CHAPTE

Economic Growth I:
Capital Accumulation and
Population 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
standard of living after

annual growth
rate of income
per capita

25 years

50 years

100 years

2.0%

64.0%

169.2%

624.5%

2.5%

85.4%

243.7%

1,081.4%

CHAPTER 7.01

slide 2

How Solow model is different

from Chapter 3s 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. the consumption function is simpler

4. no G or T
CHAPTER 7.01

slide 3

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)
CHAPTER 7.01

where f(k) = F(k, 1)

slide 4

The production function

Output per
worker, y

f(k)
MPK = df(k)/dk

Note:
Note: this
thisproduction
productionfunction
function
exhibits
exhibitsdiminishing
diminishingMPK.
MPK.
Capital per
worker, k
CHAPTER 7.01

slide 5

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

CHAPTER 7.01

slide 6

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 = (1s)y

(per worker)

CHAPTER 7.01

slide 7

Saving and investment

saving (per worker)

= y c
= y (1s)y
=

sy

National income identity is y = c + i

Rearrange to get: i = y c = sy
(investment = saving, like in chap. 3!)

Using the results above,

i = sy = sf(k)
CHAPTER 7.01

slide 8

Output, consumption, and

investment
Output per
worker, y

f(k)

c1
sf(k)

y1
i1
k1
CHAPTER 7.01

Capital per
worker, k
slide 9

Depreciation
Depreciation
per worker, k

== the
the rate
rate of
of depreciation
depreciation
== the
the fraction
fraction of
of the
the capital
capital stock
stock
that
that wears
wears out
out each
each period
period
k

CHAPTER 7.01

Capital per
worker, k
slide 10

Capital accumulation
The basic idea: Investment increases the capital
stock, depreciation reduces it.
Change in capital stock
k

= investment depreciation
=
i

Since i = sf(k) , this becomes:

k = s f(k) k
CHAPTER 7.01

slide 11

The equation of motion for k

k = s f(k) k
The Solow models 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 = (1s) f(k)

CHAPTER 7.01

slide 12

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.

CHAPTER 7.01

slide 13

The steady state

Investment
and
depreciation

k
sf(k)

k*
CHAPTER 7.01

Capital per
worker, k
slide 14

Moving toward the steady state

Investment
and
depreciation

k = sf(k)
k

k
sf(k)

investment

depreciation
k1
CHAPTER 7.01

k*

Capital per
worker, k
slide 15

Moving toward the steady state

Investment
and
depreciation

k = sf(k)
k

k
sf(k)

k
k1 k2
CHAPTER 7.01

k*

Capital per
worker, k
slide 17

Moving toward the steady state

Investment
and
depreciation

k = sf(k)
k

k
sf(k)

investment

depreciation
k2
CHAPTER 7.01

k*

Capital per
worker, k
slide 18

Moving toward the steady state

Investment
and
depreciation

k = sf(k)
k

k
sf(k)

k
k2 k3 k*
CHAPTER 7.01

Capital per
worker, k
slide 20

Moving toward the steady state

Investment
and
depreciation

k = sf(k)
k

sf(k)

Summary:
Summary:
As
As long
long as
as kk << kk**,,
investment
investment will
will exceed
exceed
depreciation,
depreciation,
and
and kk will
will continue
continue to
to
grow
grow toward
toward kk**..
k3 k*
CHAPTER 7.01

Capital per
worker, k
slide 21

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
1/ 2 1/ 2
Y K L
K

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

y f (k ) k 1/ 2
CHAPTER 7.01

slide 22

A numerical example,

cont.

Assume:

s = 0.3
= 0.1
initial value of k = 4.0

CHAPTER 7.01

slide 23

Approaching the steady state:

A numerical example

Assumptions:
Year
Year
11

kk
4.000
4.000

22
33

4.200
4.200
4.395
4.395

4
4.584

10
5.602

25
7.351

100
8.962

7.01
CHAPTER9.000

k;

s 0.3;

ii
0.600
0.600

kk
0.400
0.400

kk
0.200
0.200

2.096
2.096 1.467
1.467

0.615
0.615
0.629
0.629

0.420
0.420
0.440
0.440

0.195
0.195
0.189
0.189

2.141

1.499

0.642

0.458

0.184

2.367

1.657

0.710

0.560

0.150

2.706

1.894

0.812

0.732

0.080

2.994

2.096

0.898

0.896

0.002

3.000

2.100

0.900

0.900

0.000slide 24

yy
cc
2.000
2.000 1.400
1.400
2.049
2.049 1.435
1.435

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 = s f(k) k
to solve for the steady-state values of k, y, and c.

