CHAPTER TWO

CLASSICAL AND NEOCLASSICAL GROWTH THEORIES

Growth theories attempt to explain the conditions that are necessary for development to occur, and
weigh up the relative importance of particular conditions. Early theories focused on understanding
economic growth, and attempted to find general determinants of growth that could be applied
to any instance under consideration. By looking at patterns of growth the hope was to discover
some of the laws or principles which govern growth at all times and in all countries. Modern
theories tend to accept that conditions for growth change over time, and are often more critical of
the attempts to generate one-size-fits-all growth theories.

There are several broad categories of growth theory. In this chapter we will discuss about the two
famous growth theories: The Harrod-Domar growth model and the Solow-Swan growth model.
We will see that each growth theories offer valuable insights and a useful perspective on the nature
of the development process.

Learning objectives: Having completed this chapter, and the essential reading and activities, the
students will be able to:
 Explain the characteristics of Harrod-Domar growth model
 Understand the characteristics of Solow-Swan growth model
 Differentiate Harrod-Domar growth model from the Solow-Swan growth model and
 Understand the main drawbacks of each model.

2.1. The Harrod-Domar growth model (The Classical Growth theory)

2.1.1. Introduction
The Harrod-Domar model was developed independently by Sir Roy Harrod of England in 1939
and Professor Evsey Domar of the United States in 1946. It is a growth model which states the
rate of economic growth in an economy is dependent on the level of saving and the capital output
ratio. If there is a high level of saving in a country, it provides funds for firms to borrow and invest.
Investment can increase the capital stock of an economy and generate economic growth through
the increase in production of goods and services. According to this model the growth rate of gross
domestic product (g) depends directly on the national net savings rate (s) and inversely on the
national capital-output ratio (c).

The capital output ratio measures the productivity of the investment that takes place. If capital
output ratio decreases the economy will be more productive, so higher amounts of output is
generated from fewer inputs. This again, leads to higher economic growth.

The variables chosen by Harrod and Domar are the broad aggregates, e.g. investment, capital and
output. It is assumed that capital and labour are used in a fixed technical or behavioural
relationship, and that output is related to the capital stock by the capital-output (c) ratio. The
concept of the capital-output ratio has greatly dominated theories of growth and planning for
LDCs and hence justifies some special attention.

2.1.2. The Model

Basic assumptions of the model:
The Harrod–Domar model makes the following a priori assumptions
1. There is an initial full employment equilibrium level of income.
2. The model operates in closed economy i.e. there is no foreign trade.
3. Capital is the binding constraint: Output is a function of capital stock:
4. There is no government interference in the functioning of the economy i.e. the policy of
laissez-faire prevails in the economy.
5. That capital and labour are used in a fixed technical or behavioural relationship.
6. The marginal product of capital is constant;
7. The production function exhibits constant returns to scale. This implies capital's marginal
and average products are equal.
8. The product of the savings rate and output equals saving, which equals investment
9. The change in the capital stock equals investment.

Every economy must save a certain proportion of its national income, if only to replace worn-out
or impaired capital goods (buildings, equipment, and materials). However, in order to grow, new
investments representing net additions to the capital stock are necessary. If we assume that there
is some direct economic relationship between the size of the total capital stock and total GDP, Y.
For example, if $3 of capital is always necessary to produce a $1 stream of GDP- it follows that
any net additions to the capital stock in the form of new investment will bring about corresponding
increases in the flow of national output, GDP.
This relationship, in economics is known as the capital-output ratio. This ratio shows the units
of capital required to produce a unit of output over a given period of time.
If we define the capital-output ratio as c and assume further that the national savings ratio, s, is
fixed proportion of national output and that total new investment is determined by the level of total
savings, we can construct the following simple model of economic growth:
1. Saving (S) is some proportion, s, of national income (Y) such that we have the simple
equation
S=sY (2.1.1)
2. Net investment (I) is defined as the change in the capital stock, and can be represented by
ΔK such that
I=ΔK (2.1.2)
But because the total capital stock, K, bears a direct relationship to total national income
or output, Y, as expressed by the capital-output ratio, c, it follows that
K/Y=c
Or ΔK/ΔY= c
Or finally ΔK= c ΔY (2.1.3)

