SolowSwan model

While neoclassical growth model redirects here, it may 1.2 Short-run implications
also refer to the RamseyCassKoopmans model.
In the short run, growth is determined by moving to the
The SolowSwan model is an exogenous growth new steady state which is created only from the change
model, an economic model of long-run economic growth in the capital investment, labor force growth and depreset within the framework of neoclassical economics. It ciation rate. The change in the capital investment is from
attempts to explain long-run economic growth by look- the change in the savings rate.
ing at capital accumulation, labor or population growth,
and increases in productivity, commonly referred to
as technological progress. At its core is a neoclassical aggregate production function, usually of a Cobb
Douglas type, which enables the model to make contact with microeconomics.[1]:26 The model was developed independently by Robert Solow and Trevor Swan in
1956,[2][3] and superseded the post-Keynesian Harrod
Domar model. Due to its particularly attractive mathematical characteristics, SolowSwan proved to be a convenient starting point for various extensions. For instance, in 1965, David Cass and Tjalling Koopmans
integrated Frank Ramseys analysis of consumer optimization, thereby endogenizing the savings ratesee the
RamseyCassKoopmans model.

1.3 Long-run implications

The standard Solow model predicts that in the long run,
growth will be equal to the new steady state. This is
the biggest weaknesses of the model because it means
that, in the long run, there is no growth. The idea that
a country reaches steady state and stays there forever is
considered by some Economists to be unrealistic, and to
allow a continued growth condition in the long-term the
Solow Romer model is used. By combining the Solow
and Romer models, economists are able to predict a long
run situation that includes sustained growth. However,
there are natural limits to economic growth within the
planetary boundaries that are not addressed by the Solow
Romer approach.

Background
1.4 Assumptions

The neo-classical model was an extension to the 1946

HarrodDomar model that included a new term: productivity growth. Important contributions to the model
came from the work done by Solow and by Swan in 1956,
who independently developed relatively simple growth
models.[2][3] Solows model tted available data on US
economic growth with some success.[4] In 1987 Solow
was awarded the Nobel Prize in Economics for his work.
Today, economists use Solows sources-of-growth accounting to estimate the separate eects on economic
growth of technological change, capital, and labor.[5]

1.1

Extension
model

to

the

The key assumption of the neoclassical growth model is

that capital is subject to diminishing returns in a closed
economy.
Given a xed stock of labor, the impact on output of
the last unit of capital accumulated will always be less
than the one before.

Assuming for simplicity no technological progress or

labor force growth, diminishing returns implies that at
some point the amount of new capital produced is only
just enough to make up for the amount of existing capital
lost due to depreciation. At this point, because of the
HarrodDomar assumptions of no technological progress or labor force
growth, we can see the economy ceases to grow.

Assuming non-zero rates of labor growth complicates

matters somewhat, but the basic logic still applies in
the short-run the rate of growth slows as diminishing re Adding labor as a factor of production;
turns take eect and the economy converges to a constant
And capital-labor ratios are not xed as they are in steady-state rate of growth (that is, no economic growth
the HarrodDomar model. These renements allow per-capita).
increasing capital intensity to be distinguished from Including non-zero technological progress is very simtechnological progress.
ilar to the assumption of non-zero workforce growth, in

Solow extended the HarrodDomar model by:

