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Question 1
Production is given by:
Yt F (Kt , Lt ) = AKt L1
t
where Lt+1 = (1 + n)Lt and (0, 1).
a. Show that F exhibits a constant return to scale technology
Solution. This implies showing that F : R2 R is homogeneous of degree 1. Thats it, we need to
show that for > 0, F (Kt , Lt ) = F (Kt , Lt ). Then:
= AKt L1
= F (Kt , Lt )
t
c. Find the wage rate per worker and the rental rate per capital.
Solution. Prot maximization (either by a social planner or by the representative rm in the economy)
yields:
wt
Rt
F (Kt , Lt )
= (1 ) AKt L
= (1 ) Akt
t
Lt
F (Kt , Lt )
= AKt1 L1
= Akt1
t
Kt
Note that this assumes that the good acts here as a numeraire (its price is set to 1).
e-mail:j.chavez-cotrado@warwick.ac.uk
Problem Set # 1
d. Find the dynamical system (describing the evolution of kt over time) under the assumption
that the saving rate is s (0, 1) and the depreciation rate is (0, 1].
Solution. We need to characterize the path of {kt }
t=0 given s (0, 1) and (0, 1]. That is, we need
to nd the non-linear dierence equation kt+1 = (kt ).
Start from the law of motion of the aggregate stock of capital:
Kt+1 = sYt + (1 )Kt
Put everything in per-worker terms by dividing both sides by Lt+1 :
kt+1
Yt Lt
Kt Lt
Kt+1
=s
+ (1 )
Lt+1
Lt Lt+1
Lt Lt+1
sAkt + (1 ) kt
(kt )
1+n
(1)
where I am using yt = f (kt ) = Akt . Sometimes it useful to re-express this condition in terms of
kt+1 . To do so subtract kt from both sides of (1) to get:
kt+1 =
sAkt (n + ) kt
1+n
kt+1 kt
sAkt1 ( + n)
=
kt
1+n
f. Find the steady state level of the stock of capital per worker k, income per worker y and
consumption per capita c.
ss
= ktss = k, which implies that k = 0. Then from the expression for
Solution. In steady-state kt+1
k t :
(
k=
sA
+n
)1/(1)
y = f (k) = Ak = A
1
1
s
+n
) 1
Finally, to get consumption per worker in steady state note that in general yt = ct + it , it = syt and
ct = (1 s)yt . Then, in steady state:
(
c = (1 s) y = (1 s) A
Jorge F. Ch
avez
1
1
s
+n
) 1
Problem Set # 1
g. What is the Golden Rule value of k? (k in steady state s.th. the consumption in steady state
is maximized?)
Solution. The Golden Rule value of kt is the stock of capital per worker that maximizes consumption
in steady-state. Recall that in general:
ct
= (1 s)yt
= f (kt ) sf (kt )
Note that there is no way to maximize consumption in all states as consumption is a function of f (kt )
which is unbounded (we can only get the corner solution kt = 0 if we look for a stationary point).
However, the steady-state condition is:
sf (k)
| {z }
(n + ) k
| {z }
(2)
ss
which is true for any steady-state (any setting in which kt+1
= ktss = k). Then because ct =
f (kt ) sf (kt ), in steady state:
c = f (k) (n + )k
which now will accept an interior solution. The FONC for the maximization problem is:
c
= f (k) (n + ) = 0
k
(
)
f k GR = n +
(
)1
A k GR
=n+
(
)1/(1)
A
n+
(3)
The concept of the Golden Rule for the case of the Solow model is illustrated in gure 1.( There
) you can
see three alternative saving rates, and you can visualize the Golden Rule condition f k GR = n + :
the slope of f () must be equal to the slope of the (n + )k line.
i. Find the elasticity of y with respect to s (in steady-state). Can observed dierences in saving
rates explain the observed dierences in income per-capita across the world?
Jorge F. Ch
avez
Problem Set # 1
c1
cGR
(n + )k ss
s1 f (k ss )
c2
sGR f (k GR )
s2 f (k ss )
k2 k GR
k1
k ss
ln s + . . .
ln A +
1
1
| {z }
ys
Suppose that = 1/3 as it is usually found in empirical studies and there is a dierence in saving rates
of 3 times across countries (300%). Then the elasticity will be /(1 ) = 0.5 which implies that the
dierence in y according to this model (with Cobb-Douglas technology) should be 0.5 300% = 150%.
However the observed dierence is nearly 20 times (this comes from the lecture notes).
j. Find the dynamical system describing the evolution of yt under the assumption of full depreciation = 1.
