Ch 6: Growth Models

(A) Harod-Domar Growth Model

is a functional economic relationship in which the growth rate of

GDP (g) depends,
directly on the national net savings rate (s)
and inversely on the national capital-output ratio (c).

Every economy must save a certain proportion of its national

income,
if only to replace worn-out or impaired capital goods
(buildings, equipment, and materials).
However, in order to grow, new investments representing net
additions to the capital stock are necessary.
If we assume that there is some direct economic
relationship,

between the size of the total capital stock, (K) and total
GDP (Y)—

for example, if 3 birr of capital is always necessary to

produce an annual 1 birr stream of GDP—

it follows that any net additions to the capital stock, in

the form of new investment,

will bring about corresponding increases in the flow of

national output, GDP.
Suppose that this relationship, known in economics as the
capital-output ratio, is roughly 3 to 1.

- If we define the capital-output ratio as c,

- and assume that the national net savings

ratio, s, is a fixed proportion of national output
(e.g., 6%),

- and that total new investment (I) is determined by

the level of total savings(S),

we can construct the following simple model of economic

growth:
1. Net savings (S) is some proportion, s , of national
income (Y) such that we have the simple equation

S = sY………………eqn. 1

2. Net investment (I) is defined as the change in the

capital stock (ΔK) and can be expressed by

I = ΔK…………………eqn. 2
But because the total capital stock, K, bears a direct
relationship to total national income or output , Y ,
as expressed by the capital-output ratio , c , it follows
that

k/y = c

or ΔK/ ΔY = c (where k = ΔK and y = ΔY )

or finally ΔK = c ΔY……………………eqn. 3
3. Finally, because net national savings , S, must
equal net investment , I , we write this equality as

S = I…………………………eqn. 4

But from eqn.1 we know that S = sY and from

eqn. 2 and 3 we know that

I = ΔK = c ΔY
But the rate at which an economy can grow for any
level of saving and investment i.e.,
—how much additional output can be had from an
additional unit of investment—

can be measured by the inverse of the capital-output

ratio, 1/c, because this inverse is simply,
the output–capital or output–investment ratio = y/k .

It follows that multiplying the rate of new investment,

s = I/Y, by its productivity, 1/c = y/k,

will give the rate by which national income or GDP will

increase. This is the main point.
In the context of the Harrod-Domar model, labor force
growth is not described explicitly.

This is because labor is assumed to be abundant in a

developing-country context,

and can be hired as needed in a given proportion to

capital investments (this assumption is not always valid).
In a general way, technological progress can be
expressed in the Harrod-Domar context as,

a decrease in the required capital-output ratio, c = k/y

giving more growth for a given level of investment,
as follows from Equation 7 or 7’.

This is obvious when we realize that in the long run this

ratio is not fixed,
but can change over time, in response to the functioning
of financial markets and the policy environment.

But again, the focus was on the role of capital

investment.
(B) Solow Growth Model

The Solow growth model shows how

saving,
population growth,
and technological progress

affect the level of an economy’s output and its growth

over time.

The Accumulation of capital

First step is to examine how the supply and demand

for goods determine the accumulation of capital.
In this first step, we assume that,
the labor force and technology are fixed.

We then relax these assumptions by introducing

changes in the labor force later,
and then by introducing changes in technology next.

The Supply and Demand for Goods

By considering the supply and demand for goods, we can see,

what determines how much output is produced at any given

time,
and how this output is allocated among alternative uses.
The Supply of Goods and the Production Function:

The supply of goods in the Solow model is based on the

production function,
which states that output depends on the capital stock and
the labor force:
Y = F(K, L).

The Solow growth model assumes that the production

function has constant-returns to scale.

This assumption is often considered realistic, and, as we

will see shortly, it helps simplify the analysis.
Recall that a production function has constant returns to
scale if
zY = F(zK, zL)

for any positive number z.

That is, if both capital and labor are multiplied by z,
the amount of output is also multiplied by z.

Production functions with constant returns to scale allows,

to analyze all quantities in the economy relative to the
size of the labor force.
To see that this is true,
set z = 1/L in the preceding equation to obtain

Y/L = F(K/L, 1).

