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Understanding the Solow Growth Model

May 9, 2025

Lecture Notes on Economic Growth and Solow Model

Introduction

  • Recent FED hike of 25 basis points, as expected.
  • Communication suggests further hikes are no longer guaranteed.
  • Uncertainty and market reactions to the FED’s decisions.
  • Objective: Introduction to the first model of economic growth.

Robert Solow and Economic Growth

  • Robert Solow, Emeritus Professor at MIT, Nobel Prize winner (1987).
  • Contributions to economic growth theory.
  • Solow's work forms the basis of the next few lectures.

Basic Mechanism of Economic Growth

  • Economy's factors: labor and capital.
  • Capital stock is variable; labor is more fixed (population growth influence).
  • Differences from historical Malthusian theories.
  • Capital accumulation:
    • Income → Savings → Investment → Capital Stock → Income.
  • Investment is capital accumulation, balanced against depreciation rates.

Model Foundations

  • Population is assumed constant initially.
  • Output per capita is a function of capital per capita (concave due to decreasing marginal product of capital).
  • Closed Economy Assumptions:
    • No public deficit: Private savings = Private investment.
    • Savings is proportional to income (different from short run model).

Solow Growth Model

  • Investment equals savings in the long run.
  • Capital stock changes based on investment and depreciation.
  • Key Formula: Change in capital per person = Savings - Depreciation.
  • Equilibrium achieved when investment equals depreciation.

Dynamics of the Solow Model

  • Steady State: The state where the capital stock does not grow.
  • Transitional growth occurs as economies move towards the steady state.
  • Poorer economies grow faster due to lower initial capital; richer economies grow slower.

Impact of Increasing Savings Rate

  • Increases transitional growth, not long-term growth rate.
  • Increased savings rate shifts the investment curve upwards.
  • Example: Asian Miracle driven by higher savings rates.

Consumption Concerns

  • Higher savings can lead to higher output but not necessarily higher consumption due to the need to maintain capital.

Mathematical Illustration

  • Example with production function: equal weight to capital and workers.
  • Steady State Solutions:
    • Capital and output per worker equations derived.
    • Doubling saving rate results in doubled output per worker over time.

Population Growth

  • Population growth impacts the capital per worker calculations.
  • Requires adjustments to maintain per worker capital levels.
  • Conclusion: Population growth can lead to overall output growth but does not change output per worker growth in the model.

Final Thoughts

  • Importance of understanding the Solow model and how savings and population growth affect economic growth.
  • Upcoming discussions on alternative growth mechanisms (e.g., technology).

These notes cover the key concepts and mechanisms presented in the lecture, focusing on the Solow growth model and its implications for economic growth and policy.

Full transcript