Roland Bénabou Spring 2016

WWS 512c
MIDTERM EXAM

Part A (15’) Discussion question: True, false, uncertain? Be brief (about 1 page, 1.5
at the very most) but precise in your explanations. You may use a graph if you wish, or not,
but no derivations; be sure, on the other hand that your answer is (broadly) fact-based. The
reason for America’s consistently low growth performance over several decades is that private
sector investment has been increasingly crowded out by government spending.

Part B (45’). Con‡icting Advice. The newly elected president of Solovia, a lower-middle
income country in Central Europe, is receiving con‡icting advice from her two main advisers
and calls you in for consultations. As described in the fact sheet you are given, the country’s
productive structure is well-approximated by a production function Y = K 1=3 [AN ]2=3 ; labor
e¢ ciency A(t) = egt with g A=A_ = 2% and a depreciation rate d = 1%: The current population
growth rate is n = 3% and the national savings rate s = 10%: The president wants to raise the
country’s income level and living standards.

1. Write down the general, standard equation governing the growth rate of capital per e¤ective
unit of labor k; for arbitrary values of the parameters (i.e., without plugging in numbers)
except for the capital share, which is …xed at 1=3: How does the growth rate of y relate to
that of k (no derivation here, result should be immediate)?

2. The …rst expert, Dr. Ian Vesting, a former advisor to many East-Asian countries, rec-
ommends increasing the savings rate, currently quite low, to 15%: The second, Dr. Burt
Raithe, a former advisor to China and India, argues that it would instead be more e¤ective
to bring down the population growth rate, to a level of 1% similar to that of most devel-
oped countries. Both claim that their recommended policy will deliver the highest long-run
income per capita. The president asks you who is right; what is your answer, and why have
you now made two enemies?

3. To further his case, Dr. Raithe argues that, of the two competing policies, his will undoubt-
edly deliver the higher level of long-term welfare for the country’s citizens. Is he right or
wrong? No derivation necessary.

4. To further his own case, Dr. Vesting quotes Keynes’famous observation that “in the long
run, we are all dead”, so that it makes more sense to judge results over a much shorter
horizon; the president, concerned about reelection, nods approvingly. Dr. Vesting then
argues that, of the two policies, his will deliver faster income growth in the next couple of

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 years. Is he right, wrong, or what does it depend on? Hint: compute, under each policy, the
_
initial value of the growth rate of at time 0, that is, k(0)=k(0); taking as given the starting
level k(0); then, compare the two growth rates. Brie‡y interpret the answer.

5. In what follows, we treat the economy as starting not too far from steady-state. We denote
ys (t) its path under Dr. Vesting’s recommended higher-savings policy, yn (t) its path under
Dr. Raithe’s recommended population-slowdown policy, and y(0) the initial level, from
which we start under either scenario. Using a standard formula, write down (do not derive!)
the paths of y(t) under each policy. Then, recall your answer to question 2 about long-run
y to show that, at any time t;

st nt
ln ys (t) ln yn (t) e e [ln y(0) ln y ] ; (1)

saying what y ; s and n are and computing the latter two. Note: if you don’t remember
the “standard” formula, recalling the underlying intuition about “ where you start, where
you end up, and how fast you move from one to the other should help.

6. The president, who now understands things much better thanks to your having sorted out
the two advisors’claims about the short and / or the long run, rephrases her question in a
more speci…c way. Which of the two policies, she asks, will deliver higher consumption per
capita 4 years from now, when she runs for reelection? Answer Mrs. President, for the cases
where y(0)=y = 0:77 and y(0)=y = 0:2: Hint: using above formula, compute the relative
consumption gap ln [cs (t)=cn (t)] at the relevant horizon. What intuition is re‡ected in how
the answer depends on how poor the country initially is?