2 MATHEMATICS OF THE MODEL

terms of eective labor": a new steady state is reached

with constant output per worker-hour required for a unit

1
of output. However, in this case, per-capita output grows Y (t) = K(t) (A(t)L(t))
at the rate of technological progress in the steady-state where t denotes time, 0 < < 1 is the elasticity of
(that is, the rate of productivity growth).
output with respect to capital, and Y (t) represents total
production. A refers to labor-augmenting technology or
knowledge, thus AL represents eective labor. All fac1.5 Variations in the eects of productivity tors of production are fully employed, and initial values
A(0) , K(0) , and L(0) are given. The number of workIn the Solow-Swan model the unexplained change in the
ers, i.e. labor, as well as the level of technology grow
growth of output after accounting for the eect of capiexogenously at rates n and g , respectively:
tal accumulation is called the Solow residual. This residual measures the exogenous increase in total factor productivity (TFP) during a particular time period. The inL(t) = L(0)ent
crease in TFP is often attributed entirely to technological
progress, but it also includes any permanent improvement A(t) = A(0)egt
in the eciency with which factors of production are
The number of eective units of labor, A(t)L(t) , therecombined over time. Implicitly TFP growth includes any
fore grows at rate (n + g) . Meanwhile, the stock of cappermanent productivity improvements that result from
ital depreciates over time at a constant rate . However,
improved management practices in the private or public
only a fraction of the output ( cY (t) with 0 < c < 1 ) is
sectors of the economy. Paradoxically, even though TFP
consumed, leaving a saved share s = 1c for investment:
growth is exogenous in the model, it cannot be observed,
so it can only be estimated in conjunction with the simultaneous estimate of the eect of capital accumulation on
K(t) = s Y (t) K(t)
growth during a particular time period.
dK(t)
The model can be reformulated in slightly dierent ways where K is shorthand for dt , the derivative with reusing dierent productivity assumptions, or dierent spect to time. Derivative with respect to time means that
it is the change in capital stockoutput that is neither
measurement metrics:
consumed nor used to replace worn-out old capital goods
Average Labor Productivity (ALP) is economic out- is net investment.
put per labor hour.
Since the production function Y (K, AL) has constant
it can be written as output per eective
Multifactor productivity (MFP) is output divided by returns to scale,
[note 1]
unit
of
labour:
a weighted average of capital and labor inputs. The
weights used are usually based on the aggregate input shares either factor earns. This ratio is often
Y (t)
= k(t)
quoted as: 33% return to capital and 67% return to y(t) =
A(t)L(t)
labor (in Western nations).
The main interest of the model is the dynamics of capital
In a growing economy, capital is accumulated faster than intensity k , the capital stock per unit of eective labour.
people are born, so the denominator in the growth func- Its behaviour over time is given by the key equation of the
[note 2]
tion under the MFP calculation is growing faster than SolowSwan model:
in the ALP calculation. Hence, MFP growth is almost
always lower than ALP growth. (Therefore, measuring

= sk(t) (n + g + )k(t)
in ALP terms increases the apparent capital deepening k(t)
eect.) MFP is measured by the "Solow residual", not
The rst term, sk(t) = sy(t) , is the actual investment
ALP.
per unit of eective labour: the fraction s of the output
per unit of eective labour y(t) that is saved and invested.
The second term, (n + g + )k(t) , is the break-even
2 Mathematics of the model
investment: the amount of investment that must be invested to prevent k from falling.[8]:16 The equation imThe textbook SolowSwan model is set in continuous- plies that k(t) converges to a steady-state value of k ,
time world with no government or international trade. A dened by sk(t) = (n + g + )k(t) , at which there is
single good (output) is produced using two factors of pro- neither an increase nor a decrease of capital intensity:
duction, labor ( L ) and capital ( K )in an aggregate production function that satises the Inada conditions, which
1
) 1
(
imply that the elasticity of substitution must be asymptots

