CHAPTER 5: MODELS OF MACROECONOMIC GROWTH

5.1 INTRODUCTION: MODELING ECONOMIC GROWTH

 Definition of Economic Growth: Economic growth is an increase in a country’s productive capacity
identifiable by a sustained rise in real national income over a period of years.
 It is a condition in which a society’s output of goods and services is growing faster than the increase in its
population.
 The level and rate of growth determines the level of living, quality of life, job opportunities and level of
employment and over all the material wellbeing of the people.
 Economic growth also determines the honor and respectability a country commands in the world
community. And it also ensures the economy independency of a free nation.
 When we say there is an economic growth in a country or nation, we are obviously relating it with
economic development. Both terms have close relation.
 As we defined above, we say a country is enjoying an economic development, when it is experiencing
economic growth and undergoing major structural change in economy, like changing from agriculture to
manufacturing sector. So to put a clear image of what developed and less developed country:
 Developed country – is a country in which real national income per capita is relatively high and which
enjoys a relatively high standard of living.
 But when we say less developed country, it is a country with low real national income per capita, a large
agriculture sector, high population growth, and a low capita – labor ration and poor infrastructure.

DETERMINANTS OF ECONOMIC GROWTH

1. Human resource and its quality
 It is comprised of the available labor force and the level of its education, training, and its invention and
innovative abilities. It is the main determinant of quality and quantity of manpower.
 Growth of labor force is one of an important factor in determining economic growth. And these labor
forces also depend on the main factors like:
 Natural increase in population
 International migration
 The participation rate: Means the proportion of the economically active populating to the total
population. The level to which the different age groups and the sexes, customs, tradition and attitude
determines it.
2. Natural resources

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3. Capital formation: Requires sparing and material resources from their use in consumer goods and
transforming into goods. It means scarifying current consumption and saving incomes to be invested. In
general the countries with a high rate of saving and investment have a higher rate of economic growth.
4. Technology (technical progress): Refers to scientific method and technique of production. Means the
amount of machinery and technical equipments used with a given amount of labor. Capital – labor
ratio is a good measure of technology. Technology progress or development means improved techniques
of production, improved machinery, invention and improvement of education in other word it is anything
which improve the quality of capital stock or labor force.
 There are three basic classifications of technological progress: neutral, labor-saving and capital
saving.
 Neutral technological progress: Occurs when higher output levels are achieved with the same
quantity and combinations of factors inputs. Simple innovations like those arise from the division of
labor can result in higher total output levels and greater consumption for all individuals.
 Labor – saving: The use of electronic computers, automated textile loans, high speed electric drills,
tractors and mechanical ploughs – these and many other kinds of modern machinery and equipment
can be classified as labor saving.

 Capital – saving: This is a much rare phenomenon. In the developed world almost all the scientific
and technological research is conducted to save laborer and not capital. In the labor – abundant
(capital – scarce) countries of the developing world, however, capital – saving technological progress
is the main focus.

Generally the major factors in or components of economic growth in any society are:-
1. Capital accumulation, including all new investments in land, physical equipment, and human
resources.
2. Growth in population and thus, growth in the labor force.
3. Technological progress
Algebraically, these components can be written in the standard neoclassical “production function” format as
Y = f (L, K, t)
Where Y – National output
L – Labor
K – Capital
t – Technical progress.
5.2 Theories of Economic Growth

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1. The Harrod - Domar Growth Model

It has a special analytical appeal to development planners. The planners have to make appropriate
assumptions about capital- Output and labor – output ratios, the sources of saving and the rate of population
growth when formulating their development plan. It is one of the simplest growth theories, which extends the
simple short run Keynesian model into the long-run. It is an extension of Keynesian short-term analysis of full
employment and income theory and provides “a more comprehensive long period theory of output.”

