The Supply of Goods: Supplemental Notes To The SOLOW Growth Model Adapted From Mankiw 6e

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Supplemental notes to the SOLOW growth model adapted from Mankiw 6e

The Supply of Goods

The production function represents the transformation of inputs (labor (L), capital
(K), production technology) into outputs (final goods and services for a certain time
period). The algebraic representation is: Y = F (K,L)

Key Assumption: The Production Function has constant returns to scale.

Therefore zY = F (z K , zL )

Constant returns to scale imply 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. So, from now on, let’s denote all quantities in per worker terms
Y/L = F ( K/L , L/L )

in lower case letters. Here is our production function , y=f(k) where f(k) =
F(k,1).

The production function shows 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: if k increases by 1 unit, y increases by
MPK units. MPK it tells us how much extra output per worker will be produced if capital per
worker is increased MPK = f(k + 1) – f (k)

The Demand for Goods and the Consumption Function

Recall we write everything in per-capita terms: c = C/Y; i = I/Y. We have


equilibrium in the market for goods: y = c + i.

We also have a simple consumption function: c = (1 – s) y


This model writes the consumption function in terms of the saving rate s. We
immediately have the familiar result that investment equals saving(there is
equilibrium in the market for loanable funds):

i = sy = sf (k).

NB. Output is divided between consumption and investment.

Growth in the Capital Stock in the Steady State

Investment means that the economy is acquiring new factories, machines, houses,
and so forth, which tends to increase the economy’s capital stock and allow for
more production. But, at the same time, some of these machines and factories wear
out and have to be replaced. This depreciation decreases the capital stock. If there
were no investment at all, the capital stock would decline over time. We suppose
that δ percent of the capital stock wears out each period, so if the capital stock at
the start of the period is k, the depreciation during the period is δk. The rate of
depreciation can be interpreted in terms of the lifetime of the typical piece of
capital.

The overall change in the capital stock is the net effect of new investment and
depreciation:

Δk = sf (k) – δk.

The economy will be in steady state if the capital stock is constant: Δk = 0.


In this case, the only investment being undertaken is replacement investment. The
equilibrium condition is just

sf (k) = δk.

This equation defines the steady-state value of k, which we call k*.

Explicit example for the Cobb–Douglas case where y = k1/2. This means
that in the steady state

sk1/2= δk where sy= δk

⇒ s = δk1/2

⇒ s/δ = k1/2

⇒ k* = (s/δ) 2.

While a higher capital stock implies higher output, this does not mean that a higher
capital stock is necessarily desirable. To sustain a high level of the capital stock, a
lot of output may have to be devoted to replacement investment, so it will not be
available for consumption. We now compare steady states in terms of consumption.

Population Growth
The Solow model teaches us that we cannot explain sustained economic growth in
terms of growth in capital per worker, since the economy will tend toward a steady
state where capital per worker is constant. We now consider population change as a
possible explanation of sustained economic growth. We will assume a population
growth rate equal to n.

For example, if n = 0.07, then the population increases by 7 percent every year. If it
is 100 million one year, it will be 107 million the next year.

The Steady State With Population Growth


The difference this makes to the model is that the change in the capital stock
becomes

Δk = i – δk – nk,

since population growth decreases the amount of capital per worker, other things
equal. To keep the capital–labor ratio constant, we not only need investment to
replace depreciated capital, we also need investment with which to equip new
workers; we need to supply the n new workers with k units of capital each. So the
steady-state capital stock is now defined by

i = sf (k) = (n + δ)k.

With this one change, our analysis proceeds much as before. Graphically, we simply
look for the intersection of sf (k) with (n + δ)k.= steady state

Population growth is another possible cause of income differences across countries.


The Solow growth model predicts that, other things equal, countries with higher
rates of population growth will have lower steady-state capital–labor ratios- (K/L).

Including technology
Note

1. Technological progress is the sole determinant of growth in living standards in


the long run.

2. Policymakers would like to raise saving and technological progress, but these
goals are not easy to achieve. In addition, the productivity slowdown of the past two
decades presents one of the most important and perplexing problems currently
facing economists and policymakers.

3. A weakness of the Solow growth model is its failure to explain what drives
technological progress. Endogenous growth theory attempts to incorporate the
source of technological progress into a growth model.

The Efficiency of Labour

Technological progress can enter the production function in different ways; it may
increase the productivity of capital or labor. The simplest form to analyze is
laboraugmenting technological progress. Return to the production function and
amend it so that

Y = F(K, L × E).
Here E measures the efficiency of labor. The bigger E is, the more output can be
produced with a given amount of labour. We suppose that technological progress
comes about from increases in the efficiency of labor over time. This assumption
makes analysis simple, since increases in the productivity of labor now look just like
increases in population. If either L or E increases, output is affected in just the same
way, for this reason we call L × E the number of effective workers. In other words,
labor-augmenting technological progress works as if we are getting more workers. If
we have progress at the rate g = 0.02, then 100 workers can produce this year
what it would have taken 102 workers to produce last year. If L grows at the rate n
and E grows at the rate g, then L × E grows at the rate n +
g.

The Steady State with Technological Progress

Now redefine k to be capital per effective worker (k= K/LE), and likewise, y= Y/LE.
The analysis of technological progress is now exactly analogous to that of
population growth. The economy will be in steady state with k constant when

Δk= sf(k) – (n + δ + g)k= 0


or
sf(k) = (n + g + δ) k.

The Effects of Technological Progress

In steady state, output, capital, and consumption per worker are all growing at the
rate g. The model can now explain rising living standards. According to the Solow
model, technological progress is the only source of rising living standards over time.

Summary
Steady state or Balanced growth occurs when the labour force, capital stock
and real output grow at the same time. At the steady state the ratio of capital to
output equal the ratio of the savings rate to the labour force growth rate

Check textbook for graphical representations of these


conditions.

Chapters 7 and 8 are required readings for this topic

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