ECO 7272, Practice Problem Set 1

Len Cabrera

1. A decrease in the investment rate. Suppose the U.S. Congress enacts legislation that discourages saving and investment, such as the elimination of the investment tax credit that occurred in 1990. As a result, suppose the investment rate falls permanently from s' to s''. Examine the policy change in the Solow model with technological progress, assuming that the economy begins in steady state. Sketch a graph of how (the natural log of) output per worker evolves over time with and without the policy change. Make a similar graph for the growth rate of output per worker. Does the policy change permanently reduce the level or the growth rate of output per worker? Concept. Dont think in terms of time; think of the destination (new steady state) and then worry about how you get there.
~ y ~ y1 * ~ y *
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Steady State. Decrease in s causes steady state output per s' ' ~ y effective worker and capital per effective worker to decline. ~ ~ ~ Based on the formulas: k k 2* k1 * ~ ~ y = Ak and k = k / A steady state output per worker and capital per worker will also decline. The growth rates, however will not be affected in the steady state: ~ ~ y k y k = ~ = 0 and = =g ~ y k y k

~ y ~ (n + g + )k s' ~ y

Transition. Focus on two equations that are valid all the time (not just in steady state): ~ ~ ~ ~ y = k and k = s~ y + ( n + g + )k ~ The second equation can be rewritten by substituting ~ y = k and dividing both sides ~ by k : ~ ~ ~ k / k starts negative and then k s gets bigger and bigger as it ~ = ~ (n + g + ) k k 1 approaches zero ~ ~ This helps us describe the transitional dynamics by plotting k / k at t0 + 2 ~ ~ ~ k / k at t0 + 1 sk 1 and (n + g + ). The difference between the curves gives ~ ~ ~ (n + g + ) k ~ k / k , the growth rate of capital per effective worker; in this ~ <0 s k 1 k ~1 1 ~ 1 ~ ~ s2k case, the lower savings rate drops the sk curve so k / k < 0. ~ ~ ~ k 2 k1 k To determine the effect on output per worker, we start with the ~ modified production function that relates k to y : ~ y = Ak To figure out what happens to y, we do the ln-differentiate trick:

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~ y A k = + ~ = g + y A k

~ k ~ k

~ ~ We know g doesn't change and we just showed that k / k < 0. Therefore, output per ~ ~ worker will grow at a lower rate initially. This rate may be negative if k / k > g , but there is not enough information in the problem to determine if that is the case. We can, however, determine that the growth rate of y will approach the original growth rate in a convex way based on the graph shown earlier. The two cases are shown below (not necessarily to scale).
y/y
Case 1 ~ ~ k / k > g

y/y

Case 2 ~ ~ k / k < g

g t0 Time

g t0 Time

ln y

ln y
Slope of ln y is always g in steady state t0 Time t0 Time

Therefore, the change permanently reduces the level of output per worker.

2. An increase in the labor force. Shocks to an economy, such as wars, famines, or the unification of two economies, often generate large one-time flows of workers across borders. What are the short-run and long-run effects on an economy of a one-time permanent increase in the stock of labor? Examine this question in the context of the Solow model with g = 0 and n > 0. Steady State. The steady state growth rates are y k Y K L = = 0 and = = =n y k Y K L therefore, the one time change in the population (L) doesn't affect these rates.
y y1 y2 y (n + )k sy k2 k1 k

Transition. Focus on two equations that are valid all the time (not just in steady state): y = k and k = sy + (n + )k The second equation can be rewritten by substituting y = k and dividing both sides by k :

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k s = 1 (n + ) k k This helps us describe the transitional dynamics by plotting sk 1 and (n + ). The difference between the curves gives k / k , the growth rate of capital per worker; in this case, the sudden increase in population causes an immediate drop in capital per worker (k). As the transition graph indicates, the lower value of k results in a positive growth rate in k. (Intuitively, what's happening is an increase in capital in order to return to the original level of capital per worker.) To determine the effect on output per worker (y), do the lndifferentiate trick to the intensive form production function: y k = y k k/k

k / k starts positive and then gets smaller and smaller as it approaches zero k /k

at t0 + 1 k / k at t0 + 2
(n + ) sk 1

k >0 k

k2

k1

y/y

We just showed that k / k > 0 , so we also have y / y > 0. According to the 0 transition graph shown above, these growth rates will drop in a convex way Time Time t0 t0 until they return to zero. ln y ln k To relate these growth rates to total capital (K) we look at the definition of k: K = kL We know L doesn't directly affect K, so this equation explains why k dropped Time Time initially. Do the ln-differentiate trick to t0 t0 get: ln Y ln K K k L k Slope of ln Y and = + = +n ln K is always n K k L k in steady state Since n is constant, we can ignore that and realize the change in the growth Time Time rate of capital is the same as the change t0 t0 in the growth rate of capital per worker. To relate these growth rates to total output (Y) we look at the full production function: Y = K L1 Here we do have an initial effect form the change in L (i.e., Y increases at t0). Do the ln-differentiate trick to get: Y K L K = + (1 ) = + (1 )n Y K L K Again, n is constant so the change in the growth rate of output will mirror the change in the growth rate of capital.

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3. An income tax. Suppose the U.S. Congress decides to levy an income tax on both wage income and capital income. Instead of receiving wL + rK = Y, consumers receive (1 - )wL + (1 - )rK = (1 - )Y. Trace the consequences of this tax for output per worker in the short and long runs, starting from steady state. (1 - ) cancels so there's no difference in the production function. The per capita capital accumulation function does change: k = sy (1 ) (n + )k Substitute y = k and divide both sides by k:

k s (1 ) = (n + ) 1 k k Steady State.
s (1 ) 1 k s (1 ) = (n + ) = 0 k* = 1 n+ k k So the income tax effectively lowers the investment rate (same as problem 1).
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4. Manna falls faster. Suppose that there is a permanent increase in the rate of technological progress, so that g rises to g'. sketch a graph of the growth rate of output per worker over time. Be sure to pay close attention to the transition dynamics. Steady State. Increase in g causes stead state capital per worker (k) and output per worker (y) to increase to g'. Transition. Focus on two equations that are valid all the time (not just in steady state): ~ ~ k / k starts negative and then ~ ~ ~ ~ ~ gets less and less negative as y = k and k = sy (n + g + )k it approaches zero ~ ~ ~ Divide the equation on the left by k to see how g relates to the k / k at t0 + 2 ~ ~ ~ growth rate of k : k / k at t0 + 1 ~ ~ 1 ~ k (n + g' + ) k (n + g + ) ~ = sk <0 ~ (n + g + ) k k ~ sk 1 ~ ~ Therefore, k / k = g (as shown in the first diagram) ~ ~ ~ k 2 k1 k To figure out what happens to y, we use ~ y = y / A and the lny/y differentiate trick we did before: ~ ~ g' y A k k = + ~ = g + ~ g y A k k We see that when g increases to g', the growth rate of output per Time t0 worker (y) increases, but the increase is less than g because of the drop in the growth rate of capital per effective worker which equals -g (its effect doesn't totally counter g because < 1). Eventually the growth rate of y will increase to g' as shown in the second diagram.
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