Solutions Manual to accompany Advanced Macroeconomics Second Edition David Romer University of California Berkeley Prepared by Jeffrey Rohaly University of California. Berkeley ‘al McGraw-Hill ffi irwin son BArrRige tL. Dubugee.IA_ Madson WI NewYork Sun Fano St. Lal ‘Bangkok Bogoth Caracas Kiala Limpur Lisbon Landen Mairi! Mexice City Milan Montreal New Denk Santiago Seoul Singapare Spey Taipei TorontoMcGraw-Hill Higher Education zz ‘A Dison of The McGrew Hill Compan, ihe! y Merit. a npn te Mr Copies, e121 Ave fe ‘Ries Sew NY 08 Copp 9 My te Mere apne we Ae “dc tron at ep na nyse sed inayat Tua ae eon gorse dicen STs 2o4serssoqsnasn0987654321Preface “This Soltions Manual is designed to accompany the second edition of Advanced Macroeconomics by David Romer. It contains suggested solutions to all of the problems at the end ofeach chapter, withthe exception of ome ofthe empirical exercises. Thave made every attempt to provide a very detailed, step- ‘by-tep answer to cach problem Only basic algebraic manipulations have been cecasionally omite, { would like to thank many individuals for their holp with this manual. David Romer provided numerous belpfl ints, comment, and suggestions that have grat improved the quality ofthese solutions. Andres cde Michels, Fabio Ghironi, and Galina Hale provided drafts of answers to some ofthe problems in ‘Chapters 1,3, and 1, Tn addition, thank you to thse who pointed out errors inthe fist etion ofthe ‘manial and provided suggestions for improving the solutions inthis secend edition.SOLUTIONS TO CHAPTER 1 Problem : - {@) Since the growth rat ofa variable equals the tne derivative of ts log, a8 show by equation (10) in the text, we can write fy 20, dn219 _abfxioveo] Zo” at & Sic the log ofthe product oftwo variables equals the sum oftheir logs, we have 200 _dfinX(+in¥(O]_ din Xie) din Yoo Zw) orsimply zy _ xo Ze) x xo Yo (0) Aaa, since the growth ate of variable equal th time derivative os lg, we can write co) 208820) _alXOXO] Z0~ dt & Since the og ofthe rato of wo variables eas the difference in thi ops, we have 6) 20 eXO-BYEO] _ainxto _diee a &@ ~ & & * cor simply 20) _ xo Yo @ 20,30 _ Yo © 20)" x0 YO « (0) Weave cy 2 diaz, dix") Zo" ét at Using the et hat nf XE J ~ aX), we have 20_dawxo] ax”, X0 2) dt at X(t)” svhore we have sed he fc that is constant ooblem 1.2 (a) ing theinforatin provided in the question, the patho the growl rate of, X(0/X(0), scopic in | XCO| the figure at ight. x00 From time 0 to time t , the growth rate of X is constant and equal to a> 0. Attime tthe growth rate of X drops to 0. From time t; to time ts, the growth rte of | gf} X rises gradually from Oto a, Note that we have made ‘the assumption that X(t)/X(t) rises at a constant rate fom t, tots. Finally, aftr time ts, the growth rate of Xi constant and equal to a again2 Solutions to Chapter 1 (b) Netethat he slope of inX¢) plated gains time is ‘equal tothe grow rte of X(Q, Thats, we know diaxe) Xo & XC (See opuaton (1.10) inthe txt.) From time 0 totime tthe slope oflX¢) equals a> 0, The InX¢) lous hasan inflection point att ‘an the grows rate of X() changes discontinuously from ato 0, Baweent and tthe lope of Xi) rises gradually fom Ot. After time tthe slope of TeX() is constant and equal t a> O again, Problem 13 (@) The slope ofthe break-even investment ie is sive by (+ g8) and thus a fallin the rate of epreciaton, 8, decreases the slope of the breakeven investment ao. “The actual investment curve, sf is unaffected From the gure a right we can soe hat the balanced ‘romi-pats level of eapial per unit of cetive labor fer Grom k*t0 sew (8) Since the slope ofthe break-aven investent line is given by (2+ g'+ 8), arisen the rate of technological progress, g, makes te beak-ewen investment line steeper. “The actual investment curve, s(}), i unaffected, From the figure a ght wo can sc tha the balanced rowth-pat lve of capital per unit of effective labor falls fom kt Ks(©) The break-even investment in, (a + 8+ 8k, is unaffected by the rise in capital's share, “The effect ofa change in onthe actual investment carve, sk", can be determined by examining the derivative G(2Va. It is possible to show that oO S sk® ink For 0 0,ork> 1, 2k? /60> 0 and othe new actual investment curve lis above the ld one. For Ink <0 ork <1, dk /2a.<0 and so the new actual invest curve ies below the oi one. Atk that c= 0, the new actual investment curve intersects the od one In adtion, the effect ofa rise in a on k* is ambiguous and depends onthe relative magnitudes of s and Gat gt). leis possibleto show that a risoin capital's share, a, will cause k* to rise ifs > (n +g 8) ‘This is the case depicted inthe figure above (2 Suppose we modify the intensive form ofthe production function to include a non-negative Constant, B, so thatthe actual investment curve is given by SBA), B > 0. ‘Then workers exerting more effort, s that output per mit of effective labor is higher than before, can be sdeled as an increase in B. This increase in B ifs the actual investment curve up The break-even investment line, (a + g+ Sk, is unaffected. From te fgute at right we can see that he balanced growt-path level of capital per unt of effective labor ‘ss ftom K* to kts Problem 1.4 (@) Atsome time, call tte ther isa discrete upward jump inthe number of workers. This reduces the amount of capital per unit of effective labor ftom k* to kxew . We can se this by simply Tooking atthe 0, this fallin the amount of capital per unit of effective labor reduces the amount of output per unit of effective labor as well. Inthe figure below, y falls ftom y* to Ysew4 Solutions to Chapter 1 (©) Now at this lower kyrw , actual | investment investment per unit ofeffetvelabor_| ett ab ‘exceeds break-even investment per yo ft) anit of effective labor, Thats, ry sfQkaaw) > G+ Sw . The (e+ 3k ccmomy is now saving and investing more than enough to offct sew ‘depreciation and technological Drogress a this lower kaw. Thus k bogins rising back toward k*. As ‘capital pe unit of effective labor begins rising, so does output per uit SF ‘of effective labor, That is, y begne rising fiom Ju back toward y* ew (©) Capital per wit ofeftiv labor wil continue tors ntl evetally rust the orginal eve of 1, Atk, mvexmene por uit of effictiv labor i again just cough to offet tecnologia progress end depreciation and keep K costar. Sips krecus os orga value oF * onc the economy aga ems tor balanced growth path, output pe nt of efctive labor ls returns tos orignal vale of ya) eoblem 1 (a) The oquaton describing he evolution ofthe capital stock per nit ofeffeive labor i given by ( k= 2f()-Gore+dk Substituting in for the intensive frm f te Cobb-Douglas, 1) =", ils kask®—(o4g +k (n the balanced growth path iis zr avestment per unit fective labors qual to break-even investment por uit of fective labor and sok remain constant Denoting the balanced growth path value oFkas ke, webave sk" = (us g-r0K*, Rearanging wo solve fork yields @) ke=[sa+g+5]!™. “Togo the balanced-growth-pat ale of output per unit of fective labor, substints equation 2) ithe intensive fom of the production fcc, y =I ©) yt-[yler819"™ Consumption pr unit of ffi abr onthe balanced growth path is given by Substituting equation G) mt this expression yields © otc -a9fyarg +5] sy (0) By det, the goldon- ea of the cpal tock thet leve at which oot per nt of effcctive labor is maximized. To derive this level of k, take equation (2), which expresses the balanced- (gowtrpath lee, ac marige taste Gor e1 oe" Nov ebatiteoqation (ito equation): ~(a+g+k*"*fasgs5k"*/ase+6] Afr some sraigifonvard algerie mnipltin, this spies ieSolutions to Chapter 1 § © choke (arg roe Equation (6) can be caily interpreted. Consumption per unt of effective labor is equal to ourpt per unit of effective labor, k*, less actual investment per unt of effective labor, which on the balanced growth path is the same as break-even investment per unit of effective labor, (n-+g + 8)k* "Now use equation (6) to maximize c* wit respectto i, The first-order condition is given by de/ter nok" -(a+g+5)=0, [Note that equation (7) i just a specific form of f(k") = (n+ 8+), which isthe general condition that implicitly defines the golden-ale level of capital per uit of effective labor. Equation (7) has a graphical imtorprtation: it defines the level oF kat which the slope ofthe intensive form of the production fiction is ‘equa tothe slope ofthe break-even investment line, Solving euton 7 forthe golden ee of yes © Rog =levla+a+9] (©) Tosget tho saving rte that will yield tho golden-rule level , substitute equation (8) into (5) son min +g +BJafin+g +a], whieh simplifis to ©) sox =. ‘With a Cobb-Douglas production function, the saving rate required to reach the golden rule is equal tothe laticity of ourput with respect to capital capitals share in output (if capital earns its marginal product) coblem 1.6 (@) Since there ie no technological progress, we can cary ou the entire analysis in terms of capital and ‘output per worker rather than capital and output per unit of effective labor. With A constant, they betave the same, Thus we can define y= Y/L and k= KIL. ‘The fal inthe population growth rate makes the break-oven investment line attr. Inthe absence of technological progres, the per unit time change in k, capital per worker, is given by Keasf(k)~(+m)k. Since k was 0 before the decrease in n ~the economy was ona balanced growth path ~the decrease inn causes k to x become postive, At", actual investment por ‘worker, sk"), now exceeds break-even investment por workor, (haw + 9k", Thus k moves toa new higher balanced growah path level. See the figare at right ry (mw + ‘As k rst, y ~ output per worker ~ also rises. ‘Since a constant faction of output is saved, consumption per worker ~ rises as y rises. This is summarize inthe figures below.6 Solutions to Chapter 1 (&) By dein, output can be writen a5 Y= Ly, Thus the grovah rate of opt is ¥/¥ =L/L-+ ify. Onthe inital balanced growth path, 3/9 =0 — output per worker is constant ~ fo ¥/¥=L/L=a, On the final balanced growth path, V/y = 0 again ~ output per worker is constant agtin— and s0 Y/Y = L/t= In the end, ouput wil be growing ta permanent owe at, NEw . Tint bc di ote ed em eatin le clenn © ope bce war ct err tt Stem nprttetensr hand tepoine se @) tog Tax tome be Seglpeharlsyonw end inne yew o_o ete SHEE Se yu med pon oes ter te tine gop Aree SRST ae nat tcp pater bg ako mas See Niet etme go peter nora “The growth rt ofthe marginal produc of apa, + fete] _ 00k Fr fk) £0) As ries toward Kt ths growth rate is negative since £"(R)> 0, €" (4) <0 and K > 0, Thus, 2 the ‘Sonamy moves fora eto the marginal product of capitals. Tha is, tows a ats ess than on the balancod growth path where ts gro ate 0 Problem L10 (@) By detintion a balanced growth path ocurs when all he variables ofthe model are growing at Constant ates. Despite the differences baween this model andthe usual Solow mode, it tums out that we ‘an again show thatthe economy wil converge toa balanced wrowth path by examining the behavior of k= RIAL. “Taking the time derivative of bth sides ofthe dfisiton of k = K/AL gives us we(&} REAL)-KILA-AL] kK Eta] {i,4) “Nan ay? aL ALL AL SAL LA. ‘Subsitating the capital accumulation equatic, K =[9F(K, AL}/2K]K—BK, andthe constant growth rates ofthe labor force and technology, L/L= and AJA = ito equation (1) yields [ark atyex] K-8K oFK,AL Ce AL aK Substituting 0K ALK = 0) into equation 2) gives us k= £(kOk-Bk~(n-+)k oF simpy ©) k=[P)-(a+8+5)k. ase) k-8k-(048)k Capital per unto effective labor willbe constant when = 0, ie. when (f°) (n+ g + 8)] k= 0. This condition holds if k= O(a case we wil ignore) or") -(a-+ +8) 0, Thus the balanced-growth-path level ofthe capital stock per wit of effective labor is implicitly defined by fk) = (0+ g +8). Since capital per unit of effective labor, k = KIAL, is constant onthe balanced growth path, K must grow atthe Same rate 38 AL, which grows at rate +g” Sios the prodction function has constant etums to capital ‘nd effective later, which bath grow at rate n g on the balanced groweh pa, ouput must also grow atSolutions to Chaprer} 11 rato +g onthe balanced growh