EC 502: Midterm Exam for Fall 2019

SOLUTIONS

Exam Instructions

• There are 75 points in total on this exam. You have exactly 75 minutes to complete the
exam. Budget your time accordingly, i.e. allocate 1 minute per point.

• There are questions on every page, including the very last page.

• You may not use any outside written material or any electronic device.

• You must show your work for all questions. You will not receive full credit for simply writing
the correct answer without any justification.

NAME:
BU ID:

BEFORE WRITING ANYTHING, RECORD YOUR NAME AND BU ID NUMBER ABOVE

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1. True/False/Uncertain (20 points total)
Please indicate whether the statement in each part is true, false, or uncertain given the
information provided. You must briefly justify your answer, i.e. you will not receive full credit
for simply stating the answer without an explanation.

(a) (7 points) In the Solow model, changes in the capital depreciation rate affect the long-
run growth rate of living standards.
FALSE. In the Solow model, the long-run growth rate of living standards is equal to the
growth rate of technology. The capital depreciation rate therefore plays no role in the
long-run growth of living standards.

(b) (7 points) Pricing above marginal cost is required to incentivize firms to generate inno-
vation in models of endogenous growth.
TRUE. Under perfect competition with increasing returns to scale, firms would other-
wise have no resources left over with which to pay for the costs of innovation.

(c) (6 points) With a neoclassical production function, doubling physical inputs leads to a
doubling of output.
TRUE. Under the definition of CRTS with λ = 2, doubling physical inputs K and L
leads to a doubling of physical output, i.e.,

F (λK, AλL) = λF (K, AL)

F (2K, A2L) = 2F (K, AL).

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2. Solow Model (25 points total)
Time is continuous, and output Y (t) is given by the neoclassical production function Y (t) =
K(t)α (A(t)L(t))1−α , where K(t) is capital, A(t) is technology, L(t) is labor, and the capital
elasticity satisfies 0 < α < 1. The exogenous laws of motion for technology and labor are
Ȧ(t) L̇(t)
A(t) = g and L(t) = n. Investment is a constant fraction of output with I(t) = sY (t), and
the law of motion for capital is given by K̇(t) = I(t) − δK(t). To fix terminology, g > 0 is
the technology growth rate, n > 0 is the population growth rate, 0 < s < 1 is the savings
K(t) Y (t)
rate, and 0 < δ < 1 is the capital depreciation rate. Let k(t) = A(t)L(t) and y(t) = A(t)L(t) be
α
capital and output per efficiency unit of labor, respectively. y(t) = k(t) is the intensive form
of the production function. Note that the law of motion for k(t) is given by

k̇(t) = sk(t)α − (n + g + δ)k(t),

a result which you may take as given.

(a) (5 points) The term sk(t)α in the law of motion for k(t) is realized investment per effi-
ciency unit of labor. The term (n + g + δ)k(t) is known as break even investment. Draw
a figure which plots both realized investment per efficiency unit of labor and break even
investment as a function of k(t). On the horizontal axis, mark the steady state level k ∗
such that k̇(t) = 0 whenever k(t) = k ∗ .
The figure will look something like

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(b) In the long run, the level of capital per efficiency unit of labor approaches the steady
state level, i.e. k(t) → k ∗ . Similarly, if y ∗ = k ∗ α , then output per efficiency unit of labor
approaches y ∗ , i.e. y(t) → y ∗ . You make take these results as given. For each of the
sub-questions (i)-(iii) in this part, justify your answer using final expressions involving
only parameters from the following list: A(0), L(0), g, n, k ∗ , s, and y ∗ .
i. (3 points) Derive an expression for the steady-state level of capital per efficiency
unit of labor k ∗ .
The steady-state level of k(t) by definition satisfies

sk ∗ α = (n + g + δ)k ∗
s
= k ∗ 1−α
n+g+δ
  1
∗ s 1−α
k = .
n+g+δ

ii. (3 points) Derive an expression for the steady-state level of ouptut per efficiency
unit of labor y ∗ .
The steady-state level of y(t) by definition satisfies

y∗ = k∗ α
  α
∗ s 1−α
y = .
n+g+δ

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iii. (5 points) Derive the long run growth rate of consumption per capita C(t) L(t) , where
C(t) = Y (t) − I(t) is total consumption in the economy.
First, note that C(t) = Y (t) − I(t) = (1 − s)Y (t). In the long-run, we know that

y(t) → y ∗

Y (t)
→ y∗
A(t)L(t)
(1 − s)Y (t)
→ (1 − s)y ∗
A(t)L(t)
C(t)
→ (1 − s)y ∗
A(t)L(t)
C(t)
→ (1 − s)y ∗ A(t)
L(t)
C(t)
→ (1 − s)y ∗ A(0)egt .
L(t)
We conclude that the long-run growth rate of consumption per capita is g, the
growth rate of technology.

