Lecture 3: Growth Theory

SOLOW GROWTH MODEL

Mathematical Techniques

Growth rate in continuous time. Suppose Y (t ) is a function of time (i.e., they change through time). Denote the time
dY
derivative =¿ Ẏ . Then its growth rate can be expressed as:
dt
Ẏ
g y= ,
Y
Some quick to use short-cuts:
If k (t)=K (t) L(t ) then growth rate of k can be expressed as (using product rule)
gk =g K + g L

K (t)
If k (t)= then growth rate of k can be expressed as (using quotient rule)
L(t)
gk =g K −g L

Economic Growth. Expansion of output/income of an economy. Closely related but different from the concept of
development.

- What determines Economic growth in the long run?

- What are the factors can sustain continuous growth in income per capita?

Solow Growth Model (Neoclassical Growth Theory). Key parts.

1. Production Function
2. Savings/Investment Function
3. Breakeven/Required Investment Function
THE PRODUCTION FUNCTION

The production function expresses the relationship between the inputs and the amount of output produced.
Y =F ( K , L )

Where K is the amount of Capital and L is the amount of Labor used to produce the Output Y.
Laborers are paid wages (W) and owners of capital rent (R).

Returns to Scale. Production Functions can exhibit Constant Returns to Scale, Increasing Returns to Scale, or
Decreasing Returns to Scale.

Constant Return to Scale (CRS). An x % increase in all factors of production also increases output by x% (e.g.,
doubling both labor and capital also doubles the output)
z Y =F ( z K , z L ) ,
Where z >0.

As a homework, learn what is Increasing Returns to Scale and Decreasing Returns to Scale.

Marginal Product of Labor (MPL). The additional amount of output a firm gets from one additional unit of labor (L),
holding the amount of capital constant.

Can be expressed as
MPL=F ( K , L+1 )−F ( K , L )

Alternatively, using notations of calculus

∂ F ( K , L)
MPL=
∂L

Exhibits Diminishing Marginal Product. MPL decreases as L increases i.e., each additional laborer adds fewer output,
holding capital fixed.
Why is this the case? Given an example where diminishing marginal product of labor is at work.

Marginal Product of Capital (MPK). The additional amount of output a firm gets from one additional unit of capital
(K), holding the amount of labor constant. MPK is the slope of the per capita production function.

Can be expressed as
MPK =F ( K +1 , L )−F ( K , L )

Alternatively, using notations of calculus

∂ F ( K , L)
MPK =
∂K

Exhibits Diminishing Marginal Product. MPK decreases as K increases i.e., each additional capital adds fewer output,
holding capital fixed.
Why is this the case? Given an example.
The Production Function

PER CAPITA PRODUCTION FUNCTION. Like GDP per capita, per capita production function is derived by dividing
Y by the total amount of laborers, L.
Y
L
=F
K
L ( )
,1

Y
Defining y= and k =K / L, we have
L
y=f ( k )

What does y represent? What does k represent?

y is output per worker
k is capital each worker can work with

THE COBB – DOUGLAS PRODUCTION FUNCTION

α 1−α
Y=A K L

Where α is the share of capital to total output while 1−α is the share of labor.*
0< α <1

CDPF says that both Capital and Labor are necessary? How is this so?

Where A is a parameter measuring the productivity of available technology also known as Total Factor Productivity
(TFP).

In class exercise:
1. Derive the per capita production function
 2. Show that Cobb-Douglas PF has constant returns to scale
3. Derive MPK and MPL
*can also be interpreted as elasticities

The Cobb-Douglas Per Capita Production Function

Y A K α L1−α
=
L L
α −α
y= A K L

( )
α α
AK K
y= α = A
L L

α
y= A k

The Cobb-Douglas production function has constant returns to scale

α 1−α
Y=A K L

Suppose you double the amount of labor and capital

Y new = A ¿

Distributing the exponents of 2

 α α 1−α 1−α
Y new= A 2 K 2 L

Combining all the terms with same base, we get

Y new =2α+1−α A K α L1−α =2 A K α L1−α

Noting that the term in green is the original Y , we can show that new output is double of old output
Y new=2Y

Suppose war destroys half of K and L of a certain economy with CDPF, what happens to output?

Exercise: What happens if instead of 2, we divide it by ½ or 0.5?

MPL. Differentiate Y with respect to L
∂ F ( K , L ) ∂ [ A K α L1− α ]
MPL= =
∂L ∂L

Using the rules of differentiation, we get

MPL= A K α ( 1−α ) L1−α −1=( 1−α ) A K α L−α
( 1−α ) A K α
MPL= α
=(1−α ) A k α
L

Notice that since L is in the denominator, as capital further increases, MPK decreases which indicates diminishing
marginal product of labor.

