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Page 1 of 19

Problem Set II

Macroeconomics

Academic Year 2012-2013 – BIEMF

Solutions

(To exercises NOT discussed in class, Part 3)

CHAPTERS 6 & 18

The IS-LM model and economic policy in an open economy

Exercise 64 – Equilibrium with and without foreign trade

In country Gamma only the goods market exists. The consumption function is given by

the following expression: C = 100 + 0.75(Y – tY), where Y is the national income and tY

are the taxes citizens pay to the government. The tax rate, t, is equal to 20%.

Government spending (G) is equal to 200 and investments (I) amount to 500.

a) Compute equilibrium income, indicating both the value of the multiplier and of the

autonomous spending.

b) Suppose now that the economy is open to foreign trade. Net exports are given by: NX

= 100 – 0.2Y. Compute the equilibrium income again. Do the autonomous spending

and the multiplier increase or decrease, compared to part a)? Explain.

Solution:

a) From the equilibrium condition Y = C + I + G, by substituting and solving, we can

compute equilibrium income:

Y =

100 + 500 + 200

1! c 1! t ( )

=

800

1! 0.75 " 0.80

= 2000

Autonomous spending A appears at the numerator of the previous expression and is

equal to 800. The multiplier is: 1/[1 – c(1-t)] = 2.5.

b) The new equilibrium condition is Y = C + I + G+ NX. By substituting and solving,

equilibrium income becomes:

Y =

100 + 500 + 200 +100

1! c 1! t ( ) + 0.2

=

900

1! 0.75 " 0.80 + 0.2

=1500

Autonomous spending A is now bigger and equal to 900, since it also includes the

component of net exports which does not depend from income (100). On the contrary,

the multiplier is smaller and equal to 1/[1 – c(1-t) + 0.2] = 1.66. Part of any given in-

crease in autonomous spending will fall on foreign goods. This will positively affect

foreign - rather than domestic - income.

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 2 of 19

Exercise 65 – Equilibrium with and without foreign trade

a) Consider country XYZ, which is open to foreign trade in goods, services and financial

assets, and whose exchange rate is fixed. Suppose that, starting from an initial equi-

librium described by the open economy IS!LM model and by the interest rate parity

condition, the foreign interest rate increases. What is the effect on the production and

the interest rate of country XYZ, if the country wants to keep the exchange rate fixed?

Why? Explain in detail.

b) Can the Central Bank implement a monetary policy in order to offset the effects on

output of the increased foreign interest rate? Why or why not?

Solution:

a) Ceteris paribus, when the foreign interest rate increases, foreign bonds become more

attractive and the exchange rate tends to depreciate. In order to prevent such deprecia-

tion from taking place, the Central Bank of country XYZ must decrease M so as to

make the domestic interest rate increase exactly as much as the foreign interest rate

has increased. The resulting monetary contraction leads to a decrease in equilibrium

output.

b) In order to avoid the decrease in output, the Central Bank could implement an expan-

sionary monetary policy. However, by doing that, the Central Bank would allow the

domestic interest rate to be lower than the foreign interest rate. In such a case, the ex-

change rate could not be kept fixed and the currency of country XYZ would depreciate.

In the case of fixed exchange rates, monetary policy cannot be used to pursue domestic

output goals. Monetary policy can be used only to keep the exchange rate fixed.

Exercise 66 –– Reduction in foreign output

Consider a country Alfa with an open goods market, financial markets and a flexible ex-

change rate regime. Domestic and foreign prices are constant and, for simplicity, assume

they are equal (P = P* =1). Using graphs for the "IS-LM model for the open economy" /

"the interest rate parity", show the initial equilibrium. Indicate with i0, Y0, and E0, the

values of interest rate, output and exchange rate in that equilibrium. Assume now that

there is a reduction in the foreign output Y*, for the given foreign interest rate i* and

the given values of the other exogenous variables. Study graphically, and explain in de-

tail, the effect of such an exogenous reduction of Y* on the equilibrium levels of output,

interest rate, exchange rate and net exports of Alfa. How would your answer change if Al-

fa had a fixed exchange rate regime and if its Central bank would have intervened to

maintain the exchange rate constant at E0?

