Chapter 08

Economic Growth Part One

ECON 502 • Macroeconomics • 2022-23

Sumit Mishra
IFMR, Sri City
Facts about Economic Growth
India and its neighbours
Per-capita income over time
Gross Capital Formation Over Time
Consumption over Time
Economic Growth I: Capital Accumulation and
Population Growth
The Accumulation of Capital
We will construct the Solow model which shows how the following interact:

growth in capital stock,

the labour force,
changes in technology.
The Accumulation of Capital
The Supply of Goods
Y = F (K, L)

Assumption: this production function has a constant returns to scale.

What does this assumption mean?

In plain language, if you multiply each input by a constant (z) , the output also gets multiplied
by the same constant.
The Supply of Goods
Divide both sides by L.

Y K
= F( , 1)
L L

We have now established a relation between per-capita output and per-capita amount of
capital.

The assumption of constant returns to scale implies that the size of the economy—as
measured by the number of workers—does not affect the relationship between
output per worker and capital per worker.

Let Y

L
= y and K

L
= k . We can rewrite the production function as:

y = f (k)
Let Y

L
= y and K

L
= k . We can rewrite the production function as:

y = f (k)

The slope of this prodn function shows how extra output a worker produces when given an
extra unit of capital.

M P K = f (k + 1) − f (k)
The Demand for Goods
The demand for goods in Solow model comes from households and firms.

The output per worker y is divided between consumption per worker c and investment per
workerk i.

y = c + i

NOTE: we ignore the role of the government and international trade out here.
The Demand for Goods
The model assumes that every year people save a fixed fraction of their total income (s) .

We can define a consumption function as:

c = (1 − s)y

y = (1 − s)y + i

sy = i
Solow Model
Summary
We have a production function determining the supply-side.

We have a consumption function denoting the demand-side.

Two parameters of interest are: (k): the capital to labour ratio, and (s) : the saving rate in
the economy.
Growth in capital stock
y = f (k) , and i = sy .

We can rewrite:

i = sf (k)

In plain language: the existing stock of capital (k) determines the accumulation of new capital
(i).
Depreciation
Machines grow old and there's wear and tear.

Our model should incorporate this factor.

Enter depreciation.

Mathematically:

Depreciation = δk
Growth in Capital
Change in capital stock = Investment − Depreciation

Δk = i − δk

From our previous discussion, we know that: i = sf (k) .

Therefore,

Δk = sf (k) − δk
Capital Accumulation and Growth
If you have higher stock of capital, there will be higher investment...

If you have higher stock of capital, inevitably there will be higher level of depreciation.

What's the optimal stock of capital (k∗ )?

When investment is just enough to cover for the depreciation.

at k = k∗ , Δk = 0.

k
∗
represents the steady-state level of capital in the economy.
The Steady State
∗
k = k

The economy will eventually get to the long-run equilibrium.

Scenario 1: economy begins with capital (> ∗

k ) .

Depreciation is higher than the investment.

Capital stock will keep falling until k = k∗ .

Scenario 2: economy starts with capital below the steady-state level.

Investment is higher than depreciation.

Over time, capital accumulates until k = k
∗
The Steady State: Example
Consider the following production function Y = K
1/2 1/2
L .

1/2
y = k

Assume that s ;
= 30% δ = 10% .

The economy starts with 4 units of capital (per labour).

The Steady State: Example
1/2
y = k

Assume that s ;
= 30% δ = 10% .

The economy starts with 4 units of capital (per labour).

What's the condition for steady state?

i = δk

or

sy = δk or sf (k) = δk
The Steady State: Example
1/2
y = k

sf (k) = δk

or
∗
k s
=
∗
f (k ) δ

Plug in the values, you get: k

∗1/2
=
0.3

0.1
k

In the end: k∗ = 9
How Saving Affects Growth
If the saving rate is high, the economy will have a large capital stock and a high level
of output in the steady state. If the saving rate is low, the economy will have a small
capital stock and a low level of output in the steady state.

Policies that alter the steady-state growth rate of income per person are said to have
a growth effect

a higher saving rate is said to have a level effect because only the level of income per
person is influenced by the saving rate in the steady state.
The Golden Rule Level of Capital
Question: Is 100% saving rate feasible?

Answer: Of course, not, because you also need to carefully calibrate the level of consumption in
the economy.

Therefore, the policymaker would choose a level of capital such that consumption is
maximised. This is known as the Golden Rule level of capital.

At the Golden Rule level of capital:

MP K = δ
The Golden Rule Level of Capital: Example
−
y = √k ; depreciation, δ = 0.1 .

We know that:
∗
k s
=
∗
f (k ) δ

Plugging in values, we get:

∗ 2
k = 100s

We should now make use of the condition:

MP K = δ
The Golden Rule Level of Capital: Example
We should now make use of the condition:

MP K = δ

1
MP K = −
−
2√K

We know that δ = 0.1 . We can compute k∗gold .

∗
k = 25
gold
The Golden Rule Level of Capital: Example
We now have k∗gold = 25 .

We also know that k∗gold = 100s

2

Plugging in the value of capital, we can calculate s∗ .

∗
s = 0.5
Transition to the Steady State
Case I: The economy starts with too little capital.

In this case the policy-maker should try to increase the savings rate.

This will cause a temporary fall in the consumption levels, but eventually consumption will
be higher due to capital accumulation.

Case II: The economy starts with more capital (than the steady-state level).

In this scenario, the policymaker will try to reduce the savings rate.

The reduction in savings rate will cause a rise in the level of consumption.

Eventually, investment-level would be lower and consumption higher than the it was before
the change in savings rate.
The Steady State with Population Growth
We will modify the change in capital stock equation to accommodate population growth:

Δk = i − (δ + n)k

The break-even level of investment occurs at Δk = 0 .

(δ + n)k
The Impact of Population Growth
The steady-state level of consumption will be:

∗ ∗ ∗
c = sf (k ) − (δ + n)k

∗
↑ n ⇒↓ k

Higher population growth will lead to lower economic growth.

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

MP K = δ + n