Problem Sets Macroeconomics Page 1

Part I - Long-Run Macroeconomics

1. Growth Theory

1.1. The Solow(-Swan) model

Problem 1.2.1.
Derive the savings rate that maximises long-run consumption per worker in a Solow
(1956) - Swan (1956) model with Cobb-Douglas production function and no technical
progress.

Problem 1.2.2.
[Problem 1.1. from Barro & Sala-i-Martin (2003), p. 81]
a) Explain the differences among absolute convergence, conditional convergence, and
a reduction in the dispersion of real per capita income across groups.

b) Under what circumstances does absolute convergence imply a decline in the

dispersion of per capita income?
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Problem 1.2.4.
[Problem 1.4. from Barro & Sala-i-Martin (2003), p. 82]
Consider this statement: "Devoting a larger share of national output to investment would
help to restore rapid productivity growth and rising living standards.” Under what
conditions is this statement accurate?

Problem 1.2.6.
Consider a set of economies sharing the same neoclassical production function and
labour-augmenting technical progress. Considering the issue of dynamic efficiency, show
that, in the long run:
 when the savings rate is exogenous (Solow model), the economy with the highest
value for capital per worker is not necessarily the one with the largest consumption
per worker.

It is possible to observe on the graph that the golden rule and the stock of capital may not coincide
with the stock of capital in the long-run, which is when the actual investment per unit of effective
labour (sf(k)) is equal to the break-even investment ((𝑛 + 𝑔 + 𝛿)𝑘).
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Problem 1.2.7.
Consider an economy that can be adequately described by the Solow model, with a
Cobb-Douglas production function, and for which it is known that:
 the capital-elasticity of output shows a value between 0.2 and 0.4;
 the long-run savings rate shows a value between 0.15 and 0.25.
Should we fear this economy may be in a dynamic inefficiency area? Why? Explain
the economic intuition behind all the calculations you have to do.
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Problem 1.2.8.
For a Solow model without technical progress, consider the production function in its
intensive form is given by y = A.k1/3 . Now, assume the savings rate, s, increases from
0.16 to 0.25. Find the values for the proportional increases in both the long-run output
and consumption per worker. Explain all your calculations.
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Problem 1.2.12.
Assume the economy of Angola is well represented by a simple (closed-economy no
–government) Solow model in the 1980-2012 period, with a Cobb-Douglas
production function given by, in its intensive form,
y = f(k) = 𝑘 = k0.66 ,
where y represents output and k is the capital stock, both measured per unit of effective
labour. Furthermore, suppose that the following rates are approximately constant along
the period: the savings rate is s = 0.123 (12.3% of output), the rate of growth for the
population is n = 0.036 (3.6%), the annual growth rate for labour- augmenting technical
progress is g = 0.017 (1.7%), and the annual depreciation rate for the capital stock is 
= 0.10 (10%).
Under the conditions above, should we expect that the Angolan economy is heading
towards a long-run dynamic-inefficiency situation, i.e. an excess-saving situation?
Provide economic intuition for your calculations.
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1.2. The Ramsey(-Cass-Koopmans) model

Problem 1.3.2.
Explain why dynamic inefficiency can occur in the Solow model, but not in the
Ramsey model.

Problem 1.3.4.
Demonstrate that:
 any steady state in a Ramsey economy is also a steady state in a Solow economy;
 there are some steady states in a Solow economy that are not steady states in a
Ramsey economy.
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Problem 1.3.5.
The following figure, taken from Romer (2012)3, represents the long-run equilibrium
in the Ramsey model:

Analyse the modifications in the curves c  0 and k  0, and in point E, that occur

when the value of 𝜃 diminishes. Provide economic foundations for the result obtained.

