Question

Q1. Explain the solow-swan model in detail with graph.

Answer 1

Model grew out of work by Robert Solow in 1956.  The Solow Growth Model is an exogenous model of economic growth that analyzes changes in the level of output over time in an economy as a result of changes in the population growth rate, the savings rate, and the rate of technological progress.

Main points about solow growth model:

1)This model believed that a sustain rise in capital investment increases the growth rate only temporarily because the ratio of capital to labor goes up.

2) The marginal product of additional units of capital may decline therefore an economy moves back to a long-term growth path, with real GDP growing at the same rate as the growth of the workforce and a factor to reflect improving productivity.

3) Differences in the pace of technological change between countries are said to explain much of the variation in growth rates that we see.

4) 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.

5) Economists believe that to raise the trend rate of growth requires an increase in the labour supply + a higher level of productivity of labour and capital

6) Catch up growth

• The Solow Model features the idea of catch-up growth that means 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 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.

7) Productivity growth- The neo-classical model treats productivity improvements as an 'exogenous' variable – they are assumed to be independent of the amount of capital investment.

8) Real interest rate and real wage- if the economy is a competitive market economy, the real interest rate is the marginal product of capital; and the real wage is the marginal product of labor.

Since the capital/labor is constant in the long-run steady state, the marginal products of capital and labor are constant. Hence the real interest rate and the real wage are constant.

9) A change in the saving rate - Although the saving rates does raise the rate of economic growth in the short run, it has no effect on the rate of growth in the long run.

A higher value s does raise the steady-state capital/labor ratio k.
Hence the steady-state output per capita rises. In the steady state, the real interest rate is now lower, and the real wage is higher.