Homework 3

1. Suppose the depreciation rate in an economy decreases. In the Solow model, determine the
effects of this change on the quantity of output per worker, consumption per worker, and capital
per worker in the steady state. Use a diagram to illustrate your answer.

Suppose that the depreciation rate decreases from d to d’. More current savings will be used to
accumulate capital in the next period, i.e., k’(1 + n) = szf(k) + (1 − d’)k. The line (n + d’)k* becomes
flatter. In the steady state, the capital per worker increases from k1* to k2*. The output per
worker is y2* and the consumption per worker is CD.

2. Suppose that the economy is initially in a steady state and that some of the nation’s capital stock
is destroyed because of a natural disaster or a war.

a. Determine the long-run effects of this on the quantity of capital per worker and on
output per worker.
The long-run equilibrium is not changed by an alteration of the initial conditions. If the
economy started in a steady state, the economy will return to the same steady state. If
the economy were initially below the steady state, the approach to the steady state will
be delayed by the loss of capital.

b. In the short run, does aggregate output grow at a rate higher or lower than the growth
rate of the labor force?
 Initially, the growth rate of the capital stock will exceed the growth rate of the labor
force. The faster growth rate in capital continues until the steady state is reached.

c. After World War II, growth in real GDP in Germany and Japan was very high. How do your
results in parts (a) and (b) shed light on this historical experience?
The rapid growth rates are consistent with the Solow model’s predictions about the likely
adjustment to a loss of capital.

3. Assume an economy where a government promotes population control through family planning
and birth control. In the Solow model, the effect of this policy on the standard of living as
measured by consumption per worker cannot be determined. Explain.

Family planning and birth control policies will lower the population growth from n1 to n2. In panel
(a), the line (n2 + d)k* becomes flatter. The new steady-state of capital per worker, k2*, increases.
However, the effect of an increase in k* on the steady-state of consumption per worker depends
on the position of k1* relative to the golden-rule level of capital stock per worker, kgr*.

Note: steady state production per capita which is GDP per capita will rise, but the consumption
may or may not rise depending on the situation.

In panel (b), if k1* is smaller (larger) than kgr*, then an increase in k* will raise (lower)
consumption per worker.
4. Suppose that we modify the Solow growth model by allowing long-run technological progress.
That is, suppose that z=1 for convenience, and that there is labor-augmenting technological
progress, with a production function Y=F(K,bN), where b denotes the number of units of “human
capital” per worker, and bN is “efficiency units” of labor. Letting b’ denote future human capital
per worker, assume that b’=(1+f)b, where f is the growth rate in human capital.

"
a. Show that the long-run equilibrium has the property that 𝑘 ∗∗ = #$ is a constant. At what
rate does aggregate output, aggregate consumption, aggregate investment, and per
capita income grow in this steady state? Explain.

First, bN evolves over time with the growth rate of (1+f)(1+n), because b grows at the
rate of f and N grows at the rate of n.

Then we just need to redo the analysis of the competitive equilibrium and the steady
state as in the book, replacing every N by bN, every (1 + n) by (1 + f)(1 + n), and every n
by f + n. The new steady-state per efficiency unit capital is then:

𝑠𝑧𝑓(𝑘 ∗∗ ) (1 − 𝑑)𝑘 ∗∗
𝑘 ∗∗ = +
(1 + 𝑓)(1 + 𝑛) (1 + 𝑓)(1 + 𝑛)

All aggregate variables then grow at the rate of f + n, while per capita aggregates grow at
the rate f.
 b. What is the effect of an increase in f on the growth in per capita income? Discuss relative
to how the standard Solow growth model behaves.

An increase in f increases the growth rate of per capita income by the same amount, as f
is its growth rate. This happens because the exogenous growth in b raises instant capital
and income for everyone without a need to invest in capital.

5. Alter the Solow growth model so that the production technology is given by Y=zK, where Y is
ouput, K is capital, and z is total factor productivity. Thus, output is produced only with capital.

a. Show that it is possible for income per person to grow indefinitely.

% "
Production linear in capital: =𝑧 = 𝑧𝑓(𝑘) à 𝑓(𝑘) = 𝑘.
$ $

Recall Equation (20) from the text, and replace f(k) with k to obtain:
(𝑠𝑧 + (1 − 𝑑))
𝑘& =
1+𝑛

% '% ' %!
Also recall that = 𝑧𝑘 à 𝑘 = and 𝑘 & =
$ ($ ( )!

