SOLUTIONS MANUAL TO ACCOMPAKY ROMER ADVANCED MACROECONOMICS JERFREY ROWALYIrwin/McGraw-Hill ego GoP;GoPscs8 PrinirBincer Greycen Press “This solutions manus is designed to accompany Advan Macroecnamic by David Roms. contains suggested solution eal ofthe endochapter problems, wi he exception of Some ofthe oops exerciues Ihave made every tempt to provide avery deal, sip-bystep answer to each problem Only base slgebrate manipulauons have bes occasionally ted Comments and suggestions for inpovement are welcomed and should be addressed to Jetrey Reha, Departmen of Economics, Universty of Cahfomsa, Barely, Califia 94720, can alsobe resched via e-mail at rohaly@econ berkeley la 1 would lke to thank David Romer for is geerous lp wh this manual. He provided many sopgestions and corrections that have erty improved the quality ofthese answers, Any eros that may remain ate, of couse, ny oveSider Problem 2) Since there 20 technological progress, we can carry ct teenie analysis in terms of capital and ‘uct per worker ruber han eapral nd out pe unit of effective labor. With A constant, they bebave ‘Gevame. Thus fr the purposes of this problem we cn define y « Y/L and k » KIL. “Te filth population grovch rate makes the tyeak-even esment lie fazer. Inthe sbrence of technological progress, the per unt {ane change capa per worker, sven by Cy Kr sf(k)= (Geek. Since & was 0 before the decease ina ~ the economy was on balanced growth path ~ the decrease inn causes k to (oan # frcome portive, At, acral investment per woke, Si), now exceeds breakeven invesment per worker, Oye + B)K™. Thus k mover 3 new higher balanad-growth-pah level ~ se the diagram, ‘As rises,y ~ ouput per worker — also rises ‘Sisce a constant action of ouput saved, ¢— consumption per worker — ses as y mses. This ‘eal eummarzed nthe diagrams below. ©) By definition, output can be writen 38 YaLy, Thus the growth rte of ouput is YIV=ULes/y. On the ital balanced growth th, 5/20 = apn pr works it constant ~ 50 Y/V =L/L=n. Onthe fal balanced growth th, y= 0 again ~ output por worker iz oestant again ~and so Y/Y = L/L= mygew 0 £4 oil be pov Now se ete (2) nd he second anv wh spc te Fk ef [yeep -feP HA] fom fh H FM of OH JMO poh] ‘We ean factor te exresson as flows Foapalyerlfyertie J {gto siti ingen 2 ie oe ‘We tow that fork 0, (FG) > 0. Ths "wil be negative when the fllownng condition bos * kM eco > ATCSaluvons to Chater 1 Rico => m0 ‘Thos £* ) <0 forall postive values of 4 Wekave fay Me jerome aa oP ee weet i £16) in - at = wtho>t ties £4) = tim Ww Problem 1 23) At sometime ~ call ity ~ theres | eiscrete upward jump inthe rumber of workers. This reduces the amouot of capa pr unt of ‘fective bor from k* 19 ew. We ‘an see his by simply lonking tthe 0, this fll inthe amount of eaptal per anit of tffecive aborreces the amount of ‘utp per un of effective abor a8 swell nthe agra, falls fiom y* oye" 8) Now ai this lower ew actual ‘avert pr ut of effeaive labor exceeds break-even investment per uni of effective labor. Tha i Moen) >(g-+Skyaw The soonamy is now saving and vering more than eno to offset depreciation and technological progress a this lower kaw Thus k begins rising back toward k*. As ‘pital per unt ofeffecive abor begins sing, so does ouput er unt of effec labor. Tat i, y begins sing fom aw back toward y* ©) Capital pr unit of effcsive labor will coniueto is nt eveualyreturas tothe original evel of Es Ath, nvesment per unt of effecve labor is aga jst ough to oe technological progress and depreciation and Keep k constant Since k returns tots ongmal valu of ence the economy again recurs tof balanced groweh path, ouput per un of effective labor also retums tots gaa value of "= Rk") Problem ‘Tae derive of y* =) with espero is given by (D ayrin = (44/00) “Toind c/o se the equation forthe evoltion ofthe eptl stock per unit of effective labor, f(k) (0-45 +8)k. laadtn, use the fot that on a balanest growth pat, k=0, k=K* and thos Mk) = (n= g+ 5)" Taking the derivative of both sides ofthis expression wih respect tom yields & a 30) negra Syke er) Satara Solutions to Chapter 1s and arangig elt: = te he ere Substingeqeation 2 to eatin (1) gives us Pa =u) foe 6 ayer) tearge he conn that impli des *~ fk) =(o ++ Okt ~and sae fr siding ppereren cy Sosa equation) fo eusin (): ee Toe © ere DREN AG woe “Torum is ioe els hat we want, mali bath tes of equation (5) by 2a Pees tae) Fo eres) RGNK AGNI ang the definition at 0) = POE KOT) ge yee nf agi) | a Greed Lima o® ana Now, with (4) = 13, 74, we nent calcul the effect on y* of fallin a from 29% to I%. Using the midpoint of ar ow (48 Ya Goons -oare00s) WT-173 Sothis 50% drop athe population grow ate (Fem 2%to 19) wil endo a (0.50) (-0.12) = (Meincresce nthe level of onpit pe Un of efectiv abe This iusats the pos that observed ‘Gffrmees in population growth rer across counties are at neatly enough to account for differences in y that we se, O15 to calculate the elaicny gives us Problem 1.6 2) Assuring that avesmentrige by the ful amount ofthe lin he def, the hare of outa that is Alvord to investment ~ the saving ate ~ should nse fom $= 015 to syay = 0.18. Nowe that thi i 20% ‘ncresue nthe saving rate (0.03 is 20% of 0.15). From equa (1.72) the tx, he elasicty of out ‘wh expect othe saving ati ty Eg SRD yt & “eg whet a (i the share of income paid to capital (assuming that capa spi its marginal produ), We are tld to asume that ag (?)= 1. Substruting his in gives us Say at) V3 1 ¥ Trag@) 1-132 Thur the elasticity of epi wath respect tothe saving ates 12. So this 20% increas inthe saving rate = fom" 0 15 0 saw "0.18 ~wil cause outpetorierltive fo what woul have been by about 10%. For sucha huge poiey change tral elumapatca of the budget deft ~ ths appears tobe a rather ‘modest benefit [Note thatthe analyse hae realy been camed out interme of ouput er anit of effecive6 Solutions to Chaper | labor. Since the path of A and L arena affected, however, f up per unt of effective labor ries by 10%, ouput tent also 10% ghar han what would have Baz ») Consumptic wll ite eve lee than expt Although output winds up L0% higher than what woud Ihave bea, the Fac ha the svg rates hgher means that we ae consuming a smaller faction of outpct than before the defiet redaction Thus we donot gett enjoy the enize 103s increase in Out 88 increstedconsumpoen. Note tha by consumption, we are imple including goverment purchases ‘We can ealeulate the els of consumpion wa respect tthe saving rate On the balanced growth ath, consumption is gbven by @ e=a-ay" Taking the derivative wih respect to yells “Tour this into an elasty, multiply both sides of equatien (3) by se fer eave as ee aay ee Toaye where we have substtuted * = (1-5)y* on the nighthand side. Simplifying gives us ens tt o oe e*G-8)” & (-ay* From part, the socnd tem ~ the elaicity of ouput with esac tothe saving rate ~ i equal 0 W/2. We can use the mudpout baten £= 0.15 and Shaw = 0.18 calculate the arity Bet ON, a er 0165) ‘Thus the elasticity of consumption with respect tothe saving rate is approximately 03. Sothis 20% increase athe svg fate — fom $= 0.15 to pew = 0.18 ~ wil lead to cenmompion being approximately 6% sbove what would have been. Again, the Solow mode! pel nly madert benefits from rather large change in goverment policy. ©) The immadias effet ofthe deficit rducon is that easumption fl Alhough y* does ct jump immediately ~ only begins to move towards bet, higher balance! growth pth level ~ we afe now svg a greater fraction and thus consuming a smaller Eacuon ofthis same y* At the moment of te tee ins by 3 percentage pots ~ since c= (1 -s)y* andy" is unchanged ~e falls Ia fa, the percentage change ine willbe the percentage change in (1-5). Now, (1 ~s) fal from 085 to 0 82, whichis agproximatcly a3 5% drop ~ 0.03 is about 3.5% of 0.88. Thus athe moment ofthe seas, consumptie falls by about three and a half percent \We ean use some result from te text onthe sped of convergence to deine how long it takes for contumgsio to resam to what would have doen wthow te defi reduction, Afr the mil rise a s© remains constant tvoughos Since c= (I= #y, thie mans that consumption wil row athe same rte {yon the way tothe sew balanced gro path in the ext te show tha the ate of ecavergence of k and {y~aflera inca approumati ~is even by A= (I~. n+ g #8). Wath (9+ 48) = 6% per year mid ‘ax 173, this yes 2.24% ‘This means that kand y move 4% ofthe remain distance toward tec balanced-growthpath values of kt andy" each year. Since cs proporional ty ~¢= (= 2)y = it alo approaches ts new talancad-growth-gath value at hat same consart ae. That is, analogous to equation (126) detent, we could wre © alo nat eH eC) “) Soltions Chapter) 7 or equivalent eo me ‘The tem on the right-hand side of equation (6) the faction ofthe distance tothe balanced growth path that rnaine to betaveled ‘We now that consungsin il iiialy by 35% and wil eventually be 696 higher ha would have been. Thus t mus change by 95% an the vay tothe balanced grow path, Iwill hrefore be equ! what t would have boen, 3.99 5% = 36.8% ofthe way othe ne alaned growth path. Equvalety, ‘his when the rematning dizance to the new balanad growth paths 63.2% af he ecgial stance In ‘order to Find cut how lang ths wil take, we end to id 21" that sles @ &* =06: “Taking the naval log of bth sides of equation (7) yl: Atte tn(0632) = 04891008 andthe (@ E115 yous [ew take aft long time ~ over a decade ~ for consumption orem to what it would have been inthe abamnce ofthe dei reduction ble 1.7 2) Defie the marvinal product of labor as w = 2E(K,ALVCL. Then wres the production incon as ALf(e) = ALITR/AL), Taking the partial denvative of uu wah respect to Ll: () we OY/2L = ALE" Q)-AUAL } + Affe) = AICIUAL)E" +] = ALAR) KFC) So we do have w= Aff) = KF") 1) Define de marginal product of capital as = F(KALYK. Ago, wring the production funcion a¢ ALE) = ALAKVAL) and now talng the pial denvatve of ouput wath empoct to K yas ( 12 2YIKK = ALE (LUAL]=£°) Sebsttute equations (1) and (2) ito w+ 1K wht rR AAR) =A] LF GOK = ALM) - FQ KVALTAL + (3K Senplifying gives us @) WL FR ALfll) -#°00K +" GOK = ALA) = ALFIK/AL, 1) Finally, since F is constant reams o scale, equation (3) can be rewrite as: (w+ i= FIALWAL, AL)=F(K, AL) ©) As shown stove, =). Since kis const ona balincd roth pth 0s) and thus In cther words, ons tlanced growth pa, =O. Ti fen of Fars syd acaba powth which athe em to copia i approniatly constant Since epee pais marge rode, he Sore of pi gong to cpl KAY On tlc owt ah (a (ma) “Thus cn a balancd gro path the sare of ouput gogo capa is conta Soe he shares of ut sto capa sd lor smo ts nplis at sar of en gong to lb isl const on tbe alc prow pas $HfesW/K-V/V=0+(0+8)-(a+)=0 fi bSolutions to Chapter 1 4) Wo nod to dataonine wat ic happening tothe grow rate of w 36 kes toward k* As shown above, (f) 111). Taking te ume dervauve of te logo ts expression yee the grow ate ofthe ‘argnal produc of aber: (rook ‘Ts is uve because the denominator i postive since RK) ia concave fiction, wil the numerator s postive because k and k are postive while f* (kis negauve. Thus the marginal produc of Ibori ‘rowing faster than onthe balanced grow path Intl, the marginal product of abor ries bythe Inte of growth of the effectiveness of labor on the balanced growth pth since thats what is mereaing the ‘marginal preductoflaber. As we move fom kok", bowever the amount of capital per une of effective labors also sm which also makes labor more producuve an this iereases the marginal produc of labor even more ‘The growth ate ofthe marginal product of capa, is + [roel _ Po ra) FO, ‘Tis growth aes negative since £"(K)>0,£"(k) Oas kis towards kt Thus asthe conan moves fom k tok, the marginal produc of capa lls That grows at a ate less than on the balanced growth path whereas growth fate iO. Problem 1.8 2) By diana balanced growth pth is when al he vavables ofthe adel ae growing constant ‘aus’ Despite te dierences betwen ths made andthe wal Slow madeline out hat we can agin show tht the eenomy vl converge toa balanced rot path by examining the behavior of k= K/AL “Taking the ine derive of both ses of he defen of = KIAL ie fy bef #) NAD=KILA-AL] KY LavAL] “aan? at acl” at Subst he apa accumultion equation ~ K = F(K,AL/2K]K ~8K andthe constant growth rae ofthe labo ce and tecnology ~ L/L=nand A/A =~ to eqn () yal ay «LF AD eR] aK a Subsining 2FOKALYEK = 10) ito equation 2) ges ws k= PIO -Bk (0 +4) oF simply ©) k=[P0-(ar8+5)k Cai pr unit of effive abor wil be constant when =O, i¢ when f° ()-(a-+¢ + 8)}k=0. This condcon wi old k= (a case we wil gore) or when") => g 8) =0. Thus the balanced soveh th level of be expt sock per uni of efictve abr implcy defied by € Ke) = (ns + 8) Since capital per unit of effective labor, k KUAL, is constant on the balanced growth path, K mist grow aethe same ate as AL, which en +g Since the production function Ras enstan eure fo captal and effecive abr, which bh grow at ate a * gn he laced growth pth, expt mus also grow ate 1+ gon th balanced growth path, Thus we have indeed fund 2 balanced prow path wee al the ‘ables ofthe model grow af conan et, _ IK AL) (a+ pk k-tk-(a+e)k ‘The next stop ie to show that the economy actully converges to thie Blanca grownh path Atk, £°0)=(@ #8) I>, FQ) <(0->g-+ 5) This because we are assuming at F< 0 meaning that” () falls as krtaes Thus > Kt, weave ke Oo hat wl fl toward ts blancs Solstionsto Chapter! 9 grombsgath vale Ifle ht, £°()> (a+ g +8), The because we ae assuming that f° (k) <0 rreanng that f°) ges ask fils. Thus if k Oso thatk wil ise toward ts balanced rowdh-pathvahie Thar regardless ofthe ia vale of (log 35 is et k= 0), the ecenamy el Eesverge to 3 balanced gronth path ak, wheel the vanabes in he model ate growing a a eanstat by The glden-us level of k~ the eel ofthat maize consution pa uit of effective labor — is ‘efacd mpl by ©) = (a +g +8), which canbe interpreted graphically athe slope of the production function being ual tothe slope ofthe break-even investment ne Note that thsi exacly the level of that he economy converges to ere where all eapial nome is saved and all labor income is ensued, In thie mode, we are saving cpt contribution to utp, hich ie the marginal product of capital times ‘he amount of apeal.Ifthatcontnbutonexcode break-even inverment (0+ g + S)k-—K nics. Wis Jes than break-even investment, fall. Thus k sees down toa pomt where saving ~ the marginal product of capital times k-~ equals break-even investment ~ (n+ g+ Sk. That, the economy sees fw toa pout where f'(Qk= (n+ g-+ kor equivalently "(= (n+ +8). Problem 1.2 2) Since te lbor force giows exponentially arate — L(t) = aL(t) —we can write the labor force at @ L@ =e" Lo Using equation (1), the amount of effective abr at imei given by DAP LO =F PLO =a oO) Soe ex K(O) =e, L(0) and thus solving fer 10}: © LO) = fee KO, Substituting equation G3) into equation 2) yi ce Le) ere fo KOE, cox snply © cee LQ) = exe KO) ‘Tras e¢ Kid ep €™ Li) for ali equivalent too Kit © KO=e"" KO) fer alle Enuatcn (5) simply sates Wat the capt ck grows exponentially at ate (a) Thus ‘6 K() =e, LQ) for ati equralet to © Kw/Kay=ntg forallt se e°® Ki) fo alto sply ow, dividing the epital accumulation equation — K(t)=¥(t) = BK(t) = by Kip yeh Key sto @ SOMO, Ka” Ko, Svbstneing the production Function ito eqution (1) gives ws Keo _s-malerkenerst Lo] Ke KO Wi Ke) = ox oF (frat, we can wnt i og Ki), cee” Li) 5 sqution (6) ec KO)™ e &” Lt) for all equivalent to RW) 5 Ka) ® ce Kt), Using this fact as well10 Solutions to Chapter esl (oy at pean “Thus cx Ki) = 61 & Li) forall ifthe parameters are such tht equation (10) olde, Cleaty there is ne paticular reason to believe that equation (10) must hold 1) Teco Lg is groming farterthan ex K(Q), the ameust of labor hat exceeds Kt) wil be tnemployed. Since cy K(O)~ 0, LO), he difference betwaen the quart of effertive labor andthe ‘quantity of capa i sing overtime Thats, the quantity of anployed peopl wil be ising overtime fd the unemployment rate will approach 100% 6) Wo: Kise growing faster han cy Li), te amount of ep hat exceed ye Lt) wil ot be Uilized Since cx K(O) =e. L(O), the difference beeen the quatzy of capa and the quantity of effective lar esi ove tine Thus the ration ofthe capital sock that et utlzed will be nsng a) We already have by assumption that A/A =g, L/L=n and R/R=0. Thus we need to show that seryeriricemmme ag Ut wth eater cae cee Tigao ace D BKK" KKK EEE Tosi sttapuom fem ph tne K a) Rg As long as K/K is constant, then ¥/Y will be constant as well. Thus we need to show that the economy. ‘converges to a situation where the growth rate of capital, gx « K/K,, is constant — that is, a situation where te = {K/h cervtive of (K/K) wih respect ie, 0 ee ay “Taking the derivative of baths of equation (1) with pet oti ik aoe eee), | ate Sle Kt] © tke eK Rearrangingequton 2) tsa forthe change in iptv: 4) Y=Yfogx +Pcn+8)) Sensing sui (at ton) eh Mee VD Fy fe Eleven + Heel erranging equation (I) yields (9 Y/Ke gp +3 Subst equation (6 io equation (9) elds 9) x=] Solutions to Chapter 11 0 x le -3)-[la-n55 + Pla) (0 bated growth path, we ned © [og +8)-[(@-Dsy + pens )]-0 “There arto pores Dex =-8 and 2) eg = Bln 0)/1-e) “The phase diagram implied by equation (7} is spiced at ight Equation (7) yes an ‘nvered parabola wath these wo rots We an see tha gc* = Bn + (0-0) iea sable tance? growth path while gy = 8 snsable “To ottin the growth rate of ouput onthe balanced growth path subttatethe value of gy ska equation a ¥_ odin) Bila + 2) + Blo) aims) ¥" (=a) Ime or sinply Y oF {From guation (9), Y/Y willbe pstive so hr wil be parmana roth in cup. Is lo posible {come up with 2 coin on some ofthe parameter which ensure tnt ouput pr person is aso song a postive rate onthe balanced sews pth, For eat ofan, define y= 1 - Probe che Shoe of ouput wh respect lind Th Bone) Ire" Bey here thet sep earanging a +B+9= 1 oreplace 1 =. Fue singh (Vit) _ pia 2-10 wa Bry Bry Sfx patie oh in pet pope et seve 20 or -m>0 or poten ree Pe-rn>d eF ‘Thus the bigger is g (the higher the grown rate of technology), the bigger is (the more important effective inbor is in production), the smaller i (he less porte aad st the production process) and ‘he smaller is a (the smaller the population growth rate), he more ky for here to be permanene ‘rowth in curs per person. Basically, lhouph the sock of land i fed at long 2s technology Improving fast enough, a5 leg a land i nt oo mportnt n the prodction proces and 3 long a6 he umber of people in the economy snot sing too quickly, the sim amour of land canbe used ina more 7 Productive way an the economy can experience long-run growth fom De ere, Problem 111 ‘The production function wat captal-augmenting technological protess is given by12 ‘Satons to Chapter 1 @) Yee =[Acn Ken] Ley Diving ba sides of piston (1) by AL) vil vo {awk FT te OF Lawn! [ROMO] and spi vith Fa OK orp uo dhs fey xe _xo AO" H0 LAF | Now, defining $ = o/(1 ~ a), k(t) = K(tWACt)*L(t) and y(t) « Y(QWvA()*L(Q) yields: @ wo-Ko aoa}: to Ain) ATED F In order o analyze the dynamics of K(), take thet derivative ofboth sides of Ki) = KIQ/AG LA) eg HOLA? Le =Keolen [aot Lol? Kok fA, to] AmtLa am La LAG "Le, and then using kit) « K(Q/AQ)*L(), A(O)/A(t) = w