This model is named after its originators, the English economist, Sir Roy Harrod and the American, E.
Domar. The alternation of economists was drowning towards the problem of a steady and sustained economic
growth by the great depression and subsequent by the economic devastation caused by the Second World
War. The central issue of inquiry was to explore the requirements and conditions for steady growth in output
and employment. Harrod and Domar had in their separate writings concerned themselves with the problem.
Assumptions of Harrods – Domar model
a. The economy is closed and that there is no government economic activity.
b. There are only two factors of production, labor (L) and capital (K), and in our simple version of the
model, there is no technical progress.
c. Labor is homogenous, measured in its own units and grows at the constant natural rate of growth.
d. There are constant returns to scale. This means that if a given proportion increases both labors and
capital, output will also increase by that proportion.
e. Saving (s) is a fixed proportion of income (Y) that is S = sY where s is both the average and marginal
propensity of save. Investment (I) is autonomous and there is no depreciation.
f. The potential level of national income (Yp) is proportional to the quantity of capital and to quantity of
labor. Thus, we can write K = vYp and L = uYp, where v is a constant capital – output ratio and u is a
constant labor – output ratio. This type of production function is called fixed proportions production
function.
Based on the assumptions mentioned above Harrod-Domar model assumes that the national income is
proportional to the stock of capital, Y = kK (K > 0)
Where Y = national output; K = total stock of capital; and k = output/capital ratio.

Since output/capital ratio is assumed to be constant, any increase in national output (DK) must be equal to k-
times K, Y = k DK. Since increase in capital stock (DK) in any period equals the net investment (I) of that
period the equation can be written as DY = kI

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Also this model assumes at equilibrium level of output, the desired savings must equal to the desired
investment. Thus (I) can be substituted for: I = sY
Where s is marginal propensity to save. Finally the whole equation can be written as follows:
DY = ksY
ΔY
= k. s
To get the growth rate we divide both sides by Y. thus Y According to Harrod-Domar model, a target
growth rate can be achieved either by increasing marginal propensity to save and increasing simultaneously
the stock of capital by increasing the output/capital ratio.

2. The Neo-classical Growth model

The emergence of economic growth theories can be traced back to Adam Smith’s Wealth of Nation. Theories
made by Smith and other economists who follow this idea collectively known as ‘classical theory of
economic growth.’ Since mid-fifties the contributions made to the growth theory by Tobin, Solow, Swan,
Meade, Phelps and Johansson have been given a collective name as “The Neo-Classical growth Theory.” The
approach adopted by these growth theorists in their model is based on the assumptions usually made by the
neo-classical economists like Marshall, Wicksell and Pigou. The assumption are:
i. Perfect competition in commodity and factor markets
ii. Factor payments equal their marginal revenue productivity
iii. A variable capital/output ratio
iv. Full employment

2.1. The Accumulation of Capital

The Solow growth model is designed to show how growth in the capital stock, growth in the labor force, and
advances in technology interact in an economy, and how they affect a nation’s total output of goods and
services. We build this model in steps. Our first step is to examine how the supply and demand for goods
determines the accumulation of capital. In this first step, we assume that the labor force and technology are
fixed. We then relax these assumptions by introducing changes in the labor force and technology in the next.

2.1.1. The supply and demand for goods

The supply and demand for goods plays a central role in the Solow model, just as it did in a static model of
the economy. In a static analysis, the supply of goods determines how much output is produced at any given
point in time, and the demand determines how this output is allocated among alternative uses.

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A. The Supply of Goods and the Production Function

The supply of goods in the Solow model is based on the now-familiar production function, which states that
output depends on the capital stock and the labor force: Y = F(K, L).

The Solow growth model assumes that the production function has constant re-turns to scale. This assumption
is often considered realistic, and as we will see shortly, it helps simplify the analysis. Recall that a production
function has constant returns to scale if zY = F(zK, zL) for any positive number z. That is, if we multiply
both capital and labor by z, we also multiply the amount of output by z.

Production functions with constant returns to scale allow us to analyze all quantities in the economy relative
to the size of the labor force. To see that this is true, set z = 1/L in the preceding equation to obtain
Y/L = F(K/L, 1)

This equation shows that the amount of output per worker Y/L is a function of the amount of capital per
worker K/L. (The number “1” is, of course, constant and thus can be ignored.) The assumption of constant
returns to scale implies that the size of the economy—as measured by the number of Workers—do not affect
the relationship between output per worker and capital per worker. Because the size of the economy does not
matter, it will prove convenient to denote all quantities in per-worker terms. We designate these with
lowercase letters, so y = Y/L is output per worker, and k = K/L is capital per worker. We can then write the
production function as y = f (k), where we define f (k) = F(k,1). Figure 5-1 illustrates this production function.
The slope of this production function shows how much extra output a worker produces when given an extra
unit of capital. This amount is the marginal product of capital MPK. Mathematically, we write MPK = f (k +
1) − f (k).

