Question

READ AND ANSWER THE FOLLOWING QUESTIONS

4.According to the life-cycle hypothesis, explain the pattern of saving for an individual over his/her lifetime? What impact does this behaviour have on the saving rate?

5. Give an example of a country with a low savings rate. Are the implications positive or negative? Explain

While a higher capital stock implies higher output, this does not mean a higher capital stock is desirable. To sustain a high capital stock, a lot of output will have to be devoted to investment, leaving less available for consumption.

Golden Rule: The capital stock per-worker that maximizes consumption per-worker. In the Solow Growth Model with no population growth and technological progress, this occurs where

δ =MPK

Recall, at steady state, investment is equal to total depreciation because savings is equal to investment.

Steady state: * *)( k ksf δ = Total savings = total investment: * *)( i ksf = * * ki δ =⇒



A country that is saving too much, has a steady state capital stock that is above k*G, a country that is saving too little has a steady state capital stock that is below k*G. Notice that only one savings rate s will ensure that the economy achieves the golden rule capital stock at steady state. On the graph, this savings rate will ensure the savings function crosses at point A on the graph.

The golden rule can be interpreted in terms of marginal product of capital and depreciation. A one-unit increase in k raises output by MPK; this is the added benefit of increasing k. It also implies that an extra δ units of output must be set aside to maintain the capitallabor ratio at its new higher level; this is the additional cost of increasing k. The level that maximizes consumption will be where the added benefit (MPK) equals the additional cost ( δ ).

• If MPK > δ, then increase in k will increase output by more than the implied increase in depreciation, so consumption rises because there is more output leftover for consumption. The extra benefit (MPK) associated with an increase in k outweighs the cost ( δ ), so we should increase k. • If MPK < δ, then increase in k will increase output by less than the implied increase in depreciation, so consumption falls because there is less output leftover for consumption. The extra cost ( δ ) associated with an increase in k outweighs the benefit (MPK), so we should decrease k.

In the model with population growth and technological progress, the modified golden rule is:

)( δ ++= gnMPK

The interpretation in terms of marginal product is somewhat more difficult, but the general idea is the same as in the simple model. Notice that when there is no population growth (n = 0) or technological progress (g = 0), this modified golden rule collapses to the simple one at the top of the handout

Answer 1

4. According to lifecycle theory hypothesis, an individual tends to borrow when his/her income is low and tends to save more when his/her income is more. Life cycle hypothesis divides the entire life cycle of a man into three parts, in the first part an individual tends to consume more which exceeds their income, this generally happens for younger people. Then for the middle aged people, income tends to rise and individuals will clear off yheth debts, this is the second phase. In this phase people will tend to save more. Then finally in the last phase, which is the post retirement age people tends to wear off their savings as they consume their previous savings.

The savings rate will be low during the initial years, then for the middle aged people it will grow, however, it will again decline for the retired people.

5. Guinea is a country with low savings rate. This low savings rate has occurred due to recent ebola break. The implications of this low savings rate is definitely begatneg for Guinea, as the investment opportunities has decreased there. So the growth prospects have also declined. The poverty rate has risen. This low savings rate definitely has a negative implication.