4,212,2 Macroeconomics III

Exercises and Independent Studies

Maria Bolboaca & Alexander Tonn

February 28, 2023

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Outline

I Short Recap of Main Topics in Lecture 1

I Discussion of Results of Take-Home Exercises for Session 1

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Long Run Growth
I Robert Lucas (Nobel Prize winner) said that “Once you start to
think about growth, it is difficult to think about anything else.”

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Technicalities (Recap)
I Why plot series in natural logs? GDP grows exponentially over
time which implies the slope gets steeper as time goes by. The
log of an exponential function is a linear function which is
much easier to interpret. The slope of a plot in the log is
approximately just the growth rate of the series.
I Why use real GDP instead of nominal GDP?
I GDP may change over time because prices change or quantities
change. Changes in quantities are what we care about for
welfare. To address this, real GDP uses constant prices over
time to measure changes in output.
I Why real GDP per worker?
I GDP can go up either because there are more people working
in an economy or because the people working in an economy
are producing more. For thinking about an economy’s
productive capacity, and for making comparisons across time,
we want a measure of GDP that controls for the number of
people working in an economy.
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Long Run Growth: Stylized Facts
I “Stylized” means that these facts are roughly true over
sufficiently large periods of time
I Stylized fact 1: Some countries are rich and some are poor.
However, there is some tendency towards a more equal world
income distribution, though not much at the very bottom.
I Stylized fact 2: Growth rates vary substantially between
countries, and by the process of growing or declining fast, a
country can move from being relatively poor to being relatively
rich, or from being relatively rich to being relatively poor.
I Stylized fact 3: Growth can break in a country, turning from
a high rate to a low one or vice versa.
I Stylized fact 4: Convergence: If one controls appropriately for
structural differences between the countries of the world, a
lower initial value of GDP per worker tends to be associated
with a higher subsequent growth rate in GDP per worker.
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Long Run Growth: Stylized Facts
I Stylized fact 5: Real GDP per worker grows at a sustained,
roughly constant, rate over long periods of time (in advanced
economies).
I Stylized fact 6: Labor’s share of GDP has stayed relatively
constant, hence the average real wage of a worker has grown
by approximately the same rate as GDP per worker.
Wt Lt
Labourshare =
Yt
I Stylized fact 7: Capital’s share and the rate of return on
capital have shown no trend, therefore the capital- output ratio
K/Y has been relatively constant, and the capital intensity K/L
has grown by approximately the same rate as GDP per worker.

rt Kt
Capitalshare = 1 − Labourshare =
Yt
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Balanced Growth

I GDP per worker, consumption per worker, the real wage and
the capital intensity all grow at one and the same constant
rate, g.
I The labour force (population) grows at a constant rate, n.
I GDP, consumption and capital grow at the common rate, g+n.
I The capital-ouput ratio and the rate of return on capital are
constant.

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What is a (Macro) Model?

I To an economist, a model is a simplified representation of the

economy in which only the main ingredients are being
accounted for.
I Ideally, we would like to perform experiments like in other
sciences, but this is possible only in some few areas of
economics (behavioral economics). In macroeconomics,
however, things are different.
I We build macro models to conduct experiments that we cannot
run in the real world and use the results from these
experiments to inform policy-makers.
I A macro (economic) model is composed of a set of
mathematical relationships through which one determines how
variables affect each other (direction of relationships) and
quantifies their impacts.

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The Basic Solow Model

I The Solow Model is the principal model for understanding long

run growth and cross-country income differences.
I Robert Solow won a Nobel Prize for his work!
I The key equations of the model are:
1. an aggregate production function;
2. a consumption/saving function;
3. an accumulation equation for physical capital.

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The Aggregate Production Function

I Denote Kt as the stock of capital and Lt as the total number

of workers in period t.
I Let Yt denote output produced in period t. Suppose that there
is a single, representative firm that leases labor and capital
from a single, representative household each period to produce
output. The production function is given by:

Yt = F (Kt , Lt ).

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The Aggregate Production Function

The function F (·) is assumed to have the following properties:

I FK0 > 0 and FL0 > 0 (i.e. marginal products are always positive:
more of either input means more output);
I 00 < 0, F 00 < 0 (i.e. diminishing marginal products in both
FKK LL
factors: more of one factor means more output, but the more
of the factor you have, the less an additional unit of that factor
adds to output);
I 00 > 0 (i.e. if you have more capital, the marginal product of
FKL
labor is higher);
I F (λKt , λLt ) = λF (Kt , Lt ) (i.e. production function has
constant returns to scale);
I F (0, Lt ) = F (Kt , 0) = 0 (i.e. both capital and labor are
necessary to produce).

