Solow Growth model

Supply of goods is related to production Function

𝑌 = 𝐹 𝑘, 𝐿 ; K= Capital; L= Labor Force

It is assumed that Production function exhibits CRTS with respect to K & L. so multiplying
both input by z, we can write,
𝑧𝑌 = 𝐹 𝑧𝐾, 𝑧𝐿
1
Putting 𝑧 = 𝐿 we get;

𝑌 𝐾
=𝐹 ,1
𝐿 𝐿
𝐾
Defining = 𝑘; k= capital per worker
𝐿
𝑌
= 𝑦; y= output per worker and noticing that 1 is a constant, we can write the
𝐿
production function in ‘intensive form’.
𝑦=𝑓 𝑘
Marginal Productivity of capital, 𝑀𝑃𝐾 = 𝑓 𝑘 + 1 − 𝑓 𝑘 can be approximated by 𝑓 ′ 𝑘
Demands for goods in the solow model come from consumption & investment.
𝑦 = 𝑐+𝑖
‘c & i’ are consumption & investment per worker.

𝑓(𝑘)

𝑠𝑓(𝑘)

k
If saving rate is s, then we have 𝑐 = 1 − 𝑠 𝑦
and i= y-c = y- 1 − 𝑠 𝑦
or, 𝑖 = 𝑠𝑦 = 𝑠𝑓 𝑘
Investment tends to increase in capital stock. However capital depreciates at the rate of 𝛿.
We also assure that labor force grows at the same rate as population growth, 𝑛. Thus, net
addition to capital per worker can be written as
Δ𝑘 = 𝑠𝑓 𝑘 − 𝛿𝑘 − 𝑛𝑘 = 𝑠𝑓 𝑘 − 𝑛 + 𝛿 𝑘…… (*)
In the steady state growth rate is stable and some of the important ratios are constant.
Evolution of Capital (*) depends on k. So in the steady state it is constant i.e. Δ𝑘 = 0
𝑠𝑓 𝑘 − 𝑛 + 𝛿 𝑘 = 0
𝑠𝑓 𝑘 = 𝑛 + 𝛿 𝑘

𝑓 𝑘
Y* 𝑛+𝛿 𝑘

E
𝑠𝑓 𝑘

k
k*

This is steady state in the solow model, which is to adjust at point E in the graph. Steady
state capital per worker and output per worker is denoted by k* and y*.
If k<k*, 𝑠𝑓 𝑘 > 𝑛 + 𝛿 𝑘, ⇒ Δ𝑘 > 0 i.e. is k is increasing
if k>k*, 𝑠𝑓 𝑘 < 𝑛 + 𝛿 𝑘, ⇒ Δ𝑘 < 0 i.e. is k is decreasing.
Thus, this is the way the economy converges to steady state as it is away from it for any
reason. Hence, steady state is stable.

An Increase in Saving Rate

An increase in saving rate shift the 𝑠𝑓(𝑘) curve of the graph upward. As a result steady state level of
capital stock per worker (k*) and output per worker 𝑦 ∗ = 𝑓(𝑘 ∗ ) increase.

𝑓 𝑘
Y1* 𝑛 + 𝛿 𝑘𝑐
Y2*
𝑠𝑓 𝑘

𝑠𝑓 𝑘

K 1* K 2*
But steady stat growth of capital and output per worker remains zero as before. However, as the
economy moves from a lower level of output per worker to higher level of output, growth of output
per worker increases during the transition period. A declines in saving rate will have opposite result.
A decline in population growth will have similar result as an increase in saving rate.

Golden Rule of Accumulation

We have seen that higher savings rate increase steady state output (income) per worker. Increase in
income definitely increase consumption.

An increasing in saving rate will reduce the consumption out of given income. However, as we have
seen, as increase in saving rate increases the steady state income. This increased income may
increase consumption for a given saving rate. Thus, increase in saving rate has two opposing effect
on steady state consumption per worker. Golden rule refers to that rate of savings and the
corresponding capital per worker that maximizes consumption per worker.

𝑐 ∗ = 𝑦 ∗ − 𝑠𝑓 𝑘 ∗ = 𝑓(𝑘 ∗) − 𝑠𝑓(𝑘 ∗ )
In the steady state, 𝑠𝑓 𝑘 ∗ = 𝑛 + 𝛿 𝑘 ∗
thus, 𝑐 ∗= 𝑓 𝑘 ∗ − 𝑛 + 𝛿 𝑘 ∗
𝛿𝑐∗
F.O.C for maximizing =0
𝛿𝑘∗

⇒ 𝑓 / 𝑘∗ − 𝑛 + 𝛿 = 0
⇒ 𝑓 / (𝑘 𝐺𝑂𝐿𝐷 ) = 𝑛 + 𝛿
Is the golden rule of Accumulation.
Solow Model with Technical Progress
𝐿 = # 𝑜𝑓 𝑤𝑜𝑟𝑘𝑒𝑟
𝐸 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 𝑜𝑓 𝑤𝑟𝑘𝑒𝑟
𝐿 × 𝐸 = 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑊𝑜𝑟𝑘𝑒𝑟
𝑌 = 𝐹 𝑘, 𝐸𝐿
𝐺𝑟𝑜𝑤𝑡𝑕 𝑜𝑓 𝐸 = 𝑔
𝑦 𝐾
=𝐹 ,1
𝐸𝐿 𝐸𝐿
𝑌𝑒 = 𝑓 𝑘 ∗
𝑊𝑕𝑒𝑟𝑒, 𝑌𝑒 = 𝑂𝑢𝑡𝑝𝑢𝑡 𝑝𝑒𝑟 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑤𝑜𝑟𝑘𝑒𝑟
𝑘𝑐 = 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑝𝑒𝑟 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑤𝑜𝑟𝑘𝑒𝑟
Δ𝑘𝑐 = 𝑠𝑓 𝑘𝑐 − 𝑛 + 𝛿 + 𝑔 𝑘𝑐
𝑆𝑡𝑒𝑑𝑎𝑦 𝑆𝑡𝑎𝑡𝑒 Δ𝑘𝑐 = 0
⇒ 𝑠𝑓 𝑘𝑐 − 𝑛 + 𝛿 + 𝑔 𝑘𝑐 = 0
⇒ 𝑠𝑓 𝑘𝑐 = 𝑛 + 𝛿 + 𝑔 𝑘𝑐

𝑓 𝑘
Y* 𝑛 + 𝛿 + 𝑔 𝑘𝑐

𝑠𝑓 𝑘

𝑘𝑐

K c*

Symbol Steady State Growth

𝐾 0
𝑘𝑐 =
𝐸𝐿
𝑌 0
𝑌𝑒 =
𝐸𝐿
𝑌 𝑔
𝑦=
𝐿

𝑌 𝑛+𝑔

(Additional Materials from Book)