Slides Topic1

Applied Macroeconomics (ES50113)
1. Neoclassical Growth Models

Topic 1
The Solow Growth Model
Nikos Kokonas1
University of Bath
Department of Economics
Semester 1
2020-21
1
I would like to thank Andreas Schaefer for sharing his slides with me.
Contents
Topic 1) The Solow Growth Model
1. Introduction and Stylized Facts

2. Production
3. The Fundamental Dynamic Equation
4. The Dynamics of the Solow Model
5. Increase in the Savings Rate
6. Increase in Population Growth
7. Technological Progress
8. Growth Accounting
9. The Convergence Hypothesis
1 / 63
Literature
R. Barro and X. Sala-i-Martin (2004). Economic Growth, MIT.

M. Burda and C. Wyplosz (2009). Macroeconomics, Oxford
University Press.
D. Acemoglu (2009). Introduction to Modern Economic Growth,
MIT.
D. Romer (2012). Advanced Macroeconomics, McGraw Hill.
P. Aghion and P. Howitt (2009). The Economics of Growth, MIT.
Remark:
Burda and Wyplosz is a very illustrative introduction into the material.
The rest is redundant, so you can read what you like most. Probably
Barro and Sala-i-Martin as well as Romer are more appropriate for the
beginning. Acemoglu is quite advanced and leaves no question open. It
provides in the introduction a lot of empirical facts and discussions
about the state-of-the-art. Aghion and Howitt have a decent summary of
neoclassical growth theory.
2 / 63
• we begin this course by studying the evolution of an economy

over longer periods of time
• we consider the growth trend of an economy
• we abstract from fluctuations around this trend, i.e. business
cycles
• the first part of this course is dedicated to the long-run
• the second part is dedicated to rather short run
fluctuations/policies
• closely related to the question how economies evolve over time
is the question why do countries grow at different rates over
longer periods of time?
• this question is as old as the theory of economic thought →
Adam Smith (1776): Inquiry into the Nature and Causes of the
Wealth of Nations
3 / 63
• the emergence of a formal growth theory in line with empirical

observations occurred with the work by Solow (1956) and Swan
(1956)
• the engine of economic growth is capital accumulation
• other sources of economic growth like human capital formation
or innovations are not considered
• the appealing feature of the Solow model is its relative simplicity
• despite obvious shortcomings it provides with few equations
reasonable predictions
• the implementation of innovations into growth models succeeded
only in the 1990s
4 / 63
The importance of economic growth
• real per capita GDP in the US grew on average by 1.75% per

year between 1870 and 1990
• an annual growth rate of one percent less would match the
long-run growth experience of India (0.64%), Pakistan (0.88%)
or the Philippines (0.86%) between 1900 and 1987
• US real per capita GDP is around 39 times the value of Ethiopia
• If Ethiopia would grow at a rate of 1.75% per year, it would take
239 years to catch up with the 1990 level of the US and still 152
years if it would start to grow at Japan’s long-term growth rate of
2.75% per year.
• Singapore, Taiwan, Botswana, Malta, and Japan made similar
growth experiences between 1960 and 1990 and raised their
levels of real per capita GDP by a factor 5 (over one generation)
(see Barro and Sala-i-Maritn for further details)
5 / 63
Evolution of world gdp per capita
7000
6000
5000
GDP per Capita (int. $)
4000
3000
2000
1000
0
1720 1770 1820 1870 1913 1950 2000
6 / 63
Evolution of gdp per capita in different regions of the world
30.000 Western Europe Western Offshoots
Latin America East Europe

25.000 Asian countries Africa - Afrique
GDP per Capiita (int. $)
20.000
15.000
10.000
5.000
0
1820 1870 1913 1950 2000
7 / 63
Korean peninsula at night
8 / 63
Stylized facts of the growth process in the developed world (1)
3. Wirtschaftliches Wachstum
Regularity #1: output per capita and captial per capita (capital intensity) are increasing over time
35 90
USA 80
30
UK 70 USA
25
Japan 60 UK
Japan
1990 $
20 50
1990 $
15 40
30
10
20
5
10
0 0
1820 1840 1860 1880 1900 1920 1940 1960 1980 2000
1820 1840 1860 1880 1900 1920 1940 1960 1980 2000
output per unit of labor (approx. output per capita) capital per unit of labor (capital intensity)
9 / 63
Regularity #2: the capital coefficient (K/Y) is more or less constant over time
1913 1950 1973 1992 2008*
France n.a. 1.6 1.6 2.3 2.7