Solution:

The reduction of foreign income reduces net exports (NX) and moves the IS to the left.

Under flexible exchange rates, the new equilibrium is at point 1, with a lower income (the

decline in net exports reduces aggregate demand and thus the production) and a lower

interest rate (the reduction in income leads to less demand for money; for given money

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 3 of 19

supply, the equilibrium interest rate must be lower). Given that the domestic interest rate

has been reduced, that the foreign interest rate has remained unchanged and the expected

future exchange rate did not vary, the interest rate parity implies a depreciation of the

exchange rate. In point 1, it is not clear whether NX falls or increases (NX tend to worsen

due to a reduction of foreign income, but the exchange rate depreciation and the decline of

income tend to have a positive effect on NX).

If the country had a fixed exchange rate regime, the central bank would be obliged to in-

tervene in the foreign exchange market (by buying domestic currency and selling foreign

currency) to avoid the depreciation of the exchange rate. The central bank's intervention

is reflected in a reduction of money supply and a shift to the left of the LM until it reaches

LM2. In point 2, which is the new equilibrium under fixed exchange rates, the domestic

interest rate and exchange rate are unchanged, the income has decreased more than un-

der flexible exchange rates (due to the reduction of M that was necessary in order to keep

the exchange rate unchanged). Finally, since at point 2 the domestic interest rate is un-

changed, the impact on Y and NX of the fall in Y* is the same as the one studied by look-

ing at the goods market only (Chapter 18, par. 1.2): Y falls and NX worsen.

Exercise 67 –– Some definitions …

Explain briefly but rigorously what we mean by:

i. Real exchange rate;

ii. Marshall-Lerner condition;

Solution:

Real Exchange rate: ! = (EP)/P

*

is the relative price of goods produced domestically in

terms of foreign goods. An increase of ! (a real appreciation) implies a loss of competitive-

ness of national products, and therefore a reduction of exports and an increase of imports.

Marshall-Lerner Condition: Condition under which a real depreciation generates an in-

crease in net exports. Consider a depreciation, the effects of an increase in quantities ex-

ported and a reduction in quantities imported are stronger than the effect of the change in

real prices (remember that a real depreciation makes foreign goods more expensive in

terms of domestic goods).

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 4 of 19

Exercise 68 –– Fixed and flexible exchange rates

The world economy has 2 countries: country A (domestic) and country B (foreign), and it

is characterized with perfect capital mobility, fixed prices, and a fixed exchanges rate.

a) Suppose that the interest rate in country B increases after Its Central Bank adopts a

contractionary monetary policy. Describe and represent graphically (with the IS-LM

model) the effects on output and interest rate in country A.

b) Suppose now that countries are under a flexible exchange rate regime. What are the

effects of an increase of the foreign interest rate on the domestic level of output and

prices? Explain your answer and represent it graphically Explain the difference with

the results in part a).

Solution:

a) Because of an increase in the foreign interest rate (i*), financial activities in country B

are more profitable. This causes a capital outflow from country A to country B. The

domestic interest rate is lower than the foreign one. The exchange rate will depreciate.

Nevertheless, because exchange rates are fixed, country A's central bank intervenes re-

ducing money supply. LM shifts leftward until point B where we have again interest

rate parity. The interest rate is increased and the level of production is decreased.

b) An increase in the foreign interest rate causes, as above, an out flow of capital from

country A to country B. But in this case, the exchange rate can depreciate. This induces

an increase in the competitiveness of country A and thus an increase of the national

goods demand. IS curve shifts rightward. The domestic interest rate and production

increases. Thus a monetary contraction in a foreign country has an expansionary effect

on the domestic economy. In the case of fixed exchange rates, a monetary contraction in

a foreign country decreases the level of production both domestic than foreign.

