ECON3102-005

Chapter 6: Economic growth:

The Solow growth model (Part 1)

Neha Bairoliya

Spring 2014
 Motivations

• Why do countries grow? Why are there poor countries? Why are
there rich countries? Can poor countries be rich? If they cannot,
why? If they can, why are they still poor?
 Motivations

• Why do countries grow? Why are there poor countries? Why are
there rich countries? Can poor countries be rich? If they cannot,
why? If they can, why are they still poor?

• As Robert Lucas put it, “Once you start thinking about growth, its
hard to think about anything else.”
 Motivations

• Why do countries grow? Why are there poor countries? Why are
there rich countries? Can poor countries be rich? If they cannot,
why? If they can, why are they still poor?

• As Robert Lucas put it, “Once you start thinking about growth, its
hard to think about anything else.”

• We’ll use the framework we have learned and try to get some
answers to the questions above. Now, there are some empirical facts
that could help to motivate the discussion.
Observations
 Observations
• Before the industrial revolution, standards of living differed little
over time and across countries.
 Observations
• Before the industrial revolution, standards of living differed little
over time and across countries.
• Since the industrial revolution, per capita income growth has been
sustained in the richest countries. In the US, average annual growth
in per capita income has been about 2% since 1869.
Observations
 Observations
• There is a negative correlation between the population growth rate
and output per worker across countries.
 The Solow Growth Model

First, consider the consumers in the economy. We’ll add some dynamics
here, as we analyze the economy in terms of the current and future
periods. We also throw in some assumptions:
 The Solow Growth Model

First, consider the consumers in the economy. We’ll add some dynamics
here, as we analyze the economy in terms of the current and future
periods. We also throw in some assumptions:

• Population N grows at an exogenous rate n, following the equation

N 0 = (1 + n)N, ∀n > 1.
 The Solow Growth Model

First, consider the consumers in the economy. We’ll add some dynamics
here, as we analyze the economy in terms of the current and future
periods. We also throw in some assumptions:

• Population N grows at an exogenous rate n, following the equation

N 0 = (1 + n)N, ∀n > 1.

• In each period, the consumer has one unit of time available.

Consumers do not value leisure, so labor supply equals one. Then,
the population equals the labor force: N represents both the number
of workers and the population, and n is its growth rate.
 The Solow Growth Model

First, consider the consumers in the economy. We’ll add some dynamics
here, as we analyze the economy in terms of the current and future
periods. We also throw in some assumptions:

• Population N grows at an exogenous rate n, following the equation

N 0 = (1 + n)N, ∀n > 1.

• In each period, the consumer has one unit of time available.

Consumers do not value leisure, so labor supply equals one. Then,
the population equals the labor force: N represents both the number
of workers and the population, and n is its growth rate.

• There is no government; consequently, no taxes.

 The Solow Growth Model (cont’d)

• Consumers receive Y , current real output, as income. They face the

decision of how much of current income to save and how much to
consume. We assume they consume a constant fraction of income:

C = (1 − s)Y , s < 1,

where C is current consumption, s the savings rate, and current

savings are S = sY .
 The Solow Growth Model (cont’d)

Consider the representative firm.

• Output is produced by a representative firm, according to the

production function
Y = zF (K , N), (1)
which satisfies all the assumptions of Chapter 4.
 The Solow Growth Model (cont’d)

Consider the representative firm.

• Output is produced by a representative firm, according to the

production function
Y = zF (K , N), (1)
which satisfies all the assumptions of Chapter 4.

• Since it is CRS, dividing (1) by N gives

Y K N K
= zF ( , ) = zF ( , 1) (2)
N N N N
 The Solow Growth Model (cont’d)

Consider the representative firm.

• Output is produced by a representative firm, according to the

production function
Y = zF (K , N), (1)
which satisfies all the assumptions of Chapter 4.

• Since it is CRS, dividing (1) by N gives

Y K N K
= zF ( , ) = zF ( , 1) (2)
N N N N
Y
• Here we let Nbe output per worker, and KN capital per worker.
Then (2) tells that the output per worker depends on the capital per
worker.
The Solow Growth Model (cont’d)

• Rewrite (2) as

y = zf (k), (3)

where y = Y /N, k = K /N,

f (k) = F (k, 1).
 The Solow Growth Model (cont’d)

• Finally, let’s add a depreciation rate to the production side.

 The Solow Growth Model (cont’d)

• Finally, let’s add a depreciation rate to the production side.

• Here, depreciation is denoted by d, where 0 < d < 1.

 The Solow Growth Model (cont’d)

• Finally, let’s add a depreciation rate to the production side.

