Chapter 6

Economic
Growth: from
Malthus to Solow
 Two Primary Phenomena that
Macroeconomists study are:
Economic Growth
Business Cycle

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 Economic Growth is Important!

If business cycles could be completely

eliminated, the worst events we would able to
avoid would be deviation from the trend of
GDP by 5%.
If changes in economic policy could cause
the growth rate of real GDP to increase by
1% per year to 100 years, the GDP would be
2.7 times higher than it would otherwise have
been.
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 Economic Growth Facts

Pre-1800 (Industrial Revolution):

constant per capita income across time
and space, no improvement in
standards of living.
Post-1800: Sustained Growth in the
Rich Countries. In the US, average
growth rate of GDP per capita has been
about 2% since 1869.

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 Figure 6.1 Natural Log of Real per
Capita Income in the United States,
18692002

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 Economic Growth Facts Cond
High Investment High Standard of
Living
High Population Growth Low
Standard of Living
Divergence of per capita Incomes:
18001950.

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 Figure 6.2 Output per Worker vs.
Investment Rate

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 Figure 6.3 Output per Worker vs.
the Population Growth Rate

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 Economic Growth Facts Cond
No conditional Convergence amongst
all Countries
(Weakly) Conditional Convergence
amongst the Rich Countries
No Conditional Convergence amongst
the Poorest Countries

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 Figure 6.4 No Convergence Among
All Countries

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 Figure 6.5 Convergence Among the
Richest Countries

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 Figure 6.6 No Convergence Among
the Poorest Countries

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 The Malthusian Model

Idea was provided by Thomas Malthus

in his highly influential book An Essay
on the Principle of Population in 1798.
He argued technological change
improvement in standard living
population growth reduce the average
person to the subsistence level again

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 In the long run there would be no
increase in the standard of living unless
there were some limits on population
growth.
It is a pessimistic theory!

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 The Malthusian Economy
Production technology

Y zF ( L, N )
L is the fixed amount of land, N is the labor
input. F has all the properties.
No investment technology (no refrigerator, food
perish)
No government

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 No leisure in the utility function.

U (C ) C
We normalize the labor endowment of
each person to be 1, so N is both the
population and the labor input

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 Assume the population growth depends
on the quantity of consumption per
worker (standard of living)
N' C
g( )
N N
g is a increasing function

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 Figure 6.7 Population Growth Depends
on Consumption per Worker in the
Malthusian Model

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 In equilibrium, we have
C Y
Hence
C zF ( L, N )

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 N' zF ( L, N ) L
g( ) g ( zF ( ,1))
N N N

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 Steady State

When N=N, we say the economy

reaches the steady state (SS).
In SS, N=N*, C*=zF(L,N*).
Define variable in terms of per capita,
for example, y=Y/N, c=C/N, l=L/N. we
have
y=f(l) (f(l)=F(l,1))
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 In equilibrium, c=y. Hence we have
c=zf(l) (1)
Law of motion of population
N/N=g(c) (2)
(1) + (2) consist the dynamic economic
system for this economy

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 In SS, N/N=1, this determines the SS value of
consumption per capita c
1=g(c*)
Then in equation (1), c* in turn determines l*
through
c*=zf(l*)
Finally, the SS population size N* is determined by
N*=L/l*

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 Figure 6.8 Determination of the
Population in the Steady State

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 Figure 6.9 The Per-Worker
Production Function

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 Figure 6.10 Determination of the
Steady State in the Malthusian Model

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 The Effect of TFP on the SS
Do not improve the standard of living c*
in the long run ( c* is determined by
1=g(c*) )
Only increases the population (l*, N*)

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 Figure 6.11 The Effect of an
Increase in z in the Malthusian Model

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 Figure 6.12
Adjustment to
the Steady State
in the Malthusian
Model When z
Increases

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 Policy Implication: Population
Control
Government directly controls the population
growth: g(c)
In SS, c1* c2*. Standard of living increases.
The quantity of land per worker increases too,
l1* l2*. That leads to the SS population size
decreases N1* N2*.
Theoretical foundation of Chinese One Child
policy.

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 Figure 6.13 Population Control in
the Malthusian Model

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 Evaluation of Malthusian Model

Consistent with the growth facts before 1800:

production was mainly agricultural, population
grew over time, but no significant
improvements in the average standard of
living
What did happen after 1800?
Sustained growth in standards of living in the
richest countries
The richest countries also have experienced a
large drop in birth rates

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 Malthus was wrong on these two dimensions
He did not allow for the effect of increases in K on
production. Capital can produce itself.
He did not account for all of the effects of
economic forces on population growth. As
economy develops, the opportunity cost of raising
a large family becomes large. Fertility rate
decreases.
We need a GROWTH theory!

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 Source: Fernandez-Villaverde (2001)
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 Source: Fernandez-Villaverde (2001)
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 Source: Bar and Leukhina (2005)

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 The Solow Model: Exogenous
Growth
Consumers
Utility function: U(C)=C
Budget Constraint: C+S=Y (Why?)
Consumers have to make consumption-
saving decisions
We assume the consumers consume a
constant fraction of income in each period
C=(1-s)Y, S=sY

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 Firm
Production function Y=zF(K,N)
It has all of the properties we discussed in
Chapter 4 (CRS, increasing, concave,)
We can rewrite everything in terms of
per capita variables
Y K
zF ( ,1)
N N
y zf ( k )

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 The capital stock evolves according to
K=(1-d)K+I
I is the investment. 0<d<1 is the
depreciation rate.

