EC 450 Department of Economics

Advanced Macroeconomics Wilfrid Laurier University

Instructor: Sharif F. Khan Winter 2008

Suggested Solutions to Assignment 4 (REQUIRED)

Submisson Deadline and Location: March 27 in Class

Total Marks: 50

Part A Short Questions [10 marks]

Explain why the following statement is True, False, or Uncertain according to

economic principles. Use diagrams and / or numerical examples where appropriate.
Unsupported answers will receive no marks. It is the explanation that is important.
Each question is worth 10 marks.

A1. According to the growth theory, an increase in the investment rate in

physical capital in a closed economy does not have any impact on the long-
run growth rate of output per worker. [Diagrams required]

Uncertain

The answer depends on the growth theory we are considering. In the basic Solow model,
the general Solow model, the Solow Model with human capital and the semi-endogenous
growth model, an increase in the investment rate in physical capital in a closed economy
does not have any impact on the long-run growth rate of output per worker. However, in
the AK growth model, an increase in the investment rate in physical capital leads to a rise
in the long-run growth rate of output per worker.

In the general Solow model with exogenous technological progress, an increase in the
investment rate in physical capital ( i.e., the savings rate) will have no effect on the long-
run growth rate of output per worker, y t . It will cause a shift in the steady-state growth
path of y t from one level to a new and higher level, with the long-run growth rate being
the same before and after as the rate of exogenous technological progress, namely g.

See Figure 5.3, Figure 5.4, Figure 5.5, Figure 5.6, and pages 135 to 138 of the textbook
for a graphical explanation.

In the AK model, it can be shown that on the balanced growth path output per worker
and capital per worker grows at a common constant endogenous growth rate g e = sA − δ ,
where s is the investment rate in physical capital, A is a constant defined as L1−α , where
L is the fixed amount of labor in the economy, δ is the constant depreciation rate. An
increase in the investment rate in physical capital (s) will lead to an increase in sA − δ ,
which can be illustrated by leftward rotations in the (sA + 1 − δ )kt and sAkt curves,

Page 1 of 9 Pages
and a vertically upward shift in the sA curve in Figure 8.3 of the textbook. Figure 8.3
thus shows that an increase in the investment rate in physical capital will lead to a
permanently higher growth rates in capital per worker and GDP per worker.

The ‘growth brake’ from the Solow models and the semi-endogenous growth model,
diminishing return to capital, is simply no longer present in the aggregate production
function of the AK model. The source of growth in the AK model is thus aggregate
constant returns to the reproducible factor, capital. See pages230-233 of the textbook for
a detailed explanation.

Page 2 of 9 Pages
Part B Problem Solving Questions [40 marks]
Read each part of the question very carefully. Show all the steps of your calculations to
get full marks.

B1. [40 Marks]

Consider an economy with the following Cobb-Douglas aggregate production

function.

Yt = K tα ( At Lt )
1−α
, 0 < α < 1,

where Yt is aggregate output, K t is the stock of aggregate capital, Lt is total labor

and At is the effectiveness of labor at period t. Assume that Lt grows exogenously at
constant rates n. Capital depreciates at a constant rate δ .

The evolution of aggregate capital in the economy is given by

K t +1 − K t = sYt − δK t , 0 < s <1, 0 < δ < 1,

where s is a constant and exogenous saving rate.

Assume that the labour productivity variable, At , depends on aggregate output

because of learning-by-doing productive externalities which arise from workers
being involved in production. The following equation shows this external learning
by doing effect.
1
At = Ytφ , 0 <φ <
1−α
1. Show that the aggregate production function in this model is:

Yt = K tα [1−φ (1−α )]L(t1−α ) [1−φ (1−α )] .

