Oliver Landmann Advanced Macroeconomics I

Markus Epp PS1: Solow model

Problem Set 1: The Solow Model

1. Consider the Solow model where production follows the Cobb-Douglas production
function Y = ( AL)1−α K α and where population and technology grow at their respec-
tive exogenous rates of n and g. The capital stock evolves according to K̇ = sY − δK.
K
a) Let capital stock in efficiency units be defined as k ≡ AL . Derive the steady state
capital stock k∗ .
b) Establish stability of the steady state formally or verbally or graphically.
c) Compute steady state output and consumption in efficiency units.
d) Derive the golden-rule level of capital k GR and specify the range of dynamically
efficient savings rates.
Hint: Remind yourself of what Pareto-efficiency requires.
e) How are the factor prices rt and wt determined? Derive w∗ and the steady state
rental rate to capital r ∗ .
f) Show that dynamic efficiency implies r ∗ > n + g.
g) Compute the growth rate of w∗ L and relate your result to part f).

2. Consider Solow’s model of economic growth with exogenous technological progress

and exogenous population growth. What are the dynamic effects on aggregate out-
put growth of
a) an increase in the savings rate?
b) a permanent fall in the rate of technological progress or population growth?
c) a one-time jump in the number of workers (due to a rise in the retirement age,
say)?
d) What are the dynamic effects on per-capita consumption in the last case?
(from the final exam, summer 2012)
Oliver Landmann Advanced Macroeconomics I
Markus Epp PS1: Solow model

Revision
Mark the following statements as True (T) or False (F). No explanations required in this
part.

The steady-state equilibrium of the Solow model conforms to all of Kaldor’s

1.
stylized facts of growth.
The Solow model explains the convergence of per-capita income levels among
2. OECD countries in the post-war period as a consequence of different initial
conditions, but similar steady-state conditions.
In the Solow model an acceleration of technological progress lowers the steady-
3.
state level of output per effective labor input.
If the aggregate production function of the Solow model is Cobb-Douglas, a
4.
slowdown of economic growth does not lead to a higher income share of capital.
In the Solow model, when capital per unit of effective labor k is greater than the
5.
steady-state level of k, actual investment exceeds break-even investment.
Oliver Landmann Advanced Macroeconomics I
Markus Epp PS1: Solow model

Problem Set 1: Solutions

1. a) The condition for a steady state is k̇ = 0. You have to first derive the law of
motion for k however. For this, note that
∂ log x ẋ
= gx =
∂t x
Here:
∂ log k ∂(log K − log A − log L)
gk = = = gK − g A − g L ≡ gK − g − n
∂t ∂t
K̇
Inserting gK = K we obtain
K̇ sY − δK
gk = −g−n = − g − n = skα−1 − (δ + g + n)
K K
⇒ k̇ = skα−1 k − (δ + g + n)k = skα − (δ + g + n)k
so that the steady state can be derived by solving the last equality for zero:
  1
∗α ∗ ∗ s 1− α
sk = (n + g + δ)k ⇔ k =
n+g+δ

b) Formally: Stability of a variable can be formally established by checking whether:


∂ ẋ 
<0
∂x  x= x∗
Why? Note first that ẋ = 0 if x ∗ is a steady state. The derivative is equivalent to
the following two statements: If x undercuts x ∗ , ẋ gets positive (since ẋ  x= x∗ = 0)


so that x rises again. If x is increased beyond x ∗ , ẋ gets negative (since ẋ  x= x∗ =



0) so that x falls. These statements imply in combination that x does not deviate
from x ∗ but gravitates back to x ∗ . Here:
 i 
∂k̇  h
= sαkα−1 − (n + g + δ)  = ...
∂k  ∗
k=k ∗
k=k
= (α − 1)(n + g + δ)
hence, if n + g + δ > 0 is assumed to hold,

∂k̇ 
<0 ⇔ α<1
∂k k=k∗
Verbally: For k < k∗ , k̇ > 0 as investment outweighs depreciation and dilution
(dilution: as capital stock is defined in efficiency units, additional capital in effi-
ciency units is only added if additional effective workers AL are also equipped
with additional capital K.). Hence, k converges to k∗ for k < k∗ . Vice versa,
k > k∗ implies k̇ < 0 as depreciation and dilution outweigh investments.
Graphically:
Oliver Landmann Advanced Macroeconomics I
Markus Epp PS1: Solow model

Y
c) As y = AL = kα ,
  α
∗ s 1− α
y =
n+g+δ
follows immediately. Moreover, c = (1 − s)y∗ implies
∗

  α
s 1− α
c ∗ = (1 − s )
n+g+δ

d) k GR : capital stock (in eff. units) that maximizes steady state consumption (in eff.
units). Two ways to solve the problem:
1. Find the golden rule savings rate sGR for which steady state consumption is
at its maximum. Compute the corresponding capital stock.
2. Find the golden rule capital stock k GR directly by noting that consumption
is the difference between output y and investments (n + g + δ)k.
If we are not directly interested in computing the golden rule savings rate sGR
we solve therefore
k GR := arg max {kα − (n + g + δ)k }
k >0

The first order condition to this problem specifies k GR implicitly:

α −1
αk GR = (n + g + δ)
Oliver Landmann Advanced Macroeconomics I
Markus Epp PS1: Solow model

It follows from this condition:

  1
α 1− α
GR
k =
n+g+δ

All capital stocks k > k GR imply that a lower saving rate improves consumption
c in the short and the long run. Hence, all saving rates s > α cannot be dynami-
cally efficient as any generation can be made better of by lowering s. Thus, [0, α]
is the range of dynamically efficient saving rates.
e) Factor prices are derived from the representative firm’s problem:

max Π := Y − wL − RK
K,L

The FOCs define implicitly aggregate demand for K and L dependent of the
prices w and R:
∂Π
= α( AL)1−α K α−1 − R = 0
∂K
∂Π
= (1 − α) A1−α L−α K α − w = 0.
∂L
Because of R = r + δ:

r = αkα−1 − δ
w = (1 − α) Akα

In the steady state:

