PROBLEM SET 2 – THE BASIC SOLOW MODEL

SOLUTIONS TO SELECTED EXERCISES

1) The effects of a decrease in the population growth rate. Consider an economy that is
initially in steady state. Explain the economic effects according to the basic Solow model
of a decrease (at some time) in the population growth rate from one constant level to a
new and lower constant level, answering to the following questions:
a) How does this change affect the Solow diagram?
b) How does it affect the steady-state values of capital, income and consumption per
capita?
c) Explain qualitatively the transition from the old steady state to the new one: what
initiates the growth process, and what keeps it alive for some time?
d) Sketch a graph of how the (natural log of) output per worker evolves over time,
before and after the change. Draw a similar graph showing how the growth rate of
output per worker evolves over time.
e) Does the change in the population growth rate permanently change the growth rate
of output per capita?

In class.

2) The effects of an increase in TFP (inspired on problem 2 in Jones (2020)). One

explanation for China’s rapid 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. Assume that the sole result of these policies is a permanent increase in
total factor productivity 𝐴 (when the production function in per capita terms is 𝑦 =
𝐴𝑘 𝛼 ).
Do all you were asked to do in the previous exercise (there for a decrease in the
population growth rate), only this time for a permanent increase in total factor
productivity 𝐴.
a) Solow diagram: If A’>A, both the production function (not shown in the diagram
below) and the saving (=investment) per capita curves shift up: the economy is
more productive at any level of 𝒌, and thus can save and invest more at any 𝒌.
 (𝒏 + 𝜹)𝒌(𝒕)

𝒔𝑨′𝒌(𝒕)𝜶

𝒔𝑨𝒌(𝒕)𝜶

𝒌(𝒕)

b) The steady-state value of capital per capita increases, as can be appreciated from
the Solow diagram above. As a consequence, steady-state output per capita also
increases (since the production function is increasing: to a higher level of 𝒌 there
corresponds a higher level of 𝒚). The steady-state consumption per capita is also
higher, since 𝒄 = (𝟏 − 𝒔)𝒚 and 𝒚 is higher in the new steady state.
c) Assume the change in A happens at 𝒕𝟎 . Then, in 𝒕𝟎 , given the initial value of capital
per capita 𝒌𝟎 , the economy produces a higher level of output per capita and,
correspondingly, saves and invests more than the replacement investment
(𝒏 + 𝜹)𝒌𝟎 needed to keep 𝒌𝟎 constant. As a consequence, there is an increase in
capital per capita (if we thought of time as discrete, this increase would happen
between 𝒕𝟎 and 𝒕𝟎 + 𝟏): we move to the right of 𝒌𝟎 . The higher capital per capita
leads to a higher production per capita and to a saving/investment per capita that
is higher than replacement investment: more capital is accumulated than needed
to compensate for depreciation and population growth. As capital per worker
increases, the marginal product of capital decreases until a new steady state is
reached, where investment per worker just covers the (now increased)
replacement investment needed to compensate for depreciation and population
growth.
d) I simulated the values of the logarithm of GDP and growth rate of output per
capita over time for a 10% increase in A at period t=10 (and for a specific set of
parameters). Here is the result:
 Log of output per capita
0,7

0,6

0,5

0,4

0,3

0,2

0,1

0,0
1 10 19 28 37 46 55 64 73 82 91 100 109 118 127 136 145
Time

Growth rate of output per capita

12%

10%

8%

6%

4%

2%

0%
1 10 19 28 37 46 55 64 73 82 91 100 109 118 127 136 145
Time

e) The permanent increase in total factor productivity changes the level of output per
capita (increasing it), does NOT change its growth rate (which goes back to zero in
the long run).

