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Growth Lectures 1 + 2: The Solow Growth Model and Beyond

Peter Sinclair
University of Warwick Masters Macroeconomics: October 24, 2012

A: The Solow Model (QJE 1956)
2 equilibrium concepts: steady state growth (SSG) and balanced growth (BG).
SSG: all relevant variables are stationary in level or rate of change.
BG: variables that grow, grow at a common rate.

Like any equilibrium concept in economics, SSG and BG prompt 4 questions:
a. existence? [is there an equilibrium?]
b. Uniqueness? [if it exists, is there just one?]
c. Stability? [does a chance divergence establish forces restoring it?]
d. Optimality [does it maximize welfare?]?

The assumptions of the simplest version of Solows model are:
1. population grows at n, exogenous and positive
2. savings (or, equivalently, investment) share of income is s, exogenous and positive
3. production function, y=f(k), has constant returns to scale, is twice differentiable with f>0>f,
and capital-output ratio, v, able to take on any positive value (y and k are output per head and
capital per head).
4. no depreciation
5. no technological progress
6. perfect competition (including marginal product factor pricing, full price flexibility and
information, and market clearance).

The implication of these assumptions is that existence, uniqueness and stability (but not optimality) are
guaranteed.

Reasoning: the growth rate of capital is, by definition, INVESTMENT/CAPITAL, which may be
written s/v. BG requires this to equal n. From 3, there exists some value of k at which v=s/n.
Geometrically, n/s is the gradient of a ray from the origin depicting the average product of capital in
balanced growth: this proves existence. Since the idea that f(k) could be zero at some positive k makes
it possible that n/s could be so steep as to exceed the highest possible value of 1/v , f(0)=0, so that
f>0>f bars multiple equilibria: equilibrium is unique. Stability is assured since, if k is below (above)
its BG value, the average product of capital is above (below) n/s, so the capital labour ratio is rising
(falling). More on optimality below.

Consider now the balanced growth equilibrium (BGE) effects of a rise in n or fall in s. The ray with
gradient n/s must steepen. So it will cut f(k) to the south west of the old BGE. So we infer at once that
y, and k must fall. From concavity, v must fall, too, while the real interest rate (equals the marginal
product of capital from assns 4 and 6, which is the gradient of the tangent to f(k)) must rise. The real
wage rate falls ( . 0 ) ( ' ' ) ( ' ' ) ( ' ) ( ' / )} ( ' ) ( { / k kf k kf k f k f dk k kf k f d dk dw )
The profit share of national income is subject to conflicting forces: a higher rate of profit, but less
capital per head. The first effect dominates the second if , the elasticity of substitution between
capital and labour in the production function is less than unity; they cancel if the production function is
Cobb Douglas, where 1; and the profit share falls if 1, so that capital and labour are
substitutes rather than complements. A mnemonic for the impact of n on r: the late 1960s / early
1970s slogan, Women in labour keep capital in power.

In all these cases, faster population growth is similar to a fall in the savings ratio. Here are two
variables for which this is not true: the growth rate of output (call it g), and consumption per head. IN
BGE, g=n. This means that faster population growth must imply faster long run output growth (one for
one), but that a change in the savings ratio has no effect on the long run growth rate of output. Higher
s raises the long run level of output per head, but the growth rate of capital gradually slips back, as v
rises, to equal n in the long run.

Consumption per head, c, equals nk k f ) ( in BGE. Differentiating this with respect to k gives
n k f ) ( ' . So c reaches a maximum where the growth rate and the real interest rate are equal.
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(Prove it is a maximum by showing that ). 0 ' ' /
2 2
f dk c d This is the GOLDEN RULE. But it
is only by chance, with n and s given, that BGE satisfies this. Hence the answer to the optimality
question is, generally NO. The Golden Rule condition n k f ) ( ' implies that the savings ratio
should equal the profit share of income in BGE (proof: multiply both by v).

The Golden Rule is straightforward and illuminating. But it has drawbacks. One is that it does not
prescribe a path towards the best BGE if you are at an inferior BGE. (By contrast, Ramsey does do
this). Further, it cannot properly handle extensions, such as to exhaustible natural resources or
technological progress, the first of which will tend to make c drift downwards over time, and the
second, upwards.

Technology trends can be incorporated provided technical progress is Harrod-neutral (equivalently,
labour augmenting). So if Y, K and N are aggregate output, capital and labour, the production function
is written Y=Y(K,BN) where B advances at a given, constant rate (say x). Since returns to scale are
constant, we may write (using the same notation as in the Ramsey model) )) (
~
( ) (
~
t k f t y ; in a BGE,
) (
~
t k is stationary, and the relevant geometry of a BGE requires that 1/v = (n+x)/s. Faster technical
progress raises the rate of profit and reduces the long run value of capital per human efficiency unit,
k
~
. The BGE growth rate of output is now n+x, and both output per head, and consumption per head,
climb at x.

