Neoclassical Growth theory: Solow Model

Paper: ECO402C –Intermediate Macroeconomics-I

Lecture note
___________________________________________________________

Solow growth model is a neoclassical model developed in 1956 by Robert Solow of MIT.
Solow model shows that an economy will tend towards a long-run equilibrium capital-labour
ratio 𝑘 ∗ at which output per head 𝑦 ∗ is also in equilibrium, so that output (𝑌), capital (𝐾) and
labour (𝐿) all grow at the same rate.

The model has the following propositions:

• The level of per capita income depends on the saving and investment ratios. The level
of per capita income varies positively with the savings-investment ratio, and negatively
with the population growth rate.
• There exists an inverse relation between 𝑘 (capital per worker/head) and the
‘productivity of capital’. Hence, given identical technology across countries, poor
countries with lower 𝑘 should grow faster than rich countries with high 𝑘 . This should
lead to the convergence of per capita incomes and living standards across the world.
• In steady state, the growth of output is determined by the rate of growth of the labour
force in efficiency units (growth of the labour force plus the rate of growth of labour
productivity).

The model is based on three key assumptions

• The labour force grows at a constant exogenous rate, 𝑛
• Output is a function of capital and labour: 𝑌 = 𝐹 (𝐾, 𝐿). The production function
exhibits constant returns to scale, but diminishing returns to individual factors of
production, and has a unitary elasticity of substitution between factors.
• All saving is invested: S = I = sY. There is no independent investment function.

The most commonly used neoclassical production function is the Cobb-Douglas production
function with constant returns to scale: [or we can use a more general production function
with two inputs, 𝑌 = 𝑓(𝐾, 𝐿)]
𝑌 = 𝑏𝐾 𝛼 𝐿1−𝛼

1
The sum 𝛼 + (1 − α) = 1, that is, a 1 per cent increase in K and L will lead to a 1 per cent
increase in Y. Hence, production function exhibits constant returns to scale).

To write the production function in labour intensive form, divide both sides by L, giving per
capita output-
𝑌 𝑏𝐾 𝛼 𝐿1−𝛼 𝐾 𝛼
= = 𝑏( )
𝐿 𝐿 𝐿
𝑦 = 𝑏𝑘 𝛼
𝑦 = 𝑓(𝑘)

𝑦 = 𝑓(𝑘) shows per capita output (or output per worker) as a function of per-capita capital, 𝑘
(capital per worker, 𝑘). The diminishing slope of the function is due to diminishing marginal
product of capital. Further the savings per capita in any time period are given by
𝒔𝒚 𝑜𝑟 𝒔. 𝒇(𝒌), and since investment per capita is assumed to be equal to savings per capita
always, flow of gross investment per capita 𝒊 = 𝒔. 𝒇(𝒌). (𝑁𝑜𝑡𝑒: 𝑠 = Saving ratio)

Vertical axis: Per capita output or income; Horizontal axis: Per capita capital
stock

Investment leads to addition to the stock of capital. But during any given time period capital
per capita also gets reduced due to increase in labour force which grows at the constant rate
𝑛 and the depreciation of capital equipment. Let the rate of depreciation be denoted by 𝛿. The
capital per capita therefore gets reduced at the rate of (𝑛 + 𝛿)𝑘 . The change in per capita
capital stock (w.r.t. time) is therefore given by-
𝑑𝑘
= ∆𝑘 = 𝑠. 𝑓(𝑘) − (𝑛 + 𝛿)𝑘
𝑑𝑡

2
 Hence,
Per capita capital 𝑘 grows if 𝑠. 𝑓(𝑘) > (𝑛 + 𝛿)𝑘
Per capita capital 𝑘 declines if 𝑠. 𝑓(𝑘) < (𝑛 + 𝛿)𝑘
Per capita capital 𝑘 remains unchanged if 𝑠. 𝑓(𝑘) = (𝑛 + 𝛿)𝑘

