Question

5. Under the assumptions of Solow's growth model, assume the economy is in a steady state. How will the steady-state levels of output and consumption per capita change in response to the following events: (a) A large part of the capital stock disappears - is "blown up", as in a war. (This is what happens in most wars, though wars kill people too.) (b) A huge refugee wave (as we see currently flowing from Syria): the population goes up (instantly) and then stays constant forever. (c) Technology advance: the level of the production function rises (instantly), and then stays constant forever (the A in the Cobb-Douglas production function jumps up and then stays constant). (d) An immediate and permanent fall in the savings rate. (e) The switch to bad labor-market (or other) institutions, leading only a fraction of the people to find work in any given period (thus, there is permanent unemploy- ment). Again, the change occurs instantly. Support your answers with graphs with total capital or capital per capita on the x-axis and y, i investment), and c on the y-axis.

Answer 1

A) when a large part of the capital stock disappears, the saving investment curve will shift downwards. As a result of which now less capital will be depreciated and there will be low savings in the economy. The total capital will be low.

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B) when the population rises, more capital is required for the additional population. This acts as a negative force like depreciation. Thus with increase in the population the depreciation curve shifts upwards and the saving rate and capital falls.

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C) when there is an advancement in technology, the people working will become more efficient in what they do. This will act both in a positive and negative manner. As technology improves, labor will become more efficient and will produce more than before. It also leads to a similar effect like an increase in the population as the increase in efficiency means that the present labor will be able to work more. The saving investment curve will shift upwards and more capital will be produced with an increase in the technology.

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D) when the savings rate fall, the investment falls. This leads to a fall in the savings and investment curve which means a fall in the capital per worker.

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