Macroeconomics

Chapter 6 Part 1:
Long-Run Economic Growth

ECON2220 Intermediate Macroeconomics

Wataru Miyamoto
Spring 2024

Copyright © 2024 Pearson Education Ltd. 1

Chapter Outline
• The Sources of Economic Growth
• Long-Run Growth: The Solow Model
• Endogenous Growth Theory
• Government Policies to Raise Long-Run Living Standards

2
Preparation: Growth rates
• How long does it take to double income if income grows at a rate 𝑔%
per year?
• Rule of 70
70
𝑌𝑒𝑎𝑟𝑠 ≅
100 × 𝑔

• 1% growth: Income doubles every 70 years

• 2% growth: Income doubles every 35 years
• 3% growth: Income doubles every 23 years
• 5% growth: Income doubles every 14 years

3
Preparation: Growth rates
• Useful formula
• Growth rate and natural log

𝑋𝑡
𝑙𝑛 = 𝑙𝑛 1 + 𝑔𝑡 ≅ 𝑔𝑡
𝑋𝑡−1
if 𝑔𝑡 ≅ 0.
• If 𝑍𝑡 = 𝑋𝑡 𝑌𝑡 , then 𝑔𝑡𝑍 ≅ 𝑔𝑡𝑋 + 𝑔𝑡𝑌
𝑌𝑡
• If 𝑍𝑡 = , then 𝑔𝑡𝑍 ≅ 𝑔𝑡𝑌 − 𝑔𝑡𝑋
𝑋𝑡
• If 𝑍𝑡 = 𝑋𝑡𝑎 , then 𝑔𝑡𝑍 ≅ 𝑎𝑔𝑡𝑋

4
Preparation: Growth rates
• Why?
• 𝑍𝑡 = 𝑋𝑡 𝑌𝑡
𝑍𝑡 𝑋𝑡 𝑌𝑡 𝑋𝑡 𝑌𝑡
𝑙𝑛 = 𝑙𝑛 = 𝑙𝑛 + 𝑙𝑛
𝑍𝑡−1 𝑋𝑡−1 𝑌𝑡−1 𝑋𝑡−1 𝑌𝑡−1
𝑔𝑡𝑍 ≅ 𝑔𝑡𝑋 + 𝑔𝑡𝑌
𝑌𝑡
• 𝑍𝑡 =
𝑋𝑡
𝑌𝑡
𝑍𝑡 ൗ𝑋 𝑌𝑡 𝑋𝑡
𝑡
𝑙𝑛 = 𝑙𝑛 = 𝑙𝑛 − 𝑙𝑛
𝑍𝑡−1 𝑌𝑡−1ൗ 𝑌𝑡−1 𝑋𝑡−1
𝑋𝑡−1
𝑔𝑡𝑍 ≅ 𝑔𝑡𝑌 − 𝑔𝑡𝑋
• 𝑍𝑡 = 𝑋𝑡𝑎
𝑍𝑡 𝑋𝑡𝑎 𝑋𝑡
𝑙𝑛 = 𝑙𝑛 𝑎 = 𝑎 × 𝑙𝑛
𝑍𝑡−1 𝑋𝑡−1 𝑋𝑡−1
𝑔𝑡𝑍 ≅ 𝑎𝑔𝑡𝑋

5
Long-Run Economic Growth
• Overview
• Income, population, life expectancy, inequality, and aging population
• Gapminder.org
• Income: Link
• Inequality: Link

6
Figure: Population by Age Group

7
Figure: Population by Age Group: Japan

8
Long-Run Economic Growth
• Three key facts about growth
1. Growth was close to zero from the beginning of time to about 1800

2. Since 1800 we have seen sustained 1-2% growth of the richest countries for
over 200 years yielding a 60-fold increase in standards of living

3. Many countries have fallen behind and not experienced the huge
transformation of standards of living that the richest countries have
experienced

9
Figure: Per capita GDP growth

10
Figure: Per capita GDP growth

11
The Sources of Economic Growth
• What causes economic growth?
• What are the forces and policies that might affect growth?

• Why are some countries so far behind the frontier? What can be done about
it?