This equation shows that the amount of output per worker

Y/L is a function of the amount of capital per worker K/L.
(The number 1 is constant and thus can be ignored).

The assumption of constant returns to scale implies that,

the size of the economy, as measured by the number of

workers, does not affect the relationship between
output per worker and capital per worker.
Because the size of the economy does not matter, it will
prove convenient to denote all quantities in per worker
terms.

We designate quantities per worker with lowercase

letters,
so y = Y/L is output per worker,
and k = K/L is capital per worker.

We can then write the production function as

y = f (k),

where we define f(k) = F(k, 1).

Figure 7-1 illustrates this production function.

The slope of this production function shows,

how much extra output a worker produces when given an
extra unit of capital.

This amount is the marginal product of capital MPK.

Mathematically,

MPK = f(k + 1) − f (k).

The Demand for Goods and the Consumption
Function:

The demand for goods in the Solow model comes from

consumption and investment.

In other words, output per worker y is divided

between
consumption per worker c
and investment per worker i:

y = c + i.
This equation is the per-worker version of the national
income account’s identity for an economy.
Notice that it omits,
government purchases (which for present purposes we
can ignore),
and net exports (because we are assuming a closed
economy).

The Solow model assumes that,

each year people save a fraction s of their income
and consume a fraction (1 – s).
We can express this idea with the following consumption
function:

c = (1 − s)y,
where s, the saving rate, is a fraction (number between
zero and one).

Various government policies can potentially influence a

nation’s saving rate.

So, one of our goals is to find what saving rate is desirable.

For now, however, we just take the saving rate s as given.

To see what this consumption function implies for
investment
substitute (1 – s)y for c in the national income account’s
identity:
y = (1 − s)y + i.

Rearrange the terms to obtain

i = sy.
This equation shows that investment equals saving.

Thus, the rate of saving s is also the fraction of output

devoted to investment.
We have now introduced the two main ingredients of the
Solow model—
- the production function and
- the consumption function,
which describe the economy at any moment in time.

For any given capital stock k,

the production function y = f(k) determines how much
output the economy produces,

and the saving rate s determines the allocation of that

output between consumption and investment.
Growth in the Capital Stock and the Steady State

At any moment, the capital stock is a key determinant of

the economy’s output,

but the capital stock can change over time, and those
changes can lead to economic growth.

Two forces influence the capital stock: investment and

depreciation.

Investment is expenditure on new plant and equipment,

and it causes the capital stock to rise.
Depreciation is the wearing out of old capital, and it
causes the capital stock to fall.
Let’s consider each of these forces in turn.

As we have already noted,

investment per worker i = sy.

By substituting the production function for y, we can

express investment per worker as a function of the
capital stock per worker:

i = sf(k).
This equation relates the existing stock of capital k
to the accumulation of new capital i.
Figure 7-2 shows this relationship. This figure illustrates,
how,
for any value of k, the amount of output is determined
by the production function f(k), and,

the allocation of that output between consumption

and saving is determined by the saving rate s
To incorporate depreciation into the model, we assume that
a certain fraction δ of the capital stock wears out each year.

Here δ (the lowercase Greek letter delta) is called the

depreciation rate.

For example, if capital lasts an average of 25 years, then

the depreciation rate is 4 percent per year,
100% /25 (δ = 0.04).

The amount of capital that depreciates each year is δk.

Figure 7-3 shows how the amount of depreciation depends

on the capital stock.
We can express the impact of investment and depreciation
on the capital stock with the following equation:

Change in Capital Stock = Investment − Depreciation

k = i − δk,
where k is the change in the capital stock between one
year and the next.

Because investment i equals sf(k), we can write this as

k = sf(k) − δk.
Figure 7-4 graphs the terms of this equation –
investment and depreciation – for different levels of the
capital stock k.

The higher the capital stock, the greater the amounts

of output and investment.

Yet the higher the capital stock, the greater also the
amount of depreciation.

