Intermediate Macroeconomics Heman Das Lohano

Solow-Swan Model

1. Neoclassical production function

2. National Income Identity: Y = C + I
3. Consumption function: constant fraction of income
4. Depreciation rate
5. Labor force growth (previously it was assumed to be constant)
6. No technological change: A is constant (which we will change in the next chapter)
7. Equilibrium in each year: Saving = Investment.
8. Next year, the level of capital is determined by state equation (equation of motion) and
depends on investment and depreciation.
9. To reduce the number of state equations, Solow-Swan model defines the variables in
terms of per worker.
Q:
Suppose an economy has the following production function:

𝑌 = 𝐴𝐾 𝛼 𝐿1−𝛼

where Y is output (real GDP), K is the amount of capital, and L is the amount of labor. The
economy’s saving rate is denoted by s, and the capital depreciation rate is denoted by 𝛿. Labor
force (L) grows at a constant rate n. Assume a Solow-Swan model with population growth and
no technological change.

Denote the per worker quantities as k = K/L, y = Y/L, and c = C/L.

(a) Write the state equation (also called the equation of motion) for capital (K), the state
equation for labor (L), and the state equation for capital per worker (k).

(b) Define the steady state capital per worker. Using the state equation for k found in part (a),
find the steady state capital per worker as a function of 𝛿, n, s, A and 𝛼.

(c) Find the steady state output per worker (y) and consumption per worker (c), as functions of
𝛿, n, s, A and 𝛼.

(d) Suppose we have 𝛼 = 0.5, A = 1, 𝛿 = 0.1, n = 0.02, and s = 0.3. Find the steady state levels
of k, y and c.

(e) Define Golden Rule steady state. Suppose we have 𝛼 = 0.5, A = 1, 𝛿 = 0.1, and n = 0.02.
Find the saving rate (s) that results in the Golden Rule steady state.

(f) Find the Golden Rule steady state levels of k, y and c.

Key:

(a) Write the state equation for capital (K), the state equation for labor (L), and the state
equation for capital per worker (k).

(i)
𝐾𝑡+1 = 𝐾𝑡 + 𝐼𝑡 − 𝛿𝐾𝑡

𝐾𝑡+1 = 𝐾𝑡 + 𝑠𝑌𝑡 − 𝛿𝐾𝑡

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 𝐾𝑡+1 = 𝐾𝑡 + 𝑠𝐴𝐾𝑡 𝛼 𝐿𝑡 1−𝛼 − 𝛿𝐾𝑡

We can also write it in terms of change:

𝐾𝑡+1 = 𝐾𝑡 + ∆𝐾𝑡 or 𝐾𝑡+1 − 𝐾𝑡 = ∆𝐾𝑡

∆𝐾𝑡 = 𝑠𝐴𝐾𝑡 𝛼 𝐿𝑡 1−𝛼 − 𝛿𝐾𝑡

(ii)
𝐿𝑡+1 = 𝐿𝑡 (1 + 𝑛)
(iii)
𝑘𝑡 + 𝑖𝑡 − 𝛿𝑘𝑡
𝑘𝑡+1 =
1+𝑛

𝑘𝑡 + 𝑠𝑦𝑡 − 𝛿𝑘𝑡
𝑘𝑡+1 =
1+𝑛

This can be written as: (see proof at the last page)

𝑠𝑦𝑡 − (𝛿 + 𝑛)𝑘𝑡
∆𝑘𝑡 =
1+𝑛

𝑠𝐴𝑘𝑡 𝛼 − (𝛿 + 𝑛)𝑘𝑡
∆𝑘𝑡 =
1+𝑛
where
𝐾𝑡
𝑘𝑡 =
𝐿𝑡

𝐼𝑡
𝑖𝑡 =
𝐿𝑡

𝑌𝑡
𝑦𝑡 =
𝐿𝑡

𝑦𝑡 = 𝐴𝑘𝑡 𝛼

(b) Define the steady state capital per worker. Using the state equation for k found in part (a),
find the steady state capital per worker as a function of 𝛿, n, s, A and 𝛼.

𝑠𝐴𝑘𝑡 𝛼 − (𝛿 + 𝑛)𝑘𝑡
∆𝑘𝑡 =
1+𝑛

At the steady state: ∆𝒌𝒕 = 𝟎 and thus 𝒌𝒕+𝟏 = 𝒌𝒕 = 𝒌.

𝒔𝑨𝒌𝜶 = (𝜹 + 𝒏)𝒌
Solving for k yields:
1
𝑠𝐴 1−𝛼
𝑘∗ = ( )
𝛿+𝑛

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(c) Find the steady state output per worker (y) and consumption per worker (c), as functions of
𝛿, n, s, A and 𝛼.