12
The Sources of Economic Growth
• What causes economic growth?
• Potential explanation
• Investment
• Technological progress
• Education
• Institutions
• Geography
• Culture
• etc.

• How can we answer this question?

• Let’s focus on investment
• Does investment cause growth?

13
The Sources of Economic Growth
• Theory
• Build models that illustrate how certain factors cause growth or are barriers to
growth
• Solow Model

• Empirical evidence
• Test whether implications of various theories are consistent with the data
• Study relationship between growth and various variables using the data
• Make causal inference: Use empirical evidence to show that some factor has
caused growth

14
The Sources of Economic Growth
• Evaluating empirical evidence

• Does investment cause growth?

• How would you go about figuring out the answer to this question?

• First step: Figure out if high investment is correlated with high growth

15
Figure: Investment and growth

16
The Sources of Economic Growth
• Investment is clearly positively correlated with growth
• Can we conclude that investment causes growth?

• Not necessarily. Why not? Correlation vs causation

• Reverse causality: It may be that growth causes investment
• Omitted variable bias: It may be that some other factor causes both growth and
investment

• What might such a factor be?

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Figure: Education and growth

18
The Sources of Economic Growth
• Causal inference: How is it done?
• Natural sciences
• Run experiments
• Hard to do in macroeconomics
• What causes growth to differ across countries?
• Many factors that may affect growth
• Investment, education, geography, culture etc.
• Difficult to use cross-country correlations to answer this question
• Might be an unobserved factor

• Economics
• Sometimes “nature” will come very close to running an experiment for us
• Natural experiment

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The Sources of Economic Growth
• Natural experiment
• Example
• Institutions may play a key role for economic growth
• Simplistic evidence
• All rich countries have “capitalist” institutions
• Private property, enforcement of contracts, freedom to engage in trade and
choose jobs
• No centrally planned country “successful”

• But hard to rule out that capitalist countries started off with some advantage
• Can we run an experiment?
• Has nature ever run such an experiment for us?

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The Sources of Economic Growth
• Natural experiment
• Division of Korea after Korean War
• Before war both sides virtually identical
• War split country in a relatively random way
• After split: South growth miracle, while North disaster
• Division of Germany after WWII
• Hong Kong vs Guangdong

• Much of what empirical economists do is to search for natural

experiments
• Can we find natural experiments for investment?
• Difficult, so let’s use a model to figure out whether investment causes growth
next

21
The Sources of Economic Growth
• Next, let’s think about theoretical approach
1. Growth accounting
2. Solow model

• Growth accounting
• Idea: Use production function and see which input is important for growth
• Total factor productivity, capital and labor
𝑌 = 𝐴𝐹 𝐾, 𝑁
• We do not consider what determines the levels of 𝐴, 𝐾 and 𝑁 for the time
being
• Let’s see which factor is important first
• Q: Is investment/capital important for growth?

22
The Sources of Economic Growth
• Express the production function in growth rates
• Use Cobb-Douglas Production Function

𝑌 = 𝐴𝐾 𝑎 𝑁 1−𝑎
• Then,
∆𝑌 ∆𝐴 ∆𝐾 ∆𝑁
= +𝑎 + 1−𝑎
𝑌 𝐴 𝐾 𝑁

∆𝑌 𝑌𝑡 −𝑌𝑡−1
where is percent change in 𝑌, i.e., growth rate of 𝑌 = if we
𝑌 𝑌𝑡−1
focus on annual changes

23
The Sources of Economic Growth
• Take the ratio of production function for year 𝑡 and year 𝑡 − 1
𝑌𝑡 𝐴𝑡 𝐾𝑡𝑎 𝑁𝑡1−𝑎
= 𝑎 1−𝑎
𝑌𝑡−1 𝐴𝑡−1 𝐾𝑡−1 𝑁𝑡−1
• Take natural log
𝑌𝑡 𝐴𝑡 𝐾𝑡𝑎 𝑁𝑡1−𝑎
𝑙𝑛 = 𝑙𝑛 𝑎 1−𝑎
𝑌𝑡−1 𝐴𝑡−1 𝐾𝑡−1 𝑁𝑡−1
𝐴𝑡 𝐾𝑡 𝑁𝑡
= 𝑙𝑛 + 𝑎𝑙𝑛 + 1 − 𝑎 𝑙𝑛
𝐴𝑡−1 𝐾𝑡−1 𝑁𝑡−1

