: UNIT 3 THE SOCOW MODEL

i
; Structure
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3.0 Objectives
3.1 Introduction
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3.2 Features of the Solow nilode1
3.2.1 Supply of Goods
3.2.2 Demand for Good5
3.3 The Steady State
3 3.1 GrowthofGapital and Steady State
Gromth and Steady State
3.3.7 Populatio~~
-5.5.3 Ttctl;lological Progress and Steady State
34 7'heC;oldenRule
3.5 hasition to the Golden Rule Steady State
3.6 Let Us Sum Up
3.7 Key Wot'ds-
3.8 Son~eUseful Hooks
3.9 Answers/k-lintsto Check Your Progress Exercisec
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30
r . OBJECTIVES
After going through this unit you should be in aposition to
explain the basic premises on which the neoclassical Solow i~lodelis based:
describc the properties of neoclassical production function;
identify the implicationsof Solow model; and
explain the steady state growth of an economy.

.3 .1 1NTROI)UCTION
Tn the previous block we ohsewed that when saving is translate(! illto investments,
accumulation ol"capita1stock takes place. Such accumulatiorn in capital stock implies
an increase in the level of capital itlput. A basic feature of capital input is that it does
not get exhausted in a single use, that is, it is durable in nature. However, capital
input undergoes wear and tear, generally termed depreciat ion, during the course of
produc~ion.Thus when we deduct depreciation from gross investment we obtain
net investment, which tantamount to addition to capital stock.

As you know, capital and labour are two primary inputs used iri production process
and with the aid of technology trans^; rin intermediate inputs into output. If we assume
no shortage of intermediate input? 'le production capaci ty of an economy depends
upon the quantity, quality and util 'tation of the primary inputs. We should note that
most of thc growth models are built upon the premise of.'assured availability of raw
materials.
Economic Growth The classical economists in general did not pay much attention to the long-run im act
of investment. In the classical framework the economy passed through the s me
cycle of production period after period. The post-Keynesian economists, padc arly '
Harrod and Domar, emphasized the increase in capital stock due to investment see
Block 1 of the course MEC-004: Economics of Growth and Development). ater
on neoclassical economist R. M. Solow presented a model of economic gro
1956 which continues to remain as a lardmark in growth theory. Subsequent grdwth
models have brought in refinements and innovations into the Solow model. s he
Solow model explains the effect of saving, population growth and mchnological
progress on the economy's output growth. We discuss below the basic featured and
implications ofthe Solow model.
in 1 I
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3.2 FEATURES OF THE SOLOW MODEL
The Solow model considers an aggregate production function for the economJ/as a
whole such that a composite good is produced through a common tcchnolo y by
utilizing homogenous inputs, labour and capital. The first step to understan the
model is to study what determines the supply of and demand for goods i 1i the
economy.
1
3.2.1 Supply of Goods I

The supply of goods in the Solow model is determined by the production fundtion.
The production function has.three inputs (K, L, A ) and one output ( Y )variableb ancl
takes the form I

Y = output I

K = capital

L = labour

A =technology of pjroduction

The variable, in equation (3.1) denotes time that does not enter the model di
It implies that oveli time change in Ywill take place only due to change in
L and A ,
It is worthwhile to note that change in A occurs as a consequence of technol gical
progress. Labour and effectiveness of labour are introduced in the ode1 C
f
multiplicatively such that AL means effeclive labour. It meails that technol gical
progress is labour-augmenting, i.e., it increases the productivitj or efliciency of 1 bour.
Thus even if quantity of L remains unchanged, technological progress increa es the
quantity of effective labour (AL)in the economy.
I I
The production function d.escribed at (3.1) presents constant returns to scale ( ~ R s )

t
This assumption greatly simplifies the analysis and is often considered 'Fealist' . Tkic
presence of CRS implies ,that if we double all the inputs output will be dou led.

F(aK aAL)=aF(K, AL) ...(3.2

 where a can be my non-negative constant. The Solow Model

,The CRS assumption can be utilized to ccllvert the production function specified in
1
e$yition (3.1) to per effective labour terms. If o =-we can represent (3.1) as
'

AL
I

This form of the production function given at (3.3) is known as the intensive form. It
allows us to analyse all variables in the-economy relative to the size of effective labour
force.

