Stylized facts The Solow model Empirical evidence Implications for inequality Summary References Appendix

Solow Growth Model in

Continuous Time
Hoang Khieu

Fulbright University Vietnam

May 18, 2022

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Stylized facts The Solow model Empirical evidence Implications for inequality Summary References Appendix

Outline

1 Stylized facts
2 The Solow model
3 Empirical evidence on convergence
4 Implications for inequality
5 Summary

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WE LIVE IN AN UNEQUAL WORLD!

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Quick quiz
1 Which country/territory has lowest per capita GDP in 2019?
a. Uganda
b. Burundi
c. Sudan
d. Senegal

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Quick quiz
1 Which country/territory has lowest per capita GDP in 2019?
a. Uganda
b. Burundi
c. Sudan
d. Senegal
Answer: b

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Stylized facts The Solow model Empirical evidence Implications for inequality Summary References Appendix

Quick quiz
1 Which country/territory has lowest per capita GDP in 2019?
a. Uganda
b. Burundi
c. Sudan
d. Senegal
Answer: b
2 Which country/territory has highest per capita GDP in 2019?
a. Macao SAR, China
b. USA
c. Switzerland
d. Qatar

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Stylized facts The Solow model Empirical evidence Implications for inequality Summary References Appendix

Quick quiz
1 Which country/territory has lowest per capita GDP in 2019?
a. Uganda
b. Burundi
c. Sudan
d. Senegal
Answer: b
2 Which country/territory has highest per capita GDP in 2019?
a. Macao SAR, China
b. USA
c. Switzerland
d. Qatar
Answer: a

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Stylized facts The Solow model Empirical evidence Implications for inequality Summary References Appendix

Quick quiz
1 Which country/territory has lowest per capita GDP in 2019?
a. Uganda
b. Burundi
c. Sudan
d. Senegal
Answer: b
2 Which country/territory has highest per capita GDP in 2019?
a. Macao SAR, China
b. USA
c. Switzerland
d. Qatar
Answer: a
3 Per capita GDP of the richest country/territory is of a factor of X
higher than that of the poorest country/territory. What is the
value of X?
a. between 20 and 50
b. between 50 and 80
c. between 80 and 100
d. more than 100

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Stylized facts The Solow model Empirical evidence Implications for inequality Summary References Appendix

Quick quiz
1 Which country/territory has lowest per capita GDP in 2019?
a. Uganda
b. Burundi
c. Sudan
d. Senegal
Answer: b
2 Which country/territory has highest per capita GDP in 2019?
a. Macao SAR, China
b. USA
c. Switzerland
d. Qatar
Answer: a
3 Per capita GDP of the richest country/territory is of a factor of X
higher than that of the poorest country/territory. What is the
value of X?
a. between 20 and 50
b. between 50 and 80
c. between 80 and 100
d. more than 100
Answer: d
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Income inequality across countries

Figure 1: Histogram of per capita GDP (USD) across countries (The World Bank Database 1990)

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Income inequality across countries

Figure 2: Histogram of per capita GDP (USD) across countries (The World Bank Database 2019)

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Income growth across countries

Most countries grow
Some grow significantly faster than the others

Figure 3: The evolution of per capita GDP of selected countries

Note: The time series plotted is Xt /X1990 where Xt is real GDP per capita in t

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Questions

Why is a country richer than another (in terms of per capita

GDP)?
Why does a country grow faster than another (in terms of per
capita GDP)?
What are the determinants of growth?
Do countries converge in terms of per capita GDP?

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Solow growth model

Solow (1956): closed economy, continuous time

Households
are identical → representative household
own capital stock K s and rent it to firms at the rate of return R
supply labour Ls inelastically at the wage rate w
save at constant rate s
consume C and invest I = sY units of final good Y (will not be
optimizing)
Firms
have access to the same production function → representative firm
produce a unique final good employing capital and labour
Production function
exhibits constant return to scale
is shifted by exogenous productivity, which is free

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Solow growth model

Figure 4: Solow model economy

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Aggregate production function

Consider the Cobb-Douglas production function

1−α
F (A(t), K (t), L(t)) = K (t)α (A(t)L(t)) ,0 < α < 1 (1)

where A, K , and L are labour productivity, capital demand and

labour demand, respectively
This production function exhibits
continuity
differentiability
positive and diminishing marginal products
constant return to scale

