Question

Consider an economy at the steady state according to the Solow Growth Model with a per capita production function  where n=0.04, d=0.08, and s=0.3. Suppose a change in the age profile of the population leads to a reduction of the savings rate to s=0.28. As a result,

		consumption initially falls and continues to decline until reaching the new steady state.
		consumption initially rises and continues to increase until reaching the new steady state. that is above the original.
		consumption initially rises but then decreases to a new steady state level of consumption that is below the the original.
		consumption initially falls but then increases to a new steady state level of consumption that is above the the original.

Answer 1

Answer:

Given that:

Consider an economy at the steady state according to the growth model with a per capita production function .

Ans: (option 1) consumption initially rises and continues to increase until reaching the new steady state.

Explanation:

The economy starts with a steady state saving rate s and capital stock k*. If now the saving rate decreases from s to s', the investment curve i = sf(k) shifts downwards.

As soon as the saving rate falls, investment automatically goes down.
And since, Y= C+I, consumption rises as investment fall.
Also, since both capital stock and depreciation remain unchanged in a steady state, depreciation now exceeds equilibrium investment. As a result the capital stock continues to fall.
The process goes on until the economy reaches the new steady state, which has a smaller volume of capital k'* and lower level of output compared to that in the old steady state.
As soon as the new steady state is achieved, the economy stays there and the rise in consumption stops, consumption is now at a higher level.