Solow Growth Model Analysis - Coursework Example

The Solow growth model

Well-known economic scholars, Trevor Swan and Robert Solow developed the Solow growth model which is also referred to as neoclassical theory. It is a model of capital growth in an economy with pure production, meaning prices are excluded, and production equals real income. It assumes a closed economy where every individual’s labor input and ideas are constant in the economy (Hoeffler, 2002). The same also assumes a fixed constant investment from their savings derived from their income. The rate of depreciation in such an economy is accounted to be constant (Boianovsky & Hoover, 2009). Therefore, this model can be accurately described as a postponement of the Harrod-Domar model by adding labor force and capital productivity. These are some of the issues for discussion in this paper. The paper will also discuss the basic components as well as the assumptions given by the Solow growth model and explore the role played by the golden rule in its context. The paper will further discuss the potential weaknesses of the model by using relevant empirical evidence. There are several basic components of the Solow growth model. These include technology, population, labor force and the capital accumulation. The model assumes that these are the factors which drive the economic growth. However, this paper will only discuss these basic components in exclusion of the population and technology.

The Solow growth is based on a number of assumptions. The first assumption is that only one composite good is produced. The model assumes that in a constant economy, the results of a growing economy are from the production of a single commodity (Okada, 2006). The commodities are manufactured with factors such as technology being constant. Another assumption is that the economic growth occurs with a continuous duration of time. This means the model can only work in an uninterrupted period (Boianovsky & Hoover, 2009). In such an economy, depreciation is a key aspect that is always considered. The net output therefore factors in depreciation of capital. The returns to scale are also accounted to be constant which therefore means that the function of production is homogeneous of the first degree (Jensen, 2009). The labor factor in the economy is assumed to grow at a constant rate especially with increase of population growth. Provided with a fixed labor force, the effect on production of the previous unit of capital added is less than the one in the previous period.

In the Solow growth method, capital and labor which are the two factors of production in this model are paid based on their respective marginal physical productiveness. It is assumed that the capital and labor inputs equal the outputs in the given productions. Moreover, in any given economy, the Solow growth model assumes that wages and prices are flexible. There is not only full employment of capital available but also the employment labor is assumed to be full. Another important factor to note is that in this model, assets and labor substitute one other. In the given economy, the savings given out of the income are constant in every period. Finally, the technical progress is determined as being neutral (Boianovsky & Hoover, 2009). Therefore, based on the aforementioned assumptions it is important to note that the Solow model is convergent to the equilibrium path. This means that labor-capital ratio adjusts itself over time to the direction of the equilibrium ration. However, this is based on the model having a variable technical coefficient.

In economics, the golden rule may be used to determine how savings in an economy and the amount of investment both determine together a steady-state level of income and capital in the Solow growth model. This rule is used to determine the appropriate balances between these factors to effectively develop a certain economy (Vinod & Kaushik, 2007). For instance, for improved standards of living, the society has to impose decisions relating to optimal consumption and savings. High savings rate is not always the best thing. For instance, in the economical welfare, where there are high rates of savings of the overall income, it will fall when consumption is lacking. The golden rule can study how an economy can use the Solow model to establish the optimal level of investment in countries to maximize improved living conditions through consumption spending. The figure below further elaborates on this notion

Source: (Vinod & Kaushik, 2007).

The figure above highlights that steady state of depreciation and output as being functions of a steady state of capital stock. The difference between depreciation and output yields a steady state of consumption. From the above figure, it is certain there is only a single level of capita that results to the maximization of consumption

Source: (Gundlach 2005).

The figure above notes that as the capital-labor ration increases from zero the distance between investment and output gets bigger. The output increases faster than the consumption per worker and investment as the capital- labor heightens. This proceeds up to a point where the distance is achieved beyond which the consumptions begins to decline. This point of maximum consumption is what is known as the golden rule.

An important note is that higher levels of investments have an effect on both depreciation and the output (Hoeffler, 2002). Where the capital falls below the level of the golden rule, growth in capital increases output faster than depreciation. This makes the consumption to increase. When this occurs, the function becomes steeper than that of solid-state depreciation meaning that the difference between the two curves becomes vertical. Similarly, when the capital exceeds the golden rules, it reduces consumption. The line of depreciation and that of production function k display a similar slope implying high possible level of consumption.

At the golden rule level of capital, characterized as function f, the slope of both the depreciating line and that of the production function are equal meaning that the golden rule implies that k; the production function is similar or equal to the rate of depreciation. This is the main condition imposed the Golden rule for it to achieve its purpose (Boianovsky & Hoover, 2009).

For a steady supply of consumption in the initial period to be achieved, there is need for a reduction on consumption. Eventually however, consumption levels rise hence improving the living conditions of the society. This however depreciates if the economy begins at a point above the golden rule. In such situations, the golden rule is achieved each time when there is a higher consumption in the economy (Gundlach 2005). When the Golden rule is higher at the time when an economy begins, it becomes paramount to reduce consumption primarily for it to increase consumption later in the future.

In the society, today, the Solow model forecasts the gap between the developing and the developed countries will reduce. This can be referred to as the concept of catch-up growth. The developing countries are limited to capital to begin with, meaning every additional unit of investment has a higher return than that in the developed countries (Hoeffler, 2002). For instance, this explains China’s growth average of 9% over the last thirty years while the UK recorded only an average of 2%. In this concept, China is assumed poorer than the United Kingdom. The same was observed in countries such as Germany and Japan in that regardless of the fact that the two countries lost in the Second World War, their economy grew faster than that of the United States and the United Kingdom over the 1960’s.

The Solow model however has many weaknesses. The Solow model fails to take into consideration the problem of balance of Harrods’s Actual Growth Rate (G) and Warranted Growth Rate (Gw). However, it only factors in the power balance of Warranted Growth Rate (Gw) and Natural Growth Rate (GN). In the introduction of the investment function in the Solow model which is always absent results to problem of instability which is also characterized by the Harrodian model. the assumption between capital and labor therefore doesn’t seem to be main difference neo-Keynesian growth studies and neo-classical growth studies (Nonneman & Vanhoudt 1996). The main difference certainly seems to emanate from the function of investment and ultimate failure to provide a significant role to future entrepreneurial expectation.

Labor-augmenting technical progress is also key weakness of the Solow model. However, it is important to note that it is a special of Harro-neutral technical progress which doesn’t have any empirical justification (Hoeffler, 2002). As had earlier stated, this model assumes flexible price factor. This assumption certainly provides a big drawback in the achievement of steady path in the achievement of steady growth rate. For example, the interest rate may be curtailed from going below a predetermined minimum level that is a prerequisite in the achievement of the equilibrium growth path. The paper had earlier mentioned that the model is also based on a similar and flexible growth. The assumption of malleable and homogeneous capital as outlined by the Solow model is completely unrealistic. In fact, capital goods in the real sense are very heterogeneous which results to the problem of aggregation (Hoeffler, 2002). Therefore, this means it is very difficult to attain a path of steady growth as there are varieties of capital goods.