𝑌𝑡 𝑌𝑡 −𝑌𝑡−1 𝑌𝑡 −𝑌𝑡−1 ∆𝑌
• Notice 𝑙𝑛 = 𝑙𝑛 1 + ≅ =
𝑌𝑡−1 𝑌𝑡−1 𝑌𝑡−1 𝑌
• Remember 𝑙𝑛 1 + 𝑥 ≅ 𝑥 if 𝑥 ≅ 0

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The Sources of Economic Growth
• Interpretation
∆𝑌 ∆𝐴 ∆𝐾 ∆𝑁
= +𝑎 + 1−𝑎
𝑌 𝐴 𝐾 𝑁

• A rise of 10% in 𝐴 raises output by 10%

• A rise of 10% in 𝐾 raises output by 𝑎 times 10%
• A rise of 10% in 𝑁 raises output by 1 − 𝑎 times 10%

• Remember 1 − 𝑎 is labor share and in data 0.6~0.7.

25
The Sources of Economic Growth
• Growth accounting
∆𝑌 ∆𝐴 ∆𝐾 ∆𝑁
= +𝑎 + 1−𝑎
𝑌 𝐴 𝐾 𝑁
• Four steps in breaking output growth into its causes (productivity growth, capital
input growth, labor input growth)
1. Get data on ∆𝑌Τ𝑌, ∆𝐾 Τ𝐾, and ∆𝑁Τ𝑁
2. Estimate 𝑎𝐾 = 𝑎 and 𝑎𝑁 = 1 − 𝑎 from historical data
3. Calculate the contributions of 𝐾 and 𝑁 as 𝑎 ∆𝐾 Τ𝐾 and 1 − 𝑎 ∆𝑁Τ𝑁, respectively
4. Calculate productivity growth as the residual: ∆𝐴Τ𝐴 = ∆𝑌Τ𝑌 – 𝑎 ∆𝐾 Τ𝐾 – 1 − 𝑎 ∆𝑁Τ𝑁

• ∆𝐴Τ𝐴 is sometimes called “Solow residual”

∆𝑌 ∆𝐴 ∆𝐾 ∆𝑁
• Note: Textbook uses = + 𝑎𝐾 + 𝑎𝑁 but just assume 𝑎𝐾 = 𝑎 and 𝑎𝑁 = 1 − 𝑎
𝑌 𝐴 𝐾 𝑁

26
Table 6.2: The Steps of Growth Accounting: A Numerical
Example

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The Sources of Economic Growth
• Application: The US economy (1948-2017)
• TFP growth accounts for more than 50% of growth in the U.S.
∆𝑌 ∆𝑁
• 2.3% average growth rate for output per capita ( − )
𝑌 𝑁
∆𝐴
• 1.2% due to TFP growth ( )
𝐴

∆𝑌 ∆𝑁 ∆𝐴 ∆𝐾 ∆𝑁
− = +𝑎 −
𝑌 𝑁 𝐴 𝐾 𝑁

• Contributing factors in recent decades

• Major innovations in computing, fiber optics, internet, information and
communications technologies, etc.

28
The Sources of Economic Growth
• Application: Asian Tigers
• Growth “Miracle” of Asian “Tigers” (1966-1990):
• Korea 10.3%
• Taiwan 9.4%
• Singapore 8.7%
• Hong Kong 7.3%

• Is their growth driven by TFP growth or growth in capital and labor inputs?
• Young (1995): Tyranny of Numbers

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The Sources of Economic Growth
• Hong Kong (1966-91)
• Average annual growth rates
∆𝑌 ∆𝐾 ∆𝑁
• = 0.073, = 0.08, = 0.032, 𝑎 = 0.372
𝑌 𝐾 𝑁
• TFP growth (Solow residual)
∆𝐴 ∆𝑌 ∆𝐾 ∆𝑁
= − 𝑎 + 1−𝑎
𝐴 𝑌 𝐾 𝑁
∆𝐴
= 0.073 − 0.372 × 0.08 + 1 − 0.372 × 0.032
𝐴
= 0.023
• 2.3% TFP growth while 7.3% total income growth
• Contribution of capital: 0.372 × 0.08 = 0.03
• Contribution of labor: 1 − 0.372 × 0.032 = 0.02

30
The Sources of Economic Growth
• Singapore: TFP growth only 0.2% while income growth is 8.7%
• Young (1995):
• Growth driven primarily by growth in capital and labor, not TFP
• Maybe growth is not sustainable

• However, this finding was later criticized

31
The Sources of Economic Growth
• The criticism of Young’s results (Hsieh (2002))
• A measurement problem of capital
• Overstating capital accumulation
• Some of recorded public investment was not really spent on investment
• Much of it gets diverted into the pockets of politicians, bureaucrats, and their
friends
• What happens to ∆𝐴Τ𝐴 if ∆𝐾Τ𝐾 is overestimated?
∆𝐴 ∆𝑌 ∆𝐾 ∆𝑁
= − 𝑎 + 1−𝑎
𝐴 𝑌 𝐾 𝑁

• If you fix the measurement problem, TFP growth = 4.8% instead of 0.2% for
Singapore

32
The Sources of Economic Growth
• We focused on growth in one country
• How about cross-country differences in income?
• Use Cobb-Douglas production function again
𝑌 = 𝐴𝐾 𝑎 𝑁 1−𝑎
where we set 𝑎 = 1Τ3
• We focus on output per person instead of total
• Define income per capita 𝑦 = 𝑌Τ𝑁 and capital per capita 𝑘 = 𝐾 Τ𝑁
1 2
𝑌 𝐴𝐾 3 𝑁 3 1
𝑦= = = 𝐴𝑘 3
𝑁 𝑁
• Determined by two factors:
1. TFP
2. Capital per capita

33
The Sources of Economic Growth
• Production function in per capita
1
𝑦= 𝐴𝑘 3
• We can measure income 𝑌, capital 𝐾 and population 𝑁
• Harder to measure 𝐴

• We can instead pick 𝐴 for each country to match the data of 𝑦

• Same idea as Growth Accounting

34
The Sources of Economic Growth
• Compute 𝐴 for country 𝑋 using the data of 𝑘 and 𝑦
𝑦𝑋
𝐴𝑋 = 1
𝑘𝑋 3

• What is the implied level of technology 𝐴𝑋 ?

• Different countries have different efficiency 𝐴?

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Figure: Measuring TFP So the Model Fits Exactly

36
The Sources of Economic Growth
• 𝐴 is higher in rich countries
1
𝑦𝑋 = 𝐴𝑋 𝑘𝑋 3
• Significant differences: Can be 10 times larger in rich countries

• Five richest and five poorest in 2000:

1
𝑦𝑟𝑖𝑐ℎ 𝐴𝑟𝑖𝑐ℎ 𝑘𝑟𝑖𝑐ℎ 3
= ×
𝑦𝑝𝑜𝑜𝑟 𝐴𝑝𝑜𝑜𝑟 𝑘𝑝𝑜𝑜𝑟
45 = 10 × 4.5
• 𝐴 is an important factor to explain income differences across
countries

37
The Sources of Economic Growth
• Does this mean we have explained differences in output per capita?

• No!!
• We didn’t have independent data on TFP

• Part we assign TFP is “a measure of our ignorance”

• Differences in capital could explain a (small) fraction of differences in output

per capita

• Crucial question:
• Why does TFP (the measure of our ignorance) differ so much across
countries?
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Summary
• Production function approach

• Growth accounting
• Decomposition of income growth over time for each country
• 𝐴 explains over 50% of US growth
• Asian Tigers, controversial but likely TFP important

• Cross-country comparison
• Differences in 𝐾 explain a small fraction of differences in 𝑌
• 𝐴 explains a large fraction

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Long-Run Growth: The Solow Model
• Next question
• 𝐴 is more important
• Why? Can’t we sustain growth by investment only? What is the mechanism
behind the finding?

