The Basic Solow Model

Myung-Ho Park
 “All theory depends on
assumptions which are not quite
true. That is what makes it
theory. The art of successful
theorizing is to make the
inevitable simplifying assumptions
in such a way that the final
results are not very sensitive.”
(A Contribution to the Theory of Economic Growth,
QJE, V.70, No.1 (1956), p.65)

- Robert Solow, winner of the Nobel Prize in Economics in 1987

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<Outline>
1. The Basic Solow Model
1.1 Introduction
1.2 Setting up the model (Basic elements of the Solow model)
1.3 Solving the Model
1.4 The Solow Diagram
1.5 Properties of the Steady State
1.6 Economic Growth in the Basic Solow Model
1.7 Comparative Statics
1.8 The Golden Rule of Capital Accumulation

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1. Introduction
□ Think of two countries’ experience in economic growth.
○ In 1960, the two countries (A and B) were similar in many aspects.
­ Both were relatively poor:
· GDP per capita was about $1,500 in both countries, around 10% of the U.S. level.
­ Both had populations of about 25 million, about half of whom were of
working age.
· Similar fractions of the population in both countries worked in industry
and agriculture.
­ College enrollment rates were about 5% (in A) and 15% (in B), respectively.
○ In 2014, country A’s per capita GDP approached $35,000, more than 2/3
the U.S. level.
­ In contrast, country B’s per capita GDP was only $6,600, less than 20% of
Country A’s level.

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 ○ Between 1960 and 2014, the paths of these two countries diverged
dramatically.
­ In country B, per capita GDP grew at a relatively modest rate of about 2.4%
per year.
­ In contrast, country A became one of world’s fastest-growing economies,
with growth of more than 6% per year.

Q: How do we understand this astounding difference in economic performance

between these two countries that on the surface looked relatively similar?
Why was growth in Country A so much faster than that in Country B?

⇒ The starting point in economics for thinking about these questions is what’s
known as the Solow growth model.

Q: Do you know the countries A and B represent?

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□ The Solow growth model was developed in the mid-1950s by Robert Solow of MIT
and was the basis for the Nobel Prize he received in 1987.
○ Since the 1950s, the model has been extended in a number of important
directions and is now probably the most widely used in all of
macroeconomics.

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□ 7 stylized facts of economic growth and development presented in Ch. 1.
○ Fact 1 : There is enormous variations in per capita income across economies.
­ For example, the poorest countries have per capita incomes that are less
than 5% of per capita incomes in the richest countries.

○ Fact 2 : Rates of economic growth vary substantially across countries.

○ Fact 3 : Growth rates are not generally constant over time.

­ For the world as a whole, growth rates were close to zero over most of
history but have increased sharply in the 20th century.
­ For individual countries, growth rates also change over time.

○ Fact 4 : A country’s relative position in the world distribution of per capita

income is not immutable.
­ Countries can move from being “poor” to being “rich,” and vice versa.

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○ Fact 5 : In the United States over the last century,
① the real rate of return to capital,  , shows no trend upward or downward.
② the shares of income devoted to capital,   and labor,    show no
trend (neither); and
③ the average growth rate of output per person has been positive and
relatively constant over time – that is, the U.S. exhibits steady, sustained
per capita income growth.

○ Fact 6 : Growth in output and growth in the volume of international trade are
closely related.

○ Fact 7 : Both skilled and unskilled workers tend to migrate from poor and to
rich countries or regions.

⇒ In Ch. 2, we develop the model proposed by Solow and explore its ability
to explain the stylized facts of growth and development discussed in Ch. 1.