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 5 of 19

Exercise 69 –– Fiscal policy and exchange rate

Happyland is an economy open to international trade in which financial markets do not

exist. Assume that domestic and foreign prices are constant.

a) Write the expression of net exports in terms of domestic goods, NX, defining all the

variables that appear in it. Does a depreciation of the real exchange rate necessarily

imply an improvement in net exports? Explain.

b) Starting from an equilibrium in the goods market and a trade balance, indicate which

mix of fiscal policy and exchange rate would allow Happyland to reach a new equilib-

rium characterized by an unchanged level of income and a trade surplus. Explain

which assumption you are making about the impact of changes in the exchange rate

on net exports, and illustrate graphically the effects of the combination of economic

policies that you propose.

Solution:

a) The expression of net exports is:

NX = X Y

*

,!

( )

+," ( )

"

1

!

IM Y,!

( )

+,+ ( )

If both exports and imports are not sensitive to the exchange rate, a variation of the ex-

change rate would affect only the component1/!. In particular, in the case of a depre-

ciation, net exports would decrease rather than increase.

b) In order to maintain the equilibrium income unchanged and create a trade surplus, it

is necessary to adopt a restrictive fiscal policy and simultaneously to generate a depre-

ciation of the exchange rate. Because of the restrictive fiscal policy, DD and ZZ shift

down by the same amount. Assuming that the Marshal/Lerner condition holds, a de-

preciation of the exchange rate improves net exports, hence both the NX and the ZZ

shift upwards (in the figure, ZZ returns to its original position). The income level for

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 6 of 19

which the trade balance is in equilibrium increases, while the equilibrium level of in-

come remains unchanged.

Exercise 70 –– Reduction in foreign prices

Consider an economy open to trade, where prices are constant and where only the goods

market exists. Assume that the country we are considering is initially in equilibrium on

the goods market and trade is balanced.

a) Draw in the two graphs below the initial equilibrium and show how it changes due to

a generalized reduction in foreign prices, P*. In particular, explain if and why income

and net exports change in the new equilibrium.

b) The government wants to restore the initial level of income and trade balance. In or-

der to achieve such objectives, the economist Albert proposes to change net taxes,

while the economist Tim suggests to intervene on exchange rates. Explain if and why

you agree with Albert (defining in this case whether net taxes should be increased or

decreased) or with Tim (explaining if in this case, the government should generate' an

appreciation or a depreciation of the exchange rate) and represent in the graph above

the consequences of the intervention you propose.

Solution:

a) A reduction in foreign prices increase the real exchange rate ! =EP/P*. The ZZ shifts

down as well as the NX because, given Y, net exports decrease. This reduction in net

exports causes a reduction in AD and equilibrium production. Although Y decreases,

in the new equilibrium net exports will be lower, as shown in the graph below - there

will be a trade deficit.

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 7 of 19

b) A reduction of net taxes can lead income back to the higher initial level and precisely

for this reason it would also worsen further the trade deficit. In order to restore the ini-

tial level of income and the trade balance it is necessary to intervene on exchange rates.

More specifically, the government should generate a depreciation of nominal exchange

rate E in order to restore the initial real exchange rate, so that ZZ and NX go back to

their initial position.

Exercise 71 –– True or false?

Explain whether the following statement is true or false. Motivate your answer in a brief

but rigorous way, by making explicit reference to the relevant theory. Lack of proper ex-

planations will result in zero points.

Assume that the government of a country thinks that output is too low. The country has

a trade surplus. If the government aims at increasing Y, it should increase T and/or de-

preciate the real exchange rate.

Solution:

False the first part, true the second. In order to increase output, the government can either

increase G or decrease T. So doing, the demand for national goods increases, the ZZ line

shifts upwards and output increases. Moreover, we could also add that since Y has in-

creases, 1M increase as well and thus NX decreases. In order to increase output, the gov-

ernment can also depreciate the real exchange rate. If the Marshall-Lerner condition is

satisfied, the real depreciation increases NX, thus the demand for national goods increas-

es. The ZZ line shifts upwards and output increases.

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 8 of 19

Exercise 72 –– True or false?

Explain whether the following statement is true or false. Motivate your answer in a brief

but rigorous way, by making explicit reference to the relevant theory. Lack of proper ex-

planations will result in zero points.

