Solow Growth Model

Solow Model Part (1)

Exercise session 3

1) General question on solow model :

1 .
What is the key mechanism in the solow model that generates GDP growth ?
capital accumulation
The key mechanism is @Kt += It -akt
:

=
5Yt -
Tkt

In the short run .

GDP grows because capital accumulates .

(disminishing returns to capital slow this process over time

Long-term growth in GDP per capita requires technological progress (A) , since cap
.

acc .
cannot sustain growth indefinity alone.

2 .
Is the Solow model consistentwl the fact that poor countries tend to experience faster growth than rich countries ?
Yes , as poor countries which start with lower capital per worker (k) , have high marginal returns to capital leading
, to faster GDP growth.

does the solow model fail to deliver economic Because at steady state fixed.
3 .

Why growth in the

long run ? ,
everything remains

Because the solow model predicts that :

~
Capital accumulation has
disminishing returns Growth slows >
-
over time.

~
At steady state (K
*
) investment capital depreciation
,
=
, means that capital per worker stops increasing
.
~
Since output per worker depends on capital per worker , GDP per capita stops growing unless there is
technological progress (A)
y f (k)
= (k)

4 . Would this conclusion be the same if the

Marginal Product of Capital (MPK) were constant ?
HO . If MPK were constant then investment would
,
generate continuous capital accumulation without disminishing returns ,
leading
to sustained growth even without technological progress.
In the standard solow model , MPK declines as capital increases >
-
Growth slows down

If MpK were constant , there would be NO

steady state (K *
) and the
economy could grow indefinitely by accumulating capital.
[Graphically , it would show that It does not flatten out ,
meaning K could grow indefinitely .]
It =
SY :
sF(kiL)
solow
diaigen

I
or lower thank

=> Infinite growth of

cap .
acc ..
as I>K ,
I will accumulate 1

K ,
in

the principle of transition ?

5 .

What is
dynamics
An economy below k* grows faster because capital accumulation has high returns.
depreciation and dilution exceed investment.
*
An above k shrinks
economy as

The further is from its steady-state the faster it grows (or declines)·
an
economy ,

6 . In the basic Solow model , if we take into account population growth would , there be a
steady-state level of GDP (Y) ?
Not steady-state for total GDP (Y) , BUT steady-state for GDP per worker (y Y/2).=

Total GBP (Y) has no steady-state because GDP will grow at rate n forever as the number of worker increases .

GDP per worker (y =

Y/2) has a
steady-state y
*
Cremains constant at y* ) unless technological progress exists.
 2) Saving rate :
3 = 0 . 15
*-
function AKEL
Depreciation rate 0 10
Cobb-Dunghass Y
:

d = =
: -

Total factor productivity :

A =
20
steady-state condition :
SY = &K
(2)
Population :
L =
100 (fixed)

< = 0 .
3) (exponent of K in the
Cobb-Douglass prod func ).

1 . Obtain the level of income (4) , of Capital (K) as well as the

per capita income level (y) of this
steady state.
Derived from LKt+= 0
(*).
=
k* =

" o
. g**
(0x0 5833/100
*I
= 10 = 928 .

13827 8749 92 1858

= =
. .

*
k =
164318
2
. Growth rate of > in terms of Land K.
=
k state S
y= >
- At the
steady 0 ,

FORMULA for grath rate :

(93 =
ga +
EgK + 591/

.
3 Short-run Growth Rate of Income (gy) when
changes occur :

*
(2) The saving rate doubles
Snew =
2 x U 15 .
=
0 38 .

gy ga = + 5gx + 59
pa temporary leading to high so , s doubled
if
,
only 5g1
will change .
A & I will be fixed.

=
31 . 14 %

(b) 10 % increases in TFP (A) ()

Population increases
by
30 %

Anew =
1 1 x20
.
= 22 2 new = 1 .
3 x 100 =
130

en (Anew) en(A) In (Lnew) 1n(2)

gy
-

gy = -
:
1 -
d
=
In 130 -
In 100
=

1122- Io0 =
0 . 2624
=
u 138)

!
.

=
26 .

24 %
=
13 81
.
%

4.
Long-Run Change in Per Capita Income (1)
In the
long run only changes in savings ,
or
technology affect per capita income .

Pop changes do
-

not .
affect

To
compute the
percentage change in
per capta income
(y Y/2)
: :

(a) savings- (b) productivity (c) population ,

* ·
UNCHANGED

5 =
1

y
*
=
(
2x5 y* =
()
=
2 .

