BLOCK -I UNIT 3 THE NEO –CLASSICAL GROWTH

MODEL –THE SOLOW MODEL ⁎

Structure
3.0 Objectives
3.1 Introduction
3.2 The Solow Model
3.2.1 Assumptions
3.2.2 Structure of the model
3.2.3 A Comparison with the Harrod-Domar Model
3.2.4 A Critical Appraisal of the Model
3.3 Extensions of the Neo-Classical Model
3.3.1 Depreciation of Capital Stock
3.3.2 Variable Savings Rate
3.3.3 Population Growth
3.4 Money in the Neo-Classical Growth Model
3.5 Convergence and Poverty Traps
3.5.1 Convergence
3.5.2 Poverty Trap
3.6 Let Us Sum Up
3.7 Key Words
3.8 Some Useful Books
3.9 Answer/ Hints to Check your Progress Exercises

3.0 OBJECTIVES
After going through the unit, you will be able to:
 describe the structure of the Solow model with the assumptions under which
it holds;
 specify the equilibrium condition in the Solow model;
 outline how consumption is treated in the Solow model;

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 compare the HDM with the Solow model; The Neo –Classical
Growth Model –The
 critique the Solow model; Solow Model

 indicate how the significance of ‘population growth’ is accounted for in the

Solow model;
 write a note on ‘money in the neoclassical growth models’;
 discuss the concepts of convergence and poverty traps.

3.1 INTRODUCTION
In the past few decades, there have been three waves of interest in growth theory.
The first was associated with Harrod and Domar. The second wave was from the
development of the neo-classical economists. The third wave was as a reaction
to the omissions and deficiencies in the neo-classical models. In this unit, we
will study about the second wave of interest in the growth theory i.e. one of the
popular neo-classical growth models namely the Solow model.

Robert Solow and Trevor Swan, like Harrod and Domar, worked independently
of each other around 1956. Hence, in literature, their model is referred to as the
Solow-Swan model. The basic idea of the Solow-Swan model was also revealed
by James Tobin who also worked around the same time. Hence, our discussion
in this unit will concentrate on the Solow’s version of the model. In fact, Solow
model serves to represent a class of neo-classical models of many contributors
who all worked with similar basic idea.

3.2 THE SOLOW MODEL

In 1956, Professor R.M. Solow published a seminal paper on growth and
development entitled, ‘A Contribution to the Theory of Economic Growth’. In
this paper, he suggested a model which was in fact the first major extension and
improvement over the Harrod-Domar model (HDM). Recall that the HDM had
(i) clarified the role of capital accumulation and (ii) emphasized the importance
of technological progress as the ultimate driving force behind a sustained
economic growth. Solow argued that the ‘fixed proportions production function’
(made by HD as a ‘crucial assumption’) results in an instability. He, therefore,
added labour as a factor of production and allowed capital-output ratios to vary.
Solow’s main purpose was to ignore the short-run fluctuations in employment
and savings rates focusing instead on their long-run relationships. Hence,
Solow’s model attempts to explain long-run economic growth by concomitantly 43
 looking at capital accumulation, labour or population growth, and increases in
BLOCK -I
productivity. Note that (i) the productivity increase is commonly referred to in
economics literature as ‘technological progress’ and (ii) many other economists,
who later worked on similar idea as Solow (e.g. David Cass, Tjalling
Koopmans), referred to the Solow model as the base line model.
3.2.1 Assumptions
Solow Model is based on the following assumptions.
1) The economy produces one composite good which can either be
consumed or accumulated as a stock of capital. The single good
represents a set of ‘composite’ or ‘aggregated’ good.
2) Implication of the above is that there is no international trade or
foreign trade.
3) Labour supply is homogeneous. In other words, no distinction is
made between workers with different skills i.e. between blue-
collared and white-collared workers.
4) People save a constant proportion of income i.e. if S denotes the
aggregate saving at the economy level, then S = sY, where the small
s refers to the constant proportion of income saved by individuals.
5) Labour force grows at an exogenous growth rate i.e. gL = n where
labour force at time ‘t’ is given by Lt = L0ent.
6) There is a stock of capital accumulated from the past. This capital
and the labour are the two factors of production i.e. are inputs in the
production process.
7) The production function exhibits constant returns to scale. This
means, if labour and capital are increased by a certain proportion,
say , output also increases by the same proportion . Thus, there is
a continuous aggregate production function displaying constant
returns to scale.
8) There is no government intervention i.e. there are no taxes or
government purchase.
9) Technology is exogenous i.e. technology available to firms is
unaffected by the actions of the firms like research and
development.
Under the above assumptions, Solow showed that with variable technical co-
44 efficient, capital-labour ratio tends to adjust itself over time. This means, if the
initial ratio of capital-labour is more, capital and output will grow slower than The Neo –Classical
Growth Model –The
labour force and vice-versa. Solow Model

