Solow Economic Model - Essay Example

Solow Economic Model Solow growth model implies the summation of all the contributions made by the economist towards economic growth within the framework of neoclassical economics. Nobel laureate Robert Solow forwarded Solow Economic Model. Harrod Domar Model was preamble to Solow Model, the model introduced a new terminology of productivity growth. Modifications in Solow Economic model included, 1. “Productivity is the function of labor. 2. Introduction of time varying technology distinct from capital and labor. 3. Providing diminishing and constant returns to labor and capital separately.” (Solow Economic Model Review) The varying capital output and capital labor ratios allow increased capital intensity, well distinguished from technological innovation. The Solow model neglects the temporary slides of the business cycle and predicts the potential income on long-term basis. The graph on right side, is the representation of Solow’s Economic model, where the characteristic parameter of production factor is curve, output is function of labor and capital stock. The initial model keeps the labor force at restricted level. Solow model is based on many other limitations, therefore it cannot be termed as generalized model. The implications of Solow model can be categorized on the basis of short and long-term basis. SHORT TERM DEBACLES 1. The long run growth rate is independent of the impact of investment and taxation subsidies; Solow’s model ignores such consequences. 2. Growth is affected on short-term level as the economy converges towards optimized steady state output level. 3. Rate of Capital Accumulation is criterion towards determining the growth rate of economy. 4. Rate of Capital Accumulation is the function of rate of capital depreciation and saving rates. LONG TERM DEBACLES 1. Surprisingly the rate of long-term return is determined beyond the parameters of the model. It is assumed the economy converges towards steady state growth rate, which is dependent upon the rate of technological progress and growth rate of labor force. 2. Technological innovation contributes significantly rather than capital accumulation. SOLOW’S MODEL PRACTICAL EVIDENCE The key prediction of Solow Model is that ultimately the economy of the poor countries will saturate with the economy of the rich countries. The results of such models have been practically validated on average basis. Considering the economy of former poor country Japan, the Japanese economy has converged with the economy of rich nations, the convergent growth rates are still expected, even after the reaching point of convergence; leading to over flow of positive investment. Another example is of convergence within countries. In case of United States, the income levels of the Southern states of United States have tended to converge to the economic level of Northern states. These examples have validated the concept of convergence, however the occurrence of convergence depends upon the particular country and environment. The factors involved are, 1. Arrangement and functioning of institutions; authoritative function. 2. Opportunity of trade in free market; the trade policy negotiated with other countries. 3. Educational policy The reliance of economic model on technological progress is another subject of criticism, had the productivity level being dependent upon the development in technological front, a significant rise in productivity would have been observed, but certainly there has been no economic revolution due technological boom. The example of East Asian countries supports the claim, though the economies have rose significantly but none of their rapid growth had been due to rising per capita productivity. ACHIEVEMENTS OF SOLOW’S ECONOMIC MODEL The Solow growth model predicts the following: 1. “A country with high investment (or saving) rate enjoys high GDP per capita in the long run. 2. Two countries with the same initial capital stock, the country with higher investment (or saving) rate grows faster. 3. Two countries with the same saving rate, the country with lower initial capital stock grows faster. 4. A more sophisticated quantitative analysis (regression analysis) also supports the Solow growth model.” (Solow Economic Growth Model: Part Two) EVALUATION OF SOLOW’S MODEL The empirical evidence doesn’t strong support the Solow’s economic model. Limitations of the models are, 1. The failure of the Solow’s model take account firstly of entrepreneurship, catalyst behind the economic progress, and secondly of strength of institutions which facilitate economic surge. 2. It fails to explain how and why technological progress occurs, the model excludes the discussion of introducing and sustaining the technological progress. 3. The Solow’s Model was rejected on the grounds economic growth rate is determined outside of the model, generally by an assumed rate of technological progress and an assumed rate of labor force growth. Therefore the conclusion of Solow’s model is highly unrealistic. 4. The neoclassical model was proposed another impractical approach i.e. changes in the savings rate will not affect economic growth, but will increase income levels. ALTERNATE THEORIES The failing of Solow’s Economic model has led to the development of Endogenous Growth Theory, which endorses the technological progress along with knowledge accumulation. Economist also view as Theory of Business Cycles as alternate to Solow’s Economic model, critics’ view that the theory explains the economic growth in long run. ENDOGENOUS GROWTH THEORY The New Growth Theory: Endogenous Growth Theory was developed in 1980’s to avoid the shortcomings of Neo-classical growth model. The theory endogenizing the rate of technological progress. The theory laid significant importance to the production of the new technologies and human capital. The increase in productivity isn’t the function of technological advent solely, rather it is more incentive based where an individual or firm offers incentive to invent in order to exploit an advantage over the competitors, thereby improving their own productivity. The theory implies that policy measures have an impact on the long run growth rate of an economy, even if those measures hardly change the aggregate savings rate. The theory is based on the assumptions of constant marginal product of capital. This implies that larger firms will be efficient. It goes so far as to imply that only one firm (an ultra efficient monopoly) should exist. This assumption permits increased returns to scale in aggregate production, and is frequently focused on the role of externalities in determination of the rate of return on capital investments. The theory proposes that higher savings levels will lead to higher economic growth. Graphically, the theory relates that saving curve is straight line, and it’s always greater than the required investment curve. Since the gap determines the rate of growth in capital labor ratio, the theory predicts that high income will lead to high savings and high savings will lead to high growth rates. Subsidies on research and development or education increase the growth rate in some Endogenous Growth Theory models by increasing the incentive to innovate. However the theory still fails to explain the phenomenon of convergence, and that is why some countries are still much richer than others. THEORY OF BUSINESS CYCLE “The Theory of the Business Cycle formulates a relationship between sustainable savings induced boom and credit induced boom” (Wikipedia). The market processes are set into motion by the savings of households, and credit expansion initiated by central bank. The consequences of these initiatives are such that initial allocation on the economy’s capital structure is similar, however ultimate affects vary significantly. The cyclic business activities are estimated on the basis of the gross domestic product. It’s the responsibility of the government to smooth for ensuring the smooth functioning of business cycle, reducing the unexpected fluctuations. REFERENCES 1. Solow. R. M., Technical Change and the Aggregate Production Function. Review of Economics and Statistics, 39. 2. Rosario N. Mantegna, H. Eugene Stanley, An Introduction to Econophysics: Correlations and Complexity in Finance, Cambridge University Press 3. Charts referred from the given link, http://en.wikipedia.org/wiki 4. Roger W. Garrison, The Austrian Theory of Business Cycle. Read More