Therefore:
𝑌 & (𝑠𝑧 + (1 − 𝑑)) 𝑌
=
𝑍& (1 + 𝑛) 𝑁
(+(,('-.))
As long as (',0)
> 1, per capita income grows indefinitely.

b. Also show that an increase in the savings rate increases the growth rate in per capita
income.
The growth rate of income per capita is therefore:

𝑌& 𝑌
&−𝑁 𝑠𝑧 + (1 − 𝑑) 𝑠𝑧 − (𝑛 + 𝑑)
𝑔=𝑁 = −1=
𝑌 1+𝑛 1+𝑛
𝑁

Obviously, g is increasing in s.

c. From parts (a) and (b), what are the differences between this model and the basic Solow
growth model? Account for these differences and discuss.

This model allows for the possibility of an ever-increasing amount of capital per capita. In
 the Solow model, the fact that the marginal product of capital is declining in capital is the
key impediment to continual increases in the amount of capital per capita.

6. In the Solow growth model, suppose the per worker production function is given by 𝑦 = 𝑧𝑘 1.3 ,
with 𝑠 = 0.4, 𝑑 = 0.2, and 𝑛 = 0.02.

a. Suppose that in country A, z=1. Calculate income per worker and capital per worker in
the steady state.

k’(1 + n) = szf(k) + (1 - d)k

In the steady state, k’ = k.
By substitution, k0.6 = sz/(d + n)
kss = 2.71
yss = z(kss)0.4 = (2.71)0.4 = 1.49

b. Suppose that in country B, z=2. Calculate income per worker and capital per worker in
the steady state.

k’(1 + n) = szf(k) + (1 - d)k

In the steady state, k’ = k.
By substitution, k0.6 = sz/(d + n)
kss = 8.60
yss = z(kss)0.4 = 2(8.6)0.4 = 4.73

c. Will countries A and B converge in terms of income per worker? Explain.

Countries A and B will not converge. Country B’s income per capita is always higher than
that of Country A because Country B has a higher total factor productivity.

d. Based on your answers to parts (a) and (b), if both countries increase z to 3, which
country would have higher economic growth during the transition period to the steady
state?

kss = 16.9
yss = z(kss)0.4 = 3(16.9)0.4 = 9.3
Both countries will converge to income per capita, 9.3, in the steady state.
Referring to answers (a) and (b), Country A has lower income per capita than Country B.
For both countries to reach the same level of income per capita, Country A has to grow
faster than Country B.
7. Introduce government activity in endogenous growth model as follows. In addition to working 𝑢
units of time in producing goods, the representative consumer works 𝑣 units of time for the
government and produces 𝑔𝑣𝐻 goods for government use in the current period, where 𝑔 > 0.
The consumer now spends 1 − 𝑢 − 𝑣 units of time each period accumulating human capital.

(a) Suppose that 𝑣 increases with 𝑢 decreasing by an equal amount. Determine the effects on the
level and the rate of growth of consumption. Draw a diagram showing the initial path followed by
the natural logarithm of consumption and the corresponding path after 𝑣 increases.

The equation of motion for the economy is now given by:

H' = b(1 - u - v)H
A change in v, holding u v constant, has no effect on the path of H. Consumption is
lower because the time spent working for the government cannot produce consumable goods.
The two paths of logC are depicted in the second in the following set of figures.

(b) Suppose that 𝑣 increases with 𝑢 held constant. Determine the effects on the level and the
rate of growth of consumption. Draw a diagram showing the initial path followed by the natural
logarithm of consumption and the corresponding path after 𝑣 increases.

Holding u constant, an increase in v reduces the growth rate of human capital. The level of
consumption falls as workers are taken away from producing consumption goods. The growth
rate of consumption also decreases due to the reduction of the growth rate of human capital.
The two consumption paths are depicted in the second figure of the preceding set.

(c) Explain your results and any differences between parts (a) and (b).

Offsetting changes in u and v change the level of consumption. However, the equation of motion
for H is unchanged, so the rate of growth is unchanged. In part c, the growth rate of H is changed,
and so is the growth rate of C.