• The Solow model

• Key question: How does investment and capital accumulation
contribute to economic growth?
• Widely believed in the 1950’s that investment was the key to growth
• Does this make sense?

40
The Solow Model
• Setup of the Solow model

• Population/workforce 𝑁 grows at rate 𝑛

𝑁𝑡 = 1 + 𝑛 𝑁𝑡−1

• Given initial population 𝑁0

• Economy is closed and no government (𝐺 = 0)

𝑌𝑡 = 𝐶𝑡 + 𝐼𝑡

41
The Solow Model
• Production function
𝑌𝑡 = 𝐴𝐹 𝐾𝑡 , 𝑁𝑡
• Assume no productivity growth for now
• As usual, diminishing marginal returns to inputs
• Additionally, we assume constant returns to scale in 𝐾 an 𝑁, i.e.
𝑌 = 𝐴𝐹 𝐾, 𝑁
and
𝐴𝐹 𝛽𝐾, 𝛽𝑁 = 𝛽𝐴𝐹 𝐾, 𝑁 = 𝛽𝑌
for 𝛽>0
• E.g. If you double your inputs (𝛽 = 2), you double your output, i.e.
𝐴𝐹 2𝐾, 2𝑁 = 2𝑌

42
The Solow Model
• Capital accumulation
𝐾𝑡+1 = 1 − 𝑑 𝐾𝑡 + 𝐼𝑡
• 𝑑 is depreciation rate
• Given initial capital 𝐾0

• Saving decision
• People save a constant fraction of income
𝑆𝑡 = 𝑠𝑌𝑡
• This means 𝐶𝑡 = 1 − 𝑠 𝑌𝑡

• Investment? It has to equal saving

𝐼𝑡 = 𝑆𝑡 = 𝑌𝑡 − 𝐶𝑡

43
The Solow Model
• Building blocks
• Production function
𝑌𝑡 = 𝐴𝐹 𝐾𝑡 , 𝑁𝑡
• Capital accumulation
𝐾𝑡+1 = 1 − 𝑑 𝐾𝑡 + 𝐼𝑡
• Labor force
𝑁𝑡 = 1 + 𝑛 𝑁𝑡−1
• Resource constraint
𝑌𝑡 = 𝐶𝑡 + 𝐼𝑡
• Allocation of resource
𝐼𝑡 = 𝑠𝑌𝑡

44
The Solow Model
• Solving the model
• Rewrite everything in per-person(worker) terms:
𝑦𝑡 ≡ 𝑌𝑡ൗ𝑁𝑡 , 𝑐𝑡 ≡ 𝐶𝑡ൗ𝑁𝑡 , 𝑘𝑡 ≡ 𝐾𝑡ൗ𝑁𝑡
• 𝑘𝑡 is also called the capital–labor ratio

• The per-person(worker) production function

𝑦𝑡 = 𝐴𝑓 𝑘𝑡
• Where does this production function come from?

45
The Solow Model
• Divide both sides of production function 𝑌 = 𝐴𝐹 𝐾, 𝑁 by 𝑁
1
𝑦 = 𝐴𝐹 𝐾, 𝑁 = 𝐴𝐹 𝑘, 1 ≡ 𝐴𝑓 𝑘
𝑁

• E.g., Cobb-Douglas production function

𝑌 = 𝐴𝐾 𝑎 𝑁 1−𝑎
Then, the per-person production function is
𝐴𝐾 𝑎 𝑁 1−𝑎
𝑦= = 𝐴𝑘 𝑎 11−𝑎 = 𝐴𝑘 𝑎
𝑁

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Figure 6.3: The per-person(worker) production function

