SOLUTIONS TO CHAPTER 4

Problem 4.1
(a) From equation (4.11) in the text, output per person on the balanced growth path with the assumption
that G(E) = eE is given by
 Y  bgp e  nE  e  nT
(1)    y * A ( t )e  E ,
N 1  e  nT
where y* = f(k*) which is output per unit of effective labor services on the balanced growth path. We
can maximize the natural log of (Y/N)bgp with respect to E, noting that y* and A(t) are not functions of E.
The log of output per person on the balanced growth path is
 Y  bgp
(2) ln 
N
   
 ln y *  ln A ( t )   E  ln e  nE  e  nT  ln 1  e  nT ,

and so the first-order condition is given by

 ln(Y / N ) bgp 1
(3)     nE  nT
e  nE ( n)  0 ,
E e e
or
 
(4)  e  nE  e  nT  ne  nE .
Collecting the terms in e-nE gives us
(5) ( - n)e-nE = e-nT,
or simply
  nT
(6) e  nE  e .
n
Taking the natural log of both sides of equation (6) yields
(7) - nE = [ln - ln( - n)] - nT.
Multiplying both sides of (7) by - 1/n gives us the following golden-rule level of education:
1   
(8) E*  T  ln  .
n   n 

(b) (i) Taking the derivative of E* with respect to T gives us

E *
(9)  1.
T
So a rise in T – an increase in lifespan – raises the golden-rule level of education one for one.

(b) (ii) Showing that a fall in n increases the golden-rule level of education is somewhat complicated.
From equation (6), we can write
n
(10) e  n( T E*)  ,

or
 n( T E*) n
(11) 1  e  .

Multiplying both sides of equation (11) by /n gives us

(12) [1  e  n( T E*) ]  1.
n
Now note that the left-hand side of equation (12) is equivalent to
4-2 Solutions to Chapter 4

T E*
(13) V    e  nsds .
s 0
Thus, totally differentiating equation (12) gives us
V V
(14) dn  dE*  0,
n E*
and so
dE * V n
(15)  .
dn V E *

Now note that

V T E*
(16)    se  ns ds  0 ,
n s0
and
V
(17)  e n( T E*)  0 .
E *
Thus dE*/dn < 0 and so a fall in n raises the golden-rule level of education.

Problem 4.2
(a) In general, the present discounted value, at time zero, of the worker's lifetime earnings is
T
(1) Y   e  rt w ( t ) L( t )dt .
tE
We can normalize L(t) to one and we are assuming that w(t) = begteE. Thus (1) becomes
T T
(2) Y   e  rt be gt e E dt  be E  e  ( r g) t dt .
tE tE
Solving the integral in (2) gives us
 T 
be E
E  1
(3) Y  be
 ( r  g)
e  ( r g) t 
 r  g
 
 e  ( r g) T  e  ( r g) E ,
tE 
which can be rewritten as
(4) Y 
b
rg

e E( r g) T  e[( r g)]E . 
(b) The first-order condition for the choice of E is given by
Y
(5) 
E r  g
b

e E( r g) T  [  ( r  g)]e[( r g)]E  0 .
This can be rewritten as
(6) [  ( r  g)]e[( r g)]E  eE( r g) T .
Dividing both sides by eE and rearranging yields

(7) e  ( r g)( ET)  .
  ( r  g)
Taking the natural log of both sides of equation (7) gives us
  
(8) ( r  g)( E  T)  ln  .
   ( r  g) 
 Solutions to Chapter 4 4-3

Dividing both sides of (8) by ( r  g) and then adding T to both sides of the resulting expression gives us
1   
(9) E*  T  ln  .
r  g    ( r  g) 

(c) (i) From equation (9),

E *
(10)  1.
T
Thus an increase in lifespan increases the optimal amount of education. Intuitively, a longer lifespan
provides a longer working period over which to receive the higher wages yielded by more education.

(c) (ii) & (iii) The interest rate, r , and the growth rate, g, enter the optimal choice of education through
their difference, ( r  g) . Intuitively, it should be clear that a rise in r , and thus a rise in ( r  g) , will
cause the individual to choose less education. Getting marginally more education foregoes current
earnings for higher future earnings. A higher interest rate means that the higher future wages due to
increased education will be worth less in present-value terms and hence the individual chooses less
education.

Showing this formally is somewhat complicated, however. Taking the inverse of both sides of equation
(7) gives us
  ( r  g)
(11) e  ( r g)( T E*)  ,

or
( r  g)
(12) 1  e  ( r g)( T E*)  .

