SOLUTIONS TO CHAFTER1 growth rate ofa variable equal the time derivative of its lg, as shown by equation (1.10) in ‘he text, weean write bX YC] & « Since the lg ofthe preduct of two variables equa the sun of tir ons we have ox) +in¥e] _dnXW) , din Vo es a dt ) 2X0 YO 70) Xe "Vo (0) Anan, since te groweh rat ofa variate equal te tine drvativ oft og, wecanwrte oy 20) anzey alo] Zt) at dt Since the lg ofthe ra eft vrable qual th difornc inthe legs, wehave 2G) _dlnX@)-ln¥(o)]_dnXiy Ain Vie) & Ze & a @ ate )_X@_YOo gy Ue Xo _¥O © 20" xo Vo © Webave 2) _AlnZ) _dlalX(*] 20 é {sing th fac at lafX)"] = ahXE), wove 20, Mleloxe) _atnxeo | 80 Zt) dt a X(t)" how ne hve we th facta i conan ‘Eroblem 1.2 (Q)Usiag the information provided inthe question, the path ofthe growth rate of X, X()/X(), is dapicted in| X00 the figure at right. xo| From time 0rotime tthe growth rate of X is constant and equal toa > 0, Attime ty, the growth rate of X ‘drops to0, From timet; to time ty, the gronth rate of at-— ‘X rises gradually fom 0 to a, Note that we have made the assumption that X(t)/X(t) rises at a constant rate fromts tots. Finally, ater time ts the growth rate of ‘Xis constant and equal toa again2 Solutions to Chapter 1 () Note that the slope of nx") placed againsttime is equal to tho growth rate of X(t) That is, we know dinxe) (0) at XW) (See equation (110) in hotest.) From time 0 to tet the slope of nX(t) equals a>0. The iX() locushas an infection point a ts, ‘wen the growth rat of X() changes discontinuously ‘from 2t00. Between ty and ty, the slope of nXit) rises gradually from Oto a. Alter time tthe slope of 1nX() is constant and equal toa >0 again, Problem 1.3 (a) The slope ofthe break-even invesment line is sven by (n+ +8) andthes a fall inthe rate of deprecation, 8, decteasts the slope ofthe break-even investment ine, ‘The actual investment curve, sf) is unaffected, From the figure a right wo san see thet the belanced srowth-path level of capital per unt of effictive labor rises from 0 Kew () Since the slope ofthe break-even investment ine is given by (a+ g+8), arise inthe rate of technological progres, g, rake the break-even investment line steeper. ‘The actual investment curve fk), is unaffected From the figure a right we can see thatthe balanced: growth path level of capéal per unt ofeffective labor fale from Et kta NeenSolutionsto Chapter 1 3 (0 Thebreak-even investment line, n+ g+8),is |, unaffected by th rise in capital’ share, a. arin “The effect ofa change ina on the actual investment carve, sk, can be determined by examining the ater erivative Qsk"V0. is possible show dat ak" og oy Sk lnk For 0 @ <1, and for postive values of, he sign of OGk"/Cu is determined by the sig of lnk, For Ink 0, oF k> 1, 04k" /ou > 0 and 0 the new actual Paw k fnvesument curve Hes above the od ene. For ~ Ink <0 oF k< 1, Osk™ /oa <0 and so the new actual investment curve lies below the cld one. Atk = 1, 50 that k © 0, emew actual invesiment curve imersets te old one. Ts adition the affect of arise in x on It ie ambiguous and depends on tho relative magnitude of ¢ and (e+ g +8). leis posible o chow thit aries in captale charg, will eauselet to sseifs> (a +2+8), ‘This isthe case depicted in the figure above (@) Suppose we modify the intensive form ofthe production funcion to include a non-neative Constant, B, so thatthe actual investment curveis gen by SBI, B > 0 ‘Then werkors exerting more off, so that cutput por unit of effective labor is hiher than before, ean be rmoddedas an increase in B. This increase in B shifts the actual investment curve up. “The break-even imestment line, (0+ +3), is ‘uafeced From the figure right ws can ote that tho balanced. growth path level of espital par unit of effective labor rises from k*toktaw Problem 14 (@) At sometime, call it, there isa diserte upward jump inthe number of workers. This reduces the amount of capital per unit of efesive labor from K* to kxrw - We can see tis by siruply looking atthe defintion, K= K/AL An increase n L without a jump it K or A causes kto fall. Since £" (> 0, tis fl inthe amount of capital per unit of effective labor reduces the amoust of oxtptx per wit of effective labor as well. ta the figure below, falls from y* © yspw.4 Solutions to Chapter 1 (b) Now at this ower ee, actual |Iovestment investment per nit of efecive labor |r ib, exci break-venivectvnt per 0 tnt ofeffctive ber Tha ” sflisy)> (8+ Blew. The (e+e secony Stow avngindinestng | ‘mor than enugh to oft wo ‘deprecation and technological progress at dis lower key. Thus k begins rising back toward k*. AS capital per unit of effective labor besins rising, so does ourpus per ust of effective labor Thats, y besins Fising fom yyew back toward y* ew ke ke KAL (©) Capa pe nt of eecive lator wll cone to rise unt exenually rus the ei lew of i Atk’ instant per unt of efecivelabor iain jus enough to ofrecer deprcintn and Lepk cont, Since retums tot rgnal va of Kone the oman oes ‘oababnced srovth path, up pr eit of effective aban Feu tos creat a y= fe) Problem 18 ‘The equation describing the evluton of the capil tock per nt of efocive labor given by () kes) (0+ 84k Subtitetng in forthe intensive form ofthe Cebb Doss, fh) kad ~(a49+5)k (On tie tlanced pow pat, kis zr investor pr uit of effctve ako is equal to break-even iavetmant per un of effective lnbor and sok remains constant. Denon the talent gro ne value fas, wehave sk" = (ng +k. Reawangingtosobe ioe poke 0) b-[oiaege9]!? ‘To gt the balaaced-gtowh-pth vale of spat pr mit fective ako, eubstinte ouatio 2) i te itersve form of he prod ncn, = ©) y*=[sa +848] Consumption per unit of efeive lator on he balanced grout this given by e* = Subsitting equation G) nto this expression vide @ &=0-9)s/0 +848) yields soy © By cent, the golden ee the epi! sock that oe st which consumption pe unt of efecivelabor it maxinized. To dene thisleval otk. tak euaton ) wtich aroun a eines 1ow-path eval of and rearrange ito sl fore © s=@ +g +5), Now state equation (9) to eqution (9) (nape fiaeg+dK*faee 25] Aersonesrightorrard ale mipslaton th einpifeetoSolutions to Chapter 1S 0) ct=K (nt s+ Okt Equation (6) can be easly interpreted, Consumption per unit of effective labor is equal to output per unit of effective labor, k*, les actual investment por unit of affective labo, which onthe balanced growth path is the same as break-2ven investment per unit of effective labor, (n + g + S)k* [Now use equation (6) to maximize c* with respect ok". The first-order contin i given by betf0k *=ak + -(n+g+8)=9, or simply () akt*~@ +848). [Note that equation (7) is just a specific form off" (kt) ~ (n+ g + 8), which isthe general condition that impliily defines the goldon-rul level of capital per anit of effective labor Equation (7) hat a graphical interpretation: it defies the evel of kat which the slope of the intensive ferm ofthe production Function i ‘equal tothe slope of the bresk-even investment ie, Solving equation (7) forthe golden-ule level of yields ©) kon =[a/(a +g +8)]" (©) Togetthe saving rat that wll yield the golden-rle level ofk,substtte eqution (8) ico (8): Son =(0 +8 +B)o/in +a+] which simpli rane With a Cobb-Douglas production function, the saving rate required to reach the golden rule is equal tothe elasticity ef output with respect to capital or expt’ share in output (i capital eems its marginal produc). Problem 1.6 (a) Sines there ieno technological progroes, wo can carty out tho entire analyisin terme of capital and output per worker rather than capital and cutput per wnt of efostive labor With & constant, thay bohave the same, Thus we can defie y= Y/Land k= KIL. ‘The fallin the population growth rate makes the break-even investment line fer. In the absence oftecanologcal prowess, the pr anit Sime change ink, capaal per worker, is given by. | yay fi K asftk)-(Grmk. Since K was 0 before the decrease inn ~ the ecncmy was o blanced _rowth path —th decreas iam causes kta Become positive, Att, actual invert per worker, fk") now excous break-2ven investrent per worker sew +5". Thus k ‘owes oa new higher balanced gronth pah level See the Sigue at riht. (see +k st) As K rises, y ouput per worker ~ also rises Since a constant faction of eur is saved, © ~ consumption pr worker ~ rises a y rizae, This 's summarized in he figures below.6 Solutions ta Chapter 1 If Le 4 Le (©) By definition, cup ean be writen at Ys Ly, Thus the grow rae of expt is Y/¥=L/L+4/y. On the iil blanced prow pat, 5/y = 0~ euput pr workers consant so ¥/Y=L/L=n. On the final bslanced growth path, ¥/y =O again ~ ouput per worker is constat gain ~ andso V/Y = L/L = ayrw . This etre because the denominator ofthe second term ‘on the righthand side of equation (6) is postive because fk) isa concave function. The numerszor of that sume tem is postive because k and kare positive and f" (kis negative. Thus, ak rises toward K?, the ‘marginal produc of labor grows faster than onthe balanced prowth path. Intuitively. the margial product of labor rises by the rate cf growth ofthe effectiveness ofabor onthe balanced growth path. As we meve ‘fiom kt kt, however, the amount of capital per uit of effective labor is also rising which also makes {bor more productive an¢ this increases the marginal product of labor even more “The growth rate of the marginal product of capital, r, © 0 Fao) _ Franke 7 FW FD As krises toward K, tis growth rate ismegative since £(K) > 0, £"(K) <0 and k > 0. Thus, as the ‘economy maves fram ktokt, the marginal product of capital fll, Thais, it grows a arate les than on the balanced growth path where tz growth rato 0 Problem 1.10 (@) By efititin a balanced growth path occurs when all the variables ofthe model are growing at ‘constant rates. Despite the diferences between this model and the usual Solow model, it tums ovt that we cen again show that the econcmy will eonverge to a balanced growth path by examining the behavior of k = WAL, “Taking the tine dtvnve ofboth sides of the detain ofk = KVAL givesus *) KiAD-K[LA-AU] kK Kf tavtt| x ne 4) © Far, aL aval at a Atta. Stbsituing the caital-acamulaton uation, K = [(K,AL)/OKJK-8K, and te conta: growth ts ‘ofthe labor force and technology, L/L =n and A/A =g, into equaticn (1) yields \OF(K,AL)/OK] K~ 6K _(KAL) ate AL OESwE oK ‘Substituting OF(K,AL)CK = f'(k) into equation (2) gives us k = £"(k)k ~ 8k ~(n +g)k or simply @ k=|P@)-(re+d)k. kok (4K, Capital per unit of effective labor willbe constant when k-=0, ie. when [F" (= (n+ g-+5)]k=0. This K4,£"00< (9 +¢-48), Thie follows fom the atsumption that £"() < O which means that £6) fallsask rises. Thus ifk> K*, we have k < 0 sothatk will falltoward is balanoad- srovth-path value Ifk (a +g-+8). Again, this fllows fron: the assumption tat £" ) <0 which means that (k)rises a k fills. Thus ifk< Kt, we have k > 0 so that k will rise toward its balancel-growh-path value. Thus, regardless ofthe inital value of (as longas isnot zo), the ‘economy will merge toa balanced growth path a kt, wee all the variables inthe model are growing at (b) The golden lavl ofthe level ef that mariage consumption por unt of efctive aber ~ ia defined impicly by (0%) = (+g + 8). Graphically, this eccars when the spe ofthe preducion fico eqal the slepe ofthe bres-even nvesnen line, Noe that hss exady te leve of thatthe economy converpes tein this medel where all apéal income is saved ard ll labor income iscorsuned In this mocel, we are saving capitals contribution to output, which isthe marginal product of capital tines the amcuat of saptal. If that contrsution excoods break-even investment, +g +3}, then k nes. Iti lessthan break-even iavestment, k falls. Thusk sees down to a point where saving, dhe marital product ‘of capital times k, equals break-even investment, (1+ g + 8)k, Thats, the economy settles down toa point where £ Qk = (0+ g+ 3k or equivalently Fk) = (a +g +8). Problem LU (a) The production fiction wth epital-augenting technological progres is given by ( YO=[AMKO|* LEY Dividing bath sides of equation (1) by AQ)*" ML) sels so aan | AOL La@* Lo Lam La)” andl ite xy __ [anit A) Ley Le sndthus finally yw { Ki) | AFL) LAZO PLE, Now, defning § = ail -0), (= KOVAG)L() and yt) = YOAQLA) yk 2) ye) = ko. tn cde to analy the dynamics oF), take etme denvave of both ies oF KN) = KIYAC"LE: se Ke [A@*Lo]-Keo paw AMue+LOao*] [aoteol?12 Solutions to Chapter 1 iyeKO___ Ko [re to] AtLD A@PL@l’AwD Lin! and hen usg KO » KOQ/ACILOD, A(O/ACE)= and Liey/L(t)=a yelds @) KG) =KO/AW*LE ~ Gu +m k(), “The evolution ofthe total capal tock is given by the usual @) RO=s¥(0 3K Substituting equstcn (4) ino (3) gives we Ke =svo/ae* Leo -akin)/A()* Lit)~ + nlk(® =sy() — (uta +5)K(0. Fhaly, wing equation (2), y() =k", we have 6) Kis) =ak(t)® = Gu+n+)K() Equation (5)is very similar tothe basic equation ‘governing the dynamics ofthe Solow moe with Tabor augmeating technological progress, Here, however, weare measuring in unite of AW)*L(®) rather then in nits of effective labor, ACOLC Using the same graphical technique a¢ wih the basic Solow model, we can graph both ‘components of k(t). See the figure at right (out n+ omc) ‘When actual investment per uit f A()*L(0), ski)", exceeds break-even nvestent per unt of, AGHLE), given by (M+ n+ KC), k will rise toward k*. When actual investriet per unit of we LO = Kigrs@OLD AG)'L() falls short of breae-oven investment per unit of Al)*L(), k will fall toward kt. oring the case is which the intial level ok s zero, the {economy will converge oa situation in which ke eanstant at ¥ Since y =k, y will zo be constant whem the economy comerges to kt ‘The tetal capital stock, K, can be written as A*Lk. Thus when is constant, K will be growing atthe ‘constant rate of 41 +n. Similarly, total cutpat, Y, can be written as A*Ly. Thus when y is constant, ouput growsat he constant rate of 4-1 aswel, Since Lard A prow at consant rates by assumption, ‘wehave found a balanced growth path where allthe varabes ofthe model grow at consart aes, (©) The prodicton funtion iano given by YE) =I"! Deine JG) = (WA). The production fancion can then te writen as OM Ye) =[Aoiof* LO. Proceed as in part (a). Divide both sides of equation (7) by A()™"*'L(t) and simplify to obtain xo |i Io Lae Non, defing = 2 2, i) = Tey/A)'L() andy) = VAAL) yellsSolutions to Chapter 113 In crder to analyze the dynamics of j(t), take the time derivative of both sides of j(t) Je{a@*Lo|-Tolpro"* dou one!) JAOLO?: hotel Jie) Tet) Aw Le} 10", UD AC m0 ao Lol andthen using 3) =T(Q/A°L@), A(@/AG) =H and LO /L4e) =n yilde (19) 50 =Teo/Ae* Lee - Gu em HO. Tuonent cp i to got an oxprossoe for Fie), Take the tine derivative ofboth sides of Tt) = 10/ACQ) Jy OAM OA _Jo_Ae HO, roy AQ Aw AO Now use Tio = /AC@, ACO/A(® =H and Jt) = 5A (OYE ~ 614) to obtain AQ 850) Jo Aw Alt) Hae ox simply AD T@=s¥@e)- (+ HTO Substitate equation (11) into equation (10). KO =sY(0/ACOFLO —CH+ T/A LEO- + M}O Finally, using equation (9), y(t) = j(t)", we have (12) J) =S(0" - [046+ +9] 0. ‘Using the same rephial technique asin the besic Solow model, we can graph both components oft) syit)[n+0+ H+ 90]. See the igure at right. Ignoring the possbilty thatthe intial value of jis zero, the economy will converge to 3 situation where jis emstantat j Since y= J, y will also be consant when the economy converges to j* Inv 5-+nt +90) so" The level oftoul ona, Y, ean be ‘writen as A°Ly. Thus when y is constant, output grows atthe constant rate of gute, By definition, T= A9L}. Once the economy converges tothe situation where } isconstant, J grows atthe constant rate of +n, Since Je TA, the offoctive capital stock, J, grove atrate ua + orm pl 4). Thus the e:onomy does convergs toa balanced growth path where all the variables ofthe madel are growing at ‘constant rate, io=ko/a@tuo,14 Sclutionsto Chapter 1 (©) On the balanced growth path, j(t) = ( and thus from equation (12): S=[s8+n0+ Ol) => HM =sfnsd+nasp), ands 03) Fr=[yflo45 snc+e)] Substitute equation (13) into equation (9) to get an expression for cutput per mit of A(t*Lt) on the balanced growth path: 14) ytofofln +8 +ncr+g)]™ Take the derivative of y* with respects: SlSlestmal total tn ode totur ths into anelasiciy, ruliply both sides by s+ using the expression fr 3* fram cqustion (14) on the right-and sie: tea) aa a Lommal [astroy (ato Simpiing yes ats [sees a arerMieel (@) A frstorder Tavorapproxination of around the balanced giowdpath vale of y= wl bof tbe form 06) 9205/8, Ly—y 4] ‘Taking the time derivacive of bot sides of equation (8) elds OD 9-054, Substitute equation (12) ino euation (17) y= [F(a 45+n0+9)], (8) ¥=s0j**"—ai"[n+5-+p(1 +9]. . . Equation (18) expresses ¥ interns of j. We can express jin trme oy sino y~ j* me can wie Jy". Thus 09 /0y evaluated at y= y* is given by [5 [=[sa02a— D2 a2 hn ssc of 4 aul aye Now, "is simply j'* since y = j and thus = 82a. DPE MOD FH 5 C14 §)] =a(00-D)" ~a[n+8+pcr+g)) iSolutons to Chapter 115 Final soba out for by arangingequticn (13) 0 ctan s=]"*[o 484+ +49] ands 3} Jar 5+p(l+gy]a- pj" -afa+3+narel, {1-a)|n+8+ p(t +9] Sulbstitatng equation (19) into eqn (16) gives the ist-erder Taylor expansion 20) y=-(1-a)in+5-+n(1+0) [y-¥"] Solving this diferent equation asin the text) yn 2d) yity-yt= eT MOM Ly(0)-y9] a means thet the economy moves fractien (] - a)[n + 5 + u(] + 4)] of the remaining distance toward y* cach yer. (©) The elesticty of cutput with resect tos isthe same inthis mods asin the basic Solow model. The spool of convergeace's faster inthis model. In the basic Solow model, the ate of convergence is given by (1 -a)fa +8 +, which sles than the rare of convergence in this model, (1 -a)ja +8 pil + 4)} since $= all -0) is postive Problem 12 (a) The gowl-accountng technique of Section 1.7 pes the ellowing expresic fr the growth mateof cutpat pr person: ote Lae ae where ox (0 isthe elaticty of output with respect to captal at met and R(t) isthe Solow residual Now inagie spplying ths growh-accunting equtcn to a Solow economy that ion its balnesd growth path. On the balanced growth path, th growth rates of outpt per worker and capital per worker are bath {qual tog, the growth at of A- Thus eqstion I) implies tat grovth accounting would tebe 2 fraction cof growth in cutput per worker to growth capital per worker, It would tribute he rex ~ ftacon 1 = ox technological progres, as this is what would beet in tie Solow esidal, So with ou ‘sual eaiateof ox = 1/9, gront accounting would atrbut abut 6796 cf te prow in ote per sorler to achaolgial progres and about 38% ofthe growdh in ouput per worker growth in capital fer worker FRe _ Ue (©) nan accounting sense, the resut in part (@) would be true, but ina deeper serse it would not: the reason that the eapitablator rato grows a rate g cn the balanced growth path is because the effectiveness oflabor is growing at rate g. That i, the rowch inthe effecsivenss of abor ~ the growth in A ~ raises ‘output per worker through two chamels, Firs, by directly ratsing output but also by (fora given saving rate) increasing te resources devoted to capital accumulation an hereby raising te captaHlabor ratio. Growth accourtingatrbator the rics in output por worker through te socond channel to growth in the capitalabor ratio, and not to its underlying source. Thus, although growth accounting is often instructive, it is not appropriate to interpret it a shedding light onthe underlying determinants of growthenue wo Cnapter 1 Problem, 2 Sedity leas squares (OLS) yells a bstdesimste fhe slope conti ofa regression ithe ‘vPlanatory variables correlated withthe enor term, We are verde © 9] 0,9] =2+b4 VPN one 2) aL) se] In| YPN) Subsiutingequaton (2) nto) and vearangng yells © ollv7),,.5 + bla|(¥N) go] fea by) [Running an OLS regression cn model (3) wil yield a biased estimate of ‘flees correlated with Hachem (6-0 ~ Dn}. In goea of course ths wl be the ase ee a measurement etor rege fo dterninethe val o CY Nhl tht we gt obese Fron the special casein Farce tee valu of = 1, th enor ern mmotel 3) stapye Trnen ‘will be anbiaced since the explanatory varable will ro lnger be cmrlated wih these to {2 Neaturemest or inthe dependent varibl wil not cause a pobien for ‘OLS estimation and is, in ‘Sr ene of the justifications for the dsturbanceter ina earecon soot Intitively, ithe meesurement converges Ir necme er capita the explanatory variable thorewill bea bce ee finding 2 gh ned eo BONE FE capa owersate,sromth undead, The an ‘comergence: Sk ats income couary growing sowy. Silay, INTO hess vr capita is understated, gow “overtaed. This leo looks ke conergnce: "low" intial neame cashey cea ne ‘ily convergence than here cally isin the cats ‘hat isneedd fra balanced growth paths that K and ¥ ae eich growing ata constant rate. The impli te growth rate of Kis, ko "ke ae padi he ex VIK muse be constant in oder forthe growth ate of Kote consant Thatis, the growth rates of Y and K must be eoual [ake los of kth sides of te production fnaton, (e)= KC)" RATE [ACLA)|"* 7, velds Sato = aeK (+ Bl) + nT) + C =a B-nlaaty nL] Dieentating both sides of (2) with respect to tine giesSolutions to Chapter 117 ©) sy(t)=a8x (0) +Pex t+ wrt) + (1-a-B- yaa (+g, 0] Subsitating inthe facts that the growth ates of RT and L areall equal ton andthe growth ae of Ais equal tg give us sy) 28, 6) +Ba+ m+ (1a P~ yXn+g). simpli a) 2xON AKL + G++ C-a)n~ G4 a+ O-0- Be 208K (+00 +(1-a-B- Dg Using th fac that gy and gy. must bo equal ona balanced growth path avs ws with, f= 00) *(0-ah+(1-a-B-vg, (-aey = -an + --B-e, sods he owt feat cn salar roth path ey oo ap Sees Oee BoD ‘The.growth rate of ouput per worker en the balanced growth pa ¢ ber _ gh y” BL Using equation (5) andthe fact that L grows at rato m, we can write qhp o@a +o Bye Ua (-a-B~)e--an ne Aacdhis tally gy eB © epee B pe Equnien (6 side equation (150) in hetSOLUTIONS TO CHAPTER 2 Problem 2.1 (a) The Fri problem is to cheor the qunttiesof capital K, and effective labo, AL, in onder to Minimize oss, WAL +. suyetto the prodictionhamte, Y= ALRW) Seto the Lge ZewAL rk +3[¥- ALAK/AL] Thefirt-otdr conditions are given by Es F- AALE (K/ALXAL) ww), WO oe 2 we + CKY/AL?]=0 = wealth) =H] 2 aay 2[FOK/AL) + ALE(K/AL\(-K)/ (AL) -ALfCk) = kf"e)}. (2) Diving equation (1) by squation 2) gives us » £2 fi OF =H Enuaton 2) implicitly defines th cotminimiing choice of Clearly this choies doesnot depend upen the level ofouput,Y, Nate that equation () it the etandad cost mnimizing condition te ico he rmaginal costo th two puts, capital and efitve bor, must eqval he ratio of the mergieal products of the ovo inputs (2) ‘Since, as shown in part (a), each fim chooses the same value ofk and since we ate tld that each fm ‘has the same value of A, we can write the ttal amount produced by the N cost-miniming finns as By,= Fated =aray St, = Abo, a ‘where T isthe total amount of labor employed. ‘The single frmalzo has th seme vale of A and would choot the same value ok the choice ofk does ‘et depend on V. Thus it used all f the abor employed by theN cost minimizing fms, L, the sgle firm would produce Y= AL.Ak). This i enacythe same aout of expr rodeo in xa by the cest-miinising firms Problem 2.2 ("The mdiviuat' problem isto maximize life utility given by Gr ct 1-8 “Isp 1-0” subject tothe life budget constant given by @) FC. +P.C.=W, where W represents i ou Rearrange tho budge constraint to solve for Cx @) G=Wh, -C2, 2 ‘Substzute equation (3) into equation (1): 9 vel, we -o e o 1-8 “l+p 1-8 ‘New we can solve the unconstrained problem of maximizing utility, as giren by equation (4), with respect ‘0 ret period consumption, C;. The firs-order condition is given bySolutions to Chapter 219 cufec =C,? (y+ perm /P2)=9 = CP =(yt+e)(P/P) C2, orsinply o 6) C=(1+)™(2,/8)""ey Ineaterto soe fr; subse equation (it equation Co-=W/Pa—(1+5)"9(R,/%)*Ca(8,/P) = Ca[t+(t9}""(05/m)” =w/Ps, or simply W/P Pa (te)!(R/1)? | Fiat gett pina choice of subst eatin (6) inten (5) ta)! /mi) (wits) (ire) (myn)? | oc (b) From equation (5), he optinal ati of frs-period to secondperiod consumption s ® C/C2= (+5) /%) ‘Taking the log of both sides of equation (8) yields ®) ‘nlc, /Ca)=(1/o)in( + o)+{1/0)inl Pa /,) ‘The lasicty of substitution between C; and Cs. defiedin sucha way that it is postive is given by Acc, aseves) (F/R) (C12) oftm(ra/n)] where we have used equation (9) to fndthedesivatve. Thus higher valesof@ iply thatthe individual is Jess willngto substi consumption between periods Problem 23 (@) Wecan use analysis similar 1 the iatukive derivation ofthe Euler equation in Seation 2.2 ofthe tex. “Think ofthe heuschold'sconsummptin at two momantsoftime, Specifically, considera short (formally infinitesimal) pared of ime At for (t £)t0 te +8) Tagine the household reducing consumption per unit of effective labor c, at (ly #) ~ an instant before the ‘confscation of wealth ~ by a small (agzn, infinitesimal) ameunt Ac. Itthen invest this addtional saving and consumes the proceeds at (t+ 6). IF the household is optimizing, the marginal impact ofthis change ‘a lifetime utility must be 2er0 ‘Ths experiment would havea utlity cost of u Vows JAc, Ordinarily, since the instantaneous rate of return it (), cat time (a+ 0) couldbe increased by e"""8)" Ac, But here, half ofthat increase wil be ‘confiscated. Thus the utility benefit would be [1/2}u'(Cafmr )e!""®-S!4 Ac, Thus for the path of ‘consumption tobe wtilty-maximizng t must satisfy ©) Henne ete Rather informally, we can cancelthe Acs and allow dt 0, leaving us with20. Solutions to Chapter 2 Wane), iccontinuous jump in cansurption atthe time ofthe confiscation of weath. Specifically. consumption will jump dow, lnutivaly, thehovschols consumption willbe high before because it will havean incentive not to save so 28 to avoid the weulth confiscation. (b) In ths case, from the viewpoint ofan individual househol, it ations will nt affect the amount of ‘wealth that is confiscated. For an individual housebold, essentially a predetermined amount of wealth will bbe confiscated a time t and thus the households optimization and its cheice of consumption path would take this into accourt. The householc would stil prefer to smeoth consumption overtime and there will not bea discentinuoas jump in consumption at tine Problem 2.4 ‘Weneed o solve the households problem assuming log utility andin por capita torme rather than in wits cofeffetive labor, The households problem isto maximize lftime uility subject tothe budget centri: Tint is, ts problem sto maximize v= Femme a, subjec to ue, ‘Wecan ute the informal method, presented inthe text, for solving this type of problem. Sec up the Lagrangian: Tere ncn acral we Te ® cy Ter moot Paralw- Teme Ha ‘The first-order condition is given by 28 eoetcqy-! Hyg Rty WO, Beret eto Wg Cancctng he LO yes G) eee! = ne R, wich impli A) CO =e™ A eR, thay ws ote pl min qin ges oo Fertile cit] HO gy “ : Since L(Q = e" L(0), this implies. (6) 7 LO Forty Hoo {As long as p-n1> 0 (which t must be, the integral is equal to l/(p~n) and thus his given bySolutions to Chapter 221 0-0) on ing euaton (7) int eatin (0) lds Key ae 0-H) (pa =e! nl’ | BE con unin pr pen, 7 we pr ius nd Gt me ot people howehold, Thus W/TL(0V/H] is wealth per person. “This equation says that intial consumption pet Bs person is a constant fraction of initial wealh per person, and (p ~n) ean be interpreted as the marginal path ofthe real inforest rato. Also notethat the bigger ie the households dicoant ate p= the more the old discounts the fature ~ the bigger isthe fraction of wealth that it initially censumes 'W dmoes the households intial wealth pus the present value ofits liftime labor income. Lethe hand side of equation (2.6) inthe text. Note hat the real interest rate is assumed to be consant. use the informal method, presented inthe text, for solving this type of problem. Setup the oot CO" Let) rece) XC ae 0 6t) wT Te asad J ‘co. | first-order condition i given by 4 - ue « Lit) eee 20 Rw tty wing te LH sin 1B) eR ceyt ane Dieta bath sds of equation (3) with respect tote 5 FAL e(0]- pe FC? sa Piece ota Bm) 0, ee Oty ® ~pe"Pcay ‘Now eubstiute the first-order coudition, equation (3), into equation (4): 0 thet =022 Solutions to Chapter 2 COD ow “ eet pret 4s cw“? Canceling the 22“" aad solving forthe gronth ate of consumption, C()/C(t), veld ea) =p Oars ° ‘Thus witha corstat eal interest rate, the growth ate of consumption i a constant. If» p—that i, if the rate thatthe market pays to difercorsumption exceeds the houscholé’ dscoun rate ~ consumption “ill be rsing overtime. The value of determines the magnitude of consuryption growth i exceeds p. A lower vaiue of @ ~ andthus a higher valve ofthe elaeicity of substation, 1 ~ means tht eousumpticn ‘roth will be higher for any given difference between and p ‘We now need to solve forthe path of C(). Firs, note that equation (S) can be rewritten as oo 28) a" 8 legate equation (6) forward fram tme r= Ota tne ¢ = incey ~incO)=[[r-p)/6] 4, vic sinptites to © wfew/cco]=[(r~ Aft “Taking te exponential function o bath sides ofequation sles Cay/cco=al 99, snd ths @) ce =coall-A9K ‘We can now solve for iitistconsumytioe, C(O), by using the fact that it ste be chosen to sais the householés budget constraint, Substzute equation () into oqutien (2): Je-*cyyll0it LO ge wy si ‘crop aw Using he fac that L(t)= L(Oe* yds () LOO. Foe ts Aslongas [p=1+ 8(¢-m)]8 > 0 we en sove the integral 1g f lorsee-aledy, 8 0 p18) Substiute equation (10) into equation (9) nd soive for C(} W |onn 1) C(0)= | OD epg On c= a ete Finally to get an expreston for consumption at each instant inte, seb equation (11) nto uation ® a2 co =d!Solutions toChapter2. 