Problem set 3

April 27, 2023

Total: 30 pts

Question 1 [10 points]

Consider the simple model of growth and development from section 1 of chapter 6
in Jones and Vollrath 2011. There, we postulated a skill accumulation equation:
ḣ = µeψu Aγ h1−γ . Along a balanced growth path, we argued that h would grow at
the same rate as A, which we denoted by g.
Suppose that the time spent accumulating skills falls, i.e. there is a fall in u.

(a) Starting from steady state, analyze and illustrate (with ḣh on the y-axis and
time on the x-axis) the short-run and long-run effects of this fall on the growth
rate of h. [5]
In the long run, ḣh grows at rate g. In the short run, a fall in u lowers ḣh as skills
are accumulated more slowly, which ultimately leads to faster growth along the
transition path back to steady state, as Ah rises back to its new steady state
level (see (b)).

(b) Plot the behavior of Ah over time. [5]

h

1
µeψu γ h
A
= g
, so a decline in u would lead to a lower steady state value of A
.
h
Hence, A falls steadily until it attains its new, lower steady state value.

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Question 2 [8 points]

Consider the two-country model of technology transfer from Lecture 7 and Chapter
8 of Weil’s textbook.
Assume that the two countries have labor forces of equal size.

(a) Suppose that the cost-of-copying function is:

A1
−β
µc = µi , 0<β<1
A2

.
Using this function, solve for the steady-state ratio of A
A2
1
as a function of the
value of γA in the two countries. How does this depend on the value of β? [4]
Let the labour force in either country be L. The growth rates of technology in
country 1 and 2 are:

γA1 L
Â1 =
µi

γA2 L
Â2 =
A −β


µi 1
A2

In steady state, the two countries grow at the same rate. Equating the two
expressions above, one obtains:

A1 γA1
β1
=
A2 γA2

As β ↑, for A1 < A2 , the cost of copying falls, such that A2 rises and the ratio
of steady state technologies is lower.

(b) Suppose that γA1 > γA2 and that the two countries are in steady state. Assume
that the cost of copying is the general function c( A
A2
1
), satisfying c′ < 0, c(∞) = 0
and c(1) = µi .
Suppose now that Country 1 raises the fraction of the labor force that is doing
R&D, i.e. γA1 ↑. Draw a picture showing how the rates of growth in Countries

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 1 and 2 will behave over time. [4]
Now, the steady state condition would yield:

A1 µi γA2
c( )=
A2 γA1

As c(.) is a decreasing function, an increase in γA1 raises the ratio A

A2
1
. In terms
of growth rates, Â1 is immediately and permanently raised, since Â1 = γA1 µi
L
. Â2
does not rise immediately, but converges to the new (higher) steady state growth
rate. In the figure below, I have assumed that the cost of copying function c(.)
is convex.

Question 3 [12 points]

Consider the two-period consumption-savings problem augmented with labour supply

choice. As in lecture 9, assume that consumers live for two periods, 1 and 2.

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Let ct denote consumption in period t, at denote savings in period t and lt denote
labour supplied in period t, where t = {1, 2}. Assume that initial bank balances, b1 ,
are zero. The interest factor is R = (1 + r).
Now, we assume that consumers earn income by supplying labour given wage w in
each period. Hence, yt = wlt . The total endowment of time for a consumer in each
period is 1, and can be used for either labour or leisure. If a consumer chooses to
supply labour lt , then she has 1 − lt time remaining for leisure. Individuals derive
utility from leisure.
The lifetime utility function, given a discount factor β, is:

u(c1 , l1 ) + βu(c2 , l2 )

and the period utility function u(., .) is:

u(ct , lt ) = 0.5 log(ct ) + 0.5 log(1 − lt )

(a) Write down the intertemporal budget constraint (IBC). [2]

The IBC is:

c2 wl2
c1 + = wl1 +
R R

(b) Derive the Euler equation, i.e. the equation linking c1 and c2 . Does it depend
on l1 and l2 ? [3]
The separability of the utility function w.r.t c and l suggests that the Euler
equation linking c1 and c2 shouldn’t depend on l1 and l2 . The consumer’s
objective is to maximize the following w.r.t c1 and c2 subject to the IBC:

0.5 log(c1 ) + 0.5 log(1 − l1 ) + 0.5β log(c2 ) + 0.5β log(1 − l2 )

Set up the Lagrangean with multiplier λ on the IBC:

 wl2 c2 
0.5 log(c1 )+0.5 log(1−l1 )+0.5β log(c2 )+0.5β log(1−l2 )+λ wl1 + −c1 −
R R

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 The first-order conditions w.r.t c1 and c2 are:

0.5
=λ
c1

0.5βR
=λ
c2
Combining the two conditions, one obtains the Euler equation:

c2 = βRc1

(c) Derive the optimal choices of consumption and labour supply in either period.
[2]
Take the first-order condition w.r.t l1 (for instance):

0.5
= λw
1 − l1

Combine this with the F.O.C for c1 derived in (b) to obtain:

0.5 0.5w
=
1 − l1 c1

i.e. c1 = w(1 − l1 ). One can similarly obtain an analogous expression for c2 as

a function of l2 , c2 = w(1 − l2 ).

(d) Use the Euler equation, the IBC and the first-order conditions in (c) to express
l1 as a function of β and R. [5]
As mentioned in the question, first use the Euler equation to obtain:

w(1 − l2 ) = c2 = βRc1 = βRw(1 − l1 )

which reduces to:

l2 = 1 + βRl1 − βR

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Now, use the IBC, c2 = βRc1 and the above equation:

w(1 + βRl1 − βR)

c1 (1 + β) = wl1 +
R

Expressing c1 = w(1 − l1 ) using (c), one obtains a single equation in l1 which

simplifies to:
(1 + R) + 2βR
l1 =
2R + 2βR