ECON208 Tutorial Week 2

Consider the Solow model with the production function de…ned as

1 1
Y = K2N 2

the growth rate of the population gn = 0:07, the saving rate s = 0:2 and the
depreciation of capital = 0:03:

1. Verify the properties of the production function (i.e. marginal products

and returns to scale)
Answer: This function has positive and diminishing marginal products:
1
@Y 1 N 2
MPK = = >0
@K 2 K
1
@Y 1 K 2
MPN = = >0
@N 2 N

and
@M P K 1 3 1
M P K0 = = K 2 N2 <0
@K 4
@M P N 1 3 1
MPN0 = = N 2 K2 < 0
@N 4

Moreover this function exhibit constant returns to scale.

We say a production function Y = F (K; N ) has constant returns to scale
(CRS) if
F (zK; zN ) = zF (K; N ) = zY
In our case
1 1 1 1 1 1
F (zK; zN ) = (zK) 2 (zN ) 2 = z 2 K 2 z2N 2
1 1 1 1
= z 2+2 K 2 N 2 = zF (K; N ) = zY =) CRS

2. Write the production function in intensive form, i.e. in terms of per capita
variables and represent it graphically
Answer:
Since we have proven that the production function has CRS we can mul-
tiply each input factor by N1t and express them as per-capita variables.

Yt Kt
Yt = F (Kt ; Nt ) ) yt = =F ;1 = f (kt )
Nt Nt

1
 Kt
where yt and kt = Nt are respectively the output per capita and the
capital per capita.
1 1
@yt 1 @M P k
Therefore yt = kt2 , M P k = @kt = 2 (kt ) 2
> 0 and M P k 0 = @kt =
3
1
4 (kt ) 2
<0

2
3. Calculate the steady state values for capital and output
Answer: The steady state (ss) is characterised by the condition

sf (k) = (gn + ) k

you can explain that this condition ensures that per capita variables re-
main constant while aggregate variables grow at the growth rate of the
population.

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in terms of growth rates in fact

k = sf (k) (gn + ) k
k sf (k)
= (gn + )
k k

4
 In ss
sf (k) = (gn + ) k
1
0:2k 2 = (0:07 + 0:03) k
1 0:2
k2 =
0:1
k =4
and from the production function we obtain

1
y = (k ) 2
y = 2

4. What happens if population start growing faster with gn0 = 0:12

Answer:

sf (k) = (gn0 + ) k
1
0:2k 2 = (0:12 + 0:03) k
1 0:2
k2 =
0:15

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 0
(k ) = 1:76
0
(y ) = 1:33
graphically

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and the dynamics can be represented as

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5. What happens if the economy described in point 3) is hit by an earthquake
which destroys part of the capital stock (without killing anyone)?
Answer:
The ss does not change!

8
The dynamics is

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6. Calculate the saving rate such that the steady state level of capital corre-
sponds to the golden rule level of capital.
Answer:
The golden rule level of capital (k GR ) is that level which maximise the ss
level of consumption.
The consumption is given by what you don’t save of your income it can
be analytically represented as

c = f (k) sf (k) = (1 s) f (k)

and it can be shown that graphically it is represented by the distance be-

tween the production function and the saving function.

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This distance is maximised then when the slope of the production function
is equal to (gn + )

@f (k)
k GR : = (gn + )
@k
1 1
k 2 = 0:1
2
2
k GR = (0:2) = 25

the saving rate sGR which guarantees that k = k GR is given by

sGR f k GR = (gn + ) k GR
1
sGR (25) 2 = (0:1) 25
sGR = 0:5

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