3. Finally, because net national savings, S, must equal net investment, I, we can write these
equation as
S=I (2.1.4)
But from equation-2.1.1 we know that S=sY and from equation 2.1.2 & 2.1.3 we know that
I=ΔK= c ΔY
It therefore follows that we can write the identity of saving equaling investment shown by
equation-2.1.4 as
S=sY= c ΔY=ΔK=I (2.1.5)
Or simply sY= c ΔY (2.1.6)

Dividing both sides of the equation 6 first by Y and then by c, we obtain the following
expression:
ΔY/Y=g= s/ c (2.1.7)
Or ΔY/Y=g= s.v (2.1.8)
Where v =1/c measures output capital ratio (Productive capacity of the economy or capital
productivity)
If we recognizes that capital depreciates, equation-2.1.7 and 2.1.8 can be expressed as:
ΔY/Y=g= (s/ c) –δ = (s.v) – δ

where δ is the rate of depreciation per year

Note that the left hand side of equation 2.1.7, ΔY/Y, represents the rate of change or the
rate of growth of GDP, g.
Equation-2.1.7 which is the simplified version of the famous equation in the Harrod-Domar theory
of economic growth stated simply that the rate of growth of GDP (ΔY/Y) is determined jointly by
the national savings ratio, s, and the national capital-output ratio, c. More specifically, it says that
in the absence of government, the growth rate of national income will be directly or positively
related to the savings ratio (i.e, more an economy able to save –and invest-out of a given GDP, the
greater the growth of that GDP will be) and inversely or negatively related to the economies capital
output ratio (i.e, the higher k is, the lower the rate of GDP growth will be).

The economic logic of equation-2.1.7 is very simple. In order to grow, economies must save and
invest a certain proportion of their GDP. The more they can save and invest, the faster they can
grow. But the actual rate at which they can grow for any level of saving and investment-how much
additional output can be had from an additional unit of investment-can be measured by the inverse
of capital-output ratio, c, because this inverse, l/c, is simply the output-capital or output-investment
ratio. It follows that multiplying the rate of new investment, s=I/Y, by its productivity, l/c, will
give the rate by which national income or GDP will increase.

Numerical Example-2.1.1: Assuming the saving rate is 10% and the Capital output ratio is 4,
calculate economic growth rate?
ΔY/Y=g= s/ c = 10%/4= 2.5%. Therefore the economy would grow at 5% per year.

Numerical Example-2.1.2: If the savings rate is 10% and the capital output ratio is 2, then a
country would grow at 5% per year.

2.1.3. Limitations of the Harrod-Domar model

 The model is too aggregative and hence does not provide the basis for a detailed
quantitative study, nor does it highlight the structural and regional problems
 The assumption of a fixed coefficient of production may also be questioned just as it is
equally possible to doubt the assumption about the absence of trade. However, the
theoretical search for stability of the HD model continued and one way out was suggested
by the neoclassical economists.
 All savings may not be transformed into investment. This is because of institutional or
attitudinal problems or problems of confidence.
  Saving and hence investment is only a necessary factor for growth but not a sufficient
condition. For instance, technological skills, infrastructures and other factors are there that
affect growth.
 Overall, the task of estimating capital output ratio is difficult anywhere (LDCs or DCs).
Even if the data or the information is available in LDCs you can’t estimate such a ratio
reliably due to the heterogeneous nature of capital.
 In Harrod-Domar model capital refers only physical capital but not other forms of capital
like human capital. Human capital embodied in labor in the form of training is excluded.
But, this is very important in LDCs.
 Labour along with capital is another input in the process of production. Even in a so-called
labour surplus LDC, evidence suggests that such surplus is sometimes observed only
seasonally.

