Macroeconomics & The

Global Economy
Ace Institute of Management
Session 9: Economic Growth
Instructor
Rijan Dhakal
dhakalrijan2010@gmail.com
9851069004

The Solow or Neo Classical Model

A major paradigm by Robert Solow:
widely used in policy making
benchmark against which most
recent growth theories are compared
The rate at which the output of the economy
grows basically depends on the rate at which the
followings grow over time:
Capital Stock
Factors of Production
Labour Force
Technological Progress
- Production Function

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Economic Growth I

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The Solow Model- Accumulation of

Capital Stock in an Economy
How much capital an economy can
accumulate depends on:
supply of goods (Output) : depends on

Production function
demand for goods (Input): depends on

Consumption function

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The production function

In aggregate terms: Y = F (K, L )
where

Y = Output
K = Capital Stock
L = No. of Labour

Assumption: Constant return to scale. So,

zY = F (zK, zL ) for any z > 0
Suppose, z = 1/L. Then,
Y/L = F (K/L , 1)
Output per worker (Y/L) is the function of
capital per worker (K/L) .
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The production function

Assume, Y/L = y and K/L = k. Then,
y =

f(k). Ignore 1 as a constant. (i)

Eqn, (i) shows how much extra output a

worker produces given an extra capital
(Marginal Product of Capital-MPK).

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The production function

Output
per
worker, y

Note:
When capital
per worker is
high, extra unit
of capital
produces lower
output
Vice Versa.

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f(k)
MPK
1
Note:
Note: this
this production
production
function
function exhibits
exhibits
diminishing
diminishing MPK.
MPK.

Economic Growth I

Capital
per
worker, k
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The Demand for Goods and Services

y=c+i

(remember, no G : Two Sector)

In per worker terms:

Output per worker is divided into consumption per
worker and investment per worker
Since people save and consume their income,
If savings rate = s, then, c = (1-s)
So, fraction of the income that people consume is c
= (1-s)y .. Consumption Fn.
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The Demand for Goods and Services

Substituting the value of c in y;
y = (1-s)y + i

or

i = sy
Shows that investment equals saving
where s is the fraction of the output/
income devoted to investment.

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Economic Growth I

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Basis of Neo-Classical Growth Model

The main building block of the model: production
function (Y depends on K, L and the technological
progress)
Investment : K
Depreciation : K
So, When I > D; K
When I < D; K
When I = D; K- Unchanged (Steady State)
Big Question: When does investment exceed
depreciation, and when does it fall short of it?

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Basis of Neo-Classical Growth Model

Depreciation: we may safely assume it as a
constant (usually shown by 45 degree).
Investment: Can be shown in terms of savings.
Saving is a fixed share of total income. Therefore,
savings and/or investment at different capital
stocks can be presented as a part of the total
output (Income).

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Output Per Worker

Graphical representation without Technology

Steady State

Capital Per Worker

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The Golden Rule

level of capital
accumulation is
the steady state
with the highest
level of
consumption.

Output Per Worker

Golden Rule level of Capital

C*gold
Steady State
I*gold

k*gold
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Economic Growth I

Capital Per Worker

slide 12

Output Per Worker

The model and increase in the saving rate

Capital Per Worker

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The model and increase in population

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Effect of Technological Advancement

Productivity per y
worker increases
y*
Shifts the
Production
y*
functions upward
Saving rate shifts
upward
Capital stock per
worker increases
New Steady State is
formed
Output per worker
is increased but
greater than k
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Economic Growth I

y = f(k)
y = f(k)
ir = dk
i = s' f(k)
i = s f(k)

k* k1*

k
slide 15

Policy issues:
How to increase the saving rate?
Reduce the government budget deficit
(or increase the budget surplus).
Increase incentives for private saving.
Example: Reduce tax

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Economic Growth I

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Policy issues:
Allocating the economys investment
In the Solow model, theres one type of
capital.
In the real world, there are many types,
which we can divide into three categories:
private capital stock
public infrastructure
human capital: the knowledge and
skills that workers acquire through
education.
How should we allocate investment among
these types?
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Policy issues:
Allocating the economys investment
Two viewpoints:
1. Let the market allocate investment to the
type with the highest marginal product.
2. Industrial policy by government:
Govt should actively encourage investment
in capital of certain types or in certain
industries, because they may have positive
externalities
that private investors dont consider.

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Policy issues:
Establishing the right institutions
Creating the right institutions is important
for ensuring that resources are allocated
to their best use. Examples:
Legal institutions, to protect property

rights.
Capital markets, to help financial capital

flow to the best investment projects.

A corruption-free government, to promote

competition, enforce contracts, etc.

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Policy issues:
Encouraging tech. progress
Patent laws:
encourage innovation by granting
temporary monopolies to inventors of new
products.
Tax incentives for R&D
Grants to fund basic research at universities
Industrial policy:
encourages specific industries that are key
for rapid tech. progress
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Thank You

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slide 21