Macroeconomics III (Exercises)

UAB
2 A. In…nite Horizon Models: the Solow Model
ANSWERS

1. The Solow model without technological progress.

(a) Write down the assumptions of this version of the Solow model and obtain the
fundamental equation that characterizes the evolution of capital per worker
See the class notes:
1
kt+1 = [sf (kt ) + (1 )kt ]
1+n
(b) Assume that the economy is at a steady state. Draw in separate charts (with time on
the horizontal axis):
(i) the evolution of output per worker;

y = f (k )

(ii) the evolution of aggregate output;

Yt = Lt yt = (1 + n)t L0 yt =) Yt = y (1 + n)t L0
(iii) the evolution of the growth rate of aggregate output;

Yt = y (1 + n)t L0 =) gY;t = n for all t

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 (iv) the evolution of the growth rate of output per worker;

yt = y =) gy;t = 0; for all t:

(v) the evolution of the logarithm of aggregate output.

ln Yt = ln y + ln L0 + t ln(1 + n)
| {z } | {z }
ln(y L0 ) n

(c) Show that at the steady state the gross investment per capita I=L satis…es the following:

I K
= (n + ) :
L L

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 Y K
In a steady state, sf (k ) = (n + )k =)s = (n + )
L L
I K
Since sY = S = I, then = (n + ) .
L L
(d) Obtain analytically the e¤ect of a change in s, n and on the steady-state level of
capital per worker.
At a steady state
sf (k ) (n + )k H (k ; s; n; ) = 0

Applying the implicit function theorem,

@k Hs f (k )
= =
@s Hk sf 0 (k ) (n + )

f (k ) f (k )
= sf (k )
= >0
sf 0 (k ) 0 f (k )
k s f (k )
k
| {z }

Note that FL (K; L) = f (k) kf 0 (k) > 0

f (k) f (k)
=) f 0 (k) > 0 =) f 0 (k) <0
k k

@k Hn k
= = <0
@n Hk 0 f (k )
s f (k )
k
| {z }

@k H k
= = <0
@ Hk 0 f (k )
s f (k )
k
| {z }

(e) Find the value of capital per unit of output in the long run.
The capital-labor ratio in the long run satis…es

sf (k ) = (n + )k =) sy = (n + )k

K K=L k s
=) = = =
Y Y =L y n+
(f) Analyze graphically the evolution (transitional dynamics) of capital per worker when
k0 < k .

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(g) Draw the evolution (with time on the horizontal axis) of capital per worker in the
situation described in (f).

(h) Analyze graphically the e¤ects of an increase in s, n and on the steady-state level of
capital per worker.

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(i) Draw the evolution (with time on the horizontal axis) of capital per worker and output
per worker following an increase in s; n and .
Increase in s :

Increase in n or :

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2. The Cobb-Douglas production function.

(a) Write the fundamental equation of the Solow model without technical progress with this
function.

1
kt+1 = [sAkt + (1 )kt ]
1+n
(b) Calculate the steady-state values of k, y and c and analyze how they are a¤ected by
changes in A; s; n and . Calculate the elasticity of the steady-state output per capita
with respect to A; s, n and .
See the class notes:

1=1
sA 1 s 1
k = ; y = A1
n+ n+

1 s 1
c = (1 s)A 1
n+

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 8 8 8
>
< k " >
< k " >
< k #
A " =) y " s " =) y " n or " =) y #
>
: >
: >
:
c " c ? c #

The e¤ect of s on c is ambiguous. In fact, it can be proved that c increases with s if

> s, whereas c decreases with with s if < s: Check it!
1
ln y = ln A + ln s ln(n + )
1 1 1
s @y A @y 1
=) = > 0, = >0
y @s 1 y @A 1
@y @y @(n + ) @y @y @y
= = . Similarly, =
@n @(n + ) @n @(n + ) @ @(n + )
n+ @y @ ln y
= =
y @(n + ) @ ln(n + ) 1
n+ @y n + @y n @y n
= = =) = <0
y @(n + ) y @n 1 y @n (1 )(n + )
@y
Similarly = < 0.
y @ (1 )(n + )
(c) Derive the capital per worker ( kgr ) and the saving rate ( sgr ) that maximize steady-state
consumption per worker. In other words, …nd the golden rule values of both capital per
worker and saving rate.
See the class notes:
sgr =

1
A 1
kgr = :
n+

3. The Solow growth model: the growth rate of capital per worker.

(a) Suppose you have a production function of the form Y = F (K; L), with constant returns
to scale and an accumulation equation of the form: Kt+1 = sF (Kt ; Lt ) + (1 )Kt with
population growing at a constant rate n. Using these elements, obtain the equation
expressing the growth rate of capital per worker. Which are the other assumptions
that characterize the neoclassical production function? Are they necessary to obtain the
equation for the growth rate of capital per worker?
See the class notes:
1 sf (kt )
gk;t+1 = (n + )
1+n kt

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 We have used the assumption of constant returns to scale (CRS).
( )
1) FK > 0; FL > 0; FKK < 0; FLL < 0
The other assumptions: are not necessary
2) Inada conditions
to obtain the previous equation.
Assume from now on that the production function is Cobb-Douglas.
(b) Write the equation driving the evolution of the growth rate gk;t+1 of capital per capita.

