Question

What is the effect of an increase in the investment rate on the level of steady-state output per worker in the Solow model? Show in a graph.

Answer 1

Answer) In a simple Solow model steady state is reached when gross investment is equal to level of depreciation. The economy has attained steady state of capital stock per capital which implies steady state of output per capita.

To the left of K* capital stock per capita is rising because the rate of investment is higher than rate of depreciation. However investment is increasing at decreasing rate (due to neo classical production function) while depreciation takes place at a constant rate therefore at K* the two become equal & economy reaches steady state at this point output per capita remains constant because there is no change in labor force. The capital output ratio becomes constant only in steady state it keeps increasing due to diminishing marginal productivity of capital.