23, Peabo 26 {5 The eu describ he yams of he cai sock per it of eoctve abort 0 k= Mk) -e%)-(o+nk Fora giv thelowl of Hat imple =O i given bye = y= (a+, Thulin grate Ive ofc concent wth K=O tighr fora gan Thats the = care shits up. ntutvey, omer {makes Breakceveirvesmen er aay given kan thi allows for mor sauces tobe devtd to fonsuoticn and aillmantan agien L Sac (o+ kale prporicatly mor athe evel afk trek =0 carve shifts up note at higher lvls of Sete figure (2) Thecqatndeseribng he dams of onsumton pr uit fefeive labor is gen by at) Pk) p88 ati “Thus he cron required for &=0 i ie by f°) = p +0, Aer thefallin must be ower in cede for €=0. Snes" (is pativeths means tat the knesed for €-0 thot ses Ths a0 eave shits whe rght (0) Atte timeof the change in g, he salue of, tho tock of eaptal per unit of fective Labor, is given by the history of the economy, and & cannet change ‘scontiuously. I remains equal tothe 1 onthe old balanced growth path In contrast, ¢, the rte at which household are consuming in unis of effective labor, can jump a de time of ‘the chock. In cede forthe economy to raach the new balanced growth path, ¢ ‘ust jump at the instant of the change so that the economy is onthe new saddle path, However, we cannot tll whether the new saddle path passes above or below the orginal point E, Thus we ‘cnn tell wheter c jumps up of down and infact, ifthe new saddle pth passes rght through point E, © ‘might even remain he sare a dhe instant wat g falls. Thereafter, cand k rise gradually to heir new balancod-growth-path values; these are higher tan their values on ths origizal balanced grow path @) Ona balanced growth path, the action of ouput that is saved and inverted i given by [ak*) = AYR. Sinco kis consan, or = 0 ona balanced aronth path thn, fam equation (1), can vite fit) -c* = (2+ DK". Using this, we can rewrite the retion of output that i savedon a lanes srowthpathas ©) s= lens ery), ‘iffceiating both sides of equation (3) with respect to yields & _ FWY eMAk*/0g)+k*] (a+ wk VK" /ee) orev : te {re which simplifies to24 Sclutionsto Chapter 2 & _ (4 ghFCat)— ke PG 0p) + FC os fan]? Since kt is defined by £4) ~p + Op, diferentiating both sides of this expression gives us F"q( ekg) = 8, Solving fer Ze*/ég gives us (6) Ailey “0 <0. Substituting equation (6 into equation (5) yields &_ (ne gif(it)—k* F(ke)}0+ FORK Et) oF - ee [een erry “The first tem inthe numerator is postive, whereas the socend is negative and sothe sign of Os'0pis ambiguous. Thue ws eat tll whether the fling raises or lowers the eaving at onthe new balanced ‘growth path ° (6) When the production fnction is Cobb-Douglas, f) = 1°, (4) = ak" and 0) = ofa - DR" Substituting thes fats nto equation 7) yields 4 beak eek ka(a ket? oy 2 {orate kta? es ht kata o Ke Fafa Dk which simplifies to . (oy 2 = Otek O00 Co eo Oe teak ake HCek Fa ‘which implies 00 = Thus, finally, wehave | G99) | © ay S20 G2) ae (+a) (0+ 88? Prablem 2.7 ‘The tvo equations of motion ao FRC) Pe oO aT ee and (2) Kee) = £(KCO) — oft) (+ BDK(t). (a) Arise in9 oca fallin te eascty of substi, 1/8, means that housholds become less wing te substitute consumption between poviods. also neaas that the marginal tility ‘of contunption fll off mere apy a8 A consumption rises. Ifthe economy is growing, this tendsto make houscholds val present ‘consumption more than future consumption, y ‘The captal-accumulation equation is unaffected. ‘The cendtion required for ¢= 0 is given by £°Q)=p- Og, Since £*(K) <0, the fC) that makes é~0 is now higher. Thus the valve of k that satisfies &=0 ie lower, The &= ( lorue keke kSolutions to Chapter 225 ‘hits tothe Ie. The economy moves up to point A on the rew sadil path; poopie consume mere now. Movertentis then down along the nw saddle pa until the economy reaches point E'. At that post, c* and k are lover than their eriginal values. (b) Wecan assume that a downward shift of the production function means that for any given k, both (k) and fk) are lower than before ¢ eo 1%) a y= A) q T= fy 1 Gre o k-0 Te fy k The condition required for k— 0 is given by ©~ f{k)~(a-tg)k. We ean se fom the figure onthe right ‘hat te K = 0 locas will shit down more at higher levels of. Also, siace fora given k, £" (is lower now, the golder-rle k will be lower than befor. Thus the k= 0 locus shits as depicted inthe gure The condition requted for &= is given by £(k)= p+ Og. Fora given, f() ie now lower, Thus we need a lower kto keep "(the same and satsfythe €=0 equation. Thus the €=0 locus shifts let. Tho economy will eventually reach point "with lower c* and lowerk*. Whether ¢ intially jumps up ox down depends upon whether the new saddle path passes above or below point E, () With a positive rate of depreciation, 8 > 0, the new exptal-accumuation equation is 8) KC) =£0A(0) ~~ G+ 8 + BK) e=026 Solutions to Chapter 2 ‘The level of saving and investment required justo keep any given k constant is now higher ~ andthus the amount of ecnsumption possible is now lower ~than i the cave with no depreciation. ‘The level of extra investment required i leo higher at highor lovee of, Thus tie k =D locus shifts down more a higher levels of Inadeition, the real retum on capzal is now (k(t) ~§ and so the households mavimization wil yield elt) _£(k(t) -5-p- 0g oD ; ‘The condtion required for ¢=0 is f'(k)=8+ p+ 0g. Compared tothe case with ne depreciation, f (k) ‘ust be higher and k lover inorder for €= 0. Thus the &=0 locas shits tothe lef. The economy will, ‘eventually Wind up at point E "wth lower levels of ¢* and k*. Again, whether e jumps up or dow intially ‘depends upon whether the new saddle pat passes above or below the orignal equilibrium poirt of E. Pra Woh a positive deprecietion rate, 8 ~ 0, the Euler equation and the capita by at) _ F{k(o) att) oe = f{e¢t) (0 —[n-+8 + Ow % + and 2) eit) = ek) -e(t) -[n +g +8)(), ‘We begin by aking first-order Taylor approximations to (I) and 2) arouad k=k* an can wate cumulation equation are given Bynes Benen ay vgs enn © can tk-k4 ae ‘|, and Ok: ark a et, here i, 3, an 2 areal vet at =k and ee Define €=e~ct and E=k—k¢. Sincoct andi are constants, é end k are equivalent io & and & respectively. We can therefore rewrite 3) and (2) as a, a md) Rete Using equations (1) and (2)to compute these dervatives yields feet wo 0 8 ep -+gta]h-e [6+ p+0g)-n +g +8)] ke fk-@ ‘The second line of equation (12) uses the fic that (1) implies that fk) = 8 + p+@g, The third Ine user the deftion of = p-n- (1-8)Solutions to Chapter 2 27 Diving equation (I1) by € and dividing equation (12) by K yields E_ fire ke cy F2FNO ead (18) FEB-E "Note that these are exactly the sameas equations 2.31) and (2.32) in the text adding a postive deprecation rate doesnot alter the expressions forthe prowth rates of @ and K.. Thus equaton (2.36), the expression for the constant growth rte of both & and & as the evoncmy maves toward the balanced srowth path isstil valid. Thus arene 18 2 6) Fe Sauarns both sds of equation (16) gives yee? snd equation (17) ca be ent at (SMD a1 4-5)" 19) FR" sap! 9D eK ake? a F(R) Inaldition, defini tobe the saving rat onthe balanced aroha, we an writ the balanced sowtpat evel of emsumticn 3s 20) c= (stk) Subsiatng equations (19) nd (20) int (15) ils 2 gf PNP ape 8-6 (je dose) H z Cancsing the 9 and tying thr bythe minus sign yilde @) w= ‘On the batancod growth path the condition reqired for € ~0 is gen by ¢ =p + Ogand ths 22) rt +8~p+0g+5, In addition, acta nvng, £4), equi break-ovn invsctmont, (+ g+ kt, and thus Gsetdk (teed) 3) st SHEA = 2 1) ok where we have used equation (16), #* +8 ak" From equation (23), we esn write (e°48)-a(n+e 8) 35) Substituting equations (27) and (24) into equation (21) yields eH (-s)28 Solutions ta Chapter 2 p- {(o+0g +8) [p+05 +8-aca+g+0)] 29 H- 2 Eqtation (25) is analogous to equation (2.38) in the text. Itexprestes the rate of adjustment in tems ofthe ‘underiving parameters ofthe model. Keeping the values in he text a = 1/3, p= 4%, n= 2% g = 1% ‘and 6 = 1 = and using 5 = 3% yields a value for us of approximately -8.8%. This is faster convergence than the -5 4% obtained with no depreiation, Pesblem 29 (a) The real sfectax rate of rum on capital is now given by (I -3)f" (Kid). Thus the households ‘maximization would now yield the following expression dozeribing the dyeamics of consumption per wit of y £0 [ec - ° The condition required for €= 0 is given by (1-9)f'(8)~ p+ Og. The afler-tax rte of return must equal +6g. Compared tothe case without tax on capital, (th pro-tax ate of retum on capita, must be effective lor 9-60 et higher andthus komt be loner inorder for €= 0. Thus the &= 0 locus sis tothe lef The equation deseribing the dynamics ofthe capital sock per unt of effective labor is stil given by 2) k( = £0) ~c(t)- @+B)KIt) Fora given k,the level of ¢ that implies k = is give by e() =k) - (a +g)k. Since theta is rebted to households inthe form of lump-sum transfer, this k = O locus is unaffected. (©) Attime 0, when the taxis putin place, the value of the stock of capital per unit of elfeive labor, is given by the history of the econony, and cannet change Aiscontinucusly. 1 remaine equal tothe kt nthe cd talanced growth path Ih contrast, c, the rate at which househelds ae consuming in units of effective labor, ‘an jump atthe time that the taxis introduced. This jump inc is net, inconsistent wih the consumption smosthing behavior implied by the housthelds optimisation problem since the tax was unexpected and could net be prepared for Im order forthe ecenomy to reach the new balanced growth path, t shouldbe clear what must occur. AC ime 0, ¢ jumps up so that the economy is on ‘he new sadile path. In the igure, the economy jumps ffem point Eto &point such as A. Since the ream to saving and accumulating capital is now lower than befer, people swatch away from saving and into conceptionSolutions to Chapter? 29 ‘After time 0, the economy will gradually move down the new saddle path unt it eventually reaches the new balanoed growth path at Exaw (©) Ox the nev balanced growth pith at Exe , the istortionary tax on invesament income has caused the economy 1 havea lower level of capital per ent of effete labor as well asa lower level of eansengtion per nit of efecto aber. (@@) Fromithe analysis above, we know thet the higher isthetax rate on investmet incone, +, the lower ‘willbe the balanced-growth-path level of k* all else equal, In terms ofthe above story, the higher is tthe sere thatthe ¢= O locus shiftsto the left and hence the more that k* falls. Taus Ck*/0t <0. Ona talance growth path, the fraction of output that is saved and invested, the saving rate, is given by [fG*)-c*V/ RK), Sincek is eomstant, or k= 0, ona balancxd growth path then from qi) =#(K(t)~eft)= (a+ gDK(t) we can write kt) - ct =(n + gk*. Using this we can rewrite the fraction of utp tht is saved ona balanced growth pah as @) sa tok YA. ‘Use equation (3) 10 take the derivative of he saving rate with respect tothe tx rte, x: (gy 2a BMG LB Fe) Cas wk POH LER* EO) o Key Simplifying yikes (63 _ (048) ok? mepieracyen” eg ae/ Lea] Be F008) Or FOR) FR) or Fe) aL FR) Recall that k'f" k*)K*) = ax (*) is capita’ (pretan) share in income, which must be les than one. Since ck < Owe an write OBO a Oa Ty oF [i-axc*)] <0 ‘Thus the saving rate onthe balanced growth path is decreasing in (@) (i) Ctizas in low-r, high-e, high-saving countries donot have the incentive to investin low-saving ‘countries, From par (a), the condition required for ¢= 0 (1 -1)f"()=p +0g. Thats, th after-tax tate of retum must equal p ~ Og. Assuming preferences and technology are the sme across counties 50 that p, 0 and g ae the seme across countries, deaftetax rate of retum willbe the same across counties Since the after-tax rate of rtura is thus th seme in low saving countrics as itis in high saving countriss, there ie no incentive to shift saving from a high-eaving toa low saving country (€) Should th goverment subsidize investment instead and fund this with a lump-sum tax! This would lead tothe opposte resuit from above andthe ecenomy would have higher c and k on the new balanced ‘arowth path+ sums eo naprer 2 Theanswer ieno. The orginal maiket outcome is already the one that would be chosen by a sentra planner attempting to maximize the lifetime uty of 4 representative household subject to the capital ‘sccumuation eqution, Ietherefore gives the household the highest possible iene uty Staring ot point E, the implemertaton ofthe subsidy ‘would leadto a short-term drop in consumgtion at point A, but would eventually result in permanently higher consumption at pont Exsw It would turn out that the utility lst fom th shor-temn sacrifice ‘would oxtweigh the utility gamed in the long-term (all 'n present value tems, appropriately dissouted), {iis is the same type of argument used to expla the reason that households do ner choose toconee oat the golden-rule level. See Section 24 for a more complete description ofthe welfare impliatons of tic mode! (0 ‘Suppose the government does not rebate the tax revenue to households but instead wees tt nuke goverment purchases. Let it) represent govemment purchases per uni of effective labor The equation 0, or Ink > V(1 a), an inetesse in ce meanea higher Ie for ¢ given ke and thus the ke fuetin shifts up over this range of y's. However. for Ink < M/C), anineresee in ac rmeans {over kes forgiven ky. Thus the kx. function shifts down over this range of k's Finally, right at ‘nk,= U/C, the old and new k., functions intersect fu[a-coink, i} 2 (@) We esd to find an expression fr hn a5 a frction cf, Next period's copital stock is equa te this Betis capital stock, plus any investment done this pried, less any depreciation that occurs "Thus ) Key = K+ 2, 08K, ‘To convert this into units of effective Inbor, divide beh sides of equation (1) by AciLey Ker KGa) 4e¥) K0"8)+e¥, ky -5) eatly) Aviles Auilia — C+m(4gAdy @rayleg) * hich spits to 1-8 s es +] It © ke is} lool Ko (0) Weneed to sketch. ata function ok, [Note that 18 Pk, Araya) and using the Inads conditions <0, 2, lassie ot aE Temp lim 2h , keso okey ie Ok, Greyrg < ‘Thus the Furcten eventually has a slope of Iss than one and willtheefere cross the 45 degre line at some ‘Point Also, the function is well-behaved and wil cross th 43 degree line cay onceSclutionsto Chagter2 37 ‘As long as kstarts cut at some value other than 0, the ‘econcmy will convergeto k*, For example, fk stats cut below Kt, we se that er wil be greater than k and te economy will move toward k*. Simlary, if starts out above k", we see that ky, will be Below ky and again ue ecomomy will move owardk*. ACK*,y = £(k") is also constant and we have 2 balanced growth path (00m tne routhpats oy “KH ad som eon 1-3 : Geoniea | Lara which smolfiesto je Lentptng 123) fs | emi Slarmare “Thus ona balanced growth pith @) Beg +ng + 8)= if) Rearranging eqiaton (3) to st an expression fr son the blanca srowth path yields @ s= (n+ g=na+ OKA) ‘Consusptin per unit of effective labor on he balanced prow paths given by ©) = (1-3), Subsite ute (nt cuon (argengsdke], [flkt)—keinse+ne+d)]. ray ete fe Canceling the fk) yields © c= fU)-(at gre 45K" ka, Sie tk) “To get an expression forthe f(k) that maximizes consumption per un of effective abo onthe balanced owt pat, wo need maximize c* wih respect tok The fs-ode coudion i given by det/ok*=F'(k)- (a+ 5+15+8)=0. “hus the gelden-rle eptal sock is defined impicily by O) Fea) m0 g 05 +5). () (Substitute + Cobb-Douglas production funtion, fk )= 8 i eat =| Ia] ee o ntal a (8 G Ona balanced gro pith, ey —hy= Kt. This fom equation): mal lioaal inna) Trae dyes=~ semtions co Chapter 2 Tame > esses +5, Ce aKtg) [ ot eemes, and hs aly ©) = Ela gs ng +50 Using equation 8) Co) Skeet oe et dee | ge meg) (+ayit+gy Ssbstulng he balmexdgrowthpathvlueof equation (9) ito equaticn (10) yields ay I-35 ae (erecagso] thee C4059 Taare wil beset to wien +595 +8)a5 140X145) <1 “5 ide | G-9 +2f(i ++ =(1-8) ae ha raya) Simplifying futher yields 4 0-90-a) emargy [0-8 a/ct+ma ely eo), auton (12) implis (B) ky = 10° 80-eV/ Cte abt fey i. ‘ath each prio Some simple algebra simplifies the, expression for this rate of convergence to Galas e+ng-+8)(1+0y+g), wale Ai3.0= We 8 2% and 8 ~ 3%, ts ae of serpeBenes of about 3.9%. This is swe than the rate ‘ofconvergence found inthe continious tine Eroblem 2.15 cure Coat eS ales oe ‘subject to the budget constraint 1 @ Cut Carel = Aywy ar AS in the text, with no depreciation, the ‘action of income saved, s(r., )= Cay Aon, is given by i © sig)= a 1+ pase yee a ——————————— Tiusthe somony mows facion 1=[a + (1-8) pl + 201+ ofthe way othe bataced promtSolutions to Chapter? 39 stuustheway in wbich the action fico saved depends on thera iatrest cate, wichange ‘Toshi iference is thatthe real intees rte tes now £" (kus) ~9, rater than jus hes) Tae clock in penodt + | equals the amount ave by young individuals period, Ths @ Ker=Sike, Gree Sys the amount of saving done bya young person inpriodt. Not that S.