Solow Growth Model
Outline
Introduction
Production Function
General Form
Homogeneous of Degree One
Intensive Form
Slope of Production Function
Consumption and Investment Functions
Evolution of the Inputs
Inputs
Change in the Stock of Capital
The Dynamics of the Model
The dynamics of k
The Balanced Growth Path
Continued...
The Impact of changes in Saving Rate
On Output
On Capital Stock
On Balanced Growth Path
The Impact of changes in Population Growth
On Output
On Capital Stock
On Balanced Growth Path
The Impact of changes in Technological Progress
On Output
On Capital Stock
On Balanced Growth Path
Conclusion
Introduction
Solow (1956) presented this model.
The idea was how output responds to the changes in
Savings
Population Growth
Technology in the form of Knowledge
According to Solow
Yt = f (Kt , AtLt)
Whereas: Yt = Level of Output in time t
Kt = Units of Capital in time t, Lt = Units of Labour in time t
At = Technical Progress in the form of Knowledge in time t
At Lt = Labour Augmented Technical Progress in time t
Continued...
Solow (1956) assumed that his production function is
homogeneous with degree one.
Slope of his production function is positive.
CRS are possible for large nations where land and other natural
resources are ignored.
Letting
Yt = J x Yt , Kt = J x Kt , and Lt = J x Lt
Where,J = Any Constant Number,
Therefore,
JYt = f (JKt , At JLt)
Let
JYt = Y*t so
Y*t = f (JKt , At JLt)
Y*t = J x f (Kt , At Lt)
Y*t = J1 x Yt
Continued...
This shows that multiplying production function of Solow with
any constant number say J and in the end, that constant number
has completely factors out with degree, hence it indicates that
Production function of Solow is Homogeneous with degree one.
Intensive Form of Solows Production Function
As
Yt = f (Kt, AtLt)
Dividing both sides with AtLt
(Yt / AtLt)= f (Kt / AtLt , AtLt / AtLt)
or
(Yt / AtLt)= f (Kt / AtLt , 1)
Ignoring 1
(Yt / AtLt)= f (Kt / AtLt )
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Continued...
Or
Yt = AtLt x f(Kt / AtLt )
This is required Intensive form of Solows Model
Now for obtaining the production function we consider the
equation
Diminishing
y
(Yt / AtLt) = f(Kt / AtLt )
Marginal Product
Let
Yt / AtLt = yt
and
Kt / AtLt = kt
f(k)
MPK
1
Therefore,
yt = f(kt)
This is the required Production Function
Continued...
This production function states that output per effective worker
depends on capital per effective worker.
Slope of the Production Function
As we know that
Slope of the Production Function = d/dK (Yt) = MPK > 0
Or d/dK (Yt) = d/dK [AtLt x f(Kt / AtLt)]
= AtLt x [d/dK {f(Kt / AtLt)}]
= AtLt x [f/(Kt / AtLt ) x d/dK (Kt / AtLt)]
= AtLt x [f/(kt) x {AtLt x d/dK (Kt) - Kt x d/dK (AtLt)} / (AtLt)2]
= AtLt x [f/(kt) x {AtLt - 0} / (AtLt)2]
= AtLt x [f/(kt) x {AtLt / (AtLt)2]
= f/(kt) x [AtLt x AtLt / (AtLt)2]
Slope of the Production Function = d/dK (Yt) = MPK = f/(kt) > 0 8
Demand for Goods and
Consumption Functions
As we know that
AD = Yt = Ct + It . . (a)
and
AS = Yt = Ct + St . . (b)
Solving equation (b) for C:
Ct = Yt St whereas; In the long run:
so,
Ct = Yt sYt = Yt (1 s)
St = sYt
now substituting C in eq. (a)
Yt = Yt (1 s) + It or
Yt Yt (1 s) = It
Yt (1 1 + s) = It
Yt (s) = It
or
Dividing with AtLt on both sides
(sYt) / (AtLt) = (It) / (AtLt) or
Yt / AtLt = yand
It / AtLt = i
so,
sy = i
or
y = f (k)
so,
s . f (k) = i required Investment Function
Continued...
Now rewriting equation (a) as:
Yt / AtLt = Ct / AtLt + It / AtLt
or
y=c+i
c=yi
and
or
c = f (k) s . f (k)
required Consumption Function
Output, f (k)
c (per worker)
Investment, s f(k)
y (per worker)
i (per worker)
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Continued...
Amount of Depreciation:
The amount of depreciation increases as stock of capital per
efficient worker increases. Therefore, it is upward slopping.
