Chapter 5

The Solow Growth Model

5.1 Introduction
In this chapter, we learn
• how capital accumulates over time.
• how diminishing marginal product of capital
explains differences in growth rates across
countries.
• the principle of transition dynamics.
• the limitations of capital accumulation, although a
significant part of economic growth is still left
unexplained.
Changes in the Model
The Solow Growth model augments the production
model with capital accumulation.
• Capital stock is no longer exogenous.
• Capital stock is now endogenized.
The accumulation of capital is a possible engine of
long-run economic growth.
5.2 Setting Up the Model (Production)
Begin with the previous production model.
• Add an equation for the accumulation of capital over
time.
The production function:
• Cobb-Douglas
• Constant returns are to scale in capital and labor.
• Assume exponent of one-third on capital.
Variables are time subscripted (t)
Setting Up the Model (Resources)
Output can be used for consumption or investment.

• 𝐶𝐶𝑡𝑡: consumption
• 𝐼𝐼𝑡𝑡: investment
This is called a resource constraint.
• Assumes no imports or exports
Capital Accumulation—1
Goods invested for the future determine the
accumulation of capital.
Capital accumulation equation:

• : next year’s capital

• this year’s capital
• this year’s investment
• depreciation rate
• Usually,
Capital Accumulation—2
Change in capital stock defined as

Thus

Future capital depends on investment today.

Case Study: An Example of Capital Accumulation
Assume that the economy begins with 𝐾𝐾0.
Suppose:
• The initial amount of capital is 1,000 bushels of
corn.
• The depreciation rate is 0.10.
Model Setup (Labor)
For simplicity, labor supply is not included.
The amount of labor in the economy is given
exogenously at a constant level.
Model Setup (Investment)
The economy consumes a fraction of output and
invests the rest.

 𝐼𝐼𝑡𝑡: investment

Therefore:

Consumption is the share of output not invested.

Five Equations and Five Unknowns
Case Study: Some Questions about the Solow Model
Differences between the Solow model and production
model:
• Added dynamics of capital accumulation
• Omits capital and labor markets and their prices
Why include the investment share but not the
consumption share?
• It would be redundant.
• Preserve five equations and five unknowns.
Variables
Stock
• A quantity that survives from period to period
• Tractor, house, factory
Flow
• A quantity that lasts a single period
• Meals consumed, withdrawal from ATM
A change in the stock of capital is investment.
5.3 Prices and the Real Interest Rate
Adding the wage and rental price:
• Two more equations, two more unknowns
• w = MPL and r = MPK
• Omitting them does not change the model.
The real interest rate (in units of output):
• Amount earned by saving one unit of output for a
year
• Cost to borrow one unit of output for a year
Saving
Saving:
• The difference between income and consumption,
which is equal to investment

where is saving
5.4 Solving the Solow Model
The model needs to be solved at every point in time,
which cannot be done algebraically.
Two ways to make progress:
• Show a graphical solution.
• Solve the model in the long run.
Begin by combining equations algebraically.
Solving the Solow Model
Combine the investment allocation and capital
accumulation equation.

Substitute the fixed amount of labor into the

production function.
The Solow Diagram
Using the Solow Diagram
If the amount of investment > depreciation
• Capital stock will increase until the amount of
investment being undertaken is equal to the amount
of capital that wears out through depreciation.
• Here, the change in capital is equal to 0.
• The capital stock will stay at this value of capital
forever.
• This is called the steady state.
If depreciation is greater than investment, the economy
converges to the same steady state as above.
Model Dynamics
•When not in the steady state, the economy exhibits a
change in capital toward the steady state.
•As K moves to its steady state, output will also move to
its steady state.
•At the rest point of the economy, all endogenous
variables are steady.
•Transition dynamics take the economy from its initial
level of capital to the steady state.
The Solow Diagram with Output
Solving Mathematically for the Steady State
In the steady state, investment equals depreciation.

