Economics 448 Lecture 4

September 13, 2012

Solow: Endogenize CapitalOutput Ratio

Retain the rst assumption, constancy of the savings rate S (t ) = sY (t ) = I (t ). Equation for the capital stock: K (t + 1) = (1 )K (t ) + sY (t ) Let Population growth P (t + 1) = (1 + n)P (t ). (1 + n)k (t + 1) = (1 )k (t ) + sy (t ) (3.9)

Note equation is expressed in per capita quantities (lower case).

Interpretation

Right hand side (RHS) two parts depreciated per capita capital and current per capita savings. Together they give us (almost) the new per capita stock. True if n = 0, but population growth puts downward drag on per capita capital stock. Hence, adjust for population growth by term 1 + n on LHS. Note: the larger the rate of population growth, the lower is the per capita capital stock the next period.

Relationship between k and y (Fig 3)

Production function y=f(k)

Output per Capital

Output--Capital Ratios

Capital per Capita (k)

Dynamics of the Solow Model (Fig 4)

(1+n)k

(1-)k+sy

k(0)

k*

Steady State

1. if k (0) < k 2. if k (0) > k

Long Run Growth in Solow Model?

In Solow model the savings rate has no longrun eect on the rate of growth. (contrary to HD). Whats the resolution between HD and Solow?

Level Eects versus Growth Eects

Savings rate does not aect longrun growth rate of per capita income, but aects the longrun level of income. The steady state (k (t + 1) = k (t ) = k ) and manipulating eqn 3.9 to yield s k = y n+ Increase this lowers the RHS. But this means that the capitaloutput ratio on the LHS must decline this means that k and y decline. Whats the economic interpretation?

Population Growth

Higher population growth, lowers the steadystate level of per capita income. But the total income must grow faster as a result. Economy converges to a SS level of per capita income, which is impossible unless longrun growth of total income equals the rate of population growth. Labor is both an input in production and a consumer of nal goods. First raise total output and drives higher rate of growth of total income; second lowers savings and investment and brings down the SS level of per capita income.

Summary of Far
Note: We have not discussed technical progress. 1. Solow model that parameters such as savings rate has only level eect. 2. Solow model implies there is a steadystate level of per capita income to which the economy must converge. 3. Convergence (in LR) does not depend on historical starting point. 4. Solow model infers regardless of initial per capita capital stock, two countries with similar savings rates, depreciation rates, and population growth rates will converge to similar standards of living (in the LR).

Convergence

The empirical tests of the Solow model center on testing convergence. As you might expect, convergence comes in two forms: 1. Unconditional 2. Conditional (on savings and population growth rates)

Unconditional Convergence

This is the strongest prediction (with the fewest assumptions) and the easiest to refute. Suppose that countries, in the long run, have no tendency to display dierence in the rates of technical progress savings, population growth, and capital depreciation. The Solow model predicts then in all countries, capital per capita converges to the common value k , and this happens regardless of the initial state of each economy, as measured by their starting levels of per capita income (or equivalently per capita capital stock).

Meaning of Unconditional Convergence

If the parameters governing the evolution of the economy are similar, then history in the sense of dierent initial conditions does not matter. Initial conditions is not some long ago level, but rather k (0) is the level of the per capita capital stock that we can rst reasonably measure. In the long run, the starting point of the process does not matter. All possible histories converge at the steady state k . If empirically true this would be huge.

Illustration of Unconditional Convergence

Log Per Capita Income

Time

Data

Implementation issue: Use a smaller set of countries over a long time period OR Use a larger set of countries over a shorter period of time.

Resolution to Data Choice

Choice: Do Both. Informative to do both because the set of countries with data available for the longest time period are the current rich countries (OECD). Data available only recently for developing countries. Should we reject unconditional convergence on one set of countries but not the other may be evidence against unconditional convergence.

Evidence

Ray discusses Baumols study which concluded that unconditional convergence could not be rejected. Yet when the analysis was expanded to include more countries there is substantial evidence against unconditional convergence. Another piece of evidence: the standard deviation (dispersion) of per capita income among Western European countries declined over 19601985. But among Asian countries over the same period dispersion increased. Moreover, the divergence dates back to 1900 (so not just a recent phenomenon).

Implication

The simplest Solow model with only population growth does not produce longrun growth. In the long run income per capita is constant and equal to the stead state value. Hence, need to extend the model to generate longrun income growth as observed for the last two hundred (or so) years.