Note that in Figure 1, as the amount of capital increases, the production function becomes flatter, indicating
that the production function exhibits diminishing marginal product of capital. When k is low, the average
worker has only a 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, so an extra unit increases
production only slightly.

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Figure1: Production Function

B. The Demand for Goods and the Consumption Function

The demand for goods in the Solow model comes from consumption and investment. In other words, output
per worker y is divided between consumption per worker c and investment per worker i. y = c + i

This equation is the national income accounts identity for the economy. It differs slightly from the usual
national income identity because it omits government purchases and it assumes a closed economy.

The Consumption Function

The Solow model assumes that the consumption function takes the simple form: c = (1 - s)y where s, the
saving rate, is a number between zero and one. This consumption function states that consumption is
proportional to income. Each year, a fraction (1 – s) of income is consumed and a fraction s is saved.

The investment Function

To see what this consumption function implies, substitute (1 - s)y for c in the national income accounts
identity: y = c + i, y = (1 - s)y + i Rearranging: i = sy

This equation shows that investment, like consumption, is proportional to income. Since investment equals
saving, the rate of saving s is also the fraction of output devoted to investment.

C. The Evolution of Capital and the Steady State

At any moment, the capital stock is a key determinant of the economy’s output, but the capital stock can
change over time, and those changes can lead to economic growth. In particular, two forces influence the
capital stock: investment and depreciation. Investment refers to the expenditure on new plant and equipment,

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and it causes the capital stock to rise. Depreciation refers to the wearing out of old capital, and it causes the
capital stock to fall. Let’s consider each of these in turn. As we have already noted, investment per worker i
equals sy. By substituting the production function for y, we can express investment per worker as a function
of the capital stock per worker: i = sf(k).

This equation relates the existing stock of capital k to the accumulation of new capital i. Figure 2shows this
relationship. This figure illustrates how, for any value of k, the amount of output is determined by the
production function f (k), and the allocation of that output between consumption and saving is determined by
the saving rate s. Figure 2 shows how the saving rate s determines the allocation of output between
consumption and investment for every value of k. At any level of capital k, output is f(k), investment is sf(k),
and consumption is: c= f(k) - sf(k) The higher the level of capital k, the greater the levels of output f(k)and
investment i. This equation incorporates both the production and consumption functions and relates the
existing stock of capital k to the accumulation of new capital i.

Figure2:Output, consumption and investment

To incorporate depreciation into the model, we assume that a certain fraction d of the capital stock wears out
each year. Here δ(the lowercase Greek letter delta) is called the depreciation rate. For example, if capital lasts
an average of 25years, then the depreciation rate is 4 percent per year (δ= 0.04). The amount of capital that
depreciates each year is δk. Figure 3 shows how the amount of depreciation depends on the capital stock. We
can express the impact of investment and depreciation on the capital stock with this equation:

Change in Capital Stock = Investment – Depreciation ∆k = i – δk where ∆k is the change in the capital stock
between one year and the next. Because investment i equals sf (k), we can write this as ∆k = sf(k) − δk.

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Figure 3: Depreciation

D. The Steady-State level of Capital

Figure4 depicts the terms of the a equation: ∆k = sf(k) − δk—investment and depreciation—for different
levels of the capital stock k. The higher the capital stock ,the greater the amounts of output and
investment .Yet the higher the capital stock, the greater also the amount of depreciation. As Figure 4 shows,
there is a single capital stock k* at which the amount of investment equals the amount of depreciation. If the
economy ever finds itself at this level of the capital stock, the capital stock will not change because the two
forces acting on it—investment and depreciation—just balance. That is, at k*, ∆k = 0, so the capital stock k
and output f (k) are steady over time (rather than growing or shrinking). We therefore call k* the steady-state
level of capital.

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. 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 k1in Figure 4. In this case, the level of investment exceeds the amount of depreciation. Overtime,
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 2. In
this case, investment is less than depreciation: capital is wearing out 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 there is no pressure for the capital stock to either increase or decrease.