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□ Key Simplifying Assumptions of the Solow Model
○ (A1) Countries produce and consume only a single, homogeneous good.
⇒ There is no international trade in the model.
○ (A2) Technology is exogenous.
⇒ The technology available to firms is unaffected by the actions of the firms,
including research and development (R&D).
○ (A3) Individuals save a constant fraction (  ) of their income and work a
constant fraction of their time.
⇒ We don’t have to solve how much to save for consumption in the
future and how much time to spend working in the labor market.
○ (A4) All of the inputs to the production function are grouped into two
categories, labor (  ) and capital (  ).
­ Examples of capital: bulldozers, semiconductors, whiteboards, desks, video projectors, etc.
­ Examples of labor: # of engineers, # of steel-workers, # of instructors, etc.

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○ (A5) The production function takes the Cobb-Douglas form with the
constant returns to scale:             
⇒ If all of the inputs are doubled, output will exactly double.

○ (A6) There is perfect competition in the input and output markets.

⇒ There are a large number of firms/consumers in the economy and the
firms/consumers are price takers.

○ (A7) Population growth is exogenous (  ) and the labor force participation

rate is 100%.
⇒        &        for all  .

○ (A8) The capital stock decays at a constant rate (  ).

⇒ During the production process, the capital stock wears out at a
constant rate every period regardless of how much output is produced.

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2. Setting up the Model – ① Production Function & Resource Constraint
□ Production Function
○ The Cobb-Douglas production function:

(2.1)             ,     

­ This production exhibits constant returns to scale:

※ Recall that if       for any number    , then we say that the
production function exhibits constant returns to scale.

□ National Income Identity

○ The output can be used for one of two purposes, consumption or investment:

     .
○ This equation is also called a resource constraint: it describes a
fundamental constraint on how the economy can use its resources.

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<Returns to Inputs>
○ Normalizing the price of output to unity, profit-maximization firms solve
the problem:
max         

­ Note that the price of capital,  , is the rental price, not the asset price.

○ The first-order conditions:

∂ 
    
∂    
 



∂ 
        
∂     
      .


­ Profit maximization implies that real input prices are equated to marginal
products of labor and capital respectively.

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<Implications>
1. Input payments completely exhaust the value of output produced so that
there is no economic profits to be earned:
     .

2. The marginal product of capital (labour) declines as capital (labour) is

increased, holding the other input constant:

   
          

∂   
 
          .
∂

3. Input shares are constant over time.

 
   ;   .
 

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② Evolution of Capital
□ The capital accumulation equation :

(2.3)       ,   .

○ This equation shows that the capital stock grows through investment but
also declines due to physical decay at the constant rate,  .
­ Here,  is a parameter. Think of corn gradually going moldy in the barn or
being gradually being eaten up by rats and mice.

○
 = the (instantaneous) rate of change in the capital stock over time


= .

○ The initial level of capital is given by history:
    .

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③ Household Behavior
□ Allocation of resources and Investment
○ By the assumption # 3, households save a constant fraction,  , of their
combined wage and rental income,      .
­ Because of the national income identity, they consume a constant fraction,
    , of their income,
○ The assumption # 1 implies that the economy is closed, i.e., there is no
trade in this model.
○ These two assumptions imply that investment  , equals savings  :
   ⇒    ,      .
­ Notice that the only use of investment in this economy is to accumulate
capital for future production.

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□ Labor supply
○ By assumptions (A7 & A3), population grows at a constant, exogenous
rate, and households devote a constant fraction of their time to work.

    ,

where    .


※ The labor force participation rate is assumed to be constant at 100%. So the

population growth rate is equal to the labor force growth rate.

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④ Summary
□ The basic Solow model consists of the following 5 equations and 5 unknowns:
(1) (Production function)      
(2) (Capital accumulation)     
   

(3) (Labor force)    

(4) (Recourse constraint)     
(5) (Allocation of resources)    .
○ 5 unknowns(endogenous variables):         

□ For the basic Solow model, we have 6 parameters:       

○  and  relate to capital, while  and  relate to household behavior.
○  and  represent two initial conditions,      and      .

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3. Solving the Model
□ Solving the model means obtaining the values of each endogenous variable
when given values for the exogenous variables and parameters.
○ So, the solution gives the time path of the endogenous variables (  ,  ,

 ,  ), starting from their given initial values.

