Assignment 2

ECON 202 Intermediate Macroeconomics (Spring 2021)

Instructor: Sonan Memon

Total Marks: 50

Due: 12th April, 2021, 5 pm. Please submit the assignment on LMS under
the relevant tab. No late submissions will be accepted.

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 Each of the following questions has 10 marks. Do not forget that you get absolute 1%
bonus marks for using LATEX. The bonus will be higher if your LaTeX usage is more impres-
sive or advanced. Best of luck!
Question 1A: 5 Marks (GLS (2020))
It has been widely reported that income inequality within the US and other industrialized
countries is growing. Yet one of the stylized facts is that capital does not seem to benefit
from economic growth (as evidenced by the approximate constancy of the return to capital
across time). If this is the case, what do you think must be driving income inequality in the
US?
Solution:
If the return on capital is roughly constant, then wage income, another major source of
income may be displaying a lot of variation across the various economic strata. Indeed, there
is a substantial body of research showing that wage inequality in the US started going up in
the late 1970s and continued through the end of the century.
Other acceptable answers could focus on lack of progressive income taxation in the US,
especially since the Reagan years as well as low capital gains tax. Yet another acceptable
answer, which is one possible cause of wage inequality is the so called skill biased technical
change and globalization, which has increased skill premia and widened income inequality
across high and low skilled workers in the US and other advanced economies.
Question 1B: 5 Marks (GLS (2020))
We have assumed that the production function simultaneously has constant returns to
scale and diminishing marginal products to labor and capital. What do each of these terms
mean? Is it a contradiction for a production function to feature constant returns to scale
and diminishing marginal products? Why or why not?
Solution:
Constant returns to scale means that doubling all the inputs exactly doubles output.
An input has a diminishing marginal product if increasing that input, while holding all
other inputs fixed increases output at a diminishing rate. No, it is not a contradiction for
a production function to have diminishing marginal product and constant returns to scale.
The key words in diminishing marginal product are leaving all other inputs fixed. Constant
returns to scale says that doubling all inputs doubles output.
Question 2A: 5 Marks (GLS (2020))
What are the Inada conditions? Explain how the Inada conditions, along with the as-

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sumption of a diminishing marginal product of capital, ensure that a steady state capital
stock exists.
Note: You are required to use only graphs and intuition to answer this question. I do
not expect or require a rigorous, mathematical proof.
Solution
The Inada conditions state that the marginal product of capital goes to 0 as capital goes
to infinity and the marginal product of capital goes to infinity as capital goes to 0 in the limit.
Given these conditions and the other assumptions of the production function (diminishing
marginal product and monotonicity), we know the 45 degree line will intersect the capital
accumulation line once in the interior of the domain.
The following two examples illustrate that if the Inada conditions were violated, we face
problems regarding either lack of existence of interior steady state (Figure 1) or multiplicity
of interior steady states (Figure 2). In Figure 1, the law of motion for capital only intersects
the 45 degree line at the origin. In Figure 2, there are multiple points of intersection between
the curve and the 45 degree line. In both cases, the Inada conditions are violated and the
uniqueness of interior steady state fails.
Note: The graphs below do not constitute a formal proof of the necessity of Inada condi-
tions, but are merely suggestive of the kind of problems that we run into without the Inada
conditions.

kt+1

kt = kt+1

kt

Figure 1

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 kt+1

kt

Figure 2

Question 2B: 5 Marks (GLS (2020))

What would be the saving rate which would maximize steady state output? Would the
household like that saving rate? Why or why not?
Answer
s = 1. Households would not like this because they would not be consuming anything
but since y ∗ is increasing in s, it is maximized when s = 1.
Question 3: 10 Marks (GLS (2020))
Assume that the production function has the following CES (constant elasticity of sub-
stitution) form:

−1 −1
 
−1

Yt = AF (Kt , Nt ) = A αKt + (1 − α)Nt 
, where  ≥ 0, A > 0 and α ∈ (0, 1)

(a) Prove that this CES production function features constant returns to scale.
(b) Compute the partial derivatives with respect to Kt and Nt i.e YKt and YNt and argue
that both are positive.
(c) Compute the own-second order partial derivatives with respect to Kt and Nt i.e YKK
and YN N and show that these are both negative.
(d) As  → 1, in the limit, how do the partial derivatives YKt and YNt compare with
the partial derivatives for the case covered in lecture 15 in which Yt = AKtα Nt1−α (Cobb-
Doughlas)?