Multiplying both sides of equation (12) by / ( r  g) gives us

(13) [1  e  ( r g)( T E*) ]  1 .
( r  g)
Now note that the left-hand side of equation (13) is equivalent to
T E*
(14) V    e  ( r g) s ds .
s0
Thus, totally differentiating equation (13) gives us
V V
(15) d ( r  g)  dE*  0 ,
 ( r  g) E*
and so
dE * V ( r  g)
(16)  .
d ( r  g) V E *

Now note that

V T E*
(17)    se  ( r g) s ds  0,
 ( r  g) s0
and
V
(18)  e  ( r g)( T E*)  0 .
E*
Thus dE*/d ( r  g) < 0. So a rise in r decreases the optimal choice of education; a rise in g increases the
optimal choice of education.
4-4 Solutions to Chapter 4

Problem 4.3
(a) The country’s output is described by Yi  Ai Qi eEi Li and the quality of education is described
by Qi  Bi (Yi Li )  . Solving for output per worker and taking logs, we have
(1) ln(Yi Li )  ln Ai  ln Bi   ln(Yi Li )  Ei .
Thus, the difference in log output per worker between two countries would be
(2) ln(Y2 L2 )  ln(Y1 L1)  ln A2  ln A1  ln B2  ln B1  (ln(Y2 L2 )  ln(Y1 L1))  (E 2  E1) .
Intuitively, attributing amount (E 2  E1) of the difference in log output per worker to education would
capture only the direct effect of a higher level of education on output per worker. It would miss the fact
that a higher level of education leads to higher output per worker, which results in a higher quality of
education that in turn increases output per worker even more.

(b) We can solve equation (2) for the difference in log output per worker, giving us
1 1 
(3) ln(Y2 L 2 )  ln(Y1 L1 )  (ln A 2  ln A1 )  (ln B2  ln B1 )  (E 2  E1 ) .
1  1  1 

For a more accurate measure, we should attribute (E 2  E1 ) of ln (Y2 L2 )  ln(Y1 L1) to
1 
education. Note that the larger is γ—the greater is the effect of output per worker on the quality of
education—the larger is φ/(1-γ) and the more we would understate the true effect of education by simply
using (E 2  E1) .

Problem 4.4
(a) We know the production function is given by Y  K (eE L)1 and that the marginal product of
capital is the first derivative of output with respect to capital. Therefore, we get
(1) Y K  K1(eEL)1 .

(b) There is perfect capital mobility so the marginal product of capital equals the world rate of return.
That is, Y K  r* . Setting the marginal product of capital equal to r* in equation (1) and solving for K,
we have
(2) K  (r * )1  1 LeE .

(c) We would like to find an expression for  ln Y E so substitute the expression for K in equation (2)
into our production function and take the natural log of both sides. Simplifying we get

(3) ln Y  ln (r * )  ln L  E .
1 
Taking the partial derivative with respect to E results in
(4)  ln Y E   .

(d) From our result in equation (4) we can see that capital mobility increases the impact of the change in
E on output. With perfect capital mobility, more education increases the marginal product of capital as
we can see in equation (1). That implies that for the marginal product to remain equal to the world rate of
return, the capital stock must increase to offset this. This is reflected by the fact that K is increasing in E
in equation (2). The increase in the level of the capital stock causes output to rise more. Note that without
the response of the capital stock,  ln Y E  (1  ) , which is less than φ.
 Solutions to Chapter 4 4-5

Problem 4.5
(a) Substituting the expression for output given by equation (1),
(1) Y(t )  K(t ) H(t ) (A(t )L(t ))1 ,
into the definition of output per unit of effective labor, y(t) ≡ [Y(t)/A(t)L(t)], gives us
K( t ) H( t ) (A( t )L( t ))1 
(2) y( t )  .
A( t )L( t )
Now using the definitions of physical and human capital per unit of effective labor, k(t) ≡ [K(t)/A(t)L(t)]
and h(t) ≡ [H(t)/A(t)L(t)], we can rewrite equation (2) as
(A( t )L( t )k ( t )) (A( t )L( t )(h ( t )) (A( t )L( t ))1 
(3) y( t )  .
A( t )L( t )
Noting that we have A(t)L(t) in both the numerator and
denominator, this simplifies to
k(t) (k  0)
(4) y(t )  k(t ) h (t ) .
k  0
(b) Differentiating both sides of the definition of k(t) 
K(t)/A(t)L(t) with respect to time yields
 ( t )A ( t ) L( t )  K( t ) A  ( t )
 ( t ) L( t )  A ( t ) L
(5) k ( t ) 
K
. (k  0)
 A( t ) L( t ) 2

Using the definition of k(t)  K(t)/A(t)L(t), equation (5) can

be rewritten as h(t)

K( t )   
A ( t ) L( t ) 
(6) k ( t )     k( t) .
A ( t ) L( t )  A ( t ) L( t ) 
Substituting the capital-accumulation equation, K  (t )  s Y(t )  K(t ) K
 ( t )  sY( t )   K( t ) , as well as
k K
the constant growth rates of knowledge and labor into equation (6) gives us
s Y( t )  K( t )
(7) k ( t )  k  (n  g)k ( t ) ,
A( t )L( t )
which simplifies to
(8) k (t )  s k y(t )  (n  g  )k(t ) .
Substituting our expression for output per unit of effective labor given by equation (4) into (8) yields
(9) k (t )  s k k(t ) h(t )  (n  g  )k(t ) .

