Introduction:

The fundamental questions of long run macroeconomics revolve around the TIME PATH of the economy.
What determines the path that an economy is on?
How can the path be altered?
If an economy is bumped off the path, will it return or never catch up?

The Solow Model: Scroll right to the see the basic idea. -->
The Solow Model relaxes the assumption that Y, K, L, and technology are fixed. It attempts to explain
how these crucial variables adjust over time.
It remains important to understand how output is allocated because allocation determines changes in
future output. Consider two economies, in A, all output is consumed; while B pumps half of
its output into Investment. What do you think will happen over time?
Isn't it obvious that A's economy will remain stagnant (or decline if there is depreciation) while B's will grow?
After all, B's economy is Investing, that is, adding new plant and equipment, which can be used to make
MORE output next year.
The Solow Model 's principal focus is on how output is allocated to Investment and how that changes
output over time. Because it examines the time path of variables, it is a dynamic model.

This workbook explores a simplified version of the Solow Model. It emphasizes capital accumulation and assumes away
population growth and technological change.

"For his contributions to theory of economic growth," Robert Solow won the Nobel Prize in Economics in 1987. Learn mo
http://almaz.com/nobel/economics/economics.html

To begin studying this simplest version of the Solow Model, go to the ProdFn sheet.
TIME PATH of the economy.

Click on the button to walk through the basic idea of the Solow Model

INITIAL
Year 1 Year 2 Year 3 Year 4
sic idea. --> Capital 100 150 211.2372 283.9073
pts to explain Labor 100 100 100 100

es changes in Output 100 122.4745 145.34 168.4955

B pumps half of Rate of Growth 22.47% 18.67% 15.93%

epreciation) while B's will grow? 1/2 Consumption 50 61.23724 72.67002 84.24774
which can be used to make 1/2 Investment 50 61.23724 72.67002 84.24774

that changes
amic model.

ccumulation and assumes away

n Economics in 1987. Learn more at

a of the Solow Model
The Production Function in the Solow Model
We have seen that a production function describes the maximum output that can be produced as function of the inputs
Y = f(K,L)
The Solow Model relies on a simplified production function that has the property of constant returns to scale.
The CRS Cobb-Douglas production function has this property.
Y = AKL1-
where 0 < < 1

Three Important Properties of the CRS Cobb-Douglas Production Function

Property 1: If you multiply both K and L by some constant, z, then Y will increase by that same constant, z
Change the value of z in cell B19 and pay close attention to how the value of Y, output, and Y/L, output per worker, chan
From z= 1 to z=2, you should note that the value of Y doubles, but Y/L stays the same.
Keep flipping back and forth from z=1 to z=2 and verify that the value of Y really does respond according
From z=1, change cell B19 to z=10. What happens to Y and Y/L?

A 10
0.25
z 1
L 64
K 4
Y 320
Y/L 5

Property 2: Output per worker (Y/L) depends only on capital per worker (K/L)
Through all of the changes of z, have you noticed that Y/L has stayed exactly the same at 5?
That means that changing the the number of workers and machines by the same ratio
does NOT affect the output per worker. Only the ratio of K/L affects output.
In fact, we could write the production function in terms of K/L and get the exact same output per worker:
Y/L 5 Please click on cell B30 and note the formula for the cell.
To get output, Y, we would multiply by L:
Y 320 Please click on cell B32 and note the formula for the cell.

Property 3: Output per worker as a function of capital per worker is subject to diminishing returns because
A, from cells B17 and B18.
K/L Y/L
0 0
0.01 3.16227766 Figure 4-1: The Production Function
0.05 4.728708045
0.0625 5 14
Output per worker (Y/L = y)

0.25 7.071067812
12
0.5 8.408964153
0.6 8.801117368 10
0.7 9.146912192 8
0.8 9.45741609
0.9 9.740037464 6
1 10 4
1.1 10.24113689
2
1.2 10.46635139
1.3 10.67789972 0
1.4 10.87757306 0 0.5 1 1.5 2 2.5
1.5 11.0668192
Capital per worker (K/L = k)
1.6 11.2468265
1.7 11.41858345
1.8 11.58292185 As K/L increases, that means we're adding MORE machines per each worker.
1.9 11.74054886 Because of the diminishing marginal productivity of capital, output per worker increases
2 11.89207115 at a decreasing rate as capital per worker increases.
How can we have Constant Returns and Diminishing Returns at the same time? That seems to be inherent
Well, it's not because the two are based on different changes in the inputs. Economists are sloppy speakers, but logical
"Constant returns" is really "Constant Returns to Scale" and it refers to the change in output when BOTH (or ALL) factors
by the same proportion. "Diminishing Returns" is really "Diminishing returns to a factor" and it's about the effect on out
when a SINGLE factor is changed, holding the other (or all others) fixed.
Now you'll love this one. To describe a production function where doubling the inputs leads to less than double the outp
economists use the term "Decreasing Returns" (although it's even clearer to say, 'Decreasing Returns to Scale").
So, decreasing returns and diminishing returns are NOT the same thing. Ouch . . .

