Question

Graphically illustrate and explain the effects of an increase in the saving rate on the Solow growth model. In your answer, you must clearly label all curves and the initial and final equilibria. In your answer, explain what happens to the rate of growth of output per worker and the rate of growth of output as the economy adjusts to this increase in the saving rate.

Answer 1

Sokution:-

The Solow Growtth Model depends upon three conditions:

•The intial equilibrium
•The effect of changes in capital per head and outputper head ratio
•Steady equilibrium
In the following diagram we have production function curve Y=f(k), investment curve dk and savings curve sy. The economy is in the intial equilibria where investment curve intersecting savings curve determining the capital per head is K* and output per head is Y* Now if the savings rate decreases the savings curve will shift down from sy to sy'. We can see the economy will reach to new steady state and the equilibrium point will move leftwards. As a result income will decrese from Y* to Y**. If the income per head decreases the output per head also decrease due to lack of effeciency. The capital per head also reduces from K* to K** because people has less money now to invest. Hence, the economy goes to the situation of underequilibrium and the growth rate reduces.