Macroeconomics & The Global Economy

Ace Institute of Management

Session 6: Economic Growth

Instructor Sandeep Basnyat Sandeep_basnyat@yahoo.com 9841 892281

The Solow or Neo Classical Model

A major paradigm by Robert Solow: widely used in policy making benchmark against which most recent growth theories are compared The rate at which the output of the economy grows basically depends on the rate at which the followings grow over time: Capital Stock Factors of Production Labour Force Technological Progress - Production Function

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The Solow Model- Accumulation of Capital Stock in an Economy

How much capital an economy can accumulate depends on:
supply of goods (Output) : depends on

Production function

demand of goods (Input): depends on

Consumption function

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The production function

In aggregate terms: Y = F (K, L ) Define: y = Output k = Capital Stock L = No. of Labour Assumption: Constant return to scale. So, zY = F (zK, zL ) for any z > 0 Suppose, z = 1/L. Then, Y/L = F (K/L , 1)

Amount of Output per worker (Y/L) is the function of amount of capital per worker (K/L) .
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The production function

Assume, Y/L = y and K/L = k. Then,

y =

f(k). Ignore 1 as a constant. (i)

Eqn, (i) shows how much extra output a

worker produces given an extra capital (Marginal Product of Capital-MPK).

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The production function

Output per worker, y

Note: When capital per worker is high, extra unit of capital produces lower output Vice Versa.

f(k)
1

MPK

Note: this production function exhibits diminishing MPK.

Capital per worker, k

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The Demand for Goods and Services

y = c + i (remember, no G : Two Sector) In per worker terms: Output per worker is divided into consumption per worker and investment per worker

Since people save and consume their income,

If savings rate = s, then, c = (1-s)

So, fraction of the income that people consume is

c = (1-s)y .. Consumption Fn.
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The Demand for Goods and Services

Substituting the value of c in y;

y = (1-s)y + i
i = sy

or

Shows that investment equals saving where

s is the fraction of the output/ income

devoted to investment.

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Basis of Neo-Classical Growth Model

The main building block of the model: production function (Y depends on K, L and the technological progress)

Investment : K
Depreciation : K So, When I > D; K

When I < D; K
When I = D; K- Unchanged (Steady State) Big Question: When does investment exceed depreciation, and when does it fall short of it?

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Basis of Neo-Classical Growth Model

Depreciation: we may safely assume it as a constant (usually shown by 45 degree).

Investment: Can be shown in terms of savings.

Saving is a fixed share of to total income. Therefore,

savings and/or investment at different capital stocks can be presented as a part of the total output (Income).

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Graphical representation without Technology

Output Per Worker

Steady State

Capital Per Worker

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The model and increase in the saving rate

Output Per Worker

Capital Per Worker

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The model and increase in population

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Effect of Technological Advancement

Productivity per y worker increases y* Shifts the Production y* functions upward Saving rate shifts upward Capital stock per worker increases New Steady State is formed Output per worker is increased but greater than k
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y = f(k) y = f(k) ir = dk i = s' f(k) i = s f(k)

k* k1*

k
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Golden Rule Level of Capital

y

Bench mark for highest level of movement of steady state The Golden Rule level of capital accumulation is the steady state with the highest level of consumption.

ir = dk y = f(k)

C*gold

i = s f(k)

I*gold

k*gold
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Policy issues: How to increase the saving rate?

Reduce the government budget deficit (or increase the budget surplus).

Increase incentives for private saving. Example: Reduce tax

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Policy issues: Allocating the economys investment

In the Solow model, theres one type of capital.

In the real world, there are many types, which we can divide into three categories: private capital stock public infrastructure human capital: the knowledge and skills that workers acquire through education.
How should we allocate investment among these types?
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Policy issues: Allocating the economys investment

Two viewpoints: 1. Let the market allocate investment to the type with the highest marginal product. 2. Industrial policy by government: Govt should actively encourage investment in capital of certain types or in certain industries, because they may have positive externalities that private investors dont consider.

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Policy issues: Establishing the right institutions

Creating the right institutions is important for ensuring that resources are allocated to their best use. Examples:
Legal institutions, to protect property rights. Capital markets, to help financial capital flow

to the best investment projects.

A corruption-free government, to promote

competition, enforce contracts, etc.

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Policy issues: Encouraging tech. progress

Patent laws: encourage innovation by granting temporary monopolies to inventors of new products. Tax incentives for R&D
Grants to fund basic research at universities Industrial policy: encourages specific industries that are key for rapid tech. progress
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Thank You

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