=2(6» JA: he ier ving dae equal tothe resin of nconeeavedties fhe amount oFineame, Ts eqtaton (canbe rwriten as © Kors Late A So gets ino ant fine +1 fev hb, vie th ier fein) Ab Kar Atl fata OF patan Peal Ol Since Avy (1+ JA, weave AA = Ke Aes Las ko Thus © ba= [sede] (1+). Similarly, Le Les = V(1 +n), In adn, (enydl+a) Finally, substtte for tvs = f° (kes) 8 and'we ‘ fll) kif" Oe: ® bia raya rplt(Pow-si]ltcen kk] “This shouldbe compared with equation (2.58) ia the tex, the analogous expression with no depreciation, whichis 1 erat “taal eed) [FY EPO] ‘Thus adding depreciation does ater the relationship between ky and ke Whether ks will be higher or Tower fora given k, depends cn the way im which saving varies With (©) Wir garth wey, the aon ofincme saved do not den wpe he ate of rer on eaving Sanne © hon) = 2+ 0) Frade, wits Cabb-Dovgls production y=? the eal wage i w= hi kak tution (becomes 09) k _ 1 Gat “1° Graarelaret MS We aed ocoupars hs with equton Q) inthe sli to Protlam 214 the analogous expression inthe Uscrtetine Solow moda) wih the adtionlasungton of 100% deprecation (ie. = 1 -a)k. Thas ‘The saving rate inthis economy is total saving divided by total oatput. Note that this i not he same as “Aéw, whic is simply the fracton of thei labor income thatthe young save. Denote the economy’: total ‘saving rateas §. Then 3 will equal the saving of the young plus the dssaving of the old all divided by {otal output and in aden, all variables are measured in unts of effective labor, “Thesavingot the youg is [(2+ pl] 1~a)k,*. Sic ther is 100% depreciatien, the od do nt get to dissave by the amount ofthe capital stock, there is no dissavng by the old. Thus We+o)a-ak* 1 4 k: Tp > ‘Tous equation (10 can be rewriten asie 40 Solutions to Chapter 2 sro +077, Tite Sepesmstheindvidalssvng inthe fpr. Ae fr te nda s omen ate fra on oil ecu. eal isl pat beatae oes oe is (1 + no: ). From equation (3), (1 +uSe= C2441 - (1+ n)T. Solving for §, yields. Cau (len) Tt Now subsite eution (ino equation 2) {Stil ge one ea) COT OT Tet Rexranging we eth itennerl dt contin 1 ae ana G © CT am Gee Mie hat wih legac ily, th invidual wil consume tain (1+ (2+ ) ether ittine ‘wealth inthe frst period. Thus (=) Teste fans rp, his ti) in) s (22 Pere i | tp, Cite | B+ 00+ )=C4 pyr 0) © 5. -[Vl2~pllawy ct C+ pv rai) - eta if torn. saving seduced one-one bythe social scuntytox. Ite: >a, seving fll ess than one-for-one. Finally, ifs kx, he ald generation would again gain due tothe exta ‘henefits. In this case the redaction in k* would actually allow for higher consumption for future ‘generations and would be welfare-impreving. The introduction ofthe tax in this case would reduce oF possibly eliminate the dynam inefficiency caused by the over-accumulation of capital. ©) @) Equaten @) becomes 3) Chay = Ler DS +t rT. AAs far a the individual is concemed, the rate of ern on social security isthe same as that en private saving. We can now derive the ntertemporal budget constraint. From equation (16), 4) 8,= Coy /[14 01) -T. Substituting equation (14) into equation (2) yields cyt Tt cmp 2401 09) Cae pe ‘Thies usttheusal intertemporal budget contrat n the Diarond mode! Solving he individuals saxmizatio problem yields the usta Euler equation Cayo =[Yl Merry Aw) -T+T, Subsitting this ito the budget contra, eqtation (15), yields 16) Cp =[(1+ A/(2 + pl] Aw.2 Solutions to Chapter 2 Tose saving pr prsn, si quan (6) mt sqaton 2) Sy =Avv, —[(1+6)/(2+ pllAw, —1, orsinply {2+ paw, —7 ‘The svi secury tx causes 3 one-for-one reductim i private saving Hse bth sides oF (8) by AL to conver this nto unis of ctv labor and using equation (17) vieas (19) Wy tales th std dng ea =lMMCe a H/o, Vien tone tangy 89) kr =[yltsa))[Yarp) cane ieee fillyfunded social seunty system hs no effect onthe relationship baton the capital stock in ‘sicesssive periods eaREatofretim as private saving inavidual aw infers tao thesaving. Thus ‘nfividvls offs one-for-one any saving thatthe goverament does fo hone 2.7 (0) athe decenratzad outrun, tere wil be no intergeneration trae, Even ifthe young would Hike Tata seth ered fr goo next peri, the only prope award anes are the old, ‘afore, the od wil edad — and thus inno poston voconphag gee et peried ‘The individual's wtilty function is given by @ tay, +19 ey ‘The constains are @+h=a, and) Coy ‘here F isthe amount stored bythe individual AF, jetting uation (2) nto 2 yields the intertemporal budget contin: © Cy +Cryafxea anes So maxinizlitine ily, s gen by eg (1), abject he ‘stenenpon tuigetcontrant as give by eqaton (d), Stop te oan f= IC Hace + A[A-Cy_ ~Creui/x The rs-orer contin are given bySoltions‘o Chapter2 43 Az/OC yy =YOy-A=O => YCy= Rand 84/2Co=YCoun-Hx=9 > YOu = Mx. ©) Substitute equation (5) into equation (6) and reerrangeto obtain Caper =*Cix Substitute equation (7) nto the intertemporal budget constrict, equation (8), to obtain Cyt xCafe A, ocsinply @ Cyy=A/2. “To ota an expression for stcond pied consumption sabsitute equation (into equation (7) 0) Coes = XA/2. ‘hea young, ech individual consumes hal of ter endowment and stores the oer hal tht, f= 1/2 “This allowster to consume xA/2 when ld, Nee that with lg bly, the faction of er endewnsent that the individual sores does at depend upen te retum to storage (0) Whatis consumption per uni ofefitve labor attime ¢? Fis calculate teat consumption a tnot Cp -Cyhy + Codes tee deearet youu ad a. ol indviuns alive atime. Each young prec eonsumsthofacton Un exdovenent that she doe not oe, (1-AL and eth i orem gets to connie the gist eta on {Se facion afer mdowment that she sored, feA. Thus C20 PAL, HEAL, “To camert ths into urits of tet fective labor, dvi bah sides by AL at CAL, =) f[s/014)] “Thus eonsumption per unt ote tofictve labor is» weihted average of one and Somehig ess han ee. since x (1+). Iwaltheefre be maxamied when he weight on one ioe; thats, whe f= 0. (We coul also eany out his analy on eansumpin per person abve a time whic Would not chinge theres hr) “The decentralized squiibsum, with = 1/2, snot Pareto efficent, Since intergencratonal trade is not possible, individuals ae “forced” into storage because that isthe only way they can save and consuae in ‘ld age, “They must do this even if the return on storage, x, is low. However, at any postin tim, a socal planser could tke one unt from each young person and give (I~ n) units to each old perton since there sre fewer of ther With (I +n) > x this gives a beter reum than storage. Therefore, th secial planner ‘could raise welfare by taking the hal of each goneraton’s endowment that t was going tostre and instad Siveit to the old. The planner cculd then do this each period. This allows individuals to consume A/2 ‘units when young the same as in the decentralized equiibriam ~ but now they get to consume (1-+n)A/2 units when old. Thisis grater than the xA/2 unis of consumption when old that they woule have had in the decentralized equilibrium with storage Proven 218 {@) Thc individual as a tly function given by ) ney + Caco aad contri, expresed in units of money, given by @) P(Cy, = RA-PR - Mf yand ©) PaCopai = Peak ME whore Mf ie nominal money demand aud F, isthe amount stored44 Solutions to Chapter 2 Adepend upon the gros rato oF retum en storage, x, teative The gross rate ofretum on money is PYP., since the \ ofconsumption i period tand get, units of money. In perodt © raven Shezeuion cons Panis of mane and thas ene nit of neey wil ba Pe a of consumption, ‘Thus the indvidits Panes of mene will uy PP. unis of eoncmnion period t+1 CASEI: x>P./P. Fa uh hereon, eth ot wd any mony sine het tu oo ‘money isles than tert of tum on sage, Tes CunAR R=AR MEJe=0 Creag aeaje CASE2: x Pa = Be flea), ‘This analysis holds fer all time periods t > 0 and so P,, »./(1 +a) ig an equilibrium, “This shows that if sore natrolucd nos racy neice cotony. tongs wie be used. The monary ‘equilibrium will thus result in attainment of the "golden-rule” level of storage. See the solution to part (b) of Pete 217 fora explanation of teem at zr sage mans cnsumptn pe i of fete Ibo. (©) Ths isthe situation where F/R. = x;the etum on money’ equalto the et on sore, Inthis ase inviduls are indies to how much of thir saving 0 Sore andhow mh tohot inthe frm of money. Let ey « 0,1} be the fraction ofsavinghel in the frm of money is period Wea agin. derive exprassion for aggregate rea money domand end supply in period t sgegete ral money demand ~ Lya,[A/2, and aggre al money spy [Lo +m] 4/2, =| /c1=0)"']/2 We canthen use the equilibria cordition o solve for Py Le,[a/2]=[L./a+m|M/, = = 2M/faaaem"!] @ We can similarly drive expression for real maneydemaad znd supply in porad t+ 1 sagrepste real money demand = Ly A/2] = (1+n)L,044,[A/2], nd aagrgae al money supoly= [Ly +0)"] 4/2. We cantne use the equilibrium condition to salve for Ps C+ ayLoaild/]=[L/d+m" m/e, > Pua =2M/fardcem™]. Diving equation (8) by (7) yields Poa /Pe=[0 (are [VO+n] For BP. x, wensed Feral lyara]=yx > [era/m] -[/rny]0 is equivalent tox = Q,/ Qui forall t> 0. Ta other words, the ate of retam (on storage is equal tothe rate of retum on trading and hence the individual is indiffrent a to the amount © store and the amount to trade. Let cy {0, 1] epresent the faction of "caving", A/2, thatthe individeel sells in peiodt. That is, the individual slls 0, (4/2) in period t. This allows the indvidualto buy the amount o4(Qu/Qes XAV2) when she is oldin period t+ 1. The individual stores a faction (1, )of her saving”. Thus &) S.=(1-o, 142), Consumption in pericd t+ 1 willbe equal to the amount the individual buys plus the amount she hes ‘hough storage. Thus 4) Cao = 04(Qi/Qe1 WA2) + (1 =)RCA2) Since we are considering a casein which Q, /Q.1 ~ x, equation (4) can be ewsten as (8) Cony = 04 (4/2) + (1 =, )0(A2) = XA), Consider some peiodt + 1 and et L represent the total number of individuals bom each period, which is onstant. Aauregate supply in period t+ 1is equal tothe total number of young individual, L,smukipbed ‘by the amount that each young individual wishes to sll, cu. (A/2). Thos (8) Aggregate Supply.r = Loy (A/2) Aggregate derand in period t +1 is equal tothe total numberof od individual, L, miplied by the ‘amount each old individual wishes t buy, (QQ), (A/2). Thus ©) Aguregate Demand.s= 1(Q, QJ, (A/2). For the market to clear, aggregate supply must equal zggregate demand or Lose (N2) = LQe/Qes My (A, ‘simply @ a. (Qs), ‘Since the proposed price path hat Q. = Q, x, tho equilibrium cenlion given by equation (8) can aso be swritten as ©) G4 = 20, ‘Now consider the situation in perod 0. The old individvals simply canseme their endowment, Thus we ‘ust have oy equal to zero in order forthe market to clear in period Thus eqiation (9) mplioa thee we -musthave 0, = for allt 2 0.Solutionsto Chapter 247 -hereatng suis the same astht inpae of Problem 2.17. Theva ones halfot Pte cndowneatin fist period oi, tes there and coeunes xA2in fe sornd period of ie Mesrtat ih <1#n bere(snoen =O nds <1), this equlitrium is ynaicaly neficiet Ths ‘iain nol rath by aloving sida ota eee the art of ime ds celine Sumi eiey (a) (i) Suppose te auctioneer anncunces Qh Qi oF equivalently x> (Q4/Qu for sme ditt. ‘This means that storage dominatss trading forthe young at date t This means thatthe young at date twill want to store their entire endewnent and wil want to buy A/2. For the old at éatot, Qui irelevart ‘They besed their decision of how much o trade when old on Q, /Q.s which was equa to x. Thuseach od individual was not planning to buy cr sell anything. Thus aggregate demand exceeds angregate supply and ‘the market for the goo! will not clear. Thus the propesed price path camnot bean equilibrium. (©) Consider the soil planer’ problem. ‘The planner can divide the resoarces available for consumption ‘between the young an the old in any mater, The plaaner can take, for example, cne unit ofeach young person's endowment and transfer itt the eld. Since there are the same numberof old and young peep in ‘his model, this increases the consumption of etch old person by one. With x « I, thie mathod of ‘tanefering frem the young t the old provides a bater return than storage. Ifthe eccnomy did not end at some dete T the planner could prevent this change from making anyone worse off by cequiing the next seneration of young to make the same transfer in the following period. However, ifthe economy ens at some det, the planer cannot do this. Taking enything from the young at date T would make them worse off sce the plenner cannot give them anything in retum the next period; there is no next peried. ‘Thus the planer cannot make some generations beter off without making anther generation worse off Thus the decenralized equilibrium is Preto-eficient (© Ris infite duration thatis the rource ofthe dynamic ineiciency. Allowing individuals to ade fore the aa of tine require «pice path thet ete in an equlitram which is equivalent toto situation whore such a market does rot exis. This aquirium fenctParto-ficint a social planner could raise welfare by doing the procedure described in part (b). However, removing infinite duraticn also ‘Femoves the sosial planner’s ability to Pareto improve the decentralized equilibrium, as explained in part ). Problem 220 (@) The nivduathaswty function given by Crs Cayat® 1-0 * 1-8 “The constraints expressed in nits of meney are @ PC=RA-Me, and @) PrsCayyy = ME ‘Combining equaticas (2) and (3) yields the lifetime budget constraint. eet48 Solutions to Chapter 2 RC +PeaCa ay = PA. ‘Neto that @ <1 meaas that theelaticty of substitution, 1/8, is greater than one. Thus when the rate of ‘etunton ving incteasss, the substititon effect dominates, the individual will eons eve now aad save Bray, TH is essentially what we wil be showing here. As the rate of return on holding money, whic PP nos the individual wishes tohold ore mene. ‘The intivihuas problem is to maximise (I) sbjet wo (4). Setup the Lagrangia Cis! Copa? } fee co HPA -PC1, ~PraCasn] The fer conions ate PAAR =O Su and (5) iAP =O => rae ‘ ae 0, Bey ORB =O Cay Paar © Subst (5) nto (6 to obtain 6 Cont aCe P/M (Cr /Cia) or simpy e ® Corer =(Pe (Pat) Cy ‘This the Euler equation, whch can now be subsite int the budget contin (4 RCic +PealP/Post) Cie =PeA Dividing by Peis 18 Cie # (Mal PI( RP! aed sinpliing yes 7 Cu Hl/Pal CA Gy [t(7./P.a)| aus consurgton when youre is gven by © C= A Pu) Pt > Cora /Cy, 1-80 14 (PJP? Comma snout of er exdowment that te individual sels for money (fal ern), we an use equaton (2), expressed in reel terms “ye Satis quintet chain soot {1 Helm aO PT tele) Simolivieg by esting «common denominator yelds Me o% ving the tp and botom of the righthand side of equation ©) by (P,P) "2 yitdeSolutions toChapter2 49 10) M____4 OOF ro Tus Cac fe enowa ht envi sts be one ay by a (Pe Pea) 1 Itis straightforward to show thatthe fiaction ofher endowment that the agnt sels for money isan increasing function ofthe rato of rtm on Roig money ahy Je-», je} ( Palo ART [lamp We can also stow that asthe rate of ret on money goes to zero, the amcunt of her endowment thatthe ‘nivale formaney gos oz, Use euation (0 ewsite yas (PP) 14a sndthus lim — hy taboo 0 frO< 1. aa+o)=0 (0) The canscais expressed in real ens a 2) CyHA-ME/R, md 6) Copa = BE Pr Since teres population gronth, we ca nomalizs the pepultien to one withet loss of generality From (a generation bom at met plans to Duy Mi Py units ofthe good when. itis od. Thus, the generaton bom aire O plas to buy My /P uk ve k's ol Ga peti 1), Use equation (10) Sad Mis substan 0 Toa = Ma,_[Pomla_ (ei)? +1 A (Re) a From equation 2, a pneraton bom a tine pan o sll MP, nits ofthe god fr money. Thus the generation bom at time 1 plans to sell M*, /P, units of the good. Substituting t = | into equation (10) gives ay MEA D7 (mim) vt Jn der forthe amour ofthe consumption good that generation O wishes to bay wit is mney, given by equation (12),to be equal tothe anmurt of tie coesumption good tht generation {wisest sll for taeney gen by equation (13), wo aoe [ovr] a A (roi i) Par ay (rom) 41 Umrao FL Nove with P< 1, wend (raynJ@P stem /mJPP 1 > (rem) 1, wo obtain the eppesite result forthe path of prices. That i, P,/Puy will rise overtime P,P ® 12 Pi, indso = 4, ia Poot From equation (1) we an se that this means thatthe ratien of the endowment sod for money will goto ‘one. In ether word, the etonomy approsches the situation where no one cossumes anything ithe Bre Period and individuals sel their entre endowment for money. Thus, otal real money demand wil goto A, ‘the endowment ofthe young (we have normalized the population to ene). But with this pa of prices the price level ges to zero, which means that ral money supplied by the old goes t infinity. Thus ths cannot ‘soresent an equilibrium path forthe economy tecase ther willbe atime period wher real money soppy wal exceed real money demand ard the market willnot clearSOLUTIONS TO CHAPT! Problem 3.1 ‘The production functions for output and new knowledge ae given by @ YOWAMM-AILO, — and Q) AQ =BALTLTAM® — <1 (2) On a balanced growth path, A(D/A(®) = ax?