ECON2220 Solow Growth Model

Solow growth model

Part 1: Reaching the Steady-State

Basic assumptions and variables
a. Population and work force grow at a constant rate n
b. Capital depreciates at a constant rate d
c. Economy is closed and G = 0
d. Ct = Yt − It
e. Rewrite everything in per-worker terms: yt = Yt/Nt; ct = Ct/Nt; kt = Kt/Nt
f. kt is also called the capital-labor ratio

𝐊
This model is to find a state that the capital-labour ratio (𝐤 = ) remians
𝐍

unchanged forever.
After finding such a state, some implications about the economic growth can be
derived.
To find the steady-state, the following terms are exogenously given as constants

Economics Variables Symbol

Population growth n
Depreciation rate d
Saving rate s
Parameter α

The key variable is the capital-labour ratio k, and y, c, i depend on k.

Whether A is exogenously fixed or not, depending on whether we assume there is
technological growth.

To begin with, Y = C + I,

[Change them into per-worker form]

𝑌𝑡 Ct It
= +
𝑁𝑡 Nt Nt
yt = ct + it

Page 1
ECON2220 Solow Growth Model

[Get the per-worker saving]

yt − ct = it
syt = it
where s is NOT per-worker saving, s is the saving rate (or MPS), y is the per-
worker real output, sy is therefore the per-worker saving.

And thus we get the saving-equal-to-investment identity in per-worker form:

𝐬𝐲𝐭 = 𝐢𝐭

[Find out the amount of per-worker investment i so that the capital-labour

ratio remains the same overtime]

K
➔ The capital-labour ratio = k t = Nt
t

➔ There are two factors that would reduce the k overtime, the population
growth n and the depreciation rate d.

➔ The higher the population growth n, the lower the capital-labour ratio k in the
next period, holding other factors constant.

➔ The higher the depreciation rate d, the lower the amount of capital K and thus
the the lower the capital-labour ratio k in the next period, holding other
factors constant.

➔ We can say the decrease in capital-labour ratio overtime = (n + d)k.

➔ In other words, the minimum amount of i that is necessary to keep k

remain unchanged over time is 𝐢 = (𝐧 + 𝐝)𝐤.

➔ Remember our goal: to find a state that the capital-labour ratio remains
constant forever!

Page 2
ECON2220 Solow Growth Model

Part 2: Understanding the Steady-State by graph

The only possible steady-state capital-labor ratio is k*

Output at that point is y* = f(k*); consumption is c* = f(k*) − (n + d)k* → and we can

represent these values on the graph.

If k begins at some level other than k*, it will move toward k*

➔ For k below k*, saving > the amount of investment needed to keep k constant,
so k rises

➔ For k above k*, saving < the amount of investment needed to keep k constant,
so k falls

To summarize, with no productivity growth, the economy reaches a steady state,

with constant capital-labor ratio, output per worker, and consumption per worker.

It is the equilibrium state of the economy.

Page 3
ECON2220 Solow Growth Model

We can also mathematically prove that 𝐢 = (𝐧 + 𝐝)𝐤 is the minimum amount

of investment that keeps the capital-labour ratio k constant forever.

[Consider the capital accumulation formula]

𝐾𝑡+1 = 𝐾𝑡 (1 − 𝑑) + 𝐼𝑡

𝐾𝑡+1 = 𝐾𝑡 (1 − 𝑑) + 𝑠𝑌𝑡

𝐾𝑡+1 = 𝐾𝑡 (1 − 𝑑) + 𝑠𝐴𝐾𝑡𝛼 𝑁𝑡1−𝛼

[Divide both sides by worker at time t 𝑵𝒕 ]

𝐾𝑡+1 𝐾𝑡 𝑠𝐴𝐾𝑡𝛼 𝑁𝑡1−𝛼

= (1 − 𝑑) +
𝑁𝑡 𝑁𝑡 𝑁𝑡
𝐾𝑡+1 𝐾𝑡 𝑠𝐴𝐾𝑡𝛼
= (1 − 𝑑) +
𝑁𝑡 𝑁𝑡 𝑁𝑡𝛼
𝐾𝑡+1
= 𝑘𝑡 (1 − 𝑑) + 𝑠𝐴𝑘𝑡𝛼
𝑁𝑡

[We can’t get anything helpful from dividing 𝑲𝒕+𝟏 by 𝑵𝒕 , so that we add
𝑵𝒕+𝟏 𝐨𝐧 𝐭𝐡𝐞 𝐥𝐞𝐟𝐭 𝐡𝐚𝐧𝐝 𝐬𝐢𝐝𝐞]

