Problem Set #5

Seth Neumuller

Econ 202

1. Over the last 25 years, China has experienced a protracted rise in total factor
productivity and a decrease in the population growth rate. Use the Solow
Growth Model to analyze the effects of a simultaneous increase in z and decrease
in n on the dynamics of capital per worker, output per worker, investment per
worker, consumption per worker, rental rate, and real wage.

Solution: Suppose the economy is initially in the steady state character-

ized by k1 units of capital per worker depicted in Figure 1. An increase in z
causes the production function and actual investment curve to shift up for
any given level of capital per worker, the firm can now produce more output
(y = zk ) and, as a result, actual investment rises given a constant savings rate
(i = sy). A decrease in n causes the required investment curve to rotate down
(flatter slope) a lower rate of population growth implies less investment is
required to maintain any given level of capital per worker.
After all curves have shifted, at k1 actual investment exceeds required investment,
and therefore the capital stock begins to increase and will continue to increase
until it reaches k2 at which point actual and required investment are equal. In
the new steady state, output per worker, investment per worker, and output per
worker are unambiguously higher since y = zk , an exogenous increase in z
and endogenous increase in k cause y to rise; because i = sy and c = (1 s)y, an
increase in y holding s constant leads to an increase in both i and c. To isolate
the effect on the rental rate and real wage, recall that both capital and labor are
paid their marginal product:
 1
1 1 1
r = zK N = z
k
and
w = (1 )zK N = (1 )zk
While an increase in z tends to push up the rental rate, the endogenous increase
in k tends to push down the rental rate. On impact, an increase in z causes the

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 rental rate to rise, while over time the rental rate then declines as k increases.
Hence, the net effect is ambiguous. An increase in z and k, however, cause the real
wage to increase between the initial and terminal steady states. On impact, an
increase in z causes the real wage to rise, while over time the real wage continues
to rise as k increases. Intuitively, an increase in z makes both capital and labor
more productive. Over time as k rises, capital becomes relatively less productive
while labor becomes relatively more productive.

y2*
Output, Actual Investment, Required
Investment per Worker

y = z' k

y = z k c2*

y1*

c1* ireq = (n+)k

iact = s z' k
iact = s z k
ireq = (n'+)k
k1* Capital per Worker, kt k2*

Figure 1: An increase in z and decrease in n.

2. Consider a numerical example using the Solow Growth Model. Suppose

Yt = zt F (Kt , Nt ) = zt Kt0.5 Nt0.5 ,
with zt = 1, t = 0.1, st = 0.2, and nt = 0.01.
(a) Determine capital per worker, output per worker, consumption per worker,
rental rate, and real wage in steady state.

Solution: In the standard version of the Solow Growth Model, the

steady state level of capital per worker is that for which actual investment
is equal to required investment:
sz(k1 ) = (n + )k1
Solving this equation yields:
 1
 1
sz
k1 =
n+

2
 Plugging in known values to this equation implies that k1 = 3.31 units of
capital per worker.
Output per worker can be found using the production function evaluated at
k1 :
y1 = z(k1 ) = (1)(3.3)0.5 = 1.82
The representative consumer invests a fraction s of her income (total output)
and consumes the remainder each period. Thus,

i1 = sy1 = (0.2)(1.8) = 0.36

c1 = (1 s)y1 = (1 0.2)(1.8) = 1.46

To find the rental rate and real wage, recall that both capital and labor are
paid their marginal product:
 1  0.5
1 1 1 1
r1 = zK N = z = (0.5)(1) = 0.28
k 3.31

and

w1 = (1 )zK N = (1 )zk = (1 0.5)(1)(3.31)0.5 = 0.91

(b) Suppose the economy is initially in the steady state you calculated above.
Then st increases to 0.4 (i.e. st = 0.2 for t < 1, then st = 0.4 for all t 1).
i. Determine capital per worker, income per worker, consumption per
worker, the rental rate, and real wage in the new steady state.

