The Solow Growth Model Revisited. Introducing Keynesian Involuntary Unemployment

In this paper we extend the Solow growth model by introducing a simple mechanism which allows to determine involuntary unemployment explained by the weakness in aggregate demand. In our base model, we introduce a simple investment function and we find that an increase in aggregate demand (due to a reduction in the saving rate or to an increase in public expenditures) stimulates real GDP and reduces unemployment. Then, we modify the investment function in order to take into account the crowding-in/crowding-out effect on investments. This allows us to build a class of models which are between neoclassical supply-driven models and keynesian demand-driven models depending on the value of a key parameter that measures the degree of the crowding-in/crowding-out effect on investments and which lies between zero (for keynesian models) and one (for neoclassical models). Estimations on six OECD countries show that our key parameter lies between 0.6 and 0.8, implying that the fiscal multiplier is between 1 and 2, which is quite consistent with the empirical evidence.