EC1B3 Problem Set 3

due on Sunday at 6 PM

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Learning outcomes:
- The basics of the Solow growth model: derivations

- How to draw a diagram and graphically find the steady state

- Working with per worker variables

Short Question: Can Aid Buy Growth?
(Note: this type of question appears in Section A of the exam. You are expected to answer using
words, equations and diagrams as you see fit.)
Many developing countries receive foreign aid for development purposes. This exercise will help
you in thinking about the effects of foreign aid on economic growth, in the context of the Solow
growth model.
Poorland has an initial level of capital per worker equal to !! , and we note the steady state level
of the economy is ! ∗ > !! . Richdonia in year 0 sends an amount of foreign aid #$% which
consists of capital goods. This is a one-off donation, therefore in the following years there is no
additional foreign aid. This foreign aid is such that, given !! , # < ! ∗ − !! .
Assume population is constant to $%. The rest of the economy works as in the Solow growth
model seen in the lectures. The production function is given by *# = ,-(/# , $), where , is the
constant total factor productivity and -(/# , $) is a constant return to scale function with positive
but decreasing marginal product for labour and capital (for example, /#$ $%&$ ). For notation, you
'
can assume 2(!) = - 3 , 15.
(

a. Using the diagram and the equations seen in the lecture, explain the effects of this foreign
aid on economic growth. Explain the effects on economic growth in the short run, and
what happens in the long run (i.e. the steady state). Does the steady state change? Do all
your reasoning using capital per worker rather than aggregate capital. [10 marks]
b. Imagine now that the production function is such that the standard diagram to find the
steady state looks like in the image below. How would your answer to the previous
question change? [Would your answer depend on where the initial level of capital per
worker is? Think of all the possible cases… ] [10 marks]

h k
Short Question

Poorland ko k ko

at k k so
Richdonia k ko a

K's a ko

outputperworker
p I
a on g
5 dkt
59 i i

sy dkt

i
K
k k k

initial equation Sy Ok y Ale

when given foreign aid k Ko t a

in short run the capital per worker will increase

by a amount from

ko to k thus increasing the output per worker from yo to y

however as this is a one off donation there is no change in the long

run Thus the steady state will not change

b There will be 2 possible scenarios

µ
if ko is located where dk sAf k then ko will decrease
by a amount

and vice versa

in the long run the steady state of the economy will depends on where

the initial level of capital per worker is The economy will move to the
nearest k
Long Question: Better Call Saul
The mayor of Albuquerque is worried about the increase in meth consumption in her district.
There is a new product in town called “Blue Sky”, which is of a higher quality, and the mayor
wants to do something about it. On the other hand, the mayor is interested in being re-elected and
she knows that the best predictor for re-election is GDP per worker in the current year, and the
prediction for GDP per capita in the long run. Therefore, she wants to get tough with meth
dealers only if this does not have negative effects on the GDP per worker.
The mayor hires Saul Goodman, a respected lawyer/economist, to produce some estimates of the
effect of this policy on the living standards for Albuquerque in the long and short run. Saul uses
the Solow growth model for his analysis, adding the government spending to it. His proposal is
to hire new policemen and put them in the streets, so drug dealers won’t be able to work. Saul
tells the mayor she needs to spend 6 per worker, i.e. she will spend a total of 7 = 6$, where $ is
the constant number of workers. The mayor should finance this spending with lump-sum taxes 8
on consumers, and, given that the council has a no-debt rule, we have 7 = 8. Consumers will
consume a fraction 1 − 9 of their disposable income, as they must pay taxes, i.e. :# = (1 −
9)(*# − 8# ) while the rest of the disposable income will be saved and therefore become
investment ;# = 9(*# − 8). The production function is given by *# = ,-(/# , $), where , is the
constant total factor productivity and -(/# , $) is a constant return to scale function with positive
but decreasing marginal product for labour and capital (for example, /#$ $%&$ ). The mayor wants
to see the details of the proposal before any decision.
'
a. Derive the equation for the evolution of capital per worker !# = (! , and the equation
characterizing the steady state for capital per worker. Show that the steady state can be
computed as the solution of this equation:
9,2(! ∗ ) = 96 + =! ∗
'
where 2(!) = - 3 ( , 15, and = is depreciation rate. [Hint: remember that 7 = 8 ]
(QR STUVW)
b. Use a diagram to show that, depending on the value of 6, there may be two steady states,
one with high capital per worker and one with low capital per worker. (10 marks)
c. Assume the value of 6 is such that there are two steady states, and ignore the one with low
capital per worker. What are the long-run consequences of this policy with respect to the
case with no government spending? What is the policy recommendation given to the
mayor? Explain your reasoning using a diagram. (10 marks)
a G gl 1 5 Y T
G T It s Yt T

ΔKt It dkt Yt AK L where L is constant

0 s Yt T Iki
Yi AKIE
s Yt G dkt
L L AK I
y
s y g dlet Yt F
dlet
ly
syt sg
sAf k Sgt dk Yt Ok

b
if p c diet sg

SAF K

59

k k kt
2k kt

if the value of sg a diet then capital per worker will locate kz

This will lead for economy to reach steady state at ko low capital

per worker

if the value of sgs dkt then the economy's steady state is k high
capital per worker
c

Ip diet so

skin

sg

ko kt
k k

when there is no government spending sAf k dk

the curve will move downward to dk
in the long run this will cause the steady state to increase from
k to k increasing the capital per worker
as the government spending increase the steady state will decrease
so the mayor best g per worker
spend if the current
capital per worker located in between k and k