Economics 334: Approaches to Economic Growth

The Solow Growth Model

Source: OECD - Maddison (2001) The World Economy: A Millennial Perspective

Real GDP per capita growth rates, selected countries 1820-1998

Country 1820-70 1870-1913 1913-1950 1950-73 1973-98

United Kingdom Germany

1.26 1.09

1.01 1.63

0.92 0.17

2.44 5.02

1.79 1.60

France
Italy Western Europe

0.85
0.59 1.00

1.45
1.26 1.33

1.12
0.85 0.83

4.05
4.95 3.93

1.61
2.07 1.75

United States
Canada Japan

1.34
1.29 0.19

1.82
2.27 1.48

1.61
1.40 0.89

2.45
2.74 8.05

1.99
1.60 2.34

China

-0.25

0.10

-0.062

2.86

5.39

Source: OECD - Maddison (2001) The World Economy: A Millennial Perspective

Theories of Economic Growth

Classical Economists:
David Hume (1711-1776) Adam Smith (1723-1790) Thomas Malthus (1766-1834) David Ricardo (1772-1823) Karl Marx (1818-1883)

Twentieth Century
David Harrod-Evsey Domar 1940s (Keynesian)
Robert Solow 1950s (Neo-classical) Paul Romer 1980s (Endogenous Growth)
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SOLOW, R. M. (1957) Technical Change and the Aggregate Production Function, Review of Economics and Statistics, Vol 39, No 3, pp. 312-320
The problem: What explains growth? A case study of the U.S. economy between 1909 and 1949. During this period, the economy grew approximately 80 percent. What explains this average annual growth rate? How much is due to: growth in the labour force? capital accumulation? technological change?

The growth accounting framework has developed from Solows model and is widely used to determine the relative contribution of these factors in economic growth

His argument:
That the amount of output produced by a given K(t) and L(t) increases over time as technology A(t) grows.

How does Solow make his case?

He doesn't have data for A(t) but he argues that growth in technology can be inferred from the growth in output capital and hours worked. To do this he brings in a more general economic framework, a production function with constant returns to scale. (Recall the definition of constant returns to scale?)
The most convenient (and widely accepted) way to illustrate the growth accounting framework is to use a Cobb-Douglas production function:
(1)

Y = AK a Lb

See Diagram I

where Y=output, A="technical progress", K=capital stock, L=labour supply,

a and b represent the shares of capital and labour in production.

Output (Y)

Y2
Y1

Y=Af(K)

sY=sAf(K)

Extensive Growth
Capital (K)

K1

K2

 But we want to disaggregate the contribution of each of the factors of production and technology to growth in output, Y over time.

This can be accomplished by a mathematical manipulation of the Cobb-Douglas production function (taking the logarithm and differentiating with respect to time*) to get the equation in linear form. (Why would we want to do this?)
A simple representation of the results of this manipulation is: DY DA DK DL This equation represents = +a + (1 - a ) ; "extensive growth" Y A K L
DL Where D represents "change", eg. L 2 -L1; So, =growth rate of labour and so on. L
* For those of you who may wish to know, ln( xy) = ln x + ln y . The mathematics behind the derivation of the growth accounting equation is not necessary for this course.

 The contribution of technical progress can be determined by subtracting the contribution of the other factors from output growth.

DA DY DK DL That is, = -a - (1 - a ) A Y K L

This is the Solow Residual.

But what about "intensive growth?" We are interested in growth in per capita incomes.
To get to the intensive form of the growth accounting equation we divide (1) by L:

K L Y = A L L L

where y=output per capita (or per worker) and k=capital to labour ratio.

This gives us y = Ak a
Taking the logarithm and derivative with respect to time once again, we have:

Dy DA Dk = +a y A k

So growth in per capita income is a function of technological change and capital accumulation. But if capital is subject to diminishing returns, then in the long run growth in output is determined by technological change. Solow's findings: 7/8ths of output growth in the period 1909-1949 was due to "technological progress."

Another way to represent the model:

Formal refinements of this model take into account depreciation, d and population growth, n.
Firms must invest sufficient capital to replace worn out machinery and equipment And to keep growing, an economy must provide the growing labour force with capital - That is, to maintain the capital to labour ratio that allows the growth of per capita income to remain at its desired rate Taking into account depreciation only we can represent this mathematically as : K (Investment)=sF(K,L)-dK Taking into account both depreciation and population growth in extensive form:

K=sF(K,L)-(d+n)K

or K=sY-(d+n)K

Again, we are interested in intensive growth:

That is, we are interested in determining the savings necessary to maintain the desired growth in per capita income after taking in to account the depreciation of capital and population (work force) growth. - the STEADY STATE level of capital accumulation is such that....

sy=(d+n)k
THAT IS, WHERE SAVINGS PER CAPITA IS JUST SUFFICIENT TO COVER DEPRECIATION AND POPULATION GROWTH

We can represent these relationships graphically:

y*

sy=sf(k)

THE ECONOMY WILL TEND TOWARD THE STEADY STATE RATE OF GROWTH.

k1*

k*

k2*

What if the population growth rate falls?

y2*
y*

sy=sf(k)

k*

k2*

What if the savings rate rises?

So increasing the proportion of income allocated to savings, raises per capita income.

y2*

sy2=s2f(k)

sy=sf(k)

....But what determines whether the members of a society raise the share of savings from income (individually or in aggregate)?

k2*

How would we represent the Solow model with technological change graphically?

two issues to think about here:

Firstly, that it is usually the case that when technological change occurs, further investment in capital is required to implement the change That links to a second assumption, that technical change tends to be labour augmenting (that it makes each worker more productive) Y=f(K,AL) We can now think of capital per worker in terms of capital per effective worker, since now each worker is made more productive by technological change.
Note: for a good mathematical representation of this model, see jones, c. (2001) Introduction to Economic Growth. For a nice tutorial on the neoclassical growth model with some interactive pages see www.Fgn.Unisg.Ch/eurmacro/tutor/neoclassicalgrowth-index.Html.

 Secondly, if population is growing at the rate of n, and technology is growing at the rate of a, then the required investment to maintain the steady state rate growth of output, output per worker (now effective worker), and consumption per capita is (n+d+a)k.

 This is why technology is seen to be crucial to increasing the standard of living. Without technological change, the steady state growth rate of output is just sufficient to keep up with population growth (n) and depreciation (d). With technological change, output per worker will rise and potentially incomes as well. What determines whether workers incomes will rise?
Question: If technological change is labour augmenting and the rate of population growth is falling, what implications does this have for economic growth? What are the options available to an economy characterized by this situation (Europe and other industrialized countries)?

Question: If the nature of existing technological change is labour augmenting and the birth rates are falling, what implications does this have for economic growth?

What are the options available to an economy characterized by this situation (Europe and some other industrialized countries)?

But just what does thetechnology residual, A, represent?