Scribd
Upload
165 views28 pages

Lecture4-Solow Growth Model

The simplified Solow growth model describes an economy with consumers who consume a constant fraction of GDP and save the rest, and firms that use capital to produce output. The model shows that the capital stock increases over time as savings are reinvested, approaching a steady state level. If productivity or the savings rate increase, the steady state capital and output levels will be higher. The model suggests productivity growth, not just capital accumulation, is key to increasing a country's long-run wealth.

Uploaded by

Madiha Khan
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
165 views28 pages

Lecture4-Solow Growth Model

The simplified Solow growth model describes an economy with consumers who consume a constant fraction of GDP and save the rest, and firms that use capital to produce output. The model shows that the capital stock increases over time as savings are reinvested, approaching a steady state level. If productivity or the savings rate increase, the steady state capital and output levels will be higher. The model suggests productivity growth, not just capital accumulation, is key to increasing a country's long-run wealth.

Uploaded by

Madiha Khan
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 28

Simplified Solow Growth Model

Consumers: Consume a constant fraction of GDP and own all the capital in the economy Not modeling: Unemployment (everyone always works) Lifecycle (no children, students or retirees) Within-country income inequality Consumers described by one equation: I=sY where s, a number between 0 and 1, is the fraction of output that gets invested.

Simplified Solow Growth Model


Firms: Use the capital to produce output Not modeling: Labor markets (searching for workers) Finance (borrowing to take on projects) Executive compensation

Firms described by one equation: Y=AK where Y is GDP, A is productivity and K is the capital stock

Simplified Solow Growth Model


Equilibrium: All output is used either in investment or consumption (no trade, no government): Y=C+I How the stock of capital changes over time: K = I + (1- )K where K is the capital stock next year, K is the capital stock this year, I is investment this year, and is the depreciation rate

Simplified Solow Growth Model


So the entire model is described by four equations:

Households: Firms: Capital Accumulation: GDP:

I=sY Y = A K0.3 K = I + (1- )K Y=C+I

Rearranging terms:

I = s Y = s A K0.3 K = I + (1- )K = s A K0.3 + (1- )K

How does the capital stock change over time?


K

How are capital this year, and capital next year related?

K= K

How does the capital stock change over time?


K
K = s A K0.3 + (1- )K

K= K

The equation above tells you how much capital there will be next year

How does the capital stock change over time?


K
K = s A K0.3 + (1- )K

Suppose the economy starts with some low capital level K0

K= K

K0

How does the capital stock change over time?


K
K = s A K0.3 + (1- )K

K1

K= K

Then the equation says that next years capital stock will be K1

K0

How does the capital stock change over time?


K
K = s A K0.3 + (1- )K

K1

K= K

Using the red 45 degree line as a reference, we can find K1 on the horizontal axis.

K0

K1

How does the capital stock change over time?


K
K = s A K0.3 + (1- )K K2 K1

Then we can find K2

K= K

K0

K1

How does the capital stock change over time?


K
K = s A K0.3 + (1- )K K2 K1

K= K

Repeating these steps, we can find the capital stock in any future year

K0

K1

How does the capital stock change over time?


K
K = s A K0.3 + (1- )K K2 K1

K= K

Repeating these steps, we can find the capital stock in any future year

K0

K1

K2

How does the capital stock change over time?


K
K = s A K0.3 + (1- )K K3 K2 K1

K= K

Repeating these steps, we can find the capital stock in any future year

K0

K1

K2

How does the capital stock change over time?


K
K = s A K0.3 + (1- )K K3 K2 K1

K= K

Repeating these steps, we can find the capital stock in any future year

K0

K1

K2 K3

How does the capital stock change over time?


K
K = s A K0.3 + (1- )K

K4 K3 K2 K1

K= K

Repeating these steps, we can find the capital stock in any future year

K0

K1

K2 K3

How does the capital stock change over time?


K
K10 . K3 K2 K1 K = s A K0.3 + (1- )K

K= K

Notice that the capital stock is approaching the point where the two lines meet

K0

K1

K2 . K10

How does the capital stock change over time?


K
K* K = s A K0.3 + (1- )K The point where the two lines meet is the steady state level of capital. Once the economy is at this level, the capital level does not change. K*

K= K

Some Things to Notice


The further the economy starts below the steady state level of capital, the faster the economy initially grows Mankiw refers to this as the catch-up effect This is due to the effect of diminishing returns The amount of extra output from each additional unit of capital goes down as the capital stock gets larger Growth slows over time until the capital stock reaches the steady state level

Further Remarks
This model can be made more complicated (and realistic) by making A grow over time The mechanics of the model are the same, except instead of reaching a steady state, the capital stock grows at the same rate as productivity This is called a balanced growth path

Savings and Productivity


What happens if the savings rate of the country changes? Increase s from its initial level to a higher level

Increase in the Savings Rate


K
K* K = s A K0.3 + (1- )K Suppose the economy is in a steady state with savings rate s.

K= K

K*

Increase in the Savings Rate


K
K* Then the savings rate increases to s. K = s A K0.3 + (1- )K

K= K

K*

Increase in the Savings Rate


K
K1
Now capital accumulates according to the new equation with the higher savings rate K = s A K0.3 + (1- )K

K= K

K*

Increase in the Savings Rate


K
K1
K = s A K0.3 + (1- )K

And we proceed exactly like before.

K= K

K*

Increase in the Savings Rate


K
K* K0 Eventually a new, higher steady state capital stock is reached. K = s A K0.3 + (1- )K

K= K

K0

K*

Savings and Productivity


If the savings rate is increased, the economy transitions to a higher steady state capital level What happens if instead productivity is increased? Same thing. Income goes up, so consumers have more to invest, which increases the capital stock. How are they different? Higher savings: Decreases consumption today, increases it in the future Higher productivity: Increases consumption both today and in the future

Savings and Productivity


Back to what Solow found: Savings rates (even historical) have little relationship to relative wealth Apparently the wealth of countries that are now rich is not because of long term savings and investment per se That is, clearly the fact that rich countries are rich is partly because they have more capital. BUT they have more capital because they have high productivity.

Savings and Productivity


This is an extremely important finding. Suggests that a long history of capital accumulation is not necessary to be wealthy If a country is able to increase its productivity, capital will catch up quite quickly This shifted the emphasis in the study of promoting development in low income countries away from trying to send them capital, and toward trying to make their economies more efficient How do you do that? Perhaps the most important open question in social science.

You might also like