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(c) Assume the economy begins at steady state with k(t) = k ∗ . Then, suddenly, a dictator
commands that the savings rate s be increased and the population growth rate n be
decreased.

i. (5 points) Determine whether the steady-state level of capital per efficiency unit of
labor k ∗ increases, decreases, or stays the same.
By graphical argument, the curves in the figure from part (a) shift up (realized
investment) and down (breakeven investment), both of which serve to increase
the steady-state level of k ∗ . Alternatively, one can use the formula for k ∗ derived
above to demonstrate that k ∗ must increase, since s is in the numerator and n is
in the denominator.

ii. (4 
points)  Draw a graph, with time t on the horizontal axis and log living standards
Y (t)
ln L(t) on the vertical axis, depicting the evolution of living standards before and
after the policy change.
The figure will look something like

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3. Levels Accounting (15 points total)
Assume an aggregate neoclassical production function
1 1
Y = AK 2 L 2

where Y is output, A is technology, K is capital, and L is labor in an economy. It can be

shown that living standards are a function of technology and the capital-labor ratio
 1
Y K 2
=A .
L L

Then, for any two economies i and j, you can write the ratio of living standards as a function
of the ratios in technology and the capital-labor ratio according to

Y


1
K 2
L i Ai L i
Y

=
1 .
L j
Aj K 2
| {z } |{z} L j
Ratio in Living Standards Ratio in Technology | {z }
Ratio in Capital-Labor Terms

Consider two nations, Happyplace and Blissland, with macro aggregate values laid out in
the table below.

Y A K L
Happyplace 48 12 16 1
Blissland 180 2 270 30

(a) (4 points) What is the ratio of living standards in Happyplace divided by living standards
in Blissland?
The ratio in living standards in the two economies is given by
Y

48
L H 1 48
Y

= 180 = 6 = 8.
L B 30

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(b) (3 points) What is the ratio in technology across the two nations?
The ratio in technology in the two economies is given by

AH 12
= = 6.
AB 2

(c) (3 points) What is the ratio in capital-labor terms across the two nations?
The ratio in the capital-labor terms in the two economies is given by

K 2

1 16
√

1
2
L H 1 16 4

1 = 1 = √ = .
K 2 270 2

9 3
L B 30

(d) (5 points) Based on your answers to parts (a) - (c), do the differences in the two
economies better match the conclusions in Mankiw, Romer, and Weil (1992) or the
conclusions in Hall and Jones (1999)? Explain your reasoning.
We can write the difference in living standards across the economies as
4
8 = 6 .
|{z} |{z} 3
Ratio in Living Standards Ratio in Technology |{z}
Ratio in Capital-Labor Terms

Note that since 6 >> 43 , the contribution of technology is much stronger than the
contribution of capital-labor ratios. This result is broadly similar to the conclusion drawn
by HJ (1999), which emphasizes technology differences rather than input differences
as an explanation for differences in living standards across nations.

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4. Endogenous Growth and Population Size (15 points total)
Let time t be continuous. GDP or output Y (t) is given by Y (t) = A(t)LY (t). In this production
function, A(t) is the level of knowledge in the economy. LY (t) is labor used in production.
At any point in time, the change in knowledge Ȧ(t) is a function of the existing stock of
knowledge A(t) as well as the level of labor dedicated to innovation LA (t), with Ȧ(t) =
A(t)LA (t). The total size of the population at time t is fixed at a constant level L(t) = L̄ > 0,
and labor may be used for production or innovation according to LY (t) + LA (t) = L(t) = L̄.
There is an exogenously given share sA ∈ (0, 1) of labor dedicated to innovation in this
economy, so LA (t) = sA L(t) at all times.

(a) (5 points) Show that the growth rate of knowledge A(t) is given by

gA = sA L̄.

We have by the idea production function that

Ȧ(t)
= LA (t)
A(t)

Ȧ(t)
= sA L(t)
A(t)
Ȧ(t)
= sA L̄.
A(t)
The immediate implication is that the growth rate of technology or knowledge A(t) is
given by sA L̄.

Y (t)
(b) (5 points) Show that the growth rate of living standards L(t) is given by

g Y = sA L̄.
L

We have by the output production function that

Y (t) = A(t)LY (t)

Y (t) = A(t)(1 − sA )L(t)

Y (t)
= A(t)(1 − sA )
L(t)
Y (t)
= (1 − sA )A(0)egA t .
L(t)
The immediate implication is that g Y = gA = sA L̄.
L

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(c) (5 points) Assume that there is a one-time, unexpected wave of immigration leading to
an increase in the population size. Does growth in living standards increase, decrease,
or stay the same in the long run? Explain the intuition behind your answer.
A one-time unexpected wave of immigration would increase the population growth rate
L̄. By the same derivations used in part (b), we immediately see that the growth rate
of living standards will increase in the long-term as well. Intuitively, immigrants bring
more labor to contribute to the development of new ideas, which increases the growth
rate of output and hence living standards.

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