Answers to 2

nd
Midterm (Spring 2012)
April 16, 2012
Question 2 (25 points in total)
Part A (15 points)
The saving rate falls (5 points)
To show the path of output per worker over time, we need to investigate long-run,
short-run and intermediate eects, respectively.
1. Long-Run eect: In basic Solow model (without technological change) with
Cobb Douglas production function y = k

, the equilibrium is dened by

k
t
= 0
or
s(k

)
1
= (n + ) (1)
The solution of this equation (1) yields;
k

= (
n +
s
)
1
1
(2)
To see how the steady state level of output per worker changes in the long-run,
we need to investigate the path of capital per worker by dierentiating (2) to
get:
k

s
=
k

(1 )s
> 0 (3)
According to the above dierentiation, as s decreases, the new steady state
level of capital per worker (k

) gets smaller. It is also observable in Figure 1.

As s decreases, the saving function (sf(k)) shifts down and the point where it
intersects with the straight line that stands for break-even investment shifts
to the left.
Given the long-run eect of saving rate on capital per worker, the long run
eect on output per worker will be expressed in the following equation:
y

s
= (k
1
)
k

(1 )s
> 0 (4)
Thus, as s decreases, the new steady state level of output per worker (y

) gets
smaller.
1
2. Short-run Eect: To see short-run eect of change in saving rate on output
per worker, we investigate the level of output per worker at the time when the
change in saving rate occurs (t
0
), before k
t
changes, i.e. k
t
remains at k

:
y
s
|
k
t
=k
= 0 (5)
Thus, there is no jump in output per worker at t
0
.
3. Intermediate Eect (t > 0): Analyzing this eect gives us the path that capital
per worker follows between two steady states, k

and k

(See Figure 1), so

does the path of output per worker.
y
t
= y
k

k
t
= k
1
t

k
t
as

k
t
(6)
As saving rate increases, k decreases to converge to a lower steady state level, thus
equation states that output per worker decreases.
All these eects can be observable in Figure 2.
There is one-time improvement in the production function: F(K,L) rises for
any K and L. (The production function does not change after this one-time
shift (5 points).
This one-time improvement in the production function can be characterized by new
production function i.e. y = Bk

where B > 1. Accordingly, the equilibrium that

denes steady state levels of capital per worker, and output per worker is modied
as follows:
sB(k

)
1
= (n + ) (7)
The solution of this equation (7) yields;
k

= (
n +
Bs
)
1
1
(8)
1. Long-run Eect: To see how the steady state level of output per worker changes
in the long-run, we need to investigate the path of capital per worker by
dierentiating (8) to get:
k

B
=
k

(1 )B
> 0 (9)
2
According to the above dierentiation, for the values of B, which is greater
than 1, the new steady state level of capital per worker (k

) is higher. It is
also observable in Figure 1. For the values of B, which is greater than 1, the
saving function (sBf(k)) shifts up and the point where it intersects with the
straight line that stands for break-even investment shifts to the right.
2. Short-run Eect: To see short-run eect of change in saving rate on output
per worker, we investigate the level of output per worker at the time when the
change in the production function occurs (t
0
):
y
B
|
t=t
0
> 0 (10)
For the values of B that greater than 1, and for any levels of K and L, Y
increases, so does y. Thus, there is a jump in y at t
0
.
3. Intermediate Eect (t > 0): Analyzing this eect gives us the path that capital
per worker follows between two steady states, k

and k

, so does the path of

output per worker.
y
t
= y
k

k
t
= k
1
t

k
t
as

k
t
(11)
As explained in long-run eect, for the values of B, which is greater than 1, we have
higher capital per worker in the new steady state. So, the equation (11) suggests
that output per worker increases as k increases converging to its new steady state
level.
All these eects can be observable in Figure 3.
Half the population suddenly leaves the country. At the same time, the popu-
lation growth rate rises by a small amount (the people who remain the country
start having more children) (5 points).
1. Long run eect: The long-run eect eects of two events should be investigated
separately. For the same set of parameters, k

, thus y

would be the same in

the long-run, however as n increases, the nal change in steady state level of
k is determined by the below dierentiation:
y
n
= y
k
k
n
< 0as
k
n
< 0 (12)
Thus, in the long-run, the new steady state level of y will be lower.
3
2. Short-run Eect: In the same manner, the short-run eect eects of two events
should be investigated separately. On one hand, for any K and L/2, output per
worker at t
0
will be doubled. On the other hand, to see the short-run eect
of an increase in population growth rate (n) is characterized by the below
dierentiation:
y
n
|
k
t
=k
= 0 (13)
Thus, total eect of these events in the short-run is observable as an upward
jump in output per worker.
3. Intermediate Eect (t > 0): As stated above, k decreases while converging to
its new steady state level, which is lower. We can see how it determines the
path of output per worker by the below dierentiation:
y
t
= y
k

k
t
= k
1
t

k
t
as

k
t
(14)
Since

k
t
< 0, we have y
t
< 0. All these three eects can be seen in Figure 4.
Part B (10 points)
The saving rate falls (4 points).
The path of Y, which is y L depends on the path of output per worker. Having
studied short-run, long-run and intermediate eects of a decrease on the path of
output per worker above and knowing that Y grows at the rate of population growth
in the steady state, we can easily conclude about the path of output. In Figure 5,
the slopes of path of output (Y) before and after the event dont change and are
both equal to n. At time t
0
, as we have stated above, there is no jump in output
per worker, so there is no jump in output. However, as the new steady state level
of y is lower, the new steady state level of output will be lower for the same level of
population (L). In Figure 5, the path of output converges to a lower level with the
same level of growth, which is equal to n.
There is one-time improvement in the production function: F(K,L) rises for
any K and L. ( The production function does not change after this one-time
shift (3 points).
In the same manner, the path of Y, which is y L depends on the path of output
per worker. At time t
0
that one-time improvement in production function occurs, Y
4
increases for any level of K and L. This is observable as an upward jump in Figure
6. After this jump, Y converges to a new steady state, which is higher. In other
words, for the same level of L, as we stated above, the new production function
implies higher output in the long run. Furthermore, in Figure 6, the slopes of path
of output (Y) before and after the event dont change and are both equal to n.
Half the population suddenly leaves the country. At the same time, the popu-
lation growth rate rises by a small amount (the people who remain the country
start having more children).(3 points)
Given the path of output per worker that we have studied above, the output
follows the path given in Figure 7. Before the event, Y grows at the rate of population
growth which is equal to n. At t
0
, for given level K and half the population, Y jumps
down. After t
0
, Y converges to a lower level of steady state of output that grows at
a higher growth rate, which is denoted by steeper slope in Figure 7.
5
Figure 1: in saving rate: Investment and Break-even Investment
Figure 2: in saving rate: The path of output per worker
6
Figure 3: One-time Improvement in Production Function: The path of output per
worker
Figure 4: L L/2 and n : The path of output per worker
7
Figure 5: in saving rate: The path of output
Figure 6: One-time improvement in production function: The path of output
8
Figure 7: L L/2 and n : The path of output
9