4,212,2 Macroeconomics III

Take-Home Exercise 1

deadline: CET 12:00 pm (noon) on Tuesday, February 28th, 2023

SOME RULES / GUIDELINES

1. Please work in groups of maximum 3 on the exercises. Only one team member has to
upload the solutions using the file naming convention: lastname1 lastname2 lastname3.filetype.
Make sure you submit the homework as a group and not as an individual, using the
preset groups.

2. Please upload your answers using the “Assignments” folder for the relevant take-
home exercise on the StudyNet (Canvas) page of the lecture (4,212,2.00).

3. You are responsible for verifying that you can upload files to the required folder
prior to the deadline. Unfortunately no extensions will be given.

4. As long as all submitted work is legible, files can be submitted using any standard
file format: (.pdf, .jpeg, .xls, etc.). However, all results should be made available to
the reader without having to run codes (e.g. if you have a Matlab/R code, submit
your output in an additional file). You may submit multiple files for one exercise.

5. If you upload multiple files, archive them in a zip file and name it according to the
rule in 1. Clearly indicate the names and student numbers on all files that you
submit.

GOOD LUCK!

Exercise 1.1
This is a pen and paper exercise and relates to the basic Solow model, discussed in lecture
1. The aim of this exercise is to familiarize you with the basic mechanisms of the model.
As in the lecture and the corresponding textbook chapter, small variables are ratios to
labor, e.g. k = K α 1−α , aggregate
L . Production is assumed to be Cobb-Douglas Yt = BKt Lt
capital evolves according to Kt+1 = sYt + (1 − δ)Kt , and population grows at rate n, i.e.
Lt+1 = (1 + n)Lt .

a) Derive the law of motion (or transition equation) of capital per worker, i.e. find kt+1
as a function of kt and model parameters.

b) Draw the transition diagram, i.e. draw the transition equation in a (kt+1 , kt )-diagram
and indicate k ∗ . Derive the slope of the transition equation and use this expression to
argue why the economy will always converge to k ∗ .

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c) Derive the Solow equation (i.e. kt+1 − kt as a function of kt ). Draw the Solow diagram
(i.e. draw sBktα and (n + δ)kt as a function of kt ) and indicate k ∗ . Using the Solow
equation, argue why the economy will always converge to k ∗ . Add per capita production
Bktα to the diagram and indicate per capita consumption in the steady state.
d) Using the Solow equation, find k ∗ . In part c) you showed that per capita consumption
on the steady state is B(k ∗ )α − (n + δ)k ∗ . From this expression, find the golden rule
k ∗ , that is the k ∗ that maximizes per capita consumption in the steady state. What is
the condition for the economy to fulfill the golden rule?

Exercise 1.2
This is a simulation exercise. For help getting started with simulations in Excel, please see
the document excel simulationexample.xls. Otherwise, feel free to use other Software
you may like more. The relevant equations for the simulation can be found in the book
chapter 3 and Lectures 1b and 1c on StudyNet (Canvas).
a) Explain the economic effects according to the basic Solow model of a decrease (at
some time) in the population growth rate, n, from one constant level to a new and
lower constant level using the transition diagram and the Solow diagram. How does it
affect the steady state values of capital, income and consumption per worker? Explain
qualitatively the transition from the old steady state to the new one: what happens in
the period of the change, and what happens in the periods after that?
b) Consider the parameterization of the basic Solow model: B = 1, α = 13 , δ = 0.05,
n = 0.03, and s = 0.08. Assume that in period zero the economy is in steady state at
these parameter values, and then in period one the population growth rate drops to
n = 0.01, other parameters remaining unchanged. By what percent does the reduction
in the population growth rate change the steady state values of real wage, real interest
rate, capital, income, and consumption per worker, respectively?
c) Carry out a simulation of the model over the periods 0 to 100, and show in a diagram
the evolution of yt , ct , wt , ρt and the growth rate (yt − yt−1 )/yt−1 (or the approximate
one ln(yt ) − ln(yt−1 )), over the 100 periods. Does the country reach a new steady state
during this time? Comment your findings.

Exercise 1.3
This is an empirical exercise that tests the steady state predictions of the basic Solow
model. The data for this exercise is from the Penn World Table 10.0. Please use the excel
sheet DATA.xls posted on StudyNet (Canvas) for this exercise.
The steady state prediction of the Solow model is tested below by plotting (across 112
countries) GDP per worker in 2019 against investment rates (averaged from 1970 to 2019)
and population growth rates (averaged from 1970 to 2019); see figures 1 and 2 below.
The directions of these empirical relationships are nicely in accordance with the basic
Solow model. However, more precisely, the Solow model predicts (as shown in equation
(1) below), that there should be a linear relationship between ln(y ∗ ) and ln(s) − ln(n + δ),
α
and that the slope should be 1−α :
1 α α
ln(y ∗ ) = ln(B) + ln(s) − ln(n + δ). (1)
1−α 1−α 1−α

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 Figure 1: Investment Rate vs. Real GDP per Worker

Source: Calculations using data from PWT 10.0

Figure 2: Population Growth vs. Real GDP per Worker

Source: Calculations using data from PWT 10.0

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a) Explain the economic reasoning behind the direction of the relationship in the above
figures for investment rates and population growth rates.

b) Test the relationship in equation (1) by creating a figure that (scatter-)plots ln(y i )
against ln(si ) − ln(ni + δ) across the same 112 countries (i indexes countries). Set
δ = 0.1. Add a line of best fit; what is its slope? Discuss how this matches up with
the precise prediction of the Solow model according to equation (1).