modeling economic growth using differential equationsmodeling economic growth using di erential...

Modeling Economic Growth Using Differential Equations

Chad Tanioka

Occidental College

February 25, 2016

Chad Tanioka (Occidental College) Modeling Economic Growth using DE February 25, 2016 1 / 28

Overview

1 Introduction

2 Setting up the model

3 Solow’s fundamental differential equation

4 Solving for equilibrium solutions

Chad Tanioka (Occidental College) Modeling Economic Growth using DE February 25, 2016 2 / 28

Introduction

The Solow-Swan growth model was developed in 1957 by economistRobert Solow (received Nobel Prize of Economics).

Solow’s growth model is a first-order, autonomous, non-lineardifferential equation.

The model includes a production function and two factors ofproduction: capital and labor growth.

Chad Tanioka (Occidental College) Modeling Economic Growth using DE February 25, 2016 3 / 28

Setting up the model

The Production FunctionLet Y(t) or Q be the annual quantity of goods produced by K units ofcapital and L units of labor at time t. The production function isexpressed in the general form

Q = Y (t) = F (K (t), L(t)) (1)

Note: Even though K and L are functions of time, we will use K instead of K(t)

and L instead of L(t).

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Assumptions

Assumption 1: The first important assumption of this model is that theproduction function, Q, is twice differentiable in capital, K and labor, L,known as the Inada conditions.

FK (K , L) ≡ ∂F (K , L)

∂K> 0 (2)

FL(K , L) ≡ ∂F (K , L)

∂L> 0 (3)

FKK (K , L) ≡ ∂2F (K , L)

∂K 2< 0 (4)

FLL(K , L) ≡ ∂2F (K , L)

∂L2< 0 (5)

Chad Tanioka (Occidental College) Modeling Economic Growth using DE February 25, 2016 5 / 28

Assumption 2: The function F is linearly homogeneous of degree 1 in Kε R and L ε R if

F[λK(t),λL(t)]=λF[K(t),L(t)] for all λ ε R+

(6)

In economic terms, the production function F is said to have constantreturns to scale.

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Using assumption 2, we want to rewrite the production function inper-worker terms.

Let λ=1/L,

λQ = F (λK , λL) (7)

Q

L= F (

K

L, 1) (8)

k = capital per worker and q = output per worker

k =K

Land q =

Q

L(9)

q = f (k) (10)

where f is defined by f(k) = F(k,1).Chad Tanioka (Occidental College) Modeling Economic Growth using DE February 25, 2016 7 / 28

Figure 1 shows the production function of the form f(k)=√k .

Figure 1: q=f(k)

rate of change of k = marginal product of capital

downward concavity = diminishing marginal returns to capital

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An example of a production function of form f(k) =√k

Does f(k) =√k satisfy the initial conditions?

f(k) =√k = F(K,L) = K 1/2L1/2

FK (K , L) ≡ ∂F (K , L)

∂K=

1

2K−1/2L1/2 > 0 Assumption 1

FKK (K , L) ≡ ∂2F (K , L)

∂K 2= −1

4K−3/2L1/2 < 0 Assumption 1

λF (K , L) = (λK )1/2(λL)1/2

λF (K , L) = λ1/2K 1/2λ1/2L1/2

λF (K , L) = λK 1/2L1/2 Assumption 2

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Solow’s fundamental differential equation

Solow’s differential equation is outlined by{Rate of change of capital stock

}=

{rate of investment

}−{

rate of depreciation

}(11)

and is defined by

dk

dt= sf(k) - δk (12)

Chad Tanioka (Occidental College) Modeling Economic Growth using DE February 25, 2016 10 / 28

Rate of investment:i = sq = sf(k) (13)

where s is a constant representing savings rate, between 0 and 1.

Rate of depreciation:

Annual depreciation = δk (14)

where δ is a proportionality constant, referred to as depreciation rate.

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Graphical behavior solutions

What is an equilibrium solution?

An equilibrium solution is a constant solution y=y∗ to a differentialequation y ′ = f(y) such that f(y∗) = 0.

Set the dkdt equal to 0 and solve for equilibrium solution ks .

dk

dt= sf(k) - δk = 0 (15)

sf(k) = δk (16)

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Solutions can be found at the point where δk intersects curve sf(k)

Figure 2: graphical solution

Two solutions: k=0 and k = ks . In economics, ks is known as thesteady-state level of capital.

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Classifying the Equilibrium Solutions

Are the equilibrium solutions asymptotically stable?

An equilibrium solution is asymptotically stable if all solutions with initialconditions k0 ‘near’ k = ks approach ks as t approaches ∞

Figure (3) is a graph of the differential equation, where g(k) = dkdt

Figure 3: Graph of Solow’s DE

dkdt > 0 when 0 < k < ks , and dk

dt < 0 when k > ks .

Chad Tanioka (Occidental College) Modeling Economic Growth using DE February 25, 2016 14 / 28

Figure (4) graphs the level of capital versus time.

Figure 4: capital and time

k will increase towards its equilibrium level ks if 0 < k0 < ks .

k will decrease towards its equilibrium level ks if k0 > ks .

k = ks is asymptotically stable.

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Example 1: Cobb Douglas Production Function

An example of a production function:

Q = F (K , L) = AKαL1−α, (17)

where 0 < α < 1, and A is another positive constant that represents totalfactor productivity.

total factor productivity = a residual that measures the output notexplained by the amount of inputs.