= wit -0) ° Dividing both sds of equation 2) by A) yields ACO/AC =Bay "KOT AW? Eauating @) and (4) yields Bay TLOTACO™ = 70/0) => AQ =yn/0-Ba, TLD" ‘Simplifying and solving for A) yields (9 Ae=[a=0pB0, 71497 fro" (0) Sabot equation (into equtin (1) y40=[0~084, 71007 fo]! aay )L4 =[C1-9B/ra]! 9,24 day yLeah-" Wecan ainia the oof opt wih reset to nor maximise Yet-€inft—0)8/10]+[y/--O]ina, + tna) [(r/00-0) +lLey “Theft onions given by ano Lt aL Some simple algebra yields an expression for ax" y ‘Thehigher is 8, the importance of nowlodge inthe production of new kaowlede, andthe higher i the mponance of labor in the production of new knowledge, the more ofthe labor free that should bo ‘employed inthe knowledge sector Problem 32 Substituting the production function, Yi) = K (into the capital accumlation equation, Kyd=s¥iC0, ves @ K@=5K\", @>1 Dividing bth sides of equation (1) by K; () gives an expression forthe growth rate ofthe capital tock, be ® BK; =Ki0/K,O =KiO" “Taking the time derivative of the log of equation (2) yields an expression forthe growth ate ofthe growth rae of capital ©) axis /exi=O-DeKs, snd thus @) Bs) =@-Dax 50"52 Solutions to Chapter 3 Equation (4) is ploted at right. With 8 > 1 Srv be abvays increasing, Theinal | | ¢ value of gs is determined bythe inital capital stock andthe saving rate; see equaticn (2) Since beth economies have the same K(0) but one has a higher saving rate, then from ‘equation (2), the economy withthe higher s will have the higher inital ge (0). From uation (3), the growth rte of gu is increasing in gx; Thus the growth rate ofthe capital stock in the high-saving economy wil — lays exceed the growth rte ofthe apital ee stock nthe low-saving economy. That, we TRE S(O > aes (0 fr alle 20, Infact he gap betwen the two growth ater wil bearing over carly sing the pdt fncton, we can wth rif putin the igh eaving coun ‘county I to oupat inthe low-sving country, country as © Y/Y =[KyO/K (0), Tekst ime derivative ofthe og of esto () yl an expression forthe promth ato thro of stp in the hghsving economy to ouput inthe low aatng emery (t)/ ¥2(t) () 1 6 More afi Aa Momo] “Kyo “k@ | Aecrplaind above, gs () will exceed gs () fr all> 0. Infact, the sap between the wo wil be TRegty ovr tine Thus the growth ate of te output ratio willbe poste and ncredeng eo ane Thats tert of ouput nthe ih-savng ceo to cupat inte leasing eee ential rising, and ning aan ceasing ne [ex -ax200]>0. Problem 3.3 Problem 3.3 ‘The equation ofthe 8, = 0 and & © éx snd lines are given by © fa =0 = =O ‘The expretsins othe promt tes of capital and knowledge are © sx C=eg[AOLO/KO]™ og ex-agy"ay)* ©) BA@=eaKOPLEOTAM™ cy a Pay(2) From equation (1), fora given ga, the value of gc that satisfies gy =O is now s; higher asa result ofthe rise in population © growth fom nto maw. Thus the i = Jocus shits up. From equation 2), fora given gu the value of ge that satistos Ba =0 isnow lower. Thusthe g =0 locus shits down. Since n doesnot appear in equation (3), ‘there is no jump inthe value of x atthe moment ofthe increase in population ‘rom. Similarly, since docs nct appear in equation (4, there i no jmp in the value of gaat te moment ofthe ne in population ‘yowth (@) Note that ag does not appear in ‘equation (I), the fy. = 0 ine, oF equation (@),the & =0 line. Thus neither the {Bx =Onor the, =O line shifts asa result ofthe increase in the fraction ofthe capital stock usd inthe knowedge sector fom ag From equation (3), the sein ag causes the growth rate of capital, gx, to jump down, rom equation (4), the growth rate of nowiedge, ge jumps up at the instant of ‘the rise in ax. "Thus the economy moves to «point such as F in the figure. “m8 i (©) Since 8 doos not appear in equation (1, there is | no shift ofthe gx = 0 locus asa resut ofthe rise in ! 6, the coefficient on knowledge in the knowledge production function, From equation (2), the 8, =0 Focus has slope (I 6) and therefore becomes 1 flaner afer the rise in 9. See the figure Since 0 doesnot appear in equation (3), the growth rate of capital, doesnot jump at het ofthe Fis in 8, 6 does appear in equation (4) and thus we need to determine the effect that hers in @ has on the growth rate of knowiedge, Ittums out that Bx54 Solution to Chapter 3 ‘ay jump up, jump down or stay the same at the instant ofthe change in, Taking the log of beth sides of ‘equation (4) gives us Ings (= ines + lnK() + 7nL() + @- Nina t Taking the derivative of bth sides of this expression with respect to@ yields (9) Angas (0100 = indy, Soi A() i es than on, so that InA() <0, th growth rat of knowledge jumps down a the nstant ofthe tise in 8, However, if A) is greater than one, so that nA() > 0, the growth rte oF knowledge jumps up at the instant ofthe rise in 6. Finally, if A) is equal to ove atthe time of the change in , there i no nial jump in ge. This means the dynamics ofthe adjustment to Esaw may differ depending onthe valu of at the ime ofthe change in 8, bu the end result isthe same, Peoblem3.4 Theiss ofthe =O and, <0 foc ae oe (0 fe=0 > axetq ta, md) by 20 > gg MARte ‘Toe equations defining the growth rates of capital and knowledge at any point in time are ©) ge C=eR(AMLO/KO] cx eatl~ag)* a, @ eq @=eaKOPLODTAWM™! — cg =Bagfay? (2) Since the saving rate , does not appear in equations (1) of (2), nether the 8x =O nor the 4 =0 locus hits when s increases. From equation (4), the growth rate of knowledge, Ba, does not change athe moment thats Increases. However, from equation (@),a ris in eauses an upward jmp ‘nthe growth rate of capital, gc. Inthe figure, the economy jumps fem its balanced growth path at Etoa point such as F atthe moment that = (0) At point F the economy is above the 8, =O locas and thas ge rising. Due to the increase in s, the growth rate of capital is higher than it would have been ~ the amount of capital going into the production of knowledge is higher than it would have been ~ and so the growth rate of ‘nowiedge begins to rise above what it would have been. Also at point F, the economy i above the f= 0 4ocus and so gs falling. The economy drifts tothe southeast and eventually crosses the , =O locus at ich pint gs begins to fll aswell Since there are decreasing returns to capital and knowledge inthe production of new knowledge ~8 + <1 ~ the inrease in s doesnot havea permanent effect onthe {rowth rates oF K and A. The economy eventually retums to point E “The production function i given by 1eag)k)"[A@lt ayeSolutions to Chapter3 55 “Taking the time derivative of the log of equation (5) wil yield the growth rate of total ouput: xe) ©) gy) +(1-a)[sq (0+), oO ava (On the intial balanced growth path, fom cquation (I), gx" = gx" +n. From equation (6), ‘tis means that total ouput is also growing at rate get = gat +n onthe intial balanced growth path ‘Thus output per person, Y(Q/L(), is intially growing at ato gt. During the transition period, bath gx and ga are growing at a higher rate than con the balanced growth path and so output per ‘worker must also be growing at arate greater than 5 ma its balancod-growth-path value of g,*. Whether the growth ate of ouput per workers rising or fling will depend, among ether things, onthe valu of since there is a period of time wien ge ie fling and ga i ising. The figure shows the growth rate of ‘output per worker intially rising and then fling, but the important point is that during the entire transition, the growth rat itself is higher than its balanced-growth-path valu of gx. Inthe end, once the economy retums to point E, output per worker is again growing at rate gx, which has not changed. (6) Note thatthe effects of an increae ins in this model are qualitatively similar to the effects in the Solow ‘model. Since there are net decreasing fetus tothe produced factors of production here ~ 0+ <1 —the increase in has anlyalevel effect on output per worker. The path of cutput per worker lies above the path t would have taken bu there tno permanent effec on the growth rate of output per worker, which on the balanced growth path sequal tothe growth rate of nowledge, This is the same effect that a rise ins has inthe Solow model in which ther ae diminishing returns to the produced factor, capital (Quanttativey, the effec is larger than inthe Solow model (or a given st of parameters). This is veto the fact that ere, Arges above the path i would have taken whereas that i nt tre inthe Solow model ‘Problem 3.5 (@) From equations (3.14) and (3.16) in the tet, the growth rates of exptal and knowledge ae given by @D Bq(O=KO/KO=eR[ACOLEO/KEO]™, where ox = afl ag P11 a), and ©) sq @=AQ/AWM=eqKOPL(OTACO™, where on = Basa’ With th assumptions of +8 = 1 and n= 0, these equations simplify to G) ee O=feeL'TAMKOY, and A) ga (0)= [eLTIKVAOY ‘Thus given the parameters ofthe model andthe population (which is conta), the ratio AK determines bath growth ates. The two grt ate, a andg.,wilb equal when [ech HACKED] = aL TIKGVAO? = TA@IKET*? = [64x IL". “Thus the value of AIK that yes equal growth rats of capital and Inowiodge is piven by 9) AIK D=[(e4 ex]. (0) In order to inthe growth ate ofA and K when gx = Bx =a, subsite equation (3) into): eolect* pate] -0Kat8) atefext] [lea ene Sinpiffng the exponents yields58 Solutions to Chapter 3 oferta seytrntnr tat fe or simply (6) gt=[egPeq!aut-ersn] 0-2-8) (©) norer to so the way in which an increas in safes the long-run growth ate of the econo, Substitute the definitions of and cx nto equation (6) ae 1) Lay) BIg Hag, Way neyo] M-eH) Taking the og of oth sides of equation (7) gives us (8) ing V-a+)] Bins+(1~a)y +a)InL +(1-a)lnB+ a(t ay) +(1-a)inay] + (-of6in@~a,)+yina,} {sing equation (te elastic of he gan growth ate ofthe emomy wih respec tothe saving ate ©) dings = BAL -0 + )>0. Thus increase inthe saving rate acrease the long-run growth ate of te economy This exsentally because it increases the resources devoted to physical capital accumulation andi the mel nes constant retums tothe produced factors of production (2 We can maining? with epsom heft of apt sock at shod Crelyed nib RAD seo moter tomatisee agen yey ah ae nl cna ame 8 [a az] , Gee “Grasplinag ag | Sct espinal yi ail-ae)=(-ayag => Gag=I-agtaay-a > O=1-ay, and thus (10) ax = (1-0, ‘Thus the optimal faction of the capital stock to employ in the R&D sector is equal to effective labor's share inthe production of output. Note that, capta's share in the production function for new. knowledge, does not affect the optimal allocation of capital othe RAD secior The reason for this is that fan increase in has two effects. It makes capital more important in the RAD sector, hereby tending to raise the as that maximizes g A rise in also makes the production of new capital more valuable ee ‘new capital is produced when there is more ouput tobe saved and invested. This tends to lower the a that maximizes g* sinc it implies that more resources shouldbe devoted tothe production of eutput rather than Knowledge. In the case we are considering hate two effects exally cancel each eter out Problem 3.6 (3) Substituting the assumption that x6) = K/A for 0 © by! Fxp%ai=t “Thus the Lagrangian forthe firm's cost minimization problem is o le to aon nt ora] ) Gi Sew-na-anty brea oly int ‘The ftst-order conditions ae given by aby taxi? ) Gi) Since there willbe fll employment, we can find the demand fo capital good i, x9, with oy and the ps taken a piven, Dividing equation (8) by (9) gives us (qo) % -—__o— PO aby ancy Lyx) Using the cost-miniization constrain, equation (6), this simplifies to (joc o ee ae PO a Lye Ly ‘We ean now solve for an expression for the demand fr capital gnod x), Rearanping equation (11) ils eee seo “aking both sides of equation (12) othe exponent 1/1 leaves us wth Using the fact that labor inthe goods-producing sectors pad its marginal produc, oF58 Solutions to Chapter 3 j i wo fsecoty hate ‘we can rewrite equation (13) a8 ; [confor PO a) Substituting the cost-ninimization constraint, equation (6), ito (14) yields . 1 aby F a Peo tea) as, | "Note that we can write the elasticity of demand for capital good i a5 2x) pO) ainxdi) pli) xGi) AInptiy Toking the natural log of both sides of equation (15) gives us iv (0) tox = fina -Inp6] stab. ‘And thus he elastic of demand i given by das) 00000 dine) 24) x6) ~ ap)” T=aw as required, “1 ‘To se why this implies thatthe prof of a mencpolistic supplier of capita good iat the profmaimizing Price, is (1 ~ aps, note that proft fora produce of capital good given by = [p( -c(D)x0), here c(i is the anit cost of producing capital good i. The fim chooses quantity to maximize profit, so the Sears cmd’ ai) _2p4i) 09) Sey ayy tO *PO=e0=0. Dividing both sides of equation (18) by () and using equation (18) to substitute forthe inverse ofthe ‘lasticity of demand for capital goo i gives us ey 241-2 a Solving equation (20) fr pO) gives us Oa} pm) or sinply 2) p= (i) at This expression itstrate the fact that the pic ofthe monopolist is r/(n =I), times cost. Substituting the eFiton of, which is = 1(1 =o, into equation (21) yields a58 Solutions to Chapter 3 wc oty heoea, ' Ly i } we can rei quia (2) 8 } 1 cary hata | oe 2 4) x6 Lee | fie ‘Substituting the cost-inimizaton constraint, equation (6), to (14) yields . r Ss)-isPo "Not that we can write the elasticity of demand fr capital god iat 6) 220000. 2x) Pa 9) x6 U0 x0)" aap) Taking the natural log ofboth sides of equation (15) gives us it 7 nx( = fina ~Inp69]+inLy ‘And thus the elasticity of demand is given by 5) 2020 20) x6)" ap) "=a 5 required To see why this ines hate prof af menepltic spl of capa goodi at hepa maiming Pris, (1 ~ p(x, note that prof fora predacerofesial good oer 0) et), wae ci the nt cot of producing capital ood, The fim choses ua to maxiize prof, she Festorder conden 2x0) 290) 19) S20 6) pt) —et=0. 0 “ang * 4g 8190 - Dividing bth side of euaton (19 by and using equation (18) taut forthe iver of the elasticity f dona or eaptal pods greete 2 41 ” Salvin equation (20) fr 0) gers of) n=l a ‘This expression illustrates the fat thatthe price of the monopolist i (n= 1), times ost. Substiting the Aefniion of, which ism = 1/(1~ 2, ito equation (21) yieldsSolutions to Chapter3 $9 == [20 - ap, orsimply @3) ==(1 appt) Problem. (@) The present discounted value ofthe profi from renting out a capital good at ime i ae 0) PMV Jee acoae From equation (23) inthe solution to Problem 3.6, profit at any pont in ime is x= (1 - apt We are ‘examining a balanced growth path where x) and p() ae independent of i and constant overtime and ‘where F and % = K/A. are the balanced growth-path price and quantity ofeach capal good, Thus ‘equation (1) becomes 7 Juwa (1-opp xa. ( ) pay tion ne erence tent run-up ato we have ‘ 0) PM = Fe" a -ayprde = (1-09 Selvin thine in ution) yes mv See iy xP" pec-apx]-te™™OL, Jea-apex{-to-0], and ins (xP (y= () The wage ofa worker inthe knowledge producing sector will qual the marginal product of labor in ‘the knowledge sector multiplied by the price ofthe good produced by the knowledge sector or the price of Jnowladge. More concretly, the price of knowledge canbe interpreted asthe price ofa design fora new capital good. This price wil be bid up uni it equals the present discounted value ofthe prof that a monopolistic supplier ofthe new capital good can extract. Using equation (4) and denoting Pas the price cof knowledge gives us 6) Pg = OES From A =Bay LA, the marginal product of labor in the knowledge-producing sectors aA © LE ‘Thus the wage ofa worker inthe knowledge producing sector, dented Wa, is60 Solutions to Chapter 3 -epxB O Wy ie From suis (5a te lon bln 36, he and or cape god © ofa) i pCi). Thins bt as fet (oe pnt (1-2) dons nel oth ph ecan re 9) x Ly, Sty Song fr seus 0) P=aLy!ex-(-2) Satsang tion (10 ts xetion ine area centese (0 iy by A csi (©) Asin the solution to Problem 3.6, we can define L 1-4 JL-as the amount of labor employed in the ‘seeds producing sector. From the production function, x Paco on te ance goth pa wehave : a9 vauy'f ‘Thus the marginal produc of labor in the goods producing sector ie 19) ed ayty #84, 09 Ty n-aty Car etution nth slo to rolam 36, ouput when 3) = KA given by 1S) Y= [C1 ~ a, JALY!