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THE NEOCLASSICAL

GROWTH MODEL
KOEN VERMEYLEN

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Neoclassical Growth Model and Ricardian Equivalence Contents

Contents
1. Introduction 3
2. The neoclassical growth model 4
3. The steady state 9
4. Ricardian equivalence 11
5. Conclusions 12
Appendix A 13
A1. The maximization problem of the representative rm 13
A2. The equilibrium value of the representative rm 15
A3. The goverments intertemporal budget constraint 15
A4. The representative households intertemporal budget constraint 16
A5. The maximization problem of the representative household 18
A6. The consumption level of the representative household 18
Appendix B 19
References 21

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2
Neoclassical Growth Model and Ricardian Equivalence Introduction

1. Introduction

This note presents the neoclassical growth model in discrete time. The model
is based on microfoundations, which means that the objectives of the economic
agents are formulated explicitly, and that their behavior is derived by assuming
that they always try to achieve their objectives as well as they can: employment
and investment decisions by the rms are derived by assuming that rms maxi-
mize prots; consumption and saving decisions by the households are derived by
assuming that households maximize their utility.1

The model was rst developed by Frank Ramsey (Ramsey, 1928). However, while
Ramseys model is in continuous time, the model in this article is presented in
discrete time.2 Furthermore, we do not consider population growth, to keep the
presentation as simple as possible.

The set-up of the model is given in section 2. Section 3 derives the models steady
state. The model is then used in section 4 to illustrate Ricardian equivalence.
Ricardian equivalence is the phenomenon that - given certain assumptions - it
turns out to be irrelevant whether the government nances its expenditures by
issuing public debt or by raising taxes. Section 5 concludes.

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3
Neoclassical Growth Model and Ricardian Equivalence The neoclassical growth model

2. The neoclassical growth model

The representative rm Assume that the production side of the economy


is represented by a representative rm, which produces output according to a
Cobb-Douglas production function:

Yt = Kt (At Lt )1 with 0 < < 1 (1)

Y is aggregate output, K is the aggregate capital stock, L is aggregate labor


supply, A is the technology parameter, and the subscript t denotes the time
period. The technology parameter A grows at the rate of technological progress
g. Labor becomes therefore ever more eective.3

The aggregate capital stock depends on aggregate investment I and the depreci-
ation rate :
Kt+1 = (1 )Kt + It with 0 1 (2)
The goods market always clears, such that the rm always sells its total pro-
duction. Yt is therefore also equal to the rms real revenues in period t. The
dividends which the rm pays to its shareholders in period t, Dt , are equal to the
rms revenues in period t minus its wage expenditures wt Lt and investment It :
Dt = Yt wt Lt It (3)
where wt is the real wage in period t. The value of the rm in period t, Vt , is then
equal to the present discounted value of the rms current and future dividends:


 s


1
Vt = Ds (4)
s=t s =t+1
1 + rs

where rs is the real rate of return in period s .

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4
Neoclassical Growth Model and Ricardian Equivalence The neoclassical growth model

Taking current and future factor prices as given, the rm hires labor and invests
in its capital stock to maximize its current value Vt . This leads to the following
rst-order-conditions:4
Yt
(1 ) = wt (5)
Lt
Yt+1
= rt+1 + (6)
Kt+1
Or in words: the rm hires labor until the marginal product of labor is equal to
the marginal cost of labor (which is the real wage w); and the rm invests in its
capital stock until the marginal product of capital is equal to the marginal cost
of capital (which is the real rate of return r plus the depreciation rate ).

Now substitute the rst-order conditions (5) and (6) and the law of motion (2)
in the dividend expression (3), and then substitute the resulting equation in
the value function (4). This yields the value of the representative rm in the
beginning of period t as a function of the initial capital stock and the real rate
of return:5
Vt = Kt (1 + rt ) (7)

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5
Neoclassical Growth Model and Ricardian Equivalence The neoclassical growth model

The government Every period s, the government has to nance its outstan-
ding public debt Bs , the interest payments on its debt, Bs rs , and government
spending Gs . The government can do this by issuing public debt or by raising
taxes Ts .6 Its dynamic budget constraint is therefore given by:

Bs+1 = Bs (1 + rs ) + Gs Ts (8)

where Bs+1 is the public debt issued in period s (and therefore outstanding in
period s + 1).

