Economics W3213.

Intermediate Macro
Problem Set 3 - Solutions

(1) Human Capital

a) Given that we have an AK production function, Y = AK . In per capita terms, it can be written as y = Ak . Then, the fundamental equation, which provides us with the rate of growth of capital per capita, k = sA (n + )

If sA > n + , then this economy will experience positive growth forever

b) An increase in s will increase the rate of growth if sA > n + or make it less negative if sA < n + c) Remember that n = f ertility mortality + netmigration. Then, if the fertility rate goes down, n will decrease, and we have the same consequences as in part b). d) Too much of a decrease in n means that in the long run there could be shortage of labor force to the economy, holding mortality and net migration constant. At worst, negative population growth rate by way of decreasing fertility rate leads to 0 population and the country disappears and so, it cannot be unambigously good. e) Human capital has a number of characteristics: First, everybody is born with zero human capital or skill. Second, unlike physical capital skills cannot be transmitted from parents to children (when a parent dies, the BMW stays with his children. His skills as a doctor die with him). Third, human capital accumulation requires time (especially, student time). And nally, lifetimes are nite so there is a nite amount of time within which skills need to be.

If sA < n + , then this economy will experience negative growth forever

This means that there is a limited amount of skills that people in the economy can acquire with a constant technology and within a lifetime. Once that point is reached, human capital must remain constant at that maximum level. Then, it cannot grow without bounds. Remember that we can get the AK production function from Y = AK H (1) where H = hL. We obtain the AK production function assuming that K and H grow at the same rate, since people want to equate the returns of physical capital to the returns of human capital (if not, there are investment opportunities in one of the types of capital). However, once H reaches its bound, and it cannot grow more, the production function becomes, (1) Y = AK H is xed. In per capita terms, where H (1) y = Ak h (1) which is constant, to get = Ah Call A y = Ak which is a Cobb-Douglas production function in per capita terms. Then, we go back to the normal Solow Model, so that in the long run the rate of growth is 0, because we have again diminishing marginal product to capital. 1

(2) Technological Progress

(a) The time inconsistency problem emerges in the context of R&D related to invention of cures for diseases for the poor because the policy or market structure before the invention is no longer optimal after the new drug has been invented. R&D involves huge xed cost. A competitive market structure is not compatible with R&D invention. Perfect competition involves pricing at the marginal cost which does not cover average cost if xed cost is involved in order to pay for innovation. To support R&D we need a monopoly market structure where prot maximization yields a price greater than the marginal cost. However monopoly has the disadvantage of higher price and lower output compared to perfect competition, leading to loss of social welfare. Due to this there occurs a divergence between ex-ante and ex-post policy. Thus we see that monopoly is needed before invention in order to induce invention. After invention however perfect competition is optimal since it maximizes social welfare. So market structure before and after invention is different, rms know this and they will not invest in discovering vaccines. (b) One way to solve the problem is create a fund that would be used for buying the vaccine by non-prot groups at the monopoly price which can then be distributed among the poor at marginal cost. The rm that develops the vaccine rst will be compensated for its investment in R&D that was needed to invent the vaccine. Hence rms will have an incentive to develop the vaccine and the poor would be able to procure it at a lower price through some intermediate non-prot organization. It appears to be the perfect solution for the time inconsistency problem, but unfortunately it is not. It will always tempting to use the fund to address many other pertinent problems rather than let it sit idle till the vaccine is discovered at some uncertain future date. If companies feel that fund would be spent elsewhere they will not have incentive to invest in new vaccine.

(3) Convergence
(a) The nding that the growth rate of real per capita GDP shows little relation to the initial level of real per capita GDP does not conict with the neoclassical model. The Solow-Swan model predicts conditional, rather than absolute, convergence. Poor countries are probably very different from the rich ones in terms of their rates of saving s, population growth n, depreciation , technology A, and even income share . Hence they have different steady states. (b) Absolute convergence simply means that poor countries tend to grow faster than rich ones. If there is a negative relation between income per capita and growth rate, this is absolute convergence. Notice that if poor countries are growing faster, eventually they will catch up with the rich ones and then will all grow at the same rate. Thats why its called absolute convergence, or simply convergence. Conditional convergence means that poor countries grow faster than rich ones only if they have similar parameters (saving rate, population growth, technology, and depreciation). Notice that it implies that they have similar steady states. Hence poor and rich countries will converge only if they have the same steady states. Romers AK model does not predict any kind of convergence. In the AK model, if two countries have the same parameters A, s, n, , they will be growing at the same rate forever. If one is richer than the other, the poor will never catch up. If, on the contrary, they have different parameters and hence different growth rates, the country with the higher growth rate will grow faster forever. The high-growth country will be eventually richer than the low-growth one, even if it was initially poor. Hence, there is no convergence.

