Question

1. We have learned in this class that the steady condition is given as: sf (k) = (n + S + g)k . Use this condition for steady state to find the steady state (long run) equilibrium values of capital per effective worker, k* , output per effective worker, y* ; consumption per effective worker, c* ; and investment per effective worker, i* , for this economy.

2. If the United States adopts policies that permanently decrease savings and investment, illustrate graphically how such a policy would affect the level of output per effective worker and capital per effective worker

3. Carefully explain three major predictions from the Solow growth model and how governments of developing (poor) countries can use those predictions to improve living standards in their economies.

Answer 1

(1)

(2) Graphical represntation of the model as follows. Consider that US's initial steady state captal per worker = k*. When the saving and investment decrease, i.e., saving rate decreases, the production function or the curve sf(k) shifts down. Investment is lower, but capital stock and decpreciation are constant. Therefore, depreciation exceeds investment which result in fall of k subsequently until the economy reaches new steadt state level where capital per worker becomes k1*. With lower level of k, output per worker (y) also falls.

(3) The Solow model shows that the saving rate is a key determinant of the seady state capital per worker or the capital stock. If the saving rate is high, the economy will have a larger capital stock and a high level of output. The governments of developing countries should, therefore, formulate their fiscal policy in order to increase saving rate of the economy which subsequently can help in the growth of their economy.