 Chapter 5: Economic Growth Models

5.1 Harrod-Domar Model

 According to Harrod and Domar model, economic
growth is the result of capital accumulation.
 Saving is the key factor to economic growth.
 The model assumed,
A constant saving rate
Constant capital- output ratio (v)
No diminishing return to capital accumulation
It assumes saving is automatically converted in to
investment. 10/06/2024
 The Harrod and Domar model can be illustrated in a simple
algebra as follows.
 Let t= time, 1, 2,…..t, Yt= total output at time t,
◦ Ct= consumption at time t,
◦ St= saving at time t, and
◦ It= investment at time t.
 And assume a closed economy, an economy with no import and
export.
 Total income (output) is dividing between consumption and
saving.

 The other side of the coin is that the value of produced output
must to be matched goods produced for consumption plus
those needed by investors; that is

 And the macroeconomic balance equation is that,

St=It……………………………… (3) 10/06/2024
 The accumulation of capital stock (k) or the stock of
capital over time.
Kt+1= K t + It - K t
where = rate of depreciation of capital stock, 0<<1
 Depreciation rate (δ), δ , where is total Depreciation
(D=δK total Depreciation) and K total capital, δ is
usually lies between 0 & 1; 0<δ<1.
 Depreciation will reduce stock of capital or production

capacity.
 Thus, one of the purposes of investment is to replace

the capital Depreciation or replacing the wear out

capital in the production process.

10/06/2024
 If I total investment expenditure is greater than D, there
will be additional capital which increases the existing
stock of capital, ∆K=It- δKt>0.
 If It = δKt then ∆K=0, no change on the existing capital
stock.
 Note also that ∆K=It – δKt is refers to net investment or

net addition to capital stock, amount of investment

above the total depreciation at the given point in
time.
 Kt+1= (1 - δ) Kt + It ……………………………. (4)
 This equation shows how capital stock built over time

or at time t+1 period and

 Kt denotes stock of capital at time’ t’ which could also

rewritten as
 Kt+1= Kt + It - δKt 10/06/2024
 Kt+1=K t +∆K
 I= ∆K
 Now we introduce two important concepts; the saving rate
(α) and capital output ratio (v). Thus the saving rate is given
by α= St/Yt …………………………………………. (5)

0< α <1 and St= αYt – total saving

And the capital – output ratio is given by:

v=K t /Yt or K t =vYt

 This ratio, v, shows the amount of capital required for

producing a single unit of output in the economy, or the
capital required per unit of output. 10/06/2024
 It is measure of the efficiency of the use of capital – a
smaller unit of capital output ratio means less capital is
needed to c reate a certain amount of output (or that of a
given amount of capital will create more output).
 Combining equation (3) & (4) gives
Kt+1= (1 - δ) K t+ St…………………………6

Kt+1= (1 - δ) K t+ α Yt; where I=S= α Yt total saving =total investment

vYt+1= (1 - δ) vYt+ α Yt………………………7

vYt+1-vYt= α Yt- δ vYt

V(Yt+1-Yt) = α Yt- δvYt

Dividing both sides by vYt, we arrive at the rate of growth output:

10/06/2024
 Dividing both sides by vYt, we arrive at the rate of
growth output:
α /v – δ
= α /v - δ …………………………8
g = = – annual growth rate of gross output or gross
income g= α /v - δ …………………………………………9
 The Harrod- Domar model links the growth rate of the
economy to two fundamental variables: the ability of
the economy to save and capital output ratio.
 By pushing up the rate of savings, it would be possible
to accelerate the rate of growth.
10/06/2024
 A small amendment to the Harrod-Domar model allows
incorporating the effects of population growth. It should
be clear that as the equation (i.e. equation, 8) currently
stands, it is a statement regarding the rate of growth of
total gross national product (GNP), not GNP per capita.
 To talk about per capita growth, we must net out the
effect of population growth.
 If population (p) grows at rate n, we can use the
following formula to determine the growth in GNP per
capita.
10/06/2024
 s/v = g* +n+ OR g*= s/v - n-
 This is an expression that combines some of the
fundamental features of growth. Which includes,
i. The ability to save and invest (captured by s)
ii. The ability to convert capital in to output (which depends
inversely on v)
iii. The rate at which capital depreciates ()
iv. The ratio of population growth (n)
Capital output ratio (v), rate of deprecation of capital
stock () and population growth rate (n) are inversely
related to per capita growth rate (g*)
 on the other hand, there is a direct relationship

between per capita growth rate) g*) and saving rate (s).

