Solow Residual - History

History

In the 1950s, many economists undertook comparative studies of economic growth following World War II reconstruction. Some said that the path to long-term growth was achieved through investment in industry and infrastructure and in moving further and further into capital intensive automated production. Although there was always a concern about diminishing returns to this approach because of equipment depreciation, it was a widespread view of the correct industrial policy to adopt. Many economists pointed to the Soviet command economy as a model of high-growth through tireless re-investment of output in further industrial construction.

However, some economists took a different view: they said that greater capital concentrations would yield diminishing returns once the marginal return to capital had equalized with that of labour—and that the apparently rapid growth of economies with high savings rates would be a short-term phenomenon. This analysis suggested that improved labour productivity or total factor technology was the long-run determinant of national growth, and that only under-capitalized countries could grow per-capita income substantially by investing in infrastructure—some of these undercapitalized countries were still recovering from the war and were expected to rapidly develop in this way on a path of convergence with developed nations.

The Solow residual is defined as per-capita economic growth above the rate of per-capita capital stock growth, so its detection indicates that there must be some contribution to output other than advances in industrializing the economy. The fact that the measured growth in the standard of living, also known as the ratio of output to labour input, could not be explained entirely by the growth in the capital/labour ratio was a significant finding, and pointed to innovation rather than capital accumulation as a potential path to growth.

The 'Solow growth model' is not intended to explain or derive the empirical residual, but rather to demonstrate how it will affect the economy in the long run when imposed on an aggregate model of the macroeconomy exogenously. This model was really a tool for demonstrating the impact of “technology” growth as against “industrial” growth rather than an attempt to understand where either type of growth was coming from. The Solow residual is primarily an observation to explain, rather than predict the outcome of a theoretical analysis. It is a question rather than an answer, and the following equations should not obscure that fact.