UNIT 2 THE SOLOW MODEL

Structure
2.0 Objectives
2.1 Introduction
2.2 Sources of Economic Growth
2.3 Assumptions of the Solow Model
2.4 Steady State Growth Path
2.4.1 Dynamics of the Model
2.4.2 Steady State Level of Capital
2.4.3 Balanced Growth Path
2.5 Golden Rule Level of Capital Accumulation
2.6 Determinants of Long-run Living Standards
2.6.1 Impact of Increase in Saving Ratio
2.6.2 Impact of Population Growth Rate
2.7 Technological Progress in the Solow Model
2.7.1 Balanced Growth Path
2.7.2 Golden Rule Level of Capital
2.8 Let Us Sum Up
2.9 Answers/Hints to Check Your Progress Exercises

2.0 OBJECTIVES
After going through this unit, you will be in a position to
 explain economic growth with the help of neoclassical growth model;
 outline the implications of the assumptions made in the Solow model;
 determine how steady state growth can be achieved in an economy with an
exogenous population growth rate and technological progress;
 determine the growth of key variables such as output per worker (means per
unit of labour) and capital per worker on the balanced growth path;
 examine the impact of saving rate and population growth on the long run
living standards; and
 comment on the golden rule level of capital.

2.1 INTRODUCTION
The limitations of the Harrod-Domar model prompted many economists to think
further. Recall from the previous Unit that the warranted growth rate in the


Dr. Archi Bhatia, Associate Professor, Department of Economics and Public Policy, Central
University of Himachal Pradesh, Dharamshala.
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Economic Growth Harrod-Domar model was given by the ratio of ‘s’ (saving rate) and capital-
output ratio ‘v’. The razor edge problem came up because s and v are constants,
so that their ratio is a constant, and there is no scope for altering this ratio. In real
life, however, economies do not face such razor edge problems and policy
makers do have certain flexibility. In order to make the Harrod-Domar model
more realistic, economists proceeded on two lines. In a major contribution to
economic growth theory, Robert M. Solow developed the neoclassical model of
economic growth in 1957, for which he was awarded Noble Prize in economic
sciences in 1987. Solow has made a huge contribution to our understanding of
the factors that determine the rate of economic growth for different countries.
Solow extended the Harrod-Domar model by adding labour as a factor of
production, and assuming that capital-output ratio is not constant.
The Solow growth model shows how saving, population growth, and
technological progress affect the level of an economy’s output and its growth
over time. It also explains why national income grows, and why some economies
grow faster than others.
In this Unit, we begin with the assumptions of the model. Subsequently we derive
the steady state growth path. We then introduce the golden rule capital-labour
ratio. We also understand how the changes in the savings rate, population and
technological progress affect the output per person and capital per person in the
steady state. We conclude by discussing implications of the Solow Model for the
economies of the world.

2.2 SOURCES OF ECONOMIC GROWTH

Solow considers an aggregate production function which defines the relationship
between output (Y) and two inputs, viz., capital (K) and labour (L). In symbols, it
is given by
𝑌 = 𝐸𝐹(𝐾, 𝐿) ... (2.1)
where E denotes the level of technology.
In equation (2.1), if the levels of inputs (K and L) are constant and the level of
technology is the same, output will be constant – there will be no economic
growth. For the level of output to grow, either the levels of inputs grow or the
level of technology must improve (that means, there should be ‘technological
progress’ or ‘productivity growth’), or both. Thus growth of output has two
sources, viz., (i) growth in inputs, and (ii) productivity growth. According to
Solow, relationship between the rate of output growth, the rates of input growth,
and productivity growth is
∆ ∆ ∆ ∆
= +𝑎 +𝑎 ... (2.2)

where
∆
= rate of output growth

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∆
= rate of productivity growth The Solow Model

∆
= rate of capital input growth
∆
= rate of labour input growth

𝑎 = elasticity of output with respect to capital

𝑎 = elasticity of output with respect to labour
Equation (2.2) is called the ‘growth accounting equation’. Growth accounting
provides useful information about the sources of growth. It however does not
completely explain a country’s growth performance. Because growth accounting
takes the economy’s rates of input growth as given, it cannot explain why capital
and labour grow at the rates they do. The growth of capital stock is the result of
saving and investment decisions taken by the households and firms, while the
growth of labour depends on population growth. By taking capital stock and
labour as given, growth accounting presents a static picture. In the next section
we take a closer look at the dynamics of economic growth, or how the growth
process evolves over time.

