Government College Women University Sialkot

(GCWUS)

BS Commerce ( 4th semester)

ASSIGNMENT

Course Title: Macroeconomics

Submitted To: Maam Iqra

Submitted By: Nabeela Muhammad Boota

Roll no. BS-Com-R-005

 Solow growth model
The Solow Model shows how saving, population growth, and technological progress affect
the level on an economy’s output and its growth over time.
The Solow model is designed to show how growth in the capital stock, growth in the labor
force, and advances in technology interact in an economy as well as how they affect a
nation’s total output of goods and services.

Assumption
The Solow Growth Model is based on several key assumptions, including:
 The economy has a fixed labor force and a fixed stock of capital.
 The production function exhibits diminishing marginal returns to capital.
 There is a constant rate of technological progress.
 The economy is closed, meaning that there is no international trade

The Accumulation of Capital

The Supply for Goods and the Production Function
By considering the supply and demand for goods, we can see what determines how much
output is produced at any given time and this output is allocated among alternative uses.
Y=F(K,L)
The model is built in a series of steps:

Examine how the supply and demand for goods determine the accumulation of
capital. Assume that labor force and technology are fixed. Later on, we will introduce
changes in labor and technology.
Assumptions:

Production function has constant returns to scale. This means that an increase in all
inputs proportionately, Y will increase in the same proportion. Recall that a
production function has constant returns to scale if:
zY = F(zK, zL)
For any positive number z. That is if both capital and labor are multiplied by z, the amount of
output is also multiplied by z.
Production functions with constant returns to scale allow us to analyze all quantities in the
economy relative to the size of the labor force.

The assumption of constant returns to scale implies that the size of the economy—as
measured by the number of workers—does not affect the relationship between output
per worker and capital per worker.
Because the size of the economy does not matter, it is convenient to denote all quantities in per-
worker terms. Quantities per worker are designated with lowercase letters, so y= Y / L is output per
worker, and k = K / L is capital per worker. The function will look like this y = f (k).

The production function show how the amount of capital per worker k determines the
amount of output per worker y = f(k).
The slope of the production function is the marginal product of capital (MPK). If k
increases by 1 unit, y increases by MPK units. The production function becomes flatter as
k increases, indicating diminishing marginal product of capital. The slope of this
production function shows how much extra output a worker produces when given an extra
unit of capital. Mathematically:
MPK = f ( k + 1 ) - f ( k )

The Demand for Goods and the Consumption Function

The demand for goods in the Solow model comes from consumption and investment.
Output per worker y is divided between consumption per worker c and investment per
worker I:
y=c+i
Assumptions:
Each year people save a fraction s of their income and consume a fraction ( 1 – s ).
Consumption function:
c = ( 1 – s ) y,
To see what this consumption function implies for investment, substitute (1 − s ) y for c
in the national income accounts identity:
y = (1−s) y + i.
Rearrange the terms to obtain
i = s y.
This equation shows that investment equals saving. By now we’ve seen the two main
ingredients of the Solow Model – the production function and the consumption function.
Conclusion:
For any given capital stock k, the production function y=f(k) determines how much
output the economy produces, and the saving rate s determines the allocation of that
output between consumption and investment.
Growth in the Capital Stock and the Steady State
Capital stock is a key determinant of the economy’s output, but the capital stock can
change
over time, those changes can lead to economic growth. Two forces influence the capital
stock: investment and depreciation.
Investment – is expenditure on a new plant and equipment, and it causes the capital
stock to rise.
Depreciation – is the wearing out of old capital due to aging and use, and it causes
capital stock to fall.
Investment per worker is a function of the capital stock per worker:
i = s f( k )
This figure illustrates how, for any value of k, the
amount of output is determined by the production
function f(k), and the allocation of that output between
consumption and investment is determined by the saving
rate s.