Solution: Using the equations outlined in Part (a)...

 1
 1  2
sz (0.4)(1)
k2 = = = 13.2
n+ 0.01 + 0.1

y2 = z(k2 ) = (1)(13.2)0.5 = 3.64

i2 = sy2 = (0.4)(3.64) = 1.46
c2 = (1 s)y2 = (1 0.4)(3.64) = 2.18
 1  0.5
1 1
r2 = z = (0.5)(1) = 0.14
k2 13.2
and
w2 = (1 )z(k2 ) = (1 0.5)(1)(3.31)0.5 = 1.82

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 ii. Use Excel to compute capital per worker, output per worker, con-
sumption per worker, the rental rate, and real wage in each of the 200
periods following the increase in the savings rate.

Solution: Use the capital accumulation equation to compute

the sequence {kt }10
t=2 given k1 = 3.31 and st = 0.4 for all t [1, 10]:

1
kt+1 = [szkt + (1 )kt ]
1+n
Once we have obtained the entire sequence {kt }10
t=1 , we can compute the
remaining endogenous variables as follows:

yt = zkt

it = syt
ct = (1 s)yt
 1
1
rt = z
kt
wt = (1 )zkt
iii. Create time-series plots of capital, output, and consumption per
worker, rental rate, and real wage over the 200 periods following the
increase in the savings rate. Describe the evolution of capital.

Solution: n/a

3. In the standard Solow Growth Model, suppose = 1/3, savings rate is s = 0.25,
depreciation is = 0.1, and population growth is n = 0.02.

(a) Suppose that in country A, total factor productivity is z = 1. Calculate

per capita income and capital per worker in steady state.

Solution: For the standard Solow Growth Model, actual investment

is
it = st zt kt
while required investment is
it = (nt + t )kt

The steady state level of capital per worker is that which equates actual and
required investment, or
 1
 1
sz
k =
n+

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 where we have assumed that all exogenous variables are constant in steady
state. Plugging in values for the exogenous variables yields:
 1
 11/3
(0.25)(1)
kA = = 3.0
0.02 + 0.1
From the production function, it follows that
yA = zA (kA )1/3 = (1)(3.0)1/3 = 1.4

(b) Suppose that in country B, total factor productivity is z = 2. Calculate

per capita income and capital per worker in steady state.

Solution: Using the same formula as derived in Part (a), except

with z = 2, we have
  1
(0.25)(2) 11/3
kB = = 8.5
0.02 + 0.1
or more than twice the capital per worker as country A. From the production
function, it follows that
yB = zB (kB
1/3
) = (2)(8.5)1/3 = 4.1

(c) In terms of GDP per capita, how much richer is country B than country
A? What does this imply about the ability of differences in total factor
productivity to explain differences in living standards across countries?

Solution: Country B has twice the level of total factor productivity,

but is nearly 3 time richer in terms of real GDP per capita than country
A. This result implies that relatively small differences in total factor
productivity, can explain relatively larger differences in living standard
across countries.
(d) Suppose country A begins to raise its total factor productivity through the
exchange of ideas and technology with country B. Describe how this change
might effect the dynamics of per capita income and capital per worker in
country A.

Solution: As zA increases, so does output per worker, and therefore

so does actual investment per worker. Since required investment per worker
is unaffected by an increase in total factor productivity, actual investment
will begin to exceed required investment. As a result, capital per worker
in country A will begin to grow, along with output per worker. If zA
eventually converges to zB , assuming everything else is held constant, then
living standard in country A will also converge over time to the same level
as those in country B.

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4. Modify the Solow Growth Model to include a government that consumes an
amount Gt = t Nt at each date t, where t > 0 is an exogenously given model
parameter. Assume that the government finances its purchases through lump-
sum taxes Tt levied on the representative consumer and that the representative
consumer saves a fraction st of her after-tax income each period.

(a) Define the problems of the representative consumer, representative firm,

and government. Define a competitive equilibrium for this model economy.

