Horizontal innovation,

In his work, Romer developed the idea of knowledge through the introduction of the concept of
horizontal innovation, it is related to number of goods used in production and the concept of
specialization. According to Ricardo theory, the comparative advantage should bring country to
specialize in the sectors in which it has comparative advantage, though the empirical evidence doesn't
support this.
∑
Kjt represents the capital allocated in j-th sectors. This equation represents the concept of horizontal
innovation, because increasing the level of Nt, it is possible to increase the production itself.
…
The no-arbitrage condition of the return on investment is stated as
Which equals the return on each investment and avoids flows among investment . Assuming a cobb-
dauglas production function.
( )
The stock of capitalism necessary for the production of each intermediate good
( ) ̅
Define the aggregate levelof capital as
∑ taking the sum ̅ . putting this to the production function, we get:

( ) ( )

This implies that we observe increasing returns to scale due to specialization (Nt). Consider again
equation ∑ . Any additional intermediate goods do not affect the profits of the
previous production. Entrepreneur is not interested in the future innovation, since it does not affect the
current and future profits derived from the current production. In particular, expected profits of the
current production are influenced by the size of the market, whit in turn influenced by the demand side
The dynamics of Nt can be described by: ̇

That is the production of new ideas, blue prints is a function of the determinants of R and D
sector: Financial resources, human capital and actual stock. We can consider Nt as a proxy of the stock of
knowledge. In this framework the long-run growth is also related to price. The lower the price to
innovate, the higher the growth rate. In this model firms compete to each other to innovate
and createnew intermediate goods. They will enter the market only if the cost to innovate is equal to or
lower that the expected profits.
Vertical innovation
With the expression of vertical innovation, we indicate an improvement in the methods of production
that determines a replace of the old methods. In a dynamics perspective, the innovator should always be
aware of the next innovator, which is his main competitor. After the introduction of the
new intermediate goods, the old one is not sufficient enough, and then it is destroyed. Consider the
production function where at is a measure of the quality of the intermediate good Xt
is the only intermediate good. Let the total GDP at time t be Which assume that prices
and depreciation rate of capital is equal to one. The locus of production of intermediate goods, which
brings profits in magnitude
That is we assume producer of intermediate goods is a monopolist. On the other hand, the final sector is
competitive, since we assume that every firm can buy the intermediate good and use it in the production
of final goods. The price set by the monopolist is at every point in time is equal to the marginal
productivity of the intermediate good.

1
The optimal conditions of the monopolist:
Which implies that the size of the market determines the size of the profits, measured by L, that are in
turn the main incentive for innovation. However, we must not forget the effect of the quality of the
innovation measured by At. Also we should notice that α is a parameter for the elasticity of demand: low
elasticity brings more profits. As a result, it is not so clear whether the innovation rate is maximized in
perfect competition since high level of competition will bring lower profits, so less incentive for
innovation.
The optimal level of production: and total GDP

In each periods an entrepreneur attempts to find an innovation, if she success the technology of Xt will
shift , If she fails .
The probability of getting a new idea that actually becomes an innovation : the term
measures the total resources invested in R and D sectors that is the state of frontier of knowledge. The
intuition is that, the higher the frontier of the knowledge the higher must be invested for new
innovation. We can specify as ( ) where and λ is a positive parameters. Therefore
the expected value of the innovators profit:

The potential innovator sets Rt in such a way that it maximizes the expected value of future profits, that
is: ( )
The F.O.C for the static optimizaztion problem:

Where measures the market power of the monopolists while L accounts for the size effect. Therefore

𝛾 1 with prob 𝝁𝒕
The growth rate between two consecutive periods is 0 with prob 1-𝝁𝒕

Which implies also that whole economy should take into account the stochastic component of
innovation that influences growth.

Next question, (free trade)

In this framework we should consider the consequences of having free trade on the horizontal
innovation. As we have seen in the beginning the horizontal innovation is higher when the number of
intermediate goods high. So, free trade would improve the efficiency of the market and the chance to
innovate
Next, need of patent law
A lack of patent law creates weak property rights which allows for imitation. According to our simple
framework, this determines a lower growth rate. If we allow for imitation , the
consequences is the lost of market power. This brings to a decrease in the profits which is the main
incentive to innovate.
Next, the size of economy
GDP is proportionally growing with the size of the economy, as well as Yt and . The policy implication
is that there should be effort to keep labour supply high and to make people be part of the labour force.
2
Next, intensity of marketcompetition
μ and α are strictly limited. The elasticity of demand has a crucial role in the monopolistic framework.
The elasticity depends on α, so that α is a measure of monopolistic power. This is a trade-off; either we
decrease monopoly or we ensure more equality, but we lose the reward for innovation with increasing
inequality. We can say that a certain level of competition is good, only if it is not so high since it lowers
profits too much.