path. Thus we have found a balanced growth path where al the variables of the model grow at constant rates. ‘Tho nes sep isto show that the economy actually converges to this balanced growth path. Atk k*, £° (4) =(a+ +8). [Fk > kt, £08) < (a+ @ +8). This follow fom the assumption that £" (k) <0 which ‘means tht (fll as k rises, Thus iFk > kt, we have K <0 so that k will ll toward its balanced sroweh-path value. Ifk (0+ +8). Again, this follows from the assumption that f° (k) <0 which means that fk) rises as i falls. Thus if < k*, we have k>0 sothat k will rise toward ts balanced growth-path value. Thus, regardless ofthe initial value of (as long as it isnot zero), the ‘economy will converge toa balanced growth path atk, where all he variables in the model are growing at ‘constant rates (8) Tho golden-rle level ofk~ the level ofk that maximizes consumption per uni of effective labor ~ i efined implicitly by £'0¢) = (a 4g + 8). Graphically, this occurs when the slope ofthe production function equals the slope of the break-even investment line. Note tha this is exactly the level of kthat the ‘economy converges to inthis model where all capital income is saved and all abor income is consumed, In this model, we are saving capitals contibuton to output, which isthe marginal product ofeapal times the amount of capital. If dat contribution exceeds break-even investment, (n+ g + BD, then rises, Iti Jess than break-even investment, k falls. Thus k settles down tos point where savin, the marginal product cof capital times k, equals bresk-even investment, (a+ g+5)k, Thats the economy settles dawn to a point where f° (Qk = (a+ g + 5k or equivalently f'(k) = (a+ g-+8). Peobtem Lak (@) Theprodicion function with eaptal-augmenting technological progress is given by ACK) LO! Diving bth sides of equation (1) by ACY" -*L¢) yields “yo {awk Ff _uo J OTL LaLa [aE sad ping yo [acts AML ut J . sod aly vo {wT ROTH LOE ‘Now, defining @ = a/(1 - a), k(t) = K(QVA()"L{t) and y(t) = Y(tVACQ"L(D yields @ y= ky” Inert anal amie of, ak he tine info ids ft) = KAU *NRO|AOLO] “KONO AOL LOAG] [ac*Le]”12 Solitons to Chapter 1 iq —8O___KO. f,A@ Lo} rE AwPLOL’ Aw” Lo and then using KX) = KOOVACOMLE), ACO /A(O =H and L¢0/L(Q) 0 ye ©) K=KEO/AC* LO) n+ MKC “The evoltion ofthe ttl capital stock is given bythe usual @ KQ)=2¥0 -8KO. Sabstiuting equation (4) into (3) gives us ke =s¥(0/ A Lt) -3K(0/ ACO? LE — G+ MRC =s9(0)— GH +A FIKL. Finally, esing equation 2), yO) = Ki, weave ' eG = KIO" ~Gu+n+5}KC). Equation (3) is wry similar tothe basic equation ‘governing the dynamics ofthe Solow model with Jaber-augmenting technological progres. Here, however, we aremeacuring in units of A(*Li) rather than in unite of effective labor, ACL(), ‘Using the sme graphical technique as with the basie Solow model, wo can graph beth components of L (2). See the figure at right. ou-+n + 5) ‘When actual investment per unit of AGLED, sk(" excoed breakeven investment per unit of ACO*LE), given by + OKC), k wil ise | toward kt, When acual investment per unit of| a iq) « KACOLAD | A()°L0) fll short of break-even investment per unit of A(QPL(, k wil fall toward kt. Ignoring tho casein which the initial level of kis 20 the ‘economy will converge Co situation in which kis constant atk*. Since y=, y wil also be constant ‘shen the economy converges to Kt “Thetotal capital stock, K, can be writen as APL. Thus when kis constant, K wil be growing atthe constant rat of bu +n, Silly, eta ouput, ¥, canbe writen as APLy. ‘Thus wien y is constant, ‘output grows a the constant rate of rn as well Sine Land A grow at constant rates by assumption, ‘we have founda balanced growth path where al the variables of the made grow at constant rates, (©) The production function snow given by OYO=HOL"™ Define Jt) = (VAC). The production faction can then be writen as © YH=[A@IE)]" LEO Proceed as in pat). Divide toh sides of equation (1) by AOL) and simply to obtain yo f__iw © 50" L0 Law U0)” "Now, defining = o/( -<, jt) = (ALA) and yd) = YONAQLED yields ©) 10 jo"Solutions to Chapter! 13, In order to analyze the dynes of), tke the ine derivative of both sides of jt)» Tey /A(O"L: Fo[acot eo] -Te[saco* AOL + Lea’) ‘ [acre . J@ Jo _[, aw Ley] ROrL® A@*LOL” Aw "Le! and then using J@) = T0/AQ'LED, ACW /ACO =H and L(O/L(t)=n yields 00) jo=Fo/a@*Lo-quemio. ie, ‘The next step is to get an expression for J(t). Take the time derivative of both sides of J(t) = J(t)/A(t): Ag? A® AW A® Now use J(t)=J(t)/A(0), Act)/A(t)=1 and J(®) = sA()Y(®) - 8)(t) to obtain 1-80, = AD Fe=s¥O-HH TO Substite equation (11) into equation (10): JQ) = 8¥(0/A PLE) ~ (+ BO /A(O LO ~ Gu+ MIO = sy) — [045-4 w+ GIO, Finally, sing equation ©), 30) J(O", we have (2) j= 510% -[n+5+ ud +H]0 ‘singh same apical technique sn the base Solow model we cn graph beth components) Sot gure gt. Inorg he — poss tht tial val of] ero te economy wl ener 98 (neo pt0) Simation were isco at | Since y= 3°, yillalo be constant win. | shot the eno converge fo J* | “The level of total output, ¥, ean be writin as AYLy. Thus when y is ‘constant, output grows a the constant rate of ut By definition, J=A*Lj, Once the ‘economy converges to the situation where J isconstant, J grows atthe constant rate of Gu +n. Since J= J A, the effective capital stock, J, grows at rate gu + n+ worn + y(l +). Thus the economy does converge to a balanced growth path where al the variables of the model are growing at constant rates. io Ten/aemtuey4 Solutions to Chapter (6 Ont atncad growth path, () = 0s om ation (12 ssrusplj =F Paxfass+na4, [fln+5+uctegy] Substitute equation (13) into equation (9) to get an expression for output per unit of A()*LA) onthe balanced growth path 4) yt=[y(n+5 + 10+9))] “Taketh derivative oy ith eps rt a] Slices. avdenid) | tn oder totum thin an elastic, mtipy bth sides by sng the expression for y* om equation (0) on th ghar sie e242 leatca) lial er Sinplifing ils ea [is pestemteatf aye lina s lavdeultea) i seh fly ay Eat ! wy ie (6) A first-order Taylor approviation of around the balanced ronth-ath val of y= wil be of the orm 9 yse/,_,[y-y"] "ie i tic ote Saba sation (12) to eatin (7 year asdend 0). +Seu(t44)) . Equation (18) expresses interme of j. We can express Jim tarms of: since y~ J*, we can writ Jy", Ths 29 evaluated a y= is given by af fal jal ly ean a2 Harssu0 ft] Now, yo is simply j'°* since y= 7" and thus a Myaye 20.- DROID _ MDa 454 (14g) =a(2~DI™" ofa +5+u0+9)Solutions to Chapter 11S [a5 + nO +9) and thos Substncing equation (19) int equation (16) gives the first-order Taylor expansion: 20) ys-C~a)[n+5+40+4) [y-y4] Solving this differential equation a inthe tex) yes QD y)-y* se talastent ty by@-y"4} “This means thatthe economy moves faction (1 ayfa +8 + (1 +4) ofthe remaining distance toward y* cach year (©) The slaty of ouput with respect to s isthe same in ths model as in the basic Solow model. The speed of convergence is faster in this model. In the basic Solow model, the rate of convergence is given by ((.a[a-+3 +) which is less than the rare of convergence inthis model, (I - ain +8+ pl +] since all ~ ‘Asin bo model th text, YK mst be constant in order for the growth rat of Kobe constant. That i, ‘be powth ates of Vand K must be equal “Taking logs of bath sides of the production function, Yit)= K(O" RDP TEOT[ACLEO] =F, vss @) YC) = oink () + HARE + YE) + C1 -a.-B ~7llaA@) + LE) ilfereniting beth sides of 2) with respect totime gives usSolutions to Chapter 1 © sy)=aa¢ (0+ Pea +er(t)=(-a-B- Yaa +8.) Substituting in the facts thatthe growth ates of RT and Late all equal tom andthe growth ate of A is equal tog ves us By ()=age (t)+Ba+m+(-c-P-r(0+8) Simplifying gives ws ip BVO = HBR +B+n+-adn~(Bry)ne (-e-P—E gx (t) +(1-a)n+(0-a~B-ne ; Using the face that ay and x must be ual on a balanced growth path eaves us with fyeany +(1-aa+(-a-B-), (1-aigy=(1-a)n+(1-a-B-Y)5, and hus the growth rate of output on the balanced growth path is given by (-a)nt a6 © ap eee pone “The growth rate of output per worker onthe balanced growth path is gow =g0? 9h BY = BY" Using equation (5) andthe fact that L grows at rate n, we ean write veg (i-aat(-a-B-Ye- (-alnr(1-a~B-yg-C-a)n Bie ae ‘And thos finally © WR a-B. Ta ‘Equation (6) ie tdentcal to equation (1.50) inthe text. 0SOLUTIONS TO CHAPTER? Problem 2.1 {G) Tho firms problem ito chose the quantities of apa, K, and effective aber, AL, in ode to iniize costs, wAL + 1K, subject tothe production facie, Y= ALT). Setup he Lagrangian Z=WAL+ eK +2[¥- ALFK/AL)] “The istorder condition are piven by 5 -A[ALPEK/ALMAL]=0 > £6), ae Pony w ~ 2 F(K/AL) + ALF(CK/AL\-K) /(AL) 0 => wealftk)—kfdo]. @) Dividing equation (1) by equation (2) gives us Equation (3) implicitly defines the cost-minimizing choice of k. Clearly this choice doesnot depend upon the level oF output, Y- Noto that equation (3) isthe standard cost- minimizing condtion: the rato of the marginal cost ofthe two inputs, capital and effocve labor, must equal the ato ofthe marginal products of the two inputs i (@) Since, as show in part (a), each fim chooses the same value ofkand sine we are tld that each firm haste sae value of A we can wetethe total amount produced by the N cost minimizing firms as Ey, Eanea=ario ds ‘where Tis the total amount of lator employed. “Tho single frm aso as the sam value of A and would choose the same value ofk; the choice of k does ‘ht depend on ¥. Thus if usod all ofthe labor employed by the N cost-minimizing fms, L, the single firm would produce Y = ALA). This is exactly the same amount of ouput produced i teal by the N costaminimizing finns. Problem (@) The individuals problem iso maximize life wily given by Cr ct? @ ve 1-0 “Isp 1-8 subject tothe lifetime budget contain given by @ PC. +P.C:=W, whete W represents lifetime income Rearrange the bud constraint to solve for C2 ©) G=WP,- Cir. Substitute equation (3) into equation (1) a yo, 1 LwiPs Co F Pal OU ett 1-0 Now we can solve the unconstrained problem of maximizing uly, as given by equation (4), with espe tos period consumption, C, The fst-order condition i given bySolutions to Chapter? 19 au foc, =Cy% +(+e}Cz9(-F:P3)=0 => CP =(yt+)(PL/P2)C2*, or simply 7 - . 6) &=(1+9)"(Py/%)"C> In onder to solve for Cy, subst equation (5) nto equation (3): Ca=W/Pp—(1+9)"(Bo/i)'Ca(B/22) => Cal LeCire)™"(02/A) exsingly wr, © ¢=-——»2» * foe, 2) -98) wpe, f Final to gt the optimal hoe of, subtits equation (6 into equation (5) (1+ 0) "(P,/01)"*(wira) oc [centre (b) From equation (5), the optimal ratio of first-period to second-period consumption is © &/C, =(1+)™%(0,/))” “Taking the log of both sides of equation (8) yields @) tolCy/C3) =(yo)te( +p) +()in{Ps /P)) “The lastcky of aubsttionbutween Cand Cz defined in such a way that is pone, i ven by alcyica} (2m) Acc) P,P) (Cris) ~ afin(r 8” where we have used equation (9) to find the derivative, Thus higher values of imply tha the individuals ies wiling to substitute consumption beeen periods Problem 2.3 (@) We can use analysis similar tothe intuitive derivation ofthe Euler equation in Section 2.2 ofthe text Think of the household's consumption at to moments of time. Specifically, consier a short (formally infinitesimal) period of time At from (-) t0 (ta *2) Imagine the household reducing consumption pet unit of effective labor, c, a (ta ~¢) an instant before the confiscation of wealth ~ by a small (again infitesimal) amount Ae. Tt then invests this addtional saving snd consumes the proceeds at (+8). Ifthe household is optimizing, the marginal impact ofthis change on liftime utility must be zero. “This experiment would havea utility cos fw xine). Ordinarily, sine the instantaneous rt of retum is 1), at time (+ 6) could be inceasd by e314, But here, half ofthat increase wil be canfscated, Thus tho ulity beet woud be [/2]0(ape "Fa. Thus forthe path of ‘consumption tobe utilty-maximizing, it mast satisfy 1 to, 0) wee d8E= 50 age OEM Be, Rather infeemaly, wo can canes the A's and allow 3 ->0, eaingus with,a 20 Solutions to Chapter 2 1 746) 2) Wet “Thus there willbe a discontinuous jump in consumption atthe time of the confiscation of wealth Specifically, consumption wil jump down, Intuitively, the housholds consumption