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Figure4: Investment, Depreciation and the Steady-State

E. Approaching the Steady State: A Numerical Example

Let’s use a numerical example to see how the Solow model works and how the economy approaches the
steady state. For this example, we assume that the production function is

Y = K 1/2 L 1/2 To derive the per-worker production function f (k),divide both sides of the production function
by the labor force L

This form of the production function states that output per worker is equal to the square root of the amount of
capital per worker. Now assume that:

 30% of output is saved (s = 0.3),

 about 10% of the capital stock depreciates every year (δ=0.1), and
 that the economy starts off with 4 units of capital per worker (k = 4).

We can now examine what happens to this economy over time. Look at the production and allocation of
output in the first year. According to the production function, the 4 units of capital per worker produce2 units

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of output per worker. Since 70%t of output is consumed and 30% is saved and invested, c= 1.4 and i = 0.6.
Also, since 10% of the capital stock depreciates, δ k = 0.4. With investment of 0.6 and depreciation of 0.4,
the change in the capital stock is ∆k =0.2. The second year begins with 4.2 units of capital per worker. Every
year, new capital is added and output grows. Over many years, the economy approaches a steady state with 9
units of capital per worker. In this steady state, investment of 0.9 exactly offsets depreciation of 0.9, so that
the capital stock and output are no longer growing. Following the progress of the economy for many years is
one way to find the steady-state capital stock, but another way require fewer calculation.

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F. Changes in the Saving Rate (How Saving Affects Growth)

Consider what happens to an economy when it’s saving rate increases. Figure 5 shows such a change. The
economy is assumed to begin in a steady state with saving rate s1and capital stock k*1. When the saving rate
increases from s1to s2, the sf (k) curve shifts upward. At the initial saving rate s1and the initial capital stock
k*1, the amount of investment just offsets the amount of depreciation. Immediately after the saving rate rises,
investment is higher, but the capital stock and depreciation are unchanged. Therefore, investment exceeds
depreciation. The capital stock will gradually rise until the economy reaches the new steady state k*2, which
has a higher capital stock and a higher level of output than the old steady state.

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Figure 5: An Increase in the Saving Rate

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. If the saving rate is
low, the economy will have a small capital stock and a low level of output. This conclusion sheds light on
many discussions of fiscal policy. As you know, a government budget deficit can reduce national saving and
crowd out investment. Now we can see that the long-run consequences of a reduced saving rate are a lower
capital stock and lower national income. This is why many economists are critical of persistent budget
deficits.

What does the Solow model say about the relationship between saving and economic 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.

2.2. The Golden Rule Level of Capital

So far, we have used the Solow model to examine how an economy’s rate of saving and investment
determines its steady-state levels of capital and income. This analysis might lead you to think that higher
saving is always a good thing, for it always leads to greater income. Yet suppose a nation had a saving rate of
100 percent. That would lead to the largest possible capital stock and the largest possible income. But if all of
this income is saved and none is ever consumed, what good is it? This section uses the Solow model to
discuss what amount of capital accumulation is optimal from the standpoint of economic well-being. Later,

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we describe how government policies influence a nation’s saving rate. But first, we present the theory behind
these policy decisions. To keep our analysis simple, let’s assume that a policymaker can set the saving rate at
any level. By setting the saving rate, the policymaker determines the economy’s steady state. What steady
state should the policymaker choose?

A. Comparing Steady States

When choosing a steady state, the policymaker’s goal is to maximize the well-being of the individuals who
make up the society. Individuals themselves do not care about the amount of capital in the economy, or even
the amount of output. They care about the amount of goods and services they can consume. They care about
Consumption level. Thus, a benevolent policymaker would 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*gold. How can we tell whether an economy is at the Golden Rule level? To
answer this question, we must first determine steady-state consumption per worker. Then we can see which
steady state provides the most consumption. To find steady-state consumption per worker, we begin with the
national in-come accounts identity y = c + i And rearrange it as c = y − i.

Consumption is simply output minus investment. Because we want to find steady-state consumption, we
substitute steady-state values for output and investment. Steady-state output per worker is f (k*), where k* is
the steady-state capital stock per worker. Furthermore, because the capital stock is not changing in the steady
state, investment is equal to depreciation δk*. Substituting f (k*) for y and δk* for i, we can write steady-
state consumption per worker as

c * = f(k*) − δk*.

