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Muhammad Ali Zafar - 17020101

Ayesha Ali

ECON 240

18 September 2016

Homework Assignment 2

1.1. s = savings rate

θ = capital output ratio

δ = depreciation rate

n = population growth rate

1.2. By increasing the rate of savings, it would be possible to increase the rate of growth. By pushing
up the rate at which capital produces output (lowering the capital-output ratio) which means a lower θ; the
economy can increase growth rate. A lower depreciation rate and lower population growth rate will also
contribute to an increase in growth rates.

1.3. For a particular target growth rate, there is a required investment rate. A country may have an
investment rate lower than this. The difference between the required investment rate and the country’s
current savings rate is termed the financing gap. Development practitioners devised policies that entailed
foreign aid filling the financing gap.

1.4. This model is based on the link from aid to investment to growth. First it assumed that aid would
lead to higher investment; that aid would go one for one into investment. Secondly, it assumed that GDP
growth will be proportional to the share of investment spending in GDP. Thirdly, it originated in an era in
which there was an abundance of labor, and thus assumed that there would always be an excess of labor.

1.5. i) In the short run, the evidence tells us that there is no statistical association between growth and
investment. Countries should have positive correlation between growth and previous year’s investment
and should have investment patterns which give considerable financing gaps: only 4 of the 138 counties
passed this test. Increase in investment is neither necessary nor sufficient for increases in growth rate.
This is again because of the same assumption that there is always an abundant supply of labor. In
countries where there is an abundance of labor, this model will not work. There will be an incentive to
employ more workers and use fewer machines.

ii) In the long run as well, evidence shows us that investment does not necessarily lead to growth.
It is technology that has a more significant role here. This is seen in the detailed evidence about Zambia’s
long-term growth provided by William Easterly. Despite the fact that it already had a high investment rate
before aid, and it received a lot of aid on top of that. This can be explained by the fact that over time,
Zambia’s investment rate went down and not up. Thus, considering constant savings rates, only subject to
government policy is not a practical assumption.
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1.6. I agree with this statement. This statement makes sense in light of William Easterly’s arguments.
Individuals in economies with low savings rates, will have their reasons and incentives to save or not.
They might be getting a low return on their investments. Thus, they will have a preexisting preference to
consume most of their income. Just handing aid over to these economies will not change any of those
incentives, and the financing gap that will be filled will only be filled using the money received from aid.
Since we have seen that this aid will not necessarily lead to growth, it can be seen that these economies
will continue to require aid financing to maintain their investment levels, since the individuals are still
continuing their initial low saving patterns. Thus, there will be a persistent reliance by these economies on
foreign aid.

2.1. By abstaining from consumption households make a pool of funds available that can be used to
buy capital goods. This is investment. It is a way to add capital into the economy. This is It.

But, the economy will already have some capital already existing. This will be Kt. Some of this capital
will be lost or depreciated due to wear and tear. The rate at which this happens is δ. Thus, depreciated
capital will be δKt. Putting all of these together gives us the capital accumulation equation,

Kt+1 is capital in the next time period after time period t.

Kt+1 = Kt - δKt + It., which simplifies to

( )
2.2. A production function which has diminishing returns to capital is one in which we see a falling
output-capital ratio as we increase capital or capital per capita capital. As we keep increasing capital
while keeping labor fixed, each additional unit of capital adds marginally less and less to the overall
output. This means that the next unit of capital we employ will add to total output an amount less than
what the previous unit added. This is because there is a fixed number of workers in this analysis. Thus
adding more and more machines will be beneficial initially, when there are some workers who don’t have
machines. However, once every worker already has a machine to work with, each new machine will not
be put to as much productive use.

2.3.

(Diagram attached on extra sheet)

This diagram shows the standard Solow model’s prediction of the economy reaching a steady-state in
which the per capita growth rate is 0. Regardless of how much investment is increased, which manifests
itself in a larger s and hence a higher steady-state level, the economy will simply reach a higher level of
long-run output and there will be no change in the growth rate of per capita income. There is a level
effect and no growth effect.

2.4. Unconditional convergence is a hypothesis made using the Solow model. It uses the assumption
that all long-run parameters are similar. These long run parameters are rates of technological progress,
savings rates, population growth rates and capital depreciation rates. Under this assumption, the model
predicts that in the long run, all countries will have the same value of capital per efficiency unit of labor.
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2.5. We need to incorporate technical progress into the model. We need to distinguish between the
working population and the effective population. The effective population is found by multiplying
efficiency of an individual, a new addition into the model, and the working population. This efficiency
grows at a rate of π, the rate of technical progress. This gives our entire analysis in terms of not per capita
capital, but capital per efficiency unit of labor.

3. i) Electricity: This development made electric lighting possible, as well as appliances such as the
washing machine and refrigerator.

ii) Internal combustion engine: This made it possible to ease the burden of manure in urban
centers, as well as making it possible to free up land for agriculture instead of horse feed.

iii) Underground sewage system: Made easy access to water possible. It also caused
disappearance of waterborne diseases.

4. Agree.

I) The large degree of fine variation that exists in the world.

Through my brief experience with micro level analysis, it is clear that the level of detail
with which microeconomics analyses particular issues puts the issue into more focus. Huge data sets
contain detailed information about a multitude of variables about each observation. Banerjee also points
this out in his piece, by producing arguments that resounded well with an understanding on
microeconomic analysis. Fine variation seldom shows up in macro data and it is these small differences
that are the essential cause of the big differences that macroeconomics analyses. Thus, we can in a way
say, that microeconomics is more capable of bringing us to the root cause of each particular problem and
not just a general analysis.

II) It is the acknowledgement of the subjectivity of each different case that can lead to well
informed policy decisions.

Reason number I points to the fact that policy cannot be made using a general analysis of the issues and
problems faced by different countries. There is such fine variation, that there is a lot of subjectivity
involved in analyzing each case, and producing a relevant policy decision. Apart from a general analysis,
Banerjee’s inclination is towards a more localized analysis of each particular problem: which can be seen
through the real-life examples and an emphasis on their practical aspects that are characteristic of this
piece and his other writings. This commitment to empirically and statistically testable and practical
analyses is what adds credence to Banerjee’s claims.