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Problem Set 2
(Due Monday October 15 in Class)
Please Print and Answer in the Provided Space
To calculate the growth rate of TFP, we can use the growth accounting equation
!A !Y !K !N
= " aK " aN
A Y K N
aK , aN are the elasticities of output with respect to capital and labor. With Cobb-Douglas
production function we know that the factor shares equal the elasticities, hence a N is the
labor share. With constant returns, we also have aK = 1 − aN .
Substituting the data we have in the question, we get TFP growth of 0.2% in economy 1,
1.95% in economy 2, and 0.85% in economy 3.
The way we calculate TFP growth rates is a residual of the growth of output that is
unexplained by the growth of the factors of production. Therefore, the more the factors of
production grow, the more is “explained” by them, and lower weight is attributed to the
residual.
Now assume three economies that experienced similar growth patterns of output,
capital and labor. In all countries output grew by 5% on average, capital by 10%,
and labor by 1%. The countries differ in their average labor’s share of income. The
labor share is 0.7 in country 1, 0.65 in country 2, and 0.6 in country 3.
Assume all countries have a constant returns to scale Cobb-Douglas production
function.
(c) What is the growth rate of TFP for each economy?
Substituting the data that is given in the question, we have TFP growth rates of 1.3% for
economy 1, 0.85% for economy 2, and 0.4% for economy 3.
!A !Y !K !N !M
= " aK " aN " aM and the intuition is straightforward: this is the typical
A Y K N M
growth accounting equation with one more factor of production that we have to take into
account. In this case, aM is the elasticity of output with respect to raw materials.
(b) Now assume that (1) F(K,N,M) is Cobb-Douglas, i.e. Y = AK ! N " M 1!! !" ; (2)
! = 0.3; " = 0.6 ; (3) Real GDP grew by 10%; (4) Capital stock grew by 3%; (5) the
labor input grew by 5%; and (6) Raw materials grew by 8%.
What is TFP growth in this case?
!A !Y !K !N !M
= ! aK ! aN ! aM = 0.1! 0.3" 0.03! 0.6 " 0.05! 0.1" 0.08 = 0.053
A Y K N M
i.e. TFP grew by 5.3% over the same period.
(c) Now assume that same data as in part (b), but also assume that the growth
accounting calculation assumes a production function of labor and capital only:
Y = AK 0.35 N 0.65
What is TFP growth in this case?
!A !Y !K !N
= ! aK ! aN = 0.1! 0.35" 0.03! 0.65" 0.05 = 0.057
A Y K N
i.e. TFP grew by 5.7%
(d) Provide intuition for the difference between your answers in (b) and (c).
Raw materials is the “fastest growing” input in the production function. In part (c) we
ignore this input, and assign relatively more weight to capital and labor that demonstrated
slower growth. As GDP grew by the same % in both examples, it is therefore not
surprising that more of GDP growth as been assigned to the residual term, TFP.
(3) (Increase in TFP in the Solow Model)
Assume an economy that follows the typical assumptions of the Solow model, and
starts from some initial steady state. Now assume that the level of TFP has increased
(permanently).
(a) What happens to the production curve, the depreciation line, and the saving
curve?
Production curve “increases”- at zero we still get zero production, but then we have more
output for any positive level of k. The depreciation line in unchanged. The saving rate
increases as well, as we have more output, and we save a constant fraction of it.
(b) What happens to the capital-labor ratio, output per capita, investment per
capita, and consumption per capita at the new steady state?
k clearly rises. Since both TFP and k increase, output per capita increases as well. As the
depreciation rate and population growth rate do not change, it must mean that we “move
up” the depreciation line, so we need to invest more in order to maintain the higher level
of k. Consumption increases as output increases and the saving rate remains unchanged
(c=(1-s)y).
(c) Does the golden rule level of capital-labor ratio change? If so, is it higher or
lower? What happens to the consumption curve (i.e. the curve that relates steady
state consumption to steady state k)?
We know that the golden rule level of k must satisfy this condition: Af '(kGR ) = (n + ! )
(reminder: this is the point where the production curve and the depreciation line share the
same slope, and have the highest difference or distance between them; in other words,
this is where consumption is maximized).
Notice that the right hand side of the equation is unchanged, and on the left hand side A
increased. Since this condition must hold with equality for max consumption, it must
imply that f '(kGR ) is lower. Therefore it must be that kGR is higher.
As the depreciation line remains in place, and the production curve shifts up, it also
means that other than k=0, the consumption schedule should also increase.
(4) (Analytical Question #4, p. 221, 5th Canadian Edition of the Textbook)
In a Solow-Swan type economy, total national saving, S is St = sYt − hKt . The extra
term −hKt reflects the idea that when wealth (as measured by the capital stock) is
higher, saving is lower. (Wealthier people have less need to save for the future.)
Assume a Cobb-Douglas production function in capital and labor Y = AK α N 1−α
(a) Find the steady state values of capital-labor ratio, output per worker, and
consumption per worker.
