Questions answered by Solow Model

ƒ looks at the determinants of economic

growth and the standard of living in the long
run within a country
ƒ Why do poor countries grow faster than rich
countries?
ƒ Will the poor catch up with the rich?

slide 1

How Solow model is different from

IS-LM model
1. Dynamic

2. How is output (Y) produced?

3. population growth.

4. The consumption function is simpler.

5. No G or T

slide 2

1
 The production function
ƒ In aggregate terms: Y = F (K, L ); A = 1
ƒ Define: y = Y/L = output per worker [per capita
income]
ƒ k = K/L = capital per worker [capital-labor
ratio]
ƒ y = f(k) “per worker production function,”
shows how much output one worker could
produce using k units of capital.

slide 3

A numerical example
Production function (aggregate):
Y = F (K , L ) = K × L = K 1 / 2L1 / 2
To derive the per-worker production function,
divide through by L:
1/2
Y K 1 / 2L1 / 2  K 
= = 
L L L 

Then substitute y = Y/L and k = K/L to get

y = f (k ) = k 1 / 2

slide 4

2
 The production function
Output per
worker, y
f(k)

Note:
Note: this
this production
production function
function
exhibits diminishing MPK.
exhibits diminishing MPK.

Capital per
worker, k
slide 5

The national income identity

ƒ Y=C+I (remember, no G )

ƒ In “per worker” terms:

y=c+i
where c = C/L and i = I/L

slide 6

3
 The consumption function

ƒ s = the saving rate, the fraction of income

that is saved (s is exogenous)
ƒ S = s Y ; S = I; Y = C + I; then
ƒ Y = C + sY; C = (1- s) Y

ƒ Consumption function: c = (1–s)y

(per worker)

slide 7

Saving and investment

ƒ saving (per worker) = y – c
= y – (1–s)y
= sy
ƒ National income identity is y = c + i
Rearrange to get: i = y – c = sy
(investment = saving)

ƒ Using the results above,

i = sy = sf(k)
slide 8

4
 Output, consumption, and investment

Output per f(k)

worker, y

c1
y1 sf(k)

i1

k1 Capital per
worker, k
slide 9

Depreciation

Depreciation δδ == the
the rate
rate of
of depreciation
depreciation
per worker, δk == the
the fraction
fraction of
of the
the capital
capital stock
stock
that wears out each period
that wears out each period

δk

δ
1

Capital per
worker, k
slide 10

5
 Capital accumulation

The
Thebasic
basicidea:
idea:
Investment
Investmentmakes
makes
the
thecapital
capitalstock
stockbigger,
bigger,
depreciation
depreciationmakes
makesititsmaller.
smaller.

slide 11

Capital accumulation

Change in capital stock = investment – depreciation

∆k = i – δk

Since i = sf(k) , this becomes:

∆k = s f(k) – δk

slide 12

6
 The equation of motion for k

∆k = s f(k) – δk
ƒ the Solow model’s central equation
ƒ Determines behavior of capital over time…
ƒ …which, in turn, determines behavior of
all of the other endogenous variables
because they all depend on k. E.g.,
income per person: y = f(k)
consumption per person: c = (1–s) f(k)

slide 13

The steady state

∆k = s f(k) – δk
If investment is just enough to cover depreciation
[sf(k) = δk ],
then capital per worker will remain constant:
∆k = 0.

This constant value, denoted k*, is called the

steady state capital stock.

slide 14

7
 The steady state

Investment
and δk
depreciation
sf(k)

k* Capital per
worker, k
slide 15