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Questions
1. Production Function and Intensive Form
Consider an economy whose production function is characterized by the following Cobb-Douglass ex-
pression: Y = K α L1−α where K and L denote the amount of capital and labour employed respectively
and 0 < α < 1.
(a) Let y = Y /L and k = K/L. Express y in terms of k. Explain whether or not output per capita y
exhibits a decreasing marginal returns to capital intensity k.
(b) Let r be the cost per unit capital and w the wage rate per unit labour. It is known that r = dY /dK
and w = dY /dL. Show that y = rk + w.
(a) Express output per effective unit of labour in terms of capital per intensive unit of labour (y in
terms of k).
(b) Assume technology grows at a rate a (∆A = aA). The expression for change in capital per effective
unit of labour is given as ∆k = ∆K ∆L ∆A
K α
K − L − A AL . Show that ∆k = sk − (δ + n + a)k.
(c) Find the steady state capital per effective units of labour k ∗ and the steady state output per
effective unit of labour y ∗ in terms of s, n, α, a and δ.
(d) Find the rate of growth in steady state per capita output(Y /L) and the steady state capital per
unit labour (K/L).
(a) In steady state, it is known that the following condition should hold sf (k) = (δ + a + n)k. Derive
the first order condition for the maximization of consumption in steady state. (The expression
should contain the parameters δ,a and n).
(b) Assuming f (k) = k α , solve for the golden rule steady state capital per effective labour (kgr ) and
output per effective labour (ygr ).
(c) Compare the expressions for kgr to the steady state value k ∗ obtained in 3(c). Under what
condition are these expressions equal?
(d) Assume that the following holds currently in the economy: s > α. Is the economy experiencing
dynamic efficiency? What would you recommend that they do to consumption today?
Answers
Question 1
(a)
Y = K α L1−α
Y K α L1−α
= dy
L L = αk α−1
dk
y = K α L−α 1−α
α 1
K =α
= k
L
y = kα
dy
From the right hand side of the equation, dk is decreasing in k. Thus, y exhibits a decreasing marginal
returns to k
(b)
dY K α−1
r= = α α−1 = αk α−1
dK L
dY Kα
w= = (1 − α) α = (1 − α)k α
dL L
Question 2
(a)
sK α L1−α − δK K α−1
∆K ∆L K sY − δK
∆k = − = −n k = − n k = s α−1 k − (δ + n)k
K L L K K L
= sk α−1 · k − (δ + n)k = sk α − (δ + n)k = sf (k) − (δ + n)k
(c)
1
∆k = 0
α−1
δ+n
k=
0 = sk α − (δ + n)k s
1
sk α = (δ + n)k
1−α
∗ s
k =
δ+n
sk α−1 = (δ + n) α
1−α
δ+n ∗ ∗ α s
k α−1
= y = (k ) =
s δ+n
(d)
Technically, the growth rate of a variable x is written as ∆x x . It is useful to note that this expression
can be derived by differentiating the natural logarithm of x, ie d ln x = ∆x
x .
Y = y∗ L K = k∗ L
ln Y = ln y ∗ + ln L ln k = ln k ∗ + ln L
d(ln Y ) = d(ln y ∗ ) + d(ln L) d(ln K) = d(ln k ∗ ) + d(ln L)
∆Y ∆y ∗ ∆L ∆K ∆k ∗ ∆L
= ∗ + = ∗ +
Y y L K k L
=0+n=n =0+n=n
When a variable is constant its growth rate is 0. Thus, the variables K and Y can be constant only if n = 0
since they both grow at rate n.
Question 3
(a)
Y = K α (AL)1−α
Y K α (AL)1−α
=
AL AL
y = K α (AL)−α
α
K
=
(AL)
y = kα
(b)
∆K ∆L ∆A K sY − δK
∆k = − − = −n−a k
K L A AL K
sK α (AL)1−α − δK K α−1
= −n−a k = s k − (δ + n + a)k
K (AL)α−1
= sk α−1 · k − (δ + n)k = sk α − (δ + n + a)k = sf (k) − (δ + n + a)k
(c)
1
∆k = 0
α−1
δ+n+a
k=
0 = sk α − (δ + n + a)k s
1
sk α = (δ + n + a)k
1−α
∗ s
k =
δ+n+a
sk α−1 = (δ + n + a) α
1−α
δ+n+a s
k α−1 = y ∗ = (k ∗ )α =
s δ+n+a
(d) Note that Y /L = y ∗ A and K/L = k ∗ A, hence they both grow at the rate of a.
Question 4
(a)
c = f (k) − sf (k)
= f (k) − (δ + a + n)k since sf (k) = (δ + a + n)k in steady state
dc
= f ′ (k) − (δ + a + n) = 0
dk
f ′ (k) = (δ + a + n)
(b)
1
1−α
f (k) = k α α
kgr =
δ+a+n
f ′ (k) = αk α−1
ygr = (kgr )α
αk α−1 = (δ + a + n) " 1 #α
1−α
δ+a+n α
k α−1 = =
α δ+a+n
1
δ + a + n α−1
α
α
1−α
k= =
α δ+a+n
(c)
1
1−α
s
The steady state value for capital per effective labour given is given as k ∗ = δ+n+a while kgr =
1
1−α
α
δ+n+a . These expressions are equal only if s = α.
(d)
The golden rule steady state by definition is the steady state at which consumption is maximized. There-
fore, any other steady state yields less consumption compared to the golden rule. s > α then suggests the
economy is saving too much, so it is experiencing dynamic inefficiency. The economy should consume more
today (save less) in order to consume more tomorrow.