Question

Suppose a Solow economy is initially at its steady state k*, and suddenly is hit by a decrease in the depreciation rate δ, from δ to δ1. This change does not alter any of the other exogenous parameters in the model a. Depict this situation in a graph

Answer 1

In a Solow economy, a decrease in the depreciation rate (δ) leads to an increase in the per capita output (Y*) and a shift to a higher steady state (k*1) in the long run.

Step-by-step explanation:

In a Solow economy, a decrease in the depreciation rate (δ) would affect the per capita capital stock (k) and the steady state level of output (Y) in the long run. Let's assume the initial steady state is k* and the economy is in equilibrium at this point. When the depreciation rate decreases from δ to δ1, it means that the capital stock is no longer depreciating as quickly as before. This would increase the accumulation of capital, leading to an increase in the per capita output (Y*) and a shift to a higher steady state (k*1) in the long run.

Graphically, this can be represented by a rightward shift of the production function and an upward shift of the per capita output function. The new steady state point (k*1) would be higher than the initial steady state (k*). The diagram would show an increase in the per capita output (Y*) on the vertical axis and an increase in the per capita capital stock (k) on the horizontal axis.