To derive the k  0 locus, set the right-hand-side of equation (9) to 0 to obtain

(10) s k k(t ) h(t )  (n  g  )k(t ) .
Solving for k(t) gives us
ng 1
(11) k ( t ) 1  ,
sk h ( t )
and thus finally
1 
 sk 1
(12) k ( t )    h ( t )1 .
ng
To describe the k  0 locus, we can take the following derivatives:
4-6 Solutions to Chapter 4

  1

(16) dk ( t ) dh ( t ) k 0  c k h ( t ) 1  0 , and
1 
  1
    1 1
2 2
(17) d k ( t ) dh ( t )  ck h ( t ) 1 0,
k  0 1  1 
1
 sk 1 
where we have defined c k     0 . The second derivative is negative because α + β < 1.
ng
Thus, the k  0 locus is upward sloping and concave in (k, h) space. From equation (9) we can see that
k is increasing in h(t) and so to the right of the k  0 locus, k is positive and so k is rising To the left
of the k  0 locus, k is negative and so k is falling. See the figure above.

(c) Differentiating both sides of the definition of h(t)  H(t)/A(t)L(t) with respect to time yields
 ( t )A ( t ) L( t )  H ( t ) A
H  ( t )
 ( t ) L( t )  A ( t ) L
(18) h ( t )  .
 A( t ) L( t ) 2
Equation (18) can be simplified to
 (t)
H A  (t) L  (t) 
(19) h ( t )     h( t ) .
A ( t ) L( t )  A ( t ) L( t ) 
Substituting H  (t )  s Y(t )  H(t ) , the human-capital-accumulation equation, as well as the constant
h
growth rates of knowledge and labor into equation (19) gives us
s Y( t )  H( t )
(20) h ( t )  h  (n  g)h ( t ) ,
A( t )L( t )
which simplifies to
(21) h (t )  s h y(t )  (n  g  )h(t ) .
Substituting our expression for output per unit of effective labor given by equation (4) into (21) yields
(22) h (t )  s h k(t ) h(t )  (n  g  )h(t ) .

To derive the h  0 locus, set the right-hand-side of equation (22) to 0 to obtain

(23) s h k(t ) h(t )  (n  g  )h(t ) .
Solving for k(t) gives us
ng
(24) k ( t )  h ( t )1 ,
sh
and thus finally
1 1
 n  g   
(25) k ( t )    h ( t )  .
 s h 

To describe the h  0 locus, we can take the following derivatives:
 Solutions to Chapter 4 4-7

1  
1 
(26) dk ( t ) dh ( t ) h 0  c h h(t )   0 , and
 k(t)
1 
1  1    1
2
(27) d k ( t ) dh ( t ) 2
 ch h(t )  0, h  0
h 0   (h  0)
1
 n  g   
where we have defined c h     0 . The second (h  0)
 sh 
derivative is positive because α + β < 1. Thus, the h  0
locus is upward sloping and convex in (k, h) space. From
equation (9) we can see that h is increasing in k(t) and so h(t)
above the h  0 locus, h is positive and so h is rising Below the h  0 locus, h is negative and so h is
falling. See the figure at right.

(d) Putting the k  0 and h  0 loci together, we can

see that the economy will converge to a stable k(t)
balanced growth path at point E. This stable balanced
k  0 E
growth path is unique (if we ignore the origin with k =
h = 0). From the figure, physical capital per unit of
effective labor, k(t)  K(t)/A(t)L(t), is constant on a h  0
balanced growth path. Thus physical capital per
person, K(t)/L(t)  k(t)A(t), must grow at the same
rate as knowledge, which is g. Similarly, human
capital per unit of effective labor, h(t)  H(t)/A(t)L(t),
is constant on the balanced growth path. Thus human
capital per person, H(t)/L(t)  H(t)A(t), must also h(t)
grow at the same rate as knowledge, which is g.

