Professional Documents
Culture Documents
Solow SL
Solow SL
L. Hendricks ()
Solow Model
1 / 51
In the production model capital is exogenous. We learn how much capital matters, but we cannot learn why some countries lack capital. We need a model with capital accumulation (investment, saving). That also answers the question: Does capital drive long-run growth?
L. Hendricks ()
Solow Model
2 / 51
The Model
We add just one piece to the production model:
an equation that describes how capital is accumulated over time through saving.
Time is discrete: t = 1, 2, 3, ... Production function (cf Production model): Yt = F (Kt , Lt ) = AKt L1 t
(1)
L. Hendricks ()
Solow Model
3 / 51
The Model
Or Kt
= Kt + 1 Kt = I dKt
(4) (5)
L. Hendricks ()
Solow Model
4 / 51
Capital accumulation runs out of steam - with constant It the growth of K slows down.
L. Hendricks ()
Solow Model
5 / 51
Choices
People make two fundamental choices (in macro!):
1 2
Work: we assume L is xed. Consumption / saving: We assume that people save a xed fraction of income: Ct = (1 s ) Yt (6) Equivalently: It = sYt (7)
L. Hendricks ()
Solow Model
6 / 51
Model Summary
The rental prices of K and L are the same as in the production model (w and r ).
L. Hendricks ()
Solow Model
7 / 51
Even this simple model cannot be "solved" algebraically. That is, we cannot write the endogenous variables as functions of the parameters. This is almost never possible in dynamic models.
Dynamic means: there are many time periods. All interesting macro models are dynamic.
What we can do is
1 2
graph the model and trace out qualitatively what happens over time. solve the model for the long-run values of the endogenous variables (e.g. Kt as t ! ).
L. Hendricks ()
Solow Model
8 / 51
We condense the model into a single equation in K . It will be a dynamic equation that tells us Kt +1 as a function of Kt . Then we graph the equation.
L. Hendricks ()
Solow Model
9 / 51
= sYt = AKt L1 t
+ (1
d ) Kt dKt
(9) (10)
L. Hendricks ()
Solow Model
10 / 51
L. Hendricks ()
Solow Model
11 / 51
Steady state
Denition
A steady state is an equilibrium in which all (per capita) variables are constant over time. Figure 5.1 shows:
1
2 3
The economy converges to the steady state for any initial K0 . For the economy to grow, it must be on the transition path to the steady state.
L. Hendricks ()
Solow Model
12 / 51
Steady state
Why does the economy settle in a steady state instead of growing forever? The reason is diminishing returns to capital in production. Recall K = sY dK . Save a constant amount each period (constant I = sY ). It contributes less and less to output (falling marginal product of K falling Y ). It adds the same amount to depreciation.
L. Hendricks ()
Solow Model
13 / 51
Steady state
Why does the economy settle in a steady state instead of growing forever? The reason is diminishing returns to capital in production. Recall K = sY dK . Save a constant amount each period (constant I = sY ). It contributes less and less to output (falling marginal product of K falling Y ). It adds the same amount to depreciation. Note: this is not quite right!
With constant s we have rising I over time. And if K falls over time, so does the additional depreciation.
L. Hendricks ()
Solow Model
13 / 51
L. Hendricks ()
Solow Model
14 / 51
Set Kt = 0 to obtain sY = s AK L1
= dK
(11)
or with 1/ (1
1/(1 k = K /L = [s A/d ]
(12)
) = 3/2.
L. Hendricks ()
Solow Model
15 / 51
(13) (14)
)
(15) (16)
1/(1 )
L. Hendricks ()
Solow Model
16 / 51
Reality check
A key prediction of the model: sY = dK or K /Y = s/d. Countries with higher saving rates have higher capital output ratios.
L. Hendricks ()
Solow Model
17 / 51
[s/d ]/(1
(18)
L. Hendricks ()
Solow Model
18 / 51
= 23 /2 = 2.8.
In the Solow model, the contribution of A to output gaps is larger why? Draw a picture...
L. Hendricks ()
Solow Model
19 / 51
Our previous answer was: K /L accounts for a factor near 4. In the Solow model: yUS ypoor AUS poor A 32 = 16 2
3/2 1/2
sUS spoor
(19) (20)
Why factor 2 for saving rates? Because s (or K /Y ) diers by a factor near 4.
L. Hendricks ()
Solow Model
20 / 51
This is a central and robust result: Capital accumulation accounts for only a small fraction of cross-country income gaps.
L. Hendricks ()
Solow Model
21 / 51
Long-run Growth
There is no long-run growth in the Solow model. The reason is diminishing returns to capital. This is perhaps the central lesson from the model:
Fact
Capital accumulation is not a source of long-run economic growth. How does this square with the fact that politicians always talk about promoting growth through investment?
L. Hendricks ()
Solow Model
22 / 51
We want to understand how the economy responds to changes in certain parameters. This is useful for understanding short-term growth experiences of countries. We will come back to that when we talk about business cycles, too.
L. Hendricks ()
Solow Model
23 / 51
L. Hendricks ()
Solow Model
24 / 51
L. Hendricks ()
Solow Model
25 / 51
L. Hendricks ()
Solow Model
26 / 51
The model says: more investment (or lower consumption) generates a period of faster growth. Isn everybody saying: the U.S. is in a recession (slow growth) t because consumption is too low? How does the contradiction get resolved? Where is the eect of lower consumption demand in the Solow model? Where is the demand side anyway?
