SOLOW GROWTH MODEL: STEADY STATE EQUILIBRIUM

Equilibrium - A state where variables are stable and no longer

change.

In the Solow Model, this is the steady state where capital per
capita is stable -neither decreases nor increases over time

Steady State Condition:

Δ𝑘 = 0
𝑆𝑎𝑣𝑖𝑛𝑔𝑠 = 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

In our simple model:

𝑠𝑦 = 𝛿𝑘 BREAKEVEN/REQUIRED INVESTMENT
Recap:
Output is determined by the amount of capital per capita 𝑘
(𝑦 = 𝐴𝑘 𝛼 ).

The change in 𝑘 at any point in time is determined by

savings/investment and depreciation (Δ𝑘 = 𝑠𝐴𝑘 𝛼 − 𝛿𝑘).

If 𝑖 > 𝛿𝑘 → Δ𝑘 > 0 → 𝑘 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠 𝑜𝑣𝑒𝑟 𝑡𝑖𝑚𝑒.

Output/Income per capita grows.

If 𝑖 < 𝛿𝑘 → Δ𝑘 < 0 → 𝑘 𝑑𝑒𝑐𝑟𝑒𝑎𝑠𝑒𝑠.

Output/Income per capita decreases.

Capital will accumulate or decline until it reaches 𝒔𝒕𝒆𝒂𝒅𝒚 𝒔𝒕𝒂𝒕𝒆 𝑘 ∗

where 𝑖 = 𝛿𝑘. The economy will stay in this steady state until other
factors changes (e.g., technology).

Growth Model Numerical Example:

Steady State in a Simple Model:
Numerical Example: Consider a hypothetical economy with the
Δ𝑘 = 0
following production function
Δk = sy − 𝛿𝑘 1 1
𝑠𝑦 = 𝛿𝑘 𝑌 = 10𝐾 (2) 𝐿2
𝑠𝐴𝑘 𝛼 = 𝛿𝑘 Savings rate is equal to 15% and depreciation is 10% per
𝟏 annum.
𝒔𝑨
𝒌∗ = ( 𝜹 )𝟏−𝜶 Solve for the steady state 𝑦 ∗ , 𝑘 ∗ , 𝑖 ∗ , 𝑎𝑛𝑑 𝑐 ∗ .

1. Derive output per capita function 𝒚(𝒌) [𝒀/𝑲]

2. What is savings as a function of 𝑘, 𝒔(𝒌) [𝒔 ∗ 𝒚]
3. What is the depreciation function?
4. Impose steady state condition and 𝒔𝒚 = 𝜹𝒌 and solve for steady
state 𝑘 ∗ .
5. Solve for steady state output, savings/investment, consumption
and depreciation.

1. Derive output per capita function 𝒚(𝒌)

𝟏
𝒚 = 𝟏𝟎𝒌𝟐

2. What is savings as a function of 𝑘, 𝒔(𝒌)

𝟏
𝒔 = 𝟏. 𝟓𝒌𝟐

3. What is the depreciation function?

𝒅𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 = 𝟎. 𝟏𝟎𝒌
4. Impose steady state condition and 𝒔𝒚 = 𝜹𝒌 and solve for GOLDEN RULE LEVEL OF CAPITAL
steady state 𝑘 ∗ . For households, what matters most is the level of consumption,𝑐.
1
1.5𝑘 2 = 0.10𝑘
𝑘 ∗ = 225 What is the level of capital that maximizes household consumption
𝑐?
5. Solve for steady state output, savings/investment,
consumption and depreciation. GENERAL SOLUTION FOR COBB-DOUGLAS PF
𝑦 ∗ = 150, 𝑖 ∗ = 22.5, 𝑑𝑒𝑝∗ = 22.5, 𝑐 ∗ = 127.5 Steady State Condition:
Δ𝑘 = 0
0 = 𝑠𝐴𝑘 𝛼 − 𝛿𝑘

Which implies
Numerical Example: Consider a hypothetical economy with the 𝛿𝑘 = 𝑠𝐴𝑘 𝛼
following production function
1 1 Solving for 𝑘 ∗
𝑌 = 10𝐾 (2) 𝐿2 𝑠𝐴
𝑘 1−𝛼 = 𝛿
𝟏
Savings rate is equal to 20% and depreciation is 10% per 𝒔𝑨 𝟏−𝜶
∗
annum. 𝒌 =( )
𝜹

Solve for the steady state 𝑦 ∗ , 𝑘 ∗ , 𝑖 ∗ , 𝑎𝑛𝑑 𝑐 ∗ . What happened to Note: Only true for Cobb-Douglas Production function specified
steady state 𝑘 ∗ when savings rate increased? above with no population growth and efficiency of labor
augmenting technology. May not be true for other production
function specifications.

Graphical Exercise:

Show graphically the impact of higher TFP (A) to:

A. Steady-state capital per capita (𝑦 ∗ )
B. Steady-state income per capita (𝑘 ∗ )
C. Stead state savings per capita (𝑠𝑦 ∗ )

Exercise: What if in the previous example, 𝐴 = 20 instead of 𝐴 =

10 i.e.,
1 1
𝑌 = 20𝐿2 𝐾 2
𝑠 = 0.20, 𝛿 = 0.10

Solow Growth Model: Steady State Equilibrium

Assume that the policy maker in the economy can influence the
What happens when savings rate increases? savings rate of households.
Suppose s increases:
𝑠1 > 𝑠 How do we maximize the consumption of households?
𝑠1𝑓(𝑘) > 𝑠𝑓(𝑘)

Breakeven/Required Investment What is the level of 𝑘𝑔∗ that maximizes consumption?

