5

5.1

The Solow Growth Model

Models and Assumptions

What is a model? A mathematical description of the economy. Why do we need a model? The world is too complex to describe it in every detail. What makes a model successful? When it is simple but eective in describing and predicting how the world works. A model relies on simplifying assumptions. These assumptions drive the conclusions of the model. When analyzing a model it is crucial to spell out the assumptions underlying the model. Realism may not a the property of a good assumption.
67

5.2

Basic Assumptions of the Solow Model

1. Continuous time. 2. Single good produced with a constant technology. 3. No government or international trade. 4. All factors of production are fully employed.
5. Labor force grows at constant rate n = L . L

6. Initial values for capital, K0 and labor, L0 given.

68

Production Function

Neoclassical (Cobb-Douglas) aggregate production function: Y (t) = F [K(t), L(t)] = K(t) L(t)1 Y = A K L1

To save on notation write:

Constant returns to scale: F (K, L) = F (K, L) = A K L1

Inputs are essential:

F (0, 0) = F (K, 0) = F (0, L) = 0

69

 Marginal productivities are positive: F = AK 1L1 > 0 K F = (1 ) AK L > 0 L Marginal productivities are decreasing, 2F = ( 1) A K 2L1 < 0 K 2 2F = (1 ) A K L1 < 0 L2

70

Per Worker Terms Dene x = X as a per worker variable. Then L Y A K L1 = =A y= L L K a L 1 = A k L L

Per worker production function has decreasing returns to scale.

71

Capital Accumulation K = sY K

Capital accumulation equation:

Important additional assumptions: 1. Constant saving rate (very specic preferences: no r) 2. Constant depreciation rate

72

 Dividing by K in the capital accumu equation:

K K Y sK
Y L sK L

K K

Y = s K .

Some Algebra:

y = sk

Now remember that: k K L K K k = = n = +n k K L K K k We get k y + n = s k = sy ( + n) k k k Fundamental Dierential Equation of Solow Model: k = s A k ( + n) k

73

Graphical Analysis Change in k, k is given by dierence of s A k and ( + n)k If s A k > ( + n)k, then k increases. If s A k < ( + n)k, then k decreases. Steady state: a capital stock k where, when reached, k = 0

Unique positive steady state in Solow model.

Positive steady state (locally) stable.

74

Steady State Analysis Steady State: k = 0

Solve for steady state sA ) (n + )k k = 0 = s A (k n+

s A 1 n+
1 1

Steady state output per worker

Steady state output per worker depends positively on the saving (investment) rate and negatively on the population growth rate and depreciation rate.
75

Comparative Statics

Suppose that of all a sudden saving rate s increases to s > s. Suppose that at period 0 the economy was at its old steady state with saving rate s.

(n + )k curve does not change. s A k = sy shifts up to s y.

New steady state has higher capital per worker and output per worker.

Monotonic transition path from old to new steady state.

76

Evaluating the Basic Solow Model

Why are some countries rich (have high per worker GDP) and others are poor (have low per worker GDP)?

Solow model: if all countries are in their steady states, then: 1. Rich countries have higher saving (investment) rates than poor countries 2. Rich countries have lower population growth rates than poor countries

Data seem to support this prediction of the Solow model

77

The Solow Model and Growth

No growth in the steady state

Positive or negative growth along the transition path: k = s A k (n + )k k gk = s A k1 (n + ) k

78

Introducing Technological Progress

Aggregate production function becomes Y = K (AL)1

A : Level of technology in period t.

Key assumption: constant positive rate of technological progress: A =g>0 A Growth is exogenous.

79

Balanced Growth Path

Situation in which output per worker, capital per worker and consumption per worker grow at constant (but potentially dierent) rates

Steady state is just a balanced growth path with zero growth rate

For Solow model, in balanced growth path gy = gk = gc

80

Proof Capital Accumulation Equation K = sY K

Y Dividing both sides by K yields gK K = s K K

Remember that gk k = K n k K Hence Y k gk = s (n + ) k K In BGP gk constant. Therefore gy = gk

Y Hence K constant.

It follows that gY = gK .

81

What is the Growth Rate?

Output per worker Y K (AL)1 K (AL)1 y= = = = kA1 L L L L1 Take logs and dierentiate gy = gk + (1 )gA We proved gk = gy and we use gA = g to get gk = gk + (1 )g = g = gy BGP growth rate equals rate of technological progress. No TP, no growth in the economy.
82

Analysis of Extended Model

in BGP variables grow at rate g. Want to work with variables that are constant in long run. Dene: y Y = A AL = k = K k A AL y = Repeat the Solow model analysis with new variables: y = k k = s (n + g + )k y k = sk (n + g + )k

83

Closed-Form Solution

Repeating all the steps than in the basic model we get: k(t) = y (t) =
s +n+g s +n+g

+ +

1 k0 1 k0

s +n+g s +n+g

et 1 et
1

Interpretation.

84

Balanced Growth Path Analysis Solve for k analytically (n + g + )k 0 = sk k = s n+g+

1 1

Therefore y = s n+g+
1

85

k(t) = A(t)

s n+g+

1 1

s y(t) = A(t) n+g+ K(t) = L(t)A(t)

s n+g+

1 1

s Y (t) = L(t)A(t) n+g+

86

Evaluation of the Model: Growth Facts

1. Output and capital per worker grow at the same constant, positive rate in BGP of model. In long run model reaches BGP. 2. Capital-output ratio K constant along BGP Y 3. Interest rate constant in balanced growth path

4. Capital share equals , labor share equals 1 in the model (always, not only along BGP)

5. Success of Solow model along these dimensions, but source of growth, technological progress, is left unexplained.
87

Evaluation of the Model: Development Facts

1. Dierences in income levels across countries explained in the model by dierences in s, n and .

2. Variation in growth rates: in the model permanent dierences can only be due to dierences in rate of technological progress g. Temporary differences are due to transition dynamics.

3. That growth rates are not constant over time for a given country can be explained by transition dynamics and/or shocks to n, s and .

4. Changes in relative position: in the model countries whose s moves up, relative to other countries, move up in income distribution. Reverse with n.
88

Interest Rates and the Capital Share

Output produced by price-taking rms

Hire workers L for wage w and rent capital Kfrom households for r

Normalization of price of output to 1.

Real interest rate equals r

89

Prot Maximization of Firms max K (AL)1 wL rK

K,L

First order condition with respect to capital K K 1 (AL)1 r = 0 K 1 = r AL k1 = r In balanced growth path k = k, constant over time. Hence in BGP rconstant over time, hence r (real interest rate) constant over time.

90

Capital Share

Total income = Y, total capital income = rK

Capital share capital share = = rK Y K 1 (AL)1 K K (AL)1

Labor share = 1 .

91

Wages

First order condition with respect to labor L (1 )K (LA)A = w (1 )kA = w Along BGP k = k, constant over time. Since A is growing at rate g, the wage is growing at rate g along a BGP.

92