MACRO 2

2024
RECITATION No. 3 – Solow model / Chapters 8 and 9
Yosi Ganel
Solow – building the model

K and L are no longer fixed

No G or T

We are looking at changes over time

 𝑆𝑢𝑝𝑝𝑙𝑦 𝑠𝑖𝑑𝑒 (𝑜𝑢𝑡𝑝𝑢𝑡): 𝑌 = (𝐾, 𝐿)

 𝑆 – 𝑠𝑎𝑣𝑖𝑛𝑔 𝑟𝑎𝑡𝑒
 𝛿 − 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
Solow – building the model

Assumption: constant return of scale

𝑧 ∗ 𝑌 = 𝐹 (𝑧𝐾, 𝑧𝐿)
𝐼𝑓 𝑧 = 1/𝐿 𝑤𝑒 𝑔𝑒𝑡
𝑌/𝐿 = 𝐹 (𝐾/𝐿, 1)
• All measurements are per worker (lower case)

• 𝑆𝑢𝑝𝑝𝑙𝑦: 𝑦 = 𝑓 (𝑘)
• 𝐷𝑒𝑚𝑎𝑛𝑑: 𝑦 = 𝑐 + 𝑖
Solow – building the model

 𝑐 (𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛) = (1 − 𝑠)𝑦
Plugging in the demand:
 𝑦 = (1 − 𝑠)𝑦 + 𝑖
 𝑤𝑒 𝑔𝑒𝑡: 𝑖 = 𝑠𝑦 = 𝑠 ∗ 𝑓(𝑘)
Solow model
Capital accumulation

 Changes in capital stock:

 The Steady state

Δk = 0
s*f(k) = δ*k
The Golden rule
The Golden rule - too much capital
The Golden rule - too little capital
Population Growth
The golden Rule with population growth
Q1 – Question for review
 How does the saving rate affect the steady-state level of
income? Rate of growth?

 In the Solow growth model, a high saving rate leads to a large

steady-state capital stock and a high level of steady-state output. A
low saving rate leads to a small steady-state capital stock and a
low level of steady-state output.
 Higher saving leads to faster economic growth only in the short run.
 An increase in the saving rate raises growth until the economy
reaches the new steady state. That is, if the economy maintains a
high saving rate, it will also maintain a large capital stock and a
high level of output, but it will not maintain a high rate of growth
forever. In the steady state, the growth rate of output (or income) is
independent of the saving rate
Q3 – Question for review
 Might a policymaker choose a steady state with more
capital than in the Golden Rule steady state? With less
capital than in the Golden Rule steady state? Explain

 If the economy begins above the Golden Rule level of

capital moving towards the Golden Rule leads to higher
consumption in all period of time.
The Golden rule - too much capital
Q3 – Question for review
 Might a policymaker choose a steady state with more
capital than in the Golden Rule steady state? With less
capital than in the Golden Rule steady state? Explain

 If the economy begins below the Golden Rule level of

capital moving towards the Golden Rule leads to higher
consumption in the future but not in the current time
The Golden rule - too little capital
Q2 – Problem and Application
 In the discussion of German and Japanese post-war
growth, the text describes what happens when part of
the capital stock is destroyed in a war. By contrast,
suppose that a war does not directly affect the capital
stock, but that casualties reduce the labor force.
Assume the economy was in a steady state before the
war, the saving rate is unchanged, and the rate of
population growth after the war is the same as is was
before.
Q2 – Problem and Application
 Assumptions:
 War didn’t decrease the capital stock
 Labor force is reduced
 Saving rate and rate of Pop. Growth is the same

a. What is the immediate impact of the war on output

and output per worker?
 𝑌 = 𝐹(𝐾, 𝐿) - if L is lower – total output falls
 𝑘 = 𝐾/𝐿 – if L is lower - capital per worker is
higher
So every worker has more capital = 𝑦 is higher
Q2 – Problem and Application
b. What will happen to output per worker in the postwar
years? What will happen to the growth rate of output per
worker compared to before the war?
 The economy has higher k than the steady state

 Capital per worker falls

 Output per worker also falls

 The growth rate is negative

until the economy reach the
new steady state
Q3 – Problem and Application
. .
 𝑌 = 𝐹(𝐾, 𝐿) = 𝐾0 4𝐿0 6

 a. What is the per worker production function?

To derive the per-worker production function f(k), divide both sides of
the production function by the labor force L:

𝑌 𝐾 0.4 𝐿0.6 𝑌 𝐾 0.4

= ⇒ =( )
𝐿 𝐿 𝐿 𝐿

Because y = Y/L and k = K/L, this becomes:

𝟎.𝟒
𝒚 = 𝒌
Q3 – Problem and Application
. .
 𝑌 = 𝐹(𝐾, 𝐿) = 𝐾0 4𝐿0 6

 b. what is k, y, c as a function of s and δ

 Recall that:
 Δ𝑘 = 𝑠𝑓(𝑘) – 𝛿𝑘.

