The Solow Growth Model

Production function:

The Solow model defined production at time t as a function of capital stock K at
time t, technology level A at time t, and labor force L at time t. A and L enter the
model multiplicatively as effective labor AL (this is known as labor augmenting
of knowledge, which indicts the belief that possession of knowledge directly
affects the effectiveness of labor force in the process of production.)
Mathematically, the model is expressed as the following:

( , )
t t t t
Y F K AL =

In this model, constant returns to scale in both capital and effective labor is
assumed. (*see Romer 10 for explanations) This means effectively the following:

( , ) ( , ) F cK cAL cF K AL =

This implies

1
,1 ( , )
K
F F K AL
AL AL
| |
=
|
\ .
, if we set
1
c
AL
=

We know
1
( , )
Y
F K AL
AL AL
= . Now define the following:

K
k
AL
Y
y
AL
=
=


We now can write output per unit of effective labor as a function of capital per
unit of effective labor, or the intensive form of production.

( ,1)
( )
y F k
y f k
=
=
or

This function is assumed to satisfy (0) 0, '( ) 0, "( ) 0 f f k f k = > <

Definition of Inputs:

Define the following

( )
( )
( )
( )
L t
n
L t
A t
g
A t
=
=


*note: the phrase the growth rate of X refers to the quantity
( )
( )
X t
X t
, where ( ) X t is a
shorthand for
( ) dX t
dt
. We may also write
ln ( ) ln ( ) ( ) 1
( )
( ) ( )
d X t d X t dX t
X t
dt dX t dt X t
= = .
Thus we may note that
ln ( ) ln (0)
ln ( ) ln (0)
L t L nt
A t A gt
= +
= +
, and
( ) (0)
( ) (0)
nt
gt
L t L e
A t A e
=
=
, i.e. we assume
that L and A grow exponentially.
--end of note

We also assume output of production is divided between saving and
consumption. What is saved is invested in capital stock. Capital stock
depreciates at the rate of o . Thus:

t t t
K sY K o =

The Dynamics of K:

Combine the above expression and production function we defined previously,
we have:

( , )
t t t t t
K sF K AL K o =

Reduce it to the intensive form

( ,1)
( )
K K K
sF
AL AL AL
K
sf k k
AL
o
o
=
=


We also know that

( )
2
2 2
1
( )
( )
K
k
AL
dk ALdK K dAL AdL
AL
dK dA dL
dk K K
AL A L AL
dK dA dL
dk k k
AL A L
=
= +
=
=


We have already defined the following previously,

( )
dA
g
A
dL
n
L
dK
sf k k
AL
o
=
=
=


Thus

( )
( ) ( )
dk sf k k gk nk
dk sf k g n k
o
o
=
= + +


This equation states effectively that the rate of change of the capital stock per unit
of effective labor is the difference between the actual investment per unit of
effective labor and the breakeven investment, or the amount of investment that
must be done just to keep k at its existing level.

Let k* denote the level of capital stock at which actual investment equals
breakeven investment. At this point, dk is equal to 0.

The Balanced Growth Path:

The capital stock, K, equals ALk; since k is constant at k*, K is growing at the rate
of n+g, (i.e. / K K n g = + ). Under constant return of scale (CRS), output Y is also
growing at n+g. Finally, K/L and Y/L are growing at g, i.e. on the balanced
growth path, the growth rate of output per worker is determined solely by the
rate of technological progress.

The Effect of Saving:

Consider a Solow economy on a balanced growth path; suppose that there is a
permanent increase in s, the saving rate.

short term effect

Long run effect

A change in the saving rate has a level effect but not a growth effect: it changes
the economys balanced growth path, and thus the level of output per worker at
any point in time, but it does not affect the growth rate of output per worker on
the balanced growth path. In the Solow model only changes in the rate of
technological progress have growth effects, all other changes have only level
effects.