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Firm optimization

Let us suppress time argument for convenience (Time does not

matter anyway. Why?)
The problem of the representative firm

max F (A, K , L) − wL − RK (2)

K >0,L>0

The firm is a price-taker

The first-order necessary conditions imply

∂
w= F (A, K , L) (3)
∂L
∂
R= F (A, K , L) (4)
∂K

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Market clearing conditions

The market clearing conditions imply

Capital market: K s (t) = K (t)
Labour market: Ls (t) = L(t)
Good market: Y (t) = C(t) + I(t)
Let us use K , L, and Y as capital, labour, and output in equilibrium

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Productivity, population, and capital accumulation

Labour productivity grows at a constant rate g

dA(t)/dt Ȧ(t)
≡ =g (5)
A(t) A(t)

Population (also the number of employed workers) grows at a

constant rate n
dL(t)/dt L̇(t)
≡ =n (6)
L(t) L(t)
Capital accumulation is given by

dK (t)
≡ K̇ (t) = sY (t) − δK (t) (7)
dt
where s and δ are the saving rate and depreciation rate, respec-
tively

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Transitional dynamics/Phase diagram analysis I

Analyzing the dynamics of this economy is difficult as variables are

growing
We therefore work with the ratio of capital to effective labour

K (t)
k̃ ≡
A(t)L(t)

The growth rate of k̃ is given by

˙
k̃ (t)
= sk̃ (t)−(1−α) − (δ + g + n) (8)
k̃ (t)

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Transitional dynamics/Phase diagram analysis II

The growth rate of k̃ (t) at k̃0 is

higher than at k̃1
Consider a poor country with
capital per effective worker of
k̃0 and a rich country at k̃1
The marginal productivity of
capital at k̃0 is higher than at
k̃1
Investment at k̃0 leads to faster
increase of capital stock and
faster growth of GDP
Figure 5: The dynamics of capital per effective labour

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Transitional dynamics/Phase diagram analysis III

Distances (relative and abso-

lute) in GDP per capita reduce
over time between poor and
rich country
The poor country catches up
relative to the rich country
The gap between two coun-
tries equals zero only in the
long run

Figure 7: The dynamics of capital per effective labour

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But countries differ in

saving rate
labour productivity growth
population growth
depreciation rate
...

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Two countries with different saving rates

Poor country saves less than

rich country
Poor country with low capital
per effective labour k̃1 and rich
country with high capital per ef-
fective labour k̃2
Poor country converges to its
steady state at k̃1∗ while rich
country converges to k̃2∗
The gap between two coun-
tries in the long run remains
Figure 6: The dynamics of capital per effective labour: Two
positive countries with different saving rates

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Long-run equilibrium I
The long-run equilibrium is when capital per effective labour k̃ (t)
˙
no longer changes over time (equivalently k̃ (t)/k̃ (t) = 0), i.e.

˙
k̃ (t)
= sk̃ (t)−(1−α) − (δ + g + n) = 0 (9)
k̃ (t)

Solving this equation for k̃ yields the steady-state value k̃ ∗

 1
 1−α
K (t) s
k̃ ∗ ≡ = (10)
A(t)L(t) δ+g+n

An increase in s leads to higher k̃ ∗

An increase in δ, g, or n reduces k̃ ∗
Higher α causes higher k̃ ∗ if the saving rate is sufficiently large, i.e.
s >δ+g+n

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Long-run equilibrium II

Capital per effective labour being constant in the long run implies
that long-run growth of capital stock is driven by labour productivity
growth and population growth

K̇ (t) Ȧ(t) L̇(t)

= + =g+n (11)
K (t) A(t) L(t)

Long-run GDP growth is also driven by labour productivity growth

and population growth

Ẏ (t) Ȧ (t) L̇ (t)

= + =g+n (12)
Y (t) A (t) L (t)

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Long-run equilibrium III

Per capita GDP is defined as

Y (t)
y (t) ≡
L(t)

Per capita GDP growth in the long run is given by

ẏ (t) Ẏ (t) L̇ (t)

= − =g+n−n =g
y (t) Y (t) L (t)

Long-run GDP per capita grows faster only if labour productivity

grows faster!

