Endogenous Growth Theory Lectures Notes 2
Endogenous Growth Theory Lectures Notes 2
Endogenous Growth Theory Lectures Notes 2
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 2/52
The Economic Environment of the Basic
Solow Model
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 3/52
Households and Production I
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 4/52
Households and Production II
Assume households save a constant exogenous fraction s of their
disposable income
Same assumption used in basic Keynesian models and in the
Harrod-Domar model; at odds with reality.
Assume all firms have access to the same production function:
economy admits a representative firm, with a representative (or
aggregate) production function.
Aggregate production function for the unique final good is
Y (t ) = F [K (t ) , L (t ) , A (t )] (1)
Assume capital is the same as the final good of the economy, but
used in the production process of more goods.
A (t ) is a shifter of the production function (1). Broad notion of
technology.
Major assumption: technology is free; it is publicly available as a
non-excludable, non-rival good.
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 5/52
Key Assumption
∂F (·) ∂F (·)
FK (K , L, A) ≡ > 0, FL (K , L, A) ≡ > 0,
∂K ∂L
∂2 F (·) ∂2 F (·)
FKK (K , L, A) ≡ < 0 FLL ( K L A ) ≡ < 0.
∂K 2 ∂ L2
, , ,
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 6/52
Review
Definition Let K be an integer. The function g : R K +2 → R is
homogeneous of degree m in x ∈ R and y ∈ R iff
mg (x , y , z ) = gx ( x , y , z ) x + gy ( x , y , z ) y
for all x ∈ R , y ∈ R and z ∈ R K .
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 7/52
Market Structure, Endowments and Market
Clearing I
We will assume that markets are competitive, so ours will be a
prototypical competitive general equilibrium model.
Households own all of the labor, which they supply inelastically.
Endowment of labor in the economy, L̄ (t ), and all of this will be
supplied regardless of the price.
The labor market clearing condition can then be expressed as:
L (t ) = L̄ (t ) (2)
for all t, where L (t ) denotes the demand for labor (and also the level
of employment).
More generally, should be written in complementary slackness form.
In particular, let the wage rate at time t be w (t ), then the labor
market clearing condition takes the form
L (t ) ≤ L̄ (t ) , w (t ) ≥ 0 and (L (t ) − L̄ (t )) w (t ) = 0
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 8/52
Market Structure, Endowments and Market
Clearing II
But Assumption 1 and competitive labor markets make sure that
wages have to be strictly positive.
Households also own the capital stock of the economy and rent it to
firms.
Denote the rental price of capital at time t by R (t ).
Capital market clearing condition:
K s (t ) = K d (t )
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 9/52
Market Structure, Endowments and Market
Clearing III
Implies that we need to keep track of an interest rate across periods,
r (t ), and this will enable us to normalize the price of the final good to
1 in every period.
General equilibrium economies, where different commodities
correspond to the same good at different dates.
The same good at different dates (or in different states or localities) is
a different commodity.
Therefore, there will be an infinite number of commodities.
Assume capital depreciates, with “exponential form,” at the rate δ: out
of 1 unit of capital this period, only 1 − δ is left for next period.
Loss of part of the capital stock affects the interest rate (rate of return
to savings) faced by the household.
Interest rate faced by the household will be r (t ) = R (t ) − δ.
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 10/52
Firm Optimization I
Only need to consider the problem of a representative firm:
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 11/52
Firm Optimization II
and
R (t ) = FK [K (t ), L(t ), A(t )]. (5)
Note also that in (4) and (5), we used K (t ) and L (t ), the amount of
capital and labor used by firms.
In fact, solving for K (t ) and L (t ), we can derive the capital and labor
demands of firms in this economy at rental prices R (t ) and w (t ).
Thus we could have used K d (t ) instead of K (t ), but this additional
notation is not necessary.
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 12/52
Firm Optimization III
Y (t ) = w (t ) L (t ) + R (t ) K (t ) .
