Question

Suppose that a closed economy is in a steady state equilibrium in the long-run. If there is a decrease in the depreciation rate of this economy, discuss what will happen to the steady state equilibrium, output per worker and capital per worker in this economy. Graphically show and explain the developments by clearly labeling your graphs.

Answer 1

The initial steady state occurs at point E where the investment curve s*f(k) intersects the upward sloping depreciation line at point E. The steady state output and capital per worker are k* and y*.

A decrease in the depreciation rate causes an inward movement of the depreciation line. It cuts the investment curve at point E1. The new steady state output and capital per worker are y1 and k1*

The capital stock increases by transition dynamics due to fall in the depreciation rate.

S, both y* and k* increases to a new level.