Key Terms
Harrod-Domar growth model: A functional economic relationship in which the growth rate of
gross domestic product (g) depends directly on the national net savings rate (s) and inversely on
the national capital-output ratio (c).
Capital-output ratio: A ratio that shows the units of capital required to produce a unit of output
over a given period of time.
Net savings ratio: Savings expressed as a proportion of disposable income over some period of
time.
Review questions
1. Assume the productive capacity of country X is 25% per year, the marginal propensity to
save- s is 12% per year and initial national income (Y) is $150 billion per year. then;
A. Find the amount of investment, if full employment is maintained.
B. Find the increase in productive capacity associated with this investment level(see
A above)
C. Find the rate of economic growth, GDP (in %)
2. If in 2013, the Investment/ GDP = 11% , Capital stock / worker = 400, GDP / worker =
200, Depreciation = 0% , Growth in workforce = 0%
A. What is the predicted growth rate in 2013 using an ICOR of 2?
B. If the country is targeting a 7% growth rate, how much more (if any) investment
as a % of GDP will be needed?
C. What is the financing gap?
 2.2. The Solow-Swan growth model (The Neoclassical Growth theory)

2.2.1. Introduction
The American economist Robert Solow, who won a Noble Prize in Economics and the Australian
Economist Trevor Swan, who are the two well-known contributors to the neo-classical theory of
growth, constructed the Solow–Swan model in 1956. It is an exogenous growth model which
attempts to explain long-run economic growth by looking at capital accumulation, labor
or population growth, and increases in productivity, commonly referred to as technological
progress.

The key modification from the Harrod-Domar growth model is that the Solow–Swan model allows
for substitution between capital and labor. In the process, it assumes that there are diminishing
returns to the use of these inputs. The aggregate production function, Y = F(K, L) is assumed
characterized by constant returns to scale.

2.2.2. The Model

The Solow–Swan growth model is designed to show how growth in the capital stock, growth in
the labor force, and advances in technology interact in an economy, and how they affect a nation’s
total output of goods and services. It postulates that growth of per-capita output is the result of
capital accumulation and/or technological progress. But the model also predicts that such an
increase in growth cannot last indefinitely. In the long run, the country’s growth rate will revert to
the rate of technological progress, which neoclassical theory takes as being independent of
economic forces, or exogenous. Underlying this pessimistic long-run result is the principle of
diminishing marginal productivity, which puts an upper limit to how much output a person can
produce simply by working with more and more capital, given the state of technology.

Basic assumptions of the model:

The model is based on the following assumptions:
1. One composite output is produced and the economy is closed.
2. There are constant returns to scale.
3. There are diminishing returns to an individual input.
4. The two factors of production, labor and capital, are paid according to their marginal
physical productivities.
 5. Prices and wages are flexible.
6. There is full employment of labor.
7. There is also full employment of the available stock of capital.
8. Labor and capital are substitutable for each other.
9. There is no technical progress.
10. The saving ratio is constant.
11. Saving equals investment.
12. Capital depreciates at the constant rate, d.
13. Population grows at a constant rate, n.

Given these assumptions, let us build this model in steps.

Y = F (K, L) (2.2.1)
Where Y is income or output, K is capital and L is labor.

The aggregate production function, Y = F(K, L) is assumed characterized by constant returns to

scale. Because of constant returns to scale, if all inputs are increased by the same amount, γ, then
output will increase by the same amount γ.

