Tue | Oct 17, 2017

Analysing the Solow growth model

Published:Wednesday | October 8, 2014 | 12:00 AM
Dr Andre Haughton
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Why are some countries rich and others poor?

WE BEGIN here by explaining the Solow growth model, the most basic of macroeconomic models used to explain growth.

The Solow growth model highlights that in the long run, the rate of savings in an economy determines the size of the country's stock of capital and, therefore, its level of output.

According to the Solow growth model, the more a country saves and invests, the higher its level of capital stock, and therefore, the higher its level of income. Within this framework, a higher savings rate can result in a higher growth rate of output, but savings within itself is useless. In other words, a country that saves more is in a good position to grow, but this country has to invest its savings in the right avenues.

If a country saves and invests in a small fraction of the income, this country will earn over time and grow very little. The data support this claim as countries with higher proportions of income devoted to saving and investment, for example, Korea and Japan have a higher level of output growth. On the contrary, countries with a low level of savings, such as Nigeria, Rwanda and maybe Jamaica, have lower levels of income per person. The savings rate which results in investment varies from country to country due to differences in economic conditions, income levels, people's propensity to consume, tax policies and the development of financial policies.

How does a country accumulate capital?

Labour productivity is determined by the amount of capital available per person. In the initial stages when the capital stock is low, an increased capital stock yields more output. When capital stock is high, the economy encounters diminishing returns to capital since more machinery with nobody to operate them will lead to inefficiency. Individuals do not care about the amount of capital that a country accumulates. Jamaicans for example, mostly care about how much is available for us to consume or how we can improve our standard of living.

The aim of policymakers should be to help each individual maximise their consumption patterns and increase their standards of living. The policymakers should choose the optimal level of capital stock that allows its citizens to do so. This steady state level of capital that maximises the level of consumption is the golden rule level of capital stock. The Solow model highlights the fact that more savings equal more investment, hence more growth. This might mislead us to think that if a country saved 100 per cent of its income and consumed none, it might be better off. This is not the case as production without consumption makes no sense.

What about population growth?

The Solow growth model assumes that capital growth alone cannot cause the high growth in output materialised by some countries. Growth in capital must be accompanied with population growth and technological advancement.

The Solow model implies that capital depreciation and population growth reduces capital available per person. Investment per year must be enough to at least cover the rate of depreciation per annum to keep the country from being worse off than it was last year. Although population growth is important, countries with lower population growth rates have higher income per person. The data support this - Denmark and Norway have lower population growth but have high income growth while Zimbabwe and Gambia's high population growth is associated with lower levels of output.

What are the alternative theories on population growth?

Thomas Malthus (1766- 1834) in his book titled An Essay on the Principles of Population as it affects the future improvement of society, argued that as the population size increases, the more pressure people put on the country's resources, the less economic growth there is over time. In this case, his theory argues that a population size that is ever increasing will put more strain on society's resources and the country will forever remain in poverty.

An alternative theory on population growth was posited by Michel Kramer. While Malthus saw population growth as a threat to increasing standards of living, Kramer saw population growth as a positive. He believed that the more people in the world, the more professionals there will be, including lawyers, doctors, engineers etc. With more professionals, there are more problem solvers addressing the issues that we face and higher probability to solve these issues.

Dr André Haughton is a lecturer in the Department of Economics on the Mona campus of the University of the West Indies. Follow him on Twitter @DrAndreHaughton; or email editorial@gleanerjm.com.