Solow Growth Model

Economic Department
 Outline of the presentation

· Explain the steady state in the Solow model and

implications for economic growth in the LR.
· Explain how changes in the capital stock where k is
below(above) steady state k impact the level of
output and the growth rate of output.
· Summarise the growth phenomenon in the Solow
model.

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 Assumptions of the Solow model

· One composite commodity is produced.

· Output is regarded as net output after making allowance
for the depreciation (δ) of capital.
· There are constant returns to scale.
· The two factors of production labour and capital are paid
an income according to their marginal physical
productivities
· Prices and wages are flexible.
· The rate of depreciation (δ) in the model is a constant
(which gives the curve its straight-line shape).
· There is perpetual full employment of labour.

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 Assumptions of the Solow model

· There is also full employment of the available stock of

capital.
· Labour and capital are substitutable for each other.
· There is neutral technical progress.
· The saving ratio is constant (s) a proportion of output or
income, giving s its shape.
· There are diminishing returns to capital or labour
· We assume a closed economy

These assumptions are critical to the operation of the model.

We will see next how they each work but try and see if you can match each
assumption to some part of the model.

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 Capital accumulation and economic growth

· The point of the Solow model is that capital accumulation

is the driver of growth.
· In the model capital accumulation is driven by savings
where:
○ I= S

∆k = (savings rate*y) - depreciation(δ)

This equation means that we save a constant proportion of

income which funds investment in the per capita stock (∆k).
However, since not all new investments contribute to the growth
of capital stock, we must adjust for depreciation.
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The Solow model and the steady state

· The steady state is so important that the rest of the model

focuses on this.
· What is the steady state?
○ The steady state is the level of output reached when
the change in the capital stock =0.
○ At that level all investments in k = depreciation so that
there is no change in the capital stock.
○ The steady state is also the level where the growth
rate of output is =0 and where economic growth stops
because the economy has reached its full capacity.
○ Beyond the steady state level of output diminishing
returns kick in and the growth rate in output becomes
negative.

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 The Solow model and the steady state where
ΔK = 0

Output-
labour Production function
ratio B y =f (k )
(y=Y/L) C
depreciation = k

A saving =s f (k )

k Capital-labour
ratio
(k=K/L)
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 Variables of the Solow model

· Y = output which is a function of k. when we say y

is a function of k (capital intensity) we mean that
when we increases k, output increases.
· Savings a function of y = s*y what this means is
that when y increases savings increases because
savings are a (constant) proportion of income.
· Depreciation is a function of k (d = d*k) which
means that when we increase the capital stock
depreciation also increases.

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 Explaining the variables

Depreciation (δ) constant ratio of the capital stock

constant fraction (d) of capital per worker is used
up (decays, melts) in production each period
depreciation = k
Savings (s) a constant ratio of income is saved
every period. What is not saved is consumed so
(Y-s) is the proportion of income that is consumed.
saving =s f (k )
Output (y) and capital intensity (k) are endogenous
variables while s (savings rate), d (depreciation
rate), and growth rate of L (labour) and/or A
(technology) are exogenous variables.
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 Saving is a function of k

Output- Saving per worker depends on y. We save a

labour constant fraction (s) of our gross income
ratio f (k ) y =f (k )
3
(y=Y/L)f (k )
2

f (k1) 3
2
1
s f  k3 
s f k 2 
s f k1 

0 k1 k2 k3
Capital-labour
ratio
(k=K/L) 10
 The savings function

· Recall: I=S
· Savings = the savings rate (s) times output s*Y
· Another way to express this in terms of our
production function is to say that in the model
savings are a function of output or savings are
determined by the savings rate.
· This gives the savings function its shape.

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 Depreciation Function

Output-
labour Gross vs. net
ratio output
y =f (k )
(y=Y/L)
depreciation = k
Gross output
=f (k ) Net output
=f (k )   k

gross
output  k = replacement investment needed
to maintain constant capital intensity

0 k Capital-labour
Depreciation is represented ratio
by the straight line (k=K/L)
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 What happens if we do not exactly consume the net
product?