K
Thus --- is capital expressed relative to effective labour, i.e,.,it is capital pa unit effective
AL
Y
labour. Moreover, F(% = - which is output unit effective labour. We
AL -

K Y
-
designate these in Iowercase letters such as - = k and - = Y andflk) = F(k, 1)
AL AL

so that the production h c t i o n in (3.3) can be written as

Y =f@) ...(3.4)
Fig. 3.1 illustrates the above production function

Fig. 3.1 :Neoclassical Production Function

I In Fig. 3.1 we measure k on the x-axls and y on the y-axis. Since k represents capital
/ labour ratio, as we move along x-axis the amount of capital available per unit of labour
I increases. A basic feature of (3.1) is that while CRS prevails, there is diminishing returns

i to capital input. It implies that when both K and L are increased proportionately there is
Economic Growlh CRS.On the other hand. if there is an increase in Kwhile keeping AI, constant, we

~
obtain diminishing returns to K. -

The slope of the producthn function gives the marginal productivity of capital (MPK)-
K
that shows the extra output per effecthe labour produced when - is increased by 1
AL
unit. MPK can be mathematically written as .

MPK -.flk+l) - 8 k ) ...(3.5)

The intensive form of production h c , ion given at (3.4)and depicted through Fig. 3.1
is assumed to satisfjithe following con&tions:

1) a) at k = 0, f(k) = f(0) = 0

b) MPK is positive, that is, f '(k) > 0

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c) MPK declines as k rises, that is. f "(k) 4

2) The intensive form in addition is also assumed to satisfLingthe lnuu'u conditions.

(a) yz .f '(k) = ,which implies that when capital stock is too small the MPK
is very large.

(b) klim
- + y ~ -f '(k) =O, which implies that MPK is very small when the capital stock

is too large.

These conditions are much stronger than are needed to derive the results of the model
* and have been introduced to ensure that the growth path of the economy docs not
diverge.

Tt is evident from Fig. 3.1 that a tangent drawn at any point on the curc e has a positive
slope, but the slope of tangents is declining as we go towards the right (as k rises).
Hence MPK is positive but declining. Moreover at k = 0 the tangent to the production
function is a vertical line (which implies that MPK = a ) . As k rises the production
function becomes flatter and when k--+ we have MPK = 0. It is important to note
here that Solow model assumes other inputs beside K, L and A not to be important and
hence are not included in the production function.
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3.2.2 Demand for Goods
In a Solow economy goods are demanded fitr consumption and investment purposes.
n1us

Tf we express (3.6) in per effective labour terms (that is, divide by

1
-)we obtain
AL ~
We omit government expenditure and net exports in (3.6) which are present in the
national income accounti identity (see Unit 1). While government expenditure is ignored
 for simplificationin presentation, net exports (that is, exports minus imports) is excluded The Solow Model
because the economy is assumed to be closed.

Each year people save a fraction s of their income. Thus s is the saving rate and it
assumesa value between 0and 1.The relationshipbetween output and saving is depicted.
in Fig. 3.2.

V. Output f(k)

Fig. 3.2: Output and Saving

Saving per effective labour = s y

Therefore, consumption c = (1 - s)y

asy=i ...(3.9)
L
Equation (3.9)shows that saving equal investment, a condition necessary for equilibrium
in the economy.

Check Your Progress 1

1) What are the basic assumptions on which the Solow model is based?

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Economtc Growth

2) What is the basic equilibriumcondition depicted by the Solow model? I

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3.3 THE STEADY STATE

As seen in equation (3.9) investment per unit of effectivelabour equals savingper unitlof
effective labotir:
i = sy
Sincey =f(k) we can write equation (3.9) as

The above shows the relationshipbetween existing capital stock (k) and accumulatibn
of new capital (i) expressed in'per effectivelabour' tenn.
~
As you know, increase in capital stock is due to investment. Thus the diffaence betw&n
capital stock in two successive years is equal to investment that has taken place duribg
the year. In other words, the rate of growth capital stock is equal to the rate of investmebtt.
In per effective labour term, we can express (3.10) as

k = sf (k) ...(3.11)
where k refers to the growth rate in k (In general we put a dot over a variableto
represent its growth rate). I

The above equilibrium condition is true for an economy where there is no depreciatibn
to capital stock, there is no population growth and technological progress does not &e
place. Let us assume for the time being that there is no population growthand technologi
progress in the economy. We will relax these unrealistic assumptions later on. I

3.3.1 Growth of Capital and Steady State

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The Solow model assumes that existing capital depreciates at the rate S.Thus each y
SK amount of capital is depreciated.

hivestment and depreciation act in opposite directionsand the growth in

net of the two quantities.

k(t) = i(t) - Sk(t) I

since i = sf(k(t)) i
 The Solow Model

Fig. 3.3: DepreciationRate

From (3.12) we infer that capital stock rises when sf k(t)) > &(t); falls when sf(k(t))
< &(t) and remains constant when sf(k(t)) = &(t).