Note that when 𝑛 = 0, the (0 + 𝛿)𝑘 line will be flatter than the (𝑛 + 𝛿)𝑘 line. Note
that 𝑠. 𝑓(𝑘) − (𝑛 + 𝛿)𝑘 represents net investment per capita. For any 𝑘 > 𝑘 ∗ , 𝑠𝑓(𝑘) <
(𝑛 + 𝛿)𝑘 i.e. net investment is negative. Hence, 𝑘 will decline. On the other hand, for
any 𝑘 < 𝑘 ∗ , 𝑠𝑓(𝑘) > (𝑛 + 𝛿)𝑘 i.e. net investment is positive. Hence, 𝑘 will rise. Therefore
in the long run the equilibrium per capita capital stock will be 𝑘 ∗ (𝑘 eventually remains
steady at 𝑘 ∗ ), at which per capita output will also remain steady at 𝑦 ∗ . Notice that, given 𝑦 =
per capita income, 𝑠. 𝑓(𝑘) = per capita savings, the difference 𝑦 − 𝑠. 𝑓(𝑘) i.e. the vertical
distance between 𝑓(𝑘) and 𝑠. 𝑓(𝑘) curves is the per capita consumption. At 𝑘 ∗ , per capita
consumption c will be: 𝑐 ∗ = 𝑦 ∗ − 𝑠. 𝑓(𝑘 ∗ ) = 𝑓(𝑘 ∗ ) − (𝑛 + 𝛿)𝑘 ∗ .

In Solow model, the per capita capital that persists in the long run is known as the steady-
state per capita capital stock, denoted by 𝑘 ∗ . When 𝑘 remains constant in steady state, so
will the per capita output , 𝑦. Hence, all the macro variables - output (𝑌), labour (𝐿) and
capital (𝐾) will grow at the same rate – a rate equal to 𝑛.

Note that, given the production technology, steady state per capita capital stock (𝑘 ∗ ) will-
• rise as 𝑠 increases, implying that economies with higher saving ratio will have
higher 𝑘 ∗ and higher 𝑦 ∗ compared to economies with lower saving ratios.
• fall as 𝑛 increases, implying that economies with higher population growth rate
will end up with lower 𝑘 ∗ and 𝑦 ∗ .
• fall as 𝛿 increases, implying that higher the depreciation rate 𝛿, lower will be the
𝑘 ∗ and 𝑦 ∗ .

3
 So, given production technology, steady state per capita capital stock can be written as a
functions of three parameters 𝑠, 𝑛 and 𝛿; 𝑘 ∗ = 𝑘 ∗ (𝑠, 𝑛, 𝛿).

Golden rule steady state:

In the preceding section, we saw that 𝑘 ∗ = 𝑘 ∗ (𝑠, 𝑛, 𝛿). Hence, for given n and 𝛿, all possible
steady state 𝑘 can be maintained by choosing an 𝑠 in the economy. In a centrally planned
economy, the government may choose a rate of savings 𝑠 to arrive at that steady state 𝑘 that
maximizes consumption per capita in the economy. Such a rate of savings is called the
golden rule level of savings and denoted by 𝑠𝑔𝑜𝑙𝑑 . The steady state 𝑘 that maximizes
consumption per capita is known as golden rule level of capital and is denoted by 𝑘𝑔𝑜𝑙𝑑 .
The corresponding saving rate that generates 𝑘𝑔𝑜𝑙𝑑 steady state per capita capital may be
indicated by 𝑠𝑔𝑜𝑙𝑑 .

The condition for maximum per capita consumption is 𝑀𝑃𝐾 𝑜𝑟 𝑓 ′ (𝑘) = (𝑛 + 𝛿). The
maximum per capita consumption is given by:
𝑐𝑔∗ = 𝑓(𝑘𝑔𝑜𝑙𝑑 ) − (𝑛 + 𝛿)𝑘𝑔𝑜𝑙𝑑

Vertical axis measures per capita output, 𝑦

The above diagram shows different steady state k for different levels of saving ratios. For
example, for saving ratio 𝑠1 , steady state 𝑘 is 𝑘1∗ , for 𝑠2 it is 𝑘2∗ , and for saving ratio 𝑠𝑔𝑜𝑙𝑑 it is
𝑘𝑔𝑜𝑙𝑑 .

