The Solow Growth Model

5 The Solow Growth Model 5.1 Models and Assumptions • What is a model? A mathematical description of the economy. • Why do we need a model? The world is too complex to describe it in every detail. • What makes a model successful? When it is simple but effective in describing and predicting how the world works. • A model relies on simplifying assumptions. These assumptions drive the conclusions of the model. When analyzing a model it is crucial to spell out the assumptions underlying the model. • Realism may not a the property of a good assumption. 5.2 Basic Assumptions of the Solow Model 1. Continuous time. 2. Single good produced with a constant technology. 3. No government or international trade. 4. All factors of production are fully employed. 5. Labor force grows at constant rate n = L̇ L. 6. Initial values for capital, K0 and labor, L0 given. Production Function • Neoclassical (Cobb-Douglas) aggregate production function: Y (t) = F [K(t), L(t)] = K(t)α L(t)1−α • To save on notation write: Y = A K α L1−α • Constant returns to scale: F (λK, λL) = λ F (K, L) = λA K α L1−α • Inputs are essential: F (0, 0) = F (K, 0) = F (0, L) = 0 • Marginal productivities are positive: ∂F = αAK α−1L1−α > 0 ∂K ∂F = (1 − α) AK αL−α > 0 ∂L • Marginal productivities are decreasing, ∂ 2F α−2 L1−α < 0 = (α − 1) αA K ∂K 2 ∂ 2F α L−α−1 < 0 = −α (1 − α) A K ∂L2 Per Worker Terms • Define x = X L as a per worker variable. Then Y A K αL1−α y= = =A L L µ ¶ µ ¶ K a L 1−α = A kα L L • Per worker production function has decreasing returns to scale. Capital Accumulation • Capital accumulation equation: K̇ = sY − δK • Important additional assumptions: 1. Constant saving rate (very specific preferences: no r) 2. Constant depreciation rate • Dividing by K in the capital accumu equation: • Some Algebra: K̇ K = Y sK −δ = Y L sK L K̇ K Y − δ. = sK − δ = s ky − δ • Now remember that: k̇ K̇ L̇ K̇ K̇ k̇ = − = −n⇒ = +n k K L K K k • We get k̇ y + n = s − δ ⇒ k̇ = sy − (δ + n) k k k • Fundamental Differential Equation of Solow Model: k̇ = s A kα − (δ + n) k Graphical Analysis • Change in k, k̇ is given by difference of s A kα and (δ + n)k • If s A kα > (δ + n)k, then k increases. • If s A kα < (δ + n)k, then k decreases. • Steady state: a capital stock k∗ where, when reached, k̇ = 0 • Unique positive steady state in Solow model. • Positive steady state (locally) stable. Steady State Analysis • Steady State: k̇ = 0 • Solve for steady state µ sA α ∗ ∗ ∗ 0 = s A (k ) − (n + δ)k ⇒ k = n+δ • Steady state output per worker y∗ = ³ ¶ 1 1−α ´ α s A 1−α n+δ • Steady state output per worker depends positively on the saving (investment) rate and negatively on the population growth rate and depreciation rate. Comparative Statics • Suppose that of all a sudden saving rate s increases to s0 > s. Suppose that at period 0 the economy was at its old steady state with saving rate s. • (n + δ)k curve does not change. • s A kα = sy shifts up to s0y. • New steady state has higher capital per worker and output per worker. • Monotonic transition path from old to new steady state. Evaluating the Basic Solow Model • Why are some countries rich (have high per worker GDP) and others are poor (have low per worker GDP)? • Solow model: if all countries are in their steady states, then: 1. Rich countries have higher saving (investment) rates than poor countries 2. Rich countries have lower population growth rates than poor countries • Data seem to support this prediction of the Solow model The Solow Model and Growth • No growth in the steady state • Positive or negative growth along the transition path: k̇ = s A kα − (n + δ)k k̇ gk ≡ = s A kα−1 − (n + δ) k Introducing Technological Progress • Aggregate production function becomes