wil be high before ty ‘because it will have an incentive nt to save fo 35 to avoid the wealth confiscation. () Inthis case, fom the viewpoint of an individual household, ts actions will not affect the amount of ‘wealth tht is confiscated, Foran individual household, essentially a predtemnined amount of wealth will be confiscated a time te and thus the householi's optimization and its cheice of consumption path would tae this into account. The household would stil prefer to smooth consumption over ie and there will nt bea discontinuous jump in consumption at time ty Problem 24 ‘We nced to solve th house's problem assuming log lity and in pe capita torms rather than in units ‘of effective labor. The household's problem is to maximize liftime utility subject tothe budget constraint That i, its problam is to maximize Fo Lo, once @ v= Femmew ra, ibjecto 0 4 KO 7 gn Le FoR cH eK. T Macon ww we E., 7 ROR We, weve wR. TAO, a We can use the informal method, presented in th tet or solving this ype of problem. Set vp the Lagangian , u ence area we F ea Peeve “The first-order condition i given by U0 | Wy ec) Canceling the LQVH yields @ oFcey tne, which impli & CEOmera' Substituting this into the budget constraint, equation (2), pives us Fe ROfeaictgR] Oe © Foro [Law Sat Lt) = € LO his implies 6 2120 Frog [As long asp -1 > 0 (which it must be), tho integral is equal to Wp =n) and thus is given by ~Solutions to Chapter 2 21 O* “Loy Substiating equation (7) into equation (4 yields i Ton") Initial consumption is therefore W. ©) CO) Tom” a), (p=) aay © Cone [Note that C(0) is consumption per persn, W is wealth pe household and L(OWH isthe numberof people per household. Thus WifL(0)H] is wealth per person. Thit equation says that ial consumption per person is a constant fraction of inital wealth pee person, and (p~n) can be intorpreted asthe marginal propensity to censume out of wealth. With logartimic utility, ths propensity to consume i independent of| the path ofthe real interest rate. Also nat that the bigger isthe households discount rate p ~the more the household discounts the future —the bigger isthe lation of wealth that itinitially consumes Problem 25 "The household's problem isto maximize liftime uility subject tothe budget constraint. Thats ts problem is to maximize can 1-0 Hf abject to F ey LO ote a= @ & OT aw, “where W denotes the housshoes initial wealth pls the reser salue ofits liftime labor income, ie. the righthand side of equation (2.6) in the text. Note that the real interest rate, , i assumed to be constant \We can use the informal method, presented in the text, for solng this type of problem. Setup the Lagrangian: : on cy i on CO LO aly Footeyy MO Tes spade I cone “The Sond condtin igen by Ce ne ot) yn He BE cetegy 56 ay OO Coming LO yas @) ee = 20" Dies se of ution wh peti er aca 'e3)-pe Peay one =o, ‘This can be rearranged to obtain coo) © os heyy 9g C(—)-? — por © 0G eMC? pe RCH ihe [Now substitute the first-order condition, equation (3), into equation (8)22 Solutions to Chapter 2 | constant. Ifr> p that iif ‘the rate thatthe market pays to defer consumption exceeds the households discount rate ~ consumption will orising over time. The value of 9 determines the magnitude of consumption growth ifr excads p. A lower value of ® — and thus a higher value ofthe elasticity of substitution, 1/0 ~ means that consumption growth willbe higher for any given difference batwoen rand p. ‘We now new to salve forthe path of C0). First, note that equation (5) can be rewriten as (6 208 a8 Integrate uation (6 forward from tie ¢= Oto ime = InCtt)- In C(O) =[{r ~ pl /ehe{ hich simples to 0 wfcre/C10]=[(e~ A Ale i “Taking the exponential function of ath sides of equation (7) yelde ce/c(oynellA, snd ths © co=cood Keane We an now soe fo nal consumption, C(), by using tho fc tat must be chsen ost the ouch budget contin. Subsite equation (into equation @) F erstcqoyllt oA LO, i ‘cine Al ‘Using the fact that L(t {0je™ yiekds 9 LOMO Tartar As long as [pr + 8(¢=m)V/0> 0, wo can solve the integral ° 1a) Jolene © pF 6-8) Subsite equation (10) nto equation 9) ad solve for C(): 0 C= PP sm To. 6 ! Finally, to ge an expression for consumption a ach insta in ine, substitute equation (11) into equation @ 2) cw Keno _W [0-4 9] Lov qiSolutions to Chapter 223 Problem 2.6 (a) The equation describing the éynamice ofthe capital stock per unit of effective labor is ©) KO=Hk(o) = (Ca DK, For a given k, the level of that impli k=0 is given by ©= fk) = (n+ gk. Thus a fallin g makes the level of c consistent with k-=0 higher fora given k. Thats, the k=O curve shifts up. Inutively lower _g makes break-even invesoment lower at any given kand thus allows for more resources to be devoted £0 ‘consumption and stil maintain a given k. Since (n + g)k falls proportionately more at higher levels of k, the k-=0 curve shifts up more at higher levels oF k. Seo the igus. (©) The equation describing the dynamics of consumption per uit of effective labors given by att) _ €'(k(0)—p- 98 oe) ° “Thus the condition requicd for €=0 is piven by f"()= p+ Og, Afer the fll ing, £(K) must be lower in andr for €=0. Since "(ie negative this means that the kneaded for é= 0 therefore ries, Thus the ‘ave shifts to the right (6) Atthe time ofthe change ing, he value of, the stock of capital per unit of effective labor, i given bythe history of the economy, and it cannot change discontinuously. It remains equal tothe lt onthe old balancod growth path, Incanrast, the rte st which oushols are consuming inunis of etic labor, ca ump a the tine of the shock, In order fr te economy t0 reach the now balanced growth path, ¢ tut jump atthe instant of the change 0 that the economy ion the new sade path ew x However, we cannot tell whether the new saddle path passes above or blow the original point E. Thus we ‘cannot tell wheter ¢ jumps up or down and in fact, if the new sale path passes right through point E, © ‘night even remain the same at the instant tat g falls. Thereafter, e and k rise gradually to their new ‘alanced-growth-path values these are higher than thir values onthe original balanced growth path {€) On balanced growth path, the faction of ouput that is saved and invested is given by [fey eM), Since kis constant, or k= 0 on a balanced growth path the, from equation (1), we can verte ke) -c# = (a+ gk. Using this, we can rewrite the Faction of ouput that is saved on a balanced ‘roth path as ©) s=[+akeyAe Differentiating bth sides of equation (3) with respect tog yields oe £0k*Hn + gM 2k */2p) +k #}—(n + B)k* F(R CK */8) 28 eae ‘which simplifies to24 Solitons to Chapter 2 2 (a NECkt) KP PUAI CKO) RY oe rey? Since kis defined by £(k*)= p + 8g iferentiating both sites of this expression gives us £°GNGAtIeg) = 8, Solving eZee ier ue (© Atle OF") <0 Substiuting equation (6) into equation (S) yields 7 = BEE) REFNO FC A) 2% rows? ry ‘The fist term inthe numerator is postive, whereas the second i egtive and 0 tho sign of Zl is ambiguous. Thus we cannot tel whether the fallin g aies ot lowers the saving rat on the new balancod growth path (6) When the production funtion is Cobb-Douglas, fk) =", £'0) = ak and £40) = ala - 1% Substtuting these facts into equation (7) yes & _ (at eyikt® “kt akt ork t kt afk? o Ox 1 ala De ich simplifies to i oy & DY 090 Cak ake Oe E(l-apk**(ak*™yak* jay” bic impies Gio) Srna *8=(0 4601 a (oy Tins, ally, we have “as 7 (09-9) _ | (9-20) (p+Osy (p+ 88)” tetena2 ae Sar oy ae taiy-od- arose (a Alors ein esate ee eS Soiree ena mia Tisweicrcetaty Tame aiancr as a ee cores cries Smaimnan nen cope ‘The capitalaccurmulation equation is unaffected The condition required for €= 0 is given by £" (= p+ 8g, Since £" (W) <0, the that makes €=0 is now higher. Thus the value of that satisfies €= 0 is lower, The.¢=0 locusSolutions to Chapter? 25 shifts to the left. The economy moves upto point A on the new saddle path, people consume more now. “Movement is then down along the new sad path until the economy reaches point E'. At that point, * ‘and k* are lower than their orginal values. (b) We can assume that a downward shift of the production funtion means that for any given k, both £0) and €"(K) are lower than before “The condition required fork =0 is given by = f(k)~ (a+ g)k. We can see from the figure onthe right ‘thatthe k-=0 locus will chit down more at higher lovels of Also, since fora given k, fk) is lower ‘now, the golden-rulek willbe lower than before. Thus the k= 0 locus shifts as depicted inthe figure. “The condition required for €= 0 is given by f(k)= p+ Og. Fora given k, f°) is ow lower. Thus we need a lower kto keep £* (i) the same and satisfy the €= 0 equation. Thus the é= 0 locus shifts left. The economy wil eventually reach point E' with lower e* and ower k*. Whether initially jumps up or down ‘depends upon whether the new sade path passes above or below point E. (©) With a positive rate of deprecation, 8> 0, the new eapital-accumuation equation is @) (0) = FERC) ~e(0 ~ (2+ + OKC26 Solutions to Chapter 2 “The level of saving and investment required just to keep any givun constants now higher and thus the amount of consumption possible is now lower than in the cae with no depreciation, ‘The lve of extra investment required i alo higher at higher levels ofk, Thus the k= 0 locus shifts down more at higher levels of In addition, the el rtm om capital is now f(x) ~8 and so he hourcols maxization wil yield 20 LEO & woe t =) @ } “The ceniton quired for &=0 is Fk) =B+ pO. Compared to th case with no depreciation,” (R) mus be higher and k over inode fr €=0. ‘Thus the € 0 lots shi othe le. The ecnomy will ‘retually wind wpa pot E* wih lower levels of "and k*. Ai, wheter cups up or down intally ‘spends upon whee he pew sadl pat passes above ox below the ergmalequilium poi of E soblem 22 {Wt postive depreciation ate, 5 > 0, te Euler equation andthe capita accumulation eqn are gies oy se _ Fito) 8-9-6 » teen) spc and) KD =H{K(O)-eC-(n-+ 5 +2)RCO. ‘We bein by taking first-order Taylor approximations to (1) and (2) around can vite and c=c%. That is, we eek ew Bte-et nd ks Ses Bee where 06/8, 2, dk ke and dk are all evaluated at k~ k* nde" Define E=c~c* and E=k-k*, Since ct and k* are constants, ¢ and i are equivalent to € and i respectively. We can therefore rewrite (3) and (4) as em ad FEE 6 baGee Se Substatingoton (7) and (8) int) an esatins (9) and (10) into (6) ks ay 22 OF, ana ay 2[06+006—)-(a+e+3] ez fiz. “The socnd line of equation (12) uses the fact tht (implies that #44) =8-+p-+Op, The third ine uses the definition of = p-n-(1-2)g,Solutions to Chapter? 27 Dividing equation (11) by € and dividing equation (12) by yields é x E os Band 0H Fap~ [Note that these ar exactly th same as equations 231) and (232) in tho text adding a positive depreciation ate doesnt ake the expressions forthe gromth ates of € and &. Thus equation (236). he expression fry the constant growth rat of both & and asthe economy moves toward the balanced ‘owth pth is sil valid, Thus it aeuere p= yp? ar aeri8 (15) 4 = ‘were we have chosen the negative growth reso thi and I are moving toward cand kt, ot sway ‘om them. [Now consider the Cobb-Douglas production fntion, fk) =k®. Thus UH) FOeDaakeart4s, and (17) Ftk#) =a(o- Dk ‘Squaring both sides of equation (16) gives us (is) (148)? 