ECON 2HH3:

Intermediate Macroeconomics II
Winter 2021

Bettina Brüggemann & Marc-André Letendre

1
Chapter 7
Economic Growth: The Solow Model

2
Overview
1. Economic growth facts

2. Solow growth model

3. Growth accounting

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 3

Economic Growth Facts
• Key empirical regularities relating to growth within and across
countries

• There are seven primary facts of economic growth that are key to
organizing our thinking about economic growth

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 4

Fact 1: Little Change in Per-Capita Income
before 1800
• Before the industrial revolution (before 1800) standards of living
differed little over time and across countries

• Population growth kept up with growth in aggregate income, so that

there was little change in per capita income

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 5

Fact 2: Sustained Income Growth Since
Industrial Revolution
• Since the Industrial Revolution, per capita income growth has been
sustained in the richest countries

• In Canada, growth in per capita income has not strayed far from 2%
per year (excepting a few major events, such as the Great Depression)
since 1870

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 6

Figure 7.1
Natural Log of Real per Capita Income in Canada, 1870–2014

Copyright © 2018 Pearson Canada Inc.

Fact 3: Investment Rate and Real Per-Capita
Income

• Across countries, real per capita income and the investment rate are
positively correlated.

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 8

Figure 7.2
Real Income Per Capita vs. Investment Rate

Copyright © 2018 Pearson Canada Inc.

Fact 4: Population Growth and Real Per-
Capita Income

• Across countries, real per capita income and the population growth
rate are negatively correlated.

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 10

Figure 7.3
Real Income Per Capita vs. the Population
Growth Rate

Copyright © 2018 Pearson Canada Inc.

Fact 5: Divergence in Per Capita Income

• Differences in per capita incomes increased dramatically among

countries of the world between 1800 and 1950, with the gap widening
between the countries of Western Europe, the United States, Canada,
Australia, and New Zealand, as a group, and the rest of the world

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 12

Fact 6 and 7: Real Per-Capita Income and
Per-Capita Income Growth

• There is essentially no correlation across countries between the level

of output per capita in 1960 and the average rate of growth in output
per capita for the years 1960-2000

• Rich countries are more alike in terms of rates of growth than are poor
countries.

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 13

Figure 7.4
Growth Rate in per Capita Real Income vs. Real Income per Capita for the Countries of the World

Copyright © 2018 Pearson Canada Inc.

The Solow Growth Model
• This is a key model which is the basis for the modern theory of
economic growth.

• A key prediction is that technological progress is necessary for

sustained increases in standards of living.

• Does a good job at explaining economic growth facts.

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 15

Population Growth
• In the Solow growth model, population is assumed to grow at a
constant rate 𝑛:
𝑁! = 1 + 𝑛 𝑁

• Each consumer has one unit of time to supply as labour

• Population is equal to the labour force (everyone works)

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 16

Consumption-Savings Behaviour
• Consumers are assumed to save a constant fraction 𝑠 of their income,
consuming the rest:
𝐶 = 1−𝑠 𝑌

• We call 𝑠 the aggregate savings rate. For now: exogenous.

• For consumers:
𝐶 + 𝑆 = 𝑌,
where 𝑆 = 𝑠𝑌.

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 17

Representative Firm’s Production Function
• Output is produced by representative firm according to:

𝑌 = 𝑧𝐹(𝐾, 𝑁)

• Constant returns to scale implies:

𝑌 𝐾
𝑦 = = 𝑧𝐹 , 1 = 𝑧𝑓(𝑘)
𝑁 𝑁
where 𝑘 is capital per worker and 𝑦 is output per worker.

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 18

Figure 7.12
The Per-Worker Production Function

Copyright © 2018 Pearson Canada Inc.

Evolution of the Capital Stock
• Future capital 𝐾 ! equals the capital remaining after depreciation, plus
current investment 𝐼:

𝐾! = 1 − 𝑑 𝐾 + 𝐼

• 0 < 𝑑 < 1 is the constant rate of depreciation

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 20

Competitive Equilibrium
• The income expenditure identity holds as an equilibrium condition:
𝑌 =𝐶+𝐼

• We know from above that 𝐶 = 1 − 𝑠 𝑌 and 𝐼 = 𝐾 ! − 1 − 𝑑 𝐾:

𝑌 = 1 − 𝑠 𝑌 + 𝐾! − 1 − 𝑑 𝐾

• Solve for 𝐾 ! :
𝐾 ! = 𝑠𝑌 + 1 − 𝑑 𝐾

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 21

Competitive Equilibrium (cont’d)
• Substitute for output from the production function
𝐾 ! = 𝑠𝑧𝐹(𝐾, 𝑁) + 1 − 𝑑 𝐾

• Re-write in per-worker form (using that 𝑁 ! = 1 + 𝑛 𝑁):

