Part I Paper 2

Lecture 7

Predictions and extensions

of the Solow model

Chryssi Giannitsarou
Outline
 Solow model predictions
 Population growth
 The Golden rule
 Transition

Lecture 7 Predictions and extensions of the Solow model slide 1

Predictions about growth rates
 We know that A
 Using growth rate rules

 In the long run, capital per worker at steady

state and
 If productivity constant, i.e. if = 0, then

 In levels:

Lecture 7 Predictions and extensions of the Solow model slide 2

Predictions of the Solow model
 If labour/worker supply L and
productivity/technology A are fixed, then
there is no long-run economic growth in
the Solow model
 In the steady state, growth stops, and all of
the following are constant:
– Output
– Capital
– Output per person
– Consumption per person

Lecture 7 Predictions and extensions of the Solow model slide 3

Predictions of the Solow model
 Empirically, however, economies appear to
continue to grow over time, a important
drawback of the model
 According to the model:
– Capital accumulation is not the engine of
long-run economic growth
– After we reach the steady state, there is no
long-run growth in output per person
 Long run levels of output?
 Comparative statics?
Lecture 7 Predictions and extensions of the Solow model slide 4
Predictions of the Solow model
 Total (level) of capital in the long run

 Total (level) of output in the long fun

 Long run output depends on productivity A,

saving rate s, depreciation rate , labour
supply L and labour share
Lecture 7 Predictions and extensions of the Solow model slide 5
Predictions of the Solow model

A A

 Comparative statics/dynamics:
 depreciation
 savings rate
 labour/capital share
 productivity
 (labour supply)
Lecture 7 Predictions and extensions of the Solow model slide 6
 An increase in the depreciation rate
An increase in δ raises depreciation…
…causing the capital stock to grow toward a lower steady state

Investment 2k
and 1k
depreciation

sf(k)

k
Lecture 7 Predictions and extensions of the Solow model slide 7
 An increase in the saving rate
An increase in the saving rate raises investment…
…causing the capital stock to grow toward a higher steady state
Investment
and k
depreciation s2 f(k)
s1 f(k)

Lecture 7 Predictions and extensions of the Solow model slide 8

An increase in the saving rate
 Higher s  higher k*
 And since y = f(k) ,
higher k*  higher y*
 Thus, the Solow model predicts that countries with
higher rates of saving and investment
will have higher levels of capital and income per
worker in the long run
 However, saving and investment do not sustain
perpetual long-run growth due to diminishing
returns
Lecture 7 Predictions and extensions of the Solow model slide 9
Investment rates and income per person

Lecture 7 Predictions and extensions of the Solow model slide 10

Think about these…
 A change in capital share
 A change in productivity
 A one-off change in labour supply
(population)
 … population growth?

Lecture 7 Predictions and extensions of the Solow model slide 11

Population growth in the Solow model
 Can growth in the labor force lead to overall
economic growth?
– It can in the aggregate
– It cannot in output per person

 Intuition: The presence of diminishing

returns means capital per person and
output per person approaches a steady state
 This occurs irrespective of the number of
workers, i.e. even as the number of workers
(labour supply) grows
Lecture 7 Predictions and extensions of the Solow model slide 12
Population growth in the Solow model
 Assume that the population (and labor force)
grow at rate n, constant and exogenous
 Write fundamental equation in aggregate
levels

Lecture 7 Predictions and extensions of the Solow model slide 13

Population growth in the Solow model
 In per capita terms

 We want to have Δk on the LHS

Lecture 7 Predictions and extensions of the Solow model slide 14

Population growth in the Solow model
 Note that is an ‘approximation’ for a
derivative, i.e.

Growth rate of
population, n
Lecture 7 Predictions and extensions of the Solow model slide 15
Our assumption so far
 If population (labour force) does not
change, then its growth rate is zero, which
means

 Putting this back to the fundamental

equation we have


Lecture 7 Predictions and extensions of the Solow model slide 16

And if population grows?
 Then

 Substitute in from above:

Lecture 7 Predictions and extensions of the Solow model slide 17

Equation of motion with population growth

actual
investment break-even
investment

Lecture 7 Predictions and extensions of the Solow model slide 18

In steady state

break-even
investment
… is the amount of investment that keeps k constant.
It includes:
•  to replace capital as it wears out
• to equip new workers with capital
(otherwise, k would fall as the existing capital stock
would be spread more thinly over a larger population
of workers)
Lecture 7 Predictions and extensions of the Solow model slide 19
The Solow Model diagram

Investment,
k = s f(k)  ( +n)k
break-even
investment
( + n )k
sf(k)

k* Capital per
worker, k
Lecture 7 Predictions and extensions of the Solow model slide 20
Changes in population growth

Investment,
break-even ( +n2)k
investment
( + n1 )k
An increase in n sf(k)
causes an increase
in break-even
investment,
leading to a lower
steady-state level
of k.

k 2* k1* Capital per

worker, k
Lecture 7 Predictions and extensions of the Solow model slide 21
Predictions of the Solow model
 Higher n  lower k*

 And since y = f(k) ,

lower k*  lower y*

 Thus, the Solow model predicts that countries

with higher population growth rates will have
lower levels of capital and income per worker
in the long run.