2.3 ASSUMPTIONS OF THE SOLOW MODEL

The main assumptions of the Solow model are as follows:
i) The economy is operates under full employment of inputs.
ii) There is no government interference in the functioning of the economy (it
is a free market economy).
iii) There is no external trade so that it is a “closed economy”.
iv) The economy operates under a neoclassical production function. It
exhibits constant returns to scale. For example, if all factors of production
(K and L in this case) are doubled, output will be exactly doubled. In
notations,
𝑧𝑌 = 𝐹(𝑧𝐾, 𝑧𝐿) ... (2.3)
for any positive number z.
Both capital and labour are essential for production. This production function
allows us to analyze all quantities in the economy relative to the size of the
labour. If we set 𝑧 = in equation (2.3) we get,

=𝐹 ,1 ... (2.4)

The output per worker is a function of capital per worker

Let us define 𝑦 = , output per worker, and = , capital per worker.

Thus we can write the production function given at (2.4) as 𝑦 = 𝐹(𝑘, 1), which
can be re-formulated as
𝑦 = 𝑓(𝑘) … (2.5)

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Economic Growth The production function given as equation (2.5) is assumed to satisfy three
conditions, viz., 𝑓(0) = 0, 𝑓 (𝑘) > 0 𝑎𝑛𝑑 𝑓 " (𝑘) < 0. We interpret these
conditions as follows: First, output is zero when capital per worker is zero.
Second, marginal product of capital per unit of labour is positive. Third, marginal
product of capital per unit of labour increases at a decreasing rate (In other
words, marginal product of capital is positive but it declines as capital per unit of
labour increases). The production function given at (2.5) above is shown in Fig.
2.1. You can observe that the production function has a positive slope but it
becomes flatter as the amount of capital per worker increases, indicating that it
exhibits diminishing returns. When k is low, the average worker has very little
capital to work with, so an extra unit of capital is very useful and produces a lot
of additional output. When k is high, the average worker has a lot of capital
already, so an extra unit of capital increases production only slightly.

Output Fig. 2.1: Neoclassical Production Function

per
worker, 𝑦
Output, 𝑓(𝑘)

MPK

1 unit

Capital per worker, 𝑘

Fig. 2.1 shows that the output per worker depends on capital per worker.
The slope of the production function, marginal product of capital – is
positive but becomes flatter as 𝑘 increases, exhibiting diminishing returns
to capital per worker.

v) Growth of labour input is exogenously determined (given from outside

the model) at a constant rate of n. In notations,
𝑛= , ̇
= 𝐿(𝑡) ... (2.6)

vi) and Technology, E (which we will introduce later) and g respectively. ,

and 𝑔 = and = 𝐸(𝑡) ̇

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vii) The Solow model assumes that each year people save – a fraction s of The Solow Model
their income and consume a fraction (1–s). The saving rate is fixed. The
consumption function can be expressed as
𝑐 = (1 − 𝑠)𝑦 ....(2.7)
viii) The capital stock depreciates at a constant rate δ every period. Change in
capital stock between one period and the next depends on Investment
which raises the capital stock and depreciation, which wears out the
capital stock.
Change in capital Stock = Investment – Depreciation
𝐾 (̇ 𝑡) = 𝐼 − 𝛿𝐾(𝑡) , 𝐾(̇ 𝑡) = ...(2.8)

The higher the capital stock, the greater is the amount of depreciation.
Check Your Progress 1
1) State the properties of the production function used in the Solow model.
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2) Describe the growth accounting equation.

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2.4 STEADY STATE GROWTH PATH

The demand for goods comes from consumption and investment.
𝑦 =𝑐+𝑖 ...(2.9)
This is the national income identity for a closed economy with no government
purchases. The goal is to determine the saving rate which is desirable. Substitute
for c from equation (2.7) in equation (2.9)
𝑦 = (1 − 𝑠)𝑦 + 𝑖 ...(2.10)
We get, 𝑖 = 𝑠𝑦 ...(2.11)
This equation shows that investment equals saving. Thus the rate of saving s is
also the fraction o output devoted to investment. Let us substitute 𝑦 = 𝑓(𝑘) in
equation (2.11). This gives us
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Economic Growth 𝑖 = 𝑠𝑓(𝑘) ...(2.12)
Equation (2.12) expresses investment per worker, 𝑖, as a function of the capital
stock per worker, 𝑘. Fig. 2.2 shows for any given capital stock, , the production
function 𝑦 = 𝑓(𝑘) determines how much output the economy produces, and the
saving rate 𝑠 determines the allocation of that output between consumption per
worker 𝑐 and investment per worker 𝑖 .
Output
per Fig. 2.2: Output, Consumption and Investment
worker, 𝑦

Output, 𝑓(𝑘)

𝑦, output

per worker

𝑐, consumption
per worker

Investment, 𝑠𝑓(𝑘)

𝑖, investment per
worker

Capital per worker, 𝑘

The saving rate 𝑠 determines the allocation of output between
consumption and investment. For any level of capital 𝑘, output is 𝑓(𝑘),
investment is 𝑠𝑓(𝑘), and consumption is 𝑓(𝑘) − 𝑠𝑓(𝑘).

