The Transition to the Golden Rule Steady State

So far we have assumed that we can choose the economy's steady state and jump there immediately. In this case, the policymaker would choose the Golden Rule steady state to maximise consumption.

We now suppose that the economy is in a steady state other than the Golden Rule. We will examine what happens to consumption, investment and capital when then economy transitions to another steady state.

The economy currently has less capital than in the Golden Rule steady state, which we can reach by increasing the saving rate:

The increase in the saving rate at $t=0$ causes an immediate fall in consumption and rise in investment (before the capital stock starts to increase). As investment has increased whilst depreciation is constant, the capital stock is no longer in a steady state. As the capital stock increases, so does output, consumption and investment. After around 5 periods, consumption exceeds the initial steady state level. Since the initial saving rate was below the Golden Rule, the increase in saving eventually leads to a higher level of consumption.

Since the new steady state level of consumption is higher than the initial level, the increase in saving raises economic welfare. However, achieving the new Golden Rule steady state requires an initial period of reduced consumption.

We now consider the case in which the economy begins in a steady state with more capital than in the Golden Rule steady state (click here to set the economy to this state). In this case, the policymaker should reduce the saving rate to diminish the steady state capital stock:

The reduction in the saving rate at $t=0$ causes an immediate increase in consumption and an equal decrease in investment. Because investment and depreciation were equal in the initial steady state, investment will now be less than depreciation. Hence, the capial stock falls, leading to a reduction in output, consumption and investment. The economy reaches the Golden Rule steady state, in which consumption is higher than it was before the change in the saving rate, even though output and investment are lower.

Unlike when we started with too little capital, consumption is higher not only in the new steady state but also along the entire path to it.