Problem Set 17

EC201: Intermediate Macroeconomics

1. (Solow growth model) Suppose that the production function in a country is given
by:
Yt = F (Kt , At Lt ) = Ktα (At Lt )1−α
Where Yt is total output at time t, Kt is the level of capital, At is the level of
technology, Lt is the labour force and 0 < α < 1 is a constant.
(a) Let yt = AYt Lt t , the output per unit of effective labour. Using the production
function show that yt = ktα , where kt = AKt Lt t , capital per unit of effective
labour.
Answer:
Yt K α (At Lt )1−α
= t
At Lt At Lt
Kt (At Lt )1−α
α
yt =
(At Lt )α (At Lt )1−α
yt = ktα

(b) Denote with s the constant saving rate, with n the growth rate of labour force,
with g the growth rate of technology and with δ the capital depreciation rate.
Write down the capital accumulation equation and show that the steady state
 1
 1−α
∗ s
level of capital per unit of effective labour is: k = n+g+δ . Show the
steady state of the economy in a graph.
Answer: The general capital accumulation equation is

∆kt+1 = it − (n + g + δ)kt

Using the savings identity of it = sf (kt ) and the production function, we get
a capital accumulation equation of:

∆kt+1 = sktα − (n + g + δ)kt

1
 To find the steady state, set kt = kt+1 = k ∗ , and solve for k ∗ :

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

(c) Using your solution in (b) find the output per unit of effective labour in
steady state and the output per worker. What are the growth rates of output
per unit of effective labour and of output per worker?
Answer: Using our formulas from (a) and (b), the output per unit of effective
labour in the steady state is:
" 1
 1−α #α  α
 1−α
∗ s s
y = =
n+g+δ n+g+δ

Output per worker is:

 α
 1−α
Yt s
= y ∗ ∗ At = At
Lt n+g+δ

The growth rate of y ∗ is zero, since it does not depend on any variable that
changes over time. It is a function of constants. Since LYtt = y ∗ ∗ At , its growth
rate is the same as At , so that output per worker grows at rate g.

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(d) Find an expression for consumption per unit of effective labour in the steady
state, c∗ .
Answer: Consumption per unit of effective labour is the amount of output
per unit of effective labour that is not saved. In the steady state, it is given
by c∗ = (1 − s)y ∗ :
 α
 1−α
∗ s
c = (1 − s)
n+g+δ
(e) Suppose that s = 0.2 (a savings rate of 20%), δ = 0.05, n = 0.01, g =
0.03, α = 0.3. Find the value of capital per unit of effective labour, output
per unit of effective labour, and consumption per unit of effective labour in
the steady state.
Answer:
 1
 1−0.3
∗ 0.2
k =
0.01 + 0.03 + 0.05
  107
20
= ≈ 3.13
9
 0.3
 1−0.3
∗ 0.2
y =
0.01 + 0.03 + 0.05
  73
20
= ≈ 1.41
9
 0.3
 1−0.3
∗ 0.2
c = (1 − 0.2)
0.01 + 0.03 + 0.05
  37
20
= 0.8 ≈ 1.13
9

(f) Using the values of δ, n, and g, in (e), as well as the condition that c∗ =
f (k ∗ ) − (n + g + δ)k ∗ in the steady state, use calculus to find the golden rule
level of capital per effective unit of labour.
Answer: The golden rule level of capital per effective unit of labour is that
which maximizes consumption per unit of effective labour in the steady state.
This maximum is found by taking the formula above, substituting in the
formula for output per unit of effective labour, and taking the derivative with

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 respect to k ∗ :
dc∗ d
∗
= 0 = ∗ [k ∗ α − (n + g + δ)k ∗ ]
dk dk
0 = αk ∗ α−1 − (n + g + δ)
αk ∗ α−1 = (n + g + δ)
n+g+δ
k ∗ α−1 =
α
  1
∗ n + g + δ α−1
kGold =
α
 1
 1−α
∗ α
kGold =
n+g+δ

Using our parameter and constant values:

 1
 1−0.3
∗ 0.3
kGold = ≈ 5.6 (1)
0.01 + 0.03 + 0.05

(g) Is capital per unit of effective labour higher or lower than the golden rule
value in part (d)? In order to maximize steady state consumption, would you
recommend that the savings rate be increased or decreased from s = 0.2?
Answer: Capital per unit of effective labour is lower than the golden rule
value when the savings rate is 20%. In order to increase steady state con-
sumption, the savings rate should increase.
This is more than the question asks, but the golden rule savings rate is 30%.
A shortcut to see this is to look equation (1), and see the value of 0.3 in
the numerator. This is where the savings rate s sits in the formula for k ∗ .
So, the ideal policy in terms of steady state consumption is to increase the
savings rate to 30%.

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