The steady state level of k is determined by the usual “actual investment = required
investment” condition. Actual investment is determined by saving.
St = sYt − hKt ⇒
sy − hk = ( n + δ )k ⇒
sAk α − hk = (n + δ )k ⇒
1 α α
1
α −1 n +δ + h ⎛ sA ⎞ 1−α ⎛ sA ⎞ 1−α ⎛ s ⎞ 1−α
k = ⇒ k * = ⎜ ⎟ ⇒ y * = Ak α = A ⎜ ⎟ = A1−α ⎜ ⎟
sA ⎝ n + δ + h ⎠ ⎝ n + δ + h ⎠ ⎝ n + δ + h ⎠
C = Y − S = Y − ( sY − hK ) = (1 − s )Y + hK ⇒
α 1
1
* * * ⎛ s ⎞ 1−α ⎛ sA ⎞ 1−α
c = (1 − s ) y + hk = (1 − s ) A 1−α
⎜ n + δ + h ⎟ + h ⎜ n + δ + h ⎟
⎝ ⎠ ⎝ ⎠
Looking at the equations above, clearly higher h leads to lower k and lower y.
This is ambiguous. On the one hand, you have lower k and y – both imply a lower level
of consumption. On the other hand, you save less when h is lower, so you keep more of
the (lower) output.
If you calculate the derivative of c with respect to h and set it equal to zero, you can see
that h may be positive and actually depends on the other parameters of the problem.
Hence, there is a positive level of h that maximizes consumption per worker. This implies
that in some parameterizations of the model, higher h may imply higher consumption per
worker.
α 1 α 1
1
* * * ⎛ s ⎞ 1−α ⎛ sA ⎞ 1−α ⎛ n + δ + h ⎞ α −1 ⎛ n + δ + h ⎞ α −1
c = (1 − s ) y + hk = (1 − s ) A ⎜ 1−α
⎟ + h ⎜ ⎟ = (1 − s ) ⎜ ⎟ + h ⎜ ⎟
⎝ n + δ + h ⎠ ⎝ n + δ + h ⎠ ⎝ s ⎠ ⎝ s ⎠
Where in the last equation we assume that A=1 in steady state.
α 1 1
−1 −1
∂c (1 − s ) α ⎛ n + δ + h ⎞ α −1 ⎛ n + δ + h ⎞ α −1 1 1 ⎛ n + δ + h ⎞ α −1
= ⎜ ⎟ + ⎜ ⎟ + h ⎜ ⎟ =0
∂h s (α − 1) ⎝ s ⎠ ⎝ s ⎠ s (α − 1) ⎝ s ⎠
1 1 1
−1
⎛ n + δ + h ⎞ α −1 (1 − s ) α ⎛ n + δ + h ⎞ α −1 1 1 ⎛ n + δ + h ⎞ α −1
⎜ s ⎟ = s (1 − α ) ⎜ s ⎟ + s (1 − α ) h ⎜ s ⎟
⎝ ⎠ ⎝ ⎠ ⎝ ⎠
−1
(1 − s ) α 1 1 ⎛ n + δ + h ⎞ (1 − s ) α 1 1 ⎛ s ⎞
1= + h ⎟ = s (1 − α ) + s (1 − α ) h ⎜ n + δ + h ⎟
s (1 − α ) s (1 − α ) ⎜⎝ s ⎠ ⎝ ⎠
sh
(1 − α ) s = (1 − s )α +
n +δ + h
sh
s −α =
n +δ + h
( n + δ )( s − α ) + sh − α h = sh
( n + δ )( s − α ) = α h
( n + δ )( s − α )
=h
α
(5) Assume an economy with a production function Y = F ( K , N ) = K + 2 N . The saving
rate is s > 0 , the depreciation rate is 1 > δ > 0 , and the population growth rate is n > 0 .
(a) show that the production function is constant returns to scale
F ( λ K , λ N ) = λ K + 2λ N = λ ( K + 2 N ) = λ F ( K , N )
Hence the production function is homogeneous of degree one, so constant returns to
scale.
(b) Write the production function in “per worker” terms.
Y K + 2N K
y= = = +2=k +2
N N N
(c) Write the condition for steady state capital-labor ratio with the assumed
production function
In general we know that we can solve for the steady state using sAf (k ) = (n + δ )k .
In this case s(k + 2) = (n + δ )k
(d) Plot the saving and “required investment” on a graph (k on the horizontal axis).
Is it possible that there is no steady state? (you can also use your answer in (c)).
As the production function has a positive intercept at k=0, so does the saving function.
Therefore, the only way to guarantee that the saving curve crosses the required
investment line is if s < (n + δ ) .
(Aside: in the general model we assume concavity of the production function in the sense
that f '(0) = ∞ and f '(∞) = 0 hence it is guaranteed that the saving curve and the required
investment line intersect the saving curve; In this case the production function is linear,
so it is not necessarily the case).
