Over simplified Solow growth model

A
technology level, productivity, the force that combines capital and labors and turn them into goods
and services (Y)
K
Capital
L
Labors
Y （ real GDP) e
Education and trainings
Y
Real GDP (income=output=expenditure)
Y=Af(K, eL)

The slop of the production function gets flatter and flatter because law of
diminishing returns on capital input

Potential growth can be illustrated on the diagram as real GDP Y increases

along the pathway Y=Af(K,eL)

K (capital)
Y （ real GDP)

Y=Af(K, eL)

Depreciation(D): wear out of the capital (factories and

machineries) ,it is a fraction of capital K, denoted as δK

K (capital)
 At K1: depreciation=investment

When newly accumulated capital

Y （ real GDP)
through investment equitizes capital
worn out or depreciation, growth will
be stopped. Investment<depreciation
implies a decrease in physical capital and
Y=Af(K, eL) level of output Y

Depreciation: D=δK

Saving=Investment, fraction of Y according to marginal propensity of savings (MPS, HL)

K1 K (capital)
 An economy A (LEDC) with less physical capital stock is growing
faster than the other one B with higher level of physical capital
stock (MEDC). The key engine for growth is investment. In
Y （ real GDP) reality, LEDCs are catching up with MEDCs at an economic
growth rate over 10% every year.

Y=Af(K, eL)

B
Depreciation: D=δK

S=I=MPS*Y
A

K1 K (capital)
 When an economy C has accumulated a lot of physical capital, the growth rate becomes slower,
newly invested capital are used to replace the old ones(depreciation).

In order to promote economic growth, the government should encourage savings, since increased
saving implies increased investment at any given depreciation level δK.

Y （ real GDP) Saving is the key engine for economic growth especially for some LEDCs. (In the section of
development economics, we will learn that foreign direct investment (FDI) and capital inflow
can fill in the saving gaps)

Y=Af(K, eL)

S’=I’=MPS’*Y Depreciation: D=δK

S=I=MPS*Y

K1 K2 K (capital)
 Alternatively, government can promote economic growth through investment into research and development and
improvement in the technology factor A. This is termed as cutting edge growth

As shown on the diagram when technology level increases from A to A’, real GDP will be increased from Y to Y’ at
any given level of capital K1, Saving and Investment also increased to S’ and I’ due the increment of real GDP. It
speeds up the level of capital accumulation and real GDP growth rates at the same time.

Y （ real GDP)
Y’=A’f(K, eL)

Y=Af(K, eL)

S’=I’=MPS*Y’ Depreciation: D=δK

S=I=MPS*Y

K1 K2 K (capital)