MPK. Differentiate Y with respect to K

∂ F ( K , L ) ∂ [ A K α L1−α ]
MPK = =
∂K ∂L

Using the rules of differentiation, we get

MPK =Aα K α−1 L1−α
   α 1−α
αA K L
MPK =
K

Notice that since K is in the denominator, as labor further increases, MPL decreases which indicates diminishing marginal
product of labor.
SAVINGS/INVESTMENT FUNCTION
We assume that government does not exist in our simple closed economy, hence output is just the sum of
consumption and investment (recall identity). In per capita terms,
y=c+i

Savings of households are what is left after paying for consumption expenditures c (how about taxes?).

In this model, we assume that households set aside a fraction s (savings rate) of their income as savings and use ( 1−s ) for
consumption.
c= (1−s ) y
savings=sy

In class exercise:
Show that total savings in the economy is equal to to investment, that is: sy=i
Y =C + I
In per capita terms
y=c+i
y= (1−s ) y+i
y− (1−s ) y=i
y− y+sy =i
i=sy

Hence, household savings is what funds investment in our simple closed economy

Does savings depend on labor and capital?

Yes, but how?
y=f ( k ) → sy=sf (k )

How does the savings function graph look like?

Note:
c= (1−s ) y
c= y−sy
BREAKEVEN/REQUIRED INVESTMENT

How does the capital per capita ( k ) change over time?

Define Δk =k t +1−k t , the absolute change in capital per capita between time t and t + 1.
If Δk >0, capital per capita increased,
If Δ k <0, capital per capita decreased, and
If Δ k=0 capital per capita remained constant over the two periods.

Δ k=i−δk
change ∈the stock of captial per capita=investment ( new )−what is lost ¿ depreciation

Depreciation. The wearing out of capital due usage. Expressed as fraction of capital δ . For example, if δ =.10 , per year
this means that 10% of capital is lost due to depreciation every year.

Example: What is the change in capital per capita if current stock is at 200, investment is 100 but depreciation is at
15%? Did the capital per capita stock increase?
Δ k=100−(0.15 x 200)
Δk=70

What happens to capital per capita if depreciated capital is greater than investment? How about when it is lower?

How does the depreciation function graph look like?

We now have all the needed curves for steady state analysis: f ( k ) , sf ( k ) , depreciation

SOLOW GROWTH MODEL: STEADY STATE EQUILIBRIUM

Equilibrium - A state where variables are stable and no longer change.
In the Solow Model, this is the steady state where capital per capita is stable -neither decreases nor increases over time
Steady State Condition:

Δ k=0
Savings=Required Investment

In our simple model:

sy=δk

Steady State in a Simple Model:

Δ k=0
Δk =sy−δk
sy=δk
α
sA k =δk

( )
1
¿ sA 1−α
k=
δ
Recap:
Output is determined by the amount of capital per capita k
( y= A k α ).

The change ∈k at any point in time is determined by savings/investment and depreciation ( Δ k=sA k α −δk ¿.

increases
If i>δk → Δ k >0 → k .
time
Output/Income per capita grows.

If i<δk → Δ k <0 → k decreases .

Output/Income per capita decreases.

¿
Capital will accumulate or decline until it reaches steady state k where i=δk . The economy will stay in this steady state
until other factors changes (e.g., technology).

Growth Model Numerical Example:

Numerical Example: Consider a hypothetical economy with the following production function
( 12 ) 1
Y =10 K L2
Savings rate is equal to 15% and depreciation is 10% per annum.
¿ ¿ ¿ ¿
Solve for the steady state y , k ,i ,∧c .

1. Derive output per capita function y (k ) [Y / L ¿

2. What is savings as a function of k , s ( k ) [ s∗y ]
3. What is the depreciation function?
4. Impose steady state condition and sy=δk and solve for steady state k ¿.
5. Solve for steady state output, savings/investment, consumption and depreciation.
1. Derive output per capita function y (k )
1
2
y=10 k

2. What is savings as a function of k , s ( k )

1
2
s=1.5 k

3. What is the depreciation function?

depreciation=0.10 k

¿
4. Impose steady state condition and sy=δk and solve for steady state k .
1
1.5 k 2 =0.10 k
¿
k =225

5. Solve for steady state output, savings/investment, consumption and depreciation.

¿ ¿ ¿ ¿
y =150 ,i =22.5 , de p =22.5 , c =127.5

Numerical Example: Consider a hypothetical economy with the following production function
( 12 ) 1
2
Y =10 K L

Savings rate is equal to 20% and depreciation is 10% per annum.

¿ ¿ ¿ ¿ ¿
Solve for the steady state y , k ,i ,∧c . What happened to steady state k when savings rate increased

Solow Growth Model: Steady State Equilibrium

What happens when savings rate increases?

Suppose s increases:
 s1 > s
s1 f ( k ) > sf (k)

Breakeven/Required Investment
Numerical Example: Consider again the hypothetical economy with the following production function
( 12 ) 1
Y =10 K L2

Savings rate increases to 25 % and depreciation is still 10% per annum.