()
*
=
1 .

41 y
:
Steady state ↑
by
② 5 = 0 15
.

d =
0 .
18

A =
26

2= 1000

L= +

1
steady. state level :

Y *:
() ** =

(i)*. 205 .
1000 =
109 544

:
y * =
109 544 .

K *:?
K
*
164318
find
=

To

2
. Wih Y : Ak LE
↓

gy =
gn
+
59k =g +

.
3 solve gy
=
ga + 59k =g +

a) double 5

to set
- doubling
Saving

KtH
&

=
16431

1643/
we have
Kt =
16431 , LKt + =

g =0 =
101

O 5X10 3 35 %
Cy 1) by 3 33 % )
Gi
= + + 0 = . increase .

b) A increases 10 %
by
>
-
K will be affeted since @Kt += 5 Yt-k +
=
5 (Atk5() -
-k

-
=

(1 .
1 ) k5 LE
+
-
dkt
=
51 1 Yt-dKE .

109544 10 x164318
=
0 . 15 x 1 .
1 x - 0 .

=
1643 .

:
gr = = 1

gy =
10% + 5X1 % = 10 33
.
% - the
change in
Y

C) -

gy = 20 .
66/
3) Per Capita GDP in the
long run
(a) The
investment rate decreases (b) The depreciation rate falls ak be flatter
:

Investment depreciation
,

8
F k **

We will have a downward shift of . 1

I
will become
higher than K ,
K will decrease til K2 .

At the time of the change , K > 1 It

We have the accumulation of
*
K

until it reaches K*

2) K5 L
e F(K , 1
= . .
=

**
() The productivity level rises :
I-sY shiff upward (d) An earthquake destroys half of the
capital shock : no line
shifting
Investment depreciation
,

is

Capital 11) decrease to 12 ,

and it will be
govery
in the future until it reaches K*

eT
= F(k, 2) -
A .
15
(e) Population increases :
I = 34 shift upward
 The Solow GrowthModel

~ Let
~
88 We will make capital K
endogeneou (instead of
exogeneous)

key equation :
"Production function"

Y =
F(k , 2) = AKL · = real output
L = labour

and capital
You
producesmy withlabour capita sees
k =

i =

productivity

when we make 1 endogenous,

kt =
k+ + 1t A+
Investment
-

+ 1
It =

LKt += It- * Kt
·

d =
rate of depreciation of capital

Other equation Ye C It
Jassumption
.
= +
for
simplicity
It :
5 Y

The Solow Model : 5 equations & 5 unknowns

5 Unknowns/endogenous variables : Yt , Kt Lt. , Ce ,

It

5 Equations
1 Production function Ye :
AKL
.
c
Capital accumulation @Kt+= It-R+
.
3 Labour force It :
I

.
4 Resource constraint Ct + It = Yt

.
5 Allocation of resources It =
5 Yt

Parameters A :

,
5 i
d I Ro
, .

What does the mudel imply ?

~
Key question in the Solow model :
what will determine the level of capital in the long run ?
(investment)
The steady-state level of capital per worker (K )
*
in the Solow model is determined by the balance between capital accumulation
and capital depreciation.
The main factors this
influencing are :

Saving rate (s) higher investment in capital

*
higher savings increasing k
1 : >
-
>
-

Depreciation rate (d)

*
.
2
higher - lower k :

Population growth rate (n) (more capital is needed to maintain capital worker)
*
.
3
higher pop lower k :
.
-
>
per

Technology (A) and Productivity improvement in technology higher k

*
4
. : >
-

(k ) steady-state capital worker

*
:
the level where investment exactly offsets depreciation and dilution from population growth.
The Solow Diagram It
First combine the 2nd and
3
5th equation LKt =
5Y + * ke
equations allow build
:
-

This you to
,
I

* I*
Then , combine the 1st and 3rd equation :
Y = F(K , 2) =
AK the Solow
Diagram

Investment depreciation ,

Depreciation : K

Investment 54

Investment
·
:

O >
>
7 7 737 Capital .
K
Ky

What happen before & after K*? (a transition dynamic

The
economy naturally moves toward k
*
over time ,
whether it starts below or above this level.

The speed depends on parameters like saving rate (s) depreciation rate (d) and population growth.
of
convergence , .

