Solow Growth Model

Let's consider the basic Solow growth model presented in the lecture. Within this model framework, illustrate with a diagram what happens to the steady-state level of capital per worker and output per capita if a country

a) decreases its saving rate

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Initially, a country's saving rate is equal to s1. Given the production function f(k) and deprecation line δk, the associated steady-state level of capital per worker is kss1 and the steady-state level of output per capita is equal to yss2. Then, a country decides to decrease its saving rate to s2, where s2 < s1. What happens is that the investment curve shifts downwards causing the steady-state level of capital per worker to decrease from kss1 to kss2 (kss2 < kss1). Due to the lower steady-state level of capital per worker, the steady-state level of output per capita drops from yss1 to yss2, the new steady-state level of output per capita being smaller than the initial one.

b) experiences an increase in the depreciation rate

EMBED PowerPoint.Slide.8

Before any changes in depreciation rate, the steady-state level of capital per worker is kss1 and the corresponding level of output per capita is yss1. Then, there is a change in depreciation rate which goes up from δ1 to δ2. This causes the depreciation line to shift up which has negative effects on capital per worker. The new steady-state level of capital per worker is kss2, which is associated with lower level of output per capita than before the change in depreciation rate.