Substitute into the production function:

Solving for the Steady State—1
Solve for K*

The steady state level of capital is positively related to

the
• investment rate.
• size of the workforce.
• productivity of the economy.
• Negatively correlated with the depreciation rate
Solving for the Steady State—2
• Plug K* into the production function to get Y*

• Plug in our solved value of K*

𝛼𝛼
1 𝑠𝑠̅ 1−𝛼𝛼
𝑌𝑌𝑡𝑡 = 𝐴𝐴̅1−𝛼𝛼
∗
𝐿𝐿�
𝑑𝑑̅

• Higher steady state production caused by higher

productivity and investment rate.
• Lower steady state production caused by faster
depreciation.
Solving for the Steady State—3
• Divide both sides by labor to get output per person
in the steady state:
𝛼𝛼
𝑌𝑌 ∗ 1 𝑠𝑠̅ 1−𝛼𝛼
∗
𝑦𝑦 = = 𝐴𝐴̅1−𝛼𝛼
𝐿𝐿� 𝑑𝑑̅
• Note the exponent on productivity is different here
than in the production model.
• Higher productivity has additional effects in the
Solow model by leading the economy to
accumulate more capital.
5.5 Looking at Data through the Lens of the Solow Model
Recall the steady state:

The capital to output ratio is the ratio of the

investment rate to the depreciation rate:

Investment rates vary across countries.

It is assumed that the depreciation rate is relatively
constant.
Explaining Capital in the Solow Model
Differences in Y/L
The Solow model shows TFP is more important in
explaining per capita output.
• Can be used to understand differences in y
Take the ratio of y* for two countries, assuming the
depreciation rate is the same:

From Chapter 4 See figure 5.3 (previous slide) slide)

5.6 Understanding the Steady State
The economy reaches a steady state because
• investment has diminishing returns.
• the rate at which production and investment rise is
smaller as the capital stock is larger.
Also, a constant fraction of the capital stock
depreciates every period.
• Depreciation is not diminishing as capital increases.
Eventually, net investment is zero.
• The economy rests in steady state.
5.7 Economic Growth in the Solow Model
Important result:
• There is no long-run growth in the Solow model.
In the steady state, growth stops, and
• output,
• capital,
• output per person, and
• consumption per person