In case the government of a country wants to increase output, its trade partners would

prefer that the government chooses an expansionary monetary policy rather than the

depreciation of the exchange rate.

Solution:

True. The trade partners of the country prefer an increase in G or a decrease in T because

such a policy makes the trade surplus of the country decrease, and consequently, makes

the trade deficits of the trade partners decrease. On the contrary, a depreciation would

further increase the trade surplus of the country.

CHAPTERS 11 & 12

Facts of growth, saving, capital accumulation, and output

Exercise 73 – The Facts of Growth

Consider the following production function: Y = F(K, N) = K

"

N

1–

"

, where " < 1.

a) Define how much Y would vary if both factors of production are multiplied by a con-

stant #. Describe this property of the production function.

b) By using the result in point a), compute how much Y/N would vary if both factors of

production are multiplied by a constant #.

c) Divide both Y and the right side of the production function equation by N. What de-

termines the level of output per worker Y/N?

d) By using the expression found in point c, explain how Y/N varies when both factors of

production are multiplied by a constant #.

Solution:

a) Y = (#K)

"

(#N)

1–

"

= #

"

+1––

"

K

"

N

1–

"

= #K

"

N

1–

"

= #Y. Y is multiplied for the same constant #.

The production function exhibits constant return to scale.

b) Using the result of a, Y/N = #Y/#N = Y/N. The output per worker does not vary.

c) Y/N = (K

"

N

1–

"

)/N = (K/N)

"

. Y/N is defined by the level of K/N.

d) Y/N = (#K/#N)

"

/ = (K/N)

"

. Since Y/N is defined by the level of capital per worker and

the level of capital per worker does not vary, Y/N remains constant.

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 9 of 19

Exercise 74 – The Facts of Growth

Use the following graph to answer the following questions:

a) What can you say about the growth rate of out per capita in country B? What could be

a reason for the line to shift upwards?

b) What is the meaning of the slope of the line? What could be a reason for the slope to

increase? In which case would the line be flat?

Solution:

a) In country B, Y/N is growing over time. If K/N increases, then the curve will shift

upwards, since a higher level of K/N would bring about a higher level of Y/N in each

period.

b) The slope represents the growth rate of output per capita. It is the technological growth

rate. Thus, the slope would increase if the technological growth rate increased. The

line is horizontal when there is no growth at all.

Exercise 75 – Solow model without technological progress

a) Using the Solow growth model without technical progress and constant population,

define the golden rule level of capital.

b) Given the production function Y = K

1/2

N

1/2

, calculate the saving rate associated with

the golden rule.

Solution:

a) The golden rule level of capital is that level of capital associated with the saving rate

that maximizes consumption in the long run.

b) Given the production function Y = K

1/2

N

1/2

we obtain that Y/N = (K/N)

1/2

; so the

steady state condition s(Y/N) = $(K/N) becomes s(K/N)

1/2

= $(K/N). We have then

K/N = (s/$)

2

and Y/N = s/$. Consumption equals production minus savings, C/N =

Y/N – sf(K/N), from which it derives that C/N = Y/N – $(K/N), i.e. C/N = s/$ –

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 10 of 19

$(s/$)

2

= s(1 – s)/$. Applying the maximizing condition for consumption dC/ds = 0,

we obtain that consumption is at its maximum when (1 – 2s) = 0, i.e. when s = 0.5

Exercise 76 – Solow model without technological progress

a) Consider the Solow growth model without technological growth. The production

function is Y = K

3/4

N

1/4

, and the depreciation rate, $, is 0.1. Compute the saving rate,

s, such that in the steady state the capital per capita is equal to 100. Represent

graphically the steady state.

b) Suppose that the marginal propensity to consume decreases. What happens to capital

per capita and output per capita in the steady state? Explain your answer and

represent graphically the differences with respect to the steady state in point a).

Solution:

a) Output per worker is (Y/N) = (K/N)

3/4

= 100

3/4

. In steady state output and capital per

worker are constant from the condition:

sf

K

N

!

