The Chinese University of Hong Kong

Department of Economics

ECON3021
Intermediate Macroeconomic Theory
2024-2025 (First Term)

Lecture 4: Economic Growth 2

Wallace K C Mok
 Solow Model Review
dk

f(k)
y=f(k*)

sf(k*) = dk*

k*
 Solow Model Review
1. Increasing the Savings Rate f(k)

Investment
and depreciation
dk
B
s2 f(k)

A s1f(k)

k1* k 2* k
 Solow Model Review
2. Increase in the depreciation rate
d2k
Investment
and d1k
depreciation
A
B s1f(k)

k2 * k1* k
 Evaluating the
Basic Solow Growth Model
a) A useful starting point.

b) No growth in the long run equilibrium

(steady state). Growth occurs only during
adjustment to the steady state.

Does incorporating population growth in the

Solow model helps?
 Economic Growth
Introduction to Economic Growth

Exogenous Growth Models Endogenous Growth Theory

Solow Growth Model

Basic With Population Growth With Technology

 Log Differentiation
• Recall again the following derivation:
K
k
N
ln k  ln K  ln N

d ln k d ln K d ln N
 
dt dt dt
dk dK dN
dt  dt  dt
k K N
k 'k K ' K N ' N
 
k K N

Growth Rate of k (capital per capita) ≈

Growth Rate of K (capital stock) – Growth Rate of N (Population)
 Log Differentiation
• Hence in general, if:
b
a
c
Growth Rate of a ≈ Growth rate of b – Growth Rate of c
 Solow Model with Population growth
• When the population does grow, the economy requires
more capital in order to grow:

• Capital Widening: Extra units of capital needed for the

new arrivals.

• Capital Deepening: For the economy to move from one

steady state to another – more capital per person needed
 Solow Model with Population growth
• Let n be the growth rate of the population:
N ' N
n
N
Recall again the capital per capita equation:
k 'k K ' K N ' N
  Recall:
k K N K’ = K +(sY-dK)

k 'k sY  dK
 n
k K
k 'k  sf (k )  (n  d )k
 Solow Model with Population growth

k 'k  sf (k )  (n  d )k

For the level of capital stock to grow, investments have to

compensate both the depreciation of the capital stock
and the extra population.

Capital Widening

Capital Deepening
Solow Model with Population Growth
(n+d)k
 Solow Model with Population growth
At the steady state, k = k’ = k*
sf (k*)  (n  d )k *

Therefore:
k 'k K ' K N ' N
  0
k K N
K ' K N ' N

K N
Growth Rate of the Economy’s capital stock = population growth rate

But capital per person does not grow in the steady state,
hence output per capita does not grow in the steady state
 Predictions of the Solow Growth Model
sf (k*)  (d  n)k *
3. Higher Population Growth Rate

Investment, break-even
investment (d+n2) k
(d +n1) k
sf(k)

k2 k1
ECO2021 Intermediate Macroeconomic Theory
Capital per worker, k
*
Lecture 3: Economic Growth I
Professor Wallace K C Mok *
Population Growth vs Income per capita

ECO2021 Intermediate Macroeconomic Theory

Lecture 3: Economic Growth I
Professor Wallace K C Mok
 Evaluating the
Solow Model with Population Growth
a) Total output and Capital Stock in the
economy grow at the same rate as population
growth.

b) Still no growth in output per person in the

long run equilibrium (steady state). Growth
occurs only during adjustment to the steady
state.
 Evaluating the
Solow Model with Population Growth
c) So far, we assume there is no growth in
technology, is this a good assumption?
 Economic Growth
Introduction to Economic Growth

Exogenous Growth Models Endogenous Growth Theory

Solow Growth Model

Basic With Population Growth With Technology

ECO2021 Intermediate Macroeconomic Theory

Lecture 3: Economic Growth I
Professor Wallace K C Mok
 Technological Progress
Technology: Enables higher level production without
needing extra labor or capital (or extra cost)

The real price of computer power has fallen an average

of 30% per year over the past three decades.
Percentage of U.S. households with ≥ 1 computers: 8% in 1984, 62% in 2003

1981: 213 computers connected to the Internet

2000: 60 million computers connected to the Internet

2001: iPod capacity = 5gb, 1000 songs.

2005: iPod capacity = 60gb, 15,000 songs.

 Technological Progress
How to incorporate technological progress in the model?

Let A be the state of technology

Assume the level of technology grows at a rate of g – i.e.

A' A
g
A
 Types of Technological Progress
Given our model, there are three types of technological progress:

1. Hicks Neutral: Y = AF(K, N)

2. Labor-Augmenting: Y = F(K, AN)
3. Capital-Augmenting: Y = F(AK, N)

The Solow model considers “Labor-Augmenting” Technological Progress.

Y = F(K, AN)

Let output per person be:

y=f(k,A)
Technological progress

sf(k*, A3)

sf(k*, A2)
sf(k*, A1)
 Deriving the Capital Evolution Equation (Again)
Does it mean that there is no steady state?