3 Op. cit. p. 63.

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Problem 1.3.8.
Suppose the economy of Angola is well represented by a simple (closed-economy no-
government) Ramsey model in the 1980-2013 period, with a Cobb-Douglas production
function given by, in its intensive form,
y = f(k) = 𝑘 = k0.66 ,
where y represents output and k is the capital stock, both measured per unit of effective
labour. Furthermore, assume the following quantities are approximately constant along
the period: the elasticity of intertemporal substitution in consumption is 1/ = 0.025,
the annual discount rate is  = 0.05 (5%), the annual rate of growth forpopulation is n =
0.036 (3.6%), the annual rate of labour-augmenting technical progress is g = 0.017
(1.7%), and the annual depreciation rate for the capital stock is 𝛿 = 0.10 (10%).
Compute the capital stock, output and consumption per unit of effective labour, and also
the savings rate for the long-run (steady-state) equilibrium. Provide economic intuition
for your calculations.
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Problem 1.3.11.
Assume that the economy of Bangladesh is well represented in the long run by the
Ramsey-Cass-Koopmans model studied in this course with the following characteristics:
 the production function is Cobb-Douglas with constant returns to scale and 𝛼
= 0.49;
 current levels of (annual private) consumption and capital per unit of effective
labour are given by c0 = 2.22 and k0 = 10.58, both measured in the appropriate
units.
 the annual depreciation rate (𝛿 ) is 3.9%, rate of population growth (n) is 2%,
discount rate (𝜌) is 6.3%, the reciprocal of the elasticity of intertemporal
substitution (𝜃 ) is 2.82, and there is no technical progress.
Compute the steady-state values for consumption and capital per unit of effective labour.
How do they compare with their current values? Provide economic foundations for your
calculations.

Overlapping-generations models

Problem 1.4.1.
Compare both the specifications and the main results obtained with the Ramsey model
(RM) and with overlapping-generations models (OLGM), as the Diamond (1965) model.
When writing your comment do not forget to mention the dynamic inefficiency issue
and also the possibility of a modified OLGM converging to a RM.
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Problem 1.4.7.
Consider the Diamond OLG model studied. Assume the felicity function is logarithmic
and the production function is Cobb-Douglas. Now, assume that government spends Gt
per unit of effective labour each period in goods and services (that are wasted) and
finances this spending by raising a lump-sum tax on the young generation. What is the
effect of an increase in government spending in the long-run capital accumulation?
Explain your position.

1.3. Endogenous growth

Problem 1.5.2.
Considering the learning-by-doing model, succinctly explain why the growth rate is
smaller in a decentralised economy than in a central-planned one and also why there are
scale effects (the growth rate depends upon employment) in both cases.
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Problem 1.5.4.
Can the savings rate be smaller in the decentralised case than the central-planner one for the
Ramsey model? What about the learning-by-doing model with endogenous savings rate? Give
economic foundations for your answers, comparing both models.

Problem 1.5.7.
What distinguishes the Solow (1956) model from the learning-by-doing model (Romer,
1986) as studied in this course? Report briefly the existing differences in terms of
assumptions and results amongst both growth models.

Problem 1.5.8.
Consider the following figure that represents the annual average growth rates for the
population (n) and for real GDP per capita (gY/Pop) for 137 countries in the 1950-2016
period:

Source: Maddison Project (2018)

Does this evidence support the endogenous-growth models with knowledge production
studied in this course? Explain your position.
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Problem 1.5.9.
Consider the learning-by-doing model studied (Romer, 1986) with positive population
growth, no depreciation, an elasticity of the stock of knowledge with respect to capital
(𝜙) smaller than one, and a constant savings rate (à la Solow). What is the effect of a
permanent increase in the savings rate in the rate of growth of the capital stock both in
the short and in the long runs? Explain your position.
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Part II - Short-Run Macroeconomics

2. The New Classical School

Problem 2.1.
Considering the Lucas (1972) model, assume that
1 2
𝑝 = 𝐸(𝑚) + [𝑚 − 𝐸(𝑚)] , 𝑦 = [𝑚 − 𝐸(𝑚)]
3 3

a) Explain the reason why only unanticipated monetary policies lead to changes in the
aggregate output.

b) Assuming monetary policy follows the rule mt = mt-1 + 0.02 + ut, where ut is a white-
noise disturbance, calculate the average inflation rate and provide the economic intuition
for the result obtained.
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Problem 2.3.
Consider a Lucas supply function, y = b.(p – E[p]), where b increases with Vz and
decreases with Vm. Provide the economic intuition for this result. (Remember that zi
represents the shock on the demand for good i ).

Problem 2.6.
In the Lucas model of imperfect information, we obtain the following expression for
the expected value of 𝑟 = 𝑝 − 𝑝, given 𝑝 , the relative price of good i:
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Problem 2.7.
Make a comment on the following statement:
Lucas (1976) attacked the established practice of using large-scale macroeconometric
models to evaluate the consequences of alternative policy scenarios, given that such policy
simulations are based on the assumption that the parameters of the model remain
unchanged when there is a change in policy.
In Snowdon et al (1994), p. 214.

Problem 2.8.
Considering a Lucas supply function, demonstrate the aggregate supply curve is
always steeper than each individual producer supply curve.