and L(t)/L(t) = yields: ©) ke =K0/AOFLED=GutKO The oli ft tla ok by thus @ koe 3K Subang qn (to) ges ie Kee = <7(0/Ae*L(Q) -8KE/ ACO LD — (hu + mIRC = sy) — GH D+ THC) Faly, ug uation 2) ~ 0) = Kt)" ~ we have () KQD=ski0)* ~ Gun FHKE Equation (5) is very sma tothe basic equation g2vering the dynamics ofthe Solow med wah Tabor augmenting ecological prepress. Here, however, everything im ants of AOL) rather than units of efetve labo, ALA, Using the re praphial technique a wih the basic Solow mes, we can graph bo components of k(t), See he diagram at nek When actual nvesement por unit of ACL) ~ sk)" ~ excad breakeven investment er unt OF AWLE)= (hu tn + IK) — wl vse towards "When actual investment pe unt of -M()L(D fas shor of break-even investment urn okey ky = KOA Solutions to Chapter | per wit of A()*L), k il fall towards k*. The econcny wil converge to a suation where kis constant cK* ignore the possibly that thesia lvl iki er). Since y=, y wil also be constant when the economy converges tok ‘The teal capital tock, K, can be writen 35 A'LK. Thus when ki constant, K wl be growing a he consane rat of bu +. Silly, teal oupu,Y, can bewnttn as AML. Thus when ys constant, loupetsrws a the constant ate of hu +n aswel, Since Land A grow a constant ates by aeSumpric, wre have found a balanced growh path where allthevarables ofthe movel grow at constant ates, ) The production action snow gen by (6) Y= HQ? Lee) Define J(t) = J4t)/A(t). ‘The production function can then be written as: core |*uo"* Proceed as in part (a). Divide both sides of equation (7) by A(t)” L(t) and simplify to obtain: vo fio 2) Lae 9 J Now ening = a(t a), (0 = Te)/ACOL) and yo) = YOVACOMLAD yes: & x0=50% ‘In order to analyze the dynamics of j(t), take the time derivative of both sides of j(t) = T(t) /AW)*L(0: Fi9{a00* Lay] -Teo[paco* ACU) + LAC] [acoPue Sot fa to} Aore@ ae@tu@ Paw” Le) and then using J(t) = TONAL, ACO/AC 00) jo=feo/ae* Le Gu mKo and Ley/Lee) viel: The ner spi opt an expen for Fit, Tak the tine devative of bat sides of T= J/AC) io JOAO=IOAD HO AL JO. Ca CORT) Now sie) # HO/A(), ACD/AG) = ad it sAOYO BND 10° x a NO «snp An 10 =110-G 90 Sabu eqation (1) negation (10) Ho =sVin/ACor Le) 4+ dT0/ A LO) =n “OH Feslhasag oman ©) ~ 0 = (0 —we have 12) jt) = 51) =[n+ 8 + Cl + O9)7000 singe same graphical etmque a with he base Slow motel we can graph bath component of it) LA()Y() 8108) to obtain 0 =[a45 ena reo1“ 0 Chapter | Sethe ingram at sight, Ts eomomy © vel ecovegetoa sation were | it estan a" Grog te possibly tha the nti eve j= 0). Since y= 5° yw ao be cnsane when he ‘conaiy converesto 3" for8oet e950 sto" The level of oa output, Y, can be writen as AtLy. Thu whan y is ensant, ope grows atthe constant ate | oon By definition, T= AL}. Once the ronomy converges tothe situation where 3 ss constant, J grows a the constant rate of fp-ta, Since J= J+A, the effective capital tock, }, grows at rate gun jor simply n+ HCl + 4) Th the economy does converge toa balanced growth path wire al the variables of the mode are ‘rowing at constant rates and dus fom equation (12): ©) On the balanced growth path, j¢t) FP eslnss-rn01+0)) HFaforseeo =F and us 3) jr [yas no) Subttate eatin (1) sequin (9) ean expression for ott per i of NL) ote balned gre pa [sfln+5+ wave) “abe he derivative of)" wi espero ae feif is peers 1 _} @ Lica! lavseuneo] [averwaal In order totum this toa slaty, kip bt se by owing he exes for fm gute G5 on the nga side re oe fells PHT 1 ow @ yr linal |e | irererier i esrerice i} singin ye att {a Vnsdeniea ls] ay lines Slaveratioa) and thus finaly. Solutions to Chapter! 15 6) A fiscorder Tair approxination of § around te bled romps value of y=" wl bof te feo 09) 50/5 Taking these deave ob eof eqn) le a 5-355 Saute eto (12) sain 17) [58 —(a+8+ nds Oi) 8) y=s0}*" =o) foods 14] . . Euston (18) expresses j inte of} We can expat J a termeafy sce y= 3°, we en te Jay Ths dy ey eal 9 spre by ei A i SB TL fata nj8D a2 Hasse nae] fz a [alow | Le | U Mle J som, 99s simply j!"since y= J and thas: Baap REP gia css ycle gi eae 0} fm + H+] hae Finally, substi out fers by rearanging equation (13) 0 oben #= [a +5-+ ll +4) and tus x Ia454 ule gyi2e—DiT ola +d-+ +4) ox sing a9 a -c1-aifard+nc +o) Please Substituting equation (19) ino equation (16) ives the fender Taylor expansion (20) y2-t1-aylnrd+ uCi+d)}-fy-¥"] Solving this lft equation ae nthe ext) yes Qd yi yee eH 0-9] “This means that the economy moves fasion (1 -a) (a+ 8 wl 6)] ofthe remaining distance towards yy each ye. The eaten of pat wt respect tos th same inthis vel inthe asc Solow model The Saad of comernoce i fae’ nemo, ln te basic Solow model e eof cavern Ben bY Gayla 5 whereas ths motel ais (1 -ab{n 8H» 6) wich is rene sine @ wai) Yeablem 112 2 The rom acouning techniques of Seton .7 yield he allowing epesion forthe ro te oF pat pr pose: obey Yo" te [ko Leo] Lk@ Leo! x +R)16 Solutions to Chater 1 hore a () i the elasticity ofcurpetwih espe to copa a timet and RG) isthe Solow resid [Now image appying this growdh-acounting equation t 3 Solow economy that in ke Slane growth path, On the Balanced growth path, he prow rates of aurput per worker an capa per worker ate beh ‘sual othe growth rte of A” Thus equation (1) ample at growth accounting would arbte fraction ck of growth in ouput per worker growth i eaptal per worker, It would abut the ert fraction 1 ~ax ~to technological popes, 2 this s what would be eR i the Solow vesidal. So with our sual estimate of ax = 13, growth accounting would siibute about 67% ofthe growth in ue pot ‘worker to tchaolgtal progres and abut 33% ofthe growth in ouput per worker to groweh a capital per worker: ') Inan accounting sess, the resuk in par (a) would be tus, btn dope sense it would not the ‘eason thatthe captal-lbor rato grows stat othe balanced greweh path is because the efecveness of labors growing at rae g. That i the growth in he effectiveness of labor ~ the growth in A~ rates cuput per worker trough two chanel Fis, by directly raising output but als by (fra given saving rat) increasing the resources devoted to capal accumulation and thereby rising the eaptal labor rao Grow accounting atributes the rien output per worke through the second channel to growth i the ‘xprallbor rato, and no to ts undeiyng source. Thu, athough growth aceousting i of isu ‘1s not appropriate to wterpret it ae Shon igh on he underiying determinants of proveh eoblem 113 8) OLS wil yc a bins etimate of the slope coeficent ofa regsesson if the explanatory variable i ‘omlated withthe ror term, Weare given at © Hf gH gl 24 ef 8 E 2) lg) =2[(¥) 59) hore aid are assumed tobe uncorelated wih each ther and withthe tre unobservable 1870 income er person vanabl, [CN el Subsitng equation (2) ot (1) ad eran yells ©) tl (7), yp9] iV") go] 2 +b- tl), ex) le Ruin a 15 reo ms ©) wi ye ised onto b(n corte wh Seerertem f-'+bu pu) one dw conser’ te ene er Shans ocacmie be ec (UADin a we gate tse Howes meses wee vabecth=-h dential @hisspiye Th OLS ee soe ane Senta ei wig bcd i ete om b) Measuresien error in the depend variable willatcauze a problem for OLS estimation and is, in fac, one ofthe ustiiations for the dturbance term 8 regression mode! nutively, f the measorement ‘orn 1870 income ge capita), the exlanatery variable, here wil bea bias towards fodng onvergence. 1F1870 income is overstated, growth is understated. Tis looks like convergence 2 “high" intial ncome country growing slowly. Sirulty, f 1870 income is understate, growth is overatd, “Ths also locks lke convergence ~2 "Tow" ital income country growing aul. Solutions to Chapter | 17 rote insta tis ony 1979 income ger cpt) bjt to rnd, mea ro measurement rer, Wien 197 acon overated sis goth fora piven evel of 1870 came, When 1979 cane SSundested, so growth fra given 1670 meome. ser ase equally ely = overstng 1979 tex fo any gue 187 inn uly wdesing (rere rely, eae Tor San sverge seal os), Tir the roo eto roel cee Wo se moro se enrages the realy ih iSOLUTIONS TO CHAPTER? Problem 24 Dy the fs problem isto choose the quantities of apa, K, and effective labor, AL order f0 Psomze coms WAL 41K ~ subj tobe poducen funcion, Y= ALA), Se up te Lagrangian WwAL + [¥~ ALFR/AL)] “he fsx conics ae pve by er -afAL-OK/AL) VAL] =0 raw @ ee Som lrasnvenerovat caer] =o = wealtan-1-F00} 2) Ding eatin 1 by ion o tf =" Wk FO) Equation (3) implicitly defines the cost minimising choice of k_ Cle this choice does net depend pen. tbe level of utp, ¥_ Note that equatioe (3) is the standard cor-mnimizing concition whichis that the ‘ato of the marginal cost ofthe two inputs, captal and elective labor, must eqal the ato of the argue product ofthe two put 1) Since shown in part () each firm chooses the same value af kad since we are tld that each firme ‘hs the same value of A, we can wie the total amount produced by the N cor minimizing firms as By, Eaneay=aray $1, « abr “where Tis the total amount of labor employed. “The single firm also asthe same valve of A and woud chose the sme value of ~ the choice of k dos te dopenl on Y-Thus if osed all ofthe labor employed bythe N eas-rniizing ims, the ingle fe would produce ¥ = AL{(}). This s exacythe same amount of curt produce i tal bythe N coxemunmizing fms. rablem 22 5) The nda’ problem eto maximize Limo uly given by cet Get Typ 1-8 subject tothe lifetime budget constraint given by @) PC. + PGW ‘re W repress lifetime income. Rearrange the budget conti 0 8 Cs ©) Gy=WiPs Cy Pi Ps Stlstute equation (3) toga (1: chy fw, cy-F/Py]* ale isp 0 ‘ow we an Sle te unconstrained problem of maxing ily ~ as given by equation 4) ~ with reopen tort prod consumption, The fstordr conten 69 by Soluionsto Chapter? 19 20 fey =r lung) co? (-%)=0 > CF=lytse (Ra) ce cx snot 65) Cy ={1+ (Py /P))"" Cy Inder t solve for Cube eatin (i equation). Co= W/Ps (146) -( 2/01)! Co-[P/Pa) => Calte(t+o}¥® (Pa/m)” awry oe spl wiry (ram) el Fall to get theeptinal coe of Cy, subset oust (6) no equation (3) (i+ of" (Pa m)"* (wir) 2) From equstion (the optinal ati offi pid to second peri consumption i (8) C,/Cy =(1+9)"* (2 /R1)* alin th og of both ies of equation (8 yl (9) tel Cy /Cp} {1/8} tal + pl +18) ol /2,) “Te lsc of eubttvtin betwen Cr C,~ defined in such way tat ti pave ~ ven by Aci /C2) (P2/P) altn(CriCa)] _ a AP, /%1) (Cy/Ca) ” afta(/e;)] © where the last tep ses uation (9) find the sive. Thus higher values of 8 ply that the Indivdsal ste willing to ebute consump brween pend Problem 2.3 ‘We need o solve the houshokts problem keeping everthing in pr cap tem rather than ia units of effcive labor and assuming log wily The housdol's problem isto maximize Lfeuneublay subjecto ‘he budget constraint. Thats, problem st maumize Ten uo a us Teminc®, oy us Temncentt subject 2) Te Bg Mg KO. F ARQ meg t® oe eure ue ‘AWOwOE KO) ni Le Now in Wa BO, F eRe at ews Pat ‘We can use the formal metho, presented ete text, for sling this type of problem Set up the Lagrangian uw 4] Fe Rica OH Fence Maer) 4 ue mews ae af “The frs-order condition enbySolutions to Chapter 2 rey LO, 1" he 1 ° ect) coy conseye yt GB) eC) ne RO nn meee en Sc ung nmi ene o Temofenct a0] WO gy sect -e U0, asp -1 HO) 7, (9) LO Fook wy ort os Aslngas 22> 0 (sich mt bo hte gto Ip -8) and th given by: raggenn Submsing eqn (ot eqn 0 ys (8) Cc =e | _W p~n} co lear (e-*)| tna cosa there ‘Nate that C(0) is ensumyion pe person, W i wealth per housdold and LOVE isthe numberof people er household, Thus W/{L(O)/E] i wea per person. This equation say that mal consumption pet evs is constastfactioo of intial wealth per person, and(p-a) canbe interpreted a the marginal ropensty to consume ot of wealth. With lgartunc tly, his prepeasity to consume is independent of the path of the real iter ate Also ate that the bigger i the houses dscoant rate p —the more the housthld discounts the frre ~ the bigger isthe fraction of wen that intlly consumes Problem 24 ‘The housaboli's problem sto maximize lft wiley subject tothe budget constrain. That is problem sto maximize Fa cot? Ley ue Tee Oe LoD Ot eH subjects 0 Tee new 2 ue corre we W detest ln wth pl te ps al fine ana th Tetons ep 3) tc mtr nl et ed co ‘tesanetenStmal cho pnd ite igs pean See Domne Fn Moa, 7 Solutions to Chapter? 21 1x-orecondion te by Oe ote yn HO ecw Oe caning he LO is 6) eC P= he Ditto ses of ut (wth eet ie: © [-0c1y Eee] - pe MCU? + rhe =0 ‘This an be erranged to cbr me ee ee ee 9 aE ‘Thus with a constant eal erst te, th growth te of consumption sa censtant. Ur > p ~ thats if the ae atthe marke pays to defer consumption exceds the houshol's discount rate ~ eousurgtion| val tenisng overtime. ‘The vale of dermines how fst consumption will grow ifs exceeds p. Lover Value of @ ~ and thus higher valuse of the laity of substation, 1/8 — mans that consumption growth nl be higher for any given difference between nd, ‘We now need to solve forthe pth of C0, Fist, ace that equation (5) ean be rewriten as Be, a) Imogateequstion (6) forward mine «= Oto ne tax =inceoy «fle ee} ih spies to © w{cv0/c10} =[(r- le Taking te exponential fncin of bah sides of eqn (7) yi cence =ell 9 sedis © C4 =Cioy-e14I Wear now sive fornia consrtion, 1), by wingthe it atk must be chown to say he howsaoids budge consvant, Subainde ein (8 a equation) Femexoellaltl Ly aye Tete “ Using theft Lt (ye yields: (0) LDLOD Fort a y w22 Solutions Chapter 2 As log as [9-1 + 6(¢-))0> 0, we ean solve the negra on) ycellsale, [lon 2) coy ropailses Problem 25 2) The equation describing the dynamics ofthe capital stock pe nit of fete labor i A) et) = ACO} - (8) = C+ BKC For s given k, the level ofthat ini k= Oe given by €= Rk) => gk Thus fling makes the level of eeosisent with k= 0 hiher fora given k. That, the f= 0 cuve sits yp. Inukively a lover fakes break~evn investment lower at any given kand thus allows fr mare esouoes to be devetad to onsumjtion and sill maintain a given k- Sine (2+ ek fll propersonstaly more a higher levels of, the k=O curve sit up more at higher levels Fk. Sethe diagram. 2) Toe ition dri th amis of stunt er of ese teri by econ “8 “Thr cnc required for ¢=0 gem by £€)=p +85 Arse in gf) muse wea cite 20" Soce "(9s aeave lc eae he nec hr ses Ths 20 cove sits toe ©) Atthe time ofthe change i the Value of k= the tock ofeapial per unit of effective labor =i given by history ofthe eesnomy, and eannct change ‘Escontinuusly. romans equal tte eon the old balanced growth pth In contrat, ©~ the rate a which household ae consuming in nts of ‘ffetve labor ~ can jump at he tine of the shock. In order ford economy 19 ach the new balanced growth path, ¢ st jump athe stant ofthe change 50 thatthe economy onthe now sade ah However, we cant tll wheter he new sad path pases above or below the xginal pot E, Thus we Cannot tll whether cmp up oF down ad s ae ~Fthe new sade path passes nght hough pow E~ Sotaions to Chapter 2 ‘might even msi he same athe stan that g fills Theres er, cand ke gradually to their new balaicedroush-path values; thee ae higher an ther values n he orgs balanced growth path 4) On balanced growth pth the fraction of utp that enved nd invested given by Uf") ~e*) AK), Since is canta, or k=O on a balanced growth path hen ~ from equation (1) ~ we can wate ft) -cF = (a gh. Us this, we can rewnte te fracicn of eutput that is saved ona balaiced growth pat a: @) s=[e=sryM) Differenuating bot sds of equation (3) wath espact tog ss Gea + eX Ck * og) +k) (at ge PTA OW ee which simplifies to (oy 28 OBES) FOCI) ee ray? Since ks defined by £4") =p + Og, differeniaing bth sides ofthis expression gives us "XE 8. Solving for ery gives ue (©) Beleq= OG) <0 ‘Subsututing equatin (6) nt equation (5) ves oy oe a BME) ke P= REDE AY es TROP Fe) “The fis term in the numerator ie postive, while the soond i negative ands he sgn of is ambiguoor ‘Thur we canner tll whether the fll m grat or lowers the saving rte onthe ne blanca srowth pth 2) When the production function it Cobb-Douglas, £8) =k, () = ak and £08) = ala - 1% Substinting these facts into equation (1) yields Be (ne gike® -ktake™ Ne rk ke ala oy Ha BABIis’ “heehee aK usta oe Fala Dk which simplifies to (25 _(org)k** (1 a)8- (= aye ak 28 (-0-ak which implies: (i 2 ng 28 =o) es (mre) ‘Thos, rally, we have pee? ° Problem 2.6 Theres eatin of maton: ¢) 2. fA Fs a S sed) L(= FAO) - e+ KIO)24 Solutions o Chapter 2 3) Ansein 8, Thisisa fallin the elastiny of substrution - 1 ~which means that people became less nilingo substnneconsugtion bere pesods. Iso meaas thatthe maepizal wily of consumption falls off more apy ae consumgtion izes fhe economy i rowing, ths tends to make howsehoas ‘ale present consumption more tan fire consump ‘The copa accumulation equation i unafeted, ‘The concn requted for =O ie gen by £0 9+ 0g. Sine F"(k) <0, the Fh) dat makes €1 0 iow higher Thus he value of that satis =O ie loner, The &= 0 locus SiR tothe le Th exmomy moves upto point A nthe new sade path — people cosume more now. Movement itm down slong the new saddle pai utile economy reaches poi E At that point, c* and kare lowe thn their original values 1) A downward sit ofthe production inti. ‘Wecan assume tat this means for any given k, Bath) and "(are lower than before, ‘The condition requir fork 0s given by € Fk) (a+ g)k. We can see fom the right diagram tht te ‘older-ek willbe over than before Thus the k= 0 lacus hie ae depicted ithe diagram ‘The contion roqied for €= Os given by Pk) = +O. Fora gren kf") isnow lower Thus we needa ewer kt kop the same ad satsy the ¢= 0 equation Thus the €= 0 locus ahi let, The ‘sconce wll eventually ach pont E" with lower ead lower kt Whater cially jumps up o down ‘rpm won whether te new Sade pth pastes above of Below pint E locus wil shift down mote at higher levels of Alto, since fora given k, f° (is lower now, the Solutonsto Chapter? 28 ) Apostive rate of depreciation. “Tae new eapitl-accumultion equation (0) Hee) = URC) ~e€)-o+ B+ RC) “Te eve of saving and investrneraquired just to keep any given k constant it now higher ~ and thus the mount of consumption posible nvr lower = than i the case with no depreciation, The evel of exra invement required i also hiherahgherevls oF k. Thus the k= O locus shifts dowm more a higher levels of nado, the real reun on capitals now Fk) = 8 and so the household's maximization wil yield 0 POR) 8-9-0 08 = ‘Tee condton required for €=0 is F(K) =5+ p88. Compared tothe case wth no deprecation, () sear be hiher and K lower i order for ¢= 0, Thus the €=0 locus shits tothe lf. The economy will retualy windup at pot "wth lower lavels of cand. Agaia, whether c jumps up or down iially ‘pends upon whether the new sale pth pastes above ot below the engaal equlibrum pot of . lem 2. i ‘Wiha portve depreciation rate ~8 > 0 ~ the Euler equation andthe apt accumulation equation are som by a) _ FRO) -8-p-85 ay £0 eo) Spr a ee os ; ad @) Ki We egin by taking frstoder Taylor approximations to (1) and 2) around k= KY and e=e*. Thats, we (ko) =) (a8 +8)Kt0 & & a &, © es S pepe Bene bz % fends He-e4} ) Seer Si ad) ke fk SE he 88 0k, 2 Oe, Dk/Sk and Ok /de areal evaluated at k= and e= e+ Sincectand kt are constants, © and ate equvalant 9 ¢ =e and k=* respectively. We can Uerfrerewrte (3) and (2) 3826 Soins to Chapes 2 Fiennes Stee & ze Using equations (1) an (2) to compas tese den oe Tee ee Fk) ~bp=be “eo © lege ® a al @ 8 =r0)-o+8+9 a Se loop Blea Sbstiting equations (7) and (8) int (5) and equations () and (10) ico (6) yes Parje" OE cs 8 irr) —(ore-+6)} kk ee) toate seo secre =plk-Ke)=le~e4] “The second ine of equation (12) uss the fact at (2) implies hat f° ‘the definition of Bas p-n~ (1-8. ane (02) kk p0g The third line uses Dividing equation (11) by (€~<%) and dividing equation (12) by Ok") iets: Coen Pt er hake tke ee Cale=e sage ilen(enes recent eve eee rca ga dcaenetntesahe tn sco mer 09 bee and Now consider the Cobb-Dowga production fin — A) 4. Ths (16) £(k*) mak Ort and (a7) F(kt) =a(a~ Dk From equation (16) sang es (8) (445)? ak also equa (7)can be sevens) wre 1 qa? ok O and U"(e)<0, In adition, since the expected value of Yi qual toe, wecanwnte ¥;= Ys t € wa E10) =0 Solwtions to Chapter? 