1
Why have we assumed φ < ? Show that the aggregate production
1−α
function has increasing returns to (K t , Lt ) whenever φ > 0 . Show also that if
φ = 1 it has constant returns to K t alone. [5 marks]

2. Show that in this model:

αφ [1−φ (1−α )] [φ (1−α )] [1−φ (1−α )]

At +1 ⎛ K t +1 ⎞ ⎛ Lt +1 ⎞
= ⎜⎜ ⎟⎟ ⎜⎜ ⎟⎟ .
At ⎝ Kt ⎠ ⎝ Lt ⎠
[3 marks]

Page 3 of 9 Pages
 yt and kt be defined as usual: kt ≡ kt At ≡ K t ( At L t )
~ ~
Assume now that φ < 1 . Let ~
yt ≡ yt At ≡ Yt ( At Lt ) .
and ~

~
3. Show that the transition equation for kt is:
1

[ ]
1− φ
⎛ 1 ⎞1−ϕ (1−α ) ~ ~α −1
kt skt + (1 − δ ) (1−α )
~
kt +1 = ⎜ ⎟ 1 − φ
⎝1+ n ⎠
1− φ
1−φ (1−α )
1
⎛ 1 ⎞ 1−ϕ (1−α ) ⎡ ~ 1α−φ ~ 1−φ ⎤ 1−φ (1−α )
=⎜ ⎟ ⎢ skt + (1 − δ )kt ⎥
⎝1+ n ⎠ ⎢⎣ ⎥⎦

~
Find the steady state values for kt and ~
yt , and show that these are
meaningful whenever (1 + n ) > (1 − δ ) (which we assume). Show also that
1 (1−φ )

the transition equation implies convergence to steady state. [16 marks]

4. Find the expression for the growth rate, g se , of output per worker in steady
state. Comment with respect to what creates growth in output per worker in
this model (when φ < 1 ). [6 marks]

Now assume φ = 1 and n = 0 , so Lt is equal to some L for all t.

5. Show that the model can be condensed to the two equations:

1−α
Yt = AK t , A≡ Lα ,
K t +1 = sYt + (1 − δ )K t .

Find the growth rate, g e , of output per worker. Comment with respect to
what creates growth in output per worker in this model (when φ = 1 ).
[10 marks]

This question is same as Exercise 7 of Chapter 8 of the textbook.

Page 4 of 9 Pages
Endogenous Growth: Productive Externalities 16

Average annual growth rate of

GDP per worker, 1960-2000
0.070

0.060

0.050

0.040

0.030

0.020

0.010

0.000

-0.010

-0.020
0 0.05 0.1 0.15 0.2
½ ½
(sK) (sH)

Exercise 8.7. Semi-endogenous growth and endogenous growth if the pro-

ductive externality arises from Yt rather than from Kt
Note the typo in this exercise in the first print of the book. The transition equation in
Question 3 should read:
µ ¶ 1−φ(1−α)
1
³ ´ 1−φ(1−α)
1−φ
1
k̃t+1 = k̃t sk̃tα−1 + (1 − δ)
1+n
µ ¶ 1−φ(1−α)
1 µ α 1−φ(1−α)
¶ 1−φ(1−α)
1−φ
1 1−φ 1−φ
= sk̃t + (1 − δ) k̃t .
1+n
[α−φ(1−α)]/(1−φ)
That is, the k̃t on the left hand side should be replaced by k̃t+1 , and the sk̃t
α/(1−φ)
inside the parenthesis in the second line should be replaced by sk̃t .
1. The aggregate production function is found by inserting At = Ytφ into (6):
³ ´1−α
Yt = (Kt )α Ytφ Lt ⇔
Endogenous Growth: Productive Externalities 17

1−φ(1−α)
Yt = Ktα L1−α
t ⇔
α 1−α

Yt = Kt1−φ(1−α) Lt1−φ(1−α) .

Assuming that φ < 1/ (1 − α) ensures that the exponents on Kt and Lt are positive.
α 1−α
The sum of the exponents in the aggregate production function is: 1−φ(1−α)
+ 1−φ(1−α)
=
1
1−φ(1−α)
> 1, so this function exhibits increasing returns to Kt and Lt . When φ = 1 the
production function reduces to
1−α
Yt = Kt Lt α ,

which has constant returns to Kt alone.

