Growth Theory

SOLOW GROWTH MODEL

Start with a Constant Returns to Scale (CRTS) production function: Y = f (K,L). CRTS implies that by
multiplying each input by some factor “z”, output changes by a multiple of that same factor:
zY = f ( zK, zL)
In this case, let z = 1/L. That means: Y * 1/L = f (K * 1/L, L * 1/L)
or
Y/L = f (K/L, 1)
define y = Y/L and k = K/L, so that the production function can now be written as y = f (k), where y is
output per worker and k is capital per worker.

A graphical depiction of the production relation is:

The production function shows the production of goods. We now look at the demand for goods. The
demand for goods, in this simple model, consists of consumption plus investment:
y=c+i
where y = Y/L; c = C/L; and i = I/L.
Investment, as always, creates additions to the capital stock.
We can also write the same condistion as sy = i
which means that sy = i: savings equals investment.
i = sy = s f(k)
The higher the level of output, the greater the amount of investment:

Assume that a certain amount of capital stock is consumed each period: depreciation takes away from the
capital stock. Let “d“be the depreciation rate. That means that each period d*k is the amount of capital that
is “consumed” (i.e., used up):
We can now look at the effect of both investment and depreciation on the capital stock:
Dk = i – dk, which is stating that the stock of capital increases due to additions (created by investment)
and decreases due to subtractions (caused by depreciation). This can be rewritten as Dk =s* f(k) – dk.
The steady state level of capital stock is the stock of capital at which investment and depreciation just
offset each other: Dk = 0:

if k < k* then i > dk , so k increases towards k*

if k > k* then i <dk , so k decreases towards k*
Once the economy gets to k*, the capital stock does not change.

The Golden Rule level of capital accumulation is the steady state with the highest level of consumption.
The idea behind the Golden Rule is that if the government could move the economy to a new steady state,
where would they move? The answer is that they would choose the steady state at which consumption is
maximized. To alter the steady state, the government must change the savings rate.
Since y = c + i,
then c = y – i
which can be rewritten as c = f(k) – s f(k)
which, in the steady state, means c = f(k) –dk.
Since we want to maximize c = f(k) – dk, we take the first derivative and set it equal to zero:
dc/dk = f’(k) – d = 0
The result that at the Golden Rule, the marginal product of capital must equal the rate of depreciation: MPK
=d.
Introducing Population Growth
Let “n” represent growth in the labour force. As this growth occurs, k = K/L declines (due to the increase
in L) and y = Y/L also declines
Thus, as L grows, the change in k is now:
Dk = s*f(k) – d*k – n*k,
where n*k represents the decrease in the capital stock per unit of labour from having more labour. The
steady state condition is now that s*f(k) = (d+n) * k:

In the steady state, there’s no change in k so there’s no change in y. That means that output per worker
and capital per worker are both constant. Since, however, the labour force is growing at the rate n, Y (not
y) is also increasing at the rate “n”. Similarly, K (not k) is increasing at the rate n.

Introducing Technological Progress

We shall assume that technological progress occurs because of increased efficiency of labour. That idea
can be incorporated into the production function by simply assuming that each period, labour is able to
produce more output than the previous period:
Y = f (K, L*E)
where E represents the efficiency of labour. We will assume that E grows at the rate “g”. Still assuming
constant returns to scale, the production function can now be written as:
y = Y / L*E = f ( K/L*E , L*E/L*E ) = f (k), where k = K/L*E
We are now looking at output per efficiency unit of labour and capital per efficiency unit of labour.
Since k = K / L *E, we can see how k changes over time:
The steady state condition is modified to reflect the technological progress:
dk = s*f(k) – (d+g+n)*k,
when dk = 0 (i.e., at the steady state), s*f(k) = (d+g+n)*k.

At the steady state, y and k are constant. Since y = Y/L*E, and L grows at the rate n while E grows at the
rate g, then Y must grow at the rate n+g. Similarly since k = K/L*E, K must grow at the rate of n+g.
The Golden Rule level of capital accumulation with this more complicated model is found by maximizing
consumption at a steady state, which yields the following relation:

,
which simply indicates that the marginal product of capital net of depreciation must equal the sum of
population and technological progress.

