The Solow Growth Model (Part One)

The steady state level of capital and how savings affects output and economic growth.

Model Background

Previous models such as the closed economy and

small open economy models provide a static view of the economy at a given point in time. The Solow growth model allows us a dynamic view of how savings affects the economy over time.

Building the Model: goods market supply

We begin with a production function and assume constant
returns. Y=F(K,L) so zY=F(zK,zL)

By setting z=1/L we create a per worker function.

Y/L=F(K/L,1)

So, output per worker is a function of capital per worker. We

write this as,

y=f(k)

Building the Model: goods market supply

The slope of this function

is the marginal product of capital per worker. MPK = f(k+1)f(k) It tells us the change in output per worker that results when we increase the capital per worker by one.
y

MPK

change in y change in k

y=f(k)
Change in y

Change in k

Building the Model:

goods market demand

We begin with per worker consumption and investment.

(Government purchases and net exports are not included in the Solow model). This gives us the following per worker

national income accounting identity. y = c+I

Given a savings rate (s) and a consumption rate

(1s) we can generate a consumption function. c = (1s)y which makes our identity, y = (1s)y + I rearranging, i = s*y so investment per worker equals savings per worker.

Steady State Equilibrium

The Solow model long run equilibrium occurs at the

point where both (y) and (k) are constant. These are the endogenous variables in the model.

The exogenous variable is (s).

Steady State Equilibrium

By substituting f(k) for (y), the investment per worker
function (i = s*y) becomes a function of capital per worker (i = s*f(k)).

To augment the model we define a depreciation rate (). To see the impact of investment and depreciation on capital
we develop the following (change in capital) formula, k = i k substituting for (i) gives us, k = s*f(k) k

Steady State Equilibrium

If our initial allocation of (k) were too high, (k) would decrease because depreciation exceeds investment.
s*f(k),k If our initial allocation were too low, k would increase because investment exceeds depreciation. s*f(k*)=k* k

s*f(k)

At the point where both (k) and (y) are constant it must be the case that, k = s*f(k) k = 0 or, s*f(k) = k this occurs at our equilibrium point k*. At k* depreciation equals investment.

klow

k*

khigh

Steady State Equilibrium (getting there)

Suppose our initial
allocation of (k1) were too low.
k2=k1+k k3=k2+k
s*f(k),k k

k4=k3+k
k5=k4+k

s*f(k*)=k*

s*f(k)

This process continues until we converge to k*

k1

k2 k3 k4 k5 k*

K2 is Kstill is4still too K is5still is too still tootoo 3K low low so low so low so so

A Numerical Example

Starting with the Cobb-Douglas production

function we can arrive at our per worker production as follows, Y=K1/2L1/2 dividing by L, Y/L=(K/L)1/2 or, y=k1/2

recall that (k) changes until,

k=s*f(k)k=0

...i.e. until, s*f(k)=k

A Numerical Example

Given s, , and initial k, we can compute

time paths for our variables as we approach the steady state.

Lets assume s=.4, =.09, and k=4. To solve for equilibrium set s*f(k)=k. This
gives us .4*k1/2=.09*k. Simplifying gives us k=19.7531, so k*=19.7531.

A Numerical Example

But what it the time path toward k*? To get this

use the following algorithm for each period.

k=4, and y=k1/2 , so y=2. c=(1s)y, and s=.4, so c=.6y=1.2 i=s*y, so i=.8 k =.09*4=.36 k=s*yk so k=.8.36=.44 so k=4+.44=4.44 for the next period.

A Numerical Example

Repeating the process gives

period
1 2 . 10 .

k
4 4.44 . 8.343... . 19.75...

y
2 2.107... . 2.888... . 4.44

c
1.2 1.264... . 1.689... . 2.667...

i
.8 .842 . 1.126... . 1.777...

k
.36 .399 . .713 . 1.777...

k
.44 .443 . .412 . 0.000...

A Numerical Example

results Time Paths of Variables 20Graphing our results in Mathematica gives us,

15

10

20

40

60

80

100

period

Changing the exogenous variable - savings

We know that steady state
is at the point where s*f(k)=k
s*f(k),k k s*f(k)

s*f(k*)=k*

What happens if we
increase savings?

s*f(k*)=k*

s*f(k)

This would increase the

slope of our investment function and cause the function to shift up. This would lead to a higher steady state level of capital.
rate leads to a lower steady state level of capital.
k* k**

Similarly a lower savings

Conclusion

The Solow Growth model is a dynamic model that allows

us to see how our endogenous variables capital per worker and output per worker are affected by the exogenous variable savings. We also see how parameters such as depreciation enter the model, and finally the effects that initial capital allocations have on the time paths toward equilibrium.

In the next section we augment this model to include

changes in other exogenous variables; population and technological growth.