Question

Might a policymaker choose a steady state with more capital than in the Golden Rule steady state? With less capital than in the Golden Rule steady state? Explain your answers.

Answer 1

If an economy starts with a steady state with more capital than it would have in the Golden Rule steady state, the appropriate course of ac­tion for the policymakers would be to reduce the saving rate in order to reduce the stock of capital.

When an economy starts with less capital than in the Golden Rule steady state, public policy can be used to raise the saving rate to reach the Golden Rule. In Fig. 4.10 the increase in the saving rate in time t0 leads to an immediate fall in consumption and a corresponding rise in investment.

With the passage of time as more and more investment occurs the economy’s capital stock continues to increase. With capital accumulation, output, consumption and investment continue to increase. The process comes to halt only when each variable reaches its steady state level.

Since the initial steady state was below the Golden Rule, an increase in saving ultimately leads to a higher level of consumption than what originally prevailed. However an in­crease in the saving rate can just enable an economy to move from one steady state to an­other.

This is known as the transitional dynamics of the Solow model.