Germany n.a. 1.8 1.9 2.3 2.5
Japan 0.9 1.8 1.7 3.0 3.7
UK 0.8 0.8 1.3 1.8 2.1
USA 3.3 2.5 2.1 2.4 3.0
* estimated
10 / 63
Regularity #3: the average real wage per hour is increasing over time
140
120
100
80
60
Canada
Japan
40
France
Italy
20
United Kingdom
Real hourly compensatipon in manufacturing, CPI basis, 1950‐2007, Indexes: 1996=100;

Source: U.S. Department of Labor, Bureau of Labor Statistics, September 2008
11 / 63
Regularity #4: the real interest rate is trendless
10
5
Real interest rate in %
‐5
Germany
France
‐10
United Kingdom
United States
Japan
‐15
Quelle: International Monetary Fund; eigene Berechnung
12 / 63
Regularity #5: the labor income share (wL/Y) and the capital income share (rK/Y) are trendless
100%
90%
capital income share Kapitaleinkommensquote
80%
70%
60%
Lohnquote
50%
labor income share
40%
30%
20%
10%
0%
Germany: Volkswirtschaftliche Gesamtrechnungen; Statistisches Bundesamt; 2007
13 / 63
2. Production
Production function
• We consider an economy in which many firms produce

final output with the same production technology using
physical capital and labor as inputs
• Aggregate output (Y ) is a function of aggregate physical
capital (K ) and aggregate labor (L)
Y = F (K , L) (1)
• The production function F (K , L) satisfies the neoclassical
properties
1) each factor of production is essential
2) positive but diminishing marginal returns
3) constant returns to scale
4) satisfies the Inada-conditions
→ What does this mean and why are this conditions

needed?
14 / 63
2. Production
1) Each factor of production is essential
• ... in other words: without a positive input in physical

capital or labor, there is no output
• in order to produce something, we need capital and labor
• we can not produce only with labor or only with capital
• formally
Y = F (0, L) = F (K , 0) = 0 (2)
• graphically: the production function starts in the origin
15 / 63
2. Production
2) Positive but diminishing marginal returns
• marginal return: the increase in output in response to an

increase (everything else equal) in one(!) input by an
infinitesimal small amount
• formally, the first derivative of the production function with
respect to K or L is positive, i.e.
∂Y ∂Y
>0 and >0 (3)
∂K ∂L
but the marginal contribution of a production factor to final
output is declining, i.e. the second derivative is negative
∂2Y ∂2Y
<0 and <0 (4)
∂K 2 ∂L2
• graphically: the production function is concave

16 / 63
2. Production
3) constant returns to scale
• the increase in all(!) inputs by the same(!) amount induces

an increase in output by the same(!) amount
• formally, the increase of K and L by a factor λ > 0 implies

and increase in Y by the factor λ
F (λK , λL) = λF (K , L) = λY (5)
• example: a doubling in all inputs (λ = 2) implies a doubling

outputs
17 / 63
2. Production
4) The Inada-conditions are fulfilled
For the moment we don’t

care!
• since they just imply stronger concavity assumptions...
More on this follows later
18 / 63
2. Production
Graphical presentation of a neoclassical production function (1)
• keeping one input fixed, Y = F (K , L) can be presented in

• two-dimensional space
Teil 2: Die reale Makroökonomik
→ let K be variable and L be fixed at L̄ = const.
Y =F(K,L)
condition 1)
0
K
19 / 63
2. Production
• consider an increase of physical capital from K1 by ∆K

→ final output increases by ∆Y1
Y =F(K,L)
 Y1

K
0 ‫ܭ‬ଵ K
20 / 63
2. Production
• consider now an increase of physical capital from K2 by ∆K

