Question

The Solow growth model

Suppose an economy was in steady state with population growing at 2% yearly, and suddenly its population growth rate doubles to 4% yearly. What happens to this economy in the short and long run? Illustrate with a diagram.

Answer 1

In the solow model,aggregate output grows with growth in the population growth rate but this does not effect the growth rate of per capita output permanently.An increase in the population rate leads to a lowering of the steady state level of the growth rate of per capita output.Per capita income is used to measure the standard of living in an economy.If the economy's population is increasing ,real GDP will increase but the growth rate of per capita output will become low  in the short run.In the long run the economy will move to its original position.

The diagram shows the steady state of the economy with constant growth of population initially by the line K.Point A is the initial steady state.If the population increases suddenly as a result of immigration, the capital labour ratio in the economy will fall and the new short run equilibrium will be at point B.The fall in the capital labour ratio will lead to fall in per capita income.But GDP will increase because the immigrants can find jobs. The equilibrium at point B is a temporary state.In course of time the economy collects more capital in order to increase the capital labour ratio and as a result the per capita income rises in the long run and the economy moves to point A.