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ECON 110A: Intermediate Macroeconomics

Midterm Fall 2021
University of California, San Diego

STATEMENT OF ACADEMIC INTEGRITY: I confirm that I have neither given nor

received unauthorized assistance in the completion of this exam. My integrity and that of the
university has been upheld.

Signature Date

DIRECTIONS: Please answer all questions in the space provided. Place the answers to the multiple
choice on the front page of the exam (below). Ambiguous multiple choice answers will be marked
wrong. Good luck!
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SECTION 1 Short Questions [25 points; 5 points each]

For each question, please provide a brief answer in the alotted space.

1. Long-Run Growth Facts Sustained economic growth is about more than just rising in-
come levels. In class, we discussed how sustained growth also appears to transform the
socioeconomic characteristics of society, including the way people live and work. List five big
transformations of society we observe in the data that accompany long-run growth.

2. Measuring GDP Suppose that nominal GDP in country A is 100 trillion U.S. dollars. In
country B, nominal GDP is 550 trillion pesos. If the exchange rate from pesos to dollars is
4:1, which country is wealthier in terms of its GDP? Show your work.

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3. Growth Accounting Consider a production technology given by Yt = At Kt Lt . Trans-
form the equation to provide an expression for the growth rate of output, as a function of
the growth rates of TFP, capital K, and labor L. If the economy is growing at 10% a year,
while capital grows at 4% and labor grows at 1.5%, what is the growth rate of TFP?

4. Development Accounting In the various development accounting exercises we reviewed

in class, we found that the majority of differences between rich and poor countries was
explained by differencess in Total Factor Productivity (TFP). Provide three reasons why
countries might differ in their TFP with explanations for why these reasons cause rich coun-
tries to have higher GDP than poor countries.

5. Non-Rivalry and Increasing Returns Consider a bio-pharmaceutical company which

develops new drugs to treat novel diseases. On average, assume new drugs cost the firm $1
billion dollars to develop, but can then be produced at marginal cost of $1 per pill. How
much does the drug company need to charge per-pill if they sell 100,000 doses to make sure
they break even? Explain why the price is different from the marginal cost of $1 per pill?
What would happen to the market for new pharmaceuticals if the government required firms
to charge this competitive price equal to marginal cost.

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SECTION 2 Long Questions [75 points; 25 points each]

For each question, please provide a brief answer in the alotted space.

1. Neoclassical Production with Human Capital Consider a competitive market of firms

which use production technology Y = F (M, H) given by,

F (M, H) = AM α H 1−α + ψM

where Y is output, M is the intermediate materials, and H is the human capital. You
can think of human capital H as the total productive contribution of the labor force. It is
the number of workers adjusted by their level of education, reflect the higher productivity
or more educated labor. The term ψM represents the fact that a fraction 0 < ψ < 1 of
intermediate goods create byproducts that can be sold along with the primary output (as an
example, consider the petroleum industry). The firm’s profit maximization problem is,

max Π = F (M, H) − pM − wH
M,N

where p is the price of materials, w is the wage rate per unit human capital, and the output
price is normalized to one.

(A) Does the production technology F (M, H) exhibit decreasing, constant, or increasing
returns to scale? Justify for your answer and explain what it means in economic terms.

(B) The firm’s optimal choice (demand) for human capital and materials are given by the
follow optimality conditions:

w = (1 − α)AM α H −α (Demand for Human Capital)

p = αAM α−1 H 1−α + ψ (Demand for Materials)

Explain what these conditions say in economic terms. Using either calculus or an intu-
itive explanation, show that these equations characterize optimal behavior for the firm.
Hint: If you are not using calculus, you should examine what happens if these equations
do not hold.

For the remaining parts, let ψ = 0. Also, suppose that human capital grows over time as
society invests in education and teaching. In particular, assume investment into human
capital is a constant fraction µ of total output, so that human capital tomorrow is given
by,
Ht+1 = It + (1 − δ)Ht
where It = µ × Y is investment in education. The parameter 0 < δ < 1 reflects the
fact that some human knowledge is forgotten or becomes obsolete over time, so a frac-
tion δ of Ht is lost every period. For completeness, the household budget constraint is
Ct + It = Yt .

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(C) Explain what it means for the economy to be in steady state. Using the formula, cal-
culate the steady state level of human capital.

(D) The government proposes stimulating development by increasing investment in educa-

tion by raising µ. If the economy begins in steady state, explain what happens in the
short-run and long-run after a sudden rise in education investment µ. Does the economy
produce more output? Are household’s better off in the long run compared to before
the change?

