Chapter 6

The Sources of
Growth and the
Solow Model
 Economic Growth Around the
World

• Since 1960, the United States has remained

the richest country with steady economic
growth
• Convergence occurred when different with
different initial levels of per capita income
gravitated to a similar income level
• Some “growth miracle” countries in Asia
have shown “convergence big time”
• Some African countries (Kenya, Nigeria)
have experienced a “growth disaster”
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 FIGURE 6.1 Real Per Capita GDP in
Ten Countries

Note: The vertical axis in this

figure is a ratio scale in which
equal distances reflect the same
percentage change, so that the
slope of a curve indicates how
fast an economy is growing.

Source: Penn World Tables in

Federal Reserve Bank of St.
Louis, FRED Database.
http://research.stlouisfed.org/fre
d2/

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 Building Blocks of the Solow Growth
Model

• The Cobb-Douglas aggregate production

function with constant returns scale (recall
Chapter 3):
Yt = F(Kt, Lt) = AKt0.3Lt0.7
where
Yt = output at time t
Kt = capital stock at time t
Lt = labor at time t
A = available technology, total factor productivity

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 Building Blocks of the Solow Growth
Model (cont’d)

• Given a fixed level of labor (L), the Solow

model can be expressed in per-worker
terms:
Yt
yt  (output per worker)
Lt
Ct
ct  (consumption per worker)
Lt
It
it  (investment per worker)
Lt
Kt
kt  (capital per worker or capital - labor ratio)
Lt
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 Building Blocks of the Solow Growth
Model (cont’d)

• Production function in per-worker form:

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 Building Blocks of the Solow Growth
Model (cont’d)

• Assuming a closed economy and that

government spending is zero, the total
demand for output is:
yt  ct  it

• Further assume the saving rate (s) is a fixed

fraction of income, so that saving is:

yt  ct  syt

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 Building Blocks of the Solow Growth
Model (cont’d)

• The output demand equation means it  yt  ct

so that:
it  syt

• Substituting the per worker production

function into the above equation gives an
investment function, which relates per
capita investment to per capita capital
stock: 0.3
it  sAkt
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 Building Blocks of the Solow Growth
Model (cont’d)

• The capital stock is determined by: it  yt  ct

– Investment
– Depreciation
• The Solow model assumes the depreciation
rate as a constant fraction  of capital
• Capital-accumulation equation shows the
change in the capital stock per worker:
kt = it   kt
Change in capital = Investment  Depreciation
stock per worker per worker per worker

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 Building Blocks of the Solow Growth
Model (cont’d)

• Substituting in for investment from the

investment function, the capital-accumulation
equation becomes:
kt  sAk t
0.3
  kt

• The steady state occurs when kt  0 so that:

sAkt0.3   kt
Investment = Depreciation

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 Dynamics of the Solow Model

• The steady-state level of capital per worker is

k* in the Solow diagram (Figure 6.3)
• If an economy’s initial capital-labor ratio is at
k1, then kt>0 so that kt rises over time until
kt=k*
• If an economy’s initial capital-labor ratio is at
k2, then kt<0 so that kt falls over time until
kt=k*
• Output per worker also moves its steady-state
value y*(point S in Figure 6.4) as kt moves
toward its steady-state value
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 FIGURE 6.4 Output and Consumption
in the Solow Model

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 Dynamics of the Solow Model
(cont’d)
• Because ct = (1-s)yt, consumption per
worker also reaches its steady state ct = c*
when yt = y*
• The steady state at k*, c*, and y* is where
the economy will move to and stay if it
initially starts away from the steady state at
kt= k*
• In other words, the steady state is where
the economy converges to in the long run
and so is the long-run equilibrium for the
economy
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 FIGURE 6.6 Evidence on
Convergence, 1960-2012 (a)

Sources: Penn World Tables. http://pwt.econ.upenn.edu/php_site/pwt_index.php; and The World Bank.

World Development Indicators. http://data.worldbank.org/data-catalog

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 FIGURE 6.6 Evidence on
Convergence, 1960-2012 (b)

Sources: Penn World Tables. http://pwt.econ.upenn.edu/php_site/pwt_index.php; and The World Bank.

World Development Indicators. http://data.worldbank.org/data-catalog

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 Saving Rate Changes in the
Solow Model

• Suppose s increases when the economy is

at its steady state:
– The increase in saving results in higher steady-
state levels of capital and output per worker
– Changes in the saving rate affect the level of
capital and output per worker, but not the long-
run growth rate of these variables

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 Saving Rate Changes in the
Solow Model (cont’d)

• Assuming that the ratio of workers to the

population is similar across countries, then:
– the higher is a country’s national saving rate
and hence the higher is its level of investment
relative to income, the higher is its per capita
income

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 FIGURE 6.7 Response to an Increase
in the Saving Rate (a)

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 FIGURE 6.8 International Evidence on the
Relationship of Per Capita Income and the
Saving Rate

Sources: Penn World Tables in Federal Reserve Bank of St. Louis, FRED Database. http://research.stlouisfed.org/fred2/; and
The World Bank. World Development Indicators. http://data.worldbank.org/data-catalog

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 Population Growth in the Solow
Model

