Unit 4 Macro: Economic Growth - the Solow Model

The economist Robert Solow (pictured) developed the neo-classical theory of economic growth. Solow won the Nobel Prize in Economics in 1987.

Growth comes from adding more capital and labour inputs and also from ideas and new technology.The Solow model believes that a sustained rise in capital investment increases the growth rate only temporarily: because the ratio of capital to labour goes up. However, the marginal product of additional units of capital may decline (there are diminishing returns) and thus an economy moves back to a long-term growth path, with real GDP growing at the same rate as the growth of the workforce plus a factor to reflect improving productivity.

“Since 2000, nearly 30 developing countries have grown by 6 percent or more a year. Developing countries are now the engine driving the global economy, accounting for around two-thirds of global growth There are many differences across countries but there are some common elements to countries that have grown continuously. They have stable governments that pursue prudent economic policies, provide essential infrastructure and services, and take a long-term perspective. They use the opportunities provided by global markets and they have a dynamic and competitive private sector” Source: Jim Kim, President of World Bank, July 2012

Capital investment as a % of GDP

A ‘steady-state growth path’ is reached when output, capital and labour are all growing at the same rate, so output per worker and capital per worker are constant.

Neo-classical economists believe that to raise the trend rate of growth requires an increase in the labour supply and also a higher level of productivity of labour and capital.Differences in the rate of technological change between countries are said to explain much of the variation in growth rates that we see.The neo-classical model treats productivity improvements as an ‘exogenous’ variable – they are assumed to be independent of the amount of capital investment.The Solow Model features the idea of catch-up growth when a poorer country is catching up with a richer country – often because a higher marginal rate of return on invested capital in faster-growing countries.The Solow model predicts some convergence of living standards (measured by per capita incomes) but the extent of catch up in living standards is questioned – not least the existence of the middle-income trap when growing economies find it hard to sustain growth and rising per capita incomes beyond a certain level.