As Figure 7-4 shows, there is a single capital stock k* at

which the amount of investment equals the amount of
depreciation (i* = δk*).
If the economy finds itself at k* level of the capital stock,
the capital stock will not change,

because, the two forces acting on it—investment and

depreciation—just balance.

That is, at k*, k = 0, so the capital stock k and

output f(k) are steady over time (rather than growing
or shrinking).

We therefore call k* the steady-state level of capital.

The steady state is significant for two reasons.

As we have just seen, an economy at the steady state

will stay there.
In addition, and just as important, an economy not at
the steady state will go there.

That is, regardless of the level of capital with which the

economy begins, it ends up with the steady-state level of
capital.

In this sense, the steady state represents the long-run

equilibrium of the economy.
Approaching the Steady State: A numerical example

Let’s use a numerical example to see how the Solow

model works and how the economy approaches the steady
state.

For this example, we assume that the production

function is
Y = K1/2L1/2.

To derive the per-worker production function f(k),

divide both sides of the production function by the labor
force L:
Rearrange to obtain

Because Y/L = y and K/L = k , this equation becomes

y = k1/2,
which can also be written as

y = √k
This form of the production function states that output per
worker equals the square root of the amount of capital per
worker.
To complete the example, let’s assume that,

• 30 percent of output is saved (s = 0.3),

• 10 percent of the capital stock depreciates every year
(δ = 0.1),
• and let the economy starts off with 4 units of
capital per worker (k 1 = 4).

Given these numbers, we can now examine what happens

to this economy over time

The production and allocation of output in the first year,

when the economy has 4 units of capital per worker, is
With the production function y = √k , the 4 units of capital
per worker (k = 4), produce 2 units of output per worker
(y = 2).
Because 30 percent of output (y = i + c) is saved and
invested and 70 percent is consumed, i = 0.6 and c = 1.4.

Because 10 percent of the capital stock depreciates,

(δk = 0.4).
With investment of 0.6 and depreciation of 0.4, the change
in the capital stock is k = i – δk
= 0.6 – 0.4
= 0.2.
Thus, the economy begins its second year with 4.2 units of
capital per worker (k 2 = 4.2).
How Saving Affects Growth

Consider what happens to an economy when its saving

rate increases. Figure 7-5 shows such a change.

Assume the economy begins in a steady state with saving

rate s1 and capital stock k*1.
When the saving rate increases from s1 to s2, the sf(k)
curve shifts upward.
At the initial saving rate s1 and the initial capital stock
k*1, the amount of investment just offsets the amount of
depreciation.
Immediately after the saving rate rises, investment is
higher, but the capital stock and depreciation are
unchanged.
Therefore, investment exceeds depreciation.

The capital stock will gradually rise until the economy

reaches the new steady state k*2,

which has a higher capital stock and a higher level of

output than the old steady state.
The Solow model shows that the saving rate is a key
determinant of the steady-state capital stock.

If the saving rate is high, the economy will have a large

capital stock and a high level of output in the steady state.

If the saving rate is low, the economy will have a small

capital stock and a low level of output in the steady state.

Thus, the long-run consequences of a reduced saving rate

are, a lower capital stock and lower national income.

This is why many economists are critical of persistent

budget deficits.
What does the Solow model say about the relationship
between saving and economic growth?

Higher saving leads to faster growth in the Solow

model, but only temporarily.
An increase in the rate of saving raises growth only until
the economy reaches the new steady state.

If the economy maintains a high saving rate, it will

maintain a large capital stock and a high level of
output,
but it will not maintain a high rate of growth forever.
The Golden Rule Level of Capital

So far, we have used the Solow model to examine how an

economy’s rate of saving and investment determines its
steady-state levels of capital and income.

This analysis might lead you to think that higher saving

is always a good thing because it always leads to greater
income.

Yet suppose a nation had a saving rate of 100 percent.

That would lead to the largest possible capital stock and

the largest possible income.
But if all this income is saved and none is ever
consumed, what good is it?

This section uses the Solow model to discuss the optimal

amount of capital accumulation from the standpoint of
economic well-being.
Comparing Steady States

To keep our analysis simple, let’s assume that a

policymaker can set the economy’s saving rate at any
level.

