Macroeconomics & The
Global Economy
Ace Institute of Management
Chapter 7 and 8: Economic Growth I
Instructor
Sandeep Basnyat
Sandeep_basnyat@yahoo.com
9841 892281
The Solow or Neo Classical Model
 A major paradigm by Robert Solow:
– widely used in policy making
– benchmark against which most
recent growth theories are compared
 The rate at which the output of the economy grows
basically depends on the rate at which the followings
grow over time:
– Capital Stock
Factors of Production
– Labour Force
– Technological Progress - Production Function
CHAPTER 7
Economic Growth I
slide 1
The Solow Model- Accumulation of
Capital Stock in an Economy
 How much capital an economy can
accumulate depends on:
– supply of goods (Output) : depends on
Production function
– demand of goods (Input): depends on
Consumption function
CHAPTER 7
Economic Growth I
slide 2
The production function
 In aggregate terms: Y = F (K, L )
 Define: y = Output
k = Capital Stock
L = No. of Labour
 Assumption: Constant return to scale. So,
zY = F (zK, zL ) for any z > 0
 Suppose, z = 1/L. Then,
Y/L = F (K/L , 1)
Amount of Output per worker (Y/L) is the
function of amount of capital per worker (K/L) .
CHAPTER 7
Economic Growth I
slide 3
The production function
 Assume, Y/L = y and K/L = k. Then,
y =
f(k). Ignore ‘1’ as a constant. …(i)
 Eqn, (i) shows how much extra output a
worker produces given an extra capital
(Marginal Product of Capital-MPK).
CHAPTER 7
Economic Growth I
slide 4
The production function
Output per
worker, y
Note:
When capital
per worker is
high, extra unit
of capital
produces lower
output
f(k)
1
MPK
Note: this production function
exhibits diminishing MPK.
Vice Versa.
Capital per
worker, k
CHAPTER 7
Economic Growth I
slide 5
The Demand for Goods and Services
 y = c + i (remember, no G : Two Sector)
 In “per worker” terms:
Output per worker is divided into consumption per worker
and investment per worker
 Since people save and consume their income,
If savings rate = s, then, c = (1-s)
 So, fraction of the income that people consume is
c = (1-s)y ….. Consumption Fn.
CHAPTER 7
Economic Growth I
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The Demand for Goods and Services
 Substituting the value of ‘c’ in y;
y = (1-s)y + i
or
i = sy
Shows that investment equals saving where
‘s’ is the fraction of the output/ income
devoted to investment.
CHAPTER 7
Economic Growth I
slide 7
Basis of Neo-Classical Growth Model
 The main building block of the model: production function
(Y depends on K, L and the technological progress)
 Investment : K
 Depreciation : K
So, When I > D; K
When I < D; K
When I = D; K- Unchanged (Steady State)
 Big Question: When does investment exceed
depreciation, and when does it fall short of it?
CHAPTER 7
Economic Growth I
slide 8
Basis of Neo-Classical Growth Model
 Depreciation: we may safely assume it as a constant
(usually shown by 45 degree).
 Investment: Can be shown in terms of savings.
 Saving is a fixed share of to total income. Therefore,
savings and/or investment at different capital stocks can
be presented as a part of the total output (Income).
CHAPTER 7
Economic Growth I
slide 9
Output Per Worker
Graphical representation without Technology
Steady State
Capital Per Worker
CHAPTER 7
Economic Growth I
slide 10
Output Per Worker
The model and increase in the saving rate
Capital Per Worker
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Economic Growth I
slide 11
The model and increase in population
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Economic Growth I
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Effect of Technological Advancement
•Productivity per y
worker increases
y*’
•Shifts the
Production
y*
functions upward
•Saving rate shifts
upward
•Capital stock per
worker increases
•New Steady State is
formed
•Output per worker
is increased but
greater than “k”
CHAPTER 7
Economic Growth I
y’ = f(k)
y = f(k)
ir = dk
i = s' f(k)
i = s f(k)
k* k1*
k
slide 13
Golden Rule Level of Capital
y
•Bench mark for highest
level of movement of
steady state
ir = dk
y = f(k)
•The Golden Rule level of
capital accumulation is the
steady state with the
highest level of
consumption.
C*gold
i = s f(k)
I*gold
k*gold
CHAPTER 7
Economic Growth I
k
slide 14
Policy issues:
How to increase the saving rate?
 Reduce the government budget deficit
(or increase the budget surplus).
 Increase incentives for private saving.
Example: Reduce tax
CHAPTER 7
Economic Growth I
slide 15
Policy issues:
Allocating the economy’s investment
 In the Solow model, there’s one type of
capital.
 In the real world, there are many types,
which we can divide into three categories:
– private capital stock
– public infrastructure
– human capital: the knowledge and
skills that workers acquire through
education.
 How should we allocate investment among
these types?
CHAPTER 7
Economic Growth I
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Policy issues:
Allocating the economy’s investment
Two viewpoints:
1. Let the market allocate investment to the type
with the highest marginal product.
2. Industrial policy by government:
Govt should actively encourage investment in
capital of certain types or in certain industries,
because they may have positive externalities
that private investors don’t consider.
CHAPTER 7
Economic Growth I
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Policy issues:
Establishing the right institutions
 Creating the right institutions is important for
ensuring that resources are allocated to their
best use. Examples:
– Legal institutions, to protect property rights.
– Capital markets, to help financial capital flow
to the best investment projects.
– A corruption-free government, to promote
competition, enforce contracts, etc.
CHAPTER 7
Economic Growth I
slide 18
Policy issues:
Encouraging tech. progress
 Patent laws:
encourage innovation by granting temporary
monopolies to inventors of new products.
 Tax incentives for R&D
 Grants to fund basic research at universities
 Industrial policy:
encourages specific industries that are key for
rapid tech. progress
CHAPTER 7
Economic Growth I
slide 19
Thank You
CHAPTER 7
Economic Growth I
slide 20