"

#

$

%

&

= '

K

N

( s100

3/4

= 0.1)100

From this equilibrium saving rate is s

*

= 0.32.

b) A reduction of marginal propensity to consume implies an increase in the saving rate

from s to s', the investment curve moves upward. At point E savings per worker is

greater than the capital per worker, the accumulated capital grows until it restores the

balance at the point E', where K'/N is again steady but at a higher level.

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 11 of 19

Exercise 79 –Solow without technological progress and constant population

Consider the Solow model without technological progress and without population

growth.

a) Assume that the usual assumptions about the aggregate production function are val-

id. Indicate with s the savings rate. Write down the equilibrium condition for the

goods market. From this condition, derive the expression for the relationship between

the change of capital per capita, investment per capita and depreciation per capita,

which is the fundamental equation of the Solow model. Finally, show in the graph the

long run equilibrium. Indicate clearly both capital per capita and output per capita in

the steady state.

b) Explain what the “golden rule level of capital per capita” means. Now consider the

following statement: “Since a reduction in savings rate, s, reduces steady state output

per capita (Y*/N), then a reduction in s will always also cause a reduction in the

steady state level of consumption per capita C*/N”. Do you agree? Explain your an-

swer using intuition.

Solution:

a) From the goods market equilibrium condition: From the goods market equilibrium

condition: !

!

! !

!

! following the assumption that savings are proportional to output,

then dividing both sides by N and using the assumption that the production function

has constant returns to scale, you get:

K

t +1

N

!

K

t

N

= sf (

K

t

N

) !"

K

t

N

Both terms on the right hand side of the equation are shown in the figure. The produc-

tion function is shown in ‘per capita’ terms. The steady state values are indicated with

an *.

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 12 of 19

b) The statement is false. The “golden rule level of capital per capita” is the level of capi-

tal per capita K/N, which maximizes consumption in the steady state. While it is true

that a reduction of the savings rate always reduces capital and production in the

steady state, consumption per capita is not a monotone function of the savings rate. In

particular, a reduction in the savings rate will necessarily lead to a reduction in con-

sumption only if the level of capital per capita was initially below the golden rule level.

If instead K/N was higher than its golden rule level, a reduction in s may increase

C*/N. In fact, on the one hand, a reduction in s will lead to a steady state in which

K*/N and Y*/N are lower and less resources are available for consumption; on the

other hand, however, in the new steady state fewer resources will be required to keep

the level of capital constant, so the amount of output available for consumption in-

creases. If K*/N was initially lower than the golden rule level of capital, the first effect

prevails. If instead K*/N was larger than the golden rule level, the second effect can

dominate the first and C*/N can increase as s falls.

Exercise 80 – Solow model with constant population

The production function of an economy is given by: Y = K

1/3

N

2/3

. The population of the

economy is constant, the saving rate is s = 0.9 and the depreciation rate is " = 0.3. As-

sume that in the steady state capital per capita and output per capita are 27 and 3 .

a) How do output per capita (Y/N) and capital per capita (K/N) in steady state change if

the depreciation rate falls to s' = 0.6? Represent graphically the new equilibrium.

b) Starting now from the same situation as in point a), suppose that the depreciation

rate falls to $ = 0.2. How do output per capita and capital per capita in steady state

change? Show graphically the new steady state using the previous graph.

Solution:

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 13 of 19

a) In steady state the following condition holds: sf(K/N) = $(K/N). The production func-

tion per capita is given by: Y/N = f(K/N) = (K/N)

1/3

. By substituting the new saving

rate in the equilibrium condition, we get:

2/3 3/ 2

( / ) 0, 6 / 0, 3 / 2 8 K N K N = ! = =

( )

3 1

*

1/3

1/3

2 3

/ / ( 8) 2 2 Y N K N = = = = .

Given the reduction in s, the level of depreciation of capital exceeds the investment.