3
Knowledge as engine of growth
Romer (1986), the general scheme is that human capital is embodied in the production
function process while knowledge is disembodied from the production function, in a sense that
it does not enter the production process directly but govern the technological progress. In fact
the human capital is still related to the accumulation of calssical factrs of production, while the
accumulation of knowledge, that is the ppl of knowledge acquired from human capital.
Thestartingpoint is the attempt to defineknowledge in economc terms. In particular , knowledge
can be consider as a public good, which must respect the followning characteristic: 1) non-
rivalry:that is the posibility to use the knowledge without affecting others ability to use the
same knowledge at the same time ,2) non-excludability: whichis the requirement should be
fulfilled by knowledgeforits own nature and is fundamental forbothits creation and diffusion.
Romer stated thatat firm level t is characterized by the following eq:
: is th e stock of phisical capital, ite sum of the stock of phisical capital
of all other firms; is other factors thathave a role in the level of A( ex R&D).
The introduction of the knowledge spillover concept: the capital of a firm contributes also to
the knowledge of others because of the characteristic of knowledge. In particular we have thatAi
depends on and . The accumulation of knowledge in Romer model happend principally
via learn by doing and for tis we have that so that technological progress is proportional
with income, with Solow’sequation we can state that and thatswhy theeqaution
depends on k. Now he added some assumption regarding the hope of
1) The function reproduce private factors is constant return to scale( the
assumption is needed to guarantee the competitive equilibrium):

So the overall producstin has increasing return toscale because of the spillover. If we
unify solow and Romer theory we get:
̇
Solow: with
̇
Romer: here we need more assumptio. We take a representative
̇
firm and we replace the equation:
We assume and
̇
Then we have
̇

If we assume that , we have a stable equilibrium that coresponds tothe

stagnation of the economy. While the right graph shows when we assume
here we have unstable equilibrium.
 𝒔𝝓 𝒌 𝒇 𝒌
𝜶 𝜷 𝟏 𝜸 𝟏 and 𝜹 𝒏
𝒌
we have constant growth rate of capital per
worker

a) An increase in saving rate

̇
In the case of 2 and 3 it creases the growth rate of while the case 1 is juast the levelof capital
in equilibrium.

b) Increasing in the growth rate of employment

As before in 1 it decreases just the level of capital in equlibrium while in 2 and 3 we have growth
effect

c) Existance of scale effect: the N is known also as size effet and since we have knowledge
spillover we have that if N↑ we will have solow effect as saving rate increases
d) Existance of the patent lawsystem: the effect will be on γ, but the system is not dynamics.
- Investing a lot and you donot wnat to share the knowledge
- You want to share the knowledge because it increases the competition and to
innovate
POVERT TRAPS

RELATION BETWEEN SAVING AND INCOME

Variation of saving rate is exogenous and sudden shifting to the right. There will be an
output level and transitional effect. We should now consider the consequences having s as a
function of capital K. Lets recall the keynesian formula forsavings:
̅
̅ ̅ , dividinng for y we get
̅
. The higer y, the higher the savings s=f(y), and s=f(k).

̇
we have a new interraction to consider.

Assuming an initial non-negative level of consumption. We should

consider the interaction between two curve. Apossible solution of
new formulation is the one steading light on the so-called take off
countries.

there are 3 equilibrian and only E1 and E3 are stable. The

particular feature of this framework is the possibility of a
movement of takee-off. Indeed if a country being at @2, it needs
to find a policy that can move them to the rigght, the dynamics of
the model not only would allow to have positive 𝒌̇ /k but also
growing rate of change of capital.it is basically a movement in
which saving are changing d=faster than f(k)/k.

There is a need of a policy in which influence the saving rate of the poor country, which is structural
variable. One possible solution is to cut taxes on personal income, increasing disposal income with
hoping that it will lead people to change their saving habits. Another possible solution is to decrease
taxes to firms, so that investment is more profitable and saving increase.

1
RELATION BETWEEN N AND INCOME

Sollow during his study witnessed an empirical fact concerning population, the so-
called demographic transition. By this empirical law, as income grows in a country, fertility grows to a
certain level until when it starts to reduce sharply. It is because people start to think about something
else rather than number of children.
that is n=f(y) and then n=f(k).once we have this
assumption, we shall consider a particular possible core
of dynamics of the system.
fertility

mortality
As we can see, there are 2 different equilibrias, and only
income
one of them is stable, E1. This is the so-called poverty
trap. let’s suppose that poor country start from Kpoor. The
dynamics of the model would not let the country to
grow but,let t to E1 therefore the poor will remain poor.

>>>E1<<< |<< E2>> rich

The possible soulution is to change the relation between n and k, with this also we can reach a
higher level of capital.

2
PUBLICT DEBT

Public debt is sustainable if Government respects its intertemporal budget constraint.

The intertemporal budget constraint of Government can be expressed as:

∑ ∑

where Pt is the (expected) level of price at period t, Tt the real value of Government revenues, Gt
is the real value of public expenditure, B0 the nominal stock of public debt, and i the nominal
interest rate paid on public debt. The left hand side of Eq. Is the discount sum of the
Government revenues; the right hand side is the discount sum of Government expenditure plus
the initial level of public debt. We observe that we are assuming that Government has a infinite
horizon and that the interest rate paid on public debt is constant over time. The we get

where Tt - Gt represents the primary surplus at period t. The equation cannot be easily used
without further assumptions. First, assume that the level of price will growth at constant rate,
i.e.: . where is the expected inflation rate. Second, assume that the
primary surplus is a constant share of income β, i.e.: . Finally, assume that
income growth will growth at constant rate , i.e.: . Substituting them
we will get:
∑ that is ∑ ( )

Under the plausible assumption that gY and rα are not negative, from the fisher equation i.e
and

There is several empirivcal examlase where ( ) was not satidfied, but atthe
same tme we did not observe any signal of possible default in the bondmarket. Since the
investor seems more interested to the ratio between bond and income.

Next question, reduce in the expected GDP

Bt+1 = (1 + i)Bt - (Tt+1 - Gt+1) ; where Bt+1 is the public debt at period t + 1. By dividing
both sides by PtYt we have:

That is

It describes the dynamics of the ratio between public debt and income. Such dynamics
crucially depends on the relationship between and . Asumming > then the

1
dynamics of depend on . If < 0 then we will observe a divergent dynamics of ,
if on the contrary the we have unstable equilibrium (Point E).