Problem 2.9.
Consider two economies, A and B, which can be well represented by the New Classical
model of a Lucas economy with imperfect information. These economies are identical
in everything, but their central banks’ behaviour: the central bank in A frequently tries to
surprise the economic agents with large monetary-policy shocks, whilst the central bank
in B seldom does it and always uses small shocks. In both economies, producers face
demand curves with unit elasticities. Taking this framework into account, what can we
expect for the relative effectiveness of monetary policy in these two countries? Give
detailed explanation for your position.
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Problem 2.17.
Consider and economy for which the expectations-augmented Phillips curve is given
by
y  4.7  𝜋 − 𝜋 ,
where y represents the log of actual (normalised) output and 𝜋(𝜋 )is the actual
(expected) inflation rate. We also know that, due to existing frictions, the log of
Walrasian potential output is y* = 0.05 and the social target for inflation is 𝜋 ∗ = 0.02.
The political decision-makers are choosing the new governor of the central bank.
Assuming a quadratic loss function, what should be the minimum weight (𝜀) given by
the chosen governor in order to keep inflation at no more than 2.5 per cent? Provide
economic foundations for your answer.
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Problem 2.19.
Consider the figure below, taken from Milani & Treadwell (2012), that represents the
impulse-response function (IRF) of output gap to one-standard-deviation
unanticipated (“surprise”) and anticipated (“news”) monetary-policy (MP) shocks in
the US, 1960:I-2009:I.

Is this evidence compatible with the Lucas imperfect-information model (the

archipelago economy) studied? Explain your position.
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3. Real Business Cycles

Problem 3.1.
Consider the class of Real Business Cycles (RBC) models that followed the seminal
work of Kydland & Prescott (1982).
a) Explain how the RBC model can presented in Romer (2012) and studied in this
course be seen as an extension of the Ramsey model in two directions:
 introducing a stochastic component.
 allowing for employment variations.

b) Still for the same RBC model, a temporary increase in public consumption leads to
temporary increases in output, employment, and interest rates, and to temporary decreases
of wages and capital stock. Provide the intuition why the interest rate increases,
connecting this variation with the evolution of employment and capital stock.

Problem 3.3.
In the RBC model presented in Romer (2012) and studied in this course, a positive
technological shock leads to temporary increases in consumption, employment, and
capital stock. Provide the intuition why the immediate effects on consumption are smaller
and the effects on employment and savings are larger, when the shock is less persistent.
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Problem 3.4.
In the RBC model studied in this course, the intertemporal substitution in labour supply
is extremely important. Explain what is and what determines this substitution, and why it
is so important for the results obtained.

Problem 3.5.
Explain why RBC models produce real wages with a high degree of procyclicality.
Considering the empirical evidence points to slightly procyclical or a cyclical real wages,
what would be necessary for these models to generate a more realistic correlation between
real wages and output (or employment)?

Problem 3.7.
Assume the economy of the European Union is well represented by a simple RBC model,
identical to the one studied in this course.
For the above-mentioned economy we know the following long-run parameters: the Elasticity of
intertemporal substitution for private consumption: is 1, the Household time-discount rate (annual):
10.4%, the Fixed-capital depreciation rate (annual): 4.5%, the Labour share in GDP: 58.4%
We also know the capital stock per unit of effective labour [K/(A.L)] for 2008 is expected to be
0.26% below its balanced-growth path and private consumption in 2007 was 0.25% below its
long-run value.
Calculate the expected proportional deviation of 2008 private consumption 2008 with respect to
its balanced-growth path. Provide economic intuition for your calculations.
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Problem 3.8.
Consider the following figures, calculated with AMECO data, for the US economy in
2003:
Y C K I
0.020 -0.004 0.000 -0.067
Balanced-growth path calculated using the HP filter.

X represents the proportional deviation of variable X from its balanced-growth path and
X = Y (output), C (private consumption), K (fixed capital stock), and I (gross investment).
Present a plausible explanation for this short-run behaviour of the macroeconomic
variables using the RBC framework.

Problem 3.10.
Consider the following figures, calculated with AMECO data, for the US economy in
1975:
Y C K I L
-0.042 -0.018 -0.000 -0.218 -0.029
Balanced-growth path calculated using the HP filter.
X represents the proportional deviation of variable X from its balanced-growth path and
X = Y (output), C (private consumption), K (fixed capital stock), I (gross investment), and
L (employment).
Present a plausible explanation for this short-run behaviour of the macroeconomic
variables using the Real-Business-Cycle framework.
(SAME AS 3.8.)

