Forecasting the Economy’s Destiny:

The typical Solow growth model makes estimating an economy’s long-run progress destiny normal:

a) Compute the steadystate capital output ratio, k*=s/(n+g+δ), equivalent to the savings share divided by investment requirements.

b) Increase the steady state capital output ratio k* by increasing it to power of growth multiplier λ = (α/(1-α)), where α is production function’s diminishing returns to scale parameter.

c) Multiply result by the present efficiency of labor Et.

You have just calculated output for each worker on economy’s balanced-growth path. If you just wish to understand the present, you are done. If you wish to also estimate the future, then:

Estimate that balanced growth output for each worker will increase at similar  proportional rate g as labour efficiency.

If economy is on its balancedgrowth path, you are done. Except if economy isn’t currently on its balanced growth path, then:

a) Estimate that the economy is heading for its balanced-growth path.
b) Estimate that the economy will grow along its balanced-growth path after it has converged to it.

The growth model makes forecasts of the long-run destiny of the economy straightforward, and provides an easy way to analyze how the factors making for (a) higher capital intensity and (b) better technology and labor efficiency determine output per worker.

How to Calculate the Economy’s Balanced-Growth Path:

Calculating the balanced-growth level of output per worker is simple: (i) calculate the steady-state capital-output ratio k* (ii) raise k* to the power of the growth multiplier λ, and (iii) multiply the result by the efficiency of labor Et.

What happens if there is a change in economic policy or in the economic environment—if something happens to change s, the savings rate; n, the labor force growth rate; g, the efficiency of labor growth rate; or δ, the depreciation rate? If any of these change, the economy’s steady-state balanced-growth path changes as well. So calculate the new steady-state balanced-growth path, and then forecast that the economy will converge to this new balanced-growth path.

Why, and how, does this growth model work? Why is there a steady-state growth path? Why do these calculations above tell us what it is? To understand these issues, we need to back up and dig a little deeper.

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