2
1.The neoclassical sollow model
The sollow model is one of the most important model in the tradition macroeconomics concerning
growth. In order to understand the model, we should start from the main futures and
assumption. Y=F(K,L) --> production function. The big assumption is that there is no difference between
firm and individuals, which is considered to be impossible by many scholars. a second point is that
technology is non rival neither neutral Y=AF(K,L). Since it it augmenting. The last main feature of
production is that the presence of constant return to scale. That is, if we multiply the input with λ, we
will get λ times output λY=F(λK, λL). In other words the size is doesn’t matter for the efficiency. If we
take that λ=1/AL then we will get y=f(k, 1) or y=f(k) which is the intensive production function.
Accordingly we cansay that there is no production function without capital. We shall now considering
the main assumptions (Inada condition), developed by UZAWA.
1. The function goes through the origin that f(x)=o when x=0
2. The function is concave, so the hessian matrix is negative semi definite
3. ∂y/∂k > 0, ∂y/∂L> 0 while both the second derivative is less than 0. the intuition is that although a
more unit capital on labor has positive marginal impact on output, this impact is decreasing in
infinity
4. The Inada conditions imply and . there is no chance of an
infinite growth via accumulation
Now we need to find Solow equation in order to study the dynamics of the model K = I - D. Since we are
in closed economy I=sy where s is the marginal propensity to saving and D is the constant term of the
capital depreciation D= δK

Where g is exogenous element indicating thegrowth rate of technology

As we know that y=f(k), if the rate change f capital is (0) at the

𝒀
equilibrium level then therate of y is also (0). 𝒚 𝑨𝑳 
𝒚 𝒀/𝑳 𝒀/𝑳
𝒈 so in eqilibrium 𝒈. At the equilibrium output
𝒚 𝒀/𝑳 𝒀/𝑳
per workers grow at the rate of the technology.

Now we should consider the change in the growth rate of

population (↑n), since n is exogenously and suddenly. The
change in the growth rate of population has 2 detachable
effects. Firstly, there will be a level effect since K E has changed
to lower KE1.this implies that a lower level of output per capita.
We may think that the higher the number of population simply
will force output split in lower parts. Although we will still have
that at equilibrium the growth will still at technological rate.
Secondly is that there will be a transitional effect, which by the
graph shown by the grey area in which economy has growth
lower than zero, that means the economy is doing bad.

1
Now we shall cosider the case where the growth rate of population can depend on the level of income
and the potential implications for the analysis. We may consider that n is function of
capital. Sollow during his study witnessed an empirical fact concerning population, the so-
called demographic transition. By this empirical law, as income grows in a country, fertility grows to a
certain level until when it starts to reduce sharply. It is because people start to think about something
else rather than number of children.
that is n=f(y) and then n=f(k).once we have this
assumption, we shall consider a particular possible core
of dynamics of the system.
fertility

mortality
As we can see, there are 2 different equilibrias, and only
income
one of them is stable, E1. This is the so-called poverty
trap. let’s suppose that poor country start from Kpoor. The
dynamics of the model would not let the country to
grow but,let t to E1 therefore the poor will remain poor.

>>>E1<<< |<< E2>> rich

show the effect on the equilibrium of an increase in the saving rate.

Variation of saving rate is exogenous and sudden shifting to the right. There will be an output level
and transitional effect. We should now consider the consequences having s as a function of capital K.
Lets recall the keynesian formula forsavings:
̅
̅ ̅ , dividinng for y we get
̅
. The higer y, the higher the savings s=f(y), and s=f(k).
̇
we have a new interraction to consider.

Assuming an initial non-negative level of consumption. We should

consider the interaction between two curve. Apossible solution of
new formulation is the one steading light on the so-called take off
countries.

there are 3 equilibrian and only E1 and E3 are stable. The

particular feature of this framework is the possibility of a
movement of takee-off. Indeed if a country being at @2, it needs
to find a policy that can move them to the rigght, the dynamics of
the model not only would allow to have positive 𝒌̇ /k but also
growing rate of change of capital.it is basically a movement in
which saving are changing d=faster than f(k)/k.
2
Show the effect on the equilibrium of an increase in the depreciation rate
If δ grows exogenously and suddenly, there will be a shift of curve (n+g+d). As so there would be level
and transitional effect. Considering a model with depreciation as a function of technological progress. It
is reasonable to think that they have positive relationship. since with the higher technology the factor
capital is getting older and inefficient compared to the new means of production. We should consider
that the equlibrium level of capital in sollow model leads to have ̇ /k=0.

At the equilibrium level 𝒌̇ /k=0, so that 𝒚̇ /y=0 because there is no

change in the growth rate of output per capita in efficiency units if
there is no change of growth rate of capital 𝒚̇ /y=0 --> (𝒀̇ /L/(Y/L))=g.

If we consider a change in the growth rate of technological progress and we assume that δ(g), we can
notice that there are some consequences in the analysis which is cumbersome and in some way at
uncertain. If g increases we do not change the level of Y/L of equilibrium directly yet we are changing its
growth. However, since δ(k), as g increases moving the line (n+g+ δ) to the up. The effect of two changes
re in somewhat at odds. Even though increases in g making growth faster, the change in δ has lowered
the capital of equilibrium and hence output level of equilibrium

3
The theory of human capital.

The sollow model without technolocgical progress predicts that economy willconverge to a steady state
with zero percapita growth because of the assumption of diminishing returns to capital. However
empirical evidence doesnotsupport this result. The model examines whether the Solow growth model is
consistent with the international variation in the standard of living: an augmented Solow model that
includes accumulation of human as well as physical capital provides an excellent description of the cross-
country data. It also examines the implications of the Solow model for convergence in standards of
living, that is, for whether poor countries tend to grow faster than rich countries. There are 3 main
channels ofaccumulation Human Capital.