Dividing the production function, equation (1) by L(t) gives us an expression for output per person:
 
Y( t )  K ( t )   H( t ) 
(28)      A( t )1 
L( t )  L( t )   L( t ) 
Since K(t)/L(t), H(t)/L(t), and A(t) all grow at rate g on the balanced growth path and since the
production function is constant returns to scale, output per person also grows at rate g on the balanced
growth path.

Problem 4.6
(a) To solve for the balanced-growth-path values of k* and h*, we can use equations (12) and (25) to
write
1  1 1
 sk 1 1  n  g    
(1)   h*    h *  .
 n  g     s h 
Solving for h* gives us
1  1 1
  sk 1  sh 
(2) h *  1      .
ng ng
4-8 Solutions to Chapter 4

The exponent on h* simplifies to (1    ) /[(1  )] . Taking both sides of (2) to the inverse of that
exponent then gives us
 1  1
1  1  
(3) h*  s1K  s1H    .
ng
To find k*, we can then substitute the expression for h* into equation (12) to obtain

1 1   1  1  1 
 1 1   1   1   1 1  
(4) k*  s1k    s K sH    .
 ng   ng   
 
Simplifying gives us
1   1 
 
 1        )
k*  s1k (1)(1 ) s1h  
1 (1 )(1
(5)  .
 ng

The exponents then simplify, leaving us with
1      1   
 1   )(1  )
k*  s k(1)(1 ) s1h  
(1
(6)  ,
ng  
and thus, finally
1  1
 1    
k*  s1k  s1h  
1
(7)  ,
 ng

where we have used the fact that (1      )  (1  )(1  ) to simplify the exponent on s k .

(b) Since technology is the same in both countries, we can compare output per unit of effective labor.
From equation (4) in the solution to problem 4.5, the ratio of output on a balanced growth path in country
A to that in country B is given by
 
 k*   h* 
y*A
(8) *   *A   *A  .
y B  k B   h B 
We know that   1 3 and   1 2 . Substituting these values into equations (7) and (3) yields
6
 1 
(9) k*  s3k s3h   ,
ng
and
6
1  
(10) h*  s 2K s 4H   .
ng
Substituting equations (9) and (10) into equation (8) gives us
1 1
y*A  s3k , As3h , A  3  s 2k , As 4h , A  2  s k , As h , A   s k , As 2h , A 
(11)  3 3   2 4   .
y*B s s  
 k , B h , B   s k , Bs h , B 
  s k , Bs h , B   s k , Bs 2h , B 
  
We also know that s k , A  2s k , B and s h , A  2s h , B . Everything else is identical between Countries A and
B. Thus, equation (11) becomes
 Solutions to Chapter 4 4-9

y*A
(12)  2  2  2  22  32 .
y*B
Thus, output per worker in country A will be 32 times higher than in country B.

(c) We can compare the amount of skills per unit of effective labor since technology is the same across
the two countries. Using equation (10), the ratio of skills in country A to those in country B is given by
h*A  s k , As h , A 
2 4
(13) *  2 4 .
h B  s k , Bs h , B 

Substituting s k , A  2s k , B and s h , A  2s h , B into equation (13) yields

(14) h*A h*B  22  24  64 .
The level of skills per worker on the balanced growth path will be 64 times higher in country A than in
country B.

Problem 4.7
(a) Since G(E) does not enter the expression for the evolution of the capital stock, K , the balanced-
growth-path values of capital and output per unit of effective labor services, k and y, are not affected by
changes in E. We can write output per worker as
(1) Y/L = AG(E)y.
Thus, the growth rate of output per worker is given by
Y / L A  G(E)E y
(2)    .
Y/L A G (E) y
On a balanced growth path, output per unit of effective labor services is constant so the last term is zero.
Technology grows at rate g. Since G(E)  eE , where E  m , we can therefore rewrite equation (2) as
Y / L eE E
(3)  g  E  g  m .
Y/L e

(b) We are given that   0.1 , m = 1/15, and that growth of output per worker is 0.02. Therefore, from
equation (3), the ratio of education’s contribution to the overall growth rate of output per worker is given
by [(0.1)(1/15)]/(0.02), which equals one-third.

(c) The lifespan of an individual is fixed at T years, so years of education must be less than or equal to T.
Therefore, E ( t ) cannot equal m forever since years of schooling will eventually be longer than one’s
lifespan. However, that is not to say that E ( t ) cannot equal m ever. For periods of time that E ( t )  m ,
output per worker growth would be larger, allowing for convergence for poorer economies.