10/06/2024
  Example
1. Calculate the rate of growth of output if the saving ration is
6%, capital output ration is 3% and rate of deprecation () is
zero.
2. Assume that saving ration (s) is 6%, capital output ratio (=3%),
population growth rate is (n = 2.5%),  = 0. Find the per capita
growth rate (g*) of the economy?
3. Assume that Ethiopia's target of per capita income growth rate
is 4% =3%, n=3%, and s= 7%, then what is the required
saving rate and financial gap to achieve the stated per capita
income growth rate? (Assuming that  =0).

10/06/2024
 1. Solution: Given Solution
s= 6%
v= 3%
g =?
= 0
 2.

3 s/v = g* +n+
 s/v = g* +n (assuming  = 0)
 s = v (g*+n)
 s = 3 (4+3) = 21%, that is the saving rate required is 21%
 The financial gap = potential (required) saving rate - Actual
Saving rate
10/06/2024
 Saving gap = 21-7 = 14%
Criticism of H-D growth model
 Problem with the argument that GDP growth is
proportional to the share of investment expenditure in
GDP
 Low rate of savings in developing countries gives rise to
savings gap and capital constraint
 Savings and investment is a necessary condition for
accelerated economic growth but not a sufficient
condition
 5.2. Solow Model
 The Solow model is built around two equations, a
production function and a capital accumulation
equation.
 The production function describes how inputs are

combined to produce output.

 To simplify the model, we group these inputs into two

categories, capital, K, and labour, L, and denote output

as Y.
 The production function is assumed to have the Cobb-

Douglas form and is given by

Y = F(K, L) = KαL1-α,
where α is some number between 0 and 1.
 Notice that this production function exhibits constant

returns to scale if all of the inputs are doubled, outputs

10/06/2024
 - i.e. a production function has constant returns to scale
if
zY = F(zK, zL) for any positive number z. That is, if we
multiply both capital and labour by z, we also multiply
the amount of output by z.
 In line with the above stylized facts, we are interested in

explaining output per worker or per capita output.

 With this interest in mind, we can rewrite the

production function in equation [1] in terms of output

per worker, y ≡ Y/L, and capital per worker, k ≡ K/L - i.e.
setting z = 1/L.
Y/L = F(K/L, 1)
y=f(k) where f(k) = F(k, 1)

10/06/2024
 Solow growth model
 The Solow model considers an aggregate production function
for the economy as a whole such that a composite good is
produced through a common technology by utilizing
homogenous inputs, L & K.
 The first step to understand the model is to study what
determines the SS & DD for goods in the economy.
 The SS of goods in the Solow model is determined by a
production function with three inputs viz. K, L, and A, i.e.,
capital, labor & technology of production, respectively.
 Thus, the SS function would be Yt = F(Kt , At, Lt)
 In a Solow economy, goods are demanded for consumption &
investment purposes. Thus, Y = C + I is the demand function.

15 June 10, 2024

 Solow model assumptions:
1. Closed economy,
2. Produce one good using both labor and capital;
3. Technological progress is given and the saving
rate is exogenously determined;
4. No government involvement in economy
5. Fixed number of firms in the economy, each with the
same production technology;
6. Output price is constant
7. There is constant returns to scale production
16 June 10, 2024
Supply of Goods
 Four variables considered:
 flow of output, Y;
 stock of capital, K;
 number of workers, L;

 Technology of production, A.

 Aggregate production (AS) function given by,

Y = F(K,AL)…………………………. (1)
 Change in Y will take place due to change in inputs K,
L and A.
 A and L enter multiplicatively, where AL is effective
labor, and technological progress enters as labor
augmenting.
17 June 10, 2024
 Labor-augmenting implies the effect of technological
progress on increasing labor productivity or efficiency.
 The production function described at (1) presents constant
returns to scale (CRS) implying doubling inputs lead to double
output.

