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=y–i
• We want steady state “c” so we
substitute steady state values for both f(k*),δk* δk*
output (f(k*)) and investment which
equals depreciation in steady state (δk*)
giving us c*=f(k*) – δk* f(k*)

• Because, consumption per worker is the

difference between output and c*gold
investment per worker we want to
choose k* so that this distance is
maximized.
k*
• This is the golden rule level of capital k*gold
k*gold
• A condition that characterizes the Above k*gold,
golden rule level of capital is Below k*gold,
increasing k* increasing k*
MPK = δ
increases c* reduces c*
 Building the Model:

• While the economy moves

toward a steady state it is
not necessarily the golden
rule steady state. f(k*),δk* δk*
• Any increase or decrease
f(k*)
in savings would shift the
sf(k) curve and would sgoldf(k*)
result in a steady state sgoldf(k*)
with a lower level of
consumption.
k*
k*gold

To reach the The economy

golden rule needs the right
steady state… 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/δ = k*/f(k*)
• assume depreciation is 10% and the policy maker
chooses the savings rate and thus the economy’s steady
state. Equation (2) becomes,
s/.1 = k*/√k*
Squaring both sides yields,
k* = 100s2
• With this we can compute steady state capital for any
savings rate.
 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–δ=0 and k*=25.
s k* y* δk* c* MPK MPK-δ
0 0 0 0 0 ∞ ∞
.1 1 1 .1 .9 .5 .4
.2 4 2 .4 1.6 .25 .15
.3 9 3 .9 2.1 .167 .067
.4 16 4 1.6 2.4 .125 .025
.5 25 5 2.5 2.5 .1 0
.6 36 6 3.6 2.4 .083 –.017
.7 49 7 4.9 2.1 .071 –.029
.8 64 8 6.4 1.6 .062 –.038
.9 81 9 8.1 .9 .056 –.044
1.0 100 10 10 0 .05 –.05
 A Numerical Example

• Another way to identify the golden rule

steady state is to choose the level of capital
stock where MPK – δ = 0
• In this example MPK = 1/(2√k) – .1 = 0
so… 1 = .1(2√k)
and… 5 = √k
and… 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
• δk = .1*4 = .4
• Δk = s*y – δk so Δk = 1.0 – .4 = .6
• so k = 4+.6 = 4.6 for the next period.
 A Numerical Example

• Repeating the process gives…

period k y c i δk Δk
1 4 2 1.0 1.0 .4 .6
2 4.6 2.144... 1.072... .536… .46… .612…
. . . . . . .
10 10.12... 3.087... 1.543... 1.543... .953… .590…
. . . . . . .
∞ 25 5 2.5 2.5 2.5 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 Output, y
investment.
• Over time, as the capital
stock falls, output, Consumption, c
consumption, and Investment, i
investment fall.
• The new steady state has a
higher level of consumption t0 Time
than the initial steady state.
At t0, the savings
rate is reduced.
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 Output, y
investment.
• Over time, as the capital Consumption, c
stock grows, output,
consumption, and
investment increase. Investment, i
• The new steady state has a
higher level of consumption t0 Time
than the initial steady state.
At t0, the savings
rate is increased.
 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.