Macroeconomics

Lecture 5: Economic Growth

Santosh Kumar Dash
IRMA, Anand
20-12-2023

Lecture 5 – Economic Growth slide 0

▪ “Is there some action a government of India could take
that would lead the Indian economy to grow like
Indonesia’s or Egypt’s? If so, what, exactly? If not, what
is it about the “nature of India” that makes it so? The
consequences for human welfare involved in questions
like these are simply staggering: Once one starts to think
about them, it is hard to think about anything else.”
—Robert E. Lucas, Jr., 1988 – Nobel Laureate in
Economics

Lecture 5 – Economic Growth slide 1

 Agenda for today’s class

▪ The closed economy Solow model.

▪ How a country’s standard of living depends on
its saving and population growth rates.
▪ How to use the “Golden Rule” to find the optimal
saving rate and capital stock.

Lecture 5 – Economic Growth slide 2

 Questions to Think!

▪ Why are some countries rich and some poor?

▪ Why do some countries grow faster than others?
▪ Why are poor countries poor?
▪ Why India is poor and the US is rich?
▪ What makes a country grow?

Lecture 5 – Economic Growth slide 3

 Why growth matters

Economic growth raises living standards and reduces

poverty….
Lecture 5 – Economic Growth slide 4
 Income and poverty in the world
selected countries, 2000
100
Madagascar
90
India
living on $2 per day or less

80 Nepal
70 Bangladesh
% of population

60 Kenya Botswana
50 China
40 Peru
Mexico
30 Thailand
20
Brazil Chile
10 Russian
S. Korea
Federation
0
$0 $5,000 $10,000 $15,000 $20,000
Income per capita in dollars
Lecture 5 – Economic Growth
 Why growth matters

▪ Anything that effects the long-run rate of economic

growth – even by a tiny amount – will have huge
effects on living standards in the long run.

Percentage increase in per capita

income after...
Growth 10 25 50 100
7.5% 106.1 509.8 3619.0 138207.7
8.0% 115.9 584.8 4590.2 219876.1

Lecture 5 – Economic Growth slide 6

 The lessons of growth theory
…can make a positive difference in the lives of
hundreds of millions of people.
These lessons help us
▪ understand why poor
countries are poor
▪ design policies that
can help them grow
▪ learn how our own
growth rate is affected
by shocks and our
government’s policies

Lecture 5 – Economic Growth slide 7

 The Solow model

▪ What causes these differences in income over time and

across countries.
▪ Due to Robert Solow,
won Nobel Prize for contributions to
the study of economic growth
▪ a major paradigm:
▪ widely used in policy making
▪ benchmark against which most
recent growth theories are compared
▪ looks at the determinants of economic growth and the
standard of living in the long run

Lecture 5 – Economic Growth slide 8

 The Swan Model
The Unlucky Economist!
▪ Trevor Swan - Australian Economist - also wrote
a paper – exactly same as Solow.
▪ But Solow “got” all credit, though Solow greatly
acknowledged Swan’s contribution in 1997. In
fact he explained why he got all the credit.
▪ Sadly, Swan’s name kind of stopped appearing
in Growth textbooks.

Lecture 5 – Economic Growth slide 9

 Key Assumptions of the Solow
model
1. K is no longer fixed:
investment causes it to grow,
depreciation causes it to shrink
2. L is no longer fixed:
population growth causes it to grow
3. no G or T
(only to simplify presentation;
we can still do fiscal policy experiments)

Lecture 5 – Economic Growth slide 10

 The production function
▪ In aggregate terms: Y = F (K, L)
▪ Define: y = Y/L = output per worker
k = K/L = capital per worker
▪ Assume constant returns to scale:
zY = F (zK, zL ) for any z > 0
▪ Pick z = 1/L. Then
Y/L = F (K/L, 1)
y = F (k, 1)
y = f(k) where f(k) = F(k, 1)

▪ It shows how much output one worker could produce

using k units of capital.
Lecture 5 – Economic Growth slide 11
 The production function
Output per
worker, y
f(k)

MPK = f(k +1) – f(k)

1

Note: this production function

exhibits diminishing MPK.

