The Solow Growth Model (Part Two

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The golden rule level of capital, maximizing consumption per worker.

This is known as the golden rule level of capital (k*gold) .Model Background ‡ As mentioned in part I. We also learned about the steady state level of capital. we assume policy makers can set the savings rate to determine a steady state level of capital that maximizes consumption per worker. the Solow growth model allows us a dynamic view of how savings affects the economy over time. ‡ Now.

increasing k* increases c* Above k*gold.Building the Model: ‡ We begin by finding the steady state consumption per worker. increasing k* reduces c* . ‡ This is the golden rule level of capital k*gold k* k*gold ‡ A condition that characterizes the golden rule level of capital is MPK = Below k*gold. consumption per worker is the difference between output and investment per worker we want to choose k* so that this distance is maximized. k* substitute steady state values for both output (f(k*)) and investment which equals depreciation in steady state ( k*) giving us c*=f(k*) ± k* k* f(k*) c*gold ‡ Because. we get c=y±i ‡ We want steady state ³c´ so we f(k*). From the national income accounts y=c+i identity.

. k*gold f(k*). k* ‡ Any increase or decrease k* f(k*) sgoldf(k*) sgoldf(k*) k* To reach the golden rule steady state« The economy needs the right savings rate. in savings would shift the sf(k) curve and would result in a steady state with a lower level of consumption.Building the Model: ‡ While the economy moves toward a steady state it is not necessarily the golden rule steady state.

k* = 100s2 ‡ With this we can compute steady state capital for any savings rate.1 = k*/¥k* Squaring both sides yields. s/. Equation (2) becomes.A Numerical Example ‡ Starting with the Cobb-Douglas production function from part I. (1) y=k1/2 recall that the following condition holds in steady state. (2) s/ = k*/f(k*) ‡ assume depreciation is 10% and the policy maker chooses the savings rate and thus the economy¶s steady state. .

5 .167 .1 2.8 .125 .029 ±.9 1.062 .067 .025 0 ±.1 10 c* 0 .5 3.4 .A Numerical Example ‡ Using the functions from the previous slide and solving for a range of savings rates « ‡ We can see that at s=.1 .05 .4 2.038 ±.5 so at savings rate of .1 . Also note that at that level MPK± =0 and k*=25. s 0 .0 k* 0 1 4 9 16 25 36 49 64 81 100 y* 0 1 2 3 4 5 6 7 8 9 10 k* 0 .071 .056 .9 1.7 .5 .6 .4 .044 ±.083 .6 2.15 .6 2.9 0 MPK ’ .9 1.017 ±.5 consumption per worker is maximized.1 .9 6.2 .5 2.5 we get c*=2.4 .6 .6 4.4 8.05 MPK’ .1 1.25 .4 2.3 .

A Numerical Example ‡ Another way to identify the golden rule steady state is to choose the level of capital stock where MPK ± = 0 ‡ In this example MPK = 1/(2¥k) ± .1 = 0 so« and« and« 1 = .1(2¥k) 5 = ¥k 25 = k* .

5 so c = . y = 2. ‡ ‡ ‡ ‡ ‡ ‡ .6 for the next period. so i = 1. and y = k1/2 so. and s = .5y = 1.4 k = s*y ± k so k = 1.A Numerical Example ‡ But what is the time path toward k*? To get this use the following algorithm for each period. k = 4.0 i = s*y.1*4 = . c = (1 ± s)y.0 ± .0 k = .6 = 4.6 so k = 4+.4 = .

’ k 4 4. . .... 2...0 1.5 k .543. 10.144.5 k . ..4 .46« . 1.0 ... .A Numerical Example ‡ Repeating the process gives« period 1 2 .543.536« .. 1. .612« . .087.6 . 3.. 0.5 i 1.6 .953« . 2. 10 . 2.12.. . 25 y 2 2.0 And we converge to k=25 . 5 c 1..590« .072. .

The Transition to the Golden Rule Steady State ‡ Suppose an economy starts with more capital than in the golden rule steady state. Time ‡ The new steady state has a higher level of consumption than the initial steady state. y ‡ Over time. Output. ‡ This causes an immediate increase in consumption and an equal decrease in investment. Consumption. i t0 At t0. as the capital stock falls. the savings rate is reduced. . and investment fall. output. c Investment. consumption.

as the capital Consumption. . c Investment. output. stock grows. ‡ This causes an immediate decrease in consumption and an equal increase in investment. y ‡ Over time. and investment increase. Output.The Transition to the Golden Rule Steady State ‡ Suppose an economy starts with less capital than in the golden rule steady state. Time ‡ The new steady state has a higher level of consumption than the initial steady state. i t0 At t0. the savings rate is increased. consumption.

This is known as the golden rule level of capital (k*gold) ‡ In the next section we augment this model to include changes in other exogenous variables.Conclusion ‡ In this section we used our knowledge that savings affects the steady state and chose the savings rate to maximize consumption per worker. population and technological growth. .

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