Immediately following the increase in the saving rate, output grows rapidly. As the economy approaches its new steady state, the growth rate:
A) gradually increases.
B) gradually declines.
C) is constant.
D) is negative.
E) None of these answers is correct.

Question

Quizplus · Accepted Answer

When the saving rate increases, investment increases which leads to an increase in capital stock. This increase in capital stock leads to an increase in output in the short run. However, as the economy approaches its new steady state, the growth rate gradually declines and eventually stabilizes. This is because the increase in the capital stock leads to diminishing returns, and thus the marginal product of additional capital declines over time. Therefore, the growth rate gradually declines.

Immediately Following the Increase in the Saving Rate, Output Grows