Capital per
worker, k
Lecture 5 – Economic Growth slide 12
 The national income identity

▪ Y=C+I (remember, no G )
▪ In “per worker” terms:
y=c+i
where c = C/L and i = I /L

Lecture 5 – Economic Growth slide 13

 The consumption function

▪ s = the saving rate,

the fraction of income that is saved
(s is an exogenous parameter)
Note: s is the only lowercase variable
that is not equal to
its uppercase version divided by L

▪ Consumption function: c = (1–s)y

(per worker)

Lecture 5 – Economic Growth slide 14

 Saving and investment

▪ saving (per worker) = y – c

= y – (1–s)y
= sy
▪ National income identity is y = c + i
Rearrange to get: i = y – c = sy
(investment = saving)

▪ Using the results above,

i = sy = sf(k)

Lecture 5 – Economic Growth slide 15

 Output, consumption, and investment

Output per f(k)

worker, y

c1
y1 sf(k)

i1

k1 Capital per
worker, k
Lecture 5 – Economic Growth slide 16
 Depreciation
Depreciation  = the rate of depreciation
per worker, k = the fraction of the capital stock
that wears out each period

k


1

Capital per
worker, k
Lecture 5 – Economic Growth slide 17
 Capital accumulation

The basic idea: Investment increases the capital

stock, depreciation reduces it.

Change in capital stock = investment – depreciation

k = i – k

Since i = sf(k) , this becomes:

k = s f(k) – k

Lecture 5 – Economic Growth slide 18

 The equation of motion for k

k = s f(k) – k
▪ The Solow model’s central equation
▪ Determines behavior of capital over time…
▪ …which, in turn, determines behavior of
all of the other endogenous variables
because they all depend on k. E.g.,
income per person: y = f(k)
consumption per person: c = (1–s) f(k)

Lecture 5 – Economic Growth slide 19

 The steady state

k = s f(k) – k
If investment is just enough to cover depreciation
[sf(k) = k ],
then capital per worker will remain constant:
k = 0.

This occurs at one value of k, denoted k*,

called the steady state capital stock.

Lecture 5 – Economic Growth slide 20

 The steady state

Investment
and k
depreciation
sf(k)

k* Capital per
worker, k
Lecture 5 – Economic Growth slide 21
 Moving toward the steady state

k = sf(k) − k
Investment
and k
depreciation
sf(k)

k
investment

depreciation

k1 k* Capital per
worker, k
Lecture 5 – Economic Growth slide 22
 Moving toward the steady state

k = sf(k) − k
Investment
and k
depreciation
sf(k)

k

k1 k2 k* Capital per
worker, k
Lecture 5 – Economic Growth slide 24
 Moving toward the steady state

k = sf(k) − k
Investment
and k
depreciation
sf(k)

k
investment
depreciation

k2 k* Capital per
worker, k
Lecture 5 – Economic Growth slide 25
 Moving toward the steady state

k = sf(k) − k
Investment
and k
depreciation
sf(k)

k

k2 k 3 k* Capital per
worker, k
Lecture 5 – Economic Growth slide 27
 Moving toward the steady state

k = sf(k) − k
Investment
and k
depreciation

Summary: sf(k)
As long as k < k*,
investment will exceed
depreciation,
and k will continue to
grow toward k*.

k 3 k* Capital per
worker, k
Lecture 5 – Economic Growth slide 28
 Now you try:

Draw the Solow model diagram,

labeling the steady state k*.
On the horizontal axis, pick a value greater than k*
for the economy’s initial capital stock. Label it k1.
Show what happens to k over time.
Does k move toward the steady state or
away from it?

Lecture 5 – Economic Growth slide 29

 A numerical example

Production function (aggregate):

Y = F (K , L ) = K  L = K 1 / 2L1 / 2

To derive the per-worker production function,

divide through by L:
1/2
Y K L 1/2 1/2
K 
= = 
L L L 

Then substitute y = Y/L and k = K/L to get

y = f (k ) = k 1 / 2
Lecture 5 – Economic Growth slide 30
 A numerical example, cont.

Assume:
▪ s = 0.3
▪  = 0.1
▪ initial value of k = 4.0
Calculate:
▪ y, c, i, k, k

Lecture 5 – Economic Growth slide 31

 Approaching the steady state:
A numerical example

Year k y c i k k
1 4.000 2.000 1.400 0.600 0.400 0.200

Assu
2 4.200 2.049 1.435 0.615 0.420 0.195
3 4.395 2.096 1.467 0.629 0.440 0.189
4 4.584 2.141 1.499 0.642 0.458 0.184
…
10 5.602 2.367 1.657 0.710 0.560 0.150
…
25 7.351 2.706 1.894 0.812 0.732 0.080
…
100 8.962 2.994 2.096 0.898 0.896 0.002
…
∞Lecture 5 –9.000
Economic Growth
3.000 2.100 0.900 0.900 0.000slide 32
 Exercise: Solve for the steady state

Continue to assume
s = 0.3,  = 0.1, and y = k 1/2

Use the equation of motion

k = sf(k) − k
to solve for the steady-state values of k, y, and c.