2a2k 22, and s0 equation (17) can be rewritten as cers (@=) an 1(et48)? ak a FR) a9) #1"): In addition, defining e to be the saving rate onthe balanced growth path, we can write the balanced _growth-path level of consumption 28 QO) oF = (1-4) ~ Substituting equations (19) and (20) into (15) yields a N)(e 38)? py (2) ane @) fe m= ae Canceling theft) and mukipiing through bythe minus sign yields 2 M12) 2 BoP =e Jeter) 2 y= z (n the balanced grovth path, te conden required for € = 0 i ghen by r*=p + 8g and has pererecans In adtion acta saving, sk), equals bresk-evn investment, + g+ 3k and thas (avgradee (+gts) alnea 3) 3) at ATELY (ores) einen =8) ca (kt) we wher we ave uted epuation (16), 2+ (8) -atn+8 48) aay cts) C8849) Ce (rt 48) Subsiing equations (2) and (24) iat equation (21) is From oquation 23), we can write28 Solutions to Chapter 2 (oes +8) fo+0e+5—ain-+e9)] pee 5) Hy 7 Equation (25) is analogous to equation 2.38 inthe tet. It exprestes the rate of adjustment in terms ofthe sunderjng parameters ofthe model, Keeping the values inthe text a= 1/3, p= 4%,0= 2% g= 1% nd0~ 1 and using 5 = 3% ys a vale for ys of approximately -8.8%, This is faster convergence than the -5.4% obtained with no depreciation, Problem 2.9 (@) The eal after-tax rate of otum on capital is now given by (1 - =} k(t). Thus the household's ‘maximization would now yield the following expression describing th dynamics of consumption per unit of tse labor: a _[0-9eKen)—p-ea] oO Bi “The contin required for &= Os given by (1-2)f"(Q)= p-+0g. The after-tax rate of return must equal p+ 0g, Compared to the case without a ax on capital, (2), the pretax rate of rtum on capita, must be Figher and thas k must be lower in order for €=0, Thus the &= O locus shifts tothe lef. “The equation describing the dynamics ofthe capital stock per unit of effective labor is til given by 2) HO = MAIO) (9 - (+ DK) For a given k, the level ofc that implies k= 0 is given by et) = 1) - (a gk, Since the taxis rebated to ‘household in the form of lump-sum transfers thie = 0 lous is unaffected, () Attime 0, when the tax i put in place, the value of, the stock of eaptal per unit ofeffective labor, is given by the history of the ecenomy, andi eannt change ‘iscontinuouly. Ke remains oqual tothe kt ‘on tho old balanced growth path Tn contrat, the rate at which houscolds are consuming in mits of effective labor, an jump atthe time that the axis ‘introduced, This mp in cis not inconsistent withthe consumption smoothing behavior implied by the Ihowseolds optimization problem since the taxwas unexpected and could not be prepared fr. Kew x In order forthe economy to reach the new balanced growth pth, shouldbe lea what must occur. AC time 0, c jumps up so that the economy ison ‘thenow saddle path, inthe figure, the economy jumps ffom point Eto a point suchas A. Since the retar to saving and aceumulating capital is now lower than before, people switch away from saving and into consumption,Solutions to Chapter? 29 ‘After time 0, the economy will gradually move down the new saddle path until it eventually reaches the new balanced growth path at Esew (6) On the now balanced growth path at Eye , the distortionary tax on investment income has caused the ‘economy to have a lower lvel of eapital per unt of effective labor as well a a lower level of consumption per unit of effective labor. (@ ( From the analysis above, we know thatthe highor is the tax rte on investment income, tthe lower willbe the balanced growth-path level of Kall else equal. ln terms ofthe above story, the higher is the ‘more that the &= 0 locus shits tothe le and hence the more that k* falls. Thus Gk¥/é< 0. ‘On a balanced growth path, the faction of output that is saved and invested, the saving rate, is given by EK) ~ VK"). Since k is constant, or k= 0, oa balanced growth path then from Eq) = (0) ~cf0)~ (+ ek) we can wrt Met) ~c# = (+ gk. Using this we cam revit the fraction of output that is saved ona balanced growth path as ©) s=[ get} ‘Use equation 3) to take the derivative ofthe saving rate with respect ote tax rate, Gs _ (ot a)(CK* Ce)FCKt)— (a hk FER) (CK) Oe Fe)? Simplifying iki Bs _(ntg)ck* (ata) k* FE) de® (nse cee] kere) ae fk) oO) FY oH) OL FD Recall that KF (K*)/NK*) = x (A) i capa (pre-tax) share m income, which must be les than ene Since ekt/6t <0 we can write @ (og) ) SOHO KY a an]co w) er f(k*) a <9] “Tus the saving sate onthe balanced gro path is decreasing in (@) Gi) Caizens in low-r, igh-4*,high-saving countries donot have the incentive to invest in low saving ‘countries. From pat (3), the condition required for ¢= 0 i (1 2)" (k)= p+ Og.. That i, the after. rate of retum must equal p+8g. Assuming preferences and technology are the same across countries so that p, @ and g are the same across countries, the after-tax rate of retura willbe the same across countries. ‘Since the after-tax rate of return i thus the same in low-saving counties as tis in high-saving countries, ‘there is no incentive to shift saving from a high-saving to a low-saving country. (@) Should the government subsidize investmont instead and fund this wth a hmp-sum tax? This would lead tothe epposite result from above and the economy would have higher and k on the new balanced ‘growth path30 Solutions to Chapter 2 The answer is no, The original market outcome is already the one that would be chosen by a central planner attempting to maximize the liftime wit of a representative houthold subject tothe eapital- accumulation equation. Ie therefore gives the household the highest possible lime utility. Staring at point E, the plementation ofthe subsidy ‘would lead toa shor-term drop in consumption st point A, but would eventually result in permanently higher consumption at point Eyew . It would tum cut ‘that the tity lot from the short-term sacrifice ‘would ouvwegh the utility gained inthe long-term all in presen value tems, appropriately discounted). ‘This isthe same ype of argument used to explain the reason that household donot choose to consume at the goldenrue level, See Section 2.4 for a more complete description ofthe welfare implications ofthis model (8, Suppose the goverment does nt rebate the tax revenue to households but instead uses i to make ‘goverment purchases. Let G() represent goverment purchases por unit of effective labor. The equation 0, oak > V(t ~a), an increase inc means higher kes for a ven kad has tho function shits up over tis ang of k's. However for ln, leatatag pe Lintgene 198 a+) “Thus on a tlanced growth pat @) Keg tagt dof) Rearranging equation (9) 93 an expression for onthe balanced growth pth elds @ sere eAg dK) (Coasamption per ent fective labor nthe balanced gronh paths given by we Oma). Jos Gerad se) Sebastain ; (o+g4ng+5k* ft) k*(a-rg+ng+8) eel *Vecaey | SAD HM O88 + ge as ro Canceling the fK*) yields © oF =f) FB tng + Ht ‘To.getan expression forthe f" (that maximizes consumption per unit of effective labor onthe balanced srowth path, we necd to maximize c* with respect to k*. The fis-order condition is given by Bc*/k*=F"(k*)—(n¥ +28 +8)=0. “Thus te golden-rule capital stock is defined implicily by © F'kox) = +B 4B +8) (6) Sete Cot Doas prac fnin, ,)=H toeon 1s w ®) Ket] a i re ait Lame) (8) (@ Ona balanced growth path, ks e+, Thus from equation (8) ath he ot Tmare! Lermare | Simplijing il38 Solutions to Chapter 2 fasmare-a-o}, fs Gemtew Laermer sods foal ©) kt = [siin +g +ng +5)". (@) Gi) Using exuation (8 1-8 es Ce ey |eas CMF)” Cea) a) Substsing the blanced-growth-path value of kt ~ eoation (©) ~ into equation (10) yields at as_|(neg+n+d)] Gwy Cmte = J el be useful to write (2+ g +ng +8) as (1+ n}(1+8)-(1-6) sks A-8) +a d+ay(t+e)—G-8)] ky asm) Simin aber yells ' chest G-8(l~a) 1 Be sar OD ae leew MDC E) Replacing eatin (8) by fsx Taslor approximation ond k= (12) yyy Sk *fa+(1-8)11-a)/(1+0)C1+9)][ke, -k 4 Since we an wrth singly e0 ea Halas (1-8K-29/C+mVL +9) “k4, cavation (12) inpie (13) kk fa +00) 09 4096148" fko Ke] “Thus the economy mows ation 1~[a+(1-8)1~ah/(1+9)(1+ 2] ofthe way tothe balanced growth ath each period. Some simple algebra sinlisth expen fr ti rat of envergmce to (l-a)(n +g +ng+5)/(+n)(1+g). With a= 1/3, a= 1%, g= 2% and 5 = 3%, this yields a rate of onvergmcs of abut 3.9% Thi slower than th tof onverpece found in he continourtine Solow mode Problem 2.15 (@) The individ optimization problem is not affect by the prion which means that =f) -B. The hustholds problem is sil to maize wily a5 given by 1p voli gt Saas Oe tise 1-0 subject to the budpet constant 1 © Cit Cana Ame ‘As inthe tot, with no deprecation, the ection of income saved, sn) = (Cu Ao in by i © sea Trae pan eDPSolutions to Chapter? 39 “Thus the way in which the faction of income saved depends on the real interest rat, fy is unchanged “The only difermce ie thatthe real interest rate itself now f° (ket )~ 8, rather than just f° (es) “The capital stock in period t+ 1 equals the amount saved by young individuals in period t. Thus @) Kea=Sb, where Ss the amount of saving dane by a young person in period t. Note that Sy = tir YAas the amount of saving done is equal tothe faction of income saved times the amount of income. Thus equation (8) can bo rowriten as (9) Ker=Lesloos Ao Toph ony inet +1 cea, debts fet (5) Arlen @ (Bue [sud] Teatin Brite Since Ary =(U+ 2)A., we have A: /Ars = (1+ 8). Similarly, Lig = iC +n). Th adéition, Ke /Aeolas tes. Thus koa = wi © kt Teaygraleomd Fay, tie fr fof (ho) -Band w= Mh“) 8) iat “Zr paapl tlt ean) A] fF) —KeF Oe ® aml" =a) -kF"&)] “This shouldbe compared with equation (258) inthe text, the analogous expression with no depreciation, which i 1 es = fal Feel Re Trap ltl ennlllteeo Ker] “Thus aching depreciation does alter the relationship betweon and ky. Whether wil be higher oF lower fora given ky depends on the way in which saving varies with nx : (©) With logarithmic tity, the faction of income saved dos not depend upon the rateof rum on saving andin fact, ©) 601) = 10+) Tn addition, with Cobb-Douglas production, y cxuatin (becomes 1 1 | a-ak Gemirglare "| ‘We aed io compre this wih equation (2) th solution to roblen 214, he analogs expression she discrete-time Solow mods, with the additional assumption of 100% deprecation (.e.8= D. the ral wage is w= Ke -eak®" = (1a, Thus 9) Kyat “The saving rat inthis economy is total saving divided by total ourput. Note that this isnot dhe same as ‘(a ), which is simply te fraction oftheir labor income thatthe young save. Denote the economy's otal saving rate as 3, Then 3 will equal the saving of the young plus the dissaving of the ol, all vied by total output and in addition, all variables are measured in units of effective labor. The saving ofthe youn is [/(2+)](1-oky*. Since there is 100% depreciation, the oli do nt ge to dis by mont fh cpt ek hie weg eo, Tas (vero) 0-aki* ke zp “Thus equation (10) canbe rewritten as 0-840 Selutions to Chapter 2 s 1 3 Tan" Larnre Noto that his is exatiy the same asthe expression for ky asa function of, inthe discrete-time Solow rodel with 8= 1. That, iis equivalent to equation (2) nthe solution to Problem 2.14 with 5 se to one. “Thus tha version ofthe Solow model does have some microeconomic foundations, although the assumption of 100% depreciation ie quite reals CD kee ke Problem 2.16 5) €) The tty function i given by Cys +LH/(1+ 9) nCo 00 ‘With the social security tax of T per perso, the individual fice the fllowing constraints (with the growth rats of technology, equa 00, Ais simply a constant throughout) @) Cy #8, = Aw, =T, and @) Capa C+ rDS +0407, where S represent the individual’ saving inthe fst perod, As far asthe individual is concemed, the rate (of retum on social security is (1+); a geeral this wil ot be equal othe return on private saving which is (1+ tox). Fromoquation (3), (1+ yt)8; =Czzei =(Q+m)T. Solving for yields Coy __d+) Teter OF hep ‘Now subattut equation (4 into equation 2}: & 1, Cassi (+0) Cu Teg MOT As hay Rearranging, we et the intertemporal budget constant: Copa a) 1 Curry ft. Fee tre) ‘We know that with logarithmic utility, the individual wil consume faction (1 + pV(2-+p) of her liftime ‘wealth inthe frst period. Thus ( ‘i; (i j . 