35 2 The india pb io choose Cy and Cy oder to maximise UIC) ~ UC) sb to: OG 0- 0G 0-0) We ean soba for Cyan save he unconstrained problem of choosing Cy ‘rax UCC))+ E[UlO= 4p) -C, +0 4% #0 ‘he irs-ode condone by: Vic + EU, x-D] =0 x snaly @ UC)=EUCs)] {Fie inavidual optimisng, th marginal tity of coneuretion in pend | must ois te expected arpa wy of consump pried 2. by IFYs nt rnd, the fet order condsin redvessta U(C\) = (Ca). Wah UE) <0 evenrbere, ts imelns ht C= Ce. iy i guna then U" (Cerin C. Using te hint ~ [U'%C)}= U{E(C)] ~ te fester condn given by equation (2) canbe revriten at V(C)= ULECCs)). Since U°()<0 everywhere, this implies that Cy = E(C)) Now, U"()>0, (0) <0 and U" (9 >0. Marga wily istow a ces acon of ansumpion 2 so by Jenene EUCCa)]> UfECC:)] Combing this with frsvorer canon ~ U(Cy)=E[U%Ca)] ~ yes LIC) VIE]. See U()> 04nd U") 0, he india! undertakes £2) The goverment ic curing ft peiod axes (2) and raising scond-peiod taxes (im Each a way that, eect ax revenue remains unchanged. Expected tax revenue, R, canbe expressed Vit t2 EY) ee)= R. Using the fat that Ee) = 0, wo ean solve fort avenyek = Ryn In order to keep F constant, the change in taxes mst sais ) ea /éy=-1 ‘The questions whether or at ths change nthe ing of taes ars the aus consumption beaver Susie equate (I) eto the rcordr conden ~ ego (2) to obtain @ VE ELU[A=4)¥, -C, «0-H, <0] Ditters beth sides of equation wrth spect ol: UHC) eC, fee, = ELUUCI-Vs 204/201 OH, +02 and now wens equstion @) ~ 2 1 awoke VC) -2C, fe, = FLUTE IY = eC4/20, +¥5 re] UC) 2 ee, = E[UUCa)-[-€C fem} + FLUC). [Ue + efu-eCay]} ec, jer, = ELUC.)-«]Solutions to Chapter 2 Now as the fa: tht fr any two random variables X and Y, ECKY) = EQOECY) + cow(X.¥) vc) +H UC2)]}-2€; jee) =F[UUC.)] Ele sco UrtCare) Finally (6) = 0 and ths th change in fist-penodconsuprion ds to this change ia the ining of tones ig sive by __ corfu} wep-eUren) ©) FY: se random then «= 0 always and thus the covananc inthe numerator of equation (5) i 0. ta addon if walt qusdratc, then "(a eaasart and again the covariance sO In both ofthese ‘ies 2C; /ory =O and thus firs period consumption does nochange in response othe tan exe 8) Inthe case of U"(0)> Owe needto show that 2 /ér) <0. That is, we need to show that Cy nse in tpnse tothe rection in, Inuively the ihe se the bigher wil be Cy The individ spy ‘onsurncy any ext random income nthe second pn If U" («) > then ap Cartes so mill (en), and ths & willbe the case that covfU" (Co}> 0, The denominator of equate (3) wl be negative ssce "(<0 and hus 06/2 <0 as required. The enution is thatthe change in Ue timing of tes leaves {he individual wih the same expected after ax fete ince, but more oft comes with certany inthe Sis period tbe incivavals doing precationary saving ~ fU"(e)>O she the amount of uch saving will be reduced and she will eonsume more inthe ts period 1) The CRRA uty fincon ad its fist two derivatives ae given by wo=c*/a-3 = VIQ=C% = UC~-3e™ and di: UIO=-0-8-C7P* = 74/020 fero>0 Thus the CRRA unity Function does imply the preauionary saving behavior desrbed above Problem 213 Equation (2.61) inthe text describes the rlatonship between kes and ki the special case of logarithmic vali and Cobb-Douglas predation Ta naky* «Dk Grease Tap OWE" = Phe 26) kes Solutions to Chapter? 37 than t woul have been in che absence ofthe increas in population growth andthue capital per ait of {flee labor in period +1 is Lower fora giver 'b) With the parameter B added to te Cobb-Dousas production funtion ~ Rk) = Bk" —eqution (2.61) 0 kit *Gpmdaw Tap Co eB ee (0 koa = Tanta) Zee This fallin B causes the ky faction to shift down, See the diagram from pata. A lower B means tht 2 ‘ven amount of cpital per unto effective labor in period now produces less carpet pr uit of eect Inborm period, Since the fraction ofthc abo income thatthe young save doesnot depend on Bhs leads to less ttl saving and 2 lower capital stock per unt of effective labor in period +! for 3 given ©) Wenoud to determine the efit on kn fora given ofa change in a. From equation (2.61): ky 1 ui ax] 4h =, | 4 (1a: oft carl oe | Seon du Bey oa @) Aaftay/éa nk, Now note that we can write io) 2), fla) dia 2a Bink) oa and thus finaly () aac» fain, Therefore, we have "ba Fey __ insta) [emnayiara] ee lnk. Subst his ft into equation (2) yields: 2)? ky 2a” Grayiee) tee cor simply fee [a-epink, — Tramp To fee took, Thus, fo (I~ a)lnk-1>0, oF nk, > VC ~a), an ncaa in mane higher lo for 3 given ky and thas the ks fimction shits up over hi range of y's. However, for lnk = Ii(I~a), an increase no means 3 lower a fora given k Thus th key function shits down over ths range of k's. Fall ght st 'ak,= 11-2), the od ad new ha Functions intersect. Problem 2.14 2) We ned to find an expression forks 26 function of, Nox period's capital stock is eu to this Penods capital tock pus any investment doe this period las any depreciation that occurs, Thut ) Kae Kyee¥,-3K, To conver this into units of efeive labor, divide bth sides of equation (1) by Ais Keg Kell8)48Y) Ky) Ky(-8) + fky) Arabia Avalis (eas gyAib +ayl +e) tie gest ants _j, fs Omarp | lasmare38 Solutions to Chaps 2 1b) We na to sketch he a. function of ky sk.) “Gemare ky) 20 and ‘Trodsp ‘Lomita ) and using he ats cones a, a, tim 2a jim R18 sb “ay wu ak, Geen) “Thus the fnction eventually has a slope of less than 1 and wil therefore rose 45 degree line a some pout Also, the fancon swell iehaved and wil crssthe 4S degre line oly coc, ‘As jong ask starts outa sane valve ther han 0, he ‘conomy wil eomvergeto i". For example, ik stated ‘ut teow et, we se tht wl be greater than I nd the cconcmy wil move worardsk*. Sully. if ‘Sars out above *, we ace that fs wl be bol land again the econamy will move towards K™ At, "= Akt) iv also constant and we have a balanced ‘row path ©) Ona ularcod prow path has =e ndshas rom egution ice : < feed Irae lacmacel Vaswae ee Fienegeng—148) f 5 1 otha basa near Bee in ron etal pont ree tae Sei Saab poet ty cee) Oo am eon acgsarOh he pe een Pe amis crmnyia pent fee td Tegan 0 pr pe eee ene wy ng+8)] need) | Solutions to Cupter2 39 43) Subsite» Cobb-Dovelasprodvtion function ~ fk) wel fs Grease larmare = into equation) sel oka 4) Ona balanced growth path, 1 Thas from equation (8) vie el lasaate! “larmaa! Sinplifjn yes : - fasmi-p-0-9}, [shoe azmise |" lavexire sd dus ally (0) r= [olla gong +5)" i) Using equation ( Sal, 18 ~ ak Inge OF AMIFD Gem re Suttuing the blaned-rowt path ale of kt ~ equation (9) ~ nto eatin (10) ik Sal Tore+ne+8)] ay hae Gomde) Oemtow willbe wel towne (a+ ng +6) 56 (1 0K +6) -(1-3) 00) 18 a aka] _ (-8)+af(lemtieg) 0-8) ah Neate CesT) Sinpliing forber yields as 0-0-0 aw OO Bela Or® Replacing eqition (8) by fst Taylor approniticn around k= (2) yg BR slastt-aja-ayfemer~a [ee] See we can wet thie smply as: += 891/01 9)0+ 9) fg] qui (12) pls. (8) k= uk 3M ay/c1+ y+ gi ko] ‘Tos the economy moves fraction I= [a+ (1 8){1=a)/(V+n)(+g)] ofthe way tote balanced gromth ‘ah ech paiog. Some sample algebra simplifies the expression for is rae of convergence to (mayinsgeng=d)/Urn+ 8 With a = 3,1 = 1%, = 2% and 8= 3%, this ved arate ofconvermence of= 3.9%. This is simlar but slower than the ate of onvergence found nthe conumuoue tine Solow mods.40 Soltions to Chapter 2 Problem 215 2) The individ opamization problem not affcted by the depreciation which mean hat ‘= £0) =5. Tae hoveholds problem ssl to manne ty ie subject the budget canara . © Ce Ca = Avy Asin th text — with a depreciation —the faction of income saved, ses) = (U-Cy, DAM gan by i 8) s3)®——gt— eee ede a+ Tha te nay in ch he actn fica saved deeds nthe ear fs, ican “hw oly tec ta helmet slic Os) rae an st Os) Thera gach apnedtI eu Se aout yoy aivauts mpenot ar @keosts sere th moat of eig de bya yun esi pil, Nath sw the Shoat saving coe welt te faci fone sve ns he meu toscana eatin (Gea te ewrin ©) Rese tosten ‘geist ftet + thane be eb fern) les i Arstbest Arabia Esea-ma] Soce Ul epi wehae Ahn =U) Silty fle = #9), Inada, Rovian eh a 0) hig = sad © bea aaa ew Fly, baie fr sf Q)- Bad m= A) bef) er 6) bya 8}. (ea =r t40] hoa etre Latha [= yF) “This scl be cpa wth equicn 260 he ten ~ the nla exresicn with no depreciation eros 1 , aay Mr fy ero} “Thus adding deprecation des alter the relationship between kn and. Whster ks wil be higher or lower fora given ke depends on how saving ares with ov kia © angi ye ae i po bem i a Beit haere 00) bea em ook} eaten mn tant pin de ST ey Solutions to Chapter? 41 “qe saving tte inthis esonomy is txal saving divided by total carp, Note that hii nt the are at TT) hich s simply the fraction of tha aboriacome tat the young save. Denote the economy's ttl HegkiNeas § Then # wal equal he soving ofthe young pls the desovng of theo all dvded by fel ouput and we can do hiss n unt of eecuve labor ‘re sving ofthe young i [/(2+p]-(1~a)-k,2, Sine teres 100% depreciation, theo do nt get to rave by the amount ofthe capita stock ~ thee two dsavng by he old Thus Has) O-e)-k* 1 ay Ke “Tee “Thus equation (10) can be writen a8. 1 2 0) es bn >| ley 0) ke Tha “laeware Note hat this is exactly the same asthe expresion for ka a incon of, inthe dere Solow redel wih 8 =|. That, is equivalent o equation (2) n Problem 214 with et to 1. Thus that ‘ernon ofthe Solow model does have some microeconomic foundations, aldhough te assumption of 100% recite ie gute unrealistic. eblem 26 2) PayrkeVeu-Go Social Scary 3 Th ety ncn sie by 0) tay, +L pl] tn Ca0t ‘Wate oil ear tx of T pr pein, niviua fcshe lowing cons (wh the pow ate of ecology ~oqalt00, A's Sng) contat houphow) Burs =Am-T © Cais C4 aS +0407 hee §, orcs the india saving he pod. Asi 25th indivi is concerned, he rate feu on soil secre (+8), wich genera i et be equal he eam on priate saving ichigo) Brom aquton G), + a)St=Cayss (Lm), Seving for Sys: oy 5, = S21 tb) OS Tia Otte Now subst ution (0) quate 2): cig Bh aw, Te Fer OU OF ty Rearanging, we gr the intertemporal budget constr: (eu =9) Medes) ehnow ta mh oer ily, the indivi wl ensue acon (t+ p+ poe ie ‘wea inte fe ped. Ths, Seale (reels Tote fran per perien subst equaton (ino eaaton 2)Solutions Chapter 2 free) (tu =2'h Gasp) tizah fe =Li2- law + 0 S1=[Ml2 eld | aoe) Nowe that if or =n, saving ruc one-frone bythe rota eeurty tx, Hy > 0, sing flee than oe fore. Feallyy ify, saving fall ore ta ene rn Denate 2, = [2+ pt +r) (1+ PNG ~0]/2+ pL) and hs equation 7) Becomes 5, =| allaw, 2.7 Ie il tue thatthe capa tock period wl be gual tthe tal saving ofthe young in eid hence O) Key" Site Ceavertog this nto units of efctve labor by dividing bat sides of) by ALer and wing eatin 8) yrds 29) Kear =[YC0-+ al] [(YO+ ed) - 27/4] Wiha Cobb-Douglas production fiction the el wage i ve by- a wade Subsiing (1) so (10) gives te new relaiship between cepa prod + 1 and captain eri, Ail ius of effective aber (12) Keg =[1/(1+a)] (yop) aye ~2, T/A] 3) Tos what effete inaction of th sc sey syste has nh alae growth vee fe we mas dtrmie he of I poste te ntoducen of he nT, Su dome Pe en une and edees Oe talancat grove pu orf So nehaad =e PNtar a) ele pX1+1))~ (pts “md Gs exis) @rpMena singling fete allowe aston Z ener s(rpfds a) Cas-al] Wane 0-20 G+ Kirn) Grp na “Tht, the as care sis Gown = bie othe cse wot he socal scr = and i duce 20 i) the economy is intially dynamically efcet marginal increas in T resuks in 2 gain othe old generation who receive the extra benefits. However, reves k further below koe and th leaves Eure ‘snerations worse of, eth lower conzumpten posible. Ifthe economy was mally dynamical Inefficient ~s0 that k* > hoy =the old geeratcn aga gains veto the extra benefits, Now, the reduction sn k* actualy allows for higher consumption for future generations and is welfaresimproving The Introduction of the tx im this case reduees or may possibly elimmnate the dynamic neffceney caused by ‘the over-acramulation of capital ') Fully-Fandd Social Security 2) Equation (3) becomes: 09 Cae) =O aS +02 HIT |As far asthe individual is concerned, the rate of eur co sci sect the same as that on private saving We an now derive die eteremporal badge constraint, From eiston (16) Soluionst0 Chapter? 43 049) $= Cora /(lt nai) T Sosnuting equation (14) equation 2 els ¢: Cute ihe aw ret ersimely 0) Gur ean “is ijt eempol bgt courant rend ma, Shing envi tounaien pods bul Es eons Cop01 = [Yl al) Cera) Ciy Subsining his no he bags enrique (15) — yl 00) Gir =[e 020A, “Toget saving pr pr, size eunion 15) a euin 2) Sp = Awy =[[1+ o}/{2+ jaw, = ox siny 7 §, =[Yl2+ pl]Aw, -T ‘Te ssl ery tx ses ne fone oan in pit ing ‘Te capa stock in period +1 wil be qual othe sum of ttl private saving of the young pls the etal mount invest by the goveramen, hence 8) Ker= 5). TL Dividing both sites of (18) by AL, to conver thi ito unt of fective laber, and uring equation (17) pelt ; Ly) olpayer ws -(ea} ape eR) ich implies to ews =[YOra)-[Y[2+ 0-7 Usiog enation (11 subse rhe wage ys 19) Kaa = [Yd] [y(2-+ pl] epee Thus the flyin sos system as no fet nthe eles betwee heap ck ete pres 1) Stace there iso efet onthe relationshipbarten ky and, te balanced-growh path value of kis the same as i was before the muoduction ofthe fully funded seta eecary yam. (Nee that we have been assuming that the amount of he ax i ot pester than the amour of sang each individual would have done inthe abeence ofthe tax). The basic ea is that tual invesueat and saving ssl the same ‘ch period ~ the goveramentssiply doing some ofthe savng forthe young, Suce socal secuny pays the same rate of cum as private saving, india are iiferet ao who does the sang, Thus ‘ndividualsoffct one-for-one any saving that he government does fr the, Problem 2.17 4) ln he decescalied equilibrium, there wil be no iexgeneratinal ade. Even ifthe young woud like ‘otrade goods this period for goods next peciod the only peopl around to trade wth ae the ol, Uaforsunately, theo wil be ead ~ and tus no poten fo complet the trade ~ net ped,44 Solutions to Chapter 2 “he indvidat sey Action gen by. (Gee aC ae The consis ar Qqehed ad) Cyn erh ere Fis the soi ted bythe nda Substring equation () wo 2) elds te enemporl ode constant Ci Caaf ‘The nda proba to maximise ifime ula ~ ae gn by uation (1) ~ bjt tothe smenenpora but contrat ~ as gen by euaion(). Setup te Lagann Anta +ICapai MA~Cip ~ Capes] ‘The fonder contin are given by ee/eie=VCp-d0 > YC=2 24/240)“ WCaqu)~Wa=O > YC Subse equation () ato oqo (6 and rans oan O Cntr Subetiae equtin (7) to the intertemporal bugs conaaint~ equation (4) ~ to obain Cuetxtha/e or spy @ Cy=ar “To olan an exresion fr secondperiod consumyric, substitute equation (8) nto equation (7) Cry xa?2 ‘When young, ech vidal consumes half of her endowment ad stores the cher half ~ thai, € = 12 This allows hero consume xA/2 when old. Note that with log wlity, the faction of het endowment that ‘he invidal stores does n0t depend upon the eta to soap £) Whats ons er ni of cv abr at ie Fis, elt consumption atime C=C re Ne ether aN, young nd ld pole alive aint, Each oun person consumes the faction of ther endowment thy donor sare (1 DA wil ech of person gets tceatme he gon ery cnn facon of eeu ta ey ord “BA, Thus Geen AN tA Ney To omer tists f tine efve Ibo, ide bth sides by AN ae Cyfan, =-8= Ay] “Thus case pr nt of tine fice aor isa weight average of 1 and sarge han 1, sce x(1 1), wl hrfore ba mannizd when te weg on 1 that when f= 0. (You coud Aso ss for canst er pre lv a tine which wel oc hae fe rer her), ‘Tee decmerlized equiltrium, with f= 12, in Pte efficent Since intargeneatoel trade not posible, people areforeat” nto storage bocaure thatthe only way they ca save and consume m old age. They must do this even ifthe retum on storage, is low However, at any point in time, a socal Planner could ake Tuna from each young person angie (I) und to each od person since there are fewer ofthe. Wa (I -n)>x this pers beter rum than rage Thetefoe, te socal planner could ‘air wife by taking the al ofeach generation's endowment tht they were going to sore and mead {geesttothe old. The planner could then do his each period Thi allows people to sl ensue A/2 wnt Solio to Chapter? 