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 Figure 6.14 The Per-Worker
Production Function

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 Competitive Equilibrium

In equilibrium, S=I
So we have Y=C+I
Y=(1-s)Y+K-(1-d)K
K=sY+(1-d)K
K/N=szF(K,N)/N+(1-d)K/N
(K/N)(N/N)=szF(K/N,1)+(1-d)K/N
Assume the population growth rate is n. We have N=(1+n)N

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 szf (k ) (1 d )k
k'
1 n 1 n
When k=k, we reach the steady state (SS).

Solow model predicts that eventually k will

converge to SS value k*

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 Figure 6.15 Determination of the Steady
State Quantity of Capital per Worker

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 Model Prediction
There is no long run economic growth in per
capita variables.
But there is a long run economic growth rate in
aggregate variables. (If n,s,z are constant.)
K=k*N, K=k*N K/K=N/N=1+n, so
(K-K)/K=n
Y=y*N=zf(k*)N Y/Y=1+n
Since S=I=sY S/S=1+n
Same as C
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 All aggregate variables grow at the rate
n!
This is the reason why Solow model is
an exogenous growth model. The long-
run growth is determined by exogenous
labor force growth.

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 Analysis of the Steady State

In SS, k=k=k*. So we have

szf (k *) (1 d )k *
k*
1 n 1 n
or
szf ( k *) (n d )k *
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 Figure 6.16 Determination of the Steady
State Quantity of Capital per Worker

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 Experiment: The Effect of s in SS

The SS level of per capita capital stock

k* will increase. Hence c*,y* also
increase.
It predicts a positive relation b/w s
(investment rate) and y (GDP per
capita). Confirmed by data!
But there is no change in the growth
rates of the aggregate variables (still n).
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 Figure 6.17 Effect of an Increase in the
Savings Rate on the Steady State
Quantity of Capital per Worker

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 Figure 6.18 Effect of an Increase in
the Savings Rate at Time T

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 Consumption per Worker and
Golden Rule
In SS, the consumption per worker is
c=(1-s)zf(k*)=zf(k*)-(n+d)k*
The golden rule quantity of capital per
worker k *gr is k such that c is
maximized
MPk=n+d

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 Figure 6.19 Steady State
Consumption per Worker

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 Figure 6.20
The Golden
Rule Quantity
of Capital per
Worker

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 Experiment: The Effect of n in SS

The SS quantity of capital per worker

(k*) decreases.
y* and c* also decrease. Hence n
(population growth rate) is negatively
correlated with y. Confirmed by data
But the aggregate variables Y, K, C all
grow at higher rate

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 Figure 6.21 Steady State Effects of an
Increase in the Labor Force Growth Rate

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 The prediction of Solow Model

Solow model predicts saving rate

(investment rate) y, and n y
It is consistent with the data (recall it)

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 Experiment: The Effects of TFP

To make y continuously, we need s and n

continuously. But sooner or later, they will hit
the boundary.
To make an unbounded long run growth, we
need TFP (or z)
TFP k, hence y, c
Now recall what Malthus model says about
the TFP, we can have long-run growth now
with Solow model

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 Figure 6.22 Increases in Total Factor
Productivity in the Solow Growth Model

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 Growth Accounting

Typically, growing economies are

experiencing growth in factors of
production and in TFP.
A natural question is can we measure
how much of the growth in Y is
accounted for by growth in each of the
inputs to production and by increases in
TFP.

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 We call this exercise is Growth
Accounting.
Start from aggregate production
function
1
Y zK ( N )
Profit maximization implies

MPN (1 ) zK ( N ) w
1
wN (1 ) zK ( N ) (1 )Y
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 (1-) is the share of labor incomes in
GDP. In postwar US data, it is 0.64.
Similarly, =0.36 is the capital share in
national income.
Hence the production function is
Y zK 0.36
(N ) 0.64

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 The z, called Solow residual, is
measured from the production
Y
z 0.36 0.64
K (N )

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 Table 6.1 Average Annual Growth
Rates in the Solow Residual

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 Figure 6.23 Natural Log of the
Solow Residual, 19482001

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 Figure 6.24 Percentage Deviations from Trend
in Real GDP (black line)and the Solow Residual
(colored line), 19482001

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 Growth Accounting
Decomposition
Take a natural log on aggregate
production function
ln Y ln z 0.36 ln K 0.64ln N
Take first order derivatives w.r.t. time t
on both. sides
. . .
Y z K N
0.36 0.64
Y z K N
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 Growth rate of output =
Growth rate of TFP
+ 0.36 * Growth rate of capital
+ 0.64 * Growth rate of labor

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 Table 6.2 Measured GDP, Capital Stock,
Employment, and Solow Residual

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 Table 6.3 Average Annual Growth Rates

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 An Example: East Asian Miracles

Alwyn Young did a growth accounting

exercise for Four Little Dragons
Found high rates of GDP growth in these
countries were mainly due to high growth
rates in factor inputs.
Implication: East Asian Miracle is probably not
sustainable over a longer period. (Japan
recession in 1990s, South Korea Financial
Crisis)

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 Table 6.4 East Asian Growth Miracles
(Average Annual Growth Rates)

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