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Growth, fluctuations and innovation - Short- and medium-run macro models and growth theory

6 important questions on Growth, fluctuations and innovation - Short- and medium-run macro models and growth theory

Describe the short-run macro model

A Keynesian consumption function and an investment function where investment depends inversely on the real interest rate. The goods market equilibrium is fixed by the equation of planned savings with planned investment.

Describe the paradox of thrift

Higher planned savings means lower aggregate demand because in the short-run model there is no mechanism through which the higher savings translate into higher investment spending. Lower aggregate demand depresses output, and the intention to save more is thwarted as the economy settles at a lower level of output, leaving total savings unchanged and equal to the level of planned investment.

Describe the effect of an increase in the savings rate in the medium-run macro model

The rise in saving would have led to a negative output gap and lower forecast inflation. The central bank would cut the interest rate, thereby shifting the investment function up and the economy would have returned to its medium-run equilibrium.

Describe the heart of the Solow model (introduction)

A production function with diminishing returns to capital which means that the marginal product of capital is positive but declining.

Explain the effect of an increase in the savings rate for the Solow model

The equilibrium capital stock is at the point where the savings curve intersects with the depreciation curve. The capital stock will stay unchanged at this level because the amount of saving and investment in each period is exactly what is required to replace the depreciated capital stock. When the saving rate goes up, the capital stock will increase. There is a more capital-intensive method of production, so output per worker will be higher and the total output in the economy will go up.

Explain the role of the central bank when the saving rate goes up

The central bank must reduce the interest rate in order to stimulate investment. This will prevent output from declining and stimulate investment to make use of the additional savings in the economy. It sets the new interest rate such that r+delta=MPK. The economy will move to equilibrium at the higher output and a more capital intensive method of production.