45 shea young and now (1 *n)A/2 its when ld. This is geater chan the xA/2 units of consumption when (Boe they would have had nthe decenralizad equa with storage Problem 2.8 Te ndvidal haem ley function given by Gy ey tC ast sd constants pressed in units of money ~ given by @) PiCi = PA- PR ME ©) PuaCaset = Prareh ME whee M3 iz nominal money demand and Fis the amount stored ‘one way of thinking about the problem eth following, The individual has wo decisions to make, The fat sto desde how much of her endowment o concur and how much te "sae Thon she must decide Howto save. through storage, by hlding money ora eombinati of bath. Wa log uty, we can pate the two decisions since the rte of retum on “ating” wil nt aft he faction ofthe fist peiod evowment tats saved From Problem 2.17, we know she will onsume bal ofthe endowment in the frst ered, regadlese ofthe rate of return ca money o storage, Thus: C22 Wha does she do withthe other half? That will doped upon the gross rate of ret on storage x ~ relsave tothe gross rate of return on money, which sP/Pay. It is PP since the individual ean sil 1 tne of consumption n period and get Punts of money. Tn period ¢ +1, ene unt of consumption costs rasan of money and thut one wit of many wll bay 1/1 units of consumption, Thus the individuals ute of money sl buy het P/P., unts of eonsumpacn in period +1 CASE Lx P,P She wn consume half of her endowment, sore the ret and not hold any money since the até of eur en mony ie es than the rate of retum on sage, Thus Cusaa Raa? MER =0 Coy aA/2 CASED: xP, /Pe Now storage s domunated by holding money. She wil consume half fer endowment and then sll the 1 for money Cy sar 0 ME/P=A2 Cori [P/F [6/2] CASE 3: x= P,P Money ad storage pay the same rt of tum. She will consume half of her endowment andi then indie a8 to how much ofthe ter halfto ore and how much of to sl or money. Leto € {0,1} be the fasten of saving that isin the form of money. Thus: Cysaj2 F=d-aa2 ME =xaj2=[P./Pial-{A2] 1) Eauitbrium equives that aggregate real menay demand equal aggregate real monty supply ‘Wecan derive expressions for both rel money demand and supply in pid ¢ ‘regate rel money demand = N, [4/2]46 Solitons o Chapter? agree ren money spy = [No t+ )}4/2 [s+ 94/8 “uv expression for arate rest mene sry wt the fc tht m prod 0 ech peren ~ andthe ae Noy 2 often = ecves Muon of more. Th a sep chen tse fc at since population grows arate, Nr= +0) Na and har Ny= A 2 can te ue equim end ole or Ns Niden"yf, > Remyfaden"] ‘ec smitty dre express fore one oranda spy pid + aggregate real money demand = N,,y -[A/2] = (l+n)-N, -[A/2] aggregate real money supply = [Ny /(+0)'"]M/Pyas ‘Wecan ten uth equa anton the fr deoyne-[Aal=[Ne/on"M/es > Ray=2nfaasny?] © Dividing qin 6) yeni (3) ys RaleMileny a Pia /On) “Tas mails feral tine prods 2 and oP. #8) a equim. Ths howe ati ‘nays ocr into jialy ef econ rege en be mated, Te ey cul wl seam taunt oft arr’ aug. Se pele 2 17spa {Sean cplnaon af hy ere orge matin conanpin pe at of ecu abr ©) Ths eth station where , oa =X ~the ret oo money i ql tothe etm on rage tn thi ‘se individuals re differen gt how mich ofthe saving to store ard how mich o had the fom ‘ot manny. Let ye [0,1] Bethe faction of svinghld nthe frm of money in period. We ca again enw expressions for aggregate ral money demand 38 supply in pened ad] ssgregate ral moey suply = [No (+ ]s4/2 = [N/m] 4/2, ‘We can then ue the equim condition to save for P Nealaa]-[Nocra' M/A, = R=2M/fa,aa+n""} 0) aggregate real money demand ‘We ean smilary drive expressions for real mont aggregate real money demand = Nj. -@43[A/2] demand and spy period + +9) Ne eal A/2] aggregate real money supply = [Nc /(-+ 891} ‘We ean thn wet euibriu candtio to save oP (+n) -No oa A/2} =| [0-209 Diving equation (8) by (7) yes: Prar/Pr = [ero] [YO] For Pe P= Le, we nee foedesu)-[ycemp=tix > [aser/ae]=[x/tin)] 0 is equivalent tox=Q,/ Qe forall t> 0, ln cher words, the rate of eu (on storage is equal tothe at of eum en trading and hence the india is nee sto how muchto store and how mach to trade. Let cy € (0, 1) represent the facicn of savng",A2, hat the indvidual tells m pened t Thais, the individsal sels 2 (A/2) in period Tis allows the individal to buy the ‘mount, (Q,/Qes KAR) when they ae olds period t+ 1. The anvadual tres a faction (1-2) of er Seaway” Thos 8) S=(-, AR) ‘Consumption in period +1 wil be equal to he amour he india buys plus the amount they have through storage. Thus (8) Cans = 04 (QQ: KAD) + (1 3,996 02) Since ve are considering a case where Q, Qui" x, equation (5) canbe rewrten 35 = a, x(A2) = (1 ay (AL2) = (422) ‘ som period t+ 1 and let N represen the total number of individuals bom each ped, which i somstant. Aggregate supply in period «+ 1 equal to he taal number of young dvds, N, mahi by teamount tat each young individual uncer to al, x (A/2). Thus 8 Aegregate Supplies = Now (A2) ‘Aggregate demand n period t+ 1 sequal tothe total numberof dnd, N, mu ‘mount each ol individual wishes to buy, (Q,/Qey Ja, (AL2). Thos ( Atgregate Demands = NCQ, Ques (AM2)48 Soluiens to Chapter 2 For the market to clea, aggregate supply must qual aggrerate demand Nas (A/2) = NIQ, IQ es (A) cx singiy @) 24 QQ 36, Siace the proposed pce path has Qu = Q, th equilib condition given by equation (10) can also be ©) ona [Now consider the smusuon in penod 0. The old individuals simply consume their endowment, Thus we rt have as equal to zeroin order forthe markt to clear in pend 0. Thus usin (1) umphes that we must havea, =D forall 20, The resuing equilibrium che same as hatin gat (a) of Problem 2.17. Te individual consumes half of ‘het endowment inthe fs ered of hfe, sores the rex and consumes xA/2 nthe cand pico fe [Note that with x < 1 +m here since n =O and <1), this equim i dynamvcaly inefficient Thus ‘hminaing incomplete markets by allowing individuals to trade belo the start of me does dt eliminate ynamic neticiency, 9) Suppose the auctioneer announces Quy Qs or euivalety x> (Q./Qe for some date & ‘Ths means that storage dominates wading forthe Young at date This mesa hat the young at date ¢ wil ant to store ther enare endowment and will want to buy A/2. Fo the ld at date, Quis eleva, ‘They based their decison how much to trade when old on Q, Qu which was equl tox. Thus each old ‘ndivdual vas nt planing to buy of sel anything. Thus aggregate demand excetsaperegate supply ad ‘the market forthe good will ct lear. Thus the proposed pic pth canna be an egiriam. 1) Consider the sri! planner’ problem. The planar can divide the resources available for cansugtion| berwoen the young andthe ol in any mater. The planer can tke for example, one unit of each young person's edowmeat and transfer #0 the ed. Sice ther are the sume numberof old and young people in ‘his model, he erases the consumption of each old pesen by 1 With x= I, this metod of wansterring fom the young toto old provides a bate eum than rage [Pte economy dnt end at some date T, the planne could prevent this change from making anyene worse of by requnag the nex generatn of ‘young to make the sme transfer inthe following period. However, ifthe economy ends at some date T, the Planer canot do this. Taking anything fom the young at date T woud make them worse of since the planner canoe pve thar anything in rerun the nex peiod ~ ther is no ext perio. Ths the planner ‘cannot make some geatons beer of wathou making anther generation worse off, Th the decentralized oquibriom is Pareto ecient ©) tis inti duration thatthe source of the dynamic eticiecy. Allowing individuals to trade before the art of ume rues a pice path ha els an ogra which t qatalent othe statin ‘where sucha market doce not exis, This equim hot Paretoffcent a focal planer could aise Solutions to Chapter? 69 welfare by doing the procedure describe in part (). However, removing ite duration azo removes the ‘eat planner’ ably to Pareto improve the decealized equilibrium, as explained in par) Problem 2.20 the aval hae wii fanction ven by “The contin expe in unit of eye C= RAHME and) PasCryn Condi eqns Q) a) lth tine bes essai (8) PCL * Piet Canet = PA rae of Net that 0 {meant he atch sain, 19 reat thn on Ths who te NOES ii ncesses th sabtain eft wa out etd consume le no ds TOE GRE Testmay sat we wl beshowag ere As that of atm co hlding money = which PrP tate ial wishes tld more ey ‘The indiviua's problem sto maximize (1) subj to). Setup the Lagrangian Cus Coat? #h[PAHP.Cys ~PoaCasl 11-8 “Te fs order conditions at: cu? oe ue =e = ° ae, R see ecart a0 > Coser PARA ay Sebamie (5) nto (619 obtain: Cara =CayPealP > (Cazsa/Cig) *P/Par > Capa/Cre “(P/F ecsinply © Cat =(B iP)” Crs “Thisis the Euler enon, which an now be ssa it the budge consti): PCa +PoalP/Poa Che = PA Dividing by Peis: Ce +(Pai/Pe) AP Pea) simplifying yi: Ww cy Hlerral Med > Cu [tele mal Jew “Thor consumption when young given by @ cy “To.tthe amount of her eiowment tha the individual sl for money (in eel tems), we can use equation (2) expreie in el tems © Mime A~Chaso Sal osto Chapter 2 Subat eqatin (nto so ta, Me A mé tema % ‘Smplifying by gening a commen denominator yl: tea) i ae Diving he top and bom of he nig-hand ideo equation ) by (FP am MEA Fe (Pal “Ths the eactionofher endowment thatthe indivi sls or monty i 1 ay ee Cv ae It is straightforward to show thatthe fraction ofhercadowmen tht the agen sells for money is an increasing function ofthe at of rum on bldg mane: om -f@-0/9} (2%)! WIA Llama” a] We ean also show tha asthe rat of rear en meney gots ozo, the amount of er endowment that he ‘maida sells for money goes o 220. Use equation (9) t rowrteh (Pia * Thala and thus: lim he = 010-0) «0 —>0 for8<1 a ©) Te constrains express in ates ae: = Mi/e, and) Co = MEP 3s no popuition growth we can nomalie he popula owt ls of genera. From G),a gern bor et plas to bay MP wits fe good wien hey fe old. Tas, he ‘rerauon bom at tne O plan to buy Ms, unt wi they areal (peo 1). Useequati (10). fad My subsuing = 0 RA ad fom OTe [PoP a me 2) From equation (2), generation bom af tee plans to sll My, unas ofthe good for money Thus. the generation bom at time I plan to sell MP, unas of the good. Sebsuuang t™ {nto equatic (10) ges Soluvonsto Chater? 51 03) eO In orer forthe amount ofthe concungion god that de generation © poop wish to buy with heir meney = given by equation (12) ~ tobe equal tothe amount ofthe eansugtion god tha the generation 1 pple wish sll for money ~ven by equation (13) ~ we ned ai A (roma A oR Hey (rome a Rm) OO (He ‘Now wth sy < 1 we ned (7/7)? +1<(P,/P) +t = (Po/P, and snc @- 10 neste, is implies yon y* 1, we obtain the opposte result forthe path Py RB Py 1220 A ands0 Pt 40 Ane Pa From equation (1) we can se that thie means that he faction f the endowment sold for money wil 9919 1 ta tier words, the economy approaches the stuston wher no ene consumes anything in the ise Period and sells their nite endowment for money. Thus, ttl real money demand wil go te A, the tnvdowrent ofthe young ~ we have normalized the population tot, But with ths path of pices, the price level goes to zr, which means tha eal money supplied by the old gest ining. Thus, this annex represent an equilbrium path forte oconomny because there wl be 3 te penad when rel money supply will exceed ral money demand andthe market wll not clear prices. That is, Py Py wile over time:SOLUTIONS TO CHAPTER 3 Problem 3.1 ‘The prodetion fincons for ouput and new knowledge are given by () YO=AGKT-AILA— and) A= BALTLOTAM® — OT 4) Ona balanced growth path, A(t)/A()=8, =m/(I-9) G) Diving bh ser of equation 2) by NO ls: (4) AW/AG= Bay LNT AC) Equating (3) and (4) yields: BayTLO*AO™ «19/8 > ACO =70/(1-0)Ba "L007 ‘Simplifying and solving for A(t) be a= yBay7L¢9" fre] 1) Subsets eqn () to squation (1) Ye =[0-0)4, 7100" fa may He afa-oB/re aya LO! ‘We cn maine the lg of opt with spect 10, WY) =[1/c1=85] a1 - 8/10] +[r/-Cy} tna, + tact 93.)+ [(1/0-9)) + fin Ley “The fmt-ocdercndtion i given by VO 1 a, “0-9 ay an Some simple algebra yes an exprescn fora 1 Ono “The higher is © the importance of knowledge inthe prodction of new knowlege ~ and the higher is — the unponanee of labor nthe production of inowledge ~ the mare ofthe labor force shoud be ceployed inte mowiedgesecor. Problem 3.2 batting the production function ~ (= Ki (0 Ki =5Yj(0 ~ vs @ Kye=sKyO® O>1 Dividing bah sides of equation (1) by Ki (ves an expression forthe growth ate of the capital tock, ser @ acide KO/KD=5 KO" “Teking the time derivative of the log of equation (2) yes an expression forte growth at ofthe growth rat of eapeal: 8) be sO/aKi=6-DeKs 0 and tt ) Bate 30? inc the capital accumulation uation — Solusons to Chapters 53 union) pled tight Wah — ce ccten recnee, Thee ae deme! by te al copia eee Pietornpre te enatin ©) $s Mn coon te RO) SLT iper erin em oe ca Ohaecomeny vik agers SUR per mala) Fee Spaten ) de pow ou Sethe pat Ts ne po fe fea noc eg pvng sony il SRiprowcd he gone ae pal R2oU ew cup canny. Tint EEXUG ceso teanese, Intec be gp ten Geo growth er ibe beeing ver SFiS tly asng te prosicen hatin, nea weer of pt wept Sa eat eos ay coe ea & WOMO=[KO/K 0) ‘hn ert fe gut (9) yl an exes orth gow nt be of Sapeinehagesrng amy onan close como 9 foro) fio Ks] Meme) To As xn! sone Bs (wl ead s(n 20, ai ap Bw eo be See Be pes ate cpu te we poe aa rang rete That, the rat of curpt i the high-aving economy to cuput in the low-saving economy will be coninally ing ~ and ning stan meessing rate, [bx100~axato]>o Problem 33 ‘The relevant equations are ) Y@=AMC-aL —@) AM=BaLLIQ) —G) I= Sa-e 1) Soppose that a possible scltion for A) is AQ) = Ce? Taking the ime derivative ofthis pues” sels ACQ)= Coe. Thus we can write the chang in Aa time (1) a: AG= spect? Subriting equation (nt eustion 3) and solving th itera yl: H0= Fa-e" cast Par Dao ede 10) = F cgetae— Teget 9 acm coe Fert ae— cont Teac Tene gaol Lemans eval! cone} sy=ane fetes anoles ease ane hich simplifies to (5) Jay = tv BAG)St Solutions to Chapter3 1 Isthere actually ag> Osuch that AQ) = Ce" —such shat A()/ACD= g7 Dividing bath sides of equation (2) by ACD yl: © ACW/AG) = Bay LWIA Swbsating equation (5) ico equation (6) yee: © ACo/AC)= Bay Lyle) For our guets tobe corre, there must exist 2 g> 0 such tht B= Balw+g = or simply B+ ¥g-Baly=0 Using the quadratic formula, we have avs +4a,by i Fl ety? soaked mm er ol po + yy? 44BayLy @e v z teed tp pd Yad whens jee pct, sec ec es ((F same) (Pate) penne = eZ aff? +4ba,Lv) +20 AF eaoztv+) Dividing the top and bottom by 2v yields ZBa,L o Clearly, fom equation (9), higher values ofv imply higher values of . That is, the sgn of 2p is positive, Taking the ims ofthe expression for g given in uation (9) 5 ¥ gos to ity Yields: Ne edb ns vie Fis EI 19 represents the tock of knowledge tht i sel i the production of ew knowiodge and i ot the entire stock of knowledge at time t From equation G), wah v> 0, 1) iat simply the “sun” ofall pat imcreaces the stock of knowledge. When "summing up, changes in the tock of owl ae exetate (1-064 -10 B Solationsto Chapter? $5 ‘Te expression forthe growth rats of capital and knowledge ae 6) Bx O= ee [ACCOR] ey asta =a) 9 EA@=caKWOPLEDTAO™ — cy « BayPagt 4) Anse in population growth fom a 0 mw From equation (1), for given ga, the valve cof that satises By =O is now higher. ‘True the bx =O lous shit op. From equation), fora given ga, the valu of that satisfies gq » O1snow lower. Thas te in =O lots hits down Since n des not appear in equation (3), there it 90 jmp in the vale of x atte ‘moment af the increase im population ow ‘Simi, since does not appeae in tsution (thet sno jump inthe value of gy atthe moment ofthe nein population pow, ') An increase in the faction ofthe capital stock usd inthe knowledge sector rom a 102,” [Nae tata dots not appear in equation (1) the by =O le ~ or mequrton (2) = the fq =Oline, Thus nother the gy. = 0 nor the in Olin shits asa tesa ofthe From equation (3), he ne in 3g cause the gomth rte of capital, ge, to jmp down From equation (4), the growth rate of Inowedee, by jumps up atthe mstant of the ise ay.” ‘Thus the economy moves to 1 pon ice Fin the diagram ©) Aris in 8 the cocFicent on knowledge inthe nowlede production fiction56 Sohtonsto Chapter Since doesnt appase in equation (), there tno shi ofthe gy =0 locus From oquaton (2), the bq =0 locus as slope (1-8) and therefore becomes fate aftorthe nse in 8. Sethe diagram, Since 0 doesnot appear in equation 3), the grove fate of capital, gx, does noc jump 2 theta of the ‘se n 8.8 docs appear in equstio (6) and ths we ‘owd to derma he ait that the rst 8 has on the growth rate of owledge Iu ou that ga may jump up, jump dows o stay the ame a the insane ofthe change in 9, ‘Taking the log of both side of uation () ges Ing (0 =Inca + BK() + YALE) + @- ind) “Thus, taking the derivative with respect to 8 ye (9 Ginga (28 = WAC) Soif Ais es than on ~ 0 that nA) 0 dhe growth ate of knowiedse jumps up atthe instant ofthe rise in. Finally if AC) is equal to one atthe time ofthe change in 5, there ‘sno ital jp mg. This'means the dynamics ofthe adjustment o Exew may differ depending cathe value of atthe ine ofthe change in 0, bt the end el he same Problem 3.5 ‘The equations ofthe gx =O ad gg © 0 loci are Oe =10 8 ‘The equations defining the gromth ees of captal and inowlee at any pot i ime are ©) ee (O=eg(AOUO/KO|!® — cg =xl-ag)"A=21)™ ) en@=eAK(DPLIOTAG™ — eg wBagPayt () a =0 > eee ts @B4=0 = Bq 2) From equations (1) and 2) ~ since the saving rte, , des nt appa — he Bk loc hie wh increase From quate (he gant te of Ie, does xt change atthe ‘hats increres However, from equation), nae in eases an pward jump inthe growth rate of {Spt ge Inthe nga, the onan jmps fom ts belanced ‘roweh path a Eto ponte Fat ‘he momen thats neta 2) Atpoint Ft cen is stove | ™P the gq = oc and sg ng De toe inzeaze in the growth ate of opal irhighr than would have Ben ~ te mount of capil Solutions to Chapter3 57 going into the production of mowedge is higher ha ic would have bee ~ the growth rate of nowledge Elgar to nse above what would have been Also at pout F the economy is above the gy. =0 and s0 Bx {nfoling. The economy des tothe soubeas snd eventually crosses the 8, =O lous at which point bepias to fall wel. Sine thee are decreasing rexuns to apt and knowledge i he predacion of sew nowladge ~@ ~ P <1 —the increae in «doesnt have a pemanent effect on the growth rates of K and Ik The cconemy evel reams to pot Te protctin Sanction ge by ©) Yeoa{(1~ax)Keof [acolia, 00] ‘king nine eva oft logo eqn wl ied he ro tof tal ouput a FO nea, (0+ -29f64(0 +8) © yor Le } eae ‘on ein blancad growth path, from fusion (1), gut = gat #2. From equatic (), {hs means tht total output i also growing arte {r= Ba" +n onthe tal Balanced gronch path ‘Thus oun per person, Ye, i italy rowing arte gu" During the tanto period, toh ge and paar growing a higher eats than ‘on the balanced groweh path ~ output per worker rus alto be growing mate greater than 5 al Talancad-roweh-pat value of gat. Whether the owt at of output pr worker is sing or fling will depend, arnong oer things, on the value of Stace thesia peo of tne when gis aling and gs sing. The diagram shows the growth at of ‘output per worker intially ssing snd then flag, bt the important poin that doing the ene ansition, ‘tha grow rate els higher tan ke balanced-growh-path value of gx". Inthe end, once the economy ‘retumsto point E, opt per workar is again growing at ate gat, whlch has not changed ©) Note hat he effets of an increase ins inthis model ae qualitatively similar to the effets inthe Solow ‘model. Since there are at decreasing returs to the preduce factors of pruction here = 8-+8 <1 =the ‘ncrege in has cnly a lavel effect on output per worker, The pth of ouput per worker les above the ‘pa x would have taken but there a0 permanent effet on the growth rate of our per worker, which on the balanad growth pat is equal tthe growth rat of nowledge. Tie the same effc that sein = "as inthe Solow model where there are crunching eur tothe produced factor, capital. Quantitative, ‘the effects larger than in the Solow mode (fra given set of parameters), This i du eo the fat that here ‘Anse above the path would have taken whe that isnt true i the Solow model, Problem 3.6 2) From equations (3.14) and 15) inthe tex te groth ts of apt ancl knowledge ae gin by ) x)= REO/KO=cx[ALE/K(O]!® — where og s(t [AKIO = fecleg LE ‘Thur the value of A/K that elds equal growth rts of capil and knowledge Bien by leprae In order to find the growth rate ofA and K when ax = ta =, substitute equation (S) nto equation (3) Pelee") fear ere Simplifying the exponents yl: thet Pefextorae,vaytontrcay] ox simpy soa (© ar [extent =umsrere 6) In order to sec how an increas in safes the oog-in growth rte of he enemy, subnet Aefintions of x and ex to egution ©) gre fPanayy aay "ahaha onary] “aking th og of bath is of qustion (7) gives us @ tngr=[/-a+p)]-(ins+(1-a)-(y +e)aL+(1-a)inB+flala(ay) + (-a)laagl+ (-e)find—8,)+ roa, Using equation (the elasicty fhe engrn growth ate of the economy with respect to the saving mt ®) angles = il -a.