UNIT 7: THE ECONOMY IN THE

LONG RUN

SHIRSENDU ROYCHOWDHURY
ST.XAVIER’S COLLEGE (AUTONOMOUS), KOLKATA
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INTRODUCTION :-

Economic Growth is a long run phenomenon. So, whenever we discuss the economy in the long
run, we basically discuss the theories of Economic Growth.
Economic growth is defined as the sustained increase in the volume of goods and services
produced in the economy. So, if real GDP increases over time, the economy is said to experience
economic growth.
The subject called “Growth Theory” became popular in the post 2nd world war period (1939 to
1945).The Growth theories seek to explain the income differences among nations over time. The
main sources of growth are : growth of labour force, capital accumulation and technological
progress. The most celebrated model of economic growth is the “Harrod-Domar” model.
In this chapter we will discuss the “ Solow Growth Model”. R.M. Solow presented the principal
theory of equilibrium economic growth in the form of a model which is popularly known as the
Solow Model of Economic Growth. This is also known as the neoclassical growth theory. This
model has been developed in the context of a closed economy (in which there is no foreign trade)
without Government. This model of economic Growth has fascinated the economists since the
second half of 1950s.

SOLOW GROWTH MODEL :-

Objective :-

The Solow Growth Model aims to show how

• Saving
• Population growth and
• Technological progress …….affect the economic growth of a nation.

Variables :-

The Solow Growth Model focusses on four variables :-

• Output (Y)
• Capital (K)
• Labour (L)
• Knowledge / Efficiency of Labour (E)

Assumptions :-

• Closed Economy ; No Government Sector ( Basically the economy comprises of two

sectors : Households and Firms )
So, In Equilibrium : Private Savings (S) = Investment (I)
[ refer to Savings – Investment identity in a two sector economy in chapter 1 ]
• S = s.Y ; Savings is proportional to income ( “s” represents both “aps”and “mps”
and ( 0 < s < 1 ))
• No Technological Change ( This assumption will be changed later )

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• Change in stock of capital = Gross Investment – Depreciation

• Labour force (L) is assumed to grow at a constant exogenous rate of “n”
• CRS production function (i.e Homogeneous of degree 1)
Y = f ( K,L ) => zY = f ( zK , zL )where “z” is a positive number.

Main Model :-

Section 1 : The Supply of Goods

The aggregate production function states how supply of goods (output - Y) depends on the stock
of capital (K) and the labour force (L).
Y = F (K , L)
Production function is homogeneous of degree 1, i.e it exhibits CRS
So, z Y = f (z K, z L )……..’z’ is any positive number.
Let z = 1 / L
Then, Y/L = F (K/L , L/L)
or, Y/L = F (K/L , 1)
Here,
• Y/L is output per worker
• K/L is capital per worker
• 1 is constant ,
Ignoring the constant “1” we can write
Y/L = f (K/L)
i.e
the size of the economy, measured by the size of the Labour force, does not effect the
relationship between output per head(Y/L) and per capita availability of capital (K/L) – This is
the implication of CRS assumption
Let y = Y/L
k = K/L
So, y = f (k)

Now, if we plot the production function : y = f (k) with “k” in the horizontal axis and “y” in the
vertical axis, then the production function is represented by a concave to the “k” axis curve.
This is because the production function is subject to the law of diminishing MPK.
Marginal productivity of Capital (MPK) means how much extra output is produced by one
extra unit of capital, usage of labour remaining same.