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Problem of the Firm
The optimization problem of the firm is to choose capital and labor
so as to maximize profits (Πt ):

max Πt = F (Kt , Lt ) − Wt Lt − rt Kt ,
Kt ,Lt

I where Wt denotes the real wage paid to workers and rt denotes

the real return to capital.
I The first order conditions (FOCs) are:

Wt = FL0

rt = FK0
I FOCs imply that the firm ought to hire capital and labor to the
point at which the marginal benefit of doing so (the marginal
product of capital or labor) equals the marginal cost of doing
so (the factor price).
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Problem of the Household
I There exists a representative household in the economy. Its
budget constraint is:

Ct + St = Wt Lt + rt Kt + Πt .

I Although separate decision-making units, the household owns

the firm, hence dividend payment equal any profit earned by
the firm.
I However, the firm earns no profit under the assumption of
constant returns to scale (Wt Lt + rt Kt = Yt ). In other words:

Ct + St = Yt .

I “Biology”:

Lt+1 = (1 + n)Lt .

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Capital Accumulation Equation
I The Solow model assumes that savings represent a constant
fraction of output:

St = sYt ,

where 0 < s < 1 denotes the saving rate (equivalently, the

investment rate St = It ).
I The initial level of capital, Kt , is given, but future levels of
capital can be influenced through investment.

Kt+1 = sYt + (1 − δ)Kt ,

where 0 < δ < 1 is the depreciation rate (the fraction of the

capital stock that becomes obsolete each period).
I Note that the real interest rate is defined as:

ρt = rt − δ.

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The Complete Set of Equations
Assume: F (Kt , Lt ) = B(Kt )α L1−α
t . Then:

Yt = B(Kt )α L1−α
t , (1)
Kt+1 = St + (1 − δ)Kt , (2)
Wt = (1 − α)B(Kt )α L−α
t , (3)
α−1 1−α
rt = αB(Kt ) Lt , (4)
Ct + St = Yt , (5)
St = sYt , (6)
Lt+1 = (1 + n)Lt , (7)
ρt = rt − δ. (8)

5 Parameters: B, α, s, n, andδ. 8 Endogenous variables: Y , K , L, r ,

w , S, C , and ρ of which Kt and Lt are state (predetermined)
variables.

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Transformations in per Worker Terms

Kt Yt
Define: kt = Lt and yt = Lt . Then:

Kt+1 Lt+1 Yt Kt
=s + (1 − δ) ,
Lt+1 Lt Lt Lt

and using that

Lt+1 = (1 + n)Lt ,

we get
yt kt
kt+1 = s + (1 − δ) ,
(1 + n) (1 + n)

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Transformations in per Worker Terms

The set of equations with transformed variables in per worker terms

is:

yt = B(kt )α ,
yt kt
kt+1 = s + (1 − δ) ,
(1 + n) (1 + n)
wt = (1 − α)B(kt )α ,
rt = αB(kt )α−1 ,
ct + st = yt ,
st = syt ,
ρt = rt − δ.

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The Transition Equation
Replacing the production function: yt = B(kt )α in the capital
accumulation equation, we obtain the transition equation:
Bktα kt
kt+1 = s + (1 − δ) . (9)
(1 + n) (1 + n)
The transition diagram

k t+1 =k t
k t+1

-1
k* k t+1 = (1+n) (sBkt + (1 - )kt )

kt
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Slope of the Transition Equation

dkt+1 sαB 1 (1 − δ)
= 1−α
+ .
dkt (1 + n) kt (1 + n)

dkt+1
I If kt → 0 then the slope dkt → ∞
(1−δ)
I If kt → ∞ then the slope dkdkt+1
t
→ (1+n)
I Interpretation: The plot starts out steep at the origin, and
flattens out as kt gets bigger, eventually having a slope equal
(1−δ)
to (1+n) < 1. The 45 degree line has a slope of 1. The kt+1
plot starts out with a slope greater than 1, but then it goes
below 1. Since it is a continuous curve, this means that the
plot of kt+1 crosses the 45 degree line exactly once away from
the origin. We indicate this point with k ∗ and refer to it as the
“steady state.”

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Steady State

I The steady state is a natural point of interest. This is not

because the economy is always at the steady state, but rather
because, no matter where the economy starts (provided it does
not start with kt = 0), it will naturally gravitate towards this
point.
I To algebraically solve for the steady state capital stock, take
the transition equation (eq. 9) and set kt+1 = kt = k ∗ :
  1
∗
1 s (1−α)
k =B (1−α)
n+δ

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Steady State
  1
∗
1 s (1−α)
k =B (1−α) ,
n+δ
  α
∗ ∗ α
1 s (1−α)
y = B(k ) = B (1−α) ,
n+δ
  α
∗ ∗ α
1 s (1−α)
w = (1 − α)B(k ) = (1 − α)B (1−α) ,
n+δ
 −1
∗ ∗ α−1 s
r = αB(k ) =α ,
n+δ
  α
∗ ∗
1 s (1−α)
c = (1 − s)y = (1 − s)B (1−α) ,
n+δ
 α 
∗ ∗ s 1(1−α)
s = sy = sB (1−α) ,
n+δ
 −1
∗ ∗ s
ρ =r −δ =α − δ.
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The Solow Equation

Bktα kt
∆kt+1 = kt+1 − kt = s − (n + δ) .
(1 + n) (1 + n)

Interpretation: Additions to capital per worker come from

investment (savings per worker), syt = sBktα , minus what is needed
to compensate for depreciation and thinning out caused by
population growth, (n + δ)kt .

