Solow Model

Assumptions
1. One composite commodity is produced
2. Full employment
3. Two factors of production – Labour and Capital
4. There is neutral technical progress (K/Q ratio is constant)
5. Saving ratio(personal saving/disposable income) is constant
6. Technical Coefficient (K/L) is variable
7. Prices and wages are flexible
8. Output is regarded as net output after making allowance for the depreciation of capital.
9. There is constant returns to scale( output changes in the same proportion as changes in
input)
Production Function
Y = AF (K, L)
Aggregate output in any period is determined by the inputs of K and L.
A – Current status of technical knowledge and the overall efficiency in the use of factors of
production K and L.
If there is technological improvement (rise in overall efficiency) over time, A will increase and Y
will be higher for given levels of factors of production K and L.
K changes through savings and investment
L changes due to population growth that adds to the Labour force.
Constant Returns to scale
If factor inputs are increased by a certain proportion, output rises by exactly the same proportion.
Two Sources of Growth
Per capita output (or income) of an economy can grow for 2 reasons:
1. Growth of capital stock per worker
If capital rises from K1 to K2, income rises from Y1 to Y2. An increase in K is known as an
increase in capital intensity of production.

2. Technical progress or improvement in factor productivity (rise in A).

The per capita output curve shifts up so that income income curve shifts up so that income
rises to Y3 from Y2 even if capital stays at K1.
Steady State
Assumptions

1. No change in A
2. Labour force is growing over time at an exogenously given rate ‘n’ ie, ΔL = n
L
3. I = sY ; I = S = sY

4. A constant fraction d of the existing capital stock depreciates each period. So that the amount
of total depreciation in any period is dK.

ΔK = I – dK

Addition to capital stock equals net investment which is gross investment minus
depreciation.

A steady state or a balanced growth is defined to be a situation where Y, K and L are

growing at the same rate over time. Since L, by assumption is growing at n , in steady state,

ΔY = ΔK = ΔL = n
Y K L
 sY = Actual investment per worker

(n+d)k = Gross investment per worker needed to keep per capita K unchanged for a labour
force growing at n. (Desired level of investment )

To the right of K*, sY < (n+d)k and k will fall.

To the left of K*, sY > (n+d)k and k will increase towards K*
Thus k converges to K* from either direction.

Steady State with technical Progress

Production function is Y = F (K, L*E) when efficiency of labour(technical Progress) is included.

Labour

L = no: of workers

E = Efficiency of workers

L X E = Effective number of workers.

Efficiency of Labour improves with technical progress and L*E is effective number of workers.
The rate at which efficiency of L grows is assumed to be constant and this rate is denoted by ‘g’.
The rate at which labour force (population) grows is denoted by ‘n’. This form of technological
progress is called labour augmenting. So effective number of workers L*E is growing at a rate
‘n+g’

Capital

Investment required to maintain a constant level of capital per capita.

Required Investment = (n+d+g)K

Steady State Equilibrium is the long run equilibrium of the economy. It is the combination of per
capita income and per capita capital where the economy remains at rest. At this point investment
required to provide capital for new workers, to replace machines that are worn out and capital
required to provide for the effective workers created by technical progress(g) is just equal to the
saving generated in the economy.

Capital per capita at steady state is K*

Income per capita at steady state is Y*

At steady state

sY = (n+d+g)k

Criticisms

1. Absence of Investment Function

2. Unrealistic Assumptions
3. No Study of Technical Progress (treated it as exogenous)
4. Ignores the Composition of Capital Stock (treats as homogenous)
5. Flexibility of Factor Price may bring Certain Problems