1. Education the introduction of public education was done in erussia during Bizmrk periode to
answer the need of educated people to faster the industrialization of the country.
2. Learning by doing: it is simply the concept of acquiring knowledge and skills during the
production just by doing something
3. No market interaction: the interaction among agents in the system is a source of accumulation of
skills and it produces an affect of local accumulation of human capital.

Consider a
production function , now we introduce HUMAN CAPITAL
. In efficiency units . As in solow model, the marginal productivity of the
factors production (physical and human capital) are positive and decreasing and inada condition are
fullfilled. The new fundamental assumption is that which provides the intuition that an on-
going accumulation of human and physical capita, i.e. longrun economic growth, is possible.
We can express the law motion of capital and human capital making from the assumption that sh ≠ s
(human capital has different depreciation rate). The investment rate in human capitalcan be imagined as
investment in education and in the formation of skilled labor. The depreciation is the resulof the
constant inflow and outflow of skilled labour. The explicit formulation for the accumulation of human
capital can be suumerized as:
̇ ̇
a) ̇
̇ ̇ ̇

̇
b) ̇
The model is identified by these two equations and the non-zero value of k and h at the initial level.
𝐡̇ The system is in equilibrium when the two variables
1. 𝐬𝐡 𝐤 𝛂 𝐡𝛃 𝟏
𝐧 𝐠 𝛅𝐡
𝐡 grow at constant rate O; 𝐤̇ and 𝐡̇ under two conditions
𝐤̇
2. 𝐬𝐤 𝛂 𝟏 𝐡𝛃 𝐧 𝐠 𝛅 h(0)= h0 and k(0) =k0. We are interested in the steady
𝐤
state: 𝐡̇ 𝟎 𝐚𝐧𝐝 𝐤̇ 𝟎
𝟏 𝟏 𝛃
𝐧 𝐠 𝛅𝐡 𝐧 𝐠 𝛅
𝐡 [ 𝐬𝐡
] 𝛃−𝟏 and 𝐤 𝐬

Consider the case where human capital is accumulated by financial investment; discuss the properties of
long-run equilibrium and the effect of an increase in the level of the rate of investment in physical
capital.

̇ ̇ ̇
Consider the dynamics of z is

1
Accordingly the long run growth is driven by the competition of two forces. To study the properties of
the long-run equilibrium, we can plot theequation as two different functions:
̇
a) which describe the long-run growth driven by physiclcapital acumulation.
̇
b) describes that the long-run growth driven by humn capital accumulation.

Moreover, the equilibriumis globally asymptotically stable, that is:

̇

Indeed, in the equilibrium we observe a positive long-run growth rate of income per worker determined

Suppose that there is an in the accumulation of

human capital through financial investment.we can
see that the higher rate of saving rate (investment in
physical capittal) leads to higher income in steady
state, which is turn leads to higher level of human
capital. There is a continues feed-back through this
self-reinforcing mechanism that determines a
significant augmented.

b) Time devoted to education: Lets now consider a model developed by LUCAS in 1988, in which it
implies that human capital is no longer the result of investment coming from output, but it is a
number of time spent in education and trainig.the production functio is
. In this framework H is involved in the process of output’s production, minus
component where is the share of the skilled labour used to train other labours. We can find
the law of motion of physical capital and human capital.
̇
̇ ̇

THE PHYSICL CAPITAL ONCE AGAIN MOVES WITHTHE SMA LOW OF MOTION.
̇
̇
The model is identified The model is solved when 𝒉̇ 𝟎 𝒂𝒏𝒅 𝒌̇
̇
𝟎
𝝁 𝒏 𝒈 𝜹𝒉
𝒏 𝒈 𝜹 𝟏 𝜷
̇ 𝒌 𝒔
Investing more will lead to higher level of k

2
c) Consider the case where human capital is accumulated by financial investment and the existence of
an overall constraint on the total amount of resources available for the investment. Discuss how
these resources should be divided between the investment in physical and human capital to
maximize the long-run growth.
Lets now suppose that β=1-α, we gte an infite number of equilibria.
̇ ̇
( ) ; ( )
̇ ̇ ̇
If we take z=k/h then in dynamics is

̇ ̇ ̇
̇
̇ ̇ ̇
Now we know that . but since in the euilibrium thegriwth rate of k
̇ ̇
are equal we have . Thismeans that we have endogenous growth fkr the inocme per worker
̇ ̇ ̇ ̇
in effciency units. + g.
Here there are differen policy implications. In particular, if you intervene human capital or investmen
rate. In solow model, for example, if youaugment investmen you just get a level effect ( the growth rate
depends on technological progress). Here a policy intervention on K/h has a growth effecr, as it is an
incentive to have an active policy in education. Now if we assume that δ=δh we will get,
̇ ̇ ̇
 ̇

̇ ̇ ̇
( ) the same applies to .
̇
Let us take ̅ , α is fixed and let’s maximize with respect to s and
Max
̅
( ) ( ) ̅

F.O.C
̅ ̅
THEREFORE THE OPTIMAL CONDITION S AND Sh are : S*h = ̅ and S*= ̅
̅

Discuss the implication forthe convergence of countries

The fundamental implication that determines endogenous growth in the model is the assumption of
non-decreasing return to scale in the factor of production. Therefore countries that save more grow
faster indefinitely and they will generally not converge to the same level of income, even if they have
the same preference and technology (conditional convergence). Since in endogenous growth model
there is no steady state level of income differences in income per capita among countries can persist
indefinitely even if countries have the same saving and population growth rates. More generally, the
result presented by Mankiew, Romer, Weil (1992) indicate that Solow model is consistent with the
international evidence. If one acknowledged the importance of human as well as physical capital. The
augmented solow model say that the difference in saving education and population growth should
explain cross-country differences in income per capita, in particular these three variables should explain
most of the international variation.

