THE BASIC SOLOW MODEL

Suggested readings:
Chapter 2 Jones and Vollrath (2013)
Overview
General principles for specifying an economic model
The basic Solow model: features of the economic
environment and agents behavior
Solving the basic Solow model
The long run equilibrium: steady state

Comparative statics
Growth in the basic Solow model
Conclusions
General principles for specifying a model
An economic model is an abstraction that captures the essential
features of the world needed for analyzing a particular economic
question.

To build a macroeconomic model we must specify:

- the features of the economic environment (economic actors,
characteristics of the markets, technology, etc.)
- consumers and firms (and Government) behavior
- a notion of equilibrium

The basic characteristics of the macro model will depend on

whether it is meant to study a long-run or a short-run
phenomenon.
Macroeconomic models: objectives

We would like a macroeconomic model to:

Match the qualitative features of the economy;

Match the quantitative features of the economy, given the

appropriate parameter values;

Be used to run policy experiments or to make forecasts

about the future behavior of the economy.
Introduction: the Solow model

Workhorse model in studying economic growth

Answer to the question: is it possible for an economy to
enjoy positive growth rates forever by simply saving and
investing in its capital stock?
In other terms: how does the growth rate of an economy
relate to its investment (saving) rate?
What are the determinants of growth?
Why are we so rich and they so poor?
Key elements of the basic Solow model
A country produces only a single, homogeneous good
(output);
No international trade, no Government;
Output is determined by the supplies of capital and labor
(inputs) through a Cobb-Douglas production function;
Technology is exogenous and there is no technological
progress;
All output is devoted to either consumption or gross
investment (which is used to accumulate capital);
Households save an (exogenous) constant fraction of output.
Markets are perfectly competitive, there are no externalities
and information is complete (neoclassical assumptions).
Structure of the model
Object: Closed economy
Agents: Households and firms
Commodities and markets: Output, capital services and labour
services
Households: own the inputs in the economy; inelastically supply
their labor to firms; save a constant fraction of their income.
Firms: hire inputs (capital and labor) and use them to produce
goods that they sell to households. They maximize their profits.
Competitive markets: Prices adjust to equate supply and demand
in all markets. Agents take these prices as given.

Two key equations of the model:

Production function
Capital accumulation equation
Production function
The production function is assumed to be the following
(Cobb-Douglas):

= , = 1 , 0<<1

where is aggregate output, is aggregate capital, is

aggregate labor, and represents total factor productivity
(the technological level), constant over time in the basic
Solow model. , and can change over time in this model.

Lets analyze the properties of this production function.

 Properties of the Production function

Constant returns to scale: , = > 0

(,) (,)
Positive marginal products: > 0, > 0.

Decreasing marginal products (decreasing returns) in each

input:

2 (, ) 2 (, )
2
< 0, 2
< 0.

Prices and firms behavior
Let be the wage rate paid to each unit of labor.
Let be the rental rate of each unit of capital.
Normalize to one the price of a unit of output.
(Note: again, and can change over time in this model)

If we assume identical firms, we can solve the problem of a

representative firm.
Representative firm chooses and to maximize its profits :

= ,

taking as given the prices and (markets are competitive).

Prices and firms behavior (cont.)
According to the first order conditions for this problem, it must be:

(, ) 1 1

= = =

(, )

= = (1 ) = (1 )

Notice that + = : there are no economic profits to be

earned (perfect competition).

Also, notice that = (share of output paid to capital) and


= (1 ) (share of output paid to labor), constant over time

(coherent with Stylized Fact 5, point 2).
Households
(Identical) households own capital and labor;
They inelastically supply one unit of labor each, at the wage
rate . The labor force participation rate is 1.
They rent capital to firms at the rental rate ;
They save a constant fraction of their income (denote the
saving rate with , a number between 0 and 1) , so that
aggregate saving in the economy is = .
As a consequence, aggregate consumption is = =
1 .

Total population grows at the constant rate (> 1):

() = 0 (so that =
= is the growth rate of )

Capital accumulation equation
Capital depreciates at the positive constant rate .
Given total gross investment , by definition we have:

=

where is the change in capital stock over time ( = )

In a closed economy, it must be that = (from the

equilibrium in the output market and the definition of
aggregate saving).
Moreover, = .
Thus the capital accumulation equation is the following:

=
Summing up the basic Solow model:
= 1

() = 0

given 0 and 0 .

Endogenous variables (i.e., determined within the model):

, , , , , over time.
Exogenous variables (i.e., determined outside the model):
over time.
Parameters (i.e. constant numbers) of the model:
, , , , , 0 , 0 .
Solving the basic Solow model
Solving a model means determining the value of the
endogenous variables given the values for the parameters and
the exogenous variables.
If possible, we would like to express the endogenous variables
as a function of the parameters and the exogenous variables.
Sometimes a diagram can be useful to understand the nature
of the solution.

Next, we first look at a general procedure to analyze the basic

Solow model.
We then make use of diagrams to give some insight about the
nature of the solution.
And we derive an analytical solution for the long-run values of
the most important endogenous variables.
 Solving the basic Solow model
1) To solve the model, it is convenient to express all equations in per

capita terms: define per capita output: and per capita capital:


.

