Week 4

The Solow Growth Model

5.1 Introduction
In this week, 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, and how 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.
�, is exogenous in the Production Model.
• Capital stock, 𝐾𝐾
• Capital stock, 𝐾𝐾, is endogenous in the Solow Model.
The accumulation of capital is a possible engine of long-run
economic growth.
Perhaps some countries are richer than others because they
invest more in accumulating capital.
South Korea and the Philippines
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 to scale in capital and labor.
• Assume exponent of one-third on capital.
Variables are time subscripted (𝑡𝑡)

̅ 𝑡𝑡𝛼𝛼 𝐿𝐿1−𝛼𝛼
𝑌𝑌𝑡𝑡 = 𝐹𝐹 𝐾𝐾𝑡𝑡 , 𝐿𝐿𝑡𝑡 = 𝐴𝐴𝐾𝐾 𝑡𝑡

1
𝛼𝛼 =
3
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 𝐾𝐾�0 =1,000 units.
Suppose:
• Invests a constant amount of 200 units each year.
• 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.
𝐶𝐶𝑡𝑡 + 𝐼𝐼𝑡𝑡 = 𝑌𝑌𝑡𝑡
⟹ 𝐶𝐶𝑡𝑡 +𝑠𝑠𝑌𝑌𝑡𝑡 = 𝑌𝑌𝑡𝑡
⟹ 𝐶𝐶𝑡𝑡 = (1 − 𝑠𝑠)𝑌𝑌𝑡𝑡

oInvestment share together with the resource constraint imply

the consumption share.
• 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

• Real interest rate equals to rental price of capital. Why?

Saving
Saving:
• The difference between income and consumption, which is
equal to investment

where is saving
5.4 Solving the Solow Model
To solve the model, we need to write the 5 endogenous variables
𝑌𝑌𝑡𝑡 , 𝐾𝐾𝑡𝑡 , 𝐿𝐿𝑡𝑡 , 𝐶𝐶𝑡𝑡 , 𝐼𝐼𝑡𝑡
as function of parameters 𝐴𝐴,̅ 𝑠𝑠,̅ 𝑑𝑑,̅ 𝐿𝐿� , 𝐾𝐾�0 .
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.

1/3 � 2/3
𝑌𝑌𝑡𝑡 = 𝐴𝐴𝐾𝐾𝑡𝑡 𝐿𝐿

If 𝐾𝐾𝑡𝑡+1 = 𝐾𝐾𝑡𝑡 , then Δ𝐾𝐾𝑡𝑡 = 0, and we had two equations, and two
unknowns, 𝑌𝑌𝑡𝑡 , 𝐾𝐾𝑡𝑡 which could be solved.
We see next how this could be done graphically.
The Solow Diagram

1/3 � 2/3
̅ 𝑡𝑡 𝐿𝐿
𝑠𝑠𝐴𝐴𝐾𝐾
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 – long run equilibrium.
If investment < depreciation, the economy converges to the
same steady state from 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
1/3 � 2/3
𝑌𝑌𝑡𝑡 = 𝐴𝐴𝐾𝐾𝑡𝑡 𝐿𝐿
𝐶𝐶𝑡𝑡 + 𝐼𝐼𝑡𝑡 = 𝑌𝑌𝑡𝑡
Solving Mathematically for the Steady State
In the steady state, investment equals depreciation.

̅ ∗
𝑑𝑑𝐾𝐾 = 𝑠𝑠𝑌𝑌
̅ ∗

Substitute into the general Cobb-Douglas production function:

̅ ∗ ̅ ∗𝛼𝛼 �1−𝛼𝛼
𝑑𝑑𝐾𝐾 = 𝑠𝑠̅ 𝐴𝐴𝐾𝐾 𝐿𝐿
Solving for the Steady State—1
Solve for K*
1
𝑠𝑠̅ 𝐴𝐴̅ 1−𝛼𝛼
𝐾𝐾 ∗ = 𝐿𝐿�
𝑑𝑑̅

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*

∗ ̅ ∗𝛼𝛼
𝑌𝑌 = 𝐴𝐴𝐾𝐾 𝐿𝐿 �1−𝛼𝛼

• Plug in our solved value of K*

𝛼𝛼
1 𝑠𝑠̅ 1−𝛼𝛼
∗
𝑌𝑌 = 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
̅ ∗ 𝛼𝛼 .
the production model: 𝑦𝑦 ∗ = 𝐴𝐴𝑘𝑘
• 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 in the Production Model
We learned last week that the Production model
• Can be used to understand differences in y
Take the ratio of y* for two countries 𝑦𝑦 ∗ = 𝐴𝐴̅𝑘𝑘� 𝛼𝛼
Differences in Y/L in the Solow Model
The Solow model shows TFP is even more important in
1
explaining per capita output. ̅
𝑠𝑠̅ 𝐴𝐴 1−𝛼𝛼
• Can be used to understand differences in y 𝐾𝐾 ∗ = 𝐿𝐿�
𝑑𝑑 ̅
Take the ratio of y* for two countries, assuming the
depreciation rate is the same:

See previous figure (5.3)

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?
𝛼𝛼
1
𝑠𝑠̅
• It can in the aggregate output (𝑌𝑌 = 𝐴𝐴̅ 𝐿𝐿� ).
∗ 1−𝛼𝛼
1−𝛼𝛼
𝑑𝑑�
𝛼𝛼
1
𝑠𝑠̅
• It cannot in output per person (𝑦𝑦 = 𝐴𝐴̅
∗ 1−𝛼𝛼
1−𝛼𝛼 ).
𝑑𝑑�

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.
• Output declines rapidly at first, and then gradually
settles down at its new, lower steady state level Y**.
 �
Behavior of Output after an Increase in 𝒅𝒅
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, 1960–2017
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.