F (γ K, γ L) = γ F (K, L) for all γ, K, L>0 (2.2.2)

This formula makes sense under our assumption that the state of technology is given, for if capital
and labor were both to double, then the extra workers could use the extra capital to replicate what
was done before, thus resulting in twice the output. Suppose that everyone in the economy always
supplies one unit of labor per unit of time, and that there is perpetual full employment. Thus the
labor input L is also the population, which we suppose grows at the constant exponential rate n
per year. With constant returns to scale, output per person y = Y/L will depend on the capital stock
per person k= K/L. That is, equation (2.2.2) implies that, in the special case where γ = 1/L,

Y/L = F (K, L)/L= F (K/L, 1) (2.2.3)

Or y = ƒ (k)

Where y = Y/L is output or income per worker, k = K/L is the capital-labor ratio, f is the per
capita production function. Here the y = ƒ (k) indicates what each person can produce using his
or her share of the aggregate capital stock.
The concave shape of ƒ(k)—that is, increasing at a decreasing rate—reflects diminishing returns
to capital per worker, as can be seen in Figure -2.1

If the production function is Cobb-Douglas production function: 𝒀𝒕 = (𝑲𝒕 )𝜶 𝑨𝒕 (𝑳𝒕 )𝟏−𝜶

where Y is gross domestic product, K is the stock of capital (which may include human capital as
well as physical capital), L is labor, and A(t) represents the productivity of labor, which grows
over time at an exogenous rate. We can specify the per capita production function as:

𝒚 = 𝒇(𝒌) = 𝑨𝒌𝜶 (2.2.4)

Equation (2.2.4) states that output per worker is a function that depends on the amount of capital
per worker. The more capital with which each worker has to work, the more output that worker
can produce. The labor force grows at rate n per year, say, and labor productivity growth, the rate
at which the value of A in the production function increases, occurs at rate λ.

The Solow-Swan equation (Equation-2.2.5) gives the growth of the capital-labor ratio, k (known
as capital deepening), and shows that the growth of k depends on savings sf(k), after allowing for
the amount of capital required to service depreciation, δk, and after capital widening, that is,
providing the existing amount of capital per worker to net new workers joining the labor force, nk.
𝜟𝒌 = 𝒔𝒇(𝒌) – (𝜹 + 𝒏)𝒌 (2.2.5)

The process through which the economy increases the amount of capital per worker, k, is called
capital deepening. Economies in which workers have access to more machines, computers,
trucks, and other equipment have deeper capital base than economies with less machinery, and
these economies are able to produce more output per worker.

In some economies, however, the amount of saving is just enough to provide the same amount of
capital to new workers and compensate for depreciation. An increase in the capital stock that just
keeps pace with the expanding labor force and depreciation is called capital widening (refers to a
‘widening’ of both the total amount of capital the size of the workforce). Capital widening occurs
when sf(k) is exactly equal to (δ + n)k), implying no change in k.

The total capital stock grows when savings are greater than depreciation, but capital per worker
grows when savings are also greater than what is needed to equip new workers with the same
amount of capital as existing workers have. That means the net change in capital per worker
(capita-labour ratio) k over time is the excess of saving per worker over the required investment
to maintain capital per worker,

Since depreciation is a constant, δ per cent of the capital stock, δk is the investment needed to
replace worn-out capital. This depreciation investment per worker δk is added to nk, the
investment per worker to maintain capital-labor ratio for the growing population. Therefore the
investment required to maintain capital per worker would be:

(𝒏𝒌 + 𝜹 𝒌) = (𝒏 + 𝜹) 𝒌 (2.2.6)

For simplicity, we are assuming for now that A remains constant. In this case, there will be a state
in which output and capital per worker are no longer changing, known as the steady state. (If A is
increasing, the corresponding state will be one in which capital per effective worker is no longer
changing. In that case, the number of effective workers rises as A rises; this is because when
workers have higher productivity, it is as if there were extra workers on the job).

