SOLOW GROWTH MODEL
-The Solow Growth Model, for which Robert Solow of the
Massachusetts Institute of Technology received the Nobel Prize, is
probably the best known model of economic growth
- Although in some respects Solow’s Model describes a developed
economy better than a developing one, it remains a basic reference
point for the literature on growth and development
- It implies that economies will conditionally converge to the same level
of income if they have the same rates of savings, depreciation, labor
force growth, and productivity growth
- Thus the Solow Model is the basic framework for the study of
convergence across countries
- The key modification from the Harrod-Domar Growth Model, is that
the Solow Model allows for substitution between capital and labor. In
the process, it assumes that there are diminishing returns to the use of
these inputs
-The aggregate production function, Y = F(K,L) is assumed
characterized by constant returns to scale. For example, in the special
case known as the Cobb-Douglas production function
Fast Overview of the Model
Assumptions:
-Time (dynamic model); Close economy
- Variables and parameters
- per capita or per worker
- goods market
- Technology, Production Function; Constant Returns to Scale, positive
but diminishing marginal returns
- Capital accumulation equation
- Converting variables into per-capita terms
- The steady state
- Solow Diagram
- Transition dynamics, time series
-Shocks, effect of a change in savings, depreciation, Total factor
productivity, etc…
Variables endogenous, dynamic
Yt : output, income Lt : Labor, population, workers
Kt : capital It : Investment, savings
Ct : consumption
Where: Yt – Aggregate output; Kt – Aggregate capital
Lt – Aggregate labor; It – Aggregate investment
Ct – Aggregate consumption
Parameters: exogenous, constant
s : savings rate (between 0 and 1)
δ : depreciation rate (between 0 and 1)
g = gA : growth rate of technology
n = gL : population growth rate
Per capita variables
kt = Kt/Lt ; yt = Yt/Lt ;
it = It/Lt ct = Ct/Lt
Goods Market
Yt = Ct + It
It = sYt
Ct = (1 – s)Yt
Technology, Production
Yt = F(Kt, Lt) = Akαt L(1-α)t
Law of Motion of Capital or Capital Accumulation Equation
Kt+1 = Kt – δKt + It
- The Law of Motion of Capital – tells how the capital changes
through time
aka “Neoclassical Growth Model”
aka “Solow Swan Growth Model”
aka “Exogenous Growth Model”
Solow Model
-Shows that in the long run the economy’s rate of savings determines
the size of capital stock and therefore the level of production and its
per capita output
- The higher the level of savings - the higher the stock of capital
and the higher the level of output
- The model relates the economic growth the changes in factors like L
and K and interest rates, depreciation, growth and level of technology
Technology, Production
Yt = F(Kt, Lt ) = AKαt L(1-α)t -- Cobb-Douglas Production
Function
-The production function exhibits constant returns to scale
- Per –worker production function is characterized by positive and
diminishing returns to scale
FK(K, L) = ∂Y/∂K > 0 ; FL (K, L) = ∂Y/∂L > 0
FKK(K, L) < 0 ; FLL(K, L) < 0
Inidata assumptions
limK 0 FK = infinite and limL 0 FL = 0
limK→infinite FK = 0 and limL→ infinite FL = 0
Also the factors are important
F(0,0) = 0; F(0, L) = 0 and F(K, 0) = 0
FKL > 0 = Capital and labor are compliments
Cobb-Douglas Production Function
Note: Show Figure 1
Per capita production, y = f(k)
yt = Yt/Lt = F(K,L)/L y = f(k)
= F (Kt/Lt , Lt/Lt ) = Y/L
= F (kt , 1) = Akαt L(1-α)t / L
= f(kt) = Akαt L(1-α)t
= Akαt /L(1-α)t
= A (K/L)α s
y =f(k) = Akα (Production function
in terms of per capita)
↓
A is the total factor productivity
y – is output per person/worker
Capital accumulation equation
