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Lecture 1

The document outlines the Solow growth model, focusing on economic growth defined as the average rate of growth in real GDP per capita over long periods. It discusses central questions of growth theory, growth facts, and the assumptions underlying the Solow-Swan model, including capital accumulation and the concept of break-even investment. The document concludes with the implications of the model for understanding growth rates of aggregate and per capita output.

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Ahmed Khan
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2 views

Lecture 1

The document outlines the Solow growth model, focusing on economic growth defined as the average rate of growth in real GDP per capita over long periods. It discusses central questions of growth theory, growth facts, and the assumptions underlying the Solow-Swan model, including capital accumulation and the concept of break-even investment. The document concludes with the implications of the model for understanding growth rates of aggregate and per capita output.

Uploaded by

Ahmed Khan
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Econ 905 Macroeconomics

Economic growth: The Solow model


Outline
• Readings for weeks 1 and 2
– Background: GLS chs 1-3
– Solow’s Growth model: Romer ch - 1
What is growth?
• When economists say “growth,” they mean
average rate of growth in real GDP per
capita over long horizons
• Long run: frequencies of time measured in
decades
• Not period-to-period fluctuations in the
growth rate
• “Once one begins to think about growth, it
is difficult to think about anything else” –
Robert Lucas, 1995 Nobel Prize winner
Central Questions of Growth Theory.

1. Why are some countries so rich and others so


poor?
2. Why do growth rates vary across countries and
over time?
3. What are the policies that can change growth in
the short and long run?
4. Why do some countries “take off” while others
fall behind?
Think about the growth of Sub-Saharan Africa, East
Asia, OECD...
Growth facts
Kaldor’s (1961) list of stylized facts
1. Per capita output (Y/L) grows over time. [Growth
rates need not be constant over time.]
2. Physical capital per worker (K/L) grows over
time.
3. Rate of return to capital (r) nearly constant.
4. Ratio of physical capital to output (K/Y) nearly
constant.
5. Shares of labour ((w.L)/Y) and physical capital
((r.K)/Y) in national income nearly constant.
The Solow-Swan growth model
The basic assumptions of the model
1. Focuses on four variables: output (Y), capital
(K), labour (L), and “knowledge” or the
“effectiveness of labour” (A).
 Y(t) ═ F((K(t), A(t), L(t))
 A and L enter multiplicatively. AL is referred to as
“effective labour”.
2. Constant returns to scale in its two arguments,
capital and effective labour.
 F(cK, cAL) ═ cF(K, AL) for all c ≥ 0
Assumptions (...cont.)
We can use the concept of CRS to derive the intensive form
of the production function:
 Let c ═ 1/AL
 Applying CRS: F(cK, cAL) = F(k,1) = f (k), where k = K/AL
 likewise: y = Y/AL = f (k).
 This is the intensive form of the production function.

3. The intensive-form production function, (k), is


assumed to satisfy f
1. f (0) = 0
2. f '(k) >0
3. f ''(k)<0
Assumptions (...cont.)
4. Inada Conditions are satisfied.
limk0 f '(k) = 
limk f '(k) = 0

This and what we know about f '(k) & f ''(k)


implies shape of production function
The Production Function
y
f(K/AL)

k
Assumptions (...cont.)
• Factors of production are fully and
efficiently employed.
• Capital depreciates at a constant rate d.
• Capital markets clear so all savings are
invested, or, S = I.
• Labour (L) and knowledge (A) grow at
constant rates ‘n’ and ‘g’ respectively.
Assumptions (...cont.)
L and A grow at constant rate over time:

dLt
nLt
dt
dAt
 gAt
dt

where n and g are the growth rates.


Equivalent ways of expressing
growth rates

To see how we get the last equivalence:


Capital Accumulation
• Start from the national income accounting equation
 Y = C + I + G + NX
• Assume for now no government (i.e., G = 0) and start
with closed economy (i.e., NX = 0)
• Capital stock K(t) depreciates at a constant rate δ > 0
• Capital stock changes over time according to
 dK/dt = I(t) − δK(t)
• Since capital markets clear in equilibrium
 I(t) = S(t) = sY(t)
• Therefore, dK/dt = sY(t) − δK(t).
Capital Accumulation
• The growth rate of capital is determined by
savings and depreciation.
dK/dt = sYt – dKt
 With both s and d exogenous constants.
• Capital stock will grow so long as:
sYt > dKt
• How does k=K/AL evolve over time?
It depends on n, g and the rate of depreciation d as
well as savings, s, as we see next.
Differentiate ‘k’ w.r.t time
To save on notation, we assume here xdt=dx/dt,
where ‘x’ is any variable.
dt dt
K A L  K ( A L )
k dt  t t t t t
( At Lt ) 2

K dt At Lt  K t ( At Ldt  Adt Lt )

( At Lt ) 2

K dt At Lt K t ( At Ldt  Adt Lt )
 2

( At Lt ) ( At Lt ) 2
Differentiating k
dt
dt K Kt dt dt
k   2
[ At L  A Lt ]
At Lt ( At Lt )
K dt K t At Ldt K t Adt Lt
  2
 2
At Lt ( A L
t t ) ( A L
t t )

K dt K t Ldt K t Adt
  
At Lt At Lt Lt At Lt At
Differentiating k
dt
K
k dt   kt n  kt g
At Lt

sYt  K t
  kt n  kt g
At Lt

Yt Kt
s   kt n  kt g
At Lt At Lt
Differentiating k
k dt syt  kt  kt n  kt g
sf kt    n  g kt
• We substitute yt = f (kt) above.
• A concept of break even investment is
important for a steady state to be achieved.
• Break even investment occurs when
savings are just sufficient to stabilize
K/AL,
i.e. where: syt = (n + g + d)kt
Break Even Investment

sy (n+g+)k

k
Solow Growth Model

sy (n+g+)k

sf(K/AL)

k* k
Balanced Growth Path
Growth converges to balanced growth path at steady
state.
On this growth path what are the growth rates of:
– Aggregate capital and output Kt, Yt
– Per capita capital and output, K/L,Y/L
– Per efficiency unit of output, yt
The answers are:
 Kt grows at rate n+g
 So does Yt
 yt stagnates at this point
 Y/L grows at rate g
Can you show how?

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