3 The Solow Growth Model 3.1 Introduction In this third chapter, we will analyze the determinants of wealth and poverty during the industrial era among nations most of which have managed to escape from the Malthusian trap. Rather than focusing on short-term phenomena like business cycles, we will try to understand long-run patterns of development, for example why some of the richest countries such as Switzerland and Norway haye a level of GDP that is about one hundred times greater than the GDP of some of the poorest countries such as Niger and Haiti.! Population growth will play no important role in this framework since it is assumed to have stabilized at relatively low (exogenous) levels. The key factor of production is instead physical capital and the key process is that of conver- gence, showing how economies that initially start off with relatively low levels of physical capital per worker should grow faster than relatively richer countries. The neoclassical growth model builds fundamentally on the work of Robert Solow (1956) and has become one of the most important models in macroeco- nomic research. We start by deriving the well-known k-equation and the most important implications that follow from it such as convergence. In the final sections, we present some extensions to the Solow model where we demon- strate how technological progress and human capital can be included in the basic framework. 3.2 Basic assumptions The main contribution of the Solow growth model from a theoretical point of view is that it makes the accumulation of physical capital endogenous, as will soon become clear.” i The simplest version of the Solow growth model assumes an aggregate produc- tion function F of the following form: Y, = F(K(t), L(t)) G.1) where Y; is total GDP measured from the production side, K (¢) is total physical capital that is a function of time f, and L(f) is the aggregate labor force.> K (t)ng run ‘ 90 The long s the total stock of factories and Machine: : Q * S] might be thought of rit of workers. K and L (we wij hencefy. * Coun, total num ition) are thus Us L(t) as the tation for ease of expositio ) hus Production facty Lally th the time (1) nO oduction process. "SOF ing r Y tn regate pl : , ions: Dy in the Meee the following more technical assumptions: \ We also 1 urns to scale: FAK, M(L)) = AF(K, L). Ii factors of production have positive but diminishing Marginal yo ae e Ali ja : . OF 2 Ths; OP levels of K; > =F, sc) 22F Rs = Fr 0, aK? of L. The constant-returns assumption means oe : tt aes double the leg, of K and L simultaneously, we will get a - ts OF total output 4 © Seng assumption implies that F has a concave relations ip with both Production fata and that the marginal product-is always positive, This is the Same “ iat assumption of diminishing returns as was used in the Malthusian Model, It is further assumed that we can transform the aggregate production Functi in the following way: F(K,L Sb K K yee MGA) as@.. vreei* This transformation is referred to as the intensive form of (3.1) and k is for mally referred to as capital per worker. As we shall see, using this intensive-fom expression simplifies the algebit’si gnificantly in the sections ahead, The intensive form of the production function has the same basic properties a above: ZS ° £(0)=0; f/(k) > 0; F"(k) < Oat all levels of k > 0. The most often used functional form for the production function in growth theory is Cobb-Douglas: Y=F(K, L)=K%1-a (33) meee : Widing through by L gives us the intensive form, or output per worker J: Ota y= fj Seis ee (4) if = ip ihen k a Dynamics All Variables ; ey thell ; In the : : ify dynamics OF laws pe are functions Of time, so the next step is t0 SP — med !° Fe Su! Motion. The growth of labor 1 is in this setting *The Solow growth model 21 be exogenously given, i.e. not explained by the model: aL(t : Dp oO sient, where n > 0, eye" In this expression, n is the (percentage) growth rate of the labor force (or of population size). Although time derivatives indicate instantaneous changes in the stocks, we normally think of £, for instance, as the growth rate during a year, as in the national accounts.5 A typical level for n would thus be 0.01-0.05. The key dynamic equation in the Solow model is that specifying the rate of change in the physical capital stock: K=sy=sK (3.5) In this expression, 5 > 0 is the fraction of total output Y that is being saved and 6 > Ois the capital depreciation rate, i.e. the fraction of total physical capital that is worn down every year. (Typical and often observed levels are s=0.2 and 6=0.05.) The same expression can be restated as sY = K +6K =1, which tells us that total savings s¥ can be used for net investment K (leading to actual increases in the capital stock) and replacement investments 8K (replacing the capital that has been worn down), and which together sum to total aggregate investment J. The Solow growth model implicitly assumes a closed economy without trade and where there is no government. Hence, the user side of the economy contains only investment and consumption (compare with the fundamental equation (1.1) above). Therefore, we can write Y=K +5K+C€=I+C where C is the aggregate level of consumption. We want to express K in intensive form, i.e. we want to find k. Recall that k(t) = K (t)/L(t). Hence, by using the chain and quotient rules of differentiation, we can write ok(0)t eo SKS — =k=—- si ar Le KL s¥(t)—8K(t) === (See 3 a ke 7 nk (3.6) =sf(k) — (5 +n)k The expression in the third line of (3.6) is the central equation of the Solow growth model. 3.4 Equilibrium The k-equation can also be drawn as in Figure 3.1. The vertical axis simply shows levels whereas the horizontal axis shows capital per unit of effective labor, k.92 The long run Figure 3.1 The neoclassical growth diagram. The two most important lines here are the sf(k) and (6 +n)k Curves, where j is important to note that the former is concave since f”(k) <0. sf (k) is som times referred to as the actual level of investment and (6 + n)k as the break-eve level of investment. Beyond these curves, however, there is also the f(k) cure, Note that the vertical distance between the sf (k) and f(k) curves equals c=C/l, i.e. consumption per unit of labor. At low levels of k, k> 0, whereas at high levels of k, k <0. The only stable equilibrium in Figure 3.1 occurs at k*, which is defined by the point where the sf (k) and (5 +n)k curves cross. This is also the level of k where k =0, implying that K and L grow at a “balanced” rate.° k* is often also referred to as the stead state equilibrium.