Impact on Consumption (Household behaviour and the Golden Rule)

s
dk (dy)
k
k*
1
k*
2

s1f(k)
s2f(k)
Let c* denote consumption per unit of effective labor on the balanced growth
path so that:

* ( *) ( *) c f k sf k = ,
and on the balanced growth path * ( *) ( ) * c f k n g k o = + + , since
( *) ( ) * sf k n g k o = + +

max * ( *) ( ) *
s
c f k n g k o = + +

k* is determined by s and the other parameters of the model, n, g, and o , thus
* *( , , , ) k k s n g o =

| |
* * *
'( *) ( )
f.o.c
*( , , , )
'( *( , , , )) ( ) 0
'( *( , , , ))
dc dk dk
f k n g
ds ds ds
k s n g
f k s n g n g
s
f k s n g n g
o
o
o o
o o
= + +
c
+ + =
c
= + +


Whether the increase raises or lowers consumption in the long run depends on
whether '( *) f k -- the marginal product of capital is more or less than n+g+. If
'( *) f k is less than n g o + + , then the additional output from the increased capital
is not enough to maintain the capital stock at its higher level. In this
consumption must fall to maintain the higher capital stock. If '( *) f k exceeds
n g o + + , on the other hand, there is more than enough additional output to
maintain k at its higher level, and so consumption rises.

We can also look from another perspective

'( *) f k n g
dy n g
o
o
= +
= +


i.e. the real growth of the economy ( dy o , the growth minus depreciation) must
equal the population growth and technological development.

We can present the previous ideas graphically:




The Quantitative Approach

Know that * ( *) y f k = is the level of output per unit of effective labor on the
balanced growth path. The long run effect of a rise in saving on output is given
by:

* *( , , , )
'( *)
y k s n g
f k
s s
o c c
=
c c


1) Find
* k
s
c
c


On the balanced growth path 0 k = , thus

( *( , , , ) ( ) *( , , , ) sf k s n g n g k s n g o o o = + +

and take derivatives of the two sides with respect to s

* *
'( *) ( *) ( )
* ( *)
( ) '( *)
k k
sf k f k n g
s s
k f k
s n g sf k
o
o
c c
+ = + +
c c
c
=
c + +


and therefore
( ) n g k o + +
'( ) ( ) f k n g k o = + +
consumption
k c
( ) f k
k
* ( *)
'( *)
( ) '( *)
y f k
f k
s n g sf k o
c
=
c + +


Multiply both sides with
*
s
y

* '( *) ( *)
* ( *) ( ) '( *)
s y s f k f k
y s f k n g sf k o
c
=
c + +


We also know that ( *) ( ) * sf k n g k o = + +

| |
* ( ) * '( *)
* ( ) ( *) ( ) * '( *)
( ) * '( *)
( ) ( *) * '( *)
* '( *)
( *) * '( *)
* '( *) / ( *)
1 * '( *) / ( *)
s y n g k f k
y s n g f k n g k f k
n g k f k
n g f k k f k
k f k
f k k f k
k f k f k
k f k f k
o
o o
o
o
c + +
=
c + + + +
+ +
=
+ +
=

The portion
* '( *)
( *)
k f k
f k
is known as the elasticity of output with respect to capital
at * k k = . If markets are competitive and there are no externalities, capital earns
its marginal product. In this case, on the balanced growth path capital earns
* '( *) k f k , and the share of total income that paid to capital is
* '( *)
( *)
k f k
f k
.

We denote the elasticity as ( *)
K
k o . Thus the previous expression can be
rewritten as

( *) *
* 1 ( *)
K
K
k s y
y s k
o
o
c
=
c


In most countries, the share of income paid to capital is about 1/3, which implies
that the elasticity of output with respect to the saving rate in the long run is
about 1/2. (
1/ 3 1
1 1/ 3 2
=

).




