In this chapter, we learn:

how capital accumulates over time, helping us understand economic growth.

the role of the diminishing marginal product of capital in explaining differences in growth rates across countries.

the principle of transition dynamics: the farther below its steady state a country is, the faster the country will grow.

the limitations of capital accumulation, and how it leaves a significant part of economic growth unexplained.

The Solow growth model is the starting point to determine why growth differs across similar countries it builds on the Cobb-Douglas production model by adding a theory of capital

accumulation developed in the mid-1950s by Robert Solow of MIT, it is the basis for the Nobel Prize

he received in 1987

capital stock is “endogenized”: converted from an exogenous to an endogenous variable. the accumulation of capital is a possible engine of long-run economic growth

Start with the Cobb-Douglas production model and add an equation describing the accumulation of capital over time.

Yt = F(Kt ,Lt ) = A Kt1/3Lt

2/3

ProductionThe production function:

has constant returns to scale in capital and labor has an exponent of one-third on capital decreasing returns to capital

Variables are time subscripted—they may potentially change over time

Output can be used for either consumption (Ct) or investment (It): Yt = Ct + It

Capital Accumulation the capital stock next year equals the sum of the capital started with this year plus the

amount of investment undertaken this year minus depreciation

Depreciation is the amount of capital that wears out each period ~ 10 percent/year

Labor

the amount of labor in the economy is given exogenously at a constant level, L

Investment

the amount of investment in the economy is equal to a constant investment rate, s, times total output, Y

It = s Yt

Total output is used for either consumption or investment therefore, consumption equals output times the quantity one minus the investment

rate

Ct = (1 - s) Yt

The Model Summarized

Prices and the Real Interest Rate

If we add equations for the wage and rental price, the MPL and the MPK would pin them down:

w = MPL, r = MPK the real interest rate, r, (measured in constant dollars, not in nominal dollars)

= the amount a person can earn by saving one unit of output for a year

= the amount a person must pay to borrow one unit of output for a year measured in constant dollars, not in nominal dollars

saving is the difference between income and consumption: St = Yt - Ct = It » Saving equals Investment

In the long-run when output is at full-employment potential output, a unit of saving is a unit of investment, which becomes a unit of capital: therefore the return on saving must equal the rental price of capital the rental price of capital is the real interest rate which is equal to the

marginal product of capital

r = MPK

To solve the model, write the endogenous variables as functions of the parameters of the model and graphically show what the solution looks like and solve the model in the long run. combine the investment allocation equation with the capital accumulation

equation

net investment is investment minus depreciation substitute the supply of labor, L, into the production function:

These two equations, the capital accumulation relation and the production function, are all we need to solve the Solow model

(change in capital) (net investment)

Solving the Solow Model

Investment, Depreciation

Capital, Kt

At this point, dKt = sYt, so

The Solow Diagram graphs the production function and the capital accumulation relation together, with Kt on the x-axis:

The Solow Diagram:When investment is greater than depreciation, the capital stock increases

The capital stock rises until investment equals depreciation: At this steady state point, ΔK = 0

Depreciation: d K

Investment: s Y

Investment, depreciation

Capital, KK*

Net investment

K0

Suppose the economy starts at K0:

Investment, Depreciation

Capital, Kt

K0

•The red line is above the green at K0:

•Saving = investment is greater than depreciation at K0

•So ∆Kt > 0 because

•Since ∆Kt > 0, Kt increases from K0 to K1 > K0

K1

Now imagine if we start at a K0 here:

Investment, Depreciation

Capital, Kt

K0

•At K0, the green line is above the red line

•Saving = investment is now less than depreciation

•So ∆Kt < 0 because

•Then since ∆Kt < 0, Kt decreases from K0 to K1 < K0

K1

We call this the process of transition dynamics: Transitioning from any Kt toward the economy’s

steady-state K*, where ∆Kt = 0 and growth ceasesInvestment, Depreciation

Capital, Kt

At this value of K, dKt = sYt, so

K*

No matter where we start, we’ll

transition to K*!

