THE SOLOW MODEL (Ghulam Samad)

Introduction
What are the sources of output growth in capitalist economies? The now-standard
model of economic growth was devised by the Nobel prizewinner Robert Solow in
the 1950s. It forms the subject of the next two lectures.
First, note some ‘stylized facts’ about growth in developed economies. A good
model should account for these. (3) and (4) are, perhaps, the puzzling ones.
1. Output (Y) per worker (N) grows through time.
2. Capital (K) per worker grows through time.
3. Y/K has no long-run trend and is typically around 1/3.
4. The rate of profit on capital, π, has no long-run trend.
5. The share of labour income in national income has no long-run trend and is
typically around 2/3.
N.B. (5) follows from (3) and (4), assuming that all income is wages or profits,
because they imply that the profit share, πK/Y, is trendless and therefore so is the
wages share, wN/Y=1- πK/Y. A simple implication of wN/Y being roughly constant
is that w, the wage, grows at about the same rate as output/head, Y/N.
Building blocks of the Solow model
The first is the aggregate production function, which we write:
Y = F(K,N) (1)
This involves a drastic simplification of reality, by suppressing heterogeneity of:
(a) (Value-added) output. There is only one type of output.
(b) Machines. Not only are all machines the same, but all are made of ‘output’.
(c) Labour. No skill differences, for example.
Given this, eq.(1) states that the amount of output produced depends in a
definite way on the amount of capital input and labour input utilized. F is the
function that tells us what Y will be for given K and N. We can think of F as
depending on the state of technology, which you might think of as a set of
blueprints.
Are you going to swallow the story so far? If you are worrying that advanced
technology is partly embodied in machines, so that the separation of ‘capital’
and ‘technology’ is not really acceptable, then I agree. Put this worry to one
side for the moment. 
Returns to factors and returns to scale
We assume factors have positive but diminishing marginal products. Think of
adding computer terminals, one-by-one, to, say, the SOCCUL School Office,
while keeping labour input constant.
We also assume constant returns to scale (CRS): doubling K and N results in a
doubling of Y. This seems reasonable - surely we could ‘clone’ the economy - but
‘lumpy’ capital is a complication (you can’t do much with half a bridge!).
Algebraically, CRS implies that:
2Y = F(2K, 2N) (2)
and indeed for any number x
xY = F(xK, xN) (3)
Now for a fancy trick. Let x = 1/N in eq(3), then:
Y/N = F(K/N, 1) (4)
This says that, given CRS, output per head is determined just by capital per
head, K/N. Well, that is the whole point of CRS - scaling up K and N in equal
proportion raises Y in the same proportion, so it leaves Y/N unchanged.
We can now save a bit of ink by writing output per head as ‘y’ and capital per
head as ‘k’. Therefore (4) becomes:

y = F(k, 1) (4)

And to save even more ink, we can define a new function, f, linking capital per
head to output per head, thus (eq.5 just defines f):

y = f(k) = F(k, 1) (5)

The following picture from BLA summarizes where we have got to:
Here we see constant returns to scale (which is what allows us to plot Y/N
against K/N; otherwise we coulddn’t).
We also see diminishing returns to capital, embodied in the decreasing slope
of the curve. To see this, it is easiest for a moment to think of N as fixed. Then
AB and CD, equal to one another, correspond to equal additions of K but to
quite different additions of output - C’D’ is much smaller than A’B’.
The sources of growth
It is clear from the preceding picture that, in this model, there are just two
sources of growth in output/head.
Capital accumulation, which is clearly going to be linked to the amount of
saving, will move us along the curve, provided that it raises capital per head.
Technological progress will shift the curve upwards, raising output per head for
given capital per head. This is illustrated by another BLA picture.
Will positive savings necessarily raise capital per head and therefore output per
head? This breaks down into several questions.
(a) Are savings translated into gross investment. The Solow model assumes the
answer is ‘yes’.
(b) Does gross investment translate into more capital?
The answer is: not entirely, as we must subtract the depreciation of old
machines. And the more capital we have, the higher is depreciation.
(c) Does more capital mean more capital per head?
That depends on how fast population is growing. If population growth is fast
enough, capital per head might not be growing at all. In that case all savings
would be going into equipping new workers with the same tools as the old ones
have. This is called capital widening. Where capital per head is rising, we refer
to capital deepening.
So net investment goes into a combination of capital widening and capital
deepening. What the Solow model is going to tell us is that there is a natural
limit to capital deepening - a point will be reached where all savings are ‘soaked
up’ by depreciation or population growth.
From output to capital accumulation
The production function gives us the link from capital (per head) to (output per
head). We now need the inverse link from output to capital growth. We follow
BLA ch11 and temporarily assume zero population (and labour force) growth.
We also make three ‘simplifying’ assumptions:
1. The economy is closed.
2. There is no government, so G and T are zero.
3. Savings are proportional to income.
‘Simplifying’ assumptions are supposed not to matter much, in the sense that
we’d get similar (but more complicated) results if we dropped them. We should
ask later on whether these assumptions are really of this kind. (2) and (3) are,
but maybe not (1).
Using assumptions (1) and (2) we have two identities:
Y=C+I (6)
(whatever part of output that is not consumed is invested)
Y=C+S (7)
(whatever part of output/income that is not consumed is saved)
Using (3) we have:
S = sY (8)
Since (6) and (7) give us S=I, we can plug that into (8), and put in some time
subscripts, to get:
It = sYt (9)
How are we going to interpret equation (9)? In the simple (Keynesian) income-
expenditure model that you are familiar with, the causation in (9) runs left to
right. Investment, assumed exogenous, causes income. So a fall in investment
can cause recession and unemployment, via the implied fall in aggregate
demand.
In the Solow model, we assume that causation in (9) runs right to left. A
mechanism is assumed to exist which converts full-employment savings into
investment (so investment is certainly not exogenous). What is the mechanism?
In essence, the idea is that - in the medium-run - the real rate of interest adjusts
to achieve this (see BLA 7 and especially BLA 14.4, p.302). One empirical
justification for this assumption, for medium-term analysis, is the fact that
recessions do not last for ever
To put this key assumption more simply, the Solow model assumes full
employment of the factors of production; output and income are determined
from the supply side by the production function, and savings cause investment.
We now derive from (9) an equation for capital accumulation. We allow for
depreciation by supposing that a fraction δ of the capital stock decays each year
- think of δ equal to, say, 0.08 (it varies across types of capital good). So we can
write:
K t 1  (1  )K t  I t (10)

