Development Economics

Solow Model
LPR Chapter 4

The Basic Growth Model

Aggregate Production function
Is based on five equations
1. Aggregate production function Y=f (K,L)
2. Saving(S)= sY
3. S= I (Saving=Investment)
4. K=(I- dK) where d=depreciation and K=
capital
5. L= nxL n=population growth and L=Labor
force,
Combining 2,3,4, leads to K =sY-dK
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The Solow Model

The Solow model is an improvement over
Harrod-Domar Model
It allows for substitution between factors of
production, capital and labor
Y= f(K,L) Labor and capital are substitutable
The production function or Isoquant is ushaped showing substitution as in figure 4.2

a to b: same as FPM

K-intensive

L-intensive

Basic Equations:
Divide Y=f (K,L) by L to express all variables
in per-worker terms
Y/L=F(K/L,1)
y=f(k)
We have diminishing returns to capital as in
(4.3)

Since K =sY-dK:
k=sy-(n+d)k
k is determined by:
s, -nk, and dk,
where nk is the reduction in capital per worker
due to an increase in population.
Thus: S (and I) adds to K-per-worker, while L
growth and depreciation reduces K-per-worker
When sy>(n+d)k then k is increasing
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at the intersection: point A:

k= and y=f(k)=
at A (steady state): sy=(n+d)k
if k= and y= : sy>(n+d)k, so k grows
if k= and y= : sy<(n+d)k, so k falls
all move towards A!

the amount of K needed b/c of n and d just to keep k

constant

sy>(n+d)k
production function

saving function

sy<(n+d)k

The Solow Growth Model (see 4.4)

Point A is where new savings sy = amount of new
capital needed for growth in the labor force and
depreciation (n+d).
Point A is steady state level of capital per worker
where stable equilibrium occurs
At steady state total output continues to grow at
the rate of population (n) or labor force, but GDP
per capita (y) is constant.
The savings need to be sufficient to replace
depreciated capital and provide new workers
with a sufficient amount of capital to maintain
the level of capital per worker (k).
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The Effect of Changes in Saving Rate and

Population Growth in the Solow Model
An increase in the S in the Solow Model from s
to s, k increases from to or A to B
An increase in the n to n will drop k from
to or A to C

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Saving Rates in the Solow Model

Higher s implies higher saving rates and a higher
level of steady-state output.
Higher s means that the economy will have
higher economic growth rates in the short run.
The economy will grow till it reaches its steadystate level of output.
An economy with a high saving rate will maintain
a large capital stock, high level of output but will
not experience high growth rates forever.

Population Growth in Solow Model

Higher the population growth rate, n, lower
the steady state level of capital per worker in
the economy and in turn lower the steady
state level of output.
An increase in population growth rates will
lead to a steeper slope of the (n+d)k line,
which implies a lower capital per worker and
income per worker at the steady-state level.

Calculate the Steady-State Equilibrium

k=1.67, d=0.02, n=0.05, s=0.1, y=?

sy=(n+d)k
0.1y=0.07(1.67)
y=1.17
Output per worker is 1.17.
Higher n results in lower capital per worker and
lower output per worker.
At steady-state level, output has to grow at n in
order for output per worker to remain constant.

Evaluating the Solow Model: Strengths and

Weaknesses
It is an improvement over H-D Fixed coefficient
model
With neoclassical production function it allows
for substitution between inputs
Provides good insights about the relationship
between role of technology and innovation on
growth
Limitations: How can factors that drive steady
state influence output, and assumes saving rate,
population growth , and technical change as
given. It does not explain how these parameters
change over time
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Beyond the Solow Model: New

Approaches to Growth
The Solow model assumes fixed or exogenous
saving rate, growth rate of savings and labor force.
Recent works provides models where these
variables are determined within or endogenously in
the model.
These new models allow for increasing returns to
scale and positive and negative externalities
They are called endogenous models but their
estimation suffers from lack of good data.

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The Korean Peninsula

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