Hence, capital per capita and output per capita in steady-state fall. Graphically, the

investment curve shifts downward (s’f(K/N)) and the new equilibrium level corre-

sponds to point B in the graph with lower Y/N and K/N.

b) If the depreciation rate falls from ! = 0.3 to ! = 0.2, capital depreciates less or equiva-

lently, it accumulates faster. Substituting the new level of depreciation in the equilib-

rium condition we obtain:

1/3 3/ 2

0, 6( / ) 0, 2( / ) / 3 27 K N K N K N = ! = =

( )

1/3

/ / 3 Y N K N = =

This brings us back to the initial steady state level (point A). Graphically, the deprecia-

tion line shifts downward until it reaches new steady state level K/N and Y/N corre-

sponding to point A.

Exercise 83 – Capital and output per capita in the steady state

Consider two countries M and C characterized by the following equations:

• Production functions: y

M

= 5k

M

1/2

; y

C

=10k

C

1/2

(y and k are output and capital per capita for each country)

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 14 of 19

• Saving rates: 1 . 0 =

M

s ; 05 . 0 =

C

s

• Depreciation rates: 05 . 0 = =

C M

! !

a) Define and compute capital and output per capita in the steady state in both coun-

tries. Compare and explain the difference between the two.

b) Which saving rate in country M would allow it to have the same output per capita in

steady state as country C? Explain the adjustment process until the new steady

state.

Solution:

a) The steady state capital and output per worker are the values which the economy con-

verges in the long run or a situation in which both variables are constant. The condi-

tion of equilibrium state is: sf(k) = $(k).

In country M we have 0.1! 5k

M

1/2

= 0.05k

M

"k

M

=100 . Output per worker will be yM =

5!100

1/2

= 50.

Instead in country C we have 0.05 !10k

C

1/2

= 0.05k

C

"k

C

=100 . Output per worker

will be yC = 10!100

1/2

= 100.

Although the country C is characterized by a lower savings rate than the country M,

the income is double while the capital per worker is equal in the two countries. At the

steady state income per worker depends positively to technology/production function

and the saving rate. The saving rate is lower in C, but having better production tech-

nology C compensates having less saving, so the income is higher.

b) So that M could reach a level of income per worker equals to the one in C, the following

condition must be satisfied:

y

M

= 5k

M

1/2

=100

Or the capital per worker in the economic system should be kM = 400. The saving rate

compatible with this level of capital per employee will be:

s

M

! 5k

M

1/2

= 0.05k

M

" s

M

=

0.05k

M

1/2

5

=

0.05! 400 ( )

1/2

5

= 0.2

The increase in the saving rate in the country M causes an upward shift of saving

function. In initial equilibrium there is an excess of savings per worker that causes a

progressive increase in both the capital per worker and the output per worker. The ad-

justment ends when the capital per worker reaches the value 400 and the output per

worker is 100, thus defining the new steady state of the economy. In the process of ad-

justment the rate of output growth per worker is positive and it turns back to zero only

when economy reaches the new steady state.

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 15 of 19

Exercise 84 –– True or false?

Explain whether the following statement is true or false. Motivate your answer in a brief

but rigorous way, by making explicit reference to the relevant theory.

“The figure below plots for various countries the level of output per capita around 1885

against their growth rate in the period 1885-1994. The clear negative relationship sug-

gests that those countries with lower GDP per capita grew faster than those having

higher GDP per capita, hence providing evidence against the Solow model." Illustrate

your answer with the help of a simple Solow model (with no technological change) dia-

gram and/or the law of capital accumulation.

Solution:

False. The negative relationship in the plot indeed suggests that those countries with low-

er GDP per capita grew faster than those having higher GDP per capita, but this is one of

the predictions of the Solow model. If we assume that all countries have similar technolo-

gy (i.e. f(.)), saving rates (s) and depreciation rates (!), those that are initially poorer (la-

beled with P in the graph) will have a higher marginal productivity of capital per worker

and hence grow faster than richer countries (labeled with R in the graph). They will all be

going to the same steady state K*/N (that is, they will converge to the same equilibrium),

but at decreasing speed. This can be also seen in the dynamic equation of capital accumu-

lation, as given the diminishing returns to capital per worker, capital accumulation will

be larger in poorer countries, hence leading to larger changes in output per worker.