Explanation:
The saving rate s determines the allocation of output between consumption and investment.
For any level of capital k, output is f(k), investment is sf(k), and consumption is f(k) - sf(k).
Now we have to incorporate depreciation into the model, assuming that a certain fraction
of δ the capital wears out each year. Here, δ is the lower-case Greek letter delta called the
depreciation rate. The amount of capital that depreciate each year is δk. The figure below
represents how the amount of depreciation depends on the
capital stock.
A constant fraction of δ of the capital stock wears out every
year. Depreciation is therefore
proportional to the capital stock. We can express the impact of
investment and depreciation on the capital stock with this
equation:
Change in Capital Stock = Investment − Depreciation
Δk = i − δk
Where Δk is the change in the capital stock between one year and the next. Because
investment i equals sf(k), we can write this as:
Δk = s f(k) − δk.
Now let’s put investment and depreciation in a graph. The higher the capital stock, the
greater the amount of output and investment. Yet the higher the capital stock, the greater
also
the amount of depreciation.
Population Growth
First two sections assumed that population is fixed
- Assumption: population and labor force grow at a constant rate n
o If population grows by 1 percent each year, n=0.01
o If 150 million are working one year, 151.5 million are working the next
(150 x 1.01) and 153.015 million the year after (151.5 x 1.01)
The Steady State with Population Growth
Factors that influence capital per worker
o Investment increases capital stock
o Depreciation decreases capital stock
o Growth in number of workers cause capital per worker to fall
- ∆ k=i−( δ+n ) k is the Change in Capital per Worker where lowercase letter stand for
quantities per worker
K Y
o Where k = is the capital per worker and y= is the output per worker
L L
and number of workers is growing over time
o Investment increases k , whereas depreciation and population growth
decrease k
o ( δ +n ) k is the Defining Break-Even Investment (amount of investment
necessary to keep the capital stock per worker constant)
 Depreciation reduces k by wearing out the capital stock, whereas
population growth reduces k by spreading the capital stock more
among a larger population of workers.
Steady state if capital per worker k is unchanging (k ¿ ¿ ¿)¿
- If k < ¿ k ¿, investment is greater than break-even investment, so k rises
¿
- If k > ¿ k , investment is less than break-even investment, so k falls
 - SS: Positive effect of investment balances negative
effect of depreciation and population growth
- At k^*,∆k=0 and i^*=δk*+nk*
- In a SS, investment has two purposes: δk* replaces the
depreciated capital and nk* provides new workers with
steady-state amount of capital.

The Effects of Population Growth

1. It brings us closer to explaining sustained economic growth – capital per worker &
output per worker are constant but total capital & total output grows (because of
population growth)
2. Explains why some countries are rich and others are poor – higher population ->
reduced capital per worker and therefore output per worker -> lower GDP per person
3. Affects our criterion for determining the Golden Rule (consumption-maximizing)
c= y−i
¿
c ¿ =f ( k ¿ )−(δ +n)k ¿ because ss output is f ( k ¿ ) and ss investment is (δ +n)k
MPK =δ+ n since it is the level of k ¿ that maximizes consumption
MPK −δ=n
o GRSS: marginal product of capital net of depreciation = rate of population
growth n
Alternative Perspectives on Population Growth
- SGM – highlights interaction between population growth and capital accumulation
- High population growth reduces output per worker (forces capital stock to be
spread thinly -> less capital)
- Some other potential effects of population growth: natural resources and technology
- The Malthusian Model – an ever-increasing population would continually strain
society’s ability to provide for itself (continue to live in poverty because of
inadequate resources)
o Prediction about poverty is wrong (population increased but standard of
living is higher)
  Hunger is present because of unequal income distribution, not
inadequate food
o Prediction about passion between sexes is true but has been broken by birth
control
- The Kremerian Model – population growth will advance economic prosperity

Technological Progress in Solow Model

The Efficiency of Labor
Production Function: Y=F (K, L)

