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BMAK 2024
Problem Set 2
Question 1
Let’s consider a representative firm which hires labor L, and rents capital K from the households to produce Y using the
following Cobb-Douglas production function:
Y = AK α L1−α ,
where the parameter α ∈ (0, 1) is the degree of capital intensity in production and A is the exogenous level of technology.
The profit function is:
Π = P Y − RK − W L,
where P is the price level; R and W are nominal rental price and wages, given by perfectly competitive product and factor
markets.
a) Derive the wage level, W , and the rental rate, R, paid by the firm as as results of its profit maximization behavior.
b) Show that the income share of capital owners is α, and of labor owners is (1 − α).
c) Derive the equations of labor and capital demand by the firm.
d) Suppose that households supply labor according to a function Ls which is an increasing function of the real wage, and
capital is also supplied according to a function K s which is increasing in the real rental rate. Derive the impact on the
equilibrium real rental rate and real wage due to an increase in the level of technological progress.
e) Suppose for this question that capital and labor supplied by the households are fixed at K̄, and L̄, and that the quantity
theory of money holds, i.e. M V = P W . Show that the levels of nominal wages and rental price are proportional to the level
of money supply.
f) Please explain why in the long run, the claims that "Inflation robs me of my purchasing power" is called an inflation fallacy.

Question 2
Consider the economy of MacroDreams, which can be described by the simple Solow model, Yt = Ktα . Every year, 3% of
the capital stock wears out. The households save a constant fraction of 30% of their income. The elasticity of output with
respect to capital in the country’s production function is 0.4.
a) Determine the steady state value of capital.
b) Calculate output, investment and consumption at the steady state level of capital. c) Suppose the government could
provide incentives for households to increase the saving rate to 40%. Calculate the new steady state levels of capital, output,
investment and consumption.
d) What would happen if the saving rate further increased up to 50%? Compare the steady state levels of consumption at
the different saving rates 30%, 40% and 50%.
e) Show analytically that the savings rate of 40% leads to the steady state that maximizes consumption.

Question 3
In the country of Tropicana it rains so much that a high fraction of the capital stock depreciates every year. The rate of
depreciation in the country of Sahara is much lower. Otherwise the two economies are identical. Use the Simple Solow Model,
, Yt = Ktα , to determine graphically which of the two countries has the higher steady state level of output.

Question 4
Consider the following Solow-type growth model with standard assumptions as discussed during our class with an exception
that the economy is open to international trade and capital flows.
Yt = Ktα (At Lt )1−α , 0<α<1
Kt+1 = Kt (1 − δ) + It , 0<δ<1
It = St − CAt ,
where CA is the current account of the economy.
St = s.Yt , 0<s<1
CAt = m.Yt , 0 < m < 1.

a) Derive the steady-state level of income, and the steady-state growth rate of income.
b) Derive how the steady-state level of income depends on the coefficient m reflecting the current account surplus,0 < m < s.
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Provide economic reasoning for your result.

c) Suppose that some years after the economy had reached steady state, a natural disaster destroys half of the economy’s
capital stock. Describe both graphically and verbally what will happen in this economy after the natural disaster has struck.

Question 5
A country’s production function is given by
Yt = At .Kt0.65 L0.35
t ,
In the year 2017, we observed:
Kt = 10, 000, Lt = 100, and Yt = 10, 000.
Suppose that from 2017 to 2018, GDP grew by 2.6%, the capital stock grew by 1.2%, and employment grew by 0.5%. What
is the rate of technological progress between 2017 and 2018? What is the level of technology in 2017?

Question 6
Consider an economy, in which labor input grows by 1% per year and technology improves by 3% per year. Every year, 3%
of the capital stock wears out. The households save a constant fraction of 35% of their income. The elasticity of output with
respect to capital in the country’s standard Cobb-Douglas production function is 0.5.
a) Determine the steady state value of capital per effective worker.
b) Suppose the government could provide incentives for households to either increase or reduce the saving rate. If the
government’s aim was to maximize consumption per effective worker, should the households save more or less of their
output?
c) Given the result you found in (b) what are the consequences for output, investment, capital, consumption per effective
worker following a change of your policy recommendation. Provide a detailed economic rational on how the outcomes arise.

Question 7
Suppose an economy’s output per worker was $50,000 and its labor force had a of size 1 million people in 2015. The saving
rate was 20%, labor force grew at a rate of 0.5%, capital depreciated at a rate of 3% while technology improved by 1%.
Further the capital share of production in the economy was roughly 0.35.
a) Compute the level of technology for this economy in 2015 given the economy is in steady state.
b) Assume the economy stays on its balanced growth path. What is your prediction for output per effective worker, output
per worker and output in 2030 for this economy. Also comment on the growth rate.
c) Now suppose the growth rate of the labor force was to decrease to -1%. What is your prediction for consumption per
effective worker, consumption per worker and consumption in 2030?
Hint: You do not need to calculate exact figures for quantities asked after the policy change, rather a prediction relative to
the benchmark is suffcient.

Question 8
Assume labor-augmenting technological progress in the production function with a share of capital on production of 13 . In
the richest country in the world, output per person is 50 times as high as in the poorest country. The poorest country has a
saving rate of 5%, the richest has one of 30.125%. Also there are no differences in countries’ depreciation, population growth
and technological progress rates. Further the initial capital stock of the economies’ is their respective steady state. What
would you conclude concerning the level of technology A in the richest country compared to the poorest one?

Question 9
One explanation for China’s rapid economic growth during the past several decades is its expansion of policies that encourage
“technology transfer.” By this, we mean policies— such as opening up to international trade and attracting multinational
corporations through various incentives— that encourage the use and adoption in China of new ideas and new technologies.
This question asks you to use the Solow model to study this scenario.
Suppose China begins in steady state. To keep the problem simple, let’s assume the sole result of these technology transfer
policies is to increase A by a large and permanent amount, one time. Answer the following questions:
a) Analyze this change using a Solow diagram. What happens to the economy over time?
b) Draw a graph showing what happens to output in China over time. What happens to output per person in China in the
long run?
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c) Draw a graph showing what happens to the growth rate of output in China over time. Explain.
d) Discuss in a couple of sentences what your results imply about the effect of technology transfer on economic growth.

Question 10
Let us suppose that income per worker in Mexico in 2017 equals $ 16,000. Also, suppose that the economy-wide rate of
saving s = 0.15 (with a balanced government budget and net exports, net factor payments from abroad as well as net
unilateral transfers equal to $ 0), the rate of worker growth n = 0.01, the rate of depreciation of capital δ = 0.03, the rate of
technological progress g = 0.02, and the Cobb-Douglas production function

Yt = ·Ktα · (At Lt )1−α ,

with α = 0.4. Assume that capital per effective worker in Mexico in 2017 is in the steady state. a) If no further information
is given, what do you predict regarding Mexico’s income level per worker in 2020?
b) Now take into account the following additional information: from 2017 to 2018 onward, the rate of technological progress
was to decrease to g = 0.01; what is your new prediction regarding the level of income per worker in Mexico in 2020? Provide
a detailed economic rationale for the change in your prediction.
c) For 2017, derive the golden rule level of consumption per effective worker. If technological progress for 2017 and all
following years was equal to g = 0.02, what is the time path of consumption per worker implied by this golden rule level of
consumption per effective worker in 2018-2020?