Solow model predictsY/LandK/Lgrow at same rate (g), so thatK/Yshould be constant. Thisis true in the real world. Solow model predicts real wage grows at same rate asY/L, while realrental price is constant. Also true in the real world.CONVERGENCESolow model predicts that, other things equal, “poor” countries (with lower Y/L and K/L) shouldgrow faster than “rich” ones. If true, then the income gap between rich & poor countries wouldshrink over time, and living standards “converge.” In real world, many poor countries do NOTgrow faster than rich ones. Does this mean the Solow model fails? No, because “otherthings” aren’t equal. In samples of countries with similar savings & population growth rates,income gaps shrink about 2% / year. In larger samples, if one controls for differences insaving, population growth, and human capital, incomes converge by about 2%/year.
Macroeconomics ECO 403VU© Copyright Virtual University of Pakistan69What the Solow model really predicts is conditional convergence - countries converge to theirown steady states, which are determined by saving, population growth, and education.And this prediction comes true in the real world.FACTOR ACCUMULATION VS. PRODUCTION EFFICIENCYTwo reasons why income per capita are lower in some countries than others:Differences in capital (physical or human) per workerDifferences in the efficiency of production (the height of the production function)Studies:Both factors are important.Countries with higher capital (phys or human) per worker also tend to have higher productionefficiency.Explanations:Production efficiency encourages capital accumulation.Capital accumulation has externalities that raise efficiency.A third, unknown variable causes cap accumulation and efficiency to be higher in somecountries than others.ENDOGENOUS GROWTH THEORYIn Solow model, sustained growth in living standards is due to tech progress. The rate of techprogress is exogenous. While endogenous growth theory is a set of models in which thegrowth rate of productivity and living standards is endogenous.A basic modelThe production function for endogenous growth model can be written as:Y = A K, where A isthe amount of output for each unit of capital (A is exogenous & constant). Key differencebetween this model & Solow model is that MPK is constant here while diminishes in Solowmodel.Investment: sYDepreciation:KEquation of motion for total capital:∆K = s YKDivide through byKand useY=A K, get:Ifs A>, then income will grow forever, and investment is the “engine of growth.” Here, thepermanent growth rate depends ons. In Solow model, it does not.DOES CAPITAL HAVE DIMINISHING RETURNS OR NOT?Yes, if “capital” is narrowly defined (plant & equipment). Perhaps not, with a broad definition of“capital” (physical & human capital, knowledge). Some economists believe that knowledgeexhibits increasing returns. In the endogenous growth model, the assumption of constantreturns to capital is more plausible.
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- Spring '19
- Macroeconomics, Inflation, Copyright Virtual University of Pakistan, Copyright Virtual University
