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# P ROFESSOR X AVIER P RESENTS ...

PROBLEM SET 2

T HIS PROBLEM SET IS DUE ON MONDAY, O CTOBER 7 TH DURING THE LECTURE . Y OU MUST BRING A HARD COPY OF YOUR SOLUTIONS . N O ELECTRONIC SUBMISSIONS . N O LATE P ROBLEM S ETS . A BOVE ALL , H AVE F UN !!!!!

Problem 1.
Consider an economy with an aggregate wage bill of 200 billion dollars and an aggregate GDP of 400 billion. The aggregate GDP growth rate for this economy over the last 10 years was 8 percent (that is ΔY/ Y=0.08) and the growth rates of capital and labor were 5 percent (ΔK/ K=0.05) and 5 percent (ΔL/L=0.05) respectively. • (a) What are the “capital share (α)” and the “labor share (1 − α)”? • (b) What was the growth rate of “A” for this country? • (c) Imagine now that aggregate GDP is the SAME, but the wage bill is 300 billion. What is the growth rate of productivity now if the growth rates of GDP, capital and labor are still .08, 0.05 and 0.05 respectively? Explain intuitively why your answer is or is not different from (b). • (d) Repeat part (b) under the assumption that ΔK/K=0.10. Explain intuitively why your answer is or is not different from (b).

Problem 2.
Consider the Solow-Swan growth model, with a savings rate, s, a depreciation rate, δ , and a population growth rate, n. The production function is given by Y = AK + BK 0.5 L0.5 where A and B are positive constants. Note that this production is a mixture of Romer’s AK model and the neoclassical Cobb-Douglas production function. • (i) Does this production function exhibit constant returns to scale? Explain why. • (ii) Does it exhibit diminishing returns to capital? Explain why. • (iii) Express output per person, y = Y /L, as a function of capital per person, k = K/L. 1

Problem 4. B = 2. the production function would look like the “AK” production function. (Hint: as k goes to inﬁnity. What number does the savings curve approach as k goes to zero? As k goes to inﬁnity. the growth rate converges to some value as time goes to inﬁnity. In your discussion. you may provide examples of each type of goods. Why? • (viii) Imagine that we have two countries with the same parameters (same A. does the ratio y/k approach zero?) • (v) Use the production function in per capita terms to write the fundamental equation of the Solow-Swan model. What is this value? Problem 3. Draw the savings curve and the depreciation curve. will there be positive growth in the long run? Why? • (x) If s = 0. the savings curve approaches a number: what number is that? Is it zero? • (vii) Under these parameters. • (a) If the production function is AK and the savings rate is constant at rate “s”. what would the growth rate of the economy be? • (b) What would be the macroeconomic consequences of increasing the savings rate in this economy? • (c) What would be the consequences of a decrease in fertility in this economy? • (d) Would the consequences of decreasing fertility be UNAMBIGUOUSLY GOOD? • (e) Can human capital grow without bounds? Explain why or why not (make sure you discuss the physical nature of human capital). B. In class we argued that if people could accumulate human as well as physical capital. One of them is rich and the other is poor. Discuss the following economic concepts: (A) Public Good (B) Non-Rival Good (C) Non-Excludable good.• (iv) Write down an expression for y/k as a function of k and graph. Is technology a Rival or non-Rival good? Is it always non-excludable? Discuss the role of excludability as it relates to the incentives may have to develop new ideas.18 and n = 0. • (vi) Suppose ﬁrst that sA < δ + n. and the rates of depreciation and population growth are δ and n respectively. δ = . A = 1. Under these circumstances. • (f) What is the growth rate of the economy (in the absence of technological progress) if human capital cannot grow without bounds? 2 . will there be positive growth in the long run? (Remember that A and B are constants). and n). Draw the savings and depreciation curves. δ.4. Which one of the two will grow faster? Why? Will those two countries eventually catch up? • (ix) Suppose now that sA > δ + n.02. s.