It is natural to require that the governments public debt (or public wealth, if its
debt is negative) does not explode over time and become ever larger and larger
relative to the size of the economy. Under plausible assumptions, this implies
that over an innitely long horizon the present discounted value of public debt
must be zero:
 s
 1
lim Bs+1 = 0 (9)
s
s =t
1 + rs

This equation is called the transversality condition. Combining this transversa-


lity condition with the dynamic budget constraint (8) leads to the governments
intertemporal budget constraint:7


 s

 s


1
1
Bt+1 = Ts Gs (10)
s=t+1 
s =t+1
1 + rs 
s=t+1 s =t+1
 1 + rs 

Or in words: the public debt issued in period t (and thus outstanding in period
t + 1) must be equal to the present discounted value of future tax revenues minus
the present discounted value of future government spending. Or also: the public
debt issued in period t must be equal to the present discounted value of future
primary surpluses.

The representative household Assume that the households in the economy


can be represented by a representive household, who derives utility from her
current and future consumption:

 st
1
Ut = ln Cs with > 0 (11)
s=t
1+

The parameter is called the subjective discount rate.

Every period s, the household starts o with her assets Xs and receives interest
payments Xs rs . She also supplies L units of labor to the representative rm, and

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6
Neoclassical Growth Model and Ricardian Equivalence The neoclassical growth model

therefore receives labor income ws L. Tax payments are lump-sum and amount to
Ts . She then decides how much she consumes, and how much assets she will hold
in her portfolio until period s + 1. This leads to her dynamic budget constraint:

Xs+1 = Xs (1 + rs ) + ws L Ts Cs (12)

Just as in the case of the government, it is again natural to require that the
households nancial wealth (or debt, if her nancial wealth is negative) does not
explode over time and become ever larger and larger relative to the size of the
economy. Under plausible assumptions, this implies that over an innitely long
horizon the present discounted value of the households assets must be zero:
 s
 1
lim Xs+1 = 0 (13)
s
s =t
1 + rs

Combining this transversality condition with her dynamic budget constraint (12)
leads to the households intertemporal budget constraint:8


 s
  s

1
1
Cs = Xt (1 + rt ) + ws L
s=t s =t+1
1 + rs s=t s =t+1
1 + rs


 s


1
Ts (14)
s=t s =t+1
1 + rs

Or in words: the present discounted value in period t of her current and future
consumption must be equal to the value of her assets in period t (including interest
payments) plus the present discounted value of current and future labor income
minus the present discounted value of current and future tax payments.

The household takes Xt and the current and future values of r, w, and T as
given, and chooses her consumption path to maximize her utility (11) subject to
her intertemporal budget constraint (14). This leads to the following rst-order
condition (which is called the Euler equation):
1 + rs+1
Cs+1 = Cs (15)
1+
Combining with the intertemporal budget constraint leads then to the current
value of her consumption:



s
1 

s
1
Ct = Xt (1 + rt ) + ws L Ts
1+ s=t s =t+1
1 + rs s=t s =t+1
1 + rs

(16)

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7
Neoclassical Growth Model and Ricardian Equivalence The neoclassical growth model

Or in words: every period t, the household consumes a fraction /(1 + ) of her


total wealth, which consists of her nancial wealth Xt (1 + rt ) and her human
wealth (i.e. the present discounted value of her current and future labor income),
minus the present discounted value of all her current and future tax obligations.9

Equilibrium Every period, the factor markets clear. For the labor market, we
already implicitly assumed this by using the same notation (L) for the represen-
tative households labor supply and the representative rms labor demand.

