ECON 805: Solow Growth Model

What Predictions Does This Model Deliver?

1. Predictions about growth rates. 2. Predictions about the cross-sectional distribution of income. Key Concepts: Steady-State: A steady-state is said to exist when the endogenous variables do not change. In our model, the key variable will be the capital stock (dened in either per capita terms or in eective labor units). In the basic Solow model, the economy reaches a steady-state, the two forces that impact capital accumulation (investment and depreciation exactly oset). At this point, we will also show that consumption and investment (both dened in either per capita terms or in eective labor units) will also attain a steady-state. Balanced Growth Path: A balanced growth occurs when all endogenous variables in grow at a constant rate. Typically, the rate is determine by the growth rate of the of the exogenous variables. As a reminder, and endogenous variable is a variable that is determined inside the economics model and exogenous variable is a variable that is determined outside of the model. In the context of the basic Solow model, we assume that population growth (and the growth rate of technology) are exogenous. The endogenous variables include the capital stock, consumption, investment.

Solow Model: Introduction

The Solow model is a simple dynamic, general equilibrium model which is useful as a starting point to explain dierences in income across countries and dierences in growth rates over time. We start with some simplifying assumptions probably too simple. In particular, we assume the following: individuals save (or consume) a constant fraction of their income, the growth rate of the population is exogenous, (later) we assume that there is an underlying growth rate of technology that also is exogenously given.

All of these assumptions are extreme, in that, we think that rational agents make optimal choices when deciding how much to consume today and how much to consume in the future; that is, savings and the savings rate is not literally exogenous. We also think that agents are rational in the sense that they make choices about the number of children they would like to have; that is, population growth is not exogenous. Finally, we think that technological progress does not grow exogenously. Real resourcestime and goodsmust be allocated to enhance the productivity of inputs used in the production process. Finally, there are other aspects of the real world that are not incorporated in this model. For example, the model does not include actions by the government (taxing and spending), the model also does not incorporate money or uncertainty. As the course progresses, we will relax all of these assumptions to construct a more general model. For now these, assumptions allow us to get a rst look at why some countries are so rich and some countries are so poor. The basic Solow model presumes dierences in income across countries are due to the amount of physical capital available for production. Intuitively, all else held equal, we would expect countries that have more capital would also produce more output. To see if this indeed is the case, we plot the amount of (natural log) of the per capita capita stock on the x-axis and natural log of output per capita on the y-axis. We see that there is a strong relationship between the two variablesthe correlation coecient is 0.97.

Figure 1: Per Capita Capital Stock and Per Capita Real GDP

The question we seek to answer in these notes is to what extent can dierences in capital stocks and savings (investment) rates account for dierences in income. Savings rates are important part of this explanation because a societys decision to save implies that it is foregoing current consumption in favor of future consumption. When and individuals save, the savings must be channeled somewhere. As we show below, in a closed economy, what is not consumed (that is what is saved) must be allocated to investment and capital accumulation. Let us now be more clear what we mean by capital and investment. Capital (as stated by Weil) has ve key characteristics. They are: Capital is productive, Capital is produced, Capital can earn a return, Capitals use is limited, and Capital wears out. 3