3
Cross-country convergence in income
Applying Solos’s model as to understand the pathway of growth and any possible distribution policy,
let’s analyze the condition under which we have a good world with absolute convergence namely a
world with countries follow the same path of growth, ending up in the same level of output per capita.
̇
The conditions are the equalities of parameters among the
countries. The only different is determined by the initial level of capital.
, , ,

If we suppose that KP is the initial level of capital in a poor

country and KR is rich’s. We can see that in the long-
run there will be a same level of growth of output per capita for
𝒀̇ /𝐋
both countries. 𝐘/𝐋=g not only this we can also see that the poor
country will paradoxically luckier as the decreasing marginal rate
𝒑 𝑹
𝒌̇ 𝒌̇
of capital implies that Kp<KR.. 𝒌
> 𝒌

There would be a faster growth in the poor country. In this framework the policy implication is
basically absent. Indeed rich and poor country eventually will converge to the same equilibrium. Let's
now analyze the condition under which we have a bad world with conditional convergence, namely
there are differences between parameters of the countries. The assumption are the same, only si ≠ s .
It is reasonable to think that poor countries have lower rate of savings, since they maybe concerned with
issues of food supply, health care and so on. Let’s imagine the two countries; one with low s, and the
other high s. they have different level of capital (Kp, KR).

1. The pathaway of the long-run equilibrium is no longer the same

and the final level of output per capita will be extremely different.
2. Not only that the output level will be different, the poor countries
have lost their advantages in the transitional dynamics. Indeed
the initial level of capital will make rich country experience fast
growth rate better than poor (shades area)

The impication is wide. There is a need of a policy in which influence the saving rate of the poor country,
which is structural variable. One possible solution is to cut taxes on personal income, increasing disposal
income with hoping that it will lead people to change their saving habits. Another possible solution is to
decrease taxes to firms, so that investment is more profitable and saving increase.
Present the Solow model with a lower bound to the marginal productivity of capital
If we consider a lower bound to the marginal productivity of capital, we basically leave
the inada condition that the Limk->∞ f’(k)=0. The framework has new formulation Limk->∞ f’(k)=α, that is
α>0. In other words the productin function has had an asymptotical behavior as K -> ∞. As K -> ∞ if f(K) -
> ∞. We can use l’hopitals to show that the limit as K -> ∞ of the marginal product and average product
f(k)/k is the same.

1
The implication of lower bound is crucial and we can analyze 2 different scenarios.

Implications

1) α>> in this scenario there is no equilibrium. the average product is higher than the line
̇
(n+g+δ) so that there will be always positive and there is endogenous growth.

if we imagine this framework considering different regions, we

can see that the crucial point is the level of s. is s is sufficiently
large to have …..., there will be an infinity growth attained by
accumulation of capital. However, if s is not sufficiently large we
will find ourselves in the situation of the sollow equilibrium and
the growth path away will depend by the initial level of capital

2) α<< we will find ourselves in the situation of the previous equation.

2
GOLDEN RULE
If we consider first welfare theoremm, we have that competitive equilibrium is the best solution. The
main assumption is that agent has infinite life so that all decisions are internalized and maximization
problem satisfies all the generation coming. When it comes to inter-temporal framework
this assumption is too strong and it is not plausible to think that the best decisions for the current
generation would be the best decision also for upcoming generation. We should consider the
maximization problem.
Show how Golden Rule can be applied to identify the social optimal level of investment in the Solow
model.
̇ Golden gives us the optimality condition concept in solow model. We are
interested in equilibrium allocation and the allocation is invariant over time.

( ) ( )
.We apply golden rule
to Solow’s equation. The focus is the long-run equilibrium.in this model the utility of individual is the
same to the level of consumption. We are interested to maximize this level of consumption. Then we
calculate the level of capital which maximizes consumption.by taking the FOC for maximization. We get
f’(Keq) -(n+g+ δ)=0. Capital of golden rule is equal to marginal productivity of capital and real interest
We can imagine a situation in which there are 3 different rates of
rate.
savings S1<SGR<S2. as we can see form the graph, the level
of consumption is maximized only where KEQ=KGR and the level
of savings SGR and S=S1.and S=S2, the system
is dynamically inefficient. If S=S1 the agent should save more in order
to maximize consumption in the inter temporal framework. A
government should increase taxes and make savings grow. For S=S2 ,
government should decrease taxes and make consumption grow.