L. Hendricks ()
Solow Model
27 / 51
L. Hendricks ()
Solow Model
28 / 51
L. Hendricks ()
Solow Model
29 / 51
L. Hendricks ()
Solow Model
30 / 51
Fact
In the Solow model, the farther away the economy is from its steady state, the faster it grows (or shrinks) Why is this true? Look at the examples of rising s or rising d - the growth rate of Y rises / falls over time. But we should derive this algebraically ...
L. Hendricks ()
Solow Model
31 / 51
The claim: the growth rate of K (Kt /Kt ) increases with the gap between current and steady state capital (K /Kt ). Proof: The law of motion for K is Kt Yt =s Kt Kt Sub in the production function: Kt = s AK Kt
1 1
(21)
(22)
L. Hendricks ()
Solow Model
32 / 51
Sub in K = (K /K ) K : Kt = s A (K /K ) Kt
1
(K )
L1
(23)
Everything on the RHS (incl. K ) just depends on parameters, except for K /K . Plot that ...
L. Hendricks ()
Solow Model
33 / 51
Empirical Evidence
Countries that were poorer in 1960 grew faster after 1960. We could do the same with K /L instead of Y /L on the horizontal axis.
L. Hendricks () Solow Model September 17, 2009 34 / 51
Empirical Evidence
Should we conclude that transitional growth explains cross-country dierences in output growth? No! Figure 5.8 only shows OECD countries - mostly rich Western European countries + North America.
L. Hendricks ()
Solow Model
35 / 51
Empirical Evidence
In a broader set of countries, those that are poor initially do not grow faster.
L. Hendricks () Solow Model September 17, 2009 36 / 51
Empirical Evidence
But gure 5.9 is the wrong experiment! The Solow model does not say: "poor countries grow faster" It says: "countries that are poor relative to their steady states grow faster." That is true in the data. Figure 5.9 tells us: much of the growth since 1960 is not of the transitional dynamics type - not explained by the Solow model.
L. Hendricks ()
Solow Model
37 / 51
Convergence Clubs?
L. Hendricks ()
Solow Model
38 / 51
Convergence Clubs?
The Solow model makes a quantitative prediction about growth rates. If you work out the numbers, countries should converge fairly quickly to their steady states (perhaps within 20 years). Then they all should grow at almost the same rates.
Fact
The Solow model cannot explain why countries grow at dierent rates for long periods of time. Post-war growth may look like Solow convergence to a common steady state, but it is not. Post-war growth is driven by growth in TFP, not by growth in K /L.
L. Hendricks ()
Solow Model
39 / 51
Exercise
Take a spreadsheet. Fix parameters at plausible empirical values: = 1/3, d = 0.08, s = 0.2. Compute the steady state. Fix K0 at some multiple of K . Compute the transition path for Kt by iterating over Kt +1 = sYt + (1 d ) Kt . Plot the growth rate of Yt against time.
You should see that growth is very high initially, if K0 is small. But growth slows dramatically very quickly.
Now plot the growth rate of Yt against over 40 years against initial Yt - this is the model analogue of gure 5.8.
You should see that the model relationship is much atter than the data relationship. The model fails to explain large variation in 40 year average growth rates.
L. Hendricks () Solow Model September 17, 2009 40 / 51
0.07 0.06 0.05 0.04 0.03 0.02 0.01 0 20 40 60 Year 80 100 120 140
L. Hendricks ()
Solow Model
41 / 51
0.035
Avg growth over 35 years
0.03
0.025
0.02
0.015 0.4
0.5
0.9
1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 20 40 60 Year 80 100 120 140 K/KSS Y/YSS
Convergence is too fast. In the data, the "half-life" is about 30 years 10 years in the model. Convergence is even faster when the saving rate is endogenous.
L. Hendricks () Solow Model September 17, 2009 43 / 51
No, we did not. Countries grows faster when their capital stocks are low. But this does not account for the observed dierences in long-run (40 year) growth rates across countries. It does account for growth rates at business cycle frequencies (we come back to that later).
L. Hendricks ()
Solow Model
44 / 51
The Tigers
There are a few countries that sustained growth by capital accumulation for a long period of time. How? It cannot work with a constant saving rate s - the Solow model shows this. Such countries must have saving rates that rise over time. Examples are: South Korea, Singapore, Hong-Kong.
L. Hendricks ()
Solow Model
45 / 51
The Tigers
L. Hendricks ()
Solow Model
46 / 51
Simulate the Solow model with a saving rate that rises from 10% to 40% (Singapore). Start the model in steady state: K0 = K . Show that the growth rate of y stays positive for a long time. You could now compare that growth path with data for Singapore and convice yourself that a large share of Singapore spectacular s growth since 1960 is indeed due to capital accumulation (as shown by Alwyn Young).
L. Hendricks ()
Solow Model
47 / 51
L. Hendricks ()
Solow Model
48 / 51
As a model of growth or large cross-country income dierences, the model is a failure. But its failure contains important insights:
1 2
Capital does not drive growth. Capital does not drive large fractions of cross-country income gaps.
Both ndings are surprising - and often not understood in the policy debate.
L. Hendricks ()
Solow Model
49 / 51
But the main signicance of the Solow model itself is as a building block for macro models. We always have to keep track of how capital is accumulated. A Solow block is therefore part of virtually every model. The same logic extends to other accumulated factors: human capital, knowledge capital, organization capital. The Solow transition dynamics is an important piece for understanding business cycle dynamics.
L. Hendricks ()
Solow Model
50 / 51
Reading
L. Hendricks ()
Solow Model
51 / 51