Introducing Advanced Macroeconomics:: Chapter 3 - First

Introducing
Advanced
Macroeconomics:
Chapter 3 first
lecture
Growth and business

cycles
CAPITAL
ACCUMULATION
AND GROWTH: THE
BASIC SOLOW
MODEL
The basic Solow model
How can a nation become rich, i.e., initiate a growth

process leading to higher GDP/consumption per
capita in the long run.
The basic Solow model provides some first answers:
It predicts how the evolution and the long run levels
of GDP and consumption per capita depend on
structural parameters such as the rate of investment
and the growth rate of the labour force.
Key elements of the Solow model:
In each period output is determined by the supplies of

capital and labour through the production function
Exogenous savings/investment rate, s, exogenous growth
rate of labour force, n, and exogenous depreciation rate, .
Explicit description of capital accumulation:
Accumulation of capital is the main driving force for wealth.
K Kt It Kt
Basic model: No technological progress. t 1
The micro world of the Solow

model
Object: Closed economy.

Time: A sequence of periods/years,t 0 ,1, 2,...
Agents: Households and firms (and government).
Commodities and markets: Output, capital
services and labour services (one asset = physical
capital).
The market for output: Supply = firms
Yt
output, . Demand from households for
consumption and investment =
. Relative
Ct I t
price = 1.
One-sector model: Output can be used either for
consumption or for investment.
The market for capital services: Consumers

Kt
own the capital stock,
, and rent its services to
firms.
K td
K ts
Supply of capital services =
. Firms demand =
Relative price (in unitsrt of output) for renting one unit of
capital for one period:
t rt = real rental
rate for capital.
Real interest rate:
is the rate of
rt t , where
depreciation. Or:
.
(Alternative interpretation: The firms own the capital,t
borrow for the purchase of capital at an interest rate of
and bear the cost of depreciation themselfes).
rt t
User cost
.
Lt (= the
Labour market: Households supply
=
d
L
labour force). Demand from firms =t
. Relative
price: wt = the real wage rate.
Competitive markets:rt andwt adjust to equate
full (or
supply and demand in all markets
natural) utilization of ressources.
The production sector
The basic Solow model is built around two equations, a

production function and a capital accumulation equation .
The production function is modelled as if all

production (all of GDP) comes from one profit
maximizing firm thatYproduces
value added, K t,d
t
from of capital services,
(machine-years),
and
Ldt
labour services,
(man-years)., according to the
production function:
Yt F K td , Ldt
F K td , Ldt F K td ,Ldt
1. Constant returns to scale:
.,
for all >0. The replication argument!
2. Positive marginal products:
F ' K K d ,Ld 0, F ' L K d ,Ld 0.
3. Marginal products are decreasing in the amount

of the factor used:''
''
FKK 0 , FLL
0
Diminishing Returns: the input of one
production factor is assumed to increase when
the input of the other factgor increases.
''
''
FLK
0, FLK
0
rt
Profit maximization: Given
choosesYt ,K td andLdt to:
wt
and
, the firm
max Yt rt K td wt Ldt , s.t . Yt F K td ,Ldt

The usual necessary conditions for an optimum:
FK' K td ,Ldt rt , FL' K td ,Ldt wt
(These two equations do not determine
and
Ldt
K td
from given and , they only determine
)
rt
wt
K td / Ldt
Competitive market clearing

Ldt Lt
K td K t
and
Lt
Kt
, where
and
are the supplies in period t:
FK' K t ,Lt rt , FL' K t ,Lt wt
Since K t andLt are predetermined in any given

period,rt andwt are determined this way.
K t and Lt predetermined: what does that
mean?
The income distribution

rt FK' K t ,Lt rt K t FK' K t ,Lt K t
wt FL' K t ,Lt wt Lt FL' K t ,Lt Lt
1. No pure profits. Eulers rule

F K t ,Lt FK' K t ,Lt K t FL' K t ,Lt Lt 0
2. The functional income distribution

'
'
F
K
,L
K
F
rt K t
wt K t
K
t
t
t
L K t ,Lt Lt
and
Yt
Yt
F K t ,Lt
F K t ,Lt
The income share of each factor is the
elasticity of the production function with
respect to the factor in question.
According to empirics, labours share is relatively constant around

2/3 over long periods except for short run fluctuations:
Labours share of domestic factor incomes
Is there a production function that fulfills all of our

assumptions and has fixed output elasticities
independently of
? Yes, the Cobb-Douglas
Lt
K t and
F K t ,Lt Bt K t L1t , Bt 0, 0 1,
where Bt is total-factor-productivity (TFP).
Check: It follows that
K t
rt FK Bt
Lt
'
K
t
and wt FL 1 Bt
Lt
'
rt K t
wt Lt
and
1
Yt
Yt
The Cobb-Douglas function seems as a realistic

long run assumption. We even have reason to
1/ 3
believe that
.
Households
The number of households in period t is Lt , which is
predetermined. Household behaviour:
1. Each supplies one unit of labour inelastically. Total
Lt
supply
.
Kt
t
2. Own the capital stock, , which is predetermined in
Kt
r 0
period . Supply
=
(ast long as
).
3. The representative household decidesCt givenYt , and hence
St Yt Ct
. The intertemporal budget
constraint:
K K S K , 0 1
t 1
We assume that the result of the consumers considerations

