Daniele Angelini University of Vienna
MACROECONOMICS
Problem Set 3: The Solow Model
This Problem Set is graded. All details on Moodle.
Deadline: Monday, April 13th, 14:00hrs
Exercise 1
The Solow Model
Consider two economies, A and B, with the following production function:
Y = T F P × K 0.3 × L0.7 ;
where, in both economies, T F P = 1, L = 30, the capital stock depreciates at the annual rate of
10%, and 20% of annual GDP is devoted to investment. However, the initial capital stocks are
different: KA = 30 and KB = 60.
1. Plot output as a function of the capital stock (for K = 0, 10, 20, ..., 100) and discuss the
shape of the resulting relationship.
2. Find the marginal product of capital and plot it against the capital stock (for K =
0, 10, 20, ..., 100) Discuss the shape of the graph in light of your previous answer.
3. Locate the initial positions of countries A and B in the output-capital plot. Which country
will grow faster next year? Why?
4. Given the depreciation and investment rates, what will be the capital stocks of the two
economies next year (KA ′ and K ′ )? Assuming that total factor productivity and employment
B
do not change, what will be the output levels of the two countries next year (YA′ and YB′ )?
5. Calculate the real GDP growth rates (from this year to the next) of countries A and B and
interpret your results in light of your answer to 1.3.
6. Suppose now that total factor productivity does increase by 10% next year (T F P ′ = 1.1).
Revise your calculations of YA′ and YB′ . Which country benefits the most from this positive
productivity shock? Explain.
The next two questions concern both A and B, independently of the initial capital stocks.
In other words, these questions are about long-run steady-states.
7. Assume again that T F P = 1. Find the steady-state capital stock (KSS ) and the associated
levels of output and consumption. Plot this point in the output-capital diagram.
8. Find the optimal (golden rule) investment rate and the implied optimal (golden rule) capital
stock, output, and consumption. Compare this consumption level with that found in the
previous question. Explain.
1
Now, things are getting a bit more complicated. The following questions are about the speed
of convergence in country A only. You can solve the next two exercises by iterating on the
equation for capital accumulation: compute the evolution of the capital stock year by year.
(This is particularly easy using Excel).
9. Assume again that T F P = 1. In country A, where the initial capital stock is KA = 30.
For this country, how many years does it take until it has covered half the distance to its
steady state? In other words, how many years does country A need, to get from KA to
K = (KA + KSS )/2?
10. Related to your answer to 1.9: Does the economy converge faster or slower if the rate of
depreciation is higher? What about if the rate of investment is higher? Briefly discuss and
give some intuition.
Exercise 2
Human Capital
Consider the same two economies and the same production technology of the previous exercise, but
assume now that T F P = T F P × H 0.7 , so that:
Y = T F P × H 0.7 × K 0.3 × L0.7
where H is the stock of human capital, now disentangled from the total factor productivity index.
Assume that the stock of human capital is proportional to the stock of physical capital: H = 13 K.
For both countries, employment is L = 30, total factor productivity (now excluding human capital)
is T F P = 0.2, the investment rate is 20%, and the depreciation rate is 10%. Again, the initial
physical capital stocks differ: KA = 30 and KB = 60.
1. Plot output as a function of the capital stock (for K = 0, 10, 20, ..., 100) and discuss the
shape of the resulting relationship.
2. Find the marginal product of capital and plot it against the capital stock (for K =
0, 10, 20, ..., 100). Discuss the shape of the graph in light of your previous answer.
3. Locate the initial positions of countries A and B in the output-capital plot. Which country
will grow faster next year? Why?
4. Given the depreciation and investment rates, what will be the capital stocks of the two
economies next year (KA ′ and K ′ )? Assuming that total factor productivity and employment
B
do not change, what will be the output levels of the two countries next year (YA′ and YB′ )?
5. Calculate the real GDP growth rates (from this year to the next) of countries A and B. Will
they eventually converge? Why (not)?