Fig. 3.4 depicts equation (3.12) graphically.

v

1 Fig. 3.4: Steady State of an Economy

Ecoriomic Growth The two curves, saving and depreciation curves, intersect at point X, where capital
stock is k* and depreciationequals investment.At this point there is no growth in capital.
stock hence output also remains steady. k* is therefore known as the steady state level
of capital. There are two unique features of the steady state: (i) economy in steady sate
will remain there till there is change in any other variable, and (ii) economy will always
move towards the steady state. For example, if the economy starts at k, level of capital,
where k,< k* (see Fig. 3.4), investment exceeds depreciation.As a result, capital st&k
k, along with outputf(k) rises till kreaches k*. On the other hand, if the economy s W s
at k2level of capital, which is greater than k*, investment is less than depreciatibn.
Consequently there is a decline in capital stock and output in the economy until stekdy
state capital, that is, k* is reached.
Once the economy attains the steady state there is no pressure on k to increasd or
decrease hence the economy stays there. Thus the Solow model does not explhin
sustained economic growth.An economy with a high saving rate will have higher lev4 of
output and capital as compared to a country with low rate of saving. Thus saving date
is an important determinant of an economy's output and capital. This to some extbnt
explains the disparity in output across countries. Saving rate may vary across c o u n t h
due to plethora of reasons ';ke development of financial markets. tax policy. cultdral
differences,retirement policies, political stability and political institutions.Empidcal
evidence given by Mankiw comparing income per person with investment as percentage
of output of 84 countries confirmsthe association between high savinglinvestment date
and high level of income per person. ow ever 1.ecites the case of ~ e x i c and
o Zimbdwe
that have similar investment rates but income per person in Mexico is thrice ofthait in
Zimbabwe. This leads us to the question that besides saving and investment there hre
otherpotential factorsthat determine living standards.We study two ofthem below, diz..
population growth and technical change.

3.3.2 Population Growth and Steady State

To analysethe effect of population growthwe expand the Solowmodel. we now consiber
the case where population and the labour force grow at a constant rate n. When labur
force grows, additional capital is required to maintain the same level of k. Hence tthe
economy should have adequate investmentsto take care of depreciation (6k) as well as
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population growth (nk). In order to introduce n we modifjr equation (3.12) as

i ( t ) = sf (k(t)) - (n + 6)k(t) ...(3.13) ~

For steady state the amount of investment required must not only cover depreciadon
(a) but also provide new workers with capital (nk). Break-even investment now wo(u1d
be (n+ S)k. The steady sate is achieved at the point of intersection of investment b d
(n+ S)k curves. The line 2% in Fig. 3.4 accordingly is adjusted to represent (J+ n)k.

investment is greater than break even investment so k and y rise. On the other han I if
k,>k*, k declines till it reaches k*.
d'
The steady state is reached in a similar manner as discussed in earlier section. If k, k*

Population growth succeedsin explaining sustained economic grad in an econom .In

this framework, however, output per effective labour remains unchanged. Reme!n ber
that at the steady state we witness constant k andy But capital stock ( K ) and output)(v
keeps on growing at the rate n to keep k and y constant. Such a feature explainsthe
cross-country disparity in incomes. Let us assume that country I has population grab
of n, and country I1has n2such that n,>n2.Saving rate in both countries is assume1to
 The Solow Model

k,' -
Steady state
capital declines
k,'

-- State in Two Countries

Fig. 3.5: Steady
.

be the same.Accordingly, in Fig. 3.5 we draw a line (&n,)k with a slope greater than
that of (&n,)k.
We can easily comprehend from Fig. 3.5 that the country with high growth rate of
population n, has lower level of k* (the steady state level of k) and thus lowery. Empirical
evidence cited by Mankiw supports the above model. Thus it is often emphasized by
policy makers in India to conml population growth in order to attainhigher living standads.

3.3.3 Technological Progress and Steady State

To explain growth in output per effective labour, we need to introduce technological
progress in the Solow model. As stated earlier technological progress is assumed to be

(n + +6 )k

*
sf (k)

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k' k
Fig. 3.6: Steady State
Economic Growth labow-augmenting.Thus technological progress increases the quantity of effective la+
(AL). Let us assume that the rate of technological progress is g.
I

The change in k over time is now modified as

~
k(t) = sf (k(t)) - (n + g + S)k(t) ...(3.14)
In fact, equation (3.14) is the key equation of the Solow model of growth. Fig. 31.6
explains the equation through a diagram.

