Part IIB.

Paper 2 Michaelmas Term 2010

Economic Growth

Lecture 2: Neo-Classical
Growth Model

Dr. Tiago Cavalcanti

 Readings and Refs
Main Text:
(*)Jones ch.2;
Advanced Texts: BX chs.1,10; Romer ch.1.
Original Articles:
Solow R. (1956) ‘A contribution to the theory of economic
growth’ Quarterly Journal of Economics, 70, 65-94.
Solow R. (1957) ‘Technical change and the aggregate
production function’ Review of Economics and Statistics, 39,
312-320.
Swan T. (1956) ‘Economic growth and capital accumulation’
Economic Record, 32, 334-361.
The Neoclassical Growth model
Solow (1956) and Swan (1956)

• Simple dynamic general equilibrium model of

growth
Neoclassical Production Function
Output produced using aggregate production
function Y = F (K , L ), satisfying:
A1. positive, but diminishing returns
FK >0, FKK<0 and FL>0, FLL<0
A2. constant returns to scale (CRS)
F (K , L)  F ( K , L), for all   0
– replication argument
Production Function in Intensive Form
• Under CRS, can write production function
K
Y  F ( K , L)  Y  L.F ( ,1)
L
• Alternatively, can write in intensive form:
y = f(k)
- where per capita y = Y/L and k = K/L
Exercise: Given that Y=L f(k), show:
FK = f’(k) and FKK= f’’(k)/L .
 Competitive Economy
• Representative firm maximises profits and take price
as given (perfect competition)
• Inputs paid by their marginal products:
r = FK and w = FL
– inputs (factor payments) exhaust all output:
wL + rK = Y
– general property of CRS functions (Euler’s THM)
 A3: The Production Function F(K,L)
satisfies the Inada Conditions
lim K 0 FK ( K , L)   and lim K  FK ( K , L)  0

lim L0 FL ( K , L)   and lim L FL ( K , L)  0

Note: As f’(k)=FK have that

limk 0 f ' (k )   and limk  f ' (k )  0

Production Functions satisfying A1, A2 and A3

often called Neo-Classical Production Functions
 Technological Progress
= change in the production function Ft
Yt  Ft ( K , L)

1. Ft ( K , L)  Bt F ( K , L)
2. Ft ( K , L)  F ( K , ( At L))
3. Ft ( K , L)  F ((Ct K ), L)
Hicks-Neutral T.P.
Labour augmenting
(Harrod-Neutral) T.P.
Capital augmenting
(Solow-Neutral) T.P.
A4: Technical progress is labour augmenting
Ft ( K , L)  F ( K , ( At L))
and
At  A0 e gt

Note: For Cobb-Douglas case three forms of

technical progress equivalent:

Ft ( K , L)  Bt K  L(1 )  K  ( At L) (1 )  ( Dt K ) L(1 )

(1 ) 
when Bt  At  Dt
Under CRS, can rewrite production function in
intensive form in terms of effective labour units
~ ~
y  f (k )
~ Y ~ K
where y  and k 
AL AL

-note: drop time subscript to for notational ease

- Exercise: Show that
~ ~
f ' (k )  FK and f ' ' (k )  AL FKK
 Model Dynamics
A5: Labour force grows at a constant rate n
nt
Lt  L0e
A6: Dynamics of capital stock:
dK
 K  I  K
dt
net investment = gross investment - depreciation
– capital depreciates at constant rate 
 … closing the model
• National Income Identity
Y = C + I + G + NX
• Assume no government (G = 0) and closed
economy (NX = 0)
• Simplifying assumption: households save constant
fraction of income with savings rate 0  s  1
 I = S = sY
• Substitute in equation of motion of capital:

K  sY  K  sF ( K , AL)  K
 Fundamental Equation of
Solow-Swan model
~
dk ~ ~ ~
 k  sy  ( n  g   ) k
dt
~ K ~
Proof : k   ln k  ln K  ln A  ln L
AL
~
d ln k d ln K d ln A d ln L
   
dt dt dt dt
~
k K sY s~
y
 ~  g n   (n  g   )  ~  (n  g   )
k K K k
 Steady State
Definition: Variables of interest grow at
constant rate (balanced growth path or BGP)
~
k  0 ~ y  c~  0

• at steady state:

 
~* ~*
sf k  (n  g   )k  0
 Solow Diagram
~ =  ( ~
)
~_ =   ( ~
 ) ¡ (  +  +  ) ~

( +  +  )~

~

 ~ =   ( ~
)

0
0
~
 (0) ~¤
~ 4
 x 10
 Existence of Steady State
• From previous diagram, existence of a (non-
zero) steady state can only be guaranteed for all
values of n,g and  if
~ ~
limk~ 0 f ' (k )   and limk~  f ' (k )  0

- satisfied from Inada Conditions (A3).

 Transitional Dynamics
~ ~*
• If k  k ,
then savings/investment exceeds
~
“depreciation”, thus k~  0  g  k~  0.
~
k
~ ~* k
• If k  k , then savings/investment lower than
~
“depreciation”, thus k~  0  g  k~  0.
~
k
k
• By continuity, concavity, and given that
f(k) satisfies the INADA conditions, there
~* ~* ~*
k such that f (k )  (n    g )k
must exists an unique
 Transitional Dynamics

_
~  ( ~)
 ~ = ~ =  ~
 ¡ ( +  +  )
 ~

 ~  0
~
¤  ~  0

~

 Properties of Steady State
1. In steady state, per capita variables
grow at the rate g, and aggregate
variables grow at rate (g + n)
~ K K
Proof: as k  and k 
AL L
d log K d log L d log k
gK     n  gk
dt dt dt
~
d log k d log A d log k
gk     g  g k~
dt dt dt
 g in Steady State
 2. Changes in s, n, or  will affect the
levels of y* and k*, but not the growth
rates of these variables.
- Specifically, y* and k* will increase as s
increases, and decrease as either n or  increase

Prediction: In Steady State, GDP per worker will

be higher in countries where the rate of investment
is high and where the population growth rate is low
- but neither factor should explain differences in
the growth rate of GDP per worker.
 Golden Rule and Dynamic
Inefficiency
• Definition: (Golden Rule) It is the saving rate
that maximises consumption in the steady-state.
~ ~* ~* ~*
max c  (1  s) f (k )  f (k )  (n  g   )k
*
s
~ ~* ~* ~*
c *
f (k ) k k ~*
 ~*  (n  g   )  0  f ' (kGR )  (n  g   )
s k s s
~* ~*
sf (kGR
~*
)  (n  g   )kGR
• Given kGR ,we can use
to find sGR .
 Golden Rule and Dynamic
Inefficiency
~¤ = (1 ¡  )  ( ~
¤)

~¤

0
0  
1

 Changes in the savings rate
• Suppose that initially the economy is in the
~* ~*
steady state: sf (k1 )  (n  g   )k1
~* ~* ~
• If s increases, then sf (k1 )  (n  g   )k1  k  0
• Capital stock per efficiency unit of labour
grows until it reaches a new steady-state
• Along the transition growth in output per
capita is higher than g.
 Linear versus log scales
4
x 10 L inear-Scale Log-Scale
 (  ( )) )
 (  ) =      (0)   (  (  ) ) _
 =  = 

 (  ( ))
 ( )



0 0
0 0
 
Changes in the savings rate
 (  ( )) Log of ca pit a l per ca pit a

 per ca pit a
Log of out put
 (  ( ))


Log of consumpt ion per ca pit a
 (  ( ))


 Next lecture
Testing the neo-classical model:
1. Convergence
2. Growth Regressions
3. Evidence from factor prices