 The steady-state value of capital per worker k* is defined as the

value of k at which capital per worker is constant, so Δk = 0.
 It follows that in steady state
 0 = 𝑠𝑓(𝑘) – 𝛿𝑘,

𝑘∗ 𝑠
=
𝑓(𝑘 ∗ ) 𝛿
Q3 – Problem and Application
. .
 𝑌 = 𝐹(𝐾, 𝐿) = 𝐾0 4𝐿0 6 ; k, y, c as a function of s and δ

𝑘∗ 𝑠
=
𝑓(𝑘 ∗ ) 𝛿

 Substituting this equation for steady-state capital per worker into the
per-worker production function from part (a) gives:
Q3 – Problem and Application
 Consumption is the amount of output that is not invested. Since
investment in the steady state equals δk*, it follows that
Q5 – Problem and Application
Draw a well-labeled graph that illustrates the steady state of the Solow
model with population growth. Use the graph to find what happens to
steady-state capital per worker and income per worker in response to
each of the following exogenous changes:

a. A change in consumer preferences increases the saving rate

b. A change in weather patterns increases the depreciation rate.

c. A one time, permanent improvement in technology increases the

amount of output that can be produced from any given amount
of capital and labor
Q5 – Problem and Application
a. Increase in savings rate

 Capital per worker - rise

 Output per worker – rise
Q5 – Problem and Application
b. Increase depreciation rate

 Capital per worker - fall

 Output per worker – fall
Q5 – Problem and Application
c. Increase in 𝑓(𝑘)

 Capital per worker - rise

 Output per worker – rise
Q6 – Problem and Application
 Many demographers predict that the United states will
have zero population growth in the coming decades, in
contrast to the historical average population growth of
about 1 percent per year.

 Use the Solow model to forecast the effect of this

slowdown in population growth on the growth of total
output and the growth of output per person. Consider
the effects both in the steady state and in the transition
between steady states.
Q6 – Problem and Application
Population growth rate decreases
In the new steady state
 Capital per worker - rise
 Output per worker – rise

 In steady state, total output grows at rate n, whereas output per-

worker grows at rate 0. Hence, slower population growth will lower
total output growth, but per-worker output growth will be the same
 During the transition period the output per worker grow at a rate
faster than zero. than decreasing until reaching zero.
 Test yourself #1
Assume an economy that follows the Solow model (without growth in
effectivity of workers) and has reached the steady state. The country
receives a gift in the form of many machines from a foreign country. As a
result:

a. No change would occur in the economy

b. Output per worker would immediately decrease. The new steady state
output per worker would be lower than before.
c. Output per worker would immediately increase. The new steady state
output per worker would be higher than before.
d. Output per worker would immediately increase, but it would be followed
by a negative growth rate, bringing the economy eventually to the
original output per worker.

Solution : D
 Test yourself #2
Assume an economy that follows the Solow model (without growth in
effectivity of workers) and has reached the steady state of the golden rule
People have decided to increase the saving permanently. As a result:

a. In the new steady state, output per worker and consumption per worker
would increase.
b. Capital per worker would decrease along the convergence to the new
steady state.
c. There is no change in the steady state.
d. In the new steady stat, output per worker would increase, but
consumption per worker would decrease.

Solution : D
Tech. Improvements in Solow Model
 Notations and definitions :
 E = Labor efficiency
 g = rate of increase of labor efficiency = ΔE/E

The production function is :

𝑌 = 𝐹(𝐾, 𝐿 ∗ 𝐸)
𝐿 ∗ 𝐸 = 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑤𝑜𝑟𝑘𝑒𝑟𝑠

𝑦 = 𝑌/𝐿𝐸 – output per effective worker

𝐾 = 𝐾/𝐿𝐸 – capital per effective worker
𝑦 = 𝑓(𝑘) – production function per effective worker
𝑠𝑦 = 𝑠 ∗ 𝑓(𝑘) – saving and investment per effective worker
Tech. Improvements in Solow Model
 Notations and definitions :
 (δ + n + g)k = break-even investment (how much is needed to keep k the same)
Tech. Improvements in Solow Model
 The steady state:
Tech. Improvements in Solow Model
The Golden Rule
Practice question
a. Assume a Solow-type economy with a production function 𝑌 = 𝐾 0.4 (𝐿𝐸)0.6 , that
has reached a steady state. Saving rate is 𝑠, depreciation rate is 𝛿,population
growth is 𝑛, and E is growing at a rate of 𝑔.
What is the output per effective worker? Calculate, and show the convergence
to steady state on a graph, assuming the economy starts with less capital then the
steady state’s.
b. Cont. from section a – people have decided to decrease population growth
rate to zero, while at the same time 𝑔 has decreased to 0.
What would happen to the output per effective worker in the years following the
change? Whet would be the growth rate of output per effective worker and
output per worker in the new steady state?
Practice question
a. Assume a Solow-type economy with a production function 𝑌 = 𝐾 0.4 (𝐿𝐸)0.6 , that has reached a
steady state. Saving rate is 𝑠, depreciation rate is 𝛿,population growth is 𝑛, and E is growing at a
rate of 𝑔.
What is the output per effective worker? Calculate, and show the convergence to steady state on
a graph, assuming the economy starts with less capital then the steady state’s.