2) The per capita production function is then:
1
= = =


3) Knowing that ,

a) Take logs:
ln = ln ln

b) Take the derivative with respect to time and substitute for = :

= = =

Solving the basic Solow model (cont.)
5) Multiplying the above equation by in both sides, we get
the capital accumulation equation in per capita terms:

= +

Change in
capital per Decrease in capital per capita
capita due to depreciation and
population growth
Gross investment
(also called break-even or
per capita = Saving
replacement investment
per capita
per capita: the amount of new
Increase
investment per person
in capital per capita
required to keep the capital
per capita constant)
 Dynamic behavior of capital per capita: the Solow
diagram
Replacement investment
per capita
Production per +
capita; Gross
investment per = Production per
capita; capita
Replacement
investment per =
capita Gross investment per
capita

= +

 Steady state in the Solow diagram
Replacement investment
per capita
Steady-state
+
output per
capita

*


Gross investment per
Steady-state capita
consumption
per capita =

Steady-state capital
per capita
At , = + .
 Steady state
The figure shows that capital per capita tends to reach the value
in the long run (note: this is also true if the initial 0 is higher than
. Try and show it in the diagram!) .
Thus output per capita will tend to reach the value = ( ) in
the long run, consumption per capita will reach the level = (1
) , etc.
The values , , , etc. define the steady state of the economy,
i.e., its long-run equilibrium.

If 0 < (>) , capital per capita grows (decreases) until its steady-
state level.
Once capital per capita reaches the steady state, growth in capital
per capita stops: capital per capita stays constant over time.
Why? Because of the decreasing marginal product of capital!
Steady state values of capital per capita and output per capita
The long-run values of capital per capita, output per capita,
etc., depend on parameters. How? What makes a nation rich?
In steady state, it must be that = 0, because is constant.
Then use the Solow equation to solve for :

sB k
*
n k*
1
s
1 This equation gives
1
k B
* 1
the basic Solow
n models answer to the
question Why are we
s
1
y B k
1
* so rich and they so
*
B 1

n
poor?

(similarly, you can determine the values of , , , etc. in the long run)
Introduction to Economic Growth, 3rd Edition
Copyright 2013, W.W. Norton & Company
Introduction to Economic Growth, 3rd Edition
Copyright 2013, W.W. Norton & Company
The natural interest rate
1 1
s s
r* *

n n
The real rate of interest is determined by productivity and thrift
in the long run:
Higher capital is more productive demand of capital per worker
increases (ceteris paribus) higher equilibrium interest rate (the price of
capital).
Higher supply of capital per worker increases the equilibrium
interest rate decreases.
1
Reasonable parameter values on an annual basis, = = ,
3
0.22, = 0.005, = 0.05, imply = 8.3% and = 3.3%.
This value for is very close to empirical observations of the
real interest rate!
Comparative statics
Comparative statics is used to analyze how the endogenous
variables respond to a change in the value of some parameter
of the model, or to a shock (for example, a sudden increase in
the population).
We will consider an economy that is initially in steady state but
experiences a parameter change or a shock.

For example, what happens if there is an increase in the saving

(=investment) rate ?
Or a sudden decrease in the capital stock?
We can use the Solow diagram to answer these questions.
Introduction to Economic Growth, 3rd Edition
Copyright 2013, W.W. Norton & Company
The Golden rule of saving

Is there an optimal saving (investment) rate?

s
1
1
y* B 1

n

1 s
1
s 1
c* B 1

n

The that maximizes , which is = , is called the

golden rule savings rate.
Introduction to Economic Growth, 3rd Edition
Copyright 2013, W.W. Norton & Company
Growth in the basic Solow model
The basic Solow model predicts that there is no growth in
output per capita in the long run: not in accordance with
stylized facts!
The growth rate of GDP in the long run is predicted to be equal
to the population growth rate, (why?).
In this model, an economy with a capital per worker below its
steady-state value will experience positive growth rates of
and of along the transition path to the steady state.
Due to decreasing marginal returns, however, growth rates will
decrease over time as the economy approaches the steady
state, and will be zero in the long run.
This is clearer if analyzed with the diagram in the following
page.
Transitional dynamics: modified Solow diagram
Growth
rate of
capital
per Positive, decreasing
capita
growth rate

+

Negative, increasing growth rate

Modified Solow equation: = 1 + ]

Conditional convergence
Given two countries characterized
Growth by the same parameters, the
rate of growth rate of the poorer country
capital is higher than the growth rate of
per the richer one.
capita

Policy conclusions in the basic Solow model
What can a (poor) country do to create a transitory growth in
GDP per capita resulting in a permanently higher level of
income and consumption per capita?

The basic Solow model provides the following answers:

Increase the saving (investment) rate
Reduce the population growth rate
Reduce the rate of depreciation of capital, i.e., invest better
Improve the level of technology
Policy conclusions in the basic Solow model (cont.)

Attention! The technology level, the saving rate, the population

growth rate and the depreciation rate all affect the levels of the
various variables in steady state
but do not affect their long-run growth rate, which goes back to
zero for variables per capita (and back to for aggregate
variables).

Due to the diminishing marginal product of capital, an economy

cannot experience positive growth rates in the long run by simply
saving and accumulating capital.
Conclusions: the basic Solow model and the
stylized facts of economic growth
The basic Solow model fits several of the stylized facts we
observe from the data:
It generates differences in per capita incomes across
countries
It generates a constant capital-output ratio in the long
run
It generates a constant real interest rate in the long run
It predicts conditional convergence

However, the model fails to predict a very important

stylized fact:
Most Western economies exhibit sustained per capita
income growth