Question

a. Your friend is a Psychology major who has never taken a course in Economics and asks
you to explain what the steady-state level of capital is. Explain to your friend what this is
in the context of the Solow growth model.

b. Suppose that an economy is initially in a steady-state and that some of the nation’s
capital stock is destroyed because of a natural disaster or a war. Using the Solow growth
model, determine the long-run effects of this on the quantity of capital per worker and
on output per worker [Show graphically].

Answer 1

Answer 1) In a simple Solow model steady state is reached when gross investment is equal to level of depreciation. The economy has attained steady state of capital stock per capital which implies steady state of output per capita.

To the left of K* capital stock per capital which is rising because the rate of investment is higher than rate of depreciation. However investment is increasing at decreasing rate ( due to neo classical production function) while depreciation takes place at a constant rate therefore at K* the two become equal & economy reaches steady state at this point output per capita remains constant because there is no change in the labor force. The capital output ratio becomes constant only in steady state but at any point before steady state it keeps increasing due to diminishing marginal productivity of capital.

2) The destruction of some of a country's capital stock in a war would have no effect on the steady state ,because Capital per worker in the steady state depends upon the saving rate, technological progress, depreciation and population growth rate and hence, does not depend on any capital level . The long run equilibrium condition is not changed by an change in steady state condition. If the economy started in a steady state it will return to the same steady state. If the economy were below the steady state then the process to steady state will be delayed by loss of capital.

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