2.

7 SOLOW MODEL
2.7.1 Notation
The following presentation and notation follows Jones’s book ’Introduction
to Economic Growth’. See also the appendix for the notation.
²
² X ´ dX=dt

²
² X=X =growth rate of X, %-change

² ’Taking logs and derivatives with respect to time’ of a variable to get

its growth rate:
² ²
dY dY dX 1
Y (t) = log X(t) =) dt
= dX dt
= X
X = X=X
²
E.g. the growth rate of the capital stock (K) is d log K=dt = K=K

² If X grows at a constant rate g ( X(t) = X0 egt ),

X(t)¡X(t¡1)
then g = log X(t) ¡ log X(t ¡ 1) ´ ¢ log X(t) t X(t)

²
² Notation: gX = X=X

2.7.2 Basic model

In the modi…cation of the Harrod-Domar model where we accounted for
endogenous population growth, we got the result that even a temporary
change in policy (e.g. a family planning program) can have lasting long-run
e¤ects on the growth rate. This temporary change could move the economy
out from the development trap, and it could reach the area where sustained
growth is possible. More generally, factors that we treat exogenous (e.g.
savings rate) may well be a¤ected by the outcomes that they supposedly
cause (e.g. output or its rate of growth). If these feedbacks are signi…cant,
our understanding about the economy and about policy may need to be
fundamentally altered. The growth model developed by Solow (1956) had
such a major impact on how the economists think about growth. He altered
the Harrod-Domar story by making the capital-output ratio endogenous.
Solow’s model is based on the diminishing returns to individual factors of
production. Capital and Labor (L) are both needed to produce output.
Unlike in Harrod-Domar-model, the K=Y ratio is no longer …xed but depends

20
e.g. on the economywide relative endowments of capital and labor. As we
will see, the e¤ects of policy on growth will be radically changed.

Assumptions:

² Savings rate (ratio of savings to income), s; is constant: Savings will be

channeled into investment as previously.
²
² Population growth rate is constant: L=L = n, where L denotes popu-
lation or labor.

² There is perfect competition: the …rm takes the market wages on labor
and rents on capital as given.

² Constant returns to scale. If labor and capital inputs are doubled, the
output gets doubled as well.

E.g. in the case of Cobb-Douglas production function. (Price of output

normalized to one)

Y = F (K; L) = K ® L1¡® (3)

where K denotes the capital stock, Y output and ® is a parameter in the
production function, which shows how capital and labor need to be combined
to produce the output.
As opposed to Harrod-Domar, there are now diminishing marginal prod-
ucts to labor (M P L) and capital (MP K) individually. If one input is in-
creased while the other stays …xed, the marginal product of the input that
is used more will increase but less and less. So, K=Y is not …xed at some µ:
As we can see in the below graph, increasing capital per labor will lead to
falling Y =K as there is relative shortage of labor. So, µ is rising.

21
 ( Note:
The …rm maximizes the pro…ts:
maxK;L F (K; L) ¡ rK ¡ wL
1st order conditions:
w = @F@L
= (1 ¡ ®) YL
@F Y
r = @K = ® K

wL + rK = Y )

Rewrite the model in per capita form:

Production function (divide both sides of the production function by L):

y = k® (4)
where y ´ Y=L ja k ´ K=L

Capital accumulation equation describes how capital accumulates. It says

²
that the change in the capital stock, K , is equal to the amount of gross in-
vestment, sY , less the amount of depreciation during the production process

22
 ²
K = sY ¡ dK (5)
where
²
K = dKdt
d = rate of depreciation (e.g. 0.05, so that 5% of the capital wears out
each year).

Rewrite capital accumulation equation in per capita terms (from capital

to small letters): ’take logs and then derivatives with respect to time’
²
k=k ?
Start with k = K=L
Take logs of both sides =) log k = log K ¡ log L
² ² ²
Take derivatives with respect to time => k=k = K=K ¡ L=L (see
Jones Appendix A)
²
K = sY ¡ dK
²
K sY
=) K
= K
¡ d
² ² ²
Y =L y
=) k=k + L=L = sY =K ¡ d (note : Y
K
= K=L
= k
and L
L
= n)
²
=) k=k = sy=k ¡ n ¡ d

²
k = sy ¡ (n + d)k (6)

23
 Denote the Steady state by: y¤ ; k ¤

Steady state k ¤ can be solved from the following equation (remember the
de…nintion of a steady state).
²
k = 0 =) sy = (n + d)k

Draw the Solow diagram.