Part C (30’). Fuzzy vs. Smooth Thinking on Consumption Smoothing. Progresa,

established in 1997, is a Mexican program that provides cash transfers to selected poor families
in marginal rural communities, conditional on their children using health facilities on a regular
basis and attending school. A total of 507 localities were randomly assigned to the program (320
to “treatment”) or not (186 to “control”), and for each household in either group we have panel
data on their income (both from work and private transfers, e.g. from family) and consumption
(non-durables), as well as some demographic variables. The baseline survey was collected in
October 1997, with 24,000 households in the 506 localities (in 7 states) interviewed, who were
then reinterviewed every 6 months until November 2000. Using (some of) this data, the author of
a recent study proposes to: (i) test the PIH; (ii) examine whether being in the program, and thus
having access to an additional source of income, allows agents to better smooth their consumption
(in the face of idiosyncratic shocks due to health, weather and other environmental shocks, etc.).
The baseline regression run by the author is

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 Ci;t = 0 + 1 Inci;t + 2T + 3A + uit ; (2)

where Ci;t and Inci;t are respectively the percentage changes in consumption and income for
household i between the October/November 1998 and October/November 1999 interviews, T is
a dummy for participation in the “Progresa” program (based on the initial randomization), and
A is a vector of di¤erent measures of household size in 1999.1 The results are given in Table 1a:

Based on these results, the author concludes that:

(a) The PIH model can be rejected, and is not a satisfactory model of consumption decisions.
(b) “Despite not being a consumption insurance program, Progresa helps treated families to
smooth consumption”.

1. Do you agree with Conclusion (a)?

2. What exactly does Table 1a show about the e¤ects of program participation? Does it provide
an appropriate test of Hypothesis (b)?

3. What regression would you propose running to examine Hypothesis (b)?

4. Can credit constraints explain the e¤ect of program participation T (which, remember, was
determined in 1997) in Table 1? What else might explain it (think, for example, of changes

1
The study does not use years later than 1999 because, starting in 200, some families located in the initial control
localities were added to the program (started being "treated”).

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 in either preferences or productivity). Be concise in your answers (at most 1/2 of a page
in total).

5. To explain the size of some coe¢ cients, the author writes that “income for poor families is
already very low, so that consumption may not be very responsive to its negative ‡uctua-
tions.”How does this square with the idea that poor families may be liquidity constrained?
(Think about the marginal propensity to consume).

6. In addition to Table 1a, the author also runs the speci…cation in Table 1b below, which adds
an interaction term, health shocks, and environmental shocks (whether household su¤ered
from droughts, plagues, …res, frosts, ‡oods, hurricanes, or earthquakes. Say what more all
this allows us to say about the PIH, both in general an in relation to the Progresa program.

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Roland Bénabou Spring 2016

WWS 512c
MIDTERM EXAM SOLUTIONS

Part A (15 points) This statement is false. In general, government spending could indeed crowd
out private investment, resulting in a slowdown or even decline in capital accumulation, which
in turn would lower growth in the U.S. (more speci…cally growth in Y and Y =N but not T F P
growth in an neoclassical / Solow world; possibly in T F P as well in an endogenous-growth). In
the US facts, however, there is absolutely no evidence that private sector investment has been
increasingly crowded out by government spending. This is based on the following observations:

First, gross private investment as a share of GDP (Ipriv =GDP ) has been relatively stable
over many decades, as Figure 4.6 in ABC shows. As we saw in class, once depreciation it
taken into account there is a slight decrease in net investment, but nothing major.

Second, government expenditure as a share of GDP (G=Y ) in the U.S. has remained rel-
atively stable, if not decreased, over several decades. This is also shown in Figure 15.1 of
ABC and in Figure 2-5 of the Economic Report to the President (February 2016).

Third, if private investment was indeed being crowded out, this would occur through higher
real interest rates (especially long-term interest rate): recall how high government expen-
ditures lead to a decline in national savings (SN = Spriv + Sgov curve shifts to the left),
which leads to an increase in the equilibrium r (in a closed economy, or one like the US
whose foreign borrowing is big enough to a¤ect the world interest rate) and a corresponding
decline in I. This is clearly not the case in the data: real interest rates in the U.S. have
been declining for several decades, including long-term ones. This is shown for instance in
Figure 6-5 of the Economic Report to the President (February 2016).