· If we happen to save more than what is required for

replacement capital (d*k ) then k will increase over
time.
· If we fail to save as much as what is needed for
replacement capital (d *k) then k will decrease over
time

ΔK= (s*Y)- (d*k)OR Δk= sf(k)- d. k

i.e. Change in capital stock = Savings (or Investment)-

Depreciation

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 Change in k

Output- At k1, d .k < s .f(k) and k will

labour rise.
Production function
ratio B y =f (k )
(y=Y/L) A
depreciation = k

C saving =s f (k )
k  0 
Steady state

k1 k Capital-labour
ratio
(k=K/L)
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 How does the solow model work?

Output- An increase in output is =

labour movement from A, B to S
Production function
ratio S y =f (k )
(y=Y/L) ys B
y2
depreciation = k

y1 A
saving =s f (k )

An increase in
the capital stock
is represented
but a movement k1 k2 k Capital-labour
from k1 to k2 and ratio
so on (k=K/L)
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 How does the Solow model work?

· In the previous slide we have shown the process of capital

accumulation which is the increase in the capital stock from k 1 to k2

and so on.

· We have also shown the increase in output from y 1 to y2 and so on

until the steady state (S).
· At S we reach the steady state output and also the steady state k.
You will notice that S is the maximum attainable output given the level
of technology.
· Increasing the capital stock beyond this point leads to declining
output as shown by the slope of the production function.

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Capital accumulation and economic growth

· Can capital accumulation proceed in an unlimited

fashion?
· Does more savings always mean faster growth?
· Is it always a good idea to save more?

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Understanding the steady state

· The steady state in the Solow model describes

the long-run behavior of the economy.
· In the steady state:
• The growth rate in output per capita (y) and labour productivity
are constant.
• Why?
• Economic growth initially accelerates as k increases and MPK is
high.
• However, the growth rates approach 0 as MPK declines and the
economy approaches the steady state and stops when
economies reach the steady state.
• The implication is that economies that are far from the steady
state grow faster while economies closer to the steady state will
on average grow slower than those.

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 At this steady state point, ΔK = 0

Output-
labour Production function
ratio S y =f (k )
ys
(y=Y/L)
depreciation = k

saving =s f (k )

At this point change

in K=0
Capital-labour
ratio
(k=K/L) 19
Why growth stops at the steady state

Hint, the change in k is =0 at the steady state, can

you see that?
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The growth phenomenon

· In the Solow model capital accumulation continues

until the economy reaches a steady state.
· Each economy has its steady state determined by its
endowment of capital and labour.
· Driven by high MPK before the steady state growth
initially accelerates.
· However, as economies approach the steady state
growth slows down as MPK declines; once the steady
state is reached, growth stops.
· The implication is that economies that are far away
from the steady state will grow faster while economies
closer to the steady state will on average grow slower.

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Summary of points

 The fact that capital runs into diminishing returns

means that the model does not lead to sustained
economic growth.
 As the economy accumulates more capital,
depreciation rises one-for-one, but output and
therefore investment rise less than one-for-one due
to diminishing marginal product of capital.
 Eventually, the new investment is only just sufficient
to offset depreciation, and the capital stock ceases
to grow.
 Output stops growing as well, and the economy
settles down to a steady state.
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At K below the steady state level

 When the economy is growing and the capital

stock and output rise.
 Why?
 Investment > depreciation we are saving more
than what is required to cover depreciation hence
capital increases until the steady state point,
where investment equals depreciation and Δk = 0

Note: change in the capital stock tells us

which direction the economy is headed. If a
change in capital stock is positive, the
economy is growing.

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At K above the steady state level

 When the change in the capital stock ∆K <0 the

capital stock and output are declining.
 Why? Investment/savings < depreciation, the
capital stock decreases since we are not saving
enough to cover depreciation.
 K and output will fall until the economy is back at
the steady state point, where investment is again
equal to depreciation and ΔK = 0
Note: again the change in the capital stock
tells us which direction the economy is
headed. When k is falling growth is also
falling.
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Capital Alone Cannot be the Key to Economic
Growth

· WHY?
· Because of diminishing MPK - as capital increases,
depreciation increases at a constant rate = d.
· Output increases at a diminishing rate and
because investment is a constant fraction of
output, investment also increases at a decreasing
rate.
· This all means that at some point depreciation will
be equal to investment and the capital stock will
start declining.

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Overall Conclusion

· Regardless of where the economy starts, it moves

towards a steady state.
· Can capital accumulation continue beyond the
steady state?
· No!!!!
· Since as the economy gets closer and closer to the
steady state net investment shrinks until is equal to
nil in the steady state and declines beyond the
steady state.

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Thank you!!!