According to this equation, steady-state consumption is what’s left of steady-state output after paying for
steady-state depreciation. 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.

Figure 6 shows steady-state output and steady-state depreciation as a function of the steady-state capital stock.
Steady-state consumption is the gap between output and depreciation. This figure shows that there is one level
of the capital stock—the Golden Rule level k* gold—that maximizes consumption.

When comparing steady states, we must keep in mind that higher levels of capital affect both output and
depreciation. If the capital stock is below the Golden Rule level, an increase in the capital stock raises output
more than depreciation, so that consumption rises. In this case, the production function is steeper than the δk*

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line, so the gap between these two curves—which equals 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, since the
increase in output is smaller than the increase in depreciation. In this case, the production function is flatter
than the δk* line, so the gap between the curves—consumption—shrinks as k* rises. At the Golden Rule level
of capital, the production function and the δk* line have the same slope, and consumption is at its greatest
level.

Figure6; Steady State Consumption

We can now derive a simple condition that characterizes the Golden Rule level of capital. Recall that the
slope of the production function is the marginal product of capital MPK. The slope of the δk* line is δ.
Because these two slopes are equal at k*gold, the Golden Rule is described by the equation MPK = δ

At the Golden Rule level of capital, the marginal product of capital equals the depreciation rate. To make the
point somewhat differently, suppose that the economy starts at some steady-state capital stock k* and that the
policymaker is considering increasing the capital stock to k* + 1. The amount of extra output from this
increase in capital would be f(k* + 1) − f(k*), which is the marginal product of capital MPK. The amount of
extra depreciation from having 1 more unit of capital is the depreciation rate δ. Thus, the net effect of this
extra unit of capital on consumption is MPK − δ. If MPK − δ> 0, then increases in capital increase
consumption, so k* must be below the Golden Rule level. If MPK − δ< 0, then increases in capital decrease
consumption, so k* must be above the Golden Rule level. Therefore, the following condition describes the
Golden Rule: MPK − δ= 0.

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At the Golden Rule level of capital, the marginal product of capital net of depreciation (MPK − δ) equals
zero. As we will see, a policymaker can use this condition to find the Golden Rule capital stock for an
economy.

B. The Saving Rate and the Golden Rule

Keep in mind that the economy does not automatically gravitate toward the Golden Rule steady state. If we
want any particular steady-state capital stock, such as the Golden Rule, we need a particular saving rate to
support it. Figure 6-7 shows the steady state if the saving rate is set to produce the Golden Rule level of
capital. If the saving rate is higher than the one used in this figure, the steady-state capital stock will be too
high. If the saving rate is lower, the steady-state capital stock will be too low. In either case, steady-state
consumption will be lower than it is at the Golden Rule steady state.

Figure 7; The Saving Rate and the Golden Rule

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Page 16 of 25
Using this formula, the last two columns of Table 3 present the values of MPK and MPK − δ in the different
steady states. Note that the net marginal product of capital is exactly zero when the saving rate is at its Golden
Rule value of 0.5. Because of diminishing marginal product, the net marginal product of capital is greater than
zero whenever the economy saves less than this amount, and it is less than zero whenever the economy saves
more. This numerical example confirms that the two ways of finding the Golden Rule steady state—looking
at steady-state consumption or looking at the marginal product of capital—gives the same answer. If we want
to know whether an actual economy is currently at, above, or below its Golden Rule capital stock, the second
method is usually more convenient, because estimates of the marginal product of capital are easy to come by.
By contrast, evaluating an economy with the first method requires estimates of steady-state consumption at
many different saving rates; such information is hard to obtain.

2.3. Population Growth

The basic Solow model shows that capital accumulation, by itself, cannot explain sustained economic growth:
high rates of saving lead to high growth temporarily, but the economy eventually approaches a steady state in
which capital and out-put are constant. To explain the sustained economic growth that we observe in most
parts of the world, we must expand the Solow model to incorporate the other two sources of economic growth
—population growth and technological progress. In this section we add population growth to the model.
Instead of assuming that the population is fixed, we now suppose that the population and the labor force grow
at a constant rate n. For example, the Ethiopian population grows about 1 percent per year, so n = 0.01. This
means that if 150 million people are working one year, then 151.5 million (1.01 × 150) are working the next
year, and 153.015million (1.01 × 151.5) the year after that, and so on.

