PART III Growth Theory: The Economy in

the Very Long Run

Economic Growth I: Capital

Accumulation and Population Growth

Chapter 8 of Macroeconomics, 8th

edition, by N. Gregory Mankiw
ECO62 Udayan Roy
 The Solow-Swan Model
This is a theory of macroeconomic dynamics
Using this theory,
you can predict where an economy will be
tomorrow, the day after, and so on, if you know
where it is today
you can predict the dynamic effects of changes in
the saving rate
the rate of population growth
and other factors
 Two productive resources and one
produced good
There are two productive resources:
Capital, K
Labor, L
These two productive resources are used to
produce one
final good, Y
 The Production Function
The production function is an equation that
tells us how much of the final good is
produced with specified amounts of capital
and labor
Y = F(K, L) Y = 5K L 0.3 0.7

labor
Example: Y = 5K0.3L0.7 0 10 20 30
capital 0 0 0 0 0
1 0 25.06 40.71 54.07
2 0 30.85 50.12 66.57
3 0 34.84 56.60 75.18
4 0 37.98 61.70 81.95
 Constant returns to scale
Y = 5K0.3L0.7
Y = F(K, L) = 5K0.3L0.7 labor
0 10 20 30
Note: capital 0 0 0 0 0
if you double both K and 1 0 25.06 40.71 54.07
2 0 30.85 50.12 66.57
L, Y will also double
3 0 34.84 56.60 75.18
if you triple both K and L, 4 0 37.98 61.70 81.95
Y will also triple
and so on
This feature of the Y = The Solow-Swan model
5K0.3L0.7 production assumes that production
function is called functions obey constant
constant returns to returns to scale
scale
 Constant returns to scale
Definition: The production function F(K, L)
obeys constant returns to scale if and only if
for any positive number z (that is, z > 0)
F(zK, zL) = zF(K, L)

Example: Suppose F(K, L) = 5K0.3L0.7.

Then, for any z > 0, F(zK, zL) = 5(zK)0.3(zL)0.7 =
5z0.3K0.3z0.7L0.7 = 5z0.3 + 0.7K0.3L0.7 = z5K0.3L0.7 = zF(K, L)
At this point, you should be able to do
problem 1 (a) on page 232 of the textbook.
 Constant returns to scale
CRS requires F(zK, zL) = zF(K, L) for any z > 0
Let z be 1/L.
Then,
1 1 1
F K , L F ( K , L) So, y = F(k, 1) .
L L L
From now on, F(k, 1) will
K F ( K , L) Y be denoted f(k), the per
F ,1
L L L worker production
function.
k = K/L denotes per y = Y/L denotes
worker stock of capital per worker So, y = f(k) .
output
 Per worker production function:
example k
0
y
0
1 5
2 6.156
Y F ( K , L) 5 K 0.3 L0.7 3 6.952
4 7.579
0.3 5 8.103
K
0.3 0.7 0.3 0.3
Y 5K L 5K K 6 8.559
10.7 5 0.3 5 7 8.964
L L L L L 8
9
9.330
9.666

y 5k 0.3 f (k )
10 9.976
11 10.266
0.3 y = 5k 12 10.537
14 13 10.793
12 14 11.036
15 11.267
10
16 11.487
8
17 11.698
At this point, you This is what a typical per
6 18 11.900
should be able to do 4
worker production function 19 12.095
problems 1 (b) and 3 2
looks like: concave 20 12.282
(a) on pages 232 and 0
233 of the textbook. 0 5 10 15 20 25
 The Cobb-Douglas Production
Function
Y = F(K, L) = 5K0.3L0.7
This production function is itself an instance of a
more general production function called the Cobb-
Douglas Production Function
Y = AKL1 ,
where A is any positive number (A > 0) and
is any positive fraction (1 > > 0)
 Per worker Cobb-Douglas production
function
Y = AKL1 implies y = Ak = f(k)
1
Y AK L
1 1
Y AK L AK L
y 1
L L L L

