Macroeconomics
Lecture 21
Review of the Previous
Lecture
• Steady State
– Movements towards steady state
– An increase in savings rate
Topics under Discussion
• The Golden Rule
– Capital Stock
• Population Growth
– Break-even Investment
The Golden Rule: introduction
• Different values of s lead to different steady
states.
How do we know which is the “best” steady
state?
• Economic well-being depends on
consumption, so the “best” steady state has
the highest possible value of consumption
per person:
c* = (1–s) f(k*)
The Golden Rule: introduction
• An increase in s
• leads to higher k* and y*, which may
raise c*
• reduces consumption’s share of income
(1–s),
which may lower c*
• So, how do we find the s and k* that
maximize c* ?
The Golden Rule Capital Stock
*
kgold
the Golden Rule level of capital,
the steady state value of k
that maximizes consumption.
To find it, first express c* in terms of k*:
c* = y* i* In general:
= f (k*) i* i = k + k
= f (k*) k* In the steady
state: i* =
k* because k =
0.
The Golden Rule Capital Stock
steady state
output and
depreciation k*
Then, graph
f(k*) and k*,
f(k*)
and look for the
point where the
gap between
them is biggest. C*gold
i*gold = δk*gold
Y *
gold = f(k *
)
gold
k*gold steady-state
capital per
worker, k*
The Golden Rule Capital Stock
c* = f(k*) k* k*
is biggest where f(k*)
the slope of the
production func.
Equals the slope
C*gold
of the epreciation
line:
MPK = k*gold steady-state
capital per
worker, k*
The transition to the
Golden Rule Steady State
• The economy does NOT have a tendency to
move toward the Golden Rule steady state.
• Achieving the Golden Rule requires that
policymakers adjust s.
• This adjustment leads to a new steady state
with higher consumption.
• But what happens to consumption
during the transition to the Golden Rule?
Starting with too much capital
If k * k gold
*
y
then increasing c *
requires a fall in s.
In the transition to c
the Golden Rule, i
consumption is
higher at all points
in time. t0 time
Starting with too little capital
If k * k gold
*
then increasing c*
requires an y
increase in s. c
Future generations
enjoy higher
consumption, i
but the current one
experiences an initial t0 time
drop in consumption.
• The basic Solow model cannot explain
sustained economic growth. It simply
says that high rates of saving lead to
high growth temporarily, but the economy
eventually approaches a steady state.
• We need to incorporate two sources of
growth to explain sustained economic
growth: population and technological
progress.
Population Growth
• Assume that the population--and labor force-- grow
at rate n. (n is exogenous)
L
n
L
• EX: Suppose L = 1000 in year 1 and the
population is growing at 2%/year (n=0.02).
Then L = n L = 0.02 1000 = 20,
so L = 1020 in year 2.
Break-even investment
( + n)k = break-even investment,
the amount of investment necessary
to keep k constant.
Break-even investment includes:
k to replace capital as it wears out
• n k to equip new workers with capital
(otherwise, k would fall as the existing capital
stock would be spread more thinly over a larger
population of workers)
The equation of motion for k
• With population growth, the
equation of motion for k is
k = s f(k) ( + n) k
actual
investme break-
nt even
investme
nt
The Solow Model diagram
Investment,
k = s f(k) (
break-even +n)k
investment
( + n ) k
sf(k)
k* Capital per
worker, k
The impact of population
growth
Investment,
break-even ( +n2) k
investment
( +n1) k
An increase in n
sf(k)
causes an
increase in break-
even investment,
leading to a lower
steady-state level
of k. k2* k1* Capital per
worker, k
Prediction:
• Higher n lower k*.
• And since y = f(k) ,
lower k* lower y* .
• Thus, the Solow model predicts that
countries with higher population growth
rates will have lower levels of capital and
income per worker in the long run.
International Evidence on Population
Growth and Income per Person
Income per
person in 1992
(logarithmic scale)
100,000
Germany
Denmark U.S.
Canada
Israel
10,000 Mexico
U.K. Japan Singapore
Finland France
Italy
Egypt Brazil
Pakistan Ivory
Peru Coast
1,000 Indonesia
Cameroon
Kenya
India
Zimbabwe
Chad Uganda
100
0 1 2 3 4
Population growth (percent per year)
(average 1960–1992)
The Golden Rule with
Population Growth
To find the Golden Rule capital stock,
we again express c* in terms of k*:
c* = y* i *
= f (k* ) ( + n) k*
In the Golden
c is maximized when
*
Rule Steady State,
MPK = + n the marginal product
of capital net of
or equivalently, depreciation equals
MPK = n the population growth
rate.
Summary
• The Golden Rule
– Capital Stock
• Population Growth
– Break-even Investment
Upcoming Topics
• Technological Progress in Solow
Model
• The Golden Rule Capital Stock
• Policies to Promote Growth
– Evaluating the Rate of Saving