A. The Steady State with Population Growth

How does population growth affect the steady state? To answer this question, we must discuss how
population growth, along with investment and depreciation, influences the accumulation of capital per
worker. As we noted before, investment raises the capital stock, and depreciation reduces it. But now there is
a third force acting to change the amount of capital per worker: the growth in the number of workers causes
capital per worker to fall. We continue to let lowercase letters stand for quantities per worker. Thus, k = K/L
is capital per worker, and y = Y/L is output per worker. Keep in mind, however, that the number of workers is
growing over time. The change in the capital stock per worker is ∆k = i - (δ+ n)k. This equation shows how
investment, depreciation, and population growth influence the per-worker capital stock. Investment increases
k, whereas depreciation and population growth decrease k. We saw this equation earlier in this chapter for the
special case of a constant population (n = 0).

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We can think of the term (δ+ n)k as defining break-even investment—the amount of investment necessary to
keep the capital stock per worker constant. Break-even investment includes the depreciation of existing
capital, which equals δk. It also includes the amount of investment necessary to provide new workers with
capital. The amount of investment necessary for this purpose is nk, because there are n new workers for each
existing worker, and because k is the amount of capital for each worker. The equation shows that population
growth reduces the accumulation of capital per worker much the way depreciation does. Depreciation reduces
k by wearing out the capital stock, whereas population growth reduces k by spreading the capital stock more
thinly among a larger population of workers. Our analysis with population growth now proceeds much as it
did previously. First, we substitute sf (k) for i. The equation can then be written as ∆k = sf(k) - (δ+ n)k.

To see what determines the steady-state level of capital per worker, we use Figure 6-8, which extends the
analysis by including the effects of population growth. An economy is in a steady state if capital per worker k
is unchanging. As before, we designate the steady-state value of k as k*. If k is less than k*, investment is
greater than break-even investment, so k rises. If k is greater than k*, investment is less than break-even
investment, so k falls. In the steady state, the positive effect of investment on the capital stock per worker
exactly balances the negative effects of depreciation and population growth.

That is, at k*, ∆k = 0 and i* = δk* + nk*.

Once the economy is in the steady state, investment has two purposes. Some of it (δk*) replaces the
depreciated capital, and the rest (nk*) provides the new workers with the steady-state amount of capital.

Figure8: Population Growth in the Solow Model

D. The effects of population Growth

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Population growth alters the basic Solow model 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. Be-cause 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 9 shows that an increase in the rate of
population growth from n1to n2 reduces the steady-state level of capital per worker from k 1* 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 GDP per person

Figure9: The Impact of Population Growth

Finally, population growth affects our criterion for determining the Golden Rule (consumption-maximizing)
level of capital. To see how this criterion changes, note that consumption per worker is c = y − i. Because
steady-state output is f (k*) and steady-state investment is (δ+ n)k*,we can express steady-state consumption
as c * = f(k*) − (δ+ n)k*.

Using an argument largely the same as before, we conclude that the level of k* that maximizes consumption
is the one at which MPK = δ+ n, or equivalently, MPK − δ= n. In the Golden Rule steady state, the marginal
product of capital net of depreciation equals the rate of population growth.

2.4. Technological Progress

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We now incorporate technological progress, the third source of economic growth, into the Solow model. So
far, our presentation of the Solow model has assumed an unchanging relationship between the inputs of
capital and labor and the output of goods and services. Yet the model can be modified to include exogenous
technological progress, which over time expands society’s ability to produce.

A. The Efficiency of Labor

To incorporate technological progress, we must return to the production function that relates total capital K
and total labor L to total output Y. Thus far, the production function has been Y = F(K, L). We now write the
production function as Y = F(K, L × E ), where E is a new (and somewhat abstract) variable called the
efficiency of labor. The efficiency of labor is meant to reflect society’s knowledge about production methods:
as the available technology improves, the efficiency of labor rises. For instance, the efficiency of labor rose
when assembly-line production transformed manufacturing in the early twentieth century, and it rose again
when computerization was introduced in the late twentieth century. The efficiency of labor also rises when
there are improvements in the health, education, or skills of the labor force. The term L × E measures the
number of effective workers. It takes into account the number of workers L and the efficiency of each worker
E. This new production function states that total output Y depends on the number of units of capital K and on
the number of effective workers L × E. Increases in the efficiency of labor E are, in effect, like increases in
the labor force L.