Numerical Example:
Let Y = K1/3(LE)2/3
with s = .25, n = .01, d=.1, and g = .015
The production function, because it exhibits CRTS, can be rewritten as

To find the steady state, recall that Δk = 0, so s*f(k) = (d+n+g) k

which can be rewritten as:
s/ (d+n+g) = k / f(k)
Since f(k) = k1/3, this can be rewritten as:

With this value for k*, we can find y* = (k*)1/3 = 1.41, and c* = y* - s y* = 1.06.
To find the Golden Rule level of capital accumulation, recall that at the GR,
MPK =(d+n+g).
Since Y = K1/3(LE)2/3 then

Since, at the Golden Rule, the above calculated MPK must equal (d+n+g),

Since k** = 4.35,

y** = k1/3 = 1.63
c** = y** - .125k** = 1.088
s** = 1 – (c**/y**) = .333
The graph depicting this would be:

Note: if there if total factor productivity in the basic Solow model in the form of A,

If

A is a constant.
Predictions of the model
If the Solow model is correct, and if growth is due to capital accumulation, we should expect to find
1. Rich countries have higher saving (investment) rates than poor countries
2. Rich countries have lower population growth rates than poor countries
3. Growth will be very strong when countries first begin to accumulate capital, and will slow down as
the process of accumulation continues.
4. Countries will tend to converge in output per capita and in standard of living. As Hong Kong,
Singapore, Taiwan (etc) accumulate capital, their standard of living will catch up with the initially
more developed countries. When all countries have reached a steady state, all countries will have
the same standard of living (at least if they have the same production function, which for most
industrial goods is a reasonable assumption).

Types of convergence

Absolute convergence predicts that all countries eventually converge to the same steady-state level of
capital per worker and GDP per capita. In other words, poor countries should eventually catch up to rich
ones given enough time. In the neoclassical growth model, this relies on the assumption that everyone
shares the same technology, the same savings rate and the same depreciation parameter. These are very
strong assumptions, and they imply that a country should grow faster, the poorer it is. Empirically, it
doesn’t hold well.

Conditional convergence is a more specific prediction which follows directly from the Solow model. It
predicts convergence among countries which share the same fundamental parameters A, s, n and δ but
does not imply that poorer countries will entirely catch up to richer ones if, for instance, they save less. In
other words, a country will grow faster, the further it is from its own steady state, but each country has a
different steady-state value of GDP per capita and there is no reason why long-run income per capita
should be equal across countries.

Certainly, there is some evidence favoring these predictions. However, there are some problems as well:
1. The US growth rate was lower , at least on a per capita basis, in the 19th century than in the
twentieth century.
2. The Soviet Union under Stalin saved a higher percentage of national income than the US. Because
of the higher savings rate and because it started from a lower level of capital, it should have caught
up very rapidly. It did not.
3. Less developed countries, with some exceptions -- such as Taiwan, Korea, Singapore and Hong
Kong -- are not in general catching up to the developed countries. Indeed, in many cases, the gap
is increasing .

Do these facts mean that the Solow model is wrong? Not necessarily, since increase in output per capita
can be due to an increase in multifactor productivity as well as an increase in capital per worker.

What Happens to w and r in the solow model?

 Human capital

production function :
where human capital H is allowed to accumulate over time the same way as physical capital, and
depreciates at the same rate δ. Savings rates sk and sh are still exogenous and may differ for each type of
capital. Hence the equations of motion for physical and human capital are given by:
Growth accounting equation : will be done in class

HW
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The Harrod-Domar Model

Main Prediction: GDP growth is proportional to the share of investment spending in GDP.

Assumptions:
1. Assume unemployed labour, so there is no constraint on the supply of labour.
2. Production is proportional to the stock of machinery.

Growth Rate of GDP

We want to determine the growth rate of GDP, which is defined as:
G(Y) = (change in Y) / Y where Y = GDP
To do this, we estimate the Incremental Capita l-Output Ratio (ICOR), which is a measure of capital
efficiency.
ICOR = (change in K) / (change in Y) where K = capital stock

A high ICOR implies a high increase in capital stock relative to the increase in GDP. Thus, the higher the
ICOR, the lower the productivity of capital.

Since capital is assumed to be the only binding production constraint, investment (I) in the Harrod-Domar
model is defined as the growth in capital stock.

I = (change in K)
But investment is also equal to savings (S), which is equal to the average propensity to save (APS) times
GDP (Y).
Denote APS = s
I = S = APS * Y = s*Y
So,
ICOR = (s Y) / (change in Y)
Rearranging terms,
(change in Y) / Y = s / ICOR which is the growth rate of GDP

s / ICOR is also called the warranted rate of growth in the Harrod-Domar model

The natural rate of growth is n- the rate of growth of labour supply.

The Harrod -Domar full employment equilibrium condition is that s / ICOR = n