ECO 402

Spring 2013
Didar Erdin
Economic Growth
Solow Model
The Neoclassical Growth model
Solow (1956) and Swan (1956)



Simple dynamic general equilibrium model of
growth


Output produced using aggregate production
function Y = F (K , L ), satisfying:
A1. positive, but diminishing returns
F
K
>0, F
KK
<0 and F
L
>0, F
LL
<0
A2. constant returns to scale (CRS)
0 all for ), , ( ) , ( > = L K F L K F
Neoclassical Production Function
Production Function in Intensive Form
Under CRS, can write production function
) 1 , ( . ) , (
L
K
F L Y L K F Y = =
Alternatively, can write in intensive form:
y = f ( k )
- where per capita y = Y/L and k = K/L
Exercise: Given that Y=L f(k), show:
F
K
= f (k) and F
KK
= f (k)/L .
Competitive Economy
Representative firm maximises profits and take price
as given (perfect competition)
Inputs paid by their marginal products:
r = F
K
and w = F
L

inputs (factor payments) exhaust all output:
wL + rK = Y
general property of CRS functions (Eulers THM)
A3: The Production Function F(K,L) satisfies
the Inada Conditions
0 ) , ( lim and ) , ( lim
0
= =

L K F L K F
K K K K
0 ) , ( lim and ) , ( lim
0
= =

L K F L K F
L L L L
Note: As f (k)=F
K
have that
0 ) ( ' lim and ) ( ' lim
0
= =

k f k f
k k
Production Functions satisfying A1, A2 and A3
often called Neo-Classical Production Functions
Technological Progress
= change in the production function F
t
) , ( L K F Y
t t
=
) , ( ) , ( . 1 L K F B L K F
t t
= Hicks-Neutral T.P.
)) ( , ( ) , ( . 2 L A K F L K F
t t
=
Labour augmenting
(Harrod-Neutral) T.P.
) ), (( ) , ( . 3 L K C F L K F
t t
=
Capital augmenting
(Solow-Neutral) T.P.
A4: Technical progress is labour augmenting
gt
t
t t
e A A
L A K F L K F
0
and
)) ( , ( ) , (
=
=
Note: For Cobb-Douglas case three forms of
technical progress equivalent:
o o
o o o o o o
t t t
t t t t
D A B
L K D L A K L K B L K F
= =
= = =

) 1 (
) 1 ( ) 1 ( ) 1 (
when
) ( ) ( ) , (
Under CRS, can rewrite production function in
intensive form in terms of effective labour units
)
~
(
~
k f y =
-note: drop time subscript to for notational ease
- Exercise: Show that
KK K
F AL k f F k f = = )
~
( ' ' and )
~
( '
AL
K
k
AL
Y
y = =
~
and
~
where
A5: Labour force grows at a constant rate n
nt
t
e L L
0
=
A6: Dynamics of capital stock:
K I K
dt
dK
o =

net investment = gross investment - depreciation
capital depreciates at constant rate o
Model Dynamics
National Income Identity
Y = C + I + G + NX
Assume no government (G = 0) and closed
economy (NX = 0)
Simplifying assumption: households save constant
fraction of income with savings rate 0 s s s 1
I = S = sY
Substitute in equation of motion of capital:
closing the model
K AL K sF K sY K o o = = ) , (

Fundamental Equation of
Solow-Swan model
k g n y s k
dt
k d ~
) (
~
~
~
o + + =

) (
~
~
) (
~
~
d
ln d
d
ln d
d
ln d
d
~
ln d
ln ln ln
~
ln
~
:
o o + + = + + = =
=
= =
g n
k
y s
g n
K
sY
n g
K
K
k
k
t
L
t
A
t
K
t
k
L A K k
AL
K
k

Proof
Steady State
0
~ ~
0
~
= = = c y k

( ) 0
~
) (
~
* *
= + + k g n k sf o
Definition: Variables of interest grow at
constant rate (balanced growth path or BGP)
at steady state:
Solow Diagram
0
x 10
4
0
~
g
~E
~ E= (
~
g)
(_+ + =)
~
g

~
g= (
~
g)
~
g(0)
~
g

_
~
g= (
~
g) (+ =+ _)
~
g
Existence of Steady State
From previous diagram, existence of a (non-
zero) steady state can only be guaranteed for all
values of n,g and o if
0 )
~
( ' lim and )
~
( ' lim
~
0
~
= =

k f k f
k k
- satisfied from Inada Conditions (A3).
Transitional Dynamics
If , then savings/investment exceeds
depreciation, thus
If , then savings/investment lower than
depreciation, thus
By continuity, concavity, and given that f(k)
satisfies the INADA conditions, there must
exists an unique

*
~ ~
k k <
. 0
~
~
0
~
~ > = >
k
k
g k
k

*
~ ~
k k >
. 0
~
~
0
~
~ < = <
k
k
g k
k

* * *
~
) ( )
~
(
~
k g n k f that such k + + = o
Transitional Dynamics
Properties of Steady State
1. In steady state, per capita variables
grow at the rate g, and aggregate
variables grow at rate (g + n)
Proof:
State Steady in
~
log log log
log log log
and
~
as
~
g
g g
dt
k d
dt
A d
dt
k d
g
g n
dt
k d
dt
L d
dt
K d
g
L
K
k
AL
K
k
k
k
k K
=
+ = + = =
+ = + = =
= =
2. Changes in s, n, or o will affect the
levels of y* and k*, but not the growth
rates of these variables.
Prediction: In Steady State, GDP per worker will
be higher in countries where the rate of investment
is high and where the population growth rate is low
- but neither factor should explain differences in
the growth rate of GDP per worker.
- Specifically, y* and k* will increase as s
increases, and decrease as either n or o increase
Golden Rule and Dynamic
Inefficiency
Definition: (Golden Rule) It is the saving rate
that maximises consumption in the steady-state.




Given we can use
to find .

) ( )
~
( ' 0
~
) (
~
~
)
~
(
~
~
) ( )
~
( )
~
( ) 1 (
~
max
*
* *
*
* *
* * * *
o o
o
+ + = =
c
c
+ +
c
c
c
c
=
c
c
+ + = =
g n k f
s
k
g n
s
k
k
k f
s
c
k g n k f k f s c
GR
s
,
~
*
GR
k
* *
~
) ( )
~
(
GR GR
k g n k sf o + + =
GR
s
Golden Rule and Dynamic
Inefficiency
Changes in the savings rate
Suppose that initially the economy is in the
steady state:
If s increases, then
Capital stock per efficiency unit of labour
grows until it reaches a new steady-state
Along the transition growth in output per
capita is higher than g.
*
1
*
1
~
) ( )
~
( k g n k sf o + + =
0
~ ~
) ( )
~
(
*
1
*
1
> + + > k k g n k sf

o
Linear versus log scales
0
0
x 10
4
4
E
(
4
)
Linear-Scale
0
0
4

(
E
(
4
)
)
Log-Scale
E(4) = ]
=E4
E(0)
(E(4)) )
-( E( 4) )
-4
=
_ E
E
= =
E
=
E
Changes in the savings rate
4

(
4
)
)
Log of capi t al per capi t a
Log of out put per capi t a
4

(
4
(
4
)
)
4

(
`
(
4
)
)
Log of consumpt i on per capi t a