Why will the economy converge to particular level of capital

Reference no: EM132206553

Question: Consider a Solow model economy where the production function is Y = 4K0.25L0.75. This economy has 500 workers, a 20% savings rate, and a 10% depreciation rate.

a) Solve for both a general algebraic expressions (all variables) AND specific equations (K is the only variable) for the level of savings and the level of depreciation in this economy. Use these to provide a general expression and a specific value for the steady-state level of capital in this economy. Why will the economy converge to this particular level of capital?

b) Calculate the level of steady-state output (Y*), consumption (C*), and savings (S*). Draw the Solow Model graph for this economy, showing K*, Y*, S*, C*. Some of the intermediate results will be ugly decimals, but you should get nice round numbers for all these variables.

c) In an effort to increase per capita income, the people of this economy decide to save more, raising the share of their income that they save to 67.5%. Repeat the calculations above for this new level of savings. Include the new outcome in your graph, and discuss how our variables of interest have changed. Why does a higher savings rate generate these outcomes? Think carefully about your graph it's similar, but not identical to our examples from class.

d) Some would argue that the policy has its intended effect, while others would argue that this policy made the savings rate â€œtoo high.â€ Discuss each of these positions using your results from above. Both positions have merit. What did we say was the fundamental motivation for saving?

Reference no: EM132206553

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