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 13/52
Second Key Assumption
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 14/52
Production Functions
F(K, L, A) F(K, L, A)
K K
0 0
Panel A Panel B
Figure 1.1: Production functions and the marginal product of capital. The
example in Panel A satisfies the Inada conditions in Assumption 2, while the
example in Panel B does not.
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 15/52
Fundamental Law of Motion of the Solow
Model I
Recall that K depreciates exponentially at the rate δ, so
K (t + 1) = (1 − δ ) K (t ) + I (t ) , (6)
Y (t ) = C (t ) + I (t ) , (7)
Using (1), (6) and ( 7), any feasible dynamic allocation in this
economy must satisfy
K (t + 1) ≤ F [K (t ) , L (t ) , A (t )] + (1 − δ) K (t ) − C (t )
for t = 0, 1, ....
Behavioral rule of the constant saving rate simplifies the structure of
equilibrium considerably.
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 16/52
Fundamental Law of Motion of the Solow
Model II
Note not derived from the maximization of utility function: welfare
comparisons have to be taken with a grain of salt.
Since the economy is closed (and there is no government spending),
S (t ) = I (t ) = Y (t ) − C (t ) .
S (t ) = sY (t ) , (8)
C (t ) = (1 − s ) Y (t ) (9)
Implies that the supply of capital resulting from households’ behavior
can be expressed as
K s (t ) = (1 − δ)K (t ) + S (t ) = (1 − δ)K (t ) + sY (t ) .
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 17/52
Fundamental Law of Motion of the Solow
Model III
K (t + 1) = sF [K (t ) , L (t ) , A (t )] + (1 − δ) K (t ) . (10)
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 18/52
Definition of Equilibrium I
Solow model is a mixture of an old-style Keynesian model and a
modern dynamic macroeconomic model.
Households do not optimize, but firms still maximize and factor
markets clear.
Definition In the basic Solow model for a given sequence of
{L (t ) , A (t )}t∞=0 and an initial capital stock K (0), an
equilibrium path is a sequence of capital stocks, output
levels, consumption levels, wages and rental rates
{K (t ) , Y (t ) , C (t ) , w (t ) , R (t )}t∞=0 such that K (t )
satisfies (10), Y (t ) is given by (1), C (t ) is given by (24),
and w (t ) and R (t ) are given by (4) and (5).
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 19/52
Equilibrium Without Population Growth and
Technological Progress I
Make some further assumptions, which will be relaxed later:
1 There is no population growth; total population is constant at some
level L > 0. Since individuals supply labor inelastically, L (t ) = L.
2 No technological progress, so that A (t ) = A.
Define the capital-labor ratio of the economy as
K (t )
k (t ) ≡ , (11)
L
Using the constant returns to scale assumption, we can express
output (income) per capita, y (t ) ≡ Y (t ) /L, as
K (t )
y (t ) = F , 1, A
L
≡ f (k (t )) . (12)
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 20/52
Equilibrium Without Population Growth and
Technological Progress II
R (t ) = f ′ (k (t )) > 0 and
w (t ) = f (k (t )) − k (t ) f ′ (k (t )) > 0. (13)
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 21/52
Example: The Cobb-Douglas Production
Function I
Very special production function and many interesting phenomena
are ruled out, but widely used:
Y (t ) = F [K (t ) , L (t ) , A (t )]
= AK (t )α L (t )1−α , 0 < α < 1. (14)
= αAk (t )−(1−α) .
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 22/52
Example: The Cobb-Douglas Production
Function II
w (t ) = Ak (t )α − αAk (t )−(1−α) × k (t )
= (1 − α) AK (t )α L (t )−α ,
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 23/52
Equilibrium Without Population Growth and
Technological Progress I
The per capita representation of the aggregate production function
enables us to divide both sides of (10) by L to obtain:
k (t + 1) = sf (k (t )) + (1 − δ) k (t ) . (15)
The economy will tend to this steady-state equilibrium over time (but
never reach it in finite time).
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 24/52
k(t+1)
45°
sf(k(t))+(1–)k(t)
k*
k(t)
0 k*
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 25/52
Equilibrium Without Population Growth and
Technological Progress II
The thick curve represents (15) and the dashed line corresponds to
the 45◦ line.
