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Test / practice exam, questions and answers, Solow model

Macro-economie (Erasmus Universiteit Rotterdam)

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Questions
1. Production Function and Intensive Form
Consider an economy whose production function is characterized by the following Cobb-Douglass ex-
pression: Y = K α L1−α where K and L denote the amount of capital and labour employed respectively
and 0 < α < 1.

(a) Let y = Y /L and k = K/L. Express y in terms of k. Explain whether or not output per capita y
exhibits a decreasing marginal returns to capital intensity k.
(b) Let r be the cost per unit capital and w the wage rate per unit labour. It is known that r = dY /dK
and w = dY /dL. Show that y = rk + w.

2. Capital Accumulation and Steady State

Assume the economy either saves a constant fraction (s) of total output to invest in capital or consumes
from total output. If capital depreciates at the rate δ, the the change in capital can be written as follows:
∆K = sY − δK. Again assume L grows at rate n (ie ∆L = nL).

(a) The change in capital intensity k = K/L is given as ∆k = ∆K ∆L K

K − L L . Using this information,
α
show that ∆k = sk − (δ + n)k.
(b) What will the expression for ∆k be if there is no growth in L (n=0)?
(c) In steady state, we expect the amount of intensive units of capital, k to remain constant (ie
∆k = 0). However, this does not necessary imply that K is constant in steady state. Find the
steady state intensive unit of capital k ∗ and the steady state output per capita y ∗ in terms of s,
n, α and δ.
(d) Find the growth rates of K and Y in steady state. Under what conditions will these two variables
be constant?

3. Solow Growth Model with Technological Change

With the presence of technology A the production function becomes Y = K α (AL)1−α . We redefine
k as capital per effective labour (ie k = K/(AL)). Output per effective labour is similarly defined as
y = Y /AL.

(a) Express output per effective unit of labour in terms of capital per intensive unit of labour (y in
terms of k).
(b) Assume technology grows at a rate a (∆A = aA). The expression for change in capital per effective
unit of labour is given as ∆k = ∆K ∆L ∆A

K α
K − L − A AL . Show that ∆k = sk − (δ + n + a)k.

(c) Find the steady state capital per effective units of labour k ∗ and the steady state output per
effective unit of labour y ∗ in terms of s, n, α, a and δ.
(d) Find the rate of growth in steady state per capita output(Y /L) and the steady state capital per
unit labour (K/L).

4. Golden Rule Steady State and Dynamic Efficiency

It is assumed that output can be used for consumption and investment only. Thus, the expression
consumption per effective units of labour, c is given as c = f (k) − sf (k).

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(a) In steady state, it is known that the following condition should hold sf (k) = (δ + a + n)k. Derive
the first order condition for the maximization of consumption in steady state. (The expression
should contain the parameters δ,a and n).
(b) Assuming f (k) = k α , solve for the golden rule steady state capital per effective labour (kgr ) and
output per effective labour (ygr ).
(c) Compare the expressions for kgr to the steady state value k ∗ obtained in 3(c). Under what
condition are these expressions equal?
(d) Assume that the following holds currently in the economy: s > α. Is the economy experiencing
dynamic efficiency? What would you recommend that they do to consumption today?

Answers
Question 1
(a)

Y = K α L1−α
Y K α L1−α
= dy
L L = αk α−1
dk
y = K α L−α  1−α
 α 1
K =α
= k
L
y = kα
dy
From the right hand side of the equation, dk is decreasing in k. Thus, y exhibits a decreasing marginal
returns to k

(b)

dY K α−1
r= = α α−1 = αk α−1
dK L

dY Kα
w= = (1 − α) α = (1 − α)k α
dL L

rk + w = αk α−1 · k + (1 − α)k α = αk α + (1 − α)k α = k α = y

Question 2
(a)

sK α L1−α − δK K α−1
       
∆K ∆L K sY − δK
∆k = − = −n k = − n k = s α−1 k − (δ + n)k
K L L K K L
= sk α−1 · k − (δ + n)k = sk α − (δ + n)k = sf (k) − (δ + n)k

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(b) Given n = 0, the final expression becomes ∆k = sk α − δ)k.

(c)
1
∆k = 0
  α−1
δ+n
k=
0 = sk α − (δ + n)k s
1
sk α = (δ + n)k
  1−α
∗ s
k =
δ+n
sk α−1 = (δ + n)  α
 1−α
δ+n ∗ ∗ α s
k α−1
= y = (k ) =
s δ+n

(d)

Technically, the growth rate of a variable x is written as ∆x x . It is useful to note that this expression
can be derived by differentiating the natural logarithm of x, ie d ln x = ∆x
x .

Y = y∗ L K = k∗ L
ln Y = ln y ∗ + ln L ln k = ln k ∗ + ln L
d(ln Y ) = d(ln y ∗ ) + d(ln L) d(ln K) = d(ln k ∗ ) + d(ln L)
∆Y ∆y ∗ ∆L ∆K ∆k ∗ ∆L
= ∗ + = ∗ +
Y y L K k L
=0+n=n =0+n=n

When a variable is constant its growth rate is 0. Thus, the variables K and Y can be constant only if n = 0
since they both grow at rate n.

Question 3
(a)

Y = K α (AL)1−α
Y K α (AL)1−α
=
AL AL
y = K α (AL)−α
 α
K
=
(AL)
y = kα

(b)
   
∆K ∆L ∆A K sY − δK
∆k = − − = −n−a k
K L A AL K
sK α (AL)1−α − δK K α−1
   
= −n−a k = s k − (δ + n + a)k
K (AL)α−1
= sk α−1 · k − (δ + n)k = sk α − (δ + n + a)k = sf (k) − (δ + n + a)k

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(c)
1
∆k = 0
  α−1
δ+n+a
k=
0 = sk α − (δ + n + a)k s
1
sk α = (δ + n + a)k
  1−α
∗ s
k =
δ+n+a
sk α−1 = (δ + n + a)  α
 1−α
δ+n+a s
k α−1 = y ∗ = (k ∗ )α =
s δ+n+a

(d) Note that Y /L = y ∗ A and K/L = k ∗ A, hence they both grow at the rate of a.

Question 4
(a)

c = f (k) − sf (k)
= f (k) − (δ + a + n)k since sf (k) = (δ + a + n)k in steady state
dc
= f ′ (k) − (δ + a + n) = 0
dk
f ′ (k) = (δ + a + n)

(b)
 1
 1−α
f (k) = k α α
kgr =
δ+a+n
f ′ (k) = αk α−1
ygr = (kgr )α
αk α−1 = (δ + a + n) " 1 #α
 1−α
δ+a+n α
k α−1 = =
α δ+a+n
  1
δ + a + n α−1 
α
α
 1−α
k= =
α δ+a+n

(c)
 1
 1−α
s
The steady state value for capital per effective labour given is given as k ∗ = δ+n+a while kgr =
 1
 1−α
α
δ+n+a . These expressions are equal only if s = α.
(d)

The golden rule steady state by definition is the steady state at which consumption is maximized. There-
fore, any other steady state yields less consumption compared to the golden rule. s > α then suggests the
economy is saving too much, so it is experiencing dynamic inefficiency. The economy should consume more
today (save less) in order to consume more tomorrow.

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