Amount of Depreciation = (k)
Whereas: = rate of depreciation
k = stock of capital per efficient worker
k
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The Evolution of the Inputs
Solow assumed that inputs like Labour and Technology (L t , At)
grows at constant rate say n and g respectively. So,
L*t = n (Lt) or L*t / Lt = n and A*t = g (At) or A*t / At = g
The log form of the above information may be stated as
ln L*t = ln [n (Lt)] ln A*t = ln [n (At)]
ln L*t = ln (n) + ln (Lt)
ln A*t = ln (g) + ln (At)
ln L*t = n (t) + ln (Lt)
ln A*t = g (t) + ln (At)
ln L*0 = n (0) + ln (L0)
Let t = 0 so,
ln A*0 = g (0) + ln (A0)
ln L*0 = 0 + ln (L0) ln A*0 = 0 + ln (A0)
ln L*0 = ln (L0)
ln A*0 = ln (A0)
ln L*t = n (t) + ln (L0)
so,
ln A*t = g (t) + ln (A0)
Taking this information in the power of exponentioal
e [ln (L*t)] = e [n (t) + ln (L0)] e [ln (A*t)] = e [g (t) + ln (A0)]
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Continued...
e [ln (L*t)] = e [n (t) + ln (L0)]
e [ln (A*t)] = e [g (t) + ln (A0)]
L*t = e [n (t)] x e [ln (L0)]
A*t = e [g (t)] x e [ln (A0)]
L*t = e [n (t)] x L0
A*t = e [g (t)] x A0
L*t = L0 e [n (t)] A*t = A0 e [g (t)]
This shows that both inputs grow at exponential rate over time.
Now the changes in the stock of capital could be expressed as:
Change in stock capital = investment amount of depreciation
k = s f (k) - (k)
13
The Dynamics of the Model
The Dynamics of k
As Lt and At are exogenously determined and it is difficult to handle
Kt. So, we are proceeding with the dynamics of adjusted k.
So,
k = (Kt / AtLt)
Taking change of capital with respect to time.
dk / dt = k = (dKt / dt) x (AtLt) (d AtLt / dt) x (Kt) / (AtLt)2
= (K/t) x (AtLt) / (AtLt)2 [Ltx(dAt / dt) + Atx(dLt / dt)] x (Kt) / (AtLt)2
= (K/t) / (AtLt) (Kt) x [Ltx (A/t)] / (AtLt)2 + [Atx (L/t)] / (AtLt)2
= (K/t) / (AtLt)[{(Kt) / (AtLt) x (A/t) / (At)} + {(Kt) / (AtLt) x (L/t) / (Lt)}]
= (K/t) / (AtLt) [(Kt) / (AtLt) x (g + n)] and
K/t = It - Kt = sYt - Kt
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Continued...
Therefore,
= (sYt Kt) / (AtLt) [(Kt) / (AtLt) x (g + n)]
= (sYt / (AtLt) (Kt) / (AtLt) [(Kt) / (AtLt) x (g + n)] or
= s (Yt / AtLt) (Kt) / (AtLt) [(Kt) / (AtLt) x (g + n)] or
= s (Yt / AtLt) (Kt) / (AtLt) [ + (g + n)] or
k = sy (k) x [ + g + n] or
k = i (n + g + ) x (k)
If
If
If
i > (n + g + ) x (k)
i < (n + g + ) x (k)
i = (n + g + ) x (k)
then k > o so, k will increase
then k < o so, k will decrease
then k = o so, k will remain same
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Investment per efficiency unit of labour
Actual and Break-even Investment
[n+g+ ]k
break-even investment
sf(k)
actual saving
k*
Capital per efficiency unit of labour
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Phase Diagram For Solow Model
balanced growth path k = k*
dk/(t)/dt
k*
k
sf(k(t))- [n+g+ ]k
k = k* when dk(t)/dt = 0; so sf(k*) = [n+g+]k* which determines k*
17
The Balanced Growth Path (BGP): How does the model
behave once k has converged to k* ?
Once k has converged to k* :
K(t) / A(t)L(t) = k*, where k* is constant. Or
K(t) = A(t)L(t)k*
Now gL(t) = n and gA(t) = g, so K(t) grows at the rate (n+g).
Since K(t) and A(t)L(t) both grow at rate (n+g), and the
production function exhibits Constant Returns to Scale, Y(t)
grows at rate (n+g).
Since C(t) = (1-s)Y(t) consumption also grows at rate (n+g).
K(t)/Y(t) is constant.
K(t)/L(t) and Y(t)/L(t) grow at rate g. Thus g determines the
growth rate of income per capita.
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Change in Saving rate
The Solow Model shows that if the saving rate is high, the economy
will have a large capital stock and high level of output. If the saving
rate is low, the economy will have a small capital
Investment
stock and a low level of output.
and
Depreciation, k
depreciation
New Balanced Growth Path
Old Balanced Growth Path
i2* = k2*
Investment, s2f(k)
i1* = k1*
Investment, s1 f(k)
An
Anincrease
increasein
inthe
the
saving
savingrate
ratecauses
causes
the
thecapital
capitalstock
stock
totogrow
growtotoaanew
new
steady
steadystate.
state.
k1*
k2*
Capital
per worker, k
19
Change in Saving rate
s
sNEW
sOLD
dk/dt
t0
t0
k*NEW
k*OLD
t
t0
20
Change in Saving Rate
Thus a change in the saving rate affects only the level of activity in
steady state (not its growth rate).
