Macroeconomics: Solow Model

What are four proximate causes of wealth?

1. Physical capital

   1. Machinery, tools, etc.

2. Human capital

   1. Skills and knowledge of population

3. Technology

   1. Innovation and new methods

4. Total factor productivity (TFP)

   1. Efficiency of material use

What are the five biggest institutions for economic growth?

1. Property rights

2. Honest government

3. Dependable legal system

4. Political stability

5. Open and competitive market

What is some evidence that better institutions lead to more prosperous economies?

According to Acemoglu, societies in the 18th and 19th century who had better institutions (colonizers that set up extractive institutions, the country didn’t prosper long term. Colonizers that set up settler institutions (ones that included the locals in the economy and had the goal of prosperity for all citizens) had better results) are more prosperous right now.

What is the equation for the top line of the Solow Curve?

Y = AK^x

What is the equation for capital growth, ɣ? What is capital growth?

ɣ = (amount saved / amount consumed), capital growth = ɣ (AK^x). Capital growth is output which is saved or invested rather than consumed.

What is capital depreciation? How do we calculate it?

Capital depreciation is the gradual decrease in value of assets over time due to damage and other things. 𝛿 = depreciation rate (on a scale to 1). Capital depreciation = 𝛿 (K).

What is the steady state capital stock in the Solow Model?

When investment = depreciation. No growth, no decline.

What happens when investment is greater than depreciation? And vice versa? What happens to the steady state?

1. Investment > depreciation = capital stock grows, steady state moves right.

2. Investment < depreciation = capital stock lessens, steady state moves left.

What does A represent in the Solow Model?

Technical advancements/new knowledge.

What is the equation to find K in the steady state?

K* = (ɣA / 𝛿)^(1/(1 - x)).

How do you calculate the steady state of the rest of the variables after using the main equation?

Plug the K* value in and then find everything else.

How to calculate current income per worker?

Current income per worker (y0) = Ak^x

What is K in the Solow Model?

Capital stock (machines, etc).

How to calculate current savings per worker?

Current savings per worker = ɣAK^x

How to calculate change in capital stock?

Change in capital stock = current savings per worker - 𝛿K.

How to calculate next year’s capital stock per worker?

This years capital stock per worker + change in capital stock.

How to calculate next year’s output per worker?

Plug in next year’s capital stock per worker and calculate.

Which countries have the highest potential for growth?

Countries with the lowest GDP per capita.

Which countries will become the most wealthy? Why?

Countries with the highest savings rate because a higher savings rate pushes the steady state farther out in the production function.

What does the idea of conditional convergence say?

Poorer countries, given they have similar production functions to rich countries, will grow a lot faster compared to richer countries because they are just copying and improving. This speedy “catching up” will stop once they also reach the cutting edge.

What is the main driver of growth outside of capital stock?

Ideas, A.

Ideas have a high research and development cost but a low replicating cost. How do we incentivize ideas? Why are ideas always underproduced?

We can incentivize the creation of ideas by having patents, copyrights, and trademarks. Ideas are always underproduced because their marginal social benefit is greater than their marginal private benefit, meaning they have positive spillovers.

What does Gordon say about growth?

He says that the Golden Age of growth is done and that now growth is continuing to slow down. He says that we already had our three big industrial revolutions, the third being 1970 - present but this one has had much less of an impact.

Where does supply of loanable funds come from? When is it high and when is it low?

Supply of loanable funds comes from savings. It is high when interest rates are high, low when interest rates are low.

Where does demand for loanable funds come from? When is it high and when is it low?

Demand for loanable funds comes from investment. It rises when interest rates fall and falls when interest rates rise.

What is the equilibrium real interest rate?

When savings = investment.

What are the four things that determine how much people save?

1. Desire to smooth consumption.

2. Amount of income.

3. Patience.

4. Interest rates.

What are financial intermediaries?

Banks, finance companies, insurance companies, mutual funds, etc.

What do financial intermediaries do? List the three things.

1. Overcome information asymmetry.

2. Diversify risk.

3. Provide liquidity (can take your money back any time).

What are bonds? Who issues them?

A promise to pay some fixed amount in the future. Issued by the Federal Government, large corporations, municipalities.

How to calculate the future value of bonds?

Future value = present value x (1 + interest rate)^years.

How to calculate the present value of bonds?

Present value = future value / (1 + interest rate)^years.