3.2.2 Structure of the Model

The aggregate production function considered here is of the Cob-Douglas form.
That is:
Y = F (K, L) = K . L1- 0<<1 (3.1)
Let ‘w’ be the wage per worker and ‘r’ be the interest paid for one unit of capital.
Since the firms are assumed to be competitive, the profit maximizing equation for
the firms is:
MAXK,LF (K, L) = rK + wL (3.2)
Firms will hire labour until the marginal productivity of labour is equal to ‘w’
and will rent capital until the marginal productivity of capital is equal to ‘r’. If
we write the production function in terms of output per worker i.e. y = Y/ L and
capital per worker i.e. k = K/ L (and plot it as in Fig. 3.1), we get the function of
capital-labour ratio as:

Y/ L = F (K/ L, L/L)
Y/ L = F (K/ L, 1)
y = f (k, 1)
y = f (k) = k

Sometimes income is used as synonymous to output. Denoting output by Q and

output-labour ratio by q, we have q = f(k). With more capital per worker, firms
produce more output per worker. However, since diminishing returns to capital
per worker operates, as the per capita capital increases, the output-capital ratio
falls. Note that in Fig. 3.1, any point d on the curve f(k) gives the ratio of output
to capital. Note that d is = Q/ K which is the reverse of capital-output ratio (V).
Let us now consider the equilibrium of growth. We have:
k = K/L
Taking logarithms, we get: ln (k) = ln (K/ L)
ln k = ln K – ln L
Differentiating w.r.t. time, we get: d/dt (ln k) = d/dt(ln K) – d/dt (ln L)
45
1/ k = 1/K – 1/L
 dk/dt(1/k) = dK/dt(1/K) – dL/dt(1/ L)
BLOCK -I
k' = K'– L' (3.3)
We have: S = sY and I = dK/ dt (∵ dK/dt = Investment)
At Equilibrium, Savings = Investment. Therefore: dK/ dt = sY.
The second term on the Right Hand Side of (3.3), L', shows the proportional
growth rate of labour which we have denoted by n. Hence, (3.3) can be written
as:
k' = sY/K - n
Dividing Y and K by L. we get
k' = sf(k)/k – n (3.4)
Equation (3.4) is the fundamental equation of the Solow Model. Equation (3.4)
gives k', the rate of growth of k, in term of k itself. The equilibrium value of k
is the one for which dk/dt(1/k) is 0 i.e. dk/dt = 0 or where k, once it reaches that
value, does not change. Setting k' = 0 in (3.4), we get
k' = 0 = s f(k*)/ k* - n
s f(k*)/ k* = n
where a star (*) above k denotes its equilibrium value. The equilibrium value of
q is obtained as:
q* = f(k*) = nk*/s
sq(k*) = NK*
The above is shown with the help of a diagram (Fig. 3.2).
At any point to the left of k*, where k < k*
sf (k)/ k > n
and at any point to the right of k*
sf (k)/ k < n
From equation (3.4) we can see that, if k' > 0,
k < k* and k' is increasing. Likewise, we
can see that if k > k*, k' is falling. In
equilibrium, when k equals k*, q reaches its
equilibrium q*. Since q* is a constant:
dθ/dt (1/t) = dL/dt (1/t) = n
The economy thus converges to a steady state growth where θ' = K' and capital
output ratio ‘V’ is constant. However, θ' and K' are not greater than L' but equal
to it. Hence, the equilibrium condition in the Solow Model is:
46 sf (k*)/k* = n
which can be written as The Neo –Classical
Growth Model –The
F(q)/Q = q/ Q = (Q/L)/(K/L) = Q/K = 1/V* Solow Model

where, V is capital-output ratio. We thus have, n = S/V* which is the Harrod-

Domar condition for balanced full employment growth. However, the Solow
model allows V to vary and explains how the economy will turn towards a
growth path. The capital output ratio V* emerges as an equilibrium value and
not as a necessary technology assumption.
3.2.3 Consumption in the Solow Model
We know that in a closed economy with no government intervention, in
equilibrium we have:
Y=C+I
where Y is aggregate output, C is aggregate consumption and I is investment.
Writing in per-worker form, we have:
Y/L = C/L + I/L
Since Y/ l = y = f (k), we have: f (k) = Y/L + C/L
Since we are assuming K = I (where K = Net investment and I = Gross
Investment) and we are taking depreciation = 0, we have:
Y/L =C/L + K/L (3.5)
Now, let us assume, k =K/L where, k is capital-labour ratio. Then:
dk/dt . 1/k = dK/dt . 1/K – dL/dt . 1/L
or k' = K' – L'
where ' denotes proportional growth rate.
k' = K' – n
or k*/ k = K*/ K - n
Dividing both sides by K/ L,
k*/ k. K/L = K*/K . K/L – n. K/L
k*/ k. K/L = K*/L – nk
k' = K*/L - nk
K*/ L = k' + nk (3.6)
Using (3.6) in (3.5), we get: f(k) = C/L + k'+ nk (3.7)
Note that when capital goods increase faster than the increase in labour, so that
the capital-labour ratio rises, it is called capital deepening. But when capital
goods rise merely to keep pace with the rise in labour force, so that the capital
labour ratio remains constant, it is called capital widening. Equation (3.7) divides
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 output per worker between (i) consumption per worker, (ii) capital deepening and
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(iii) capital widening.
3.2.4 A Comparison with the Harrod-Domar Model
The first basic difference between the Solow model and the Harrod-Domar model
is that in the Solow model the capital-output ratio is not exogenously fixed. It is
endogenously determined. The second difference is that the process of
adjustment in the variables is different in the two models. In the HD model, there
are two knife-edges: the balance between the actual and warranted rates of
growth, and between the warranted and natural rates of growth. Solow’s model
does not address this question. It instead assumes that planned investment equals
planned savings at all times. This is because s, v, n were all considered fixed in
the HD model, whereas in the Solow model, there is a spectrum of values that the
capital-output ratio (COR) can take. The COR adjusts to that value at which the
warranted rate of growth equals the natural rate of growth. The third major
difference between the Harrod-Domar model and the Solow model is that the HD
model assumes constant marginal returns to capital while the Solow model
assumes decreasing marginal returns to capital. Thus, in the Harrod-Domar
model a change in the savings rate (s) has a permanent effect on the growth rate
of GDP per capita, while in the Solow model a change in the savings rate has
only a temporary effect on the growth rate of GDP per capita.
3.2.5 A Critical Appraisal of the Model
Solow takes a continuous production function to analyze the process of growth.
With the assumption of substitutability between capital and labour made, Solow’s
growth process provides a touch of realism. In a long-run economic system, the
Harrod-Domar model needs a knife-edge balance between the three key
parameters of saving ratio, capital-output ratio and the rate of increase in labour
force. If the magnitudes of these parameters were to slip even slightly from the
dead centre, the consequences would be either growing unemployment or chronic
inflation. In Harrods’s terminology, this balance is poised on the equality of Gw
(which depends on the saving and investing habits of households and firms) and
Gn (which, in the absence of technical change, depends on the increase of the
labour force).

