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Solow Growth Model

The Solow growth model assumes diminishing returns to capital and labor. It predicts that economies will converge to a steady state level of income determined by savings rates, population growth, and technological progress. The key equations are the production function, capital accumulation equation, and steady state solution. The model shows how savings impacts the long run capital stock and output. Transitional dynamics illustrate convergence over time to the steady state, and how shocks like changes in savings or technology affect levels and growth rates of output, capital, and income.

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Hella Mae Rambunay
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369 views17 pages

Solow Growth Model

The Solow growth model assumes diminishing returns to capital and labor. It predicts that economies will converge to a steady state level of income determined by savings rates, population growth, and technological progress. The key equations are the production function, capital accumulation equation, and steady state solution. The model shows how savings impacts the long run capital stock and output. Transitional dynamics illustrate convergence over time to the steady state, and how shocks like changes in savings or technology affect levels and growth rates of output, capital, and income.

Uploaded by

Hella Mae Rambunay
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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SOLOW GROWTH MODEL

-The Solow Growth Model, for which Robert Solow of the


Massachusetts Institute of Technology received the Nobel Prize, is
probably the best known model of economic growth
- Although in some respects Solow’s Model describes a developed
economy better than a developing one, it remains a basic reference
point for the literature on growth and development
- It implies that economies will conditionally converge to the same level
of income if they have the same rates of savings, depreciation, labor
force growth, and productivity growth
- Thus the Solow Model is the basic framework for the study of
convergence across countries
- The key modification from the Harrod-Domar Growth Model, is that
the Solow Model allows for substitution between capital and labor. In
the process, it assumes that there are diminishing returns to the use of
these inputs
-The aggregate production function, Y = F(K,L) is assumed
characterized by constant returns to scale. For example, in the special
case known as the Cobb-Douglas production function

Fast Overview of the Model


Assumptions:
-Time (dynamic model); Close economy
- Variables and parameters
- per capita or per worker
- goods market
- Technology, Production Function; Constant Returns to Scale, positive
but diminishing marginal returns
- Capital accumulation equation
- Converting variables into per-capita terms
- The steady state
- Solow Diagram
- Transition dynamics, time series
-Shocks, effect of a change in savings, depreciation, Total factor
productivity, etc…
Variables endogenous, dynamic
Yt : output, income Lt : Labor, population, workers
Kt : capital It : Investment, savings
Ct : consumption
Where: Yt – Aggregate output; Kt – Aggregate capital
Lt – Aggregate labor; It – Aggregate investment
Ct – Aggregate consumption

Parameters: exogenous, constant


s : savings rate (between 0 and 1)
δ : depreciation rate (between 0 and 1)
g = gA : growth rate of technology
n = gL : population growth rate

Per capita variables


kt = Kt/Lt ; yt = Yt/Lt ;

it = It/Lt ct = Ct/Lt
Goods Market
Yt = Ct + It

It = sYt

Ct = (1 – s)Yt

Technology, Production
Yt = F(Kt, Lt) = Akαt L(1-α)t

Law of Motion of Capital or Capital Accumulation Equation


Kt+1 = Kt – δKt + It

- The Law of Motion of Capital – tells how the capital changes


through time

aka “Neoclassical Growth Model”


aka “Solow Swan Growth Model”
aka “Exogenous Growth Model”
Solow Model

-Shows that in the long run the economy’s rate of savings determines
the size of capital stock and therefore the level of production and its
per capita output
- The higher the level of savings - the higher the stock of capital
and the higher the level of output
- The model relates the economic growth the changes in factors like L
and K and interest rates, depreciation, growth and level of technology

Technology, Production
Yt = F(Kt, Lt ) = AKαt L(1-α)t -- Cobb-Douglas Production
Function

-The production function exhibits constant returns to scale


- Per –worker production function is characterized by positive and
diminishing returns to scale
FK(K, L) = ∂Y/∂K > 0 ; FL (K, L) = ∂Y/∂L > 0

FKK(K, L) < 0 ; FLL(K, L) < 0


Inidata assumptions
limK 0 FK = infinite and limL  0 FL = 0

limK→infinite FK = 0 and limL→ infinite FL = 0

Also the factors are important


F(0,0) = 0; F(0, L) = 0 and F(K, 0) = 0

FKL > 0 = Capital and labor are compliments


Cobb-Douglas Production Function

Note: Show Figure 1

Per capita production, y = f(k)

yt = Yt/Lt = F(K,L)/L y = f(k)


= F (Kt/Lt , Lt/Lt ) = Y/L
= F (kt , 1) = Akαt L(1-α)t / L
= f(kt) = Akαt L(1-α)t
= Akαt /L(1-α)t
= A (K/L)α s
y =f(k) = Akα (Production function
in terms of per capita)
↓
A is the total factor productivity
y – is output per person/worker
Capital accumulation equation