Numerical Example: Consider again the hypothetical economy

with the following production function
1 1 How do we make this level of capital per capita, 𝑘𝑔∗ the steady
𝑌 = 10𝐾 (2) 𝐿2
state given that we can influence savings?

Savings rate increases to 25 % and depreciation is still 10% per

annum.

Solve for the new steady state 𝑦 ∗ , 𝑘 ∗ , 𝑖 ∗ , 𝑎𝑛𝑑 𝑐 ∗ .

Does you answer confirm the graphical result?
 If the economy is initially at steady state with 𝑘 ∗ > 𝑘𝑔∗ , the policy
Recall at steady state: 𝑐(𝑘 ∗ ) = 𝑦 ∗ − 𝑠𝑦 ∗ maker can influence to decrease savings rate that will decrease
capital stock and move the economy to the new equilibrium
But since 𝑦 = 𝑓(𝑘 ∗ ) and 𝑠𝑦 ∗ = 𝑖 ∗ = 𝛿𝑘 ∗ consistent with the golden rule.
𝒄(𝒌∗ ) = 𝒇(𝒌∗ ) − 𝜹𝒌∗
Using our knowledge of optimization and calculus, we can Note: Unlike Steady State, economy does not automatically
achieve golden rule level. Intervention is needed
optimize the function 𝑐(𝑘) be getting its derivative and equating it
to zero.
𝑑𝑐
= 𝑀𝑃𝐾 − 𝛿
𝑑𝑘

Setting it to zero and re-aaranging TRANSITION TO GOLDEN RULE LEVEL OF CAPITAL

𝑴𝑷𝑲 = 𝜹
Starting from too much capital (𝒌∗ > 𝒌∗𝒈 )
For consumption to be at maximum, the marginal product of
capital and rate of depreciation must be equal. Graphically, this
means that the we should choose 𝑘𝑔∗ slope of production function
and depreciation must be equal.

Starting from too little capital (𝒌 < 𝒌∗𝒈 )

At 𝑘 ∗ MPK is higher than 𝛿. Flatter purple line than grey line.

The point at which the green line touches the PPF indicates the EFFECTS OF POPULATION GROWTH
level of capital where 𝑀𝑃𝐾 = 𝛿 How does population growth affect steady state?
Breakeven/Required investment function
𝑖𝑟 = 𝛿𝑘 + 𝒏𝑘
𝑖𝑟 = (𝛿 + 𝒏)𝑘
where 𝒏 is the rate of population growth. Capital accumulation
also changes to
Δ𝑘 = 𝑖 − (𝛿 + 𝑛)𝑘
 or defining 𝑀𝑃𝐾 − 𝛿 as net marginal product of capital, we get
Recall that steady state condition is: 𝑀𝑃𝐾 − 𝛿 = 𝑛
𝚫𝒌 = 𝟎 (Show as an exercise)

Hence, our new steady state condition with population growth is

𝒊 = (𝜹 + 𝒏)𝒌 SOLOW MODEL WITH LABOR AUGMENTING TECHNOLOGY
EFFICIENCY OF LABOR

Production function with efficiency of labor

𝑌 = 𝐹(𝐾, 𝐿 ∗ 𝐸)

Where 𝐸 stands for the efficiency of labor and 𝐿 ∗ 𝐸 is the

number of effective labor.

An increase in 𝐸 has the same effect as a corresponding

increase in laborer.
Cobb-Douglas:
𝑌 = 𝐴𝐾 𝛼 (𝐿 ∗ 𝐸)1−𝛼

Cobb-Douglas PPF:
𝑌 = 𝐴𝐾 𝛼 (𝐿 ∗ 𝐸)1−𝛼
Question: Is steady state capital per capita 𝑘 ∗ higher, lower, or
the same compared to steady state of model where 𝑛 = 0?
Per capita PPF
Question: In a model with population growth, at what rate is
𝑦 = 𝐴𝑘𝐸𝛼
income per capita growing? How about total output?
𝐾
Where 𝑘𝐸 is capital per effective worker (𝐿𝐸 )
Can population growth explain growth in income per capita? How
about total output?
Required investment equation
𝑖𝑅 = (𝛿 + 𝑛 + 𝑔)𝑘
Output per capita (𝑦) is no longer growing at steady state
ΔE
Where 𝑔 is the growth rate of efficiency of labor, that is 𝑔 = E
Total output (𝑌) is growing at rate 𝑛. Capital accumulation equation:
Δ𝑘𝐸 = 𝑖 − (𝛿 + 𝑛 + 𝑔)𝑘

Hence, although population growth can explain growth in total Steady-state equation:
output but not the growth in income per capita. 𝑖 = (𝛿 + 𝑛 + 𝑔)𝑘

What can explain growth in income per capita? How does the addition of 𝐸 change the steepness of 𝑖𝑅 curve?

What if population growth rate increases (𝒏𝟐 > 𝒏𝟏 )?

GOLDEN RULE LEVEL OF CAPITAL

Recall: Consumption can be expressed as

𝑐(𝑘𝐸 ) = 𝑓(𝑘𝐸 ) − (𝛿 + 𝑛 + 𝑔)𝑘𝐸

What is the Golden Rule Level of Capital with population

growth Optimizing, we get
𝑴𝑷 = 𝜹 + 𝒏 0 = 𝑀𝑃𝐾 − ((𝛿 + 𝑛 + 𝑔)
Which yields the analogous condition for maximum consumption
𝑴𝑷𝑲 = (𝜹 + 𝒏 + 𝒈)
Or
𝑴𝑷𝑲 − 𝜹 = 𝒏 + 𝒈