(e) Solve for the steady state levels of capital-labor ratio, output per worker,
consumption per worker, and investment per worker.
n +δ 2s
s(k + 2) = (n + δ )k ⇒ k +2= k ⇒ k* =
s n+d −s
2s 2( n + δ )
y* = k + 2 = +2=
n+d −s n +δ − s
2 s(n + δ )
i* = sy * =
n +δ − s
2(1 − s )( n + δ )
c* = (1 − s ) y * =
n +δ − s
(f) [BONUS] Assume you could choose the saving rate. What is the saving rate that
maximizes consumption per worker (in other words: what is the golden rule saving
rate).
This is a little tricky…
∂c* −2(n + δ )(n + δ − s) + 2(1 − s)(n + δ ) 2(n + δ )(1 − n − δ )
= =
∂s (n + δ − s )2 (n + δ − s )2
Looking at this condition, we see that it is equal to zero only if n + δ = 1 . In this case the
required investment line and the production function have the same slope everywhere,
and so the consumption level is actually constant.
If n + δ > 1 then the saving rate is always “too high” in the sense that increasing it further
actually decreases consumption per worker. Why is this the case? Because an additional
unit of capital does not produce enough to compensate for depreciation.
For similar reasons, if n + δ < 1 then the saving rate is too low. (i.e consumption will
increase if you increase the saving rate).
(6) In the Solow model, describe the effects of a permanent increase of foreign aid.
(a) What happens to output, saving, actual investment, and consumption in the
short run?
The increase in foreign aid implies that the economy’s resources increase. Graphically we
think of that as a vertical shift of the output curve.
As the saving rate is constant and exogenous in the Solow model, it must be that the
economy saves more and therefore invests more.
Consumption is also higher as long as we assume that the constant saving rate is lower
than 1.
(b) Are the capital-labor ratio and output per worker in the long run (the new
steady state) higher or lower than the old steady state?
In the new steady state both k and y are higher. (Graphically, and intersection of the same
required investment curve, but higher saving curve.)
(c) Describe the process of convergence from the old steady state to the new one.
The required investment line represents the level of investment that is needed to maintain
a given level of k. When foreign aid increases the economy invest more than required to
keep the old steady state level of k. Therefore, in the next period the economy has more k.
As long as the saving curve is above the required investment line, the same process
continues until we reach the new steady state.
(7) Government spending and investment in the Solow model.
Suppose that the government purchases goods in the amount of g per worker every
period. With N t workers in period t, total government expenditure is gNt . The
government budget is balanced every period, so that gNt = Tt , where T is total tax
revenue. Assume that the government uses some of the proceeds to increase saving
in the economy. In particular, aggregate saving are increase by mTt = mgN t Given that,
national saving is St = s(Yt ! Tt ) + mTt , where s is the (constant) saving rate.
Assume the standard Solow model assumptions: (1) yt = At f (kt ) is the production
function (per worker); (2) n > 0 is the population growth rate; (3) δ > 0 is the capital
depreciation rate; and (4) m < s
(a) Write the equation that characterizes the steady state of this model. Briefly
explain the intuition behind this equation. (Note that you don’t have to explicitly
solve for k.)
We know that in the Solow-Swan model, saving equals actual investment (a standard
goods market equilibrium condition). At the same time the line (n + δ )k represents the
level of investment that is required to keep a given level of k constant. The point where
actual investment equals the required investment is the steady state.
Under the above assumptions: actual investment is
I "Y T % T
I = S = s(Y ! T ) = s(Y ! gN ) + mT !
N
( ) ( )
= s $ ! ' + m = s y ! g + mg = s Af (k) ! g + mg = sAf (k) + (m ! s)g
#N N& N
(b) Draw the saving curve and the required investment line on the same graph (with
k on the horizontal axis). Show that there are two potential steady states.
Because of g and the assumption that m<s, the saving curve has a negative intercept with
the vertical axis. Given that there is a steady state, i.e. that there is an intersection
between the required investment line and the saving curve, we see that there are two
intersections. Therefore, potentially there are two steady states.
(Aside: Only the top higher one is stable in the sense that if we start at that point and then
there is a shock, we are guaranteed to converge back to the same point).
(c) Assume that the higher k is the actual steady state of the economy. Assume that
the government uses more of the tax revenue to save (m is higher, and g is
unchanged), what are the effects on the steady state levels of capital labor ratio,
output per worker, and consumption per worker?
The saving curve shifts upward (vertically), leading to a higher steady state level of k.
Given that, it is obvious that output per worker increases as well. Consumption increases
because output increases while the saving rate and the taxes paid aren’t changing.
(d) Is the government successful in achieving its goal? i.e is saving higher when there
is positive tax and government saving, or when are no taxes and no government
expenditure? Does the answer depend on m? if so, how?
Clearly as long as m<s the tax policy actually results in lower saving then what would be
with g=0. However, if m>s, then the government’s saving rate is actually higher than the
private saving rate, and so aggregate saving will actually increase.