[For detailed understanding refer to Appendix 1]

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Diagram :-

So,
• The supply side of the economy is summarized by the aggregate production function.
• The production function is subject to CRS
• The Aggregate Production Function is concave to the “k” axis.
• This is because of the law of diminishing Marginal Productivity of Capital (MPK)

Section 2 : The Demand for Goods

In a two – sector economy comprising of households and firms ;
Y = C + I ( from demand side )
Dividing both sides by ‘L’ we get :
Y/L = C/L + I/L
Or,
y = c + i [ y = Y/L, c = C/L, i = I/L]

Now,
C = bY [consumption function]; [ C = a + bY : a = autonomous consumption ; b = mpc ]
Assumption : autonomous consumption = 0 ; So, C = b.Y]
So, C/L = b . Y/L (Dividing both sides by ‘L’ we get) :-
Or, c = b . y

So, y = c + i ; c =by ;
Then (y – by) = i
Or, (1 - b) y = i [(1 – b) = (1 – mpc) = mps (s)]
So, sy = i [savings per worker = investment per worker]
or, s = i/y

So,
• From demand side we get : savings per worker = investment per worker
( sy = i )
Or, [sf (k) = i]

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Section 3 : The Growth of capital stock and steady state

Output at any fixed point of time is determined by stock of capital. As stock of capital increases
over time there in economic growth .

Size of capital is determined by two opposite forces :-

(i) Investment
(ii) Depreciation

• Investment increases stock of capital

• Depreciation (wear & tear) reduces it.

Now, i = s . y & y = f (k) = > i = s . f (k) [ i = gross investment ]

Let “ ” be a constant proportion which shows the rate at which the existing stock of capital
wears out every year and has to be replaced.

So, “ ” is the annual rate of depreciation.

Depreciation (D) = K So, D/L = K/L = k
Then the amount of capital per worker which depreciates each year is .k [ Depreciation ]

Growth of capital per worker is ∆ k = Gross investment - Depreciation

So, ∆ k = i - .k = s f (k) - .k
=> ∆ k = sy - .k
Now,
At steady state ; ∆ k = 0
Or, s f (k) = k
or, s f (k) / = k
Now, if k = k* at steady state ; then k* = s f (k*) /

• k* represent the steady state level of capital accumulation

• k* = s f (k*) /

Diagram :-

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At k1 => i1 > k1
or, i1 - k1 > 0
or, ∆k > 0
So, there is increase in stock of capital / worker.
Economy moves from k1 towards k*

At k2 => i2 < k2
or, i2 – k2 < 0
or, ∆k < 0
So, there is fall in the stock of capital / worker.
Economy moves from k2 towards k*

So, at k* ; growth of capital per worker (∆k) = 0

So, capital / worker is neither raising or falling.
So, k* is known as the steady state level of capital.
So, At k*, capital per worker and hence output per worker remain steady over time.

• Once the economy reaches the steady state, it will remain there.
• This means, regardless of the level of capital with which the economy begins, it ends
up at steady state level of capital.
So, steady state represents the long – run equilibrium of the economy.

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Section 4 : Saving and Economic Growth

Let s = s1 ;
Then i1 = s1 f (k)
When s rises to s2
Then i2 = s2 f (k)

Steady state capital per worker shifts from k1* to k2*

k1* = s1 f (k1*) /
k2* = s2 f (k2*) /

Explanation

When s rises from s1 to s2 , ‘i’ curve shifts upward from s1f (k) to s2f (k). But k remains
unchanged.
Now, at initial steady state at E : k = s1 f (k)
or, k = s1 f (k) /
(k = k1* ; => k1* = s1 f (k1*) / )
As soon as saving rises, investment automatically goes up.
As capital stock & depreciation remains unchanged at steady state, so equilibrium “i” > k by
EE′ which means ∆k > 0 ;
i.e capital stock per worker rises until the economy reaches new steady state which has larger
volume of capital per worker (k2*) & higher level of output compared to old steady state.
So, new steady state is reached at F where k2* = s 2 f (k2*) /
k2* > k1*

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Main prediction of Solow Model :-

Saving rate is the proximate determinant of the steady state capital stock. These is a positive
relation between ‘s’ and f (k).
If ‘s’ is high then ‘k’ is high and so f (k) is correspondingly high.
The converse of this is also true.

Policy Implication :-

If govt. runs budget deficit & there is correspondingly high public sector borrowing requirement
(PSBR), it can reduce National Saving & crowd out private investment. Long run impact of this
would be lower capital stock and reduced level of GDP. That is why many liberal economists are
very critical of persistent govt. budget deficit.

