Economics 302

Wesleyan University
Professor: David J. Kuenzel

Due date: May 9, at the beginning of class

You are allowed to discuss the questions with your classmates, but I require an individual write-
up by each student.

Problem Set 6

1. Consider the following per capita incomes in 1960 (in 2015 US Dollars) and the average
growth rates between 1960 and 2020 for Argentina, Malaysia and Norway (source: World
Bank):

Per capita Income in Average annual per capita

Country
1960 growth rate 1960-2020
Argentina $7,410 .7%
Malaysia $1,286 3.5%
Norway $19,134 2.3%

a. Given the information above, compute the three countries’ per capita incomes in 2020.

Given the information in the question, we can compute the three countries’ respective per-
capita incomes using the following formula:
60 𝑌𝑌 𝑌𝑌
�1 + 𝑔𝑔̅𝑌𝑌/𝑁𝑁 � ×� � =� �
𝑁𝑁 1960 𝑁𝑁 2020

Argentina: (1 + 0.007)60 × $7,410 = $11,261

Malaysia: (1 + 0.035)60 × $1,286 = $10,131

Norway: (1 + 0.023)60 × $19,134 = $74,876

b. For both 1960 and 2020, compute the ratio of Norwegian per capita income to the per
capita incomes in Argentina and Malaysia, respectively.

Ratios of Norwegian per capita income to Argentine per capita income:

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(𝑌𝑌/𝑁𝑁)1960,𝑁𝑁𝑁𝑁𝑁𝑁 $19,134 (𝑌𝑌/𝑁𝑁)2020,𝑁𝑁𝑁𝑁𝑁𝑁 $74,876
= = 2.58 = = 6.65
(𝑌𝑌/𝑁𝑁)1960,𝐴𝐴𝐴𝐴𝐴𝐴 $7,410 (𝑌𝑌/𝑁𝑁)2020,𝐴𝐴𝐴𝐴𝐴𝐴 $11,261

Ratios of Norwegian per capita income to Malaysian per capita income:

(𝑌𝑌/𝑁𝑁)1960,𝑁𝑁𝑁𝑁𝑁𝑁 $19,134 (𝑌𝑌/𝑁𝑁)2020,𝑁𝑁𝑁𝑁𝑁𝑁 $74,876
= = 14.88 = = 7.39
(𝑌𝑌/𝑁𝑁)1960,𝑀𝑀𝑀𝑀𝑀𝑀 $1,286 (𝑌𝑌/𝑁𝑁)2020,𝑀𝑀𝑀𝑀𝑀𝑀 $10,131

c. Based on your results in part b., have per capita incomes in Argentina and Malaysia
converged over time to the Norwegian capita income level? Why or why not?

Since the ratio of Norwegian per capita income to Argentine per capita income increased
from 1960 to 2020, Argentinian per capita income has not converged to Norwegian per-
capita income over the considered time period.

Since the ratio of Norwegian per capita income to Malaysian per capita income decreased
from 1960 to 2020, Malaysian per capita income has converged to Norwegian per-capita
income over that time span.

d. If you are only interested in answering the question in part c., would it have been necessary
to perform your calculations in parts a. and b.? Do you know a quicker way to arrive at
your conclusions from part c.? Explain.

No, the calculations in parts a. and b. would not have been necessary. The per capita income
growth rates are everything we need to know in order to conclude whether per capita income
levels are converging or diverging between countries. If the poorer country (in terms of per
capita income) grows faster than the richer economy, incomes in both countries converge,
and vice versa.

e. Assume that Argentina, Malaysia and Norway continue to grow in the future at the same
average growth rates as listed above. For each of the three countries, compute the year in
the future in which per capita incomes will have quadrupled for the first time compared to
the level observed in 2020. Show your work. Hint: The rule of 70 might come in handy
here.

The rule of 70 helps us to calculate how many years, n, it takes until per capita incomes will
double in a country. Hence, we can simply multiply this number by two to find out how long it
will for a country to quadruple its income.
70 140
2𝑛𝑛 = 2 =
𝑔𝑔 𝑔𝑔

2
 where g is the per capita growth rate in percentage points.

Argentina:
140
2𝑛𝑛 = = 200
.7
It will take until the year 2220 for Argentine per capita income in 2020 to quadruple.

Malaysia:
140
2𝑛𝑛 = = 40
3.5
It will take until the year 2060 for Malaysian per capita income in 2020 to quadruple.