Lecture 5 – Economic Growth slide 33

 Solution to exercise:

k = 0 def. of steady state

s f (k *) =  k * eq'n of motion with k = 0

0.3 k * = 0.1k * using assumed values

k*
3= = k*
k*
Solve to get: k * = 9 and y * = k * = 3

Finally, c * = (1 − s )y * = 0.7  3 = 2.1

Lecture 5 – Economic Growth slide 34
 An increase in the saving rate
An increase in the saving rate raises investment…
…causing k to grow toward a new steady state:
Investment
and k
depreciation s2 f(k)

s1 f(k)

k
Lecture 5 – Economic Growth
k 1* k 2*
slide 35
 Prediction:

▪ Higher s  higher k*.

▪ And since y = f(k) ,
higher k*  higher y* .

▪ Thus, the Solow model predicts that countries

with higher rates of saving and investment
will have higher levels of capital and income per
worker in the long run.

Lecture 5 – Economic Growth slide 36

 International evidence on investment rates
and income per person (1960-2000)
Income per 100,000
person in
2000
(log scale)
10,000

1,000

100
0 5 10 15 20 25 30 35
Investment as percentage of output
(average 1960-2000)
Lecture 5 – Economic Growth slide 37
 International evidence on investment rates
and income per person (1960-2010)

Lecture 5 – Economic Growth slide 38

 The Golden Rule: Introduction
▪ Different values of s lead to different steady states.
How do we know which is the “best” steady state?
▪ Try if s = 0.4 or 0.5 in that numerical example
▪ The “best” steady state has the highest possible
consumption per person: c* = (1–s) f(k*).
▪ An increase in s
▪ leads to higher k* and y*, which raises c*
▪ reduces consumption’s share of income (1–s),
which lowers c*.
▪ So, how do we find the s and k* that maximize c*?
Lecture 5 – Economic Growth slide 39
 The Golden Rule capital stock

k gold
*
= the Golden Rule level of capital,
the steady state value of k
that maximizes consumption.
To find it, first express c* in terms of k*:
c* = y* − i*
= f (k*) − i*
In the steady state:
= f (k*) − k* i* = k*
because k = 0.

Lecture 5 – Economic Growth slide 40

 The Golden Rule capital stock
steady state
output and
depreciation  k*
Then, graph
f(k*) and k*,
f(k*)
look for the
point where
the gap between c gold
*

them is biggest.
i gold
*
=  k gold
*

y gold
*
= f (k gold
*
) k gold
*
steady-state
capital per
worker, k*
Lecture 5 – Economic Growth slide 41
 Interpretation

▪ On this graph, the horizontal axis measures k*, not k. Thus, once
we have found k* using the other graph, we plot that k* on this graph
to see where the economy’s steady state is in relation to the golden
rule capital stock.
▪ On this graph, the curve measures f(k*), not sf(k).
▪ On the other diagram, the intersection of the two curves determines
k*. On this graph, the only thing determined by the intersection of
the two curves is the level of capital where c*=0, and we certainly
wouldn’t want to be there.
▪ There are no dynamics in this graph, as we are in a steady state. In
the other graph, the gap between the two curves determines the
change in capital.

Lecture 5 – Economic Growth slide 42

 The Golden Rule capital stock

c* = f(k*) − k*  k*
is biggest where the
slope of the f(k*)
production function
equals
the slope of the
depreciation line: c gold
*

MPK = 
k gold
*
steady-state
capital per
worker, k*
Lecture 5 – Economic Growth slide 43
 The transition to the
Golden Rule steady state
▪ The economy does NOT have a tendency to
move toward the Golden Rule steady state.
▪ Achieving the Golden Rule requires that
policymakers adjust s.
▪ This adjustment leads to a new steady state with
higher consumption.
▪ But what happens to consumption
during the transition to the Golden Rule?