1 sf (kt ) 1 1
gk;t+1 = (n + ) = sAkt (n + )
1+n kt 1+n
(c) Obtain and draw f (k)=k as a function of k.

f (k) 1 A
= Ak = :
k k1

(d) Draw the growth rate gk;t+1 of capital per worker as a function of kt .

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(e) Find the value k of capital per capita at the steady state
See the class notes:
1=1
sA
k =
n+
(f) Analyze the transition of the rate of growth of capital per capita if k0 is lower than k
and draw its evolution (with time on the horizontal axis)

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4. The Solow growth model with exogenous technological progress.

(a) Obtain the fundamental equation characterizing the evolution of capital per unit of labor
e¢ ciency in the Solow growth model with technical progress and, then, obtain its growth
rate and represent it graphically.
See the class notes:

1 h i
k~t+1 = sf k~t + (1 )k~t
(1 + n)(1 + )
2 3
sf ~t
k
1 4
gk;t+1
~ = (n + + (1 + n))5
(1 + n)(1 + ) k~t

(b) Consider the steady state in the Solow model with exogenous technological progress.
Draw in separate charts (with time on the horizontal axis):

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 (i) the evolution of output per capita;
yt = y~ Et = y~ (1 + )t ; where y~ = f k~

(ii) the evolution of the logarithm of output per capita;

ln yt = ln y~ + t ln(1 + )
| {z }

(iii) the evolution of the growth rate of aggregate output;

y Et Lt = y~ (1 + )t (1 + n)t L0
Yt =^
y [(n + )(1 + n)]t L0
=~

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 =)1 + gY;t+1 = (1 + )(1 + n); for all t:

gY;t+1 = (1 + )(1 + n) 1 +n

(iv) the evolution of the growth rate of output per capita;

yt = y~ Et = y~ (1 + )t =) gy;t+1 = for all t:

(v) the evolution of the growth rate of output per unit of labor e¢ ciency.

y~t = y =) gy~;t+1 = 0; for all t:

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(c) Calculate the long-run value of capital per unit of output. Then, compute its value when
n = = 0.

K k~ s
= =
Y y~ n + + (1 + n)

since sy = sf (k ) = (n + + (1 + n))k~ :
If n = = 0; then
K s
=
Y
(d) Obtain analytically the e¤ect of a change in the growth rate of technical progress on the
steady-state value of capital per unit of labor e¢ ciency.

sf k~ ([n + + (1 + n)] k~ H k~ ; s; n; ; =0

Then,

@e
k H (1 + n)e
k
= =
@ Hek sf 0 k~ (n + + (1 + n))
(1 + n)k~ (1 + n)k~
= ~)
= 2 3 <0
sf (k
sf 0
k~ e
k 6 0 f e
k 7
s6
4f k
~ 7
5
e
k
| {z }

(e) Analyze graphically the e¤ect on capital per unit of labor e¢ ciency of an increase in the
growth rate of technical progress starting from a situation of steady state.

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(f) Draw (with time on the horizontal axis) the evolution of capital per unit of labor
e¢ ciency and the rate of growth of income per worker in the above situation.

gy;t+1 =

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5. The absolute and conditional convergence hypotheses.

(a) State the absolute convergence hypothesis and discuss whether this hypothesis holds or
not in the Solow model.
The absolute convergence hypothesis claims that a rich country grows more slowly
than a poor one. The problem is that countries might di¤er in their fundamentals in
addition to their initial GDPs. Therefore, in the Solow model, the absolute convergence
hypothesis does not need to hold.
Example: The rich country has a higher saving rate than the poor country, srich > spoor ;

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 poor
rich
We see that gk;t+1 > gk;t+1 even if ktpoor < ktrich .
(b) State the conditional convergence hypothesis and discuss whether this hypothesis holds or
not in the Solow model. Analyze graphically the evolution of the growth rates of capital
per capita of two countries: an initially rich country and an initially poor country. Draw
the evolution (with time on the horizontal axis) of the growth rates of capital per worker
of these two countries.
The conditional convergence hypothesis tells us that, if two countries have the same
technology and the same parameters values s; n and , the richer country grows more
slowly than the poor country.

poor rich
Clearly, gk;t+1 > gk;t+1 :

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6. The market version economy of the Solow model.

