Problem Set #1 Solutions: Due: Wednesday, February 16, 2005 (In Class)

Problem Set #1 Solutions
Course 14.451 – Macro I

TA: Todd Gormley, [email protected]
Distributed: February 9, 2005
Due: Wednesday, February 16, 2005 [in class]
1. Human Capital in the Solow Model (based on Mankiw, Romer & Weil 1992)
Assume that the production function is given by:
Y = K α H λ ( AL )
1 −α − λ
where Y is output, K is physical capital, H is human capital, A is the level of

technology, and L is labor. Assume α > 0 , λ > 0 and α + λ < 1 . L and A grow at
constant rates n and g , respectively. Output can be used on a one-for-one basis for
consumption or investment in either type of capital. Both types of capital depreciate at the
rate δ . Assume that gross investment in physical capital is the fraction s K of output and
that gross investment in human capital is the fraction s H of output.
(a) Let k ≡ K / AL and h = H / AL . Obtain the laws of motion for k and h .
First, we express k& explicitly:
K& ( AL ) − K ( AL
& + AL& )
k& =
( AL )2
K& A & L& 
k& = −  + k
AL  A L 
K&
k& = − ( g + n)k
AL
o
Manipulating the movement of capital, K = I K − δ K , we have:
o
K = sKY − δ K
o
K Y K
= sK −δ
AL AL AL
o
K
= sK y − δ k
AL
where y ≡ Y / AL = kα h λ .
Plugging this into our equation for k& , we have our law of motion for k :
k& = s K kα h λ − ( g + n + δ ) k
Via symmetry, we can also show that our law of motion for h is given by:
1
h& = s H k α h λ − ( g + n + δ ) h
(b) What are the steady-state values of physical capital, human capital, and
output, all per unit of effective labor?
The steady state for k (which I will designate as k* ) occurs when k& = 0 .
Using our solution from part (a), we know this will occur when:
sK k αhλ = ( g + n + δ ) k
1
 s h λ  1−α (1)
k = K
*

 g + n +δ 
By a similar logic:
1
α
 s k  1− λ
h = H
*
(2)
 g + n + δ 
 
With a little algebra (WALA), we can use (1) and (2) to solve:
1
 s 1−λ s λ  1−α − λ
k = K H 
*
 g + n +δ 
1
 s α s 1− α  1−α − λ
h = K H 
*
 g +n+δ 
Finally, plugging k* and h * into our formula y = kα h λ , we have:

α λ
 s 1− λ s λ  1− α − λ  s Kα s 1H−α  1−α − λ
y = K H 
*
 
 g +n+δ   g + n +δ 
1
 s αK s Hλ  1− α − λ
y* =  
 ( g + n + δ )α + λ 
 
(c) What is the growth rate of output per capita in steady state?
Taking logs of our expression for y * , and differentiating with respect to

time, we see that:
Y& L& A&
− − =0
Y L A
Y& L& A&
− = =g
Y L A
Thus, the growth rate of output per capita equals the growth rate of
technology in this economy, g .
2
(i) If we think of all countries as being at their steady state, can
this model explain why income per capita grows at different
rates across countries?
If we assume that all countries are at their steady state level

(i.e. on the balanced growth path), then they should all be growing at
the same rate g , assuming that the growth of technology is the same
in every country. So, this would seem to indicate the model can’t
help us, especially since the Solow model just takes g as given and
doesn’t really provide us the tools to explain why g might differ
across countries
(ii) What if countries are at various distances from their steady

state? (No math for parts (i) and (ii). Just explain in 2-3
brief sentences).
However, if we assume that countries are not at their steady

states (i.e. they are still converging to their balanced growth path),
than the model does provide some predictive power. If two
countries have the same rates of investment, population growth, etc.,
they will converge to the same balanced growth path. A country that
is further away from the steady state, however, will be growing
faster. i.e. We should see “conditional convergence”. Poorer
countries with the same characteristics of wealthier countries should
be growing faster.
(d) This augmented Solow model can be tested empirically with cross-country
data if we assume that all countries are in their steady states.
(i) Derive a log-linear regression equation for output per worker

that you could estimate using OLS assuming you have
measures for s i ,K , s i ,H , δi , ni for each country i and that g and
A0 are known and constant across countries.
1
 s αK s λH  1− α − λ
Notice that Yt / Lt = At y * = At   .
 ( g + n + δ )α + λ 
 
Taking logs of this, we have the following:
1
ln( Yt / L t ) = ln At +  α ln s K + λ ln s H − (α + λ ) ln ( n + g + δ ) 
1−α − λ 
Then, plugging in for At = A0e gt , we have our log linear equation:
α λ α+λ
ln( Yt / L t ) = ln A0 + gt + ln s K + ln s H − ln (n + g + δ )
1−α −λ 1− α − λ 1− α − λ
3
Which, we could estimate using OLS as follows:
ln( Yi / L i ) = β 0 + β 1 ln s i ,K + β2 ln s i ,H + β 3 ln (n + g + δ )i + ε i
And, one can test this model by checking whether β 1 + β 2 + β 3 = 0
(ii) Give 1-2 brief examples of some problems that might arise in
estimating this equation by OLS.
What problems might arise from this estimation? Plenty. For

example, we might have an omitted variable bias if both investment and
income per capita are correlated with unobservable variables that may
vary across countries such as institutions, property rights, etc.. We could
also have a problem of reverse causality if population growth and savings
are a function of income. Finally, it might be very difficult to measure
many of the variables, especially the investment rate in human capital.
2. Embodied Technological Change (from Romer)
SEE Romer’s Solution to Question #2 on NEXT PAGE…

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Problem Set #1 Solutions

Course 14.451 – Macro I

Assume that the production function is given by:

where Y is output, K is physical capital, H is human capital, A is the level of

(a) Let k ≡ K / AL and h = H / AL . Obtain the laws of motion for k and h .

First, we express k& explicitly:

Finally, plugging k* and h * into our formula y = kα h λ , we have:

Taking logs of our expression for y * , and differentiating with respect to

If we assume that all countries are at their steady state level

(ii) What if countries are at various distances from their steady

However, if we assume that countries are not at their steady

(i) Derive a log-linear regression equation for output per worker

Taking logs of this, we have the following:

Then, plugging in for At = A0e gt , we have our log linear equation:

And, one can test this model by checking whether β 1 + β 2 + β 3 = 0

What problems might arise from this estimation? Plenty. For

2. Embodied Technological Change (from Romer)

SEE Romer’s Solution to Question #2 on NEXT PAGE…

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