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Is there convergence?

How to check if there is convergence?

Growth rate of capital per effective labour decreases in its level!
Data unavailability!
Growth rate of GDP per capita vs its level?
ẏ (t)/y (t) is a decreasing function of k̃ (t)
k̃ (t) is a rising function of y (t) (given labour productivity A)
ẏ (t)/y (t) is a decreasing function of y (t) (why?)
⇒ There is convergence if the data show a negative relationship
between growth rate of per capita GDP and its level

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Is there convergence?

Figure 7: Convergence of per capita GDP growth

WHAT DO THE DATA TELL US?

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Is there convergence?

Baumol (1986)
There is convergence of per capita GDP among industrialized
economies
Convergence is not so clear for centrally planned economies
No convergence for less developed countries

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Is there convergence?

Figure 8: Convergence among selected OECD countries Figure 9: Per capita GDP growth vs its level - Selected
(Baumol 1986, fig. 1) industrialized economies (Baumol 1986, fig. 2)

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Is there convergence?

Figure 10: Per capita GDP growth vs its level - Full sample (Baumol 1986, fig. 3)

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Is there convergence?
Barro and Sala-i-Martin (1992): Convergence across 48 contigu-
ous U.S. states

Figure 11: Per capita income growth vs its level - 48 U.S. states (Barro and Sala-i-Martin 1992, fig.
1)

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Is there convergence among provinces in Vietnam?

Figure 12: Histogram of annual income per capita (USD) across provinces in Vietnam (General
Statistics Office of Vietnam)

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Is there convergence among provinces in Vietnam?

Figure 13: Income growth vs log of income across provinces in Vietnam (General Statistics Office
of Vietnam)

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Is there convergence among provinces in Vietnam?

Figure 14: Income growth vs log of income across selected provinces in Vietnam (General
Statistics Office of Vietnam)

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Implications for inequality

If countries have identical structural parameters, they converge to

an identical steady state no matter where they start ⇒ no cross-
countries inequality in the long run
If countries differ in their structural parameters, they converge to
different steady states ⇒ long-run inequality across countries

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Implications for inequality

Higher saving rate implies faster capital accumulation and therefore

a higher long-run value of per capita GDP
Higher labour productivity growth implies higher growth of per
capita GDP
Poor countries catch up rich countries faster with a higher sav-
ing rate and higher labour productivity growth ⇒ cross-countries
inequality reduced

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Implications for inequality

HOW TO REDUCE INEQUALITY ACROSS

PROVINCES IN VIETNAM?
Capital accumulation
Reducing public investment gap between provinces
Preferential policies towards less-developed provinces
Labour productivity growth
Institutions to attract skilled labour
Education

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Quiz - Summary

1. What are the determinants of per capita GDP

a. Capital stock and labour force
b. Capital stock and labour productivity
c. Labour force and labour productivity
d. Capital stock, labour force, and labour productivity

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Quiz - Summary

1. What are the determinants of per capita GDP

a. Capital stock and labour force
b. Capital stock and labour productivity
c. Labour force and labour productivity
d. Capital stock, labour force, and labour productivity
Answer: d

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Quiz - Summary

1. What are the determinants of per capita GDP

a. Capital stock and labour force
b. Capital stock and labour productivity
c. Labour force and labour productivity
d. Capital stock, labour force, and labour productivity
Answer: d
2. Long-run growth of per capita GDP is determined by
a. Capital growth
b. Population growth
c. Labour productivity growth
d. All above

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Quiz - Summary

1. What are the determinants of per capita GDP

a. Capital stock and labour force
b. Capital stock and labour productivity
c. Labour force and labour productivity
d. Capital stock, labour force, and labour productivity
Answer: d
2. Long-run growth of per capita GDP is determined by
a. Capital growth
b. Population growth
c. Labour productivity growth
d. All above
Answer: c

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Quiz - Summary

1. What are the determinants of per capita GDP

a. Capital stock and labour force
b. Capital stock and labour productivity
c. Labour force and labour productivity
d. Capital stock, labour force, and labour productivity
Answer: d
2. Long-run growth of per capita GDP is determined by
a. Capital growth
b. Population growth
c. Labour productivity growth
d. All above
Answer: c