Note :- Increase in saving rate increases economic growth only in the short run, i.e there is
faster growth temporarily until the economy reaches new steady state. However higher growth
rate cannot be maintained for an indefinite period due to diminishing marginal product of capital.

Section 5 : The golden rule level of capital accumulation

Higher saving is not always a good thing. The main aim is more consumption and improved
standard of living of people. Pushing an economy to higher & higher levels of saving is not
always desirable .In an extreme situation if the economy saves entire income, there is no
consumption, then economic welfare will fall.
So, it is important to know the optimal level of capital of a society which maximises the
economic well – being of its members on terms of consumption spending.
Golden Rule Level of Capital (term coined by Edmund Phelps) refer to that steady state value
of ‘k’ which maximises consumption per worker .

c = y–i
y = f (k*) [ k = k* at steady state ]
i = k* [ at steady state i = k]
=> c* = f (k*) - k*.

First order condition for maximises of consumption per worker =>

d c* / d k* = 0 => d [ f (k*) - k* ] / dk* = f ′ (k*) - = 0 => f ′ (k*) =
Now, f ′ (k*) = MPK
Therefore , MPK = is the condition at which consumption per worker is maximized. So, this
is the condition for Golden Rule Level of Capital accumulation.

The level of steady state capital at which consumption per worker is maximized is known as
“ golden rule level of capital – kg* ”
At kg*, Consumption per worker is cg* and Investment per worker is ig*.

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Diagram :-

Section 6 : Extension of Solow Growth Model

a) Population Growth

Assumption :-
Population does not remain fixed, rather the population and labour force grow at a
constant rate ‘n’ (refer to assumption 5 of Solow Model discussed in the beginning)

Now, growth in number of workers causes capital per worker to fall.

Reason :- Capital per worker = K/L ; Growth of labour force => L rises => K/L will fall.

So, along with depreciation, now increase in labour force also reduces capital per worker.

Therefore, if Labour force is growing at the rate ‘n’

Then ∆k = i – ( + n) k

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Steady state level of capital accumulation with population growth

At steady state ∆k = 0
=> i = ( + n) k
=> s f (k) = ( + n) k
i.e k* = s f(k*) / ( + n )
Diagram :-

Golden rule steady state level of capital

c= y–i
At steady state :-
c* = y* - ( + n) k* = f (k*) – ( + n) k* [ since at steady state : i = ( + n) k* ]
(First order condition for c* maximisation) :-
dc* / dk* = 0
=> f ′ (k*) = ( + n )
or, (MPK) = ( + n )

This is the condition for golden rule steady state for Solow Model with population growth.

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b) Technological Progress

Technological progress improves efficiency of labour (E) .

Incorporating the efficiency of labour (E), the Production function takes the following form :
Y = F (K , L × E) Where E = efficiency of labour force and L × E represent the number of
effective workers

Let efficiency of labour (E) grow at a constant rate ‘g’. [ Assumption ]

(This is an example of labour augmenting technological progress where ‘g’ measures the rate of
such progress)
[ Note :- What is labour augmenting technological progress ? – Refer to Appendix 2 ]

L is assumed to increase at rate ‘n’

If efficiency of each unit of labour (E) is growing at rate ‘g’, then number of effective workers,
(L × E) is growing at the rate (n + g)
Then k = K / (L x E) => If “E” grows (rises) then (L x E) will rise and hence “k” will fall.

Therefore, now with growth of labour force (n) and growth of efficiency of labour force (g)
incorporated, both of these ( “n” and “g” ) will reduce the capital per worker “k”.

Therefore, ∆ k = s f (k) - ( + n + g) k.
At steady state ∆ k = 0
=> s f (k) = ( + n + g) k
or, k* = s f ( k*) / ( + n + g) [k* = steady state level of capital]

Diagram :-

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For golden level of capital accumulation

c* = s f (k*) - ( + n + g ) k*
First order condition for maximisation of steady state consumption per worker :-
dc* / dk* = 0 => s f ′ (k*) – ( + n + g) = 0
or, f ′ (k*) = ( + n + g )
or, MPK = ( + n + g )

This is the condition for golden rule steady state for Solow Model with population growth and
technological progress.

