Question

Suppose there are two very similar countries (call them E and F). Both countries have the same population and neither is experiencing population growth (that is, N is identical and constant in both countries). Both countries depreciate capital at the same rate, the both have the same savings rate, they both have the same technology, and there is no technological progress. Suppose that currently both countries are in steady state, when an earthquake destroys half of the capital stock of Country E, but does not kill any of its population. We would expect...

1. That Country E's output per worker ( Y/N ) will grow faster than Country F's only for some time.

2. That Country F's output per worker ( Y/N ) will grow faster than Country E's only for some time.

3. That Country F's output (Y) will be higher than Country E's only for some time.

4. That Country F's output (Y) will be higher than Country E's permanently.

This is a multiple answer question.

Answer 1

In the given situation, following are the Correct choices:

2. That Country F's output per worker ( Y/N ) will grow faster than Country E's only for some time.

3. That Country F's output (Y) will be higher than Country E's only for some time.

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As per the Solow model, this reduction in capital stock is a temporary negative shock to the Country E. This will cause a slow down in the growth rate of output per worker, but this slow down is temporary. Over time, capital will acuumulate and capital stock will be created again.

Now due to the lower capital available, output per worker will fall for Country E, and the equilibrium Y will also fall. However, this will slowly return to the steady state, as capital accumulates again.

Thus, options 2 and 3 are correct.