Problem 3.11.
Consider the following data for the USA in 2009 concerning the proportional deviation
of variable (per person age 15-64) value and its balanced-growth path (calculated using a
HP filter):
GDPmp Private Gross Capital stock at the Hours
consumption investment beginning of the worked
period
-3.0% -2.0% -16.6% 0.2% -2.2%
Are these values compatible with a technology shock-based explanation in a Real
Business Cycle Framework? Do you think this a suitable explanatory hypothesis for the
recession analysed?
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Problem 3.21.
Business-Cycle Statistics for the Portuguese Economy (1958-1991) and for a Basic

RBC Model
Variable Economy Model
𝜎 3.78 3.78

𝜎 ̃∕𝜎 0.84 0.56

𝜎 ∕𝜎 2.49 2.57
𝜎 ∕𝜎 0.28 0.63
Corr (𝐶 , 𝑌) 0.66 0.99
Corr (𝐼 , 𝑌) 0.84 0.81
Corr (𝐿, 𝑌) 0.61 1.00
SOURCE: In Correia et al. (1995), pp. 1105, 1109.
NOTES: Notation is the standard one for this course.
Consider the data in the table above. How well can a basic RBC model replicate the actual
fluctuations in the Portuguese economy? Provide economic foundations for your position.

Problem 3.24.
The following table, taken from Galí & Rabanal (2004), reports the estimated contribution
(%) of technology shocks to total variance of each variable for the US economy in the
1948:I - 2002:IV period:
yt 𝜋 rt nt 𝜔 −𝑦
23.3 6.1 0.4 0.8 0.1
where y represents the log of per capita output, 𝜋 is the inflation rate, r stands for the
nominal interest rate, n is the log of hours worked, and 𝜔 represents the log of the real
hourly wage rate.
In your opinion, does this empirical evidence support baseline Real Business Cycle
theory? Explain why.
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4. The New Keynesian School

4.1. Predecessors: Walrasian and non-Walrasian equilibria

Problem 4.1.1.
Consider a non-Walrasian equilibrium model (fixed-price model), as the one by Barro &
Grossman (1971). For this type of models, make a comment on the following statement:
The best way to reduce involuntary unemployment in an economy is using an
expansionist fiscal policy.

Problem 4.1.2.
Consider a perfectly competitive closed economy where all prices are fixed in the
short run. For this environment, make a comment on the following statement:
In a Keynesian-unemployment regime, a policy of reducing nominal wages does not
have any effect on equilibrium output.

Problem 4.1.3.
Consider an economy where the representative consumer has the following utility
function:
.
.
𝑀
𝑈=𝐶 ⋅
𝑃

where C represents its consumption, M is the money amount held at the end of the period,
and P stands for the aggregate price level. Each worker supplies a maximum amount of 1
labour unit (L.u.) per period and population is also normalised to one. At the beginning
of the period no one holds any money. Profits are totally distributed to households and
there is a lump-sum tax of 0.05 m.u. per period levied on his/her income.
Firms sell their goods in perfectly competitive markets and face a production function
given by Y  1. , where Y represents output and N stands for labour input.

In this economy, prices are set institutionally, and one can observe, for this period, the
general price level is set at 1 and the nominal wage rate is 0.528 m.u./L.u. Furthermore,
we know the government intends to spend 0.3 m.u. in public consumption.
Calculate the involuntary unemployment rate for this economy and, if necessary, propose
a policy towards its reduction. Supply the economic intuition for all the calculations made.
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Problem 4.1.5.
Make a comment on the following statement:
The existence of a national minimal wage is not a sufficient condition for excess supply
to exist in the labour market, i.e. for involuntary unemployment to exist.
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Problem 4.1.7.
Phelps & Winter (1970)4 produced the following statement:
A landing on the non-Walrasian continent has been made. Whatever further exploration
may reveal, is has been a mind-expanding trip: we need never go back 𝑑𝑝 = 𝛼(𝐷 − 𝑆)
𝑑𝑡
and q = min(S, D).

Make a comment upon this statement, identifying the meaning of the equations
presented and the main limitation of this type of macroeconomic models.
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Problem 4.1.8.
Assume that the following functions are good representations of the Portuguese
labour market intentions for 2009:
L = 5519.w0.04 , N = 9582.w-1.64 ,
where L represents the supply intentions and N stands for the demand intentions in the
labour market, both expressed in 103 individuals, and w represents the average labour
costs, measured in 103 euros per “month” (paid 14 times a year).
Taking the information presented into account, calculate the average labour cost
necessary to generate a 7.8% unemployment rate, as forecasted.
Considering the minimum labour cost for 2009 is 0,567×103 euros per “month,” what can
you conclude on the ability of this price being the main cause of the expected
unemployment, according to the non-Walrasian equilibrium models?