Problem 4.8
(a) Differentiating both sides of the definition of k(t)  K(t)/A(t)L(t) with respect to time yields
 ( t )A ( t ) L( t )  K( t ) A
K  ( t )
 ( t ) L( t )  A ( t ) L
(1) k ( t )  .
 A( t ) L( t ) 2
Using the definition of k(t)  K(t)/A(t)L(t), equation (1) can be rewritten as
K (t) A  (t) L  (t) 
(2) k ( t )     k( t) .
A ( t ) L( t )  A ( t ) L( t ) 
4-10 Solutions to Chapter 4

Substituting the capital-accumulation equation, K  ( t )  sY( t )   K( t ) , as well as the constant growth

K
rates of knowledge and labor into equation (2) gives us
sY( t )   K K( t )
(3) k ( t )   ( n  g) k ( t ) .
A ( t ) L( t )
Substituting the production function, Y( t )  [(1  a K ) K( t )] [(1  a H ) H( t )]1 , into equation (3) yields
 (1  a K ) K( t )    (1  a H ) H ( t )  1
(4) k ( t )  s      ( n  g   K ) k( t) .
 A ( t ) L( t )   A ( t ) L( t ) 
Finally, defining cK  s(1 - aK )(1 - aH )1- and using k(t)  K(t)/A(t)L(t) as well as h(t)  H(t)/A(t)L(t),
equation (4) can be rewritten as
(5) k ( t )  c k( t )  h( t )1  ( n  g   ) k( t ) .
K K

Differentiating both sides of the definition of h(t)  H(t)/A(t)L(t) with respect to time yields
 ( t )A ( t ) L( t )  H ( t ) A
H  ( t )
 ( t ) L( t )  A ( t ) L
(6) h ( t )  .
 A( t ) L( t ) 2
Equation (6) can be simplified to
H (t) A  (t) L  (t) 
(7) h ( t )     h( t ) .
A ( t ) L( t )  A ( t ) L( t ) 
Substituting H  ( t )  B[a K( t )]  [a H( t )] [A( t ) L( t )]1     H( t ) , the human-capital-accumulation
K H H
equation, as well as the constant growth rates of knowledge and labor into equation (7) gives us
 a K K( t )    a H H ( t )    A ( t ) L( t )  1  

(8) h( t )  B       (n  g   H ) k(t) .
 A ( t ) L( t )   A ( t ) L( t )   A ( t ) L( t ) 
Finally, defining cH  BaKaH allows us to rewrite equation (8) as
(9) h ( t )  c k ( t )  h( t )   ( n  g   ) h( t ) .
H H

(b) To find the combinations of h and k such that k  0 , set the right-hand side of equation (5) equal to
zero and solve for k as a function of h:
(10) cK k(t)h(t)1- = (n + g + K )k(t),
or
(11) k(t)1- = cK h(t)1- /(n + g + K ),
and thus finally
(12) k(t) = [cK /(n + g + K )]1/(1-) h(t).

The k  0 locus, as defined by equation (12), is a straight k(t)

line with slope [cK /(n + g + K )]1/(1-) > 0 that passes
k  0
through the origin. See the figure at right. From equation
(5), we can see that k (t) is increasing in h(t). Thus to the
right of the k  0 locus, k > 0 and so k(t) is rising. To
the left of the k  0 locus, k < 0 and so k(t) is falling.

h(t)
 Solutions to Chapter 4 4-11

To find the combinations of h and k such that h  0, set the right-hand side of equation (9) equal to zero
and solve for k as a function of h:
(13) cH k(t) h(t) = (n + g + H )h(t),
or
(14) k(t) = [(n + g + H )/cH ]h(t)1-,
and thus finally
(15) k(t) = [cH /(n + g + H )] h(t)(1-)/.
The following derivatives will be useful:
(16) dk ( t ) dh( t )    (1  )    c H ( n  g   H ) h( t ) (1  )   0 , and

h 0
(17) d 2 k ( t ) dh( t ) 2    (1     )   (1  )    c H ( n  g   H ) h( t ) (12  )   0 .

h 0

The h  0 locus, as defined by equation (15), is

k(t)
upward-sloping with a positive second derivative.
See the figure at right. From equation (9), we can
h  0
see that h (t) is increasing in k(t). Therefore, above
the h  0 locus, h > 0 and so h(t) is increasing.
Below the h  0 locus, h < 0 and so h(t) is falling.

h(t)

(c) Putting the k  0 and h  0 loci together, we can

see that the economy will converge to a stable k(t)
balanced growth path at point E. This stable balanced
h  0
growth path is unique (if we ignore the origin with k =
h = 0). From the figure, physical capital per unit of
effective labor, k(t)  K(t)/A(t)L(t), is constant on a E k  0
balanced growth path. Thus physical capital per
person, K(t)/L(t)  k(t)A(t), must grow at the same
rate as knowledge, which is g. Similarly, human
capital per unit of effective labor, h(t)  H(t)/A(t)L(t),
is constant on the balanced growth path. Thus human
capital per person, H(t)/L(t)  H(t)A(t), must also h(t)
grow at the same rate as knowledge, which is g.