Take cobb-douglas production function to decide optimal condition

𝒚 𝒌𝜶 intensive production function
𝜶𝒌𝜶−𝟏 marginal product of capital
( ) 𝒌𝜶−𝟏 average product of capital
If s > 𝜶 then 𝒌𝑮𝑹 < 𝒌𝑬𝑸 overaccumulation
( ) If s < 𝜶 then 𝒌𝑮𝑹 > 𝒌𝑬𝑸 underaccumulation

If we are interested in a situation of under accumulation, we have to tax current generation to increase
investment rate to reach golden rule. Then you maximize the consumption but, in the equilibrium, not
for current generation, this has political constraint. Overaccumulation condition is unlikely to happen. If
we increase public debt today, we increase consumption of current generation against the future one.
We use public debt to take some gain from the future to bring to current generation. In a growing
economy with infinite horizon, we do not have the problem of the pay back of the debt, instead we have
the problem of the stability of the debt. It is not debt of household. Golden rule is related to the

1
equilibrium of consumption generation, but it is possible that economy may not be in equilibrium. If we
are in the situation of under accumulation, we have to tax current generation to increase s to reach S GR .

How Golden Rule can be applied to identify the social optimal level of investment in the Solow model
with natural resources.
In this model supply of natural resources would remain adequate. it portrayed a competitive economy
making full and efficient use of its only scare factors, that are labour and capital. Return to scale were
to observed to be constant, and capital and labor were found to be substitutable so that the fears of
technological unemployment were dismissed.

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Growth accounting.

Present the methodology of growth accounting. Discuss the crucial hypotheses

underlining the identification of the contribution of technological progress to overall
growth. Finally, examine the implications of the omission of some crucial productive factor
for the estimate of the growth rate of technological progress.

Growth accounting is an empirical methodology that allows for the breakdown of observed
growth of GDP into components associated with changes in factor inputs and in
production technologies. Given the impossibility of measuring technological progress
directly, the growth rate of technology is measured indirectly as the growth rate in GDP
that cannot be accounted for by the growth of the observable inputs, that is, as residual
growth. The analysis start from the production function, that
can be written as: Y= F(K, H,A,R)
Where K indicates the physical capital, H the human capital, A the technology and R the
natural resources which are used in the production. Obviously, the causes of growth
depend on the model used to explain the economic development. We can operate a
logarithmic transformation on equation and compute the growth rate of Y as: Ln Y= Ln F(K,
̇ ̇
̇ ̇ ̇ ̇ ̇ ̇ ̇
H,A,R) Given that
̇ ̇ ̇ ̇ ̇
Then it becomes . Therefore, the growth rateof per capita product
̇ ̇ ̇ ̇ ̇ ̇ ̇ ̇ ̇
is:

where gk and gh are the growth rates of, respectively, physical and human capital per
capita and gA and gR the growth rate of technological progress and resources. To
determine gy, we must identify:
1) magnitude of the elasticities, which cannot be directly calculated since we do not
know the magnitude of the marginal productivity of factors at the aggregate level
(e.g. MPK = dF=dK);
2) the magnitude of the unknown variables: in particular, A is not observable to solve
the problem, we express gA in terms of the unkwon elasticities:

As a second step, we assue that the factor markets are perfectly competitive
r ; ;
So that the shareof profitsof, for instance, physical capital on the total GDP is,
we can calculate all the unknown elasticities with the only exception of to estimate ,
we assume that it is constant over time: therefore, the production functions among the
considered sample must be equal net to a constant, which is indeed our (Solow, 1957).
Consider again the assumption of competitive factor markets, i.e. factors are remunerated
at their marginal productivity and the production is su_cient to remunerate them all. This
determines the addition of another constraint on the elasticities; according to the used
theory of product allocation among different factors we have that:

Assuming further homogeneity of degree one of the production function (Euler theorem)
and constant returns to scale of technology in private factors, we have that the final
constraint is:

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GROWTH OF INTERTEMPORALOPTIMIZING AGENTS
Lets consider a framewrok with intertemporal optimizing agents, namely Ramsey model. We deal with
agents gain utility by their consumption and by theutility of their offsprings. They make natural
decisions subject to intertemporala budget contraints. The households provide labour services in
exchange for wages, receive interest income on assets, purchase goods for consumption and save by
accumulating assets. The basic model assumes identical households (same preferences, same wage rate,
same initial assets per person, same rate of population growth), so that we can use the representative
agent framework, in which the equilibrium derives from the choices of the single household. Each
household contains one or more adult, working members of the current generation. In making plans,
these adults take account of the welfare and resources of their prospective descendants. The current
adults expect the size of their extended family to grow at rate n (constant and exogenous) because of
the net influences of fertility and mortality; assume there is no possibility of migration. Normalizing the
number of adults at time 0 to 1, L(0) = 1, the family size (the adult population) at time t, is L(t)= e nt . If
C(t) is the total consumption at time t, then c(t) = C(t)/L(t) is consumption per capita at time t. Each
household wishes to maximize overall utility U, given by ∫ ( ) [ ( )]
This formulation assumes that households’ utility at time ) is a weighted sum all of future flow of utility ;
U(c). We assume that U(c) increasing and concave; u’(c) > 0 and u’’(c)<0. refers to the rate of time
(future generations). A positive ρ means that future cnsumption is less important than today.

( )
the total incomes received bt the aggregate household
Since ( ) taking derivatives
̇
( ) ̇
̇ , where na is the dimunition of average asset due to increase of popultion.

