ECON2102 - Macroeconomics 2

Assignment 1
Instructor: Gonzalo Castex
T1 - 2020

Instructions
- Due date 7th of March at 11.30pm. Electronic submission through Moodle.
- Please include a complete and signed cover sheet (available on Moodle).
- This assignment is to be completed in groups of 3 or 4 students. There are no restrictions on whom
you decide to form groups, i.e. your group members do not have to be from the same tutorial,
presentation group and you don’t have to necessarily stick to the same group members for future
group assessments.
- You must answer all the questions, but only one of the questions will be marked. If you fail to
answer one ore more questions you will be penalized.
- We advise you to firstly attempt all questions on your own then meet with your group members to
discuss your individual solutions.
- Presentation, organisation and tidiness of the assignment counts towards your mark. Make sure your
solutions are clear and easy to navigate. We are looking for a simple, but well-organised general look
for the assignment.
- You are free to type or handwrite your solutions. If you prefer to type them, make sure to use
Microsoft Word equations1 (or equivalent) to write down your equations properly, otherwise reserve
a space to handwrite them. If you prefer to handwrite the whole assignment or parts of it, make sure
the handwriting is clear, well-organised and legible.

QUESTION 1
1
Click on the “Insert tab” then “Equations”.
This question aims to explore some of the points discussed in the first lecture, with regards to the Simple
Model of Production. It is also designed to test your understanding of Chapters 3 and 4 of the prescribed
textbook.
Consider an economy with the following Cobb-Douglas production function:
1 2
Y = A K 3 L3
Further, assume the assumptions made in lecture 1 hold. Answer the following questions:

a) Provide an interpretation for the exponent of the labour input.

Since the exponent of the labour input is positive, an increase in L leads to an increase in output Y.
However, since the exponent is less than 1 (i.e. 2/3), there will be diminishing returns to labour, where the
graph would have a concave down shape.
b) Find expressions for the marginal product of capital (MPK) and labour (MPL) in this economy. Would
you say the assumption of diminishing return to inputs is satisfied? Why? (you can add a plot if you want)
−2 2
δY 1 3 1Y
MPK = = AK L3=
δK 3 3K
1 −1
δY 2 2Y
MPL= = A K3 L 3 =
δK 3 3 L
The assumption of diminishing return to inputs (capital and labour) is satisfied since when K or L increases,
MPK and MPL would decrease respectively. This can be illustrated by Figure 1, where the marginal product
of capital declines as capital gradually increases.

Figure 1. Graph illustrating the marginal product of capital

c) Derive the demand for capital from a typical firm in this economy. What can you say about the supply of
capital in the simple model of production?
To derive the demand for capital, we need to examine the profit-maximisation problem. Profits π for a firm
can be represented by the following equation:
1 2
π= Á K 3 L 3 −wL−rK
It is assumed that in a competitive market, firms will take w and r as given. Here, every additional unit of
capital has a cost r and a benefit that equals MPK . For example, a firm will rent more capital if MPK >r and
vice versa. The maximum profit a firm can make is when:
1Y
MPK = =r
3K
Hence, the demand for capital from a typical firm in this economy follows the rule for hiring capital (i.e.
1Y
when MPK = =r ).
3K
In the simple model of production, the supply of capital is exogenously given (i.e. K= Ḱ ).

d) Now, suppose there is a sudden increase in the supply of capital in this economy (ie, an exogenous
change in the level of capital). What do you expect to happen to the real rental rate and the real wage in this
economy? Provide both mathematical and graphical explanations and economic intuition.
The equilibrium solution of the simple model of production (denoted by *) is:
Capital K ¿ = Ḱ
Labour L¿ = Ĺ
1 2
Output ¿
Y = Á Ḱ Ĺ3 3

¿ 1 Y¿
Real rental rate r=
3 K¿

¿ 2 Y¿
Real wage w=
3 L¿

¿ 1 Y¿
Since the supply of capital K increases exogenously, the real rental rate r will decrease based on r =
¿ ¿
.
3 K¿
This is because K ¿ is in the denominator of the fraction, which is inversely proportional to r ¿. Figure 2
¿ ¿
shows a decrease in real rental rate from r 0 to r 1 since the vertical line (representing the supply of capital)
¿ ¿
has shifted from K 0 to K 1.

Figure 2. Supply and demand in the capital market

On the other hand, there is no change in real wage w ¿ since capital does not affect real wage, as evident by
¿ 2 Y¿
the equation w = . There will only be a change in real wage if supply of labour L¿ changes
3 L¿
exogenously.

QUESTION 2

This question aims to explore some of the points discussed in Topic 2 (Solow-Swan model). It is also
designed to test your understanding of Chapter 5 of the prescribed textbook.
Consider an economy with the general Cobb-Douglas production function:

Y t = A K tα Lt1−α .

Answer the following questions assuming that labour grows at the rate n = 0 and adopting the assumptions
made in lecture. The equation describing capital dynamics is:
K t +1=K t + I t −d K t

where d is a constant parameter.

a) Obtain the steady state levels of the capital stock (K), output (Y), capital per worker (k), output per worker
(y), consumption per worker (C/L), total savings (S), private investment (I), real wages (w) and real interest
rates (r). Make sure to show all your work.
b) Assuming that s = 0.4, d = 0.1, α = 0.4 and Á = 1, calculate the steady state values of the variables in (a).
Now, assume the policy-maker successfully implemented a policy that resulted in the increase of the total
factor productivity level to 2 (i.e., Á = 2), ceteris paribus.
c) Using the help of the Solow-Swan diagram developed in lectures and tutorials, explain the effect of this
policy on the standard of living of the economy. Make sure to include:
i) The economic explanation of why the economy experienced a change in the steady state level of
capital per worker;
Productivity gains may lead to an increased saving rate which in turn will result in higher savings by
firms. Firms will then utilise the savings to purchase capital and increase capital per worker, raising
the steady state from K ¿ to K ' .
ii) A diagram illustrating what happened to the relevant curves.
 