Solution:
The Representative Consumer
The representative consumer owns the economys capital stock Kt and rents
it to the representative firm at the rental rate rt each period for use in the
production process. The consumer also supplies labor inelastically to the
representative firm taking the wage rate wt per unit of labor as given. The
consumers labor supply, which is equal to their time endowment, is deter-
mined by the population of the economy Nt which grows at the exogenously
given rate nt . Hence
Nt+1 = (1 + nt )Nt .
The consumers budget constraint is given by

Ct + It = rt Kt + wt Nt Tt ,

where Ct is consumption, It is investment in new productive capital, and Tt

is a lump-sum tax levied by the government.
Capital depreciates at the exogenous rate t which reflects the fact that
machines and equipment tend to wear out over time with use and must be
fixed or replaced in order to to maintain their productive capacity. The sum
of the consumers undepreciated capital and their investment at date t is
equal to the amount of productive capital available at the start of date t + 1.
Thus,
Kt+1 = Kt (1 t ) + It
We assume that the consumer saves an exogenously given fraction st of her
after-tax income each period. Hence, investment at date t is given by

It = st (rt Kt + wt Nt Tt ).

She then consumes the remaining fraction (1 st ) of her after-tax income:

Ct = (1 st )(rt Kt + wt Nt Tt ).

The Representative Firm

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The representative firm has access to a Cobb-Douglas production function
that uses capital and labor to produce output:
Yt = zt Kt Nt1
where zt is the firms total factor productivity. The goal of the representative
firm is to choose the quantities of capital and labor that maximize its profits
(Kt , Nt ) = zt Kt Nt1 rt Kt wt Nt .
The optimization problem of the representative firm is therefore
max (Kt , Nt ) = max zt Kt Nt1 rt Kt wt Nt
Kt ,Nt Kt ,Nt

The Government

The government consumes Gt = t Nt units of the consumption good and

finances its expenditures with a lump-sum tax Tt levied on the represen-
tative consumer. The lump-sum tax must satisfy the governments budget
constraint:
Tt = Gt

Market Clearing

There are markets for the final consumption good, capital, and labor. The
market clearing condition for the final consumption good is given by
Yt = Ct + It + Gt
which states that the output of the representative firm must be equal to
the consumption and investment of the representative consumer, plus the
consumption of the government. As in the One-Period Model, we take the
consumption good as the numeraire and express all other prices relative to
the price of the consumption good. In equilibrium, therefore, the rental rate
of capital rt and wage rate wt must adjust to clear the markets for capital
and labor in every period t. We know from Walras Law that if the markets
for capital and labor clear, and all budget constraints are satisfied, then the
market for the final consumption good will also clear in every period.

Competitive Equilibrium

A competitive equilibrium (CE) consists of (1) policy rules {Ct , It } t=1 for the

representative consumer, (2) policy rules {Kt , Nt }t=1 for the representative
firm, (3) a fiscal policy rule {Tt }, and (4) prices {rt , wt }
t=1 such that, given
(4) and the set of exogenous variables K1 and {st , zt , nt , t , t }
t=1 :

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 (1) satisfies the consumers budget constraint.
(2) maximizes the firms profits.
(3) satisfies the governments budget constraint.
The markets for capital and labor clear.
(b) Derive the capital accumulation equation in per worker terms.

Solution: The basic capital accumulation equation is:

Kt+1 = Kt (1 t ) + It

Our goal is to express capital per worker kt+1 as a function of kt and exoge-
nous variables. To achieve this goal, we will successively replace endogenous
variables on the right hand side using equilibrium conditions.
First, lets replace It in the basic capital accumulation equation using the
consumers policy rule:

Kt+1 = Kt (1 t ) + st (rt Kt + wt Nt Tt ).

Next, we can use the government budget constraint to replace Tt :

Kt+1 = Kt (1 t ) + st (rt Kt + wt Nt t Nt ).

