Solow Growth Model Analysis - Essay Example

?SOLOW GROWTH MODEL Introduction Economic growth is defined as increased capa of a country’s economy to produce goods and services in comparison to a previous period and is measured by the gross domestic product (Song, 2009, p. 7). Economic growth leads to better living standards for the population and higher rates of employment. There are different theories that are used to explain economic growth which include classical growth theory, neoclassical growth models, endogenous growth theory and the Salter Model. Solow Growth Model is a standard neoclassical model of economic growth developed by Robert Solow. This model holds that economic growth is linked to capital accumulation and the population growth (Zhuang and St Juliana, 2010, p. 65). Solow growth model postulates that under equilibrium, the level of per capita income is determined by prevailing technology, rates of saving, rate of population growth and technical progress all which are assumed exogenous (Barossi-Filho, 2005, p. 37). Given that the rates of population growth and levels of saving are varying across countries, the model gives testable predictions on assessing how the two can influence economic growth of countries. Solow model has been criticized by different theorists given the assumptions made by this theory. This paper will explain the impacts of both population growth and increase in the saving rates upon economic growth. Moreover, the paper will explain how Solow model accounts for technological progress and assess whether Romer model improves on this. Impact of both population growth and an increase in the savings rate upon economic growth Increased production of goods and services leads to economic growth. In the light of this statement, any country that desires to achieve economic growth must have optimal factors of production (Song, 2009, p. 7). The factors of production include capital, labor, technology, land and entrepreneur. When these factors are optimized economic growth of the country will be positive. Solow growth model predicts that economic growth results from accumulation of capital and population growth rate (Zhuang and St Juliana, 2010, p. 65). Moreover, the model starts by making an assumption of capital accumulation is subject to diminishing returns (Stein, 2007, p. 193). Solow model argues that developing countries with low capital stock can achieve higher economic growth compared to developed countries by increasing their savings and investment rates. Solow model postulates that increased rates of savings leads to capital accumulation. The theory behind increased savings resulting in capital accumulation is that higher savings leads increased amount of funds that can be offered as credit for capital investment. Consequently, this borrowed capital will be invested in the production industry and therefore the gross domestic products will be higher (Song, 2009, p. 9). Investment is required for the development of infrastructure required for production. However, Liu and Guo (2002, p. 25) argues that economic growth of a country depends on its ability to deploy the savings to finance capital investment. In the Solow model, the second factor identified to influence economic growth of a country is its population growth. Population provides an important factor of production; labor and consequently as population grows it adds to the available labor it contributes to economic growth of any country. However, given the rule of diminishing returns on factors of production it is necessary to strike equilibrium between the labor and other factors of production (Song, 2009, p. 10). The combined effect of impact of increased rates of saving and population growth can be understood using the Solow model. This model offers testable predictions since these two factors are different across nations. Song (2009, p. 9) argues that countries having high saving levels usually have higher per capita incomes while those experiencing high population growth have lower per capita incomes. When population growth increases at a proportionally to that of savings, the economic growth will be experienced in a country since capital accumulation will be augmented by growth in human capital. Consequently, the level of production will increase and the gross domestic product of a country will increase. On the other hand, given the assumption of diminishing rates of return on physical capital in Solow model, if the rate of population growth is higher than the rate of savings, the economic growth will be negative. Most of the population will not be as productive as they ought to be in the production while average per capita income of the population will be lower (Stein, 2007, p. 193). Moreover, if a country experiences higher rates of saving leading to higher capital accumulation than the population growth rate, the available investment will not have adequate source of labour thereby leading to a regressed economic growth (Stein, 2007, p. 193). Solow Growth Model and Technological Growth Solow growth model developed a residual as the indicator of the percentage of economic growth that can be attributed to technological change (Hartley, 2000, p. 28). Solow postulates that technological progress happens when efficiency (A) increases over time. A unit of labour becomes more productive as efficiency increases which is learnt. As technological growth advances in the Solow model, there are more efficient units of labour in the economy which results to economic growth where by taking the constant returns to scale; this can be represented by an equation as shown below: Y=F (K, AL) yt= f (Kt) where: Y represents per capita income, K represents capital, and A represents efficiency and Kt represents the growth in effective capital. In the equation yt represents growth in income. Hartley (2000, p. 28) explains that in the Solow growth model postulates that without technological progress; capital accumulated would get to a point of diminishing returns while technological improvements frequently offsets the diminishing returns to capital. Technological improvement occurs due to increased efficiency of labor (Hartley, 2000, p. 29). In Solow’s growth model, as employees continues to stay at a job place, they learn different aspects of the production process thereby resulting in more effective labour. This means that growth in technology is exogenous such that it results from outside factors. Although this observation is correct, it is not adequate in explaining technological progress in the production process. Consequently, Romer came up with another explanation of technological advancement which supports Solow model. According to Romer, growth in efficiency is usually endogenized (Sergo and Tomcic, 2006, p. 421). Romer argues that technological progress results from innovation where he described that in the technological sector is continuously involved in carrying out research and development (Welsch and Eisenack, 2002, p. 490). They explain that technological progress results in increased number of the capital goods. Romer further argues that each variety of capital goods can be traced back to a separate industry thereby each industry acts as a producer and inventor of a particular capital resource (Welsch and Eisenack, 2002, p. 490). In his model, Romer described that efficiency in an industry results from the stock of knowledge and the number ideas that have been aggregated over time. Consequently, following continued research and development, better ways are discovered on the way a specific production can be improved to maximize returns given capital and labour invested. For instance, a sugar company may realize that the sugar they extract from sugar cane is low due to the machine employed. To reverse this negative trend, the sugar company would finance research and development to unravel ways that can be used to ensure that their machines run at higher efficiencies. Following this research, the company may invent new strategies that enhance their performance. Conclusion Solow growth model is an important tool to understand economic growth of a country. The model can be used in developing countries to understand the impacts of increased savings and population to the economic growth of the country. The model makes an assumption that capital accumulation follows the rule of diminishing returns and therefore the factors of production should always grow proportionately. High rates of savings lead to higher amounts of resources that can be offered as loans to finance capital investment thereby leading to higher capital accumulation. High capital accumulation would mean that there is increased gross domestic product. In addition increased population, leads to increased labor which is a factor of production. Adequate availability of labor implies that if other factors of production are optimal, there will be a high capita output which is an indication of economic growth. However, given the assumption in Solow model, an increase in the rate of saving which is not supported by population increase would not have a major impact to the economy since some capital would be underutilized and the productivity of the population would be outstretched. On the other hand, if population grows at a high rate than rates of capital accumulation which results from savings, then this would have regressive impact on economic growth of a country. In Solow model, technological advancement is also a critical aspect in economic growth. According to Solow, technological advancement implies increased efficiency in the production process. Efficiency of labor comes through learning as workers are continually involved in the learning process. Romer came up with a model that supports the Solow model. He argued that this technological process results from innovation which is supported by research and development in a particular industry. References Barossi-Filho, M., 2005. The Empirics of the Solow Growth Model: Long-Term Evidence. Journal of Applied Economics, Vol. 8, no. 1, pp. 31-51. Hartley, J.E., 2000. Does the Solow residual actually measure changes in technology? Review of Political Economy, Vol. 12, no. 1, pp. 27-44. Liu, J.Q. and Guo, Z.F., 2002. Positive analysis of causal relationship between saving rate and economic growth in China's economy. Zhong Guo Ruan Ke Xue, Vol. 2, pp. 25-8. Sergo, Z. &Tomcic, Z., 2006. Innovation, Adoption and Dynamics of Total Factor Productivity Growth in the Croatian Tourism and Catering Sector 1960-2000. University of Zagreb, Faculty of Economics and Business, Zagreb, Croatia, Zagreb, pp. 421. Song, Y., 2009. The domestic savings and economic growth relationship in China. Journal of Chinese Economic and Foreign Trade Studies, Vol. 2, no. 1, pp. 5-17. Stein, S., 2007. A Beginners Guide to the Solow Model. Journal of Economic Education, vol. 38, no. 2, pp. 191-193. Welsch, H. & Eisenack, K., 2002. Energy Costs, Endogenous Innovation, and Long-run Growth. Jahrbucher fur Nationalokonomie und Statistik, vol. 222, no. 4, pp. 490-490. Zhuang, H. & St Juliana, R., 2010. Determinants of Economic Growth: Evidence from American Countries. The International Business & Economics Research Journal, vol. 9, no. 5, pp. 65-69. Read More