Dividing the production function by L(t) gives us an expression for output per person:
(18) Y(t)/L(t) = [(1 - aK )K(t)/L(t)] [(1 - aH )H(t)/L(t)]1-.
Since K(t)/L(t) and H(t)/L(t) both grow at rate g on the balanced growth path and since the production
function is constant returns to scale, output per person also grows at rate g on the balanced growth path.

(d) From equation (12), the slope of the k  0 locus is [cK /(n + g + K )]1/(1-) , where we have defined
4-12 Solutions to Chapter 4

cK  s(1 - aK ) (1 - aH )1- . Thus a rise in s will make the k  0 locus steeper. Since s does not appear in
equation (15), the h  0 locus is unaffected. See the figure on the left. The economy will move from its
old balanced growth path at E to a new balanced growth path at E '.

k(t) lnY/L
h  0

E'

k  0
E

h(t) t0 t1 time
Output per person grows at rate g until the time that s rises (denoted time t0 in the figure on the right).
During the transition from E to E ', both h(t) and k(t) are rising. Thus human capital per person and
physical capital per person grow at a rate greater than g during the transition. From equation (18), this
means that output per person grows at a rate greater than g during the transition as well. Once the
economy reaches the new balanced growth path (at time t1 in the diagram), h(t) and k(t) are constant
again. Thus human and physical capital per person grow at rate g again. Thus output per person grows
at rate g again on the new balanced growth path. A permanent rise in the saving rate has only a level
effect on output per person, not a permanent growth rate effect.

Problem 4.9
The relevant equations are
 

(1) Y( t )  K( t )   1  a H  H( t ) ,  ( t )  Ba H( t ) , and
(2) H H
 ( t )  sY( t ) ,
(3) K
where 0 <  < 1, 0 <  < 1, and  +  > 1.

(a) To get the growth rate of human capital – which turns out to be constant – divide equation (2) by
H(t):
 ( t ) H( t )  Ba .
(4) g H  H H

(b) Substitute the production function, equation (1), into the expression for the evolution of the physical
capital stock, equation (3), to obtain

 ( t )  sK( t )   1  a  H( t )  .
(5) K H 
To get the growth rate of physical capital, divide equation (5) by K(t):
(6) g K ( t )  K  
 ( t ) K( t )  sK( t ) 1  1  a  H( t )  .
H
We need to examine the dynamics of the growth rate of physical capital. Taking the time derivative of
the log of equation (6) yields the following growth rate of the growth rate of physical capital:
(7) g K ( t ) g K ( t )  (  1) K ( t ) K( t )   H
 ( t ) H( t )  (  1)g ( t )  g .
K H

Now we can plot the change in the growth rate of capital, g K ( t ) , as a function of the growth rate of
capital itself, gK(t). Multiplying both sides of equation (7) by gK (t) gives us
(8) g K ( t )  (  1) g K ( t ) 2  g H g K ( t ) .
 Solutions to Chapter 4 4-13

Note that we are assuming that  < 1 which

means that there are decreasing returns to
physical capital alone. The phase diagram g K ( t )
implied by equation (8) is depicted in the figure
at right. Note that gK(t) is constant when
g K ( t ) = 0 or when ( - 1)gK(t) + gH = 0.
Solving this expression for gK(t) yields
gK* = [/(1 - )]gH.
gK(t)
Note that gK* > gH since  +  > 1 or  > 1 - .
To the left of gK*, from the phase diagram, 
g K ( t ) > 0 and so gK(t) rises toward gK*. g K*  gH
1 

Similarly, to the right of gK*, g K ( t ) < 0 and so

gK(t) falls toward gK*. Thus the growth rate of capital converges to a constant value of gK* and a
balanced growth path exists.

Taking the time derivative of the log of equation (1) yields the growth rate of output:
(9) Y ( t ) Y( t )   K
 ( t ) K( t )   H
 ( t ) H( t )  g ( t )  g .
K H
On the balanced growth path, gK(t) = gK* = [/(1 - )]gH and so
Y (t)       
(10)  g H  g H  gH  g  g K *.
Y( t ) (1  ) (1  ) (1  ) H
On the balanced growth path, output grows at the same rate as physical capital, which in turn is greater
than the constant growth rate of human capital, gH = BaH.

Problem 4.10
(a) The true relationship between social infrastructure and log income per person is expressed by
yi (t )  a  bSI i  ei . However, of the two different components of social infrastructure, we only have
data for SI iA . Therefore, we substitute for SI i and the equation becomes
(1) yi  a  bSI iA  bSI iB  ei .

