Ch08. STU. Economic Growth

Economic Growth Models
Dr. My Nguyen
I. The Solow model
• The production function: In aggregate terms: Y = F (K, L)
• Define: y = Y/L = output per worker
k = K/L = capital per worker
• Assume constant returns to scale:
zY = F (zK, zL ) for any z > 0
• Pick z = 1/L. Then
Y/L = F (K/L, 1)
y = F (k, 1)
y = f(k) where f(k) = F(k, 1)
The national income identity
• Y = C + I (remember, no G )
• In “per worker” terms:
y=c+i
where c = C/L and i = I /L
• s = the saving rate,
the fraction of income that is saved
(s is an exogenous parameter)
• Consumption function: c = (1–s)y
(per worker)
Saving and investment
• saving (per worker) = y – c
=
=
• National income identity is y = c + i
Rearrange to get: i = y – c = sy
Using the results above,
i =
Capital accumulation
• The basic idea: Investment increases the capital stock, depreciation
reduces it.
Change in capital stock = investment – depreciation
• Δk = i – δk
• Since i = sf(k) , this becomes:
The equation of motion for k
• The Solow model’s central equation

• Determines behavior of capital over time…
• …which, in turn, determines behavior of
all of the other endogenous variables
because they all depend on k. E.g.,
income per person: y = f(k)
consumption per person: c = (1 – s) f(k)
The steady state
If investment is just enough to cover depreciation

[sf(k) = δk],
then capital per worker will remain constant:
Δk = 0.
This occurs at one value of k, denoted k*,

called the steady state capital stock.
The Golden Rule: Introduction
• Different values of s lead to different steady states.
How do we know which is the “best” steady state?
• The “best” steady state has the highest possible
consumption per person: c* = (1–s) f(k*).
• An increase in s
• leads to higher k* and y*, which raises c*
• reduces consumption’s share of income (1–s),
which lowers c*.
• So, how do we find the s and k* that maximize c*?
The Golden Rule capital stock
• k gold  the Golden Rule level of capital, the steady state value of k
*
that maximizes consumption.

• To find it, first express c* in terms of k*:
c* = y* − i*
= f (k*) − i*
= f (k*) − δk*
• In the steady state: i* = δk* because Δk = 0.

The transition to the Golden Rule steady state
• The economy does NOT have a tendency to move toward the Golden
Rule steady state.
• Achieving the Golden Rule requires that policymakers adjust s.
• This adjustment leads to a new steady state with higher consumption.
• But what happens to consumption
during the transition to the Golden Rule?
Population growth
• Assume the population and labor force grow
at rate n (exogenous):
L
 n
L
• EX: Suppose L = 1,000 in year 1 and the population is growing at 2%

per year (n = 0.02).
• Then ΔL = nL = 0.02×1,000 = 20,
so L = 1,020 in year 2.
Break-even investment
• (δ + n)k = break-even investment,
the amount of investment necessary
to keep k constant.
• Break-even investment includes:
• δ k to replace capital as it wears out
• nk to equip new workers with capital
(Otherwise, k would fall as the existing capital stock is spread more thinly
over a larger population of workers.)
The equation of motion for k
The Golden Rule with population growth
To find the Golden Rule capital stock,
express c* in terms of k*:
c* = y* − i*
=
c* is maximized when
MPK =
or equivalently,
Technological progress in the Solow model
• A new variable: E = labor efficiency
• Assume:
Technological progress is labor-augmenting:
it increases labor efficiency at the exogenous rate g:
E
g 
E
• We now write the production function as:
Y  F (K , L  E )
 where L × E = the number of effective workers.
 Increases in labor efficiency have the
same effect on output as increases in
the labor force.
• Notation:
y = Y/LE = output per effective worker
k = K /LE = capital per effective worker
• Production function per effective worker:
y = f(k)
• Saving and investment per effective worker:
sy = sf(k)
(δ + n + g)k = break-even investment:
the amount of investment necessary
to keep k constant.
Consists of:
• δ k to replace depreciating capital
• n k to provide capital for new workers
• g k to provide capital for the new “effective” workers created by
technological progress
The Golden Rule with technological progress
To find the Golden Rule capital stock,
express c* in terms of k*:
c* = y* − i*
=
c* is maximized when
or equivalently,
II. Endogenous growth theory
• Solow model:
• sustained growth in living standards is due to tech progress.
• the rate of tech progress is exogenous.
• Endogenous growth theory:
• a set of models in which the growth rate of productivity and living standards
is endogenous.
• Production function: Y = AK
where A is the amount of output for each unit of capital (A is
exogenous & constant)
• Key difference between this model & Solow: MPK is constant here,
diminishes in Solow
• Investment: sY
• Depreciation: δK
• Equation of motion for total capital: ΔK = sY − δK
• ΔK = sY − δK
Y K
• Divide through by K and use Y = AK to get:   sA  
Y K
 If sA > δ, then income will grow forever, and investment is the
“engine of growth.”
 Here, the permanent growth rate depends on s. In Solow model, it
does not.

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Economic Growth Models

• The Solow model’s central equation

If investment is just enough to cover depreciation

This occurs at one value of k, denoted k*,

that maximizes consumption.

• In the steady state: i* = δk* because Δk = 0.

• EX: Suppose L = 1,000 in year 1 and the population is growing at 2%

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