Y=FK,LXE) where E is the Efficiency of Labor - society's knowledge about production

methods (technology improves -> efficiency of labor rises -> each hour of work contributes
more to the production of goods and services)
Total output Y depends on the inputs of capital K and effective workers Lx E
Manufacturing transformations, computerization, improvements in health, education, or
skills of the labor force
LXE-interpreted as measuring the Effective Number of Workers - number of each worker
and the efficiency of each worker
g=0.02-> each unit of labor becomes 2% more efficient -> output increases as if labor force
increased by 2%; technological progress called Labor Augmenting Where g is called the
rate of Labor-Augmenting Technological Progress Labor force L grows at rate n and
efficiency E grows at rate g -> effective number of workers L x E grows at rate n+g

The Steady State with Technological Progress

Technological progress causes the effective number of workers to increase
 Analytic tools used in Chapter 8 to study SGM for population growth can be
adapted
Ak=sf k-8+n+gk

The Effects of Technological Progress

Variables in a steady-state with technological progress
 Output per actual worker Y/L =y x E
 y is constant and E is growing at rate g, output per worker must also be growing at
rate g in the steady-state

 Similarly, economy's total output is Y=yx (ExL). Because y is constant in the steady
state, E is growing at rate g, and L is growing at rate n, total output grows at rate
n+g_ in the steady state.
 With the addition of technological progress, model can finally explain sustained
increases in standards of living that we observe (tech. progress -> sustained growth
in output/worker)
  High rate of saving -> high rate of growth only until steady state (once in steady
state, the rate of growth of output per worker depends on technological progress)
SGM: only tech. progress can explain sustained growth and persistently rising living
standards At the Golden Rule level of capital, the net marginal product of capital, MPK-8,
equals the rate of growth of total output ,n+g. Because actual economies experience both
population growth and technological progress, we must use this criterion to evaluate
whether they have more or less capital than they would at the Golden Rule steady state.

Solow Residual
The Solow residual represents output growth that happens beyond the simple growth of
inputs. As such, the Solow residual is often described as a measure of productivity growth
due to technological innovation. The Solow residual is also referred to as total factor
productivity (TFP).
 The Solow residual is the residual growth rate of output that cannot be attributed to
the growth in inputs.
 The Solow residual drew attention to the lack of recognition for the role of
innovation in economic growth, leading to more advanced economic analysis aimed
at capturing the role of productivity growth.
 The Solow residual is also commonly referred to as total factor productivity (TFP).
 The limitations of the Solow residual include potential measurement errors,
challenges in accurately measuring capital inputs, and difficulties in attributing
productivity changes.

Solow Residual Formula

The total factor productivity formula may take different forms depending on what is being
calculated and more importantly what type of analysis is being performed. However, the
general formula often the takes form of the following:
TFP = Y / (K^α * (L * H)^(1-α))
 Y represents the total output or GDP.
  K represents the capital input.
 L represents the labor input.
 H represents the human capital input.
 α (alpha) represents the output elasticity of capital, which measures the share of
output attributed to capital.
The formula compares the expected production of capital (K), labor (L), and human capital
(H) with the actual output (Y). The residual is the percentage of production increase that
cannot be fully explained by changes in labor and capital inputs. It includes the impact of
productivity-affecting technical advancements, efficiency gains, and other unnoticed
factors.

Implications
The Solow Growth Model has several important implications for economic growth and
policy,
including:
- Steady state: The model predicts a steady state where output per capita and capital per
capita
are constant over time.
- Convergence: The model predicts that countries with lower initial levels of capital per
capita
will grow faster and converge towards countries with higher levels of capital per capita.
- Saving and investment: The model predicts that increases in the saving rate lead to
higher
levels of capital per capita and long-run economic growth.
- Technological progress: The model predicts that technological progress is the key driver
of
long-run economic growth.

Conclusion:
- The Solow Growth Model is a theoretical framework used to explain long-run economic
growth.
- It is based on several key assumptions, including a fixed labor force, diminishing returns
to
capital, and constant technological progress.
- The model has several important implications for economic growth and policy, including
the
prediction of a steady state, convergence, and the importance of saving, investment, and
technological progress for long-run growth.
- Policymakers can use the insights from the Solow Growth Model to design policies that
promote long-run economic prosperity.