Intermediate macro
Solutions #7
Tutorial 7: week starting September 12th
Solutions
Solutions to pre-tutorial problem
1. You should be able to tell whether the following statements are true, false or uncertain and also
be able to justify your answer.
(i) Output per capita in most countries is converging on the level of output per capita in the
United States.
(ii) Capital accumulation does not change the level of output in the long run. Only techno-
logical progress affects the level of output in the long run.
(iii) The aggregate production function is a relation between output, labor and capital.
Solutions:
(i) False. The pattern of convergence is most visible for the OECD countries. However, it
remains elusive when one examines a large group of countries from different continents;
see Figure 10.3 for the lack of pattern.
(ii) False. Both capital accumulation and technological progress contribute to the level of
output in the long run.
(iii) True.
2. Consider the production function √ √
Y = K N
(i) Calculate output when K = 49 and N = 81.
(ii) If both K and N double, what happens to output?
(iii) Is this production function characterized by constant-returns-to-scale? Justify your answer.
(iv) Write the production function as a relation between output per worker and capital per
worker.
(v) Let y = Y /N and k = K/N denote output per worker and capital per worker respectively.
If k = 4, what is the value of y? Now double k to 8. What happens to y?
(vi) Does the relation between output per worker y and capital per worker k display constant
returns to scale?
(vii) Is your answer in (vi) the same as in (iii)? Why or why not?
Intermediate macro: Solutions #7 2
Solutions:
√ √
(i) When K = 49 and N = 81 output is Y = 49 81 = 63.
√ √
(ii) If both capital and labor double, output is Y = 2 × 49 2 × 81 = 2 × 63 = 126. Output
doubles.
(iii) Yes. More generally, for any number x > 0, a production function Y = F (K, N ) with
constant-returns-to-scale (CRS) satisfies
xY = F (xK, xN )
√ √
To see that this particular production function Y = K N has the CRS property, note
√ √ √ √ √ √ √ √
xK xN = x K x N = x K N = xY
In fact, any production function Y = K α N 1−α where 0 ≤ α ≤ 1 has the CRS property.
(iv) To convert the aggregate production function into per worker terms, divide both sides by
N to get √ √ √ √ √
K √
r
Y K N K N K
y= = =√ √ =√ = = k
N N N N N N
√
(v) If k = 4, then output per worker is y = 4 = 2. If k doubles to 8, output per worker is
√ √
y = 2 × 4 = 2 2 ≈ 2.83 < 4
Output per worker less than doubles.
(vi) No. Output per worker less than doubles, so this relationship does not satisfy the CRS
property.
(vii) No. The fact that in (v) y increased by less than the increase in k is due to diminishing
returns to capital. In that calculation we are looking at the impact on output when we
increase capital holding labor constant. By contrast in (iii) we are increasing both capital
and labor together in equal proportion.
3. You should be able to tell whether the following statements are true, false or uncertain and also
be able to justify your answer.
(i) A higher rate of investment can sustain a higher growth rate of output forever.
(ii) If capital never depreciated, growth would continue forever.
(iii) The higher the savings rate, the higher is consumption in the steady state.
Solutions:
(i) False. A higher saving rate that leads to a higher level of investment can only sustain
higher growth of output until output reaches its new steady-state level.
(ii) True. A constant saving rate would then produce a positive but declining rate of growth.
(iii) Uncertain. Define sG as the saving rate that produces the maximum steady-state consump-
tion per worker. For s between 0 and sG , higher saving rate implies higher consumption per
worker; but for s between sG and 1, increases in the saving rate implies lower consumption
per worker.
Intermediate macro: Solutions #7 3
4. Consider the following statement: ’The Solow model shows that the saving rate does not affect
the growth rate in the long run, so we should stop worrying about the low Australian saving
rate. Increasing the saving rate wouldn’t have any important effects on the economy.’ Do you
agree or disagree?
Solutions:
Disagree. An increase in the saving rate does not affect growth in the long run, but it does
increase growth in the short run. In addition, an increase in the saving rate leads to an increase
in the long-run level of output per worker. Finally, the average US saving rate since 1970 has
been only 17% and the average Australian saving rate has been 24%, we can be quite confident
that these saving rates are below the golden-rule rate. It implies that an increase in the saving
rate would increase steady-state consumption per worker in the long run.
5. Discuss the likely impact of the following policy changes on the level of output per worker:
(i) The right to exclude saving from income when paying income tax.
(ii) A higher rate of female participation in the labor force (for a given-sized population).
Solutions:
(i) This would likely lead to a higher saving rate, so output per worker and output per capita
would be higher in the long run.
(ii) Treat an increase in female participation as a one-time increase in employed labour. In
this case, an increase in female participation would have no effect on the level of output
per worker, but would lead to a higher level of output per capita, since a greater fraction
of the population would be employed.
Solutions to in-tutorial problems
1. Make sure that you understand the problems set in the blue sheet (pre-tutorial work) for this
week’s tutorial. Ask others in your group if you are still unsure about any of the blue sheet
problems.