2.4.1 Dynamics of the Model

We want to determine the behaviour of the economy we have just described.
Labour is exogenous and not determined within the model. Thus to characterize
the behaviour of the economy we must analyze the behaviour of the other input,
capital.
k= , we can use the chain rule to find
(̇ ) ( )
𝑘 (𝑡̇ ) = − ̇
∗ 𝐿(𝑡) ...(2.13)
( ) ( )

(̇ ) ( ) (̇ )
𝑘 (𝑡̇ ) = − ∗ ...(2.14)
( ) ( ) ( )

(̇ )
̇ from equation 2.8 and
Substitute for 𝐾(𝑡) = 𝑛 from equation (2.6) in
( )
equation (2.14)
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 ̇ = ( ) ( )
𝑘(𝑡) − ∗𝑛 ...(2.15) The Solow Model
( ) ( )

Substitute = 𝑖 𝑎𝑛𝑑 = 𝑘 in equation (2.15)

𝑘(𝑡̇ ) = 𝑖 − 𝛿𝑘 − 𝑛𝑘 ...(2.16)
Substitute 𝑖 from (2.12) into equation (2.16)
𝑘(𝑡̇ ) = 𝑠𝑓 (𝑘 ) − (𝛿 + 𝑛)𝑘 ...(2.17)
Equation (2.17) is the key equation of the Solow model. It states that the rate of
change of the capital stock per unit of labour is the difference between two terms.
The first, 𝑠𝑓(𝑘), is the actual investment per unit of labour: output per unit of
labour 𝑓 (𝑘 ) and the fraction of that output that is invested is 𝑠. The second term,
(𝛿 + 𝑛)𝑘, is break-even investment, the amount of investment that must be done
to keep 𝑘 at its existing level. There are two reasons that some investment is
needed to prevent 𝑘 from falling. First, existing capital is depreciating; this
capital must be replaced to keep the capital stock from falling. This is the 𝛿𝑘
term in equation (2.17). Second the quantity of labour is growing. Since the
quantity of labour is growing at rate n, the capital stock must grow at rate n to
hold 𝑘 steady. This is the 𝑛𝑘 term in equation (2.17). This is the amount of
investment necessary to provide new workers, 𝑛 with capital. The equation shows
that population growth reduces the accumulation of capital per worker much the
way depreciation does. When actual investment per unit of labour exceeds the
investment needed to break-even, k is rising. When actual investment falls short
of the break-even investment, k is falling. And when the two are equal, k is
constant.
2.4.2 Steady State Level of Capital
A steady state is a situation in which the economy’s output per worker, 𝑦,
consumption per worker 𝑐 and capital stock per worker 𝑘 are constant. To explain
how the Solow model works, we first examine the characteristics of a steady state
and then discuss how economy might attain it. In Fig. 2.3, there is a single capital
stock 𝑘 ∗ at which the amount of investment equals the amount of depreciation
and the amount of investment necessary to provide new workers, 𝑛 with capital.
If the economy finds itself at this level of the capital stock, the capital stock will
not change because the two opposing forces acting on it –investment and
(depreciation and population growth) – just balance. That is, at 𝑘 ∗ , 𝑘̇ = 0 , so the
capital stock per worker 𝑘 and output per worker 𝑓(𝑘) are steady over time
(rather than growing or shrinking). We therefore call 𝑘 ∗ the steady state level of
capital.
The definition of an equilibrium is a positive value of 𝑘, denoted by 𝑘 ∗ such that
𝑘̇ = 0. This is called the steady state. There is a corresponding value of output
per worker , denoted by 𝑦 ∗ such that 𝑦̇ = 0. The steady state value of 𝑘 ∗ is solved
from equation (2.17).
0 = 𝑠𝑓(𝑘 ∗ ) − (𝛿 + 𝑛)𝑘 ∗ …(2.18)

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Economic Growth Then 𝑦 ∗ is solved from
𝑦 ∗ = 𝑓(𝑘 ∗ )
The steady state is significant for two reasons. As we have just seen, an economy
at the steady state will stay there. In addition, and just as important, an economy
not at the steady state will go there. That is, regardless of the level of capital with
which the economy begins, it ends up with the steady-state level of capital. In
this sense, the steady state represents the long-run equilibrium of the economy.

