The Solow growth model focuses on long-run economic growth

Topic 1: The Solow Model of Economic Growth

Macroeconomics is not a one-size-fits-all type of field. It would be a duanting task

to even attempt to construct a model that explained all interesting
macroeconomic phenomena, and any such model would undoubtedly be
complicated and unwieldy, making it difficult to learn (and teach). For this reason,
macroeconomists tend to adopt a more eclectic approach, with models often
being developed with the intention of helping to explain one particular aspect of
macroeconomy.

The first model that we will look at in this class, a model of economic growth
originally developed by MIT’s Robert Solow in the 1950s, is a good example of
this general approach. 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 describe the long-run evolution of the economy. The resulting
paper (A Contribution to the Theory of Economic Growth, QJE, 1956) remains
highly influential even today and, despite its relative simplicity, it conveys a
number of very useful insights about the dynamics of the growth process.

The Solow model is also worth teaching from a methodological perspective

because it provides a simple example of the type of dynamic model that is
commonly used in today’s more advanced macroeconomic theory: For those
brave souls amongst you who may be interested in studying more
macroeconomics after this course, note that some of the tricks and terminology
introduced here (such as the use logs to derive growth rates, and the concepts of
steady-state growth and convergent dynamics) are widespread in modern
macroeconomics.

An Aside on Notation

We are interested in modelling changes over time in outputs and inputs. A useful
mathe- matical shorthand that saves us from having to write down derivatives
with respect to time

everywhere is to write

Y ̇t = dYt (1) dt

What we are really interested in, though, is growth rates of series: If I tell you
GDP was up by 5 million euros, that may sound like a lot, but unless we scale it
by the overall level of GDP, it’s not really very useful information. Thus, what we
are interested in calculating
The Solow Model’s Ingredients

The model assumes that GDP is produced according to an aggregate production

function technology. It is worth flagging that most of the key results for Solow’s
model can be obtained using any of the standard production functions that you
see in microeconomic production theory. However, for concreteness, I am going
to be specific and limit us to the case in which the production function takes the
Cobb-Douglas form:

Y =AKαL1−α 0<α<1 (2) t ttt

where Kt is capital input and Lt is labour input. Note that an increase in At results
in higher output without having to raise inputs. Macroeconomists tend to call
increases in At “technological progress” and we will loosely refer to this as the
“technology” term, but ultimately At is simply a measure of productive efficiency.
Because an increase in At increases the productiveness of the other factors, it is
also sometimes known as Total Factor Productivity (TFP), and this is the term
most commonly used in empirical papers that attempt to calculate this series.

In addition to the production function, the model has four other equations. •
Capital accumulates according to

K ̇ t = Yt − Ct − δKt (3)

In other words, the addition to the capital stock each period depends positively
on savings (this is a closed-economy model so savings equals investment) and
negatively on depreciation, which is assumed to take place at rate δ.

• Labour input grows at rate n:

L ̇t =n (4) Lt

• Technological progress grows at rate g:

Ȧt=g

At

• A fraction s of output is saved each period.

Yt − Ct = sYt

is Y ̇t , and this is our mathematical expression for the growth rate of a series.
We have not put time subscripts on the rate of population growth, the rate of
tech- nological progress, the rate of depreciation of capital or the savings rate,
because we will generally consider these to be constant: The Solow model does
not attempt to explain fluctuations in these variables. However, we do wish to
charaterise the dynamics of the model well enough to be able to figure out what
happens if these parameters changes. So, for instance, we will be interested in
what happens when there is a once-off increase in the savings rate.

A Digression on the Production Function

Two well-known features of the Cobb-Douglas production function are worth

recapping here:

• Constant returns to scale (a doubling of inputs leads to a doubling of outputs):

At(μKt)α(μLt)1−α = μαμ1−αYt = μYt (6)

• Decreasing marginal returns to factor accumulation (adding extra capital while

hold- ing labour input fixed yields ever-smaller increases in output):

∂Y = αA Kα−1L1−α (7) ∂K tt t

􏰄∂2Y􏰅=α(α−1)AKα−2L1−α <0 (8) ∂K ttt

This turns out to be the key element of the model. Think about why it is sensible:
If a firm acquires an extra unit of capital, it should raise its output. But if the firm
keeps piling on extra capital without raising the number of workers available to
use this capital, the increases in output will probably taper off. In the Cobb-
Douglas case, the parameter α dictates the pace of this tapering off.

.What are the basic points about the Solow Economic Growth Model?

 The Solow model believes that a sustained rise in capital investment increases

the growth rate only temporarily: because the ratio of capital to labourgoes up. 
 However, the marginal product of additional units of capital may decline (there
are diminishing returns) and thus an economy moves back to a long-term
growth path, with real GDP growing at the same rate as the growth of the
workforce plus a factor to reflect improving productivity.
  A 'steady-state growth path' is reached when output, capital and labour are all
growing at the same rate, so output per worker and capital per worker are
constant.
 Neo-classical economists believe that to raise the trend rate of growth requires
an increase in the labour supply + a higher level of productivity of labour
and capital.
 Differences in the pace of technological changebetween countries are said to
explain much of the variation in growth rates that we see.

Productivity growth

The neo-classical model treats productivity improvements as an 'exogenous'

variable – they are assumed to be independent of the amount of capital investment. 

Catch up growth

 The Solow Model features the idea of catch-up growth when a poorer country is
catching up with a richer country – often because a higher marginal rate of
return on invested capital in faster-growing countries.
 The Solow model predicts some convergence of living standards (measured by
per capita incomes) but the extent of catch up in living standards is questioned –
not least the existence of the middle-income trap when growing economies find
it hard to sustain growth and rising per capita incomes beyond a certain level.