Solow Growth Model

 Observation: Richer countries have more capital (more

machines, factories, etc.)
 Is this the cause or the result of their greater income?
 Two possibilities considered:
 Countries have more capital because they save a
greater part of their income
 Countries have more capital because their income is
higher
 The whole model is beyond the scope of this class, so we
will consider a greatly simplified version
 Simplified Solow Growth Model
Consumers:
 Consume a constant fraction of GDP and own
all the capital in the economy
 Not modeling:
 Unemployment (everyone always works)
 Lifecycle (no children, students or retirees)
 Within-country income inequality
Consumers described by one equation:
I=sY
where s, a number between 0 and 1, is the
fraction of output that gets invested.
 Simplified Solow Growth Model
Firms:
 Use the capital to produce output
 Not modeling:
 Labor markets (searching for workers)
 Finance (borrowing to take on projects)
 Executive compensation
Firms described by one equation:
Y = A K0.3
where Y is GDP, A is productivity
and K is the capital stock
 Simplified Solow Growth Model
Equilibrium:
 All output is used either in investment or
consumption (no trade, no government):

Y=C+I

 How the stock of capital changes over time:

K’ = I + (1- δ)K
where K’ is the capital stock next year,
K is the capital stock this year,
I is investment this year, and
δ is the depreciation rate
 Simplified Solow Growth Model
So the entire model is described by four equations:

 Households: I=sY
 Firms: Y = A K0.3
 Capital Accumulation: K’ = I + (1- δ)K
 GDP: Y=C+I

Rearranging terms:

 I = s Y = s A K0.3
 K’ = I + (1- δ)K = s A K0.3 + (1- δ)K
 How does the capital stock
change over time?
K’

How are capital this year, and

capital next year related?
K’= K

K
 How does the capital stock
change over time?
K’

K’ = s A K0.3 + (1- δ)K

The equation above tells you

how much capital there will be
K’= K next year

K
 How does the capital stock
change over time?
K’

K’ = s A K0.3 + (1- δ)K

Suppose the economy starts

with some low capital level K0
K’= K

K0 K
 How does the capital stock
change over time?
K’

K’ = s A K0.3 + (1- δ)K

Then the equation says that

K1 next year’s capital stock will
be K1
K’= K

K0 K
 How does the capital stock
change over time?
K’

K’ = s A K0.3 + (1- δ)K

Using the red 45 degree line

K1 as a reference, we can find
K1 on the horizontal axis.
K’= K

K0 K1 K
 How does the capital stock
change over time?
K’

K’ = s A K0.3 + (1- δ)K

K2
Then we can find K2
K1
K’= K

K0 K1 K
 How does the capital stock
change over time?
K’

K’ = s A K0.3 + (1- δ)K

K2
Repeating these steps, we
K1 can find the capital stock in
any future year
K’= K

K0 K1 K
 How does the capital stock
change over time?
K’

K’ = s A K0.3 + (1- δ)K

K2
Repeating these steps, we
K1 can find the capital stock in
any future year
K’= K

K0 K1 K2 K
 How does the capital stock
change over time?
K’

K’ = s A K0.3 + (1- δ)K

K3
K2
Repeating these steps, we
K1 can find the capital stock in
any future year
K’= K

K0 K1 K2 K
 How does the capital stock
change over time?
K’

K’ = s A K0.3 + (1- δ)K

K3
K2
Repeating these steps, we
K1 can find the capital stock in
any future year
K’= K

K0 K1 K2 K3 K
 How does the capital stock
change over time?
K’

K’ = s A K0.3 + (1- δ)K

K4
K3
K2
Repeating these steps, we
K1 can find the capital stock in
any future year
K’= K

K0 K1 K2 K3 K
 How does the capital stock
change over time?
K’

K10 K’ = s A K0.3 + (1- δ)K

….
K3
K2
Notice that the capital stock
is approaching the point
K1
where the two lines meet
K’= K

K0 K1 K2 …. K10 K
 How does the capital stock
change over time?
K’

K* K’ = s A K0.3 + (1- δ)K

The point where the two

lines meet is the steady
state level of capital. Once
the economy is at this level,
K’= K the capital level does not
change.

K* K