Countries
·

with louittal
capitalfaster g (Solow's catch-up effect conditional convergence). or

Capital accumulation phase

*
1 If K < k (before K*:
***
.

~
At low capital investment (54t) exceeds depreciation (k) & Capital ilution (nk).
levels of ,

~
As a result not capital accumulation (01 0) occurs and capital per worker increases over time.
,
> ,

#
Leads to ECONOMIC GROWTH as output per worker (y) and income per capita rise.
,

~ The economic is in a transition dynamic moving ,

towards the steady-state k*

key insight : if a
country starts w/ low capital it will ,
grow rapidly as if accumulates capital.

c . If 1 > k* (After Steady-state :

Capital depletion phase)
~
When capital per worker is two high ,
depreciation & pop-growth exceed the investment rate (0110).

~
This causes capital per worker (K) to decrease over time.

~
The economy experiences lower output per worker until it converges back to k*

key insight : If a
country has too much capital per worker(after an investment boom) , it will experience LOWER GROWTH or even a

decline until
reaching steady-state.
 steady state
The model says we will converge to a level of K . which is denoted by K*

called steady state level steady (it at constant value).

*
K is the of K :
it is where the level of capital becomes stabilises a

K , Y , and I are fixed .

WHY is Y fixed ??
u
Investment depreciation ,

Output Y

set
*
Y - -

Depreciation:
resto

>
>
7 7 737 Capital .
K
K

T is fixed when we reach K *, as k is constant at K*; y f(k )

=
*
is also constant.

In the original Solow diagram , we have K (bigk") on the X-axis.

What if the population increases here ?

*5

·
=
jY3 =
Sk

state will
~
If the population increases , I will increase , and the
steady be
higher .

would
~ If There is a constant increase in population ,
there be NO steady state in terms of 17.

a
How the question becomes : is there a steady state in terms of K (*) ?

Last time :

-k 0
(n + j)k
=

growhate op
-by
(with

>k
= jk
*
-

(n + j)k
we can
graph the solow diag .
take into acc ·

population growth
 .
We see
graphically there is a
steady state in terms K
of .

What is the VALEU of K *?

What is K
*
said that -K =:

57k5 (n j)k -
+ =
0
*
sk =
(n + j)k
5
= value
(n +)
steatly state fork when there is
populatio gat he
the
- a

While BEFORE when we had no

population growth :

I k
* =

()[
which means that per capita ,
we had -
(A) = without Population growth

How ,
taking into account population growth ,
we have a
steady state of k
** with Pop gath

↓
and kislowerWhy when population i the denominator of a
.
2 While the accumulation of capital is constant ,
the higher the population growth ,
the
higher the K will

be divided (k*= 1) by the number of

people.

What is the OPTIMAL level for K *? (here we'll ignore population growth
Basic Solow
Diagram i
Graph A
between and ?
&k Differences graph A B

Fi
graph (saving rates) is lower .

i
In B
Y , s

end consumption is
So in the
higher .

i
Consumption :
Y =
I What it illustrate is
that a
country can choose to effect consumption
.

The OPTIMAL level of K*:

could *
100 %
the
output into investment,
We K
by putting of

but then nobody would consumee... ( = C+ 1)

B
Graph
People would not really be "happy" .

F
If in contrast I would put 0% of Y into investment,
max E = > j =
5 no -> no Consumption
Golden rate proposes to chose K
*
(*) so to maximise
-(Cons. per capital
↓
Max E subject to the fact that we're in a
steady state :
OK=

1) Max (i E)

15
-

substituting .:
8 K: I - &K
·
1 =
*k + K into (1)
steadtsee

-
in a
were

S
 S
·
Order Condition of this maximisation roblem
The First
:

= P

-k5
+
-

T =
0

155 =
this level of I
(Soto
we should have
1=
MAXIMISE E

*
But we know that the general expansion for the
steady state level of k *
is :
(EA)
1 ** Lectures /week
ago

*
we need this general expansion to be equal to K =

(* )
-
: To have a
steady state where is maximised :

(A) (E)

=
S
Conclusion : To max E , a
country should save Es for its output.
 Solow Model Part (2)

Session 4

1 . EXCEL
Assuming
c .
Golden rule of capital accumulation :
proposes to choose k* ( E)
= to maximise E assuming that we're in a
steady stake => DK = 0
.

What would optimal saving rate

be the level of ?