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According to Solow, the delicate balance between Gw and Gn flows from the The Neo –Classical
Growth Model –The
crucial assumption of fixed proportions in production providing for no possibility Solow Model

of substitution between labour and capital. If the need for knife-edge balance
between Gw and Gn were to disappear, the above crucial assumption needs
relaxed. Solow, therefore, builds a model of long-run growth without making the
assumption of fixed proportions in production. He thereby demonstrates a steady
state growth. Despite these virtues, the Solow model too is critiqued for the
following reasons.
 There is an absence of investment function in the model. There is
therefore the consequent failure to assign a major role to
entrepreneurial expectations about the future.
 Solow’s model totally ignores the problem of composition of capital
stock and assumes capital as a homogeneous factor. This is
unrealistic in the dynamic world of today. Further, capital goods are
of aggregation.
 Flexibility of factor prices assumption of Solow pose difficulties in
the path towards steady growth.
 The model takes up only the problem of balance between Harrods’s
Gw and Gn and leaves out the problem of balance between G and Gw.
 By treating technology as an exogenous factor in the growth process,
the model leaves much to the causative process of technical progress.
It thereby ignores the scope for inducing technical progress through
learning, investment in research and capital accumulation.
 The Solow-Swan model performs poorly when tested
with empirical evidence. Substantial modifications have to be added
(particularly regarding technical progress) to make it data compliant.
Check Your Progress 1
1) Indicate the structure of Solow model specifying its components.
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 2) Compare the Solow and Harrod-Domar model.
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3) On what grounds the Solow model is critiqued?
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3.3 EXTENSIONS OF THE NEO-CLASSICAL

MODEL
We consider three extensions viz. (i) depreciation of capital stock, (ii) variable
savings rate and (iii) population growth.
3.3.1 Depreciation of Capital Stock
If there is no depreciation at all, then Gross Investment = Net Investment i.e. I =
K. On the other hand, if capital depreciates at say a%, then:
I = K + aK (3.8)
where, I = Gross Investment, k = Net Investment and a = Rate of depreciation.
Dividing both sides of (3.8) by L, we get:
I/ L =K/L + aK/L
I/ L = K/L(1+a) (3.9)
We know that K/L = k + nk (derived from the structure of Solow Model).
Substituting this in equation (3.9) we get:
I/ L = k + nk +ak
I/ L = k + (n + a)k (3.10)
Since in equilibrium S = I, I/L can be written as S/L which is denoted as sf(k).
Therefore, putting these values in equation (3.10), we get:
sf(k) = k + (n + a)k

50 or k =sf(k)/ k – (n+a) (3.11)

Equation (3.11) is the equation for depreciation of capital stock. It is only a The Neo –Classical
Growth Model –The
slight modification of the fundamental equation of the Solow Model. Solow Model