Y = K α (AL)1−α • A : Level of technology in period t. • Key assumption: constant positive rate of technological progress: Ȧ =g>0 A • Growth is exogenous. Balanced Growth Path • Situation in which output per worker, capital per worker and consumption per worker grow at constant (but potentially different) rates • Steady state is just a balanced growth path with zero growth rate • For Solow model, in balanced growth path gy = gk = gc Proof • Capital Accumulation Equation K̇ = sY − δK Y −δ • Dividing both sides by K yields gK ≡ K̇ = s K K • Remember that gk ≡ k̇k = K̇ K −n • Hence gk ≡ • In BGP gk constant. Therefore gy = gk k̇ Y = s − (n + δ) k K Y constant. Hence K It follows that gY = gK . What is the Growth Rate? • Output per worker Y K α (AL)1−α K α (AL)1−α α A1−α y= = = α = k L L L L1−α • Take logs and differentiate gy = αgk + (1 − α)gA • We proved gk = gy and we use gA = g to get gk = αgk + (1 − α)g = g = gy • BGP growth rate equals rate of technological progress. No TP, no growth in the economy. Analysis of Extended Model • in BGP variables grow at rate g. Want to work with variables that are constant in long run. Define: y Y = A AL k K k̃ = = A AL ỹ = • Repeat the Solow model analysis with new variables: ỹ = k̃α k̃˙ = sỹ − (n + g + δ)k̃ k̃˙ = sk̃α − (n + g + δ)k̃ Closed-Form Solution • Repeating all the steps than in the basic model we get: k̃(t) = ỹ(t) = • Interpretation. ³ ³ s δ+n+g s δ+n+g + + ³ k̃01−α ³ k̃01−α − s δ+n+g − s δ+n+g ´ ´ ´ 1 1−α −λt e e−λt ´ α 1−α Balanced Growth Path Analysis • Solve for k̃∗ analytically 0 = α ∗ sk̃ à k̃∗ = − (n + g + δ)k̃∗ s n+g+δ ! 1 1−α • Therefore à ỹ ∗ = s n+g+δ ! α 1−α à k(t) = A(t) à s n+g+δ s y(t) = A(t) n+g+δ à K(t) = L(t)A(t) à ! 1 1−α ! α 1−α s n+g+δ s Y (t) = L(t)A(t) n+g+δ ! 1 1−α ! α 1−α Evaluation of the Model: Growth Facts 1. Output and capital per worker grow at the same constant, positive rate in BGP of model. In long run model reaches BGP. 2. Capital-output ratio K Y constant along BGP 3. Interest rate constant in balanced growth path 4. Capital share equals α, labor share equals 1 − α in the model (always, not only along BGP) 5. Success of Solow model along these dimensions, but source of growth, technological progress, is left unexplained. Evaluation of the Model: Development Facts 1. Differences in income levels across countries explained in the model by differences in s, n and δ. 2. Variation in growth rates: in the model permanent differences can only be due to differences in rate of technological progress g. Temporary differences are due to transition dynamics. 3. That growth rates are not constant over time for a given country can be explained by transition dynamics and/or shocks to n, s and δ. 4. Changes in relative position: in the model countries whose s moves up, relative to other countries, move up in income distribution. Reverse with n. Interest Rates and the Capital Share • Output produced by price-taking firms • Hire workers L for wage w and rent capital Kfrom households for r • Normalization of price of output to 1. • Real interest rate equals r − δ Profit Maximization of Firms max K α (AL)1−α − wL − rK K,L • First order condition with respect to capital K αK α−1 (AL)1−α − r = 0 µ ¶ K α−1 α = r AL αk̃α−1 = r • In balanced growth path k̃ = k̃∗, constant over time. Hence in BGP rconstant over time, hence r − δ (real interest rate) constant over time. Capital Share • Total income = Y, total capital income = rK • Capital share capital share = = rK Y αK α−1 (AL)1−α K = α • Labor share = 1 − α. K α (AL)1−α Wages • First order condition with respect to labor L (1 − α)K α(LA)−αA = w (1 − α)k̃αA = w • Along BGP k̃ = k̃∗, constant over time. Since A is growing at rate g, the wage is growing at rate g along a BGP.