47
The Solow Model
• Solving the model
• Combine capital accumulation equation and allocation of resource equation
𝐼𝑡 = 𝑠𝑌𝑡
𝐾𝑡+1 = 1 − 𝑑 𝐾𝑡 + 𝑠𝑌𝑡
• Substitute the production function
𝐾𝑡+1 = 1 − 𝑑 𝐾𝑡 + 𝑠𝐴𝐾𝑡𝑎 𝑁𝑡1−𝑎
• Divide both sides by 𝑁𝑡
1 + 𝑛 𝑘𝑡+1 = 1 − 𝑑 𝑘𝑡 + 𝑠𝐴𝑘𝑡𝑎
where we used
𝐾𝑡+1 𝐾𝑡+1 𝑁𝑡+1
= = 1 + 𝑛 𝑘𝑡+1
𝑁𝑡 𝑁𝑡+1 𝑁𝑡
• Subtract 1 + 𝑛 𝑘𝑡 from both sides, then
1 + 𝑛 𝑘𝑡+1 − 𝑘𝑡 = 𝑠𝐴𝑘𝑡𝑎 − 𝑛 + 𝑑 𝑘𝑡

48
The Solow Model
• Key equation in the Solow model

1 + 𝑛 ∆𝑘𝑡+1 = 𝑠𝐴𝑘𝑡𝑎 − 𝑛 + 𝑑 𝑘𝑡

• ∆𝑘𝑡+1 ≡ 𝑘𝑡+1 − 𝑘𝑡
• Describes the evolution of the capital stock per person
• 𝑠𝐴𝑘𝑡𝑎 = 𝑠𝑦: Saving increases capital through investment
• 𝑛 + 𝑑 𝑘𝑡 : Capital depreciates 𝑑 . Why 𝑛?

• Difficult to solve analytically

• We will therefore use a graphical solution

49
Figure 6.5: Determining the capital–labor ratio in the
steady state 𝑎
1 + 𝑛 ∆𝑘𝑡+1 = 𝑠𝐴𝑘𝑡 − 𝑛 + 𝑑 𝑘𝑡

50
The Solow Model
• The only possible steady-state capital–labor ratio is 𝑘 ∗
• Steady state: Point at which capital stops growing
• Output at that point is
𝑦 ∗ = 𝐴𝑓 𝑘 ∗
• Consumption is
𝑐∗ = 𝑦∗ − 𝑖∗
= 𝑦 ∗ − 𝑠𝑦 ∗
= 1 − 𝑠 𝑦∗

• Both output and consumption per capita are constant

51
The Solow Model
• Solving for the steady state
• Steady state:𝑘𝑡 , 𝑦𝑡 , and 𝑐𝑡 are constant over time
• So, ∆𝑘 = 0. Then,
0 = 𝑠𝐴𝑘 𝑎 − 𝑛 + 𝑑 𝑘
Solving for 𝑘,
1
𝑠𝐴 1−𝑎
∗
𝑘 =
𝑛+𝑑
Then,
𝑦∗ = 𝐴 𝑘∗ 𝑎
𝑐∗ = 1 − 𝑠 𝑦∗
𝑖 ∗ = 𝑠𝑦 ∗

52
The Solow Model
• Transition dynamics
• If 𝑘 begins at some level other than 𝑘 ∗ , it will move toward 𝑘 ∗
• This growth process is called transition dynamics
1 + 𝑛 ∆𝑘𝑡+1 = 𝑠𝐴𝑘𝑡𝑎 − 𝑛 + 𝑑 𝑘𝑡
• 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

53
The Solow Model
• How do we compute the transition dynamics?
• Given 𝑘0
1
𝑘1 − 𝑘0 = 𝑠𝐴𝑘0𝑎 − 𝑛 + 𝑑 𝑘0
1+𝑛
1
𝑘2 − 𝑘1 = 𝑠𝐴𝑘1𝑎 − 𝑛 + 𝑑 𝑘1
1+𝑛
1
𝑘3 − 𝑘2 = 𝑠𝐴𝑘2𝑎 − 𝑛 + 𝑑 𝑘2
1+𝑛
…
• How do we compute 𝑦𝑡 , 𝑐𝑡 , and 𝑖𝑡 ?
𝑦𝑡 = 𝐴𝑘𝑡𝑎
𝑐𝑡 = 1 − 𝑠 𝑦𝑡
𝑖𝑡 = 𝑠𝑦𝑡
54
The Solow Model
• How do we compute 𝑌𝑡 , 𝐶𝑡 , and 𝐼𝑡 ?
𝑌𝑡 = 𝑦𝑡 𝑁𝑡
𝐶𝑡 = 𝑐𝑡 𝑁𝑡
𝐼𝑡 = 𝑖𝑡 𝑁𝑡

• What is the growth rate of 𝑌𝑡 ?