4
Technical progress in Solow model:
What happens to the per capita output when there is technical progress. Assume that the
economy witnesses Harrod’s neutral technical progress that increases labour productivity (i.e.
labour augmenting technical progress). The production function then takes the form-
𝑌 = 𝐹[𝐾, 𝐿. 𝐸]
Here, 𝐸 is the index of the technology or the efficiency of labour, and 𝐸 > 0. Notice that
𝐸 appears as a multiple of L.
Assume that 𝐿. 𝐸 = 𝐿̂ = effective labour force; Hence, 𝑌 = 𝐹[𝐾, 𝐿. 𝐸] = 𝐹[𝐾, 𝐿̂]. Divide
both sides of the function by 𝐿̂, giving-
𝑌 𝐾
= 𝐹 [ , 1]
𝐿̂ 𝐿̂
𝑦̂ = 𝑓(𝑘̂)
Here, 𝑦̂ is the output per unit of effective labour unit; 𝑘̂ is the capital per unit of effective
labour unit. Assume that technology or the labour productivity/efficiency grows at the rate
of g, and hence the total decline in 𝑘̂ will be (𝑛 + 𝛿 + 𝑔)𝑘̂ . In steady state, growth of 𝑘̂,
i. e. ∆𝑘̂ = 0. That is at 𝑘̂ ∗ , gross investment per unit of effective labour force equals total
decline in ̂𝑘.
∗ ∗
𝑠. 𝑓(𝑘̂ ) = (𝑛 + 𝛿 + 𝑔)𝑘̂
As explained in the previous section, in steady state, the per capital variables ̂𝑘, 𝑦̂ and 𝑐̂ all
remain unchanged. This implies that 𝑘, 𝑦 and 𝑐 grows at the rate of technical progress 𝑔. (See
the proof below):

Hence, all the per capita variables- 𝑘, 𝑦 𝑎𝑛𝑑 𝑐 − grow at a rate equal to the growth rate of
labour productivity (𝑔) brought about by technological progress. The aggregate variables
𝑌, 𝐶 𝑎𝑛𝑑 𝐾 on the other hand grow at a rate equal to (𝑛 + 𝑔). Note that(𝑛 + 𝑔) is the growth
of the labour force in efficiency units.

5
Proof (optional): that 𝑘, 𝑦 and 𝑐 grows at the rate of technical progress 𝑔
𝐾 𝐾 1 𝑘
̂𝑘 = =( ) =
𝐿. 𝐸 𝐿 𝐸 𝐸
Hence, growth rate of ̂𝑘
𝑘
1 𝑑 ̂𝑘 𝑑(𝑙𝑛 ̂𝑘) 𝑑[ln (𝐸 )] 𝑑[𝑙𝑛𝑘 − 𝑙𝑛𝐸) 1 𝑑𝑘 1 𝑑𝐸
= = = = − = 𝑘𝑔𝑟 − 𝑔
̂𝑘 𝑑𝑡 𝑑𝑡 𝑑𝑡 𝑑𝑡 𝑘 𝑑𝑡 𝐸 𝑑𝑡
1 𝑑 ̂𝑘
= 𝑘𝑔𝑟 − 𝑔
̂𝑘 𝑑𝑡
1 𝑑𝐸 1 𝑑𝑘
Here, 𝑔 = 𝐸 𝑑𝑡 , and assume = 𝑘𝑔𝑟 or growth rate of capital per head. However in
𝑘 𝑑𝑡
𝑑 ̂𝑘
steady state, = 0. Therefore, 0 = 𝑘𝑔𝑟 − 𝑔 or 𝑘𝑔𝑟 = 𝑔. That is, capital per head grows at a
𝑑𝑡

rate equal to 𝑔, the growth rate of labour productivity.

