Question

Suppose that the equation K* = (0.3Y)/rc determines Sri Lanka’s desired capital stock. K* is the desired capital stock, Y is the country’s GDP, and rc is the rental cost of capital.   

A. If Y is $90 billion and rc is 10 percent, calculate the country’s desired capital stock.

B. Suppose Sri Lanka’s GDP goes up to $100 billion. Assuming rental costs remain the same, calculate the country’s desired capital stock at the new level of GDP.

C. If Sri Lanka’s capital stock was at its desired level in part A, use the flexible accelerator model to calculate investment in the first and second year after the GDP change, assuming

?= 0.4.

D. Explain why the adjustment to the new level of desired capital stock is spread over a number of years.

Answer 1

A. Desired capital stock at GDP of 90 billion will be 90×0.3/10%= 270 billion.

B. Desired capital stock at GDP of 100 billion will be 100×0.3/10%=300 billion.

C. Change in desired stock is 30 billion (300-270). So in first year investment would be 30×0.4=12 billion.

In second year investment would be 0.4×18= 7.2 billion. Where, 18=30-12.

D. Adjustment to the new level of desired capital stock is spread over a number of years because additional investment depends on the rental cost of capital. When the rental cost of capital is low then larger investment can be made whereas lower investment would be made at higher rental cost. Also it is not possible to invest large amount required for adjustment in capital to be Invested at one time, because capital is for use in a longer period.