In addition, the Economic Report to the President (February 2016) actually shows that public
investment, especially in infrastructure, in the U.S. (as well as in many other G-7 countries) has
been declining in both quantity and quality. We discussed this issue in class by looking at Figure
6-2 in the ERP. So, if anything:
(i) These lower services from public capital could / should lead to a “crowding in” of private
investment, in order to substitute some increase in K priv for the decline in K pub : (Can you think
of concrete examples).
(ii) To the extent that K pr and K P ub are (clearly)( imperfect substitutes or even comple-
ments, the growth slowdown could be attributable to the slowdown or decline K pub in Y =
F (K pr ; K pu ; AN ): Note also that if this is not properly measured in the growth accounting, it
will even show up as a decline in T F P:

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 Extra. Particularly worrisome (given the importance of knowledge for long-run growth, etc.)
is the decline in federal R&D (part of public I) as a % of GDP; see

Part B (45 points).

1. [5 pts] Usual formula, with = 1=3 : y = k 1=3 ; so

k_ 2 y_ 1 k_
= sk 3 (n + d + g) and = (3)
k y 3 k

2. [11 pts] Steady-state levels of capital and output (per e¢ ciency unit of labor):
3 1
s 2 1 s 2
k = ; y = (k ) =
3 (4)
n+d+g n+d+g

Substituting in the relevant values two polices, we …nd y = 1:581 in both cases, since
15=(3 + 1 + 2) = 10=(1 + 1 + 2):

3. [6 pts] Dr. Raithe is right here. Long-run welfare is determined by the level of consumption
in steady state. Since output is the same in both cases but people save a smaller fraction
of output in Dr. Raithe’s policy (0:90: vs. 0:85), consumption will be higher –by a factor of
90=:85; i.e. by 5:88%:

4. [8 pts] From the growth equation in question, the growth rate of k under each policy is:

k_ s 2
3
k_ n 2
3
= 0:15k0 0:06; = 0:10k0 0:04 (5)
ks kn

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 Dr. Vesting’s savings-based policy yields a higher initial growth rate if
3
2
3
2
3
2
3
5 2
0:15k0 0:06 > 0:10k0 0:04 () 5k0 > 2 () k0 < = 3: 95 (6)
2

Interpretation: Increasing savings, and therefore investment, is of course more e¤ective when
the marginal product of capital is high than when it is low. This occurs when the stock of
capital is relatively low. When it is high, decreasing returns imply a low marginal product,
so higher investment will not increase growth that much. Reducing n; by contrast, always
has a constant impact on the growth rate.

5. [8 pts] Usual convergence dynamics:

s s
ln ys (t) = 1 e ln ys + e ln y (0) (7)
n n
ln yn (t) = 1 e ln yn + e ln y (0) (8)

Recall from question 1 that ln ys = ln yn = ln y ; so that subtracting above one (log) output
level from the other yields the desired formula

s n
ln ys (t) ln yn (t) = e e [ln y (0) ln y ] ;
with :
y = ys = yn = 1:581
s = (1 ) (ns + d + g) = 4%
v = (1 ) (nv + d + g) = 2:666%

6. [7 pts] The consumption gap is

ln [cs (t) =cn (t)] = ln [(1 :15) ys (t)] ln [(1 :10) ys (t)]
= ln (0:86) ln (0:90) + ln ys (t) ln yn (t)
st nt
= ln (0:86) ln (0:90) + e e [ln y (0) ln y ] : (9)

Plugging in values, we get

y(0)=y = 0:77 ) ln [cs (4) =cn (4)] = 0:0223 < 0;

y(0)=y = 0:2 ) ln [cs (4) =cn (4)] = 0:1568 > 0:

The president will therefore prefer the policy of Ian Vesting if there is a large gap between
current and steady state output (low initial k0 relative to k ), and the policy of Burt Raithe

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 otherwise. The intuition re‡ects the discussion in question 4, linked to decreasing returns.

Part C (30 points)

1. This conclusion is mostly wrong, or at least highly questionable: while the estimate of 1
is statistically signi…cant, it is also extremely small. Thus, a 10% shock to current income
results in only a 2% 10% = 0:2% change in current consumption, i.e. there seems to be
very substantial smoothing. (Extra: an alternative would be very high measurement error
on income, biasing the coe¢ cient toward zero).
Recall that the PIH states that consumption responds to changes in the present value of
lifetime resources (P V LR) rather than solely to current income. Accordingly, the response
to a transitory shock in income, such as the one experienced by the average household in
the sample is spread out over many years, and should be on the order of

1 1
C1999 1998 = C1999 C1998 [Inc1998 Inc1998 ] = Inc1999 1998 :
Te Te

If we take T 25; the predicted 1 for a temporary income shock is about 4%; so we are
even below that. If, on contrary households did not / could not smooth, we would see
a much higher 1 : Informal credit at the village level (also, within the extended family)
is usually a key mechanism through which smoothing is achieved in paces without formal
banks or other …nancial institutions.