Kt+1 = Kt – δKt + It where Kt+1 – is capital next period


= Kt (1 – δ) + It
=Kt(1-δ)+sYt
Converting to Per-capita Terms

Kt+1/Lt+1 = (1 – δ)Kt/Lt + s Yt/Lt

 kt+1 = (1 – δ)kt + syt

 kt+1 – kt = syt – δkt

Where Δk = kt+1 – kt

k dot = ∂k/∂t (where k dot is capital continuous time)


 Δk = syt – δkt - this is the steady state level of k

The Law of Motion of Capital


The Steady State Level of Capital

-A steady state for this economy is a value of per-capital-Capital, k*,


such that, if the economy have k0 = k*, then kt = k* t 1
Where k* - is steady state

The law of Motion of Capital

-In the steady state k* = 0 or Δk = 0


0 = syt – δk*
0 = s(AK*α) – δk* where A – is Total Factor Productivity

 δk* = sA(k*α)
= k*/k*α = sA/δ
= (k*)1-α = (sA/δ)
= k* = (sA/δ)1/1-α → steady state value of capital per capita

value of k per capita


Solow Diagram and Convergence Dynamics

-Transition Dynamics
- Shocks to the economy
- The effects of destruction of capital
- The effects of changes in savings
- The effect of a change in the depreciation rate
- The effect of a change in Total Factor Productivity
Golden Rule Level of Capital and Savings Rate

Steady State Capital per worker Production, Output/Income


k* = (sA/δ)1/1-α y = f(k) = Akα
Steady state value of capital per worker

The Law of Motion of Capital


Δk = syt – δkt

Investment, Savings
it = syt = sAkα
Note: Show Figure 2

Break-even Investment
-Given some value of capital, k, what is the amount of investment
required to keep the per-capita capital stock constant
- k* - is steady state capital per worker

The law of Motion of Capital

Δk = syt – δkt

k* steady state value of capital per worker

yt = f(kt) = Akt

y* = f(k*) = Ak*α

Note: Show Figure 3 and 4


Referring to Figure 4

The range of k lower than k*

-syt > δk hence Δk is positive


- so k↑ until it will converge to k*
- The difference of syt – δk gets smaller as it moves or converge towards
the steady state level, k*

The range of k above k*

-- syt < δk hence Δk is negative


- so k↓ until it will converge back to k*, towards the steady state level
- The difference of syt – δk gets smaller as it moves back or converge
back towards the steady state level, k*
Solow Model
Transition Dynamics and Time Series
Transition Dynamics and Convergence to the Steady State

Note: Show Figure 5 and 6

Note: Show Figure 7 (Time Series graph or Transition dynamics –


Lower than k* refer to Figure 5)

Note: Show Figure 8 (Time Series graph or Transition dynamics –


Above k* refer to Figure 5)
Solow Model Transition Dynamics with Technology and Population
Growth

Growth Rates vs Level Shifts


-Given a shock to one of our variables, what effects can we expect
through time?
- Time Series Graphs:
- What are level effects?
- What affects growth rates?
Solow Model Transition Dynamics with Technology and Population
Growth
Growth Rates vs Level Shifts

Level Effects Growt


h Rate
s δ g n
Capital per effective K* = K/AL K* = (s/δ+g+n)1/1-α + - - - gk=0
worker:
Output per effective ŷ*=Y/AL Ŷ*t=(s/δ+g+n)α/1-α + - - - gŷ=0
worker:
Capital per worker: k*=K/L = k k*(t)= A(t) (s/n+δ)1/1-α + - - gk=g
hat*A
Output per worker: y*=Y/L = y y*(t) = A(t)(s/n+δ)α/1-α + - - gy=g
hat*A
Investment per ί*= s*ŷ*A + - - gk+g
worker
Level Effects Growt
h Rate
s δ g n
Consumption per c*= (1-s)y hat*A + - - gy=g
worker
Labor, Lt gL=n
Capital, K*t K=k hat*A*L K(t)*=(s/δ)1/1-αA(t)L(t) + - gk=g+n
Output, Y*t Y=ŷ*A*L Y(t)*=(s/δ)α/1-αA(t)L(t) + - gy=g+n
Investment I=s*ŷ*A*L + - gy=g+n
Consumption C=(1-s)*ŷ*A*L + - g+n

Where:
g – technology
n – population growth
Solow Diagram – Adding Technology and Population Growth

Note: Show Figure 9, 10, and 11

Change in Growth Rate – g↑, Growth in Technology Increases

Note: Show Figure 12

What affects growth rates?


-The growth in technology (g )
- the growth in population growth (n )

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