­ The number of workers,  is given by the assumption #7(A7) and its initial

value:

   
○ Ideally, one would like to be able to express each endogenous variable as
a function only of exogenous variables and parameters.
○ Sometimes this is possible; other times a diagram can provide insights
into the nature of the solution, but a computer is needed for exact
values.

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< How to derive a solution for the basic Solow model?>

□ Step 1: Substituting from equations (1) and (5) into (2) and dividing
through by  :
    

             
⇒ 
↑ ↑
(5) (1)
  

⇒   

 
     


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□ Step 2: Now put all variables into per person terms:
 
 ≡  and  ≡ 
 
○ This is done to simplify the solution, but we are most interested anyway
in output and consumption per capita.
○ Here,  = output per person,  = capital per person.
○ The growth rate of output per person:

     
⇒   
     

 

(2.2) ⇒  ⇒   
 

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○ The growth rate of output per person:
 

 ⇒ log    log  ⇒     .
 

○ The growth rate of capital per person:


   ⇒ log   log   log 

 
  

⇒        
   

 
( ⇒     ).
 

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□ Step 3: Rewrite the capital accumulation equation in per person terms
○ From Step 1, we can rewrite the capital accumulation equation as follows:


            .


 
○ In per head terms (substitute in     ), this becomes:
 
 


   


   

 
∴   


 
     ⇒         .
  
­ This is a non-linear, first-order differential equation for  . Because it is
non-linear, we wouldn't normally be able to solve it explicitly. Fortunately, it
turns out that we can actually solve this particular differential equation
explicitly(See the appendix of Ch 2). But a graphical solution yields more insight.

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NB: From the growth rate of capital per worker, we can derive the capital
accumulation equation in per worker terms:
       .
­ The (instantaneous) rate of change in capital per worker is determined by
three terms.
­ Two of the terms are analogous to the original capital accumulation
equation. Investment per worker,  , increases  , while depreciation per
worker, , reduces  .
­ The new term,  , reduces  . Each period, there are  new workers
around who were not there during the last period. If there were no new
investment and no depreciation, capital per worker would decline because of
the increase in the labor force. The amount by which it would decline is
 to zero:
exactly  , as can be seen by setting 
  
 
   ⇒      ⇒     ∵ 
  .
   

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4. The Solow Diagram
□ We derived the two key equations of the Solow model in terms of output
per worker and capital per worker:
(2.4)   

(2.5)        

□ Fundamental questions of the model to ask

○ Given 6 parameter values for       and  ,
­ How does output per worker evolve over time in this economy?
· (that is) How does the economy grow?
­ How does output per worker compare in the long run between two
economies that have different investment(saving) rates,  ?

⇒ These questions are most easily analyzed in a Solow diagram!!!

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□ These two equations can be graphed as follows.

○ Figure 2.1 plots the production

function, where the curvature is
due to the assumption of
diminishing returns.
­ The slope, which represents the
marginal product of capital per
worker is positive and decreasing
in .
­ In the Cobb-Douglas case, these
reflect the assumption that    .

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 ○ Figure 2.2 shows a Solow diagram.
­ The Solow diagram consists of two
curves, plotted as functions of
capital per worker,  .
­ The first curve represents the
amount of investment per worker,
  . This curve has the same
shape as the production function in
figure 2.1, but it is translated down
by the factor  .
­ The second curve is the line
   , which represents the
○ amount of new investment per
worker required to keep the amount
of capital per worker unchanged.

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○ Notice that the difference between these two curves is the rate of change

in capital per worker, .


­ When this rate of change is positive (i.e. when    ) and the economy is
increasing its capital per worker, we say that capital deepening is occurring.
­ When this rate of change is zero but the actual stock of  is growing, we
say that only capital widening is occurring.

○ Any time an economy is away from the steady-state capital-labor ratio

( ), forces will naturally return the economy to the steady state.