Go to the ConsInvFn to see how the Consumption and Investment Functions are represented in the Solow Model.
duced as function of the inputs of capital and labor.

ant returns to scale.

ase by that same constant, z.

and Y/L, output per worker, changes.

Y really does respond according to z*Y.

tput per worker:

diminishing returns because of falling MPK.

2 2.5

= k)

per each worker.

output per worker increases
? That seems to be inherently contradictory.
are sloppy speakers, but logically consistent.
tput when BOTH (or ALL) factors are changed
and it's about the effect on output

ads to less than double the output,

asing Returns to Scale").

nted in the Solow Model.

Allocating Output in the Solow Model
y = Y/L = output per worker is made by k = K/L = capital per worker.
The output per worker is allocated to c = C/L = consumption per worker and i = I/L = investment per worker.
y=c+i
Note: G, gov purchases of goods and services, is omitted for simplification.
The focus is on how output is split between C and I.
What determines the shares to C and I?

The Consumption and Investment Functions in the Solow Model

In the Simple Model, C = cons_intercept + cons_slope*(output_produced - tax_tran).
The Investment function is I = inv_intercept + inv_slope*real interest rate.
The Solow Model has even simpler consumption and investment functions.
Both are directly proportional to income and the proportions must add up to exactly one.
i = sy
c = (1-s)y
The idea is that each year, a fraction of income is saved, sy, and a fraction is consumed.
Since whatever is not saved is consumed, the fraction consumed must be (1-s)y
so that (1-s)y + sy = y.
s is an important variable in the Solow Model. It tells us the fraction of income (and output) saved
and (1 - s) tells us the fraction consumed.

Now that we know how output is produced (via the CRS production function) and how it is allocated
(by way of the consumption and investment functions), we are ready to examine
how output changes over time. Click on the Deltak sheet to continue.
vestment per worker.

is allocated
Tying Production and Consumption/Investment Together
The idea behind the Solow Model is that you start from some initial amount of K and L which
produces some output (according to the production function). This output is distributed to
consumption and investment as dictated by the s coefficient. The amount per worker saved, sy,
impacts the amount of k, capital per worker, and hence, the output next period.
Let's explicitly model the circle of k --> y --> c + i --> k --> new k --> . . .

The Investment Function as a function of s and k:

We know that:
y = f(k) CRS production function
i = sy Investment function
Then,
i = sf(k)
i = sf(k) says that investment per worker depends on the fraction of output saved and the amount of capital per worker.
The higher k, capital per worker, the higher i, investment per worker.
The higher s, the fraction of income saved, the higher i, investment per worker.
k, is the existing STOCK of capital, and sf(k) is the FLOW of the accumulation of new capital in the year.

Depreciation
The Solow Model is extremely simplified, but even it assumes some depreciation, the wearing out of machinery.
In other words, machines don't last forever. If an economy has k = 3.5 (which means 3.5 machines
per worker) today, and it doesn't invest at all (s = 0 so that i = sy = 0), then k will fall
next year because some of the machines will wear out and have to be thrown away.
Depreciation is set at some exogenous level and assumed to be a constant fraction of k, like this:
k ( = lowercase Greek letter delta)
So, if k = 4 and = 0.25, then 25% of the machines wear out every year. If no investment is made, then
k will fall to 3 next year.
Notice how depreciation is also a FLOW--the decrease in capital per worker each year due to worn out machines.

The Total Change in Capital per Worker:

sf(k) is a FLOW that represents ADDED machines in a year and K is a FLOW for SUBTRACTED machines in a year.
Then, to get the total FLOW, or total change in capital per worker, we need to combine these two flows:
k = sf(k) - k
This equation is extremely important for it represents the equilibrium condition in the Solow Model.
When sf(k) > k, additional machinery is greater than depreciating machinery so capital per worker is increasing.
The increasing k leads to higher output, but at a decreasing rate and, eventually, sf(k) will equal k.
Thus, eventually, the economy will settle at a level of y that is determined by the steady-state, or equilibrium
level of k.
That's hard to understand. Perhaps a numerical example will help.