(4) Changing savings rates and convergence

(a) When people are poor (that is, when they have low k), they may be willing to sacrice consumption in order to save, invest, and consume more in the future (like East Asian Tigers 40 years ago). When people are rich, they may prefer to consume now (like the U.S. now). If this is the case, the saving rate is higher for low k and lower for high k. In other words, s(k ) is a decreasing function of k, where the rst derivative is negative: s0 (k ) < 0.

ii. A model with the AK technology and saving as a decreasing function of k will predict convergence. Since s(k) is a decreasing function of k, s(k)A will also be a decreasing function of k. If we assume that s(k) approaches 0 when k grows bigger and bigger, s(k)A must cross (n + ), which is still a constant. This will be a steady state. If a poor and a rich country have the same parameters, they will converge to the same steady state. Therefore, this is conditional convergence.

, where s'(k) < 0. iii. The Solow-Swan model with a decreasing saving rate still predicts convergence. Now either

, where s'(k) < 0,

or

, where s is a constant.

The function s(k)A/k1- , where s(k) is decreasing in k, decreases faster than sA/k1- , where s is a constant. The two curves s(k)A/k1- and sA/k1- may intersect at the steady state, giving the same steady state whether the saving rate is decreasing or constant (Case 1 below). They may intersect at a point to the left of k*, giving a new lower steady state k** (Case 2), or to the right of k*, giving a higher steady state k*** (Case 3). They may not intersect at all, giving either a lower or a higher steady state (Cases 4 and 5). It all depends on the particular constant saving rate (e.g. s = 0.1 or 0.45) and the particular decreasing function of k (e.g. s (k) = 1/k or 2/(5k2)). If we are interested in comparing the speed of convergence, we must select two points that

3. I Wanna Be Like You

i. Fertility is usually a decreasing function of k. In general, people in rich countries tend to have fewer children than in poor ones. As a country gets richer (that is, k grows), the wages of its residents also increase. Since raising children requires a lot of humans' time, especially women's time, having children represents a lot of forgone wages and hence a lot of forgone consumption. Having children becomes more expensive in terms of forgone income as a country becomes richer. In addition, poor countries typically do not have wellfunctioning social security systems and retirement benefits. Hence people in poor countries choose to have more children, so that at least one of them can take care of parents when parents become old or disabled. ii. Mortality is usually a decreasing function of k. In general, people in rich countries live longer than in poor ones. As a country gets richer, people are able to invest more in healthcare, thereby reducing the mortality rate. iii. If we define net migration as immigration (moving in) minus emigration (moving out), net migration is usually an increasing function of k. Poor countries tend to send migrants, while rich ones tend to receive them. iv. A model with the AK technology and a population growth rate as an increasing function of k will predict convergence. Since n(k) is now an increasing function of k, (n(k) + ) will also be an increasing function of k. If we assume that n(k) grows bigger and bigger when k grows bigger and bigger, (n(k) + ) and sA, which is still a constant, must cross. This will be

a steady state. If a poor and a rich country have the same parameters, they will converge to the same steady state. Therefore, this is conditional convergence.

, where n'(k) > 0.

v. The Solow-Swan model with an increasing population growth predicts faster convergence than with a constant population growth rate. Now (n(k) + ), where n'(k) > 0, increases faster than (n + ), where n is a constant.