¿ ¿ ¿ ¿
Solve for the new steady state y , k ,i ,∧c .

Does you answer confirm the graphical result?

GOLDEN RULE LEVEL OF CAPITAL

For households, what matters most is the level of consumption,c .

What is the level of capital that maximizes household consumption c ?

GENERAL SOLUTION FOR COBB-DOUGLAS PF

Steady State Condition:
Δ k=0
α
0=sA k −δk

Which implies
α
δk=sA k

¿
Solving for k
1− α sA
k =
δ

( )
1
¿ sA 1−α
k=
δ

Note: Only true for Cobb-Douglas Production function specified above with no population growth and efficiency of labor
augmenting technology. May not be true for other production function specifications.
Graphical Exercise:

Show graphically the impact of higher TFP (A) to:

¿
A. Steady-state capital per capita ( y )
B. Steady-state income per capita (k ¿ ¿
C. Stead state savings per capita ( s y ¿ ¿

Exercise: What if in the previous example, A=20 instead of A=10 i.e.,

1 1
2 2
Y =20 L K
s=0.20 , δ=0.10

Golden Rule Level of Capital

Assume that the policy maker in the economy can influence the savings rate of households.

How do we maximize the consumption of households?

¿
What is the level of k g that maximizes consumption?

¿
How do we make this level of capital per capita, k g the steady state given that we can influence savings?

¿ ¿ ¿
Recall at steady state: c ( k )= y −sy

¿
But since y=f (k ) and s y ¿ =i¿ =δ k ¿
c ( k ¿ )=f ( k ¿ ) −δ k ¿
Using our knowledge of optimization and calculus, we can optimize the function c (k ) be getting its derivative and
equating it to zero.
dc
=MPK −δ
dk

Setting it to zero and re-aaranging

MPK =δ

For consumption to be at maximum, the marginal product of capital and rate of depreciation must be equal. Graphically,
¿
this means that the we should choose k g slope of production function and depreciation must be equal.
Solow Growth Model: Steady State Equilibrium
¿
At k MPK is higher than δ . Flatter purple line than grey line.

The point at which the green line touches the PPF indicates the level of capital where MPK =δ

¿ ¿
If the economy is initially at steady state with k >k g, the policy maker can influence to decrease savings rate that will
decrease capital stock and move the economy to the new equilibrium consistent with the golden rule.

Note: Unlike Steady State, economy does not automatically achieve golden rule level. Intervention is needed
TRANSITION TO GOLDEN RULE LEVEL OF CAPITAL

¿ ¿
Starting from too much capital (k >k g ¿

¿
Starting from too little capital (k < k g ¿

Effects of Population Growth

How does population growth affect steady state?

Breakeven/Required investment function

i r=δk+ n k
i r= ( δ +n ) k
where n is the rate of population growth. Capital accumulation also changes to
Δ k=i− ( δ+n ) k

Recall that steady state condition is:

Δ k=0

Hence, our new steady state condition with population growth is

i=( δ +n ) k
 ¿
Question: Is steady state capital per capita k higher, lower, or the same compared to steady state of model where n=0 ?

Question: In a model with population growth, at what rate is income per capita growing? How about total output?

Can population growth explain growth in income per capita? How about total output?

Output per capita ( y ¿ is no longer growing at steady state. Total output (Y ¿ is growing at rate n .

Hence, although population growth can explain growth in total output but not the growth in income per capita.

What can explain growth in income per capita?

What if population growth rate increases (n2 >n 1 ¿?

What is the Golden Rule Level of Capital with population growth

MP=δ + n

or defining MPK −δ as net marginal product of capital, we get

MPK −δ =n
(Show as an exercise)

SOLOW MODEL WITH LABOR AUGMENTING TECHNOLOGY

EFFICIENCY OF LABOR

Production function with efficiency of labor

Y =F ( K , L∗E )

Where E stands for the efficiency of labor and L∗E is the number of effective labor.

An increase in E has the same effect as a corresponding increase in laborer.

Cobb-Douglas:
α 1−α
Y = A K ( L∗E )

Cobb-Douglas PPF:
α 1−α
Y = A K ( L∗E )

Per capita PPF

y= A k αE
Where k E is capital per effective worker (
K
¿
¿

Required investment equation

i R =( δ + n+ g ) k

ΔE
Where g is the growth rate of efficiency of labor, that is g=
E

Capital accumulation equation:

( δ +n+ g ) k Δ k E =i−¿

Steady-state equation:
i=( δ +n+ g ) k

How does the addition of E change the steepness of i R curve?

Efficiency of Labor
GOLDEN RULE LEVEL OF CAPITAL

Recall: Consumption can be expressed as

c ( k E ) =f ( k E ) −( δ +n+ g ) k E

Optimizing, we get
0=MPK−¿

Which yields the analogous condition for maximum consumption

MPK =( δ + n+ g )
Or
MPK −δ=n+ g