As is evident, the analysisof sZeady state doesnot change withthe inclusion of technologiM
progress. But the break-even investment now is (n+g+S)dc. Out of total investrndnt
sf(k), is needed to cover depreciation and nk to maintain capital per effective labdur
constant. However, as aresult of technological progressy grows at arate ofg. ~ l t h o u b
n, g and S are not individually restricted, the sum is assumed to be positive in the modiel,
i.e., n + g + S> 0.As mentioned earlier, in the steady state capital per effective labdur
and output per effective labour remains unchanged. There is a growth in output der
effective labour at a rate g and total output grows at the rate (n+g). We see that
introduction of technological progress enables us to account for increase in output +r
worker.

We concludethat according to Solow model persistently rising living standards (~h)

can be explained only through technological progress.

3.4 THE GOLDEN RULE

Let us see the impact of variation in saving rate on steady state. Let us assume that
saving rate rises while n, g, and S remain unchanged (see Fig. 3.7). Since i = sf@)
idbe higher investmentwhich in turnwill lead to capital accumulationand output gm
and the economy will eventually reach to a new steady state with higher capital
output.

Fig. 3.7: Impact of Saving Rate

 When saving rate rises from s, to s, the investment curve shifts up fiom s,f(k) to s,f@). The Solow Model
Thus the ecoriomy reaches a new steady state k,' after going through the process of
capital accumulation as described above.

It may lead us to'thinkthat a high rate of saving is always desirable since higher saving
resultsin higher capital stock and output. You may think that if saving is 100% there will
be largest possible output and capital stock in the economy.At various levels of s different
steady state are achieved with different levels of capital accumulation.However, there is
an optimum level of capital accumulation which i2called the golden rule level of capital.

At the golden rule level of capital the level of s is such @at the consumption per effective
labour is maximum at the steady state. Why is consumption per effect~belabour
maximized? This is because individuals, who make up the economy, are not concerned
about the capital stock or total output of the economy. For them what is important is the
amount of output they consume. Among the various steady states one that maximizes
consumption per effective labour is thus the most desirable one and hence called the
'golden rule level'.
You know that income (which is equal to output) is allocated on consumption and savhg
(which is equal to investment), that is, Y = C + 1. . Steazfy state consumption is output
net of investment.Thus
c* = y* - 'i -
We can write the above as

As increase in steady state capital has contrasting effect on steady state consumption -
more capital leads to more output which contributes positively to consumption, but it
also means higher break even investment (n+g+gk.

Fig. 3 . 8 illustrates steady state y and break-even investment as a function of steady

state capital, k*.
(n + g +6)k*

sf [k')

I Fig. 3.8: Golden Rule Steady State

 I
Economic Growth Steady state consumption is the gap between the steady state output and steady statk
break-even investment, which is m ~ at kiOw
~level of capid
d p r effctive labo*.
Recall that the slope of the production function is the marginal product of capital MPd.
We notice in Fig. 3.8 that at cioMlevel of consumption (golden rule level) the slope df
production function equals the slope of break-even investment, that is,
MPK= ( n + g + S )
Or
( M P K - S ) = (iz +& ...(3.16)
At the golden rule level oicapital, the MPK net of depreciation is equal to the rate bf
growth oftotal output (n + g).

The golden rule steady state is not achieved automatically.It requires a particular rate df
saving sgo, as shown in Fig. 3.9.

Fig. 3.9: Golden Rule Saving

To achieve the golden rule steady state level of capital kioida saving rate of s,, 1s
I
required such that, consumptionis maximized at ciold. I

~ f>ssgold(equivalently, k* > ki0, ) the economy is said to be dynamically inefficiedt.

willincrease consumption. On the other h U ,
In this case a fall in saving fiom s to sgOld
if s < sgOld(equivalently,k* < ki0, ) a rise in saving will decrease consumption in tne
shortrun but will eventuallylead to higher consumptionin the long run. How the transitidn
to golden rule steady sate can be achieved by changing the saving rate fiom s to sgOld
/is
dealt with in the next Section.
 The Solow Model
3.5 TRANSITION TO THE GOLDEN RULE STEADY
STATE
Let us discuss the impact of change in saving rate to achieve golden rule level of
consump60n, investment and capital. there can be two situations: (i) when s > sgoldor
steady state capital per effective labour is more thanrequired for golden rule level, and
(ii) when s < sgoldor steady state capital per effective labour is less than the golden rule
level of k;,, .

Case 1: when s > sgdd

In this case to achieve the golden rule level the saving rate needs to be decreased to
s g 0 ,. When saving rate falls consumption per effective labour immediately rises and
investment declines. The economy is no longer in a steady state as investment is less than
break-even investment of (n + g + s) k*. This leads to a decline in capital stock per
effective labour. Output per effective labour is a function of k so that Y/AL also declines.
Since c =y- i we observe that consumption per effective labour also declines. These
variablesJ c and i fall till the economy reaches anew steady state which is the golden
rule steady state.