→ final output increases now by ∆Y2 < ∆Y1
Y =F(K,L)
} Y2

K
 Y1

K
0 ‫ܭ‬ଵ ‫ܭ‬ଶ K
21 / 63
2. Production
∂Y ∂Y
• for ∆ → 0. the change in output is obtained by ∂K 1
and ∂K2
→ marginal productivities are represented by the slope
→ of the production function
Y
߲ܻ
߲‫ܭ‬ଶ
߲ܻ Y =F(K,L)
߲‫ܭ‬ଵ
condition 2)
0 ‫ܭ‬ଵ ‫ܭ‬ଶ K
22 / 63
2. Production
The intensive form of the production function (1)
1 Y
• constant returns to scale: λY = F (λK , λL) → set λ = L ⇒ L = F ( KL , 1)
Y
• y= L output per capita
K
• k= L capital intensity
→ intensive form of the production function: y = F (k , 1) ≡ f (k )
• we can thus write Y = L · f (k )

1
→ the marginal product of capital ∂Y
∂K = L · f 0 (k ) · L = f 0 (k )
23 / 63
2. Production
The intensive form of the production function (2)
• constant returns to scale: λY = F (λK , λL) → set λ = L1 ⇒ YL = F ( KL , 1)

• y = YL output per capita
• k = KL capital intensity
→ intensive form of the production function: y = F (k , 1) ≡ f (k )
y
f’ ݇ଶ
y=f ݇
f’ ݇ଵ
condition 3)
0 ݇ଵ ݇ଶ k
24 / 63
Incomes, savings, investment and capital accumulation (1)
• so far, we have a theory that represents a static picture of

production
• economic growth is a dynamic process
• the growth engine of the Solow model is capital

accumulation
• we thus need a link from
a) income to savings
b) from savings to investment
c) from investment to capital accumulation
• What does this has to do with growth?
→ an increase in capital (K ) increases incomes (Y )
25 / 63
a) income and savings

the Solow model is silent about savings decision: a
constant fraction 0 < s < 1 of aggregate income is saved
S = sY , (6)
with S denoting aggregate savings
b) savings and investment

in a closed economy without state, we know that Y = C + I
and that Y = C + S, such that
I = S = sY (7)
26 / 63
c) investment and capital accumulation

• is I greater (smaller) than capital depreciation ⇒ the capital
stock (K ) increases (shrinks)
• denote by δ the depreciation rate of physical capital and by
∆Kt the change in the capital stock over a period of time ∆t
∆Kt = (It − δKt )∆t (8)

∆Kt
⇒ = (It − δKt ) (9)
∆t
∂K (t)
⇒ lim = = K̇ (t) = I(t) − δK (t) (10)
∆t→0 ∂t
→ K̇ (t) denotes the change in K per instant of time
27 / 63
c) cont. investment and capital accumulation (K̇ (t) = I(t) − δK (t))

• if investments (I) exceed the amount which is necessary to
replace the depreciated amount of capital (δK )
I > δK ⇒ K̇ > 0 (11)
such that K is increasing.
• if investments (I) fall short of the amount which is necessary
to replace the depreciated amount of capital (δK )
I < δK ⇒ K̇ < 0 (12)
such that K is shrinking.
• if investments (I) equal the amount which is necessary to
replace the depreciated amount of capital (δK )
I = δK ⇒ K̇ = 0 (13)
such that K is constant.
28 / 63
Dynamics of K
• How can we predict K̇ R 0, i.e. the evolution of K over

time?
• Let’s piece the bricks together
(1) we know that I = S, where it is assumed that S = sY