are constant.
Economic Growth in the Solow Model
Empirically, however, economies appear to continue to
grow over time.
• Thus, we see a drawback of the model.
According to the model:
• Capital accumulation is not the engine of long-run
economic growth.
• After we reach the steady state, there is no long-run
growth in output.
• Saving and investment
• are beneficial in the short run.
• do not sustain long-run growth due to
diminishing returns.
Case Study: Population Growth in the Solow Model
Can growth in the labor force lead to overall economic
growth?
• It can in the aggregate.
• It cannot in output per person.
Diminishing returns lead 𝑘𝑘 and 𝑦𝑦 to approach the
steady state.
• This occurs even with more workers.
5.8 Some Economic Experiments
The Solow model
• does not explain long-run economic growth.
• does help explain some differences across countries.
Economists can experiment with the model by
changing parameter values.
An Increase in the Investment Rate—1
Suppose the investment rate increases permanently for
exogenous reasons.
• The investment curve rotates upward.
• The depreciation curve remains unchanged.
• The capital stock increases by transition dynamics
to reach the new steady state.
• This happens because investment exceeds
depreciation.
• The new steady state is located to the right.
• Investment exceeds depreciation.
An Increase in the Investment Rate—2
An Increase in the Investment Rate—3
What happens to output in response to this increase in
the investment rate?
• The rise in investment leads capital to accumulate
over time.
• This higher capital causes output to rise as well.
• Output increases from its initial steady state level Y*
to the new steady state Y**.
The Behavior of Output after an Increase in 𝒔𝒔�
A Rise in the Depreciation Rate—1
Suppose the depreciation rate is exogenously shocked
to a higher rate.
• The depreciation curve rotates upward.
• The investment curve remains unchanged.
• The capital stock declines by transition dynamics
until it reaches the new steady state.
• This happens because depreciation exceeds
investment.
• The new steady state is located to the left.
A Rise in the Depreciation Rate—2
A Rise in the Depreciation Rate—3
What happens to output in response to this increase in
the depreciation rate?
• The decline in capital reduces output.
•
settles down at its new, lower steady state level Y**.
 �
Behavior of Output after an Increase in 𝒅𝒅
Experiments on Your Own
Try experimenting with all the parameters in the
model:
• Figure out which curve (if either) shifts.
• Follow the transition dynamics of the Solow model.
• Analyze steady state values of
• capital (K*).
• output (Y*).
• output per person (y*).
5.9 The Principle of Transition Dynamics
If an economy is below steady state:
• It will grow.
If an economy is above steady state:
• Its growth rate will be negative.
When graphing this, a ratio scale is used.
• Output changes more rapidly if we are further from
the steady state.
• As the steady state is approached, growth shrinks to
zero.
The Principle of Transition Dynamics
The farther below its steady state an economy is (in
percentage terms), the faster the economy will grow.
The closer to its steady state, the slower the economy
will grow.
This allows us to understand why economies grow at
different rates.
Understanding Differences in Growth Rates
Empirically, for OECD countries, transition dynamics holds:
• Countries that were poor in 1960 grew quickly.
• Countries that were relatively rich grew slower.
For the world as a whole, on average, rich and poor
countries grow at the same rate.
• Two implications of this:
• Most countries (rich and poor) have already reached
their steady states.
• Countries are poor not because of a bad shock, but
because they have parameters that yield a lower
steady state (determinants of the steady state invest
rates and A).
Growth Rates in the OECD, 1960–2014
Growth Rates around the World, 1960–2017
Case Study: South Korea and the Philippines—1
South Korea
• 6.4 percent per year
• Increased from 10 percent of U.S. income to 75
percent
Philippines
• 2.5 percent per year
• Stayed around 10 percent of U.S. income
Transition dynamics predicts that
• South Korea was far below its steady state.
• Philippines is already at steady state.
Case Study: South Korea and the Philippines—2
Assuming equal depreciation rates

The long-run ratio of per capita incomes depends on

• the ratio of productivities (TFP levels).
• the ratio of investment rates.
Investment in South Korea and the Philippines, 1950–2017
5.10 Strengths and Weaknesses of the Solow Model
The strengths of the Solow model:
• It provides a theory that determines how rich a
country is in the long run.
• Long run = steady state
• The principle of transition dynamics allows for an
understanding of differences in growth rates across
countries.
• A country further from the steady state will grow
faster.
Strengths and Weaknesses of the Solow Model
The weaknesses of the Solow model:
• It focuses on investment and capital.
• The much more important factor of TFP is still
unexplained.
• It does not explain why different countries have
different investment and productivity rates.
• A more complicated model could endogenize the
investment rate.
• The model does not provide a theory of sustained
long-run economic growth.
Additional Figures for Worked Exercises—1
Additional Figures for Worked Exercises—2
Additional Solow Graph Examples
Slides 56–60 include additional Solow graph examples.
The Solow Diagram graphs these two pieces together, with Kt on the x
axis:

Investment,
Depreciation

At this point,
dKt = sYt, so

Capital, Kt
Suppose the economy starts at this K0:
Investment, •We see that the red line is
above the green at K0.
Depreciation
•Saving = investment is greater
than depreciation.
• Kt > 0 because

• Kt > 0,
Kt increases from K0 to K1 > K0.

Capital, Kt
K0 K1
Now imagine if we start at a K0 here:
Investment, •At K0, the green line is above the
red line.
Depreciation
•Saving = investment is now less
than depreciation.
• Kt < 0 because

• Kt < 0,
Kt decreases from K0 to K1 < K0.

Capital, Kt
K1 K0
We call this the process of transition dynamics: Transitioning from any Kt
toward the economy’ t=0

Investment,
Depreciation

No matter where we
start, we’ll transition
to K*!