(b) We would like to run an OLS regression on (1) but we cannot observe SI iB , so we run an OLS
regression on
(2) yi    SI iA  ei .
cov(SI iA , yi )
We know that   , where yi represents the true log income per person, shown in equation
var(SI iA )
(1). Substituting in the true log income per person and simplifying, we get
cov(SI iA , a  bSI iA  bSI iB  ei ) b cov(SI iA , SI iB )  cov(SI iA , SI iB ) 
(3)    b   b 1  .
var(SI iA ) var(SI iA )  A 
 var(SI i ) 
Remember that SI iA is uncorrelated with e i so cov(SI iA , ei )  0 .
4-14 Solutions to Chapter 4

(i) If SI iA and SI iB are uncorrelated, then cov(SI iA , SI iB )  0 . Equation (3) shows that   b , such that the
OLS regression for equation (2) would not produce a bias. Therefore, we would see the true impact of
social infrastructure on log income per person.

(ii) If SI iA and SI iB are positively correlated, then cov(SI iA , SI iB )  0 . Equation (3) shows that   b ,
such that the OLS regression for equation (2) would produce an upward bias. Therefore, we would be
overestimating the impact of the component of social infrastructure that we observe. Intuitively, since
the unobserved component of social infrastructure varies positively with the observed component, we
would be incorrectly attributing some of the impact of the unobserved component to the observed
component.

Problem 4.11
(a) False. Using this OLS method could result in bias. Assume we would like to run an OLS regression
on yi (t )  a  bSI i  ei , where yi is income per person, SI i is social infrastructure, and e i is an error term
that captures everything other than social infrastructure that has an impact on income per person. For an
unbiased estimate, social infrastructure cannot be correlated with the error term; otherwise, the estimate
will have an upward or downward bias (see problem 4.10). As discussed in the text, it is in fact likely
that social infrastructure is correlated with other factors affecting income per person such as cultural
factors or geography.

(b) False. Instrumenting a variable requires the variable to be uncorrelated with the error. Since we can
only guarantee that the instrumental variable is uncorrelated with social infrastructure, the condition
could be violated. Then, the result would be biased, and we would not measure the true effect of social
infrastructure on output per person.

(c) False. The coefficient of determination measures the correlation between variables, so a high R 2
would show a good “fit” for the data. However, a high R 2 does not help determine whether the model
reflects reality (that is, that the model captures the true effect of social infrastructure on output per
person) or whether we have accounted for common problems like omitted variable bias.

Problem 4.12
(a) (i) We have
dy i ( t )
(1)   [ y i ( t )  y*] .
dt
Since y* is a constant, the derivative of yi (t) with respect to time is the same as the derivative of yi (t) -
y* with respect to time and so equation (1) is equivalent to
d[ y i ( t )  y*]
(2)   [ y i ( t )  y*],
dt
which implies that yi (t) - y* grows at rate -. Thus
t
(3) y i ( t )  y*  e [ y i (0)  y*].
Rearranging equation (3) to solve for yi (t) gives us
(4) yi (t) = (1 - e-t)y* + e-tyi (0).

(a) (ii) Adding a mean-zero, random disturbance to yi (t) gives us

(5) yi (t) = (1 - e-t)y* + e-tyi (0) + ui (t).
Consider the cross-country growth regression given by
(6) yi (t) - yi (0) =  + yi (0) + i .
 Solutions to Chapter 4 4-15

Using the hint in the question, the coefficient on yi (0) in this regression equals the covariance of
yi (t) - yi (0) and yi (0) divided by the variance of yi (0). Thus the estimate of  is given by
cov[ y i ( t )  y i (0), y i (0)]
(7)   .
var[ y i (0)]
(If the sample size is large enough, we can treat sample parameters as equivalent to their population
counterparts.) Now, use the fact that for any two random variables, X and Y, cov[(X - Y), Y] =
cov[X, Y] - var[Y] and so
cov[ y i ( t ), y i (0)]  var[ y i (0)] cov[ y i ( t ), y i (0)]
(8)     1.
var[ y i (0)] var[ y i (0)]
Using equation (5),
(9) cov[ y i ( t ), y i (0)]  cov[(1  e t ) y * e t y i (0)  u i ( t ), y i (0)].
Since y* is a constant, and ui (t) and yi (0) are assumed to be uncorrelated, we have
(10) cov[ y i ( t ), y i (0)]  e t var[ y i (0)] .
Substituting equation (10) into equation (8) gives us
e  t var[ y i (0)]
(11)    1,
var[ y i (0)]
or
(12) e t  1   .
Taking the natural log of both sides of equation (12) and solving for  gives us
ln(1  )
(13)    .
t
Thus, given an estimate of , equation (13) could be used to calculate an estimate of the rate of
convergence, .