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 (e) Does this CES function satisfy the assumption that labor and capital are essential
goods in production process? If so, then for what values of  does it do so, if at all?
Solution
−1 −1 

(a) Yt = AF (Kt , Nt ) = A[αKt + (1 − α)Nt 
]
−1

−1 −1 
F (%Kt , %Nt ) = [α(%Kt )  + (1 − α)(%Nt )  −1 ]

−1  −1 −1 


= (%  ) −1 [αKt + (1 − α)Nt  −1]
−1 −1 
= %1 [αKt 
+ (1 − α)Nt  −1 ] = %1 F (Kt , Nt )

Thus, F (%Kt , %Nt ) = %F (Kt , Nt ) and the CES function is homogeneous of degree 1,
which means it features constant returns to scale.

(b)
 −1 −1 −1 −1
   
 −1
YKt = A[αKt  + (1 − α)Nt  ] −1 −1 αKt 
−1 
 −1 −1  − 1 −1
   
1
YKt = A[αKt + (1 − α)Nt ]
  −1 αKt 
−1 
−1 −1
−1 1
YKt = AαKt  [αKt 
+ (1 − α)Nt  −1 ]

YKt is positive because A > 0, α ∈ (0, 1),  ≥ 0, and Kt and Nt are also positive due
to essential inputs assumption in production process.

 −1 −1 −1 −1

   
1
YNt = A[αKt  + (1 − α)Nt  ] −1 (1 − α)Nt 
−1 
−1 −1
− 1 1
YNt = A(1 − α)Nt [αKt 
+ (1 − α)Nt 
]−1

YNt is positive because A > 0, α ∈ (0, 1),  ≥ 0, and Kt and Nt are positive.

(c)

α −(1+) −1 −1 1 α2 A − 2 −1 −1 2−

YKK = − AKt  [αKt  + (1 − α)Nt  ] −1 + Kt [αKt  + (1 − α)Nt  ] −1
   
−1
αA − 1  (1 − α)Nt  
=− K  
 t −1 −1
  

Kt αKt + (1 − α)Nt 

YKK is negative since there is a minus term, pre-multiplying an expression which is

entirely positive, given our assumptions on the parameters.

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 (1 − α ) −(1+) −1 −1 1
YN N = − ANt  [αKt  + (1 − α)Nt  ] −1 +

A(1 − α)2 −2 −1 −1 2−
Nt  [αKt  + (1 − α)Nt  ] −1
  
−1
(1 − α)A − 1  αKt  
=− Nt   −1

−1 
 
Nt αKt  + (1 − α)Nt 

YN N is negative since there is a minus term, pre-multiplying an expression which is

entirely positive, given our assumptions on the parameters.

(d) As  → 1, the YKt term has form A × α × K1t × 1∞ , where 1∞ is an indeterminate

form, which is undefined. Similar indeterminate form shows up in the expression for
YNt .
Thus, we must use L’Hopital’s rule and cannot work with expressions for partial deriva-
tives directly. In order to get a more convenient expression, we go back to the expression
for CES function itself and take logs on both sides, which yields:
−1 −1
 
ln Yt = ln A + −1 ln[αKt + (1 − α)Nt 
].
Then take limits on both sides as  goes to 1:
−1 −1
 
lim→1 Yt = lim→1 ln A + lim→1 −1 ln[αKt + (1 − α)Nt 
].
The above is equivalent to:
ln Yt = ln A + ln(10)×1 =⇒ ln Yt = ln A + 00 but 00 is undefined, which is why must
apply the L’Hopital’s rule, for which we first take derivatives of the numerator and
denominator. The limit has to applied after taking the respective derivatives.
  