Similarly, for output per unit of effective labour force, ̂𝑦:

𝑌 𝑌 1 𝑦
̂𝑦 = =( ) =
𝐿. 𝐸 𝐿 𝐸 𝐸
Hence, growth rate of ̂𝑦:
𝑦
1 𝑑 ̂𝑦 𝑑(𝑙𝑛 ̂𝑦) 𝑑[ln (𝐸 )] 𝑑[𝑙𝑛𝑦 − 𝑙𝑛𝐸) 1 𝑑𝑦 1 𝑑𝐸
= = = = − = 𝑦𝑔𝑟 − 𝑔
̂𝑦 𝑑𝑡 𝑑𝑡 𝑑𝑡 𝑑𝑡 𝑦 𝑑𝑡 𝐸 𝑑𝑡
1 𝑑 ̂𝑦
= 𝑦𝑔𝑟 − 𝑔
̂𝑦 𝑑𝑡
1 𝑑𝐸 1 𝑑𝑦
Here, 𝑔 = 𝐸 𝑑𝑡 , and assume = 𝑦𝑔𝑟 or growth rate of per capita output. However in
𝑦 𝑑𝑡
𝑑 ̂𝑦
steady state, = 0. Therefore, 0 = 𝑦𝑔𝑟 − 𝑔 or 𝑦𝑔𝑟 = 𝑔. That is, output per unit of labour
𝑑𝑡

grows at a rate equal to 𝑔, the growth rate of labour productivity.

Similarly, for per capita consumption c, it can be showed that it grows at a rate equal to 𝑔.

6
Special note: Population Growth in Solow Model
Population growth alters the basic Solow model (with constant population) in three ways.

First, it brings us closer to explaining sustained economic growth. In the steady state with
population growth, capital per worker and output per worker are constant. Because the
number of workers is growing at rate n, however, total capital and total output must also be
growing at rate n. Hence, although population growth cannot explain sustained growth in the
standard of living (because output per worker is constant in the steady state), it can help
explain sustained growth in total output.

Second, population growth gives us another explanation for why some countries are rich and
others are poor. Consider the effects of an increase in population growth. Figure below shows
that an increase in the rate of population growth from n1 to n2 reduces the steady-state level
of capital per worker from 𝑘1∗ to 𝑘2∗ . Because k* is lower and because y* = f(k*), the level of
output per worker y* is also lower. Thus, the Solow model predicts that countries with higher
population growth will have lower levels of output per person.

Finally, population growth affects our criterion for determining the Golden Rule (consumption-
maximizing) level of capital. With the assumption of constant population, the criterion for
determining golden rule of capital is: 𝑀𝑃𝐾 = . With population growth at 𝑛 rate, the criterion
becomes 𝑀𝑃𝐾 = 𝑛 + .

7
Special note: Saving rate and economic growth in Solow model:
What does the Solow model say about the relationship between saving and economic growth?

Consider what happens to an economy when its saving rate increases. In the Figure below,
the economy is assumed to begin in a steady state with saving rate s1 and capital stock 𝑘1∗ .
When the saving rate increases from s1 to s2, the sf(k) curve shifts upward. At the initial
saving rate s1 and the initial steady state capital stock is 𝑘1∗ . Immediately after the saving rate
rises capital stock will gradually rise until the economy reaches the new steady state rises to
𝑘2∗ (therefore, higher per capita output). The Solow model shows that the saving rate is a key
determinant of the steady-state capital stock. If the saving rate is high, the economy will have
a large capital stock and a high level of output in the steady state. If the saving rate is low,
the economy will have a small capital stock and a low level of output in the steady state.

(Depreciation curve with constant population. We may also incorporate population growth)
Higher saving leads to faster growth in the Solow model, but only temporarily. An increase in
the rate of saving raises growth only until the economy reaches the new steady state. If the
economy maintains a high saving rate, it will maintain a large capital stock and a high level
of output, but it will not maintain a high rate of growth forever. A higher saving rate is said to
have a level effect, because only the level of income per person—not its growth rate—is
influenced by the saving rate in the steady state.
---------------------------
Readings:
A.P. Thirlwall, Growth and Development with special reference to developing economies, 6th
ed. Macmillan
Robert J. Barro, Xavier Sala-i-Martin, Economic Growth, 2nd ed. PHI Learning Pvt. Limited
N. Gregory Mankiew, Macroeconomics, 7th Edition, Worth Publishers, New York