2. From At = Ytφ and the aggregate production function one gets:
φ µ ¶ αφ µ ¶ φ(1−α)
At+1 Yt+1 Kt+1 1−φ(1−α) Lt+1 1−φ(1−α)
= φ = .
At Yt Kt Lt
3. Parallel to the chapter’s analysis of the model of semi-endogenous growth (Section
2) one derives:
Kt+1 Kt+1
k̃t+1 Kt Kt
= At+1 Lt+1
=³ ´ 1−φ(1−α)
αφ ³ ´ 1−φ(1−α)
φ(1−α)
k̃t At Lt Kt+1 Lt+1 Lt+1
Kt Lt Lt
³ ´1− 1−φ(1−α)
αφ ³ ´ 1−φ(1−α)
1−φ
Kt+1 Kt+1
Kt Kt
= ³ ´ 1−φ(1−α)
φ(1−α)
= ³ ´ 1−φ(1−α)
1
+1 Lt+1
Lt+1
Lt Lt
µ ¶ 1−φ(1−α)
1 µ ¶ 1−φ(1−α)
1−φ
1 Kt+1
= .
1+n Kt
Now using the capital accumulation equation gives:
µ ¶ 1−φ(1−α)
1 µ ¶ 1−φ
k̃t+1 1 sYt + (1 − δ) Kt 1−φ(1−α)
=
k̃t 1+n Kt
µ ¶ 1−φ(1−α)
1 ∙ ¸ 1−φ(1−α)
1−φ
1 sỹt
= + (1 − δ) .
1+n k̃t
Inserting ỹt = k̃tα , which follows from the production function, gives:
µ ¶ 1−φ(1−α)
1
h i 1−φ(1−α)
1−φ
k̃t+1 1 α−1
= sk̃t + (1 − δ) ⇔
k̃t 1+n
Endogenous Growth: Productive Externalities 18

µ ¶ 1−φ(1−α)
1
h i 1−φ(1−α)
1−φ
1
k̃t+1 = k̃t sk̃tα−1 + (1 − δ)
1+n
µ ¶ 1−φ(1−α)
1 µ α 1−φ(1−α)
¶ 1−φ(1−α)
1−φ
1 1−φ 1−φ
= sk̃t + (1 − δ) k̃t .
1+n

The last formula gives two alternative expressions for the transition curve.
By definition, in steady state k̃t+1 = k̃t = k̃ ∗ . Insert this in the transition equation
(first expression) to find the steady state value of k̃t :
µ ¶ 1−φ(1−α)
1 µ ³ ´ ¶ 1−φ(1−α)
1−φ
1 ∗
α−1
1= s k̃ + (1 − δ) ⇔
1+n
µ ³ ´ ¶ 1−φ(1−α)
1−φ
1 α−1
∗
(1 + n) 1−φ(1−α) = s k̃ + (1 − δ) ⇔

1
³ ´α−1
(1 + n) 1−φ = s k̃∗ + (1 − δ) ⇔
à ! 1−α
1

s
k̃∗ = 1 .
(1 + n) 1−φ − (1 − δ)
Using ỹt = k̃tα gives the steady state value of ỹt :
à ! 1−α
α
³ ´α s
ỹ ∗ = k̃∗ = 1 .
(1 + n) 1−φ − (1 − δ)
1
Under the stated condition, (1 + n) 1−φ > (1 − δ), the denominators above are positive and
the expressions for k̃ ∗ and ỹ ∗ are meaningful.
It has thus been established that the transition equation has a unique strictly positive
intersection with the 45◦ -line. Furthermore, the transition curve passes through (0, 0) and
is everywhere strictly increasing, as can be verified directly from inspection of the second
formula for the transition curve (note that φ < 1 implies that all the exponents are posi-
tive). If the slope of the transition curve at the intersection with the 45◦ -line is smaller than
one, convergence to steady state follows from ’stair case iteration’ in the usual transition
diagram. We compute the derivative (using the first of the expressions for the transition
curve:
Endogenous Growth: Productive Externalities 19

