Consider the Solow Model with the following production function for output Y=AK

Question

Consider the Solow Model with the following production function for output Y=AK1/2 L1/2  

Being at the steady state suppose that climate changes and the global warming reduce the life of physical capital by 20%

i. While in country 0 no counter interventions are implemented, in country 1 the governmetn wants to avoid any short run fluctuation in output and consumption. Which policies could the government implement? Explain

ii. Describe what will happen in the two countries in the short run and in the long run

Explanation / Answer

1. To avoid short run fluctuations in output and consumption, the government should implement expansionary fiscal policy. It can also provide investment tax credit to companies which will help in increasing investment level in the country which will help in overcoming the impact of climate change and global warming on physical capital.

2, This might affect two countries and will lead to reduction in the level of output and consumption as production level in the economy will decline. In the short run production level will not decline much as substitutes of factors of production are available. However, in the long run, without any government intervention, this might lead to reduction in National output of the economy. Thus, government intervention is needed to prevent reduction in the level of output in both the countries.

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