To find this steady state, set Δk = 0. This is the fundamental equation for the Solow-Swan mode.
The economy reaches a steady-state when

𝑺ƒ(𝒌 ∗) = (𝜹 + 𝒏)𝒌 ∗ (2.2.7)

The Solow-Swan model is explained in Fig. 2.1 below. The notation k* means the level of capital
per worker when the economy is in its steady state. The capital per worker k* represents the steady
state. If k is higher or lower than k*, the economy will return to it; thus k* is a stable equilibrium.
Looking at the diagram, to the left of k*, k1< k* .In this case, (n + d)k < sf(k) . When (n + d)k <
sf(k), Δk > 0. As a result, k in the economy is growing toward the equilibrium point k*. By similar
reasoning to the right of k*, (n + d)k > sf(k), and as a result, Δk < 0 .As a result capital per worker
is actually shrinking toward the equilibrium k*.
 Fig. 2.1: The Steady State in the Solow-Swan model
Output per worker y is measured along the vertical axis and capital per worker (capital-labour
ratio), k, is measured along the horizontal axis. The y =f(k) curve is the production function which
shows that output per worker increases at a diminishing rate as k increases due to the law of
diminishing returns.

The sf (k) curve represents saving per worker. The (n + d) k is the investment requirement line
from the origin with a positive slope equal to (n+d). The steady state level of capital, is determined
where the sf (k) curve intersects the (𝒏 + 𝒅)𝒌 line at point E. The steady state income is y* with
output per worker k*P, as measured by point P on the production function y = f (k).

2.2.2.1. Effect of increasing saving rate on the Steady State

It is informative to consider what happens in the Solow-swan neoclassical growth model if we
increase the rate of savings, s. The Solow-Swan model shows that the saving rate is a key
determinant of the steady-state capital stock. If the saving rate is high, the economy will have a
large capital stock and a high level of output. If the saving rate is low, the economy will have a
small capital stock and a low level of output.

What does the Solow-Swan model say about the relationship between saving and economic
growth? Higher saving leads to faster growth in the Solow model, but only temporarily. An
increase in the rate of saving raises growth only until the economy reaches the new steady state. If
the economy maintains a high saving rate, it will maintain a large capital stock and a high level of
output, but it will not maintain a high rate of growth forever. Unlike in the Harrod-Domar analysis,
in the Solow-Swan model an increase in s will not increase growth in the long run; it will only
increase the equilibrium k*. That is, after the economy has time to adjust, the capital-labor ratio
increases, and so does the output-labor ratio, but not the rate of growth. The effect of saving rate
is shown in Figure2.2, in which savings is raised to s1. In contrast, in the Harrod-Domar model, an
increase in s raises the growth rate. (This is because in the Harrod-Domar model sf(k) becomes a
straight line from the origin that does not cross (n + d)k; and so, as we assume that sf(k) lies above
(n + d)k, growth continues at the now higher Harrod-Domar rate.

Fig. 2.2 shows the effect of saving rate on the steady-state. An increase in the saving rate from s

to s1 shifts the saving curve sf(k) upward to s1f(k). The new steady state point is E1.

When the saving rate increases forms s to s1 with no change in the growth rate of labour force (n),
the capital per worker will continue to rise to k1*, which will raise output per worker to y1*and so
will the growth rate of output increase. But this process continues at a diminishing rate in the
transition period. As a result, the initial growth rate of output is restored over the long run at the
new steady state equilibrium point 𝑬𝟏 𝑤ℎ𝑒𝑟𝑒 (𝒏 + 𝜹) 𝒌 = 𝒔𝟏𝒇(𝒌).

Fig. 2.2: The effect of saving rate on the steady-state

Activity-2. 1: Explain the Golden Rule Level of Capital.

 2.2.2.2. Population growth and the steady state.

The change in the capital stock per worker is

𝜟𝒌 = 𝒔𝒇(𝒌) – (𝜹 + 𝒏)𝒌

This equation shows how investment, depreciation, and population growth influence the per-
worker capital stock. Investment increases k, whereas depreciation and population growth decrease
k. We saw this equation earlier for the special case of a constant population (n = 0).
We can think of the term (δ + n)k as defining break-even investment—the amount of investment
necessary to keep the capital stock per worker constant. Break-even investment includes the
depreciation of existing capital, which equals δk. It also includes the amount of investment
necessary to provide new workers with capital, nk.