• Growth rate of product 𝑦𝑡 𝑁𝑡
𝑔𝑌 = 𝑔𝑦 + 𝑔𝑁 = 𝑔𝑦 + 𝑛
• At the steady state, 𝑔𝑌 = 𝑛

55
The Solow Model
• What is the growth rate of 𝐶𝑡 , and 𝐼𝑡 at the steady state?
• No growth in 𝑐𝑡 , and 𝑖𝑡 at the steady state
𝑔𝐶 = 𝑔𝑐 + 𝑛 = 𝑛

• What if we apply Growth accounting at the steady state?

∆𝑌 ∆𝐴 ∆𝐾 ∆𝑁
= +𝑎 + 1−𝑎
𝑌 𝐴 𝐾 𝑁

𝑛 =0+𝑎×𝑛+ 1−𝑎 𝑛 =𝑛

56
The Solow Model
• Numerical example
𝑠 = 0.1, 𝐴 = 1, 𝑛 = 0.02, 𝑑 = 0.08, 𝑎 = 0.3
• Assume the initial level of capital 𝑘0 = 1.1
• 𝑘∗ = 1
• We can compute 𝑘𝑡 (𝑡 = 1,2,3, …)as follows
1
𝑘𝑡+1 = 1 − 𝑑 𝑘𝑡 + 𝑠𝐴𝑘𝑡𝑎
1+𝑛
• We can compute 𝑦𝑡 and 𝑐𝑡
𝑦𝑡 = 𝐴𝑘𝑡𝑎
𝑐𝑡 = 1 − 𝑠 𝑦𝑡

57
Figure: Capital per capita over time
1 + 𝑛 ∆𝑘𝑡+1 = 𝑠𝐴𝑘𝑡𝑎 − 𝑛 + 𝑑 𝑘𝑡

𝑘 ∗ =1

58
Figure: Output and consumption per capita over time

𝑦∗ = 1

𝑐 ∗ = 0.9

59
The Solow Model
• Growth rate of 𝑘𝑡 is larger in absolute terms if the economy is far
from the steady state
• Below the steady state: Positive growth rate
• Above the steady state: Negative growth rate
• Why?
1 + 𝑛 ∆𝑘𝑡+1 = 𝑠𝐴𝑘𝑡𝑎 − 𝑛 + 𝑑 𝑘𝑡

• Divide both sides by 𝑘𝑡

∆𝑘𝑡+1
1+𝑛 = 𝑠𝐴𝑘𝑡𝑎−1 − 𝑛 + 𝑑
𝑘𝑡
∆𝑦 ∆𝐴 ∆𝑘 ∆𝑘
• Notice = + 𝑎 = 𝑎
𝑦 𝐴 𝑘 𝑘

60
Figure: Growth rate of capital per capita
∆𝑘𝑡+1
1+𝑛 = 𝑠𝐴𝑘𝑡𝑎−1 − 𝑛 + 𝑑
𝑘𝑡

∆𝑘𝑡+1
1+𝑛
𝑘𝑡
𝑛+𝑑

𝑠𝐴𝑘𝑡𝑎−1

𝑘∗ 𝑘𝑡

61
The Solow Model
• To summarize:
• With no productivity growth, the economy reaches a steady state, with
constant capital–labor ratio 𝑘 ∗ , output per person 𝑦 ∗ , and consumption per
person 𝑐 ∗

• What feature of the model generates this result?

1 + 𝑛 ∆𝑘𝑡+1 = 𝑠𝐴𝑘𝑡𝑎 − 𝑛 + 𝑑 𝑘𝑡

• Diminishing marginal returns to capital

62
The Solow Model
• To summarize:
• What does the Solow model teach us about long run growth?
• There is no long run growth in the Solow model
• Capital, output and consumption settle down to constant steady state values

• Central lesson of the Solow model

• Capital accumulation cannot serve as an engine of long run growth (can play a
big role for some time, e.g., Asian Tigers)

• Can we generate long run growth somehow?

63