By setting the saving rate, the policymaker determines

the economy’s steady state.
What steady state should the policymaker choose?

The policymaker’s goal is to maximize the well-being of

the individuals who make up the society.
Individuals themselves do not care about the amount of
capital in the economy, or even the amount of output.

They care about the amount of goods and services they

can consume.

Thus, a benevolent policymaker would want to choose

the steady state with the highest level of consumption.

The steady-state value of k that maximizes

consumption is called
the Golden Rule level of capital and is denoted k* gold
To see whether an economy is at the Golden Rule
level,

- first determine steady-state consumption per

worker.
- then see which steady state provides the most
consumption.

To find steady-state consumption per worker, we

begin with the national income accounts identity
y=c+i
and rearrange it as
c = y – i.
Consumption is output minus investment.
To get steady-state consumption, substitute the steady-
state values for output and investment.

Steady-state output per worker is f(k*), where k* is

the steady-state capital stock per worker.

Furthermore, because the capital stock is not changing in

the steady state, investment equals depreciation
(i = δk*).

Substituting f(k*) for y and δk* for i, we can write steady-

state consumption per worker as

c* = f(k*) − δk*.
Steady-state consumption (c*) is
what’s left of steady-state output (f(k*),
after paying for steady-state depreciation(δk*) .

This equation shows that,

an increase in steady-state capital has two opposing
effects on steady-state consumption.

On the one hand, more capital means more output.

On the other hand, more capital also means that more

output must be used to replace wearing out capital.
Figure 7-7 graphs steady-state output and steady-
state depreciation
as a function of the steady-state capital stock.

Steady-state consumption is the gap between output

and depreciation.

This figure shows that there is one level of the capital

stock—the Golden Rule level k*gold—that maximizes
consumption
When comparing steady states, we must keep in mind
that higher levels of capital affect both output and
depreciation.

If the capital stock is below the Golden Rule level,

an increase in the capital stock raises output more
than depreciation, so consumption rises.

In this case, the production function, f (k*),

is steeper than the δk* line,
so the gap between these two curves—which equals
consumption—grows as k* rises.
By contrast, if the capital stock is above the Golden
Rule level, an increase in the capital stock reduces
consumption,
because the increase in output is smaller than the
increase in depreciation.

In this case, the production function is flatter than the

δk* line,

So, the gap between the curves—consumption—shrinks

as k* rises.
At the Golden Rule level of capital,
the production function and the δk* line have the same
slope,
and consumption is at its greatest level.

We can now derive a simple condition that characterizes

the Golden Rule level of capital.

Recall that,
- the slope of the production function - f(k*) is the
marginal product of capital, MPK.

- the slope of the depreciation line - δk* is δ.

Because these two slopes are equal at k*gold, the Golden
Rule is described by the equation

MPK = δ.

At the Golden Rule level of capital, the marginal product

of capital equals the depreciation rate.

or MPK − δ = 0.

At the Golden Rule level of capital, the marginal product

of capital net of depreciation (MPK – δ) equals zero.
Population Growth

The basic Solow model shows that

capital accumulation, by itself, cannot explain sustained
economic growth:

high rates of saving lead to high growth temporarily,

but the economy eventually approaches a steady state in
which capital and output are constant.

To explain the sustained economic growth that we observe in

most parts of the world, we must expand the Solow model,
to incorporate the other two sources of economic growth
—population growth and technological progress.
The Steady State With Population Growth

How does population growth affect the steady state?

To answer this question, we must discuss how population

growth, along with investment and depreciation, influences
the accumulation of capital per worker.

As we noted before, investment raises the capital stock, and

depreciation reduces it.

But now there is a third force acting to change the amount of

capital per worker:
the growth in the number of workers causes capital per
worker to fall.
We continue to let lowercase letters stand for quantities per
worker. Thus,
k = K/L is capital per worker, and
y = Y/L is output per worker.

Keep in mind, however, that the number of workers is

growing over time.
The change in the capital stock per worker is

k = i − (δ + n)k.

This equation shows how,

investment (i), depreciation (δk), and population
growth(nk) influence the per-worker capital stock.
Investment increases k,
whereas depreciation and population growth decrease k.