𝑌 𝐾 0.4 𝐿𝐸 0.6
𝐾 0.4
= = 0.4
𝐿𝐸 𝐿𝐸 𝐿𝐸
𝐾
𝐴𝑠 𝑘 = ⇒ 𝑦 = 𝑘 0.4
𝐿𝐸
𝐼𝑛 𝑡ℎ𝑒 𝑠𝑡𝑒𝑎𝑑𝑦 𝑠𝑡𝑎𝑡𝑒:
𝑠𝑘 0.4 = 𝑛 + 𝛿 + 𝑔 𝑘

𝑠
= 𝑘 0.6
𝑛+𝑔+𝛿
𝑠 1
𝑘=( ) 0.6
𝑛+𝑔+𝛿

𝑠 0.4
𝑦=( )0.6
𝑛+𝑔+𝛿
Practice question
b. Cont. from section a – people have decided to decrease population growth
rate to zero, while at the same time 𝑔 has decreased to 0.
What would happen to the output per effective worker in the years following the
change? Whet would be the growth rate of output per effective worker and
output per worker in the new steady state?
𝑛 = 0, 𝑔 = 0
At t=0, there is no change
During the movement to 𝑘2∗ : the output per effective worker would grow at a
decreasing rate.
In the new steady state no growth in output per effective worker
As 𝑔 = 0 the output per worker in the new steady state would be 0.
𝑦

𝑘
Practice question#2
In the Solow model with productivity growth, after the economy has reached a
steady state, the people have decided to decrease the birth rate. Which of the
following claims is correct?

a. In the new steady state. Growth in output per worker will be greater than in
the original steady state.
b. In the few years following the change, growth in output per effective worker
will be 0
c. I the new steady state, output per effective worker will be the same as in the
original steady state.
d. In the few years following the change, growth in output per worker will be
greater than in the original steady state.

Solution :D
 Practice question#3
Consider a country that has a basic Solow type economy (i.e., without growth
rate in effectivity of workers), has reached the steady state.
a. The population has decided to increase the savings rate.
What would happen to the consumption per capita immediately after the
change? What would be the growth rate of output per capita in the country
during the years that follow the changes?
What would be the growth rate of output per capita in the country in the long
run(new steady state) Show the changes on the graph and explain.
b. Is consumption per capita in the new steady state greater or lower than
consumption per capita in the original steady state? Explain.
c. In another country that follows the Solow model, the effectivity of workers is
growing at a rate of 𝑔. The population has also decided to increase the
savings rate.
What would happen to output per effective worker in the new steady state,
compared to the original one? What was the growth rate of output per worker
prior to the change? After the change (in the new steady state)? Show the
changes on the graph and Explain.
Practice question#3
▪ 𝑠𝑓 𝑘 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑠.
▪ Immediately after the change 𝑐 decreases (Point A’)
▪ The Growth rate of output per capita during the years that follow will be
positive, as the economy is moving to the new steady state (Point B)
▪ Output per effective worker increases in the new steady state.
▪ In the new steady state the growth rate of output per capital will be zero
𝑓(𝑘)
𝑦 𝐵 (𝑛 + 𝛿)𝑘
𝐴′

𝐴 𝑠𝑓(𝑘)

𝑘1∗ 𝑘
Practice question#3
b. Is consumption per capita in the new steady state greater or lower than
consumption per capita in the original steady state? Explain.

It is impossible to know, as it’s depends on 𝑘𝐺𝑅

If 𝑘 ∗ < 𝑘𝐺𝑅 - increasing 𝑠 (without exceeding 𝑘𝐺𝑅 ) will

increase 𝑐 𝑝𝑒𝑟 𝑐𝑎𝑝𝑖𝑡𝑎

If 𝑘 ∗ > 𝑘𝐺𝑅 - increasing 𝑠 will decrease 𝑐 𝑝𝑒𝑟 𝑐𝑎𝑝𝑖𝑡𝑎

Practice question#3
c. In another country that follows the Solow model, the effectivity of workers is
growing at a rate of 𝑔. The population has also decided to increase the savings rate.
What would happen to output per effective worker in the new steady state,
compared to the original one? What was the growth rate of output per worker prior to
the change? After the change (in the new steady state)? Show the changes on the
graph and Explain.
Output per effective worker will increase (Point B)
The growth rate of output per worker prior to the change and after the change is the
same = 𝑔
𝑓(𝑘)
𝑦 𝐵
(𝑛 + 𝛿 + 𝑔)𝑘
𝑠𝑓(𝑘)
𝐴

𝑘1∗ 𝑘2∗ 𝑘