ECON102 - INTERMEDIATE MACROECONOMICS

Instructor: Juliana Yu SUN

Sample Questions

1. In the solow growth model, determine the effects of a decrease in capital depreciation
rate on the golden rule quantity of capital per worker and on the golden rule savings
rate. Explain your results.
Answer: The golden rule quantity of capital per capita, is such that a decrease in capital
depreciation rate, d, requires a decrease in the marginal product of capital. Therefore, the
golden rule quantity of capital per capita must increase. The golden rule savings rate may
decrease. But there is no change in the growth rates of aggregate C, Y and K.

2. In the Solow growth model, determine the effects of an increase in capital depreciation
rate on the steady state capital per worker and the growth rates of aggregate
consumption, output and capital.
Answer: An increase in capital deprecation rate requires an increase in the marginal
product of capital. Therefore, the steady state capital per worker, k2*, is lower. The
aggregate C, Y, and K still grow at the rate of population growth rate, n, because there
is no change in the population growth rate.

3. In the Solow growth model, suppose that two countries have different TFP levels. The
rich country has technology, zr, while poor country has technology zp, (zr> zp). These
two countries are the same in all other respects. Will these two countries converge to the same
growth path in the long run?
Answer: no, they will not converge in the long run. All else equal, low TFP zp leads to lower
steady state capital per worker for the poor country, so that kp*< kr* and yp*< yr*. For the
aggregate variables, they all grow at the same rate, n, the population growth rate, but they will
grow at two parallel paths.

(
)
(
)
. Capital evolves
, where d is capital depreciation rate and s is
savings rate. Population grows at the rate of n. Given z, , d and n as parameters, solve the
steady state capital per worker, output per worker, and consumption per worker.

4. In the Solow Growth model, suppose that the production function is

*
Answer: First, you derive the steady state capital per worker k* following: szf (k )

(n d )k *

*
from the model setup. From the production function, you get: szk

y*

(n d )
sz
z k*

(n d )
sz

1 s y

(n d )k * , so that

1 sz

z1

(n d )
s

(n d )
s

5. In the endogenous growth model, suppose there are two countries, poor country and rich
country. The rich country has a high level of initial human capital, Hr. The poor country has a
low level of human capital, Hp. Hr > Hp . Also the rich country has higher efficiency in
producing human capital, br. The poor country has a lower efficiency in producing human
capital, bp. br> bp. Assuming population is constant and normalized to be 1. Will these two
countries converge in their aggregate income and plot their growth paths.
Answer: these two countries will not converge. The rich country starts with higher income level
and will grow at higher rate, br(1-u)-1. The poor country starts with lower income level and will
grow at lower rate, bp(1-u)-1.

6. In the endogenous growth model, suppose there are two countries, poor country and rich
country. The rich country has a high level of initial human capital, Hr. The poor country has a
low level of human capital, Hp. Hr > Hp . Further assume that the rich country has lower
efficiency in producing human capital, br. The poor country has a higher efficiency in
producing human capital, bp. br< bp. Assuming population is constant and normalized to be 1.
Will the poor country exceed the rich country? Plot their growth paths.
Answer: Yes, the poor country exceed the rich country. Although the poor country starts with
lower income level, but will grow at higher rate, bp(1-u)-1. The rich country starts with higher
income level, but will grow at lower rate, br(1-u)-1. Eventually, the poor country will surpass
the rich country.

7. Suppose the economy starts with the goods market, labor market and money market
equilibrium. This year due to an earthquake, this economy loses 1/3 of its capital. According to
the real business cycle model, what kind of stabilization policies should be used to smooth
output due to capital loss.
Answer: A decrease in the current capital stock, K, leads to lower current output, higher real
interest rate, lower employment and wage rate. (Although Yd rises due to higher MPK, the fall
in Ys exceeds the rise in Yd. Similar analysis applies to labor market)

According to real business cycle model, money is neutral. Monetary policy doesnt work in this
situation. The government should use fiscal policy to achieve higher output and employment.
You can get the following shifts in Yd, Ys, and Ns (in red) according to our discussion about
the effects in change in government spending G in lecture 5.

8. Suppose the economy starts with the goods market, labor market and money market
equilibrium. This year due to an earthquake, this economy loses 1/3 of its capital. Use the new
Keynesian sticky price model, discuss the monetary policy to stabilize output.
Answer: For the new Keynesian sticky price model, monetary policies work. Output is
determined by demand, so the output after the capital shock is Y3 if the monetary policy keeps
interest rate at r1. The employment is determined by labor supply curve (Ns curve does not shift
because interest rate is fixed at r1 by the authority, so N rises and wage rate is higher (no need
to show Nd curve).

If the monetary policy is to stabilize output, i.e, to achieve Y1, then the interest rate r* should
be higher than r1. That is monetary policy is contractionary. (Yes, surprising!) Hint: just use
Yd2 curve because output is demand determined.

9. Suppose the economy starts with the goods market, labor market and money market
equilibrium. This year due to an earthquake, this economy loses 1/3 of its capital. According to
the real business cycle model, if the monetary policy is intended to stabilize price, what kind of
monetary policy should be applied to this situation?

Answer: A decrease in the current capital stock, K, leads to lower current output, higher real
interest rate, lower employment and wage rate. (Although Yd rises due to higher MPK, the fall
in Ys exceeds the rise in Yd. Similar analysis applies to labor market)

In the money market, money demand is lower due to higher interest rate and low output, so the
price level should be higher at P2 if there is no monetary intervention. To stabilize the price
level at P1, money supply should decrease to MS2 in the diagram. (Note that in the real
business cycle model, monetary policy could stabilize price although it cannot affect real
output).

10. Suppose the economy starts with the goods market, labor market and money market
equilibrium. This year due to an earthquake, this economy loses 1/3 of its capital. Use the real
business cycle model, could fluctuations in capital stock explain the business cycle data?
Answer: A decrease in the current capital stock, K, leads to lower current output, higher real
interest rate, lower employment and wage rate. (Although Yd rises due to higher MPK, the fall
in Ys exceeds the rise in Yd. Similar analysis applies to labor market). In the money market,
money demand is lower due to higher interest rate and low output, so the price level rises to P2.

To summarize the effects and compare with the data: in the data

In this model, consumption and investment are procyclical (because r rises and Y falls, C and I
fall). Employment and real wage are procyclical too (N and w fall when Y decreases). Price is
countercyclical. We cannot say anything about money supply here. Regarding the average labor
productivity, its not clear. It could be procyclical, countercyclical, or acyclical. So the model
fits the data in terms of C, I, P, N and w.