Question

1. Recall that in chapter 25 we learned about the aggregate production function, in which the factors of production were labour L, capital K, and technology T. Answer the following questions according to the Neoclassical growth model.
   1. Imagine that the amount of capital K increases by 10% (from 50 to 55 units) while labour and technology stay the same. How much does total GDP and GDP per worker change by? (A specific percentage is not needed, just ‘more than’ / ‘less than’ 10%.)

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2. Imagine that capital increases by 5 units again, from 55 to 60. How big is the resulting change in GDP and GDP per worker compared to the change that occurred in part a?

3. What is the term (hint: law) used to describe the relationship between K and GDP in parts a and b?

4. Based on your answers to parts a through c, is it possible to have sustained economic growth due to capital increases alone?

5. Now imagine that the amount of labour L and capital K both increase by 10%. By how much do total GDP and GDP per worker change by?

6. What is the term used to describe this relationship?

7. What is required to have sustained increases in per-worker GDP (which, in turn, results in improving living standards)?

Answer 1

The neoclassical growth model was developed in the late 1950s, by Robert Solow. He considered labor and capital determinant of output besides exogenously determining technology.

Y=TF(K,L)

Y is GPD

T is the technology which is exogenous determined

K and L are capital and labor stock

Assume

1. The constant return to scale
2. Diminishing returns to individual input.
3. labor and capital are substitutable
4. Planned saving equals investment
5. capital depreciates at (d)
6. the saving rate is constant

It predicted that the economy will converge at a steady state.

a. Output or GDP will rise with an increase in the amount of capital stock (10%). But with increasing capital, GDP per capita may not rise in proportion to the rise in the capital.

b. As capital (5%)again rises, GDP rises again but the change in GDP slows down with comparison to a 10% rise. This happens due to diminishing returns of capital and it is said that labor is assumed to be constant. GDP per capita also slows down in comparison to 10%.

c. Level effect

d. It is not possible to sustain the growth due to capital increase alone due to diminishing returns of capital. Moreover, in time, the economy converges at a steady state. First, the growth will be very high but eventually, it will converge to steady-state.

e. The higher population growth rate has a double effect. It reduces steady-state per capita income and increases the total income (GDP)

f. Growth effect

g. For sustained growth, we need to invest in research and development, investment in education, learning by doing.