* B)>0 Tus an increase i the saving rate increises the lng-nm growth rt ofthe eccnomy Ths is essential because it increases the resoureesdevted to piysiclcapal accumulation and nts model, we have constant fetus tothe produced factors of production 4) We can maxis lg" with respect to ato ein the faction ofthe capil eck that shold be employed in he RAD sect order to manish log-un growth ete ef ecnamy ‘The oder conti ogoeee pee means ne)| tag “U-arD LO-a” a Solving fr th epi yi aii na)e (savor ands (0) ae"= 0-0) “Tus the optimal faction of he capital sok to employ inthe RAD ser sou to efecive labors stare in te pron of epit Note Sat capa hate te pati ncn fe ewe Inowedg, des nt ae he pina sloeton opal oie RED ser Tu ese fer hs is at am neresen Bhs fest male aptlmoreimporant the R&D sector, derby emg faethe a tht mnaizas Arse alo mks th proacion fnew capa nee val ad ‘ew eapal spread wes hermoso be ved od tse Tet toe th ap at fmoximcr since tpl that more esoute shold be evel tote protien of exp aera Iowa nthe case we arcs. thee to ec cal cacl each eer oe ean leagtea-e OF tae Beobiem 3.7 The eleva equations are @ YO=KOAO™ — @) KEESYED 48) Substitute equation (1) ito (2): Kit) expression forthe growth rate of capital. xt) @ Bx #RO/KE)= SKE AC ‘Substitute equation (1) into 3): ACD forthe growth ste ofinowiedee (0) ©) BAW AGIA) = BKC AC sk) AC)" Divide through by K() to obtain an Solutions to Chapter © A@=BY) (EAD, Divide through by A) to obtain an expression ©) Conia “ang th tie dese of atin (2) ys te rows eof he owt at of pat Hg KO gy AD mx 5) © bx W/ex=C-Dex+0-Oe 40 From equation (6), gx wil be constant when (@- Dg (1- edge O or when gy = gx. Thos the fg =O locasis 345° line in (ge ge) space. Als, te willbe rising when (2 1g, (1 a)ga> 0 or when { ax Thus above the gq #0 tne, gy wil be nsing. Finally Be ill be fling when ag ga =O oF when gx “Be Thus below the fa =O hie, wl be fling Tex =eal 2°60 Sohitions to Chapter 3 ©) Pathe gx. =0 and fq =0 loi onto one Altnough we can se thatthe economy wil vetully ave at stuaton where gx = ga and they ae ensant, we sil do net have enough information to ‘izermine the unique balanced growth path Reverting equatins (0 and (S) 4) BR O=SKE™ AM! eslao/Keo]™ ©) Bq (= BKO™ AG) = BLAW/KO]™ [Atany pointe, the growth rates of opt and -nowledgeare linked because they Bah depend on the rato of inowladge to capital at that point in une. Is diefore pone wits ae grow ate ara function ofthe ether From ution (3), [A(b)/K(o}® = 8/8, (0 or singly ©) Aco/K(o)=[B/eq (0! Saba eution ta ition fale least be he case ha a and ga i onthe locus satsfjng equation (9) = labeled AA the Gagram. Resales ofthe inal ratio of MK the ‘economy sar somewhere onthe this locus and then moves along to point E, Thus the economy dovscoege to unmualnel gowch po = “To calculate the grow ates of cptal and owiedge onthe balanced growth pat, ate hat t poi E woare onthe gy =O and gq =0 lost where Bea Letting g* doce this commen growth ate, then fom equation), g* =f Recaranging to solve fr g* yield: (0 t=" aoe “abing the tine derivative ofthe log ofthe production inci, aquatic (1), eld the growth rate of reat cuput, Y(O/YC) =a (2) +(1a)ga (0). On the balanced growth path, = 84, and ths: QD YON =0g* +1-a)gt=gt as? ‘On the balanced growth path, expr, knowledge and carpal grow a rate 6 Soluvons to Chapter 61 4 Cleat, from equation (10), 2 ein he Sav ftes races g* and thie ries the long, fn growth cates of apt, nowledge and From oqations (6 and (7), ther he por the fa = 0 line shi when s changes 5 doesnot appea in ether equation. From equation (Gases causes gu fo ump up. Also, te focus given by equation (9) shi et. Soa the momen that¢ nse, the ecomomy moves fom balanced gromt path at pout Etoa pout like F Tthen maves down along the equation 6) locus ut reaches anew balanced growth path at post Ew Reoblem 38 4) Taking the partial denvative of oust at firm i ~ Yi = the aggregate capeal tock as given yes KYL} — th espect to Ki, treating oy, erat oy eo Ffeeoeturafetetfoal)(G) ae ee el eee rain cpt enna ti Te a XL. 1) We can employ the technique urd to tlve forthe balanced groweh path in the Solow model, Sines Kg isthe same acres fie and the production funcon has consant reruns, the aggregate production function i given by ¥ = K"L'* [KYL Jor simply @ Y=KewLI Define k= K/L andy Y/L, Diving both sides of equation (3) by L gives us vee win) Ww and thus our per workers given by @y=e" Taking the ime derivative ofboth ies ofthe definition of k= KML yields KE-KL_ (KYL TW Substiuting ihe capal accumulation equation — strate n= L/L=n ~ into equation) gives us (6) k=sV/L ak =5y-nk Sebstuting equation () for opr pr worker into equation (6) gives ws: 0) k= ne © ke 5 ~ andthe aration thatthe labor force grows62 Solutions to Chapter 3 Sus inthe Solow made, the economy will converge toa siuation where scual investment pet worker — "=i ual to breakoeveninvestnen per worker ~ nk Thus on a balanced growth path, capital pr ‘worker willbe constant. Seting k=0 giver ue setae = En ersimply @) ie = funy Substitating equation (8) into equation (2) yes: r= alsa] =" = alsin)! and thus the marginal product of capital on the balanced growth path © ean «) The analysis above does net suppor the claum. The value of docs nt afet he steady-state vale of the private marginal prodact of epi "In ation, § does net aft how hs vale of €* changes when ‘he saving ate changes From equation (9), 2:05 = (an), which does nat pend n ¢. That, postive etemaltes fem capita do not matigate the deline in the marginal produc of capa caused by 8 ‘ne inthe saving rate. Why? Its tre, a6 te claim asses, that higher § means tht # responds lest changes inthe capitalabor ratio, KL ~ see equation 2). However, is also tue that a higher meas ‘hat the capital labor ratio self esponds more tothe change m the saving rate abe equation (2) In this ‘ate, the effets cancel each echer ou Problem 39 ‘The production functions ~ after the nomalizaten of R= | ~are given by- () C=Kewr and) KG) BKK) 2) The et to employing an addon unit of capital nthe capital producing sco is vn by OK (/OK_)=B. Thihar vale Py @).B i ets of consumption goods. The rtm fom enployag ational un of opal inthe coneupton producing vectors C1/Al Kc} =a Ko (0! Eguating thse reeves @) Pe@)-Bea[ Koco] “Taking the tine denvaie ofthe lop of equation ) yl the grow ef he prc of eapit goods ‘ave to consumption goods Pe) Ba [Ke] _ Pet Kol 10 8 $c. B0] Here y fed 7B a Kew) > Ree Kew ‘he as sop uses theft that Hand ae const, Now since Ke (is gromng at ate (and dencting he pow ate of () 2 we bas @ =" Dee) 10) The growth nt of consti i given by ©) gc(0)=6W0/C()=[11¢)~pl/o= [B+ 8p (t)- el /o=[B+Ca- dex ()-al/e where the lst opus equation 6 to ube fo 1) Taking heme derivative of the log ofthe consumption production Finca, equaticn(), ye (9) gcl0) = CH/C() a[Ke(0/Ke] =aB, (0) uating the two expressions for the growth rate of consumption ~ equations (8) and (6) ~ yl Solutions to Chapin 3 63 ask ()=[B+(a-Ugx(0-pl/e > eagxtt)+(-adeg(=B-p -rmis over For Ct be prom at ate ge GK @) mst be rowing ate llowing rate (1 8x(0*(B- [0+ 0-29) by iy Wenave nyse fr) tres ofthe ning pms. Tos fr © este equation) ano oxen @ sel=e(8-afoortt-)] ) Te al eres rat pow (1 -=}(B+ >). Thus equation (5) become: =) -[B+8,0]-p_0-9-[B+e-ns«iol-9 © Be E Es here ea pe Suton) ich atone by Gn npn of eae —to sabe fr roy Epon be te cprsins forte on se of angie ~ eins) a) =e ins) [Be te- Dex) aex (= > ark +0-al-aeKt and hs o-98-, 10) Bq (De — ORF 09) BK =F +(-9-a] ‘Sebstuting equation (10) int equation (6) yl an expression forth growth ate of ensunpton as 3 onan of th undervag parameter fhe mode c=9B-o (1) wo| OB OD Bevel Sosa) in cde see th fe oft tae tate dra of) wah pet 10 _[far+a-n0—a9}-| eot-at-af o[_tecrati-ed |, & Jeora-00-a)? feora-na-a| “Tout an ners in ea ate cuss he growth ate of cmsation fl 310 2) Nat that the model ofthe narthem econoay is simply the Solow model with a constant growth rate of technology equal to g= Bays Ly. From out stlysis ofthe Solow model i Chapter 1, we Know that he Tengen growth rte of nrthem output pr worker wil be equal fo that eansant growth ate of technology 1b) Taking the time derivative of bath sides ofthe definition, Z() = Ae (VAs (ils: Aw(OAS(0 Substiing the expressions for As(t) and A(t) ite equation (1) gives us: Ay(@)[uaests(Aw it) As(®]] ~As() [BarnbwAn (0) ano ‘Simplifying yields:Solon to Chapter 3 © 20 =fparstslt-Ast0/Ax (| -[Ast0/As00}[Bevrbs) Sting te dfn of 26) «As Aw (int eatin) gives us Zio masts —bashsZl) Bayly ZO Calecting tes yd @) 2) =naysls ~[uaysls + BayyLy]Zte) ‘The phate diagram impli by equation 3) isdepited a ight Nate that equation @) andthe accompanying pase diagram do 1c aply for the case of 22 I sine Al) = 0for As? AW, “The elatinsipbrneen 240) 04210 Near wth pe salto (aus + Bovchy] <0. Fom te phase nga, f 22% then 20) > 0. Thaei€Z bopos to thea of 2+ is owardZ* over tne Silay i€2> 2, then 2) <0. Trovit Zegna othe git 02, foward L_, 2+ ower tine. Tas Z~ th a of teclog te soa To wcacogy He no ~ dos Caveat 0 sable vale’ Tosohe fr 228 20) #0 0 = youl isle Baud 12? Solving for yd ee sls OB Bots Binle ‘The nevt sp ito determine the lng-rn growth at of souher output per worker. We have just shown that 210) = As (Q/Aw (0 converges oa constant. Thus nthe ng-run, A (must be growing at the same rate a8 Ay (), Inthe log-re, thn, the south 2 Solow ecanomy wh a growth rte of techncogy equal 1 Bayy Ly, This the longum growth ate of southern ouput per worker i equal to that growth rae [Nex that nthe lng-rn, the growth rte of southem output er worker isthe same as that inthe north ‘Ths means that as ~ the faction ofthe south’ labor fore that is egaged in lnaraing thetachnlogy of the nth = dots nt afet the south long-rn growth ate, That gow ati entirely determined by how many peopl the north has working to produce new teehaclogy © Disting the ore produion fton~ Yi () = Ky (9 A XL ~ ay ey? ~ by the quan of etc aber, Ay (bn, el ie [ ra Pf anna © Roly Lawtoly) CAN UT An@ty Definng output nd capa per unt of effete labor ay (= Yo (Ay Ly and ev () = Ky (Ay 0 respectively, we can rewrite equation (3) 35 (8 yo) =b (9-200) [Now we can use the tecngue employed to salve the Salow mode to show dat on the balanced growth path, kst= kot Taling he tine devative of both edo ofthe defintion of i ) = Ky (Ay (Lx vil Solutions w Chapters 65 Ky) Kyl) Aveo Rely ANiOLy ANC subaru he ep secular eget ~ Yn Ay) Kl © HOA LOLY AN ANOLy ere the st sep uses te definitions of and (0) and subse forthe grow rate of one Wlogy Fall, sing eqanton (to suber y (yells 66) byt) =k (1-24 ~ Bayh (® {i arlogos eration forthe sou wll (00) Ks =s5ks(07~ap5)" — Bay xtyohs(O tore we howe used the fc tat inthe ng, he growth ate of technol inthe south is Bay in= Y(t) ~ into uation (7) gives us: yn (0)= Balak Using the facts thats = sand au se can se tha the equations forthe dynamics of K are the same forthe ovo ceenomis, ‘Thus we know ta the blancad-growthpathvales of and y wil Bethe same for thetwo economies That, we now atk? =ky® and "= yx" This implies: ay ye Using the definitions of and yj his implies that: NeiAshs sila AS. a3) Y/R Ywitn An uric (12) states that, nthe alee growth path, he aio of eutput per worker in the soto tpt er werker inthe north is egal othe ai of tecnology he south to technology inthe arth, From part (0), wekrow that Ax /Ax converges to Z* inthe long-run Using eatin (4 for 2 to subsite into eatin (12) eaves ur with Gy Tals washs Yu/ty Wists * Baty Nowe tht wih Bax Ly > 0, thi ratio mst be less than 1 ~ cup er person in he south wil be lower thas opt per person inthe north Alo nt hat en the balanced grow path the rat of up er eso the south to that nthe north dee depend on as ~ the faction of southern workers engaged in fexnag the north’ tectnoogy In ft the Rhesus he loser wil be the path of output perpen in fhe south otha in the noth. kon 34 2) Wenasdto id a value of uch tt [Ys (Ys ML] = te ati of st pe woke he ortho nth south = gual 0. For he or odin fin © ete Avon) Taking the time derivative of the natural log of equation (1) yields an expression for the growth rate of ‘Porthem output per worker: g Hutotn) Aveo YuO/Ly “Axl ‘Toe ast step uses the information giver inthe problem that the growth rate of nother output per worker ~dthas of ont nsledge vis per ar Since Ay) Ay) = 003 hen O More aed From the southem prodcin function 9 Yet aeo 00366 Solutions to Chapter 3 Dividing equation (5) by equation () yes an expression forthe rato of ouput pr works nthe north to ‘hatin the south Wey Anima) An oon ¥s@/ls ASM ANU “The second t las sep ste the fact that a ~ Wand that Ay () = Ac (5). The stop uses uation (3) “Thus we need as such that 210 > 00% = Mn) t= 768 years “To explain realise cross-country ferences in income per person a asia fom slow warsmisscn of Inowledge to poor courte, we need the ransmusion to be very slow Poot cous noed 1 be using technology thatthe rich counties developod in the early 1900's iF we arto explain 10-fld difference 1) Recall that inthe Solow made he Blane growth path valve of k= K/AL is dele imply 2y the condition dat actual invesment~ fG")~ equal break-even nvesment— (2+ = Bk". Thus forthe north ks" implica by © si") =G* 2+ Dia where g= Aye(O/Aw ©. We are told thts 9,5 andthe function le) ar the same for the north and the south. The ealy posible sourea of dierence isthe growth rte of southem knowledge. However, 1s Suaightforward to show tht Ast/Asio =e alo. ‘We are told thatthe Inowlodge ssn the south a time te the knowladge hat was weed nthe noth at tumet=, That OM AO= Ane “aking th ume derivative of equation (7) yi: @ Ast=Awlt-9 Dividing equation (8) by equation (7) yields: As) AnG-2) As@” AN “The groweh rate of norte knowledge i constant and equal to gat al poate in time and th: (19) AS@/As@=8 “Trorefore, foc he sout, kis implicitly defined by (1 sg") = (0 6+ Bs" ‘Sines ky” and k,* ate implicit defined by the same parameters, they mast be oul ) 10) Introducing captalwillnct change the answerto par a. Sine ha* “ket, ouput per unit of effeaive Tabor on the balanced growth path wil also be equal in the north and the south "That sy" = Ye* WHER y= (Yi/AL,)*. Wecan wrte te balanced-gromth-path value ef output per worker the north as: 2) Yu Oe = Ac Oo" Similarly, te blanced-growrh-path value of output per worker in the south: (13) Ye Oils = As Oye" Dividing equation (12) by equation (13) yes ay SHOE ANG yn At Ys(/lst) Asi-ys* Asi Ano ayo Solutens:o Chap: 3. 67 “Tae second to las step uses the fat hat yt = ys" 0), we again have Yous Ce) Aye) Yo(i)/Ls() ~ Aw(=9) “The same calculation ain parts would eld aval of += 76.8 yoars i ode for Dis Ls YOVs Ls] = 10. Tre laa nop wee AG ()™ Ay (C2), Using epuation Problem 3.12 “Tae equations ofthe k=O and b= 0 loc are (0) KO =[ax ore]! HE) eo) ked)=[m+ 8/59] "HCO From equation (1,2 nse in shits dowa the 20 locus. From equation (2) the geo shifts up the b=0 loo, At point E the ‘canomy is now above the new k-=0 looks 4nd so the amount of physical capal per twat of effecive labor, KO), fling Similarly, since a E, the economy isto the Fight of the new b=0 leas, the amoust of aman coptal per unit of effective labor, (1 falling. ‘The economy moves down and left in (oe) space ult raches the new ‘balanced growth path at pia By definition, ouput per worker can be writen ar VIL = Ay where yw om per wna of fect labor. ‘Subsuting in fo the intensive form of the prodscion function gives VIL. = AKCR?. Os the ial balanced ‘growth path, kand hare conan and so cutput pe worker grows at rate A/A =. During the transition ‘woan the two balanced growth paths, kand are falling and thus ouput por werkar grows arate est thang. When th economy reaches the new balanced growth path, and are again constant, and sothe ‘growth rate of ouput per worker returs tog Thus the permanent deceace nthe populsten growth rte leads enly toa temporary decease sn the growth rate of cuput per worker. Tee path of cup pr worker nl e below the path tedervse would have ken, however. These quaative implications are ‘seally desea wo thse ofthe Solow made ss Cee Macy perc econ bk ef ui 57) mt yl merino apt Haas sr pare maya acre " Lar efnetnt ore] Sebring qin) nto ution) te! ars ef enn pnt nee foe inch sm)? nonSolunons to Chapter} 69 65 ——_Solstions to Chapeer3 Few re out tobe ease if we maxim the log of e* wit both sds of equation (yes i fel 50-60) +9" 9) bet = . Fe aton (I) 0 ss fr ay" tna + nay tat Fa-p Fg we ata oae gape Tap Toa GD en ee ee 7 : oe diference brween log consumption pr ant of effective labor en the new balanced grows path wit Sct cndone ar 3 Roe and cht wr 8 by. (9 Inet tnd 54 =) Re tinaca hepa! OR ery tenga) 84a lag itr squatin (6) fom eqn (5) ta sn forsg™ 01 se 018, 549015, 0035 and P= 04 yl serie emma Cede: im ng if et cay TreoB oq ina-P yg? 7 oaB eB a eect = (018-015) =e 015-015) — 225 — 08) n(05] Simplg and soln ta 3h of hes aes Oy men @radse SEE cr s02itt Stas equation (ins eto) 12555, consmptn is ppocnstely 23.38% higher than wouldve ban who he f st ect dacion Se ~@lasg * T-a-B sy “Crosman singh yl ) Theil fhe dt ruin that const fils, Ag 3* docs tam ain By tn-n Pac eases cyegasto mney teva ow ruses grotph ee eae andi. Binns pose tin ands coms als ie of rae yA mat @ecne Finn formmre pone ameter any rung l et e Stung eqn (asks quo (es 5 = (8 spy pci ange mc mbt perp change ese). Now, (h-oemon) ils 07 Oar a moemnan Deen OOea ey) Teratchappninatey a £9% dept 003 tba 4299¢6f07 Thar ome of In order for consumption pr unto effective labor 1o be maximized on the balanced growth path the rein se, consumption fs by about 4.29%. ‘avin rte for poyal cpa must onal physica caps share i ouput ~ "~~ andthe fn We cn use some réuks fom Problem 319 onthe sea of eomvergcce in this mode to dterine bow oF resources devted to hasan capital accusation must equal human capitals share out ~ t= ike or consump our fo what twos have ben thease of the defi reduction. Nowe that hss analogous tothe re forthe Solow mode with 3 Cobb-Douglas production finan ferences ik oe tsais ca caghet Sere = (0 -nes ay bis ea that that case, was maximal when he saving rate ened capital share in out Soe Probie 12 cel grow ae same rate onthe ay tthe new balanced grow path Ia Probl 3.1, ite shown tha the re ofenvergecs of ~ afer a neat approximation 5 OY edia- pave) Wohin g)= 6% 2025 and)=040, k= 1.5% Ths means hat y moves 138th renal sacs twa the balanced growth value of each year. Siace ci « A ep Reprint, ss appease lane growin ale aie sae consant ae, Tht () tnye= nag +P nco+8) prec write ime : imo-5 }O) =r [stm il vale afew the more tht changes Rewring (5) (oh =e" comer he nh ip hand he futon (th rac ofthe dsanceto the alc growth path et remans to be tread Problem 3.14 2) From equation (3.57) ia he to, the log of ouput per unit af effciv labor on the balanced growth pais --0-SK (0) -e4] here we have se the vals given for @ and BA seins fom sy = 0.15 t.y8 =0.18 — which ‘hat occurs, snc we ate assunung tha the ete 3% of ouput i saved afar the defi is elimunated 120% increaee inthe saving rate for physical capital Using dhe vale of 1.4 fr te elastic, this We ow ‘hat ouput per unt of fective aber wil nse by abot (020}(I.4) = 0.28 or 28%, Since the pats fA hove and Late unaffected this ao eas that ouput self willbe 28% higher than & would have bee the deficit eduction, ‘hat consumption falls inily by 4.29% and wil eventually be 23.55% higher than t would been, Thus & mae change by a otal of 27 8% onthe way tothe balanced growh path, Fe will fore be equal to what t would have ben, 4290427 84% = 154% ofthe way tothe new balanced RrgttPathEguvaley this is when ve remaining