Fig. 2.3: Steady State Level in the Solow Model

Break-even
Investment Investment,
(𝛿 + 𝑛)𝑘

Actual Investment,
𝑠𝑓(𝑘)

𝑘 𝑘∗ 𝑘 Capital per worker, 𝑘

Steady State
The steady state level of capital 𝑘 ∗ is the level at which investment equals
break-even investment (𝛿 + 𝑛)𝑘. Below 𝑘 ∗ , i.e., at 𝑘 capital stock
increases because investment exceeds depreciation and population
growth. At 𝑘 , capital stock shrinks. An economy always ends up at the
steady state level, 𝑘 ∗ .

To see why an economy always ends up at the steady state, suppose that the
economy starts with less than the steady-state level of capital, such as level 𝑘 in
Fig. 2.3. In this case, the level of investment exceeds the break-even investment
(depreciation and population growth). Over time, the capital stock will rise and
will continue to rise, along with output 𝑓(𝑘) until it approaches the steady state
𝑘 ∗ . Similarly, suppose that the economy starts with more than the steady-state
level of capital, such as level 𝑘 . In this case, investment is less than break-even
investment; capital is reducing faster than it is being replaced. The capital stock
will fall, again approaching the steady-state level. Once the capital stock reaches
the steady state, investment equals depreciation and population growth, and there
is no pressure for the capital stock to either increase or decrease.
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Fig. 2.4 summarizes this information in the form of a phase diagram, which The Solow Model
shows 𝑘̇ as a function of 𝑘. If 𝑘 is initially less than 𝑘 ∗ , actual investment
exceeds break-even investment and so 𝑘̇ is positive- that is 𝑘 is rising. If 𝑘
exceeds 𝑘 ∗ , 𝑘̇ is negative- that is 𝑘 is falling. Finally if 𝑘 equals 𝑘 ∗ , 𝑘̇ is zero.
Thus regardless of where 𝑘 starts, it converges to 𝑘 ∗ .

𝑘̇ Fig. 2.4: Phase Diagram for 𝒌 in the Solow Model

𝑘
𝑘̇ < 0,

0
Capital per worker, 𝑘
𝑘̇ > 0, k 𝑘∗

The phase diagram above shows that the steady-state, which is unique,
is also stable: it will be reached in the long-run, i.e., asymptotically.
When 𝑘 is less than steady state level 𝑘 ∗ , rate of change in capital per worker
is positive, 𝑘̇ > 0 and capital stock per worker 𝑘 increases to reach 𝑘 ∗ .

2.4.3 Balanced Growth Path

In the steady state with population growth, capital per worker and output per
worker are constant. Because the number of workers is growing at the rate 𝑛,
total output and total capital must also be growing at the rate 𝑛.
𝑌 𝐾
𝑦= , 𝑘=
𝐿 𝐿
Additionally, in the steady state
𝑦̇ = 0 and 𝑘̇ = 0
Differentiating 𝑘 with respect to time
= − ...(2.19)

= − ...(2.20)

= − ...(2.21)

In the steady state = 0 , and = 𝑛 . Putting this in equation 2.21

=𝑛 ...(2.22)
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Economic Growth Similarly differentiating 𝑦 with respect to time
= − ...(2.23)

= − ...(2.24)

= − ...(2.25)

In the steady state = 0 , and = 𝑛 . By substituting these values in equation

(2.25), we obtain
=𝑛 ...(2.26)

In the steady state output and capital stock grows at the rate of population
growth, while output per worker and capital per worker remain constant. Thus
the Solow model implies that, regardless of its starting point, the economy
converges to a balanced growth path- a situation where each variable of the
model grows at the rate exogenously given by the population growth.

