Week 2 - Solo Model

Question 1

In the model set up what is the production function equal to?

Answer 1

Question 2

In the model set up what is the Resource constraint equal to?

Answer 2

Yt = Ct + It, output can be used for consumption (Ct) and investment (It), This is called the resource constraint, assumes a closed economy (no imports and exports), as well as no government expenditure

Question 3

In the model set up what is investment and consumption equal to?

Answer 3

Question 4

How is capital accumulated over time?

Answer 4

Investment leads to the accumulation of new capital, which can then be used in the production

Question 5

What is the capital accumulation equation and briefly describe the terms involved?

Answer 5

• Capital in period t+1= capital in the current period + the investment in the current period - the depreciation rate x capital

Question 6

What is the absolute change in capital stock given by?

Answer 6

Question 7

What are factor prices wt and rt equal to?

Answer 7

Question 8

What are all the endogenous and exogenous variables in the Solo model?

Answer 8

Question 9

What are the 2 ways in solving the Solo model?

Answer 9

1. Showing a graphical solution

2. Solving the model in the long run

Question 10

Under what conditions does the change in capital stock grow, decline, and stay constant?

Answer 10

Question 11

Draw and explain the dynamics of the solo model diagram

Answer 11

• When not in a steady-state, the economy exhibits a change In capital towards the steady-state.
• As Kt moves to its steady-state K*, output Yt will also move to its steady-state Y*
• At the steady-state, all endogenous variables are fixed

Question 12

What is the transition dynamics?

Answer 12

The process that takes the economy from its initial level of capital to the steady state

Question 13

How do you solve analytically for the steady-state?

Answer 13

Question 14

Why does the economy reach the steady-state?

Answer 14

• Investment has diminishing returns
• The rate at which production and investment rise is smaller as the capital stock is larger
• A constant fraction of the capital stock depreciates every year
• Eventually, net investment is zero, and the economy hits a steady-state

Question 15

What are the 2 key takeaways of the solo model?

Answer 15

• Capital accumulation is not the engine of long-run economic growth
• Investment is beneficial in the short run, but cannot sustain long-run growth due to diminishing returns

Question 16

What is the effect of an increase In the investment rate s bar?

Answer 16

• The investment curve rotates upwards, while the depreciation curve remains unchanged.
• Investment temporality exceeds depreciation → capital increases towards a higher steady state.
• The new steady-state has higher capital and income per worker

Question 18

What is the effect of an increase In the depreciation rate ?

Answer 18

• The depreciation curve shifts upwards, while the investment curve remains unchanged.
• Depreciation temporarily exceeds investment → capital decreases towards a lower steady-state.
• After a new steady state is reached, no growth in capital or income per worker.
• The new steady-state has lower capital and income per worker

Question 19

What is the effect on output of an increase in the depreciation rate d?

Answer 19

• Output is Y* during the steady-state and growth is constant
• As the depreciation rate increases and the economy begins to contract output decreases very rapidly.
• After some time due to diminishing returns, the fall in growth slows down and a new steady-state Y** is reached.

Question 20

Is the solo model consistent with Long-run growth rates?

Answer 20

• The solo model does not explain why we observe different long run growth rates in different economies, because of the law of diminishing returns in the LR

Question 21

Is the solo model consistent with income convergence which is the idea that poor countries are catching up?

Answer 21

The solo model predicts conditional convergence (the condition of having the same steady-state which is the same values of A bar, L bar, and d) and this is consistent with some countries such as OECD countries.

Question 22

Is the solo model consistent in predicting long-run GDP levels?

Answer 22

• The capital accumulation mechanism of the Solow model predicts cross-country gaps smaller than in the data.

Question 23

Considering 2 countries, if country 1 has a higher saving rate other than that these 2 countries are identical what does the Solo Model predict?

Answer 23

In the long run, the GDP gap between the two countries will be positive and constant

Question 24

Question 25