F(αK, αAL) = αF(K,AL)

 The CRS assumption can be utilized to convert the production
fun. In equation (1) to per effective labor terms. Thus, equation
(1) would be
 K  1
F , 1  F ( K , AL) ...............................( 2)
 AL  AL
 The above form of production function is known as the
intensive form & it allows to analyze all variables in the
economy relative to the size of effective labor force.
18 June 10, 2024
 From the above explanation, K/AL is capital expressed relative
to effective labor, i.e., it is capital per unit effective labor.
K  Y
Moreover , F  , 1  which is output per unit effective labor .
 AL  AL
K
Let us designate the above in lowercase letters such as  k;
AL
Y
 y and f(k)  F(k, 1).
AL
Therefore, y  f(k) ... .................................................................... (3)

Since k represents capital labor ratio, as

we move along x-axis the amount of y
capital available per unit of labor
increases. A basic feature of eqn. (1) is f(k)=y
that while CRS prevails, there is MPK
diminishing returns to capital input. It
1
implies that when both K & L are
increased proportionately there is CRS. On
the other hand, if there is an increase in K
while keeping AL constant, we obtain k
Fig Neoclassical Production Function
diminishing returns to K. The slope is MPK 19 June 10, 2024
Cobb-Douglas Function:
 A production function that satisfies Solow model

characteristics:

Y = F(K, AL) = K(AL)1- , 0 <  < 1, ………(4)

Intensive form Cobb-Douglas:

 Dividing both sides of equn.(4) by AL yields,

y = f(k) = (K/AL) = k , …………………….

(5)
and,
f '(k) = k  - 1 > 0,
f "(k) = - (1 - )k
20
-2
< 0. June 10, 2024
 Demand for Goods
• In a Solow economy goods are demanded for
consumption and investment. Thus,

Y = C + I …………………………............. (6)
• If we express (6) in per effective labor terms (i.e.,
multiplying by 1/AL) we obtain,

y = c + i …………………………..…….… (7)

• Each year people save a fraction s of their income.

Thus, s is the saving rate & it assumes a value b/n 0 &
1. 21 June 10, 2024
 Savings, S, defined as Y - C, a constant fraction, s, of
output:
Y= S +C ►S  Y – C = sY, 0 < s < 1 ………....... (8)
 Savings equals investment such that:
S = I = sY …………..……………….………..… (9)
• Savings per effective labor = sy
Therefore, c = (1-s)y
 y = (1-s)y + i ……………………………...... (10)
 y – (1 – s)y = i
 y - y + sy = i
 i = sy …………………………………..…… (11)
• Equation (11) shows that saving equal investment, a
condition necessary for equilibrium in the economy.
22 June 10, 2024
 Figure 11.1
The Production Function in the Solow-Swan Model

y = k
y

} f'(k) = k

D
1 i = sk


er
pti on p
c=y-i um
Cons ive labor
t
B effec

e nt pe r
stm
Inve ive labor
t
effec A
0
k

23 June 10, 2024

 The Steady State growth model
 In equation (11) we have seen that investment per

unit of labor equals saving per unit of effective

labor, i.e.,
i = sy
 Since y = f(k) we can write equation (11) as
i = sf(k) ……………………….………..
(12)
 The above shows the r/ship b/n existing capital
stock (k) and accumulation of new capital (i)
24 June 10, 2024

expressed in ‘per effective labor’ term.

 Increase in capital stock is due to investment.
 Thus, in per effective labor term, equation (12) expressed
as:
.

k  sf(k) …….………………………. (13)

0

0
where refers
k to the growth rate in k (dot over a variable
is to represent its growth rate).
• Assumptions in equation (13):
 No depreciation,
 no population growth and
 no technological progress.

25 June 10, 2024

 Growth of Capital and Steady State
 The Solow model assumes that existing capital
depreciates at the rate δ. Thus, each year δk amount of
capital is depreciated.
 Investment & depreciation act in opposite directions and
the growth in capital stock is net of the two quantities,
i.e.,
0

k (t ) = i(t) – δk(t), since i(t) = sf(k(t)

0

k (t ) = sf(k(t) – δk(t) ………………………. (14)

 Thus, capital stock rises when sfk(t) > δk(t); falls when
sfk(t) < δk(t) and constant when sfk(t) = δk(t).
26 June 10, 2024
 y

δk
δk2
i2 sf(k)
i=δk*
X
i1

δk1

k
k1 K* k2
Fig: Steady state of an economy

27 June 10, 2024

• From the above figure, The saving & depreciation curves
intersect at point X, where capital stock is k* and
depreciation is equals investment.
• At this point there is no growth in capital stock hence
output also remains steady.
• K* is therefore known as the steady state level of capital.
• There are 2 unique features of the steady state:
• economy in steady state will remain there till there is
change in any other variable, and economy will always
move towards the steady state.