K
y A Ak In problem 1 on page 232 of the textbook,
you get Y = K1/2L1/2, which is the Cobb-
L Douglas production with A = 1 and = .
In problem 3 on page 233, you get Y = K0.3L0.7,
which is the Cobb-Douglas production with A
= 1 and = 0.3.
Per worker production function: graph
 Income, consumption, saving,
investment
Output = income
The Solow-Swan model assumes that each
individual saves a constant fraction, s, of his or
her income
Therefore, saving per worker = sy = sf(k)
This saving becomes an addition to the
existing capital stock
Consumption per worker is denoted c = y sy
= (1 s)y
Income, consumption, saving,
investment: graph
 Depreciation
But part of the existing capital stock wears out
This is called depreciation
The Solow-Swan model assumes that a
constant fraction, , of the existing capital
stock wears out in every period
That is, an individual who currently has k units
of capital will lose k units of capital though
depreciation (or, wear and tear)
 Depreciation
Although 0 < < 1 is the fraction of existing
capital that wears out every period, in some
casesas in problem 1 (c) on page 219 of the
textbookdepreciation is expressed as a
percentage.
In such cases, care must be taken to convert
the percentage value to a fraction
For example, if depreciation is given as 5 percent,
you need to set = 5/100 = 0.05
Depreciation: graph
DYNAMICS
 Dynamics: what time is it?
Well attach a subscript to each variable to
denote what date were talking about
For example, kt will denote the economys per
worker stock of capital on date t and kt+1 will
denote the per worker stock of capital on
date t + 1
 How does per worker capital change?
A worker has kt units of capital on date t
He or she adds syt units of capital through saving
and loses kt units of capital through
depreciation
So, each worker accumulates kt + syt kt units of
capital on date t + 1
Does this mean kt+1 = kt + syt kt?
Not quite!
 Population Growth
The Solow-Swan model assumes that each
individual has n kids in each period
The kids become adult workers in the period
immediately after they are born
and, like every other worker, have n kids of their
own
and so on
 Population Growth
Let the growth rate of any variable x be
denoted xg. It is calculated as follows:
change in the value of x new value of x old value of x
xg
initial value of x old value of x

Therefore, the growth rate of the number of

workers, Lg, is:

(n 1) 1
Lg n
1
 How does per worker capital change?
Recall that, each individual has kt units of
capital on date t
and accumulates kt + syt kt units of capital
on date t + 1
which he/she shares equally with his n kids
(who are adult workers at time t + 1).
Therefore, the per worker capital stock at time
+
t + 1 is + =
+
 Dynamics: algebra
+
+ =
+
Using this equation and other information about
the production function, population growth and
depreciation, we would be able to use information
about the current level of k to predict the entire
future of the economy!
Lets try an algebraic example.
 Dynamics: algebra
+
+ =
+
We also saw earlier that in the Cobb-Douglas
case, y = f(k) = Ak.
Therefore, we get

kt 1
1
n 1

kt sAkt kt Now we are ready for
dynamics!
 Dynamics: algebra
kt 1
1
n 1

kt sAkt kt
A = 10 t kt yt = Akt syt kt
= 0.3 0 12 21.07436 4.214872 1.2
= 0.1
1 12.51239 21.34038 4.268076 1.251239
n = 0.2
2 12.94102 21.55711 4.311423 1.294102
k0 = 12
s = 0.2 3 13.29862 21.73412 4.346823 1.329862
4 13.59632 21.87895 4.375789 1.359632
5 13.84373 21.99763 4.399526 1.384373
6 14.04907 22.09501 4.419003 1.404907
7 14.2193 22.17499 4.434999 1.42193
8 14.36031 22.24074 4.448147 1.436031
9 14.47702 22.29481 4.458962 1.447702
10 14.57357 22.33931 4.467862 1.457357
 Dynamics: algebra
kt 1
1
n 1