(2) moreover, Y = F (K , L)
(3) since K̇ = I − δK , it follows that
K̇ = sF (K , L) − δK (14)
29 / 63
K
Dynamics of k = L
• Let’s take take account for exogenous population growth,

i.e. L grows at a rate n > 0
→ more reasonable to consider per-capita units, i.e. the
intensive form of the production function
• divide K̇ = sF (K , L) − δK by L yields
K̇ F (K , L) K
= s −δ (15)
L L L
K̇
⇒ = sf (k ) − δk (16)
L
∂K
• since K̇L = k̇ + kn (follows from k̇ = ∂tL ; details follow in
assignments)
k̇ = sf (k ) − (n + δ)k (17)
→ fundamental equation of the Solow model
30 / 63
graphical analysis of k̇ (1)
k̇ = sf (k ) − (n + δ)k
Wirtschaftliches Wachstum
ܻ
‫ݕ‬ൌ
‫ܮ‬
݂ ݇
‫ܭ‬
݇ൌ
0 ‫ܮ‬
31 / 63
k̇ = sf (k ) − (n + δ)k
0 1
31 / 63
k̇ = sf (k ) − (n + δ)k
0 1
31 / 63
k̇ = sf (k ) − (n + δ)k
ܻ
‫ݕ‬ൌ
‫ܮ‬
݂ ݇
݊൅ߜ ݇
‫݇ ݂ݏ‬
‫ܭ‬
݇ൌ
0 ‫ܮ‬
31 / 63
sf (k ) = (n + δ)k → k̇ = 0
∗
0
32 / 63
∗
0
• At k ∗ we have sf (k ) = (n + δ)k . What does this mean?

→ At k ∗ per capita savings (= per capita investments) equal the
→ amount of investments necessary to replace depreciated capital
→ (δk ) and to endow new workers with the same capital intensity per
→ capita (nk )
⇒ the capital intensity k remains at k ∗ constant, i.e. k̇ = 0,
⇒ and y ∗ = f (k ∗ ) = const.
32 / 63
sf (k ) > (n + δ)k → k̇ > 0

>0
∗
0
33 / 63
>0
∗
0
• to the left of k ∗ we see that sf (k ) > (n + δ)k

→ savings (= investments) per capita exceed the amount
→ of investments necessary to replace depreciated capital and to
→ endow new workers with the same capital intensity per capita
⇒ the capital intensity k increases, i.e. k̇ > 0, and y ↑
33 / 63
sf (k ) < (n + δ)k → k̇ < 0

<0
>0
∗
0
34 / 63
<0
>0
∗
0
• to the right of k ∗ we have sf (k ) < (n + δ)k

→ savings (=investments) per capita are smaller than the amount
→ of investment necessary to replace depreciated capital and to
→ endow new workers with the same capital intensity per capita
⇒ the capital intensity k shrinks, i.e. k̇ < 0 and y ↓
34 / 63
Stability of the steady state k ∗
=0
<0
>0
∗
0
35 / 63
Stability of the steady state k ∗
=0
<0
>0
∗
0
• For k < k ∗ we have sf (k ) > (n + δ)k such that k̇ > 0, i.e. k ↑ and y ↑
• For k > k ∗ we have sf (k ) < (n + δ)k such that k̇ < 0, i.e. k ↓ and y ↓
→ k moves from the left and the right-hand side of k ∗ towards k ∗
→ k ∗ is a unique and stable steady state
35 / 63
Steady state levels of per capita savings and per capita consumption
steady state level of

per capita consumption
∗
steady state level of

per capita savings =
per capita investment
∗
0
36 / 63
Positive correlation between investments and per capita income (y )
25,000
Europe
Level of Real GDP per capita in 2000 (US$)
Africa
20,000 America
Asia
15,000
10,000
5,000
0
0 5 10 15 20 25 30 35 40
Average investment rate (% of GDP)
37 / 63
Permanent increase in the savings rate
∗
∗
∗ ∗
0
• A permanent increase of s from s1 to s2 increases y and k permanently
• The economy converges to a higher steady state with constant k ∗ and y ∗
38 / 63
Negative correlation between population growth and GDP per capita (y )
50,000
45,000
GDP per capita in 1996 US$, 2000
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0%
Average Population Growth Rate,1960-2000 (% per annum)
39 / 63
Permanent increase in the population’s growth rate
∗ s
∗
∗ ∗
0
• A permanent increase of n from n1 to n2 reduces y and k permanently
• The economy converges to a lower steady state with constant k ∗ and y ∗
40 / 63
Is the Solow model a reasonable model? (1)
• so far, the Solow model seems to be good fit to reality
• as regards the Kaldor facts, the Solow model is compatible