We can see what happens to output, Y, and thus to growth if we rescale the vertical axis:

Investment, Depreciation, Income

Capital, KtK*

•Saving = investment and depreciation now appear here

•Now output can be graphed in the space above in the graph

•We still have transition dynamics toward K*

•So we also have dynamics toward a steady-state level of income, Y*

Y*

The Solow Diagram with OutputAt any point, Consumption is the difference between Output and

Investment: C = Y – I Investment, depreciation,

and output

Capital, K

Y0

K0

Y*

K*

Consumption

Depreciation: d K

Investment: s Y

Output: Y

in the steady state, investment equals depreciation. If we evaluate this equation at the steady-state level of capital, we can solve mathematically for it the steady-state level of capital is positively related with the investment rate, the

size of the workforce and the productivity of the economy the steady-state level of capital is negatively related to the depreciation rate

Solving Mathematically for the Steady State

In the steady state:

Once we know K*, then we can find Y* using the production function:

• This solution also tells us about per capita income in the steady state, y*, and per capita consumption as well, c*

c* = y* - sy* = (1 – s) y*

notice that the exponent on the

productivity parameter is greater than in the production function higher productivity

parameter raises output as in the production model.

higher productivity also implies the economy accumulates additional capital.

the level of the capital stock itself depends on productivity

The Capital-Output Ratio

the capital to output ratio is given by the ratio of the investment rate to the depreciation rate:

while investment rates vary across countries, it is assumed that the depreciation rate is relatively constant

Looking at Data through the Lens of the Solow Model

Empirically, countries with higher investment rates have higher capital to output ratios:

Differences in Y/L the Solow model gives more weight to TFP in explaining per capita output

than the production model does Just like we did before with the simple model of production, we can use this

formula to understand why some countries are so much richer take the ratio of y* for a rich country to y* for a poor country, and assume

the depreciation rate is the same across countries:

Now we find that the factor of 45 that separates rich and poor country’s income per capita is decomposable into:A 103/2 = 18-fold difference in this productivity ratio termA (30/5)1/2 = 61/2 = 2.5-fold difference in this investment rate ratio

In the Solow Model, productivity accounts for 18/20 = 90% of differences!

45

= 18 x 2.5

the economy will settle in a steady state because the investment curve, sY, has diminishing returns however, the rate at which production and investment rise is smaller as the

capital stock is larger a constant fraction of the capital stock depreciates every period, which implies

depreciation is not diminishing as capital increases

In summary, as capital increases, diminishing returns implies that production and investment increase by less and less, but depreciation increases by the same amount d.

Eventually, net investment is zero and the economy rests in steady state.There are diminishing returns to capital: less Yt per additional Kt

That means new investment is also diminishing: less sYt = It

But depreciation is NOT diminishing; it’s a constant share of Kt

Understanding the Steady State

there is no long-run economic growth in the Solow model

in the steady state: output, capital, output per person, and consumption per person are all constant and growth stops

both constant

Economic Growth in the Solow Model

empirically, economies appear to continue to grow over timethus capital accumulation is not the engine of

long-run economic growth saving and investment are beneficial in the

short-run, but diminishing returns to capital do not sustain long-run growth

in other words, after we reach the steady state, there is no long-run growth in Yt (unless Lt or A increases)

Investment, depreciation

Capital, K

New investment exceeds depreciation

Depreciation: d K

K**K*

Old investment: s Y

An Increase in the Investment Rate

the economy is now below its new steady state and the capital stock and output will increase over time by transition dynamics

the long run, steady-state capital and steady-state output are higher

What happens to output in response to this increase in the investment rate?the rise in investment leads capital to accumulate

over timethis higher capital causes output to rise as welloutput increases from its initial steady-state level Y*

to the new steady state Y**

The Behavior of Output Following an Increase in s

Investment, depreciation, and output

Capital, K

Y*

K*

Y**

K**

Depreciation: d KOutput: Y

New investment:

s ‘Y

Old investment:

s Y

(a) The Solow diagram with output.

The Behavior of Output Following an Increase in s (cont.)

(b) Output over time.