• Here, depreciation is denoted by d, where 0 < d < 1.

• Now we can talk about dynamics. Given the depreciation rate, the
capital stock changes over time according to

K 0 = (1 − d)K + I ,

where I denotes investment.

 The Solow Growth Model (cont’d)

Next we need to fit all this into a competitive equilibrium framework so

that our ideas are consistent.

In this economy there are two markets: labor and assets.

 The Solow Growth Model (cont’d)

Next we need to fit all this into a competitive equilibrium framework so

that our ideas are consistent.

In this economy there are two markets: labor and assets.

• In the labor market, current consumption goods are traded for

current labor.
 The Solow Growth Model (cont’d)

Next we need to fit all this into a competitive equilibrium framework so

that our ideas are consistent.

In this economy there are two markets: labor and assets.

• In the labor market, current consumption goods are traded for

current labor.

• In the assets market, current consumption goods are traded for

capital.
 The Solow Growth Model (cont’d)

Next we need to fit all this into a competitive equilibrium framework so

that our ideas are consistent.

In this economy there are two markets: labor and assets.

• In the labor market, current consumption goods are traded for

current labor.

• In the assets market, current consumption goods are traded for

capital.

• Capital is the asset in this economy, and consumers save by

accumulating it.
 The Solow Growth Model (cont’d)
• Note that the labor market clears at the inelastic supply of labor, N.
(It follows that w adjusts automatically.)
 The Solow Growth Model (cont’d)
• Note that the labor market clears at the inelastic supply of labor, N.
(It follows that w adjusts automatically.)

• Let S be the aggregate amount of savings in the current period.

Then, the capital market is in equilibrium if S = I ; since S = Y − C ,
this can be expressed as:

Y = C + I.
 The Solow Growth Model (cont’d)
• Note that the labor market clears at the inelastic supply of labor, N.
(It follows that w adjusts automatically.)

• Let S be the aggregate amount of savings in the current period.

Then, the capital market is in equilibrium if S = I ; since S = Y − C ,
this can be expressed as:

Y = C + I.

• Substituting for I and C from equations, K 0 = (1 − d)K + I and

C = (1 − s)Y , gives

Y = (1 − s)Y + K 0 − (1 − d)K

K 0 = sY + (1 − d)K . (5)
 The Solow Growth Model (cont’d)
• Note that the labor market clears at the inelastic supply of labor, N.
(It follows that w adjusts automatically.)

• Let S be the aggregate amount of savings in the current period.

Then, the capital market is in equilibrium if S = I ; since S = Y − C ,
this can be expressed as:

Y = C + I.

• Substituting for I and C from equations, K 0 = (1 − d)K + I and

C = (1 − s)Y , gives

Y = (1 − s)Y + K 0 − (1 − d)K

K 0 = sY + (1 − d)K . (5)
• Equation (5) says that future capital equals the amount of savings
plus capital left over from the current period that has not
depreciated.
 The Solow Growth Model (cont’d)

• Using equations, Y = zF (K , N) and K 0 = sY + (1 − d)K , we have

K 0 = szF (K , N) + (1 − d)K .
 The Solow Growth Model (cont’d)

• Using equations, Y = zF (K , N) and K 0 = sY + (1 − d)K , we have

K 0 = szF (K , N) + (1 − d)K .

• We can divide by N to express in per worker terms

K0 K K
= szF ( , 1) + (1 − d) ,
N N N
multiplying the first term by 1 = N 0 /N 0

K 0 N0 K K
0
= szF ( , 1) + (1 − d) ,
N N N N
 The Solow Growth Model (cont’d)

• Using equations, Y = zF (K , N) and K 0 = sY + (1 − d)K , we have

K 0 = szF (K , N) + (1 − d)K .

• We can divide by N to express in per worker terms

K0 K K
= szF ( , 1) + (1 − d) ,
N N N
multiplying the first term by 1 = N 0 /N 0

K 0 N0 K K
0
= szF ( , 1) + (1 − d) ,
N N N N
• which is
k 0 (1 + n) = szf (k) + (1 − d)k.
 The Solow Growth Model (cont’d)

• Using equations, Y = zF (K , N) and K 0 = sY + (1 − d)K , we have

K 0 = szF (K , N) + (1 − d)K .