Imagine that the economy is closed. • Imagine instead that aid takes the form of public infrastructures. A is the level of technology. • Does this production function exhibit constant returns to scale? Write down the production function in per capita terms (use the “per capita notation”: y = Y /L. Is there a steady state? Is it unique? What is the steady state capital stock per person. n. and the level of infrastructures per person.Problem 5. where K is physical capital. δ. How does the economy behave after this donation? Is your answer different from before? • Imagine now that instead of aid. as a function of the parameters A. and G is the stock of public infrastructure (G stands for Government infrastructure). machinery) and in particular. n = 0. s. In particular imagine that g increases from g = 8 to g = 27. “g ”. it is the government of the country that increases the stock of infrastructures per person. the capital stock k . s = 0. Assume that an economy has the production function Y = AK 1/3 L1/3 G1/3 . after the aid. L is labor (which we assume to be equal to population). Imagine that the World Bank gives aid to this country. that the saving rate is the constant fraction “s” and the depreciation rate is “δ”.2. Graph the “savings line” and “depreciation line”. δ = 0. • Write down the fundamental equation of Solow-Swan for the GROWTH RATE of capital stock per person. How does the economy behave after this donation? Explain why. Imagine that the amount of infrastructures per person is constant at g = 8. imagine that g remains constant at g = 8 but. • Consider the parameters A = 1. k ∗.09. Population growth is an exogenous constant number “n”. We are going to analyze the consequences of this aid. What happens to this economy in the short term and in the long term? Why do you think governments in developing countries do not continuously invest in infrastructures? 3 . in this economy? Imagine that the economy is stuck at the steady state with no growth.01. the economy has a stock of capital equal to k ∗ +1. k .k = K/L and g = G/L). • Imagine that the aid takes the form of physical capital k (for example.

75 × 0. (d) Now. grow at the same rate. (1 − α) = 0. Then.25 × 0. Then.1 − 0. (1 − α) × 0. α does not matter. Then.05. = = 200 = 0.Solutions (1) Growth Accounting (a) You should remember that (1 − α) is the share of GDP that is used to pay to workers.5 ∆A A ∆A A = = = ∆Y ∆K ∆L −α − (1 − α) Y K L 0. given that the wage bill. and therefore.5 × 0.5 × 0.03 A The intuition says that.Economics W3213. For any weight.5 400 0. or technology experienced a rate of growth of 3%. productivity growth has been less important in this economy. ∆A = 0. this factor is explaining a bigger part of the growth of GDP.05 − 0. (c) In this case. Then.08 − 0.5 × 0.005 A Given that the rate of growth of GDP is still the same.5 × 0. ∆A = 0. we observe that one of the rival factors has grown faster than before. total factor productivity.05 = 0.03 So. given that both rival inputs.05 = 0.08 − 0. Intermediate Macro Problem Set 2 .05 = 0.05 + α × 0.05 − 0. Y = 400.05 0. it does not matter which is the weight that we assign to them. wL = 200 and GDP. capital and labor.08 − 0. and since they grow at the same rate. (1 − α) α (b) You have to use the Solow Residual equation.75. 1 .

(2) Diminishing Returns (Please. When you have to show diminishing returns. and it is not very accurate. see attached) IMPORTANT CLARIFICATION The solutions that I attach now come from past years. I am going to write the proper solution here for part (b). Even if in the Recitations we start using that in order to give you the intuition. the argument in the solutions is quite naive. IN THE EXAM YOU SHOULD TAKE THE DERIVATIVES!!! Then. ∂Y 1 = A + BK −1/2 L1/2 > 0 ∂K 2 −1 1 ∂2Y 1 = × × BK −3/2 L1/2 = − BK −3/2 L1/2 < 0 2 ∂K 2 2 4 Therefore. In this case. I agree with them 99% of the times. we have diminishing returns to the marginal product of capital. So. for this model. there is something very important that I and the other TAs for the class do not agree with. you should remember that we have always used ﬁrst and second derivatives to solve for this. 2 .