kt sAkt kt
A = 10 t kt yt = Akt syt kt
= 0.3 0 12 21.07436 4.214872 1.2
= 0.1
1 12.51239 21.34038 4.268076 1.251239
n = 0.2
2 12.94102 21.55711 4.311423 1.294102
k0 = 12
s = 0.2 3 13.29862 21.73412 4.346823
At this point, 1.329862
you should be able to
4 13.59632 21.87895 do problems 11.359632
4.375789 (d) and 3 (c) on
5 13.84373 21.99763 pages 232 and1.384373
4.399526 233 of the
6 14.04907 22.09501 textbook.
4.419003 Please give them a try.
1.404907
7 14.2193 22.17499 4.434999 1.42193
8 14.36031 22.24074 4.448147 1.436031
9 14.47702 22.29481 4.458962 1.447702
10 14.57357 22.33931 4.467862 1.457357
 Dynamics: algebra to graphs
kt syt kt Although this is the basic Solow-Swan dynamic
kt 1 equation, a simple modification will help us analyze
n 1 the theory graphically.

kt syt kt kt syt kt n 1
kt 1 kt kt kt
n 1 n 1 n 1
kt syt kt (n 1)kt kt syt kt nkt kt
kt 1 kt
n 1 n 1
syt kt nkt syt ( n)kt
kt kt 1 kt
n 1 n 1
sf (kt ) ( n)kt
kt Now we are ready for graphical analysis.
n 1
 Dynamics: algebra to graphs

sf (kt ) ( n)kt
kt kt 1 kt
n 1
This version of the Solow-Swan
equation will help us understand
the model graphically.
 Dynamics: algebra to graphs

sf (kt ) ( n)kt
kt kt 1 kt
n 1
This version of the Solow-Swan 2. The economy shrinks if and only if per
equation will help us understand worker saving and investment [sf(kt)] is
the model graphically. less than ( + n)kt.

1. The economy grows if and only if per 3. The economy is at a steady state if
worker saving and investment [sf(kt)] and only if per worker saving and
exceeds ( + n)kt. investment [sf(kt)] is equal to ( + n)kt.
4. ( + n)kt is called break-even investment
 Dynamics: graph

sf (kt ) ( n)kt
kt kt 1 kt
n 1
 sf (kt ) ( n)kt
kt
n 1
Investment and
break-even ( + n)kt
investment
sf(kt)

k1 k* Capital per
Steady state worker, k
 Moving toward the steady state
sf (kt ) ( n)kt
Investment kt
and n 1 ( + n)kt
depreciation
sf(kt)

k1
investment

Break-even investment

k1 k* Capital per
Steady state worker, k
 Moving toward the steady state
sf (kt ) ( n)kt
Investment kt
and n 1 ( + n)kt
depreciation
sf(kt)

k1

k1 k2 k* Capital per
Steady state worker, k
 Moving toward the steady state
sf (kt ) ( n)kt
Investment kt
and n 1 ( + n)kt
depreciation
sf(kt)

k2
investment
Break-even
investment

k1 k2 k* Capital per
Steady state worker, k
 Moving toward the steady state
sf (kt ) ( n)kt
Investment kt
and n 1 ( + n)kt
depreciation
sf(kt)

k2

k1 k2 k3 k* Capital per
Steady state worker, k
 Moving toward the steady state
sf (kt ) ( n)kt
Investment kt
and n 1 ( + n)kt
depreciation
sf(kt)

As long as k < k*,

investment will
exceed break-even
investment,
and k will continue to
grow toward k*

k1 k2 k3 k* Capital per
Steady state worker, k
STEADY STATE
 The steady state: algebra
The economy eventually sf (kt ) ( n)kt
reaches the steady state kt
n 1
This happens when per
worker saving and sf (k ) sAk ( n)k
investment [sf(kt)] is sA k
equal to break-even k 1
n k
investment [( + n)kt]. 1

For the Cobb-Douglas sA 1

k
*

case, this condition is: n
At this point, you should be able to do
problems 1 (c) and 3 (b) on pages 232 and 233
of the textbook. Please give them a try.
 Steady State and Transitional
Dynamics: algebra