The simplest assumption about technological progress is that it causes the efficiency of labor E to grow at
some constant rate g. For example, if g = 0.02, then each unit of labor becomes 2 percent more efficient each
year: output increases as if the labor force had increased by an additional 2 percent. This form of
technological progress is called labor augmenting, and g is called the rate of labor-augmenting technological
progress. Because the labor force L is growing at rate n, and the efficiency of each unit of labor E is growing
at rate g, the number of effective workers L × E is growing at rate n + g.

B. The Steady State with Technological Progress

Expressing technological progress as labor augmenting makes it analogous to population growth. We

analyzed the economy in terms of quantities per worker and allowed the number of workers to rise over time.
Now we analyze the economy in terms of quantities per effective worker and allow the number of effective
workers to rise. To do this, we need to reconsider our notation. We now let k = K/ (L × E) stand for capital
per effective worker and y = Y/ (L × E) stand for output per effective worker. With these definitions, we can
again write y = f (k).

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This notation is not really as new as it seems. If we hold the efficiency of labor E constant at the arbitrary
value of 1, as we have done implicitly up to now, then these new definitions of k and y reduce to our old ones.
When the efficiency of labor is growing, however, we must keep in mind that k and y now refer to quantities
per effective worker (not per actual worker). Our analysis of the economy proceeds just as it did when we
examined population growth. The equation showing the evolution of k over time now changes to ∆k = sf(k) -
(δ+ n + g)k

As before, the change in the capital stock ∆k equals investment sf (k) minus break-even investment (δ+ n + g)
k. Now, however, because k = K/EL, 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. As shown in Figure 10, the
inclusion of technological progress does not substantially alter our analysis of the steady state. There is one
level ofk, denoted 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.

Figure10: Introducing Technological Progress

C. The Effects of Technological Progress

Table 4 shows how four key variables behave in the steady state with technological progress. As we have just
seen, capital per effective worker k is constant in the steady state. Because y = f(k), output per effective
worker is also constant. Remember, though, that the efficiency of each actual worker is growing at rate g.
Hence, output per worker (Y/L = y × E) also grows at rate g. Total output [Y = y × (E × L)] grows at rate n +
g. 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 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

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only on the rate of technological progress. According to the Solow model, only technological progress can
explain persistently rising living standards. The introduction of technological progress also modifies the
criterion for the Golden Rule. 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*

Steady-state consumption is maximized if: MPK = δ+ n + g, Or MPK - δ= n + g

That is, 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. Because actual economies experience both population growth and technological
progress, we must use this criterion to evaluate whether they have more or less capital than at the Golden Rule
steady state.

Table4:steady-state Growth Rates With Technological Progress

3. Beyond the Solow Model: Endogenous Growth Theory

One goal of growth theory is to explain the persistent rise in living standards that we observe in most parts of
the world. The Solow growth model shows that such persistent growth must come from technological
progress. But where does technological progress come from? In the Solow model, it is simply assumed! To
understand fully the process of economic growth, we need to go beyond the Solow model and develop models
that explain technological progress. Models that do this often go by the label endogenous growth theory,
because they reject the Solow model’s assumption of exogenous technological change. Although the field of
endogenous growth theory is large and sometimes complex, here we get a quick sampling of this modern
research.

The Basic Model

To illustrate the idea behind endogenous growth theory, let’s start with a particularly simple production
function: Y = AK, where Y is output, K is the capital stock, and A is a constant measuring the amount of

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output produced for each unit of capital. Notice that this production function does not exhibit the property of
diminishing returns to capital. One extra unit of capital produces A extra units of output, regardless of how
much capital there is. This absence of diminishing returns to capital is the key difference between this
endogenous growth model and the Solow model. Now let’s see how this production function relates to
economic growth. As before, we assume a fraction s of income is saved and invested. We therefore de-scribe
capital accumulation with an equation similar to those we used previously: ∆K= sY − δK.

