Question

4. How would each of the following changes affect the steady state values of capital per worker and output per worker? a. A large fraction of the physical capital stock is destroyed in a war. b. A negative supply shock sharply reduces productivity.

Answer 1

a.

If the large fraction of the physical capital stock is destroyed, then the k* and y* remain same and not change. It is because both are at the steady-state level. Due to convergence theory, economy will be back to its initial steady state and the capital per worker would become independent of the Actual Capital Stock.

So, Both Capital and Output per worker remains unchanged.

b.

A sharp reduction in productivity shifts the investment curve downward. As a result, a fall in the investment of new capital stock would lead to fall in capital per worker and consequently would have a negative impact on the output per worker. Also a fall in the productivity has negative impact on the long run growth of output.

So, Both Capital and Output per worker falls.

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