3.3.2 Variable Savings Rate

Solow Model does not assume saving rate to be constant. As savings increase
from S1 to S2, it leads to an upward shift in the savings curve sf(k). It causes a
new point of intersection between sf(k) and nk. At the new equilibrium point, ‘k’
and ‘y’ both will increase. Since the savings rate is a key determinant of the level
of capital per person, with a higher saving rate, the economy will have a larger
capital stock and output. But, saving has only a temporary effect on the growth
in output per person i.e. the economy will grow only till the economy reaches a
new level of equilibrium with a particular level of capital per person. This means
that any change in the savings rate has only a temporary effect on the economy’s
growth rate. This is called as the Solowian paradox of thrift. This point is
important because it is often suggested that developing countries should raise
their savings rate. This, however, requires the pushing up of the growth rates in
per-capita income. But the increase in the savings rate would push up growth
rates only temporarily. Hence, the basic lesson of the Solow model is that
permanent increase in the growth rate of per-capita income comes about only
through a major change like improvement in technology.
3.3.3 Population Growth
Let us now examine the effect of growth in population in the Solow model. We
have seen that capital accumulation by itself cannot explain long-term growth
since this has to necessarily come through technical progress. We have to
therefore focus on the other source i.e. labour or population. Let us suppose that
the population increases at a rate ‘n’. This will increase the number of workers
available and hence, capital per worker i.e. k will fall. We know that:
Δk = sf(k) – nk
Hence, an increase in population (n, not the rate, but the level) reduces k. Now,
if there is a change in the rate of population growth itself, say, population
increases from n0 to n1, then the nk line will tilt upwards. If the sf(k) curve
remains the same, the new nk line will cut the sf(k) curve to the left of the earlier
intersection point. The new equilibrium will therefore also be to the left of the
previous equilibrium point. This results in the steady state capital per worker k*
to fall. Since y = f(k), a reduction in k* results in the fall of ‘y’ too. Thus in the
51
Solow model, if the rate of growth of population rises, output per worker will
 fall. Therefore, a developing country must take care to see that population does
BLOCK -I
not increase too much as this may have a detrimental effect on the per-worker
output.

3.4 MONEY IN THE NEO-CLASSICAL GROWTH

MODEL
The role of money in the neo-classical growth models is explained by James
Tobin in his paper published in 1965. Tobin had independently developed a
growth model in l955. His model was similar to the Solow model but had the
existence of government debt (net ‘outside’ wealth). For our analysis, we assume
that there is only one such type of outside wealth: money, yielding a certain rate
of return denoted by R. In the original Solow model, physical capital was the
only form of wealth that existed. However, money being an important alternative
store of wealth, Tobin extended this to bring in outside government wealth in the
form of money. Tobin used the simple quantity theory of money i.e. MV = PY.
He assumed the velocity of money to be constant. Therefore, the growth in
money equals the difference between the inflation rate and growth in nominal
income i.e.:
M' = P' − Y'
where ' represents the proportional growth rate of a variable x. Note that if
money stock is constant (M' = 0), then prices will fall at the rate of growth of
output Y' and real money balances i.e. M/P will grow at that same rate. Let the
real wealth (A) be held in two assets i.e. real money (M/P) and physical capital
(K) in a proportion such that:
A = α(M/P) + (1-α)K
where α lies between 0 and 1, determined through portfolio selection by
households. The important thing Tobin did was to consider the real rate of return
from money as the difference between the nominal rate of interest and inflation
rate. Tobin explained that people make a comparison between R (real rate of
return) and the marginal productivity of capital. This has implications through
the function f(k) on output growth. Hence, during inflation, people hold less of
real money (because real value of money falls) and hold more of K. This further
leads to a fall in the marginal productivity of capital. The opposite will happen
during recession. Johnson (1967) pointed out that a limitation of Tobin's model
is that it treats money solely as a store value. It does not consider its use in
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overcoming transaction costs, etc. They therefore suggested extensions to the The Neo –Classical
Growth Model –The
Tobin model where money directly enters the utility function. Solow Model

Check Your Progress 2

1) What is the effect of change in the saving rate in the Solow model?
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2) What is meant by the ‘Solowian paradox of shift’?
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3.5 CONVERGENCE AND POVERTY TRAPS

