EF3441: Intermediate Macroeconomics

Prepared by Dr. Tam

Lecture 6
The Main Goal of this Lecture

▶ Understand Solow growth model by

▶ knowing how to derive the steady-state conditions,
▶ using the model to do policy analysis and find transitional
paths,
▶ applying the Solow model to explain the data,
▶ and finding facts the Solow model can/can’t explain.
▶ Understand the endogenous growth model by
▶ knowing the assumptions and facts that motivate this model
Recall the Solow Model

▶ Household
▶ Exogenous population growth:
′
N = (1 + n)N,

▶ “Rule of thumb” for saving

C = (1 − s)Y

▶ Firm
▶ Capital accumulation function:
′
K = (1 − δ)K + I
The Firm

Take the dynamic firm’s problem. i.e., the firm chooses labor and
investment to maximize its present-value profits.
( ′
)
π(K )
π(K ) = max Y − wN − I +
I ,N 1+r
Subject to:
Y = zF (K , N)
and
′
K = (1 − δ)K + I
Steady State

▶ In Solow population always grows, use the notion of per

capita steady state. Let lower case letters denote per-capita
quantities
′
K K ′
′ = = k∗ → k = k = k∗
N N
′
Y Y ′
= = y∗ → y = y = y∗
N′ N
   
F (K , N) K N K
=F , =F , 1 = f (k)
N N N N
Solving For the Steady State

▶ Our goal is to derive a condition for the equilibrium value of k.

This is important to understand questions like:
▶ How to foster growth?
▶ Why is the saving rate important?
▶ Is a capital tax good or bad?
▶ Algebra ahead: take a deep breath!!
Solving For the Steady State
Start:
′ ′
K = (1 − δ)K + I → I = K − (1 − δ)K
Substitute I from market clearing for goods and assets:
′
Y = C + K − (1 − δ)K
Substitute rule of thumb for saving and production function:
′ ′
Y = (1 − s)Y + K − (1 − δ)K → K = szF (K , N) + (1 − δ)K
Divide by N,
′ ′
K N szF (K , N) (1 − δ)K
′ = +
N N N N
′
Recall N = (1 + n)N,
′
k (1 + n) = szf (k) + (1 − δ)k
′ szf (k) + (1 − δ)k
⇒k =
1+n
Capital Accumulation

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45
k'

k' = (szf(k) + (1- )k)/(1+n)

0
0 k*
k
Solving For the Steady State
Start:
′ ′
K = (1 − δ)K + I → I = K − (1 − δ)K
Substitute I from market clearing for goods and assets:
′
Y = C + K − (1 − δ)K
Substitute rule of thumb for saving and production function:
′ ′
Y = (1 − s)Y + K − (1 − δ)K → K = szF (K , N) + (1 − δ)K
Divide by N
′ ′
K N szF (K , N) (1 − δ)K
′ = +
N N N N
′
Recall N = (1 + n)N
′
k (1 + n) = szf (k) + (1 − δ)k
′ szf (k) + (1 − δ)k
⇒k =
1+n
′
Since in steady state k = k
szf (k) = (n + δ)k
Analysis of the Steady State
Key equilibrium condition:
szf (k ∗ ) = (n + δ)k ∗
To understand it, graph both sides of the equation:

(n+δ)k

szf(k)
sy
(n+d)*k,

k k*
Analysis of the Steady State: Convergence

o
45
k'

k' = (szf(k) + (1- )k)/(1+n)

k '1
k '0

0
0 k0 k1 k2 k*
k
Analysis of the Steady State: Convergence

z
Analysis of the Steady State

What happens if s, n, d, z changes?

Changing the Saving Rate

Suppose s changes: s1 to s2 and s2 > s1 .

(n+δ)k

s 2zf(k)
sy
(n+d)*k,

s 1zf(k)

0
0
k *1 k k *2

Steady state: k1 increases to k2 . Question: what happens to y ?

Changing the Saving Rate
Changing the Saving Rate

Recall: investment and GDP level

Investment is positively correlative with GDP levels.

Changing the Population Growth Rate

Suppose n changes: n1 to n2 and n2 > n1 .

(n +δ)k
2
(n +δ)k
1

szf(k)
sy
(n+d)*k,

k *2
k
k *1

Steady state: k1 decreases to k2 .

Changing the Population Growth Rate
Recall: population and GDP level

Population is negatively correlative with GDP levels.

Changing δ and z

▶ Change δ is the same as change n.

▶ Change z is the same as change s.
How to Determine the Optimal Saving Rate?

From Perato Optimal:

▶ We need to determine the saving rate that maximizes a
household’s lifetime utility.
▶ In this model, households only care about consumption. i.e.,
we need to find a s to maximize lifetime utility.
⇒ the golden rule.
▶ First, find the steady-state consumption per worker.
Steady State Consumption per Worker
How to Determine the Optimal Saving Rate?