• Suppose population growth and thus the

size of the labor force increases at a rate of
n over time when the capital stock is kept
constant
• As the growth in labor force leads to less
capital per worker, capital dilution (nkt)
occurs in the capital-accumulation equation:
kt  sAkt0.3  kt  nkt
 sAkt0.3  (  n)kt

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 Population Growth in the Solow
Model (cont’d)

• Given the population growth rate at n, the

depreciation term in the steady state equation
is now dn
• In the Solow diagram, the steady-state level of
the capital-labor ratio k* is now at the
intersection of the investment function and the
(d+n)kt line
– If kt<k*, then investment is greater than
(d+n)kt and so kt rises
– If kt>k*, then investment is less than (d+n)kt
and so kt falls

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 FIGURE 6.9 Solow Diagram with
Population Growth

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 Changes in Population Growth

• If population growth rises, the depreciation

and capital dilation line shifts up
• The Solow model indicates that in the
steady state, higher population growth
lowers the level of output per person

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 FIGURE 6.10 Response to a Rise in
the Population Growth Rate (a)

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 Population Growth and Real GDP Per
Capita

• The Solow model predicts that higher

population growth makes the average
person in a country poor
• A scatter plot of personal GDP per capita
against population growth rates in nearly
100 countries provides support for this
proposition

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 FIGURE 6.11 International Evidence on the
Relationship of Population Growth and
Income Per Capita

Source: The World Bank. World Development Indicators. http://data.worldbank.org/data-catalog

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 Policy and Practice: China’s One-Child
Policy and Other Policies to Limit Population
Growth

• Many poor countries have implemented

policies to limit population growth
• Starting in 1979, the government in China
implemented a “one-child” policy, in which
couples with more than one child in China
were ostracized, charged penalties, and
denied access to preferential housing and
wage hikes.
• This policy lowered fertility rates by over
70%
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 Productivity Growth In The
Solow Model

• To understand why economies can

experience sustained increases in the
standard of living over time, the Solow
model need to include growth in
productivity, A

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 Technology Growth and the Steady
State

• Higher productivity means an upward shift

of the investment function it  sAkt0.3 ,
resulting in higher output at each level of kt
• Results: The direct effect of higher
productivity on output per person is
amplified by the additional positive affect
from a higher capital-labor ratio

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 FIGURE 6.12 Response to a Rise in
Productivity (a)

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 FIGURE 6.12 Response to a Rise in
Productivity (b)

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 Summing Up the Solow Model

• The results of the Solow model:

1. Economies with similar production functions and
saving rates that have low (high) initial per capita
income will have higher (lower) growth rates
2. A higher rate of saving leads to higher levels of
capital and output per worker, but does not affect
the long-run growth rate of these variables
3. Higher population growth lowers the level of output
per person
4. Increases in productivity are amplified in generating
output because there is a direct effect through the
production function and an additional positive affect
from a higher capital-labor ratio
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 Summing Up the Solow Model
(cont’d)

• Limitations of the Solow model:

1. The model does a poor job explaining sustained
increases in the standard of living
2. Productivity growth is the only factor that
explains sustained growth in standards of
living, but it is an exogenous variable that is
not explained by the model

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 Sources of Economic Growth:
Growth Accounting

• The growth accounting equation is the

aggregate production function in terms of the
growth rate of the variables:
gY = gA + 0.3gK + 0.7gL
where
DY
gY = = growth rate of output
Y
DA
gA = = growth rate of technology (total factor productivity)
A
DK
gK = = growth rate of capital
K
DL
gL = = growth rate of labor
L

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 Sources of Economic Growth:
Growth Accounting (cont’d)

• The growth accounting equation retains the

property of diminishing marginal product of
capital and labor:
– If capital grows by 5%, then output grows by
only 0.3 × 5% = 1.5%.
– If labor grows by 5%, then output grows by only
0.7× 5% = 3.5%.

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 Growth Accounting in Practice

• In the growth accounting equation, growth

in output comes from:
– productivity growth = A/A
– capital growth = 0.3K/K
– capital growth = 0.7L/L
• TFP at time t, also known as the Solow
residual, can be calculated as:

Yt
At  0.3 0.7
Kt Lt
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 Application: U.S. Growth Rates in the
Postwar Period

• The U.S. economy grew at a 4% growth

rate until 1973, and then slowed
considerably to 2.9% until 1995
• What explains this slowdown?
– Capital growth declined slightly from 1.2% to
1.0% annually
– Labor growth grew from 1.1% to 1.0% annually
– Productivity growth slowed from 1.5% to 0.9%
annually

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 FIGURE 6.13 Sources of U.S.
Economic Growth

Sources: Bureau of Economic Analysis. www.bea.gov/national/nipaweb/SelectTable.asp?Selected=N; and Economic Report of the

President. www.gpoaccess.gov/eop/tables10.html. Productivity growth is computed as Solow residual using capital share of 30%.

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 Cross-Country Differences in Growth
Accounting Rates

• Growth accounting indicates that different

economies often have different reasons for
output growth
• David Weil of Brown University found that
productivity growth is a more important
source of variation in growth rates across
countries than is factor accumulation (i.e.,
growth in labor and capital)

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