1
1
kt 1 kt sAkt kt sA 1
n 1 k
*

A= 10
n
t kt yt = Akt syt kt
= 0.3
0 12 21.07436 4.214872 1.2
= 0.1
n= 0.2 1 12.51239 21.34038 4.268076 1.251239
k0 = 12 2 12.94102 21.55711 4.311423 1.294102
s= 0.2 3 13.29862 21.73412 4.346823 1.329862
4 13.59632 21.87895 4.375789 1.359632
k* =15.03185 5 13.84373 21.99763 4.399526 1.384373
6 14.04907 22.09501 4.419003 1.404907
7 14.2193 22.17499 4.434999 1.42193
8 14.36031 22.24074 4.448147 1.436031
9 14.47702 22.29481 4.458962 1.447702
10 14.57357 22.33931 4.467862 1.457357
SOLOW-SWAN PREDICTIONS FOR
THE STEADY STATE
 There is no growth!
The Solow-Swan model predicts that
Every economy will end up at the steady-state; in
the long run, the growth rate is zero!
That is, k = k* and y = f(k*) = y*
Growth is possibletemporarily!only if the
economys per worker stock of capital is less than
the steady state per worker stock of capital (k < k*)
If k < k*, the smaller the value of k, the faster the
growth of k and y
 There is no growth!
In the long run, saving per worker is constant
and equal to sy* = ( + n)k*. Therefore,
1
+ 1 1
1
= = 1
+ +



Therefore, =
+
And consumption per worker is also constant.
It is equal to c* = (1 s)y*
 From per worker to total
We have seen that per worker capital, k, is
constant in the steady state
Now recall that k = K/L
and that L increases at the rate of n
Therefore, in the steady state, the total stock
of capital, K, increases at the rate of n
 From per worker to total
We have seen that per worker income y = f(k)
is constant in the steady state
Now recall that y = Y/L
and that L increases at the rate of n
Therefore, in the steady state, the total
income, Y, must also increase at the rate of n
Similarly, although per worker saving and
investment, sy, is constant in the steady
state, total saving and investment, sY,
increases at the rate n
 From per worker to per capita
Recall that L = amount of labor employed
Suppose P = amount of labor available
This is the labor force
But in the Solow-Swan model everybody is capable of
work, even new-born children
So P can also be considered the population
Suppose u = fraction of population that is not
engaged in production of the final good.
u is assumed constant
Then L = (1 u)P or L/P = 1 u
 Per worker to per capita
We just saw that L/P = 1 u
Stock of capital per capita (or, per person) is K/P

= = 1

Therefore, as k and u are constants in the steady
state, the per capita stock of capital is constant
too
Similarly, per capita income, (1 u)y, and per
capita saving and investment, (1 u)sy, are also
constant in the steady state
 Steady state: summary
Variable Symbol Steady state behavior
Capital per worker k Constant
Income per worker y = f(k) Constant
Saving and investment per worker sy Constant
Consumption per worker c = (1 s)y Constant
Labor L = (1 u)P Grows at rate n
Capital K Grows at rate n
Income Y = F(K, L) Grows at rate n
Saving and investment sY Grows at rate n
Population P Grows at rate n
Capital per capita (1 u)k Constant
Income per capita (1 u)y Constant
Saving and investment per capita (1 u)sy Constant
Consumption per capita (1 u)c Constant
SOLOW-SWAN PREDICTIONS FOR
CHANGES TO THE STEADY STATE
A sudden fall in capital per worker
A sudden decrease in k could be caused by:
Earthquake or war that destroys capital but not
people
Immigration
A decrease in u
What does the Solow-Swan model say will be
the result of this?
 A sudden fall in capital per worker
sf (kt ) ( n)kt
Investment kt
and n 1 ( + n)kt
depreciation
sf(kt)

At this point, you should be able to

do problem 2 on pages 232 and
233 of the textbook. Please give it
a try.
2. A gradual return to the steady state

k1 k* Capital per
worker, k
1. A sudden decline
 An increase in the saving rate

Investment
and ( + n)kt
break-even s2f(k)
investment
s1f(k)
An increase in the saving
rate causes a temporary
spurt in growth. The
economy returns to a
steady state. But at the
new steady state, per
worker capital, output,
and saving are all higher. k
Per worker consumption k1 * k2 *

is a bit trickier.
 An increase in the saving rate
1. An increase in the saving rate raises investment
2. causing k to grow (toward a new steady state)

Investment
and ( + n)kt
break-even s2f(k)
investment
s1f(k)
3. This raises steady-
state per worker
output y* = f(k*) and
saving sy*.