The equation shows that population growth reduces the accumulation of capital per worker much
the way depreciation does. Depreciation reduces k by wearing out the capital stock, whereas
population growth reduces k by spreading the capital stock more thinly among a larger population
of workers.

Capital per worker ( y) f(k)

y* (n1 + δ)k
y1*
(n + δ)k

sf(k)

K1* k* Capital per worker ( k)

Fig. 2.3: The effect of population growth on the steady-state
An increase in the rate of population growth from n to n1 shifts the line representing population
growth and depreciation upward. The new steady state K1* has a lower level of capital per worker
than the initial steady state k* .Thus, the Solow-Swan model predicts that economies with higher
rates of population growth will have lower levels of capital per worker and therefore lower
incomes.

Activity-2.2: Explain the effect of Technological Progress in the Solow Model.

2.2.2.3. Additional Formulas: Steady-State level of output per worker and

Capital per worker
Using equation (2.2.4), y=f (k) = A𝒌𝜶 , equation (2.2.5), Δk = sf(k) – (δ + n)k , we can be more
formal in our analysis.
Since f(k)= Akα , we can rewrite equation(2.2.5) as:
𝜟𝒌 = 𝒔𝑨𝒌𝜶– (𝜹 + 𝒏)𝒌 (2.2.8)
Finding the steady-state entails finding a value of capital, k*, for which equation (2.2.8) is equal
to zero.
𝟎 = 𝒔𝑨(𝒌 ∗)𝜶 – (𝜹 + 𝒏) 𝒌 ∗ which implies that

𝒔𝑨(𝒌 ∗)𝜶 = (𝜹 + 𝒏) 𝒌 ∗

To solve for k*, first divide both sides by (𝐤 ∗)𝜶 and by (δ+n). Then raise both sides to the power
1/(1-α).
𝒔𝑨 𝟏/(𝟏−𝜶)
𝒌 ∗= ( ) (2.2.9)
𝜹+𝒏
𝜶
Plugging equation (2.2.9) in to the production function y=A𝒌 , we get an expression of the
steady state level of output per worker, y*.
𝒔 𝜶/(𝟏−𝜶)
𝒚 ∗= (𝑨)𝟏/(𝟏−𝜶) ( ) (2.2.10)
𝜹+𝒏
This equation confirms that, Ceteris paribus, raising the rate of investment, s, will raise the steady-
state level of output per worker. Similarly, raising the rate of depreciation or rate of population
growth will lower the steady-state level of output per worker.

2.2.2.4. The Solow-Swan model as a theory of income difference

Equation (2.2.10) shows how a country’s steady-state level of output per worker will depend on
its investment rate. If a country has a higher rate of investment, it will have a higher steady-state
level of output per worker. Thus we may think of the Solow-Swan model as a theory of income
difference.
For simplicity, consider the case where the only difference among countries are in their investment

rates, s. We assume that countries have the same level of productivity, A, and the same rate of

depreciation, δ and population growth, n. We also assume that countries are all in their steady-
state level of income per worker.

Consider two countries, i and j. Let s1 & s2 be the rate of investment in country i & j. Their steady-
state level of output per worker are given by the equations:
𝑺𝒊 𝜶/(𝟏−𝜶)
𝒚𝒊 ∗= (𝑨)𝟏/(𝟏−𝜶) ( ) (2.2.11)
𝜹+𝒏

𝑺𝒋 𝜶/(𝟏−𝜶)
𝒚𝒋 ∗= (𝑨)𝟏/(𝟏−𝜶) ( ) (2.2.12)
𝜹+𝒏
Dividing Equation (2.2.11) by Equation (2.2.12) expresses the ratio of income per worker in
country i to income per worker in country j.