Solution. With = 1 the law of motion of the stock of capital per worker is just:
kt+1 =
1
sAkt
1+n
To see this:
log y
=
log x
Jorge F. Ch
avez
log y
y
y
log x
x
x
y
y
x
x
%y
%x
Problem Set # 1
Note that the numerator is investment in per capita terms. Then, this expression says that the new
capital stock (which is completely renewed each period) is lower than investment per worker, due to
population growth.2 We want to characterize {yt }
t=0 by analyzing a non-linear dierence equation
yt+1 = (yt ). Recall that yt = Akt . Then:
(
)
(
)
sAkt
syt
yt+1 = Akt+1 = A
=A
(yt )
1+n
1+n
( i
)
k. Suppose you estimate a regression in which ln yt+1
/yti is on the left hand side (i.e.
you)
(
i
i
estimate the log of yt + 1 across countries, where i indexes countries) and ln s , ln 1 + ni
and ln yti are on the right hand side. According to the dynamical system you dened in
question j, what would be the coecients on your explanatory variables? How would you
interpret these coecients? Is there convergence? How would you interpret the constant
term?
Solution. Consider the regression:
( i )
)
(
yt+1
ln
= ln A + 1 ln si + 2 ln 1 + ni + 3 ln yti + it
i
yt
From the model we can get an estimable form by taking logs to the law of motion of yt+1 when = 0:
i
ln yt+1
= ln A + ln s ln (1 + n) + ln yti
Then by subtracting lnyti from both sides of the equation above we can see that 0 = ln A, 1 = ,
2 = and 3 = (1 ).
Investment occurs in t while the new capital stock will be readily available in t + 1.
Jorge F. Ch
avez
Problem Set # 1
Question 2
Output per worker is an increasing and concave function of capital per worker, given by: yt =
f (kt ). Output is divided between labor income and capital income according to their marginal
productivity. Namely,
[
]
f (kt ) f (kt ) f (kt ) kt + f (kt ) kt = wt + rt kt
Suppose that the rate of saving from wage income is sw [0, 1] and the rate of saving from
capital income is sr [0, 1]. Therefore, total saving are given by
[
]
st = sw f (kt ) f (kt ) kt + sr f (kt ) kt
Population and technology are constant and the rate of capital depreciation (0, 1)
a. Derive the dynamical system governing the evolution of capital per capita: kt+1 = (kt ).
Solution. Recall that the law of motion of the stock of capital per capita comes from the law of motion
of the aggregate stock per capita:
Kt+1 = It + (1 )Kt
where It denotes aggregate investment. Because there are two distinct saving rates, we can think of
aggregate savings to be determined by an average saving rate (
s) which is a weighted sum of sw
r
and s :
Kt+1 = sYt + (1 )Kt
Now, because there is no population growth, if we divide everything by L we get:
kt+1 = st + (1 )kt
where st = sf (kt ) = sw [f (kt ) f (kt )kt ] + sr f (kt )kt . Then:
kt+1
Note that if sw = sr , then the expression for (kt ) is the same we had before with a single saving
rate.
b. Suppose there exist a range of kt where f (k) = 0 (the third derivative is zero). Find a
condition on the saving rates sw and sr such that the dynamical system kt+1 = (kt ) is
convex ( (kt ) > 0 in the range of f (kt ) = 0.
Solution. First lets get the derivatives:
(kt )
(kt )
Let k be the maximum stock of capital per worker that can be attained by economy and assume that
Jorge F. Ch
avez
Problem Set # 1
such that kt [k1 , k2 ], f (kt ) = 0. Then, for those values of kt , using (4):
k1 k2 [0, k]
(kt )|kt [k1 ,k2 ]
(2sr sw ) f (kt )
Therefore, for (kt ) > 0 we need 2sr < sw and strict concavity in the range [k1 , k2 ] (concavity is not
enough) of f .3
kt
+ (1 ) kt (kt )
1 + kt
(kt )
=
=
sw
sw
1 + kt
sw kt
(1 + kt )
(1 + kt ) kt
2
(1 + kt )
)
+ (1 )
+ (1 )
kt 0
kt +
=
=
lim
kt +
sw kt
2
(1 + kt )
+ (1 )
Note that the limit of the rst term of the RHS is not undetermined (no need to apply LHospital
rule)
3
Jorge F. Ch
avez
Problem Set # 1
[
sw
= s
1 kt2
= s
(1 + kt )
[
(1 + kt ) 2 (1 + kt ) kt
(1 + kt )
kt 0
1 kt2
(1 + kt )
Now, setting (kt ) > 0 1 kt2 > 0 kt2 < 1 kt < 1 or kt > 1. But kt is the stock of physical
capital per worker, so in principle kt 0. Thus, because (0) > 0, the range we were looking for is
[0, 1].
g. Show that for = 0 a non-trivial steady state level of k does not exist (that is, explain why
Jorge F. Ch
avez
Problem Set # 1
Solution. WTS if = 0 then @ a non-trivial steady state k > 0 for {kt }. Note that with = 0:
lim (kt ) =
kt 0
lim (kt ) = 1
kt +
which means that this system does not have an interior steady-state.
