Consider two economies – Economy A and Economy B – that are initially in BGE. Both economies have the same production function. Initially, both economies have the same levels of output per worker. Then war between Economy A and Economy B begins. The battles of the war take place only in Economy A, destroying much of its capital stock. In both economies, about 1 percent of the labor force is killed in the war. Assume that there is no change to the saving rate as a result of the war. Assume efficiency (E) is constant in both economies.
(a) After the war ends, is Economy A in BGE? Is Economy B in BGE?
Defend your answers. Draw a graph that shows the determination of the pre-war and post-war K/L and Y/L for Economy A and Economy B. Label everything clearly, using subscript "o" to denote the common pre-war position, subscript "A" to denote postwar economy A and subscript "B" to denote postwar economy B.
(b) Suppose that natural population growth is endogenous: in both economies, natural population growth decreases as output per worker increases. Explain why the war will, therefore, cause the economies of these two countries to diverge. Illustrate your answers in the graph above. Continue using subscripts "A" and "B" to distinguish between the two economies. Use superscript "*" to denote the BGE positions.