What happens to the steady state k and y if the investment rate (=savings
rate) increases or the population growth rate increases for example because
of immigration?

Solve for the steady state quantities of capital and output per capita (or
per worker):
²
k=0

=) sk ® ¡ (n + d)k = 0

24
 µ ¶1=(1¡®)
¤ s
k = (7)
n+d
µ ¶®=(1¡®)
¤ s
y = (8)
n+d
Question 1:
Why are some countries rich and others poor?

Countries tend to be richer, if they have

² higher savings/investment rates

² lower population growth (Why? - smaller fraction of savings must go to

keep the capital-labor ratio constant in the face of smaller population)

Question 2:
Why are some countries growing and others are not?

There is no per capita growth in this version of the model, since y¤ is

constant. This requires that Y and L grow at the same rate to keep YL
constant: ²
Y =L = y is constant => .Y =Y = n
Economies may however grow for a while along the transition to the
steady state, but not forever.
We see that growth slows down along the transition path:
²
k
k
= sy=k ¡ (n + d) = sk ®¡1 ¡ (n + d)

Since ® < 1, the growth rate of k gradually declines as k rises.

25
 The further the economy is from its steady state k, the faster is the
growth.

How do we understand the discrepancy between Harrod-Domar - model

and Solow model? In the former the savings rate, for example, a¤ected the
long run growth rate, while in the Solow model savings rate does not a¤ect
the growth rate. There is no sustained growth to begin with in this version
of the Solow model! This is because there are diminishing returns to capital,
which create endogenous changes in capital-output ratio. This chokes o¤
growth in the Solow model. If capital were to grow faster than labor, each
unit of capital had less labor to work with it, and the output per unit of
capital would be reduced. There can be no steady state growth.

Empirical evidence According to the simple version of Solow model out-

put levels per capita should be higher the higher the savings rate in the
country or the lower the population growth rate. This prediction is match-
ing the observations in the real data. Countries with higher s or lower n
(over 1960-2000) tend to be on average richer in 2000. See also the below
data from Weil (2005).

26
27
28
2.7.3 Basic model + technical progress
There are two broad sources of growth. One is through better and more
advanced methods of production (technical progress) and the other is through
continued increase in the inputs of production (capital, labor etc.). The
simple version of Solow model said that in the absence of technical progress
the increase in the inputs of production is not enough for sustained per capita
growth!! The diminishing returns to capital loose its force, however, if the
production function shifts continuously upward over time as new knowledge
is gained and applied in the production process. Output per capita can now
be growing in a sustained manner.

Lets look at the model into which technological progress is introduced

(by Solow himself).

- Technological progress shows in the production function through the

technology variable A: Increase in A, the level of technology, means that a
unit of labor is more productive. (This is sometimes called ’labor augmenting’
or ’Harrod- neutral’ technological progress.)

Y = F (K; AL) = K ® (AL)1¡® (9)

- Technological progress is exogenous:
²
A
= g () A = A0 egt
A
g = growth rate of technology (constant)

In reality technology is not exogenous, like ”manna from heaven”. New

growth theory (endogenous growth theory) attempts to model the technological
progress.

Capital accumulation:
²
K Y
=s ¡d (10)
K K
Rewrite in per capita terms:
E.g. Divide the production function by L and multiply the right hand side
by L®=L® :
y = k ®A1¡®
Again taking logs and derivatives you get

29
 ² ² ²
y k A
= ® + (1 ¡ ®) (11)
y k A

Balanced growth path is such that:

K; Y; C; L. are growing at contant (not necessarily the same) rates.
In the long run, we want the model to generate balanced growth (this is
desirable both empirically and technically).
²
As KK
= constant, then from (10) we know that K Y
must be constant.
(Note: this matches the empirical observations reported earlier)
=) ² ²
1. K
K
= Y
Y

² ² ²
y y
2. k
= constant =) y
= k
k
= A
A
(see 11)
²
Denote gX = X
X

gy = gk = gA = g (12)
Question 2
Sustained growth is possible, gy = gA = g
Output (and capital) per capita grows at the same rate as the exogenous
technological progress.