Equilibrium in the capital market requires that the representative household holds
all the shares of the representative rm and the outstanding government bonds.
The value of the representative rm in the beginning of period t + 1 is Vt+1 , such
that the total value of the shares which the household can buy at the end of
period t is given by Vt+1 /(1 + rt+1 ). The value of the government bonds which
the household can buy at the end of period t is equal to the total public debt
issued in period t, which is denoted by Bt+1 . This implies that

Vt+1
Xt+1 = + Bt+1 (17)
1 + rt+1

Equilibrium in the goods market requires that the total production is consumed,
invested or purchased by the government, such that Yt = Ct + It + Gt . Note that
equilibrium in the goods market is automatic if the labor and the capital markets
are also in equilibrium (because of Walras law).

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8
Neoclassical Growth Model and Ricardian Equivalence The steady state

3. The steady state

It is often useful to analyse how the economy behaves in steady state. To derive
the steady state, we need to impose some restrictions on the time path of govern-
ment spending. Let us therefore assume that government spending G grows at
the rate of technological progress g:

Gs+1 = Gs (1 + g) (18)

To derive the steady state, we start from an educated guess: let us suppose that
in the steady state consumption also grows at the rate of technological progress
g. We can then derive the values of the other variables, and verify that the model
can indeed be solved (such that our educated guess turns out to be correct).

The steady state values of output, capital, investment, consumption, the real
wage and the real interest rate are then given by the following expressions:10


1
Yt =
At L (19)
r +

1
1
Kt =
At L (20)
r +

1
1
It = (g + ) At L (21)
r +
 

g+ 1
Ct = 1
At L Gt (22)
r + r +


1
wt = (1 ) At (23)
r +
r = (1 + )(1 + g) 1 (24)

...where a superscript shows that the variables are evaluated in the steady
state. Recall that the technology parameter A and government spending G grow
at rate g while labor supply L remains constant over time. It then follows from
the equations above that the steady state values of aggregate output Y , the
aggregate capital stock K , aggregate investment I , aggregate consumption C
and the real wage w all grow at the rate of technological progress g.

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9
Neoclassical Growth Model and Ricardian Equivalence The steady state

We can now draw two conclusions:

First, suppose that the government increases government spending Gt and after-
wards continues to have G growing over time at rate g (such that government
spending is permanently higher). It then follows from equations (19) until (24)
that aggregate consumption decreases one-for-one with the higher government
spending. The rest of the economy, however, is not aected: aggregate output,
the capital stock, investment, the real wage and the real interest rate do not
change as a result of a permanent shock in government spending. So government
spending crowds out consumption.

Second, the way how the government nances its spending turns out to be ir-
relevant for the behavior of the economy: whether the government nances its
spending by raising taxes or by issuing public debt, does not matter. This phe-
nomenon is called Ricardian equivalence. Ricardian equivalence actually holds
not only in steady state, but also outside steady state. In the next section, we
explore the reason for Ricardian equivalence in more detail.

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10
Neoclassical Growth Model and Ricardian Equivalence Ricardian equivalence

4. Ricardian equivalence

Let us consider again the intertemporal budget constraint of the representative


household, equation (14). Recall that the households assets consist of the shares
of the representative rm and the public debt, such that Xt = Vt /(1 + rt ) + Bt .
Substituting in (14) yields:


 s

 s


1
1
Cs = Vt + Bt (1 + rt ) + ws L
s=t s =t+1
1 + rs s=t s =t+1
1 + rs


 s


1
Ts (25)
s=t s =t+1
1 + rs

Now replace Bt by the right-hand-side of the governments budget constraint


(equation (10), but moved backwards with one period):

 s

 s

 s


1
1
1
Cs = Vt + Ts Gs
s=t s =t+1
1 + rs 
s=t s =t+1
1 + rs 
s=t s =t+1
1 + rs


 s
  s

1
1
+ ws L Ts
s=t s =t+1
1 + rs s=t s =t+1
1 + rs
(26)

The present discounted value of tax payments then cancels out, such that the
households intertemporal budget constraint becomes:

 s
  s  s

1
1
1
Cs = Vt + ws L Gs
s=t s =t+1
1 + rs s=t s =t+1
1 + rs s=t s =t+1
1 + rs
(27)

