Consumption

Abstract: When an economy experiences crisis that reduces the level of human capital stock, such a change should be accompanied by a change in the investment level. Is this always the best thing to do? In an optimal growth model of human capital evolution this paper shows that cutting down investment during crisis may not always be the optimal response to crisis. At certain levels of human capital, maintaining the pre-crisis level of investment is optimal and may be crucial for economic success. *I wish to thank Michael Spagat, Reza Arabsheibani, Andrew Mountford, and all participants in the economics seminars at Royal Holloway for their useful comments and criticisms. 2Introduction In the course of history, various nations of the world have at one time or the other experienced shocks or crisis situations. In the last century alone, the great depression of the 1930s, the oil price shock in the late 1970s and the subsequent foreign debt crisis that rocked emerging nations come readily to mind. Common in many of these situations is the coping strategy employed by the affected countries. Countries in crisis situations often cut back on investment and smooth consumption as much as possible until the crisis subsides. Although consumption takes some of the impact, we observe that investment bears the major burden as shown on table 1. Table 1- GDP per capita, investment share of GDP, consumption share of GD