Master in Economics: Empirical Applications and Policies

Growth and Development, 2023 2024

Instructor: Amaia Iza
Second Homework 2. Topics 4, 5 and 6.
Due date: April 16, 2024

1. [Topic 4] Consider an economy that is populated by overlapping generations house-

holds. Households live two periods and their preferences, over their young and old
period consumption (c1;t and c2;t+1 , respectively), can be represented by the following
utility function:
c11;t 1 1
c2;t+1 1
Ut (c1;t ; c2;t+1 ) = + ;
1 1
where > 0, 6= 1, denotes the inverse of the intertemporal elasticity of substitution,
and the discount factor 0 < < 1. Assume that there is no population growth,
that the measure of young households is 1 and that the measure of old households
is also 1. From the output side, consider that there are a large number of …rms of
measure one. The production function of each …rm is given by the following expression:
1
Yti = A (Kti ) (Lit ) kt1 where Yti denotes output of the i-th …rm, Lit denotes labor
of the i-th …rm, Kti denotes physical capital of the i-th …rm, kt ( Kt =Lt ) is a positive
externality in the production process and 2 (0; 1) denotes the capital income share.
The aggregate production in equilibrium can be represented by the production function
AKt . Consider that there is also a government that …nances its consumption through
a constant labor income and capital income tax rates: Gt = r rt Kt + w wt Lt .
(a) Write households’budget constraints and solve their optimal lifetime consumption
pro…le fc1;t ; c2;t+1 g and savings.
(b) Obtain the expression of the equilibrium growth rate of this economy [Consider
the equilibrium wage rate and the equilibrium interest rate from class notes].
(c) Will the economy converge to a steady state? Can you get an expression for the
steady state value of income per worker?
(d) Will all consumer cohorts receive the same wage rate, wt ? What about the interest
rate, rt ?
(e) Will all consumer cohorts consume the same amount over their consumption pro-
…le? Will they all save the same amount?
(f) Will government revenues remain constant at the steady state?
(g) Show that the goods market is always in equilibrium.
(h) Consider two countries with the same value of the constant capital depreciation
rate, , capital share in total income, , capital income tax rate, r , Total Factor
Productivity, A, and same household preferences, and . However, the labor
income tax rate in country 1; w , is twice the labor income tax rate in country 2.
Will these two countries grow at the same rate? Explain your answer.
(i) Consider two countries with same parameter values (including the labor income
tax rate, w ) but they di¤er in the Total Factor Productivity, A. Will these two
countries grow at the same growth rate?

1
 2. [Topic 5] Consider the Romer’s model. In this problem you have to show that govern-
ment policies can make the equilibrium allocation to be identical to the Pareto optimal
allocation. In particular, consider that the government levies a tax per unit of skill
labor (human capital) hired by the output sector equal to YwH > 0. Assume that
government revenues are evenly returned back to all households.

(a) Assume that the output sector has to pay a proportional tax per unit of wage
rate of the human capital hired, YwH . Solve the representative …nal-good …rm’s
maximization problem.
(b) Obtain the equilibrium growth rate along the Balanced Growth Path.
(c) Obtain the optimal value of “ YwH ”, such that the government the equilibrium
human capital allocation to the R&D activities coincides with the Pareto optimal
allocation (you can consider the parameter values in the Table below).

3. [Topic 6] Consider the small open economy model as in Lucas (1988).Remember that
households’contemporaneous utility function is given by
1=
u(c1t ; c2t ) = 1 c 1t + 2 c 2t

(a) Answer the following questions assuming that the economy does not trade with
the rest of the world: i) will the economy specialize in the long-run?; ii) …nd the
long-run workforce allocation between both sectors, u1t and u2t ; iii) which is the
long-run growth rate of the economy?
(b) Now assume that the economy trades with the rest of the world: i) Which good
will this economy produce in the long run?; ii) Will this economy grow at a lower
or higher rate than under autarchy?; iii) Would an import substitution policy be
desirable?

[Topic 4] Parameter values for all students: = 0:36; annual = 0:95; annual = 0:05; =
1:5. For the rest of the parameters see the Table below.
[Topic 5] Parameter values for all students: = 0:36; = 0:35; = 1:5; = 0:5. For the
rest of the parameters see the Table below.
[Topic 6] Parameter values for all students: 1 = 0:4, 2 = 0:6, = 0:5, 1 = 1 and
2 = 0:5:

Topic 4 Topic 5 Topic 6

A w r H h1;0 h2;0 p0
Mercé Amich Vidal 10 0:05 0:04 2 0:06 0:05 2:2 1:1 4:0
Patrick Heneghan 11 0:06 0:04 2 0:07 0:06 1:1 2:2 2:0
Martin Herández Bárcena 12 0:07 0:04 2 0:08 0:07 2:2 2:2 2:2
Youssef Ibrahim 13 0:08 0:04 2 0:09 0:08 2:2 1:1 1:0
Roshani K C 14 0:09 0:04 2 0:10 0:09 2:2 2:2 0:5
Miriam Oiz Chueca 15 0:10 0:04 3 0:05 0:05 1:1 1:1 1:5
K.A. Augusto Sánchez Pajuelo 16 0:05 0:06 3 0:06 0:06 3:3 1:1 2:0
Alberto Gonzalo Sustatxa C. 17 0:06 0:06 3 0:07 0:07 1:1 3:3 2:0