Lecture 2 - Economic Growth, More on Solow Model

and Growth Accounting

Mok W S

August 13, 2023

Reference

▶ Chapter 7, Economic Growth: Malthus and Solow.

▶ Chapter 8, Income Disparity Among Countries and Endogenous Growth.

Highlights

We will expand our earlier discussion with observations and intuitions

on Solow Model and Growth Accounting. We will only do a simple
overview of Endogenous Growth model.

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Solow Growth Model

Key model for modern economic growth theory based on capital

accumulation.
Key prediction (however) is that technological progress (z) is
necessary for sustained increases in the standard of living.
▶ There will be a steady state capital per worker that the economy will
converge to.
Model element:
▶ Consumers save a constant portion s of income which is used for
investment for capital accumulation.
▶ Production function consists of capital (K) and workers (N) as inputs
with TFP, z that is exogenous such that Y = zF (K , N).

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Solow Growth Model

Consumption-Savings Behavior

S = sY =⇒ C = (1 − s)Y

Population is assumed to be growing at constant rate n.

N ′ = (1 + n)N

Firms produce with an aggregate production function with constant

return to scale.
Y K
Y = zF (K , N) =⇒ = zF ( , 1) = zf (k)
N N

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Solow Growth Model
Future capital stock equals capital remaining after depreciation plus
current investment.
K ′ = (1 − d)K + I
Equilibrium (or Market Clearing) in the credit market implies

I = S = sY

This implies

K ′ = (1 − d)K + sY = (1 − d)K + szF (K , N)

Recontext the above in per capita quantity k, k’, f i.e.

K’=N’k’=(1+n)Nk’

(1 + n)k ′ = (1 − d)k + szf (k)

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Solving for equilibrium

The last equation can be rewritten as

(1 − d)k szf (k)

k′ = +
1+n 1+n
For there to be a steady state condition, the RHS must exhibit
concavity - which is fulfilled through f(k).
If steady state exists:

(n + d)k ∗ = szf (k ∗ )

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Per worker production function and Steady state
determination

Note concavity of f(.) representing diminishing returns i.e. f ′′ (.) < 0.

δF (K ,N) δf (k)
zFk = z δK
= MPK = z δk

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Solving the Steady State for the Solow Model -Alternate
solution
If we certain that there is a solution due to the concavity of the
transition function, we can also make use of the following equation
and diagram.
(n + d)k ∗ = szf (k ∗ )

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Analyzing the Solow Model

There are 4 parameters that we would like to investigate in the Solow

Model
▶ s, the effect of savings rate on the steady state.
▶ n, the effect of population growth on the steady state.
▶ z, the effect of a change in technology level on the steady state.
▶ d, the effect of a change in depreciation rate. (in homework set)
Given that steady state is given by the equation:

(n + d)k ∗ = szf (k ∗ )

We will need to use the earlier diagrams for analysis since we did not
specify the mathematical formulation for f (k ∗ ). We only impose the
condition of concavity.

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Analyzing the Solow Model

Before we analyze the effect of s, n and z, lets evaluate the intuition

behind the steady state equation in the Solow Model.
Steady State Equation

(n + d)k ∗ = szf (k ∗ )

szf (k ∗ ) represents the investment amount per capita. This needs to

match the amount of capital depreciated dk* and provide the capital
for the new worker per existing worker, nk*.
Diminishing return of f(k) implies that if a fixed fraction, s is saved
and k is below k*, the investment per worker exceeds (n+d)k and
increases k. Above k*, I /N = szf (k) < (n + d)k and k will decrease.
(Note : k* is not the result of an optimal decision).

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Effect of an increase in savings rate s

An increase in s increases the steady state k ∗ and y ∗ = zf (k ∗ ).

After steady state is reached, growth rates in aggregate variables, Y,
C, K are driven only by population growth (n) since per worker
quantities, y*, c* and k* are in steady state (i.e. stationary).
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Effect of an increase in savings rate at time T on Ln(Y)

note convergence to original growth rate, n.

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Golden rule for savings rate(which optimizes consumption
per capita)
What is the savings rate that will optimize the steady state standard
of living, c*? In equation wise:

max(1 − s)zf (k ∗ )
s

Such that the following condition holds i.e. steady state holds.