2.5 THE GOLDEN RULE LEVEL OF CAPITAL

ACCUMULATION
If we were to introduce households into the model, their welfare would depend
not on output but on consumption: investment is simply an input into production
in the future. Thus for many purposes we are likely to be more interested in the
behavior of consumption than in the behavior of output. A benevolent
policymaker would thus want to choose the steady state with the highest level of
consumption. The steady-state value of 𝑘 that maximizes consumption is called
the Golden Rule level of capital and is denoted 𝑘 ∗ . National income accounts
identity
𝑦 =𝑐+𝑖 …(2.19)
Consumption per worker is
𝑐 =𝑦−𝑖 …(2.20)
Because steady state output is 𝑓(𝑘 ∗ ) and steady state investment is (𝛿 + 𝑛)𝑘 ∗ at
the break-even investment 𝑘 ∗ ; we can express the steady state consumption as
𝑐 = 𝑓(𝑘 ∗ ) − (𝛿 + 𝑛)𝑘 ∗ ...(2.21)
This equation shows that an increase in steady-state capital has two opposing
effects on steady-state consumption. On the one hand, more capital means more
output. On the other hand, more capital also means that more output must be used
to replace capital that is wearing out and equip new workers with high level of
capital. Fig. 2.5 graphs steady-state output and steady-state break-even
investment as a function of the steady-state capital stock.
Steady-state consumption is the gap between output and break-even investment.
This figure shows that there is one level of the capital stock—the Golden Rule
level 𝑘 ∗ that maximizes consumption. If the capital stock is below the Golden
Rule level, an increase in the capital stock raises output more than break-even
investment, so consumption rises. In this case, the production function is steeper
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than the (𝛿 + 𝑛)𝑘 ∗ line, so the gap between these two curves—which equals The Solow Model
consumption—grows as 𝑘 ∗ rises. By contrast, if the capital stock is above the
Golden Rule level, an increase in the capital stock reduces consumption, because
the increase in output is smaller than the increase in break-even investment. In
this case, the production function is flatter than the (𝛿 + 𝑛)𝑘 ∗ line, so the gap
between the curves—consumption—shrinks as 𝑘 ∗ rises. At the Golden Rule level
of capital, the production function and the (𝛿 + 𝑛)𝑘 ∗ line have the same slope,
and consumption is at its greatest level. Panel b shows consumption per worker
depends on the capital per worker. An increase in capital per worker till the
Golden rule level raises consumption per worker. A further increase in capital per
worker shrinks consumption per worker. The fundamental reason for this
outcome is the dimishing marginal productivity of capital-that is, the larger the
capital stock already is, the smaller the benefit from expanding the capital stock
further. The golden rule level of capital per worker ratio 𝑘 ∗ is given by the
condition
𝑓 ′ (𝑘 ∗ ) = 𝛿 + 𝑛 ...(2.22)
𝑓 ′ (𝑘 ∗ ) − 𝛿 = 𝑛 ...(2.23)
Equation (2.23) implies that marginal productivity of capital, net of depreciation,
equals population growth rate at the golden rule level.

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Economic Growth Check Your Progress 2
1) Explain the dynamics of the Solow Model?
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2) Explain how does an economy always ends up at the steady state?
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3) Explain the condition required to attain Golden rule level of capital.

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2.6 THE FUNDAMENTAL DETERMINANTS OF

LONG-RUN LIVING STANDARDS
What determines how well off the average person in an economy will be in the
long run? We can use the Solow model to answer this question. Here, we discuss
three factors that affect long-run living standards: the saving rate, population
growth and productivity growth.
2.6.1 The Impact of Growth in the Saving Rate
According to the Solow model, a higher saving rate implies higher living
standards in the long run, as illustrated in Fig. 2.6. Suppose that the initial saving
rate is 𝑠 so that saving per worker is 𝑠 𝑓(𝑘). The saving curve when saving
curve when the saving rate is 𝑠 is labelled “Initial saving per worker”. The initial
steady state capital-labour ratio, 𝑘 ∗ , is the capital labour ratio at which initial
saving curve and the break-even investment line cross (point A). Suppose now
that the government introduces policies that strengthen the incentives for saving,
causing the country’s saving rate to rise from 𝑠 to 𝑠 . The increased saving rate
raises saving at every level of the capital-labour ratio. Graphically, the saving
curve shifts upwards fom 𝑠 𝑓(𝑘) to 𝑠 𝑓(𝑘) . The new steady-state capital-labour
ratio, 𝑘 ∗ , corresponds to the intersection of the new saving curve and the break-
even investment line (point B). Because 𝑘 ∗ is larger than 𝑘 ∗ , the higher saving
rate has increased the steady-state capital-labour ratio. Gradually, this economy
will move to the higher steady state capital-labour ratio, as indicated by the

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arrows on the horizontal axis. In the new steady state, output per worker 𝑦, and The Solow Model
consumption per worker 𝑐 will be higher than in the original steady state.
Higher saving rate 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 growth rate forever. A
higher saving rate is said to have a level effect because only the level of output
per person- and not its growth rate- is influenced by the saving rate in the steady
state.