And substituting in from (9), we get:

K t 1  (1  )K t  sYt (11)

We can write this in per-worker terms by dividing through by N, so:

K t 1 / N  (1  )K t / N  sYt / N (12)

Remember that we have assumed N constant here, so I have left off the
time subscript. Finally, since we are going to be interested in the rate of
capital deepening, I can move capital per head at t to the left hand side:

K t 1 / N  K t / N  sYt / N  K t / N (13)

This equation says that net investment during year t equals savings
minus depreciation (all expressed in per capita terms). Or: capital
deepening equals savings per head minus depreciation per head.
So (13) gives us the dynamic behaviour of capital per head, but - given
the production function - we also get from this the dynamics of output per
head. Before seeing this in a diagram, we can write (13) more compactly
as:

k t 1  k t  sy t  k t  sf (k t )  k t (14)
What we now have can be shown in a series of diagrams in which output per
head is plotted against capital per head. So we can plot (gross) investment
per worker - equal to savings per worker - by ‘scaling down’ the output per
worker curve. Then we can superimpose depreciation per worker as the red
straight line. These are the two parts of the right hand side of equation (12).
Now we consider an economy that starts at point B, with capital per head as
indicated by point A. There is going to be positive capital deepening, since
point C lies above point D.
So, over time, the economy is moving to the right in the diagram. Capital per
head and output per head are both rising. But there is a natural limit, at capital
per head K*/N. Why is that? Diminishing returns are critical. More capital means
both more output (and saving) and more depreciation. But as K rises, its
marginal product falls, so that eventually the extra saving is all absorbed by extra
depreciation. And that is where output/head and capital/head reach steady state.
What happens if an economy that has reached its steady state, K0/N, increases
its rate of saving? We can see below that (a) the investment per worker line
shifts up, so (b) we get a period of capital deepening and rising output per head,
but (c) eventually diminishing returns bring the advance to an end, so we finish at
a new steady state with higher capital per head (K1/N) and higher output per
head.
The time path of output per head after a rise, at time t, of the savings rate from
s0 to s1 can be seen below.
Assessment This model may seem far-fetched: after all, its prediction that output
per head reaches a steady state is contrary to the facts. What has been left out
is technological change. We will soon see that this can be added to the model,
with the effect that the economy converges to a steady-state growth rate of
output per head, rather than a steady-state level of output per head. We can
illustrate this with another BLA picture, showing the dynamic effects of a rise in
the savings rate in the model with technological change.
But, aside from this ‘fix’, are any of the Solow model’s predictions borne out by
the facts? In other words, is the model of any use?!
The answer is yes. Blanchard has a box about French economic growth after
World War II. The model predicts that destruction of part of the capital stock of
an economy that starts in steady state will be followed by a period of faster-
than-normal growth of output per head. For France we have:
Population loss in WWII = 550,000, or about 1.3% of the pre-war total of 42 mn.
Capital loss in WWII = roughly 30% of pre-war total.
This constitutes a substantial negative shock to capital per head.
Between 1946 and 1950, French GDP per head grew at 9.6% per year, well
above the growth rate before or since.
So, as the Solow model predicts, post-war capital accumulation in France
yields particularly rapid growth, because (a) the marginal product of capital is
high, and (b) the amount of savings absorbed in depreciation is low.
Is this the whole story? No. Technological advances embodied in the new
capital goods were partly responsible for the rapid growth in this period.
 Too much of a good thing? Optimal saving and the ‘golden rule’.
Go back to the Solow model without technological change. Is there an optimal
rate of saving? Since, we assume, utility depends on consumption, how does
consumption per head, c, depend on ‘s’. Plainly, in steady state, s=0 means
c=0, but also s=1 means c=0! In fact, steady state c as a function of s looks like
this:
sG is the so-called ‘golden rule’
rate of savings.
If s<sG, there is a trade-off
involved in raising s - future
versus present consumption.
If s>sG, a rise in s would be
bad for consumption now and
in the future.
In practice s is usually far
below estimates of sG. Why is
that?
Does it matter? See BLA box
on page 231.