Macroeconomics

N. Gregory Mankiw

Economic Growth
I: Capital
Accumulation as
a Source of
Growth
Presentation Slides

© 2022 Worth Publishers, all rights reserved

 IN THIS CHAPTER, YOU WILL LEARN:

About the closed-economy Solow

model
How a country’s standard of living
depends on its saving rate
How to use the “Golden Rule” to
find the optimal saving rate and
capital stock

3 The
CHAPTER 1 National
Science
Income
of Macroeconomics
Why growth matters (1 of 2)

Economic growth raises living standards and reduces

poverty…
Why growth matters (2 of 2)

Anything that affects the long-run rate of economic growth—

even by a tiny amount—will have huge effects on living
standards in the long run.

Annual growth Increase in Increase in Increase in

rate of income standard of standard of standard of
per capita living after 25 living after 50 living after 100
years years years
2.0% 64.0% 169.2% 624.5%
2.5% 85.4% 243.7% 1,081.4%
The lessons of growth theory

…can make a positive difference in the lives of hundreds of

millions of people.
These lessons help us
• understand why poor countries are poor
• design policies that can help them grow
• learn how our own growth rate is affected by shocks and
our government’s policies
The Solow model

• It is named after Robert Solow, who won the Nobel Prize

for contributions to the study of economic growth
• It is:
• widely used in policymaking
• a benchmark against which most recent growth
theories are compared
• It looks at the determinants of economic growth and the
standard of living in the long run.
How the Solow model is different from Chapter 3’s
model, part 1

1. K is no longer fixed: Investment causes it to grow,

depreciation causes it to shrink.
2. L is no longer fixed: population growth (Chapter 9)
3. The consumption function is simpler.
How the Solow model is different from Chapter 3’s
model, part 2

4. No G or T (only to simplify presentation; we can still do

fiscal policy experiments)
5. Cosmetic differences
The production function (1 of 2)

• In aggregate terms: Y = F (K, L)

• Define: y = Y/L = output per worker
k = K/L = capital per worker
• Assume constant returns to scale:
zY = F (zK, zL) for any z > 0
• Pick z = 1/L. Then
• Y/L = F (K/L, 1)
• y = F (k, 1)
• y = f(k) where f(k) = F(k, 1)
The production function (2 of 2)

Note: This production function

exhibits diminishing MPK.
The national income identity

• Y = C + I (remember, no G)
• In “per worker” terms:
y=c+i
where c = C/L and i = I /L
The consumption function

• s = the saving rate, the fraction of income that is saved (s

is an exogenous parameter)
Note: s is the only lowercase variable that is not equal to its
uppercase version divided by L
• Consumption function: c = (1–s)y (per worker)
Saving and investment

• Saving (per worker) = y – c

= y – (1–s)y
= sy
• National income identity is y = c + i
Rearrange to get i = y – c = sy
(investment = saving, as in Chapter 3!)
• Using the results above,

i = sy = sf(k)
Output, consumption, and investment
 Depreciation

δ = the rate of depreciation

k = the fraction of the capital stock that
wears out each period
Capital accumulation

The basic idea: Investment increases the capital stock;

depreciation reduces it.

change in capital stock = investment – depreciation

Δk = i – δk
Since i = sf(k) , this becomes:

Δk = sf k    k
The equation of motion for capital (k)

Δk = sf k    k

• The Solow model’s central equation

• Determines behavior of capital over time . . .
• . . . which, in turn, determines behavior of all the other
endogenous variables because they all depend on k.
• Example:
income per person: y = f(k)
consumption per person: c = (1 – s) f(k)
The steady state, part 1

Δk = sf k    k

If investment is just enough to cover depreciation

[sf(k) = δk],
then capital per worker will remain constant:
Δk = 0.
This occurs at one value of k, denoted k*, called the steady-
state capital stock.
The steady state, part 2
Moving toward the steady state, part 1
Moving toward the steady state, part 2
Moving toward the steady state, part 3
Moving toward the steady state, part 4
Moving toward the steady state, part 5
 Moving toward the steady state, part 6

Summary:
As long as k < k*,
investment will exceed
depreciation,
and k will continue to
grow toward k*.
NOW YOU TRY
Approaching k* from above
Draw the Solow model diagram, labeling the steady state k*.
On the horizontal axis, pick a value greater than k* for the
economy’s initial capital stock. Label it k1.
Show what happens to k over time.
Does k move toward the steady state or away from it?
A numerical example, part 1