(a) Derive the …rst-order conditions for the problem of pro…t maximization by a …rm using
a production function in intensive form. What happens to capital per worker following
an increase in the interest rate? And in wages? Calculate the equilibrium wage with a
Cobb-Douglas production function.
See the class notes:

FK (K; L) = f 0 (k) = r^ = r + =) r " =) f 0 (k) " =) k #

FL (k; L) = f (k) kf 0 (k) = w

H(k; w) f (k) kf 0 (k) w=0

dk Hw 1 1
= = = >0
dw Hk f 0 (k) f 0 (k) kf 00 (k) kf 00 (k)

w = f (k) kf 0 (k) = A(1 )k

(b) Obtain the fundamental equation determining the evolution of capital per worker in the
market version of the Solow model.
See the class notes:
1
kt+1 = [sf (kt ) + (1 )kt ]
1+n

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(c) Draw in separate charts (with time on the horizontal axis) the evolution of the interest
rate, wages, and the growth rate of wages at the steady state.

(d) Draw in separate charts (with time on the horizontal axis) the evolution of both wage
and interest rate if k0 < k .

(e) Calculate the long-run value of the interest rate when the saving rate is at the golden
rule level sgr . How does the value of the interest rate change if s < sgr ? How can we
verify whether the economy is dynamically e¢ cient or dynamically ine¢ cient by just
looking at the equilibrium value of the interest rate?
See the class notes:

f 0 (kgr ) = n +

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 r^gr = rgr + = n + =) rgr = n:

If s < sgr =) k < kgr =) f 0 (k ) > f 0 (kgr ) =) r^ > r^gr =) r > rgr = n
Note that if k 6 kgr the economy is dynamically e¢ cient. Moreover, k 6 kgr () r >
n.
Thus, for dynamic e¢ ciency: r > n.
For dynamic ine¢ ciency: r < n.
(f) Draw (with time on the horizontal axis) the evolution of the interest rate and wages
following an increase in s. (
0
0 r <r
If s > s then k > k =) 0
w >w

(g) Assume now that agents increase their …nancial asset holdings in a constant proportion
of their net income: At+1 At = s(wt Lt + rt At ). Obtain the fundamental equation
determining the evolution of capital per worker in this market version of the Solow
model. Write this equation when the production function is AKt Lt1 .

At+1 = s (wt Lt + rt At ) + At

Dividing by Lt
(1 + n)at+1 = s (wt + rt at ) + at

In equilibrium at = kt for all t and wt = f (kt ) kt f 0 (kt ), rt = f 0 (kt ) :

Then, 0 2 3 1
1 B 6 7 C
kt+1 = @s 4f (kt ) kt f 0 (kt ) + f 0 (kt ) kt k t 5 + kt A
1+n | {z }
f (kt )

1
kt+1 = [sf (kt ) + (1 s )kt ]
1+n
Cobb-Douglas:
1
kt+1 = [sAkt + (1 s )kt ]
1+n

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(h) Assume now that agents’ saving is a constant fraction of their net capital income:
At+1 At = srt At . Obtain the fundamental equation determining the evolution of capital
per worker in this new situation. Write this equation when the production function is
AKt L1t and compare it with that obtained in (g).

At+1 At = srt At =)At+1 = (1 + srt ) At

Dividing by Lt ;
(1 + n)at+1 = (1 + srt ) at :

In equilibrium
(1 + n)kt+1 = [1 + s (f 0 (kt ) )] kt
1
kt+1 = [sf 0 (kt ) kt + (1 s )kt ]
1+n
Cobb-Douglas:
1
kt+1 = [s Akt + (1 s )kt ]
1+n
Here, the capital accumulation is smaller than in (g) as A < A:
(i) Analyze graphically the evolution of the growth rate of capital per worker in the situation
depicted in (h).

kt+1 1 1
gk;t+1 = 1= s Akt (n + s )
kt 1+n

(j) Assume now that agents’saving is now a constant fraction of labor income: At+1 At =
swt Lt . Obtain the fundamental equation determining the evolution of capital per worker
in this new situation. Write this equation when the production function is AKt L1t .

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 At+1 = swt Lt + At

Dividing by Lt

(1 + n)at+1 = swt + at

1
at+1 = (swt + at )
1+n
In equilibrium:
1
kt+1 = [s (f (kt ) kt f 0 (kt )) + kt ]
1+n
Cobb-Douglas:
1
kt+1 = [s(1 )Akt + kt ]
1+n

7. An alternative graphical analysis of the Solow model.

Draw in a chart the dynamics of the Solow model by putting the capital per worker in period
t in the horizontal axis and the capital per worker in period t + 1 in the vertical axis.

1
kt+1 = [sf (kt ) + (1 )kt ]
|1 + n {z }
(kt )

(0) = 0

0 1
(kt ) = [sf 0 (kt ) + (1 )] > 0
1+n

0 0 1
lim (kt ) = 1; lim (kt ) = 2 (0; 1)
kt !0 kt !1 1+n

00 1
(kt ) = sf 00 (kt ) < 0
1+n
The following graph shows the relationship between kt and kt+1 :

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Note that, when (kt ) is higher (smaller) than kt (i.e., the function (kt ) is above (below)
the 45 - degree line), kt increases (decreases) with time.

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