5

The Solow Growth Model

5.1

Models and Assumptions

What is a model? A mathematical description of the economy.

Why do we need a model? The world is too complex to describe it in
every detail.
What makes a model successful? When it is simple but effective in describing and predicting how the world works.
A model relies on simplifying assumptions. These assumptions drive the
conclusions of the model. When analyzing a model it is crucial to spell
out the assumptions underlying the model.
Realism may not a the property of a good assumption.
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5.2

Basic Assumptions of the Solow Model

1. Continuous time.
2. Single good produced with a constant technology.
3. No government or international trade.
4. All factors of production are fully employed.

5. Labor force grows at constant rate n = L

L.

6. Initial values for capital, K0 and labor, L0 given.

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Production Function

Neoclassical (Cobb-Douglas) aggregate production function:

Y (t) = F [K(t), L(t)] = K(t) L(t)1

To save on notation write:

Y = A K L1

Constant returns to scale:

F (K, L) = F (K, L) = A K L1

Inputs are essential:

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

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 Marginal productivities are positive:

F
= AK 1L1 > 0
K
F
= (1 ) AK L > 0
L
Marginal productivities are decreasing,
2F
2 L1 < 0
=
(

1)
A
K
K 2
2F
L1 < 0
=

(1

)
A
K
L2

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Per Worker Terms

Define x = X
L as a per worker variable. Then
Y
A K L1
=
=A
y=
L
L

K a L 1
= A k
L
L

Per worker production function has decreasing returns to scale.

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Capital Accumulation
= sY K
K

Capital accumulation equation:

Important additional assumptions:

1. Constant saving rate (very specific preferences: no r)
2. Constant depreciation rate

72

 Dividing by K in the capital accumu equation:

Some Algebra:

K
K

Y
sK

Y
L
sK
L

K
K

Y .
= sK

= s ky

Now remember that:

k
K
L
K
K
k
=
=
n
= +n
k
K L
K
K
k
We get
k
y
+ n = s k = sy ( + n) k
k
k
Fundamental Differential Equation of Solow Model:
k = s A k ( + n) k
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Graphical Analysis
Change in k, k is given by difference of s A k and ( + n)k
If s A k > ( + n)k, then k increases.
If s A k < ( + n)k, then k decreases.
Steady state: a capital stock k where, when reached, k = 0

Unique positive steady state in Solow model.

Positive steady state (locally) stable.

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Steady State Analysis

Steady State: k = 0

Solve for steady state

sA

0 = s A (k ) (n + )k k =
n+

Steady state output per worker

1
1

s A 1
n+

Steady state output per worker depends positively on the saving (investment) rate and negatively on the population growth rate and depreciation
rate.
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Comparative Statics
Suppose that of all a sudden saving rate s increases to s0 > s. Suppose
that at period 0 the economy was at its old steady state with saving rate
s.

(n + )k curve does not change.

s A k = sy shifts up to s0y.

New steady state has higher capital per worker and output per worker.

Monotonic transition path from old to new steady state.

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Evaluating the Basic Solow Model

Why are some countries rich (have high per worker GDP) and others are
poor (have low per worker GDP)?

Solow model: if all countries are in their steady states, then:

1. Rich countries have higher saving (investment) rates than poor countries
2. Rich countries have lower population growth rates than poor countries

Data seem to support this prediction of the Solow model

77

The Solow Model and Growth

No growth in the steady state

Positive or negative growth along the transition path:

k = s A k (n + )k
k
gk
= s A k1 (n + )
k

78

Introducing Technological Progress

Aggregate production function becomes

Y = K (AL)1

A : Level of technology in period t.

Key assumption: constant positive rate of technological progress:

A
=g>0
A
Growth is exogenous.

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Balanced Growth Path

Situation in which output per worker, capital per worker and consumption
per worker grow at constant (but potentially different) rates

Steady state is just a balanced growth path with zero growth rate

For Solow model, in balanced growth path gy = gk = gc

80

Proof
= sY K
Capital Accumulation Equation K

Y
=
s
Dividing both sides by K yields gK K
K
K

Remember that gk kk = K
K n
Hence
Y
k
gk = s (n + )
k
K
In BGP gk constant.
Therefore gy = gk

Y constant.
Hence K

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It follows that gY = gK .

What is the Growth Rate?

Output per worker

Y
K (AL)1
K (AL)1
A1
y=
=
=
=
k
L
L
L
L1
Take logs and differentiate gy = gk + (1 )gA
We proved gk = gy and we use gA = g to get
gk = gk + (1 )g = g = gy
BGP growth rate equals rate of technological progress. No TP, no growth
in the economy.
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Analysis of Extended Model

in BGP variables grow at rate g. Want to work with variables that are
constant in long run. Define:
y
Y
=
A
AL
k
K

k =
=
A
AL
y =

Repeat the Solow model analysis with new variables:

y = k
= s

k
y (n + g + )k
= sk
(n + g + )k

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Closed-Form Solution

Repeating all the steps than in the basic model we get:

k(t)
=
y(t) =

s
+n+g
s
+n+g

+
+

1
k
0

1
k
0

Interpretation.

84

s
+n+g

s
+n+g

1
1
t
e

et

Balanced Growth Path Analysis

analytically
Solve for k

0 = sk (n + g + )k

=
k

s
n+g+

1
1

Therefore

s
n+g+

85

k(t) = A(t)

s
n+g+

s
y(t) = A(t)
n+g+

K(t) = L(t)A(t)

1
1

s
n+g+

s
Y (t) = L(t)A(t)
n+g+

86

1
1

Evaluation of the Model: Growth Facts

1. Output and capital per worker grow at the same constant, positive rate
in BGP of model. In long run model reaches BGP.
2. Capital-output ratio K
Y constant along BGP
3. Interest rate constant in balanced growth path

4. Capital share equals , labor share equals 1 in the model (always, not
only along BGP)

5. Success of Solow model along these dimensions, but source of growth,

technological progress, is left unexplained.
87

Evaluation of the Model: Development Facts

1. Differences in income levels across countries explained in the model by

differences in s, n and .

2. Variation in growth rates: in the model permanent differences can only

be due to differences in rate of technological progress g. Temporary differences are due to transition dynamics.

3. That growth rates are not constant over time for a given country can be
explained by transition dynamics and/or shocks to n, s and .

4. Changes in relative position: in the model countries whose s moves up,

relative to other countries, move up in income distribution. Reverse with
n.
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Interest Rates and the Capital Share

Output produced by price-taking firms

Hire workers L for wage w and rent capital Kfrom households for r

Normalization of price of output to 1.

Real interest rate equals r

89

Profit Maximization of Firms

max K (AL)1 wL rK
K,L

First order condition with respect to capital K

K 1 (AL)1 r = 0

K 1

= r
AL
1 = r
k
= k
, constant over time. Hence in BGP
In balanced growth path k
rconstant over time, hence r (real interest rate) constant over time.

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Capital Share

Total income = Y, total capital income = rK

Capital share
capital share

=
=

rK
Y
K 1 (AL)1 K

Labor share = 1 .

91

K (AL)1

Wages

First order condition with respect to labor L

(1 )K (LA)A = w
A = w
(1 )k
=k
, constant over time. Since A is growing at rate g, the
Along BGP k
wage is growing at rate g along a BGP.

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