−1 −1
∂  ln αKt  +(1−α)Nt 
lim→1
ln Yt = ln A + ∂
∂ (−1) .
lim→1 ∂
   
−1 −1 −1 −1
  α ln(Kt )Kt  12 +(1−α) ln Nt Nt  12 +1×ln αKt  +(1−α)Nt 
lim→1 
−1 −1  
αKt  +(1−α)Nt 
ln Yt = ln A + lim→1 1 .
I have used in the last step above that the derivative of ag (x) with respect to x, where
g (β )
a is an exponent is ag (x) g 0 (x) ln(a). This is why the derivative of αKt with respect
g (β ) 0
to β for instance is α ln Kt Kt g (β ). Further simplification yields:
 
−1 −1
lim→1 11 α ln(Kt )Kt  +(1−α) ln Nt Nt  +1×0
ln Yt = ln A + 1 .
=⇒ ln Yt = ln A + α ln(Kt ) + (1 − α) ln Nt .

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 Notice that when we use the Cobb-Doughlas production function Yt = AKtα Nt1−α and
take logs on both sides, we also get ln Yt = ln A + α ln(Kt ) + (1 − α) ln Nt .
=⇒ lim→1 ln YtCES = ln YtCobb−Doughlas =⇒ lim→1 exp ln YtCES = lim→1 exp ln YtCobb−Doughlas
=⇒ lim→1 YtCES = YtCobb−Doughlas .
We have thus proved that lim→1 YtCES = YtCobb−Doughlas =⇒ lim→1 YKCES =
YKCobb−Doughlas and lim→1 YNCES = YNCobb−Doughlas . The partial derivatives of the
CES function approach the partial derivatives of the Cobb-Doughlas function as  → 1.
 
(e) Y CES (0, Nt ) = A[(1 − α) −1 Nt ] and Y CES (Kt , 0) = A[(α) −1 Kt ]. If both goods
are essential, we need that Y CES (0, Nt ) = Y CES (Kt , 0) = 0. However, for α ∈ (0, 1)
and A > 0, this will not be true in general. Hence, in general, the CES function does
not satisfy the essential goods assumption.
However, when  → 1, the CES function approaches the Cobb Doughlas function, which
satisfies the essential goods assumption. When  → 0, the CES function approaches
perfect complements case, which also satisfies the essential goods assumption since
the production function is of form Yt = min{αKt , βNt }. When  → ∞, the CES
function approaches perfect substitutes case, which does not satisfy the essential goods
assumption since the production function is of form Yt = αKt + βNt .
In sum, for special cases in which  → 1 and when  → 0, the CES function satisfies the
essential goods assumption but it does not do so in general due to the flexible degree
of substitutability between inputs allowed for in this function.

Question 4A: 7 Marks (GLS (2020))

Suppose we introduce a government in the Solow Model:
Each period, the government consumes a constant and exogenous fraction of output sG .
Hence, the aggregate resource constraint is:
Yt = Ct + It + Gt ,
where Gt = sG Yt . Define private output Ytp = Yt − Gt
Suppose that investment is a constant fraction s, of private output (consumption is then
1 − s times private output). Otherwise the rest of model is the same as in the textbook
and/or slides.
(a) Re-derive the central equation of Solow Model in both non-intensive and intensive
form under this modified setup.
(b) Suppose that the economy initially sits in a steady state. Suppose that there is an

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increase in sG that is expected to last forever. Graphically analyze how this will affect the
steady state value of the capital stock per worker. Plot out a graph showing how the capital
stock per worker will be affected in a dynamic sense.
Solution
(a) Start with the capital accumulation equation: Kt+1 = sYtp + (1 − δ )Kt , which can
alo be expressed as Kt+1 = s(AKtα Nt1−α − Gt ) + (1 − δ )Kt , which is the central equation
in the non-intensive form.
Meanwhile, for the central equation in intensive form, work with the equation Kt+1 =
sYtp+ (1 − δ )Kt and divide both sides by Nt :
Kt+1 Yp
Nt = s Ntt + (1 − δ ) Kt
Nt .

Use the fact that Nt = Nt+1 and define ytp and kt as per capita or per hours worked
variables to get:
kt+1 = sytp + (1 − δ )kt
The intensive form version of equation Ytp = Yt − Gt is ytp = yt − gt . Use this and the
fact that gt = sG yt to get:
kt+1 = s(1 − sG )yt + (1 − δ )kt
Finally substitute for the production function in intensive form to get:
kt+1 = s(1 − sG )Aktα + (1 − δ )kt = Φ(kt ), which is the central equation of Solow Model
in this case.
(b) Figure 3 below illustrates how a permanent increase in sG affects the steady state
capital to stock worker by plotting the Φ function for this case.
The capital accumulation curve or the Φ curve shifts down and the economy converges
to a lower steady-state stock of capital per worker.
In terms of dynamics, when sG increases, capital per worker starts to decrease (but does
not jump) in the period after the shock (it is a predetermined variable) and continues to
decrease until converging to the lower steady state. The dynamics are illustrated in Figure
4 below.

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Figure 3

Figure 4

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 Question 4B: 3 Marks (GLS (2020))
Suppose we have a standard Solow Model as in lectures/textbook and the central equation
of Solow Model in intensive form, involving kt+1 (capital per worker) is:
kt+1 = sAktα + (1 − δ )kt .
Consumption per worker is given by:
ct = (1 − s)Aktα
(a) Solve for the steady state capital stock per worker i.e k ∗ . In doing so, assume At =
A, ∀t.
(b) Use your expression for k ∗ to solve for steady state consumption per worker i.e c∗ .
(c) Use calculus to derive an expression for the value of s which maximizes steady state
consumption per worker c∗ .
Solution
(a) I provided a derivation for this in the Quiz 3 solution. The expression is:
  1
k∗ = sA
δ
1−α
.
(b)
!α
1 1
  1  
c∗ = (1 − s)A sA
δ
1−α
= (1 − s)A 1−α s
δ
1−α
.

(c) Take the derivative of c∗ with respect to s and set the expression equal to 0 (I have
used product rule below) to derive:
1 1
1  
1−α 2α−1
s 1−α α A
−A 1−α δ + (1 − s) 1−α α s 1−α = 0
δ 1−α
Simplify the expression above to get:
α
s = (1 − s) 1−α =⇒ s(1 − α) = (1 − s)α =⇒ s∗ = α.
So, the value of s that maximizes long-run consumption per worker, s∗ equals α, which
is the elasticity of output with respect to capital in the production function or equivalently
the capital share of income with Cobb-Doughlas production process.

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 Question 5 (Consumption-Saving): 10 Marks (GLS (2020))
Consider a consumer with a lifetime utility function U = u(Ct ) + βu(Ct+1 ). The period
t and t + 1 budget constraints are:
Ct + St = Yt and
Ct+1 + St+1 = Yt+1 + (1 + r )St
(a) What is the optimal savings level St+1 ? Impose the optimal value and derive the
lifetime budget constraint.
(b) Derive the Euler equation. Explain the economic intuition behind this equation.
(c) Graphically depict the optimality condition. Carefully label the intercepts of the
budget constraint. What is the slope of the indifference curve at the optimal consumption
basket (Ct∗ , Ct∗+1 ).
(d) Graphically depict the effects of an increase in Yt+1 . Carefully label the intercepts
of the budget constraint. Is the slope of the indifference curve at the optimal consumption
basket (Ct∗ , Ct∗+1 ). different than in part (c)?
(e) Now suppose Ct is taxed at rate τt so consumers pay 1 + τt for one unit of period t
consumption. Redo parts a-c under these new assumptions.
Solution
(a)
People die at the end of period t + 1 so that they have no incentive to save in period t + 1
and hence St+1 ≤ 0 since St+1 cannot be positive. Secondly, we assume the no death in debt
condition which means that despite having an incentive to borrow when old and not repay
the loan, the household cannot do this and hence St+1 = 0 is the only possibility since St+1
cannot be negative either.
The two constraints are expressed as equality form in the question since any agent with
locally nonsatiable preferences will never waste resources.
First, substitute St+1 = 0 in the old budget constraint. Secondly, Since St is a common
variable across the two equations, we can eliminate it by solving for St from the old budget
constraint. This yields:
St = Ct1++1 −Y t+1
rt+1 , which when substituted in the first budget constraint gives us (the term
in blue replaces St in young budget constraint)
Ct+1 −Yt+1
Ct + 1 + rt + 1 = Yt
Simplifying the last equation above further yields:

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 Ct + 1 Yt + 1
Ct + 1 + rt+1 = Yt + 1+rt+1 , which is the lifetime household budget constraint or also called
the intertemporal budget constraint.
(b)
Ct + 1 Yt+1
max U (Ct , Ct+1 ) = u(Ct ) + βu(Ct+1 ) subject to Ct + 1 + rt + 1 = Yt + 1 + rt + 1 .
Ct ,Ct+1
I will solve the problem above using the Lagrangian; the book uses the substitution
method.
 
Yt + 1 Ct + 1
L = u(Ct ) + βu(Ct+1 ) + λ Yt + 1 + rt + 1 − Ct − 1 + rt + 1 .

The FOC’s are: LCt = u0 (Ct ) = λ, LCt+1 = βu0 (Ct+1 ) = λ

1 + rt + 1 .

Equating λ from the last two first order conditions, we get:

u0 (Ct ) = βu0 (Ct+1 )(1 + rt+1 ) which is the consumption Euler equation.
Interpretation: The Euler equation must be satisfied along an optimal, dynamic con-
sumption saving path over time. Along an optimal path, on the margin, all alternative uses
of additional resources should have the same marginal benefit. If some uses are better than
others, then we must not be on the optimal path to begin with since a better dynamic path
is possible by adjusting existing decisions.
For instance, if I give you one more unit of endowment, you can either consume it today,
which gives you marginal utility of u0 (Ct ) = Ct−σ , the left hand side of Euler equation.
Alternatively, you could save this one unit to get (1 + rt+1 ) tomorrow, which when ultimately
consumed gives u0 (Ct+1 ) = Ct−σ+1 , but this also has to be discounted by β, yielding the right
hand side. The Euler equation posits that LHS = RHS along an optimum, dynamic
consumption path.
(c) Figure 5 below shows the graphical depiction of the Euler equation derived in part (b).
The solution is at (Ct , Ct+1 ). That is where the budget line is tangent to the indifference
curve. That is, the marginal rate of substitution between t and t + 1 consumption equals the
slope of the budget line. The slope of the indifference curve is 1 + rt at the optimal point.

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 Figure 5

(d) Consumption increases in both periods unambiguously. The increase in Yt changes the
endowment point and only has an income effect (Figure 6). It does not have the substitution
effect from the change in relative price of consumption since the slope of constraint has not
changed. Therefore the slope of the indifference curve at the optimal consumption basket is
also the same.

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 Figure 6

(e)
The budget constraint is Ct (1 + τ ) + St = Yt when young with taxes. This is because price
of unit of consumption was 1 previously but with taxation, the price of unit of consumption
is 1 + τ . The constraint for old does not change. Therefore, the lifetime budget constraint
is:
Ct + 1
Ct ( 1 + τ ) + 1 + rt = Yt + 1Y+t+r1t .
The maximization problem can now be stated as the following. Note that this is the
unconstrained maximization problem where we have substituted for Ct+1 in terms of Ct
from the lifetime budget constraint:
max u(Ct ) + βu((1 + rt )(Yt − (1 + τ )Ct ) + Yt+1 )
Ct
The first order condition is:
u0 (Ct ) − β (1 + rt )(1 + τ )u0 ((1 + rt )(Yt − (1 + τ )Ct ) + Yt+1 ) = 0
Rearranging the above gives us the Euler equation:
u0 ( Ct
βu0 (Ct+1 )
= (1 + rt )(1 + τ )
Now the opportunity cost of one unit of t consumption is (1 + rt )(1 + τ ) of period t + 1
consumption rather than just 1 + rt , so taxation of period t consumption increases the
opportunity of period t consumption in terms of t + 1 consumption.

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 The graph below (Figure 7) depicts the optimality condition with taxes and also shows
the impact of change in tax level τ . An increase in τ pivots the budget constraint inwards.
The income effect is negative which acts to reduce consumption in both periods. A increase
in τ also raises the relative price of Ct consumption. This lowers consumption in t and
increases it in t + 1. On net, consumption in period t decreases unambiguously. The change
in period t + 1 consumption is ambiguous. The Figure 7 below shows the case when there
is no change in period t + 1 consumption but it could also rise or fall.

Figure 7

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