Change versus Level

Before we examine the numerical example, there's one more important idea.
Keep separate the LEVEL of variable and its CHANGE.
k, capital per worker, is a number like 7. If k=7, there are seven machines per worker. If we ADD another
machine per worker, k is now 8 and it has increased by 1 machine per worker and by 1/7, or about 14%.
k's LEVEL is 7 and then 8 and it's CHANGE is 1 or 1/7 (14%).
We associate the word GROWTH with CHANGE, not level.
We could have an economy with a high level of y, output per person, and low growth, little change in y.
Of course, we would prefer to live in an economy with a high level of y and a high rate of growth in y.
But, choosing between a high level and low growth of y versus a low level and high growth of y isn't clear.
We want the material wealth associated with high levels of y, but remember the power of growth.
An economy with y growing at 10% per year will double every 7 years. This will cause the level of y to expand rapidly.
This is extremely important. Let's look at an example.
Growth Rate 1.0% 10.0%
Economy A Economy B
(high current (low current
level, low level, high
Year growth) growth)
Now $ 25,000 $ 2,000 Real GDP per capita measured in dollars.
5 $ 26,275 $ 3,221
10 $ 27,616 $ 5,187
15 $ 29,024 $ 8,354
20 $ 30,505 $ 13,455
25 $ 32,061 $ 21,669
30 $ 33,696 $ 34,899
35 $ 35,415 $ 56,205
40 $ 37,222 $ 90,519
45 $ 39,120 $ 145,781
50 $ 41,116 $ 234,782
55 $ 43,213 $ 378,118 The Rule of 70 approximation works well for 1%,
60 $ 45,417 $ 608,963 but it's pretty bad after 70 years for 10%.
65 $ 47,734 $ 980,741 At 1%, 2x in 70: At 10%, 7 doublings in 70 years
70 $ 50,169 $ 1,579,494 $ 50,000 $ 2,048,000
$ 169 approx error $ (468,506)
I guess the plan would be, live in country A for 30 years then emigrate to B!
This example is ridiculous. No economy has ever grown at y (real GDP per capita) at 10% per year for 70 years.
The Japanese did have spectacular (defined as real GDP per capita growth greater than 10% per year)
growth rates in the 50s and 60s and merely excellent (2% < %real GDP/person < 10%) growth in the 70s and 80s.
This enabled them to almost catch the US (which had a huge lead in 1950) in standard of living (Mankiw,
Table 4-1, p. 78).
While the 90s, as we have seen, have not been good for the Asian countries, the benefits of growth
are made clear by the economic performance of the Asian economies in the second half of this century.

Lesson: While we care about the LEVEL of y, the CHANGE and GROWTH of y can have a tremendous
impact on the level of y in a short period of time.
So remember, those percentage point differences in real GDP per capita matter a lot!

Lesson: The Solow Model as currently constructed will enable us to explain the LEVEL of y, but not
sustained growth in y. We'll have to extend the model to get sustained economic growth.

To see how the LEVEL of y is determined by the steady-state LEVEL of k, go to the EqPath sheet.
 Return to the Intro sheet
and walk through the model by clicking
on the buttons beginning at cell N4.

amount of capital per worker.

n of new capital in the year.

ing out of machinery.

is made, then

to worn out machines.

ED machines in a year.
to combine these two flows:

in the Solow Model.

er worker is increasing.

tate, or equilibrium

we ADD another
or about 14%.

change in y.

h of y isn't clear.

level of y to expand rapidly.

rks well for 1%,

t 10%, 7 doublings in 70 years

per year for 70 years.

% per year)
rowth in the 70s and 80s.
iving (Mankiw,

this century.
This sheet displays the canonical (standard) graph for the Solow Model.

