Solow Growth Model in the Economies of USA and China

With the highly globalize world economy, there are a lot of discussions in
terms of how can an economic giant can influence other minor economies.
Today, the giants are fighting a race in gaining supremacy over the world
economy. China and USA, being the today’s economic powerhouses, influence
many not only politically and culturally, but also the wealth being distributed all
over the world. Trade wars, foreign grants, and stricter tariffs are few of the
measures that each economies employ to battle the top spot for the title of being
a leader in the world.

Whenever world supremacy is being discussed among states, economic

growth is one of those areas that are being looked at to measure the viability of
the claim of a state of being on the apex. Economic growth has many indicators.
Readily available data are being offered to measure an economy’s performance
over the years. Hence, nothing can really gauge a sound economy aside from
seeing some classical indicators in the economy.

This paper seeks to answer the question of the race between USA and
China of becoming a global leader by comparing the two economies. Labour,
capital accumulation and technological advancements are the key economic
indicators to be tackled in differentiating the performance of the two countries
mentioned. And whenever those economic indicators are being mentioned, a
macroeconomic model is a reliable tool in recognizing sustainable economic
growth. It is the Solow Growth Model. The first part of the paper will expose the
model’s origin, the principle and a brief explanation. The second part will be a
discussion of the model on the respective experiences of the two economies. In
discussing the model, relevant information will be presented to back the claims
of the model.

The Solow Growth Model

The Solow Growth model was developed by Robert Solow of Massachusetts

Institute of Technology and awarded a Nobel Prize in 1990. The parameter of
model is within the neoclassical economics, more in particular the production
function of the Cobb-Douglas (Q = A 𝐾 𝑎 𝐿𝑏 ). The Solow Growth Model tries to
explain how the economy works, grow and then reach the steady state
(equilibrium). The growth, according to this model can only be sustained if there
is technological augmentation be added in the equation.

Solow’s purpose in developing the model was to deliberately ignore some

important aspects of macroeconomics, such as short-run fluctuations in
employment and savings rates, in order to develop a model that attempted to

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 describe the long-run evolution of the economy. It (Solow model) provides a
simple example of the type of dynamic model that is commonly used in today’s
more advanced macroeconomic theory. (Whelan 2005)

According to the Solow Growth Model, the relationship of output and

income in a country dictates short-term economic growth. In graph A, X axis is
being designated as capital (income) and y axis is the labour. Capital is
dependent on the saving pattern of the population. If an economy has a solid
policy on savings thus encouraging a fraction of the population’s income be put
aside for savings thus turn into investment, the economy will increase capital
available for the different economic activities. The existence of savings is a
necessary and sufficient condition for investment creation. If savings go up,
investment increases because the interest rate and economic growth will be
imminent (Najarzadeh et al 2014). On the other hand, labour is based on the
productivity of an economy. Labour productivity heavily influences the
production process and production costs, and production costs affect the
competiveness of nations in the global market (Ausina-Emsima 2014).

Looking closely in the graph A, the relationship of capital and labour is being
illustrated. The 45 degree line represents the depreciation. In point F, the capital
is greater than the depreciation. This means any injection of additional capital
means economic growth. As long as the line i is above the depreciation line, there
is an economic growth.

The Solow Growth Model also explains that capital accumulation (income)
and Labour alone cannot explain sustained economic growth. Steady state
happens when an economy becomes stagnant despite injection of much capital
through savings and investment and labour in the economy.

A steady state economy features relatively stable size. It is ideally established at

a size that leaves room for nature and provides high levels of human wellbeing.
The term typically refers to a national economy, but it can also be applied to the
economy of a city, region, or the entire planet. The size of an economy is
generally determined by multiplying population by the amount that each
person consumes. This quantity in a steady state economy neither grows nor
contracts from year to year. (Czech nd)

In the graph A, point SSE represents the occurrence of the stagnation of

economy despite increase in capital and labour output. Hence, any additional
unit of these two economic factors cannot sustain economic growth in the long
run. To realize a growth, another factor should be considered, this is technological
advancement need in the labour market. Any augmentation in the labour and
production through innovation can dictates higher output thus results in a
exponential and sustained growth. According to Zhao (2019), the boundary of

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production possibilities in a society is jointly determined by available resources
and current technology. The expansion of this boundary is mostly determined by
changes in technology, especially in the long run.

F SSE
Graph A. Labour, Capital, and Steady State in Solow Growth Model

China: Capital, Labour, and Technological Advancement

China over the years gained much global attention not only politically and
culturally but also in world economy. With the decisive election of officials in their
national government, China has been felt in all continent. Politically, many of the
Chinese foreign policies are directed towards the interest of the country. The
phenomenal economic ascent of China since the early 1980’s fully modified the
international geopolitical relations in the era of globalization (Milhiet 2017).

All of the influence of China can be traced to the ongoing economic boom in
the country. This economic expansion can only be attributed to the classic
economic fundamentals that Chinese economists and policy makers are faithfully
employing. In graph B, China, since the 90’s, has been consistent in capital
accumulation. A gradual and steady increase in this aspect of the economy
made the country resilient and sustainable. With this data, the Chinese Economy
is consistent in the macroeconomics fundamental of high capital means liquidity
in the market. Hence, more wealth can be redirected to investment in multiple
economic activities. According to Yueh (2015), capital accumulation has

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contributed around half of China’s economic growth, which is in line with other
estimates that find that most of China’s growth is accounted for mostly by capital
accumulation rather than TFP growth.

Graph B. Capital Accumulation: China and USA from 1990 – 2019.