Kt+1 = Kt – δKt + It where Kt+1 – is capital next period
= Kt (1 – δ) + It
=Kt(1-δ)+sYt
Converting to Per-capita Terms
Kt+1/Lt+1 = (1 – δ)Kt/Lt + s Yt/Lt
kt+1 = (1 – δ)kt + syt
kt+1 – kt = syt – δkt
Where Δk = kt+1 – kt
k dot = ∂k/∂t (where k dot is capital continuous time)
Δk = syt – δkt - this is the steady state level of k
The Law of Motion of Capital
The Steady State Level of Capital
-A steady state for this economy is a value of per-capital-Capital, k*,
such that, if the economy have k0 = k*, then kt = k* t 1
Where k* - is steady state
The law of Motion of Capital
-In the steady state k* = 0 or Δk = 0
0 = syt – δk*
0 = s(AK*α) – δk* where A – is Total Factor Productivity
δk* = sA(k*α)
= k*/k*α = sA/δ
= (k*)1-α = (sA/δ)
= k* = (sA/δ)1/1-α → steady state value of capital per capita
value of k per capita
Solow Diagram and Convergence Dynamics
-Transition Dynamics
- Shocks to the economy
- The effects of destruction of capital
- The effects of changes in savings
- The effect of a change in the depreciation rate
- The effect of a change in Total Factor Productivity
Golden Rule Level of Capital and Savings Rate
Steady State Capital per worker Production, Output/Income
k* = (sA/δ)1/1-α y = f(k) = Akα
Steady state value of capital per worker
The Law of Motion of Capital
Δk = syt – δkt
Investment, Savings
it = syt = sAkα
Note: Show Figure 2
Break-even Investment
-Given some value of capital, k, what is the amount of investment
required to keep the per-capita capital stock constant
- k* - is steady state capital per worker
The law of Motion of Capital
Δk = syt – δkt
k* steady state value of capital per worker
yt = f(kt) = Akt
y* = f(k*) = Ak*α
Note: Show Figure 3 and 4
Referring to Figure 4
The range of k lower than k*
-syt > δk hence Δk is positive
- so k↑ until it will converge to k*
- The difference of syt – δk gets smaller as it moves or converge towards
the steady state level, k*
The range of k above k*
-- syt < δk hence Δk is negative
- so k↓ until it will converge back to k*, towards the steady state level
- The difference of syt – δk gets smaller as it moves back or converge
back towards the steady state level, k*
Solow Model
Transition Dynamics and Time Series
Transition Dynamics and Convergence to the Steady State
Note: Show Figure 5 and 6
Note: Show Figure 7 (Time Series graph or Transition dynamics –
Lower than k* refer to Figure 5)
Note: Show Figure 8 (Time Series graph or Transition dynamics –
Above k* refer to Figure 5)
Solow Model Transition Dynamics with Technology and Population
Growth
Growth Rates vs Level Shifts
-Given a shock to one of our variables, what effects can we expect
through time?
- Time Series Graphs:
- What are level effects?
- What affects growth rates?
Solow Model Transition Dynamics with Technology and Population
Growth
Growth Rates vs Level Shifts
Level Effects Growt
h Rate
s δ g n
Capital per effective K* = K/AL K* = (s/δ+g+n)1/1-α + - - - gk=0
worker:
Output per effective ŷ*=Y/AL Ŷ*t=(s/δ+g+n)α/1-α + - - - gŷ=0
worker:
Capital per worker: k*=K/L = k k*(t)= A(t) (s/n+δ)1/1-α + - - gk=g
hat*A
Output per worker: y*=Y/L = y y*(t) = A(t)(s/n+δ)α/1-α + - - gy=g
hat*A
Investment per ί*= s*ŷ*A + - - gk+g
worker
Level Effects Growt
h Rate
s δ g n
Consumption per c*= (1-s)y hat*A + - - gy=g
worker
Labor, Lt gL=n
Capital, K*t K=k hat*A*L K(t)*=(s/δ)1/1-αA(t)L(t) + - gk=g+n
Output, Y*t Y=ŷ*A*L Y(t)*=(s/δ)α/1-αA(t)L(t) + - gy=g+n
Investment I=s*ŷ*A*L + - gy=g+n
Consumption C=(1-s)*ŷ*A*L + - g+n
Where:
g – technology
n – population growth
Solow Diagram – Adding Technology and Population Growth
Note: Show Figure 9, 10, and 11
Change in Growth Rate – g↑, Growth in Technology Increases
Note: Show Figure 12
What affects growth rates?
-The growth in technology (g )
- the growth in population growth (n )