The optimal value of 5 =

#
Y = (+ I
=> Y = Aks =
C =
Y I
-

-k = 2 -
k
2 = 2k &k
?
> +

Why
-

*
value 1 K *= ( Max E Max (E) -

Max
O Maximise of - =
:
I

Optimal value of K K ** ( -)
=
: I

H I =
Max ( -)
/
↓

③
I
=

Max (( -)
I
=
Max (n ·
()5 -)
3 =
5

5 : First-order
2 (j)-)
condition to maximise -0
! c(t)
= 0

"(E)Ak- - = 0

! ... 15 =

x E
a

( q
-
-

k
*
=
1 =

I
z
k
-

=
q
"

How the rate (s) affects consumption (c) to (*)

Saving
*
: same cases

Case I :
Case 2:

Y/y Y/y

* Fi
Klak S k/k

sY/sy

Consumption (C) is HIGHER While Consumption (C) is LOWER While

savigrate (s) is LOW savigrate (s) is

HIGH
 .
3 Two countries :
two countries (and S, for which production function is Y = AkdL ,
d= 0 5 .

/C : S 30
=

A-0 ==
Countries = 300 ,
K = 100 . ,

k Y
1
Y a) calculate the intent capital per capita ratio & income per capita (current.
y given K = 100 , L 300 =
, A = 10)

k= 100%-x30005
Y* =
=
10
=
+

=> k 0 =>
=

7
300
y =

333 = 5 . 7735
Istualy state reprived long-run equiliorm
*

k
* y
y*
k*,
y
*
b) calculate the try-state capital per capita & income per capita. levels that economics will
converge to
(without economic
( **
O Y AKdL'd
without population growth
- :
*
k
growth) ........... =
=

" =
Ak
&" =
And

(
-

(30%x00
I

Country k=
=

C :

@ Capital
I acc fr) : <K :
I- & K
20941406
.

=
. 25
Y- & K
&
=
s .

(t
I

I
in the
steady safe 2K 0 =

country
,

S :
K* =

I
: 0 = s .

Y- * K
=
-419156 25 . .
I

Rewrite in terms of Capital per

worker
:.
y*
=
Al ! s
y=. k ***
*

=
10 x 1406 250
. 5
SA .
"
k =k OY AKL"d =

.
1

② SY &K
=
=
=
375
OR SAK"L' = k
ki ()
5
* 10x156 250 !
.

y
= =
s .

:
= 125 () k
*
=
k
*
=
3
! : k
*
=
 PER CAPITA
is
c) Graphically represent the situation of
county C in a Solow diagram . Do the same for .
3

County Ci
Country S :

d Y
diy
.

al al

*
---------- Y

-
-- - -
- --

=
125

*
k =
1406 25 .

k* = 156 25
.

k
*
with d) Repeat the same as b) for
country C ,

assuming a constant population growth rate of

gu
= 4 %·

growh
leop
with population growth =)
.

I*
*=
k
(
k* =

(
=
625

:.
y = Axk
5
10 x /250
.

= 258

current situation and

*
9k .

gk e) Growth rate K
of and
y in the in its steady state of country C .

gy ,
gy
*
9 : current situation .

9K = 0 <k =
1 -

(i + n)k
found a) y 7735
S Y ( + m)k
------
=
in
.
-

= 5 .

gy 29k = =

sy-1)k k = 0 . 3333
② k =
=
(30 % x5 7735) [(8% + 4%)
.
- x 0 .
3333) =
s
: -( n) E + .

0 .
3333
=
Sy (a + n)k
-

= 5 0763 = 587 63 %

I
.
.

steady state gl 0
·
=
,

-k= 0

rate reflect
High growth
related to
the process of Fransition
** gy
:
gy is
gi by
=
>
gy
=
G .

gk
Aynamic

↑
.

in current situation ,
gy = 0 . 5 x 5 0763 .

5383 253 83 %
=
=
2 . .

in
steady state ,
gy = 0 . 5x0

=
0
4 .

Playing Solow :

Using the Solow mudel considering explain graphically the effects that would occur
, in an
economy that receives a donation (increase) of

physical capital development

(k)
asaid when this
economy is in the following situation :

a) With physical (k)capital below its steady-state value

b) with physical capital as its steady-state value
donation donation
*
9) Ka# >
- ? b) kb =
k >
-
Kb > k
*

A , y I
, A , y I
,

****
·
-
Ka

#K < K *, donation E & more

right ? -
F * K2k *
b
donation [i K > K*
K

but not
* *
sure < K or < K