Question

Suppose that the economy is initially in a steady state and that some of the nation’s capital stock is destroyed because of the natural disaster or a war.

(a) (10 points) Determine the long-run effects of this on the quantity of capital per worker, output per worker, and their growth rates.

(b) (10 points) In the short run, does the aggregate output grow at a rate higher or lower than the growth rate of the labor force?

(c) (5 points) After the World War II, growth in real GDP in Germany and Japan was very high. How do your results in parts (a) and (b) shed light on this historical evidence?

Answer 1

a) The long-run equilibrium is not changed by an alteration of the initial conditions. If the economy started in a steady state, the economy will return to the same steady state. If the economy were initially below the steady state, the approach to the steady state will be delayed by the loss of capital.

b) Initially, the growth rate of the capital stock will exceed the growth rate of the labour force. The faster growth rate in capital continues until the steady state is reached.

c) The rapid growth rates are consistent with the Solow model’s predictions about the likely adjustment to a loss of capital.