2.6.2 The Impact of Growth in the Population Rate

What is the relationship between population growth and a country’s level of
development as measured by output, consumption and capital per worker? The
Solow model’s answer to this question is shown in Fig. 2.7. An initial steady
state capital-labour ratio, 𝑘 ∗ corresponds to the intersection of the break-even
investment line and the saving curve at point A. Now suppose that the rate of
population growth which is same as the rate of labour force growth increases
from an initial level 𝑛 to 𝑛 . What will happen to living standards?
An increase in population growth rate means that workers are entering the labour
force more rapidly than before. These new workers must be equipped with
capital. Thus, to maintain the same steady-state capital-labour ratio, the amount
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Economic Growth of investment per current member of workers must rise. Algebraically, the rise in
𝑛 increases investment per worker from (𝛿 + 𝑛 )𝑘 to (𝛿 + 𝑛 )𝑘 .
This increase in the population growth rate causes the break-even investment line
to pivot up and to the left (i.e., be steeper), as its slope rises from (𝛿 + 𝑛 ) to
(𝛿 + 𝑛 ) .
After the pivot of the break-even investment line, the new the steady state is at
point B. The new steady-state capital-labour ratio is 𝑘∗ , which is lower than the
original capital-labour ratio, 𝑘 ∗ . Because the new steady state capital-labour ratio
is lower, the new steady state output per worker and consumption per worker will
be lower as well.
Thus the Solow model implies that increased population growth will lower living
standards. The basic problem is that when the work-force is growing rapidly, a
large part of current output must be diverted just to providing capital for the new
workers to use. This result suggests that policies to control population growth
will indeed improve living standards. Notice that a change in the population
growth rate, like a change in the saving rate, has a level effect on output per
person, but does not affect the steady-state growth rate of output per person.

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2.7 TECHNOLOGICAL PROGRESS IN SOLOW The Solow Model

MODEL
In the model so far, when the economy reaches its steady state. Output per
worker stops growing. To explain persistent growth, we need to introduce
technological progress into the model. The model can be modified to include
exogenous technological progress, which over time expands society’s production
capabilities. We now write the production function as
𝒀 = 𝑭(𝑲, 𝑳 × 𝑬) ...(2.24)
Where E is a new (and somewhat abstract) variable called the efficiency of
labour. The term (𝑳 × 𝑬) can be interpreted as measuring the effective number of
workers. It takes into account the number of actual workers L and the efficiency
of each worker E. This new production function states that total output Y depends
on the inputs of capital K and effective workers, 𝑳 × 𝑬. We assume that
technological progress causes the efficiency of labour 𝑬 to grow at some constant rate
𝒈, which is exogenously given.

=𝑔 ...(2.25)

This form of technological progress is called labour augmenting, and 𝑔 is called

the rate of labour-augmenting technological progress. Because the labour force
L is growing at rate n, and the efficiency of each unit of labour E is growing at
rate 𝑔, the effective number of workers 𝑳 × 𝑬 is growing at rate 𝑛 + 𝑔 . We now
analyze the economy in terms of quantities per effective worker. We now let
= , stand for capital per effective worker and 𝑦 = stand for output
( × ) ( × )
per effective worker.. With these definitions, we can again write 𝑦 = 𝑓(𝑘).
k= , we can use the chain rule to find
×
(̇ ) ( ) ( )
𝑘(𝑡̇ ) = − ∗ 𝐿(𝑡̇ ) − ( ) ( )
∗ 𝐸 (𝑡̇ ) ...(2.26)
( ) ( ) ( ) ( )

̇ = (̇ ) ( ) (̇ ) ( ) (̇ )
𝑘(𝑡) − ∗ − ∗ ...(2.27)
( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )

(̇ )
̇ from equation 2.8 and
Let us substitute for 𝐾(𝑡) = 𝑛 from equation 2.6 and
( )
(̇ )
= 𝑔 from equation (2.25) in equation (2.27). This gives us
( )
( ) ( ) ( )
𝑘(𝑡̇ ) = − ∗𝑛− ∗𝑔 ...(2.28)
( ) ( ) ( ) ( ) ( ) ( )

Substitute = 𝑖 and = 𝑘 in equation (2.28)