distance co the new balanced growth pth i 84.6% Stitoal dtance Ws ode to find out how lng this wl take, we need to find a ™ that solves 2) Consumption per unit of effective aber an the balanced growth path is given by Cte Qea(eaewy" Be Tin te natura 1 of equation (Dy Taking the log of both sides of equation 2) gives us og of bah sides of equation (7 yields70 Solutions to Chapter 3 set = by 886) = and thus ( 5111 years Teva take a fly longtime ~ over a decade ~ for consumption o return to what would have been inthe sbeenee ofthe daft reduction {4 Compared tothe rezuks forthe Solow model in Problem 1 , ouput and consumption rise much mare this model wid human eaptal, Oust ces by 28% as compared 10%, wile easumptio rises by shout 23.55% a8 compared to 6% Thus isuoducing human expaal nto the model makes the benefits cf ‘efit reduction mach more suractive. However, the fate of convergence i tus models much slower than tthe Solow model, This ofa the fact that consumocin resus to sega valu earir i the ‘Manston tothe pew balanced grow path an ths model. The end cst stata oth model, the time takes for consumption to return to what tweuld have buen in the absence af the deft eduction i quit Tong — over 1) years Problem 3.15 2) Differentiating both side of the defintion of k(t) = K(Q/ACDL() wth respect to time yl oy iy ROAD = KONAOUD + AOL [acu]? ‘ange dein of» KOVAL, emt (2) an bv a OA @ &@ toh? Substiuing the capital accumulation equation — K( rates of knowledge and labor nto equa @) giver ws 2Y(0)~Bx Kt) —s¢ wel asthe constant growth YO BeKG @ (OO oes neo Sobsasing he production function = Y(t) = (=a )K(OI*(C1~ ay) HCO ~ into equation @) viel: {e-snxeF] oa) © 40-4 Fou@ | awn | “eer Fall, defining cx = 5 = 24)°(1- ay)! and using kt) = K(Q/AG)LA) as well sh) « HOVAROLED, cquation (4) canbe rewrite as: 6) ke) =e KCN ~(O4g-+5_ IKE) icing bt sides fhe detain ot) = HQIACILA with pe tine ils HMAOL()-HOAMLE + AML) [a@ue)* Equation (6 nb simp Ho [AO , LO}, Rou Law “HoH Substituting F(t) = Bfay.K(t))"fayHCOPCAGIL(Q} WT ~ 8 H(e), the human capital aecumutaton trun, wel sth cost th as of knoe ada ue eon (ees © f= & be Selatins to Chapt 371 F axke IT ayn Wace xin TY at ee Laue) Laue! Lou) Foal defining cx = Ba lows so ew ostcn 2) (@) fit) = ck Ct)” BCA)? = (+g + dy HLL) @ bO=5) 1b) To find the combinations ofh and k such hat =O, sete nght-band side of uation (5) equal to zero and solve for kas fnction of cxk(HO™ = (0+ 8+ 5.) = and ths finaly 0) HA) = fe fin 5+ 84)" hey! = echt # Be) “he K=O fous, a fied by equation (10), isa sight Ine wih lope fn tng uh > Ocha pases, through the ong. Soothe gram art From ection (5), we can see tat (wines iti) Thurtothe ight of te =O locus, k > O ad 0) ic ting. Tote le ofthe k= Olas, k and thas Sly G1) EO) = fon Mla + 2 + By IT BEY “he flown devatives vl euch Boag =[0-O/r] [en learer dy] hor" 30 #uaofanco?, [0-6-9] [a Leni e+8ui]" eo >0 —————— Pt) Hey" = [n= 2 Bie J The =O locus, as defined by oqution (11,6 upward sloping th a postive stcend dervatve See the diagram at right) From equation (9), we ean see that h(i renting in kt). Tecefoe, above the 0 locus, b > Oand sob) is increasing Below the f= 0 Toes, h <0 and so) fling,7 Soluions to Chapes 3 ©) Pang the k=0 and =O lei topather, we ea ‘ethat the economy wll converge oa stabi balancd growth path at pot E Ths sable balanced growth Ph is unique (as long as we itor the ong ith °), From he diagram, physical capa per unit of fective aber — (= KOQVAQ)LG) is constant on a balanced sowh path, Thus physical expt per person — KiQyLe) = DAC) must grow atthe same ate as bowed, which sp. Similsly, haan capal per ant effective bor ~h) = HRVACDLED ~ is ents on the balanced grown path, Ths Buran aptal pe person ~ HO) = HAC?) ~ must also grow w dhe same rte as nowidge, which sp ving the production funtion by L(t) gives us an expression for oxtput pe person: (2) VeOL@ = [0 ae KOLO} (0 =auJHOLE™ Since Ke) and HOLE) both grow arte go the balanced growth path and sae the production fxn is constant rtums to sal, ouput per petsn also grows a ate g on the balanca row path © From equation (1), the slope ofthe k= 0 lacus ox Ka + g + 5x)" where we have defined es s(l ag)" (1a9)'*. Thus ase ¢ will male the k= 0 locus steeper Since s dove not appear a ‘equation (11), he = 0 locus is unaficiad. Soethe diagram on the lt The economy wll move frm A od almced growth path at Eto new balanced growth path at E" ‘| | (usp per person grows at cate gui he tie that ses (enoed time yin the diagram oa the rig) During the trasiton fom Eo E bth 6) and k() are rising. Thus harsan capital per person and Dye capial ec person grow at rate greater thang during the trtasiton. From equation (12) this ‘eas that out pr person grows at arate greater than dung the transition aswell Once the tonomy reaches the new balanced growth path atime inthe dra), hi) and) ate constant aga. Thus human and physical eapal per persn gow at rate g again. Ths ouput per pervon grows ae 8 sganion the new balanced grow path A permanent ns inthe saving rate has oly a level effet on ‘ipa per person, nt a parmanen growth rat fect, Solutions to Chapter 73 ooh 3.16 ‘The production fincton it given by a) Yen = Key HOP LAL] “The marginal product of physical capital is thus MPK = 2¥(t)/OK(t) =aK (yy Hey" [ACLD]*, wich ca be wrt a @ MPK=a[Keo/a@nLee™[Heo/A@LE)}® 0 oc when KH <5 Similarly. K/H wal be alin whe 5 ~ Sy (RIE) < O or when UH > sy, sy. Thus KH des onvere toa balanced-prowth path lovel of QL)" = 5 5 1) Divide bth sites of te phys capital acumuaton equation by KA) toil Go BO s¥0 Keo” Ke Subtraction finction ~ Y= Kt)" H(0!*~ to equation (6 KE) 5 K*HO* fH | 9 RO exkeot Ho’ fH Ko” KO Ke, From pr (a, we hat ne ald roth pat, = sf. Subst this ft to natin ) ges ur te prow ate of Kon be laced owt pa KO_, fn] oe 6) RO neg] once o Fane] (On th alnced growth pth, Kis onsan sn thas H mast be rowing att same rate aK Fal, Shee he proces finch constant cto sae nd Kanda bah groweg she sane ut musa ow at ae on te banal gow path 6) Since the growth ate of curt onthe balanced growth path ess, an increas in ether sx oF 5 ‘il permanestly aise the grt rate of cup This i different than athe standard un eapeal made! tthe text with dinishing rem to jus physical and human capa. in that cae, we obained Solow ‘ype resus that ace dhe sung rate had 2 "level effect” but nc permanent "growth rae eet” 20 the 4) Taking the time denvative ofthe log ofthe production funcon yields an expression forthe growth rate of output © gy= 0p. + (ada ete gx ad gy devote the growth rte of physical and human capal. Equation (S) gives ws an txpression for gy. We nod a similar expression for gu. Dividing bot sides ofthe barman expt seeumulaicn equation by HO) yi @ HO sukotHO'? | KOT HO” HLH. sana gene (peda tn as 0) wy wa (KJHI +-ayng (KTH \We can now examine bow the srt ate of opt change when the a0 of physical to human capital changes Use equation (910 tae the Genvative othe growth rate of uu wth respect tthe ratio of physical to hums capt 26 /2(K /#) =a(0-—Dsg( Kj)" + att-a)sy (KE) Factonng ou al ~ as S/H from each em ile Solutions to Chapter3 75 K x] 00 sae aat eel)? {k | ai Cleat, a1 = se KAAD > 0. Thus if Ki es than ts balanced rom pat level of ey we have Bey /O(K/H) <0, Thus when KH stants below as balancedrowth pth evel and den ngs tonards she gowe ate of oxtput mut be fling the entire tie that KH < sli. the growth ate of ou ie falling throughout and wil be equa to g* ence K/M reaches (K/H)*, must be greater ang mally, ‘Thats fH stars out at a level smaller than several balanced gow path value, the etal growth ate of output wil be greater than as grow rat on he baled prow path. sblem 3.18 [pe vetevan equation are © YO=KEOM|G-an)HO)” aef>1 —@ AO=BayH —_@) KEO=VO 2) To pa the growin which tums out to be constant ~ divide equation (2) by Hi): © x iO He b Sete the pratusion tinue (tote extn be hin ft ysl pat sch ounce (9) Keo=sK(0%[(1-ay) HO)” Feo pout ata eta de ogtin 9 2D © ax Keo/Ke) y*ffa—ay draco]? We ast to exam te dares oft pow af physical exp Tage ine eae ofthe Interest () se poe avo gronh ropa pal O tuto/ag (= Cen) Ke REN=P-HO) HE) =e pe C0 Ben Now pee cane te roth mt of al (0), 968 Rectan ero ate pl se, BIO er, fom eaten) ®) ex(t)~(o- Dex)? +Seyex( Jetums out shat wheter or nthe seamen enverges to balanced growth path dapends on | 8 (0) ‘wher is preatr ot les than one ~ ha i, weber there are increasing or decreasing rete to physical capital alone. The cae of > 1 — increasing sets to physical eptalalene — ie epcied at right In thi eave, equation (8) sa parabola witha root at gt)" 0. Regardless of the inal growth ate oF apa, as longa is 00, the growth rate of eapaal nreases without ‘bound. Thus the economy does not converge to a | lanced growth path Nowethar ihe ease of = tL ~ constant returns o physical capital alane ~ simular. In that cae, (2) isa linear incon of ext) ‘the implication i the same ~ ay) nesses who bound ad dee io balanced growth path76 Solutions Chapter 3 [Now consider the case ofa <1 = dcressing ‘eum to physical capa slone. The phase diagram s depicted at naht. Equation (8) 03 esenbes an "iver parabola. Now, gu) 5 ‘rasan when gx () = or when (= Ips) + Bay=0. Solving for gx) yds = [BiA adieu Nowe that gx" > guince a+ B> Lor > I=. Tobe le of gx fromthe phase gram, (0 > 0 and so (is towards Ba Sinuloly, othe right oft, by (@) <0 and so g(t) ils towards ge Thus, a I, the grow Fate of ‘ial converges ta constant value of gc" anda balanced growth path exists, “aking the time derivative ofthe log of equation (1) yields he gromth rate of ouput © YOO) =e K(O/K() +B HOMO @agK(0 + Baa Ont tatnced woh ath x)= = (B= en ad Yo __aB +B-aB 0) Yq" T= ayet PEK Gay PH Ty ‘nthe balanced growth path, ouput grows athe same at as physical capital, which in tum is greater Problem 3.19 2) Taking the log of the production fancon ~ yt) = KOH)? — yes (D iay(0 = aki + lon) Taking the time derivative of equation (2) gives us @) dlnyeyfat=a-b¢/k(e + P-bte/b0) Sobsunting into equation (2) the expesions fer the dynamics of physical and human capital per wit of effective labor ~ Kt) = ag h(Q HC)? ~ (+g) and Het) = sy k(QH(O)P — (a+ VAC) ~ yl: ©) ataxefae=ofeghio"™ Me? ~Ca+ 0] Hyco" we! -Ca +0] © Merde Tsim ec dione [Aenea] Aatayeve) | a "| aakey Zab) nhc the derivates are eval tthe balance grow path vale, lnk Ink doh = ht. Using {austin (oid hes derivate, weave Aatnycoral dave] ake “* ‘akit) «singly Beast] o flexeril Fane) he fase DCO H® ey” “ sg (a— DRO" TN? + Asyaktey* hay” Solutions 19 Chapter3. 77 From equations (358) and (336) the tat, the balanced growth path valuse of physical and human capa por un of eetveabor 3 hh OD va Arab) and sna ton natcin de ee] [peat] Ei caf Pea a EAB eA] OP alse eortagy he Pabr-tabiagg ge Pn"roP? | (aw a(a~Iin+)+ Pata +g) =aln+g)(a-1+6) ant aly een 9) Aes (1a BXa+8) ink) Now ase eustin() oak theater derivative required fe the Taylor approximation danyeoial |, ddiovora] aan” ane) ol ain oe pee oy Adv pecaco ne? «19—Deukor™mD™ on TAKEO RO BBs HCO NO) Subst equations (6) and (1) ~the alaned-grohpah ales of physical and human capa per wit feffecive labor = ointon () node to eva the drtative ste balanced growth path Aatoyteyia] 9 fag! Bayt TOMMY 058 PD) aon “wee Peo} + Fag Bag® OEY ng ax IKEDD) 0D See, ata meow | Com ‘Aaa, some tedious manipulation fhe exponents spies the exesionseny. Net habe rgd manipulation excl the sare a shove and ho ino pete ace. The equd simptaton yells 10) oo? 0 69 DewKeOP HOP] Sahay Toe 8) + BB —Dla +8) = Bla +)a+ B= dts inaly78 Solitons to Chapter 3 atnyeorar) inhi) ‘Sbstuting equations (8) and (10) et the Taylor approximation ~ equation (4) ~ yi Gib dlay(g/at=-o0-a~ Pia pllak®)-Ink*] Ha pyta+eplinb(o ~ ink] pla pn @) ©) auation (1) canbe rr a dlnyenjéts—(t-a- Pa plealnkt)= Pin) —(elak* plan 9) From equation (1), ly) ~ alk) Blt) and cn he balanced growth pathy ig ese facts the Taylor appronimatin can be ewe as aiay(o/atz-d-a Pa alloy’ lay*] Defining he rate of convergence a= (1 == a+), we ave equation (3.6) inthe tet dinyto/at= allay lay caok* + lat SOLUTIONS TO CHAPTERS ashes 5 he autos desing the vito of logy ae gi by (Ap Rigeky ant O)Aysdahuy stag ot Seed From cnaton (1) and eign dene vale of A in period 0, webave Ag = +4(0)+ Re Rearranging to solve for Ky gives us: @) Ko=mnAg-K Now, period 1 ~ asin quasi () and) eieArek res nein A eek eee Subotting enon) int equation) yl © Ky=pallndg A) se gy Foal, suiting eit (ino equation) ges us GA Rres paldy—A) seas weave Nom n perio 2 — vein quate () ad (2) we ave @ wAyeReageky and @) Aaepaky eas Substituting equation (6 to equation (yl (10) Kz = paloalloA~¥) ena] tas #42(aAo A) eatas tena Fly ssbatitingesnton 1) to pation (give: (1 Ag =A +2e+p92(in dy ~A)+ pata tea Now, in period 3 ~using equation (1) an (2) ~ we have: QD WAS=Av3e+A; and (3) A, Substituting equation (10) i equation (1) yield 03(tno~A)~atasrtna)*éns=Paillnde R)+Pateai* Patas tas Fel, bsing ston (1) pti (12 ges +25-+Pa3llaAy~AlPq2643 7 PAC ) Using equation (7) to find the expected valve ofA, yield E(MA,)=K +8 + pqlinAg- A) since Fleas) = 0 Using equation (1) to find the expected va of nk il: EQaA;)= A ©2¢p93(inAg~A) since Elpaeas) = pxElexs = 0, Beas) =0 ing eto (150 find he expec sale of ns EdnAs)=A%5-pq2lindy 8) since E(p,’¢a1) = px Eleas )= 0, Elpatas )= px Eleas)= 0, Eleas)= 0.104 Solutions to Chapter 5 also means a drop in ==, since is asumed fixed ~ then increases planned expenditure. Allele equal, the bigger is Es in abso value), che mote tha planned expendure wil ib ~ and thus the mote thas ‘output vl end up nesing to nse 0 re-establish the equilib condition that Y= E Problem 5:2 4) The equilbrum condition inthe money maria is MUP = L,Y), Now suppose thatthe cara bank has 1 tape mere rate of = {Ata gen level ofY, deinand for real maney balances atthe trgeicret rate Would be L(Y), To ensure money marke equim, te central bank wl simply have to aus ‘he nominal money supply, M, to mau that MUP = L{7 YY. Thus the “LM curve" ~ the set of all ‘combinations of and dat cause ral money demand snd sippy tobe equal ~ wil be horizontal at he cetral bank's targat level ofthe tre ate, 7 1) The AD curve will now be vertical. First ofall, why is AD downvtard sloping whon the contra bank targets M rater hans? Ata lower P, MIP is kighec and thus the LM eurve shuts down tothe righ Thus the level of Y hat clears the money market and equates planned and actual ependtareis now higher, The AAD curve jg all de combinations of and Y that clear the money market and equate planned and actual ‘expenditure. Hence lowe evel of Pate atsocatad wi higher level of Y along the AD curve — AD is downoad sloping [Now suppose the central bank is targsting the mtecet ate t= 7. Ata lower P, the real money supply ‘would be higher ifthe omeral bank did nt change M. But the crcl bank wil simpy lower M so that the gen combination of income and 1, M/P = L,Y) again. Thus a lower P will ot require 3 higher level of ¥to cea the money market aad equate panned and actual expedite, That, regardless of te price level there one unique level oY that lars the money markt and makes planned and actual expenditure equal ~the level of Y where the horzatal LM carve” and IS ieee ~ and thu the AD ve is verte. Probie s.3 2) 3) How does an equa inreas in G and T ~ a balanced budget” increase in goverment purchases — tfc the postion ofthe IS cure? We need to determine the effec on Y fra given io examine the extent ‘ofthe horizontal shift of the IS curve Disirennte eS curve = Y= C(V-1)+i-x6}+6 — wth respec G avec [a a] two) ac ay-nlac ac! aia) a6 ‘Although continuing to use ttl deat aan, kop in mind that we ae ow boing and censtant In aon, we are asuming tht &T = 6 and so wv ac or simply ey Fg liteet ' ‘This canbe interpreted as meaning the change in Y for a given te simpy equal tothe change ia government purchases. Thus 2 change in goverment purchaces when Accompanied by an sual change ‘taxes ~ causs the IS eurve to shi by 3 hranntal amu gual to tat change in goverment purchases Solutions to Chapter $ 105 ow wehavto allow ora vanabe intr, We watt now he exe ofthe horizontal shi of Note tas we wate know be eis on Y fora ghen bt alowng forthe eects of “rable wcerest te irene eS curve qutin — Y= CYT) 24)06 wih pesto aye fav ar, a fa oe fo" Ry nlac “acl"H-e Leo oC! LWeane bong and cosa, ile suing 7 ~ dG owe hve ey ty Betyg ise equation “DUP LU) ~ wth eps Golding Mand Pensa ae & Cyan Ne SH ag" ag and rearing tse for 6 ye ty st Te Seitting eution Qt eto (is: x i “ Solving fr €VI8G, we have T=Cyer o <1 salts Ly fli) Teeheiznal shift ofthe AD curve tet 1 Cyr} /(I~Cyr +1, ety ty] 40 0 ‘that tax revenues is when nome rises To ind the slope ofthe IS curve, differentiate ECV, n*,G, C0) wath respect, holding everything else constant: av a eye Ivete above expresion yl he slope ofthe 1S cae: ae Tey eee) (Sig HEVAEITO 0g To sx how an increase in T(Y) aes the lope, ake the derivative ofthe expression forthe slope with panto (¥)106 Soltis to Chapter 5 <0 since Ex.E, <0 oO) Ee “Thus an increase in T'() eases the slope ofthe 1S curve to become even more negative. That, causes the IS curve to become steeper. 