There are numerous other possible extensions to Solows model (eg, additional sectors for example
for capital goods; an endogenous savings ratio, displaying sensitivity to n, or factor shares of national
income, or to the real interest rate). It is a very powerful and versatile model. One controversial
aspect is that it cannot incorporate short-run Keynesian problems, such as may arise from price
rigidities and either deficient or excessive aggregate demand: it simply assumes such problems away,
invoking assumption 6.

A more serious criticism, perhaps, is that the savings ratio is not derived from optimization conditions.
It is just imposed. Responding to that criticism is simple switch to the Ramsey model (1928). But a
still more powerful criticism is that is not a model of long run growth at all. Solows model is really a
set of relationships explaining how y, k, v, r, w, c and so on vary with the fundamental parameters n, s
and x. Long run growth, n+x, is simply exogenous, and unexplained. To rectify this, we need to
explore models of ENDOGENOUS GROWTH.

We shall consider 5 such models:
a. endogenous population growth
b. exhaustible natural resources (oil)
c. training (Lucas JME 1988)
d. externalities (Romer JPE 1986)
e. invention (Romer JPE 1990)

Endogenous population growth: invoke Malthuss argument that population tends to expand (contract)
when the real wage exceeds (falls short of) subsistence level. Write n=n(w), where as before w=f(k)-
kf(k), the real wage rate. Malthus would predict n>0; let us assume this (but imagine the effect is
small). Now consider the impact of a (permanently) higher savings ratio. The Solow model showed
that the BGE value of the real wage rate must climb, in response to the additional capital per head. If n
were to rise as a result of this, we would find that the BGE growth rate of output went up. Note the
contrast with the standard Solow model, where it remained unchanged. (Note too that, if this
Malthusian relationship is strong enough, we might imperil the existence, or uniqueness, or stability of
BGE). Evidence from the 19
th
and earlier centuries supports Malthus; but recent decades, especially in
rich countries, much less so. Indeed ds dn/ may be taken as broadly negative for much of the 20
th

century, chiefly because of the labour market opportunity cost effects of bearing children for married
women, plus direct child rearing costs. If Malthusian effects hold at low and high w, but anti-
Malthusian effects at intermediate ones, note that n/s curve could be at first convex, then concave,
possibly intersecting f(k) three times.

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Later lectures will explore c, d and e; Part B of this lecture looks at b. B: Growth with an
Exhaustible Natural Resource
Peter Sinclair, University of Warwick, Growth lectures 3 and 4
October 25, 2012



Let aggregate production of final output be described by the Cobb
Douglas production function:

1
) ( )) ( ) ( ( ) ( ) ( t E t N t B t TK t Q (1)

where E(t) denotes inputs of oil, extracted at that date. (Note that the sum
of the 3 exponents is unity implying that competitive factor rewards add
up to the value of final output; each of the 3 exponents is strictly
positive). So if S(t) is the stock of unextracted oil at date t, ) (t E ) (t S
and let us define the proportionate rate of extraction,
) ( / ) ( ) ( / ) ( ) ( t S t S t S t E t x . B(t) advances at rate b, and N(t) at rate n.
There is perfect competition, the savings share of income is s and, as
again in Solow, no depreciation.

So r(t) = ) ( / ) ( t K t Q . (2)

Differentiating this last equation totally with respect to time implies

. / ) ( ) (

) ( / ) ( ) (

) (

) (

) ( t sr t Q t K t sQ t Q t K t Q t r (3)

Equation (3) is a law of motion for the real rate of interest, which we can
relate to the other key dynamic variable, x(t), a little below.

We now invoke the HOTELLING RULE (Hotelling, JPE 1931) to
explore the dynamics of the price of oil, call it P(t). Assume that oil
exporters are neutral to risk, perfectly competitive, not subject to tax, and
free of any extraction costs. These assumptions imply that the price of
oil should be expected to rise at the real rate of interest. Given foresight,
and shocks apart, actual and expected paths of oil prices should coincide,
so:

) ( ) (

t r t P . (4)

Perfect competition among final output producers implies
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) ( / ) ( ) 1 ( ) ( t E t Q t P (5)

Note that E should normally be falling over time (and must be in a steady
state), and also that Q will presumably be rising so the price of oil
should exhibit an upward trend over time.