0 cue] am-(i | (uel (naa) | { (222) (sze\(sa=2)h Sa ae Ms EET > SL aol splits [2+prd+na)-C+ exes) | 2+ pile) Na tht ts svn ieee en front yh soil earings kee thereon Fale oa arog hrm ha cneorene Dente 2; =[(2+ p)U+ Foi) ~ C+ XC —H)]/2+ pM rye) and thus equation (7) becomes @ 5, =[42+ law, -2.7 Is il te thatthe capital tock in period wil be equal tothe taal saving ofthe young period tenceSolutions to Chapter 2-41 © Kea=Sb Converting this into units of fective abor by dividing both sides of (9) by Ales and using equation (8) yields 10) Ky =[Ylt +20] [(Ye2+ 0) ~ 2.7/4] With a Cobb-Douplas production incon, the real wage i given by =a" Scbettutng (11) into (10 gives the new relationship between capital in period t | and capita in peti , Allin nits of effcivelaber: 12) kay =[YU1+0)] ee +p)) a-ak? -Z, T/A] (2) Gi) To se what effec the introduction ofthe socal security system has onthe batanced-growth-path alte ofc we must determine the sign of Hit is positive, the introduction ofthe tax, T, shits dow the ‘er curve and duces the balanced growth-pth value afk. Webave ee pMle ss) Cs pit a) _ (+L M+ fat) CLF Xa 0) = +p tha) G+ eXtt ha) and simplifying farther allows usto sign 2, p rei) + (1+ pris) —(eeai ~m)] + rin) +4 pt) 2 @+ PX rte) G+ eXl + ha) “Thus, he ky curve shifts down, relive tothe cae without the socal security, and k* is reduced, 20. (4) Gi) tf the economy was intially dynamically efficient, 2 marginal increase in T would result in again tothe old gonoration that would rcsive dh axtrn benefits However, it would reduce kt further blow ken Sd thus leave future generations worse off, with lower consumption possibilities, Ifthe economy was Jnkially dynamically inefficient, 20 that k* > kox, the old generation would again gain due tothe extra ‘benefits. a this case, the reduction in k* would actually allow for higher consumption for tare ‘penerations and would be welfare-improving, The introduction ofthe ax inthis ease would reduce or possibly eliminate the dynamic inefficiency caused by the ovr-accumulatcn of capital (b) Gi) Equation (3) becomes 3) Coat = + tye Se +4 aT. tara nds cert te ft cn ial eu ithse tn pre Bee ie cba manor sug cai. omen C9, G9) 8=Cxya [leg] 7 Sodan ee (neti (yee Caer cyy+ Bh e wy —THT, Lt ‘or simply 05) Cy +E eam Tre “This ijn the uel merteporal budge constant in th Diao mode. Solving te indvidas ‘maximization problem yields the usual Euler equation: Coan =[Y+ 8 C+ DCs Substittng this into the budget constraint, equation (15), yields 18) Cy. =[(1+ )/(2=e)}Ame42 Soluions to Chapter 2 “To get saving pr person, ubstute equation (16) into equation Sy = Aw, ~[(1+ p)/(2+ pl]Aw, -T, orsimpiy 0D §, “The social curt tax causes one-for-one reduction in private saving. “The capital tock in pri t +1 wil be equal othe sum of total private saving of the young plus the total amount invested by the government, Hence (18) Ker *S,L,*TL, Dividing bath sides of (18) by AL, to conver ths ito units of effective labor, and using equation (17) ete ‘sing oun (1). abst or be wage ls tin] fV(2+el}a~ant Thus th ly-ndd sel scuty system es no effet cn the eltnshp between te cpa tock in uote pits, (©) (Since thers is no effct onthe relationship between and, , the balaneed-growth-path value of k isthe same as it was before the introduction ofthe flly-Funde socal security system. (Note that we have ‘bon arsuming tie the anenunt of de tae at greater dan the sous of saving each individual would Ihave dene inthe absence ofthe tax). The basic idea is that total invesment and saving ssl the same cach period; the goverment is simply doing some ofthe saving forthe young. Since social security pays ‘the same rate of retum as private saving, individuals are indifferent as to who does the saving. Thus individuals offset one-for-one any saving thatthe government does for them, Problem 2.17 In the docentralind equilbrium, there willbe no intergeneration trade, Even ifthe young would ke ‘to trade goods ths period for goods next perio, the only people around to trade with are the old ‘Unfortunately, the old wil be dead — and thus in no position to complete the trade ~ next period. “he individual's ty uncton is given by Inc yy +19C 4 “The constraint are QCA, md G) Coys aR ‘whore Fisthe amount tre by the individual Subsuting ution) iat (2) yields the ineenporal bud constin Cie tCaee XA ‘The individ’ problem isto maximize time ily, give by equation (1), subj tthe iteemporl bulge canna gi by equation (0), Setup be Lagrangian: ZH IC FING 5o1 +A ~Chs Capt /) ‘The fist condos ae given bySolutions to Chapter? 43 Ag/OCyp=YCyy-¥=0 > YEjy=A,and 6) 24/2Cre1 =YCrua-Nx=0 = YOru-Ne. © Substitute equation (5) into equation (6) and rearrange to obtain © Copa = Crp ‘Substitute equation (7) into the intertemporal budget constraint, equation (4), to obtain Cy XC [ae A, or simply @) Cie =A/2. “To obtain an expression for second-period consumption, substitute equation (8) into equation (7 ©) Crgui = 24/2. ‘When young, each individual consumes half of her endowment and stores the other half that is, f= 1/2 ‘This allows her to consume xA/2 when old. Note that with log utility, the fraction of her endovement that the individual stores does not depend upon the retum to storage. (©) Whats consumption per wit of effective labora time © Fest, calculate teal consumption atime Cy =Cyhy +Co,ber were there are L, young and Ls old individuals lve atte t. Each young person consumes the faction ‘other endowment that se doesnot tore (1 =A, and each old porn gusto consume the gross retum on the faction of her endowment tht she sore, fA. Thus Cea AL, + BAL, “To caver this info nts of time effective labor, divide bath sides by AL, to get ,/ALy =(1-#)+{5/(1+n)} “Thus consumption per nit oftinetefctive labor isa weighed average of on and something es than ne, since x= (1-8) Ill therefore be maximized when the weight on oe is oe; hati, when F= 0. (We could also carryout ths analyeis on conunption pr perton alive atime t which would not change theres hee), ‘The decentralized equilbrium, with f= 1/2, i not Pareto efficent. Since intrgenerational trade is uot ‘posible, individuals are “forced” into storage because that sth only way they can save and consume in fold age. They must do this even ifthe retum on storage, x, is low. However, at any point in time, a social ‘lanaer could take one wnt fom each young person and give (1 +n) units to each old person sinoe there fre fewer of them. With (I +n) >x, this gives a better retum than storage. Therefore the social planner could raise welfare by taking the hal of each generation's endowment that it was going to store and instead give itto the old. The planner could then do this each period. This allows individuals to consume A/2 ‘nits when young ~ the same 8s inthe decentralized equilibrium — but now they get to consume (1-+n)A/2 units when old. This is greater than the xA/2 units of consumption whe old that they would Ihave had inthe decentralized equilibrium with storage Problem 2.18 (@) Ths individual has a wilt fnction given by @) inch #ICa yo, ane constraints, expressed in units of money, given by @) PCy =PA-P.R - ME, and ©) PriCaear = Peash +Mi ‘where M¢ is nominal money demand and F, is the amount stored.44 Solutions to Chapter? ‘Ove way of inking bout th problem isthe owing, Te niu has two decison oaks, The {avin t decidobow much of ter endownent ocnsue and how mucho "seve". The she mus decide {bevay a wchto save, rough storage, by holding money ora combination of bth. Wi lg ly, w= an szpart tho ovo deisions sce the rt feu on avin” not af the faction ofthe is riod endowment ats sve. From the slain to Problem 2.17, wekow se wil consul of he “omen the iat peri earls ofthat of tum on money or orgs, Ths © Cy =A? ‘What does she do withthe other half? That will depend upon the gross rate of return on storage x, relative ‘twthe gross rate of recur on ane, whichis P/Py . The gross rate of retum on mens is P/Po since the {ndividil ean sell ne unit of consumption in period t and gt P, units of money. In period t+ 1, one unit ‘of consumption costs Ps nts of money and thas ane unt of money will buy 1/P,. units of consumption. ‘Ths the individual P, uit of meney wil buy PP, units of consumption in period t+, CASEI: x>P,/Prat ‘She will consume half of her endowment, tre the rest and not hold any money since the rate of return on money is less than the rate of return on storage, Thus yaAl2 HAD ME/P =O Capen =2A/2. CASE? x Rve2nffacear™} Dividing equation (6) by equation (5) yields Pui/Pe= Vea) => Pra =P /(L+n) “This analysis holds for alltime peviods t= O and so Pes = P, (I~ a) isan equilibrium. This shows that if money is introduce into a dynamically inefficient economy, storage will not be used. The monetary ‘quidem will ths result in atainment of the “golden-rle” lve of storage. See te solution to pat (b) ‘of Problem 2.17 for an explanation ofthe reason that zero storage maximizes consumption per unt of effective labor. (©) Tis isthe situation where, Py =x; the tu on money seta tothe eum on trae. nth ‘See invite are indent sto hw mich of thi sving to tore nd how mach old in the erm af money, Let yc [01] bo the faction of nving held inthe form of money in period t. We can agin ive oxprecscn fo agurepate real money demand and spply i petiod aggregate real money demand = Lya,[A/2], and acaregte real money supply = [+] 4/2, =[l /ct+n)™] 4/2 We cn then use the eqilitriam cndtion sl fo = R=2m/faaceay™]. ‘We an similarly derive expressions fr real money demand and supply in period t+ aggregate real money demand = Lyqj04.1{A/2] = (+a) Lyeai[A/2], and saargat real money supply =[Le/C.+0)"] MPa We can then use the xuilibrum condition to solve for Psy (mp LoaeelA/2]=[L/C+a"M/Par = Pha =2M/[auadem™], @ Dining equation 8) by (yields Pea/Pe =[ae/azai] [+m] For Pr /P,= Ux, we need a /ec [ya+0)] Thus for allt 20, = laa/a=[ycem)er wil be a equilibrium fo any path of that sates ay (a) Py =: — money is worthless ~is also an equilibrium, This occurs ifthe young generation at ime 0 does not believe that money will be valued inthe next period and thus thet the generation one individuals wll not accept money for goods, In that case in period 0, the young simply consume half oftheir ‘endowment and store the rst, and the old have some useless pieces of paper to go along with their ‘endowment. This is an equilibrium with teal money demand equal to 220 and resl money supply equal 0 ‘zer0.as well. Hfno one believes the next generation will accept money for goods this equilibrium continues for all future time periods. ‘This will be the only equilibrium ithe economy ends at some date T. The young at date T will nt want to sell any oftheir endowment, They will maximize the utility of ther one-peciod life by consuming al of ‘hit endowment in period T. Thus, ifthe old at date T held any money, they would be stuck with t and it ‘would be useless to them, Thus when they are youn, in period T- 1, they will not sell any of their tendowment for meney, knowing that the money will be of no useto them when old, Thus, ifthe old at date TT ld any money, they would be stuck with and it would be useless to them. Thus the old at46 Solutions to Chapter 2 ‘T- 1 wil aot want any meney when they are youn and soon. Working backward, no one would ever ‘want to sll goods for money and money would not be valued, wtih, dividual has a utility function given by @) U=BC y+ Cava, and a lifetime budget constant given by @ Cy Qes Cros = QA.) + Qu XS From Problem 217, we know that with lg utility, the individual wants to consume A/2in the first period “The way in which the individual accomplishes this depends n the groes rate of rtum on storage, x, relative to tho gross rate of return on trading, ‘Tao individual can sll one unt ofthe good in pri t fr Q,. ln period +1 it costs Qua to obtain one amit ofthe good or equivalently, it costs one to obtain 1/Q units of the good. Thus for Q,, itis possible to obtain Q, /Qh. units ofthe good. Thus selling a unit of the god in period allows the individual to buy (Q,/Qs tits ofthe good in period t+ 1. Thus the gross rate of return on trading is QQ "Now, Qu = Qj /fralt> 0 is equivalent to x= Qy/ Qu for allt > 0. In eer words, the ate of retum i cn mrageis equal to he ate of ream on adng and hence th vidual indie aso he amount sore andthe mount trade, Let [0,1] prevent the faction of “saving, A/2 tha the individual sellin period. Thats, the inividoal sls 2, (A/2) in pid. This allows the individual o buy the mount 0 (, Qe: (A/2) when she old in period + I. The ndividal sores afaton (1 -<,) of ber Saving”. Thus © S=C-2, A) Consumption in eid t+ 1 willbe oqual tothe amount invidal bys pls the amount se has ‘Seoagh storage, This ) Cans = 6 (QQ XA) + (1-282) Since we ae considering a asin which Q, (Quix, equation (4 an be rows as ©) Cams = eex(AID + (1-04 (A/D) = (AP), Consider some period I ard let L represent the total number of ndvduals bom each prod whichis constant. Aggezate suppl in ptiodt* Ii equal tothe taal umber f youn individuals, L, multiplied by the amount that each young individual wishes to sel, oy (N2) Thus (6) Aaaresste Suppl = Ltn (2) ‘Aggregate demand a pvodt 1s equal tothe total number of od individuals, L, mui by tbe amount each od indvideal wishes to buy, (QQ Jo (A/2). Thos ©) Aseregate Demands = LQ, (Qo) (4/2) For the market to clear, aggrezate supply must qual aggregate deand or ee (82) = UQ./Qe J (AMD, cx sinpiy ® o41=(Q Qu} Sica the proposed pie path has Qn = Q, th enuibrium conto given by equation 8) canals be vwtten 28 ©) o4)=206 "Now consider the station in peiod 0. The ol individuals simply consume their endowment. Thus we ‘st have an equal to zai oder forthe markt to cleat im ped 0. Thus equation () implies that ee mast have oy =O for allt 20Solutions to Chapter? 