with Regularity #2, #4 and #5, in the sense that
K
(1) Y is constant in steady state
∂Y
(2) the marginal return to capital ∂K associated with the real
interest rate (r ) is constant in steady state
(3) this implies that rK wL
Y is constant, such that Y is constant in
steady state, too
• the Solow model fails to replicate Regularity #1 and #3 in
the sense that the Solow model is not compatible with
(1) growing per capita output (y ) and a growing capital intensity
(k ) in steady state, i.e. in the long-run
(2) growing real wages
• What is the reason for this short-coming?
41 / 63
Is the Solow model a reasonable model? (2)
• the concavity of the neoclassical production function

implies diminishing marginal returns to capital
• consequently, once the steady state is reached, the

process of capital accumulation comes to an halt
• per capita incomes cease to grow
• the reason for the incompatibility with some of the Kaldor

facts seems to be rooted in the concavity of the production
function
• in this simple form, the Solow model neglects other

sources of income growth except capital accumulation
42 / 63
Technological progress in the Solow model (1)
• Under what conditions can per capita income and the

capital intensity grow at constant rates for ever?
• There must be a force that compensates for diminishing
returns in the production function
→ technological progress
• technological progress means that more output can be
produced with the same amount of K and L
• Let the state of the technology (total factor productivity) be
captured by A(t)
→ modified production function
Y = F (K , A · L) (18)
satisfying still all neoclassical properties
43 / 63
y y=f ,
y=f ,
,
→ ,
0
k
• A permanent increase of A from A1 to A2 shifts f (k ) upwards
→ Conceptually, a continuous increase in A over time allows for continuous
→ increases in k and y
44 / 63
• what is A · L?
• an increase of A by 10% has the same impact as an increase in
employment by 10%
→ we assume labor-augmenting technological progress
• A · L is known as effective labor or efficiency units of labor
with the same K one our of work today produces more
output (is more effective) than before because A ↑
• assume that A evolves exogenously according to
A(t) = A0 · ex·t , A0 , x > 0 (19)
such that the growth rate of A is obtained as
Ȧ
=x (20)
A
and the amount of efficiency units of labor (A · L) grows at rate
n+x
45 / 63
→ so what did we gain?

• to see this, we implement the growth rate of technological
progress (x) explicitly into the Solow model
• let’s transform the modified production function Y = F (K , A · L)
into its intensive from which depends now on capital per effective
K
unit of labor, i.e. AL
• we denote output and capital per efficiency unit of labor by ŷ and
k̂ , such that
Y = F (K , AL) (21)
K
= AL · F ( , 1) (22)
AL
and
Y
ŷ = = F (k̂ , 1) = f (k̂ ) (23)
AL
46 / 63
• From the equilibrium condition K̇ + δK = I = S, it follows again
K̇ = sF (K , AL) − δK , (24)
which we devide now by the effective units of labor AL, such that
K̇ F (K , AL) K
= s −δ = sF (k̂ , 1) − δ k̂ , (25)
AL AL AL
K̇
= sf (k̂ ) − δ k̂ . (26)
AL
• As K̇ ˙ ˙ K
∂ AL
AL = k̂ + (n + x)k̂ (follows from k̂ = ∂t ) we obtain
˙
k̂ = sf (k̂ ) − (n + x + δ)k̂ (27)
47 / 63
Graphical illustration of the Solow model with technological progress
tschaftliches Wachstum
0 ∗
48 / 63
Graphical illustration of the Solow model with technological progress
0 ∗
• Obviously, k̂ converges again from both sides to a unique