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 16 of 19

CHAPTER 13

Technological progress and growth

Exercise 87 – Steady state equilibrium with technological progress

Consider the equation describing the steady state equilibrium in an economy with tech-

nological progress.

a) Suppose the saving rate falls. Show graphically what happens to the steady state lev-

els of capital per effective worker and output per effective worker. Explain what hap-

pens to the growth rate of output per effective worker, the growth rate of output per

worker and the growth rate of output.

b) Now consider that the saving rate did not change but the rate of technological pro-

gress increased. Show graphically what happens to the steady state levels of capital

per effective worker and output per effective worker. Explain what happens to the

growth rate of output per effective worker, the growth rate of output per worker and

the growth rate of output.

Solution:

a) The saving rate decreases. We use s’ to refer to the new saving rate. In general, lower

saving leads to lower investment and a lower capital accumulation. In the steady state

we have that

! s f

K

AN

"

#

$

%

&

'

= ( + g

A

+ g

N

( )

K

AN

The decrease in the saving rate from s to s’ implies that investment is now lower.

Graphically, the saving function shifted downward. Corresponding to the old steady

state level of capital per worker now we have a required investment higher than the

saving; consequently capital per effective worker decreases until the economy reaches

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 17 of 19

its new steady state where the required investment is again equal to saving. During the

adjustment period the economy undergoes a period of negative growth. In the new

equilibrium capital per effective worker and output per effective worker are lower and

their growth rate is again zero. The growth rate of output in steady state is not affected

by the decrease in saving: it still grows at a rate equal to the sum of the growth rate of

technological progress and population growth rate. Also the steady state growth rate of

output per worker is not affected by the decrease in saving: it still grows at the same

rate as technological progress.

b) The growth rate of technological progress grows from gA to gA’. This implies that sav-

ing is below the required investment. Since the following condition must hold in steady

state:

sf

K

AN

!

"

#

$

%

&

= ' + ( g

A

+ g

N

( )

K

AN

there will be a temporary reduction in the level of capital per effective worker, until the

economy reaches its new steady state, where capita per effective worker and output per

effective worker are again constant.

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 18 of 19

Despite the fact that the levels of capital and output per effective worker are lower, in

the new steady state output and output per capita grow at a higher rate because:

g

y

= g

N

+ ! g

A

d Y / N

( )

Y / N

= ! g

A

! g

A

> g

A

Exercise 89 –– Population growth rate

An economy is characterized by the following production function Y = K

1/3

N

2/3

. Assume

there is no technological progress and no population growth. The constant depreciation

rate is equal to !.

a) Represent graphically the steady state in per capita terms, and compute the level of

K/N (capital per capita, k) and Y/N (output per capita, y) in the steady state. Explain

how and why the economy moves towards the steady state.

b) Suppose that at time t population growth becomes positive and equal to gN. Show

graphically how the steady state changes and compute the new level of capital and

output per capita in the steady state. How is the growth rate in the new steady state

(in per capita terms)? How it the growth rate during the transition towards the

steady state (in per capita terms)? How is the growth rate of aggregate output, Y, in

the steady state?

Solution:

a) The production function can be rewritten in terms of variables per worker such as: Y =

Y/N = (K/N)

1/3

= k

1/3

. Steady state K can be found by solving $k = sk

1/3

, from this: k =

(s/$)

3/2

and y = (s/$)

1/2

. If k is less than the one in steady state, the investment is

greater than the depreciation: the stock of capital increases. If the investment is less

than depreciation, capital stock decreases.

Macroeconomics 2012-13 (Murphy–DeMicco) This version: 23 May 2013

Page 19 of 19

b) If the population begins to grow, the curve that needs to maintain K/N constant be-

comes steeper: ($ + gN) k. A higher investment is necessary to maintain the capital stock

per worker constant. The capital stock per worker decreases from A to B. The new level

of k in steady state will be: k = [s/($ + gN)]

3/2

. The new value of y = [s/($ + gN)]

1/2

. The

growth rate of Y/N during the transition will be negative. In the new steady state it

will be zero. The Y in the new steady state will be positive and equal to gN.

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