At this level consumption is higher than the earlier steady state although the levels of
output and investment are lower. Consumptionper effective labour is higher in the entire
period oftransition to the golden rule steady state from the earlier level.

Case 2: when s < sgo,

When at a steady state s < sw we have kt < ki,,d. In this case s needs to be
increasedto achieve the golden rule steady state. When s rises there is arise in investment
which now exceeds break-even investment (n + g + 6) and the economy is in a state of
transition. There is accumulation of capital leading to rise in output per effective labour
(Y/AL). So when saving is increased consumption per effective labour declines
immediatelybut with rise in output per effective labour it rises to a level higher than the
level which initially prevailed.
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The dilemma of whether to try to reach the golden rule steady state or not is a question
of choice between current and future consumers. It is a trade off between present and
i firture levelsof consumption. We will discussmore about the inta-tempomlconsumption
decisions in Block 4.
I
i Check Your Progress 2

I 1) What do you mean by steady State?

EconomicGrowth 2) Under what condition does &I economy realise steady state?

3) What is the golden rule steady state for an economy? I

LET US SUM UP
The Solow model explains long-term growth in per capita output experienced b
economies world over. It assumes a constant returns to scale production functionwhic 4
allows for diminishingretumsto scaleto capital input. The model depictsthat the econom
has a tendency tc; converge to a steady state where availability of capital per worke
mnainsunchanged. In its simplest form the solowmodel is built upon the equality
1
savingand investment. I
I
Investment results in increase in capital input which is durable in nature and undergoe$
depreciation during the course of production. In steady state as capital stock availabl4
per unit of labour remains unchanged,the economy should have just enough investme4
to take care of, i) depreciation, ii) population growth, and iii) technical progress.

and output, but no sustained output growth. Sustained growth in output is explained i
the model neither by higher saving nor bipopulation growth. ath her high populatiob
growth reduces the per capita availability of output and capital. According to thb
4
The Solow model concludes that saving has only a 'level effect' and no 'growth effect'.
It means that higher saving in an economy increases per capita availability of capi

Solow model sustained output growth is possible only through technological progress]

Higher saving rate, although it increases per capita output, is not always desirable. Thb
objectiveof an emnomy is to maximize consumption,not saving. The golden lule sugge&
that capital should be at that level where MPK net of kpreciation is equal to outp
growth.
 The Solow Model
3.7 KEYWORDS
Break-even Investment The amountof investmentjustm&to compensate
for the depreciationto tl% existing capital stock.

Capital Acumulation Capital input daes not get exhausted in a single use
and remains in use for a long period of time. Thus
due to investment in successive years, capital input
gets axmdated.

Depreciation Natural weal and tear undergone by capital inputs

(such as mechineries, buildig, etc.) when production
of goods and services take place.

Golden Rule The condition for obtainingthe steady state which

maximizes consumption. It is given by the equality
betwen MPK net of depreciation and output growth
rate, that is, (MPK - 6 = n + g).

Inada Conditions Two conditionsrequid forthe production function

to be well behaved, formulated by Ken-Ichi Inada
in 1961P'

Labour-augmenting Technical change that results in increasing the

Technical Change productivity or efficiency of labour.

Steady State A condition when the economy does not have to

change its capital-labour ratio.

Sustained Growth Growth in output on a sustained h i s , ova a longer

period of time.

3.8 SOME USEFUL BOOKS

e

,,
Solow, R. M., 1970, Growth Theory, Oxford University Press, Oxford.

Romer, D., 1996, Advanced Macroeconomics, McGraw Hill Company Ltd., New
York., Chapters 1,2,3.

f Mankiw, N.G, 2003, Macroeconomics (Fifth Edition), Worth Publishers, New York,
Chapters 7 & 8.
t
3.9 ANSWERSIHINTS TO CHECKYOUR PROGRESS
EXERCISES
Check Your Progress 1

I ) The basic assumptionspertain to properties of the classical production function.

en ti on these properties.Also mention that the r&delel appliesto a closed economy.

2) The supply demand equilibrium condition needs to be mentioned. Point out that
equilibriumis realized when saving =investment.
EconomicGrowth Check Your Progress 2

1) It refers to a state or condition when the economy does not need to change it6
capital stock relative to its labour force.

2) Go through Section 3.3 and explain the condition sf (k) = n + g + 6 through

diagram (similar to Fig. 3.4). Explain the process how the econon~yreverts back tb
the above equality in case there is deviation.

3) Go through Section 3.4 and answer.