• steady state with k̂ = k̂ ∗ = const.
• a constant k̂ ∗ → ŷ ∗ is also constant
→ now capital and output are in steady state constant in terms of
→ effective units of labor
48 / 63
Implications of technological progress in the Solow model (1)
• what does the constancy of ŷ and k̂ imply for y and k ?
• we know that k̂˙ = 0 in steady state
⇒ ŷ is also constant in steady state (because ŷ = f (k̂ )) → ŷ˙ = 0
• as ŷ = Y K
AL and k̂ = AL it follows that
ŷ˙ Ẏ Ȧ L̇ Ẏ
= −( + )= − (x + n) = 0 (28)
ŷ Y A L Y
˙
k̂ K̇ Ȧ L̇ K̇
= −( + )= − (x + n) = 0 (29)
k̂ K A L K
49 / 63
Implications of technological progress in the Solow model (2)
• which implies for the growth rate of per capita output y = Y

L
ẏ Ẏ
= − n = x, (30)
y Y
K
and for the growth rate of the capital intensity k = L
k̇ K̇
= −n =x (31)
k K
⇒ capital intensity and output per capita are now growing at a
constant rate x in the long-run (steady state)
• Accordingly, the growth rate of aggregate output and
aggregate capital equal the sum of population growth and
technological progress
Ẏ K̇
= = x + n. (32)
Y K
50 / 63
The emergence of steady state growth in the Solow model (summary)
• depending on whether n, x ≥ 0, we can summarize the

implications regarding the emergence of steady state growth as
follows
∗ ∗ ∗
Ẏ ẏ
n, x ≥ 0 y∗ Y∗ Y y = ẎY − n
n, x = 0 const. const. 0 0
n > 0, x = 0 const. grows n 0
n, x > 0 grows grows n+x x
• obviously, the Solow model matches all Kaldor facts if x > 0

• but what is the true "value-added" of this extension
• technological progress is exogenous and falls costlessly
from heaven
• in reality the level and the growth rate of A depend on many
factors: economic policies, institutions, skills...
• the Solow model is silent about the sources of x
51 / 63
Growth accounting and the Solow residual (1)
• disregarded the explanatory power of exogenous technological

progress, we have managed to identify three sources of
economic growth
1) growth in inputs (here: physical capital and population
growth/growth in labor supply)
2) technological progress
→ it is fair to ask: what is the contribution of this factors to growth?
• unfortunately it is difficult to measure technological progress
• Robert Solow developed a simple method which is able to reveal
the contribution of technological progress
a) specify a production function
b) national accounting documents growth in GDP,
investments, and man-hours worked
c) if we know this, the residual must be originated in the
increase in A (Solow residual)
• that’s why this method is called growth accounting
52 / 63
• Let’s specify the production technology by the following

Cobb-Douglas function
Y (t) = A(t) · K (t)α · L(t)1−α (33)
• take the logarithm on both sides yields
ln Y (t) = ln A(t) + α ln K (t) + (1 − α) ln L(t) (34)
• differentiating the above equation with respect to time gives
Ẏ (t) Ȧ(t) K̇ (t) L̇(t)

= +α + (1 − α) (35)
Y (t) A(t) K (t) L(t)
Ȧ(t) Ẏ (t) K̇ (t) L̇(t)
⇒ = −α − (1 − α) (36)
A(t) Y (t) K (t) L(t)
53 / 63
growth rate GDP (1947-

73) contribution from capital contribution from labor TFP growth rate
Canada 0.0517 0.0254 0.0088 0.0175
49% 17% 34%
France 0.0542 0.0225 0.0021 0.0296
42% 4% 54%
Germany 0.0661 0.0269 0.0018 0.0374
41% 3% 56%
Italy 0.0527 0.018 0.0011 0.0337
34% 2% 64%
Netherlands 0.0536 0.0247 0.0042 0.0248
46% 8% 46%
UK 0.0373 0.0176 0.0003 0.0135
47% 1% 52%
USA 0.0402 0.0171 0.0095 0.0135
43% 24% 34%
Barro and Sala‐i‐Martin (2004, p. 439)
54 / 63
growth rate GDP (1947-

