Question

Assume your boss is an important policymaker/decision-maker, but might not understand the economics behind his/her decisions and policies. For each of the following, brief the decision-maker on what he/she needs to know about macroeconomics to make better decisions in the given situations. Use equations, graphs, and discussion.

Policy Topic: We live in a poor country. Would boosting the savings rate fix everything?

If a country increases its savings, it would have more to spend on capital investment, and thus help its production, GDP, and per capita output. Yes?Explain what our different development models would tell policymakers in poor countries about their savings.Use math, graphs, and discussion. In particular, consider both the Solow model and the endogenous growth model,

Answer 1

Situation given is as

If a country increases its savings, it would have to spend more on capital investment and thus production , GDP and per capita output. As a policy maker, on should analyse the situation in context of the different development models and elaborate on how a poor country should manage its saving rate.

The models being discussed below are Solow model and endogenous model or AK model as commonly known. Both differ as a response to the rise in saving rate, in the AK model it is a long run growth of per capita income and not level of per capita income. Whereas in the Solow model, there is a short term rise in the level of per capita income which smoothens to the initial growth levels in the long run.

A major difference between the two development models is that on one hand, Solow model assumes diminishing returns to scale that is way there is no growth effect on per capita output when saving rate rises.

On the other hand, AK model assumes increasing returns to scale so an exogeneous increase in saving rate will not reduce long run per capita output and it will show growth effect.

The following graphs depict the comparative changes in Solow and AK model

From above picture , the model differ in their growth rate of per capita income i.e.

Hence, AK model goes far beyond the neoclassical model like Solow in predicting the relationship between government policies and economic growth.

For a poor country, saving rate cannot fix the problem till it reaches the phase when it can experience increasing returns via spillover effect and learning by doing effect so that there is a permanent effect of increase in saving rate rather than only level effect as in Solow model with diminishing returns which is its current economic scenario.