0. this production function exhibits constant returns to scale (CRS).20. Divide the expression for y from the previous section by k: When k becomes bigger and bigger. output will less than double: A(2K) + B(2K)1/2L1/2 = 2AK + 21/2BK1/2L1/2 < 2(AK + BK1/2L1/2) = 2Y.41. Hence.1 . output also doubles: A(2K) + B(2K)1/2(2L)1/2 = 2AK + B21/2K1/221/2L1/2 = 2(AK + BK1/2L1/2) = 2Y.80. I Can't Wait to be King i. Hence. In both cases capital and labor are growing at the same rate. We say that the limit of y/k as k goes to infinity is A: .1 . output must be growing at the same rate. i. 2.1 = 0. The constant B divided by a bigger and bigger number approaches 0. If we double only capital without doubling labor. Since the Cobb-Douglas function exhibits constant returns to scale. . the square root of k also becomes bigger and bigger. ii. no growth is attributed to changes in productivity...(A/A) = 0. because 21/2 = 1. when k goes to infinity.e.0. iii. If we double both capital and labor. the expression for y/k approaches A. Hence. Substitute an expression for total output Y into the defintion of output per person y = Y/L: iv.

v. As k goes to 0. the savings curve and the depreciation and population growth line ( + n) must cross once and only once. the savings curve sy/k approaches infinity as usual because the constant B is divided by a smaller and smaller number: As k goes to infinity. Growth stops in the long run because the savings curve and the depreciation and population . vii.e. sy/k approaches sA because y/k approaches A and gets multiplied by a constant s: Since sA < + n by assumption. into the expression for the growth rate of capital per person: vi. i. Substitute an expression for y/k into the Solow-Swan fundamental equation.

Examples of non-rival goods are cable TV. Hakuna Matata A. rival and nonexcludable (fish in the sea. national parks. and basic mathematical formulas.0. computer hardware.02) = 0.(0.growth line intersect once and only once at the steady state level of capital per person k*. Examples of non-excludable goods are fish in the sea. Therefore. eventually they will converge to the same steady state.). Growth rate converges to 20 percent per year in the long run. Substituting numerical values. growth in the long run is positive.) Examples of public goods and services are national defense. which is usually subject to "the Tragedy of the Commons"). We know that the savings curve converges to sA in the long run. Goods can be rival and excludable (most everyday goods such as cookies. ix. as seen in the diagram above. x. computer software. we get k/k = sA . 3.2 = 0. Although there are still diminishing returns to capital and hence the savings curve is downward-sloping. Because of diminishing returns to capital savings will be just enough to compensate for depreciation and population growth in the long run. and mathematical formulas. (For definitions see parts (B) and (C) below. A public good is both non-rival and non-excludable. the savings curve is always above the depreciation and population growth line as shown below.2. The model predicts conditional convergence because if a poor country grows faster than a rich one with the same parameters. If sA > + n.18 + 0.( + n) = 0. non-rival . housing. lighthouses. and basic mathematical formulas. C. viii. B. etc.41 . the growth rate k/k converges to sA . assuming that sA < + n.( + n) in the long run.4 . depreciation and population growth are low enough to permit long-run growth. Therefore. A good is non-excludable if one party cannot prevent other parties from using it. Notice that at least four different combinations are possible. A non-rival good is a good that can be used by more than one person at the same time without reducing each other's utility. The poor country will grow faster than the rich one.

Some non-excludable goods. for instance. Similarly. Technology is a non-rival good. computer software is non-rival. are subject to congestion and are therefore somewhat rival. For example. but its excludability depends on copyright law enforcement. It is also possible to come up with examples in between these categories. Other countries may have the legal framework mostly in place but lack resources or political will for law enforcement. It gives inventors and firms sufficient incentives to invest in research and development (R&D) and develop new ideas. or non-rival and non-excludable (basic science. such as malaria. An example that we saw in class was the decision of South Africa not to recognize patents for AIDS antiretroviral drugs and to allow production of their generic versions.and excludable (cable TV). that are primarily prevalent in poor countries. but it may or may not be excludable. in the majority of developed countries a system of patents and intellectual property rights (IPR) gives the inventor of an idea exclusive right to produce the commodity for a certain number of years or to collect royalties from those who produce it. An example is software pirating in the former Soviet Union and many other countries. Thus pharmaceutical companies that invented the drugs would not be able to receive any return on their investment in R&D from sales in South Africa. books are rival but may or may not be excludable. . Thus technology is excludable in these countries. when countries don't respect patents officially. at least for the number of years specified in the patent. This creates a disincentive for them to develop similar drugs for diseases. which is called a public good). For instance. But technology may nonexcludable. such as toll-free roads.