CHAPTER 7.01

slide 25

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*
k*

k*

Solve to get: k * 9

and y * k * 3

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

CHAPTER 7.01

slide 26

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
depreciation

k
s2 f(k)
s1 f(k)

CHAPTER 7.01

k1*

k 2*

k
slide 27

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.
CHAPTER 7.01

slide 28

International evidence on
investment rates and income per
person
100,000

Income per
person in
2000
(log scale)

10,000

1,000

100
0

10

15

20

25

30

35

Investment as percentage of output

(average 1960-2000)

CHAPTER 7.01

slide 29

Income in the US states

Gomme and Rupert
The reading shows that incomes per person in the U.S.
states have shown some convergence.

This is more or less the prediction of our model:

If the states have access to the same production

technology, f(k) and depreciation rate of capital

And the same rate of saving, s

Then no matter what the initial y (or initial k), they should
all converge to the same k*, and therefore the same y*.

Well discuss this more when we get to Chapter 8.

CHAPTER 7.01

slide 30

The Golden Rule:

Introduction
Different values of s lead to different steady states.
How do we know which is the best steady state?

The best steady state has the highest possible

consumption per person: c* = (1s) f(k*).

An increase in s
leads to higher k* and y*, which raises c*
reduces consumptions share of income (1s),
which lowers c*.

So, how do we find the s and k* that maximize c*?

CHAPTER 7.01

slide 31

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*

= f (k*)

k*

CHAPTER 7.01

In the steady state:

i* = k*
because k = 0.
slide 32

The Golden Rule capital stock

steady state
output and
depreciation

Then,
Then, graph
graph
f(k
f(k**)) and
and kk**,,
look
look for
for the
the
point
point where
where
the
the gap
gap between
between
them
them is
is biggest.
biggest.
*
*
y gold
f (k gold
)

CHAPTER 7.01

k*
f(k*)

*
c gold
*
*
i gold
k gold
*
k gold

steady-state
capital per
worker, k*
slide 33

The Golden Rule capital stock

cc** == f(k
f(k**)) kk**
is
is biggest
biggest where
where the
the
slope
slope of
of the
the
production
production function
function
equals
equals
the
the slope
slope of
of the
the
depreciation
depreciation line:
line:

k*
f(k*)

*
c gold

MPK =
*
k gold

CHAPTER 7.01

steady-state
capital per
worker, k*
slide 34

Much easier using calculus

Before we had c* = f(k*) - k*

Recall from calculus that to calculate the
maximum consumption, we calculate dc*/dk*,
and set dc*/dk* equal to zero.

From the above equation, we have

dc*/dk* = MPK - .
So the golden rule capital is found where
MPK - = 0
CHAPTER 7.01

slide 35

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?
CHAPTER 7.01

slide 36

Starting with too little capital

*
If k * k gold

then
then increasing
increasing cc**
requires
requires an
an
increase
increase in
in s.
s.
Future
Future generations
generations
enjoy
enjoy higher
higher
consumption,
consumption,
but
but the
the current
current
one
one experiences
experiences
an
an initial
initial drop
drop
in
in consumption.
consumption.
CHAPTER 7.01

y
c

i
t0

time
slide 37

Population growth

Assume that the population (and labor force)

grow at rate n.

(n is exogenous.)

L
n
L

CHAPTER 7.01

slide 38

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.)
CHAPTER 7.01

slide 39

The equation of motion for k

With population growth,

the equation of motion for k is

k = s f(k) ( + n) k

actual
investment

CHAPTER 7.01

break-even
investment

slide 40

The Solow model diagram

Investment,
break-even
investment

k = s f(k) (
+n)k
( + n ) k
sf(k)

k*
CHAPTER 7.01

Capital per
worker, k
slide 41

The impact of population

growth
Investment,
break-even
investment

( +n2) k
( +n1) k

An
An increase
increase in
in nn
causes
causes an
an
increase
increase in
in breakbreakeven
even investment,
investment,
leading to a lower
steady-state level
of k.

sf(k)

k2*
CHAPTER 7.01

k1* Capital per

worker, k
slide 42

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.

CHAPTER 7.01

slide 43

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

10,000

1,000

100
0
CHAPTER 7.01

Population Growth

(percent per year; average 1960-2000)

slide 44

The Golden Rule with

population growth
To find the Golden Rule capital stock,
express c* in terms of k*:
c* =

y*

= f (k* )

i*

( + n) k*

c* is maximized when
MPK = + n
or equivalently,
MPK = n
CHAPTER 7.01

In
In the
the Golden
Golden
Rule
Rule steady
steady state,
state,
the
the marginal
marginal product
product
of
of capital
capital net
net of
of
depreciation
depreciation equals
equals
the
the population
population
slide 45
growth
growth rate.
rate.

Alternative perspectives on
population growth
The Malthusian Model (1798)
Predicts population growth will outstrip the Earths
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.

CHAPTER 7.01

slide 46

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.
CHAPTER 7.01

slide 47

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

run, a countrys 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.
CHAPTER 7

Economic Growth I

slide 48

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.

CHAPTER 7

Economic Growth I

slide 49