3) Can we save too much? The Golden rule of saving. Consumption per capita is equal to
output per capita minus saving per capita: 𝑐 = 𝑦 − 𝑠𝑦 = (1 − 𝑠)𝑦. In the context of the
basic Solow model with the Cobb-Douglas production function (in per capita terms) 𝑦 =
𝐴𝑘 𝛼 , and knowing that in this model the steady-state value of capital per capita is 𝑘 ∗ =
1 𝛼
𝐴𝑠 ( ) 1
𝑠 ( )
1−𝛼 ∗ ( ) 1−𝛼
(𝑛+𝛿) so that the steady-state value of output per capita is 𝑦 = 𝐴 1−𝛼 (𝑛+𝛿) :
 a) Show that the level of the saving rate maximizing the steady-state level of per capita
consumption c* is s**=α. [Hint: Find 𝑐 ∗ as a function of the model parameters,
transform it in ln(c*) and notice that since the ln is an increasing function, the 𝑠 that
maximizes c* also maximizes ln(c*) ].
In class.
b) What is the marginal product of capital in the steady state if the saving rate is
s=s**=α (note: this saving rate is also called the Golden rule saving rate)? Show this
point in a Solow diagram. Be sure to draw the production function on the diagram,
and show consumption and saving and a line indicating the marginal product of
capital. [See also exercise 2.6 in García de Paso for this point].
𝑲
Marginal product of capital MPK = 𝜶𝑨𝑲𝜶−𝟏 𝑳𝟏−𝜶 = 𝜶𝑨( 𝑳 )𝜶−𝟏 = 𝜶𝑨𝒌𝜶−𝟏 .
𝜶−𝟏
𝑨𝒔 ( ) 𝑨𝒔 −𝟏 𝒏+𝜹
∗ )𝜶−𝟏 𝟏−𝜶
In the steady state MPK= 𝜶𝑨(𝒌 = 𝜶𝑨 (𝒏+𝜹) = 𝜶𝑨 (𝒏+𝜹) =𝜶 𝒔
𝒏+𝜹
Given the Golden rule saving rate 𝒔 = 𝜶, MPK= 𝜶 = 𝒏 + 𝜹: the marginal
𝜶
product of capital is equal to (𝒏 + 𝜹) if the saving rate is s**=α.
In fact, the maximum steady-state consumption is reached when the slope of the
production function (which is the MPK) is equal to the slope of the replacement
investment line (𝒏 + 𝜹).
c) Can we save too much? In class.

4) A one-shot increase in the population. What are the short-run and the long-run effects
on an economy of a one-time permanent increase in the stock of labor (that is, at some
time 𝐿 increases once and for all by a certain amount, for instance due to immigration)?
Assume that the economy is initially in steady state, and that before and after the
change the population growth rate stays unchanged at 𝑛.
In class.

5) An earthquake. (Problem 3 from Jones (2020)). Consider a Solow economy that begins
in steady state. Then a strong earthquake destroys half the capital stock. Use a Solow
diagram to explain how the economy behaves over time. Draw a graph showing how
(the natural log of) output behaves over time, and explain what happens to the level
and growth of per capita GDP.
An earthquake that destroys the capital stock produces a movement along the curves
in the Solow diagram. None of the curves shifts because the parameters that describe
the economy do not change.
Thus, assuming that k* is the steady-state level of capital per capita, after the
earthquake the economy’s capital per capita drops to half: k*/2. At this level of capital
per person, investment per capita exceeds replacement investment, so that capital
 per capita increases over time. The economy will grow until it reaches the original
steady state again.
Starting from the steady state level ln(y*) (constant over time according to this
model), the (natural log of) output jumps down and then begins to grow again until
returning to the same level ln(y*).
The growth rate of per capita output is negative immediately after the earthquake,
then is positive and decreasing until becoming zero again (as in the original steady
state).

(From previous exams):

Try and solve them, and hand in to me your solutions, I can correct them.

