Key Points of the Solow Model of Economic Growth
Bob Solow has carried out some of the most important work in macroeconomics by creating the Solow model of economic growth. His benchmark model is still taught in universities throughout the world. Here is a summary of its key lessons:
The more that people in an economy save of their income, the greater the amount of investment. This leads to economic growth and higher future living standards.
When the population growth rate falls, more capital is available for each person to use. This increases income per person.
When a firm uses a machine, it depreciates over time: that is, it’s not in as good a condition at the end of the year as it was at the beginning. The slower that capital (remember machines are capital) depreciates, the more capital exists per person and the higher living standards are in an economy.
All these effects, however, are temporary. As the economy reaches its new ‘steady state’, it stops growing again. Thus increasing savings, reducing the rate of population growth or reducing the rate at which capital depreciates in an economy only temporarily increases economic growth.
The only means to increase long-run living standards in the Solow model is through continual technological progress, so economies need to get better at turning inputs (such as land, labour and capital) into outputs (things that people want to buy).
The Solow model also predicts conditional convergence. Basically, when two countries have similar characteristics (for example, similar technology, savings rate) but one happens to be poorer than the other, that poorer country tends to grow faster than the richer country. In other words, it catches up. When two countries are fundamentally different (different technology, different institutions and so on), no reason exists to expect the poorer country to catch up. In other words, the Solow model doesn’t predict absolute convergence.