× ×

𝑘(𝑡̇ ) = 𝑖 − 𝛿𝑘 − 𝑛𝑘 − 𝑔𝑘 ...(2.29)
By substituting 𝑖 = 𝑠𝑓(𝑘) into equation (2.29), we obtain
𝑘(𝑡̇ ) = 𝑠𝑓 (𝑘 ) − (𝛿 + 𝑛 + 𝑔)𝑘 ...(2.30)

37
Economic Growth Equation (2.30) shows the evolution of capital per unit of effective worker, k .
̇ equals investment 𝑠𝑓(𝑘) minus the break-even
The change in capital stock, 𝑘(𝑡)
investment (𝛿 + 𝑛 + 𝑔)𝑘. Break-even investment includes three terms: to keep
𝑘 constant, 𝛿𝑘 is needed to replace depreciating capital, 𝑛𝑘 is needed to provide
capital for new workers, and 𝑔𝑘 is needed to provide capital for the new
“effective workers” created by technological progress.
The steady state value of 𝑘 ∗ is solved from equation 2.30 by putting 𝑘(𝑡)̇ = 0.
We drop the time-subscripts, t as output per effective worker and capital per unit
of effective labour are constant in the steady state.
Thus, we obtain
0 = 𝑠𝑓(𝑘 ∗ ) − (𝛿 + 𝑛 + 𝑔)𝑘 ∗ …(2.31)
Then 𝑦 ∗ is solved from
𝑦 ∗ = 𝑓(𝑘 ∗ )
In the steady state, capital per unit of effective labour 𝑘 ∗ is given by
𝑠𝑓(𝑘 ∗ ) = (𝛿 + 𝑛 + 𝑔)𝑘 ∗ …(2.32)
As before, in the steady state, investment equals the break-even investment. As
shown in Fig. 2.8 there is one level of k, denoted by 𝑘 ∗ , at which capital per
effective worker and output per effective worker are constant. As before, this
steady state represents the long-run equilibrium of the economy.
Break-even
Investment, Investment,
Fig. 2.8: Technological Progress and
break-even the Solow Model (𝛿 + 𝑛 + 𝑔)𝑘
investment

Actual Investment,
𝑠𝑓(𝑘)

𝑘 ∗ Capital per effective worker, 𝑘

steady state

The break-even investment now equals (𝛿 + 𝑛 + 𝑔)𝑘. In the steady state

investment 𝑠𝑓(𝑘)exactly offsets the reductions in 𝑘 attributable to
depreciation, population growth and technological progress.

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2.7.1 Balanced Growth Path The Solow Model

By assumption, we have
𝑌 𝐾
𝑦= ,𝑘 =
𝐸×𝐿 𝐸×𝐿
Additionally, in the steady state, 𝑦̇ = 0 and 𝑘̇ = 0.
Differentiating 𝑘 with respect to time, we obtain
= − − ...(2.33)
× × ×

= − − ...(2.34)
×

= − − ...(2.35)

In the steady state = 0 , and =𝑛 , = 𝑔 . By substituting this in

equation (2.35), we obtain
=𝑛+𝑔 ...(2.36)

Similarly, by differentiating 𝑦 with respect to time, we obtain

= − − ...(2.37)
× × ×

= − − ...(2.38)

= − − ...(2.39)

In the steady state, = 0 , and =𝑛 , = 𝑔 . Putting this in equation

(2.39)
=𝑛+𝑔 ...(2.40)

From equations (2.36) and (2.40), we now know that in the steady-state, the
growth rates of the aggregate capital stock 𝐾 and aggregate output 𝑌 are each in
equality with the sum of the technology growth rate and population growth rates.
= = 𝑛+𝑔

Alternatively,
− 𝑛 = 𝑔 , and − 𝑛=𝑔 ...(2.41)

The growth rates of the capital stock per labour and of output per labour are
each equal to the technology growth rate. The economy in the long run converges
to the balanced growth path. On the balanced growth path, the growth rate of
output per worker is solely determined by the growth rate of technological
progress.
With the addition of technological progress, our model can finally explain the
sustained increases in standards of living that we observe. That is, we have
39
Economic Growth shown that technological progress can lead to sustained growth in output per
worker. By contrast, a high rate of saving leads to a high rate of growth only until
the steady state is reached. Once the economy is in steady state, the rate of
growth of output per worker depends only on the rate of technological progress.
According to the Solow model, only technological progress can explain sustained
growth and persistently rising living standards.
2.7.2 The Golden Rule Level of Capital
The Golden Rule level of capital is now defined as the steady state that
maximizes consumption per effective worker. Following the same arguments that
we have used before, we can show that steady-state consumption per effective
worker is
𝑐 = 𝑓(𝑘 ∗ ) − (𝛿 + 𝑛 + 𝑔)𝑘 ∗ ...(2.42)
Steady state consumption is maximized, if
𝑓 ′ (𝑘 ∗ ) = 𝛿 + 𝑛 + 𝑔 ...(2.43)
𝑓 ′ (𝑘 ∗ ) − 𝛿 = 𝑛 + 𝑔 ...(2.44)
Equation (2.44) implies that, at the Golden Rule level of capital, the net marginal
product of capital, (𝑀𝑃𝐾 − 𝛿), equals the rate of growth of total output (𝑛 + 𝑔).
Table 2.1 The Fundamental Determinants of Long-Run Living Standards