The optimization problem of the representative firm yields the following first
order conditions for a maximum:
(Kt , Nt )
= zt Kt1 Nt1 rt = 0
Kt
(Kt , Nt )
= (1 )zt Kt Nt wt = 0
Nt
which can be rearranged to obtain the equilibrium rental rate and wage rate

rt = zt Kt1 Nt1

wt = (1 )zt Kt Nt .
We can see from these expressions that the rental rate is equal to the
marginal product of capital (rt = M PKt = Yt /Kt ), while the wage rate is
equal to the marginal product of labor (wt = M PNt = Yt /Nt ).
Plugging these expressions for rt and wt into our capital accumulation equa-
tion, we arrive at:

Kt+1 = Kt (1 t ) + st [(zt Kt1 Nt1 )Kt + ((1 )zt Kt Nt )Nt t Nt ]

which can be simplified as follows:

Kt+1 = Kt (1 t ) + st [zt Kt Nt1 + (1 )zt Kt Nt1 t Nt ]

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 = Kt (1 t ) + st [Yt + (1 )Yt t Nt ]
= Kt (1 t ) + st (Yt t Nt )
Dividing both sides of this equation by the population Nt allows us to express
the capital accumulation equation in per capita terms:
 
Kt+1 Nt+1 Kt Yt Gt
= (1 t ) + st t .
Nt+1 Nt Nt Nt Nt
or simply
kt+1 (1 + nt ) = kt (1 t ) + st (yt t )
where lower case letters represent the per capita amount of each respective
quantity. Here we have multiplied and divided the term Kt+1 by Nt+1 in
order to put it into per capita terms. We have also employed the population
growth equation to replace Nt+1 /Nt with (1 + nt ).
In a similar fashion, if we divide the production function by the population
Nt , we obtain:
   1
Yt zt Kt Nt1 Kt Nt1 Kt Nt
= = zt 1 = zt
Nt Nt Nt Nt Nt Nt
or simply
yt = zt kt .
The left hand side is output per capita. Given that the consumption good
is the numeraire, yt is real GDP per capita in the Solow Growth Model.
By combining the capital accumulation equation and production function in
per capita terms, we can obtain the following expression for the relationship
between the capital stock at any two adjacent dates t and t + 1:
1
kt+1 = [st (zt kt t ) + (1 t )kt ]
1 + nt
This equation summarizes all dynamics of a competitive equilibrium in the
Solow Growth Model.
(c) Use your answer to Part (b) to derive an equation for kt,t+1 .

Solution: Subtract kt from both sides of the above capital accumu-

lation equation and combine like-terms to get:
1
kt,t+1 = kt+1 kt = [st (zt kt t ) (nt + t )kt ]
1 + nt
(d) Illustrate the Solow Diagram for this model economy.

Solution: See Figure 1.

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 yt = zt kt

Output, Actual Investment, Required

Investment per Worker

itreq = (nt + t)kt

itact = st (zt kt - t)

- st t k1* k2*
Capital per Worker, kt

Figure 2: The Solow Diagram with government spending Gt = t Nt .

(e) Argue that this model has either 0, 1, or 2 steady states depending on the
magnitude of t relative to the other exogenous model parameters.

Solution: A typical Solow Diagram for this model economy is de-

picted in Figure 1. This Solow Diagram is nearly the same as the standard
model, except that the actual investment curve is shifted down by the
amount st t . As a result, the actual investment curve intersects the
y-axis at st t instead of the origin. We know that the slope of the
actual investment curve approaches infinity as kt 0, and decreases
monotonically to zero as kt . Given that the required investment curve
passes through the origin and has a constant slope, the actual investment
curve may intersect the required investment curve either once, twice, or not
at all depending on model parameters.
(f) A steady state in the Solow Growth Model is stable if the economy will
return to the same steady state after a small perturbation in capital per
worker away from its initial steady state value. Based on this definition,
argue that if the model has 2 steady states, then one of them is stable,
while the other is unstable.

Solution: Consider the steady state associated with k1 in Figure 1.