11) Consider two economies (A and B) that behave according to the basic Solow model.
1 1
Both economies are characterized by the production function 𝑌(𝑡) = 𝐾(𝑡) ⁄2 𝐿(𝑡) ⁄2,
where 𝑌(𝑡) is aggregate output, 𝐾(𝑡) is aggregate capital, and 𝐿(𝑡) is the total
̇ =
population, growing at the rate 𝑛 = 0.05. The capital accumulation equation is 𝐾(𝑡)
𝑠𝑌(𝑡) − 𝛿𝐾(𝑡), with depreciation rate 𝛿 = 0.05 in both economies, while the saving
rate 𝑠 = 𝑠𝐴 = 0.3 in country A, and 𝑠 = 𝑠𝐵 = 0.6 in country B.
𝑌(𝑡) 𝐾(𝑡)
a. Defining output per capita as 𝑦(𝑡) ≡ 𝐿(𝑡) and capital per capita as 𝑘(𝑡) ≡ ,
𝐿(𝑡)
express both the production function and the capital accumulation equation in
per capita terms, showing your work.
Production function in per capita terms:
𝟏 𝟏⁄ 𝟏⁄
𝒀(𝒕) 𝑲(𝒕) ⁄𝟐 𝑳(𝒕) 𝟐 𝑲(𝒕) 𝟐 𝟏⁄
𝒚(𝒕) ≡ = = 𝟏 = 𝒌(𝒕) 𝟐
𝑳(𝒕) 𝑳(𝒕) 𝑳(𝒕) ⁄𝟐
Capital accumulation equation in per capita terms:
𝑲(𝒕)
Start from transforming in logarithm 𝒌(𝒕) ≡ :
𝑳(𝒕)
𝐥𝐧(𝒌(𝒕)) = 𝐥𝐧(𝑲(𝒕)) − 𝐥𝐧 (𝑳(𝒕))
Derive with respect to time:
𝝏𝐥𝐧 (𝒌(𝒕)) 𝝏𝐥𝐧 (𝑲(𝒕)) 𝝏𝐥𝐧 (𝑳(𝒕))
= −
𝝏𝒕 𝝏𝒕 𝝏𝒕
Knowing that the derivative of the ln of a variable that changes over time is
equal to the growth rate of this variable, we have:
 ̇
𝒌(𝒕) ̇
𝑲(𝒕) ̇
𝑳(𝒕) ̇
𝑲(𝒕)
= − = −𝒏
𝒌(𝒕) 𝑲(𝒕) 𝑳(𝒕) 𝑲(𝒕)
Knowing that 𝑲(𝒕) ̇ = 𝒔𝒀(𝒕) − 𝜹𝑲(𝒕):
̇
𝒌(𝒕) 𝒔𝒀(𝒕) − 𝜹𝑲(𝒕) 𝒀(𝒕) 𝒚(𝒕)
= −𝒏=𝒔 − (𝜹 + 𝒏) = 𝒔 − (𝜹 + 𝒏)
𝒌(𝒕) 𝑲(𝒕) 𝑲(𝒕) 𝒌(𝒕)
Multiplying by 𝒌(𝒕) both sides I obtain the capital accumulation equation in
per capita terms (= Solow equation):
̇ = 𝒔𝒚(𝒕) − (𝜹 + 𝒏)𝒌(𝒕) = 𝒔𝒌(𝒕)𝟏⁄𝟐 − (𝜹 + 𝒏)𝒌(𝒕)
𝒌(𝒕)
b. Compute the steady-state level of consumption per capita in the two economies.
First, we need to compute the steady state value of capital per capita 𝒌∗ such
̇ = 𝟎:
that 𝒌(𝒕)
̇ = 𝒔𝒌∗ 𝟏⁄𝟐 − (𝜹 + 𝒏)𝒌∗ = 𝟎
𝒌(𝒕)
𝟏⁄
↔ 𝒔𝒌∗ = (𝜹 + 𝒏)𝒌∗
𝟐
𝟏 𝒔
↔ 𝒌∗ ⁄𝟐 =
𝜹+𝒏
𝒔 𝟐
↔ 𝒌∗ = ( )
𝜹+𝒏
Then,
𝟏⁄ 𝒔
𝒚∗ = 𝒌∗ 𝟐 =
𝜹+𝒏
(𝟏 − 𝒔)𝒔
𝒄∗ = (𝟏 − 𝒔)𝒚∗ =
𝜹+𝒏

Country A:
𝟎. 𝟑
𝒚∗ 𝑨 = =𝟑
𝟎. 𝟏
𝒄∗ 𝑨 = (𝟏 − 𝒔𝑨 )𝒚∗ 𝑨 = 𝟎, 𝟕 ∗ 𝟑 = 𝟐. 𝟏

Country B:
𝟎. 𝟔
𝒚∗ 𝑩 = =𝟔
𝟎. 𝟏
𝒄∗ 𝑩 = (𝟏 − 𝒔𝑩 )𝒚∗ 𝑩 = 𝟎, 𝟒 ∗ 𝟔 = 𝟐. 𝟒

c. Now assume that both economies are initially in steady state, and that the
saving rate permanently increases by 0.2 in both (that is, 𝑠′𝐴 = 0.5 and 𝑠′𝐵 = 0.8
starting from a certain 𝑡̅ onwards). Calculate the new levels of consumption per
capita immediately after the change and in the new steady state, and sketch a
graph for each country, showing how consumption per capita evolves over time
before and after the change.
Immediately after the change, 𝒄(𝒕̅) = (𝟏 − 𝒔′ )𝒚∗

In country A:

𝒄𝑨 (𝒕̅) = (𝟏 − 𝒔𝑨 ′ )𝒚𝑨 ∗ = 𝟎. 𝟓 ∗ 𝟑 = 𝟏. 𝟓

In country B:

𝒄𝑩 (𝒕̅) = (𝟏 − 𝒔𝑩 ′ )𝒚𝑩 ∗ = 𝟎. 𝟐 ∗ 𝟔 = 𝟏. 𝟐

In steady state:

Country A:
𝟎.𝟓
𝒄∗′ ′ ∗′
𝑨 = (𝟏 − 𝒔𝑨 )𝒚𝑨 = 𝟎. 𝟓 ∗ 𝟎.𝟏 = 𝟐. 𝟓 (higher than in the original steady state,
since the initial saving rate was below the Golden rule saving rate that in this
case is 𝒔∗∗ = 𝜶 = 𝟎. 𝟓 = 𝒔′𝑨 . )

Country B:
𝟎.𝟖
𝒄∗′ ′ ∗′
𝑩 = (𝟏 − 𝒔𝑩 )𝒚𝑩 = 𝟎. 𝟐 ∗ 𝟎.𝟏 = 𝟏. 𝟔 (lower than in the original steady state,
since the initial saving rate was above the Golden rule saving rate)

Using the Excel file “Simulation of the Solow model with Excel” to simulate
consumption in country A before and after the permanent change in the saving
rate:
Using the Excel file to simulate consumption in country B before and after the
permanent change in the saving rate: