Problem Set 3 – Some Answers

FE312 Fall 2010

Rahman

1 1
   
1) Assume once again that production is given by: Y  K L . First, write the
2 2

production function in per person terms (y=f(k)). Next, assume that the per person level
of capital in the steady state is 4, the depreciation rate is 5% per year, and population
growth is 5% per year. Does this economy have “too much” or “too little” capital? How
do you know? [Show your work].

Recall that when the economy is at the golden rule steady-state, MPK *   .  n
Given that f (k )  k 1 / 2 , this means that (1 / 2) * k G .R. *1 / 2    n. Using the
numbers given to us above, our solution gives us k G .R. *  25 . Given that our
steady state capital stock is at 4, it means that we have WAY too little capital (at
least compared with the golden rule level).

2) Suppose that two countries are exactly alike in every respect (meaning they have the
same levels of capital, output, depreciation, etc.) except that the citizens of country A
have a higher saving rate than the citizens of country B.

a. Which country will have the higher level of output per worker in the steady state?
Illustrate graphically.

b. Which country will have the faster rate of growth of output per worker?

output

depreciation line
investment
yA= yB (country A)

investment
(country B)

kA= kB capital per worker

While each country starts with the same amount of capital per worker (and
therefore starts with the same output per worker), we can see that country A has the

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 Problem Set 3 – Some Answers
FE312 Fall 2010
Rahman
higher steady state. Notice also that at this initial position, k A  k B . Therefore
country A will grow faster as well.

3) Suppose that two countries are exactly alike in every respect (meaning they have the
same levels of capital, output, depreciation, etc.) except that population grows at a faster
rate in country A than in country B.

a. Which country will have the higher level of output per worker in the steady state?
Illustrate graphically.

b. Which country will have the faster rate of growth of output per worker?

output

depreciation line
(country A)
depreciation line
yA= yB
(country B)
investment

kA= kB capital per worker

While each country starts with the same amount of capital per worker (and
therefore starts with the same output per worker), we can see that country B has the
higher steady state. Notice also that at this initial position, k B  k A . Therefore
country B will grow faster as well.

4) The initial steady-state level of capital per worker in Macroland is 5. The Golden
Rule level of capital per worker in Macroland is 8.

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 Problem Set 3 – Some Answers
FE312 Fall 2010
Rahman

a. What must change in Macroland to achieve the Golden Rule steady state?

Macroland clearly needs more capital per person. It can get this by increasing its
rate of savings.

b. Why might the Golden Rule steady state be preferred to the initial steady state? (two
or three sentences)

Golden rule means that long run consumption is maximized. Since conceivably
we care not only about our consumption, but also the consumption of our
children, their children, and so on, that seems like a good thing.

c. Why might some current workers in Macroland prefer the initial steady state to the
Golden Rule steady state? (two or three sentences)

In order to get to the golden rule, we will have to cut our consumption levels
NOW. Some workers might view the short-run costs as bigger than the long-run
gains, and therefore opt not to increase savings.

By the way, another approach to get closer to the golden rule would be to lower
population growth (provided n > 0). To the extent that society can effectively influence
rates of growth in population, what are the costs and benefits of doing so? Think about
it.

5) Two countries, Richland and Poorland, are described by the Solow growth model.
They have the same Cobb-Douglas production function, Y  AK  L1 , but with different
quantities of capital and labor. Richland saves 32 percent of its income, while Poorland
saves 10 percent. Richland has population growth of 1 percent per year, while Poorland
has population growth of 3 percent. (Note: the numbers are chosen to be approximately
realistic descriptions of rich and poor nations.) Both nations have technological progress
at a rate of 2 percent per year and depreciation at a rate of 5 percent per year.

a. What is the per worker production function f(k)?

The per worker production function is

AK  L1 / L  Ak 

b. Solve for the ratio of Richland’s steady-state income per worker to Poorland’s.
(Hint: The parameter α will play a role in your answer.)

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 Problem Set 3 – Some Answers
FE312 Fall 2010
Rahman

In the steady state, k  sf (k )  (  n  g )k  0 . Hence, sAk  (  n  g )k , or
after rearranging:
1
 sA  1
k*   
  n  g 

Plugging into the per-worker production function from part (a) gives:

  1
1
s
y*  A 1
  n  g 
 

Thus the ratio of steady-state income per worker in Richland to Poorland is:


 s Richland   1
 
y * Richland     n Richland  g   
  4 1
y * Poorland  s Poorland 
   n 
 Poorland  g  

c. If the Cobb-Douglas parameter α takes the conventional value of about 1/3, how
much higher should income per worker be in Richland compared to Poorland?

If alpha equals 1/3, then Richland should be 41/2, or two times richer than Poorland.

d. Income per worker in Richland is actually 16 times income per worker in

Poorland. Can you explain this fact by changing the value of the parameter α? What
must it be? Can you think of anyway of justifying such a value for this parameter?
How else might you explain the large difference in income between Richland and
Poorland?


  
If 4 1  16 , then it must be the case that    2 , which in turn requires that
1  
alpha equals 2/3. Hence, if the Cobb-Douglas production function puts 2/3 of the
weight on capital and only 1/3 on labor, then we can explain a 16-fold difference in
levels of income per worker. One way to justify this might be to think about capital
more broadly to include human capital – which must also be accumulated through
investment much in the way one accumulates physical capital.

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