Let us take each of these in turn. Capital is productive, in that, the more capital per worker employed in producing output the more output produced. For a given amount of labor, the more capital there is the more goods and services can be produced. Clearly, I could produce more output with a computer, some software, and a printer than I could if I just had a typewriter and a hand calculator. We also think that for a xed amount of workers the additional benets of adding additional unit of capital declines as more capital is added; that is, we say that capital has a positive but diminishing marginal product. We dene the marginal product of capital as the additional amount of capital that can be produced by adding one more unit of capitalholding all other inputs constant. We will say more about this below. We also say that capital is produced ; that is capital is built or created. The fact that real resources must be allocated to produce capital implies that something must be given up to produce more capital. If we think of a simple world where the output produced has two usesconsumption and investment, any additions to the capital stock that occur through investment imply that current consumption must be sacriced. Weil states that capital has to be produced so it is dierent than something like land (or a natural resource). While this is true in some sense it is also not quite true literally. If we want to use land, then some resources must be allocated to the land to make it usable. Capital earns a return. Because some current consumption must be sacriced, there must be an incentive for individuals to forego current consumption. The compensation for the sacriced consumption is the return to capital. The return may occur as dividends that are paid out to stockholders of a company. They may occur to entrepreneurs who buy capital and use it to produce output; in this case the return to capital may show up as part of their wages; that is there returns may not be as high had they not bought the capital. In this case, capitals return shows up as part of wages. Capital depreciates. When capital is used in production it will lose some of its value through normal wear and tear. For now, we will assume that the capital stock depreciates at a constant rate. Later we will allow the depreciation of capital to depend on the its usage rate; that is, when capacity utilization is high the capital stock will wear out faster.

Set-up of the Basic Solow Model

1. One good is produced: The good is consumed or saved (Denote Yt as the aggregate amount of output produced.) 2. Labor force grows at a constant rate n (n > Lt t+1 ) LLt = 1 + n, ) Lt+1 =n Lt 1) ;where Lt = L0 (1 + n)t ,

3. Aggregate household consumption is a constant fraction of output: Ct = (1 s)Yt s 2 (0, 1), 4

4. Investment: Capital accumulates in the standard fashion: Kt+1 = It + Kt which can be rearranged to read as Kt+1 = It + (1 ) Kt Kt 2 (0, 1)

which just simply implies that tomorrows capital stock (Kt+1 ) is equal to the capital stock that does not depreciate from use today ((1 ) Kt ) plus the amount of current output that gets allocated to capital accumulation (It ) . Note if the amount of output that gets allocated to capital accumulation exceeds the amount of capital that depreciates (It > Kt ) then the aggregate capital stock will grow (Kt+1 > Kt ) . Given the standard properties of the production function, if capital grows output must grow as well. 5. Households accumulate assets according to: At+1 = (1 + rt )At + wt Nt or At+1 At = rt At + wt Nt Ct Ct

where we dene At to be assets held at time t. 6. Assets come in the form of either bond holdings (Bt ) or in the form of capital (Kt ) . Individuals issue and hold bonds. In this set-up, there are no government issued bonds. Firms do not issue bonds directly. Since there is no nancial intermediaries household will issue there own bonds to borrow and hold bonds in order to save. Therefore, the only holders of bonds are households. In the aggregate net bond holding will be zero. Because for every borrower there is a saver; so net bond holdings must be zero. Keep in mind, in equilibrium, net bond holding will be zero and the only asset held is the capital stock. We will show this must be true more formally below. 7. The production function is given by:
d Yt = Zt F (Kt , Ld t)

For now, we assume that Zt = 1. We assume that the production function exhibits constant returns to scale in capital and labor; that is, if we write the production function as and if we double the inputs of capital and labor output would exactly double. Generally speaking, if we increase the amount of capital and labor by any factor, say , then output will increase d by . That is Yt = F ( Kt , Ld = 1/Ld t ) . If we let t we get Kt Yt = F ( , 1) Lt Lt 5

Yt we can dene yt = N as output per-worker and kt = t worker then we can write the production function as

Kt Nt

as capital per

yt = F (kt , 1) In this case, since the second argument in the production function does not vary, we can write the production function as yt = f (kt ) This is the form we will use below. Note again, this simply states that output per eective labor unit is a function of capital per eective labor units. An example that we will use frequently in this course is the Cobb-Douglas production function. We can write this as
Yt = Kt (Lt ) 1