Lecture 7 Predictions and extensions of the Solow model slide 22

Population growth and income per person

Lecture 7 Predictions and extensions of the Solow model slide 23

Predictions of the Solow model
 Growth rates tricks applied to output

 Population growth in the Solow model allows

aggregate level of GDP to grow perpetually
at the same rate that population grows (n)
 … but does not perpetually improve the
standards of living in the long run (output
per capita reaches a steady state)

Lecture 7 Predictions and extensions of the Solow model slide 24

Population growth
 Does population grow at a constant rate over
time?
 How do population growth rates vary across
countries?
 Change population growth =
fertility - mortality + migration

Lecture 7 Predictions and extensions of the Solow model slide 25

Demographic transition
 As material standards of living rise far above
subsistence, countries undergo a
demographic transition
– birth rates rise
– death rates fall
– birth rates fall

 Not all countries have gone through their

demographic transitions

Lecture 7 Predictions and extensions of the Solow model slide 26

Sketch of demographic transition

Lecture 7 Predictions and extensions of the Solow model slide 27

Lecture 7
0
0.50
1.00
1.50
2.00
2.50

1950-1955
1955-1960
1960-1965
1965-1970
1970-1975
1975-1980
1980-1985
1985-1990
1990-1995
1995-2000
2000-2005
2005-2010
2010-2015
2015-2020
2020-2025
2025-2030
2030-2035
2035-2040
2040-2045
2045-2050
2050-2055
2055-2060
2060-2065
2065-2070
2070-2075
2075-2080
2080-2085
2085-2090
Predictions and extensions of the Solow model

2090-2095
2095-2100
Source: United Nations (http://esa.un.org/unpd/wpp/index.htm)
Population growth rate (projected after 2015)

slide 28
Predictions of the Solow model (cont.)
 Higher s  higher k*  higher y*
 How about consumption?
– If s = 0, all income is consumed in the first period
 nothing is saved  no income to consume
thereafter, i.e. c = 0
– If s = 1, all income is saved  nothing is left to
consume, i.e. c = 0
– In between, consumption is positive

Lecture 7 Predictions and extensions of the Solow model slide 29

The golden rule: introduction
 Different values of s lead to different steady
states
 How do we know which is the “best” steady
state?
 Economic well-being depends on
consumption, so the “best” steady state has
the highest possible value of consumption per
person:

Lecture 7 Predictions and extensions of the Solow model slide 30

The golden rule: introduction
 An increase in s
• leads to higher k* and y*, which may raise c*
• reduces consumption’s share of income
(1–s), which may lower c*

 So, how do we find the s and k* that

maximize c* ?

Lecture 7 Predictions and extensions of the Solow model slide 31

Steady state consumption

maximum
c* consumption

Lecture 7 Predictions and extensions of the Solow model slide 32

The golden rule capital stock

the Golden Rule level of capital:

the steady state value of k
that maximizes consumption.

To find it, first express c* in terms of k*:

c* = y*  i*
In general:
= f(k*)  i*  
= f(k*)  (+n)k* In the steady state:

because  .

Lecture 7 Predictions and extensions of the Solow model slide 33

The golden rule capital stock
steady state
output and
depreciation (+n)k*
Then, graph f(k*)
and (+n)k*, and f(k*)
look for the
point where the
gap between
them is biggest.

steady-state
capital per
worker, k*
Lecture 7 Predictions and extensions of the Solow model slide 34
The golden rule capital stock

c* = f(k*)  (+n)k*
is biggest where (+n)k*
the slope of the
production f(k*)
function equals
the slope of the
break-even
investment line:
MPK =  + n
steady-state
capital per
worker, k*
Lecture 7 Predictions and extensions of the Solow model slide 35
 The golden rule, mathematically
 You can also derive the golden rule capital
stock as follows:
 Take consumption capita in steady state as a
function of steady state capital per capita

 Maximise it wrt to

 Then

Lecture 7 Predictions and extensions of the Solow model slide 36

The transition to the GR steady state
 The economy does NOT have a tendency to
move toward the Golden Rule steady state
 Achieving the Golden Rule requires that
policymakers adjust savings rate s
 This adjustment leads to a new steady state
with higher consumption
 But what happens to consumption
during the transition to the Golden Rule?

Lecture 7 Predictions and extensions of the Solow model slide 37

Starting with too much capital

then increasing
c* requires a fall y
in s.
In the transition c
to the
Golden Rule, i
consumption is
higher at all
points in time. t0 time
If k>k*gold the economy is dynamically inefficient

Lecture 7 Predictions and extensions of the Solow model slide 38

Starting with too little capital

then increasing c*
requires an y
increase in s.
Future generations c
enjoy higher
consumption,
but the current one
experiences
i
an initial drop
in consumption. t0 time
If k<kgold the economy is dynamically efficient
Lecture 7 Predictions and extensions of the Solow model slide 39
Readings
 Jones: Chapter 5
 Mankiw: Chapter 8

Lecture 7 Predictions and extensions of the Solow model slide 40