An increase in Causes long run Reason

output, capital and
consumption per
worker to

The saving rate, s Rise Higher saving allows for more

investment and a larger capital
stock

The rate of population Fall With higher population

growth, 𝑛 growth, more output must be
used to equip new workers
with capital, leaving less
output available for
consumption or to increase
capital per worker

The rate of technological Rise Higher productivity directly

progress, 𝑔 increases output. It also raises
savings and the capital stock.

40
Check Your Progress 3 The Solow Model

1) Why an increase in saving rate has only level effect on output per worker?
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

2) Explain how an increase in population growth from 𝑛 to 𝑛 affect the

long-run level of capital and output per worker.
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
3) Explain how an increase in the rate of technological progress results in a
sustained increase in the standards of living.

.......................................................................................................................
.......................................................................................................................
.......................................................................................................................
.......................................................................................................................

2.8 LET US SUM UP

The Solow model of economic growth is a unique and splendid contribution to
economic growth theory. It establishes the stability of the steady-state growth
through a very simple and elementary adjustment mechanism. In this unit we
have learned that in the Solow growth model saving, population growth and
technological progress interact in determining the level and growth of a country’s
standard of living. In the steady state of the Solow growth model, the growth rate
of output per person is equal to the growth rate of capital per worker. Both these
growth rates are solely determined by the exogenous rate of technological
progress 𝑔. The Golden rule (consumption maximizing) steady state is
characterized by equality between the net marginal product of capital (𝑀𝑃𝐾 − 𝛿)
and the steady state growth rate of total income (𝑛 + 𝑔). There are two
determinants of long run growth in the Solow model- a increase in the saving rate
and a fall in the population growth rate. An economy’s rate of saving determines
the size of its capital stock and thus its level of production. The higher the rate of
saving, the higher the stock of capital and the higher the level of output. An
economy’s rate of population growth is another long-run determinant of the
standard of living. According to the Solow model, the higher the rate of
population growth, the lower the steady-state levels of capital per worker and

41
Economic Growth output per worker. However, both the changes in saving rate and population rate
have level affect output per person but do not affect the steady state growth rate
of output per person. It is only the technological progress which can lead to
sustained growth in output per worker.

2.9 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) The production function has a positive slope but it becomes flatter as the
amount of capital increases, indicating that it exhibits diminishing returns.
2) The relationship between the rate of output growth and the rates of input
growth and productivity growth is called the growth accounting equation.
Check Your Progress 2
1) 𝑘 (𝑡̇ ) = 𝑠𝑓(𝑘) − (𝛿 + 𝑛)𝑘 ,
The above equation is the key equation of the Solow model. It states that
the rate of change of the capital stock per unit of labour is the difference
between two terms. The first, 𝑠𝑓 (𝑘 ), is the actual investment per unit of
labour and the second term, (𝛿 + 𝑛)𝑘, is break-even investment.
2) Refer to Fig. 2.3. Suppose that the economy starts with less than the
steady-state level of capital, such as level 𝑘 . In this case, the level of
investment exceeds the break-even investment (depreciation and
population growth). Over time, the capital stock will rise and will
continue to rise, along with output 𝑓(𝑘) until it approaches the steady
state 𝑘 ∗ .
3) The golden rule level of capital per worker ratio 𝑘 ∗ is given by the
condition
𝑓 ′ (𝑘 ∗ ) = 𝛿 + 𝑛
Check Your Progress 3
1) A higher saving rate is said to have a level effect because only the level of
output per person- and not its growth rate- is influenced by the saving rate
in the steady state.
2) According to the Solow model, the higher the rate of population growth, the
lower the steady-state levels of capital per worker and output per worker. Refer
to Fig. 2.7
3) The economy in the long run converges to the balanced growth path. On
the balanced growth path, the growth rate of output per worker is solely
determined by the growth rate of technological progress.

42