Problem Set 1: Solow Model

– with answers –

Problem 1 – Concepts
1. Discuss the meaning and empirical relevance of the following three terms
(a) Income convergence
Answer: The proposition that countries will converge to the same level
of output. Convergence is only observed for some countries and in some
periods; in general there seems to be substantial barriers to unconditional
convergence.
(b) Balanced growth
Answer: Defining
i. Production: Y
ii. Capital: K
iii. Labor: L
iv. Total wage income: W
Balanced growth is the proposition that
i. K/L and Y /L grow at the same constant rate
ii. K/Y is constant
iii. W/Y is constant
(c) Kaldor’s stylized facts
Answer: The empirical observation that growth is typically balanced.
2. Discuss the difference between steady state and balanced growth path in the Solow
model
Answer: A steady state is defined as a state rest, where the relevant normalized
variables are constant over time. If a steady state implies that the non-normalized
variables grow in accordance with balanced growth it is a balanced growth path.
The Solow model has a steady state which is also a balanced growth path.
3. Discuss the relationship between the golden rule and dynamic efficiency in the
Solow-model
Answer: The golden rule level of capital is defined as the one maximizing the
steady state consumption level. If capital is less than or equal to the golden
rule level the economy is dynamically efficient; if consumption is increased today,
decreasing consumption tomorrow is necessary. If capital is above the golden rule
level the economy is dynamically inefficient; consumption can be increased both
today and tomorrow.

1
Problem 2 – Solow model
1. Show that
ż(t) ẏ(t) ẋ(t)
z(t) = y(t)x(t) ⇒ = +
z(t) y(t) x(t)
y(t) ż(t) ẏ(t) ẋ(t)
z(t) = ⇒ = −
x(t) z(t) y(t) x(t)
Answer: From z(t) = y(t)x(t)
log z(t) = log y(t) + log x(t) ⇒
∂ log z(t) ∂ log y(t) ∂ log x(t)
= + ⇒
∂t ∂t ∂t
ż(t) ẏ(t) ẋ(t)
= +
z(t) y(t) x(t)
y(t)
For z(t) = x(t)

log z(t) = log y(t) + log x(t) ⇒

∂ log z(t) ∂ log y(t) ∂ log x(t)
= + ⇒
∂t ∂t ∂t
ż(t) ẏ(t) ẋ(t)
= +
z(t) y(t) x(t)

Extra I:
ż(t)
= g ⇔ z(t) = z(0)egt
z(t)
because
log z(t) = log(z0) + gt ⇔
∂ log z(t) ∂ log(z0) ∂gt
= + ⇔
∂t ∂t ∂t
ż(t)
=g
z(t)
Extra II: Defining
Z(t)
z(t) ≡
X(t)
X(t) ≡ X(0)ent

we have
Ż(t) = rZ(t) ⇔ ż(t) = (r − n)z(t)

2
 because
Z(t)
z(t) =
X(t)
Z(0)ert
=
X(0)ent
= z(0)e(r−n)t ⇔
ż(t)
= (r − n)
z(t)

1. Show that if a production function, F (K, L), have constant returns to scale then
1
F (K, L) = f (k)
L
FK (K, L) = f 0 (k)
FL (K, L) = f (k) − kf 0 (k)
F (K, L) = K · f 0 (k) + L · (f (k) − kf 0 (k))

K
where k ≡ L
and f (k) ≡ F (k, 1)
Hint: For the fourth equality use Euler’s homogeneous function theorem
Answer:
1 K
F (K, L) = F ( , 1) = f (k)
L L
∂F (K, 1) ∂Lf (k) 1
FK (K, L) = = = Lf 0 (k) = f 0 (k)
∂K ∂K L
∂F (K, 1) ∂Lf (k) −1
FL (K, L) = = = f (k) + Lf 0 (k)K 2 = f (k) − kf 0 (k)
∂L ∂L L
Euler’s homogeneous function theorem implies that for a function which is homo-
geneous of degree one (CRS) we have

∂F (K, L) ∂F (K, L)
F (K, L) = K+ L
∂K ∂L
= Kf 0 (k) + L(f (k) − kf 0 (k))

2. Suppose

Y (t) = F (K(t), A(t)L(t))

C(t) = (1 − s)Y (t)
K̇(t) = Y (t) − C(t) − δK(t)

3
where F is neoclassical and assume that
Ȧ(t)
= g
A(t)
L̇(t)
= n
L(t)

(a) Show that

k̇(t) = f (k(t)) − c(t) − (n + δ + g)k(t)
where
K(t)
k(t) ≡
A(t)L(t)
C(t)
c(t) ≡
A(t)L(t)
f (k(t)) ≡ F (k(t), 1)

Answer: Define H(t) = A(t)L(t) then

∂k(t) ∂( K(t)
H(t)
)
k̇(t) = =
∂t ∂t
K̇(t)H(t) − K(t)Ḣ(t)
=
H(t)2
K̇(t) K(t) Ḣ(t)
= −
H(t) H(t) H(t)
F (K(t), H(t)) − C(t) − δK(t)
= − k(t)(n + g)
H(t)
K(t)
= F( , 1) − c(t) − (n + δ + g)k(t)
H(t)
= f (k(t)) − c(t) − (n + δ + g)k(t)

(b) What must the growth rate of Y (t), C(t) and K(t) be on a balanced growth
path?
Answer: Constant capital-output ratio implies k(t) should be constant be-
cause
K(t) K(t) k(t)
= =
Y (t) F (K(t), A(t)L(t)) f (k(t))
Then K(t) = k(t)A(t)L(t) will grow with n + g and so must the Y (t) and
C(t).