We can think of the term (δ + n)k as defining break-even

investment— the amount of investment necessary to keep
the capital stock per worker constant.

Break-even investment - includes,

the depreciation of existing capital, which equals δk.
It also includes the amount of investment necessary to
provide new workers with capital, nk,

because there are n new workers for each existing worker

and because k is the amount of capital for each worker.
The equation of change in capital stock per worker

k = i − (δ + n)k.

shows that population growth reduces accumulation

of capital per worker much the way depreciation does.

Depreciation reduces k by wearing out the capital stock,

whereas population growth reduces k by spreading the

capital stock more thinly among a larger population of
workers.
Our analysis with population growth now proceeds much
as it did previously.

First, we substitute sf(k) for i. The equation can then

be written as
k = sf(k) − (δ + n)k.

To see what determines the steady-state level of capital

per worker, we use Figure 7-11,
which extends the analysis of Figure 7-4 to include the
effects of population growth.

An economy is in a steady state if capital per worker k is

unchanging.
As before, we designate the steady-state value of k as k*.

If k is less than k*, investment is greater than

break-even investment, so k rises.

-If k is greater than k*, investment is less than

break-even investment, so k falls.

In the steady state, the positive effect of investment on

the capital stock per worker exactly balances the negative
effects of depreciation and population growth.
That is, at k*,
k = i* − δk* + nk* = 0
and i* = δk* + nk*.
Once the economy is in the steady state, investment has
two purposes.

Some of it (δk*) replaces the depreciated capital,

and the rest (nk*) provides the new workers with the
steady-state amount of capital.
The Effects of Population Growth

Population growth alters the basic Solow model in three

ways.

First, it brings us closer to explaining sustained economic

growth.

In the steady state with population growth,

capital per worker and output per worker are

constant.
Because the number of workers is growing
at rate n, however,

total capital and total output must also be growing at

rate n.

Hence, although population growth cannot explain

sustained growth in the standard of living
(because output per worker is constant in the steady state),

it can help explain sustained growth in total output.

Second, population growth gives us another explanation
for why some countries are rich and others are poor.

Consider the effects of an increase in population

growth.

Figure 7-12 shows that,

an increase in the rate of population growth from n1

to n2 ,
reduces the steady-state level of capital per worker
from k*1 to k*2.
Because k* is lower and because y* = f(k*), the level of
output per worker y* is also lower.

Thus, the Solow model predicts that countries with

higher population growth
will have lower levels of GDP per person.

Notice that a change in the population growth rate,

like a change in the saving rate, has a level effect on
income per person,

but does not affect the steady-state growth rate of

income per person.
Finally, population growth affects our criterion for
determining the Golden Rule (consumption-
maximizing) level of capital.

To see how this criterion changes, note that consumption

per worker is
c = y – i.

Because steady-state output is f(k*) and

steady-state investment is (δ + n)k*,
we can express steady-state consumption as

c* = f (k*) − (δ + n)k*.
Using an argument largely the same as before, we conclude
that the level of k* that maximizes consumption is the
one at which

MPK = δ + n,

or equivalently,

MPK – δ = n.

In the Golden Rule steady state,

the marginal product of capital net of depreciation
equals the rate of population growth.
Technological Progress in the Solow Model

So far, our presentation of the Solow model has assumed an

unchanging relationship,

between the inputs of capital and labor

and the output of goods and services.

Yet the model can be modified to include exogenous

technological progress,

which over time expands society’s production capabilities.

The Efficiency of Labor

The production function, thus far relates total capital K and

total labor L to total output Y,

Y = F(K, L).

To incorporate technological progress write the

production function as
Y = F(K, L × E),

where E is a new (and somewhat abstract) variable called

the efficiency of labor.
The efficiency of labor is meant to reflect,

society’s knowledge about production methods:

as the available technology improves, the efficiency of

labor rises,

and each hour of work contributes more to the

production of goods and services.

The term L × E can be interpreted as measuring the

effective number of workers.
L × E considers the number of actual workers L and
the efficiency of each worker E.