Norway:
140
2𝑛𝑛 = = 61
2.3
It will take until the year 2081 for Norwegian capita income in 2020 to quadruple.

2. An economy’s production function is given by:

𝑌𝑌 = 𝐾𝐾 𝛼𝛼 𝑁𝑁1−𝛼𝛼 where 0 < 𝛼𝛼 < 1
Suppose the saving rate in the economy is fixed at rate s and that there is no population
growth. In addition, the capital stock of the economy depreciates at rate 𝛿𝛿 in every period.
Hint: You will find the appendix to chapter 11 very helpful to answer the following questions.
a. Explain the following properties of the production function: (i) constant returns to scale,
and (ii) decreasing returns to labor.

(i) Constant returns to scale:

A constant returns to scale production function implies that if all inputs are increased at the
same rate, output will increase by the same rate as well. For instance, if all inputs are
doubled, output will double as well.

(ii) Decreasing returns to labor:

Decreasing returns to labor imply that if the amount of labor employed is increased but all
other inputs are held fixed, output will increase but at a decreasing rate.

b. Draw a diagram with capital per worker on the x- and output per worker on the y-axis. In
your diagram, graph (i) output per worker, (ii) investment per worker and (iii) the required

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 investment per worker to hold the capital stock constant. Denote the steady state of the
economy by (𝐾𝐾 ∗ /𝑁𝑁) and (𝑌𝑌 ∗ /𝑁𝑁). Hint: in drawing the three functions you do not have to
plug in actual numbers. Make sure, however, that your sketch of the functions is consistent
with their first and second derivatives.

Output per worker

𝐾𝐾
𝑓𝑓 � �
𝑁𝑁
(𝑌𝑌/𝑁𝑁)∗
𝐾𝐾
𝛿𝛿
𝑁𝑁

𝐾𝐾
𝑠𝑠𝑠𝑠 � �
𝑁𝑁

Capital per worker

(𝐾𝐾/𝑁𝑁)∗

c. Solve for the steady-state levels (i.e., equilibrium levels) of capital per worker and output
per worker in terms of the exogenous parameters of the model (s, 𝛿𝛿 and 𝛼𝛼).

The steady-state condition for capital per worker is:

𝐾𝐾 ∗ 𝛼𝛼 𝐾𝐾 ∗
𝑠𝑠 � � = 𝛿𝛿
𝑁𝑁 𝑁𝑁

Solving for K*/N we find:

𝐾𝐾 ∗ 𝑠𝑠 1/(1−𝛼𝛼)
=� �
𝑁𝑁 𝛿𝛿

Plugging the steady-state capital per worker level into the output per worker production
function, we can also find the steady-state level of output per worker:
𝑌𝑌 ∗ 𝑠𝑠 𝛼𝛼/(1−𝛼𝛼)
=� �
𝑁𝑁 𝛿𝛿

d. Given your results from part c., compute the steady-state levels of capital per worker and
output per worker when 𝑠𝑠 = 0.4, 𝛿𝛿 = 0.05 and 𝛼𝛼 = 1/4.

4
 𝐾𝐾 ∗ 𝑠𝑠 1/(1−𝛼𝛼) . 4 1/(1−1/4)
=� � =� � = 16
𝑁𝑁 𝛿𝛿 . 05

Plugging the steady-state capital per worker level into the output per worker production
function, we can also find the steady-state level of output per worker:

𝑌𝑌 ∗ . 4 1/4/(1−1/4)
=� � =2
𝑁𝑁 . 05

e. Suppose that the saving rate in the economy decreases. How will this change your graph in
part b.? What happens to the steady-state levels of capital per worker and output per
worker? Hint: No calculations are required in this part.

In this case the slope parameter of the saving function decreases and thus the saving function
will tilt downwards. As a result, the steady-state levels of capital per worker and output per
worker will decrease.
1 2
3. Suppose a country’s aggregate production function is 𝑌𝑌 = 𝐾𝐾 3 𝑁𝑁 3 . In each period, the capital
stock of the economy depreciates at rate 𝛿𝛿. The economy saves share s of its output and the
population of workers grows at rate 𝑔𝑔𝑁𝑁 in every period. There is no technological progress.
a. Solve for the economy’s steady-state level of output per worker as a function of the
economy’s parameters (s, 𝛿𝛿, 𝑔𝑔𝑁𝑁 ). Show your work.