*K" = Ly'*4K* ‘Thus the marginal product of capital is Baty eahtKet apa ® 9 Feralas catyte( 8) Since X= K/A, we can write 7 ae 07 FeatySolutions to Chapter3 61 (@ Since labor is mobile baween the goods- and lnowledge-producing sectors, the wage in both must be ‘equal or w= Wy. Since labor willbe paid its marginal product in the goods producing sector (he price of| {he output goo! is normalized to one), using equations (12) and (14) we require a(\-ayLy!*5"BA ' (5) SE EE CL ayhy 8A, which simplifies to (9) aL Thus the amount of| 20) Le=(1-a)k. (9 Since A=Bay LA, the growth at of knowledge is given by A Fa Bab (the balanced growth path, K, A, Y, and Call grow atthe same rate, which we wll enoteg, and (2) g=Bal, (2) We know that on the balanced growth path consumption grows at rate g, thus =e ¢ CaP pa. 5) GaP Bay From equation 20), a eo Pept @5) ar-ap = o9BL.-0r. Collecting the terms in the interest rate, yes 26) 1(4-+8)=a(p + @BL), and thus the interest rato cn tho balanced gronth path is (p+ OBL) a7 SO [Note that risa decreasing function of individuals’ patience, The more patient ae individuals ~ the smaller is p, the rte at which the ftur is discounted ~ the lower isthe balanced growth path value of + (aB), and s0 23) becomes [Next we can solve forthe balanced-growth-path value of a, the fraction of he labor force employed in the Imowledge sector. From equation (20), (1a JL = 1laB, we can write (8) ay, =1-— on BL ‘Subiuting equation (27) into (28) yields (29) a, 1202081) _ (+ 0)9BL~ap- aot TT @)aBL (a+ O)aBL wich simplifies to or simply GD a= eB mea62 Solutions to Chapter 3 Ste fr the prov ate ofthe coon othe tlanced growth, Path. Substituting ‘uation (1) ito g* BagL gives us 2) gs or simply (2 Me need to examine whahe or nota can be greater thin on given cur assumptions about the Parameters. Now ay > I rom equation (3), is equivalent Soe o> aBL-px( +OBL <> ~p>opL +oaL e e “Thus at longs p 6, B, and Lar al postive, a cant be rae thn one reinPation phe rte at which they discount the fiture a ‘mowiedge are of 0 value relative to curren consumption proba peri 0 examine whether angie va of, wood be consent wih the optimization Gay rina From equation 2.2) thet with ti aes 64 p--9g>0 This simplifies to G8) (1 9)0BL- p+ po ‘canbe the case that aBL Te a9) SBE ee td e 1-6 mepnes iio ofthe bor fore employed athe knowledge prodaing sector ‘cannet actually be Bale gow ae ace sohton wid. -0 in Wis cae, The gosthce shoe eee on the balanced growth path wil be zto since p= Bak Problem 3.8, eomemesin 1) inthe solution to Problem 37, he balanced growth uth faction ofthe labor force that it employed inthe knowlege producing score given og eeSolutions to Chapter3 63 aBL-p (e+0aL @ a, () Fromeuston oS “Thus afl p ~a decrease in the rate at which individuals discount the future ~ raises the balanced row-path value of a. If individuals become more patient, the future gains from research wil be valued ‘ore eative to current consumption. Thus moe resources wil be devoted to the knowledge-producing sector and balanced growth-path growth will be higher. (©) From equation (1), 66) Sse OBL aL — pha OL 2B (+981 which splits to [a+OBL “Thus the sgn of 0x, / is determined by the sign of p+ 8)L, which is positive under our assumptions about p, a 8, and L. Inttvely, an increase in B represents an increase inthe productivity of labor inthe Inowiedge sector. Thus the wage in the knowledge sctor intialy rises. The knowledge sector atracts ‘more workers unt the wage there is once again equalized with the wage in the goods-producing sector. (© From equation (), og 2 e108 aL (+01) which simplifies to (9 BL, 2 Ua) eB UE +0) +6198 a (e+OBLT “Thus the sig of 0/0 is determined by the sin of pla +8)B, which is postive under our assumptions about p, a, 8, and B. An increase in the overall labor force will lead toa higher ration ofthe labor force ‘sing employed in the lnowledge producing sector \o+8)B From equations (12) and (14) in the solution to Problem 37, we can ste that intially, atthe original ax, 2 rise in Linereases the wage inthe knowledge sector and decreases it inthe goods sector. This causes ‘movement of labor from the goods sector tothe knowledge sector. That is, a rises unt the wage is once again equal inthe two sectors, Problem 3.9 ‘The relevant equations are @ YO=KO*AO'™, —@ K)=s¥(,and_——_@) AW = BY) (a) Substituting equation (1) into equation (2) yields K(t)= sK()" ACO)". Dividing beth sides by KU) Allows us to obtain the following expresion for the grow rate of capita, gx() © Bx =KO/KO=sKO™ AO!64 Solutions to Chapter 3 Substituting equation (1) into (3) gives us A(t)= BK(Q™ AC) Dividing both sides by A(t) allows us to obtain the following expression forthe growth rate of knowledge, 20) ©) 4" AW/AW=BKQ)*AG)™ bx =9 [ex=s,) © Coniat Taint ie drivatie of atone growth te oft growth tof cpl tO. KO. Aw $20 og) KO, gy AW, ac) KO KG) a © &O/exi 1-0)[e,(0~Bx (0) From equation (6), gc willbe enstant when B= ge Thusthe jy. =O loca is a4 ie in ee) space. Also, gc willbe sing when g.> ax. Thus gx ring below the gx = One Lay gx wil fill when 84x. Thus isang above the 0 line Knowledge Taking the time derivative of the log of equation (5) yields the, fa ROA BO KD "AG" O b/s, =a[ex ©-z4(0) From equation (7), g, wil be constant when gx = Ba Thus the f, =O locus is also a 45° line in (a ge) space. Also, gx wil be rising when gx> gy. Thus above the 6 =O line, gy willbe rising. Finally, gx ‘wil be falling when gx < ga. Thus below the x = 0 line, will be fling (©) Wecan put the fx =0 and &., =0 loci into one diagram, Atough we cn sett the economy wil evenly artve at stuaton where gu =. and they are conse, we silldo net kave enough infomation 0 FO Kew ‘The last step uses the fact that B and «are constants. Now since Ke (t) is growing at rate gx (t) and denoting the growth rte of Pr (2 ge (0), weave @ BO =@- D0. (0)09 Te growth ofcensuption sien ty © gol CW/C10=[10) p]/o=[B+8,(0-6]/o=[B+1a-DeK (alfa wire we have used equation (4 to subi fo (© Gi) Taking the time derivative ofthe log ofthe consumption production fiction, equation), yells © gclt)=CW/C() =a[KeW/Ke] "ax Equating the two expressions forthe growth rat of consumption, equations (5) ad (6), yells agx()=[B+(e-Dex)-pl/6 > aoe, (t)+0-a)ec()=B~p “Thus inorder for C tobe growing arate), Ke () aust be growing atthe following rt: © sx0)=(8-pl/face ca) (©) Gi We have already saved for (9 in toms ofthe underlying paranters. To solve fr 8), sibatite eustion (1 it equation (6) ©) gc(0=0(8-p)/[acr0~a)} (©) The eal interest rate is now (1-28 + gp). Thus equation (5) becomes a-o[prs,t0]-e d-v)[B+-bext) © se(0 i 5 ‘where we havo used equation (4) ~ which is unaffected bythe imposition ofthe tax ~to substitute for ar. Equting the two expressions forthe growth rate of consumption, equations (2) and (6, yields 1-2)[B+(a~Dee(0)- ong) B= EOE ges (yo vAl-oHe09 and thus 1-DB-p,68 Solutions to Chapter 3 (= B=p [acs a-0-«)) Substituting equation (10) nto equation (6) yields an expression forthe growth rate of consumption asa fanction ofthe underlying parameters ofthe mode [a-ve-p | 80 se00- Sh a A) ex = Tore tse tec oft ta tae th dra af (th pet act) _,[de+0-90-0)-[0-o9-g]0-0)] | bosngtt-a |< a feovd-o0-a/? fuo+a-90-a)} Thuan ices inthe tx ale cause rom tof onnumptio tl Problem 3.12 (2) Note thatthe model ofthe north economy is simpy the Solow model wth constant growth rat of| technology equal tog = Bary Ly. From cur analysis of the Solow model in Chapter I, we know thatthe long-run growth ate of nrchem output pr worker willbe equal to that constant prowh rate of technology (Taking hein drive of ath ides ofthe ion, 28)» Ae VAR, vids An(DAs(0—As WA (0 24) =BW kat = ABOANC AN@? ‘Substituting the expressions for A(t) and Ays(t) into equation (1) gives us Anto} (Ani (9 [Barta] dy AN O|varstslAw s¢ol wi] Simpliying yields ® 20) =[narsts(1-As0/Ax(O)] -[As(0/Ax (0) [Bayt] Substuting the definition ofZ¢) = As (Ay (into equation (2) gives us 20) = wayshs ~ parsts2(0)~ Bayly) Collecting ters ede ©) 2t)=parshs -[haysls + BayyLy] 200. ‘The phase diagram implied by equation (3) is depicted at right. Note that equation (3) and the accompanying phase diagram do not apply forthe case of Z >I, since slope aials + Bask 1 As(0) =O for As (2 An, ee ‘The relationship beeween Z(t) and Zit is linear with slope equal to [aul + Bayly] <0. From the phase diagram, if 2%, then Z(t) >0, Thus if begins to the left of 2°, rises toward Z* over time Similarly if > 2°, then 2(¢) <0. Thus if siti AR 8 Ca cH_ Solutions to Chapter3. 69 inst the righ ofits tard 2 over tin, Ths Zhe ati of tenon he soho ‘edologyin enor, dvs enagetoa sable aie. Tosa fo 2 20) 0 Om pauls + Bab solar 2 yl ee taysls OP ral +BBnLy “The next step isto determine the long-run growth rte of southem output per worker. We have just shown that Z(t) = As (V/A () converges toa constant, Thus inthe long-run, As () must be growing atthe same rate as Ay (). Inthe long-run then, the south is 2 Solow economy witha growth rate of technology equal to Baws Ey. Thus the long-run growth at of southem ourput per works is equa to that growth rate Nate that in the long-run, the growth rate of southem output per worker is the same as that in the noth “This mean that a, the fraction of the south’ Inbor force that is engage in Ieaming th technology ofthe north, dos not affect he outs lng-ran growth rate. That growth rate is entirely determined by the ‘numberof people the north has working to produce new technolo. (©) Dividing the northern production fnction, Yy() = Ky (0" [As (O(1~ acs Ib J", bythe quantity of effective abr, Ay (Yds Ywo { Kuo, es phy | TrOly Lawotx | ANOty | Defining ouput ad cpt per ui of effective labor a8 ys) » Yw Ay Ly and (= Ky (VA (OL tespetvely, we can rent uation (8) 38 © yO =k OU - ay )* Now we can uc th tenis employed to sve the Solow mode to show that onthe balanced growth pal, t= ky* Taking the ine dratve of bath side ofthe defition of) = Ky (Ay Dy ils Ky Ky) Ay by (ty= ENO __ En Avo 0 ENO ROLY AN(Oky AN Substituting he capital accumulation equation, Ky (0) =4y Yl), ino equation (gives ws sy¥n An Kwit) ere FL g NNO - Baybnkn(), AN@OLy Ay@ Ay(Oly ONO 7 here we have used th dfintons of yy (0) and y () and have substituted fo the growth ate of nother tecnology, Fatally sing equation (8) to subsite ory (ys (9) ey (2) = yk ye (0) apy) ~ Bayly ky (©. ‘An analogs derivation for he south would ied 10) g(t) = sgks (00-25)! ~ BayyLyks (0. ‘where we ave used the fact hat inthe lng, the ero ct of technology in the sou is Bats Ly © ke Using tho facts that 5.~ 5; and 21~ ays, we can soe that the equations fr the dynamics of kare the same forthe two economies, Thus we low that the balanced-growth-path valus ofk andy wil be the sme for thetwo economies. That is, we know that ky* = ky* and yx" = ys. This implies (11) ystyt = ‘Using the definitions of, and yy this implies that Ns/Asls Ysils_ As peels.) = tse As ay Ys /Anky Yw/ty Aw70 Solutions to Chapter 3 pate tes aon th tlscd goth pth rata of pt per wor inte oath oa Bnet ene a the rif chee ne vith o einer n besos, Pen ame knw dat As /Av converges to Z* nthe nga. Usng equation) ede eee ‘uation (12) leaves us with ¥5/ Haysls Yu/Ly ” baisls + Barby aaa cha wth Ba L> 0, his ati aa be les than one ouput per person inthe south wil lower Pam ouPuPer pen then. Alo nee th nth nant row pte ae eae or te South to hat th no docs spend on a, te faction of etm nie reer eran eles. I fact, he higher ite loser lb he pate ate the south o that inthe north Problem 3.13 wars meso find vale of + suck that (¥y (La VIVs Ve] the aio of ouput pr werk in the north to that inthe sou is equal to 10. From the nore production fn @ Yb AOU =a) ages time derivative ofthe natural logo equation (1) yes an exrestion for the growth te sorter ouput per worker @ Puey'te} Aveo YWwO/Ey “Aya ‘wher we have used he information given nthe problem that the growth ate. Trees, and ths ofonthem Inowledge, is 3% per year. Since Ay (0/Ayy( AO =C A) From the suthem production function, @ VOL = A000 darn oan () by equation (veld an expression fe the ati of ouput per wotkr athe nod to that inthe sot 5) WW/by ANO=a) AN gon YsWils ASO Ay(t-y Te wore Weave eed the fc that =, that A (= Ay) and ution (3) Sitoece iat ms be aproxinaly 768 yas, Ths, asibutng els cose country ctr come pet person to slow transmission of mowed to poor comes cies fe cerca tobe very slow. Poor countries would ned tobe using telnology tat he ake eg Geveoped in the 19208 in ond to explain a 10-od diffrence in income por frsen 2.0 Recall hatin the Slow mode, the balanced-gront-path vale of k= K/AL i defined implicitly by ee ation that actual investment, sf), equal breakeven invesinat, (2p + 5k* These north, ‘ks? is implicitly defined by ©) sfx") = (248+ 5ky2, where g= Ay (9/Ay().Solutions to Chapter3. 71 We re told thats, 8 and the function f() are he same forthe north and the south. The ony posible source of diffrence isthe growth rate of southem knowledge, However, iis straightforward to show that As(n/As@)=8 ‘We are od that the towed use inthe south at imei the knowledge that was used in the noth at time =. That is, @ AW =Av-2. “Ting the tine derivative of equtien (7) yds @) As(t)=Ay(t=*). Dividing equation (8) by equation (7) ils Ast) Aw(t=2) As) An “The gron ats of norm knowledge is constant and equal tog tal points inte and thas 0) As(O/AsO=8. “Therefore, forthe south, kis implicitly defined by (CD) sfiks*) = (0+ g + B)ks*. Since ky" and "af impiily defined by th same equation, hey must be equal (©) i) Imroducing capital will not change the answer to part (a). Since ks* =e", output per unit of ‘fective labor on the balanced growth path wl also be equa in the north an the south. Thais, yx" = ys* where y* = [¥;/A.L]*. We ean write he talaned-growth-path value of output per worker in the north st (12) Ye (Oil) = Ay Oy" Similarly, the balanced-growth-path value of output per worker inthe south is (3) Ys (ile = As ys" Dividing equation (12) by equation (1) yields (a) TRON AvOyw* AN Ay YsD/ls)” As@ys* As) An(t—9 “The seconds step uss the factthat y= ys The last step ures As () = Ax (€=1)- Using esti @).we again have Yui) __ Ar __ oor Yo(0/Ls (0 An(t-9 “The same calculation sin prt (4) would yield aval of «= 76 8 yeas inorder for Dis (OL VO¥s ils ] = 10, Problem 3 (@) Differentiating both sides ofthe definition of ki) « K(VA@)L() with respect to time yields ()~ KTAOLY + ACLIO] [auc]? ‘Using the doiton of kt) = K(QVACQL(), equation (1) canbe rewriten as Ko [AO U0 hoy ALO Law” Leo! Substituting the exptal-secunlation equation, K(0 sates of knwlge and labor int equation (2) gives us S¥(0)-5xK(O) ORO oe spk 8) ky Sy etek @ kw ¥(t)~8K(), a8 well asthe constant growth72 Selations to Chapter 3 ‘Substituting the production function, Y(t) = [(1~ a )K(t)]"((1~ aj:)H(0)]'", into equation (3) yields ve I =a )K (2 sto} gg nf SAK | OHO oa eg 5g kt oe { AWL() ALG) Coen Finally, defining ¢, = 6(1 - a )*(1 - ay)" and using kit) = K()VA()L() as well as hit) » HitvAq)L¢t), ‘equation (4) can be rewrten as ©) RQ) =egk(O*HO ~(0 +85 )KE, Ditferatiting bth sides ofthe defiton of) = HQVACOL() with spect oti yields HOAOLE)-HEOLAMLE) +AU] 6 b= BOAO HOMO) + Amt) [A@Le] Equation (6) can be simpli to 0 ye [a0 0] AeLO Lae “Le! Substtuting HQ) = Blox K(O [ay H(OT*TACOLEO]™?