The Combined Solow-Romer Model
The combination of both the Solow and Romer Growth Models presented provides a more complete
understanding of an economy’s ability to exhibit sustained growth for long periods of time, an
explanation for differing growth rates across countries, as well as different levels of sustained growth.
The Combined Solow-Romer Model exhibits constant returns to scale in capital and labor and increasing
returns to scale in capital, labor and ideas. It, too, has no long-run steady state but, like the Romer model,
converges to a balanced growth path in the long-run. It includes the principle of transition dynamics,
which provides an explanation for understanding differences in the growth rates across countries, and
behavioral parameters, that explain different growth rates between countries over long periods of time.
Romer tells us about “A” and Solow tells us about “K”; Romer tells us about long-run growth while
Solow tells us about transitions.
1. Setting up the Combined Model- The simplified Romer model is modified to include capital in
a Cobb-Douglas production function, and by including Solow’s capital accumulation equation.
The combined model features five equations and five unknowns.
The Solow- Romer Model
Unknowns Yt , Kt , At , Lyt , Lat
Output Production Function Yt At Kt1/3 L2/3
yt
Capital Accumulation Kt 1 sYt dKt
Idea Production Function At 1 zAt Lat
Resource Constraint Lyt Lat L
Allocation of Labor Lat lL
Parameters d , s , z , L , l , A0 , K0
One thing to notice about the combined model is that it is much like our original Solow model. In the
original Solow model, however, the productivity level A was a constant parameter. A onetime increase
in this productivity level produced transition dynamics that led the economy to grow for a while before
settling down at its new steady state. Now, At increases continuously over time.
This result means two things. First, it helps us understand how capital and output will continue to grow in our
combined model. Rather than achieving a steady state with a constant level of capital, we will get a balanced growth
path, where capital grows at a constant rate. Second, linking the combined model to the Solow diagram suggests that
transition dynamics are likely to be important; this turns out to be correct. In what follows, we begin by showing
how to solve for the balanced growth path, then take up the issue of transition dynamics.
1
2. Solving the Combined Model (Long-Run Growth) To illustrate the endogenous nature of
long-run growth, let’s look for a balanced growth path—that is, for a situation in the combined
model where output, capital, and the stock of ideas all grow at constant rates.
a. Step 1: Apply the rules for computing growth rates to the production function.
gye YI gyt gAtt g 39L
b. Step 2: To solve for the growth rate of output, we need to know the growth rate of the
three terms on the RHS of the equation above.
i. Divide the production function for new ideas by At to solve for the growth rate
of knowledge.
tt
aahEgat EEE
[Link] state
ii. Divide the capital accumulation equation by
Etat
Kt to solve for the growth rate of 5 [Link]
capital. Remember that s and d are constant along a balanced growth path.
gi
[Link] aEiE d tii i
iii. The growth rate of the number of workers is zero. The number of workers is a
constant fraction of population. We have assumed that the population itself is
constant.
9L 0
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c. Step 3: Substitute the three results above into our equation from Step 1 and evaluate the
expression along a balance growth path. gig gy guys
giq [Link]
J ftE gyiitrt
gy 310
art pop
2
[Link]
52
5
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growth
gym
9 a
d. Solve for the growth rate of output along the balanced growth path. This equation pins
down the growth rate of output – and the growth rate of output per person, since there is
no population growth—in the long-run of the combined model.
RAND gj g ZztI
Longmn growth RIS R
e. Step 4: Compare this solution with what we found in the Romer Model.
NRR [Link]
RIS Y If IT [Link]
Capital accumulation is the only real difference between the Romer model and the combined Solow-
Romer model. Output rises in the combined model for two reasons: (1) there is an increase in productivity
itself (a direct effect); (2) the productivity increase leads to a higher capital stock, which in turn leads to
an even higher level of output (an indirect effect). There is a direct effect of growth in knowledge on
output growth. Then the growth in output leads to capital accumulation, which in turn leads to more
output growth. So, while capital can’t itself
martinserve
s as an engine of economic growth, it helps to amplify the
underlying growth in knowledge. Long-run growth in output per person is therefore higher in the
combined model than in the Romer model.
3. Solving the Combined Model (Output per Person) Now that we know the growth rate of
output in the combined model, we can also solve for the level of output per person along a
balanced growth path.
a. Step 1: We need an equation for capital stock. Solve for the capital-output ratio along a
balanced growth path.
9
[Link] a
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Ii AtYy
b. Step 2: Substitute K* into the production function and find Y*.
AtK I
y Lf
c. Step 3: Divide by labor and solve to find output per person (y*).
E
4 [Link] Lj 3
y
A
IE c
d. This result shows that both Solow and Romer variables determine output per person
(along the balanced-growth path).
y 1 E
4. Solving the Combined Model (Transition Dynamics)
a. Step 1: With the balanced-growth per capita output determined, transition dynamics can
be revisited. Given the stock of ideas around the world, we expect all countries’ growth
paths to converge to the same growth rate. What is this growth rate?
b. A change in the underlying parameters of the model can alter the growth rate temporarily,
but due to diminishing returns to capital, the economy will transition back to a balanced
growth rate path. For the combined model, the principle of transition dynamics can be
expressed as follows: the farther below its balanced growth path an economy is (in
percentage terms), the faster the economy will grow.