k =
ically equal to one.[6][7]
n+g+

3
at which the stock of capital K and eective labour AL 3 MankiwRomerWeil version of
are growing at rate (n+g) . By assumption of constant remodel
turns, output Y is also growing at that rate. In essence, the
SolowSwan model predicts that an economy will converge to a balanced-growth equilibrium, regardless of its 3.1 Addition of Human Capital
starting point. In this situation, the growth of output per
worker is determined solely by the rate of technological N. Gregory Mankiw, David Romer, and David Weil created a human capital augmented version of the Solowprogress.[8]:18
Swan model that can explain the failure of international
K(t)
Since, by denition, Y (t) = k(t)1 , at the equilibrium investment to ow to poor countries.[11] In this model outk we have
put and the marginal product of capital (K) are lower in
poor countries because they have less human capital than
rich countries.
s
K(t)
Similar to the textbook SolowSwan model, the produc=
Y (t)
n+g+
tion function is of CobbDouglas type:
Therefore, at the equilibrium, the capital/output ratio depends only on savings, growth, and depreciation rates. Y (t) = K(t) H(t) (A(t)L(t))1
This is the Solow-Swan models version of the Golden
where H(t) is the stock of human capital, which deprecirule savings rate.
ates at the same rate as physical capital. For simplicity,
Since < 1 , at any time t the marginal product of capital
they assume the same function of accumulation for both
K(t) in the Solow-Swan model is inversely related to the
types of capital. Like in SolowSwan, a fraction of the
capital/labor ratio.
outcome, sY (t) , is saved each period, but in this case
split up and invested partly in physical and partly in human capital, such that s = sK + sH . Therefore, there
Y
are two fundamental dynamic equations in this model:
1
1
MPK =
= A
/(K/L)
K
If productivity A is the same across countries, then countries with less capital per worker K/L have a higher
marginal product, which would provide a higher return
on capital investment. As a consequence, the model predicts that in a world of open market economies and global
nancial capital, investment will ow from rich countries to poor countries, until capital/worker K/L and income/worker Y /L equalize across countries.

k = sK k h (n + g + )k
h = sH k h (n + g + )h
The balanced (or steady-state) equilibrium growth path is
determined by k = h = 0 , which means sK k h (n+
g + )k = 0 and sH k h (n + g + )h = 0 . Solving
for the steady-state level of k and h yields:

Since the marginal product of physical capital is not

1
(
) 1
1
higher in poor countries than in rich countries,[9] the ims
s

H
K
plication is that productivity is lower in poor countries. k = n + g +
The basic Solow model cannot explain why productivity
1
is lower in these countries. Lucas suggested that lower
( 1 ) 1
sK sH
levels of human capital in poor countries could explain h =
n+g+
the lower productivity.[10]

Y
If one equates the marginal product of capital K
with In the steady state, y = (k ) (h ) .
the rate of return r (such approximation is often used in
neoclassical economics), then, for our choice of the pro3.2 Econometric estimates
duction function

Klenow and Rodriguez-Clare cast doubt on the validity

of the augmented model because Mankiw, Romer, and
Y
K K
rK
Weils estimates of did not seem consistent with ac=
=
cepted estimates of the eect of increases in schooling
Y
Y
on workers salaries. Though the estimated model exso that is the fraction of income appropriated by cap- plained 78% of variation in income across countries, the
ital. Thus, Solow-Swan model assumes from the begin- estimates of implied that human capitals external efning that the labor-capital split of income remains con- fects on national income are greater than its direct eect
stant.
on workers salaries.[12]

3.3

6 NOTES

Accounting for External Eects

that have greatly raised their savings rates have experienced the income convergence predicted by the SolowSwan model. As an example, output/worker in Japan, a
country which was once relatively poor, has converged to
the level of the rich countries. Japan experienced high
growth rates after it raised its savings rates in the 1950s
and 1960s, and it has experienced slowing growth of output/worker since its savings rates stabilized around 1970,
as predicted by the model.

