The Solow Growth Model (Part Two)

The golden rule level of capital, maximizing consumption per worker.

Model Background

As mentioned in part I, the Solow growth model allows us a

dynamic view of how savings affects the economy over time. We also learned about the steady state level of capital.

Now, we assume policy makers can set the savings rate to

determine a steady state level of capital that maximizes consumption per worker. This is known as the golden rule level of capital (k*gold)

Building the Model:

We begin by finding the steady state
consumption per worker. From the national income accounts identity, y=c+i we get c=yi

We want steady state c so we

f(k*),k* substitute steady state values for both output (f(k*)) and investment which equals depreciation in steady state (k*) giving us c*=f(k*) k* k*
f(k*)
c*gold

Because, consumption per worker is the

difference between output and investment per worker we want to choose k* so that this distance is maximized.

This is the golden rule level of capital

k*gold

k*
k*gold

A condition that characterizes the

golden rule level of capital is MPK =

Below k*gold, increasing k* increases c*

Above k*gold, increasing k* reduces c*

Building the Model:

While the economy moves
toward a steady state it is not necessarily the golden rule steady state.
f(k*),k*

Any increase or decrease

in savings would shift the sf(k) curve and would result in a steady state with a lower level of consumption.

k*
f(k*) sgoldf(k*) sgoldf(k*)

k*
k*gold

To reach the golden rule steady state

The economy needs the right savings rate.

A Numerical Example

Starting with the Cobb-Douglas production function from

part I, (1) y=k1/2 recall that the following condition holds in steady state, (2) s/ = k*/f(k*)

assume depreciation is 10% and the policy maker

chooses the savings rate and thus the economys steady state. Equation (2) becomes, s/.1 = k*/k* Squaring both sides yields, k* = 100s2 savings rate.

With this we can compute steady state capital for any

A Numerical Example
Using the functions from the previous slide and solving for
a range of savings rates

We can see that at s=.5 we get c*=2.5 so at savings rate of

.5 consumption per worker is maximized. Also note that at that level MPK=0 and k*=25.
s
0 .1 .2 .3 .4 .5 .6 .7 .8 .9 1.0

k*
0 1 4 9 16 25 36 49 64 81 100

y*
0 1 2 3 4 5 6 7 8 9 10

k*
0 .1 .4 .9 1.6 2.5 3.6 4.9 6.4 8.1 10

c*
0 .9 1.6 2.1 2.4 2.5 2.4 2.1 1.6 .9 0

MPK
.5 .25 .167 .125 .1 .083 .071 .062 .056 .05

MPK-
.4 .15 .067 .025 0 .017 .029 .038 .044 .05

A Numerical Example

Another way to identify the golden rule

steady state is to choose the level of capital stock where MPK = 0

In this example MPK = 1/(2k) .1 = 0

so and and 1 = .1(2k) 5 = k 25 = k*

A Numerical Example

But what is the time path toward k*? To get

this use the following algorithm for each period.

k = 4, and y = k1/2 so, y = 2. c = (1 s)y, and s = .5 so c = .5y = 1.0 i = s*y, so i = 1.0 k = .1*4 = .4

k = s*y k so k = 1.0 .4 = .6
so k = 4+.6 = 4.6 for the next period.

A Numerical Example

Repeating the process gives

period
1 2 . 10 .

k
4 4.6 . 10.12... . 25

y
2 2.144... . 3.087... . 5

c
1.0 1.072... . 1.543... . 2.5

i
1.0 .536 . 1.543... . 2.5

k
.4 .46 . .953 . 2.5

k
.6 .612 . .590 . 0.0

And we converge to k=25

The Transition to the Golden Rule Steady State

Suppose an economy starts
with more capital than in the golden rule steady state.

This causes an immediate

increase in consumption and an equal decrease in investment. Output, y

Over time, as the capital

stock falls, output, consumption, and investment fall. Consumption, c Investment, i

The new steady state has a

higher level of consumption than the initial steady state.

t0
At t0, the savings rate is reduced.

Time

The Transition to the Golden Rule Steady State

Suppose an economy starts
with less capital than in the golden rule steady state.

This causes an immediate

decrease in consumption and an equal increase in investment. stock grows, output, consumption, and investment increase. Output, y

Over time, as the capital Consumption, c

Investment, i

The new steady state has a

higher level of consumption than the initial steady state.

t0
At t0, the savings rate is increased.

Time

Conclusion

In this section we used our knowledge that savings

affects the steady state and chose the savings rate to maximize consumption per worker. This is known as the golden rule level of capital (k*gold)

In the next section we augment this model to include

changes in other exogenous variables; population and technological growth.