Speed of Convergence
We want to determine how rapidly k approaches k*. Since ( ) ( ) k sf k n g k o = + + ,
we know that k is determined by k. Thus ( ) k k k = . When * k k = , 0 k = . A first
order Taylor approximation of ( ) k k around * k k = is known as

*
( )
( *)
k k
k k
k k k
k
=
(
c

(
c
(



Let denote
*
( )
k k
k k
k
=
c

c
. The above expression is rewritten as

| | ( ) ( ) * k t k t k .

Since 0 k > , when k is slightly below k* and 0 k < when it is slightly above.
*
( )
k k
k k
k
=
c
c
is negative and is positive.

| | ( ) ( ) * k t k t k implies that in the vicinity of the balanced growth path, k
moves toward k* at a speed approximately proportional to its distance from k*,
i.e. the growth rate of ( ) * k t k is approximately constant and equal to . Thus
| | ( ) * (0) *
t
k t k e k k

+

The specific value of is subject to the specifics of the model

| |
*
( )
'( *) ( )
( ) '( *)
( *) '( *)
( )
( *)
since ( *) ( ) * at the balanced growth path, where 0
( ) * '( *)
( )
( *)
* '( *)
define , the elastici
( *)
k k
k k
sf k n g
k
n g sf k
sf k f k
n g
f k
sf k n g k k
n g k f k
n g
f k
k f k
f k
o
o
o
o
o
o
=
c
= + +
c
= + +
= + +
= + + =
+ +
= + +
| |
K
ty of output with respect to capital at *, as ( *)
( ) ( *)( )
1 ( *) ( )
K
K
k k k
n g k n g
k n g
o
o o o
o o
=
= + + + +
= + +


We may also present of the issue of convergence graphically:

We have derived previously that

( ) ( ) dk sf k n g k o = + + +

so that
( )
( )
dk f k
s n g
k k
o = + + + , where
( ) f k
s
k
is the average productivity of
received capital and ( ) n g o + + is the necessary investment to hold the capital
stock constant.

Absolute Convergence

Conditional Convergence


The Central Conclusion of the Solow Model

The central conclusion of the Solow model is that if the returns that capital
commands in the market are a rough guide to its contributions to output, then
variations in the accumulation of physical capital do not account for a significant
part of wither worldwide economic growth or cross-country income difference.
k
( ) f k
s
k

( ) n g o + +
Growth
ln( ) d k
k

' ( ) s f k
k

'' ( ) s f k
k

k
The Solow Model with natural resources and land

We start by defining two extra variables

T = Land; 0 T =

R = Natural resources;
R
b
R
=

Now the production is a function of

(1 )
( )
t t t t t
Y K R T AL
o | o |
=

Convert it into natural logarithm formation:

ln ln ln ln (1 )(ln ln )
t t t t t
Y K R T A L o | o | = + + + +

Differentiate with respect to time t, (
ln ( ) 1 ( )
( )
d X t dX t X
dt X t dt X
= = , by the chaining
rule), we have the following:

(1 )( )
( ) (1 )( )
t t t t t
t t t t t
t t
t t
Y K R A L
Y K R A L
Y K
b g n
Y K
o | o |
o | o |
= + + +
= + + +


We also know that
t t
t
t
K sY K
Y K
s
K K
o
o
=
=
, and on the balanced path of growth the
proportion
t
t
Y
K
is constant, thus
K Y
C
K Y
= = , i.e. the growth rate of capital is equal
to the growth of production and they both equal to a constant. Thus:

(1 ) (1 )( )
(1 )( )
(1 )
t
t
t
t
Y
g n b
Y
Y g n b
Y
o o | |
o | |
o
= +
+
=

and
t t t t
t t t t
Y Y L Y
n
L Y L Y
= =

thus:

(1 )( ) (1 )
(1 ) (1 )
(1 ) ( )
(1 )
g n b n
y
g n b
y
o | | o
o o
o | | |
o
+
=

+
=

There are two interesting terms in the above expression: (1 )g o | against
( )n | + .

Essentially it illustrates the technological development weighs against the
depletion of natural resource and land by population growth.