47 “The resulting equilibrium isthe same as that in pat (a) of Problem 2.17. The individual consumes half of ‘her endownnent in the ist period of lif, stores the rest and consumes xA/2 in the second period of ie [Note that with x-< 1 +n here(since n= 0 and x <1), ths equilibrium is dynamically inefficient. Thus climinating incomplete markets by allowing individuals to trade before the start of time does not eliminate ‘dynamic ineicioncy. (4) (i) Suppose the auctioneer announces Qu Qy x or equivalently x> (Q, ‘Quer ) for some date. ‘This means that storage dominates trading forthe young at date. This means that the young at date twill vant to store their entre endowment and will want to buy A/2. For tbe old at date t, Qu is irrelevant. “They based their decision of how much to trade when old on Qi/Q which was equal tox. Thus each old individual was not planning to buy or sell anything. Thus aggregate demand exceeds aggregate supply and the market forthe good will nt clear, Thus the proposed price path cannot be an equilibrium. (@) Consider the socal planners problem. The planner can divide the resources available for consumption between the young and the old in any matter. The planner can take, for example, one unit of each young person's endowment and transfer ito the old. Since there are the same numberof old and young people ‘his model, this increses the cancumption ofeach old person by one, With x < I, this method of transfering from the young tothe old provides a beter return than storage. Ifthe economy didnot end at some date, the planner could prevent tis change from making anyone worse off by requiring the next [generation oF young to make te same transfer in the fllowing period. However, if the economy ends at ome date T, the planner cannot do this. Taking anything fom the young at date T would make them ‘worse off since the planner cannot give them anything in retum the next period; there is no next petiod ‘Thus the planner cannot make some generations beter off without making another generation worse of “Thus the decentralized equilibrium is Pareto-fficient. {) leis infinite duration that e the source ofthe dynamic inefficiency. Allowing individuals to trade ‘before the start of time requires a price path that results in an equilibrium whichis equivalent tothe ‘uation where such a market doesnot exist. This equilibrium isnot Pareto-fficent; a social planner Could raise welfare by doing the procedure decribed in part (b). However, removing infinite duration also femoves the secial planner’ ability to Pareto improve the decentralized equilibrium, as explained in part ©. Problem 220 (@) The individual has uility function given by Cys Cae o oct 1-0” 1-8 “The contains expressed in units of money are PCH RAMS, ad Combining equations (2) and (3) yields the lifetime budget constraint48 Solutions to Chapter 2 GB) PCs +PriCaua = PA [Note that 9 < I means thatthe elasticity of substitution, /,is greater than one. Thus when the rate of tum on saving increases, the substitution eft dominate; the individual wil consume les now and save ‘more. This is essentially what we willbe showing bere. As the rate of rtum on holding money, which i ./Pe ies, he invita wishes to hold moce money ‘Then prolong tomas (1) bjs (0). Se pth Lagrangian: i Cish® | C i se Safa -PCiy Pease] “Te fit eine © © Co? coxsinply ® Cajer=( Poa)" Cae i “This isthe Euler equation, which can now be subsutd int the budget consrait (): PC +Pra(P/Put) y= PA Diving by Pik \ Cu +(Fa/BllP Pu) Cae =A, ace sipifying vols Cag LPP) PCA “hus consumption en your i given by @c, s (Pal v(P Pea)” To gt te amount oer exoweent hath individu sls or mony (a rel ems), can ws eqtion ©), preset real ts @) Mi /R=A-Cy ‘Substitute equation (8) mto (2') to obtain Mi A Anas RO 14(B Pa)? Siping by stig» commen denominator yl eae a LhiPoa) “re {PL/Pea Dividing the top and baton of he hha se fenton) by (F,/P) "2 stds yeaSotuions to Chapter? 49 ao ME. —_4A (PPP 1 - “Thus the ftaction of her endowment thatthe individual sells for money is (by = — ae OR itis signet show hath fan ofr endow tht the get ell fo ney sn trannies of he reso ret on lng ot an, fo-ne}{r./P.n! APP) [rae ap [We an lo show ht asthe ate fret cn mene gosto zr, the reunt her endowment ht he divas sls for mney posto a. Ueno owe ys ems relma] >0 for0<1. and thus lim hy =0/(1+0) {RRa}o (@) The constants expressed in el tars aro 2) Cy=A-ME/R, and ‘Since there is no population growth, we can normalize the population to one without loss of generality. From Ga smeraton bom a time plan fo by MFP amis oF the god when tis. Thus, the ‘generation born at time 0 plans to buy M's /P; units when it is old (in period 1). Use equation (10) to find Mi, sitting t= 0 a wga—PA MEP ay mayer A pala ‘From equation (2'), a generation bom at time t plans to sell M’, /P, units of the good for money. Thus the ‘generation born at time 1 plans to sell M‘,/P, units of the good. Substituting t= 1 into equation (10) gives ay Mi, B (RR) ar Jn order forthe amcuntof the consumption good hat generation O wishes to buy with its money, given by scrution (12), to be egal tothe amount ofthe consumption god that aeration 1 wishes to sll for sony, ven by equation (13), we need a oy A |, (inser? x 7% au ~ ee; $1 (Pym) ar (Hy mJOPP at ‘Now with Po /P, < 1, we need o-08 \e-n0 0-09 o-n (Po /2)O PS +1<(R pr )OPP +1 = (Po/P)P® <(Py/P3)°™”, and since (@ 19 is negative, his implies50 Solutions to Chapter 2 (ting it srg fore ate of to many wave efi vn, That PA 4 PAP ants Po Re RY ‘As shown in prt (hs meas tat ts action ofthe endowment tht i sl fr monty wil ao go t0 2. The eccly pproaces te stien whens conse et endowment rt cide an gui path the eos tht very ne ped matt wll ach pro, he fel monty dandy te young wl be ole el mane xp byte ol andthe wil bth goo sro at aang. (8 1ePe/P,> 1, wo obtain the opposite result fr the path of prices. Thats, P,P. wil ise overtime: 1 do Fe, PRPS Pat ‘From eqatin (11) we can se that this means thatthe faction ofthe endowment sold for money will goto ‘one. In ther words, the economy approaches the situation where no one consumes anything inthe fst period and individuals sll their entire endowment for meney. Thus, total real money demand wil goto A, ‘the endowment ofthe young (we have normalized the popalaton tone). But with tis path of prices, the price level goes to zr0, which means that real meney supplied bythe old goes to infty. Thus this cannot represent an equlibrium pat fr the economy because thar wil be atm peciod when real money supply ‘wall exceed ral money demand andthe market wil nce clearSOLUTIONS TO CHAPTER 3 Problem 3.1 “The production functions for ouput and new knowledge are given by @ YO=AOC-a LO, and) AC)=BaTLOTAM® — <1 (@) Ona balanced growth path, A(t)/A(t) = gx* = (I -), e) Dividing both sides of equation (2) by A(t) yields @) A@/A@ = Bay LET Aw Easting Gand ils Ba, LTA =y0/C1-@ => Ao! =7n/C1-0)Ba,7L097 Simpifing and saing fr AC ide orn 0-000, fra (©) Subsite equation (5) into equation (1) ¥(@)=[(0-09B9, 7109" fra] ay phe) = [01-098 /r9] ay Aa Lege. ‘We can maximize the log of output with respect toa or maximize wY¢=[Y/1-0)]inf 1-8/9] +fr/1-)] nay, Hid ap)+|(1/A-0)) + Ito. “The first-order contin i given by ine) Ld a, G-Oa, I-ay ‘Some simple algebra yields an expression for a* 1 0% “Tosy ‘The higher is 8, cho importance of lnowledge inthe production of new knowledge, and the higher is, the importance of labor in the production of new knowledge, the more ofthe labor free that should be employed in the knowledge sector, Rroblem 32 Substituting the production function, Ys (t) = Ks (into the captal-accumulation equaticn, K,()= 5%), yields @ Ky=5 KO", OF 1 Dividing bath sides of equation (1) by K; (2) gives an expression forthe growah rate ofthe capital tock, Ber @ axi=Ki0/KO=3K 0" “aking the time derivative ofthe log of equation (2) yield an expression forthe growth rate ofthe gromth sate of epi ©) bx /ax30=0-Dexs, and thus © axs(0: ax)?52. Solutions to Chapter 3 Equation 4) is plod at cght. Wath > 1, ‘ac will be always increasing, The initial" | gy value of gx is determined by the inal capital : stock andthe saving rate; see equation (2) Since both economies have the same K(0) but ‘ene has higher saving rat, then from ‘equation 2), the economy withthe higher = will have the higher inal gus (0) From uation @), the growth rat of Bs is increasing in gx, Thus the gro rate ofthe capital tock inthe hig-saving economy wall —*s always exceed the growth rat of the capital al stock nthe low-saving economy. Tha is, we Ihave gx (0 > gx (forall 2 0, In fac, the gap between the two growth rates will be increasing ver ‘Moe formally, using the production function, we can write the ati of output inthe high-saving country, country Ito ouput the lowsavng country, connty 2, 3, © YW/%20-[K,(0/K20)" “aking the time drive ofthe log of equation (5) yas an expression forthe growth at ofthe ratio of cap inthe high avin economy fo cup inthe low-stvng erry [wy ¥200) . . fare) slerat0-axz0)>0 As explained above cs (0) will exceed gs for allt 20. In fay, he gap between thewo wile | increasing over tine, Thus the growth rate of the output ratio wl be postive and inereasng overtime, “That, tho ratio of eup n he high aving economy to out inthe low-sving economy wil bs continually rising, and rising at an increasing rte The expressions forthe growth ates of capital and knowledge are © sO =eR[AOLO/KO!™ — eg #6-ay)*-a™ © Bnl=eqKOPLOYAO™ — cy =BaxFaT(a) From oquation (1), fora given ga the value of gx that satistes = 0 is now higher as a raul of ho sss in population growth from nto nsw. Thus the locus shifts up. From equation 2), for a given ga. the value of gx that satisfies Bq =O snow lower, Thus the gq =0 Iocas shifts down, Since does net appear in equation (3), thee is no jump inthe value of gx a the moment of the increase in population growth, ‘Similaly, since n does not appear in ‘equation (4, there is no jump inthe value ‘of za the moment ofthe rise in population ‘rom (@) Note that a does not appear in ‘equation (I) the &x = 0 in, or in equation @),the gq =O line, Thus neither the ‘Bx =Onorthe §, =0 line shifts as a result ofthe increase in the faction of the capital stock used in the knowledge sector from a, toa, From equation (3), the rise in ay causes the ‘growth rate of capital, gx, to jump down, From aqution (4), the grow rate of knowledge, ga. jumps up atthe instant of the rie in x. ‘Thus the economy moves to ‘point such as F in tho igre {© Siace 8 does not appear in equation (1, there is no shift of the ¢, = 0 locus asa result ofthe rise in © the coefficient on knowledge inthe knowledge production function. From equation (2), the 8, =0 locus has slope (1 -)/P and therefore becomes ‘ator afer the rise in. See the figure. Since 0 des not appear in equation (3), the growth rate of capital, gc, doesnot jump atthe time of the rise in 8, © does appear in equation (4) and thus we eed to determine the effet that the rise in 8 has on ‘the growth rate of knowledge. It tums out that g5 Solutions to Chapter 3 3354 Solutions to Chapter 3 ‘may jump up, jump down or stay the same atthe instant of the change in 8. Taking the log ofboth sides of ‘equation (8) gives us Ings (9 = Ine + BlaK@) + lal) + (©- DinaCo. - “Taking the derivative of bth sides ofthis expression with respect to yields (9) dings (9/29 = AC. ‘So if A) is less than one, so that