Consider a Solow economy that begins with a capital stock equal to $300 billion, and suppose its steady-state level of capital is S500 billion. To its pleasant surprise, the economy receives a generous gift of foreign aid in the form of $100 billion worth of capital.
1. Use the Solow diagram, other graphs, and the mathematics of the Solow model to explain what happens to the economy, both immediately and over time. By what proportion does consumption per person initially increase? What happens to consumption in the long run?
2. Suppose instead of starting below its steady state, the economy begins in steady state, with a capital stock equal to $500 billion. Answer part (a) for this case.
3. Summarize what this exercise teaches you about the possible consequences of foreign aid. In this example, does foreign aid exert a long-run effect on the welfare of poor countries? What is the benefit of foreign aid?