Define output per “effective unit of labour” and

capital per “effective unit of labour”

~ Y ~ K
y k 
AN AN
Log differentiating:
~ ~
k 'k K ' K A' A N ' N
~   
k K A N
~ ~ ~ sY  dK 
k 'k  k   g  n
 K 
~ ~ ~ ~
k 'k  sf (k )  (d  g  n)k
 Deriving the Capital Evolution Equation (Again)
~ ~ ~ ~
k 'k  sf (k )  (d  g  n)k
~
There is a steady state in which k does not increase further:
~
(d  g  n)k

~
sf (k )

~
k
 In the Steady State
~ ~ ~*
k ' k  k
Substituting in the Capital evolution equation:

~* ~*
sf (k )  (d  g  n)k
In the steady state, both output per effective worker
~y
And capital per effective worker k~ do not grow.

Hence: ~ ~
k 'k
~ 0
k
~
y ' ~
y
~ 0
y
 In the Steady State
But how about output per worker and capital per worker?

Is there growth in output per worker (not per effective worker) in the steady state?

~ K k
k  
AN A

~ ~
k 'k k 'k A' A
~   0
k k A
k 'k A' A
  g
k A

So capital per worker grows at the rate of technology, g

 In the Steady State
By a similar argument:

y ' y A' A
 g
y A
So both output per worker and capital per worker grow at the rate of technology, g,
at the steady state, satisfying one of the Kaldor’s Stylized Facts of Growth.
 Stylized Facts of Economic Growth
• International data (averaging over long period of time) suggest the
followings:

1. Income per unit capital (Y/K) does not change.

2. Income per capita (Y/N) and Capital per capita (K/N) grow at constant rates.

3. Rental price of capital (r) is constant.

4. Wages (w) grow at a constant rate

5. Rates of growth and levels of income vary substantially across countries

(non-convergence).
Stylized Facts of Economic Growth
• 1. Income per unit capital (Y/K) does not
change.

This means both Y and K grow at the same rate.

Both K and Y grow at the rate of (n+g).

Stylized Facts of Economic Growth
• 2. Income per capita (y) and Capital per capita
(k) grow at constant rates.

Both k and y grow at the rate of g.

Stylized Facts of Economic Growth
• 3. Rental price of capital (r) is constant

Think about the Cobb-Douglas Function:

Y  K  ( AN )1
The economy’s profit function is:

  Y  wN  rK  dK
 K  ( AN )1  wN  rK  dK
Stylized Facts of Economic Growth
• 3. Rental price of capital (r) is constant

The firm chooses K and N to maximise profit, so taking First-

Order Conditions


 K  1 ( AN )1  r  d  0
K

 A(1   ) K  ( AN )   w  0
N
Stylized Facts of Economic Growth
• 3. Rental price of capital (r) is constant

From the first FOC:

r  K  1 ( AN )1  d
~ 1
 r  k  d

~ does not change in the steady state, r is constant.

Since k
 Stylized Facts of Economic Growth
• 4. Wages (w) grow at a constant rate

From the second FOC:

w  A(1   ) K  ( AN ) 
~
 w  A(1   )k
~
Since k does not change in the steady state and (1-α) is constant.

w' w A' A
 g
w A
So wages w do grow at a constant rate
Stylized Facts of Economic Growth
5. Rates of growth and levels of income vary
substantially across countries (non-
convergence).

Model predicts that all countries should have the same

long-run growth rate equaled to g – which is not what we
observe.
 Evaluating the
Solow Growth Model
a) Satisfies many Stylized Facts of economic
growth.

b) Although the growth rate in per capita output

is the same as that of technology, the latter is
exogenously given (i.e. not explained in the
model how the growth rate, g, is determined).
 Past Midterm Question A
In the Solow Growth Model, higher rate of
saving will always lead to higher income per
capita hence higher consumption per capita in
the steady state.
True/False
 Past Midterm Question B
The economy has the following production function:

Y = K0.15(AL)0.85

Where K is the economy’s capital stock, L is the level of labor,

A is the level of technology. Initially, we have A=4, K=6, L=4.

The economy’s population growth rate is 0.04, capital

depreciate at the rate of 0.2. The economy’s average savings
rate is 0.2. It is also known that the rate of technological
growth is zero.
 Past Midterm Question B
(a) Does this production function exhibits
constant returns to scale? Explain your
answer. (2 points)

(b) Derive the efficiency unit of output per

person. Comment on the intuition behind
why the efficiency unit of output per person
decreases as the technology level A
increases? (4 points)
 Past Midterm Question B
Answer for a)
A production function exhibits Constant Returns to Scale
(CRTS) if λY=F(λK, λL).

Here, F(λK, λL) = (λK)0.15 (AλL)0.85 = λ0.15+0.85 K 0.15 (AL)0.85

= λK0.15 (AL)0.85= λY.

So yes, the production exhibits CRTS.

 Past Midterm Question B
Answer for b)
 Next Lecture ………..

• Endogenous Growth Theory