𝑘′(1 + 𝑛) = 𝑠𝑧𝑓(𝑘) + 1 − 𝑑 𝑘

• Rearrange, to get:
𝑠𝑧𝑓(𝑘) 1−𝑑 𝑘
𝑘′ = +
1+𝑛 1+𝑛
(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 22
Capital and Output in the Steady State
• 𝑘 ∗ is the capital stock in the
steady state (𝑘 ! = 𝑘)
• If 𝑘 < 𝑘 ∗ , then 𝑘 ! > 𝑘: capital
increases over time
• If 𝑘 > 𝑘 ∗ , then 𝑘 ! < 𝑘: capital
decreases over time
• Since per-capita capital
converges to 𝑘 ∗ , per-capita
output converges to:
𝑦 ∗ = 𝑧𝑓(𝑘 ∗ )
(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 23
Solow Model Predictions
• Capital and output converge to steady state levels 𝑘 ∗ and 𝑦 ∗ in the
long run

• That means, if savings rate 𝑠, population growth rate 𝑛, and TFP 𝑧 are
constant, real income per worker cannot grow.
→ No improvement in standard of living in the long run

• Why?

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 24

Solow Model Predictions (cont’d)
• Reason: Diminishing marginal product of capital
• Output per worker can grow as long as capital per worker continues to
grow
• But: marg. return to investment diminishes with increasing capital
stock
• As economy grows, new investment just keeps up with depreciation
and population growth while growth in per-worker output stops
• Growth in macroeconomic aggregates (𝐾, 𝑌, 𝐶, 𝐼) determined by the
growth rate of the labour force

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 25

Determination & Analysis of the Steady State
• We saw above that
𝑠𝑧𝑓(𝑘) 1−𝑑 𝑘
𝑘′ = +
1+𝑛 1+𝑛
• We know that in steady state 𝑘 ! = 𝑘 = 𝑘 ∗
• Replacing 𝑘 ! and 𝑘 by 𝑘 ∗ and re-arranging yields
𝑠𝑧𝑓 𝑘 ∗ = (𝑛 + 𝑑)𝑘 ∗
• Can be solved for 𝑘 ∗ (given exogenous parameters)

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 26

Figure 7.14
Determination of the Steady State Quantity of Capital per Worker

Copyright © 2018 Pearson Canada Inc.

Effects of an Increase in the Savings Rate s
• In the steady state, this increases capital per worker and real output per
capita.

• In the steady state, there is no effect on the growth rates of aggregate

variables.

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 28

Figure 7.15
Effect of an Increase in the Savings Rate on the Steady State Quantity of Capital per Worker

Copyright © 2018 Pearson Canada Inc.

Figure 7.16
Effect of an Increase in the Savings Rate at Time T

Copyright © 2018 Pearson Canada Inc.

Steady State Consumption per Worker
• Consumption per worker in the
steady state is given by:

𝑐 ∗ = 𝑧𝑓 𝑘 ∗ − 𝑠𝑧𝑓 𝑘 ∗
= 𝑧𝑓 𝑘 ∗ − (𝑛 + 𝑑)𝑘 ∗

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 31

Golden Rule Level of Capital
• Golden rule quantity of capital
per worker maximizes steady
state consumption per worker
• At the golden rule:
𝑀𝑃# = 𝑛 + 𝑑
• If 𝑘 ∗ < 𝑘$%
∗
: increase in savings
rate increases 𝑘 ∗ and
consumption per worker
• Golden rule savings rate: 𝑠$%

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 32

Effects of an Increase in the Population
Growth Rate 𝑛
• Capital per worker and output per worker decrease.

• Aggregate output, aggregate consumption, aggregate investment grow

at higher labour force growth rate.

• Output and capital per worker are ultimately lower in steady state.

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 33

Figure 7.19
Steady State Effects of an Increase in the Labour Force Growth Rate

Copyright © 2018 Pearson Canada Inc.

Effects of Increases in Total Factor
Productivity 𝑧
• Sustained increases in 𝑧 cause
sustained increases in per capita
income.

• Solow model predicts that a

country’s standard of living can
continue to increase in the long
run only if there are increases in
TFP.

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 35

Growth Accounting
• An approach that uses the production function and measurements of
aggregate inputs and outputs to attribute economic growth to:

i. growth in factor inputs

ii. total factor productivity growth.

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 36

Cobb-Douglas Production Function &
the Solow Residual
• Cobb-Douglas production function given by:
𝑌 = 𝑧𝐾 & 𝑁 '(&
• The labour share in national income is approximately 0.70:
𝑌 = 𝑧𝐾 ).+ 𝑁 ).,

• The Solow residual is calculated as:

𝑌
𝑧 = ).+ ).,
𝐾 𝑁

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 37

Figure 7.23
Natural Log of the Solow Residual, 1961–2017

Copyright © 2018 Pearson Canada Inc.

Average Annual Growth Rates in the
Solow Residual

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 39

Measured GDP, Capital Stock, and
Employment

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 40

Average Annual Growth Rates

(c) 2018 Pearson Canada Inc. (modified by B. Brueggemann) 41