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## Key Concepts

- The starting point for the Solow model is the production model of chapter 4. To that framework, the Solow model adds a theory of capital accumulation. That is, it makes the capital stock an endogenous variable.
- The capital stock is the sum of past investments. The capital stock today consists of machines and buildings that were bought over the last several decades.
- The goal of the Solow model is to deepen our understanding of economic growth, but it's only partially successful. The fact that capital runs into diminishing returns means that the model does not lead to sustained economic growth. As the economy accumulates more capital, depreciation rises one-for-one, but output and therefore investment rise less than one-for-one because of the diminishing marginal product of capital. Eventually, the new investment is only just sufficient to offset depreciation, and the capital stock ceases to grow. Output stops growing as well, and the economy settles down to a steady state.
- There are two major accomplishments of the Solow model. First, it provides a successful theory of the determination of capital, by predicting that the capital-output ratio is equal to the investment-depreciation ratio. Countries with high investment rates should thus have high capital-output ratios, and this prediction holds up well in the data.
- The second major accomplishment of the Solow model is the principle of transition dynamics, which states that the farther below its steady state an economy is, the faster it will grow. While the model cannot explain long-run growth, the principle of transition dynamics provides a nice theory of differences in growth rates across countries. Increases in the investment rate or total factor productivity can increase a country's steady-state position and therefore increases growth, at least for a number of years. These changes can be analyzed with the help of the Solow diagram.
- In general, most poor countries have low TFP levels and low investment rates, the two key determinants of steady-state incomes. If a country maintained good fundamentals but was poor because it had received a bad shock, we would see it grow rapidly, according to the principle of transition dynamics.

## 5.1 Introduction

## 5.2 Setting Up the Model

- Production
- Capital Accumulation
- Case Study: An Example of Capital Accumulation
- Labor
- Investment
- The Model Summarized
- Case Study: Some Questions about the Solow Model

## 5.3 Prices and the Real Interest Rate

## 5.4 Solving the Solow Model

- Using the Solow Diagram
- Output and Consumption in the Solow Diagram
- Solving Mathematically for the Steady State

## 5.5 Looking at Data through the Lens of the Solow Model

- The Capital-Output Ratio
- Differences in Y/L

## 5.6 Understanding the Steady State

## 5.7 Economic Growth in the Solow Model

- Meanwhile, Back on the Family Farm
- Case Study: Population Growth in the Solow Model

## 5.8 Some Economic Experiments

- An Increase in the Investment Rate
- A Rise in the Depreciation Rate
- Experiments on Your Own
- Case Study: Wars and Economic Recovery

## 5.9 The Principle of Transition Dynamics

- Understanding Differences in Growth Rates
- Case Study: South Korea and the Philippines

## 5.10 Strengths and Weaknesses of the Solow Model

## 5.11 Additional Resources

- Summary
- Key Concepts
- Review Questions
- Exercises
- Worked Exercises