Let us now look at two important applications of the neo-classical model having
a bearing on development economics viz. (i) convergence and (ii) poverty traps.
3.5.1 Convergence
Solow Model claims that over a long period of time, all countries would
converge towards the same rate of growth. This is referred to as convergence.
The rationale for this is as follows.
 The rate of return on capital is higher in countries where capital is
relatively scarcer. Hence, capital will flow from the developed countries
to developing and under-developed countries.
 The above leads to the incomes of the poorer countries to rise. This
eventually leads to a balanced growth path of countries in the long run
and thereby the convergence.
 While there may be initial differences in incomes among countries (for
reasons like better stock of knowledge), eventually, as the poorer
countries gain access to the latest technologies, such differences in
incomes will shrink. 53
 The convergence can be either (i) an absolute or unconditional convergence or
BLOCK -I
(ii) conditional convergence. The former states that if ‘n’ number of countries
have three things in common [viz. (i) access to same technology, (ii) same
saving-ratio, (iii) same population growth rate] but have different capital-output
ratio, then such countries would eventually converge to same level of growth rate
called ‘equilibrium steady state growth’. To understand this further, suppose
there are two countries, one rich and one poor. Suppose the poor country has
capital labour ratio k1 and the corresponding value for the rich country is k2.
Since k1 < k2, the absolute convergence predicts that both countries will
ultimately converge to a level k*, between k1 and k2. This is because capital-
output ratio being higher in the poor country, both capital and output in the poor
country grows at a rate faster than the rate of growth of population. On the other
hand, capital and output in the rich country will grow at a rate slower than its rate
of growth of population. In other words, since k1< k2, marginal product of k will
help accumulate more capital in the poor country and hence grows at a rate faster
than in the rich country. The gap between the two countries will narrow down.
However, empirical evidence has not supported the existence of absolute
convergence.
The ‘conditional convergence’ states that if ‘n’ number of countries has access to
same technology with same population growth rate, but are different in saving-
ratios and capital-labour ratio, there will still be convergence in their growth rate.
But, the equilibrium level of capital-output ratio may or may not be equal. This
is because of the Solowian paradox of savings (which states that any change in
savings rate has only a temporary effect on the economy’s growth rate).
However, in real life scenarios, even conditional convergence is not observed
because different countries have different population growth rates.
The validity of the un-conditional convergence was examined by Baumol (1986).
He used data compiled by noted economic historian Angus Maddison. The data,
however, related to a set of 16 countries that are among the richest today.
Baumol plotted the per-capita incomes for these countries (for the period 1870-
1979) on the horizontal axis and the growth rate of per-capita incomes on the
vertical axis. If the unconditional hypothesis were true, one would find an inverse
relationship. Baumol indeed found a downward sloping scatter plot showing a
negative relationship. This proved the hypothesis of conditional convergence.
54 Notwithstanding this, Baumol’s findings was critiqued by Bradford De Long on
two grounds: (a) biased sample selection; and (b) measurement error. When The Neo –Classical
Growth Model –The
Baumol carried out the study, the countries chosen in his sample were already Solow Model