(E) If you were given control over the country’s education policy, what value of µ would
you choose? Explain your answer.

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2. The Romer Model of Economic Growth: Consider the Romer Model of economic
growth studied in class, but in a world with two countries i ∈ {1, 2} that collaborate on
research. The production technology for each country i is given by

Yi,t = Ai,t Li,y (Goods Production)

where Ai,t is the TFP in country i at time t and Li,y is thee number of workers in country i
that are engaged in production. Since countries collaborate, the research sector is given by

∆Ai,t+1 = z̄Ai,t (L1,a + L2,a ) (Ideas Creation)

where Li,a i the number of researchers from country i. Labor market clearing in each country
requires,
Li,y + Li,a = L̄ (Labor Market)
where again we focused on a rule-of-thumb allocation for labor given by,

Li,a = γi L̄ Li,y = (1 − γi )L̄

where 0 < γi < 1 is the fraction of the labor force engaged in the research sector in country
i. Assume that country i = 1 invests more intensively in research that country i = 2, so
γ1 > γ2 . Finally, assume both countries have the same population size, L̄, and begin with
the same total factor productivity, A0 .

(A) Explain what it means for an input to be non-rivalry. What are the non-rival inputs in
this model? What are the rival inputs?

(B) Derive the balanced growth path of GDP-per-capita, (yi,t = Yi,t /Li,t ) in each country i.
Provide an equation for each country’s growth rate of GDP-per-capita and explain its
meaning.

(C) A new government comes to power in country 1 and advocates cancelling the research
collaboration with country 2. The politicians argue that since they spend more in-
tensively on research (γ1 > γ2 ), they would be better off alone. Assuming research
collaboration is terminated, derive the growth rate for each economy i. Explain what
happens to the growth rate of both countries after they cease collaboration. Was the
politician’s argument about growth correct? Explain.

(D) In addition to growth, the new government is worried about global inequality. Provide
an expression for the ratio of GDP-per-capita in country 1 to that of country 2 (i.e.
y1,t /y2,t ) for the case where they collaborate (part b) and the case when they don’t (part
c). How is cross-country inequality effected by the termination of research collaboration?

(E) Referring to the results in (b)-(d) above, what does the model say about why some
countries are rich and others are poor? Why do some countries grow fast while others
grow slowly? [HINT: Recall our discussion comparing Luxembourg and the USA]

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3. The Consumption-Savings Model Recall the consumption-savings model with log utility
which we studied in class:

maximize log(ct ) + β log(ct+1 )

ct ,st ,ct+1

subject to ct + st = (1 − τt )yt

ct+1 = (1 − τt+1 )yt+1 + (1 + r)st

where ct , ct+1 are consumption choices, st is the net asset position (borrowed or saved money),
yt , yt+1 is income in each period, β is the discount factor, and r the interest rate. τt , τt+1 are
government income tax rates, so in each period, households pay fraction τ of their income
to the government, but the households do not receive any transfers from the government.

(A) In a sentence, explain the economic decision problem faced by households in the model
above. What are the endogenous variables for the households? What does β represent?

(B) Show that the two period budget constraints can be combined into a single inter-
temporal budget constraint (IBC). What technology does the household have access
to that makes this possible?

(C) Derive the Euler equation for the consumption-savings model with log-utility. Explain
in words what the mathematical equation says about the way households make con-
sumption and savings decisions.

(D) Combining the Euler Equation and IBC, provide expressions for the household’s optimal
choice of ct , ct+1 , st . Is the result consistent with Milton Friedman’s Permanent Income
Hypothesis (PIH) ?

(E) Suppose a recession hits the developing world and governments there implement social
insurance programs to stabilize the economy. Household budget constraints are now,

ct + st = (1 − τt )yt + gt

ct+1 = (1 − τt+1 )yt+1 + gt+1 + (1 + r)st

where τt , τt+1 are government income tax rates, and gt , gt+1 are social insurance transfers.
Basically, in period t, the household pays τt ∗ yt in taxes to the government as before,
but now the household also receives gt in transfers from the government. Similarly, in
period t+1, the household pays τt+1 ∗yt+1 in taxes to the government, and the household
receives receives gt+1 in transfers from the government. Suppose governments must run
balanced budgets so that,
gt+1 τt+1 ∗ yt+1
gt + = τt ∗ yt + +B
1+r 1+r

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where B is foreign-aid sent from wealthy countries to developing ones to help fight
the recession and that does not need too be repaid. What effect does the government
spending program {gt , gt+1 } have on household behavior? Explain your answer.