(n + d)k ∗ = szf (k ∗ )

Note s determines k* and vice versa. We can solve this using the
Lagrange method or by substitution of variables between s and k*.
Substituting out s with k* gives the FOC

zf (k ∗ ) − (n + d)k ∗ =⇒ zf ′ (k ∗ ) = n + d

max
∗k

We shall solve this diagrammatically in the next 2 slides.

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Steady state consumption per capita

Steady state c* can be varied by choosing s which shifts the lower

curve which will determine k*.
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Golden rule for savings rate

FOC condition to coincide with steady state condition by varying s until the gradient of
zf(k*) satisfy the condition.
zf ′ (k ∗ ) = n + d

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Notes on Golden Rule for Savings

Policy impact of Golden Rule: The Golden Rule has only importance
in theory, generally no policy will be made to adjust the savings rate.
Some reasons being the free movement of capital in the credit market
is generally efficient without interference. This includes international
borrowing which means that investment will not be at the expense of
consumption. However, excessive international borrowing is not
prudent as it has resulted in past crisis before (Asian Financial Crisis).
Policies on promoting investment spending however are important as
well as policies to pre-empt financial crisis arising from loose credit.

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Effect of an increase in Population Growth, n

k*, y*= zf(k*) and c*=(1-s)zf(k*) will decrease given s(i.e fix).
Aggregate variables will grow at the new rate, n after steady state is
reached.
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Effect of increases in TFP, z

An increase in z raises steady state k*, y* and c*. Sustained growth

rate in z implies persistent growth in k*, y* and c*.
Aggregate variables, Y, C, K will grow at the sum of the rate of
population increase, z growth rate and the induced growth rate in k*.
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Summarizing the effects of s, n and z

A higher savings rate, s increases steady state k* and per capita

income y* - this is inline with cross country observations that
investment rate correlates with per capita income.
A higher population growth rate n, decreases steady state k* and per
capita income y* - this is inline with cross country observations that
per capita income y* is negatively correlated to population growth
rate.
A higher technology z increases steady state k* and per capita
income.
Because there are limits to increases in s and decreases in population,
only sustained increases in z can lead to sustained increases in per
capita income. However, z is exogenous to the model and there is no
proposition to its origin.

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Convergence of growth rate in the Solow Model Prediction

At steady state,
szf (k ∗ ) = (n + d)k ∗
Countries with the similar z (assume z is constant) and population
growth rate n will converge towards the same steady state k*.
(depreciation rate d is the same).
If we assume that productivities are the same amongst countries and
increase at the same sustained rate which results in a sustained per
capita growth, then all countries will grow at the same rate if they
have the same k*.
Poorer countries (measured by per capita income) will grow faster as
they catch up in k*.

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Rich and Poor Countries - transition to steady state

Poor country with k=kp and rich country with k=kf .

As per previous notes, draw the staggered transition to show k’ for
poor country shows a larger increment.
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Rich and Poor Countries - Convergence to same y* across
countries in Solow Model without z increase

Standard Solow model with no sustained growth, y will converge to

y*. Pace of growth for poor country is faster as it does catch up.
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Rich and Poor Countries - Convergence in Aggregate
Output across countries in Solow Model

Standard Solow model with no sustained z growth, Y will converge to

the population growth rate, n. Pace of growth for poor country is
faster as it does catch up in capital accumulation.
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Persistent Differences Across Countries in Per Capita
Income (in reality)
We explain that differences in z drives the difference in per capita
income across countries. The causes of the difference in z are
▶ Technology diffusion takes time for technology to spread to poor
countries. Additionally, countries have different technology adoption
rates because of differences in human capital (education and training)
of the workers, culture etc.
▶ Additional barriers to technology adoption. This can be in the form of
protectionism. Countries with technology knowledge sanctions
technology transfers e.g. current semi-conductor industry sanctions
against China by the Biden admin. Or it could be protection for
domestic industry leading to poor adoption of new technology.
▶ Inefficient allocation of factors of production within a country. This
could be because of corruption or simply existing structure like state
own enterprise versus private enterprises resulting in less efficient
sectors receiving more capital investment.