inA() <0, the growth ate of knowledge jumps dwn athe instant ofthe ‘kein. However, if AQ) is reater than ore, eo that InA() > 0, the growth ate of knowledge jumps up at the instant of th rise in ©, Finally, if A() sequal to coe atthe ime of tho change in 8, there is no initial jmp in gc. This means the dynamics of the adjustment to Enaw may differ depending on the value of gx st the time of the change in 8, but the end result isthe same, Problem 34 The equsions ofthe bc =O and fg = O loci are (©) oe=0 > gx=sq 4m, md @) =O > Exe “The equtios defining the growth rates of capital and knowledge at any pon inte are [A@LO/KOO]™ eg #stt~ay)* Cay) “AK(OPLNTAO™ eg =BagFay? (@) Since the saving rate, s, does not appear in equations (1) 0 @), neither the i ~Onorthe gq =O locus shits sven sineeazes. From equation (4), the growth rate oF nowiedge, does ‘ot change atthe moment thet = increases However, from equation (@).a rises causes an upward jump inthe growth ate of capital, gx. Inthe fSgur, the economy jumps ftom its balanced growth path at Eto point such as Fat the momen thats () Atpoit F, the economy i above the § =O locus and thus gai sing eto the inerease i 5, the growth rate of capital is higher than it would have been ~ the amount of capital going int the production of lnowledge is higher than it would bave been ~ and s0 the growth rte of owledge begs to rise above what would have been. Also at point F, the economy i above the Tecus and so gx filling, ‘The economy drifts tothe southeast and eventually crosses the, =0 focus st which pont ga begins to fall ac wll, Since there are decreasing rots to capital and knowledge inthe prodoction of new knowledge ~ 6 + B <1 ~ the increase in s doesnot have a permanent effect on the {row rates of K and A. The economy eventually retums to post E. “The profuction function is give by f1~ax.)K eo] [ACoLI=ay 00)"‘Solutions to Chapter} 55 aking the time derivative ofthe log of equation (5) will yield the growth rate of total ouput: yo, Ogg +d-aofan( +4 (© Secext+t1-aifen(0 +0 7d (On the initial balanced growth path, from | ‘equation (I), gxt= ga" Fn, From equation (6), this means that ttal output is also growing at rate ibe" = gat + on the intial balanced growth path. | ‘Thus oupa pr person, Y(QVL(), is inially rowing at rate g.°. During the transition period, both gx and ga are growing at a higher rate than cn the balanced growth path and so output per worker must also be growing ata rate greater than is “ine| its balanced-growth-path value of gx", Whether the growth rat of cutput per worker is rising or fling will pend, among ther things, onthe value of since there is a period of ime when gx is falling and gis rising. ‘The figure shows the growth rate of ‘output per worker iil rising and Uhn faling, but the important point is that during the entre transition, the growth rat selfs higher than its balanced-growth-path value of g4*. Inthe end, once the economy retums fo post E, ouput per worker i again growing a ato, which has not changed, (eo) Note thatthe effects ofan increase in sin this mode! are qualitatively similar to the effects in the Solow model Since thee are net decreasing returns tothe produced factors of production bere ~0-+ <1 ~ the imerease in shas only level effect on output pet worker. The path of output per worker les above the path it would have taken but there is no permanent effet on dhe growth rat of output per work, which on the balanced growth path is equal tothe growth rate of lowledgo. ‘This isthe same effect that a rise in s ‘na in the Solow rvadel in which there are diminishing returns othe produced factor, capital ‘Quanttatively, the effet is larger than inthe Solow model For a given sot of parameter). This is due to ‘the fact that, here, A rises above the path it would have taken wiereas that is nt true in the Solow mods Problem 3.5 (@) From equation 14) and (3.16) in the tet, the growth rates of capital and knowledge are given by A) Bq KO/KOD=eK{ACL(D/K(O]'™, where oe s{2 = ax TE - an)" and @) Ba @aAW/AD=eqKOPLONTAO, whee o.= Baya’ ‘With the assumptions of f +8 = 1 and n =0, these equations simplify to @) KO=(LUAOKO! and) ga (0= AL TIKOVAOY. ‘Thus give the psramsters ofthe model and the pepuation (which is constant), the ratio A/K determines both growth rates. The two growth ates, gx and a, wil be equal wen [ouL HAWKE] = feaL"IKQVAG)® => CAQYK(QT** = [en lox JL". “Thus the value of AIK that yields equal growth rats of cpital and knowledge is given by 6) AW/K=eq/egU-O PO” (0) noiero fd the growth tof AandK when gx ~ eB sate equation (9) io (3) is ae ino at feet!| [en loxrt"™] Sinpliing te ergot ies56 Solutions to Chapter 3 seefegaetngtayronercar Pe, or simply : - 6 are[exheghautsire] 0%) (©) in order to ee the way in which an increas in fet the long-run growin ate ofthe economy, substints the definitions ofc and cy nto equati (6): 0) #t-[0P0-a0F 0-24) Bag Mraa, ass] Taking the log of bth sides of equation (7) give us @) gt =[Yl-2+ P| Blns+ Cay +a)inL+ (La) aB Alaln(t—ay) +(1-adinax] + (-a)fHInd~a,)+yn9,3) Using equation (8), the cast ofthe log-in growth rt ofthe economy with respect othe saving rte ©) Angas = Bi -a.+f)>0, “Thus an inrease in the saving ate increases the engtun growth rat ofthe economy This esseatially ‘because it incteases the resources deve o psa apa aecumlaon andi this model, we have constant fetus othe produced factor of prcion, yas) (@) We can maximize Ing* with respect to 2 to determine th faction ofthe capital stock that shoul bo ‘employed inthe R&D sectar in order to maximize the long-run growth rate ofthe economy. The first-order condtion is dingt f tale | tax 00+ PL (-ag) "ax ! Solving forthe optimal g* yields al-aq) =(-aaq aan T-agtoax-e > snd thus (0) ax* = (1-2). ‘Thus the optimal fraction ofthe capital stock to employ inthe RAD sector is equal to effective labors share inthe production of ouput. Note that, capital's share inthe production function for now Jnowiedge, does not affect the optimal allocation of capital tothe RAD sector. The reason fr this is that fn increase in Bas two effects. It makes capital more important inthe RAD sector, thereby tending to ‘ase the ax that maximizes g*. A rte in B also makes the production of ew capital more valuable, aod i new capital is produced when there is more output tobe saved and invested. This tends to lower the a. that ‘maximizes g* sine it implas that more resources shouldbe devteto the production of output rather than ‘nowledge. In the case we ate considering, these two effects exactly cancal each ater out. Problem 3.6 (Substituting the astumption that x() = K/A for is A into the production function gives us @ ve[o-anu)* Iwyaltai ‘Since (K/A)* is independent of i, this leaves us with @) Ye[a-apu}fK/al? Bai “ esSolutions to Chapter3. ST since $4i={a-0]=A, wehave @) Y= (Clan Ly*KeA", or, rearranging, (8) Y= (Cl a JALY"* (b) @ For case of notation, define Ly = amount of labor employed bythe fim. The firm's problem isto cchocse the quantities of labor and each capital good, x(n order to minimize cost given by 66) wby + face, subject otpat tng equ too nt, of © ty! bo “Tus the Lagrangian forthe fm’ cost-mininzaton proba is © fawby+ hreovoa sau hora (6) Gi) The first-order conditions are given by ae 2 bata ay M-aby ho di=0, and a © =p(-ALy a(t 70 «a @) i) Since there wil be full employment, we can ind the demand for capital good i, x(, with Ly and the p(s taken as given, Dividing equation (8) by (9) gives us 0) te 2 aya Ly ‘Using the cost minimization consi, equation (6), his simplifies to w (ee) 1 xa wy +8 > , Oa Lae LS ‘We can now solve for an expression for the demand for capital good x(i). Rearranging equation (11) yields 12) xGyh* = anes pi) -o “Taking beth sides of equation (12) tothe exponent 1] =) leaves us with 1 Ly’ 09) xf > OTeaa? | Using the fact that labor inthe goods-producing sector is pid its marginal product, or$8 Solutions to Chapter 3 wr he secant eatin (1). . Te f carrthore FF [utahorw | se) | ma | [Note that we can write the elasticity of demand for capital good i as 5) BOBO _ axe a(x) amp) “Taking the natural lg of both sides of equation (15) gives us 17) tex) = *lna-Inp(|+1aLy. ‘And thus th elasticity of demand is given by 2x6) pa). dlaxti) a) Saat Soros) as required ‘Tose why his impli th the prof of menopaitic spp of pital good athe proftenaimizing price (ete, note that pro fora producer ocptal god i ee by == [9 ck), here {ithe uni cost of praduing capital god i. The fim chooses quantity to maximize prot, so the Brsorder coins 2x) 220 vy «oe -etve 9) Fe 28.9 96) -l)=0, Diving bat ses of qution (18) by pi) and using equasn (1) 10 subst for the ves of the elaticy of demand fr cptal pod ives ux eo aa? Solving equation (20) pO vs us on ‘This expression illustrates the fact that the price of the monopolist is (1), times cost. Substuting the definition of, whic is = 1/(1~), into equation (21) yieldsSolutions to Chapter3. $9 {_va-w Vo) 2D wO=| pray na PONE. and sf) ~ (i). Substtatng for (inthe expression for profi gives us = [pl -apOIKC), ox simply 23) == -apOxO. Prshem 32 Pere ot dacouted va ofthe pro om ening ota capil galt nei glo 0 P= Feet noe From qution 03) inthe scbition role 36, a ay pit ne x= (1 -pCxt). We ae Stang lad pow ah vi x and 0 ae nepend od contant ove ine and lore and K/A eth talnetrowvpa pis nd ty fcc exp good. Ts xt (1) Bsames le reas @ = (-opprae. - { (4). In ado, sce the eal inte tei cosa, | 1 Jds|exp(-r(e—0), andso wehave pov, @ PPM ae fe Pd -a)pRde = (1-a) Solving he egal in epation ills _ A -reeony|® PV y= -aypx| ert andthus (9 2PPV (ye EE (0) The wage ofa worker in the knowledge-producing sector wll equal the marginal product of labor in the knowledge sector multiplied by the price of the good produced by the knowledge sector ar the price of Jnowiedge. More concretly, the price of knowledge can be interpreted asthe price of a design for anew capital good. This price willbe bid up until it equals the present discounted value ofthe profi that a ‘monopolistic supplier of the new capital god can extract, Using equation (4) and dencting Ps as the price oP, From A= Baz LA, the marginal product of labor in the knowledge-prodcing sector is “Thus the wage ofa worker in the knowledge-producing sector, denoted Wa is60 Solitons to Chapter 3 -2)PRBA ow 2B ‘From equation (15) inthe solution to Problem 3 6, the demand for capital good iis i [a ]re 0-5) “Taking bah sides of equation (8) 0 the exponent (1a), and on a balanced grove path, we can write Ly, great @® 3 Solving for B gives us mn) Substituting equation (10 nto equation (7) yields Lyra. ye BA (1) Wy = SE which simples to a(-a)Ly! (2) Wa = : (© Asin te soluionoPoblem3.6, we can dofne Ly =(I-a.)Lastie amount oflaboremplvedinthe s0ods producing sector. From the production finctio, Y= Ly! [ (lon the Balanced growth path “0 ay vety* hoa “Thue the marginal product of abr inthe goods producing sectors aby RA, RA (@) Note that we want an expression forthe marginal product of n extra unit of capital, evaluated on the balanced growth path, This i ditnct fom the concept ofthe marginal product ofan increase inthe balanoad-growth-path value ofeach capital good. That is, we want to find OY /OK on the balanced growth path, not 2¥/2z = 2Y/0(K/A). From equation (inthe slution to Problem 3.6, output when x( 15) Y= ((.