73) contribution from capital contribution from labor TFP growth rate
Canada 0.0517 0.0254 0.0088 0.0175
49% 17% 34%
France 0.0542 0.0225 0.0021 0.0296
42% 4% 54%
Germany 0.0661 0.0269 0.0018 0.0374
41% 3% 56%
Italy 0.0527 0.018 0.0011 0.0337
34% 2% 64%
Netherlands 0.0536 0.0247 0.0042 0.0248
46% 8% 46%
UK 0.0373 0.0176 0.0003 0.0135
47% 1% 52%
USA 0.0402 0.0171 0.0095 0.0135
43% 24% 34%
Barro and Sala‐i‐Martin (2004, p. 439)
• the growth in inputs (K and L) accounts for 1/2 to 2/3 of total

• economic growth
• this is substantial but not the complete story
→ it is important to understand the sources of technological progress
→ and to design appropriate policy instruments
54 / 63
• is there a mechanism that induces higher growth rates in poor
economies compared to rich economies
→ convergence of per capita incomes across the globe?
• in the introduction, we have seen that incomes per capita diverge
• is this the complete story?
• how does the Solow model relate to this observation?
• conceptually, there are two hypotheses related to a convergence
mechanism
1) neoclassical convergence mechanism
2) "advantages of backwardness" (Abramovitz, 1986): poor
countries can catch up by adopting technologies from the rich
countries
• 2) assumes that differences in y are only rooted in technological
differences, but
• technologies developed in the "north" may be inappropriate for
the south (differing skills, infrastructure, etc.)
• differences in incomes may be rooted in the quality of
institutions (property rights protection, corruption, red tape)
55 / 63
• 2) emphasizes again the sources of the growth rate of total

factor productivity A
• the growth rate of A is driven at large by
• innovations
• quality of institution
• public infrastructure
• we postpone the consideration of this factors and complete the
"Solow view"
→ how does the neoclassical convergence mechanism 1) work
and how does it relate to the real world?
56 / 63
Absolute convergence and the neoclassical convergence mechanism
• neoclassical convergence mechanism

• poor countries exhibit a low k thus a low y = f (k )
• hence, marginal productivity of capital f 0 (k ) is high
• this implies high incentives to invest
• given a low k , the growth impulse of any investment is
higher than in richer countries
→ poor countries should grow faster than rich countries
→ absolute convergence
• empirical test:
gyi = α + βyi,0 + ui , i = {1, ..., n} (37)
gyi : average growth rate over the observation period
yi,0 : income per capital at the beginning of the observation period
α: vector of exogenous components
ui : error term
i: country
→ absolute convergence, if β < 0 and significant

57 / 63
Jones (2002)
58 / 63
Growth
3. rate
Wirtschaftliches Wachstum Growth rate
1885‐1994 1960‐1997
per capita GDP 1885 Jones (2002)

GDP per worker, 1960
59 / 63
Average growth rate GDP
per capita 1960‐1992 in %
OECD
Africa
Asia
⇒ Dies ist das Streudiagramm für die globale Stichprobe von Ländern.
GDP per capita in 1960 (prices 1992 dollars)
60 / 63
Absolute convergence versus conditional convergence (1)
• so far the neoclassical convergence mechanism seems to be

confirmed
• however, the above samples contained structurally similar
countries
• OECD countries should be characterized by similar/identical
• savings rates (s)
• population growth rates (n)
• total factor productivities (A)
• growth rates of technological progress (x)
• such that these countries converge to similar/identical steady
states
• however: it can not be expected that the entire world is
characterized by the same structural parameters
61 / 63
Average growth rate GDP
per capita 1960‐1992 in %
OECD
Africa
Asia
⇒ Dies ist das Streudiagramm für die globale Stichprobe von Ländern.
GDP per capita in 1960 (prices 1992 dollars)
61 / 63
• obviously, the negative correlation disappeared