𝑺𝒊 𝜶/(𝟏−𝜶)
(𝒚𝒊 ∗)/(𝒚𝒋 ∗ ) = ( ) ( 2.2.13)
𝒔𝒋
Notice that the terms A, δ and n have dropped out, because all of these parameters were
assumed to be the same in the two countries.

Numerical Example 2.2.1: Suppose that country i has an investment rate of 20% and country j
has an investment rate of 5% . We use the value of 𝜶=1/3 . Substituting the value of investment
rates in to equation (2.2.13).
𝟎. 𝟐 𝟏/𝟐)
(𝒚𝒊 ∗)/(𝒚𝒋 ∗ ) = ( ) = 𝟒𝟏/𝟐 = 𝟐
𝟎. 𝟎𝟓
Thus the Solow-Swan model predicts that the level of income per worker in country i would be
twice the level of country j.

2.2.3. Conditional Convergence and the Solow-Swan model.

The Solow-Swan model predicts three basic conditional convergences.
 If two countries have the same level of investment but different level of income, the
country with lower income will have higher growth. Since their investment rates are the
same, the two countries will have the same steady-state level of income. If the rich country
has income below this steady state, then the poor will have income that is even further
below the steady-state and will grow faster. Conversely, if the poor country has income
that is above the steady state, then the rich country will have income that is even further
above the steady state, so the negative effect of moving toward the steady state will be
grater in the rich country. Finally, if the poor country has income below the steady state
and the rich country has income above the steady-state; the movement toward the steady
state will have a positive effect on the poor country’s growth and a negative effect on the
rich country’s growth.
  If two countries have the same level of income but different rate of investment, the
country with a higher rate of investment will have higher growth. Of the two countries
the one with a higher rate of investment will have the higher steady state level of output. If
both countries are below their steady state, the country with higher investment will
necessarily be further below its steady state and so will grow faster. Similarly, if both
countries are above their steady state, then the country with lower investment will be
further above its steady state, so the negative effect on growth of being above the steady
state will be more pronounced. And if the high-investment country is below its steady state
while the low-investment country is above its steady state, the high-investment country
will grow faster.

 A country that raises its level of investment will experience an increase in its rate of
income growth.
Note that: The above predictions will hold true only if there are no differences among countries
either in their level of productivity, A, or in any of other determinants of steady-states.

2.2.4. Limitations of Solow-Swan model

 First, the model is built on the assumption of a closed economy. That is, the convergence
hypothesis supposes a group of countries having no type of interrelation. However, it is
unrealistic to assume countries having no interrelation.
 The Solow-Swan model is that the implicit share of income that comes from capital
(obtained from the estimates of the model) does not match the national accounting
information.
 The equilibrium rates of growth of the relevant variables depend on the rate of
technological progress, an exogenous factor and furthermore, the individuals in the Solow
–Swan model (and in some of its successors) have no motivation to invent new goods
 It assumes that the only source of difference in income per worker across countries is
difference in their per worker capital stock, ignoring differences in other factors of
production or in the production function by which these factors are combined.
 The model argues that difference in investment rates are important but does not say
anything about the sources of these differences in investment rate.
  It does not model long-run growth, because in the steady state of the model, countries do
not grow at all.
 Etc

Key Terms

Capital: The physical objects that extend our ability or do work for us. It includes not only the
machines but also the buildings, infrastructures, vehicles and computers.

Cobb-Douglass production function: a particular functional form of the production function

widely used to represent the technological relationship between the amounts of inputs, particularly
physical capital and labour, and the amount of output that can be produced by those inputs.
Constant returns to scale: occurs when we multiply the quantities of each input by some factor
leads to an equivalent increase in the output.

Convergence to the steady state: The process by which a country’s per worker output will grow
or shrink from some initial position toward the steady state level.