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□ The Solow diagram shows the steady-state value of capital per worker.
○ Suppose an economy has capital equal to the amount of  today.
⇒ At  , the amount of investment per worker exceeds the amount
required to keep capital per worker constant.
⇒ The term  is positive, and therefore capital per worker increases over
time(⇔ capital deepening occurs).
⇒ This capital deepening will continue until   , at which point
      so that   .
⇒ At this point (   ), the amount of capital per worker remains constant
over time, and we call such a point a steady state.

Q1: What would happen if the economy began with capital per worker larger
than ?
Q2: How do you re-plot the Solow diagram in terms of the growth rate of  ?

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         ○ The  curve slopes down and is
FYI:
convex since    . The    curve
⇒         (2.6)
is just a horizontal line, since it is a
constant (doesn't vary with  ).
○ The  curve approaches zero as 
rises and approaches infinity as 
falls. So it must cut the    line
from above.

○ At  , the growth of capital per worker
is zero. The arrows indicate that this
is a stable solution: capital per worker

is growing to the left of  , falling to

the right of  .

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□ Given , we can calculate the steady-state value of output per worker.
○ Substituting    into the production function,    yields the

steady-state output per worker,    .

○ The steady-state investment

(or saving) per worker is

calculated as  .
○ The steady-state consumption
per worker becomes:

          

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4. Properties of the Steady State

□ The Steady-state quantities of  and 

○ By definition, the steady-state value of  is determined by the condition

that   .
○ How to derive the steady-state value of ?
­ Substituting from (2.4) into (2.5) and then setting it equal to zero reveal:
                  


⇒       

⇒      

  

⇒   

 
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○ How to get the steady-state value of  ?
­ Substituting the steady-state value of  into (2.4) yields:

   ⇒    
  

⇒   

 

○ Notice that in the steady state, the endogenous variables are written in
terms of parameters of the model.
⇒ We have a “solution” for the model, at least in the steady state.

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□ Predictions of the basic Solow model
○ Countries with high saving(or investment) rates will tend to be richer,
ceteris paribus.
­ Such countries accumulate more capital per worker, and countries with
more capital per worker have more output per worker.
○ In contrary, countries with high population growth rates will tend to be
poorer, ceteris paribus.
­ A higher fraction of investment in these countries must go simply to keep
capital per worker constant in the face of a rising population.
⇒ This capital-widening requirement makes capital deepening more difficult,
and these countries tend to accumulate less capital per worker.

Q: How well do these predictions of the Solow model hold up empirically?

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A: These figures imply that broadly speaking, the general predictions of
the Solow model seem to be supported by the data.

- 34 -
5. Economic Growth in the Basic Solow Model

□ Growth rates in the steady state of the basic Solow model

○ In the steady state (SS), the endogenous variables,  and  are constant
at  and  , respectively. => NO GROWTH in the steady state.
­ Since both  and  are constant in the SS,  is constant at     in
the SS.
­ So it generates a constant interest rate, i.e. the constant marginal product
of capital in the SS.
     
 
     
 
⇒ This result fits the stylized fact # 5-1: In the U.S. over the last century,
the real rate of return to capital,  , shows no trend upward or
downward.

- 35 -
○ Since  and  are constant in the steady state, there is no per capita
growth in the steady state of the basic Solow model.
⇒ This result does not fit the important stylized fact # 5-3: Economies
exhibit sustained per capita income growth.

○ But, the actual capital stock,  , and output,  , are growing at the rate
of population growth,  .

- 36 -
□ Growth rates along the transition path to the steady state

Q: What would happen if an economy began with capital per worker smaller
than ?

○ A : Since the economy begins with a stock of capital per worker below its
steady-state value,
­ The economy will experience growth in  and  along the transition path to
the steady state.
­ However, growth slows down over time as the economy approaches its
steady state, and eventually growth stops altogether.