+ ~5 HC) the human-capita accumulation equation, 35 wel asthe constant grow tes of knowledge ad labor iat equation (7) gives us rT a, Ho Tt or Ke) Panto [aque SHH || ACL a 4g +50 Fly, defining = Baa allows us to rewrite equation (8) a5 ©) io =eyk(0" B00? —(a+8-+8,0K(0 bn. he (b) To find the combinations of hand ksuch that k=O, set the right-hand sie of equation (5) equal to _22t0 and solve for kaa function of: exK(HO)'*= (+85 )K) > KEY! mecha B+ Bx), and thus finally 10) KO) = fx la + 8+ Be RO, “The k= 0 locus, as defied by equation (10), ia sigh line with stope ex la +g + Se P*> Orbat pases |gey through he origin. Sethe gure at right. From equation | (©), wean so that ki increasing inh). Thus othe righ ofthe k=O locus, k > Oand so kt) rising. To the left ofthe =0 locus, k KO'= [Oa +g+ by ieu FO, and thus fizaly (11) ka) = fonda + 5 +n HA)".Solutions te Chapter3. 73 “The following derivatives will be useful k(t AND -g =[0-¥0/ allen (a +8+8q)]" YAP >0, and Puo/areo’|, =[a-s-n/lla-Hhllen/ore+3:0)" HOF" >. ‘The h=0 locus, as defined by equation (1D), is ‘upward-sloping witha positive second derivative. ‘See the figure at right, From equation (), we can see that (is increasing in k(t), Therefore, above the h=0 locus, > O and so) is inreasing Below the h=0 locus, h <0 and so) is fling, (©) Pasting the k= 0 and f=0 loi together, we can see thatthe economy will converge toa stable balanced ‘growth path a point E, Ths table balanced growth path is unique (as long as we ignore the origin with o. From the fgute, physical capital per unit of effective labor, k(t) » K(Q/AQ)L() is constant on a balanced growth path, Thus physical capital per person, K(QIL() = K()A(9, must grow atthe same ate as Jnowiedge, whichis g. Similarly, human capital per unit of effective ler, b(t) = H(Q/ACQL(), i constant con the balanced growth path, Thus human capital per person, H@)L() = HAG), must alo grow athe same rte as knowledge, which is Dividing the production function by L() gives ws an expression fr output per person: (12) YOMLE) = (0-26 KOLOOT [0 ~ an HOWLEY Since K()/L¢) and H(Q/LA) both grow a rat gon the balanced growth path and since the production function i constant retums to sale, output per person also grows at rate g on the balanced growth path (@) From equation (10), the slope ofthe K-=0 focus is (oq a+ 2+ Bx)" where we have defined c= (1-ay)"(1~ay)", Thus rise ins will make the k=0 locus teper. Since s doesnot appear it ‘quation (11) the h=0 lous ie unaffected. See the fgure onthe let. The economy will move from ts old balanced growth path a E toa new balanced growth pth at E74 Solutions to Chapter 3 ava ‘Output per person grows at rate g uti the time thats rises (dented time tin the figure on the eight). During the transition ftom Eto E both Ni) and k(t) are rising. Thus human capital per persen and physical eapital per person grow at arate greater than g durin the transition. From equation (12), this ‘means that output per person grows at arate greater than g during the transition as well. Once the economy teaches the new balanced growth path (at time tin the diagram), h() and K() ate constant again, “Thus human and physical capital per person grow at rate gagnin. Thus output per person grows at rate g again on the new balanced growth path. A permanent rise in the saving rate has only aleve effect on ‘output per person, not a permanent growth rat effet. Peoblem 3.15 ‘he elrat equations are © Yo=KO"[(-ay)HO), — @ HO=BayHO, nd —_G) KONO, whew 0 (a) To gethe growth rate of human capital - which tums out to be constant ~ divide equation (2) by HO): @) gy =H(0/H0) = Bay (©) Subst the production Function, equation (1), ito the expression fr te evolution ofthe physical capital tock, equation (3), to obtain © R=" [(1-a) 10)" To getihe growth rat of physical apt, divide equation (5) by Kt) © gx@KO/KO=KO™ (1-24) HO]? Weneed to examine the dynamics ofthe growth rate of phyical capital. Taking he tine derivative of the Jog of equation (6) yields the following growth rte of the growth ate of physical capita © BK W/ex C= (-DKO/KE) + PHO/HE =~ Ysq 0) + Pex [Nowe we can plot the change inthe growth rate of capital, f(t), asa function ofthe growth ate of capital ‘self, (9). Mukiplying both sides of equation (7) by ge () gives us © BK (= -DaK(? +BeneK ©.Solutions to Chapter3 75 "Nowe that we are assuming that <1 which means that there are decreasing retums to physical capital alone. The phase diagram implied by esuaton (8) is depicted in the Figure at ight. Note that g(t) is constant when (0) =O or when (a Test) + Ban= 0, Solving his expression for a(t) vel ac? = [BI 2) Note that gx*> gusince a +B> 1 or B> =a. ‘othe let of gx, from the phase diagram, fg (0 > O and so gx) rss toward ax? Similarly, tothe right of ge", € (0) <0 and so x() fills toward ga. Thus the growth rate of capital converges to constant value of gx* and a balanced ‘row path exists “Taking the time derivative ofthe log of equation (1) yields the growth ate of ouput © YOHE) =aK(0)/Ke) + BHO/HO=08 <0 + Pax (One balanced growth path, ex) = x" = [BU ~agwrand so Yo __oB B+B-08 | __B - 0) Fey” Go ay bt PBK Gay BH = Gag BH “EK (On te balanced growth path, output grows atthe same ate as physical capt, which nt sgrester than the constant growth rate of buran capital Ee that G(E) = ef is given by oo Pansat ee ee maximize the natural log of (Y/N)" with respect to E, noting that y* and A(t) are not functions of E. The ocean @ uS) 0. This doesnot, however, ensure that vary (0) < arty (0), 0 thatthe variance of cross-country income is fling, The isd tothe variance of te random shocks to ‘ouput, represented by the v(t) erm in equation (14). Thus th effect of <0 or > 0, which tends to reduce the dispersion of income, canbe offset by the random shocks to output, which tendo rage income dspersen f> Othen 2.<0, From equation (14), we can see that his means vary ()] wil be greater than (0). In this case, the effet of <0 oF 3. > 0s to increase income dispersion, and thus this works in the same direction asthe random shocks which alo tend to increase income dispersion, (©)6) Since yi time-invariant, analysis equivalent to that in pat (4 () woud yield aS) ¥40) Myf +e y, (0), (©) Gi) We will determine the value of 2. implied by an estimate of Pin this model and compare i to the ‘value implied by using th formula from part (a) (i). In the cross-country growth tegession piven by 19) 40-%O=a+ BO +8, gain we have conlyi (0. ¥s(ON vary (0 _covtys(0.¥i(0) 17) p= SOON vary (OI _ ovtyi (0.950) _ oe vary] vay, (0) Then, since : (18) yi) Mylo My, (0) 405, wehave G9) covly;(t)¥;(O)]=(1-e™) covty},.y;(0)] +e™ vary; (0) Since 20) yO=y" tu =a+bX+u, wehave 21) vary (= ae Xi + vr 22) cov’, ()]=covla + bX,, a+ bX.+-0,] =b vat), since X and ware assumed tobe uncorrelated. Substituting equation (21) and (22) into equation (19) siver usSolutions to Chapter3 81 23) cont, (0,3 O1= eM 98? var X]+ be valX]+e™ vale orsimply a) covlys(0.ys (=? vasfX]+6™ varfay) ‘Substituting equations (21) and (24) ito (17) gives us = varlui) oY varlu] ran{X;}+ vara] 1b? varfX;}+ varluy] ‘We can now solve forthe value of 2. implied by equation (25) and compare it tothe one we would calculate if we used equation (13). Equation (25) implies fui) Taking te sarap ota sie 29 and cig oe 5 van Xi + vast |, mtXil+ vata) 5 | vat @n 4-4 Since ("varfX,] + vat Divas] > 1, using the formula given by equation (13) woud lead us to calculate an estimate for 2. thtistoo small in abel valve, That, if 2> 0, using the method of pat (@) Gi) would yield an underestimate ofthe rate of convergence (©) Gi Soberating yi (0) rom both sides of equation (18) gives us @) yiO-¥i=(—e™y; —-e™MYy, +4; Substituting equation (20) into (28) yields 29) yi) =0-e™)y; which simpli to 60) yt -¥=(6™ Du, +6; Defining Q=(e"™ — 1), wo can se that he repression given by GD nO-WO=at BO Ht is equivalent to projecting Qu e on a constant, (0), and X, where es simply a mean-zer, random ertor that is uncorrelated with the right-hand sido variables, Rearranging y, (0) = a + BX; + ust solve for yy tudes gives us G2 w=-2+9O)-0%, ands0 3) Qui=-Qa + Qy (0) QBX, ‘Thus, inthe regresion given by (1), an estimate of provides an estimate of Q and an estimate ofy provides an estimate of -Qb. Thus, we can construct an estimate of b by taking the negative ofthe estimate oy, divide by the estimate of B, or 1 = Ga 1-8 BeSOLUTIONS TO CHAPTER. Problem 43 (@) The equation describing the evolution of ehnology are given by (Ags Kegt+Ry, and @) Ay=pyAeittay -1 0 will ct affect equation (4.23 inthe text ~ the Euler equation ~ which relates consumption in one period to expectation of consumption the followingSolitons to Chapter 485 - ee y @%(-4)" I+r 2 hw Now substitute equation (4 ~ (7) into the lifetime budget constraint, equation (2), to obtain te fyb |yma|p Gene ade) Gwe he Mutipyng bth ies by gives as [awy—b | Awol Aw, C+ re] ve Pan StL=B), ha Bae PS Simply futher tan lee? dws °b, Foal, ovng for yelds ie PML) na te Tar ewa/0n] where we have we thf hat 1467 +067 140% +d) "Now to obtain an expresion fo irst-period labor supply, substitute equation (8) into equation (6) t0 ‘obtain oe efor wo /0+0] “CeO Fisw ido] Finally, viding the top and boom ofthe second tem byw yds ofl (wa wi) V+} (ee Nowe that a fncion ofthe relative wage wv. Ths any change in wy and ws that leaves ws changed wil eave ¢, unchanged 4 ‘Tootan an exreson fo seand period Ibo up, batt equation (8) at equation (10 tain (ene Fo ene" + was] (ee) (se")(d+ byw, [wr +wa/are) Fal, dvd th tp and btm ofthese term byw: yl ells /ma)+V0+] (se Ped) ‘Asin nte that sj fein ofthe lative wag, wv. Ths any change ian wand tat eaves fs unchnged wil eae unanged 1) & (©) @) The face thatthe household has iil wealth of Z > O will ct affect equation (4.23 inthe text ~ the Euler equation ~ which relates consumption in one period to expectation of consumption the following86 Solutions to Chapter 4 period. The fac tha the household has initial weath does nt change the marginal utility lot frm. ‘educing current consumption by a small amount today nor does it change the expected marginal utlity ‘gained by using the eeulkng greater wealth to increase consumption next period above what it otherwise ‘would have been. That i, it doesnot afet the experiment by which we informally derived the Euler coquation, The budget constrain, just asin the Ramsey mode, only becomes important when determining the level of eonsumption each period (6) Gi) The result in part (a) will not continue to old ifthe household has intial wealth, The nev lifetime ‘budget constant is given by l 1 (1) ey +e, |Z by tat eaeeeelee Tee"? Cleary, this addition of a constant to lieime wealth will not affect the four st-order conditions. Now take those first-order conditions, equations (4) trough (7), and substitute them int this new budget constant: 1 b | wal aaa arel1ads Following the same algebra steps asin part (a) will ow yield d+e)0+) (a) p= Ot fe+m +0209] [Now to obtain an expression for ist-perid labor supply, substitute equation (12) nto equation (6) to obtain 8 Uzew twain) Cae HUey [ew +0, /0ea]"" Final, dividing the top and boom ofthe second term by wy yields olziv)+1+(wa/mi)(va+n)] (+e P)l+b) “aking the derivative of with espect to wy imposing the canton tat ww remains constant — vies ei _bele? dw, (+e? +b) “Tus a change in even fits acompaned bya change in wy such that lative wages remain constant, oes affect frst perod labor supply. In fact, arse in the fist perod wage wil increas first pried labor supply. 4 (13) = ° “To obtain an expression for secondperiod labor spp, subsite ution (12 into equation (7) obtain (ane (ene Pf, +m (+0) (+e"P (+b) we (+e )(1+ byw. [wre /a]? Filly, dividing the top ad bottom ofthe second term by midseee Solutions to Chapter4 87 “Taking the derivative of; with respect to w: ~ imposing the condition that w/w remains constant ~ yields by _ Gene Pez/ws? ows” dre P48) “Thus a change in ws, even if itis acompanied by change inv such that relative wages remain constant, does affect second-pti labor supply. Infact, rise in the second period wage wll increase second period labor supply 20. Problem. (@) The el interest ate is potential random, so et = Ee+e whee ¢ isa meaner random ero. ‘Te india wants to maximize expected tly as given by () U=InG +EInc, and substiating in fo ils @) Uninc, + Eln{t+ Ee +2X¥ -C)) Sethe derivative of equation (2) with respect toC, equal to 220 to obtain the frs-order condition ©) AU/C, = YC, + ELIMI + Er+e)/0+ Br +e XY, -Cy)]=9, or singling yc, -Fi/(x, -¢,)]=9 Since W(¥s=C; is ot random its that ELV) - Cs algebra wehave @ ce%i2 Inet cae th choice of isnot affected by whether ris ean ont. Even ifr is random the individual simply consumes bal of ra-period income and saves the et. (eZ, = Cr) and ths ater some simple (b) Now the individual doesnt resve any fist perio income but reeves income Ys in period 2. Sothe Seividoats problem sto maximize expected ity as given by eatin (D, subject 0 Gabe and G6) Cy Vy — (1+ Erse)B, =¥p UEC}, ‘where By represents the amount of tortowing te individual does inthe ist period, Substiating (6) ato The expected lity Rincon (1) yds @) Ua lacy +Blny —C+Er+e)C) Sethe derivative of equation (7) with respect oC equal to 210 to inthe frst onder condition: @) OU/2C =1C; -F{A+ Er+e)/C- Use the fomula forthe expected vale ofthe produc of 2 random variables ~E[XY] = ECXIETY] + cov0K¥) to ctain ©) Yey=(+EDE{Cy]+cov(1+ Er +6,1/C3). ‘The covariance erm is poste. Inutively,a higher « means the individual has to pay more interest on her terrowing which forces hero have lover Cy an thus higher VCs Iris not random ~s0 that. WC, =(1+ ECC) = ad thus solving for Cy il Go), =¥4/20+E9) because 6 0 abays~ weave fom euton ®) Enjl¥, avec] => ¥2~C+ ENC) =(1+ENC,88 Solution to Chapter 4 Now, fom equation (0), nthe case where is randm, we sl have WC, = E{l+Er+6}E{Y/C,)-+cor(1+ Er+0,1/ Cy) ‘Since 1/C; is a convex function of C; , then by Jensen's inequality we have E[l/C)]> 1 JE[C2]. In acdtion, because the covariance ters pestve, we ean wre YC, = 1+ ENEIYCa}+cov(t+ Er+8./C3) > (1+ EOLYEIC|| ‘Substituting into this inequality the fact that E{C: ]= Ys (1+ En)Ci yields Yo, >(sED/l¥,-C+ENG] => Yz-(+ENC >1+ENC) > 21+ENC, <¥>, ‘or simply GG, <¥, /20+B5 Nat from equation (10) thatthe right-hand side of (11 isthe optimal choice of Cy under cerainty. Thus ‘ee have shown that ifr becomes random with no change in the expected vale of, th optimal cir of i becomes smaller. Essentially, if there is some uncertainty abet how much mere tre nda wl ‘have to payin the second perc, se is more cautious inher decison aso how mush to boro ack consume in theft pend Problem 4.7 (4) Imagine the household increasing its labor supply pec memter in period by a small amount ‘Suppose it then uses the resuing greater wealth to allow les labor supply per member in the next period ‘nd allowing for consumption per member to be the same in bath periods as otherwise would have been lhe household is behaving optimally, a marginal change ofthis type must leave expected lifetime tility ‘changed Household wility and the instantaneous utility incon ofthe representative member ofthe housebold are renby Ua Feuer —4)Ne/H, and @) wen bit) From equations (1) and (2), the marginal disutility of working in peod¢ is given by @) De, =e, DPI 6). ‘Thus increasing labor supply per member by A¢has a utility cost forthe household of silty Cost = (NADP -é )e ‘This change raises income per member in period t by wA4. Nate thatthe household hase imes as many ‘members in period + 1 in periodt. Thus the increase in wealth per member in period ¢+1is eC +r ee) ‘We need to determine how much tis willow labor supply per member in period t+ 1 ofall, ithe pth ‘of consumption iso be unaffected. In period t+ 1 giving up one unt of labor per mermber costs win fost income per member. Thus giving up Uys units of labor pr member means lot income of one pet member. Or, giving up [0° (+ tes Al Js units of labor results in lost income per member of © (1+ 14 de, which is exactly equal to the extra wealth per member the household has from working ‘ore last period. Thus we have determined that labor supply pec member can fll below what it oherwise ‘would have been by the amount [1 + fox )wsAe Ys while stil allowing consumption tobe the same as itetherwise would have been, The expected utility benef, a of period t, fom this allowable dep in labor ‘supply per member isSolutions to Chapter4 89 be Manaywae HO Wun Aas Since e*"%(Ny He isnot uncertain and since Ny op | Mitte | Chant oa ao () Consider the household in period. Suppose i reduce is eurrent consumption per member by a small amount Ac and then uses the resulting greater wealth to increase consumption per member in the next period above what it otherwise would have been. The following equation, (4.73) in the text, gives the condition this experiment implies, assuming the household is behaving optimally 423) 4 "Now imagine the howstold increasing ts lor soppy per mamberin period by a small amount and ing the revuing income to incense te compton n tht prod. The ellowing equation, 4.26 nthe texts the condition tat his experment impli, esuming that the hounds behaving eptialy 4.26) fn a) 1-4} Shing fre give 1 re 68) Tam Nate that eatin (426) and (4.26) odin every period. Thu fo paid +1, we an wt rece a6") ‘ on 4am Sutstinting eqns (426°) and (25 nto eqation (4.25) lds F bog |_bde na) awe Lagat utp tits by and ce Eo) =, we bae qeaewre| tote | A) Ltt “Tiss the same condition obtained from the experiment in part (3) Problem 4.8 (@) To cesn tho first-order condition or Euler equation, we can ute the infomal perturbation method ‘The expert isto suppose the individual reduces prod consumption by AC. She then uses the resulting greater wealth in period t+ I to increase consumption above what k otherwise would have bee. “Te utility cost in period tof doing oi given by Usity Cost=[Yc1+p)]'w(C,)AC =[Yal+ p)}'[I-20¢,]ac,90 Solution to Chapter 4 ‘where weave usd te instantaneous uly finn, (C.)