Section 7 : Criticisms of Solow Model

• Solow model does not examine how economy adjusts to temporary shocks such as was
and financial crisis.
• This model takes technological progress as exogenous. It does not explain it .
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Section 8 : Endogenous growth theory (Main message)

The main message of endogenous growth theory is that economic growth can be sustained
indefinitely through internal, endogenous factors, such as human capital accumulation,
innovation, and knowledge creation, rather than relying solely on exogenous factors like capital
accumulation or technological progress driven by external forces.

Unlike traditional neoclassical growth theory, which emphasizes diminishing returns to capital
and technological progress as exogenous and unpredictable, endogenous growth theory suggests
that investments in education, research and development (R&D), and technological innovation
can be actively managed and fostered within an economy to promote sustained growth.

Key ideas within endogenous growth theory include:

Human Capital Accumulation: Emphasizes the importance of investing in education and training
to enhance the skills and knowledge of the workforce, which in turn leads to higher productivity
and economic growth.
Knowledge and Innovation: Highlights the role of innovation and technological progress as
endogenous drivers of growth. Unlike in neoclassical theory, where technological progress is
often treated as an exogenous factor, endogenous growth theory suggests that policies and
investments aimed at promoting innovation can stimulate economic growth.
Externalities and Spillovers: Recognizes the presence of positive externalities and knowledge
spillovers, where the benefits of innovation and knowledge creation extend beyond individual
firms or industries. This implies that policies aimed at promoting R&D and innovation can have
broader benefits for the economy as a whole.
Increasing Returns to Scale: Challenges the assumption of diminishing returns to capital by
suggesting that certain types of economic activities, such as research and innovation, may exhibit

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increasing returns to scale. This implies that as the economy grows, it can become increasingly
productive and efficient.
Overall, the main message of endogenous growth theory is that sustained economic growth
can be achieved through deliberate investments in human capital, innovation, and
knowledge creation, leading to a more dynamic and prosperous economy in the long run.

Section 9 : Convergence Hypothesis

According to the convergence hypothesis, all countries will grow at the same rate. This
prediction holds if all countries of the world have attended their respective steady states.

There are three types of convergence

• Unconditional Convergence :- Unconditional Convergence means that the LDCs will

ultimately catch up with the industrially advanced countries so that in the long run, the
standard of living throughout the world becomes more or less same.
• Conditional Convergence :- If countries differs in the fundamental characteristics, the
Solow Growth Model predicts conditional convergence. That means standard of living
will convergence only with in groups of countries having similar characteristics.
• No convergence :- The third possibility is of no convergence. This means low income
countries will never catch up over time. The living standard may even diverge due to
widening income gap – the rich getting richer & poor getting poorer.
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Section 10 : Public Policies to promote Economic Growth

(1) Altering the saving rate

• Private saving can be reduced by reducing the personal income tax or

reducing the business tax .

• Public saving can be reduced by reducing the budget deficit and reducing the
non plan revenue expenditure .

(2) Policies to raise the productivity growth

• Improving infrastructure.
• Building human capital.
• Entrepreneurship development.
• Encourage research and development.
• Technological progress (through industrial policy).
• Reduction in govt. regulation.

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Section 11 : The Solow Residual

General assumption was that, as production function states that the level of output depends upon
the level of labour and the level of capital, so the growth of output could be explained by
combined growth of labour and capital inputs.
But a few studies made in 1950s established that the rates of economic growth that was
prevailing in the 20th century were much higher than that could be explained by combined
growth of labour and capital inputs. So, there is an unexplained “Residual Growth”.

