# Problem Set 2 fe312 Fall 2007 Rahman Partial Answer Key 1

 Problem Set 2 FE312 Fall 2007 Rahman Partial Answer Key 1) Assume that production is a function of capital and labor, and that the rate of savings, depreciation, population growth, and are all constant, as described in Chapter 7’s version of the Solow Model. Further, assume that the production per effective worker can be described by the function: where K is capital and L is labor. a. What is the per-worker production function y=f(k)? Show your work. b. If the saving rate (s) is 0.4, what are capital per worker, production per worker, and consumption per worker in the steady state? (Note: you need to set Δk = 0, to get an equation in s, δ, n, and k, and then solve for k).   c. Solve for steady-state capital per worker, production per worker, and consumption per worker with s = 0.8.   d. Is it possible to save too much? Why? Yes, it is possible to save too much, in the sense that long-run consumption could actually be higher if you saved less. Indeed, s = 0.8 appears to be too high a savings rate, since steady state consumption per person is definite smaller with s = 0.8 than with s = 0.4. Notice that we can conclude this even without knowing what the population growth rate or the depreciate rate for the economy are. By the way, could we figure out what the actual “best” savings rate is, based on just the information given? Yes, with a bit of deductive reasoning. The golden rule level of capital is where MPK = n + δ…  Thus the golden rule level of savings is 0.5. 2) Assume once again that production is given by: . First, write the production function in per person terms (y=f(k)). Next, assume that the per person level of capital in the steady state is 4, the depreciation rate is 5% per year, and population growth is 5% per year. Does this economy have “too much” or “too little” capital? How do you know? [Show your work]. Again, if we are at the golden rule level of capital, then MPK = n + δ. Given the values of the parameters, and how much capital per person there is… Since MPK > n+δ, we can conclude that there is “too little” capital in the economy. With such little capital, the marginal productivity of this capital is quite high. 3) Suppose that two countries are exactly alike in every respect (meaning they have the same levels of capital, output, depreciation, etc.) except that the citizens of country A have a higher saving rate than the citizens of country B. a. Which country will have the higher level of output per worker in the steady state? Illustrate graphically. As should be clear from the picture, the only difference between the two countries is that the savings rate in country A is higher than that of country B, and thus country A has the higher level of steady-state income per person (notice however that at the moment both countries have the same levels of income per person). b. Which country will have the faster rate of growth of output per worker? Country A. Since sA*f(kA) > sB*f(kB), country A is investing more than country B, while both countries depreciation rates are the same. Thus, country A is accumulating per person capital at a faster rate than country B, and this is allowing it to grow faster. 4) Suppose that two countries are exactly alike in every respect (meaning they have the same levels of capital, output, depreciation, etc.) except that population grows at a faster rate in country A than in country B. a. Which country will have the higher level of output per worker in the steady state? Illustrate graphically. As should be clear from the picture, the only difference between the two countries is that the population growth rate in country A is higher than that of country B, and thus country B has the higher level of steady-state income per person (notice however that at the moment both countries have the same levels of income per person). b. Which country will have the faster rate of growth of output per worker? Country B. Since (nA + δ) > (nB + δ) , country A’s per person capital is depreciating faster than in country B, while both countries investment rates are the same. Thus, country B is accumulating per person capital at a faster rate than country A, and this is allowing it to grow faster. 5) The initial steady-state level of capital per worker in Macroland is 5. The Golden Rule level of capital per worker in Macroland is 8. a. What must change in Macroland to achieve the Golden Rule steady state? It must increase its savings rate. This will increase the level of per person capital in the economy. b. Why might the Golden Rule steady state be preferred to the initial steady state? (two or three sentences) The Golden Rule is where long-term consumption is maximized, while current consumption is definitely less than this. If Macroland cares about the welfare of its future citizens, achieving the Golden Rule level is a good objective. c. Why might some current workers in Macroland prefer the initial steady state to the Golden Rule steady state? (two or three sentences) Increasing the savings rate means that per person consumption will initially go down, while the gains in consumption will occur only later. Thus, if a country heavily discounts the future (in other words, if it puts a high value of present consumption relative to future consumption), this change might be too “painful,” and it would be better off not going to the Golden Rule. 6) Two countries, Richland and Poorland, are described by the Solow growth model. They have the same Cobb-Douglas production function, , but with different quantities of capital and labor. Richland saves 32 percent of its income, while Poorland saves 10 percent. Richland has population growth of 1 percent per year, while Poorland has population growth of 3 percent. (Note: the numbers are chosen to be approximately realistic descriptions of rich and poor nations.) Both nations have technological progress at a rate of 2 percent per year and depreciation at a rate of 5 percent per year. a. What is the per worker production function f(k)? b. Solve for the ratio of Richland’s steady-state income per worker to Poorland’s. (Hint: The parameter α will play a role in your answer.) Solving for steady-state income per person for each country gives you Thus, if we write this as the ratio of steady-state incomes, we have c. If the Cobb-Douglas parameter α takes the conventional value of about 1/3, how much higher should income per worker be in Richland compared to Poorland? Here we plug in numbers for our parameters: d. Income per worker in Richland is actually 16 times income per worker in Poorland. Can you explain this fact by changing the value of the parameter α? What must it be? Can you think of anyway of justifying such a value for this parameter? How else might you explain the large difference in income between Richland and Poorland? In order to get a 16 times difference, we would need α/(1-α) such that: With α = 2/3, we get exactly that. Such an alpha implies that the share of national income that goes to the owners of capital is roughly two-thirds. We have typically said that only 1/3 of national income goes to the owners of physical capital. However, if we use a more broader measure of capital (such as education, which we often call “human capital,” we get closer to 2/3. Doing this, we can better explain real income differences across the world. Page of