For all k < k1 , actual investment is less than required investment, and
therefore capital per worker will decline. For k > k1 , but less than k2 ,
actual investment is greater than required investment, and therefore capital
per worker will increase. Thus, if capital per worker is perturbed slightly

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 yt = zt kt

Output, Actual Investment, Required

Investment per Worker

itreq = (nt + t)kt

itact = st (zt kt - t)
itact = st (zt kt - t')

- st t k2* k1*
Capital per Worker, kt

Figure 3: An increase in government spending.

away from k1 , it will either shrink to 0 or increase until it converges to k2 ,

and therefore the steady state associated with k1 is unstable. The steady
state associated with k2 , on the other hand, is stable. To see why, note
that for k < k2 but greater than k1 , actual investment exceeds required
investment, and therefore capital per worker will increase. For k > k2 ,
actual investment is less than required investment, and therefore capital
per worker will decrease. Thus, if capital per worker is perturbed slightly
away from k2 , it will converge back to k2 monotonically.
(g) Suppose the economy is initially in the stable steady state you identified
in Part (f). Analyze the impact of an increase in government spending
per worker on the steady state levels of output, capital, investment, and
consumption (in per worker terms) both graphically and analytically.
Explain the economic intuition behind your results.

Solution: Suppose the economy is initially in the steady state labeled k1

depicted in Figure 2An increase in government spending, interpreted as an
increase to t0 > t , causes the actual investment curve to shift downward.
Since the production function and required investment curve do not depend
on t , they do not shift as a result of this exogenous shock. At k1 after
the policy change, actual investment is less than required investment, and
therefore capital per worker will decrease and continue to do so until it
converges to the new steady state denoted by k2 . Since k2 < k1 , output per
worker is given by y = zk , and z is unchanged, output in the new steady
state is lower. Consumption per worker is given by c = (1 s)(y ),

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 while investment per worker is given by i = s(y ). Therefore a decrease
in y and increase in , holding s fixed, leads to a decrease in both c and i.
In this environment, an increase in government spending reduces the after-
tax income of the representative consumer. Since both consumption and
investment are a fraction of after-tax income, both must decline as a result
of an increase in government spending. The amount of investment required
to maintain the initial level of capital per worker exceeds actual investment,
which causes capital per worker to decline until actual investment and re-
quired investment are again equalized at the new, lower capital per worker
steady state.
(h) Solve for the golden rule of capital accumulation k GR and the associated
savings rate sGR for this economy.

Solution: The goods market clearing condition implies the following

relationship between steady state consumption, output, investment, and
government spending:

c = y g i = y i .

In steady state, actual and required investment per worker are equal. Hence,

c = y i .

Next, substitute in for y and i using the production function and required
investment equations to obtain

c = z(k ) (n + )k

Finally, lets find the steady state capital per worker k which maximizes
steady state consumption c :

max

c = max

z(k ) (n + )k
k k

This unconstrained optimization problem has the following first order con-
dition for a maximum:

z(k )1 (n + ) = 0

Solving this equation yields the Golden Rule of Capital Accumulation

 1
 1
GR z
k = .
n+

Note that k GR does not depend on . This is precisely because steady

state consumption is always given by the distance between the production

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function and required investment curve, neither of which are affected by
government spending.
In steady state, actual investment is equal to required investment. The sav-
ings rate sGR needed to implement k GR , therefore, must solve the following
equation:
sGR z(k GR ) = (n + )k GR
 

which implies that

(n + )k GR
sGR = .
z(k GR )
Note that while k GR does not depend on , sGR does. This is because the
steady state is defined as the level of capital per worker for which actual
investment is equal to required investment. Since actual investment is af-
fected by government spending, the golden rule savings rate is also affected
by government spending. In particular, the higher is , the higher is the
savings rate required to implement the golden rule of capital accumulation
government spending extracts resources from the economy and reduces the
amount of resources available for investment in productive capital by the
representative consumer.

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