4/3/2020 Assignment - 1 L180366 | Emaan Shahid

THE STEADY STATE OF CAPITAL UNDER SOLOW MODEL

The Solow model:
This model shows the growth in labor force, capital stock and technological advancements as well as
their effect on the economy’s output.

Assumptions:
 Labor force and technology are constant
 The production function has constant returns to scale
 The economy is closed

The steady state of capital under the solow model will be explained by first describing the accumulation
of capital through the production and consumption function and how investment and depreciation can
impact the capital stock.

1. The Production Function:

Under the solow model, the supply of goods in an economy is given by the production function:

Y = F (K, L)

 Constant Returns Production Function:

As mentioned earlier, the solow model assumes that the production function has constant returns to
scale, the size of the economy isn’t taken into consideration. The production function becomes:

zY = zF (zK, zL)

where z is a positive integer and shows that if the amount of capital and labor increases, the amount of
output increases in the same proportion. Substituting z= 1/L, the equation becomes:

Y/L = F(K/L, 1).

This shows that capital per worker is a function of output per labor. The constant returns production
function implies that the output and capital is not affected by the size of an economy. Thereby using per
worker terms, the above equation becomes:

Y = f(k)

 Slope of the Production Function:

The slope of the production function, MPK describes how
much additional output is produced with each additional unit
of capital.

MPK = f(k + 1) - f(k). MPK starts to decrease as the output

increases, showcasing diminishing returns.
4/3/2020 Assignment - 1 L180366 | Emaan Shahid

2. The Consumption Function:

Under the solow model, the demand of goods is given by the investment and consumption.

y=c+i

People either save their output “s” or consume it “(1-s)”. The output saved can be invested in the
capital, increasing the capital stock of an economy.

c = (1 - s) y, substituting “c” in the N.I. identity:

y = (1 - s) y + i

i = sy => i = sf(k)

This demonstrates that saving is a fraction of output which is devoted to investment.

3. Growth in Capital Stock

Any growth or shrinkage in capital stock is determined by investment and depreciation.

 Depreciation:
This is the wear and tear in any form of capital due to its usage.
The more capital you have the more depreciation you are charged
with. This means that the depreciation increases at a constant rate
with the increase in capital. Depreciation = 𝛿k

 Investment:
Investment is just a constant fraction “s” of our output “y”. As
established earlier “i = sf(K)”. This can be illustrated by the help of
a graph. We have shown that 30% of your output is devoted to
investment.
4/3/2020 Assignment - 1 L180366 | Emaan Shahid

 Impact of investment and depreciation on capital stock:

Change in capital stock = Investment – Depreciation

Δk = sf(K) – 𝛿k

Steady state of capital

The steady state of capital is achieved when investment = depreciation, i.e. Δk = 0, denoted by “k*”. This
point shows that all the investment is going into repairing and replacing existing capital. There is no new
capital being created. As we have assumed earlier that all other variables are constant. So, if the capital
is not increasing, nothing is increasing. Thus, your economic activity is at zero.

Capital stock growth and shrinkage

If we are on the left side of the steady state of capital, it means that our investment is greater than our
depreciation and our capital stock grows as the economy has savings to invest in new capital.

However, if we end up on the right side of the steady state, we can see that our depreciation is greater
than our investment and our capital stock shrinks. Either way, we always tend to move towards the
steady state