This is a crucial result. It means that from the households point of view, only the
present discounted value of government spending matters. The precise time path
of tax payments and the size of the public debt are irrelevant. The reason for
this is that every increase in public debt must sooner or later be matched by an
increase in taxes. Households therefore do not consider their government bonds
as net wealth, because they realize that sooner or later they will have to pay
taxes to the government such that the government can retire the bonds. From
the households point of view, it is therefore irrelevant whether the government
has a large public debt or not: in the rst case, households will have a lot of
assets, but expect to pay a lot of taxes later on; in the second case, households
will have fewer assets, but feel compensated for that as they also anticipate lower
taxes.

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11
Neoclassical Growth Model and Ricardian Equivalence Conclusions

5. Conclusions

This note presented the neoclassical growth model, and solved for the steady
state. In the neoclassical growth model, it is irrelevant whether the government
nances its expenditures by issuing debt or by raising taxes. This phenomenon
is called Ricardian Equivalence.

Of course, the real world is very dierent from the neoclassical growth model.
Consequently, there are many reasons why Ricardian Equivalence may not hold
in reality. But nevertheless, the neoclassical growth model is a useful starting
point for more complicated dynamic general equilibrium models, and the principle
of Ricardian Equivalence often serves as a benchmark to evaluate the eect of
government debt in more realistic settings.

1
Note that the Solow growth model (Solow, 1956) is sometimes called the neoclassical
growth model as well. But the Solow model is not based on microfoundations, as it
assumes an exogenous saving rate.
2
The stochastic growth model, which is at the heart of modern macroeconomic research, is
in essence a stochastic version of the neoclassical growth model, and is usually presented
in discrete time as well.
3
This type of technological progress is called labor-augmenting or Harrod-neutral techno-
logical progress.
4
See appendix A for derivations.
5
See appendix A for a derivation.
6
In general, there is a third source of revenue for the government, namely seigniorage
income. For simplicity, we make abstraction from this, and assume that seigniorage
income is zero.
7
See appendix A for derivations.
8
The derivation is similar as for the governments intertemporal budget constraint, and is
given in appendix A.
9
Derivations of equations (15) and (16) are given in appendix A.
10
Derivations are given in appendix B.

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12
Neoclassical Growth Model and Ricardian Equivalence Appendix A

Appendix A

A1. The maximization problem of the representative rm


The maximization problem of the rm can be rewritten as:
 
1
Vt (Kt ) = max Yt wt Lt It + Vt+1 (Kt+1 ) (A.1)
{Lt ,It } 1 + rt+1

s.t. Yt = Kt (At Lt )1
Kt+1 = (1 )Kt + It

The rst-order conditions for Lt , respectively It , are:

(1 )Kt A1
t L
t wt = 0 (A.2)
1 Vt+1 (Kt+1 )
1 + = 0 (A.3)
1 + rt+1 Kt+1

In addition, the envelope theorem implies that

Vt (Kt ) 1 Vt+1 (Kt+1 )


= Kt1 (At Lt )1 + (1 ) (A.4)
Kt 1 + rt+1 Kt+1

Substituting the production function in (A.2) gives equation (5):

Yt
(1 ) = wt
Lt

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13
Neoclassical Growth Model and Ricardian Equivalence Appendix A

Substituting (A.3) in (A.4) yields:

Vt (Kt )
= Kt1 (At Lt )1 + (1 )
Kt
Moving one period forward, and substituting again in (A.3) gives:
1  1

1 + Kt+1 (At+1 Lt+1 )1 + (1 ) = 0
1 + rt+1

Reshuing leads to:


1
1 + rt+1 = Kt+1 (At+1 Lt+1 )1 + (1 )

Substituting the production function in the equation above gives then equation (6):

Yt+1
= rt+1 +
Kt+1

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14
Neoclassical Growth Model and Ricardian Equivalence Appendix A