In other words, L measures the number of workers in

the labor force,

whereas, L × E measures both the workers and the

technology, with which the typical worker comes
equipped.

This new production function states that,

total output Y depends on the inputs of capital K and
effective workers L × E.
The essence of this approach to modeling technological
progress is that,

increases in the efficiency of labor E are analogous

to increases in the labor force L.

The simplest assumption about technological progress is

that,
it causes the efficiency of labor E to grow at some
constant rate g.
This form of technological progress is called labor -
augmenting,

and g is called the rate of labor-augmenting

technological progress.

Because the labor force L is growing at rate n,

and the efficiency of each unit of labor E is growing at
rate g,

the effective number of workers L × E is growing at

rate n + g.
The Steady State With Technological Progress

Because technological progress is modeled here as labor

augmenting,
it fits into the model in much the same way as population
growth.

Technological progress does not cause the actual number

of workers to increase,

but because each worker in effect comes with more units of

labor over time, technological progress,

causes the effective number of workers to increase.

We begin by reconsidering our notation.

Previously, when there was no technological progress, we

analyzed the economy in terms of quantities per worker;

now we can generalize that approach by analyzing the

economy in terms of quantities per effective worker.

We now let,

k = K/(L × E) stand for capital per effective worker and

y = Y/(L × E) stand for output per effective worker.
With these definitions, we can again write y = f(k).

The analysis of the economy proceeds, just as it did when

we examined population growth.

The equation showing the evolution of k over time

becomes
k = sf(k) − (δ + n + g)k.

As before, the change in the capital stock k equals

investment sf(k) minus breakeven investment (δ + n + g)k.
Now, however, because k = K/(L × E), break-even
investment in
k = sf(k) − (δ + n + g)k,

includes three terms, to keep k constant:

δk is needed to replace depreciating capital,

nk is needed to provide capital for new workers,

and gk is needed to provide capital for ‘the new

effective workers’, created by technological progress.

See Figure 8-1.

As shown in Figure 8-1, the inclusion of technological
progress,

does not substantially alter our analysis of the steady

state.

There is one level of k, denoted k*, at which,

capital per effective worker and output per effective

worker are constant.

As before, this steady state represents the long-run

equilibrium of the economy.
The Effects of Technological Progress

Table 8-1 shows how the four key variables behave in the
steady state with technological progress.

As we have just seen, capital per effective worker k

is constant in the steady state.

Because y = f(k), output per effective worker (y) is

also constant.
It is these quantities per effective worker that are
steady in the steady state.
From this information, we can also infer,

what is happening to variables that are not expressed in

units per effective worker.

 For instance, consider output per actual worker

Y/L = y × E.

Because y is constant in the steady state and E is

growing at rate g,

output per worker must also be growing at rate g in

the steady state.
 Similarly, the economy’s total output is
Y = y × (E × L).
Because y is constant in the steady state,
E is growing at rate g, and
L is growing at rate n,

total output grows at rate n + g in the steady state.

With the addition of technological progress, our model can

finally explain the sustained increases in standards of
living that we observe.

That is, we have shown that technological progress can

lead to sustained growth in output per worker.
By contrast, a high rate of saving leads to a high rate of
growth only until the steady state is reached.

Once the economy is in steady state, the rate of growth of

output per worker,
depends only on the rate of technological progress.

According to the Solow model, only technological

progress,

can explain sustained growth and persistently rising

living standards.
The introduction of technological progress also
modifies the criterion for the Golden Rule.

The Golden Rule level of capital is now defined as the

steady state that maximizes consumption per effective
worker.

Following the same arguments that we have used before

we can show that,
steady-state consumption per effective worker is

c* = f (k*) − (δ + n + g)k*.
Steady-state consumption is maximized if
MPK = δ + n + g,
or
MPK − δ = n + g.

That is, at the Golden Rule level of capital, the net

marginal product of capital, MPK − δ, equals the rate
of growth of total output, n + g.

Because actual economies experience both population

growth and technological progress,

we must use this criterion to evaluate whether they have

more or less capital than they would at the Golden Rule
steady state.