ECON30002 University of Manchester

Tutorial Problem Set 1 Solutions

Problem 1. Solow model diagram

Describe how, if at all, each of the following developments aects the break-even and actual
investment lines in our basic diagram for the Solow model:
(a) The rate of depreciation falls.
(b) The rate of technological progress rises.
(c) The production function is Cobb-Douglas, f (k) = kα , and capital's share, α, rises.
(d) Workers exert more eort, so that output per unit of eective labor for a given value of
capital per unit of eective labor is higher than before.
Solution 1.

(a) The slope of the break-even investment line is given by (n + g + δ), and thus a fall in the
rate of depreciation, δ , decreases the slope of the break-even investment line. The actual
investment curve, sf (k) is unaected. The steady-state level of capital per unit of eective
labour rises from k∗ to kN∗ EW .

(b) Since the slope of the break-even investment line is given by (n + g + δ), a rise in the rate
of technological progress, g , makes the break-even investment line steeper. The actual in-
vestment curve, sf (k), is unaected. The steady-state level of capital per unit of eective
labour falls from k∗ to kN∗ EW .

1
ECON30002 University of Manchester

(c) The break-even investment line, (n + g + δ) k, is unaected by the rise in capital's share, α.
Theα eect of a change in α on the actual investment curve, skα , is given by the derivative
∂(sk )
∂α
= sk α . ln k . For 0 < α < 1, and for positive values of k , the sign of the derivative is
the same as the sign of ln k. Thus, for α ∈ (0, 1), ∂(sk ⋚ 0 according as ln k ⋚ 0 or k ⋚ 1.
α)

∂α
For k > 1, the new actual investment curve lies above the old one. For k < 1 the new actual
investment curve lies below the old one, while the old and the new curves intersect at k = 1.
The eect of a rise in α on k∗ is ambiguous and depends on the relative magnitudes of s and

(n + g + δ). A rise in capital's share, α, will cause k ∗ to rise if s > (n + g + δ). This is the
case depicted in the adjoining gure.
(d) One can modify the intensive form of the production function by a non-negative constant,
say B > 0, such that the actual investment curve is now given by sBf (k). Then, workers
exerting more eort, so that output per unit of eective lavour is higher than before, can
be modelled as an increase in B , which shifts the actual investment curve up. The break-
even investment line, (n + g + δ), is unaected. The steady-state level of capital per unit of
eective labour rises from k∗ to kN∗ EW .

Problem 2. The balanced growth path

Consider a Solow economy that is on its balanced growth path. Assume for simplicity that there
is no technological progress. Now suppose that the rate of population growth falls.
(a) What happens to the balanced-growth-path values of capital per worker, output per worker,
and consumption per worker? Sketch the paths of these variables as the economy moves to
its new balanced growth path
(b) Describe the eect of the fall in population growth on the path of output (that is, total
output, not output per worker).

2
ECON30002 University of Manchester

Solution 2.

(a) Since there is no technological progress, we can carry out the entire analysis in terms of
capital and output per worker rather than capital and output per unit of eective labour.
Thus, we can dene y ≡ Y /L and k ≡ K/L.

The fall in the population growth rate makes the break-even investment line atter. In the
absence of technological progress, the per unit time change in capital per worker, k, is given
by k̇ = sf (k) − (δ + n) k. When k̇ was zero before the decrease in n, the economy was on
a balanced growth path. The decrease in n causes k̇ to become positive. At k∗ , actual in-
vestment per worker, sf (k∗ ), now exceeds break-even investment per worker, (nN EW + δ) k∗ .
Thus, k moves to a new higher balanced growth path level. As k rises, output per worker,
y , alone rises. Since a constant fraction of output is saved, consumption per worker, c rises
as y rises.

(b) Output can be written as Y ≡ L.y . Thus, the growth rate of output is YẎ = LL̇ + ẏy . On
the initial balanced growth path, yẏ = 0, that is, output per worker is constant, so that
Ẏ
Y
= L̇L = n. On the nal balanced growth path, yẏ = 0 again, that is, output per worker
is constant again, and so ẎY = L̇L = nN EW < n. In the end, output will be growing at a
permanently lower rate.
To know how output behaves in the interim period between the two balanced growth paths,
we need to consider the production function Y = F (K, L). On the initial balanced growth
path, L, K and thus Y are all growing at rate n. Then, suddenly L begins growing at some
new lower rate nN EW . Thus, suddenly Y will be growing at some rate between that of K
(which is growing at rate n) and that of L (which is growing at rate nN EW ). Thus, during

3
ECON30002 University of Manchester

the transition, output grows more rapidly than it will on the new balanced growth path, but
less rapidly that it would have without the decrease in population growth. As output growth
gradually slows down during the transition, so does capital growth until nally K , L and
thus Y are all growing at the new lower rate nN EW .

Problem 3. Inter-temporal elasticity of substitution

Consider an individual who lives for two periods and whose utility is given
C11−θ 1 C21−θ
U= + , θ > 0, ρ > −1.
1−θ 1+ρ1−θ
Let P1 and P2 denote the prices of consumption in the two periods, and let W denote the value of
the individual's lifetime income; thus the budget constraint is
P1 C1 + P2 C2 = W.
(a) What are the individual's utility-maximising choices of C1 and C2 , given P1 , P2 , and W ?
(b) The elasticity of substitution between consumption in the two periods is
(P1/P2 ) ∂ (C1/C2 ) ∂ ln (C1/C2 )
− , or, − .
(C1/C2 ) ∂ (P1/P2 ) ∂ ln (P1/P2 )
Show that with the above utility function, the elasticity of substitution between C1 and C2
is 1/θ.
Solution 3.

(a) We can set up the Lagrangian as follows:

C11−θ 1 C2
1−θ
L= 1−θ
+ 1+ρ 1−θ
+ λ [W − P1 C1 − P2 C2 ]
Then, the two rst order conditions are given by:
(1) ∂C
∂L
1
= 0=⇒C1−θ = λP1
(2) ∂C
∂L
2
= 0=⇒C2−θ = (1 + ρ)λP2
Combining (1) and (2), we get, the Euler equation, C1 = (1+ρ)1/θ (P2 /P1 )1/θ C2 . Substituting
the Euler equation into the budget constraint, we get the individual's utility-maximising
1/θ
(P2 /P1 )1/θ (W/P2 )
choices as C2 = 1+(1+ρ)1/θW/P 2
(P /P )(1−θ)/θ
and C1 = (1+ρ)
1+(1+ρ)1/θ (P /P )(1−θ)/θ
.
2 1 2 1

(b) Consider the Euler equation C1 /C2 = (1 + ρ)1/θ (P2 /P1 )1/θ . Taking logarithm of both sides
of the equation, we get, ln (C1 /C2 ) = 1/θ ln (1 + ρ) + 1/θ ln (P2 /P1 ). The elasticity of sub-
stitution between C1 and C2 is then given by − ∂[ln(C 1 /C2 )]
∂[ln(P1 /P2 )]
= ∂[ln(C1 /C2 )]
∂[ln(P2 /P1 )]
= 1/θ.