28 June 10, 2024

 Population Growth and Steady State
y
(n2δ)k
(n1δ)k
sf(k)

k
K2* K1 *
Fig: Steady state in two countries
The previous discussion can be extended to include population growth (nk) in the
Solow-Swan model.
0

k (t ) = sf(k(t) – (n+δ)k(t) …………………………………. (15)

The country with high growth rate of population n2 has lower level of k* (the steady
state level of k) & thus lower y. Therefore,
29
controlling population growth is policy
June 10, 2024
issue.
 Technological Progress and Steady State
0
y
To explain growth in output per
k (t ) = f(k(t) – (n+g+δ)k(t) …………….
(16)
effective labor, we need to (n+g+δ)k
introduce technological progress
(g) (labor augmented) in the Solow sf(k)
Br e
model. ak
eve
n in
At steady state, capital per ve s
tm
ent
effective labor and output per
effective labor remains
unchanged.
There is a growth in output per
effective labor at a rate g and total
output growth at the rate (n+g).
We see that the introduction of
technological progress enables us k
K1 *
to account for increase in output
Fig: Steady state
per worker.

We conclude that according to Solow model persistently rising living standard (Y/L)
can be explained only through technological progress.
30 June 10, 2024
 (n+g+δ)k
The Golden Rule y s2f(k)
Let the saving rate rises while n, g,
and δ remain unchanged (see the
Fig.). Since i = sf(k) there will be
higher investment which in turn will
s1f(k)
lead to capital accumulation and
output growth and the economy will
eventually reach to a new steady state
with higher capital and output.
When saving rate rises from s1 to s2 (k=K/AL)
K1 * K2*
the investment curve shifts up from Fig: Impact of saving rate
s1f(k) to s2f(k). Thus the economy (n+g+δ)k*
y
reaches a new steady state k2* after sf(k*)
en
going through the process of capital c* gold

accumulation.
At various levels of s different steady
state are achieved with different levels k*golfrn Steady state k

of capital accumulation. However, Fig. Golden rule steady state

there is an optimum level of capital We know income (output) allocated on C and S (I), i.e.,
accumulation which is called the Y = C + I.
golden rule level of capital. Steady state consumption is output net of investment.
Thus 31c* = y* - i*; rewrite c* = f(k*) -(n+g+δ)k*.June
More K
10, 2024
leads to more output → more C.
 Sum-up

• The Solow-Swan model explains long-term growth in per

capita output experienced by economies world over.
• CRS is assumed which allows for DRS to capital input
• The model depicts that the economy has a tendency to
converge to a steady state where availability of capital per
worker remains unchanged.
• It is built upon equality b/n saving & investment
• “I” results in increase in K which is durable in nature and
undergoes depreciation (δ)
• Higher S ratio implies higher per capita income but does not
influence long term growth rate of output.
32 June 10, 2024
 Cont…
• In steady state as K stock available per unit of labor
remains unchanged, the economy should have just
enough investment to take care of δ, population growth
(n) and technical progress (g)
• The model concludes that S has only a ‘level effect’ not
sustained ‘growth effect’ and high ‘n’ rather reduces the
per capita availability of output & capital.
• Accordingly, sustained output growth is possible only
through technological progress.
• According Solow model the objective of an economy is
to maximize consumption, not saving.
• The golden rule suggests that K should be at that level
where MPK net of depreciation is equal to output growth.
33 June 10, 2024
 Cont…
 Solow model's answer to the question "Why are we so
rich and they so poor?" countries that have high
saving/investment rates will tend to be richer, ceteris
paribus.
 Such countries accumulate more capital per worker,
and countries with more capital per worker have
more output per worker.
 Countries that have high population growth rates, in
contrast, will tend to be poorer, according to the
Solow model. 34 June 10, 2024
• Cont…
• A higher fraction of savings in these economies
must go simply to keep the capital-labour ratio
constant in the face of a growing population.
• This capital widening requirement makes
capital deepening more difficult, and these
economies tend to accumulate less capital per
worker
35 June 10, 2024
 I V E n! ! !
R F t io
P TE t t e n
H A ur a
F C y o
D O f or
EN yo u

a nk
 Th

36 June 10, 2024