Solving the model:

We cannot solve for the steady state by solving for k ¤ as before because k
is not constant

Let’s de…ne a new state variable, e k, and again rewrite the production
function and the capital accumulation equation in terms of variables (per
e¤ective labor in this case) that turn out to be constant at the steady state:
e
k ´ K=AL = k=A: (This is constant along the balance growth path
because gk = gA = g)

ye ´ Y =AL = y=A (output per e¤ective unit of labor)

Production function can now be rewritten as

ye = e
k® (13)

30
 ² ² ² ²
e
With same tricks as before we get: k
e
k
= K
K
¡A
A
¡ LL . (Remember also that
² ²
K
K
Y
= sK ¡ d and substitute for K
K
)
²
e
k sY
=) e
k
= K
¡d¡g¡n
sY =AL
= K=AL
¡d¡g¡n
²
e y ¡ (n + g + d)e
k = se k (14)

²
e¤ by setting e
Solve for the steady state k k=0

Solow diagram:

µ ¶1=(1¡®)
e¤ s
k = (15)
n+g+d
µ ¶®=(1¡®)
¤ s
ye = (16)
n+g+d
Solve for Y=L which is now growing in time

µ ¶®=(1¡®)
¤ s
y (t) = A(t)
n+g+d

31
 Result:
Change in the investment rate or the population growth rate a¤ect the
level of per capita output, but NOT the growth rate of output per capita.
Sustained per capita growth is possible only if there is technological
progress.

Question 1
Some countries are rich because they save more and their population
growth is smaller. (i.e. they can accumulate more capital per capita, and the
productivity of labor is higher)

Question 2
Sustained growth requires technological progress. Without it, per capita
growth will eventually cease as diminishing returns to capital set in.

The explanations this model gives to the di¤erent growth rates across countries:
- di¤erences in technological progress
- di¤erences occur during the transition dynamics as the economy is mov-
ing towards its steady state.
e.g. destruction of capital in war (Germany, Japan), or increased rate
of investment ((South Korea, Taiwan, Singapore) (see …gure 2.14 in Jones).
Notice that the level of steady state output does not depend on any of this
kind of historical events.

32
2.7.4 Basic model + technological progress + human capital

Let’s look brie‡y at how we could acknowledge that there can be increase in
human capital or the skill level of the workers.
H = Human capital: skilled labour

Y = F (K; AH) = K ® (AH)1¡® (17)

²
- A
A
= g as before
- human capital is accumulated by spending time on learning new skills
instead of working.
- u = fraction of time spent learning skills.
- L = ”raw” labor

H = eÃu L
Ã>0
Jos u = 0; H = L:
²
K = sK Y ¡ dK (18)
Only results of this model are presented here.
Per capita production function will turn out to be:

y = k ®(Ah)1¡®
where h = eÃu = constant. u is assumed to be constant (exogenous).

Along the steady state growth path

µ ¶®=(1¡®)
¤ sK
y (t) = hA(t)
n+g+d
Question 1
Some countries are rich, because they
- have a high rate of investment
- large fraction of time is used to learn new skills
- population growth rate is small
- have high level of technology
Question 2
Sustainable growth amounts to gy = gA = g

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2.8 Does the Solow model …t the data?

2.8.1 Convergence

Absolute convergence (unconditional convergence):

Poor countries grow faster than the rich ones.

Lets assume that all the countries have the same steady state with requires
that their sK ; n; d; g and the production functions are the same. Then the
following holds for all the countries
²
e
k ye
gek ´ = sK ¡ (n + g + d) = sK e
k ®¡1 ¡ (n + g + d) (19)
e
k e
k

@gek
= sK (® ¡ 1)e
k ®¡2 < 0
e
@k
Countries di¤er only by their initial capital/capita level (due to war,
changes in population, the rate of investment, or the economic policies, etc.)
A country which is poor initially (with low per capita income and capital
stock) will then grow faster than the rich country.

Empirical evidence
The growth rates of homogenous countries do converge more clearly than
the growth rates of non-homogenous countries (the US states, OECD vs. the
world).
Homogenous countries are more likely to have ’the same’ steady state.
(Figures 3.4, 3.5 and 3.6.in Jones)

Conditional convergence:
A country will grow the faster the further away it is from its own steady
state. A poor country may thus grow faster than a rich country if we consider
their di¤erent steady states.
Assumption: the steady states of the countries di¤er (their parameters
di¤er).

Empirical evidence
Conditional convergence is supported even in a large set of countries which
is what we would expect based on our neoclassical growth theories.
(Figure 3.8 in Jones)

34