A2. The equilibrium value of the representative rm


First substitute the rst-order conditions (5) and (6) and the law of motion (2) in the
dividend expression (3):
Dt = Yt (1 )Yt It
= Yt It
= Kt (rt + ) [Kt+1 (1 )Kt ]
= Kt (1 + rt ) Kt+1
Substituting in the value function (4) gives then the equilibrium value of Vt , equation
(7):
Kt+1 (1 + rt+1 ) Kt+2 Kt+2 (1 + rt+2 ) Kt+3
Vt = Kt (1 + rt ) Kt+1 + + +
1 + rt+1 (1 + rt+1 )(1 + rt+2 )
= Kt (1 + rt )

A3. The governments intertemporal budget constraint


A3. The goverments intertemporal budget constraint

Let us rst rewrite the governments dynamic budget constraint (8):


Bt+1 Tt Gt
Bt = + (A.5)
1 + rt 1 + rt 1 + rt
Moving this equation one period forward gives an expression for Bt+1 , which we can use
to eliminate Bt+1 in the equation above:
 
1 Bt+2 Tt+1 Gt+1 Tt Gt
Bt = + +
1 + rt 1 + rt+1 1 + rt+1 1 + rt+1 1 + rt 1 + rt
Bt+2 Tt Tt+1
= + +
(1 + rt )(1 + rt+1 ) 1 + rt (1 + rt )(1 + rt+1 )
Gt Gt+1
(A.6)
1 + rt (1 + rt )(1 + rt+1 )
We can then move equation (A.5) two periods forward to obtain an expression for Bt+2 ,
and replace Bt+2 in (A.6). Continuing in this manner eventually leads to
 s
 s
 s
 1   1   1
Bt = lim Bs+1 + Ts Gs
s

1 + rs s=t 
1 + rs s=t 
1 + rs
s =t s =t s =t

Using the transversality condition (9) leads then to the governments intertemporal bud-
get constraint:

 s
 s
  1   1
Bt (1 + rt ) = Ts Gs
s=t 
1 + rs s=t 
1 + rs
s =t+1 s =t+1

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15
Neoclassical Growth Model and Ricardian Equivalence Appendix A

...which can be rewritten as in equation (10):



 s
 s
  1   1
Bt+1 = Ts Gs
s=t+1 
1 + rs s=t+1 
1 + rs
s =t+1 s =t+1

A4. The representative households intertemporal budget con-


A4. The representative households intertemporal budget constraint
straint

Let us rst rewrite the representative households dynamic budget constraint (12):
Xt+1 wt L Tt Ct
Xt = + + (A.7)
1 + rt 1 + rt 1 + rt 1 + rt
Moving this equation one period forward gives an expression for Xt+1 , which we can use
to eliminate Xt+1 in the equation above:
 
1 Xt+2 wt+1 L Tt+1 Ct+1 wt L Tt
Xt = + + +
1 + rt 1 + rt+1 1 + rt+1 1 + rt+1 1 + rt+1 1 + rt 1 + rt
Ct
+
1 + rt
Xt+2 wt L wt+1 L Tt Tt+1
= + +
(1 + rt )(1 + rt+1 ) 1 + rt (1 + rt )(1 + rt+1 ) 1 + rt (1 + rt )(1 + rt+1 )
Ct Ct+1
+ + (A.8)
1 + rt (1 + rt )(1 + rt+1 )

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16
Neoclassical Growth Model and Ricardian Equivalence Appendix A

We can then move equation (A.7) two periods forward to obtain an expression for Xt+2 ,
and replace Xt+2 in (A.8). Continuing in this manner eventually leads to
 s
 s
 1   1
Xt = lim Xs+1 ws L
s 1 + rs s=t s =t
1 + rs
s =t

 s
 s
  1   1
+ Ts + Cs
s=t 
1 + rs s=t 
1 + rs
s =t s =t

Using the transversality condition (13) and rearranging, leads then to the households
intertemporal budget constraint:

 s
 s
 s
  1   1   1
Cs = Xt + ws L Ts
s=t 
1 + rs s=t 
1 + rs s=t 
1 + rs
s =t s =t s =t