 From the model Y t = A K tα Lt1−α , there is an increasing relationship between K and Y (i.e. as capital
rises from K ¿ to K ' , so will output). Since the labour growth rate equals zero, this means for the
given labour force the increase in capital produces an increase in capital per capita and output per
capita. This raises the overall standard of living.
iii) Another diagram illustrating the dynamics of the stock of capital in the economy (before, at and
after the technological shock).

iv) What must have happened to the growth rate of output per worker in the transition between the
initial equilibrium and the final one?
Prior to the technological shock, the growth rate was near 0%. The shock initially causes Y to
increase at a high rate though at a diminishing rate. As Y reaches a steady state, the closer the growth
rate will be towards 0. The growth rate of output per worker will follow a similar trend to the growth
rate of Y. iv.
e) Is the current savings rate (s = 0.4) the golden rule of savings? Hint: you don’t need to calculate the actual
golden rule, just to show that the current one is not the golden rule.
The golden rule is the maximum consumption per worker. The calculated amount in Q2(b) does not equal
0.4, hence the current saving rate of 0.4 is not the golden rule.
 QUESTION 3

This question aims to explore some of the points discussed in Topic 3 (Romer model). It is also designed to
test your understanding of Chapter 6 of the prescribed textbook.
Consider the simple Romer model developed in lectures with the following values for parameters:
ź=0.003
l=0.25
L=900
A0 =7

a) How fast are ideas growing in this economy in percentage terms? How many workers are being employed
in the goods sector?
b) Find what the stock of ideas in this economy will be in periods 200 (t = 200) and 400 (t = 400).
c) Find an expression for the output per worker in the balanced growth path. What will be the standard of
living in periods 200 and 400?
d) On a clear graph, plot the trajectory of the log of output per worker through time.
e) Now, assume the policy-maker decides to allow 100 extra workers to come from overseas, leading to an
increase in the total labour force to 1,000. Show the effects of this change on the growth rate of ideas, as
well as the effect on the plot you drew in part (d). Do you notice both a level effect and a slope effect?

QUESTION 4

This question aims to explore some of the points addressed on our discussions surrounding unemployment
issues. It is also designed to test your understanding of Chapter 7 of the prescribed textbook.
Using the help of a diagram and clear economic explanation, discuss the effects on the equilibrium wage and
employment level of an economy given the following shocks:
a) A strong increase in Australian exports, leading to a strong increase in GDP.
The strong increase in GDP will lead to higher economic growth, which generally leads to job creation. This
results in an increased demand for labour, causing the labour demand curve to shift outwards as shown in
Figure 3 below.
 Figure 3. Effect of a strong increase in GDP on the labour market

As seen in the graph, the outward shift of the labour demand curve causes both the equilibrium wage and
employment level to increase to w 1 and L1 respectively. Hence, the equilibrium will shift from A to B.

b) The breakout of a new disease leads to a strong fall in consumer and business confidence, leading to a
strong fall in overall production (please note this is pure fiction!). Does your answer change if wages are
rigid downwards? If so, present the solution when wages are fully flexible and contrast it with the rigid case.
If not, please explain in detail.
A strong fall in overall production would lead to less jobs (e.g. due to redundancies). This results in the
labour demand curve shifting inwards, causing both the equilibrium wage and employment level to decrease
to w 1 and L1 respectively (since wages are fully flexible) as shown in Figure 4. Hence, the equilibrium will
shift from A to B.

Figure 4. Effect of fall in production if wages are fully flexible

However, if wages are rigid, this would mean wages remain at a level of w 0 no matter what occurs in the
economy. In this scenario, a strong fall in overall production would result in the labour curve shifting
downwards, causing the employment level to decrease from L0 to L2 as shown in Figure 5. Compared to
fully flexible wages, wage rigidity has caused employment levels to reduce to lower than L1, leading to an
excess supply of labour (given by L1−L2). Hence, the equilibrium will shift from A to C.
 Figure 5. Effect of fall in production if wages are rigid

c) The Australian government decides to increase the wage-related taxes to increase the chances of achieve a
surplus in the next Budget.
If the Australian government increases income tax to t, this would lead to an inward shift of the labour
supply curve since workers would receive a lower wage(1−t )w1 and therefore supply less labour at L1
(shown in Figure 6). In order for the labour market to reach equilibrium again, firms must increase wages to
w 1 to offset the increase tax t. Hence, the equilibrium will shift from A to B.

Figure 6. Effect of increase in wage-related taxes

d) A natural disaster hits the Australian economy causing a large contraction on the country’s GDP, and at
the same time the government announces new legislation to lower the tax rate on Superannuation
contributions.
A large contraction on the country’s GDP will likely lead to the labour demand curve shifting inwards due to
job losses. Reduced taxes on superannuation contributions would incentivise people to make more voluntary
superannuation contributions as it represents tax savings. Since workers effectively receive more money,
there will be an increased supply of labour and the curve will shift outwards. Assuming the contraction on
the country’s GDP has a greater impact than the lower tax rate on superannuation contributions, the labour
market would react according to Figure 7 below. Here, the equilibrium wage and employment level have
both decreased to w 1 and L1 respectively. Hence, the equilibrium will shift from A to B.
Figure 7. Effect of economic contraction and decrease in superannuation taxes