Solow growth model Flashcards
Solow Growth Model meaning
The economic model that seeks to understand the long-term determinants of economic growth and the accumulation of capital in an economy.
Identical individuals - representative consumer:
Assumption: All individuals are identical and represent the population’s preferences eg saving and consumption patterns
Diminishing returns and diminishing marginal utility
Concept: As capital accumulates, each additional unit yields diminishing output.
Diminishing marginal utility: Satisfaction from consuming each additional unit decreases.
Freezing capital
Short-run assumption: Capital is fixed and cannot adjust immediately.
Realism of diminishing returns
Realistic assumption: Productivity decreases as capital accumulation increases. Similarly, in a country’s economy, when it accumulates more capital (such as factories, machines, or technology), the initial investments might lead to significant growth. But as the economy becomes more developed, finding new opportunities for high returns becomes harder, and the growth rate might slow down due to diminishing returns.
Imagine you start a small lemonade stand. At first, as you invest more money in ingredients, cups, and advertising, your sales and profits increase rapidly. However, as your stand gets bigger and you invest even more money, you might find that the extra money spent doesn’t boost your profits as much as before. This is because you’ve reached a point where adding more capital doesn’t bring the same significant returns as in the beginning.
Assumption of constant returns to scale
The model assumes constant returns to scale in production, which means that doubling both capital and labor inputs would double the output. This simplifying assumption allows for straightforward mathematical analysis but may not fully capture real-world production characteristics.
Short run vs. long run:
- In the short run, capital is assumed to be fixed, and the economy adjusts to changes in the labor force and productivity.
-In the long run, capital is no longer fixed, and the economy reaches a steady state where capital per worker and output per worker remain constant.
Factors affecting capital and labor
In the Solow model, the accumulation of capital is influenced by the savings rate (the proportion of income saved rather than consumed) and the depreciation rate (the rate at which capital wears out or becomes obsolete). On the other hand, the stock of labor is impacted by population growth and migration.
Savings rate in the steady state
For an economy to reach a steady state with constant capital per worker, the savings rate must equal the depreciation rate. If the savings rate is higher than the depreciation rate, the economy accumulates more capital over time, leading to economic growth. Conversely, if the savings rate is lower than the depreciation rate, the economy experiences capital erosion and declining output.
Stock of capital and labor
The stock of capital is either determined by saving or the rate of capital depreciation, while the stock of labor is influenced by factors like population growth and the movement of people through migration.
Conditional convergence and absolute convergence:
Conditional convergence refers to the tendency of countries with lower initial levels of capital to experience faster economic growth, “catching up” to countries with higher initial capital levels. Absolute convergence, on the other hand, refers to the general tendency of all countries to converge to the same steady-state level of capital per worker in the long run, irrespective of their initial conditions.