Lat but not least, we should consider another restriction, we want to avoid an increase of consumption
via debt and to do so, we consoder a restriction that lets to avoid the classical ponzi game.
∫[ ( ) ]
[ ( ) ] the constraint implies that,in the long run a household’s debt per
person (a(t)<0) cannot grow as fast as ( ) , so debt cannot grow at ( )
The maximizaztion Problem :
∫[ ( ) ]
Max ∫ ( ) [ ( )] S.t ̇ , [ ( ) ] ,
a(0)=a0. Then we construct the present value of hamiltonian function.
( ) ( ) ( )[ ]
where the number of adults at time 0 is normalized to 1, that is L(0) = 1. The Hamiltonian is formulated
as the sum of two components, the ow of consumption ( ( ) ) and the flow of investment at
time t. In this intepretation, is seen as the so-called shadow price of income, which allows to compare
consumption and investment in terms of standard utility. It represents the value of an increment of
income received at time t in units of utils at time Notice that depends on time because there is a
shadow price for each constraint and the household faces a continuum of constraints, one for each
instant
THE FOC
( )
1) , where c(t) is strictly positive because of the assumption of
concavity of u(c)
2) ̇ = ( ) It is a fundamental result of the optimal control theory because it expresses a
relation between the shadow price and the asset per capita
3) , so-called trasversality condition. Note that the intuition is that at the end of the
period a should be equal to zero; however, we still state that the limit has to be non-negative
1
at the end for mathematical reasons.
The system of equation for the optimization problem is therefore,
( )
̇ ̇ ̇ ̇
=(r-n)→ -σ

Where the last part of equation in the system is called Euler equation and is the basic condition for
choosing consumption over time In particular, it says that households choose consumption so that the
growth of per capita consumption equates the difference between the rate of return to saving, r, and the
rate of time preference , ρ , divided by the intertemporal elasticity of substitution. Agents prefer to
consume today rather than tomorrow for two reasons:
1. households discount future utility at rate ρ and this is part of the rate of return to consumption
today;
̇
2. if > 0 is low today relative to tomorrow and since they like to smooth consumption over time (u’’ < 0)
they would like to even out the flow by bringing some future consumption forward to
present.
In particular, if agent are optimizing, equation says that they have equated the two rates
of return and are therefore indiferent at the margin between consuming and saving. Another way to
̇
interpret Euler equation is to observe that households would select a at consumption profle, = 0, if r =
ρ. Households would be willing to depart from this at pattern and sacrifce some consumption today for
̇
more consumption tomorrow ( > 0)

Suppose we are interested in a long-run equilibrium in which all variables are growing at constant rate
(steady equilibrium).in order to obtain these result we need to assume that σ is constant overtime.
Hence this form is called constant elasticity function and can be derived by integrating two times
the euler equation

We use CES for steady state, then we use U=logC, thisis exactly the case of =1. In this case income
effect is equal to subs effect whichis crucial on consumption. Hence r – ρ is the important to decide
growth rate of consumption

FIRMS
Firms produce goods, pay wages for labour input and make rental payments for capital input. Each firrm
has access to the production technology.
Y (t) = F[K(t);L(t);A(t)]
where Y is the flow output, K is capital input in units of commodities, L is labour input in per-hours per
year and A(t) is the level of the technology, which is assumed to grow at the constant rate g≥ 0. Hence,
A(t) = egt where the initial level of technology is normalized to 1. Assume that there are no adjustment
costs, so that the maximization of the pro_ts can be reached in every period and that the interest rate is
constant, r r. Then, the flow of investment in e pressed as ∫ ( ) . Consider we are
using 1 unit of labour in production (L = 1), then the profit can be written as
() (̂) ̂ ̂ ̃ where k = K=AL is the capital in eficiency units, is the
depreciation rate of k and ̃ = W/A.
According to the firrst order conditions we have ( ) . Therefore: ( )
In perfect competitive markets profts are equal to zero (free entry condition), so that ( ) ( )
̃ which implies ̃ ( ) ( ( ) )

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Equilibrium
Consumer’s side
1.
2. a˙ ra+w-c-na
∫[ ( ) ]
3. ( )

Where and
Firm’s side
(̂ ) (̂ )
In the equilibrium we must considertogeteher consumers and firms. Consideringthat aL= ̂ AL then a=
̂ . Therefore:
̇ ̂̇ ̇ [ (̂ ) (̂ )̂
(̂ )
̂ ̂ ̂ ̂ ̂
̇ ̂̇ ( ̂)
Let , then ̂ ̂
Where is the level of consumption in effciency units while (̂ ) = s (̂ ) is the level of saving
̂̇ ( ̂)
in efficiency units. The dynamics of ̂ is given by ̂ ̂ .

̇ ̇ ̇ ̇ ̇ (̂ )

In efficiency units it must hold that both growth of consumption and the rate of capital are zero, so that
the level of consumption and capital are maximized.
1. ̇ (̂ ) : in the equilibrium (̂ ) where such
̂ exists because of the assumption of the concavity and the inada conds on the production
function. Therefore we have < EQ ̂̇ ≥0
2. ̂̇ ≥ 0 ̇ ( ̂)
( )̂ . Where the last expression on the right side ofthe last equation
describes the curve of the dynamics of capital.
e define the level of capital of golden rule, GR, that level of which ma imi es the level of
consumption with respect to , independently from the decisions of consumption. As can be seen in it is
possible that GR EQ
. Moreover, we know that if the trasversality condition is holds, than GR > EQ. n
fact, the value of solves the following ma imi ation problem.
GR
> EQ 𝐟’(𝐤𝐆𝐑) < 𝐟’(𝐤𝐄𝐐) (𝛔 𝟏)𝐠 < 𝛒 𝐧, where the last
expression is the condition we stated in order to have a finite integral,
which is therefore always fulfilled in our framework It is important to
note that the reason why consumption is not maximized with respect
to capital, is that the maximization we operated was on consumption
weighted di_erently over the different generations (expressed by 𝛒 ).
The model exhibits saddle-path stability.

