Question

5. The Solow growth model suggests all countries are converging to a steady state. Describe this steady state and explain why a country will tend to converge to a steady state.

Answer 1

In understanding the Solow model,the steady state is the most important thing.At the steady state investment is equal to depreciation.This implies that all investment in the economy is utilised for the repairment and replacement of the existing capital stock in the economy.As a result of this, no new capital is created and thus the capital stock remains the same and does not grow.

The economy will settle in a steady state because of the fact that the investment curve represents diminishing returns.Production and investment will rise when there is increase in capital.But the rate at which production and investment rise is smaller compared to the larger rate of rise in capital stock . In the Solow model,  diminishing return of capital does not lead to sustained economic growth. With the accumulation of more capital in the economy, depreciation increases but investment and output increases less because of the diminishing marginal product of capital.  Thus the new investment only helps in offsetting depreciation and so the capital stock does not grow.Output stops increasing and the economy converge to a steady state.