2. Consider the production function √ √
Y = K N
Assume that N is constant and equal to 1.
(i) Derive the relation between the growth rate of output and the growth rate of capital.
(ii) Suppose that we want to achieve output growth equal to 2 per cent per year. What is the
required rate of capital growth?
(iii) In (ii), what happens to the ratio of capital to output K/Y over time?
(iv) Is it possible to sustain output growth of 2% forever in this economy? Justify your answer.
Solutions:
Intermediate macro: Solutions #7 4
(i) The growth rate of a variable Xt between dates t − 1 and t is
Xt − Xt−1
gX ≡
Xt−1
as discussed in Lecture 10, when gX,t is small (say, less than 0.05 or 5%) this formula for
the growth rate is well approximated by the log difference
gX ≈ ln Xt − ln Xt−1
Now √
lets apply this to the production function. When N = 1 output per worker is
Y = K. Take logs of this equation to write
ln Y = 0.5 ln K
(remember ln(X a ) = a ln X etc). Therefore
(ln Yt − ln Yt−1 ) = 0.5(ln Kt − ln Kt−1 )
And so in growth rates
gY ≈ 0.5gK
(ii) We want gY = 2%, but gY = 0.5gK so we need gK = 4%.
(iii) K/Y will rise over time as capital is growing faster than output. Capital must grow faster
than output because there are diminishing returns to capital in the production function.
(iv) No. Since capital is growing faster than output, the saving rate will have to increase to
maintain the same pace. The required saving rate will keep increasing and eventually
exceed 1. So it is not possible to maintain 2% output growth forever in this economy.
3. Between 1950 and 1973, Germany and Japan experienced growth rates of that were at least two
percentage points higher than those in the USA. In the same periods the major technological
advances occurred in the USA. Can you reconcile these facts?
Solution: Even though the United States was making the most important technical advances,
the other countries were growing faster because they were importing technologies previously
developed in the United States. In other words, they were reducing their technological gap
with the United States.
4. Suppose that an economy’s aggregate production function is given by
Y = K 1/3 N 2/3
(i) Is this production function characterized by constant-returns-to-scale? Justify your answer.
(ii) Are there decreasing returns to capital?
(iii) Are there decreasing returns to labor?
(iv) Transform the aggregate production function into a relationship between output per worker
and capital per worker.
(v) For a given saving rate s and depreciation rate δ, solve for capital per worker in the steady
state.
Intermediate macro: Solutions #7 5
(vi) For a given saving rate s and depreciation rate δ, solve for output per worker in the steady
state.
(vii) Calculate the steady state level of output per worker when s = 0.36 and δ = 0.04.
(viii) Suppose that the depreciation rate remains constant at δ = 0.04 while the savings rate
decreases to s = 0.16. What is the impact of this reduction in the savings rate on the
steady state level of output per worker?
Solutions:
(i) Yes. See the answer to blue sheet question 2 part (iii) above. Notice that for any x > 0
this production function satisfies
(xK)1/3 (xN )2/3 = x1/3 K 1/3 x2/3 N 2/3 = x1/3+2/3 K 1/3 N 2/3 = xK 1/3 N 2/3 = xY
so that scaling both inputs up by x > 0 (i.e., in equal proportion) leads to a scaling up
output by exactly the same amount.
(ii) Yes. The marginal product of capital (the return to capital) is positive
∂Y 1
= K −2/3 N 2/3 > 0
∂K 3
but this return, while positive, is lower the larger the amount of capital used, that is
∂ 2Y 2 −5/3 2/3
= − K N <0
∂K 2 9
(iii) Yes. The marginal product of labor is positive
∂Y 2
= K 1/3 N −1/3 > 0
∂N 3
and similarly this is lower the larger the amount of labor used, that is
∂ 2Y 2
2
= − K 1/3 N −4/3 < 0
∂N 9
Graphically, this shows up as a production function this is increasing but concave in capital
and labor.
(iv) This comes from dividing both sides by N to get
1/3
K 1/3 N 2/3 K 1/3 N 2/3 K 1/3
Y K
y= = = 1/3 2/3 = 1/3 = = k 1/3
N N N N N N
(v) Steady state capital per worker satisfies the condition
sy = δk
where
y = k 1/3
So we want to find k that solves
sk 1/3 = δk
Intermediate macro: Solutions #7 6
Graphically, this solution is found by the intersection of the concave function of k given
by aggregate savings and the straight line through the origin with slope δ. One solution
is at the origin with k = 0, but that’s not so interesting. The unique positive solution is
given by
s 3/2
k=
δ
This is increasing in the saving rate s and decreasing in the depreciation rate δ.
(vi) Steady state output per worker is given by
1/3
1/3 s 3/2 s 1/2
y=k = =
δ δ
(vii) Plug in the values s = 0.32 and δ = 0.04 to get
1/2
0.36
y= =3
0.04
(viii) Plug in the values s = 0.16 and δ = 0.04 to get
1/2
0.16
y= =2<3
0.04
So the fall in the savings rate s from 0.36 to 0.16 reduces steady state (long run) output
per worker.