rich. In 1870, there was no way of knowing which countries were going to grow
faster. Thus, ex-post knowledge cannot be a basis for ex-ante prediction. Since
historical data are constructed retrospectively, countries for which data is
available over a long period are also likely to be those that have grown rapidly in
the past 100 years or so and who are industrialized today. Secondly, Baumol
suspects that estimates of data for 1870 may not be precise. He means that
countries whose 1870 per capita income was overstated would have grown faster
than their accurate estimates. Likewise, countries for which 1870 per capita
income was understated would have grown slower than had been measured.
Either way, there would be a bias showing convergence.
3.5.2 Poverty Trap
Empirically, the convergence hypothesis has not gained validity well. The neo-
classical model has not been very successful in showing why rates of growth
differ across countries given that many countries of the world are poor. In other
words, what has gone on is the exact opposite of what is suggested by the
convergence hypothesis i.e. some countries were showing stagnant growth, while
others are progressing very fast. This led to the idea that the poorer countries are
actually caught in a trap called ‘poverty trap’. A poverty trap is defined as ‘any
self-reinforcing mechanism which causes poverty to persist’. If it persists from
generation to generation, the trap would reinforce itself unless effective steps are
taken to break the cycle. The trap refers to a mechanism which makes it very
difficult for people to escape poverty. It is a trap because, in spite of efforts,
these countries stay at a ‘low-level equilibrium’. Such a trap is created when an
economic system requires a significant amount of various forms of capital in
order to earn enough to escape poverty. When individuals lack this capital, they
may also find it difficult to acquire it, creating a self-reinforcing cycle of poverty.
In the developing world, many factors can contribute to a poverty trap like: (i)
limited access to credit and capital markets, (ii) extreme environmental
degradation (which depletes the potential of agricultural production), (iii) corrupt
governance, (iv) capital flight, (v) poor education systems, (vi) diseased ecology,
(vii) lack of public health care, (viii) war and poor infrastructure, etc. Therefore,
two types of poverty traps can be distinguished viz. (i) technological-induced and
55
 (ii) population induced. Both can be explained using the Solow framework as
BLOCK -I
follows.
Technological Trap: In the production functions, y = f (k), or Y = F (K, L)
considered by Solow, if for certain values of K, the production function exhibits
increasing returns to scale, then there will be multiple equilibrium. Then, for
those values of k, say k*, if the economy grows at a level lower than k*, the
economy will slump back towards a low income and output level. In such a
situation, called a technological trap, the country may receive an initial injection
of capital to yield a value of k larger than k*. This is sometimes called the ‘Big
push Theory’ on which you will read more in Block 4 later. On its opposite side,
there could be a situation of poverty trap, caused by low savings and low
technology. It leads to what is called as the ‘vicious circle of poverty’ on which
too, you will read more in Block 4.
Population Trap: The second way in which poverty traps can arise is by more
than the desired population growth. In the neo-classical model, the rate of
population growth is taken exogenously. However, classical economists
considered population growth as endogenous. For instance, Robert Malthus
(1798) on whom you will study in Block 4, suggested that the rate of growth of
population depends on per capita income. As the per capita income rises, the rate
of population growth rises faster. This has come to be known as the theory of
demographic transition. We can use this idea of demographic transition in the
neo-classical model. Recall that in the neo-classical model, population grows
exogenously at a rate ‘n’. Now, suppose population growth rate is dependent on
‘y’, as suggested by the theory of demographic transition. We know that y is a
function of capital per person i.e. y = f(k, l). Thus n, the population growth rate
indirectly becomes a function of the capital labour ratio: n =g(k, l).
We may now think of some interval k2 – k1 where (i) for values of k below k1, n
is < 0, but for values of k in the range [k2, k1], n is > 0 and (ii) for values of k >
k2, n may again be < 0. Historically, in older times, in societies where k was
below k1, population was lost through wars, disease, etc. Now, consider the
range k2 – k1. Even here, n is although > 0, it can itself increase or fall. In other
words, although the population is increasing, the rate of increase may vary. Such
variations leads to situations where the saving (or investment) curve changes its
shape turning to be S shaped. We would then have multiple equilibrium points of
56 ‘k’, most of which are unstable. Any movement from these points would push
the system farther away rather than bringing it back into equilibrium. Suppose The Neo –Classical
Growth Model –The
we have two equilibrium points ka and kb. Let ka lie between k1 and k2 i.e. Solow Model

k2>ka>k1. Let kb be greater than k2. Here ka is the stable equilibrium while kb is
unstable. For any value of k greater than k2, the economy is pulled back to
equilibrium level ka. Only with an injection of capital given to push the ‘k’ level
above kb (where the equilibrium is unstable) will the k level receive the required
‘Big Push’. Earlier, we mentioned the demographic transition, which roughly
says that n depends on y and k/l. But in the last century, due to advances is
healthcare and medicine, low ‘y’ has not necessarily led to low ‘n’. As death
rates have dropped, population has increased. On the other hand, sub-Saharan
African countries like Ethiopia did see ‘n’ very low. Other countries too have
experienced under-population due to very low levels of y.
Check Your Progress 3
1) Distinguish between absolute and conditional convergence.
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2) What is meant by the concept of ‘poverty trap’?
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3.6 LET US SUM UP