At this value of K,
dKt = sYt, so

Capital, Kt
K*
We can see what happens to output, Y, and thus to growth if we rescale
the vertical axis:
Investment, •Saving = investment and
Depreciation, Income depreciation now appear
here.
Y* •Now output can be graphed
in the space above in the
graph.
•We still have transition
dynamics toward K*.
•So we also have dynamics
toward a steady state level of
income, Y*.

Capital, Kt
K*
Clicker Question 1
Imagine increases in the parameters of the Solow
model that are all identical in magnitude. Which one
of the following parameters will result in the largest
increase in steady-state output?
a. the investment rate
b. the productivity parameter
c. the amount of labor
d. They all will increase output by the same amount.
Clicker Question 1 – Answer
Imagine increases in the parameters of the Solow
model that are all identical in magnitude. Which one
of the following parameters will result in the largest
increase in steady-state output?
a. the investment rate
b. the productivity parameter
c. the amount of labor
d. They all will increase output by the same amount.
Clicker Question 2
Starting from steady state, a permanent increase in the
rate of depreciation in the Solow model causes
a. the growth rate of output to fall temporarily and the
level of GDP to fall permanently.
b. the growth rate of output to fall temporarily but
leaves the level of GDP unchanged in the long run.
c. the growth rate of output to rise temporarily and
the level of GDP to rise permanently.
d. the growth rate of output to rise temporarily but
leaves the level of GDP unchanged in the long run.
Clicker Question 2 – Answer
Starting from steady state, a permanent increase in the
rate of depreciation in the Solow model causes
a. the growth rate of output to fall temporarily and
the level of GDP to fall permanently.
b. the growth rate of output to fall temporarily but
leaves the level of GDP unchanged in the long run.
c. the growth rate of output to rise temporarily and
the level of GDP to rise permanently.
d. the growth rate of output to rise temporarily but
leaves the level of GDP unchanged in the long run.
Clicker Question 3
An economy starts in steady state. A war causes a
massive destruction of the capital stock. This shock
will cause
a. the economy to converge to a new lower steady
state.
b. the growth rate of output to rise initially as the
economy begins to converge to the old steady state.
c. the growth rate of output to rise initially as the
economy begins to converge to a new lower steady
state.
d. the economy to enter a period of negative growth.
Clicker Question 3 – Answer
An economy starts in steady state. A war causes a
massive destruction of the capital stock. This shock
will cause
a. the economy to converge to a new lower steady
state.
b. the growth rate of output to rise initially as the
economy begins to converge to the old steady
state.
c. the growth rate of output to rise initially as the
economy begins to converge to a new lower steady
state.
d. the economy to enter a period of negative growth.
Clicker Question 4
The United States and Chile have both grown at about
2 percent per year for the last 40 years. By the
principle of transition dynamics, what does this imply?
a. Both countries are below their steady states.
b. Both countries are above their steady states.
c. Both countries are at their steady states.
d. It implies nothing, because transition dynamics
only tells us how an economy moves over time.
Clicker Question 4 – Answer
The United States and Chile have both grown at about
2 percent per year for the last 40 years. By the
principle of transition dynamics, what does this imply?
a. Both countries are below their steady states.
b. Both countries are above their steady states.
c. Both countries are at their steady states.
d. It implies nothing, because transition dynamics
only tells us how an economy moves over time.
Clicker Question 5
What is an explanation for why an economy eventually
settles in steady state?
a. The production function exhibits diminishing
returns to capital.
b. The capital stock depreciates at a constant rate.
c. Eventually, investment generated is equal to the
amount of capital depreciated.
d. All of these choices are correct.
Clicker Question 5 – Answer
What is an explanation for why an economy eventually
settles in steady state?
a. The production function exhibits diminishing
returns to capital.