Depreciation: a reduction in the value of capital (an asset) over time, due in particular to wear and
tear.
Diminishing Marginal Product: says that if we keep adding units of a single input ( holding the
quantities of other inputs fixed) , then the quantity of new output that each new units of input
produces will be smaller than that added by the previous unit of the input.

Exogenous variable: Are those variables that are taken as given when we analyze a model while
Endogenous variable are those that are determined within the model.
Investment: Is the process of producing capital or it refers to the purchase of goods that are not
consumed today but are used in the future to create wealth.

Solow–Swan growth model: A model which postulates that growth of per-capita output is the
result of capital accumulation and/or technological progress, but such an increase in growth cannot
last indefinitely.
Steady state: is an unchanging condition, system or physical process that remains the same even
after transformation or change. In the Solow-Swam model, it refers to the level of capital at which
the lines representing investment and depreciation intersect.
 Review Questions
1. In the Solow model, how does the saving rate affect the steady-state level of income? How
does it affect the steady-state rate of growth?
2. In the Solow model, how does the rate of population growth affect the steady-state level of
income? How does it affect the steady-state rate of growth?
3. Country A and country B both have the production function
Y = F(K, L) A𝑲𝟏/𝟐 𝑳𝟏/𝟐
A. What is the per-worker production function, y = f(k)?
B. Assume that neither country experiences population growth nor technological progress
and that 5 percent of capital depreciates each year. Assume further that country A saves
10 percent of output each year and country B saves 20 percent of output each year. Using
your answer from part (b) and the steady-state condition that investment equals
depreciation, find the steady-state level of capital per worker for each country. Then find
the steady-state levels of income per worker and consumption per worker.
C. Suppose that both countries start off with a capital stock per worker of 2.What are the
levels of income per worker and consumption per worker?
4. A country is described by the Solow-Swan model, with a production function, y= 𝒌𝟏/𝟐 .
Suppose that k=400. The fraction of output invested, s, is 50%. Depreciation rate , 𝛅 , is 5%
and population growth, 𝒏, is 0%. Is the country at its steady state level of output per worker,
above the steady state, below the steady state? Show how you reached your calculation.
5. In country-1 the rate of investment is 5%, and in country-2 it is 20%. The two countries have
the same level of productivity, A, and the same rate of depreciation, 𝛅 and population
𝟏
growth, 𝐧. Assuming that the value of 𝜶 = , what is the ratio of steady state output per
𝟑

worker in country-1 to steady state output per worker in country-2? What would the ratio be
if the value of 𝛼 were 2/3?
6. County-x and country-y have the same level of output per worker. They also have the same
values for the rate of depreciation, 𝛅 , population growth , 𝐧, and productivity, A. In country-
x output per worker is growing, while in country-y it is falling. What can you say about the
two country’s’ rates of investment?
7. In a country the production function is y= 𝒌𝟏/𝟐 . The fraction of output invested, s, is 0.25.
The depreciation rate 𝛅, is 0.05. What are the steady state level of capital per worker, k, and
output per worker, y?
8. In a Solow-Swan economy, assume a Cobb-Douglas technology, with parameter values δ =
0.10, n = 0.02, A = 1, α = 0.33,s = 0.25, and compute the steady state value of capital.
9. Human capital factor absent in Solow-Swan model. Does ignoring human capital in the
empirical estimation of the Solow-Swan model imply an under- or overestimate of the
influence of savings rate on growth rates?

References
 Aghion P. and Howitt P. (2009). The Economics Of Growth , The MIT Press
Cambridge, Massachusetts ,London, England
 David N. Weil (2009).Economic Growth (2nd edition) , Pearson Addison Wesley, Boston
San Francisco, New York. ,
 Ghatak S.(2005). Introduction to development Economics (3rd edition), Routledge, USA
and Canada.
 Todaro, M.P. and S. Smith (2010) Economic Development (11th edition) Pearson Education
Ltd.