So that, from (4) and (5) and the definition of x(t), we have

). ( ) ( ) (

) ( t x t x t Q t r (6)

Next, it helps to eliminate the growth rate of final output, ) (

t Q . From (1),
we have

) ( ) (

)( 1 ( ) ( ) ( )) ( ) ( )( 1 ( ) ( ) (

) (

t r t Q n b t sr t x t x n b t K t Q

using (6) and (2). Simplifying:

] 1 )[ ( ) ( ) )( (

s t r n b t Q . (7)

BY SUBSTITUTING (7) INTO (3) AND (6) WE CAN NOW FIND 2
KEY LAWS OF MOTION, for the extraction and interest rates, in terms
of these variables alone:

] / 1 )[ ( ) ( ) )( ( s t r n b t r (8)

) 1 )( ( ) ( ) )( ( ) )( ( s t r n b t x t x . (9)

(8) says that the stationarity locus for r is independent of x and always
attracts r (a standard feature of Solow-type and many Ramsey-type
models). In other words, the long run real interest rate is determined by
the production function characteristics, plus the parameters b, n and s.
The savings ratio tends to lower r; b and n to raise it. So r is stable the
dynamics of r are stabilizing. Diagram 1 refers.

(9) says that the stationarity locus for x is linear in r and x, which are
related positively. Intuition: higher r implies, from Hotelling, faster rate
of ascent of the price of oil, and therefore faster extraction. The
dynamics of x are unstable. Diagram 2 refers.

Putting (8) and (9) together, into Diagram 3, shows a steady state at point
E, where the 2 stationarity loci intersect and that there is a unique
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saddle path towards E from either side. Given foresight, and knowledge
of the model and information about the parameters, agents should be able
to plot the evolution of r and x.

At point E, the steady state, the long run values of r and x (and also the
growth of final output) will be:

s
n b
g A s n b x A n b r
) 1 (
1
; ) / 1 )( ( ; ) ( , where
. / 1
1
s A

Many points of interest are apparent. One is that the (long run) growth
rate now INCREASES with s, the savings ratio. Reason: over time it
raises capital, reduces the rate of interest, and implies slower oil
extraction and therefore higher SUSTAINABLE growth. Note that the
faster oil is extracted, the faster oil inputs into production will decline,
and the slower output growth must be (eventually, at least). (Note too
that if the role of fossil fuels in production were to disappear suddenly,
1 would vanish, and g would be the sum of population growth and
labour augmenting technical progress). Another is that sensible results
require the profit share to exceed the savings ratio (otherwise we get a
nonsensical, negative solution for extraction).

The most interesting feature of all, perhaps, is how we can now use the
model to try to understand the dynamics of oil prices. An unexpected
permanent rise in the savings ratio would flatten the stationarity locus for
x, and push the stationarity locus for r leftwards, with the combined long
run effect of lowering both r and x. The saddle path to the new long run
equilibrium would show x slipping very slightly, and r slipping faster.
Diagram 4 illustrates. So the impact effect would be a big fall in x.
Counterpart: a big jump in the spot price of oil (which would
thenceforward increase more slowly). Similar consequences would
ensue from unanticipated permanent falls in (or reduced expectations of
future values of) b or n. (1970s? 2003-2006?). And falls in expected s
would have the opposite effect (mid 1980s? mid 09). As would the end
of traditional communism , adding large population, but little extra useful
capital, to the prospective advanced trading worlds endowments (late
1980s, early 1990s?). And although oil is currently (around US$83) far
below its July 2008 peak of US$ 143 per barrel, it has risen sharply over
this year so far, and now stands(in US$ at least) at well above its levels
of 3 or more years ago.

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The decline in real interest rates in the period since the early 2000s is
startling. And it is noticeable that the period from late 2002 to late 2007
witnessed rises not just in oil prices, but in the prices of many other
assets, such as real estate (most economies), gold, equities, and copper,
as well as (rather more mutedly) in indexed bonds. Demography may
be partly responsible for this. Falling fertility (particularly in China,
Japan, Germany, Italy, Russia, Spain, and most of eastern Europe) has
coincided with increased life expectation (especially in most of Asia and
Europe). The Blanchard (1985) model of annuities and random mortality,
which excludes intergenerational altruism, generates the result that steady
state real interest is reduced by reductions in both fertility and mortality
hazard.

(If you want to read more on macro models with oil, you might like to
consult applications to global warming in Sinclair Manchester School
1992 or in a Ramsey framework - Oxford Economic Papers 1994.)

Krautkraemer (JEL 98) is sceptical about Hotelling curves; Lee et al
(Journal of Environmental Economics and Management 2006) is one of
several recent papers to present arguments or pieces of evidence that take
a more favourable view of them.