α −1 (n + g + δ)
r ∗ = αk∗ −δ = α −δ
s
  α
s 1− α
w∗ = (1 − α) Ak∗
α
= (1 − α ) A
n+g+δ

f) Inserting the findings of e):

r∗ > n + g
α −1
⇔ αk∗ > n + g + δ
  α −1
s 1− α
⇔ α > n+g+δ
n+g+δ
n+g+δ
⇔ α > n+g+δ
s
⇔ α>s
All statements are tautological (i.e. equivalent) and so are r ∗ > n + g and s < α.
Hence, we could also have started from s ≤ α to derive the even more general
result r ∗ ≥ n + g.
Oliver Landmann Advanced Macroeconomics I
Markus Epp PS1: Solow model

g) The growth rate of w∗ L is the sum of the growth rates of w∗ and L:


gw ∗ L = gw  k = k ∗ + n

To derive gw k=k∗ define
  α
s 1− α
φ ≡ (1 − α )
n+g+δ
and note that 
gw  k = k ∗ = gφ + g = g
so that
gw ∗ L = n + g
The rate at which pure capital owners can accumulate wealth exceeds the growth
rate of the labor income, i.e. the rate at which pure labor owners get wealthier.
In a world where there are only pure capital owners and pure labor owners,
rising inequality results mechanically if consumption propensities of pure labor
owners are weakly higher than those of pure capital owners.
2. Note that we can truncate the analysis of impacts on aggregate output by looking at
how log of output changes. Log of output is a monotone transformation of output and
therefore reacts qualitatively equivalent, but is also a linear function of the different
(growth-)components:

log(Yt ) = log( F ( At Lt , Kt )) = log[( At Lt )1−α Ktα )]

= (1 − α)[log( At ) + log( Lt )] + α log(Kt )
Hence, we can trace back the changes in aggregate output to its growth determinants:
∂ log(Yt )
gY ≡ = (1 − α)( g + n) + αgK = (1 − α)( g + n) + α( gk + g + n)
∂t
= g + n + αgk
In the following exercises, g, n, and gk are functions of time and gk = 0 holds along
the balanced growth path of Yt .
a) While g and n stay constant, gk jumps up but decreases thereafter. The increase
of the savings rate therefore leads to a permanent increase in the level of aggregate
output. The growth rate of output rises only temporarily during the transition to
the new steady state.
b) As g (or n) is permanently lower, gY will in the long run also be lower, because
gk = 0 in the steady state. There are two competing effects on impact, however:
when g (or n) decreases, gk increases immediately as the new steady state capital
stock is higher. This implies that output growth slows down less strongly in
the short run than it does in the long run (for some parameter constellations it
might even be the case, that growth of output first accelerates and slows down
thereafter).
Oliver Landmann Advanced Macroeconomics I
Markus Epp PS1: Solow model

c) A one time jump in the number of workers leads to a temporary departure from
the old (=new) steady state. After a discrete jump in the level of output, the
growth rate of output is temporarily above the pre-shock growth rate during the
transition to the new (=old) steady state. This is due to the fact, that gk goes up
while n and g remain constant.
d) A one-time increase in the labor supply amounts to an immediate fall in the
capital-labor ratio of the economy. As a consequence, per-capita income and
per-capita consumption are reduced on impact. But since the steady-state level
of per-capita income is not affected at an unchanged saving rate, per-capita con-
sumption gradually recovers and returns to its initial steady-state path.

Revision
Mark the following statements as True (T) or False (F). No explanations required in this
part.

The steady-state equilibrium of the Solow model conforms to all of Kaldor’s

1. T
stylized facts of growth.
The Solow model explains the convergence of per-capita income levels among
2. OECD countries in the post-war period as a consequence of different initial T
conditions, but similar steady-state conditions.
In the Solow model an acceleration of technological progress lowers the steady-
3. T
state level of output per effective labor input.
If the aggregate production function of the Solow model is Cobb-Douglas, a
4. T
slowdown of economic growth does not lead to a higher income share of capital.
In the Solow model, when capital per unit of effective labor k is greater than the
5. F
steady-state level of k, actual investment exceeds break-even investment.

1. Kaldor’s growth facts (in essence) are:

1. Output per worker grows continuously.
2. Capital per worker grows continuously.
3. The rate of return on capital is steady.
4. The capital/output ratio is steady.
5. Capital- and labor income shares are steady.
6. Productivity growth across countries varies.
Oliver Landmann Advanced Macroeconomics I
Markus Epp PS1: Solow model

In the Solow model, the following is true:

1./2.: Y/L and K/L grow with rate g. X
3.: rt and Rt are constant on a BGP (balanced growth path in Y&K corresponds to
steady state in y&k) since k is constant. X
4.: Y/K is constant since Y and K grow at identical rates on a BGP. X
5.: If production is Cobb-Douglas, income shares of capital and labor are α and
1 − α, respectively, where α is a constant. X(by construction)
6.: δ and g may vary across countries, and so do growth rates of Y and Y/L. X

2. In the Solow model, convergence takes place when α, n, g and δ are similar even
when K differs initially.
  α
1− α
3. As y = n+ sg+δ falls in g, a higher rate of g implies less output per effective
worker. Note however, that output in aggregate and per capita terms still grows
faster in this case.

4. See answer to 1., 5.

5. It’s the other way round: break-even investment exceeds actual investment if k > k∗ .