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Solow Model 1

The document discusses the Solow-Swan model of economic growth, which connects output to capital and labor inputs, leading to a steady state equilibrium. It outlines key assumptions of the model, such as constant returns to scale and diminishing returns to individual inputs, and presents the fundamental equations governing the relationship between saving, investment, and capital per worker. The model's implications include that growth rates are independent of the saving rate and that without technological improvements, growth per worker will eventually cease.

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9 views14 pages

Solow Model 1

The document discusses the Solow-Swan model of economic growth, which connects output to capital and labor inputs, leading to a steady state equilibrium. It outlines key assumptions of the model, such as constant returns to scale and diminishing returns to individual inputs, and presents the fundamental equations governing the relationship between saving, investment, and capital per worker. The model's implications include that growth rates are independent of the saving rate and that without technological improvements, growth per worker will eventually cease.

Uploaded by

harshita.9533singh
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Mahatma Gandhi Central University

ECON3020: Theory of Economic Growth

Course Code: ECON3020

Unit-iii, Growth Model with Exogenous Saving Rate

By
Mr. Vijay Kumar
[email protected]
Mob No.-7549273042
The Solow-Swan Model

• The Solow-Swan model of economic growth


postulates a continuous production function
linking output to the inputs of capital and labour
which leads to the steady state equilibrium of the
economy.

• It is based on the following assumptions:


Assumptions
• 1) One composite commodity is produced.
•
(2) Output is regarded net output after making
allowance for the depreciation of capital.
•
(3) There are constant returns to scale.
•
(4) There are diminishing returns to an individual
input.
•
(5) The two factors of production—labour and
capital—are paid according to their marginal
physical productivities.
• (6) Prices and wages are flexible.
(7) There is perpetual full employment of
labour.
(8) There is also full employment of the
available stock of capital.
(9) Labour and capital are substitutable for
each other.
(10) There is no technical progress.
(11) The saving ratio is constant.
(12) Saving equals investment.
(13) Capital depreciates at the constant rate,
d.
(14) Population grows at a constant rate, n.
THE MODEL
• Given these assumptions, with unchanging
technical progress, the production function is
Y = F (K,L)
where, Y is income or output, K is capital and L is
labour.
• The condition of constant returns to scale implies
that if we divide by L, the production function
can be written as
• where, Y = Y/L is output or income per
worker, k = K/L is the capital-labour ratio, and
the function f(k) = f(k, 1). Thus the
production function can be
expressed as
• y=f(k)………………………………….(2)

In the Solow-Swan model, saving is a constant


fraction, s, of income. So saving per worker is
sy. Since income equals output,

sy=s.f(k)……………………………..(3)
The investment required to maintain capital per worker k,
depends on population growth, and the depreciation rate, d.

Since it is assumed that population grows at a constant rate n,


the capital stock grows at the rate n.k to provide capital to the
growing population.

Since depreciation is a constant, d, per cent of the capital stock,


d. k is the investment needed to replace worn-out capital.

This depreciation investment per worker d.k is added to n.k, the


investment per worker to maintain capital-labour ratio for the
growing population,

(nk+dk)=(n+d)k………………………………………(4)
• which is the investment required to maintain capital
per worker.

The net change in capital per worker (capita labour


ratio) overtime is the excess of saving per worker over
the required investment to maintain capital per worker,

k=s.f(k)(n+d)k……………………………..(5)

• This is the fundamental equation for the Solow-Swan


model, where the steady state corresponds to k= 0.
The economy reaches a steady state when
sf(k)=(n+d)k…………………………….(6)
• The Solow-Swan model is explained in Fig. 1.
•
Output per worker y is measured along the vertical axis and
capital per worker (capital-labour ratio), k, is measured along
the horizontal axis.

• The y = f(k) curve is the production function which shows that


output per worker increases at a diminishing rate as k
increases due to the law of diminishing returns.

• The sf(k) curve represents saving per worker. The (n + d)k is


the investment requirement line from the origin with a
positive slope equal to (n+d).

• The steady state level of capital, is determined where the sf(k)


curve intersects the (n+d)k line at point E.
• The steady state income is with output per worker P,
as measured by point P on the production function y = f(k).
• In order to understand why is a steady state situation, suppose the
economy starts at the capital-labour ratio k1.
• Here saving per worker k1B exceeds the investment required to keep the
capital-labour ratio constant, k1A, (k1B >k1A).
• Thus, k and y increase until k* is reached when the economy is in the
steady state at point E.
•
Alternatively, if the capital-labour ratio is k2, the saving per worker, k2C,
will be less than the investment required to keep the capital-labour ratios
constant, k2D, (k2C < k2D). Thus y will fall as k falls to k* and the
economy reaches the steady state E.

The Solow-Swan model shows that the growth process is stable. No matter
where the economy starts, forces exist that will push the economy over
time to a steady state.
IMPLICATIONS OF THE MODEL
• There are some important implications or predictions
of the Solow-Swan model of growth:
•
1. The growth rate of output in steady state is
exogenous and is independent
of the saving rate and technical progress.
•
2. If the saving rate increases, it increases the output
per worker by increasing the capital per worker, but the
growth rate of output is not affected.
Cont……..
• 3. Another implication of the model is that growth in
per capita income can either be achieved by increased
saving or reduced rate of population growth.
This will hold if depreciation is allowed in the model.
•
4. Another prediction of the model is that in the
absence of continuing improvements in technology,
growth per worker must ultimately cease. This
prediction follows from the assumption of diminishing
returns to capital.
Thank You…..

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