The stable arm is an upward-sloping curve that goes through the origin and the steady state. For any
positive initial level of , there is a unique positive initial level of that is consistent with households'
intertemporal optimization, the dynamics of the capital stock and households' budget constraint. The
function giving this initial of as a function of is known as saddle path. In particular, if the economy is
in any point ( =0, 0) on the saddle path, it will converge to the equilibrium, given by the couple ( 0;
0). Moreover, if this equilibrium exists, it must also be unique, since the presence of a unique saddle

3
path avoid any indeterminacy in the dynamics of and . To identify =0 , we use the no Ponzi condition.
Note that, in the equilibrium, the variables of the model have the same properties stated in Solow-Swan.
In particular, we have that the variables expressed in effciency units are stable, per capita variables are
growing at rate g and absolute variables are growing at rate g + n.

Finally, examine the effect on equilibrium of a taxation of the return on capital, where the collected
resources of Government are used for Government consumption.

Suppose that the government purchases goods and

services in the aggregate quantity (public
consumption). Assume that these purchases do not
inuence households' utility or frms' production and
that the government runs a balanced budget. the tax
rate on capital is the one which produces a real
distortion in the accumulation process

Finally, examine the effect on equilibrium of a taxation on labour income, where the collected resources
of Government are used for Government consumption.

The tax rate on wage income does not inuence the

equilibrium conditions, since we assumed that households
work a fixed amount of time (which implies that the
labour supply is inelastical). Moreover, it is possible to
redistribute taxation among the population (redistributive
effect), so that there is no change at the aggregate level.

Finally, examine the effect on equilibrium of a taxation on labour income, where the collected resources
of Government are equally redistributed to households.

The effectof this taxation is neutral. The model works in aggregate level so that taxation in the end has
no effect on the equilibrium level

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 1

INEQUALITY IN THE LONG-RUN

The starting point of his analysis is that functional distribution is the right perspective to study
the actual inequality, i.e. the study of inequality is the analysis of determinants of the share of
profits on total income. In particular, he argues that the dynamics of actual inequality regards
the concentration of total wealth in the hands of few individuals populating the top tail of
wealth distribution, in particular the top 1% (ranking all individuals on the base of their wealth
from the poorest to the richest and normalizing the population to 100%, they are in the last 1%).
Moreover, in top 1% profits and/or earnings assimilated to profits, as stock options, are the
main source of individual incomes; also individuals in top 1% whose main income is from wages
are generally working in financial sector, where the crucial variables for their incomes is the
dynamics of financial markets, i.e. profits. To complete the framework, he then assumes that
physical capital and wealth can be considered the same thing, i.e. physical capital is a good proxy
for wealth. This is a big issue because physical capital generally refers to a productive factor,
while wealth in actual economies is composed by a large part of financial assets, but in this way
he can use the Solow theory on capital accumulation, as we will discuss below. He propose two
fundamental laws governing the share of profits on total income. The first fundamental law
states the share of profits on total income, indicated by α, can be expressed as the multiplication
of two variables, the real interest rate r and the ratio between capital and income K/Y , i.e.:

Piketty does not take the marginalist rule for the determination of interest rate, therefore we
need two separate theories for r and K/Y . For the latter he follows Solow, i.e. starting from the
dynamics of accumulation of capital: ̇ ( ) .

where s is the saving/investment rate, n the growth rate of employment, δ the depreciation rate
of capita, and g the growth rate of technological progress. In the long-run equilibrium, i.e. for ˙k
= 0, we have that the ratio K/Y , denoted by Piketty as β, is given by: ( ) ( )

is the second fundamental law. Taking the equation together provides the basic
explanation puts forward by Piketty for the share of profits on total income:
Any changes β (caused, e.g., by an increase in s or a decrease in n, δ, and g) leads to
an increase in α and therefore in the share of total income accruing to the richest. We can verify
that ∂r/∂k has a sign depending on the value of ρ. Taking ρ = 0 we have the standard case where
α = r × β = γ. If you do not believe in marginalist rule (e.g. David Ricardo), then we have generally
refer to social classes and bargaining power in the division of total output (e.g., as in David
Ricardo).

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 2

Piketty provides also an intuition on the determinants of dynamics of inequality over

time. Suppose to consider an economy divided into capitalists and workers. All income from
capitalist is from their wealth. , i.e. physical capital K in Piketty’s framework, while all income of
workers is from wages; therefore Y = wL + rK. where w is wage and L is the number of workers.
Given our assumption a measure of inequality is the ratio between the average income of
capitalists and workers IINEQ, i.e.:

where LC is the number of capitalists. IINEQ is well adapt to measure the

dynamics of inequality of top 1% versus the rest of society. it is straightforward to derive that:
̇ ̇ ̇
assuming that LC and r are constant. As regards the accumulation of wealth,
assuming null consumption from capitalists, we have that: ̇ , i.e. capital is growing at rate
r (the presence of a limited consumption does not affect this conclusion) ,while wage w is
assumed to be growing at rate (of technological progress) g.
̇
, piketty concluded thatif r>g then ineqaulity willincrease overtime. Since r is the
netreturn on wealth it is eimmediate that taxation on the rturn on the capital can be effective
on reducing inequality, Piketty, however, it is more favourable to a taxation on wealth, given its
lower distortion on individual choices on saving and investment.

Next question, elastis substitution.

If we believe in the marginalist rule, but we consider a more sophisticated CES production
function as: ( ) : with ρ ∈ [−1, +∞) (ρ = −1 is the linear production
function, ρ = 0 is Cobb-Douglas case, and ρ → +∞ is Leontief case, where 1/ (1 + ρ) is the
elasticity of factor substitution), i.e. in intensive terms: ( ) we have that
( ) .