Another aspect to consider on the rise of the economic giant is the Gross
Domestic Product. China has been consistent as well on this aspect of the
economy. With a consistent 5% GDP (Graph D), the economy of this Asian giant
can easily eclipse any economy. This is a also a testament that the output of the
economy is consistent hence adhering to the macroeconomic fundamental of
the Solow Growth Model. Such growth has enabled China, on average, to double
its GDP every eight years and helped raise an estimated 800 million people out of
poverty. China has become the world’s largest economy (on a purchasing power
parity basis), manufacturer, merchandise trader, and holder of foreign exchange
reserves. (Morrison, 2019) As the output of the country continuously rising, other
sectors of the economy has been directed towards growth. There no doubt that
the economy of China is expanding over the years as the GDP is consistently rising.

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According Amadeo (2019), China's economy produced $25.3 trillion in 2018. This
makes the country above the EU in producing output in the economy.
Furthermore, there are also strong emphasis on other sectors of the economy like
the boom in real estate that makes up a fraction of the country’s GDP. The rise in
real estate industry can be attributed first to the booming of many Chinese cities
and the availability of capital in building infrastructure that can be attributed to
the expanding capital accumulation. In which, this capital has been redirected
to investments. The industry is one of the most important aspect of the Chinese
financial system. In 2017, housing sales totaled 13.37 trillion RMB, equivalent to
16.4% of China’s GDP (Liu and Xiong, 2018)

Graph C. Gross Domestic Product (US Dollar): China and USA

In 2019, many economist also pointed out that the Chinese economy is
slowing down. Thus, in a text book macroeconomics fundamentals, capital and
labour cannot sustain the much needed growth of the robust Asian economy.
Softness was visible last month in nearly every aspect of the Chinese economy,
with industrial output and retail sales data pointing to sluggish demand and low
confidence among businesses and consumers (Qi et al 2019). The slowdown is
inevitable as the economy reached the steady state scenario. Hence, there is
rouse between the two economic giants, USA and China, over the technological
advancement. In the first half of 2019, the two economies had fought bitter trade
war over the technological supremacy. The U.S.-China trade war is at heart a

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battle for tech supremacy and the huge commercial and national security
advantages that come with it (Wu 2019). The stir in technology industry had
bought collateral damages in both countries that banned companies in selling in
their respective countries. The Commerce Department (USA) placed Huawei and
70 of its affiliates on its “Entity List,” which is basically a trade blacklist that bars
anyone on it from buying parts and components from US companies without the
government’s approval (Stewart 2019). Though one company is singled out, in a
greater scheme of things, this is an indication that both of the countries realized
that the only way to gain supremacy over the world in terms of economy is to
take the greatest advantage in technological progress. Setting other issues aside
like the security and political agenda, this aspect of economy, as according to
the Solow growth Model, is the avenue to realize a long term economic growth.

Graph C. Gross Domestic Product – Growth Rate: China and USA

USA: Capital, Labour, and Technological Advancement

On the other side of the globe, USA is struggling to maintain its status as the
World’s powerhouse. Over the century, the United States of America has been
the leader in geopolitics, culture, and of course economy. The presence of the
United States has been felt all over the continent not only through the military

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presence but to the idealism of the country. The United States is the world's most
powerful country by far, with a globe-spanning network of alliances and military
bases (Ellis Et al 2016).

In terms of economy, the USA also has been on a strategic stance to control
the power it’s been toying since the mid 20 century. The United States will remain
the world’s only global economic superpower until 2035 even though China’s role
in the world economic landscape will become more important, according to
Beijing’s latest predictions, in an apparent toning down of the mainland’s public
ambitions for its future role in global economy (Tang 2019).

In graph B, the upward trend of capital accumulation is observable. On

the contrary there are several decline as well and the most notable is on the
year 2008 to 2010. These periods are the global financial crisis of 2008. According
to Dauton et al (2018), within a few weeks in September 2008, Lehman Brothers,
one of the world’s biggest financial institutions, went bankrupt; £90bn was wiped
off the value of Britain’s biggest companies in a single day; and there was even
talk of cash machines running empty. The downturns are economic contractions
that the USA economy periodically being experienced.
In GDP, though consistently higher than its rival, USA’s GDP growth rate is
not stellar compared to China. The growth rate is fluctuating sometimes even on
the negatives. This is an indication of highly volatile economic activity that can
affect many sectors of economy. Interestingly, graph D showed a supremacy of
China in terms of the growth rate. This is an important indicator between the
performances of the economies of the two countries.
Hence, the USA has been pressuring China in many ways to gain
supremacy in technological progress. USA has been consistent with the research
and development to pump prime the economy. The fundamentals of USA in this
aspect of economic growth is consistent thus gaining much return as it can be
seen in the sustained economic growth of the country. The 2018 report shows
the U.S. invests the most in research and development (R&D), attracts the most
venture capital, awards the most advanced degrees, provides the most
business, financial and information services, and is the largest producer in high-
technology manufacturing sectors (National Science Foundation, 2018)

Conclusion

In conclusion, USA and China have been on the forefront in economic

development in the today’s society. There are no though that the fight is not yet
done between the two in gaining the top spot. Unless there are no changes

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favoring the economic fundamentals of the Solow Growth Model of injecting
technological progress in the labour and production, capital and labour can only
bring as much growth to the economy. As being pointed out in the paper, there
are indication that this macroeconomics principle has been greatly considered
by the countries as there are battle in the technological progress.

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Graph Source:

https://data.worldbank.org/indicator/ny.gdp.mktp.kd.zg

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