The Solow model is an extension of the Harrod–Domar model. The classical
economists argued for the failure of the Harrod-Domar model because of the
assumptions on fixed proportions production function. The dialogue between the
Harrod-Domar and the Classicalists led to the creation of Solow-Swan model.
The model provides an explanation of long-term economic growth using the
fundamental factors of labour, capital and productivity. Solow removes the 57
 rigidity of capital-labour ratios basing his theory on the law of diminishing
BLOCK -I
returns to individual factors of production. If there is plenty of labour relative to
capital, a small amount of capital will suffice. On the other hand, if labour is in
short supply, capital intensive measures such as automation are required to raise
the output levels. Solow therefore regarded the capital-output ratio as an
endogenous variable i.e. not exogenous as was assumed in the Harrod-Domar
model. Therefore, the basic conclusion of the neo-classical growth model is that,
in certain circumstances, when production takes place (under the usual neo-
classical conditions of variable proportions and constant returns to scale), there
will be no conflict between the natural and the warranted rates of growth. In
other words, the extreme instability of long-run growth equilibrium is unlikely
and given sufficient time, the actual growth rate can adjust itself to any given
condition. The achievement of balanced growth in the long run is thereby
possible. Solow model theorized that in the long run only technological process
can bring growth.
The predictions of the Solow-Swan model includes that the rate of savings and
technological progress does not have any influence over the growth rate of
output. The increase in rate of savings is capital inductive as it increases the
capital accosted per labour. The biggest implication suggested by the Solow-
Swan model is that of conditional convergence. Under this theory, if countries
have the same variables like rate of savings, technology and growth rate of
population, they will ultimately converge in their overall economic growth rates
to a particular state. The other implication of this theory is that if an economically
poor country has the same variables like a rich country, in the long run, their
growth rates would converge.

3.7 KEY WORDS

Exogenous The value of which is given from outside. In modelling,
it is a variable whose values are not determined by
solving the model, but is taken as given.
Returns to Scale The concept arises in the context of production function.
It explains the behaviour of the rate of increase in output
(production) relative to the associated increase in the
inputs (the factors of production) in the long run.
Convergence This is also sometimes known as the catch-up effect. It
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 hypothesises that poorer economies' per capita incomes The Neo –Classical
Growth Model –The
will tend to grow at faster rates than richer economies. Solow Model

As a result, all economies should eventually converge in

terms of per capita income.

3.8 SOME USEFUL BOOKS

1) Lucas, Robert E. (2002), Lectures on Economic Growth. Harvard
University Press, Cambridge, Massachusetts.
2) Romer, David. (2001), Advanced Macroeconomics (2nd edition).
McGraw-Hill, Singapore.
3) Solow, Robert M. (2000), Growth Theory: An Exposition (2nd edition).
Oxford University Press, Oxford and New York.

3.9 ANSWER/ HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) k' = sf(k)/k – n where k = K/L (CLR), s = S/Y, n = growth rate of labour
and k' is the rate of growth of K.
2)
Sl. No. HDM Solow
1 Exogeneous fixation of CLR Endogenous determination of
CLR
2 S, v and n are all fixed The COR takes a spectrum of
values
3 Constant marginal returns to Decreasing marginal returns to
capital capital

3) (i) absence of investment function, (ii) assumption of capital as a

homogeneous factor ignoring its composition, etc.
Check Your Progress 2
1) It leads to larger capital stock and output but with only a temporary effect
on the per capita growth in output.
2) This is a reference to the temporary effect of increase in saving on
economy’s growth rate.

59
BLOCK -I
Check Your Progress 3
1) Convergence is said to be absolute when growth rate between countries,
having differing COR but similar savings/population/and technology
characteristics, nearly coincide. Convergence is said to be conditional
when countries with similar characteristics of technology and population
growth, but with differing savings and capital-labour ratios, experience
similar economic growth rates.
2) This is defined as a self-reinforcing mechanism causing poverty to persist.

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