Economics W3213. Intermediate Macro

Problem Set 4 - Solutions

(1) Development Aid

(a) The population growth rate may look like this when one considers the opportunity cost of having children as k increases. Specically, as k increases we see wages increase, so that the time invested in raising children by parents (mothers) becomes more costly. Hence, as k increases we would expect fertility to fall as the return on a unit of time working rises above that of raising children. For low levels of k mothers are better of raising children, but around a specic level of capital, say k , this becomes more costly and so they substitute their time from the production of children to the production of cookies. At this point, fertility falls drastically as all parents (mothers) nearly simultaneously experiece this substitution of their time. Finally, it is clear that, as one cannot have negative children (and on average any country will have positive children), the value of n(k ) is bounded below, reaching this bound at, say, k . This discussion produces the graph of n(k ) seen, with the rst and second kinks at the values k and k , respectively. However, we need to consider that n does not only include fertility. Remember that n = f ertility mortality + net migration. Empirically we also observe that there exists a negative relationship between the mortality rate and the level of capital per capita. Rich countries have access to better health care, pharmaceutical products and better food that rises life expectancy, and that reduces the mortality rate. Also, there exists a positive relationship between net migration and the level of income per capita. Rich countries attract more immigration. Then, we should expect that both the mortality and migration rates decrease n when capital is low, and increase it when k is high. Thus, if we want the graph to look like that, the effect of the fertility rate should more than offset the effects of the mortality and migration rates. (b) Yes, a steady state will necessarily exist. The reason is that, if we consider a Cobb-Douglas production function, the k) savings curve s f ( k will have the following limits, f (k ) k f (k ) lim s k k
k 0

lim s

= =

Since the maximum and the minimum of n(k ) are between 0 and , then the savings curve will cross the depreciation line at least once. (c) No, the steady state may not be unique. We might have three different cases,

(d) For cases I and II the unique steady states are stable. If we perturbate the economy to the right or to the left of the steady state, capital per capita will go back to that steady state.
00 0 In case III , k3 and k3 are stable steady states, for the same reason as before. However, k3 is an unstable steady state. If 00 me move slightly to the left (right) of that steady state, the economy will converge to k3 (k3 ). Then, the only chance that 0 the economy stays forever in the unstable steady state is that the original level of capital per capita is exactly k3 .

(e) In Case III , k3 is a poverty trap. The country will be stuck in that level of capital per capita unless we provide it with a huge amount of aid. (f) The Case III model can be used to justify large increases in foreign development aid as a large enough gift of capital to a country stuck in the poverty trap, k3 , can lift it out of the trap and to a level of capital that will ensure that it converges to the highest steady state in the long-run. Specically, for a country in the poverty trap, the gift of capital must be greater 0 than k3 k3 . (g) The rst problem with this model is has been discussed in part (a). We need the effect of the fertility rate to more than offset the effects of the mortality and net migration effects. Empirically we can observe that n(k ) does not look like that. It looks more or less constant when we consider the effects of the other rates. There is no evidence to support the fact that although fertility does decrease as income per capita increases the decrease is abrupt and not gradual. It might be difcult to know which is the necessary level of aid to get rid of the trap. The model forgets that there exists technological progress in the real world. Then, even if the population growth rate looks like that, an increase in total factor productivity might push the savings line to the right, so that we end up in case III .

(2) Development Aid

(a) and (b)

Given this structure for the savings rate, we need rst to derive how does the savings curve look like. When the country is poor, we observe a very small savings rate, that increases suddenly once we become richer. The fundamental equation of Solow-Swan is given by: k = s(k ) f (k ) (n + ) k

where in this case, s is no longer constant (hence, we should write s(k )). Notice that in the previous graph there are 3 different areas. In area A, the savings rate is constant but small; therefore, the savings curve in the fundamental equation is decreasing . This is just like the regular Solow model with a small savings rate. 2

 In area C, the savings rate is constant but big; again, the savings curve is decreasing. Solow model with high savings rate. In area B, the savings rate is increasing with capital. We are going to assume that it increases more than the negative effect of the diminishing returns to capital; then, the savings curve is increasing in that area. (Think of this, s(k ) f (k ) k

we know that s(k ) is increasing in this area, but f (k )/k is decreasing because of diminishing returns. Then, we are assuming that s(k ) grows much faster than the decrease in f (k )/k when capital increases) As a result, we obtain this graphical representation for the fundamental equation,

Notice that, even if we have the movement in the middle of the savings line, the limits of it are again (from the small savings rate area) and 0 (from the high savings rate area). Since we consider a positive and bounded n + , the savings rate will cross for sure the depreciation line at least once. But in this case the steady state might not be unique. In the case of the dashed and the dotted depreciation line, there exists only one steady sate; a low one in the case of the dotted line and a high one in the case of the dashed one. However, if we consider the solid savings curve, there are three steady states, a low one, a high one, and one in the middle. (c) In the case of the dotted and the dashed line, there is a unique steady state, which is stable. If we deviate the amount of capital per capita to the left or to the right of those steady states, the country will converge back to them. However, in the case of the solid savings curve, we have