Theodore Breton provided an insight that reconciled

the large eect of human capital from schooling in the
Mankiw, Romer and Weil model with the smaller eect
of schooling on workers salaries. He demonstrated that
the mathematical properties of the model include signicant external eects between the factors of production,
because human capital and physical capital are multiplicative factors of production.[13] The external eect of
The per-capita income levels of the southern states of
human capital on the productivity of physical capital is
the United States have tended to converge to the levevident in the marginal product of physical capital:
els in the Northern states. The observed convergence in
these states is also consistent with the conditional convergence concept. Whether absolute convergence beY
tween countries or regions occurs depends on whether
MPK =
= A1 (H/L) /(K/L)1
K
they have similar characteristics, such as:
He showed that the large estimates of the eect of human
capital in cross-country estimates of the model are con Education policy
sistent with the smaller eect typically found on work Institutional arrangements
ers salaries when the external eects of human capital
on physical capital and labor are taken into account. This
Free markets internally, and trade policy with other
insight signicantly strengthens the case for the Mankiw,
countries.[15]
Romer, and Weil version of the Solow-Swan model. Most
analyses criticizing this model fail to account for the external eects of both types of capital inherent in the Additional evidence for conditional convergence comes
from multivariate, cross-country regressions.[16]
model.[13]
If productivity growth were associated only with high
technology then the introduction of information technol3.4 Total Factor Productivity
ogy should have led to a noticeable productivity acceleration over the past twenty years; but it has not: see: Solow
The exogenous rate of TFP (Total Factor Productivity) computer paradox. Instead world productivity appears to
growth in the Solow-Swan model is the residual after ac- have increased relatively steadily since the 19th century.
counting for capital accumulation. The Mankiw, Romer
and Weil model provides a lower estimate of the TFP Econometric analysis on Singapore and the other "East
(residual) than the basic Solow-Swan model because the Asian Tigers" has produced the surprising result that aladdition of human capital to the model enables capital though output per worker has been rising, almost none
accumulation to explain more of the variation in income of their rapid growth had been due to rising per-capita
[5]
across countries. In the basic model the TFP residual in- productivity (they have a low "Solow residual").
cludes the eect of human capital because human capital
is not included as a factor of production.

5 See also

Conditional convergence

The Solow-Swan model augmented with human capital

predicts that the income levels of poor countries will tend
to catch up with or converge towards the income levels of rich countries if the poor countries have similar
savings rates for both physical capital and human capital as a share of output, a process known as conditional
convergence. However, savings rates vary widely across
countries. In particular, since considerable nancing constraints exist for investment in schooling, savings rates for
human capital are likely to vary as a function of cultural
and ideological characteristics in each country. [14]
Since the 1950s, output/worker in rich and poor countries generally has not converged, but those poor countries

Economic growth
Endogenous growth theory
Golden rule savings rate

6 Notes
[1] Step-by-step calculation:
K(t) (A(t)L(t))1
A(t)L(t)

y(t)

K(t)
(A(t)L(t))

Y (t)
A(t)L(t)

[2] Step-by-step calculation: k(t)

=
K(t)

[A(t)L(t)
+
L(t)A(t)]
[A(t)L(t)]2

K(t)
A(t)L(t)

K(t) L(t)
A(t)L(t) L(t)

= k(t)

K(t)
A(t)L(t)

K(t) A(t)
A(t)L(t) A(t)

Since

K(t)
= sY (t) K(t) , and L(t)
, A(t)
are
L(t)
A(t)
n and g , respectively, the equation simplies to
Y (t)
K(t)
K(t)
K(t)

k(t)
= s A(t)L(t)
A(t)L(t)
n A(t)L(t)
g A(t)L(t)
=
sy(t) k(t) nk(t) gk(t) . As mentioned above,
y(t) = k(t) .

References

[1] Acemoglu, Daron (2009). The Solow Growth Model.

Introduction to Modern Economic Growth. Princeton:
Princeton University Press. pp. 2676. ISBN 978-0-69113292-1.
[2] Solow, Robert M. (1956). A Contribution to the Theory
of Economic Growth. Quarterly Journal of Economics
70 (1): 6594. doi:10.2307/1884513.
[3] Swan, Trevor W. (1956). Economic Growth and Capital Accumulation. Economic Record 32 (2): 334361.
doi:10.1111/j.1475-4932.
[4] Solow, Robert M. (1957). Technical Change and the Aggregate Production Function. Review of Economics and
Statistics 39 (3): 312320. doi:10.2307/1926047.
[5] Haines, Joel D. (2006). A Framework for Managing
the Sophistication of the Components of Technology for
Global Competition. Competitiveness Review 16 (2):
106121.
[6] Barelli, Paulo; Pessa, Samuel de Abreu (2003). Inada
conditions imply that production function must be asymptotically CobbDouglas. Economics Letters 81 (3): 361
363. doi:10.1016/S0165-1765(03)00218-0.
[7] Litina, Anastasia; Palivos, Theodore (2008). Do Inada
conditions imply that production function must be asymptotically CobbDouglas? A comment. Economics Letters
99 (3): 498499. doi:10.1016/j.econlet.2007.09.035.
[8] Romer, David (2011). The Solow Growth Model.
Advanced Macroeconomics (Fourth ed.). New York:
McGraw-Hill. pp. 648. ISBN 978-0-07-351137-5.
[9] Caselli, F.; Feyrer, J. (2007). The Marginal Product of
Capital. The Quarterly Journal of Economics 122 (2):
535. doi:10.1162/qjec.122.2.535.
[10] Lucas, Robert (1990). Why doesn't Capital Flow from
Rich to Poor Countries?". American Economic Review 80
(2): 9296
[11] Mankiw, N. Gregory; Romer, David; Weil, David N.
(May 1992). A Contribution to the Empirics of Economic Growth. The Quarterly Journal of Economics 107
(2): 407437. doi:10.2307/2118477. JSTOR 2118477.
[12] Klenow, Peter J.; Rodriguez-Clare, Andres (January
1997). The Neoclassical Revival in Growth Economics:
Has It Gone Too Far?". In Bernanke, Ben S.; Rotemberg, Julio. NBER Macroeconomics Annual 1997, Volume
12. National Bureau of Economic Research. pp. 73114.
ISBN 0-262-02435-7.

