Introductory Macroeconomics

Lecture 15: Solow-Swan model, part one

long run economic
growth -

Chris Edmond

2nd Semester 2021

1
 This Lecture ✗ = AF (K ,
L )

• Solow-Swan growth model, part one

– savings and capital accumulation

– implications of diminishing returns to capital T K tr MPK

-

– transitional dynamics

• BOFAH chapter 15

2
 Solow-Swan Growth Model

• Based on two important long-run relationships

④ ±>
④
(i) amount of capital determines output produced (per period)

(ii) amount of output determines new investment (per period)

→ It →Ktti
• Together, determines the amount of capital accumulation over time
¥Éf
capital
"
we have "
today .

• Question: Can capital accumulation sustain long-run growth?

No .

3
?⃝
 g)
MPU
Solow-Swan Growth Model MPL
,
so

2) but diminishing
3) & CRS
• Aggregate production function with ‘standard properties’

Yt = AF (Kt , L)

Q O
(for simplicity, A and L constant — until next lecture)
"
-

TFP "

• National income accounting

Yt = C t + It
- -

(for simplicity, a closed economy and no government purchases)

-

4
 Capital Accumulation

-0-0
• The change in the capital stock is investment less depreciation

Kt+1 Kt = I t
0Kt , 0< <1

• A constant fraction of the capital stock depreciates each period

-

8
constant
depreciation rate

5
 Savings and Investment
• Key behavioural assumption of the Solow-Swan model:
A←
constant fraction s of output is saved each period
£ ✗ - G-
"• -
sang
St = sYt , 0<s<1 s

• Since economy is closed, investment per period is also

y

It = St = sYt
-

• Consumption per period is therefore

Ct = (1 s)Yt
-

6
 Capital Accumulation
• Since investment (= saving) is proportional to output, the change
in the capital stock is

Kt+1
" ①
Kt = I t Kt
that dumb KI .

curve
= sYt Kt some
thine
"
•

some
""
↳ )
= sAF (Kt , L) Kt a hue

depreciation
.

• Tells us how much capital there will be next period Kt+1 given
how much capital there is this period Kt

s¥ • To see how this works, graph investment (= sAF (Kt , L)) and
-

depreciation (= Kt ) and look at the difference

-

7
Solving the Solow-Swan Model

8
 Ktt ,
-
Kt Solow-Swan Diagram
-8kt
-

=
5£ 8kt
←

"

stable
←

;¥ñ¥£ if
"

.
n -0 I
sY OCS <
f
f
'

510 "
"€ i
t has
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the

shape
'

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:i
④ ¥1
:& ,

i
the
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e

prolate
Tio Ko '
hnetru

+FtÉ%o
scaled
i. !
'

"
) • * * >→ < < <<
,

i
by 's
'

s "

" unstable K
,
K
, Kz
O-
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?⃝
 Using the Solow-Swan Diagram

±
• If investment > depreciation, capital is increasing, Kt+1 > Kt

=
• If investment < depreciation, capital is decreasing, Kt+1 < Kt

- Is
• If investment = depreciation, capital is not changing, Kt+1 = Kt

[ we the
lines
two
cross
. .
.

10
YfÉif
" crossing
Steady-State Capital②
K⇤ point .

• If investment = depreciation, capital is not changing, Kt+1 = Kt

• This ‘steady-state ’ capital stock K ⇤ satisfies the equation

-

€ sAF (K ⇤ , L) =
| {z
investment
} |
K⇤
{z }
depreciation
(⇤)

• Algebraically, solve equation (⇤) for K ⇤ in terms of s, A, etc.

.

=)
• Graphically, this is the point where the investment curve
=
(= sAF (Kt , L)) intersects the depreciation line (= Kt )
"
tweets k•<
guttate11
"
> o
the K+ .
 Steady-State Output Y ⇤ and Consumption C ⇤
.
K

• Once we have determined steady-state capital stock K ⇤ from (⇤),

steady-state output Y ⇤ is given by the production function

Q -0
Y ⇤ = AF (K ⇤ , L)

• Steady-state consumption C ⇤ is then

①C ⇤ = (1
0
s)Y ⇤

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Steady-State Output Y ⇤ and Consumption C ⇤

✗
pwaheti
-

function .

0 "

0
} c-

÷
g)
.
±

c + I =
-1
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 Diminishing Returns to Capital
• Question: Can capital accumulation sustain long-run growth?

• No.

• In the short run, if Kt < K ⇤ then the marginal product of capital

is relatively high and the economy grows

• But there are diminishing returns to capital. As Kt increases, the

marginal product of capital falls and growth slows down
ÑmP
-0
• In the long run, capital Kt ! K ⇤ and growth slows down to zero.
E-

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 Increase in Savings Rate
• To see that capital accumulation cannot sustain long-run growth,
consider a permanent increase in the savings rate from s to s0 > s
Investment
←

• Shifts up investment curve along an unchanged depreciation line ok

-

– steady state capital increases from K ⇤ to K ⇤ 0

←=

– steady state output increases from Y ⇤ to Y ⇤ 0

______

• On impact, investment exceed depreciation, capital accumulates

and economy grows

• But over time, diminishing returns set in and, in the long run,
growth slows back down to zero.
-

level
-
but at a new
higher
15 of output .
Increase in Savings Rate

ji :
"
"
"
+

16
Increase in Savings Rate

-1

•#Io#÷tgun get - .

alndpwdrctm

s
-1

" "
① ③
17
 Level Effects and Growth Effects
- -

• Increase in the savings rate from s to s0 > s

– increases the level of capital and output in the long run

-
- -

-
O
– but has no long run effect on the growth of capital and output
-

ce
diminishing retinas
⇐
• Increase in savings rate moves us along production function,

0
increasing capital per worker for a given level of productivity A.

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 I
Level Effect

%
.EE?I.-----:
:
① o +
19
 But No Long Run Growth Effect

•
← sky

µ y

0 -
y
deep

-
to zero

,
•
20
Worked Example: Cobb-Douglas Production Function

21
 Cobb-Douglas Example
• Recall Cobb-Douglas production function

?
-

'
F (K, L) = K ↵ L1 ↵ 0cL <

• In this case steady-state capital stock K ⇤ solves

sAK ⇤ ↵ L1 ↵
= K⇤

• The solution is (see algebra on next slide)

II
✓ ◆ 1
⇤ sA 1 ↵
K = L

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 Cobb-Douglas Example
• Algebra:

– divide both sides of steady state condition by K ⇤ ↵ to get

⇤1 ↵ sA
K = L1 ↵

– raise both sides to the power 1/(1 ↵) to get

✓ ◆ 1 1↵
⇤ sA
K = L

• Implications: steady state capital K ⇤ is

-0
– increasing in savings rate s, in productivity A, and in labour L

– decreasing in depreciation rate

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• Question: So what can generate sustained growth?

• Answer: Productivity growth.

=
Increases in A shift up the production function, allowing more
output at any given level of capital per worker.

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 Next Lecture

• Solow-Swan growth model, part two

– productivity growth, employment growth, factor shares

– the convergence hypothesis

– growth accounting

• BOFAH chapter 15

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