From Perato Optimal:

▶ We need to determine the saving rate that maximizes a
household’s lifetime utility.
▶ In this model, households only care about consumption. i.e.,
we need to find a s to maximize lifetime utility.
⇒ the golden rule.
▶ First, find the steady-state consumption per worker.
▶ Now, we can find the optimal s, saving rate, to maximize
lifetime consumption.
The Golden Rule Quantity of Capital per Worker
Mathematically Determine the Optimal Saving Rate
▶ From PO, we need to determine the saving rate that
maximizes a household’s lifetime utility.
▶ In this model, households only care about consumption. i.e.,
we need to find a s to maximize lifetime utility.
⇒ the golden rule.
▶ S-S consumption:
maxs c ∗ = (1 − s)zf (k) = zf (k) − szf (k) = zf (k) − (n + δ)k
→ FOC : d(zfdk(k)) − (n + δ) = 0 implies d(zfdk(k)) = n + δ
▶ Intuition: when MPk = n + δ, household maximizes her
lifetime utility. Now we can solve for S-S k ∗ by solving
MPk = n + δ.
Recall: when we solve for golden-rule k ∗ , we do not use s, the
saving rate.
▶ Once we know k ∗ , we know the optimal c ∗ . Now we can solve
∗
for the optimal s ∗ = 1 − zf c(k ∗ ) .
▶ Example: Assume z = 1 and F (K , N) = K α N 1−α , solve for
the optimal saving rate s on Solow growth model.
Growth Rates

▶ Question 1: how are consumption, output and capital growth

over time?
▶ Question 2: how are consumption, output, and capital per
capita growing over time?
Growth Rates

What is the growth rate of K in a steady state?

′
′ K K
k =k → =
N′ N
so that
′ K ′
K = N = (1 + n)K
N
the growth rate is the population growth rate!
the growth rate is the population growth rate for C and Y . Why?
Growth Rates

▶ Question 1: how are consumption, output and capital growth

over time?
Y , C , K grow at rate n, the population growth rate.
▶ Question 2: how are consumption, output and capital per
capita growing over time?
Q1 implies that K/N is constant over time
Sustaining Growth
To sustain growth over time we need something other than s and
n: z!

(n+δ)k

sz3f(k)

sz2f(k)
(n+d)*k,sy

sz1f(k)

0
0 k *1 k *2 k *3
k

Increasing z generates long-term growth!

The Solow Residual

▶ We have identified z as a key source for growth. z is

sometimes called the Solow Residual.
▶ Key question: what is z in the data, and how do we calculate
it?
▶ From equilibrium condition:

Y = zF (K , N)

hence
F (K , N)
z=
Y
▶ We need information on GDP, easy to get; workers, easy to
get too; production function, hard but assume Cobb-Douglas;
capital, hard.
Cross Country Convergence

▶ Question: If the world was described as a Solow model, what

would happen eventually to identical countries with different
levels of GDP per capita ypoor and yrich today?
▶ If today ypoor < yrich it implies kpoor < krich , what happens in
steady state?
▶ Key equation:
szf (k) = (n + δ)k
▶ In the transition, what happens?
Cross Country Convergence
Cross Country Convergence

Why do poor countries grow faster than rich countries in the Solow
growth model?
▶ The model predicts the poor country accumulates capital
faster than the rich country.
▶ The poor country has a higher marginal product of capital
than the rich country.
Cross Country Convergence

Answer: In the long run, they will have the same level of GDP per
capita
Cross Country Convergence

Answer: In the long run, they will have the same level of GDP

Is this happening?
Cross Country Convergence

Levels of GDP are not correlated with GDP growth rates.

Convergence: An Explanation

What is wrong with the model?

▶ Maybe all the countries are not the same
▶ Barriers to investment
▶ Barriers to technology adoption
Cross Country Convergence

Differences in total factor productivity can explain the disparity in

income per worker across countries.
Endogenous Growth

▶ Solow explains why we have growth: it’s either z or n

▶ Does not tell us what to do to improve long-run growth: i.e.
how does z go up?
▶ we need to go further and introduce human capital
Years of Schooling

Mean Years of Schooling, 2010

Years of Schooling

Acemoglu (2008)
Endogenous Growth: Human Capital

Human capital: the stock of skills and education that workers have
at a point in time
Properties:
▶ It grows
▶ It does not depreciate
▶ Technologies using it do not exhibit decreasing returns
A Simple Model: The Consumer

Suppose:
▶ There is no leisure: Workers divide their time between work
and human capital accumulation. Let N denote time at work.
(1 − N) time at school.
▶ Human capital H s increases effective time at work: more
human capital = more output for the same amount of hours.
▶ There is no capital.
A Simple Model: The Consumer

Suppose:
▶ Budget constraint:

C =w ×N ×H

where N · H is the effective unit of labor

▶ Human capital accumulation
′
H = b(1 − N)H

b is the efficiency of human capital accumulation (quality of

schools) 1 − N is the intensity of human capital accumulation
A Simple Model: The Firm

Suppose:
▶ Firm maximize profits choosing effective labor N · H

max zN · H − wN · H
N·H

Note: we assume linear firm technology

▶ Since the problem of the firm is linear:
▶ Equilibrium wage is z.
▶ Firm is indifferent in choice of N · H.
A Simple Model: The Equilibrium

Let’s determine the consumption growth rate.

▶ From budget constraint and firm maximization problem:

C = zN · H

and
′
′ H
H = b(1 − N)H ⇒ − 1 = b(1 − N) − 1
H
Note: we assume linear firm technology
▶ Computing growth rates of consumption:
′ ′ ′
C zNH H
−1= −1= − 1 = b(1 − N) − 1
C zNH H
A Simple Model: Summary

▶ Economy grows indefinitely because of human capital

accumulation.
▶ Rate of growth determined by efficiency and intensity of
human capital accumulation.
A Simple Model: Policy

What are good policies?

▶ Increase schooling
▶ Increase efficiency of schooling
▶ World Bank