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Convergence to Steady State
The Solow Diagram

(n + )kt
sBk t ,(n + )kt

sBk t
k*

kt

I If kt < k ∗ , investment exceeds depreciation, so that the capital

stock will be expected to grow over time.
I If kt > k ∗ , then depreciation and population growth exceed
investment, and the capital stock will decline over time.
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Golden Rule
The Solow Diagram

Bk
t
sBk t ,(n + )kt,Bk t

(n + )kt
c*

sBk t

k*

kt

I ct is given by the vertical distance between the plots of yt and

st , given a value of kt .
I steady state occurs where the plot of sBktα crosses the line
(n + δ)kt .

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Golden Rule
I the vertical distance is maximized when the slope of yt is equal
to the slope of the (n + δ)kt plot, which means:
Bα(kt )α−1 = (n + δ),
I implying that k gr = k ∗ if s = α.
I The Golden rule s is the savings rate which generates a k gr
where the marginal product of capital equals (n + δ).

The Golden Rule

c*

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Decrease in the Population Growth Rate

The transition diagram

k t+1 =k t

-1
k t+1 = (1+n) (sBkt + (1 - )kt ), n low
k t+1

-1
k = (1+n) (sBk + (1 - )k ), n high
t+1 t t

kt

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Decrease in the Population Growth Rate

The Solow Diagram

(n + )kt , n high

(n + )kt , n low
sBk t ,(n + )kt

sBk t

kt

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Decrease in the Population Growth Rate

I k ∗ , y ∗ , c ∗ increase if n is reduced.
I Intuition: Next period after n falls, there will be fewer people
to share the same amount of capital (accumulated before the
decrease in n). Hence kt will increase on impact producing
higher yt and savings syt etc., thus initiating a usual
convergence process towards a new steady state.

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Decrease in the Population Growth Rate

I real wage, w ∗ , increases by 15.47%

I real interest rate, ρ∗ , decreases by 29.41%
I rental rate of capital, r ∗ , decreases by 25.00%
I capital, k ∗ , increases by 53.96%
I income per worker, y ∗ , increase by 15.47%
I consumption per worker, c ∗ , increases by 15.47%

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Decrease in the Population Growth Rate
Income
1.15

1.1

1.05

1
0 10 20 30 40 50 60 70 80 90 100

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Decrease in the Population Growth Rate
Consumption

1.04

1.02

0.98

0.96

0.94

0.92
0 10 20 30 40 50 60 70 80 90 100

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Decrease in the Population Growth Rate
Real Wage

0.76

0.75

0.74

0.73

0.72

0.71

0.7

0.69

0.68

0.67

0 10 20 30 40 50 60 70 80 90 100

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Decrease in the Population Growth Rate
Real Interest Rate
0.28

0.27

0.26

0.25

0.24

0.23

0.22

0.21

0 10 20 30 40 50 60 70 80 90 100

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Decrease in the Population Growth Rate

10 -3 Growth Rate

0
0 10 20 30 40 50 60 70 80 90 100

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Conditional Convergence

Savings and investment accumulate as capital, and capital is

productive leading to more output. Hence, countries with higher
savings rates are expected to have higher GDP per worker.

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Conditional Convergence

Higher population growth means higher growth of the labor force

and thus a larger group of people who will share the capital
accumulated in the past. Other things equal, this pulls GDP per
worker down.
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Conditional Convergence

The Solow model predicts that there should be a linear relationship

between ln(y ∗ ) and ln(s) − ln(n + δ), and that the slope should be
α
1−α , which is equal to 0.5 if α = 1/3 :

1 α α
ln(y ∗ ) = ln(B) + ln(s) − ln(n + δ).
1−α 1−α 1−α

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Conditional Convergence

The slope estimate is significantly positive and the regression line

seems to fit quite well, confirming the direction in the influence of
ln(s) − ln(n + δ) on ln(y ) predicted by the theory as well as the
linear relationship.
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Conditional Convergence

The slope estimate is significantly larger than 1/2 and we can

conclude that in the real world the structural parameters s and n
seem to have a stronger influence on y than predicted by the theory.
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