4) Weneedo Saerninc how an increase mT" (¥) ffs the impact en ouput — fora given price ~ of a ‘Ghange in. Fs, weneed the effec ofa change i Gon ¥, fora given P.Diflereniat the 1S equstion ~ Y=E(Vi-a,G. TC) — with repet 0G, holing (and P) constant @ Meey Xe See root ao" *¥ ag "es" ac 6 init LM equation MP = L,Y) ot spect G holding Pan M coat Sot &. wt ag aS 4G Subst equton (ato eaten) ag Ba aa’ aG Ly Song for 666 yi Ec Te[ectye)- aren 0 po Now to se how the impact of change in goverment purchases on eutput~ fora given rice level = is affected by a se aT" 2(4¥/46 |p) ee OT ey ole pty /ts)-Evron) ‘When T*(¥) is hiher, the increase in Y ~ for given P~ due to an increase in G is smaller. Thus we ‘bave show that te horizontal shift ofthe AD curve due 2 change in goverment purchases willbe seller, he agers T"() o (ET)GEr<0 of [Now we nate determine how an increase nT" (0 affects the snpacton ouput ~ fr give Dngela M. Fs, we eed he ef of change ia Mon Y, fora pve. Diath S V1 n*,G,T(0) ~ oh respect to M, olin G, (an P) estan: 4 r yee ee ani aM itteie the UM oquntion -MUP= L,Y) = wih respect to M, hot P cone et bye po aM YM aM PL, ol, aM ‘baat equation) so equation Fg Feet Fnarhy a am’ aM” PL, Li Sabin for dV ye: a Ere an Solions to Chapter $ 107 ay) Syl Pe Put Ey [Eby jh) ron) 20 “To se how the impact ofa change in M on Y— fora given P= is affected by aise in TV, lok athe dervative 2( a¥/aM| peace) 8 (-PLET) FTO on pe “(Egy /ti)-exTOOp “This derivative is ngative since, Ls and Ey are all megaive, When (¥)ishigher, te erase in YY fora given P ~ fiom an cease in M i smaller, Thus the horzotal shit of the AD curve doc to @ hang it the momanal quantity of money wil be smaller when T*(¥) sighs. ry <0 Problem $4 FFs iguiity tap, the LM curve is horizzeal athe low nominal interest rte that prevails, Intutvely, ta pve interest ete poople ave willing to hold any quantity of real money balances. Thus at higher invls of come (¥) poop are wing to change ther teal money balances witbst charge in the intrest fate Thus higher levels of ¥ no longer rogue higher to clear the money make, That, LM is ‘oraontal rather han upward sloping. Thi means that the AD cure wil be vertical. Gotrouph the procedure of driving the AD carve. A dcrease so P increases the supply of ral mane balances. ‘einai lower interest rate is needed to cleat te money marke fora give level of income and othe Mt eure would hit down As» teu, falls and Ynses. Thos the evel of cumput at the itersecton of thelS and LM curves is ordinanly a decreasing Funeicn ofthe price evel. That, he AD curve is “tually downward sloping ~ lower level of P rue higher levels of to clear the money ack and Inake planned expend ogel actual expenditure tn the eas of liquidity trap, the decrease in P — which increases the supply of el money balances, MP edocs net shift he horizontal LM curve, Ata give lovel of income, we doc equ a ower $10 a prope to held the extra money. People are wing Wo hold any quantity of eal maney balances a given Tove of ¥- Thus LM does ot sift down. The same level of Y couinues to clear the money Pea tmatket and make panned expenditure equal i setual expen, regardless of the price lve In other ord, the lve of ouput a tbe imersecton of te IS and LM curves eno Jeger 2 fineion of the pice level ~ AD is vertical Now, even pices ate filly exible (0 thatthe AS curve is vera, aggregate demand ea play ‘vole in determining curput. Supporethe AD fare lies othe le ofthe AS curve ae 5 a s a pct aight. The cuput bovght and sob = Inthe econcmy wil be at ¥, not Ys. Wehave situation of exces supply that cannet be eliminated by changes in price, ine pice does ne affect AD. 1) We ean now write planned expenditure a: () BZEQ 1-6, TMP) Lyn108 Solutions Chaper 5 “The inpotan pois that even ifthe ig. | [7 liquid ap ~ sothae LM isboramaal~the | [AD cure il ence again be downward 15, 5) sloping Go through the exorcise of deriving the AD ure. Suppose [Sand LM, corespond to some pres lvelP, Now considers lower pce eve Py As explained in pat 3. he Fonzosal LM wallace sbif, Butte 1S curve sell The fl in Pcises MP which 2 ompanm of wealth. With yr 6 his increase in wealth increases planned expenditure ata gen. 3 + eynesan Cross” gram, te plant expenditure lie would sit vp. Thus the level of ¥ required to quate planned and actual expat isaow higher a2 given. That, the TS curve shits tothe right to ca “This ISILM ciagram then el ws that tower Ps, the level oF that clears the money market and equates planed and acual expenditure, is now higher, Thus the AD curve ~ which i allthe combinations of P {nd Y sich that he money market ears a plansed and actual expenditure are equal ~ is once again ‘evar sloping. n this cae — lgaidity rap combined with real money holdings affecting planned fexpendnure —vercal AS curve ence gain means that AD isirelevant to output. Essenally, we have ‘evntroduced away in which pie act AD. Thus any stnatin of excess supply canbe eliminated by fling rice level ism 55 ‘fall expected inflation shits the 1S curve tothe le (0 [yew Ata given nominal ‘ meres rat, tbe eal erst ate ™ it is gow highr and thas planned ‘expendnure slower. In a“Keyaenaa Cics* 0.4, Sloot ara112 Solutions w Chapter S Cutts determined entirely inthe maney markt inthis model. In respase toa disturbance ~ since i, M and P ae constant ~ must be Yat adjusts to encureoquilbrum. Ae T fal, ¥ mus fll by an equal )Agaia we wil ook athe effets on Y fr given P ‘Weare azuming the contra bank wl ensure money market equilisrum. They will do so by mewing ‘money demand withthe appropriate money supply to ensure that he nominal exchange ate romain xed, “Thus our akeraton tothe money dems fencson es ct mean thatthe nominal exchange fat wil be affecad by tax changes — i sply mean that the ‘etal bank will have to acto ofthe efits of {3x changes on money demand Afr ill 1S® shits othe righ fo the sme reasin as desonbed above. Any increase in money ‘demand tht i caused by T fling i simply met wh an crease in he money supply by the eral bank ~ Meno longer exogenous We no longer aced a opin ¥ to maintain money markt equilib. The end esos that Y sees to Y,, We get the “usa!” resuk that 3 tax et ncreaees ouput for a given . Problem 58 Plana expenditure i given by () B=CIY-T) + IG) +G+ NXUPY) For floating exchange rte and perfect capital mobility, we ave Q Y=CW-T+lit-x)+G+NXGPIP) IS" Cure @ WP=LG,¥) LM" Cure Fora fxed exchange ote and perc captal mobile, we have equation (2) fo the IS* curve athe exchange rte equation Wore For2 floating exchange rate and imperfect capital moblty, we have (©) Y=C(-T)+i-x°)+G-CFG-i4) 1S Cune © MP=LG,%) LM Cone 8) From equation (3), wth MIP unchanged, Lr, ¥) must be unchanged a wel forthe money market remain equiibnam. Since 1 does no change and beeause Ly > 0, ¥ must, ries that mene demand rer t its ‘nga valu that gen, Thus the LM* curve shits tothe right Lew. The IS* curve is unaffected = money demand dots act appear in equation 2). Thus fra give P, Income rises to Yi and rss to aw he domes earrency deprectes), Foal since NXipy > 0, there ne meteases ne exports fora gen P Aceon tected Solutions to Chapter $113 1) Again, dhe drop in the demand for money ‘hes no affect the [S* carve ation, he smal exchange rate remains pessed st ‘he central bank simply veduces the money supply to match the decrease a money demand, Thus fra given P, income, the xchange rate and net exports ae all affected Wiha fined exchange oe, dirurbance nthe money market hye > impacton ¥ fora given P. ii) From equation (3), the IS** cune is ‘uraffected. ‘The LM curve she down. Ata {pen level of income, the interest rate must be lower erder to drive money demand ack up and keep the money marker a equlibrium, From the diagram, income fora fim Pies, Since the domestic iret ‘ate is now lower and since CF”G-i")>0, capital dows are lower. Thus NX must be bigher in onder forthe balance of payments tobe 0. Since Xen >, ¢ must be higher. ‘Tate, the domestic exrreney must have deprecated 1) The foreign interest rate rises 2) Since Le <0, the ie in tend ordi real money demand. To oft this and hep the money marke in equilibrium, Y must be higher Since Ly > 0, a higher ¥ wil kosp ‘eal money demand snchanged and ego ‘he unchanged eal money soppy. Thus the EME curve shits tothe nt From equation (2), the isin roces Planned expendinte at a given since 0, This reduces the level of Y hat quates Planned and actual expandiure ata given € In ther words, th IS* curve sits tthe lek. Thus income for a given Pres. The exchange rate rises ~ the dames curency procs. ally, see NXg > 0, net exports ise de to the depreciation Y Yew ¥114 Solutions to Chapter S {iy Again, the IS* curve shifts tothe left due oT tothe nse inthe foreign terest ate The : ae romunal exchange rate rominspoggod a © ‘The coral anki offeeting te effeas on money demand with changes ia the nominal money supply. Thus for 2 giveaP income fall Since the exchange rate does not change, ether do ne pons, Si) From equation (6), the LM curve is tmaffeced by thee in it Ata given i, the ‘nv in i edceseaptal ows and thus ~in ter forte balance of payments to equal O— ast increase nt exports Thus a2 BED i, Planned expenditure is now higher. Thus zt [Biven the level of ¥ tha equates planned and Sotual expendi is higher" The IS** curve ae tothe night AL given P, the level of ‘One way to se the effets on NX and efor gwen Pi the following, Differentiate both fides of equation (6) ~ the LM curve — with respest to, holding M and P conta: ow ae ge Seti wc age eo) bite ih of ogi () the 5 ane rep ola nd @ cmt ney at, th cre in ) ye Crt Ge hat Ge ME ‘Subsrtue equation (7) nt equation bd ud aoasmac quia Collect te ems in i" pss [Hi-eya] ey) Sohtins to hoyter S118 ote that CF" (2)> 0,1, ge €0,{1-Cya] 20, L, 0, Ths Adi < 1, Sos ses es than i that 1-1 fl and thus captal flows decrease, This meane that NX mist nerease t given Pio tosure a balance of payment ual 00. Fal, since NXoep > 0, sF NX ries it mse the case tate fee at given P. That the domestic curency depreciate ©) The country adopts pretctionst policies that net exports a a given eal exchange a af higher tan before — ') From equation (3), the LM" curve is unaffected, Since | et exports ate higher at given, panned expendeur is higher ata given «Thus the level of Y that equates planed and actual expenditure ata given ¢is higher. The IS* eure Se tothe right, Fora given P, dhe lol of come is vrchanged ~ ss determined enizely ss tbe meney market eve Allthat happens i a drop ine ~ an apprecation of the emer cutency ~ which kepe NX unchanged a given Protections policies do ce improve the tre balance in ‘his model A) Again, the IS* curve sits tothe night ‘Tae nominal exchange rate remain pegged t 7. The central bank adjusts the noral money sock to ensure that the exchange rate doer tot change. For a given P, income nies Even though the exchange rates unchangs, ret exports a gyven P wind up higher inthe ‘2d di tothe prterionis poles Thus ‘unlike with a losing exchange ate, protectionist policies do work wth a fxed change rate vegime Ii) The LM curve i unfit by the protectionist policies. [a adit, the IS** cure 1: unaffected — see equation (), where NX does nt appear. Smce CFG i) is not afc by this poy. NX canon ‘ange inthe end either, Thus income for gives P dots ax change, nor does net experts What rust Iappon is that the domestic currency apprecares —« fils ~ which oes the effet of the protectonst policies on net export, This isthe sme resut tained with perfoct capa mobility and Nenble exchange Problem 59 f 2) With the foreign exchange market aterecion, the blanc of poyments equation i 0) CFG-i)* NXCY, i-2",G, T,ePrP)=2 where >0 “Thus net exports are given by @) NNW, 1-#5,G, T, Oand soe would nee without bound. Ife were less than .€ <0 andso« would contmually fll. Thus when all prices have sijused, we mast have e~ p for #10 ‘eran usu Subs} =Oandi=€ = Othe Eten =m =p hy = 3) m= “Thus ence pices have fllyajuted,y = 0 and Ife ito jump to exaly m and then remain constant, we need an equilibrium where ¢=m and é = 0. Since = €, we must have romain equal tt filly adjusted level of. Thus with constant, must Adjust to ensure money marker oquilbium. Substinning p=6y, «=m andi = O ito the IS equztion viel: @ y=blm-p) + aby Solvang equation () fry yields: (©) y=BUI-20)}m-p) Sobstning the aesumpticn of = 0 ito the LM equation gives us © m-p=y Substnuting eqatin (6) iat equation (5) ysl @ y=[u(t-a6))ry Thus we acd the parameters to sai @) tx or equvaient ©) 308-1 | Solutions to Chapter $117 | Problem SUL Fe Tanay th denvauve of both sos of equation (5.12) ~ ¥= EC, =", G, , eBYP) — wih respect to 2) pang #67, Pr and P cons ye Eg t+ Bee ty aby Bg Boye “ing the derivative of bh sie of elas faye tin (5.21) ~ CFG 8) + NNCY Gop) Do wah pectic Y bldg 6, P nd P conan pe: a a oS any 11%, ge ee Kaye ) CPO, oy +N ge i. Rearing eatin (1) 0 sole fr Yl (ey) Eye a Ean Ear sabaing equa ) nto oan 2) eave wh 4 a NXaeellEy]_ NX “oS any +N, ee ene Ey PO gy NX ine aY Er Ene Caen terme yes: ay ee Sl cep en, ge PE xy AEE ay [FO Be PL Eee Ths aly th slope ofthe IS ares se by: Yar {roxy + S| CPN, ES We ae told that NXy + (0 = By) >0. Since NX (Een 2 I, the term in brackets ia he numerator i lke porkive and thus the numerator uel e negative. ss sraghtorard to very thatthe denominator peste and thu IS** remains downvard slong ¥) Rearranging equation (2) save for dV ils Vi] fer +nx, |S nny oy te] TO ee age else Ear {CF (0 + NX;_ 18 postive and didYuw is pte, Since NXy is gate, the mumerater i postive “The denominator is positive . Thus ae we move down the I** curve and Y rises, ies as well, Thats, ese move down the 1S** curva the domestic currency depreciate, ©) node to se the effet ofan increase in capital mobility, we equation (4) 10 take the derivative ofthe Slope ofthe IS curve with respect te CFG)118 Solutions to Chapter § (aj ) NXeoew at NXy + (1-Ey) Laven) = ecray oT [ermen, ‘Again, we ae told that NXy + (1-Ey) > 0, Since NXerey (Ege 2 I the mameratris postive, Thus « fire in CF *()~ an neease inthe depres of eapatl mobilry ~ cause the slope ofthe [S** curve tore or become less negative. Thats, te IS** curve become fer. 5)1) At price level P*— and dus at real ‘wage W/P* ~ employment and opt ae at ‘heir maximum possible levels. This is ‘were the Ibor demand curve and the labor Supply curve mtersect and there is 00 unemployment a) ii) Ata higher price, say P> PY — and ‘thus ata lower real wage W/P' 0, capris lower at L "(and P') than tie at L* (and P), 1) The above information allows us to ‘answer part (0), Ashe peice level nzes toward Pr, employment is datemined by Iabor demand. Thus employment and oust rise a the ecemomny moves down the bor ‘demand curve ‘Ac pice P*, ouput is at Ys maxima possible value As the price evel rises above P*, ‘oployment i determined by labor supply. ‘aus employment and ouput fala he economy moves down the labor supply curve. Seethe diagram for what ths implies about the shape ofthe aggregate supply curve. At prices above PY, the AS curves backward bending ‘under the "shoreside” asumpticn Problems $13 Fortis tobe the case, the effective labor demand curve mum merset thelr supply turve night a the point a which becomes etcal” Any forte rightward shit isthe CHfectveinbor demand curve would nc cause the point of intersection ofthe two curves to ‘ange. See the diagram, Thus even fe (ective Inbor demand curve site ot, employment dos not rise, Thus output eannee tie above Yous Problem 5. In Model I~ Keynes's Mod — firms ie labor upto the pont where the marginal product of labor equals the eal wage, Thats Lis determined by @ aF=W/P [At given price ~and thus ata given ral wage the level of Lat equates the marginal product withthe fea wage snow lower afer the fallin A, Thelsbor demand carve sits tothe lft Firms reduce the [mount of labor they demand ata given price. So ouput replied by Gms at a given price level is now Tomer fortwo reasons, A given amount of Inbar now produces Iss output and firms choose to hire less labor at gen P. Thus the AS cuveshits tothe let In Mosel 2 ~ sticky prices, flexible wages and a compettive labor market ~the AS curve is sil horizontal ¢ P= P out to Yue where Yu ise level of output at which marginal cos just equals the fxed price Inve. However, Yiu self will ow change ——— ‘As desenbod inthe answers to Problem $13,3¢ | yp L ‘Yaw the effective labor demand curve merece the labor supply curve right atthe point where ‘comes verucal. Now with A lovee, the downward sloping portion of the labor demand fare shifts tothe let — ata give rel wage, be level of hat equates the marginal product of labor andthe eal wage is lower. Tis mens that there is anew lower Lua. The maximum ‘amount of labor wich tis profitable tote 0 mest demand 2th Fed pie is now lowe. ‘Teerefore Yn i now lower fortwo reaons | ee | ‘The maximum amount of labor tha 5 profeabeto ie atthe Sxed pice i lower and given amount of Inbor now produces less output,120 Solution to Chapter § ln Model 3 — sucky prices, lxible wages and ral labor marie perce ~ we gt essentially he Same result 35 Model 2 The level of onspc at which marginal om jst equals the fed pce i lower ‘erthe ll m A. Thus the AS curve ic honzontal but out 93 lower Yous In Mode sargnal cox w 2) Pen ) Pema ‘Aa in A raises marginal cost ata give L. Assuming the markap doesnot depend on A the price level ‘ses for a given L. The AS curve shifts up regardless of whether = downward sloping. pad slop, chorion sucky wages, flouble ries an irpersctcompettion ~ the price estas # markup over Problem 515 211) We an she frp andres ate. Bop by ubsing he expec fo inion = 3 =0y ~ tote gnks me ep aueahip= y= ap) to soa ©) 909-49 990) Rearangg he ore mht quia codon ~ np = yle @) 40)= 0 -mide Substat egstn)atosqaicn (1) 0 obtain ¥€0-el(pe) m0) fe-Byt0}. 9) Sevens tra > cy) 0) © y= Substting (0) =O and (= mit in): © 0) (a/k) [ney ~ pee} Fr co ences <1,2>0, > 0am new (1-208) ‘The sgn ofthis derivative wil be determined by the sgn of (1-238) If (1 -280)> 00 © < 1/28 then 5V/20 <0. Thus for “anal” values of 8, a marginal inceate price Aevaalty wil reduce output volatility. 1f(1 = 238) <0 a> O> 1/28 then OVIGR > 0. Thus fr “large” sakes of, a margial increase in pace lebliy will actully increase ouput volatility. (Netethat we ‘sesumed fom the outst that 26 | or equivalently 0 < I/a.] Finally, note that he higher i a ~ where 2 ‘apres how responsive planed expenditure isto change in he ral interest rate ~ dhe smaller isthe ange ‘of rove which mereazed price Senbisty seduces out volatilityem 6,1 8 The tdividua' problem to choose labor supply, Lo maxumize expected uly, cndtional cathe fealzation of P,. Thais, the problem i: rmaxe(C\- 17) ‘Sobsting C,= Ps. P and nal aap mete) Sit ini P i woman, ie be orto a eee) e)-4 arb “ee an contin i ive by Q) EVP, PyP,] “LI =0 Lo" = EER PIP) “os epi aersaplyig y: yu =felemln}}" “aking th logo bet ses of eu (2a defi ays: ©) G= y= DPREL ID 1) The amount of labor th individual supple fhe fellows the ceaity-equvaince rule given by og: 6 [r= DEEROP. PIP. Since InP) is a concave function of (P,P) ten by Jensco's noqualty InE(P PP, ] > EEOC, PIP 1 “Thus the amount of labor the indrvidual supplies she flows the cecaity-equvalence cle less han the optimal amount derived in par (2). 