which can be written in output per capita as a function of the per capita capital stock a yt = kt For the Cobb-Douglas production function we dene the marginal product of capital as @ Yt 1 1 1 = (Kt ) (Lt ) = kt @ Kt If we were to graph the marginal product of capital it would look like the diagram drawn below Note that this production function exhibits positive but diminishing marginal product. Another property that we will use below is that in a world where there is perfect competition and inputs are paid their marginal product we can dene capitals share of output as the fraction of output (or income) that is paid to capital; that is, capitals share = (capital income)/output. If capital gets paid its marginal product then the payment to capital is 1 1 M P K K = (Kt ) (Lt ) Kt = Yt ., so capitals share of output is given by 1 1 (Kt ) (Xt Nt ) Kt Yt capital0 s share = = = Yt Yt A similar calculation would show that labors share of output is equal to (1 ). The basic properties of the production function are: (a) FL > 0, FK > 0, (Positive marginal product of capital and labor) (b) FLL > 0, FKK > 0, (Diminishing marginal products of capital and labor) 6

(c) INADA conditions: F (K, 0) = F (0, L) = 0, and limK !0 FK = 1 and limL!0 FL = 1 Technical Note: A balanced growth path implies that the economy, at a certain point in time, will reach a point where all the endogenous variables grow at a constant rate. In this model, the endogenous variables (capital, output, and consumption) all grow at a constant rate once we are on the balanced growth path. At what rate will the variables grow? The aggregate variables will grow at the rate same rate as the exogenous variables. In this model, population grows at constant rate so the aggregate endogenous variables will grow at the rate of population growth; that is, the gross growth rate of output, capital and consumption will grow at a rate of (1 + n) per unit of time. A special growth path is what is termed a steady state. When an economy reaches a steady state, the endogenous variables do not grow at all. In the basic Solow model, per capita output, capital, consumption and investment will converge to a steady state. We will use the concept of a steady state throughout the class. There are obvious reasons why we would want to do so. One reason is that it is easy to depict steady-states in two dimensions. The second reason is that steady states look a lot like standard economic equilibrium analysis; that is, the steady state occurs where two curves cross. This should become clearer below, 8. The Economys resource constraint is satised: Ct + Kt+1 (1 )Kt . Goal: 1. To use these tools to see to what extent dierences in the capital stock (savings rate) can explain dierences in income. 2. To understand why some countries grow faster than others. Yt = Ct + It or Yt =

Household and Firm Behavior

Households
We dene all of our endogenous variables in per capita terms; that is, we net out the growth rate of the variable that grows exogenously (population). By normalizing all variables by the size of the population at time t (Lt ), we remove the exogenous growth components from all the variables. We already know that per capita income in eective labor units is given by: yt = f (kt )

To get per capita consumption and the per capita capital stock, we simply divide the aggregate variable by the population; that is ct = Ct Kt and kt = Lt Lt

Recall the asset accumulation equation for the household is given by At+1 At = rt At + Wt Lt Ct

Dividing through by the population at time t, yields At+1 Lt which equals At+1 Lt At At = rt ( ) + W t Lt Lt at = rt at + Wt Ct Lt ct

Note that we did not write At+1 /Lt = at ; the reason for this is because the time subscripts on assets at time t and the population at time t do not align. There is a simple x for this problem: We rewrite At+1 At+1 Lt+1 = = at+1 (1 + n) Lt Lt+1 Lt so that the asset accumulation equation is given by at+1 (1 + n) or at = rt at + Wt ct ct

at+1 (1 + n) = (1 + rt )at + Wt

or by subtracting (1 + n)at from both sides of the above equation we have (at+1 at )(1 + n) = (rt n)at + Wt ct

It may be easier to think of this budget equation in terms of the sources of funds equal uses of funds. The sources of funds are the incomes received Wt + rt at . The uses of funds are what the individuals do with their income. They use their income to accumulate assets and to buy the consumption goods. We saw above that then change in assets is given by (at+1 at ) + at+1 n and consumption is given by ct . Thus, the economy uses of funds are (at+1 at ) + at+1 n + ct . Therefore, the budget constant is given by Wt + (rt n)at = (at+1 at )(1 + n) + ct