Nonetheless, the change in level may be quantitatively substantial.
Consider the effect on steady state y* = f(k*)
Now dy* /ds = f (k*) dk*/ ds
k* is defined by the condition that dk/ dt =0 and satisfies
s f (k*) = [n + + g ] k*,
and k* = k*(s, n, , g).
Differentiating w.r.t s: f(k*) + sf (k*) dk*/ds = [n + + g] dk*/ds.
Now, gather terms in dk*/ds and re-arrange:
dk*/ds = f (k*) / [[n + + g] - sf(k*)]
(>0 see phase diag).
So dy*/ds = f (k*) f(k*) / [[n + + g ] - s f (k*)] >0.
21
Change in Savings Rate
Rewrite as an elasticity (unit less, more convenient):
ey*,s = (s/y) (dy/ds) = ak(k*) / [1 - ak(k*) ]
where ak(k*) = k*f (k*)/f(k*)
Suppose ak(k*) = 1/3, then ey*,s
= elasticity of y w.r.t. k at k*
= income share of k at k*
= 1/2.
Then a 10% rise in s (from 0.2 to 0.22) raises y by 5%.
So the effect of s on the level of output (per efficiency unit of
labour) is relatively modest.
In the long-run, changes in the saving rate (& other parameters)
only have level effects on k* and y*, they do not affect the growth
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rate.
Population Growth
The basic Solow model shows that capital accumulation, alone,
cannot explain sustained economic growth. High rates of saving
lead to high growth temporarily, but the economy eventually
approaches a steady state in which capital and output are constant.
To explain the sustained economic growth, we must expand the
Solow model to incorporate the other two sources of economic
growth.
So, lets add population growth to the model. Well assume that
the population and labor force grow at a constant rate n.
23
The Impact of Population Growth
Like depreciation, population growth is one reason why the capital
stock per worker shrinks. If n is the rate of population growth and
is the rate of depreciation, then ( + n)k is break-even
investment, which is the amount necessary to keep constant the
capital stock per worker k.
An increase in the rate of population growth shifts the line
representing population growth and depreciation upward.
The new steady state has a lower level of capital per worker than
the initial steady state. Thus, the Solow model predicts that
economies with higher rates of population growth will have lower
levels of capital per worker and therefore lower incomes.
24
The Impact of Population Growth
Old Balanced Growth Path
New Balanced Growth Path
in reality
An
An increase
increase inin the
the rate
rate ofof
population
population growth
growth from
from nn1 1 toto
nn2 reduces
reduces the
the steady-state
steady-state
2
capital
capitalstock
stockfrom
fromk*
k*1 totok*
k*2. .
1
25
The Impact of Technological Progress
Like depreciation and population growth, technological progress is
another reason for decline in the capital stock per worker.
If g is the rate of technological progress and ( + n) is the rate of
depreciation after population growth, then ( + n + g)k is breakeven investment, which is the amount necessary to keep constant
the capital stock per worker k.
An increase in the rate of technological progress shifts the line
representing technological progress; population growth and
depreciation upward.
The new steady state has a lower level of capital per worker than
the initial steady state. Thus, the Solow model predicts that
economies with higher level of technological progress will have
lower levels of capital per worker and therefore lower incomes.
26
The Impact of Technological Progress
Old Balanced Growth Path
New Balanced Growth Path
in reality
( + n + g1) k
An
increase
in
the
An
increase
in
the
technological
technological progress
progress from
from gg1 1
toto gg2 reduces
the steady-state
2 reduces the steady-state
capital
capitalstock
stockfrom
fromk*
k*1 totok*
k*2. .
1
27
Convergence: Theory and Evidence
A key implication of the Solow model is that economies converge
towards their balanced growth paths
Solow model predicts rate of return (on capital) lower when
K/L high. This would cause funds to flow to poorer countries,
so we should expect poor countries to grow more quickly.
Solow model predicts that countries converge to BGPs; so if
Y/L differences arise from differences relative to respective
BGPs, we should expect poor countries to grow more quickly.
However in reality neither empirical results support the
Solows proposition of Convergence nor the speed of
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adjustment.
Conclusion
In the long run, an economys saving determines the size of k and
thus y.
The higher the rate of saving, the higher the stock of capital and
the higher the level of y.
An increase in the rate of saving causes a period of rapid growth,
but eventually that growth slows as the new steady state is
reached.
The higher the rate of population growth and technological
progress, the higher the rate of depreciation, the lower the stock of
capital per efficient worker and hence the lower the level of output
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per efficient worker respectively.
THANK YOU!!!
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