Exogenous Variables Endogenous Variables

A 1 technology parameter k capital per worker
alpha 0.5 capital exponent y output per worker
s 0.3 savings rate per worker c consumption per worker
0.1 depreciation rate per worker i investment per worker
initial k 4 k depreciation per worker

k k

Investment and Depreciation per w orker

k y c i
Finding Steady
0 0 0 0 0 0 1.4
0.25 0.5 0.35 0.15 0.025 0.125 1.2
0.5 0.707107 0.49497475 0.212132 0.05 0.162132
1
0.75 0.866025 0.60621778 0.259808 0.075 0.184808
1 1 0.7 0.3 0.1 0.2 0.8
1.25 1.118034 0.78262379 0.33541 0.125 0.21041 0.6
1.5 1.224745 0.85732141 0.367423 0.15 0.217423 0.4
1.75 1.322876 0.92601296 0.396863 0.175 0.221863
0.2
2 1.414214 0.98994949 0.424264 0.2 0.224264
0
2.25 1.5 1.05 0.45 0.225 0.225
0 1 2 3 4 5
2.5 1.581139 1.10679718 0.474342 0.25 0.224342 k (capita
2.75 1.658312 1.16081868 0.497494 0.275 0.222494
3 1.732051 1.21243557 0.519615 0.3 0.219615
3.25 1.802776 1.26194295 0.540833 0.325 0.215833 0.25
3.5 1.870829 1.30958009 0.561249 0.35 0.211249 0.2
3.75 1.936492 1.35554417 0.580948 0.375 0.205948 0.15
4 2 1.4 0.6 0.4 0.2 0.1

Change in k
4.25 2.061553 1.44308697 0.618466 0.425 0.193466
0.05
4.5 2.12132 1.48492424 0.636396 0.45 0.186396
0
4.75 2.179449 1.52561463 0.653835 0.475 0.178835
5 2.236068 1.56524758 0.67082 0.5 0.17082 -0.05 0 1 2 3 4 5

5.25 2.291288 1.60390149 0.687386 0.525 0.162386 -0.1

5.5 2.345208 1.64164552 0.703562 0.55 0.153562 -0.15
5.75 2.397916 1.67854103 0.719375 0.575 0.144375 -0.2 k (capital
6 2.44949 1.71464282 0.734847 0.6 0.134847
6.25 2.5 1.75 0.75 0.625 0.125
6.5 2.54951 1.78465683 0.764853 0.65 0.114853
6.75 2.598076 1.81865335 0.779423 0.675 0.104423
7 2.645751 1.85202592 0.793725 0.7 0.093725
7.25 2.692582 1.88480768 0.807775 0.725 0.082775
7.5 2.738613 1.91702895 0.821584 0.75 0.071584
7.75 2.783882 1.94871753 0.835165 0.775 0.060165
8 2.828427 1.97989899 0.848528 0.8 0.048528
8.25 2.872281 2.01059693 0.861684 0.825 0.036684
8.5 2.915476 2.04083316 0.874643 0.85 0.024643
8.75 2.95804 2.07062792 0.887412 0.875 0.012412
9 3 2.1 0.9 0.9 0
9.25 3.041381 2.12896689 0.912414 0.925 -0.012586
9.5 3.082207 2.1575449 0.924662 0.95 -0.025338
9.75 3.122499 2.1857493 0.93675 0.975 -0.03825
 10 3.162278 2.21359436 0.948683 1 -0.051317
10.25 3.201562 2.24109348 0.960469 1.025 -0.064531
10.5 3.24037 2.26825924 0.972111 1.05 -0.077889
10.75 3.278719 2.29510348 0.983616 1.075 -0.091384
11 3.316625 2.32163735 0.994987 1.1 -0.105013
11.25 3.354102 2.34787138 1.006231 1.125 -0.118769
11.5 3.391165 2.37381549 1.017349 1.15 -0.132651
11.75 3.427827 2.39947911 1.028348 1.175 -0.146652
12 3.464102 2.42487113 1.03923 1.2 -0.16077
olow Model.
Investment and Depreciation per w orker

Finding Steady-State k
1.4
1.2
1
0.8
Investment
0.6
Depreciation
0.4
0.2
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13
k (capital per w orker)

0.25
0.2
0.15
0.1
Change in k

0.05
0
-0.05 0 1 2 3 4 5 6 7 8 9 10 11 12 13
-0.1
-0.15
-0.2 k (capital per w orker)
This sheet enables numerical simulation of the Solow Model.
To see how k* (the steady-state or equilibrium level of k) can be found via algebra, click on the Algebra sheet when you are
Y = AKL and y = Ak where k = K/L and y = Y/L
Exogenous Variables Endogenous Variables
A 1 technology parameter k capital per worker
alpha 0.5 capital exponent y output per worker
s 0.3 savings rate per worker c consumption per worker
0.1 depreciation rate per worker i investment per worker
initial k 4 k depreciation per worker
EXOGENOUS VAR SETTINGS NUMBER OF YEARS
Equilibrium (Steady-state)
Condition: k=0
Year k y %y c i k k
1 4 2 1.4 0.6 0.4 0.2 2.5

1.5

0.5

0
0.8 1 1.2
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
0.8 1 1.2
the Algebra sheet when you are done here.