St sYt .
is:
4. Biology:
Lt 1 1 n Lt , n 1
The complete model

Yt BKt L1t
K t
rt B
Lt
K t
wt 1 B
Lt
St sYt
K t 1 K t St K t
Lt 1 1 n Lt ,
Parameters:B, ,s, and

n . NB: No subscript
t
B
on : Basic Solow model.
Yt , Kt , Lt , rt , wt
Endogenous variables:
St
and
of which K t and Lt are state variables:
GivenK 0 andL0
Yt , Kt , Lt ...
the model determines
St
Government in the model? Yes, simply
interpret
as private plus government
savings.
We viewed theK tcapital
accumulation
equation:
1 K t S
t Kt
as the households budget constraint.
Alternatively: By definition we have that

K t 1 K t I t K t
()
The condition for equilibrium in Ythe

output
t Ct I t
market, or the
accounting identity, is:
St national
Yt Ct
, and by definition:
. Hence
I t St ( )
()
( )
Combining
gives the capital
sand
accumulation equation again: is the savings
rate and the investment rate.
Analysing the basic Solow

model
Define:y Y / L andk K / L .
1.
t
t
t
t
t
t
2. From Yt BK t L1t we get the per capita
y Bk , 0 1
t
y
k
ln
y
ln
y
ln
k
ln
k
Note: t
t 1
t
t 1
t
t
3. Insert St sYt intoK t 1 K t St K t
to get:
K t 1 K t sYt 1 K t
4. Divide byLt 1 1 n Lt on both sides to find

that:
1
kt 1
syt 1 kt
1 n
yt Bkt
5. Insert
to get
the
1
transition
k
sBkt 1 kt
equation: t 1 1 n
kt
the
6. Subtracting
from
sides of
1 both
gives
kt 1 equation
kt
sBkt the
n Solow
kt
transition
142 43
1{ n {
equation:
technical term
appearing
because of
Replacement investment
savings per
to compensate for
capita syt
depreciation and growth
The transition diagram
sBk
dk
1
t 1 kt
t 1
kt 1
sBkt 1 kt
1 n
dkt
1 n
About the slope,

dkt 1 / dkt
It is everywhere strictly positive

It goes to infinity askt goes to zero
It goes to 1 / 1 n askt , and
1 / 1 n 1
. Indeed we assume
n that
n 0
(realistic!)
kt k *
*
*
*
* in the long
*
* 1
The
figure
shows
that
run.
yt y B k ct c 1 s y
rt r B k
Hence
and
k * , y*
The values
etc.
etc. define the steady state.
The Solow diagram

kt 1 kt
1
sBkt n kt
1 n
(n + )k t
sBk
k*
Why does growth inkt

Diminishing returns!
yt
and
have to stop?
Steady state
The long run levels
k * y*, etc. depend on
parameters. How? What makes a nation rich?
Look at the Solow equation:
1
kt 1 kt
sBkt n kt
1 n
In steady statekt 1 kt 0 . Insert this to find
sB k
k B
*
1
1
y B k
*
n k*
1
1
1
1
Some sharp predictions of the Solow model:

1
lny*
B
lns ln n .
1
1
1
*
s
The elasticity ofy
wrt.
is
(since we
1 2
1
that
s
believe
): an increase
in of 10%, e.g.
3
*
y increase in
from 20 to 22%, should give an
of 5%!
*
1
3
The 1elasticity
2
1
2
of
wrt.
and wrt. are
and
, respectively. Why is the latter not
one? Capital accumulation!
We have reached empirically testable
hypotheses! Empirics:
Real GDP per worker against the average

investment share across 85 countries
Real GDP per worker against the average annual

labour force growth rate across 85 countries

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Introducing

Growth and business

The basic Solow model

How can a nation become rich, i.e., initiate a growth

In each period output is determined by the supplies of

The micro world of the Solow

Object: Closed economy.

The market for capital services: Consumers

The production sector

The basic Solow model is built around two equations, a

The production function is modelled as if all

3. Marginal products are decreasing in the amount

max Yt rt K td wt Ldt , s.t . Yt F K td ,Ldt

Competitive market clearing

Since K t andLt are predetermined in any given

The income distribution

wt FL' K t ,Lt wt Lt FL' K t ,Lt Lt

1. No pure profits. Eulers rule

2. The functional income distribution

According to empirics, labours share is relatively constant around

Labours share of domestic factor incomes

Is there a production function that fulfills all of our

The Cobb-Douglas function seems as a realistic

We assume that the result of the consumers considerations

The complete model

Parameters:B, ,s, and

as the households budget constraint.

Alternatively: By definition we have that

The condition for equilibrium in Ythe

Analysing the basic Solow

3. Insert St sYt intoK t 1 K t St K t

4. Divide byLt 1 1 n Lt on both sides to find

The transition diagram

About the slope,

It is everywhere strictly positive

The Solow diagram

Why does growth inkt

Some sharp predictions of the Solow model:

Real GDP per worker against the average

Real GDP per worker against the average annual

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