EC3102 final exam solution-2011

1. In a Solow model, the production function has the Cobb-Douglas form, .

The capital depreciation rate is . Population growth rate is n. Technology level A is
constant. Let and .

(1) Suppose that saving rate is s. Derive the movement equation of capital per capita, k.
[5 points]
(2) We denote capital per capita and output per capita in the steady state as and .

Show that 0. [5 points]

(3) Derive the golden rule level of capital per capita, . [5 points]

Answer: (1) The movement equation of capital per capita, k, is

∆ ∆

∆ · ∆ ·

∆ ∆
·

Thus
∆

(2) From the production function we have

The steady state condition is

Thus

1
 We have

Thus

1
0

(3) The golden rule condition is

By the production function we have

Thus the golden rule level of capital per capita is

2. Use Solow growth model to explain why developed economies have slower growth rates
than emerging market economies. [15 points]

Answer: In Solow model, the growth rate of capital per capita is

∆

since ∆ . By concavity of , we know that is a decreasing

∆
function of . Thus is a decreasing function of . We know that countries with

higher capital per capita have lower growth rates. Developed economies have higher
capital per capita than emerging market economies. Thus developed economies have
slower growth rates than emerging market economies.

3. For a two-sector endogenous growth model, u is the fraction of labor force in universities.
The total labor force L is a constant. The production function in manufacturing firms is,
Y F K, 1 u LE
The movement equation of technology is,
2
 ∆
where g is the production function of knowledge.
And capital accumulation equation is,
∆
where s is the saving rate.
(1) Rewrite the production function for manufactured goods in terms of output per
effective worker, y, and capital per effective worker, k. [5 point]
(2) Write down the equation of motion for capital per effective worker, k. Use this
equation to draw a graph showing the determination of steady-state k. [10 points]
(3) In this economy, what is the steady-state growth rate of output per worker, ?

[5 points]

Answer: (1) The output per effective worker is

and the capital per effective worker is

Thus the production function for manufactured goods can be written as

, 1
, 1 , 1

(2) The equation of motion for capital per effective worker, k, is

∆ ∆

∆ · ∆ ·

∆ ∆ ·

∆ ∆
·

∆
·

, 1
3
 Thus
∆ , 1
In the steady state, ∆ 0. Thus the determination of steady-state k can be represented
as the following graph.

, 1

(3) In the steady state, , 1 is a constant since and are

constants. Thus output per worker, , has a growth rate of .

4. An agent lives for two periods: period 1 and period 2. The agent’s utility function is,
U C ,C ,W lnC lnC αlnW

where is the consumption in period 1, is the consumption in period 2, and W is the

bequest left for children. The agent’s income in period 1 is Y . The agent’s income in
period 2 is Y . >0 governs the bequest motive. The interest rate is r. Thus the agent’s
intertemporal budget constraint is,
C W Y
C Y
1 1 r

(1) Solve the agent’s optimal policy functions: C , C and W . [10 points]
(2) In period 1, the agent’s saving is . Use the result of in part (1) to derive

the saving function . Show that 0. [10 points]

4
 Answer: (1) We set up the Lagrange function
Y C W
lnC lnC αlnW θ Y C
1 r 1
F.O.C.
1
C
1 1
C 1
1 1
W 1
Thus
C 1 C
W 1 C
Plugging these two formulae into the intertemporal budget constraint, we have
Y
Y 1 r
C
2
Thus
Y
Y 1 r
C 1
2
and
Y
Y 1 r
W 1
2

(2) From part (1) we have

Y
Y
1 r
2
Y
1 1 r
2
Thus
Y
Y
1 r 0
2

5
5. In the first several years of 2000’s, Federal Reserve had very low interest rate. This made
it less expensive to get a mortgage and buy a home. Use the model of residential
investment to predict the impact of this event on housing prices and residential
investment. [15 points]

Answer: The event caused an expansionary shift in the demand for houses. The following
graphs show that housing prices would rise and residential investment would increase.

Supply Supply

Demand

6. Explain why bank failures caused a fall in the money multiplier. [15 points]

Answer: Money multiplier

1

Bank failures raise the currency-deposit ratio, cr, by reducing public confidence in the
banking system. A higher cr implies a lower m.

Bank failures raise the reserve-deposit ratio, rr, by making bankers more cautious. A
higher rr implies a lower m.

END OF PAPER