More formally:
Claim 1. There is no non-zero xed point for (kt ) (that is @k > 0 s.th. k = (k)).
Proof. Suppose not: k > 0 s.th k = (k). Then:
(kt )|=0 = sw log (1 + kt ) sw
kt
+ kt
1 + kt
sw k + k + k 2
1+k
Manipulating this expression a little bit we get to an expression that k > 0 must satisfy:
log (1 + k) (1 + k)
1+k
exp
k
1+k
)
(4)
Think about slopes. The LHS is a linear function with a constant slope equal(to 1.) The RHS is an
k
exponential function with slope < 1 for all values of k 0.5 For 1 + k = exp 1+k
to be true, the
two functions must intersect at some point k > 0. They only intersect (in fact they are only tangent)
at k = 0. This is a contradiction, which means that our starting premise was wrong. Q.E.D
Finally, the growth rate of kt is:
kt
kt+1 kt
log kt+1 log kt
k
[t
]
1
w log (1 + kt )
= s
kt
1 + kt
=
(5)
(6)
Jorge F. Ch
avez
<1
Problem Set # 1
where the second equality comes from replacing kt+1 with the expression for (kt ). Taking limits:
]
1
log (1 + kt )
= lim s
kt
kt
1 + kt
[
]
log (1 + kt )
1
w
= s
lim
lim
kt
kt 1 + kt
kt
[
]
1
1
1+kt
w
= s
lim
lim
kt 1
kt 1 + kt
[
lim kt
kt
where again, the second-to-last equality applies LHospital rule for undetermined limits.
Jorge F. Ch
avez
10
Problem Set # 1
Question 3
Production if given by:
Yt F (Kt , Lt ) = Kt (Bt Lt )1
where Lt+1 = (1 + n)Lt , Bt+1 = (1 + g)Bt and (0, 1).
a. Find the dynamical system describing the evolution of kt = Kt / (Bt Lt ) (that is the stock of
capital per-eective worker). Find the steady state level of kt . What is the growth rate of
output per worker yt = Yt /Lt in the steady state? What is the growth rate of capital per
worker Kt /Lt = Bt kt in the steady state?
Solution.
i. We want to nd the non-linear dierence equation kt+1 = (kt ) for kt Kt /(Bt Lt )
Start from the law of motion of the aggregate stock of capital Kt+1 = It + (1 ) Kt . Recall that
this is a closed economy and that there is a constant (and exogenous) saving rate s:
St = It = sYt
Putting everything in per-eective worker terms (by dividing by Bt Lt ):
Kt+1
F (Kt , Lt ) Bt Lt
Kt
Bt Lt
=s
+ (1 )
Bt+1 Lt+1
Bt Lt Bt+1 Lt+1
Bt L Bt+1 Lt+1
We get the non-linear dierence equation:
kt+1 =
skt + (1 ) kt
(kt )
(1 + g) (1 + n)
As before it is useful to also express the law of motion of kt in terms of kt+1 kt+1 kt . To
do this subtract kt from both sides of (kt ):
kt+1
=
=
skt + (1 ) kt (1 + n + g + gn 1 + ) kt
(1 + g) (1 + n)
skt (n + g + gn + ) kt
(1 + g) (1 + n)
s
k=
(n + g + gn + )
]1/(1)
To check stability of the steady-state we need to check whether lim | (kt )| is less than unity:
kt
lim | (kt )| =
kt
Jorge F. Ch
avez
1
<1
(1 + g) (1 + n)
11
Problem Set # 1
b. According to Solows growth accounting, the growth rate in Total Factor Productivity (TFP)
is calculated by:
yt
kt
At
=
At
yt
kt
where yt Yt /Lt , kt Kt /Lt ,
is the elasticity of yt with respect to kt (which is equal to
the share of capital in a competitive economy). Find TFP growth rate At /At in the steady
state according to the model in part a.
Solution. According to part (a) both yt = Yt /Lt and kt = Kt /Lt will grow at a rate g in steady-state.
Therefore:
At
At
Jorge F. Ch
avez
yt
kt
yt
kt
= g
g
=
12