 To the left of k1 , savings are greater than depreciation in average per unit of capital, and we have positive growth. If we start at a level of capital to the left of k1 , we will eventually end up in k1 . To the right, until k2 , we have negative growth, and we will end up in k1 . Therefore, k1 is a stable steady-state with a low level of capital per capita (and GDP per capita). If you depart from a point to the left of k2 , the economy will experience negative growth and will move until k1 . To the right of k2 , we observe positive growth, and the economy will end up in k3 in the long run. k2 is an unstable equilibrium. You will only remain in k2 forever as long as you start exactly in k2 . If you move just a bit to the left (right) you will go to k1 (k3 ). For k3 we can apply the same argument as with k1 . Then, k3 is a stable equilibrium, and it is associated with a high level of capital (and GDP) per capita. (d) Yes. In the previous case, k1 is a povery trap. Unless the country does not have a high income per capita, it will not go to the richer steady state, k3 . If we push the economy to a point between k1 and k2 , the country will go back to the trap, k1 . (e) The previous case can be used to justify large increases in foreign development aid as a large enough gift of capital to a country stuck in the poverty trap, k1 , can lift it out of the trap and to a level of capital that will ensure that it converges to the highest steady state in the long-run. Specically, for a country in the poverty trap, the gift of capital must be greater than k2 k1 . (f) It might be impossible to know which is the level of aid which is necessary to get rid of the trap. And then, if we do not give enough capital, we might conclude erroneously that aid does not help. Unrealistic savings function. It is quite unlikely that savings increase so dramatically in region B. There is no evidence to support the fact that the increase in savings will offset the diminishing product of capital.

This derivations rely on the fact that there is no technological progress. With technological progress, we can get rid of the poverty trap (savings curve shifts upward). Is it credible that there is no technological progress?

(3) Dual Solow

1. Given that the production funtion is a Cobb-Douglas one, then, the fundamental equation is given by k = s Ak -1 (n + ) = s 10 k 0.5 0.1 2. We are going to have two different savings curves in this problem. For countries whose capital per capita is smaller than 1000, we will have a savings line associated to s = 0.20 and for countries whose capital per capita is bigger than 1000, the savings line will be associated to s = 0.70. Then,

3. If k < 1000 then the fundamental equation is, k = 0.2 10 k 0.5 0.1 In the steady state, k = 0. Then, 2k 0.5 k 4. If k > 1000 the fundamental equation is, k = 0.7 10 k 0.5 0.1 In the steady state, 7k 0 . 5 k

= =

0.1 400

= =

0. 1 4900

5. If the economy is in the steady state k then, if we give the country D = 300, it will have 400 + 300 = 700 units of capital per capita. Howeverm 700 < 1000, and the country will still be using the low savings rate. At that point, the savings line is below the depreciation line. Average investment is smaller than average depreciation per unit of capital. Then, we have negative growth and the country will go back to k eventually. 5

6. In this case, 400 + 700 = 1100 > 1000. Then, the country will be in the area with high savings rate. At that point, we are between 1000 and k . Then, the savings line is above the depreciation line. We have positive growth and we converge to the high steady state, k . 7. No. We need to give to the country at least 600 units of capital in order to get rid of the poverty trap. Small donations will not help the country to grow to a high level of GDP per capita, as we have shown before with D = 300.

(4) Is aid harmful?

First of all, some economists argue that international aid might destroy incentives in poor countries to get more productive by theirselves, since they receive many good for free. That is, aid might keep poor countries in a servant role instead of in a self-sufcient one. If countries have this free permanent income from abroad, they do not have the incentive to increase income or to develop other sources of income like capital income. Second, and most importantly, many people argue that international aid can undermine local producers. For example, if rich countries send T-Shirts to poor countries, local producers of T-Shirts may go bankrupt. This problem has especially been critical in the case of agricultural products. Many people in poor countries survive with local farms. Food aid to help countries through a temporary famine often drives farmers out of business. It is impossible to compete with the food that wealthy western countries send for free. Also, this type of aid might reduce the price of farmers products, which is also harmful for them. It has also been argued that international aid may reduce exports and the participation of poor countries in international trade. This is harmful since many research papers show that international free trade might improve long run growth. Other problem is ineffective penetration and lack of accountability. Big aid money goes to governments rather than the people, and there are no constraints imposed on local governments on how to use the aid. This approach enables corruption and encourages irresponsible governance, which can harm long run growth, as many empirical studies suggest. You should not only consider that these governors steal the aid, but that they might end up passing laws that make difcult to be more productive, like forbidding farmers to own land.