4 Op. cit. P. 337.

Problem 4.1.10.
Unfilled Job Vacancies per 100 Registered Unemployed
Country 2007 2008 2009
France 14.3 14.3 9.5
Germany 16.5 17.4 14.2
Portugal 3.5 4.1 3.6
Sweden 25.0 25.3 11.4
Turkey 1.9 1.9 1.0
SOURCE: OECD
Is the data presented above compatible with the assumptions made for the non-
Walrasian equilibrium models studied? Provide foundations for your position.
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Problem 4.1.14.
Consider an economy where the representative consumer has the following utility
function:
.
.
𝑀
𝑈=𝐶 ⋅
𝑃

where C represents its consumption, M is the money amount held at the end of the period,
and P stands for the aggregate price level. Each worker supplies a maximum amount of 1
labour unit (L.u.) per period and population is also normalised to one. At the beginning
of the period no one holds any money. Profits are totally distributed to households and
there is a lump-sum tax of 0.05 m.u. per period levied on his/hers income.
Firms sell their goods in perfectly competitive markets and face a production function
given by Y  1. , where Y represents output and N stands for labour input.
In this economy, prices are set institutionally and one can observe, for this period, the
general price level is set at 1 and the nominal wage rate is 0.258 m.u./L.u. Furthermore,
we know the government intends to spend 0.3 m.u. in public consumption.
Calculate the involuntary unemployment rate for this economy and, if necessary, propose
a policy towards its reduction. Supply the economic intuition for all the calculations made.
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4.2. Imperfect competition in the product market

Problem 4.2.18.
Consider the simplified free-entry version of the Heijdra & van der Ploeg (1996) model
studied in this course. The reduced-form production function is given by Y = 0.833n0.04.L,
where Y represents real output, n is the mass of the continuum of goods, and L stands for
labour. The consumption function is given by C = 0.273(w +   T), where C represents
real consumption, w is the real wage rate,  stands for real profits, and T represents real
lump-sum taxes. Assume that the equilibrium values for output and employment are
respectively 0.278 m.u. and 0.333 p.u. L.
Compute the value for the (balanced budget) fiscal multiplier. Provide economic
foundations for your calculations.

Problem 4.2.19.
Consider the following figure that represents the cyclical components for annual real GDP
( Y ) and a proxy for real pure profits ( 
 ), both per person aged 15-64, for Portugal
in the 1986-2017 period and using an HP filter:

Source: European Commission (2018)

Taking into account the evidence above, should we expect the short-run fiscal multiplier
for Portugal to behave more in line with the Dixon-Mankiw model or with the Walrasian
limit case? Explain your position.
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4.3. Nominal rigidity

Problem 4.3.1.
Consider a producer under monopolistic competition facing the following demand
curve:
Y(j) = 20p(j)-6 ,
where Y(j) represents her production and p(j) stands for her posted price. We also know
the production function is given by Y(j) = 1N(j), where N(j) is her labour input, and the
expected wage rate for this period is 5/6 m.u./u.L. The price of her good has to be
posted at the beginning of the period and the producer has to face a cost of 0.03
m.u. if she has the need to change it.
What will be the rational decision for this firm if the actual wage rate reveals itself 1%
higher than its previously expected value? What are the consequences of this decision on
her output level (when compared to the alternative)?
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Problem 4.3.3.
Firm X is the only producer of the good with the same name, despite the fact there is a
large number of imperfect substitutes in the economy. Demand and production functions
for this firm are given by the following expressions:
YX = 1.5pX-10 , YX = 891.9Nx 0,75 ,
where YX represents its quantity of good, pX stands for its price, and NX is the quantity of
labour used in the production of the good. The perfectly competitive labour market is
expected to generate a nominal wage rate of 5062.47 m.u./u.L. The price of the good
for this period has to be announced before it starts and any change to it implies an
additional fixed cost of 0.001 m.u.
At the beginning of the period agents realise nominal wages are 1% lower than expected.
Calculate, presenting the corresponding economic foundations, the quantity, price,
profits, and market-power indicator (e.g. the Lerner index) for this firm, considering it is
a rational producer. Compare the values obtained with those of the unwanted alternative
and, using the market-power indicator, choose which alternative would be preferable for
the economy from the efficiency point of view.