The steady-state condition resulting for capital per worker will be:
1
𝐾𝐾 ∗ 3 𝐾𝐾 ∗
(𝛿𝛿 )
𝑠𝑠 �� � � = + 𝑔𝑔𝑁𝑁 � �
𝑁𝑁 𝑁𝑁

Solving for (K/N)* we find:

3
𝐾𝐾 ∗ 𝑠𝑠 2
� � =� �
𝑁𝑁 𝛿𝛿 + 𝑔𝑔𝑁𝑁

Plugging the steady-state capital per worker level into the output per worker production
function, we can also find the steady-state level of output per worker:
1
𝑌𝑌 ∗ 𝑠𝑠 2
� � =� �
𝑁𝑁 𝛿𝛿 + 𝑔𝑔𝑛𝑛

b. Solve for the economy’s golden-rule saving rate. Show your work.

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In order to know whether this economy is at its golden-rule level of capital, we need to find
the saving rate which would maximize consumption per worker:
1 1
𝐶𝐶 𝑌𝑌 𝑠𝑠 2 𝑠𝑠 2 (1 − 𝑠𝑠)
= (1 − 𝑠𝑠) = (1 − 𝑠𝑠) � � = 1
𝑁𝑁 𝑁𝑁 𝛿𝛿 + 𝑔𝑔𝑁𝑁
(𝛿𝛿 + 𝑔𝑔𝑁𝑁 )2

Maximizing this expression with respect to s and setting it equal to 0 we find:

1 −12 1
2 𝑠𝑠 (1 − 𝑠𝑠) − 𝑠𝑠 2
=0
1 1
(𝛿𝛿 + 𝑔𝑔𝑁𝑁 )2 (𝛿𝛿 + 𝑔𝑔𝑁𝑁 )2
which can be solved for the optimal, or golden-rule, saving rate:
1
𝑠𝑠𝐺𝐺 =
3

c. If the economy’s current saving rate is 20 percent, would an increase in the saving rate be a
good or bad decision from a public policy perspective? Explain.

We know from part b. that the golden-rule saving rate is 33.3 percent. An increase in the
saving rate would therefore be a good decision, since it would get the economy closer to the
golden-rule saving rate, implying a rise in consumption per capita.

d. Suppose that the growth rate of workers drops by 50%. Will the golden-rule saving rate
change? Why or why not? Explain.

No, the golden-rule saving rate would not be affected by a change in the population growth
rate. The population growth rate always cancels out in the calculation of the golden-rule
saving rate in part b. Intuitively, the population growth rate only affects the steady-state level
of income per capita but not the decision of what share of output should be saved in each
period to maximize consumption per capita in equilibrium.

e. Is it possible for this country to experience permanently positive growth rates of output (Y)
over time? Why or why not? Discuss.

Yes, in the absence of technological progress, the Solow growth model predicts that real GDP
will increase in the long run in tandem with population growth. That is, the growth rate of
output equals the population growth rate. Note, however, that per capita incomes in this
scenario will remain stagnant, i.e., there is no growth of output per capita in the absence of
technological progress.

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 4. Consider the same economy as in question 3 above. Suppose there is a permanent increase in
the population growth rate (𝑔𝑔𝑁𝑁 ). Draw two graphs that illustrate how the following two
variables respond to this change over time:
a. the level of output per capita. Explain the graph’s shape.

↑ 𝑔𝑔𝑁𝑁
𝑌𝑌/𝑁𝑁

𝑌𝑌 ∗
� �
𝑁𝑁 1

𝑌𝑌 ∗
� �
𝑁𝑁 2

0 Time

At the time when the population growth rate rises, per capita income will start dropping as
per capita capital accumulation decreases because more new workers in each period need to
be equipped with capital. The per capita income decreases will slowly peter out until the new
lower steady state level of per capita income is reached, (𝑌𝑌/𝑁𝑁)∗2 . The decreases in per capita
income are greatest right after the rise in the population growth rate as the declines in the
capital stock per worker are largest at that point.

b. the growth rate of output per capita. Explain the graph’s shape.

At the time when the population growth rate rises, the per capita income growth rate turns
negative as the capital stock per worker starts dropping. Once the economy has reached its
new steady state with a lower capital stock per worker, per capita income growth will again
stabilize at zero.
𝑔𝑔𝑌𝑌/𝑁𝑁

↑ 𝑔𝑔𝑁𝑁

0
Time