since people want to equate the returns of physical capital to the returns of human capital (if not. the production function becomes. which provides us with the rate of growth of capital per capita. In per capita terms. ¯ (1−α) Y = AK α H 1 . holding mortality and net migration constant. it can be written as y = Ak . if the fertility rate goes down. once H reaches its bound. student time). Then. then this economy will experience positive growth forever • If sA < n + δ . a) Given that we have an AK production function. Then. the BMW stays with his children. human capital must remain constant at that maximum level. e) Human capital has a number of characteristics: • First. At worst. • And ﬁnally. then this economy will experience negative growth forever b) An increase in s will increase the rate of growth if sA > n + δ or make it less negative if sA < n + δ c) Remember that n = f ertility − mortality + netmigration. human capital accumulation requires time (especially. it cannot be unambigously good. d) Too much of a decrease in n means that in the long run there could be shortage of labor force to the economy. and it cannot grow more. and we have the same consequences as in part b). there are investment opportunities in one of the types of capital). We obtain the AK production function assuming that K and H grow at the same rate. His skills as a doctor die with him). lifetimes are ﬁnite so there is a ﬁnite amount of time within which skills need to be. it cannot grow without bounds. This means that there is a limited amount of skills that people in the economy can acquire with a constant technology and within a lifetime. negative population growth rate by way of decreasing fertility rate leads to 0 population and the country disappears and so. γk = sA − (n + δ ) • If sA > n + δ . Y = AK . • Third. n will decrease. everybody is born with zero human capital or skill. Then. Once that point is reached. However. Remember that we can get the AK production function from Y = AK α H (1−α) where H = hL.Problem 4. unlike physical capital skills cannot be transmitted from parents to children (when a parent dies. the fundamental equation. • Second.

more machines are breaking than the new machines that the country buys. A(λK )1/3 (λL)1/3 (λG)1/3 = λAK 1/3 L1/3 G1/3 = λY b) 1/3 1/3 y=Y g L = Ak c) ∆k y = s − (n + δ ) = sAk −2/3 g 1/3 − (n + δ ) k k d) (The graph is the standard one). Yes. and since the savings curve is always decreasing. The limits of the savings curve are inﬁnity and zero. The reason is that we have diminishing returns to capital. This will imply that for a given level of public infrastructures. a) Yes.1 0. there exists one steady state and it is unique.¯ is ﬁxed. In per capita terms. where H ¯ (1−α) y = Ak α h ¯ (1−α) which is constant. the curves will not shift. Then. the country will experience a negative growth rate. Thus.4k −2/3 = = = = 0 0. Problem 5. to get ˜ = Ah Call A ˜ α y = Ak which is a Cobb-Douglas production function in per capita terms. (Graph!!) g) 2 . so that in the long run the rate of growth is 0. e) Plug the numbers. with k + 1 units of capital. because we have again diminishing marginal product to capital. On average. that steady state is unique. so that the savings curve will be decreasing too. 0. However. the depreciation line will be higher than the savings curve. so that there will be for sure one cross point. we go back to the normal Solow Model.1 4 43/2 = 8 k 2/3 k f) In this case. the average product of capital will decreasing.2k −2/3 81/3 − 0.

The problem is that developing countries usually don’t have the resources to build public infrastructures. Suddenly. They will also need to tax the citizens. and the country experiences positive growth in capital per capita. which will also distort the economy (and also. so a tax increase might reduce consumption a lot) 3 . but the steady state will be bigger than before the change. the growth rate will be zero.This will shift the savings curve to the right. In the long run. people can barely save. in developing countries. h) The eﬀect is the same as in part g). the savings curve is higher than the depreciation line at the steady state.