Their (positive) intersection gives the steady-state value of the
capital-labor ratio k ∗ ,
f (k ∗ ) δ
∗
= . (16)
k s
There is another intersection at k = 0, because the figure assumes
that f (0) = 0.
Will ignore this intersection throughout:
1 If capital is not essential, f (0) will be positive and k = 0 will cease to
be a steady-state equilibrium
2 This intersection, even when it exists, is an unstable point
3 It has no economic interest for us.
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 26/52
Equilibrium Without Population Growth and
Technological Progress III
k(t+1)
45°
sf(k(t))+(1−δ)k(t)
k*
ε
k(t)
0 k*
Figure 2.2: Unique steady state in the basic Solow model when f (0) = ε > 0.
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 27/52
Equilibrium Without Population Growth and
Technological Progress IV
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 28/52
output
k(t)
f(k(t))
f(k*)
consumption
sf(k(t))
sf(k*)
investment
k(t)
0 k*
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 29/52
Equilibrium Without Population Growth and
Technological Progress V
Proposition Consider the basic Solow growth model and suppose that
Assumptions 1 and 2 hold. Then there exists a unique
steady-state equilibrium where the capital-labor ratio
k ∗ ∈ (0, ∞) is given by (16), per capita output is given by
y ∗ = f (k ∗ ) (17)
c ∗ = (1 − s ) f (k ∗ ) . (18)
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 30/52
Proof of Theorem
The preceding argument establishes that any k ∗ that satisfies (16) is
a steady state.
To establish existence, note that from Assumption 2 (and from
L’Hôpital’s rule), limk →0 f (k ) /k = ∞ and limk →∞ f (k ) /k = 0.
Moreover, f (k ) /k is continuous from Assumption 1, so by the
intermediate value theorem there exists k ∗ such that (16) is satisfied.
To see uniqueness, differentiate f (k ) /k with respect to k, which
gives
∂ [ f ( k ) /k ] f ′ (k ) k − f (k ) w
= 2
= − 2 < 0, (19)
∂k k k
where the last equality uses (13).
Since f (k ) /k is everywhere (strictly) decreasing, there can only
exist a unique value k ∗ that satisfies (16).
Equations (17) and (18) then follow by definition.
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 31/52
Examples
sf(k(t))+(1–)k(t) 45°
k(t+1) 45° k(t+1) k(t+1)
45° sf(k(t))+(1–)k(t)
sf(k(t))+(1–)k(t)
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 32/52
Equilibrium Without Population Growth and
Technological Progress VI
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 33/52
Equilibrium Without Population Growth and
Technological Progress VII
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 34/52
Equilibrium Without Population Growth and
Technological Progress VIII
f̃ (k ∗ ) δ
= ,
k∗ as
which holds for an open set of values of k ∗ . Now apply the implicit
function theorem to obtain the results.
For example,
∂k ∗ δ (k ∗ )2
= 2 ∗ >0
∂s s w
∗ ∗ ∗ ′ ∗
where w = f (k ) − k f (k ) > 0.
The other results follow similarly.
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 35/52
Equilibrium Without Population Growth and
Technological Progress IX
Same comparative statics with respect to a and δ immediately apply
to c ∗ as well.
But c ∗ will not be monotone in the saving rate (think, for example, of
s = 1).
In fact, there will exist a specific level of the saving rate, sgold , referred
to as the “golden rule” saving rate, which maximizes c ∗ .
But cannot say whether the golden rule saving rate is “better” than
some other saving rate.
Write the steady-state relationship between c ∗ and s and suppress
the other parameters:
c ∗ (s ) = (1 − s ) f (k ∗ (s )) ,
= f (k ∗ (s )) − δk ∗ (s ) ,
The second equality exploits that in steady state sf (k ) = δk.