b. The capital stock depreciates at a constant rate.
c. Eventually, investment generated is equal to the
amount of capital depreciated.
d. All of these choices are correct.
Clicker Question 6
If net investment is negative,
a. the economy is above its steady state and growth of
output is positive.
b. the economy is above its steady state and growth of
output is negative.
c. the economy is below its steady state and growth of
output is positive.
d. the economy is below its steady state and growth of
output is negative.
Clicker Question 6 – Answer
If net investment is negative
a. the economy is above its steady state and growth of
output is positive.
b. the economy is above its steady state and
growth of output is negative.
c. the economy is below its steady state and growth of
output is positive.
d. the economy is below its steady state and growth of
output is negative.
Clicker Question 7
According to the principle of transition dynamics,
which economy will grow fastest?
a. a poor country in steady state
b. a rich country in steady state
c. a country 10 years after a natural disaster
destroyed most of the capital stock
d. the same country one year after the natural disaster
destroyed most of the capital stock
Clicker Question 7 – Answer
According to the principle of transition dynamics,
which economy will grow fastest?
a. a poor country in steady state
b. a rich country in steady state
c. a country 10 years after a natural disaster
destroyed most of the capital stock
d. the same country one year after the natural
disaster destroyed most of the capital stock
Clicker Question 8
Which of the following questions does the Solow model
NOT help to explain?
a. Why do countries have different growth rates in the
same time periods?
b. Why are some countries richer than other countries?
c. Why do countries sustain growth in the long run?
d. Will a country be richer if the investment rate is
higher than another country, all else being equal?
Clicker Question 8 – Answer
Which of the following questions does the Solow model
NOT help to explain?
a. Why do countries have different growth rates in the
same time periods?
b. Why are some countries richer than other countries?
c. Why do countries sustain growth in the long run?
d. Will a country be richer if the investment rate is
higher than another country, all else being equal?
Clicker Question 9
Total factor productivity explains a larger amount of
the difference in income per capita in the Solow model
than in the production model.
a. true
b. false
Clicker Question 9 – Answer
Total factor productivity explains a larger amount of
the difference in income per capita in the Solow model
than in the production model.
a. true
b. false
Clicker Question 10
In the long run, the real interest rate is equal to the
marginal product of capital.
a. true
b. false
Clicker Question 10 – Answer
In the long run, the real interest rate is equal to the
marginal product of capital.
a. true
b. false
Clicker Question 11
The Solow model is a static model and thus can only
tell us the levels of our endogenous variables in steady
state.
a. true
b. false
Clicker Question 11 – Answer
The Solow model is a static model and thus can only
tell us the levels of our endogenous variables in steady
state.
a. true
b. false
Clicker Question 12
In the Solow diagram, an increase in the investment
rate will cause a decrease in consumption for all levels
of capital.
a. true
b. false
Clicker Question 12 – Answer
In the Solow diagram, an increase in the investment
rate will cause a decrease in consumption for all levels
of capital.
a. true
b. false
Clicker Question 13
The investment rate in a particular economy is a
function of the amount of output (income) an economy
generates each year.
a. true
b. false
Clicker Question 13 – Answer
The investment rate in a particular economy is a
function of the amount of output (income) an economy
generates each year.
a. true
b. false
Clicker Question 14
The change in the capital stock is a flow variable.
a. true
b. false
Clicker Question 14 – Answer
The change in the capital stock is a flow variable.
a. true
b. false
Clicker Question 15
If an economy has a higher investment rate and a
higher depreciation rate, the economy will have a
higher level of output.
a. true
b. false
Clicker Question 15 – Answer
If an economy has a higher investment rate and a
higher depreciation rate, the economy will have a
higher level of output.
a. true
b. false
Clicker Question 16