Chad Tanioka (Occidental College) Modeling Economic Growth using DE February 25, 2016 16 / 28

Our production function in terms of output/per worker

q =Q

L=

AKαL1−α

L= A

KαL1−α

LαL1−α= A

(KL

)α= Akα (18)

The production function is defined by

q = f (k) = Akα, 0 < α < 1 (19)

Now we plug equation (19) into differential equation.

dk

dt= sAkα − δk (20)

Chad Tanioka (Occidental College) Modeling Economic Growth using DE February 25, 2016 17 / 28

Solving DE using Cobb-Douglas

Set dkdt = 0 and solve for ks

0 = sAkα − δk

0 = kα(sA− δk1−α)

The equilibrium solutions are k = 0 and k=ks , where

ks =(sAδ

) 11−α

(21)

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We’ll define

g(k) =dk

dt= sAkα – δ k (22)

Then compute

g ′(k) = sAαkα−1 – δ at point ks ,

g ′(ks) = αδ − δ < 0 (23)

= δ(α− 1) < 0 (24)

since α <1.

Solving the equation g ′(k) = 0, we obtain the solution k = ki , where

ki =(αsA

δ

) 11−α

(25)

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Figure 5: k vs g(k)= dkdt

g ′(k) > 0 when 0 < k < ki and g ′(k) < 0 when k > ki .

g(k) has a maximum at ki .

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Figure 6: capital vs time

If k0 > ks , then k is decreasing, concave upward and approaches ksas t → ∞.

When k0 < ki , then k is increasing, and concave upwards until itreaches ki .

When ki < k0 < ks , k is increasing, concave downwards, andapproaches ks as t → ∞.

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Solving Solow’s differential equation analytically

dkdt = sAkα - δ k

To solve analytically, we make a change of variable by defining

y = Ak1−α (26)

Using the chain rule, we obtain

dy

dt= (1− α)Ak−α

dk

dt

and rewrite it as

dk

dt=

1

1− αkα

A

dy

dt

Chad Tanioka (Occidental College) Modeling Economic Growth using DE February 25, 2016 22 / 28

Substituting this into the left-hand side of the Solow model, we obtain theequation

1

1− αkα

A

dy

dt= sAkα − δk

Then, dividing both sides by kα and multiplying by A gives

1

1− αdy

dt= sA2 − δk1−α = sA2 − δy

and simplifying yields

dy

dt= (1− α)(sA2 − δy) (27)

Chad Tanioka (Occidental College) Modeling Economic Growth using DE February 25, 2016 23 / 28

Separation of Variables

dy

dt= (1− α)(sA2 − δy)

dy

(sA2 − δy)= (1− α)dt

−1

δln(sA2 − δy) = (1− α)t + C

ln(sA2 − δy) = −δ(1− α)t + C

sA2 − δy = Ce−δ(1−α)t

The result is

y =sA2

δ+ Ce−δ(1−α)t

Chad Tanioka (Occidental College) Modeling Economic Growth using DE February 25, 2016 24 / 28

where C is an arbitrary constant. Then replacing our y with Ak1−α weobtain

Ak1−α =sA2

δ+ Ce−δ(1−α)t (28)

Use initial condition k(0) = k0 to find C.

C = Ak1−α0 − sA2

δ(29)

Substitute C into equation (26) to obtain level of capital (k at time t.

k =[sA2

δ+(Ak1−α0 − sA2

δ

)e−δ(1−α)t

] 11−α

. (30)

As t → ∞, the right hand side tends to zero, so k → ks .

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Conclusion

Solow’s economic growth model is a great example of how we can usedifferential equations in real life.

The model can be modified to include various inputs including growthin the labor force and technological improvements.

The key to short-run growth is increased investments, whiletechnology and efficiency improve long-run growth.

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References

[1] R.M. Solow, “A contribution to the theory of economic growth,Quarterly Journal of Economics”, vol. 70, 1956.[2] L. Guerrini, “The Solow-Swan model with a bounded population

growth rate”, Journal of Mathematical Economics, vol. 42, no.1, 2006.[3] O. Galor, and D.N. Weil, “Population, technology, and growth: from

Malthusian stagnation to the demographic transition and beyond”, TheAmerican Economic Review, vol. 90, 2000.[4] J.R. Barro and X. Sala-i-Martin, “Economic Growth”, Mcgraw-Hill,

New York, NY, USA, 1995.[5] D. Romer, “Advanced Macroeconomics”, Mcgraw-Hill, New York, NY,

USA, 2006.[6] P. Hartman, “Ordinary Differential Equations?An Introduction for

Scientists and Engineers”, Oxford University Press, New York, NY, USA,2007.

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References (continued)

[7] Cannon, Edwin. 2000. “Economies of Scale and constant returns tocapital: a neglected early contribution to the theory of economic growth”.American Economic Review.[8] Domar, Evsey 1957. “Essays in the theory of economic growth”. New

York: Oxford University Press.[9] Frankel, Marvin. 1962. “The production function in allocation and

growth: a synthesis”. American Economic Review. 52:995-1022.[10]Alberto Bucci. “Transitional Dynamics in the Solow-Swan Growth

Model with AK Technology and Logistic Population Change”. StateUniversity of Milan.[11] Mankiw, Gregory. 1997. “Principles of Macroeconomics.” Cengage

Learning.[12] Acemogulu, Daron. 2008. “Introduction to Modern Economic

Growth.” Princeton University Press.

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