(a) (iii) From equation (5), the variance of yi (t) is given by

(14) var[ y i ( t )]  e 2t var[ y i (0)]  var[ u i ( t )] .
From equation (13), if  < 0 then  > 0. This does not, however, ensure that var[yi (t)] < var[yi (0)], so
that the variance of cross-country income is falling. The is due to the variance of the random shocks to
output, represented by the var[ui (t)] term in equation (14). Thus the effect of  < 0 or  > 0, which tends
to reduce the dispersion of income, can be offset by the random shocks to output, which tend to raise
income dispersion.

If  > 0 then  < 0. From equation (14), we can see that this means var[yi (t)] will be greater than
var[yi (0)]. In this case, the effect of  < 0 or  > 0 is to increase income dispersion, and thus this works
in the same direction as the random shocks which also tend to increase income dispersion.

(b) (i) Since yi* is time-invariant, analysis equivalent to that in part (a) (i) would yield
(15) y i (t )  (1  e t )(a  bX i )  e t y i (0) ,
where we have used the fact that yi* = a + bXi.

(b) (ii) We will determine the value of  implied by an estimate of  in this model and compare it to the
value implied by using the formula from part (a) (ii). In the cross-country growth regression given by
(16) yi (t) - yi (0) =  + yi (0) + i ,
again we have
4-16 Solutions to Chapter 4

cov[ y i ( t ), y i (0)]  var[ y i (0)] cov[ y i ( t ), y i (0)]

(17)     1.
var[ y i (0)] var[ y i (0)]
Then, since
(18) y i ( t )  (1  e t ) y *i  e t y i (0)  e i ,
we have
(19) cov[ y i ( t ), y i (0)]  (1  e t ) cov[ y*i , y i (0)]  e t var[ y i (0)] .
Since
(20) yi (0) = yi* + ui = a + bXi + ui ,
we have
(21) var[yi (0)] = b2 var[Xi ] + var[ui ],
and
(22) cov[yi*, yi (0)] = cov[a + bXi , a + bXi + ui ] = b2 var[Xi ],
since Xi and ui are assumed to be uncorrelated. Substituting equations (21) and (22) into equation (19)
gives us
(23) cov[ y i ( t ), y i (0)]  (1  e t ) b 2 var[ X i ]  b 2 e t var[ X i ]  e t var[ u i ],
or simply
(24) cov[ y i ( t ), y i (0)]  b 2 var[ X i ]  e t var[ u i ] .
Substituting equations (21) and (24) into (17) gives us
b 2 var[ X i ]  e  t var[ u i ] (1  e  t ) var[ u i ]
(25)    1 2 .
b 2 var[ X i ]  var[ u i ] b var[ X i ]  var[ u i ]
We can now solve for the value of  implied by equation (25) and compare it to the one we would
calculate if we used equation (13). Equation (25) implies
 t b 2 var[ X i ]  var[ u i ]
(26) e  1 .
var[ u i ]
Taking the natural log of both sides of (26) and solving for  gives us
 b 2 var[ X ]  var[ u ] 
i i
 ln 1  
 var[ u i ] 
(27)   .
t
Since (b2 var[Xi ] + var[ui ])/var[ui ] > 1, using the formula given by equation (13) would lead us to
calculate an estimate for  that is too small in absolute value. That is, if  > 0, using the method of part
(a) (ii) would yield an underestimate of the rate of convergence.

(b) (iii) Subtracting yi (0) from both sides of equation (18) gives us
(28) y i ( t )  y i (0)  (1  e t ) y*i  (1  e t ) y i (0)  e i .
Substituting equation (20) into (28) yields
t * t *
(29) y i ( t )  y i (0)  (1  e ) y i  (1  e )[ y i  u i ]  e i ,
which simplifies to
t
(30) y i ( t )  y i (0)  (e  1) u i  e i .
 t
Defining Q  (e  1) , we can see that the regression given by
(31) yi (t) - yi (0) =  + yi (0) + Xi + i
is equivalent to projecting Qui + ei on a constant, yi (0), and Xi , where ei is simply a mean-zero, random
error that is uncorrelated with the right-hand side variables. Rearranging yi (0) = a + bXi + ui to solve for
ui gives us
 Solutions to Chapter 4 4-17

(32) ui = -a + yi (0) - bXi ,

and so
(33) Qui = -Qa + Qyi (0) - QbXi .
Thus, in the regression given by (31), an estimate of  provides an estimate of Q and an estimate of 
provides an estimate of -Qb. Thus, we can construct an estimate of b by taking the negative of the
estimate of , divided by the estimate of , or
 Qb
(34)     b.
 Q