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Unformatted text preview: 14.05: Section Handout #1 Solow Model TA: Jose Tessada September 16, 2005 Today we will review the basic elements of the Solow model. Be prepared to ask any questions you may have about the derivation of the model, most of the equations we will cover today will be intensively used later in this part of the class. 1 The Economy We shall first discuss the assumptions used (a) The economy is closed and there is no government sector, thus the national income identity can be written as: Y t = C t + I t (1) where Y t is GDP, C t is consumption, and I t is investment. There is some evidence that on average savings and investment tend to move to- gether even in economies that are open, somewhat validating the close economy assumption. 1 (b) Production is described by a function Y t = F ( K t ,A t L t ) (2) which is assumed to be neoclassical. Note the fact that there are three factors: capital ( K t ), labor ( L t ), and technology ( A t ) 2 , the last is an intangible factor, but we are certain that it differs from country to country (it is hard to think that Kenya has access to the same technology as the US). Some properties of the neoclassical production function: (i) exhibits constant returns to scale in capital and labor (function is homo- geneous of degree one in K and L ), (ii) marginal product are decreasing (meaning that the second derivatives are negative), and 1 The most widely cited work on this area is the one by Feldstein and Horioka (1980), even if this apparent puzzle is still unanswered, many authors have found partial explanations for this result. You can find more about this on Romers textbook. 2 Strictly speaking F () is also technology, but I will refer to A as technology for simplicity. 1 (iii) satisfies the Inada conditions: F F lim = lim = K K K K F F lim = lim = L L L L (c) Constant savings rate s ; the consumption decision is not explicitly...
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