• We can divide by N to express in per worker terms

K0 K K
= szF ( , 1) + (1 − d) ,
N N N
multiplying the first term by 1 = N 0 /N 0

K 0 N0 K K
0
= szF ( , 1) + (1 − d) ,
N N N N
• which is
k 0 (1 + n) = szf (k) + (1 − d)k.
• Dividing across by (1 + n) gives the key equation of the model:
 szf (k) (1 − d )k
k0 = + (*)
1+n 1+n
 Steady States
We want to find the steady state of the model. This is, the point at
which k 0 = k = k ∗ .
 Steady States
We want to find the steady state of the model. This is, the point at
which k 0 = k = k ∗ .

• Note that when we graph in k 0 k space, any point that crosses the 45
degree line satisfies k 0 = k.
Steady State in the Solow Growth Model

Recall equation (*):

szf (k) (1 − d)k

k0 = + (*)
1+n 1+n
Steady State in the Solow Growth Model

Recall equation (*):

szf (k) (1 − d)k

k0 = + (*)
1+n 1+n

• At the steady state, k = k ∗ and

k 0 = k ∗ ; k ∗ is the equilibrium
level of capital in the economy.
Steady State in the Solow Growth Model

• Suppose k < k ∗ . Then k 0 > k,

and the capital stock increases
from the current to the future
period, until k = k ∗ .
Steady State in the Solow Growth Model

• Suppose k < k ∗ . Then k 0 > k,

and the capital stock increases
from the current to the future
period, until k = k ∗ .

• Here, current investment is

relatively large with respect to
depreciation and labor force
growth.
 Steady State Growth Rates

• What is the growth rate of k ∗ ?

 Steady State Growth Rates

• What is the growth rate of k ∗ ?

• The answer: zero.

 Steady State Growth Rates

• What is the growth rate of k ∗ ?

• The answer: zero.

• Why? Since its a steady state, it wont move from there.

 Steady State Growth Rates

• What is the growth rate of k ∗ ?

• The answer: zero.

• Why? Since its a steady state, it wont move from there.

• Another question: What is the growth rate of y ∗ ?

 Steady State Growth Rates

• What is the growth rate of k ∗ ?

• The answer: zero.

• Why? Since its a steady state, it wont move from there.

• Another question: What is the growth rate of y ∗ ?

• The answer: zero.

 Steady State Growth Rates

• What is the growth rate of k ∗ ?

• The answer: zero.

• Why? Since its a steady state, it wont move from there.

• Another question: What is the growth rate of y ∗ ?

• The answer: zero.

• Why? Since k = k ∗ in the long run, output per worker is constant

at y ∗ = zf (k ∗ ).
 Steady State Growth Rates

• What is the growth rate of k ∗ ?

• The answer: zero.

• Why? Since its a steady state, it wont move from there.

• Another question: What is the growth rate of y ∗ ?

• The answer: zero.

• Why? Since k = k ∗ in the long run, output per worker is constant

at y ∗ = zf (k ∗ ).

• So, theres no growth in here? Are we forgetting something?

 Steady State Growth Rates

There is growth in this economy! In the long run, when k = k ∗ , all real
aggregate quantities grow at a rate n. Why?
• The aggregate quantity of capital is K = k ∗ N. Since k ∗ is constant
and N grows at a rate n, K should grow at a rate n.
 Steady State Growth Rates

There is growth in this economy! In the long run, when k = k ∗ , all real
aggregate quantities grow at a rate n. Why?
• The aggregate quantity of capital is K = k ∗ N. Since k ∗ is constant
and N grows at a rate n, K should grow at a rate n.

• Aggregate real output is Y = y ∗ N = zf (k ∗ )N, hence Y also grows

at a rate n.
 Steady State Growth Rates

There is growth in this economy! In the long run, when k = k ∗ , all real
aggregate quantities grow at a rate n. Why?
• The aggregate quantity of capital is K = k ∗ N. Since k ∗ is constant
and N grows at a rate n, K should grow at a rate n.

• Aggregate real output is Y = y ∗ N = zf (k ∗ )N, hence Y also grows

at a rate n.

• Consumption and investment follow the same logic:

I = sY = szf (k ∗ )N,

C = (1 − s)Y = (1 − s)zf (k ∗ )N.

 Steady State Growth Rates

There is growth in this economy! In the long run, when k = k ∗ , all real
aggregate quantities grow at a rate n. Why?
• The aggregate quantity of capital is K = k ∗ N. Since k ∗ is constant
and N grows at a rate n, K should grow at a rate n.

• Aggregate real output is Y = y ∗ N = zf (k ∗ )N, hence Y also grows

at a rate n.

• Consumption and investment follow the same logic:

I = sY = szf (k ∗ )N,

C = (1 − s)Y = (1 − s)zf (k ∗ )N.

• In this way, the Solow growth model is an exogenous growth model.