Explain how the Solow growth model would analyse the effects of a fall in the household saving ratio.
In this essay, I will focus on two important aspects. The first is to give a brief historical
outline of the Solow growth model. The second thread runs express how the outline on the
Solow growth model might explain the effect of a fall in the household savings ratio.My
essay will be guided by the diagram provided on which I have to make specific references
and to think through as well as explain the various steps of the Solow growth model and
what this would mean for economic growth.
Without dismissing earlier attempts, the foundations upon which modern economic growth theory rests on the foundations put by US economist Robert Solow (1924-) in the 1950s and 1960s.The Solow growth model is very neoclassic in that it focuses primarily on the supply side. The Solow model seems to implicitly assume that, as long as the supply of goods increases, economic growth can be attained. In this way it is apparently different from Keynesian models of which focus is on the demand side of the economy such as inflation and unemployment. One of the major central reason by Solow to come up with the Solow model came from the desire to know what happens in the long run to an economy in which capital accumulation is taking place. In pursuit of an answer to this question Solow came up with a degree of mathematical and analytical work. Solow pursued a model of an economy in which one has a single good that can be consumed or invested, and he says the total output in the economy Y to the total labour supply L and the stock of physical capital K. When Solow talked of physical capital he meant things like machinery, buildings, equipment, things used by labour to make products. The aggregate measurement of output is symbolised by (Y), labour (L) and capital (K). This means that Y,L and K are variables describing the whole economy. The Solow growth model tells us that in the long term, the development of a closed economy will remain at a steady state, where there is no more growth. In figure 2, the economy has settled down in point E. Here, the fraction of an average worker output that is being saved, equals the average required investment to account for the depreciation and decay. This being achieved with k1 amount of capital per worker, the economy produces an output of y1 per worker, the economy produces an output of y1 per worker. A sudden fall in the household saving ratio to s*< s leads to negative net investments F minus E: workers only save a fraction s* of still the same y1, and therefore there is not enough being saved in the economy to be able to finance the decay of the capital stock at k1. As the level k1 cannot be retained by the average worker which is (negative net investments), the output per worker y has to start to decrease. In a dynamic process, the economy will move along the curve y=f(k), that means the amount of output per worker y will decrease, until it settles at a new steady state, where the net invstements equal zero. This being achieved at point E*, the resulting capital intensity is k*, with which an output of y* can be produced with y* being smaller than y1. In other words, a fall in the household ratio leads to a decrease of the amount of capital stock, a closed economy is able to to retain in the long term. The decay in the existing capital stock cannot anymore be completely replaced by investments, as there is not enough money being saved in the economy due to the fall in the household saving ratio. These resulting negative net investments will force the economy to decrease its output to the level y*. Only here, the amount being saved in the economy can again replace the complete decaying capital stock, which means the economy settles at a new long term equilibrium, a new steady state. The fall in the household saving ratio has therefore reduced the productivity of the average worker in the...
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