Production function (aggregate):

Y = F (K , L ) = K × L = K 1/2L1/2

To derive the per-worker production function, divide

through by L:
1/2 1/2 1/2
Y K L K
= = 
L L L

Then substitute y = Y/L and k = K/L to get

y = f (k ) = k 1/2
A numerical example, part 2

Assume:
• s = 0.3
• δ = 0.1
• initial value of k = 4.0
Approaching the steady state: A numerical example

Assumptions : y = k ; s = 0.3; δ = 0.1;initial k = 4.0

Year k y c i δk Δk
1 4.000 2.000 1.400 0.600 0.400 0.200

2 4.200 2.049 1.435 0.615 0.420 0.195

3 4.395 2.096 1.467 0.629 0.440 0.189

4 4.584 2.141 1.499 0.642 0.458 0.184

5 4.768 2.184 1.529 0.655 0.477 0.178

10 5.602 2.367 1.657 0.710 0.560 0.150

25 7.321 2.706 1.894 0.812 0.732 0.080

100 8.962 2.994 2.096 0.898 0.896 0.002

∞ 9.000 3.000 2.100 0.900 0.900 0.000

NOW YOU TRY
Solve for the steady state
Continue to assume
s = 0.3, δ = 0.1, and y = k ½
Use the equation of motion
Δk = s f(k) − δk
to solve for the steady-state values of k, y, and c.
NOW YOU TRY
Solve for the steady state, answers

Δk = 0 definition of steady state

s f (k *) = δk * eq'n of motion with Δk = 0

0.3 k * 0.1k * using assumed values

k*
3  k*
k*
Solve to get: k*  9 and y *  k * 3

Finally, c* (1  s ) y * 0.7 3 2.1

 An increase in the saving rate

An increase in the saving rate raises investment…

…causing k to grow toward a new steady state:
Prediction: Countries with higher rates of saving and
investment

• The Solow model predicts that countries with higher

rates of saving and investment will have higher levels of
capital and income per worker in the long run.
• Are the data consistent with this prediction?
The Golden Rule: Introduction

• Different values of s lead to different steady states.

How do we know which is the “best” steady state?
• The “best” steady state has the highest possible
consumption per person: c* = (1–s) f(k*).
• An increase in s
• leads to higher k* and y*, which raises c*
• reduces consumption’s share of income (1–s), which
lowers c*.
• So, how do we find the s and k* that maximize c*?
The Golden Rule capital stock, part 1

*
the Golden Rule level of capital, the steady-
k gold = state value of k that maximizes consumption
To find it, first express c* in terms of k*:
 The Golden Rule capital stock, part 2

Then, graph f(k*)

and δk*, looking
for the point
where the gap
between them is
biggest.
 The Golden Rule capital stock, part 3

c* = f(k*) − δk*
is biggest
where the
slope of the
production
function equals
the slope of the
depreciation
line:
MPK = δ
The transition to the Golden Rule steady state

• The economy does not have a tendency to move toward

the Golden Rule steady state.
• Achieving the Golden Rule requires that policymakers
adjust s.
• This adjustment leads to a new steady state with higher
consumption.
• But what happens to consumption during the transition to
the Golden Rule?
 Starting with too much capital

If k * > k gold
*

then increasing c*
requires a fall in s.
In the transition to
the Golden Rule,
consumption is
higher at all points
in time.
 Starting with too little capital
If k * < k gold
*

then increasing c*
requires an
increase in s.
Future generations
enjoy higher
consumption, but
the current one
experiences an
initial drop in
consumption.
 C H A P T E R S U M M A R Y, P A R T 1
• The Solow growth model shows that, in the long run, a
country’s standard of living depends:
 positively on its saving rate

• An increase in the saving rate leads to:

 higher output in the long run
 faster growth temporarily
 but not faster steady-state growth

3 The
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of Macroeconomics
 C H A P T E R S U M M A R Y, P A R T 2
• If the economy has more capital than the Golden Rule
level, then reducing saving will increase consumption at all
points in time, making all generations better off.
If the economy has less capital than the Golden Rule level,
then increasing saving will increase consumption for future
generations, but reduce consumption for the present
generation.

3 The
CHAPTER 1 National
Science
Income
of Macroeconomics