Question

Explain, using Solow's (1956) model, (i) why the seeds of long-run output growth lie in investment, which constitutes a part of the aggregate demand (AD), and (ii) how AD grows when the long-run output grows, so that the balance in the goods market is maintained?

Answer 1

i. The seeds of long run growth in the economy lie in the level of investment in the economy because level of investment in the economy determines the level of capital stock of the economy. As the level of investment increases, the level of capital stock in the economy also increases and this increases the production capacity in the economy by increasing the potential output level in the economy and leading to long run output growth in the economy. Thus, Solow Model states that seeds of long run output growth lie in investment which constitutes a part of the aggregate demand.

ii. When long run output growth in the economy occurs, the level of Real GDP in the economy also increases and this increase in the level of GDP in the economy will increase National Income in the economy and as National Income increases, aggregate demand will increase because as income level increases, the level of aggregate demand in the economy will also increase.