4
(c) Assume the production function is Cobb-Douglas. What is the steady state
value of k(t)?
Answer: Cobb-Douglas implies

F (K(t), A(t)L(t)) = K(t)α (A(t)L(t))1−α ⇒ f (k(t)) = k(t)α

In steady state we must have

k̇(t) = 0 ⇔
(1 − s)f (k ) − (n + δ + g)k ∗ = 0 ⇔
∗

(1 − s)k ∗α − (n + δ + g)k ∗ = 0 ⇔
! 1

∗ n+δ+g α−1
k =
1−s

(d) Assume we start from steady state. Show what happens to k(t) if respectively
i. L(t) suddenly drops discretely (epidemic disease)
Answer: k(t) increase and then convergence back to steady state.
ii. K(t) suddenly drops discretely (natural disaster)
Answer: k(t) decrease and then convergence back to steady state.
(e) Consider a representative firm choosing capital and labor subject to the
following profit function

Π(K(t), A(t)L(t)) = F (K(t), A(t)L(t)) − r(t)K(t) − δK(t) − w(t)L(t)

where r(t) is the rental rate of capital, and w(t) is the wage rate of labor.
Show that under perfect competition

r(t) = f 0 (k(t)) − δ
w(t) = f (k) − kf 0 (k)

Answer: Using the results from question 1 we have

∂Π
= 0 ⇔ FK − r(t) − δ = 0 ⇔ r(t) = f 0 (k(t)) − δ
∂K
∂Π
= 0 ⇔ FL − w(t) = 0 ⇔ r(t) = f (k) − kf 0 (k)
∂L
(f) Repeat exercise (d), but now also show what happens to w(t) and r(t).
Answer: The two main points are
i. r(t) is a decreasing function of k(t): more capital relative to labor, lower
price, lower interest rate. Formally
∂r(t)
= f 00 (k(t)) < 0
∂k(t)

5
 ii. w(t) is an increasing function of k(t): less capital relative to labor, lower
wage. Formally
∂w(t)
= f 0 (k(t)) − f 0 (k(t)) − k(t)f 00 (k(t)) = −k(t)f 00 (k(t)) > 0
∂k(t)

Problem 3 – Utility Functions

1. Consider the following utility function
c1−σ
u(c) = , σ > 0, σ 6= 1
1−σ

Calculate the elasticity of marginal utility

u00 (c)c
ε≡−
u0 (c)

Give a graphical interpretation of ε.

Answer:
u00 (c)c −σc−σ−1 c
− 0 =− =σ
u (c) c−σ
σ is a measure of the curvature of the utility function.

2. Calculate the elasticity of marginal utility for the utility function

u(c) = ln(c)

Answer:
u00 (c)c − c12 c
− = − 1 =1
u0 (c) c

3. Calculate
c1−σ − 1
lim
σ→1 1 − σ

Answer: Define

f (σ) = c1−σ − 1 ⇒ f 0 (σ) = cc−σ log c(−1) = −c1−σ log c

g(σ) = 1 − σ ⇒ g 0 (σ) = −1

by L’Hôpital’s rule
c1−σ − 1 f 0 (σ) − log c
lim = lim 0 = = log c
σ→1 1 − σ σ→1 g (σ) −1

6
Problem 4 – Production functions (if time permits)
1. Consider the production function
1
F (K(t), A(t)L(t)) = (αK(t)σ + β(A(t)L(t))σ ) σ
where
Ȧ(t)
= g
A(t)
L̇(t)
= n
L(t)
For which α and β is F a neoclassical production function?
Answer: β = 1 − α, otherwise there is not constant returns to scale.
2. Define k(t) and f (k(t)) by
K(t)
k(t) ≡
A(t)L(t)
f (k(t)) ≡ F (k(t), 1)

Derive the formula for f (k(t)).

Answer:
!σ !σ
1 K(t) A(t)L(t) 1
F (K(t), A(t)L(t)) = (α + (1 − α) )σ
A(t)L(t) A(t)L(t) A(t)L(t)
1
= (αk(t)σ + (1 − α)) σ

3. Assume
Y (t) = F (K(t), A(t)L(t))
C(t) = (1 − s)Y (t)
K̇(t) = Y (t) − C(t) − δK(t)
Solve the following problem
k ? = arg max f (k) − (n + g + δ)k
k

What is the interpretation of k ? ?

Answer: k ? is the golden rule level of capital maximizing steady state consump-
tion. It is implicitly given by the following equation
f 0 (k) = n + g + δ ⇔
1 1
(αk(t)σ + β) σ −1 σαk(t)σ−1 = n + g + δ ⇔
σ
1 n+g+δ
(αk(t)σ + β) σ −1 αk(t)σ−1 =
α

7
4. Find the following limits when F is a neoclassical production function

lim log(f (k(t)))

σ→0
lim f (k(t))
σ→0
lim F (K(t), A(t)L(t))
σ→0

Answer: Use L’Hôpital’s rule

log(αk(t)σ + (1 − α))
lim log(f (k(t))) = lim
σ→0 σ→0 σ
αk(t)σ log k(t)

αk(t)σ +1−α
= lim = α log k(t) = log k(t)α
σ→0 1

and
lim f (k(t)) = exp(log k(t)α ) = k(t)α
σ→0

and

lim F (K(t), A(t)L(t)) = A(t)L(t) lim f (k(t))

σ→0 σ→0
= A(t)L(t)k(t)α
!α
K(t)
= A(t)L(t)
A(t)L(t)
α
= K(t) (A(t)L(t))1−α

For σ → 0 we CES thus converges to Cobb-Douglas.