[13] Breton, T. R. (2013). Were Mankiw, Romer, and Weil

Right? A Reconciliation of the Micro and Macro Eects
of Schooling on Income. Macroeconomic Dynamics 17
(5): 10231054. doi:10.1017/S1365100511000824.
[14] Breton, T. R. (2013).
The role of education
in economic growth:
Theory, history and current returns. Educational Research 55 (2): 121.
doi:10.1080/00131881.2013.801241.
[15] Barro, Robert J.; Sala-i-Martin, Xavier (2004). Growth
Models with Exogenous Saving Rates. Economic Growth
(Second ed.). New York: McGraw-Hill. pp. 3751.
ISBN 0-262-02553-1.
[16] Barro, Robert J.; Sala-i-Martin, Xavier (2004). Growth
Models with Exogenous Saving Rates. Economic Growth
(Second ed.). New York: McGraw-Hill. pp. 461509.
ISBN 0-262-02553-1.

8 Further reading
Agnor, Pierre-Richard (2004). Growth and Technological Progress: The SolowSwan Model. The
Economics of Adjustment and Growth (Second ed.).
Cambridge: Harvard University Press. pp. 439
462. ISBN 0-674-01578-9.
Barro, Robert J.; Sala-i-Martin, Xavier (2004).
Growth Models with Exogenous Saving Rates.
Economic Growth (Second ed.).
New York:
McGraw-Hill. pp. 2384. ISBN 0-262-02553-1.
Burmeister, Edwin; Dobell, A. Rodney (1970).
One-Sector Growth Models. Mathematical Theories of Economic Growth. New York: Macmillan.
pp. 2064.
Dornbusch, Rdiger; Fischer, Stanley; Startz,
Richard (2004). Growth Theory: The Neoclassical Model. Macroeconomics (Ninth ed.). New
York: McGraw-Hill Irwin. pp. 6175. ISBN 0-07282340-2.
Farmer, Roger E. A. (1999). Neoclassical Growth
Theory. Macroeconomics (Second ed.). Cincinnati: South-Western. pp. 333355. ISBN 0-32412058-3.
Gandolfo, Giancarlo (1996). The Neoclassical
Growth Model. Economic Dynamics (Third ed.).
Berlin: Springer. pp. 175189. ISBN 3-54060988-1.
Intriligator, Michael D. (1971). Mathematical Optimalization and Economic Theory. Englewood Clis:
Prentice-Hall. pp. 398416. ISBN 0-13-561753-7.

External links
Solow Model Videos - 20+ videos walking through
derivation of the Solow Growth Models Conclusions
Java applet where you can experiment with parameters and learn about Solow model
Solow Growth Model by Fiona Maclachlan, The
Wolfram Demonstrations Project.
A step-by-step explanation of how to understand the
Solow Model
Professor Jos-Vctor Ros-Rulls course at University of Minnesota
Professor Alex Tabarroks Solow Growth Model
lecture at MRUniversity

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