2. Conditional on changes in income and di¤erent measures of household size in 1999, the
average treated household, i.e. a household enrolled in Progresa relative to one who was
not, increased consumption growth by an additional ^ 2 percentage points per year, where
^ 2 [0:0917; 0:0935]. Contrary to the author’s interpretation, this is in no way a proper
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test of Hypothesis (b), which pertains not to average consumption growth but to a greater
ability to smooth consumption, i.e. an attenuated response to income shocks.

3. The proper test would be based on an interaction term: treated households should have a
lower elasticity 1 of current consumption to current income (which we can also think as a
lower marginal propensity to consume (MPC). The proper test would therefore be to run
the augmented speci…cation

Ci;t = 0 + 1 Inci;t + 2T + 3 Inci;t T+ 4A + uit ;

| {z }
interaction

and test whether 3 is (signi…cantly) negative.

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4. Consider the case of credit constraints such that instead of not only not being able to borrow,
but households can neither save simply because there do not exist proper vehicles to save
money for these very poor households (you might always have the possibility of hiding
your money under your mattress, but if there is a risk that a hurricane might blow away
your house at any time you might simply not want to save your money there). Hence, if all
treated households are subject to this constraint, than they might just increase consumption
more in order to use more of these resources as soon as possible and not face the risk
of losing the additional resources due to some natural disaster or a similar phenomenon.
Hence, credit constraints might help us understand part of the e¤ect of the program on
changes in consumption. In terms of preferences, it could be the case that the treatment
makes households more impatient, in which case these households would like to increase
consumption more in the present than in the future even in the presence of well functioning
credit markets. Lastly, if households perceive the treatment as leading to a permanent
increase in their productivity, this could lead to what households perceive as a permanent
increase in income leading to greater increases in consumption in line with the PIH.

5. This statement is rater at odds with the idea that households are liquidity constrained.
If they are not able to access liquidity due to a constraint, then their consumption must
decrease in line with a negative shock their income. Put di¤erently, they have a very high
marginal propensity to consume out of both positive and negative shocks to income.
For instance, in the extreme but illustrative case of a household that lives for two periods,
has no initial wealth and no access to capital markets can so that he can neither borrow nor
lend, the budget constraints become C1 = Y1 and C2 = Y2 ; so changes income translate one-
for-one with changes in consumption: C = Y , and we would expect large coe¢ cients for
1 rather than being able to explain their small magnitudes. More generally, with liquidity
constraints the Euler equation is an equality U 0 (C1 ) > (1 + r)U 0 (C2 ); and reducing current
income makes it only tighter

6. Adding the interaction term allows us to say more about the PIH, as was proposed in
question [3]. The estimated coe¢ cient on the interaction term is negative, ^ 3 = 0:0094
and signi…cant, though only at the 10% level. The estimated regression can be written as

Ci;t = ^ 0 + ^ 1 + ^ 3 Inci;t + ^ 2 T + ^ 4 A + uit ;

T
so that the income elasticity of consumption for treated households is ^ 1 ^ +^ <^ ,
1 3 1
C
^
while for the others it is 1 ^
1 . The former are thus able to better smooth consumption,
but: (i) the e¤ect is minute; (ii) it is signi…cant only if we accept the 10% level. So overall,
there is a best weak evidence that Progresa helps treated families to smooth consumption”.
Table 1b also shows negative and signi…cant response to health and especially to environ-

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mental shocks. This is what we would expect since these are typically more permanent /
less transitory shocks, to which C should respond more, as they have more of an e¤ect on
P V LR However, since unlike income these are not expressed in monetary equivalent, and
we do not know how long they typically last , it is di¢ cult to say much about whether or
not they have the proper magnitude.

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