µ ¶ 1−φ(1−α)
1
dk̃t+1 1
= ·
dk̃t 1+n
∙h i 1−φ(1−α) ¸
(1 − φ) (α − 1) h α−1 i 1−φ(1−α)
1−φ 1−φ
−1
α−1 α−1
sk̃t + (1 − δ) + sk̃t + (1 − δ) sk̃t
1 − φ (1 − α)
µ ¶ 1−φ(1−α)
1
h i 1−φ(1−α)
1−φ ∙ ¸
1 α−1
−1
α−1 (1 − φ) (1 − α) α−1
= · sk̃t + (1 − δ) sk̃t + (1 − δ) − sk̃ .
1+n 1 − φ (1 − α) t
Inserting here our expression for k̃∗ in place of k̃t gives the slope at k̃ ∗ :
¯
dk̃t+1 ¯¯
¯ =
dk̃t ¯k̃ =k̃∗
t

µ ¶ 1−φ(1−α)
1
h i 1−φ(1−α)
1−φ ∙ ³ ´¸
1 1 −1 1 (1 − φ) (1 − α) 1
· (1 + n) 1−φ (1 + n) 1−φ − (1 + n) 1−φ − (1 − δ)
1+n 1 − φ (1 − α)
µ ¶ 1−φ(1−α)
1 µ ¶ 1−φ
1 αφ
· 1−φ(1−α) µ ¶− 1−φ
1
1 1 1
= · · ·
1+n 1+n 1+n
" Ã !#
(1 − φ) (1 − α) 1−δ
1− 1− 1
1 − φ (1 − α) (1 + n) 1−φ
à !
(1 − φ) (1 − α) 1−δ
=1− 1− 1 .
1 − φ (1 − α) (1 + n) 1−φ
1
This is positive and smaller than one since: (1 + n) 1−φ > (1 − δ) implies that the parenthe-
sis is positive and smaller than one. The factor in front of the parenthesis is itself positive
and smaller than one, so the product is positive and smaller than one. One minus the
product must then also be positive and smaller than one.
4. Since ỹt ≡ yt /At is constant in steady state, yt must grow at the same rate as At ,
that is, yt+1 /yt = At+1 /At . From At = Ytφ :
µ ¶φ µ ¶φ
At+1 Yt+1 yt+1
= = (1 + n)φ .
At Yt yt

Inserting At+1 /At = yt+1 /yt (which holds in steady state) and rearranging gives:
µ ¶φ
yt+1 yt+1 yt+1 φ
= (1 + n)φ ⇐⇒ = (1 + n) 1−φ ⇔
yt yt yt
Endogenous Growth: Productive Externalities 20

yt+1 − yt φ
= (1 + n) 1−φ − 1.
yt
When φ < 1 the exponent on 1 + n is positive. Hence a larger population growth rate gives
a higher growth rate of output per worker in steady state.
5. At the end of Question 1 we found that:

1−α
Yt = Kt Lt α ,

in case of φ = 1. Setting n = 0 removes the time subscript on Lt . Define A ≡ (L)(1−α)/α .

Then:
Yt = AKt .

Since there is no population growth and the productive externality is already embedded
in the aggregate production function, the equation above and the capital accumulation
equation (8),
Kt+1 = sYt + (1 − δ)Kt ,

make up the entire model. Inserting Yt = AKt into the capital accumulation equation and
rearranging gives the growth rate of capital:

Kt+1 − Kt
Kt+1 = sAKt + (1 − δ) Kt ⇔ = sA − δ,
Kt

which, since Yt = AKt and there is a constant labour force, is also the growth rate of Yt ,
kt , and yt . We have, of course, found the same growth rate as in the chapter’s ’AK-model’,
only with a slight difference in the definition of A. All features with respect to policy
implications, scale effects etc. therefore bear over from the chapter’s model to the one
considered here.

Exercise 8.8. Taxation and productive government spending: endogenous

growth without productive externalities