Y*

Y**

Output, Y (ratio scale)

Time, t2000 2020 2040 2060 2080 2100

A Rise in the Depreciation Rate

the depreciation rate is exogenously shocked to a higher rate

the depreciation curve rotates upward and the investment curve remains unchanged

the new steady state is located to the left: this means that depreciation exceeds investment

the capital stock declines by transition dynamics until it reaches the new steady statenote that output declines rapidly at first but less rapidly as

it converges to the new steady state

A Rise in the Depreciation Rate Investment, depreciation

Capital, K

Depreciation exceeds

investment

K** K*

New depreciation:

d ‘K

Olddepreciation:

d K

Investment: s Y

What happens to output in response to this increase in the depreciation rate?the decline in capital reduces outputoutput declines rapidly at first, and then gradually

settles down at its new, lower steady-state level Y**

The Behavior of Output Following an Increase in d

Investment, depreciation, and output

Capital, K

New depreciation: d‘K Output: Y

Investment: s Y

Old depreciation: d K

Y**

K**

Y*

K*

(a) The Solow diagram with output.

The Behavior of Output Following an Increase in d (cont.)

Output, Y (ratio scale)

Time, t2000 2020 2040 2060 2080 2100

Y**

Y*

(b) Output over time.

The Principle of Transition Dynamics

when the depreciation rate and the investment rate were shocked, output was plotted over time on a ratio scaleratio scale allows us to see that output changes more

rapidly the further we are from the steady stateas the steady state is approached, growth shrinks to

zero

CHAPTER 5 The Solow Growth Model

the principle of transition dynamics says that the farther below its steady state an economy is, in percentage terms, the faster the economy will grow

similarly, the farther above its steady state, in percentage terms, the slower the economy will grow

this principle allows us to understand why economies may grow at different rates at the same time

Understanding Differences in Growth Rates empirically, OECD countries that were relatively poor in

1960 grew quickly while countries that were relatively rich grew slowerif the OECD countries have the same steady state, then the

principle of transition dynamics predicts this

looking at the world as whole, on average, rich and poor countries grow at the same rate

two implications: (1) most countries have already reached their steady states; and (2) countries are poor not because of a bad shock, but because they have parameters that yield a lower steady state

Strengths and Weaknesses of the Solow Model

The strengths of the Solow model are:1. It provides a theory that determines how rich a country is

in the long run.2. The principle of transition dynamics allows for an

understanding of differences in growth rates across countries.

The weaknesses of the Solow model are:1. It focuses on investment and capital, while the much more

important factor of TFP is still unexplained. 2. It does not explain why different countries have different

investment and productivity rates. 3. The model does not provide a theory of sustained long-run

economic growth.

Summary

1. The starting point for the Solow model is the production model of Chapter 4. To that framework, the Solow model adds a theory of capital accumulation. That is, it makes the capital stock an endogenous variable.

2. The capital stock is the sum of past investments. The capital stock today consists of machines and buildings that were bought over the last several decades.

3. The goal of the Solow model is to deepen our understanding of economic growth, but in this it’s only partially successful. The fact that capital runs into diminishing returns means that the model does not lead to sustained economic growth. As the economy accumulates more capital, depreciation rises one-for-one, but output and therefore investment rise less than one-for- one because of the diminishing marginal product of capital. Eventually, the new investment is only just sufficient to offset depreciation, and the capital stock ceases to grow. Output stops growing as well, and the economy settles down to a steady state.

4. There are two major accomplishments of the Solow model. First, it provides a successful theory of the determination of capital, by predicting that the capital-output ratio is equal to the investment-depreciation ratio. Countries with high investment rates should thus have high capital-output ratios, and this prediction holds up well in the data.

5. The second major accomplishment of the Solow model is the principle of transition dynamics, which states that the farther below its steady state an economy is, the faster it will grow. While the model cannot explain long-run growth, the principle of transition dynamics provides a nice theory of differences in growth rates across countries. Increases in the investment rate or total factor productivity can increase a country’s steady-state position and therefore increase growth, at least for a number of years. These changes can be analyzed with the help of the Solow diagram.

CHAPTER 5 The Solow Growth Model

6. In general, most poor countries have low TFP levels and low investment rates, the two key determinants of steady-state incomes. If a country maintained good fundamentals but was poor because it had received a bad shock, we would see it grow rapidly, according to the principle of transition dynamics.

Investment in South Korea and the Philippines, 1950-2000

Investment rate (percent)

Year

U.S.

South Korea

Philippines

The Solow Diagram Investment, depreciation, and output

Capital, K

Y0

K0

Y*

K*

Output: Y

Depreciation: d K

Investment: s Y

Output Over Time, 2000-2100 Output, Y (ratio scale)

Time, t2000 2020 2040 2060 2080 2100

Y*

Y0