Solow Model:

Topics
Income Disparity
Among Countries
 Convergence in
the Solow Growth Model
• If two countries are initially rich and poor, but
identical in all other respects, they will converge
in the long run to the same level and rate of
growth of per-capita income
Rich and Poor Countries
and the Steady State
Convergence in Income per Worker Across
Countries in the Solow Growth Model
Convergence in Aggregate Output Across
Countries in the Solow Growth Model
Differences in Total Factor Productivity Can Explain
Disparity in Income per Worker Across Countries
 Differences in TFP
• Why would countries have permanently
different levels of TFP?
– Effective allocation of resources
– Regulation
– Uncertainty
– Many others
Growth accounting
 Big Picture
US GDP
20.0
18.0
16.0
14.0
US$ Trillions

12.0
10.0
8.0
6.0
4.0
2.0
-
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
Nominal GDP, US$ Real GDP, 2010 US$
 Why Do We Care?
• GDP grows over time
• We want to know, what factors contribute to it
– Productivity?
– Capital?
– Others?
• Use this information to explain causes of long-
term growth
• Evaluate different theories of economic growth
 Aggregate Production Function
• Factors of production:
– Capital
– Labor
– Technology
• Combine them into a production function:

𝑌 = 𝐴𝐾 𝛼 𝐿1−𝛼
 Data
• We can read Y and L straight from the data
• α – We could get if from data on income
– Assume α=0.3
• Where can we get time series for K?
– Usually not reported, but can be estimated
– Several methods:
• Steady state method
• Perpetual inventory method
 Capital Stock
• Capital stock evolves according to the law of
motion:
𝐾𝑡+1 = 1 − 𝛿 𝐾𝑡 + 𝐼𝑡

• Estimate for 𝛿 – again, we could get if from data

– Assume 𝛿=0.08
 Capital-Output Ratio Method
• In steady state of the economy, the capital stock
is constant:
𝐾𝑆𝑆 = 1 − 𝛿 𝐾𝑆𝑆 + 𝐼𝑆𝑆
• Investment rate is also constant relative to
output:
𝐼 = 𝑠𝑌
• Combining the two, we get:
𝐾 𝑠
=
𝑌 𝛿
 Perpetual Inventory Method
• Start from an arbitrary point in time 𝑡0
• Assume some value of capital 𝐾0 at 𝑡0
• Move forward, using data on investment, to
construct time series for capital in the following
periods:
𝐾𝑡+1 = 1 − 𝛿 𝐾𝑡 + 𝐼𝑡
Perpetual Inventory Method
Capital/Output Ratio in the US
3.5

3.0

2.5

2.0

1.5

1.0

0.5

-
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

K/Y in 1970=3 K/Y in 1970=2

 Pros and Cons
• Capital-Output Ratio Method:
– Assumes the economy is in its steady state
– Can be distorted by short-term or cyclical factors
specific for a given year
– Does not require long time series
• Perpetual Inventory:
– Requires long time series
– The choice for capital stock in period 0 is arbitrary
– If time series are long enough, the choice of 𝐾0 is no
longer relevant
 Next steps
• Transform output, capital, and hours to per-
capita-terms
– Use working-age-population (15-64, or 20-64)
instead of total population
• Hours are usually reported in per-worker terms
– We need to add data on employment
– Get hours per working-age-person
 Computing A
• We can now compute the productivity
parameter A:

𝑌
𝐴 = 𝛼 1−𝛼
𝐾 𝐿
 Solow Growth Accounting
• After some algebra, we can decompose the
growth rate of output per working-age-person
in three components:
– Growth rate of productivity (𝑔𝐴 )
– Growth rate of capital stock (𝑔𝑘 )
– Growth rate of labor per person (𝑔𝑙 )

𝑔𝑦 = 𝑔𝐴 + α𝑔𝑘 + (1 − α)𝑔𝑙
 Solow Growth Accounting
Cumulative Growth and Contribution of Different Factors
100%

80%

60%

40%

20%

0%
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
-20%
Hours Capital Productivity Output