6) Weare pen tat © bi, P= Ela, PIP) +4 NOS) ‘Taking the exponen friction of both sides of equation (5) is (6) Bi/e= cE gs ‘ow take the expected vale, condationsl on of bth sides f equation (6 © Elle./e)]p,] =e PFI e(e% |x) “Thing the natural log of bth sides of equation (7) is ) E|(P,/P)]P,] = Efincr,/PyP,] +ne{e|F,} eee that tne" R,) ius comnan whose values independent of P,. Sbsiting eguatin into equation () the optimal amount of lg) abr supply — vs ws uty a) -felince, Py] +10 [e"| |} exsimply Solutionsto Chapter 6123 0) =[Vlr— 1) -Ehncr,/29R flr M}-finele™ |, “The ft ter ~ [= D} ERP, PHP} — ie te canainy-euivalence choice of og) abr supey, wile the second term isa constant. Thusthe hat maximizes expected wilt differs fom he cenaiay- tuvalence rule ony bys constant. rablem 6.2 rrr yur) 2) Tindal rode istomanminC | J 2,!"Cy%""6| sect othe budget ceostit, } P,C,8)=¥). Se up the Lagangin r rela aaa seal o 2 Laimcgronal a Lc] Te tesorder conden fo 3 epumtine d Cyi yo all zineyenng]” B}asncytrns a, 2c; We can simplify the exponent since [nf = D] += Mn = 1) and (n= In] - 1 =n, Thus the pecs epron pl @ Cy! ry } al | arcgera aking basa of quan (2) tothe exponent -n yi ie Sard 2] Fairer | é. (ae,)” z ‘2 Forcach good oth unt ier lb mato ke 0). Th fr on cher gs, Cae a ty yuh u 24] | zines % wc % far} u Dividing uation (3) by equation (4) vel ‘ 3 er cy naz, we sy124 Solutions 19 Chapter 6 Simpliing ys © Cy/ea =[77)"(Z/24) Wing ia tems of Cx we Bae 9) Cy=(%/0))"[z;/2) Substring equation (6) tothe budge constraint, | P,Cidj= VY, yes: » Fa lee"eye)eas Pulling the terms not nde by jo ofthe negra ign leaves with can | a | 2 nga, snd tg ts M —T Mize ney zis Lt 5| etn (oral got, Ths uring ton yr me sl ge re wee { Laes| 7 ziseyng) ya ; _ i crtngirtn | 4 ailing ron im + -dj | he ers) PP apnoh Izy tera ae tg htt sed ft tg gta . ay yen (i 1 qj | apa}! am Len] i[Leens] | J Taster TY vim cay) bape “s] Since (n= D]=1 = Mn= 1) VC =), equation) ean be rwrton 3: Solutions to Chapter 6125 an) ¢, | zperai| Doining he price index 25 re an Pe] Fain] wehove ane a } Notethat } 2,2, -%ay = PO" Using thief, equation (8) — individual's demand for good j ~ ean ro be rewritan a: YZ, 13) C= ©) yyy ‘his an be aang kd 09) 642, 2) (iu?) Equation (14) gives individual i's demand for good j as a function of the taste shock for good j, good j's ‘ne pes td inal eleva ©) Taking he log of bth sides of equation (14) yds: (8) ep -nG;-9) + GLP) ‘This resmbles equation (67) nthe ext However, the pice index given in equation (11) isnot simply the average ofthe individual pis, 25 isin equation (68). Problem 6.3 2) Model (given by: ya's tbat ye ‘This motel says that only the unexpected component of many, affects oupit, Mosel Gi is given by: @ y2a'm, eBoy ‘his model says that all meney maters for utp. Swbstinaing te szumgion about monetary policy ~ m= <2 + 6 into equation (2) yi: © yeast Blezisaley, or collecting the terms 2 ( yore" fens +e “Tae mode given by equations () and (@) canat be ditnguited, Given some a'and a! =a" Be! and =D have the same predictions. Instivly tis nt posible to separate the det effec ofthe 2s on cuput fom any pornbleinciec eff they may have through monary policy. Sot could be the ease that ony unenpecod money matters andthe effect of ream ouput hat we observe is semply their direct tHfex However, ould also be the case thatthe expected component of money afets ouput and thus the eff ofthe as that we observe consis ofboth the inet andindiec fees,126 Solutions to Chapter 6 1b) Substituting the new assumption about monetary policy ~ m= 2+ Was esto me els: ©) yer o'ny + Plemty wate)? % orcolleting the 2 ers (8) y= (a+ Beau + By wa + Ba In ths ease, is posible to dtinguich berween thee heorie, Model (i) ~ ely unexpected money smaters~ prods thatthe coefficients on the w's hould be zero. Model (i) all money mates ~ dove et predict is Problem 6.4 ‘Tsing he corcect price index doesnot ake he analysis ofthe individuals behavior, Thais, equation (64) eto heh Ss opal lane ice ef via pods Pole sul hold" Silat, individuals optimal choice of lbor supply is unaffected His il gven by squaton (642) in ste, oF Gy ‘We nee to solve for equlibrum ouput, Y, and the price lve, using the fcr that total pending in te ‘ecrmomy equals M, oF © Jr tte Ol ua of gat Since the production function i Q.= ouput of god is ot Mabtipying bot sides of equatcn (1) by P gives us OF a From equation (11) in Problem 62, the price index — with al the Z;'s equal to 220 ~ is given by Te ken © P=| Teri) Sobsiuing equation (S) iat the price index given by equati (6) yells en eo my pen orl 7(2w) a) (2. Jai! PACs i i Co ie «re ow Rearmngugeqnion (giver athe equilib al wage «wt Poa Subsuuting equation (9) into equation (8) gives indviual is euput Solutions Chapter 127 Substutng P= and putin (10) to euton 3) yetds (n-1) ay ta am 0) aia) Since behing iid the ie is deny webave: freely 1 an oY dae Saving equation (12 fr P gives us one M [ea=ni' Equation (13) identical to equation (6.47) inthe text. Foal since repate demand is given by Y * MUP, uiibram ouput “ (=p a uation (1) eric to equation (646) inte ext, Ths sing the comet prc index does nc ae. ‘he expression for equllbnam ps and ouput sae inacton an Y= Problem 6.5 2) Substsing the expression forthe nomial wage ~' = Op ~ int the agarente price equation — pews (I -a¥-#— yields p= Op(1-a)e-s, Solving forp yee ) p=(-a¥-svC-8) ‘Substuting the aggregate ouput equation ~ y= s + af and equation 1) forthe pic evel into the suprgate demand equation — y= m =p ~ yk s+ af=m-[(1-ai-s/01 6) Collecting the terms in Cleves ws wth f+ {() ai -€)1= m+ {a1 -8)1-5 (bing common denominator and sinplfvag Be ws: [a -6) + 1 e900) = m+ [2 -€1 Os -8) (129% -6) =m + (6510-09) tod thus finaly, employment i sven by =em=6s Oe ob Subsciatingeoustion (2) nto equation (1) yet C= ai(d=8ms6s) G-o0-e5) 0-8) Sinplifying sves us128 Solutions to Chapcer 6 Y= Bm +(1=apes~ i 1-80-28) B= a0) “Thus the agregat pie eel i ve by aye @ p= (aay Substteting equation (2) into the aggrepate cup equation — |, Bl=8)msa6s _5~085-+al1—8)m-+a0s (d=28) (=a) And therfore, erp i given by: yaaa aa) +0 ~ and simplifying yells Finally, to gt an expression forthe nominal wage, substrate equition (3) nto w= Op, “Te ex sp isto sr how th degre findeaion aes th responsiveness of employe to mentary shocks, Fir te gusto (tof bow enplaycnt erie wa = Oe G-Omets @ Oats am” =a) ‘ge bcc crt threo et fecion} 28 U-a9F o Thus as athe des of deat 9, othe anou that ploy Wl ange a ta ‘given monetary shock, : ‘Te next isto se ow the dere of indexation af the esonsivness of employment to suppl socks. Firs, se equation 2) to fd how employment varies wi. = ™ a wo 8 » oe a “Talang the derivative ofboth sides of uation (8) wah respect gives us 2] (ofi-a81-@-a) 1g 28 c-a9? Gan? “Thus an increase in the degre of wage indexation, 0, states the amount hat employment wil change due to psensoply shock. ° + Fem equine vrnce ef employment igen y fool, fo P Laas] “= “Lama] where we hiv dhe fit tat ans atndgendo anda ables wah vais Vea We ‘eed f find the vale of that munimizes his vanance af employment. The firs-order condition for his 00) Ve Soluionsto Chapter 129 Ve [oe | ew} je J} an v. 8 La-am? }" * La e8 | a-omy? J" Equation (11) selfs to (1-00 Vat OV, =0 Collecting the vera a8 gives ws f(a + V,)=(0- 2M Thus the opal dezre of wage indexation i d=2)Va ov. % ‘Given the result in pata) ~ that indeation reduces the impact on employment of monetary shocks but increases the umpact Hom supply shocks ~ equation (12) steutive. First ofa iY =O ~ $0 that there bre no supply shocks ~ the opti degre of indexation sone, In addin, the large is the variance ofthe Supply shocks elatve tthe variance ofthe monty shock, the lower ithe eptinal depee of indexation. =a) 76 1©)0) As ated in the problem: (3) my - 460-9) where >= anya (1am). Since w = Op and; ~ 0p, equton (15) becomes: (1) y=y-#0,p- 99) =¥- (0-4 From the production fincin,y,= s+ af andy 5) yo-ysale-) Selvng equation (15) or employment at frm yells (5) 6=6# (aXyi-¥) Substting uation (I) for = ito equation (16) give (1) G=6- (aN, - bp Substating eiation (2) fo agarenate employment an equation (3) forthe rie level ito equation (17) seerar + ofand thus we can wrt: ine -BHIA~2IM-8) 56 oym gaoe-( -H{C-@) =H] ay 4 == -ao a(l-ad)—~ali-ad)" hich imps 1 09) 6 Talal -0-, - 040-0] «0-6, -09} ©) From sun (19) the aiance of employ fis ie by. Fat-0-6,-90-0)|), [ooee,-08 F a ar Te sade cndtion rte vale of =the ee of wage ination tr = tht ins the ‘arc of enloypen fi 20) varte, 2Vare) | atl-6)~(@, -O)h(1-a) fa+@-08], ep aa Mla Sain PY Equation (21) simplifies to (22) (at) +8) 0. [4(1 0} © 06(1 -a)}4C1-a)Vigs (a8 +0,9 -0896Y, which pie (23) 0,4 Vy +0, (41? Va= [oll +8) + 8611 “a6 -2)Ve =a -O84V,130, Solitens to Chapter 6 ‘Tous 6s ven by: yt (208) + 4) ~a)}9C0 -a)Vig~ [04a (a 0, La) 041= HCV 104-8 PVH 180-2 Vy «iy We ned to find valu of © such ht fists condtion gn by eatin (2 bolls wha Bn Shuts, wencadto finda alae of uch i economy de xan en by, ie prectnive fr ~ mee to maize teemloent feta ~ aber coose 8 a5 wa ‘Srung 01-0 wonnien 2) gives Ge) adsense 800M. wh mp G0) ON 2G -a)Va)=0-0Ve ‘Tus Nasu ae of 8 Ve Tove, ‘Ths exacly same vale of we found in pr @) ~e eguton (12). Theale of that iin dhe varanceeaggepteMacuaton in cpl ass Nash elim Given ha he fs te ‘Soca 0 arr dege oops ndoutin hs jal for any dno Ht choos G3 el an e= Problem 66 5) The represotatve individual wil tthe rie aqua othe average of the opial price Fort and the "gan + (1=@)p. and his olds forall periods, we have (+ (1 =p.) + BE tes + C= AE po V2 1b) Wath synchronization, = x and ps x and hs: G) x= (m+ (1-4)x) + Este (1-2 Semplifing yields Sem 2G em m+ Eyes JZ => [LCs = $+ Eames 2 and that: @) x= (res Eman V2 Firms oa thar proce eal tthe average of thi peri value of m andthe expected vale of next peas value of m ©) Subst p.= x= (my +E; mys) into the aggregate demand equation to obtain yeem= (+ Eames 2 Sampling gives vs (9) y= (n= Eyres ‘Azsuming that m follows 2 random walk so that Erie =m, we hve y= (=m) or sunpy Ox Now, substating pn =.= (m+ Ey mos 72 tothe aggregate dean equation for paiod «+ 1 gives Yer Mon [Te Eyes YOY Cry» Ey )= (> Ese 2) Assung that m follows a random wall 0 x Ey ~ my We have enn m2 Solaions to Chapter 6131 or simply Yor me-m ‘The coral ecu ofthe Taylor model doesnot comin to hold. Nominal diurbaces tat occur in ‘eneds when fms ate not sting pices food through one-for-one into ouput ~ se uation (7) Hiowever once ime set prices again, curt reums os borma value of 0 ~ sx equation (6). Ibtutively, we have removed th mechanism by which the Taylor model geerates lng lasting effects of ‘ominal disturbances, Inthe Taylor model, once fms gett adjust pie they dont adjust fully toa ominal disturbance because they know tat nt al firms are adjusung tha tine. Ths fully adjusting hil ehange their elative prac, which they are alctanto do. But her, Sims know that al fis ar also ‘Zasang tec pice tthe same time Thus fms real prices vl nt change if they fly adjust and hus they dos Problem 6.7 ‘When tis eve, the price lee is given by @ prep Siete pl denotes the price st fort by individuals who st heir prices int = ~ which was an odd period Thence faction f of firme stp — while py dees the pic set fort by individuals seing pices in 12 whieh was ao eve pend ad hence fraction (I =f) of ims stp Now, uals the expectation Ss ofperiod t= ofp and thos ©) p= Eas pat = Ee Gmm+ (0-900 Scoscating equation (1) ite equation (2) and using the fat that ie leady known when pi et and is ‘hus not unearned (©) p= dsm 21-4) Op + C= fp) ‘Some simple algsbra allows us to sove frp é (00-5 > ra-@e @) pt Em OF Now pq he exec a of pid 2 ptm ©) phe Epi Ee le C9) Stina ss Cato pez ee (©) p= Exam + (1-6) [fEqs pr + C1 8p] or eee etd tan sie of ui ae ei and since pecans Moun Or eqecaionss ofponcdt-2ef deen opens arte gu. Tawa ' rerio (Bean agrgtagg team DG} ne weave oan lt feat pees tha Fy Eom =m. Stag etn) imoenten Oye _ Da=OF 9 apg? adam 4-0 A Eran, AMEE Gt 30-2 Calling tems gives us : To-¢0-aor ec-ane } fa. POOF“ O-O4 I, on, oc -9[ SM Sr eeeenoe ich anpifest: D2 Pe =p?132 Solutions to Chapter 6 Collen the ts i ge d-wf-0-00-9 19g (~eaear Pompe ory +2 o-oi" “Ta-oF And ste pce stm period ts given by © y= Eom [Nowto salve forthe price se for by those sting price int 1,sbstue uation (8 into equation (4): 6) psy pm, om, STa-or aoe ‘Adiing and sueracing Ez tothe righthand side of equi (9) ys fe rape Em Since (1-91 = 1+ (1-4)F=0 O94 (1-4) 1.6 (#9 4, equation (10) cam be rowan a fl + 10) pf = Eyam + PB, amy | cana ra-0F L “To.gt an expression forthe aggregate price level, subsite the formas for py! and py and (0) ~ so equation (1) Pint] Evam+ Simplifying yi 02)» o 1 aati eam Bram) ane. “ ilteim ram) Tosave fr apt in pest sting qui (1) ie retin fr ars demand penn . 4 0-F CCollering the wrms iE. mas wll s adding and ubractng Em tothe righthand side of equation (3) gives us 83) yy =m — Eyam — (Eame ~ Eyam) 4) Beam + le CO em Eat a pe 10 0F Since 6-1-6 =f 41 =fyand | =(0-#)f- 4 (9), equation (14) canbe rewriten 38 09 y= 8 a-oF Equations (12) and (15) give equilibrium price and ouput fer an even period {Em ~ Ey-2m) =(m ~E,-1m} “Tho analysis forthe eas oft ods entical tothe procding analysis, except that he roles of fand (1-9) ae reversed, Thus, devations analogous to those uso to aban (12) an (18) eld ws isp ele am Bam) Setions to Chapter 6 133, a any (Eyam, ~ Ey-2m)+{m ~Eya1™) i=a-0-5) uations (16) and (17) gv equilibriom price and eu for an od period Prahlem 68 TU dea sic with firms that set price in ld periods, Suppose tha period isan even period. Then Px tothe acest for an even pened y's firm ta ase pes mold penods, wile Paste price set for an (93 pad by afr that sets prices in od pends Fro equation (11) in Problem 6.7, a is given by. pe Beam + (Bete) Opus am age (Be Vida nega tan we Eo ‘ “Ta-oF veal pial poe pi . Operon te Fen) Plo 6, sgn pin an ve peli a and Baym my Ths ma) @) Pe =a (mm {Ecam = ® +t Fam) © rerBam ee 2 ai, sce flows ano wk tis egal sma ra-pF Subaiigounon (6) equi () lt opin rie in period 7 "om, te © patogmesC-Om2 ie © prema “Thus the amount of profit frm expects to lose in pes, Ee (be -Pa) proportional: r a-oet é dma tlm ma) tm A-mea + dh-0-i, =0-e >t ) Epi Pu" = Ee] + ~ma)+4m.2] Siping sve us . Eitbe-bet = Bob + mada ¢ dna ©) Biba pe Now, th price set fran dpi by 2 Fn that ss prices in xd peiods is given ©) Foo Eames Since m follows andor walk, Es, mos = my and us: 10) r= mes The optimal price for petod t+ 1 is given by OD pat = may #(4=9)Pe From eguation (1) im Problem 6.7, he aggregate pric level nan odd period is fe gE (m=) 02) Prey = Erm + 91 Eamat)134 Solatons to Chapter 6 Since Ey my my and Eyes =m, we have , acs ane ee 02) pra =m1*Fa-garH lm me) sain oat) os (1 pin pels +1 Ce 4) pated ChB +o “usta off fom eps ol ped] pre ~m) . (15) Ee(Paes —Pa"Y? = Be iat — 4M) “O-$M CCollecing erm gives us Expanding the righthand side of equation (16) yes: Eq(Pyoi “Past D? =@7ErC-4 — Ma)? + p E,[d€m.a — md E (mies Myer eg MH) + 4 (a Pp o a a Nae that sot flow ado wa, we Bae mrs metus) = Es =x) as ms man) = 0 ‘ws Sanam nth ah sd of unin (7) oo ang i fm ean icon oy Thue alacant prs msatig peso pres xp E,@a- put) + Ex Gees - Pei"), is Proportional to: f a9 F RO Pein =m 0-0-1) (18) Exp. Lessa © 47E (my 0)? +4 om,y a)? 4 [Now we will deal with Gms that se price eve periods. When pred tis ane period, analysis parallel vo tht used to derive (8) shows tht th amount of prof firm expects alse in ped ts ropertcal te: (19) Eo Ga- pit? =# Eas -m)? Analysis pall to that used to derive (17) shows that the amount of prot frm expects to lose in prod 11s properuonal te: oo i [iSaepe) Bite ‘Note that hiss identical (17) excep tha th ose of and (=f) 16 rversad, Proceeding as above, we ote that since i flows a random walk TE een = tay He =) = Ey te ~ he JE (4s =m) ™ Cy “4 Yes ~ Ma) =O “Thus dhe secand term onthe righthand sido ofequaoen (20) is eual to 0. Using tis fac, we can add suatins (1s) and (20) Thus the ttal amount of prof firm seins prices n even psiods expe to es, Es @e- Bi)? + Ey (Pen ~P*) 1s proportional Seluionsto Chapter 6 138 2 foe PS ay QY) Exp. Leste = @7E (ome. —™ (om | SRE | elma ma? 1-0-4 ‘We nd to compe the right-hand sides of equations (18) and (21), Recall hat Fs de Gation of firs ‘hat st pices in odd periods, Note that woth f< 12 — more Erm sting prices in even periods than ‘oid pends — we have (=) > € Using this andthe fet that <1, we can say that { d-eea-o Pf _a-ee on [ tao | _o-o! oa-) “Li-a-wr] since (1-9)401 8) > (1 = #)4fand 1-1 9X0-9< 1-0 “Thus the rghhand sie of equation (18) is great than the right-hand side of equation (21) This means thatthe prot a firm expects to lose if tat prices in odd periods excens the profit firm expe to lose {fit sas pce in even poids, Thus ie not opal to prices a ad perids and fs would Uke to ‘switch o sting prices in even periods. This means that wih @ <1, ifwe sant with f< 1/2, we would ‘npect tose goto zero ~ no firms wil et prc 08 periods By reasning analogous to that above, we could show tat f£> 12, the inoguaity in (22) is reverse. Firs seting prices in even period expect o lore more than firms seting ces in cd periods. Thus itis rot opinal owt pice im even pends ad firms would Like to switch to seting prices nod periods. Ths tests that woh ¢< 1 if we stan with > 1/2, we woud expect tos goto 1 = al finns wil et price fd penods “Thus if¢< |, aggered price sening wih f= 17 isnot a able eulibrum. Ifthe economy stats wah anyhing aber than f= 1/2, ageted price sexing wl 2 prevail The economy wl goto station ‘were al firms set pace in the same pend Peobiem 69 The pce by Sirs pid is 0) = 2 * pV 2= bm (pn) + (GE me + (1 Epo I where weave wed the facia p= gm (1 =p. Stee r= Ot) and ama equation) {ante wren 3 “late xe [0-61 Eos.) z Ee) Solving for yl: (9) Aloe + Boxes) # [01 -2A)Z}m, ie where Aa tt pie We need to ciminate Exe fco the expression (8) Aria the te, reasonable to gus that xis 2 linea fntion of) and mF ©) wap ede tem \We nnd to determine whether ther are acrusly value of , 2 and viha solve the model. As explained in the tet the lle price equilibrium mvoles each price equaling m. Ia pk ofthis, consider 2 station136 Selusons to Chater 6 ‘wore xy and mar beth gual to 200. If period. prceemter also thir pices tm 0, the ecm, ‘Sat ts fleubleprice equilibrium. In addsion, since ms white nog, the penodt price seers have wo ‘reason to expect mato be on average ether mote o leat han zero, and Hence no Tessin te expec a depart on average fom zero. Thus im this suai, p an Epp" ate bath equal to zro and so price, seers woud choose x= 0. In sumer, reasoableto gues that when r= m= 0,x= 0. In terms of equation (3), thi condtion is (©) O= n= 200)+ 40), fr simply x=0. Thus eqiation (5) becomes: O) x= deat omy (Our goa sto find values of and v hat salve the model. Since equation (7) hold each period, tiple tht nos Pas + vey Ths the expectation a8 of tine a ys Ay nce Ems =O. Using equasen (7) to submnie fr x ytd: 8) Eyxey Rim thom, Substituting equation (8) ato equation (8) gies us: ©) = Absa #2 + hom.) + (= 2AY2Ion ‘which ips: (10) = (A A a+ (ARY + ((1-2A)2]) 4 ‘The coeficies on and my mit be the same in equations (7) and (10). This roquies (Uy AvAK =A and (12) Alw=(1-2A)2=7 Equation (1) isthe same as equation (6 68) in theta for everson of the model where m follows a andor walk. The sluion to thi quadratic thas piven by ive Oo me Sclving fr vin equation (12) iid: (14) v(1- Aap = (1 2Ay2 From equation (11), dovidng through by A and earanging gives us |= AR = AR, Substiuting this cexpresion into quation (4) gives us ‘Subsiatig equation (1) into equation (7) yes (16) xq =A + PAS Aa Em “Ths equation (16) eth 2. given by equation (13) ste the mod We can now describe the behavior of curt. Using the defntions of A and, some simple algebra allows sto revert equation (16) 35: 09 =e + Axi) +m, 2% ae 2% aver Since ye my = prand p= 0443 V2, we have 9) yeameloet nae ‘Substting equten (17) nd equation (17) lags one penod, nto equation (1) yields where we have dein Solutions to Chapter 137 (09) ye y= + Cm + FCs 2} ors G20) sem Ap = (C2) } C2} ] Stee ave wed the eh py = +2592. Now sine ys" mas ~P ths implies {BD yey Aye - Amu (C2)m (C2 ms Cateye frees, © Jy -(n+S}oma tar g}mOa) Fal, see 2m ap wi * fay nai, 4 OoBniBee tno28 OMe a dod exution G2) an been aed asain (= Ce) whore we have substinted for m= 6 and mys = Ea. Thus ifthe money stock s white noise, output isan ARMA I process rather than an AR(I) process Problem 6.10 ‘We could proceed an the text, and cai equation (680), which holds for general proces form: Raza) (6) ay hay +2, om ABM PB MI hte mae) ne wate ne E me feral, Ths ebook ute (640 sng: ‘Noe that equation (1) i intial to aqution (16) ia Problem 6.9. We could then proce, asin Problem 69, te determine the behavior of ouput Problem 6.11 (ede ad tere we have seb for the fc thet md) inegal ges ws : © JocosrarLeslts lo5" ‘Substituting equation (2) back into equation (1) gives us the price st by indvadals atime ©) x) =e GTR) oa Lae [ere tar? The aggregate price level isthe average ofthe pices st over the last interval of length T. Thus 4 baenae & pi