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Quiz - Summary

3. What are the determinants of GDP growth?

a. Labour productivity growth
b. Population growth
c. Capital accumulation
d. All above

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Quiz - Summary

3. What are the determinants of GDP growth?

a. Labour productivity growth
b. Population growth
c. Capital accumulation
d. All above
Answer: d

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Quiz - Summary

3. What are the determinants of GDP growth?

a. Labour productivity growth
b. Population growth
c. Capital accumulation
d. All above
Answer: d
4. Cross-countries inequality of per capita GDP is caused by
a. heterogeneous saving rates
b. heterogeneous labour productivity
c. different rates of capital depreciation
d. All above

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Quiz - Summary

3. What are the determinants of GDP growth?

a. Labour productivity growth
b. Population growth
c. Capital accumulation
d. All above
Answer: d
4. Cross-countries inequality of per capita GDP is caused by
a. heterogeneous saving rates
b. heterogeneous labour productivity
c. different rates of capital depreciation
d. All above
Answer: d

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Extensions

Endogenous saving rate

Endogenous technological change

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Thank you for your attention

Hoang Khieu
hkhieu@uni-mainz.de

https://sites.google.com/site/hvkhieu/

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References I

Robert J. Barro and Xavier Sala i Martin. “Convergence”. In:

Journal of Political Economy 100.2 (1992), pp. 223–251.
William J. Baumol. “Productivity Growth, Convergence, and Wel-
fare: What the Long-Run Data Show”. In: American Economic
Review 76.5 (1986), pp. 1072–1085.
Robert M. Solow. “A Contribution to the Theory of Economic
Growth”. In: Quarterly Journal of Economics 70.1 (1956),
pp. 65–94.

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Appendix 1: Continuous time vs discrete time

In continuous time, the time derivative and the growth rate of a

variable x(t) are respectively denoted by ẋ(t) and ẋ(t)/x(t)

dx(t) x(t) − x(t − ∆t)

ẋ(t) ≡ = lim
dt ∆t→0 ∆t
ẋ(t) (x(t) − x(t − ∆t))/∆t
≡ lim
x(t) ∆t→0 x(t − ∆t)
The discrete-time counterparts

∆xt = xt − xt−1

∆xt xt − xt−1
=
xt−1 xt−1

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Appendix 2: The growth rate of capital per effective

labour
Capital per effective labour is given by

K (t)
k̃ =
A(t)L(t)

Taking natural log and deriving with respect to time yields

˙
k̃ (t) sK (t)α (A(t)L(t))1−α − δK (t) Ȧ(t) L̇(t)
= − −
k̃ (t) K (t) A(t) L(t)

Further simplification gives

˙
k̃ (t)
= sk̃ (t)−(1−α) − (δ + g + n) (13)
k̃ (t)

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Appendix 3: Long-run capital growth

Taking natural log of the Eq. (10) gives

 
ln k̃ ∗ = ln(K (t)) − ln(A(t)) − ln(L(t)) (14)

Deriving with respect to time yields the long-run growth rate of

aggregate capital stock

K̇ (t) Ȧ(t) L̇(t)

= + =g+n (15)
K (t) A(t) L(t)

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Appendix 4: Long-run GDP growth

Taking natural log and then time derivative of the production func-
tion (1) yields
" #
Ẏ (t) K̇ (t) Ȧ (t) L̇ (t)
=α + (1 − α) +
Y (t) K (t) A (t) L (t)

Using the result from (15) yields

" # " #
Ẏ (t) Ȧ (t) L̇ (t) Ȧ (t) L̇ (t)
=α + + (1 − α) +
Y (t) A (t) L (t) A (t) L (t)
Ȧ (t) L̇ (t)
= + =g+n
A (t) L (t)

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Appendix 5: Per capita income growth vs its level

" #
ẏ (t) Ẏ (t) L̇ (t) K̇ (t) Ȧ (t) L̇ (t) L̇ (t)
= − =α + (1 − α) + −
y (t) Y (t) L (t) K (t) A (t) L (t) L (t)
= αsk̃ (t)−(1−α) − α (δ + g + n) + g
" #1
1−α α
K (t) K (t)α (A(t)L(t))
k̃ (t) ≡ =
A(t)L(t) A(t)L(t)
 1
y (t) α
=
A(t)

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