𝐾𝑡+1
= 𝑘𝑡 (1 − 𝑑) + 𝑠𝐴𝑘𝑡𝛼
𝑁𝑡
𝐾𝑡+1 𝑵𝒕+𝟏
. = 𝑘𝑡 (1 − 𝑑) + 𝑠𝐴𝑘𝑡𝛼
𝑵𝒕+𝟏 𝑁𝑡
𝑁𝑡+1
𝑘𝑡+1 ( ) = 𝑘𝑡 (1 − 𝑑) + 𝑠𝐴𝑘𝑡𝛼
𝑁𝑡
Nt+1
where = 1 + n because
Nt

Nt+1 − Nt Nt+1 Nt+1

Population growth n = = − 1, therefore, =1+n
Nt Nt Nt

𝒌𝒕+𝟏 (1 + 𝑛) = 𝑘𝑡 (1 − 𝑑) + 𝑠𝐴𝑘𝑡𝛼

Page 4
ECON2220 Solow Growth Model

[Subtract both sides by (𝟏 + 𝐧)𝐤 𝐭 ]

𝒌𝒕+𝟏 (1 + 𝑛) – (𝟏 + 𝒏)𝒌𝒕 = 𝑘𝑡 (1 − 𝑑) + 𝑠𝐴𝑘𝑡𝛼 − (𝟏 + 𝒏)𝒌𝒕

(𝒌𝒕+𝟏 − 𝒌𝒕 )(𝟏 + 𝒏) = 𝒔𝑨𝒌𝜶𝒕 − 𝒌𝒕 (𝒏 + 𝒅)

(∆𝒌𝒕+𝟏 )(𝟏 + 𝒏) = 𝒔𝑨𝒌𝜶𝒕 − 𝒌𝒕 (𝒏 + 𝒅)

↑Key fundamental equation in the Solow mode↑

[In the steady-state, ∆𝒌𝒕+𝟏 = 𝒌𝒕+𝟏 − 𝒌𝒕 = 𝟎]

(0)(1 + 𝑛) = 𝑠𝐴𝑘𝑡𝛼 − 𝑘𝑡 (𝑛 + 𝑑)

𝑠𝐴𝑘𝑡𝛼 = 𝑘𝑡 (𝑛 + 𝑑)

Therefore, to keep k constant overtime, i = 𝑠𝐴𝑘 𝛼 = (n + d)k.

[Express the steady-state capital-labour ratio k* in terms of other values]

𝑠𝐴𝑘 𝛼 = (𝑛 + 𝑑)𝑘
𝑘 𝛼 (𝑛 + 𝑑)
=
𝑘 𝑠𝐴
(𝑛 + 𝑑)
𝑘 𝛼−1 =
𝑠𝐴
𝑠𝐴
𝑘1−𝛼 =
𝑛+𝑑
1
𝑠𝐴 1−𝛼
𝑘∗ = [ ]
𝑛+𝑑

Under our production function, k ∗ is the capital-labour ratio at the steady-state

which will not change overtime.
The amount of output per worker y, consumption per worker c, and the saving
per worker sy remain unchanged overtime.
But it DOES NOT MEAN total output Y, total consumption C, total investment
I, total saving S and total capital K are constant overtime.

Page 5
ECON2220 Solow Growth Model

Part 3: Finding the amount of output per worker, consumption per worker and
saving per working at the steady-state

[Output per worker in the steady-state]

Recall that output per worker = 𝑦𝑡 = 𝐴𝑘𝑡𝛼

1
∗ 𝑠𝐴 1−𝛼
➔ Since we have obtained the steady-state capital-labour ratio 𝑘 = [𝑛+𝑑]
➔ So that we can obtain also the steady-state output per worker:

𝑦 ∗ = 𝐴𝑘 ∗ 𝛼
1 𝛼 𝛼
𝑠𝐴 1−𝛼 𝑠𝐴 1−𝛼
𝑦 ∗ = 𝐴 ([ ] ) = 𝐴[ ]
𝑛+𝑑 𝑛+𝑑

[Consumption per worker and Saving per worker T the steady-state]

𝛼
𝑠𝐴 1−𝛼
Saving per worker(= investment per worker) = 𝑠𝑦 ∗ = 𝑠𝐴 [ ]
𝑛+𝑑
𝛼
𝑠𝐴 1−𝛼
Consumption per worker = 𝑦 ∗ − 𝑠𝑦 ∗ = (1 − 𝑠)𝑦 ∗ = (1 − 𝑠)𝐴 [ ]
𝑛+𝑑

Part 4: Factors affecting steady-state capital-labour ratio and steady-state output

per worker

To conclude, we can tell how different factors affect the steady-state capital-
labour ratio and steady-state output per worker:

Steady-state capital-labour ratio Steady-state output per worker

𝛼
A rise in… 1
𝑠𝐴 1−𝛼
∗
𝑠𝐴 1−𝛼 ∗
𝑘 =[ ] 𝑦 = 𝐴[ ]
𝑛+𝑑 𝑛+𝑑
s ↑ ↑
n ↓ ↓
d ↓ ↓
A ↑ ↑

What about steady-state consumption per worker?