Panes are frozen.

Execute Window: Unfreeze Panes if needed.

um (Steady-state)

2.5

1.5 y
c
1
i
0.5

0
0.8 1 1.2 Year
1.4 1.6 1.8 2
0.7
0.6
0.5
0.4 i
0.3 dk
0.2 Dk

0.1
0
0.8 1 1.2 Year 1.6
1.4 1.8 2
DERIVING k* VIA ALGEBRA
The Total Change in Capital per Worker is :
k sf (k) k
f(k) in our model is CRS Cobb - Douglas :
f (k) Ak
So the Total Change in Capital per Worker is
k sAk k
The Equilibrium Condition is that the value of k be that which makes k 0
sAk * k* 0
We need to rearrange our answer, showing k * as a function of the other variables :
sAk * k *
k *

k* sA

k * 1
sA
1
1
k*
sA
This last expression is the reduced - form for the Solow M odel.

For Mankiw's Example, the exogenous variables are:

A 1
alpha 0.5
s 0.3
0.1
Substituting these values into the reduced-form expression, we get
k* 9
This agrees with Mankiw, p. 85 and, more importantly, the results of our analysis in the EqPath sheet.

Notice also that once k* is found, the other endogenous variables in the model are determined:
y* 3
c* 2.1
i* 0.9

The Fundamental Idea Behind the Solow Model:

Economies drive toward a steady-state level of k which determines y, c, and i in the steady-state.
s, the savings rate, determines the level of investment in any one year and the steady-state level of k.
s through k determines the level of output per worker.

But the Solow Model as described in this workbook cannot explain the sustained economic growth
we observe in modern economies. An increase in s will lead to a temporary increase in y, but
eventually the economy will reach the stationary state with values of k and y that repeat themselves.

To explain sustained economic grwoth, we will have to augment the Solow Model of this workbook
with the two other primary sources of economic growth: population growth and technological progress.
EqPath sheet.

tate level of k.

t themselves.
ogical progress.
 The Total Change in Capital per Worker is:
Dk=sf (k )dk
f (k ) in our model is CRS Cobb-Douglas:
f (k )= Ak
So the Total Change in Capital per Worker is

Dk=sAk dk
The Equilibrium Condition is that the value of k be that which makes D k
sAkdk 0
We need to rearrange our answer, showing k* as a function of the other v
sAk dk
k d
=
k sA
d
k 1
sA
d 1 1
k( )sA
This last expression is the reduced-form for the Solow Model.
 in Capital per Worker is:
=sf (k )dk
glas:

orker is

value of k be that which makes D k = 0

wing k* as a function of the other variables:

m for the Solow Model.

1) Change the initial k value from 4 to 2 (in cell B9 of the EqPath sheet). Run the economy to figure out the steady-state
Does changing the initial value of k affect the steady-state solution? Why or why not?

2) Use the EqPath sheet to find the state-steady level of output per worker for two countries, A and B,
where all parameters are the same, except that A has a savings rate of 30% (the original problem) while B's s=40%.

3) Use algebra to do the comparison of countries A and B requested in the second question.

4) How do the EqPath and algebraic solutions compare? Do they give the same answers?

5) Click the Rand button (in the EqPath sheet) to get your own problem. Find the steady-state levels of k, y, c, and I.
Provide the exogenous variable values and compare this economy to the one generated by the Mankiw b
Assuming both economies had reached the steady-state, where would you rather live? Why?

6) With your own problem (constructed by clicking the Rand button), use the time path output of the EqPath sheet to co
a hand-drawn, rough-sketch Solow diagram (such as in the Canon sheet). Include your initial k value and
the economy goes to the steady-state solution.
my to figure out the steady-state value of k.
or why not?

ries, A and B,
l problem) while B's s=40%.

-state levels of k, y, c, and I.

one generated by the Mankiw button.
u rather live? Why?

output of the EqPath sheet to construct

Include your initial k value and describe how