In this model, households are not choosing consumption and saving optimally since, by assumption, the household consumes a constant fraction of income; that is ct = (1 s) [Wt + rt at ] 8

More on assets: we stated above that households can hold two dierent types of assets: bonds or capital. Total asset holdings are given by At = Bt + Kt The returns to each of these assets will determine the how much of their wealth b , they hold in bonds and capita. The return on bond holding is denoted by rt b and if an individual purchases a bond at time t (Bt ), the return is (1 + rt )Bt b b (1 + rt )Bt Bt = (1 + rt ) 1 Bt Alternatively, can obtain capital and rent it to the rm. If they do so they get a gross return of Rt Kt ; however, when the rm uses the capital stock, the capital stock depreciates by Kt . The net return from holding wealth in capital and renting it to the rm k (1 + k ) K K = (1 + ) 1 Kt t t t Note then the asset equation is given by
b At+1 = Bt+1 + Kt+1 = (1 + rt )Bt + (1 + k t

)Kt + Wt Lt

Ct

or b Bt+1 + Kt+1 = (1 + rt )(Bt + Kt )+ (k t or b At+1 = (1 + rt )At + (k t ) )

b rt Kt + Wt Lt

Ct

b rt Kt + Wt Lt

Ct

The key term is the term in brackets. Note b if (k ) rt > 0 then the return on capital is holding capital is greater t

than the return on holding bonds. In this case, everyone would want to borrow. However, not everyone can borrow! This must drive the return on bonds up! b if (k ) rt < 0 the return on holding bonds is greater than the return t to capital. In this case, everyone would want to hold bonds. However, this cannot be an equilibrium since we will show below R = FK and limK !0 FK = 1.
b ) = rt . We simply state this as (k t b ) = rt = rt or

This implies that (k t k t = rt +

Firms
Firms hire workers and rent capital to produce output. We think of rms as renting capital from households to produce output. None of the results would change if we assumed that the rms owned the capital stock and the households owned the rms. We dene Rt as the rental price of capital and so that payments to the households will be proportional to the capital stock. If we dene as the depreciation rate per unit of capital the net return of a renting a unit of capital to the rm is R . In the absence of uncertainty, the return from holding a one-period bond and the return from renting a unit of capital to the rm must be the same; that is R = r or rt + = R. So we can write the rms problem as = max F (K d , Ld ) K d W Ld
K,L

I have dropped the time subscripts here because the problem is a static problem; that is, the rm decides on how many workers and how much capital to hire each period. How much labor and capital to employ next period does not enter into the rms decision set. The maximization problem can be written in per capita terms as: = max Ld f k d k d W Ld
K,L

and the rst-order conditions are @ @k @ @L = Ld f 0 k d = f (k d )

The term in curly brackets is zero because of the rst-order condition with respect to k. These rst-order conditions imply
d f 0 kt

=0 W

kd f 0 kd

=0

= t
d = f (kt ) d d f 0 (kt )kt

Wt

Equilibrium
Now we can list the conditions and the corresponding equations that we use to solve the model: 1. Households: (a) Households budget constraint is satised (at+1 n)at + Wt ct at )(1 + n) = (rt

(b) Agents spend a constant fraction of income on consumption; that is ct = (1 s)yt = (1 s)f (kt ) 2. Firms: Firms maximize prots: f 0 (kt ) = rt + and Wt = f (kt ) 10 f 0 (kt )kt

3. No arbitrage condition: In equilibrium, the only asset held by the household is the capital stock at = kt (bond holding in the aggregate must be zero bt = 0), and the return on bonds is equal to the net return on capital. 4. Market Clearing: Markets are in equilibrium (We will often state this as markets clear.)
d (a) Factor markets clear: Lt = Ld t and Kt = Kt

(b) Goods market clearing: yt = ct + it , We should be a little more careful about the goods market clearing condition. Recall from before that we could write market clearing as Yt = Ct + Kt+1 (1 )Kt