- 37 -
○ Consider the following two equations:
­ Rewrite the capital accumulation equation in terms of the growth rate of :


(2.6)        


· Since  is less than one(⇒ diminishing returns to capital accumulation), as

 rises, the growth rate of  gradually declines.
­ The growth rate of  is proportional to the growth rate of .
 

 ⇒   
 
· Thus, as  rises, the growth rate of  gradually declines, too.

- 38 -
­ Figure 2.8 Transition Dynamics

        ○ The  curve slopes down and is

(2.6)
convex since    . The    curve
is just a horizontal line, since it is a
constant (doesn't vary with  )

○ At  , the growth of capital per

worker is zero. The arrows indicate
that this is a stable solution: capital

per worker is growing to the left of  ,

and falling to the right of  .
○ This figure indicates that the further

an economy is below(above) its  , the
faster the economy grows(declines).

- 39 -
○ Typical transition paths for  (and  )

­ Notice that when the economy is far from steady state, it will move there
quickly, but as it gets closer to steady state, the process slows down.

- 40 -
6. Comparative Statics

□ In economics, comparative statics is the comparison of two different

equilibrium states, before and after a change in some underlying exogenous
parameters.
○ As a type of static analysis, it compares two different equilibrium states,
after the process of adjustment.
○ It does not study the motion towards equilibrium, nor the process of the change
itself.

- 41 -
□ In this analysis, comparative statics shows the response of the Solow model
to changes in the values of various parameters.
○ We will examine what happens to endogenous variables ( ,  ,    ,
and  ) in an economy that begins in steady state but then experiences a
“shock.”
­ Examples of the shocks we will consider:
① an increase in the investment rate, ,
② an increase in the population growth rate,  .

- 42 -
□ An Increase in the Investment Rate, 
○ Consider an economy that has arrived at its steady-state value of output
per worker.
­ Suppose that the consumers in that economy decide to increase the
investment rate permanently from  to some value ′.

Q: What happens to  and  in this economy?

- 43 -
 ① ↑in  shifts the  curve upward
to ′ .

 
② 


  
     ⇒↑

③ This capital deepening continues

until  reaches a new steady-state
 
level,  (  ).
  
④       can be found

at    .

 
Q:  □  ? > or <

- 44 -
 <The transition dynamics with an increase in the investment rate>

◎ ↑in  to ′ raises the growth rate temporarily as the economy transits to the new SS, 

- 45 -
The effect of an increase in investment rate on 

- 46 -
○ Summary of the effect of an increase in the investment rate:
­ According to comparative statics in the basic Solow model, a high
investment rate yields a high steady-state level of output per worker.
­ According to the transition dynamics, an increase in the investment rate
causes a period of rapid growth, but growth slows down along the transition
path as the new steady state is reached.
­ Thus, the basic Solow model implies that although a high investment rate
yields a high steady-state level of output per worker, saving by itself cannot
generate sustained economic growth.

- 47 -
□ An Increase in the Population Growth Rate, 
○ Consider an economy that has arrived at its steady-state value of output
per worker.
­ Suppose that the population growth rate of the economy rises form  to ′
because of immigration.

Q: What happens to  and  in this economy?

- 48 -
 ① ↑in  rotates the     line
up and to the new line ′   .

 
② 


  
 ′    ⇒ ↓

③ This decline continues until 

reaches a new steady-state level,

 ( ).
  
④       can be found

at    .

 
Q:  □  ? > or <

- 49 -
<The transition dynamics with an increase in population growth>

The effect on  The effect on the growth rate of  The effect on 

- 50 -
7. The Golden Rule of Capital Accumulation
□ Using the Solow model, we will discuss what amount of capital
accumulation is optimal from the standpoint of economic well-being.
○ So far, we have used the Solow model to examine how an economy’s rate
of investment determines its steady-state levels of capital per worker and
output per worker.
○ This analysis might lead you to think that higher saving is always a good
thing, for it always leads to greater per capita income.
○ Yet suppose an economy had a saving rate of 100%. That would lead to
the largest possible capital stock and the largest possible income.
○ But if all of this income is saved and none is ever consumed, What good
is it?