-ay )ALT°R" = Ly", "Thus the marginal product of capital is age waa ya( Sf (19) Faby *a' RT ways Since X=K/A, we can writeSolutions to Chapter’3 61 (© Since labors mobile brwee the goos-and knowledge producing sectors, the wage in both must be equal or w= W, - Since labor wil be paid ts marginal product inthe goods-producing sector (the price of {he utp good is oman to one), Using equations (12) and (14) we requite a(\=a)Ly!"22"BA (14) SSE ak 8A, which simplifis to (19) ole ‘Thus the amount of labor employed inthe goods-producing sector is given by 20) Ly= (=a )L= HaB, Since Bay LA. the gronth te of now is given by en A-bayt Cn th balanced srowth pth, K, A, and Cal grow a the same rate, which we wil dee dso Bo ernep eto cheat ni Gp aeeo sa se0b, 22 at at id pont Gan 1 08D Novas omen cinta pice. To moat nt ni SE See eae Satya ne "Next we can solve forthe balanced-growth-path value of ay, the fraction ofthe labor force employed inthe Imowledge sector. From equation (20), (=a, )L= 1faB, we ean write 28) a ‘oBL Substituting equation (27) into (28) yields (@-OeBL” ——(@sOeBL ich simplifies BL G0) ay fs orsimply @D a (+O BL62 Solutions to Chapter 3 ally, we can ove forth rot rat of the economy onthe balanced growth path, Subs equation (31) into g = Bay gives us @BL—p (o+9BL |” G2) eB () We need to examine wheter or not a canbe greater than one given our assumptions about the parameters. Now a, > I, fom equation (1), is equivalent to ‘oBL—p @+oBL ‘Thus, as lng a5 p, 8, B, and Lar al postive, cannot be greater than one >1 © aBL-p>(a+8)BL <> —p>OBL. However, from equation (1), a, canbe negative if p > BL. Intuitively, his would mean that individuals are so impatient — p the rat at which they discount the fire, isso high — thatthe future gains from extra knowledge re of no value relative to current consumption, tis also necessary to examine wheter a negative value of would be consistent with the optimization | problem for individuals. From equation (2.2) in the tex, withthe assumption of n=O, we require i G8) p-C1-8)g>0 j to ensure chat lifetime utility does nt diverge. Using equation (33) for g, this requires | a 69 @-0) ‘This simpifes to G6) (1-0)aBL-p +8 1, it can be the case that “Thats under the restrictions on the parameters that ensures that ite wily is t,t cin sil be the case that the balanced-growth-path value of ais negative. ‘Since the fraction of the labor force employed in the knowledge producing sector cannot actully be ‘negative, we will havea comor solution with , =O inthis case. The growth rate of the economy cn the ‘balanced growth path will be zero since g= BayL. Problem 38 From equation (31) in the solution to Problem 3.7, the balanced growth path fraction of the labor fore that is employed in the knowlodge-producing sectors given bySolutions to Chapter3 63 | es BL {a From equation (1), @ 2-0. ap @+OvBL ‘toon flin pa decreas in thereat which individuals iscost th farre = ie he ne rae ofa, indivituas became moe patient, he fit pis from ese) WO valued Fort at cre consi. Ths mae resources wl be dwt tothe newdetge rodig ‘Motor and belanced-growth-path growsh will be higher Ce senerret day, , ae OE oe {(a+9)BLI ich spl to @ eee ~aBL? (049 8 e+} “Tus nash of rind by es of +L, which peti unde br asin aa ney an nts B open a easin th prot of mbt He a a he pein ohn sar mt es, Th note eso ane lo here once aga agaliand wih he wags te goderean JarOL (a+b (©) From equation (V), | fo) iL SEO [oBL 16-2918 re at ((e+)BL} shih simplifies (6 Bens Metab Meso Her OP, i a (esoBLe Thus the sig of [Ais determined by the sign of (a+ 9B, which spesitive under a ASE Fane dB. An creas inthe over bot fre wil edt hghrFatn of he nba rst being employed in the knowledge-producing sector. From equstins (12) and (14s the stint robe 37, we can se hat ily, a original a 2 ero ese the wage in the knowlege sector and decreases icin the goods sector This sms ae rot lnbor fem the good tector tthe inowledge sector, Tata sees ni the wage Sone ‘again equal in the two Sector. Problem 39 ‘The relevant equations sre @ Y@O=KOrAO™ —-@ KW yq).and —@) A= BY. (@ Substing equation (1) ao equation) yields Ket) = SKI" ACO, Diving sh sides by K0) Movs us to obtain the following expression forthe growth ate of capital, ax @ Bc O=KM/KO=sKO™ AO64 Solutions to Chapter 3 ‘Substituting equation (1) into @) gives us ACD = BKC" ACD)". Dividing bath sides by A) allows ws to obtain the flowing expression forthe growth rate of knowledge, ga: ©) Ba) =AO/AC) = BK) A (©) Cantal ‘Taking the time derivative of uation () yields the growth ate ofthe growth at of capital: $O-y KO, Ga) AO 7 ex® KO aq’ ax =9 [ex=8a) oe ol © bx O/exO=0-2)]aq(0-BK00) From equation (6), wil be constant when Bs B “Thus the x =0 locus is a 45° tin in (gs ax) spa Also, sy wl be rising when > Be. Thus x i ising below the gx =O ine. Lastly, ge wil fll when 84x Thus gis falling above the f= ine a Kole “aking the tine derivative ofthe log of eqn (5) she row at ofthe growth rate of od: Ko, Aw Ao" lex =a] [eK —B4 (0) From equation (7), ga will be constant when a= 8 ‘Thus the 4, = 0 locus is also a 45 in in (B.) space. Als, ga wil be rising when > a. Thus above the =O ie, gy wil be rsing, Finally, 2x ‘wl be filing when ge < gx. Thus below the 8 =O lin, ga wl be fling, (©) Wecanputihe fx =0 and 84 =0 loc into one diagram. _Akhough we can se thatthe economy wl ewetuaiy amv at a uation where gx ~ aa and they are ons, we il do ot have enoegh orton to determine te miqu belancedgrowh path Rowing onons (and (S) gest @) ax (Oe sk OAC)! =s{A@/Ke]'™, ad ©) B4(0=BKOAC)™ =BlAC0/K(O]™ ‘At any pint in tme, the growth ates of capital and Iowiadge ar linked because ey both depend on theSolutions to Chapter 3 ratio of knowledge to capital at that point in time, It is therefore possible to write one growth rate asa function ofthe other, From equation (5), [A@O/K(0]* = B/s (0) oF simply @) Aco/K(o=([Bjen co] ‘Substituting equation (8) into equation (4) gives us ©) ax(0=2[8/an00)° Te must be the caso that gx and g leon the locus satisfying equation (9), which is labeled AA in the figure. Regardless of the intial ratio of AK the economy starts somewhere on this cus and then ‘moves along tto point E, Thus the economy does ‘converge toa unique balanced growth path at E. ‘To calculate the growth rates of capital and Jnowiedge on the balanced growth path, note that at | point Eve aeon the gx =0 and fq =O loci trtere gx. Letingg* denote this common roth rate, then fom equation (8), 2° =s[/8 Rearranging o solve for g* yields (9) srs 3 Lt or 65 “Taking the time derivative of the log ofthe production function, equation (1), ye the groweh rate reat output, ¥(0)/¥(0)=25 4 (0) +(1-a)Bq (0). On the balanced growth path, sx™ (1) ¥@/¥) =0g* 41a)" = eh SBE = gf, andthus (On the balanced growth path, capital, Iowledge and output all grow at rate g* (4) Clearly, fom equation (10), arse in the saving rate, uses g@ and thus raises the long run growth rates of capital, mowiedge and. cout. From equations (6) and (7), neither the 6 nor the gq =0 lines shift whens changes since s does not appear in either equation. From equation (@), arse in causes ge to jump vp. Also, the focus given by equation (9) shifts out. So atthe ‘moment that rises, the economy moves from its balanced growth path at point E toa point such as F. Irthen moves down along the AA locus given ‘by equation (9) until it reaches a new balanced growth path at pont Exsw66 Solutions to Chapter3 Problem 310 (a) Taking the pal desvative of ouput at fm i~ ¥,~ KL. ( L*} — wih epee 0K, treating ‘he agprezms capital sock a hen yk : cox fate nef) (5)? t. bor ratio is equated across firms. Thus K/L mst equal the eoanomy-wide 4 OS Ky; In equilibrium, the capita ‘apita-labor ratio, whichis KL, Substituting this fat into equation (1) gives us the private marginal product of capital, a" (©) Wocan employ the technique ued to sove forthe balanced growth path inthe Solow model. Since Lie the same across firma and the production function has constant etme, the aggregte production {ieton i given by ¥ = KL! [K*L*} or simply @) YaKeML Define k= K/L and y= VIL. Dividing both sides of equation (3) by Lives us ¥. ere wu) Ww and thus output pr worker it given by @y=k* “aking the time derivative of both sides ofthe definition of ks KL yields KL-KL_K /(K)L oy c-E (SE EL Wwe Substtuing the caia-scumlationoquatcn, K=#¥, andthe assumption that the abr foes grows at raten, L/L, in equation 5) gives us (6) K=2¥/L~ak =sy-nk Subsinzing equation (4) for ouput per workr ito equation (6) gives us @) kaa —nk Justa inthe Solow mevlthesconony wil eonverge oa situation in which actual investment per worker, ‘86% isequalto break-even invest per worker, nk Thus on a balanced growth pat, capital ps worker willbe constant. Sating e= 0 gives us a = Rs, ‘rsinply @ k= fan Substituting equation (8) nto equation @) yields reals = fe, snd ths th marginal produc of capital onthe balanced growth pth is ©) = on ® (©) The analysis above doesnt support the claim. The value of doesnot aft the steady-state valu of the private marginal product of capital, *. In alton, § doesnt af th way in whichis value of * changes when the sving rate changes. From equation (9), 0/6 = an) wich does net depend os “Thats, positive exeralites fom capital donot mitigate the decline inthe marginal predict of apa caused bya rise in th saving rate. Why? It is tre, asthe claim ates, that a higher means that respond less o changes ia te capita abor rai, KUL; sx equation 2). However, tis alot thatSolutions to Chapter3. 67 higher 6 means thatthe cpital-abor ratio itself responds more tothe change in the saving rate 2 ‘equation (8), In this ese, the effets cancel each ther out Pest ‘The production functions, after the normalization of T= 1, are given by WCO=KeO*, ad — 2) KO=BK KO (a) The return to employing an ational uit of atl inthe capa preciso igen by OK(t)/2K x (t)=B. This has value Px (()B in units of consumption goods. The return from employing an ‘addtional unit of capital in the consumption producing sector is 0C(0)/2{Ke(0]=a[ Ket] Eusting these tue sve ut 6) (OB=al Keto)" ‘akin the tine derivative ofthe lg of ution (2) ld the growth at ofthe price of capital Boods sate to consumption woes, Pe. | Ket a] 5 PO gy Kel Px L Ket), Pq(t) Kew) ‘Te lst ep see the fic that Band care contants, Now since Ke (soning at ate (an denon grow ate of x (38g (, weave (4) ge @) = (a- Vee. * +(a-1) (©) The growth rate of consumption i given by ©) Bett)=C(W/C(0 =[r(t)~ p]/o=[B + ep(0)~p]/o=[B +(e Nexto al/e, ‘were we have used equation (4) to subsite for g() (©) Gi) Taking the ime derivative ofthe lag ofthe consumption production Function, equation), yields © aclt)=CW/CH)=a[Ke(0/Ke (| =28x ©). Equating the two expression forthe growth rat of consumption, equation () and (6), yields agx()=[B+(a-Dax(®)-el/o > aogx(t)+(1-a)ex()=B-p. “Thus inorder for C tobe growing at rate go (, Ke () mut be growing atthe following rate: © ae =(8-p)/[a0+(\-2)] ey (in Weave stead od fr ge) tems oft undeying parame. Tosa for a, seks equate (sto eqtion ® acit)=a(B-p)/[ao+a-a)} (ey The rel itr tei now (1 XB + gp). Ths eqn teemes Q-2)[B+e,0]-p_G-9[B+@-nexie]-e ©) Bel : where we have used eqation () which i unaffected by the imposition ofthe tx — to substitute or Ty Dyeany te eo expres fo the growth rate of ensumpin, equations) and (6, els 1-o[B+@=Dex00]- ask tales e- enor > aoe (t)+1- WI ahax (= 0-9B-P, sd ths68 Solutions to Chapter 3 aco) 10) axe a (9) ax = 7 a-o-a] Sutstiiting equation (10) into equation (6) yes an expression forthe growth rate of consumption 353 fiction ofthe underlying parameters of the mode: G=98-p_| oy sc=9| To 4a-n-a)} deems oth ak ev of wh pe fect) _,{Bao(I-90-3)] [u-98-sJd-o| | Boose 2 ec a i fpora-ae-a) 7" lfesta-90-a))? “Thus an increase inthe ex rate cause the growth ate of consumption ffl Problem 3.12 {Gy Note thatthe model ofthe nother economy is simpy the Solow model with a constant growth rat of {technology equ tog Bas Ly. From ou analysis ofthe Solow model in Chapter 1, we know thatthe Teng-run gronth tate of northern output pe worker wl be equal to that constant growth rate of tecinoloy. (b) Taking the ine derivative of bath sides of the defiion, 2) = As VA is UDAs(~ AgAw® D 2)- OS 7 Aw (ty Substnsing the expressions for A) and A(t) into uation (1) gives us An (@)[usists(Ax(0-As(6]]-As([BavtwAw Ol Ant Simplifying yilés @) 2t)=[harsts(t-As(0/Ax (0) -[As(0/Aw00] [Banta] Subsiting the dofiniton of Z() = As 4s (int equation (2) gies ws Ze) = pass — wargh-sZit)— Bapyby Zi) Collings ils 6) 20> ass —[narsts + Barbe] 20) ‘The phase diagram implied by equation 3) is depicted at right, Noe that equation (3) | 2(0} snd the accompanying phase diagram do ‘ot apply forthe cate of Z > 1, since aus As(0 =O for As @ An ©. ‘The relationship between Z(t) and Z() is linear with slope equal to ~{uaiaLe + Zi Bainky ] <0. From tho phase diagram, if ZZ", then Z(t) >0, Thus ifZ begins to the left of 2 it rises toward Z* overtime. Similaly ifZ >", then Z(t) <0. Thus if