Dividing this equation through by Lt yields: yt = ct + Kt+1 Lt (1 )kt

As with the asset accumulation equation, the time period and so we do as before we rewrite the equation as Kt+1 yt = ct + Lt+1 which can written as f (kt ) = ct + (1 + n)kt+1 or (kt+1 Now if we substitute for ct = (1 (kt+1 (1 + n)kt kt ) [(1 [(1 ) ) (1 + n)]kt (1 + n)]kt Lt+1 Lt (1 (1 )kt )kt

yt = ct + kt+1 (1 + n)

f (kt ) = ct + (1 + n)(kt+1 kt ) =

ct (n + )kt 1+n s)f (kt ), we obtain sf (kt ) (n + )kt 1+n

f (kt )

kt ) =

The resource constraint informs that the path of the capital stock is given by (kt+1 kt ) = sf (kt ) (n + )kt 1+n (1)

What happens if we start from the (aggregated) households budget constraint (written in per capita terms)? We know that at+1 (1 + n) = (1 + rt )at + Wt 11 ct

In equilibrium, kt = at and bt = 0, so that kt+1 (1 + n) = (1 + rt )kt + Wt Next recall that in equilibrium rt = t kt+1 (1 + n) = (1 + t so that )kt + Wt ct ct

d Also in equilibrium, markets clear Lt = Ld t and kt = kt . Also recall that prot maximization implies Wt = f (kt ) f 0 (kt )kt

and

t = f 0 (k )

substituting this into the households budget constraint yields kt+1 (1 + n) = (f 0 (k )t + 1 and after some rearranging kt+1 (1 + n) = f (kt ) + (1 )kt ct )kt + f (kt ) f 0 (kt )kt ct

Now subtract (1 + n)kt from both sides to obtain (1 + n)(kt+1 kt ) = f (kt )+ (1 ) (1 + n) kt (1 + n)(kt+1 or (kt+1 kt ) = kt ) = f (kt ) sf (kt ) ct (n + )kt

ct

(n + )kt 1+n

(2)

Note this is the same as equation (1) . It should not be much of a surprise (recall Walrass law): If N-1 markets are in equilibrium, the Nth market will be as well. We just showed that if the factor markets are in equilibrium (and given the factor payments), the households budget constraint must equal the resource constraint.

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Characterization of Steady-State
Figure 2: Per Capita Output and Saving

The above gure depicts the graph of the production and the saving function. Where do we end up? Ask ourselves is it possible that kt+1 kt = 0? If so, it means that the capital stock stops growing and output per worker stops growing. Dene i = (n + ) k . This means the level of investment is just sucient to keep up with the growth rate of the population, and replace the capital that gets worn out in usage. Stated dierently, i means we are investing enough to replace depreciated capital, and give every new entrant into the labor force kt units of capital. We can combine this graph with the savings to determine how the capital stock evolves. Putting the i* line together with the savings function we get

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Figure 3: Saving and i* Line

Alternatively, we can depict the relationship between savings and investment as depicted below

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Graph what happens to output, the capital stock, consumption and investment when 1. the savings rate increases. 2. population growth increases. 3. exogenous technological growth increases. The model predicts that countries with higher saving rates will tend to have higher levels of GDP per capita. A simple look at the data show that the data is consistent with this prediction.

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Figure 4: Investment Share and Per Capita GDP

The model predicts that countries with higher population growth rates will tend to have lower levels of GDP per capita. A simple look at the data show that the data is consistent with this prediction.

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Figure 5: Population Growth and Real Per Capita GDP

Comparative Steady-State Statics:

Steady state income is characterized by the following conditions: = f (kss )

yss

sf (kss ) = (n + )kss We are interested in how the steady-state level of income will change if one of the exogenous variables change.