𝑦𝑡 = 𝐴𝑘𝑡 𝛼

𝑦 ∗ = 𝐴𝑘 ∗ 𝛼
𝛼
𝑠𝐴 1−𝛼
𝑦∗ = 𝐴 ( )
𝛿+𝑛

𝑐 ∗ = (1 − 𝑠)𝑦 ∗
𝛼
𝑠𝐴 1−𝛼
𝑐 ∗ = (1 − 𝑠)𝐴 ( )
𝛿+𝑛

(d) Suppose we have 𝛼 = 0.5, A = 1, 𝛿 = 0.1, n = 0.02, and s = 0.3. Find the steady state levels
of k, y and c.
1
𝑠𝐴 1−𝛼
𝑘∗ = ( )
𝛿+𝑛

Putting 𝛼 = 0.5, A = 1, 𝛿 = 0.1 and s=0.3 in the above equation, we have:

∗
0.3 2
𝑘 =( ) = 6.25
0.12
Per worker output is:

𝑦 ∗ = 𝐴𝑘 ∗ 𝛼 = 1 ∗ 6.250.5 = 2.50

Per worker consumption is:

𝑐 ∗ = (1 − 𝑠)𝑦 ∗ = (1 − 0.3)2.50 = 1.75

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(e) Define Golden Rule steady state. Suppose we have 𝛼 = 0.5, A = 1, 𝛿 = 0.1, and n = 0.02.
Find the saving rate (s) that results in the Golden Rule steady state.

Putting 𝛼 = 0.5, A = 1, 𝛿 = 0.1 and n = 0.02 in the above equation, we have:

𝑠
𝑐 ∗ = (1 − 𝑠) ( )
0.12

𝑐 ∗ = 8.33𝑠 − 8.33𝑠 2

The steady-state value of k that maximizes consumption is called the Golden Rule level of
capital.

For maximizing the above function with respect to s, we have the first order necessary condition
as follows:
𝑑𝑐 ∗
= 8.33 − 16.66𝑠 = 0
𝑑𝑠
Solving for s yields:
𝑠 = 0.5

(f) Find the Golden Rule steady state levels of k, y and c.

1
𝑠𝐴 1−𝛼
𝑘∗ = ( )
𝛿+𝑛

Putting 𝛼 = 0.5, A = 1, 𝛿 = 0.1 and s=0.5 in the above equation, we have:

0.5 2
𝑘∗ = ( ) = 17.36
0.12
Per worker output is:
𝑦 ∗ = 𝐴𝑘 ∗ 𝛼 = 1 ∗ 17.360.5 = 4.167

Per worker consumption is:

𝑐 ∗ = (1 − 𝑠)𝑦 ∗ = (1 − 0.5)4.167 = 2.08

(e)-(f): Directly finding the Golden Rule steady state level of k:

𝑐 ∗ = (1 − 𝑠)𝑦 ∗

𝑐 ∗ = 𝑦 ∗ − 𝑠𝑦 ∗

At the steady state: 𝑠𝐴𝑘 𝛼 = (𝛿 + 𝑛)𝑘 or 𝑠𝑦 = (𝛿 + 𝑛)𝑘

𝑐 ∗ = 𝑦 ∗ − (𝛿 + 𝑛)𝑘 ∗

The steady-state value of k that maximizes consumption is called the Golden Rule level of
capital. dc*/dk = 0 (as k is monotonic function of s) yields:

𝑓′(𝑘 ∗ ) = 𝛿 + 𝑛

𝑀𝑃𝑘 ∗ = 𝛿 + 𝑛

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 𝛼𝐴𝑘 ∗ 𝛼−1 = 𝛿 + 𝑛

Solving for k yields:

1
𝛼𝐴 1−𝛼
𝑘∗ = ( )
𝛿+𝑛

In part (b), we found steady state k as:

1
𝑠𝐴 1−𝛼
𝑘∗ = ( )
𝛿+𝑛

In part (e), we found Golden Rule saving s = 0.5. As α = 0.5, the Golden Rule level of k are the
same in the above two equations.

Note: Refer to excel sheet for understanding the changes over time in variables: at per worker
level and also aggregate level.

Solow-Swan Model Implications:

1. Determinant of per worker/capita GDP in long run: s and n (see evidence in data)

2. Higher growth rates in the transition period (when k is less than the steady level) (see
evidence in data by comparing developing and developed countries)

3. All countries will eventually reach at its own steady state level.

4. Without technological change, per worker capital and per worker GDP in constant. So, we
have technological change in the next chapter.

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As already shown (for the case of no labor force growth), saving increases the capital per
worker and GDP per worker at the steady state (s is in numerator in answers to parts (b)
and (c)).

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Impact of population growth rate on the capital per worker and GDP per worker at the
steady state (n is in denominator in answers to parts (b) and (c)).

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Proof of expression given above:

kt  syt   kt
kt 1 
1 n
k  syt   kt k  syt   kt 1  n
kt 1  kt  t  kt  t  kt
1 n 1 n 1 n
k  syt   kt  (1  n)kt kt  syt   kt  kt  nkt
kt 1  kt  t 
1 n 1 n
sy   kt  nkt syt  (  n)kt
kt  kt 1  kt  t 
1 n 1 n
sf (kt )  (  n)kt
kt 
1 n

Continuous time case:

𝐾 𝑑𝐾 𝑑𝐿
𝑑𝑘 𝑑 ( 𝐿 ) 𝐿 𝑑𝑡 − 𝐾 𝑑𝑡 𝐾̇ 𝐿̇ 𝑠𝑌 − 𝛿𝐾 𝐿̇
𝑘̇ = = = = − 𝑘 = − 𝑘 = 𝑠𝑦 − 𝛿𝑘 − 𝑛𝑘
𝑑𝑡 𝑑𝑡 𝐿2 𝐿 𝐿 𝐿 𝐿
𝐿̇
where 𝑛 = 𝐿

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