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Differences in TFP resulting in disparity in income per
worker across countries

Countries with different level of z have different levels of k* and y*.

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Endogenous Growth: Human Capital Accumulation

A model of human capital accumulation that models human capital

accumulation as the driver for growth that is sustained.
▶ Human capital refers to the increase in productivity of a worker that is
related to the training and education that a worker acquires.
▶ Proposes that human capital acquisition does not suffer from
diminishing marginal returns and grows linearly with time and a
fraction of the worker’s time is spent on human capital accumulation.
▶ The production function with human capital as input does not suffer
from diminishing return.
▶ This results in sustained growth in per capita income.
This model emphasizes the importance of education and skills training
on economic growth and has implications on government policies.

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Growth Accounting

We want to attribute the contribution to economic growth to

(1)growth in the factors of production (K,N) and (2)TFP (z).
We use measurements of aggregate inputs and outputs and an
estimate of z using
A production function in the form of the Cobb Douglas Production
function:
Y = zK 0.3 N 0.7

▶ The parameterization reflects labor and capital share of factor incomes

which is fairly stable (except recently).
▶ A Cobb-Douglas Production Function is of the form:

Y = zK α N 1−α

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Solow Residue
The estimate of ln z (Solow Residual) is computed from the Cobb Douglas Function and
plotted in the graph below. (ignore the wrong y-axis label - it should be natural
logarithmn of z - williamson error)

Y
z=
K 0.3 N 0.7

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Growth Accounting - Practical Issues

Measurement issues related to GDP

▶ Different types and qualities of goods and services at any one time and
over time.
▶ Underground economy.
Measurement issues for K and N.
▶ Aggregating K and N over the differences in types and quality/skills.
▶ K includes plants and buildings, machineries and computers whereas
workers include workers in factories, programmers and developers.
Breakdown of labor share and return to capital ratio in recent years.
Labor share (1 − α) has trended down in recent years. (One
proposition is that this is due to globalisation which suppresses
wages).

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Annual Growth Rates in Solow Residue

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Annual Growth Rates - Factors and Solow Residue

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Annual Growth Rates - Factors and Solow Residue(Notes)

1960-1970, high growth rate(in %) is due to all factors growing.

1970-1980, growth rate is attributed to increase labor participation
rate due to the increase in women participation in the workforce.
2000-2009, captures the Great recession of 2008-2009.
2009-2014, recovery phase however shows low growth rate in Y(2.1%)
and also in K and N. (Jobless recovery, manufacturing plants
relocation)

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Annual Growth Rates - Factors and Solow Residue(Notes)

Short notes on how we calculate average growth rate of a variable

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Annual Growth Rates - Factors and Solow Residue(Notes)
To get the average annual growth rate over 1 decade from 1950 to
1960:
X1960 ∗
X1960 = (1 + g )10 ∗ X1950 =⇒ (1 + g )10 =
X1950
Note 10 = 1960 − 1950 so the growth is compounded over 10 years.
 X1960 1
g= 10
−1
X1950
Alternately we use (ln) transformation and 1st order Taylor series:
From earlier *, for small g compared to 1,
X1960 1  X1960
10ln(1 + g ) = ln =⇒ g ≊ ln(1 + g ) = ln
X1950 10 X1950
We take the difference in ln quantities and divide by the time period.

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What is a good measure of the well being of an average
person? Is GDP per capita a good measure?
GDP per capita does not capture several important aspects.
▶ Income inequality - recent labor share of income has declined and
structural unemployment with the shift from manufacturing to IT,
globalisation impacted income distribution.
▶ Value of leisure is not accounted for. Work/Leisure decision is the
outcome of optimization choices.
▶ Value of the state of health of an average person is also not accounted
for. But longevity is an important aspect of assessing well being.
Environmental factors like pollution and exposure to toxic chemicals in
working environment are also not taken into account.
▶ Savings and income from savings and investment. Some argue that
Gross National Income which includes income from interests payment
from abroad is used as a better measure to account for interest income
and company profits from abroad (or interest payment for debtor
countries). Japan as an example.

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