhibits CRS. This means that we can divide both
sides by  £  to obtain:
 =  ()
 
where  =  is output per e¤ective worker, and  =  is capital stock per e¤ective worker.
Like population growth, technological progress a¤ects capital accumulation. The rule of capital
accumulation (per e¤ective worker) is now:

+1 =  ¡ ( +  + ) + 
or 4 = +1 ¡  =  ¡ ( +  + )

where ( +  + ) is called a break-even investment curve because it is the amount of investment
necessary to keep capital stock constant. Appendix shows how this equation is derived.

Steady state

De…nition 3 Steady state in the economy with technological progress is an equilibrium state where
 (capital stock per e¤ective worker) is invariant.

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 y, i
y=f(k)
yss

(δ+n+g)k

i=sf(k)

0 kss k

Figure 7: An Economy with Technological Progress and Population Growth

Thus the steady state condition is

4 =  ¡ ( +  + ) = 0

To obtain a steady state, we need solving the condition for . Figure 7 presents the steady state of
an economy with technological progress.
So, is there any di¤erence? The answer is yes. Too see this recall the de…nition of each variable
is given by (see Table 2):

Table 2: Steady State Growth Rates with Technological Progress

Vars Steady State Growth Rate
 (capital stock per e¤ective worker) 0
 (output per e¤ective worker) 0
 (labor/population) 
 (e¢ciency of worker) 

 =  £  (capital stock per worker) 

 =  £  (output per worker) 
 =  £  £  (capital stock) +
 =  £  £  (output) +

The implication of the information is as follows. In an economy with technological progress,

capital stock per e¤ective worker is not growing in steady state. However, capital stock per worker

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is growing at a rate of  (a rate of technological progress) even in steady state. Why? This is
because  is growing at  in all periods by assumption and because   is de…ned by  £ . So,
even if  is not growing in steady state,  is growing at . Moreover, this means that   output


per worker (equivalent to individual income) is also growing at  even in steady state. Likewise,
capital stock and total output in the economy are growing at  + . The bottom line of the Solow
model is: technological progress explains sustained economic growth in the context of individual
living standards.

The role of the government Researchers have found what factors determine the e¢ciency
of workers in an economy. Those factors include; education, health, infrastructure (road, highways,
airport, port, utilities, to name a few), law&order, and security (police, …re …ghting, military
services). Note that many of the factors that a¤ect e¢ciency of an economy involve public goods
elements, and it is well known in economics that markets themselves cannot provide enough amounts
of public goods. Usually, governments are the only agent that have an ability to provide the su¢cient
amount of public goods, which implies that the role of the government is important in (sustained)
economic growth.

Golden Rule With the accumulation rule, the golden rule is given by:

  =  +  + 

Using this rule and the steady state condition, we can …nd a savings rate that maximizes consump-
tion in steady state.

Summary 2

² The Solow model shows how capital stock accumulates over time, determines the long-term
equilibrium, and shows how savings, population growth, and technology a¤ects an economy
in the long-term.

² Savings and population growth determine the steady state level; however, neither variable
explains sustained economic growth.

² Technological progress can explain economic growth in steady state. In steady state, output
per worker is growing at a rate of technological progress.

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 ² Governments can play a key role in improving e¢ciency of workers. Good education/health
services, good infrastructure, strict law&order systems, and security improve the e¢ciency of
an economy and thus support sustained economic growth.

² The rate of technological progress is exogenous in the Solow model. Thus the Solow model
itself does not determine sustained economic growth.

Appendix
1. Data Although it is very important to take a close look at real data in studying economic
growth, we have no time to do so. However, a large number of useful data sources for international
economies are readily available. If you are interested, try the following:

² Summers-Heston Penn World Data (University of Pennsylvania): Very useful. Contains many
key variables such as GDP, investment, labor force for most economies from 1950. Data can
be downloaded via http://pwt.econ.upenn.edu/

² World Development Indicators (World Bank): Available in Waite library, or visit http://www.worldbank.o

² Human Development Report (United Nations): Estimates unique variables for human devel-
opment. Available in Waite library or visit http://hdr.undp.org/.

The Penn World Data are used to construct the …gure and table below.

2. Examples

16000
14000
GDP per capita

12000
10000
8000
6000
4000
2000
0
60

63

66

69

72

75

78

81

84

87

90

93

96
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19

19

19

19

19

19

19

19

19

19

19

19

Year
Chad
South Korea

Why some countries grow fast while others do not? Chad and South Korea 1960-1998 (Note: 1996 prices)

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 Why some countries are rich while others are not?
The Living Standards in 12 most populous countries 1998
Country GDP per Capita Population Country GDP per Capita Population
United States 31,049 275,675 Indonesia 3,521 203,678
Japan 23,345 126,410 China 3,203 1,238,599
Germany 21,724 82,047 India 2,464 978,672
Mexico 8,060 95,846 Pakistan 2,053 131,582
Russia 6,948 146,909 Bangladesh 1,655 125,629
Brazil 7,130 165,874 Nigeria 1,025 120,827
Note: GDP per Capita (in US dollars), Population (in thousand).

3. Mathematical Notes 3-1. Derive 4 =  ¡ ( + )

Noting that


4 = =  ¡ 


= 

we have

 ()
+1 ¡  = 4 ¼ =
 
 1  
= ¢ ¡ ¢
  2 
 ¡   
= ¡
  
=  ¡  ¡ 
! 4 =  ¡ ( + )

3-2. Derive 4 =  ¡ ( +  + )

Noting that


= 


= 

 
()  ¢+  ¢
= =  + 
 

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we have

 ()
+1 ¡  = 4 ¼ =
 
 1   
= ¢ ¡ ¢( ¢ + ¢ )
  ()2  
 ¡    
= ¡ ( ¢+ ¢ )
   
=  ¡  ¡ ( + )
! 4 =  ¡ ( +  + )

3-3 We show that shares of each input factor is equal to the elasticity of each input. Assume
the aggregate production function is given by:

 =  ¢  ( )

Let  denote a rental rate of capital, and let  denote a wage rate. We want to show that
  =   
 and   ¢  =    The economy maximizes its pro…t:

max  =  ¡  ¡  =  ( ) ¡  ¡ 

The …rst order conditions are:

 
! =
 
 
! =
 
Multiply both sides in the …rst equation by  and divide them by  yields

  
= 
  
 
!   = 
| {z } 
|{z}
elasticity of labor labor share

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For capital stock,

  
= 
  
 
!   = 
| {z } 
|{z}
elasticity of capital stock capital stock share

Cobb-Douglas Production function A Cobb-Douglas production function is the most

commonly used CRS production function:

 =   1¡

The elasticities of each inputs for Cobb-Douglas are given by:


  = 


  = 1 ¡ 


So, the factor shares for capital stock and labor are given by  and 1 ¡ , respectively. This is
very convenient in practice because you need no calculation to …nd capital share once you have a
production function.

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