This equation states that the change in the capital stock (K) equals investment (sY) minus depreciation (δK).
Combining this equation with the Y = AK production function, we obtain, after a bit of manipulation, ∆Y/Y =
∆K/K = sA − δ.

This equation shows what determines the growth rate of output ∆Y/Y. Notice that, as long as sA > δ, the
economy’s income grows forever, even without the assumption of exogenous technological progress. Thus, a
simple change in the production function can alter dramatically the predictions about economic growth. In the
Solow model, saving leads to growth temporarily, but diminishing returns to capital eventually force the
economy to approach a steady state in which growth depends only on exogenous technological progress. By
contrast, in this endogenous growth model, saving and investment can lead to persistent growth. But is it
reasonable to abandon the assumption of diminishing returns to capital? The answer depends on how we
interpret the variable K in the production function Y = AK. If we take the traditional view that K includes
only the economy’s stock of plants and equipment, then it is natural to assume diminishing re-turns. Giving
10 computers to each worker does not make the worker 10 times as productive as he or she is with one
computer.

Advocates of endogenous growth theory, however, argue that the assumption of constant (rather than
diminishing) returns to capital is more palatable if K is interpreted more broadly. Perhaps the best case for the
endogenous growth model is to view knowledge as a type of capital. Clearly, knowledge is an important input
into the economy’s production—both its production of goods and services and its production of new
knowledge. Compared to other forms of capital, however, it is less natural to assume that knowledge exhibits
the property of diminishing re-turns. (Indeed, the increasing pace of scientific and technological innovation
over the past few centuries has led some economists to argue that there are increasing returns to knowledge.)
If we accept the view that knowledge is a type of capital, then this endogenous growth model with its
assumption of constant returns to capital becomes a more plausible description of long-run economic growth.

A Two-Sector Model

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Although the Y = AK model is the simplest example of endogenous growth, the theory has gone well beyond
this. One line of research has tried to develop models with more than one sector of production in order to
offer a better description of the forces that govern technological progress. To see what we might learn from
such models, let’s sketch out an example.

The economy has two sectors, which we can call manufacturing firms and re-search universities. Firms
produce goods and services, which are used for consumption and investment in physical capital. Universities
produce a factor of production called “knowledge,” which is then freely used in both sectors. The economy is
described by the production function for firms, the production function for universities, and the capital-
accumulation equation:

Y = F[K,(1 − u)EL] (production function in manufacturing firms),

∆E = g(u)E (production function in research universities),

∆K = sY − δK (capital accumulation), where u is the fraction of the labor force in universities (and 1 - u is the
fraction in manufacturing), E is the stock of knowledge (which in turn determines the efficiency of labor), and
g is a function that shows how the growth in knowledge depends on the fraction of the labor force in
universities. The rest of the notation is standard. As usual, the production function for the manufacturing
firms is assumed to have constant returns to scale: if we double both the amount of physical capital (K ) and
the number of effective workers in manufacturing [(1 − u)EL], we double the output of goods and services
(Y).

This model is a cousin of the Y = AK model. Most important, this economy exhibits constant (rather than
diminishing) returns to capital, as long as capital is broadly defined to include knowledge. In particular, if we
double both physical capital K and knowledge E, then we double the output of both sectors in the economy.
As a result, like the Y = AK model, this model can generate persistent growth without the assumption of
exogenous shifts in the production function. Here persistent growth arises endogenously because the creation
of knowledge in universities never slows down.

At the same time, however, this model is also a cousin of the Solow growth model. If u, the fraction of the
labor force in universities, is held constant, then the efficiency of labor E grows at the constant rate g (u). This
result of constant growth in the efficiency of labor at rate g is precisely the assumption made in the Solow
model with technological progress. Moreover, the rest of the model—the manufacturing production functions
and the capital-accumulation equation—also resembles the rest of the Solow model. As a result, for any given
value of u, this endogenous growth model works just like the Solow model.

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There are two key decision variables in this model. As in the Solow model, the fraction of output used for
saving and investment, s, determines the steady-state stock of physical capital. In addition, the fraction of
labor in universities, u, determines the growth in the stock of knowledge. Both s and u affect the level of in-
come, although only u affects the steady-state growth rate of income. Thus, this model of endogenous growth
takes a small step in the direction of showing which societal decisions determine the rate of technological
change.

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