- 51 -
□ Definition: The steady-state level of  that maximizes consumption per
worker is called the Golden Rule level of capital per worker and is
denoted .
○ To keep our analysis simple, let’s assume that a policymaker can set the
economy’s saving rate at any level.
­ By setting the saving rate, the policymaker determines the economy’s steady
state.
○ In addition, the policymaker’s goal is to maximize the well-being of the
individuals who make up the society.
­ Individuals themselves do not care about the amount of capital in the
economy, or even the amount of output. They care about the amount of
goods and services they can consume.
○ Thus, the benevolent policymaker would want to choose the steady state
with the highest level of consumption per worker.

- 52 -
□ How can we tell whether an economy is at the Golden Rule level?
○ First, we must determine steady-state consumption per worker.
○ Second, choose a rate of savings to maximize the steady-state
consumption per worker.

1. Steady-state consumption per worker,  can be written as:

                     

↑ ↑ ↑
① ② ③
① By the national income accounts identity

② In steady state,    ⇔      

③ By the assumption of C-D production function with CRTS

- 53 -
2. Choose  to maximize steady-state consumption per worker, 
max   


 

 

⇔ max       , where   
 
­ The FOC for  :
∂       ∂

∂
   ⇔          
∂ ∂ ∂
⇒           (⇔      )


 


⇒    (Golden Rule level of )
 
 

 
 
 
 
 

⇒   
 
⇒   

- 54 -
○ The following figures show that steady-state consumption per worker and
Golden Rule of consumption per worker.

<Steady-State Consumption per Worker> <Golden Rule Consumption per worker>

If   ′ , then    &    If   ′ , then    &    .

- 55 -
○ These figures show that there is one level of the capital per worker – the

Golden Rule level of capital per worker,  - that maximizes consumption

per worker.

­ The Golden Rule level of capital per worker,  , is produced by only one

saving rate, ′ .
­ Any change in the saving rate would shift the    curve and would move
the economy to a steady state with a lower level of consumption per worker.

- 56 -
□ The Transition to the Golden Rule Steady State
○ Consider the economy with too much capital per worker,    .

- 57 -
­ Note that, compared to the old steady state, consumption per worker is
higher not just in the new steady state but also the entire path to it.
­ When the stock of capital per worker exceeds the Golden Rule level,
reducing saving rate is clearly a good policy because it increases
consumption per worker at every point in time.

- 58 -
○ Consider the economy with too little capital per worker,    .

- 59 -
­ Because the initial steady state was below the Golden Rule, the increase in
saving rate eventually leads to a higher level of consumption per worker
than that which prevailed initially.
­ But achieving that new steady state requires an initial period of reduced
consumption per worker. That is, reaching the Golden Rule requires initially
reducing consumption to increase consumption in the future.
­ When deciding whether to try to reach the Golden Rule steady state,
policymakers have to take into account that current consumers and future
consumers are not always the same people.
­ Reaching the Golden Rule achieves the highest steady-state level of
consumption per worker and thus benefits future generations. At the same
time, reaching the Golden Rule requires raising investment and thus lowering
the consumption of current generations.

- 60 -
­ Thus, when choosing whether to increase capital accumulation, the
policymaker faces a tradeoff among the welfare of different generations.
­ If a policymaker cares about all generations equally, she will choose to
reach the Golden Rule. Even though current generations will consume less,
an infinite number of future generations will benefit by moving to the Golden
Rule.
­ Thus, optimal capital accumulation depends crucially on how we weigh the
interests of current and future generations.
­ The biblical Golden Rule tells us, “do unto others as you would have them
do unto you.”
­ If we heed this advice, we give all generations equal weight. In this case, it
is optimal to reach the Golden Rule level of capital per worker – which is
why it is called the “Golden Rule,”

- 61 -