...which can be rewritten as in equation (14):



 s
 s
  1   1
Cs = Xt (1 + rt ) + ws L
s=t s =t+1
1 + rs s=t s =t+1
1 + rs

 s
  1
Ts
s=t 
1 + rs
s =t+1

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17
Neoclassical Growth Model and Ricardian Equivalence Appendix A

A5. The maximization problem of the representative household

The maximization problem of the household can be rewritten as:


 
1
Ut (Xt ) = max ln Ct + Ut+1 (Xt+1 ) (A.9)
{Ct } 1+

s.t. Xt+1 = Xt (1 + rt ) + wt L Tt Ct

The rst-order condition for Ct is:


1 1 Ut+1 (Xt+1 )
= 0 (A.10)
Ct 1+ Xt+1
In addition, the envelope theorem implies that
Ut (Xt ) 1 Ut+1 (Xt+1 )
= (1 + rt ) (A.11)
Xt 1+ Xt+1
Substituting (A.10) in (A.11) yields:
Ut (Xt ) 1
= (1 + rt )
Xt Ct
Moving one period forward, and substituting again in (A.10) gives:
1 1 + rt+1 1
= 0
Ct 1 + Ct+1
Rearranging leads then to the Euler equation (15):
1 + rt+1
Ct+1 = Ct (A.12)
1+

A6. The consumption level of the representative household


A6. The consumption level of the representative household
First note that repeatedly using the Euler-equation (15) allows us to eliminate all future
values of C from the left-hand-side of equation (14):

 s
st
  1  1
Cs = Ct
s=t 
1 + rs s=t
1+
s =t+1
1+
= Ct

Substituting in (14) and rearranging yields then equation (16):

 s
 s 
  1   1
Ct = Xt (1 + rt ) + ws L Ts
1+ s=t 
1 + rs s=t 
1 + rs
s =t+1 s =t+1

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18
Neoclassical Growth Model and Ricardian Equivalence Appendix B

Appendix B

If C grows at rate g, the Euler equation (15) implies that


1 + r
Cs (1 + g) = C
1+ s
Rearranging gives then the gross real rate of return 1 + r :

1 + r = (1 + g)(1 + )

which immediately leads to equation (24).

Subsituting in the rms rst-order condition (6) gives:



Yt+1
= r +
Kt+1

Using the production function (1) to eliminate Y yields:


1
Kt+1 (At+1 L)1 = r +

Rearranging gives then the value of Kt+1 :

1
1


Kt+1 = At+1 L
r +

which is equivalent to equation (20).

Substituting in the production function (1) gives then equation (19):



1


Yt =
At L
r +

Substituting (19) in the rst-order condition (5) gives equation (23):



1


wt = (1 )
At
r +

Substituting (20) in the law of motion (2) yields:



1
1
1
1


At+1 L = (1 )
At L + It
r + r +

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19
Neoclassical Growth Model and Ricardian Equivalence Appendix B

such that It is given by:



1
1
1
1

It =
At+1 L (1 )
At L
r + r +

1
1

= [(1 + g) (1 )] At L
r +

1
1

= (g + ) At L
r +

...which is equation (21).

Consumption C can then be computed from the equilibrium condition in the goods
market:

Ct = Yt It Gt

1

1
1

= At L (g + ) At L Gt
r + r +
 
1

g+
= 1 At L Gt
r + r +

Now recall that on the balanced growth path, A and G grow at the rate of technological
progress g. The equation above then implies that C also grows at the rate g, such that
our initial educated guess turns out to be correct.

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Neoclassical Growth Model and Ricardian Equivalence References

References

Ramsey, Frank P. (1928), A Mathematical Theory of Saving, Economic Journal 38,


152(Dec.), 543-559. Reprinted in Joseph E. Stiglitz and Hirofumi Uzawa (eds.), Readings
in the Modern Theory of Economic Growth, MIT Press, 1969.

Solow, Robert (1956), A Contribution to the Theory of Economic Growth, Quarterly


Journal of Economics 70, 1(Feb.), 65-94.

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21