Solow's Neo-Classical Model

Solow's Neo-Classical Model

The neo-classical growth model assumes that the economy converges towards a steady-state rate of growth. Given a neo-classical production function:

Y=A×F(K, N)

Assuming a constant rate of labor force growth (DN/N=n) and no technical progress (DA/A=0) then in a steady state rate of growth of output (DY/Y) equals rate of population growth which implies there is no growth in per capita income unless technical progress takes place.

A critical difference between the Harrod-Domar model and the neoclassical growth model lies in the effect the savings rate has on growth rates. In the Harrod-Domar model an increase in the savings rate increases the growth rate. However, in the neo classical model, an increase in the savings rate increases the per capita income but it does not result in a permanent (as compared to a temporary) increase in the growth rate.

To summarize, in the neo-classical model the rate of output growth equals the rate of growth of technical progress (DA/A) and the level per capita output is determined by the steady-state equation:

sy=(d+n)k

where s: savings rate

y: per capita output

d: depreciation rate of capital stock

n: population growth rate

k: per capita capital stock

While Solow’s neo-classical model explains the first five out of the six stylized facts quite well, it cannot explain the fact that growth rates differ between countries for long periods of time. This model would suggest convergence in growth rates, something that does not seem to take place (see table).

To explain this problem, theorists have focused their attention on technical progress and have made attempts to make the growth rate endogenous (i.e. determined within the theory). Various endogenous growth theory models, proposed by economists like Robert Lucas and Paul Romer, have constructed a dynamic model where the rate of growth of output depends on aggregate stock of capital (both physical and human) and on the level of research and development in an economy.