Long-Run Implications: Change in the Savings Rate:

We totally dierentiate the system of equations with respect to the two endogenous variables {yss , kss } as the endogenous variable s changes. To this 17

end, dyss {sf (kss )

0

= f 0 (kss )dkss = f (kss )ds

(n + )}dkss

Then rearranging the second condition yields: dk f (kss ) = 0 >0 ds sf (k ) (n + ) and substituting into the rst-condition dyss s sf 0 (kss ) = 0 ds yss sf (k ) (n + ) Next noting that sf (kss ) = (n + )kss and rewriting this expression as (n + ) = sf (kss )/kss and substituting into the above expression for (n + ) yields dyss s sf 0 (kss ) = 0 ds yss sf (k ) sf (kss )/kss Finally canceling out the s term and multiplying through by kss /f (kss ) yields dyss s = ds yss f 0 (kss )kss
f 0 (k )k
ss

f (kss )

Denoting capitals share of income as (kss ) = f 0 (kss )kss /f (kss ) then implies dyss s (kss ) = ds yss 1 (kss ) Cross-country estimates of (kss ) place it in the range of .33 to 0.40. Assuming (kss ) = 1/3, then the elasticity of output with respect to a change in the savings rate is is dyss s = 1/2. yss ds So for example, the United States income in 2000 was $31843.15 and their savings rate was 19% Sierra Leone had a savings rate of 9.6 percent and their income level was 421.95. The question we ask is to what extent these dierences in income are explained by the dierences in the savings rate. Stated dierently, suppose Sierra Leone increased their savings rate to be equal to that of the United States savings rate what by how much would their income increase. 1 ds ss ds/s = (.19 .096)/.096 = 0.97917 ==> dy yss = 2 s 0.50. Sierra Leones income per person would increase to $641.72. Thus, the Solow model gets things right qualitatively it seems to miss quantitatively. You should repeat these exercises for a change in n; that is compute
dy n y dn .

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An Example with a Specic Functional Form of the Production Function:

Suppose production was given by y = k . In this case, the steady-state level of output can be solved as following steady-state savings is equal (syss ) is equal to steady-state investment ((n + )kss ) or syss = (n + )kss ) kss = syss (n + )

and substitute this expression into the production function to get syss yss = (n + ) and solving for yss yields yss = Investment is given by savingsss = s s (n + ) 1 s (n + ) 1

You should verify that steady-state savings is equal to steady-state investment; that is 1 1 1 s s s = (n + ) (n + ) (n + ) The steady-state level of capital is given by kt+1 which implies kt = 0 ) sf (kss ) (n + )kss

sk = (n + )kss 1 1 s kss = n+

With this functional form, we can infer information about factor prices (W and r) in the steady state. Recall that W = f (k ) In the steady-state, we have Wss = (1 ) 19 s n+ 1 f 0 (k )k = (1 )k

The return to capital () is given by

ss = kss 1

and substituting for kss

1 1 s = n+ yields ss = (n + ) s = (n + ) s

so that rss = ss

Cross Country Income Comparisons

Assuming similar world technology growth and similar depreciation rates, we can then compare dierences in steady-state output between two countries say the US and country j as follows: sU S U (n S + ) 1

US yss j yss j yss US yss

(3) (4) (5)

Another nice property of the Cobb-Douglas production function is that the steady-state level of output is linear in logs. Recall 1 s yss = n+ and taking the logs we have ln(yss ) = 1 ln(s) 1 ln(n + )

1 sj = (nU S + ) 0 1 1 j US s /s A = @ J
(n + ) ( nU S + )

Take-Aways
We constructed a simple model of that can account for dierences in (steadystate) income per capita that shows how saving, investment, and population growth help determine the (steady-state) level of income per capita. We can use this simple model to highlight the importance of savings and investment is for long run growth. We showed that 20

 the (steady-state) level of output increases as the saving rate increases the (steady-state) level of output is decreasing in the rate of population growth the model with a Cobb-Douglas production function allows for simple analytic solutions that is consistent with labors share of output being (roughly) constant over time capitals share of output being (roughly) constant over time the stylized fact that countries that save more (invest more) tend to have higher levels of output per capita the Cobb-Douglas production function also delivers a simple expression that is linear in logs.

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