• if different groups of countries exhibit different structural
parameters
• they will grow at different levels
• converge to different steady states
→ absolute convergence must be rejected at a global level
• nevertheless, as the OECD sample shows, the neoclassical
convergence mechanism works for structural similar countries,
i.e. ceteris paribus
→ conditional convergence
• a country’s growth rate of y is inversely related to the
distance to its steady state
• conditional on structural parameters, poor countries grow
faster than richer ones
62 / 63
• empirical test:
gyi = α0 + α1 xj,1 + ... + αm xj,m + βyi,0 + ui , i = {1, ..., n} (38)
xj,1 ..xj,m : variables that control for the position of the steady state (s, n, x, government expenditures, etc.)
gyi : average growth rate over the observation period
yi,0 : income per capital at the beginning of the observation period
α0 : vector of exogenous components
ui : error term
i: country
→ conditional convergence reflects a ceteris paribus argument that

takes account for the fact that poor countries may converge to
different steady states compared to rich countries
→ convergence clubs
63 / 63
Convergence clubs (1)
Evolution of the world income distribution
Acemoglu (2009)
63 / 63
Convergence clubs (2)
Distribution of per capita incomes in East German counties

.00020
.00016
.00012
Density
.00008
.00004
.00000
5,000 10,000 15,000 20,000 25,000 30,000 35,000
1996 Kernel 2006 Kernel
Schaefer and Steger (2010)
63 / 63

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Applied Macroeconomics (ES50113)

1. Neoclassical Growth Models

1. Introduction and Stylized Facts

R. Barro and X. Sala-i-Martin (2004). Economic Growth, MIT.

• we begin this course by studying the evolution of an economy

• the emergence of a formal growth theory in line with empirical

• real per capita GDP in the US grew on average by 1.75% per

30.000 Western Europe Western Offshoots

Latin America East Europe

1913 1950 1973 1992 2008*

France n.a. 1.6 1.6 2.3 2.7

Real hourly compensatipon in manufacturing, CPI basis, 1950‐2007, Indexes: 1996=100;

Regularity #4: the real interest rate is trendless

Quelle: International Monetary Fund; eigene Berechnung

Germany: Volkswirtschaftliche Gesamtrechnungen; Statistisches Bundesamt; 2007

• We consider an economy in which many firms produce

→ What does this mean and why are this conditions

• ... in other words: without a positive input in physical

• in order to produce something, we need capital and labor

• we can not produce only with labor or only with capital

• graphically: the production function starts in the origin

• marginal return: the increase in output in response to an

• graphically: the production function is concave

• the increase in all(!) inputs by the same(!) amount induces

• formally, the increase of K and L by a factor λ > 0 implies

F (λK , λL) = λF (K , L) = λY (5)

• example: a doubling in all inputs (λ = 2) implies a doubling

For the moment we don’t

• keeping one input fixed, Y = F (K , L) can be presented in

• consider an increase of physical capital from K1 by ∆K

• consider now an increase of physical capital from K2 by ∆K

→ intensive form of the production function: y = F (k , 1) ≡ f (k )

• we can thus write Y = L · f (k )

• constant returns to scale: λY = F (λK , λL) → set λ = L1 ⇒ YL = F ( KL , 1)

• so far, we have a theory that represents a static picture of

• the growth engine of the Solow model is capital

• What does this has to do with growth?

→ an increase in capital (K ) increases incomes (Y )

a) income and savings

with S denoting aggregate savings

b) savings and investment

c) investment and capital accumulation

∆Kt = (It − δKt )∆t (8)

→ K̇ (t) denotes the change in K per instant of time

c) cont. investment and capital accumulation (K̇ (t) = I(t) − δK (t))

• How can we predict K̇ R 0, i.e. the evolution of K over

• Let’s piece the bricks together

(1) we know that I = S, where it is assumed that S = sY

• Let’s take take account for exogenous population growth,

• At k ∗ we have sf (k ) = (n + δ)k . What does this mean?

sf (k ) > (n + δ)k → k̇ > 0

• to the left of k ∗ we see that sf (k ) > (n + δ)k

sf (k ) < (n + δ)k → k̇ < 0

• to the right of k ∗ we have sf (k ) < (n + δ)k

steady state level of

steady state level of

• so far, the Solow model seems to be good fit to reality

• as regards the Kaldor facts, the Solow model is compatible

• the concavity of the neoclassical production function

• consequently, once the steady state is reached, the

• per capita incomes cease to grow

• the reason for the incompatibility with some of the Kaldor

• in this simple form, the Solow model neglects other