Consider an economy described by the textbook Solow model with a

1 1
̅ 3𝑡𝑡 𝐿𝐿3𝑡𝑡 . The economy is producing 100
production function 𝑌𝑌 = 𝐴𝐴𝐾𝐾
units of output and the productivity parameter is equal to 1. If the
depreciation rate is 6 percent, the investment rate is 6 percent, and
there are 125 workers, the growth rate of the economy
a. is positive because the economy is below its steady state.
b. is equal to zero because the economy is at its steady state.
c. is negative because the economy is above its steady state.
d. cannot be determined.
Clicker Question 16 – Answer
Consider an economy described by the textbook Solow model with a
1 1
̅ 3𝑡𝑡 𝐿𝐿3𝑡𝑡 . The economy is producing 100
production function 𝑌𝑌 = 𝐴𝐴𝐾𝐾
units of output and the productivity parameter is equal to 1. If the
depreciation rate is 6 percent, the investment rate is 6 percent, and
there are 125 workers, the growth rate of the economy
a. is positive because the economy is below its steady state.
b. is equal to zero because the economy is at its steady state.
c. is negative because the economy is above its steady state.
d. cannot be determined.
Clicker Question 17
The level of consumption
a. is largest when the economy is in its steady state.
b. is largest when the economy is below its steady
state.
c. is largest when the economy is above its steady
state.
d. directly depends on the depreciation rate.
Clicker Question 17 – Answer
The level of consumption
a. is largest when the economy is in its steady state.
b. is largest when the economy is below its steady
state.
c. is largest when the economy is above its
steady state.
d. directly depends on the depreciation rate.
Clicker Question 18
According to the Solow model, two countries will grow
at different rates if
a. both have the same steady-state level of output and
the same capital stock below the steady-state level.
b. both have different steady-state levels of output
and the same capital stock below the steady-state
level.
c. both have the same steady-state level of output and
the same capital stock above the steady-state level.
d. they are both in their steady states.
Clicker Question 18 – Answer
According to the Solow model, two countries will grow at
different rates if
a. both have the same steady-state level of output and the
same capital stock below the steady-state level.
b. both have different steady-state levels of output
and the same capital stock below the steady-state
level.
c. both have the same steady-state level of output and the
same capital stock above the steady-state level.
d. they are both in their steady states.
Clicker Question 19
According to the International Money Fund, income
per capita in Bhutan in 2015 was Int$8,201, while
income per capita in Chad in the same year was
Int$1,214. If Bhutan’s investment rate is 40 percent
and Chad’s investment is 10 percent, what is the
𝐴𝐴̅𝐵𝐵𝐵𝐵𝐵𝑡𝑡𝐵𝐵𝐵𝐵
productivity ratio ̅ ? Round to the nearest tenth.
𝐴𝐴𝐶𝐶𝐵𝐵𝐵𝐶𝐶
Assume both countries are in their steady states.
a. 4.0
b. 3.4
c. 2.3
d. 1.5
Clicker Question 19 – Answer
According to the International Money Fund, income
per capita in Bhutan in 2015 was Int$8,201, while
income per capita in Chad in the same year was
Int$1,214. If Bhutan’s investment rate is 40 percent
and Chad’s investment is 10 percent, what is the
𝐴𝐴̅𝐵𝐵𝐵𝐵𝐵𝑡𝑡𝐵𝐵𝐵𝐵
productivity ratio ̅ ? Round to the nearest tenth.
𝐴𝐴𝐶𝐶𝐵𝐵𝐵𝐶𝐶
Assume both countries are in their steady states.
a. 4.0
b. 3.4
c. 2.3
d. 1.5
Clicker Question 20
Do the OECD countries exhibit the transition dynamics
predicted by the Solow Growth Model?
a. yes
b. no
Clicker Question 20 – Answer
Do the OECD countries exhibit the transition dynamics
predicted by the Solow Growth Model?
a. yes
b. no
Clicker Question 21
Do all countries exhibit the transition dynamics
predicted by the Solow Growth model? For example,
the South Korea and Philippines case study?
a. yes
b. no
Clicker Question 21 – Answer
Do all countries exhibit the transition dynamics
predicted by the Solow Growth model? For example,
the South Korea and Philippines case study?

a. yes
b. no