= C,-0C?, to caelateu*(C, ‘The expected utility gain in period +1 fom th above experinnt i Bop. Usiy Gain= B, [ya+p))"*a(C,, \l+ Aa] = [ya+p)}"E,f1~20¢,,,,t+a)sc, ‘here A isthe ral ineres rte. Finally shi simples to Esp. Utility Gain = [171+ p)}*f1~208 (Cy + A)AC. "ea seal is optimising, thew cox fom hs perrtaton mist el he expected vty sain: [ya+py)'p-20¢,Jac = [ya py} [1-20 (C,,. {t+ a)ac, or simply 1 20C, =[/+p)](1+A)ft~ 206, {C, 1] Using the fc that p= A and simplifying ils @ GE Cos} toy low random walk. The expected value of conumption net pei singly equate todays actual realization of consumption (©) We will guess that consumption takes the form: @ C=a+BK, +76, SCSI equation 2) andthe production fiance, Yi AK; +, it the eptal-acumultion equation, Kui =K,+¥,-G,, to obtain 1 +AK, +e; —a-BK, ~76,, Giatettm® etuton 2) and equation 2 lagged forward an perio it he fist rer eno, © e+ BK +7, = Exot BK +76.) ‘Subst equation (3) ata equation (4) se Sr Ki +76, a+ PE-a+ +A ~BK, +(t—nei]+7E leu Naring that Ese] = E[6; +.) =e, we can collect terms to an © a+ PK e419 = a(1-P)+BO+A BK, +[B-+16-p)ley th canton (5) ood we need he oes on Kano a¢ well as th ont tem, tobe ‘he same on both sides. Equating the coeficiens on K gives us =BU+A-p) > I=1sA—p, ; orsimply Obra i Equating the cooficients on g gives us 7=B+1(6-B) Using equation (65) and simplifying yields -$+A)=A, or simply A errs,Solutions to Chapter4 91 Finally, equating the constant terms yields a= a(l~B) Unless this requires ® Note that we are also ignoring the case of B= 0, 7 and no restriction on 6. (A) Subsiuting equations (6) through (8) into the guess for consumption, equation (2), and the captal~ accumulation equation, equation (3), yields A (@) Cy= AK + and (10) Ke © Gerke co x, w(estsh ‘Tokeep the analysis simple, and without loss of generality, we can assume that © and thus e, bath equal 0 until some period t. In period t, there is a one-time, postive realization oft, =1—+ A. From period t+ 1 forward, ¢= 0 again, In what follows, the change ina variable refers fo the difference between its actual value and the vale it would have had in the absence ofthe onetime shock (e, if © and ead remained at O forever), Se = wee B eo an nny A Aiea) a sa ea dar eeepc rr ey Bey4y = 980 = O(1~ $+ A). Seopaey ee -e + Ak Ake oe of -tealea-o Intel pint by (1-4 +) tempi oly by A. The i of eine Troupa (9) ns Sowedtovnmest nhs ei prog cpl sky an eal pe a te pe nowper AYa) = ASK +t = AU-#+H0-9+ A= AGA 49 +A F Eee ree nia arg Cys = AAK +] Ave-0). A a aa-pel pg tera “Thus there ae no further dynamic for eonsumption. It remain A higher than it would have been inthe slbsancs ofthe shock Sima, we can calculate these changes for period 2: eveg = 940 = 971-94 A),92 Solutions to Chapter 4 490-167 1 aKa a(t AaK yg +BGu2 = AC @)+AR1-@) 4470-64 A)= A HCG). and As, LabeAeA-PAH TARA “The pattem can now be inferred, Suppose theres a onetime shock off, =1~#+A, Inthe period of the shock, consumption rises by A and permanently stays a that new level with no further éymamics. tn ‘addition, n periods afer the shock, the change in output is AYion =A+O°-8), and the change in the capital stock is AK yg = 1-8 “The nature ofthe dynamics of ¥ and K depends upon the value of @. In the special cas in which tis equal to 0, so that there is no persistence in the technology shock, there are no further dynamics after period CI. The period afer the shock, and inal hoe thereafter, capital is higher by ene and output is higher bya, For the case of 0-<} y=-0+B) > ali-p)-a > all-A)=a = a=0.®) “Tee is anche set of parameter values tha atisies equation (5 which is = 0, cn This scond solution is economically unappealing, however, since ~0 implies that consumption dees not depend on the capital tock. This inc alse since consumption depends on output which in tur is dried bythe apa tock "Ths we cn, on ecmonie grounds, gor this ecandsoutin ya+ay, @ 1, and no restriction (@ Subsitutng equations (6, (7) and into he goss for consumption, uation 2), andthe capital- sccuulaton equation, equation 2), ls ©) CHAK, —[VO+AIye, 30d CO) Ky Ky ++I, Wich los of generality, we can assume tat v =O until sme period t when there ea eee postive realization of 4 Tokeep the analysis simple, assume that v= (1+ A). From period +1 foward, v= 0 aan In period, Kris unaffected. It is determined by lst peri’ capital stock and last perio’ saving. From te production function, Y, = AK, Ysis unabeted since Ky is unaffected. From equation (6), we can soe ‘hat consumption in period tC, is ower by [YCL+ AN] =[YC+AN]+ A) =94 Solutions to Chapter 4 In period + 1, we can se fom equation (1) hat Ks ihigher by [V(L+A)]y, =[CL+ AD]lb+A) = Intel, nt eros drop in consungtion by oe, wth unchanged ouput, meant an ineresse in saving of cee, This in tum means an nrese nhs periods capa tock by one. Though te production fncton, since Kus ihigher by one, ouput is higher by A. Funaly with vo assumes to be 0, then see Kas a ‘gher by one, Ces must be higher thant was in period t= 1 (fre the shock) by A Ths lat fc ca be seen fom equation (9) From period t+ 2 forward, assuming v= 0 forever, there willbe no further dynamics. K stays at its new higher level: one higher than in peviodt «1. Y stays atts new higher level A higher han in period. 1 C '8y8 tits new higher level: A higher than in period t- 1, All ofthis is depicted in the figure below. uot wl @ ew oom a roblem 4.10 {) From the Solo, Ramsey and Diamond models itis ler that onthe balanced growth path without Shocks, the growth ates of Y, K and Cae allequalton +g. In addition, the growth rate ofw the ‘srowth rate of Lin, andthe growth rates of Cand are zero, Note that given the logarithmic structure hore, “growth rate” means the change inthe logarithm ofthe variable. That i, the fact thatthe growth rate ‘of Kis n+ g means that nk )-InK,) =n Dividing both sides ofthe production function, ¥,= K {AL}, by Ade yolds Y/ALe= Ke{AL = [K/L Since y* and k* are the balanced-grovth-path values of Y/AL and K/AL respectively, we have () yan Similarly, dividing both sides of the capital-accumulation equation, Ke ives ue RR eee] gO, aie R Ady Ai, "Ay Aube Aly Using the fact that Kw ~ eK, on the balanced growth path and thus that Koy /Aiy = e'PK; /AdLa5 well ‘asthe ncttion give nthe question yields Q) eek yr ct Gt bk Dividing both sides ofthe equation giving the real wage, w; WA (1 -a)IK AL Denctng the value of w/A‘on the balanced growth path as w* gives us © w= (ae From equation ($4) inthe text giving the real interest ate, we have on a balanced growth path Ye CG, BK,, by Ale 1 -O)IK /AMLe PAs, by A yieldsSolutions to Chapter 495 ) Boeke 5. ‘We need to transform textbook equation (4.26), which rats the trade-off between curent consumption and current labor supply, ito an expression concerning the balanced growth path without shocks, Note that in equation (4.26), «(1 =.) =o is consumption per person, CIN, We are interested in c* ‘which is consumption pe unit of effective labor, CAL, Since C/N = (CIALLIN)A, onthe balancad _rowth path ietruethat ©= €%*A. Using this fact and dividing both sides of equation (4.26) by A, we obtain eretAA WA ano Since w* = WIA, wehave o Tae Finally, to transform textbook equation (4.23), which relates the tradeoff between current and fture consumption, frst eliminate the expectations term since there is no uncertainty without any shocks. Then muhiply bth sides of equation (4.23), Mey = 6B [(1 + te Goi J bY eo co Fe" 09 + tot). (On the balanced growth path, consumption per person grows at rate g and thus cy eile=e. Thus we have O leet Equations (1) ~ (6) are six equations inthe following six variables: y¥,k*,e*,w*,€°, and (©) Weneed to assume the following paramter values: = 1/3, g=0.005,n = 0.0025, #50015, nd €* = 1/3. Note that these are quarterly values frm, g and * 025, From equation (8), we ean obtain an expression for capital per unit of effctive labor on the balanced growth path, Ke: = [all + 8)" ‘Substituting forthe values given yells K+ =[(5y(O015 +0025)" = ‘Substituting this value for k* into equation () gives us a value for quarterly output per unit of effective labor onthe balanced growth pth yon kt" = (24.056) => yt=2.8868, ‘We are tld thatthe rato of government purchases to cutput onthe balanced growth path is (GIY)* = 0.2. ‘This mean that: IGIALYIVAL]=02 > GAL=G*=(0.2)2.888) => Gr=0.774. From equation (2), we can solve for consumption per unit of effective lbr onthe balanced growth path, byt GP Bkt =k = (1-5 -e Jkt +9" = ‘Substituting in forthe values given yield: c= (1 0.025 - Pe \24.0563) +7.8868-05774 => c= 1.5269 Itie then straightforward to te thet values for c* and y* to solve forthe share of output devoted to ‘consumption on the balanced growth path CIY= [CIALY[VIAL] = chy" = 1.526972 886 5289,96 Solutions to Chapter 4 and ths consumptin's share in output is approximately 53%. Since ouput is devoted to consumption, investment, of goverment purchases, we kiow that W=1-CY-GY = 1-05289-02=0271 and thus investments share in output is roughly 27%, Compared to actual figures forthe U.S. thi is tivng slightly too much weight to investment and slighty too litle weight to consumption. Finally, the Implied ratio of capital to annua ouput on the balanced growth pth is K/sY = [W/ALY[AYIAL] = k*dy* = 24.0563/[4)2. 8868) = 2.083, Problem 4.11 Before invoking the simplifying assumptions, the model here is the RBC model with no goverament and 100% depreciation, given by ) We KeLALe]* — @) Kor" ¥eeG — G) ny = Arete Ay @ KesppRiy teas G) WNy=Nemt © w= tn + bial -4,). In this question, we are simplifying by assuming n = g = adjustments tothe model, Population is given by G')mN=0 > N ‘We have normalized the pepulation to one and thus ¢,, labor supply per person, will be the same as total labor supply, Le. Thus we can rewrite the production function as (1) Ye KE AGT. Finally, with respect to technology, since g and K are equal to 0, we have In A, = A, and using equation (4) to rewrite this yields G") nAvm pals + ar ‘This resus inthe following (9 Detain timetas V=maxe Eerrofinc, +bin0-1))} Since wo are solving solving the social planers problem, the maximization i subject to the production function, ‘equation (1'), the eapital-accumuaton equation (2) and the technology equation (3). "Thus the value function at time tis the expected present value of lime utility, from ime t forward, evaluated at ll the ‘optimal choices of consumption and labor supply. The technique here is that we can reduce what looks lke «complicated multperod problem down toa twe-period problem, This is due tothe fact thatthe value function must satisfy Bellman Equation, which is given by VK Ar) =marlinGy+bIx0=€9) +e (Via Kia Ave] Equation (8) says thatthe value function at time t sequal owtlty a inet evaluated atthe optimal C, and, plus the discounted expected value as of time tof next prio’ value fimcton. Tati, the expected value of maximized lifetime utility is maximized liftime utility “today” plus "todays" expectation of ‘maximized lifetime uilty ftom "tomorrow" on, appropriately discounted ()) We wl guess thatthe value function is of the form (©) We(Ke, Ac) = Bo Ba lnk + Bana, ‘Substituting this guess ino equation (8), the Bellman equation, yields (10) YK Ay) = mafic; bin -4.)+7E [Bo +B Ke +Ba nA ‘aking logs and then expectations ofboth sides of equation (2), the capital-accumulation equation, yieldsSolutions toChaptsr 4 97 (1D) Esta] = Eft, - C0] = iY - Ce). ‘where we have used the fact that V,and C, are both known as of ime t. Taking expectations ofboth sides ‘of equation @') yields (12) Eindtss]= pynds, ‘were we have used the fact thatthe shocks have mean zero, Substituting equations (11) and (12) into equation (1) yields (3) Vk A= mmlnc, + bla=£9)+6[Po Pla =C+Papa MA “The fier eto for Cis O=YCy +e DA -Cy > YCr =e" /(%, C4), (1H Ye-C=e FBC, > CUE BI=N => Cr=[y/[140%P x]. C4) Tht teri of neuen op isn by 5). CoM 11 +e Ba. So clealy the ratio of consumption to ouput does not depend on K, oF As (©) The first-order condition for (noting that Ly= 6, is A/C = 64) + fe” Bx (Ys CIT aK? AI ‘Simplifying yields (16) B/C =6,) = [6* Px CMe = CCI 290% 4. Substituting equation (14) into equation (16) yields (17) bi -6,) =e Bale” Bx CCL ~ aN¥s/ &)= C6 CCL - 2 4) Substituting equation (15) ito equation (17) yields BU -G)=C-aXI+e"PxVG > BE (1-GM1-aN(L +e*Px. Further simplification allows us to obtain 4 101 -0V(1 +” Pc) +b] = (1-01 +e” Bd, and thus as oo Goayefolare*rn] ‘Ths, abr mpl per psn does et denon Kr At, In atin, wth one sip Aer, tis pole se fo opal sue, an exresin wach wb sel ae en: 9) -q)=vffa-end eq) +9] (0) Now ae hs etna cies of ouumpin nd sro wel asthe potion fio, nd ‘ttt al ts ale acon, Kl am oat gal pcs hte le cen i Ioglnearcptl nd ecology ad Formally subsite eutins(18,(14") and (19) tego (13) obtain WK A= /[t+e"PBq +a yoxd +e} + @ «fp + Bx infe“*Px¥,/l1+e"*Pg]]+PaPa nds}98 Solutions to Chapter 4 Substring equation (1 Jogarthms yields NW AdmabnK +-a9lnAy + (ag ae PP) bhfyft-ayt se the production function, into equation (20) and expanding some ofthe en +2°%o +e" leg) =I 46°F) rank, +(1-apInAy +1- 0 sothat tax revenues rise when income rises, To find the slope ofthe IS curve diferente Y= E(Vsi~,6,T(0) wih spect toi, oldng eventing es conan Foes oero® = Mpey-eron a a fs ry ai vy Err] “@ i-Ey-E;rO) Invertng the above expression yield the slope of the IS curve, Ey ~ErT(y) Ee ‘To.see how an increase in (¥) affects the slope, take the derivative ofthe expression for the slope with respect to (¥)