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 36/52
Equilibrium Without Population Growth and
Technological Progress X
∂c ∗ ( s ) ∂k ∗
= f ′ (k ∗ (s )) − δ
. (20)
∂s ∂s
sgold is such that ∂c ∗ (sgold ) /∂s = 0. The corresponding
∗ .
steady-state golden rule capital stock is defined as kgold
Proposition In the basic Solow growth model, the highest level of
steady-state consumption is reached for sgold , with the
∗
corresponding steady-state capital level kgold such that
f ′ kgold
∗
= δ. (21)
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 37/52
Golden Rule
consumption
(1–s)f(k*gold)
savings rate
0 s*gold 1
Figure 2.5: The “golden rule” level of savings rate, which maximizes steady-state
consumption.
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 38/52
Proof of Proposition: Golden Rule
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 39/52
Equilibrium Without Population Growth and
Technological Progress XI
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 40/52
Review of the Discrete-Time Solow Model
Per capita capital stock evolves according to
k (t + 1) = sf (k (t )) + (1 − δ) k (t ) . (22)
f (k ∗ ) δ
∗
= . (23)
k s
Consumption is given by
C (t ) = (1 − s ) Y (t ) (24)
R (t ) = f ′ (k (t )) > 0 and
w (t ) = f (k (t )) − k (t ) f ′ (k (t )) > 0. (25)
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 41/52
Steady-State Equilibrium
k(t+1)
45°
sf(k(t))+(1–)k(t)
k*
k(t)
0 k*
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 42/52
Transitional Dynamics
Equilibrium path: not simply steady state, but entire path of capital
stock, output, consumption and factor prices.
In engineering and physical sciences, equilibrium is point of rest of
dynamical system, thus the steady-state equilibrium.
In economics, non-steady-state behavior also governed by optimizing
behavior of households and firms and market clearing.
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 43/52
Transitional Dynamics: Review I
Consider the nonlinear system of autonomous difference equations,
x (t + 1) = G (x (t )) , (26)
x (t ) ∈ R n and G : R n → R n .
Let x∗ be a fixed point of the mapping G (·), i.e.,
x∗ = G (x∗ ) .
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 44/52
Transitional Dynamics: Review II
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 45/52
Transitional Dynamics in the Discrete Time
Solow Model
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 46/52
Proof of Proposition: Transitional Dynamics I
k ∗ = g (k ∗ ) . (28)
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 47/52
Proof of Proposition: Transitional Dynamics
II
g ′ ( k ∗ ) ∈ ( 0, 1 ) .
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 48/52
Proof of Proposition: Transitional Dynamics
III
k (t + 1) − k ∗ = g (k (t )) − g (k ∗ )
Z k∗
= − g ′ (k ) dk ,
k (t )
< 0
First line follows by subtracting (28) from (27), second line uses the
fundamental theorem of calculus, and third line follows from the
observation that g ′ (k ) > 0 for all k.
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 49/52
Proof of Proposition: Transitional Dynamics
IV
Next, (22) also implies
k (t + 1) − k (t ) f (k (t ))
= s −δ
k (t ) k (t )
f (k ∗ )
> s −δ
k∗
= 0,
Second line uses the fact that f (k ) /k is decreasing in k (from (29)
above) and last line uses the definition of k ∗ .
These two arguments together establish that for all k (t ) ∈ (0, k ∗ ),
k (t + 1) ∈ (k (t ) , k ∗ ).
An identical argument implies that for all k (t ) > k ∗ ,
k (t + 1) ∈ (k ∗ , k (t )).
Therefore, {k (t )}t =0 monotonically converges to k ∗ and is globally
∞
stable.
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 50/52
Transitional Dynamics in the Discrete Time
Solow Model III
Thus far the Solow growth model has a number of nice properties,
but no growth, except when the economy starts with k (0) < k ∗ .
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 51/52
Transitional Dynamics in Figure
k(t+1)
45°
k*
k(t)
0 k(0) k* k’(0)
Solow The Solow Model in Discrete Time Transitional Dynamics in the Discrete Time Solow Model
Ingrid Ott — Tim Deeken – Endogenous Growth Theory October 21st, 2010 52/52