Technically it can be explained as follows :-

The level of output depends on level of labour & level of capital.

i.e y = f ( K , L )
But many studies confirmed that rates of economic growth were much higher than that could be
explained by combined growth of labour and capital inputs.

i.e dy / y > α (d k / k) + ( 1 - α ) (dL / L)

Here, (dy / y) is growth rate of output

α is the share of capital in total output
dk/k is the rate of growth of capital
α (d k / k) is the contribution of growth of capital to output growth
(1-α) is share of labour in total output
dL / L is the rate of growth of labour force
( 1 - α ) dL / L is the contribution of growth of labour force to output growth

So, { dy / y - α (dk / k)+ (1 - α)(dL/L) } is known as residual growth as it is unexplained

source of growth. Now, economists define the residual growth as growth due to increase in total
factor productivity due to the technological improvement. “A” is defined as efficiency parameter
measuring the rise in total factor productivity due to technological change .
So, dA / A = dy / y – α (dk / k) - (1-α) (dL / L) ;
So, dA / A is called Solow residual, the residual factor of growth that cannot be explained by
systematic changes in inputs.

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QUESTIONS :-

• What are the main assumptions of Solow model of economic growth?

• What is meant by steady state equilibrium.
• Explain how an economy achieves steady state equilibrium (with proper diagram).
• What is meant by the golden rule level of capital accumulation? How can the golden
rule level of steady state capital be determined (Show with diagram)? State the
condition for the golden rule level of capital accumulation.
• How does saving rate influence economic growth (Use diagram)?
• Discuss the role of population growth and technological progress in the context of
the Solow model of economic growth (with proper diagrams).
• State the condition for golden rule level of steady state capital under
i) Solow Model with Population Growth
ii) Solow Model with Technological Progress
• Mention some policies to promote economic growth, based on Solow’s analysis.
• State any two criticisms of Solow Growth Model.
• What do you understand by convergence hypothesis.
• Write a short note endogenous growth theory.
• What is meant by Solow Residual ?

References/Suggested Readings :-
1. Principles of Macroeconomics by Sampat Mukherjee & Amitava Ghosh (NCBA)
2. Macroeconomics by N.G.Mankiw (Worth Publishers)
3. Principles of Macroeconomics by Soumyen Sikdar (OUP)

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APPENDIX 1
Why production function is concave to the horizontal axis ?

This is because the production function is subject to the Law of Diminishing Marginal
Productivity of Capital (MPK). Marginal productivity of Capital (MPK) means how much extra
output is produced by one extra unit of capital, usage of labour remaining same.

Suppose ∆ K units of capital produces ∆ Y units of output

Then 1 unit of capital of produces (∆Y / ∆K) units of output
So, MPK = ∆Y / ∆K
Dividing both numerator and denominator of R.H.S of the above equation by L (assuming that
Labour usage -L- remain unchanged ) we get :-

MPK = (∆Y/L) / (∆K/L) => MPK = ∆y / ∆k

Now, ∆y = f (k +∆k) – f (k) when k changes by ∆k
So, MPK = ∆y / ∆k = [f (k +∆k) – f (k)] / ∆k
If ∆k = 1 then MPK can also be expressed as :- f (k+1) – f (k)
Now, production function exhibits diminishing MPK.
So as k rises, MPK = [f (k+1) – f (k)] will rise by less and less.
This means the Production Function will be concave to the “k” axis.

Diagram :-

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APPENDIX 2

WHAT IS LABOUR AUGMENTING TECHNOLOGICAL PROGRESS ?

Labour-augmenting technological progress refers to technological advancements that increase

the productivity of labor without changing the quantity of labor input. In other words, it's a type
of technological advancement that makes workers more efficient and productive in their tasks
without necessarily requiring more workers.

This type of progress typically involves innovations in tools, machinery, equipment, or processes
that enable workers to produce more output with the same amount of effort or time. For example,
the introduction of automation in manufacturing processes, such as robotic assembly lines, is a
classic example of labour-augmenting technological progress. These advancements allow
workers to produce more goods or services in less time or with fewer resources.

Labour-augmenting technological progress is often seen as a key driver of economic growth and
increased living standards, as it enables economies to produce more output with the same amount
of input, leading to higher levels of productivity and efficiency. However, it can also have
implications for employment, as it may lead to changes in the demand for certain types of labor
or the need for workers to acquire new skills to adapt to changing technologies.

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