4. The growth rate

begins at zero,
becomes positive for a
while, and eventually
* *
k
returns to zero. k1 k2
 An increase in the saving rate
1. Recall that the saving rate is 2. What can we say about the
a fraction between 0 and 1. steady state levels of k, y, and c
when s = 0?
Investment 3. And when s = 1?
and 4. So, how is consumption ( + n)kt
per worker, c, affected by
break-even f(k)
changes in s?
investment
c* sf(k)

f(k*)
sf(k*)

k*
k
 Being the grasshopper is not good!
1. Recall that the saving rate is 2. What can we say about the
a fraction between 0 and 1. steady state levels of k, y, and c
when s = 0?
Investment 3. They are all zero!
and ( + n)kt
break-even f(k)
investment

sf(k) when s = 0

k*= 0
k
 Being a miserly any is not good either!
1. Recall that the saving rate is 2. What can we say about the
a fraction between 0 and 1. steady state levels of k, y, and c
when s = 1?
Investment
and ( + n)kt
break-even f(k) = sf(k)
investment
c*= 0

sf(k*) f(k*)

k*
k
 Effect of saving on steady state
consumption
For the Cobb-Douglas case, it can
be shown that the Golden Rule
saving rate is equal to capitals
Steady state share of all income, which is
consumption per approximately 30% or 0.30.
worker, c* = (1 s)f(k*)
The US saving rate is well below
Golden Rule 0.30. So, according to the Solow-
consumption Swan model, if we save more we
per worker will, in the long run, consume more
too!

0 Golden Rule 1 Saving rate, s

Saving rate
A decrease in the saving rate
An increase in the saving rate
 What do we get for thrift?
In the long run, a higher rate of saving and
investment gives us
A higher per worker income
But not a faster rate of growth
And consumption per worker, c* = (1 s)y*,
may increase or decrease or stay unchanged
when s increases.
At this point, you should be able to do
problem 4 on page 233 of the textbook.
Please try it.
 Whole lecture in one slide!
Solow-Swan Predictions Grid
kt+1, yt+1, kt k*, y*, i* = sy* c* = (1 s)y*
kt ? 0 0
s + + ?
A + + +
n

sAkt ( n)kt
kt
n 1 1

kt 1
1

kt sAkt kt sA
k
*

1

n 1 n
Effect of saving: evidence
 Faster population growth

3. This reduces steady-

state per worker
output y* = f(k*),
saving sy*, and
consumption (1 s)y*.

4. The growth rate

begins at zero,
becomes negative for a
while, and eventually
returns to zero. 5. The effect is the same if
depreciation increases
What do we get for having fewer kids?
In the long run, a lower rate of population
growth gives us
A higher per worker income
But not a faster rate of growth

At this point, you should be able to do

problem 6 on page 233 of the textbook.
Please try it.
Faster population growth: evidence
Alternative perspectives on population growth
The Malthusian Model (1798)
Predicts population growth will outstrip the
Earths ability to produce food, leading to the
impoverishment of humanity.
Since Malthus, world population has increased
sixfold, yet living standards are higher than ever.
Malthus neglected the effects of technological
progress.
 Alternative perspectives on population growth

The Kremerian Model (1993)

Posits that population growth contributes to
economic growth.
More people = more geniuses, scientists &
engineers, so faster technological progress.
Evidence, from very long historical periods:
As world pop. growth rate increased, so did rate of growth
in living standards
Historically, regions with larger populations have enjoyed
faster growth.
Alternative perspectives on population
growth: Kremer
Robert Solow and Trevor Swan