Lecture 5 – Economic Growth slide 44

 Starting with too much capital

If k *  k gold
*

then increasing c* y
requires a fall in s.
In the transition to c
the Golden Rule,
consumption is i
higher at all points
in time.
t0 time

Lecture 5 – Economic Growth slide 45

 Starting with too little capital
If k *  k gold
*

then increasing c*
requires an y
increase in s. c
Future generations
enjoy higher
consumption,
but the current i
one experiences
an initial drop t0 time
in consumption.
Lecture 5 – Economic Growth slide 46
 Population growth

▪ Assume that the population (and labor force)

grow at rate n. (n is exogenous.)
L
= n
L
▪ EX: Suppose L = 1,000 in year 1 and the
population is growing at 2% per year (n = 0.02).
▪ Then L = n L = 0.02  1,000 = 20,
so L = 1,020 in year 2.

Lecture 5 – Economic Growth slide 47

 Break-even investment

▪ ( + n)k = break-even investment,

the amount of investment necessary
to keep k constant.
▪ Break-even investment includes:
▪  k to replace capital as it wears out
▪ n k to equip new workers with capital
(Otherwise, k would fall as the existing capital stock
would be spread more thinly over a larger
population of workers.)

Lecture 5 – Economic Growth slide 48

 The equation of motion for k
▪ With population growth,
the equation of motion for k is

k = s f(k) − ( + n) k

actual
break-even
investment
investment

Lecture 5 – Economic Growth slide 49

 The Solow model diagram
Investment,
k = s f(k) − ( +n)k
break-even
investment
( + n ) k

sf(k)

k* Capital per
worker, k
Lecture 5 – Economic Growth slide 50
 The impact of population growth
Investment,
break-even ( +n2) k
investment
( +n1) k
An increase in n
causes an sf(k)
increase in break-
even investment,
leading to a lower
steady-state level
of k.

k2* k1* Capital per

worker, k
Lecture 5 – Economic Growth slide 51
 Prediction:

▪ Higher n  lower k*.

▪ And since y = f(k) ,
lower k*  lower y*.

▪ Thus, the Solow model predicts that countries

with higher population growth rates will have
lower levels of capital and income per worker in
the long run.

Lecture 5 – Economic Growth slide 52

 International evidence on population
growth and income per person
Income 100,000
per Person
in 2000
(log scale)
10,000

1,000

100
0 1 2 3 4 5
Population Growth
(percent per year; average 1960-2000)
Lecture 5 – Economic Growth slide 53
 The Golden Rule with population
growth
To find the Golden Rule capital stock,
express c* in terms of k*:
c* = y* − i*
= f (k* ) − ( + n) k*
In the Golden
c* is maximized when Rule steady state,
MPK =  + n the marginal product
of capital net of
or equivalently, depreciation equals
MPK −  = n the population
growth rate.
Lecture 5 – Economic Growth slide 54
 Alternative perspectives on
population growth
The Malthusian Model (1798)
▪ Predicts population growth will outstrip the Earth’s
ability to produce food, leading to the
impoverishment of humanity.
▪ Since Malthus, world population has increased
sixfold, yet living standards are higher than ever.
▪ Malthus omitted the effects of technological
progress.

Lecture 5 – Economic Growth slide 55

 Alternative perspectives on
population growth
The Kremerian Model (1993)
▪ Posits that population growth contributes to
economic growth.
▪ More people = more geniuses, scientists &
engineers, so faster technological progress.
▪ Evidence, from very long historical periods:
▪ As world pop. growth rate increased, so did rate
of growth in living standards
▪ Historically, regions with larger populations have
enjoyed faster growth.
Lecture 5 – Economic Growth slide 56
 Chapter Summary

1. The Solow growth model shows that, in the long

run, a country’s standard of living depends
▪ positively on its saving rate
▪ negatively on its population growth rate
2. An increase in the saving rate leads to
▪ higher output in the long run
▪ faster growth temporarily
▪ but not faster steady state growth.

Lecture
CHAPTER 5 –7Economic Growth
Economic Growth I slide 57
 Chapter Summary

3. If the economy has more capital than the

Golden Rule level, then reducing saving will
increase consumption at all points in time,
making all generations better off.
If the economy has less capital than the Golden
Rule level, then increasing saving will increase
consumption for future generations, but reduce
consumption for the present generation.

Lecture
CHAPTER 5 –7Economic Growth
Economic Growth I slide 58