Page 6
ECON2220 Solow Growth Model

Part 5: Implication from the Solow Growth Model

The fundamental determinants of long-run living standards

1. The saving rate

a. Higher saving rate means higher capital-labor ratio, higher output per
worker, and can lead to a higher or lower consumption per worker.

b. Should a policy goal be to raise the saving rate (s) ?

(1) Not necessarily, since the cost is lower consumption in the short run

(2) There is a trade-off between present and future consumption

2. Population growth

a. Higher population growth means a lower capital-labor ratio, lower output per
worker, and lower consumption per worker.

b. Should a policy goal be to reduce population growth (n)?

(1) Doing so will raise consumption per worker

(2) But it will reduce total output and consumption, affecting a nation’s
ability to defend itself or influence world events.

c. The Solow model also assumes that the proportion of the population of
working age is fixed

(1) But when population growth changes dramatically this may not be true

(2) Changes in cohort sizes may cause problems for social security systems
and areas like health care

Page 7
ECON2220 Solow Growth Model

3. Productivity growth

a. The key factor in economic growth is productivity improvement (A)

b. Productivity improvement raises output per worker for a given level of

the capital-labor ratio.

c. In equilibrium, productivity improvement increases the capital-labor ratio,

output per worker, and consumption per worker

(1) Productivity improvement directly improves the amount that can be

produced at any capital-labor ratio

(2) The increase in output per worker increases the supply of saving,
causing the long-run capital-labor ratio to rise

Page 8
ECON2220 Solow Growth Model

Part 6: The Golden Rule Capital-Labour Ratio and The Golden Rule Saving
Rate

The Golden Rule in the Solow Growth Model is always to find the point where
consumption per worker c is maximized.

We call the capital-labour ratio that maximizes consumption per worker c as

Golden Rule capital-labour ratio k G .

We call the saving rate that maximizes consumption per worker c as Golden
Rule saving rate sG .

To find the Golden rule capital-labour ratio k G , Golden rule saving rate 𝐬𝐆 is
not a given constant. Both k G and sG are variables. Only n, d and 𝛼 are
exogenously given.

The difference between y and sy is consumption per worker c.

To maximize consumption per worker, the capital-labour ratio should be at a

level that the output-per-worker curve and the investment curve are parallel to
each other so that their vertical distance would be largest.

Page 9
ECON2220 Solow Growth Model

When they are parallel:

[Find the slopes of the two functions]

Output per worker = y = Ak α

dy
Slope of the output per worker curve = = αAk α−1
dk
Investment = (n + d)k
Slope of the investment curve = (n + d)

[Equate the slopes of the two functions]

➔ When they are parallel, their slopes should be equal to each other.

αAk α−1 = (n + d)

➔ The capital-labour ratio k from the above equation is the Golden rule capital-
labour ratio that maximizes current consumption.

➔ The same result could be obtained by taking the FOC of the consumption per
worker:

➔ Recall that the function of the consumption per worker:

c = y − i = k α − (n + d)k

➔ If we take the first order condition:

dc dy di
= − =0
dk dk dk
➔ We can find capital-labour ratio that can maximize current consumption, and
the result of the above FOC is:

αAk α−1 − (n + d) = 0

➔ Which gives us the same result as the above.

Page 10
ECON2220 Solow Growth Model

[Find the Golden rule capital-labour ratio 𝐤 𝐆 ]

➔ Recall the condition that can be used to find out the highest current
consumption per worker:
αAk α−1 = (n + d)
(n + d)
k α−1 =
αA
αA
k1−α =
(n + d)
1
αA 1−α
kG = ( )
(n + d)

➔ The k G is the Golden rule capital-labour ratio that can maximize the current
consumption per worker.

[Find the Golden rule saving rate 𝐬𝐆 ]

➔ Recall that the steady-state (equilibrium) capital-labour ratio is:

1
𝐬A 1−α
k∗ = [ ]
n+d

➔ And the Golden rule capital-labour ratio is:

1
𝛂A 1−α
kG = ( )
(n + d)

➔ Therefore, the Golden-rule saving rate is sG = α.

➔ Of course, the Golden-rule state is also a steady-state.

➔ Under the given production function, the saving rate that equals α can result
in a steady-state capital-labour ratio k G that maximizes current consumption
per worker.

Page 11