Economic Growth and Fluctuations
Lecture 2: The Basic Solow Model

Chapter 3

Introducing Advanced Macroeconomics:
Growth and business cycles
CAPITAL ACCUMULATION AND GROWTH: THE BASIC SOLOW MODEL
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Lecture 2

THE BASIC SOLOW MODEL
• • How can a nation become rich, i.e., initiate a growth process leading to higher GDP/consumption per capita in the long run? The basic Solow model provides some first answers: It predicts how the evolution and the long-run levels of GDP and consumption per capita depend on structural parameters such as the rate of investment and the growth rate of the labour force. Key elements of the Solow model:
– – – In each period, output is determined by the supplies of capital and labour through the production function. Exogenous savings/investment rate, s, exogenous growth rate of labour force, n, and exogenous depreciation rate, δ. Explicit description of capital accumulation:
K t +1 = Kt + I t − δKt

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Lecture 2

Accumulation of capital is the main driving force for wealth. “Basic” model: No technological progress
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THE ”MICRO WORLD” OF THE SOLOW MODEL

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Object: Closed economy Time: A sequence of periods/years, t = 0,1,2,... Agents: Households and firms (and government) Commodities and markets: Output, capital services and labour services (one asset = physical capital) • The market for output: Supply = firms’ output, Yt. Demand from households for consumption and investment = Ct + It . Relative price = 1.
– One-sector model: Output can be used either for consumption or for investment.

Lecture 2

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• The market for capital services: Consumers own the capital stock, Kt , and rent its services to firms. Supply of capital services = Kts. Firms’ demand = Ktd – Relative price (in units of output) for renting one unit of capital for one period: rt = real rental rate for capital – Real interest rate: ρt = rt − δ, where δ is the rate of depreciation, or: rt = ρt + δ . (Alternative interpretation: