THE CHINESE UNIVERSITY OF HONG KONG

DEPARTMENT OF ECONOMICS

MSc Preparation Course

ANSWER KEY FOR PRACTICE PROBLEM SET 1

1. Twin Deficits Revisited

In the class, we discussed the “Twin Deficits” Idea. Find out the years when Twin
Deficits appeared in the US history since 1975. Prepare a brief statement explaining the
idea of “Twin Deficits” and about your findings (recommended length of statement – 1
page maximum including figures). All sources must be quoted.

“Twin deficits” occurs when there is both a budget deficit and a trade deficit (current
account deficit).

The chart above (pink: Trade balance, blue: budget balance) is computed using data
from the US Bureau of Economic Analysis. Twin Deficits occurred in most of the
post-1975. The most famous example of Twin Deficits is that of Ronald Reagan’s
presidency (January 1981-January 1989) – his supply side policies (cutting income taxes,
under the Economy Recovery Tax Act of 1981) coupled with increase in government
spending resulted in both the budget deficit and the trade deficit (which resulted from a
reduction in competitiveness).

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 2. Economic Policies and Economic Growth

The government of New Hamland is proposing the following policies in order to promote
economic growth and has asked for your team’s opinion. Answer these questions using
the growth models we have discussed.

(i) The average birth rate in New Hamland is currently 2 children per family.
There is currently a limit that a family can have at most 4 children. New
Hamland’s government is considering to raise the limit from 4 children per
family to 6 children per family.

Although there is a limit that each family can have at most 4 children, on average there
are only two children per family. This suggests that the current limit is not binding on
average, and it is unlikely that raising the limit will have any significant impacts on the
population growth rate. In all the growth models we have studied, this policy change is
unlikely to yield any big changes.

(ii) Machines in New Hamland are aging rapidly as they were brought in by the
industrialists some 40 years ago. New Hamland’s government is considering
a one-time grant for these industrialists to purchase new machines from
Western Europe.

Assuming that the machines made in Western Europe are better than the current
installations. Purchasing these machines will improve the quality of the capital stock of
New Hamland’s economy, leading to a lower average depreciation rate.

In the Solow Growth Model – this will yield higher income per capita, and higher capital
per capita. But steady state growth rates remain unchanged. The same conclusion is
reached in the Lucas’s two Sector model, and the Romer’s Two-Sector Model.

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Solow Growth Model

In the Romer’s One-Sector Model – the gap between the savings and the break-even
depreciation functions is widened, thus the economy will grow faster.

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 (iii) New Hamland is to set up a research university and requires every person
below age 21 to attend university before working.

Mandatory participation in higher education will boost the quality of the workforce.

In the Solow Growth model, without further assumptions on the impact of this change on
the economy’s production function, nothing will happen. If we assume that, as a result
of this policy, labor becomes more productive input, then this will likely to shift the
production function upwards, leading to higher steady state income/capita per person.
But the steady state growth rates of output/capital per person will remain unchanged,
since it depends on the growth rate of technology, which is not explicitly modeled.

In the Romer’s One-Sector Model, growth is embodied in the capital stock. Since this
policy has nothing to do with the capital stock, nothing will change.

In the Lucas model, as the economy devotes a higher fraction of its workforce to
education, the steady state output per capita growth rate will go up.

3. Solow Model’s Numerical Simulation

Consider an economy with the following production function:

Y=K0.34L0.66

Assume no technological growth, capital depreciates at a rate of 10%, the initial capital
per capita is 4, the savings rate is 40%, and no population growth.

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 a) Calculate the steady state level of capital per person, output per person, and
consumption per person.

Output per person is:

 K 0.34 L0.66 
y  f (k )     k 0.34
 L 

At the steady state, investment = depreciation, let k* be the steady state level of capital
per person, thus:

sf (k *)  dk *
 0.4k *0.34  0.1k *
 k *  8.1698

Therefore:
y* = k*0.34 = 2.042
c* = y* - sy* = 2.042 – 0.4*2.042=1.225

b) Produce a table showing how the economy’s capital per person and output per
person evolve from its initial state to the steady state. Show in your table results
for only the initial period and the subsequent 4 periods, and the steady state.
Year k y c i dk k'-k
0 4.000 1.602 0.961 0.641 0.400 0.241
1 4.241 1.634 0.981 0.654 0.424 0.230
2 4.470 1.664 0.998 0.666 0.447 0.219
3 4.689 1.691 1.015 0.676 0.469 0.208
4 4.897 1.716 1.030 0.686 0.490 0.197
…
 8.1698 2.042 1.225 0.817 0.817 0

c) Calculate the golden rule level of capital per person, and the resulting level of
consumption per person. What would you propose to do to get the economy
evolving to the golden rule level of capital?
At the golden rule level of capital per person:

f ’(k**) = d

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where f ’(.) is the derivative of f(k) and k** is the golden rule level of capital per person,
so substituting the numbers we have:
0.34k**-0.66 = 0.1
=> k** = 6.3866

The level of investment at the golden rule level of capital is the same as the level of
depreciation, so it is 0.1*6.3866 = 0.63866 . The level of output per person at the
golden rule level of capital is 6.38660.34 = 1.8784. Thus the level of consumption per
person is 1.8784-0.63866 = 1.2398.

To get the economy evolving to the golden rule level of capital per person, one can adjust
the savings rate. In part b) we saw that, when the savings rate is 0.4, the steady state
level of capital is 8.1698, which is higher than the golden rule level of capital per person,
so the savings rate needs to be lowered.

To get this savings rate, note that at the steady state, investment = depreciation, so for
the level of capital per person equals to that of the golden rule:

sk**0.34 = 0.1k**
since k** = 6.3866, solving for s yields that the savings rate needs to be 0.34 for the
economy to evolve to the golden rule level of capital per person.

4. Romer’s One Sector Model revisited

In lecture 5, we discussed the Romer’s One-Sector Model. Examine whether the model
satisfies all five Kaldor’s stylized facts of economic growth.

Stylized Fact #1 – Income per unit capital (Y/K) does not change

Since y = λ1-αk, we have:

y Y/N Y
   1 = a constant
k K/N K

So income per unit capital does not change.

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Stylized Fact #2 - Income per capita (Y/L) and Capital per capita (K/L) grow at
constant rates.

From the lecture notes, the growth rate of capital per capita is:

k
 s1  (n  d ) =a constant
k
as s, λ, α, n and d are constants

The growth rate of output per capita can be obtained by log-differentiating the output per
capita function:

y  1 k
y  k
  (1   ) 
y  k
y k
 
y k

as λ is a constant, its growth rate is zero. So output per capita grows at the same rate
as capital per capita, which is constant.

Stylized Fact #3 - Rental price of capital (r) is constant.

The rental price r, is obtained from the First Order Condition of the firm’s maximization
problem:

r  MPK  d

 K  1 ( AN )1  d
Y
 d
K
where MPK is the marginal product of capital, as Y/K is a constant term, r is also a
constant term. Note that we do not substitute A = λk in the firm’s profit function – this
is because the growth in technology is an externality ignored by the firm, and so the firm
does not consider it when deciding how much capital and labor to use.

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Stylized Fact #4 - Wages (w) grow at a constant rate

Again, wage level is obtained from the First Order Condition of the firm’s maximization
problem:

w  MPL

 (1   ) AK  ( AN ) 
Y
 (1   )
N
 (1   ) y

So after log-differentiating, wages grow at the same rate as income per capita.

Stylized Fact #5 - Rates of growth and levels of income vary substantially across
countries (non-convergence).

Since
k
 s1  (n  d )
k
The steady state growth rate depends on the following factors:
s – the savings rate
λ – how capital per worker affects the level of technology
n – the population growth rate
d – the depreciation rate

Since s, λ and n vary substantially between the rich and the poor countries, the steady
state growth rates are different also. The model predicts non-convergence.

So, all 5 Kaldor’s stylized facts are satisfied.

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 5. Unemployment and Unions

Trade unions are generally thought to be interested in both wages and employment, but
usually tolerate an increase in unemployment to achieve higher wages.

a) Using the Beveridge analysis developed in Lecture 7, show what would happen
when an economy becomes unionized.

When an economy becomes unionized, the unions push up wages and tolerate higher
unemployment. This results in a right-ward shift of the Job Creation curve (at all levels
of labor demand, there is higher unemployment). The result is lower number of
vacancies and higher natural rate of unemployment as shown in the figure below.

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It is claimed by some economists that no unionization and fully centralized unionization
(i.e. one union for the country) are better for employment than many small unions.

b) Show, using the Beveridge analysis, that there is a basis for this claim.

When the economy has many unions, each union presses for higher wages without having
to worry about the members of other unions as it thinks that it is too small to influence
demand for labor elsewhere. Thus the JC curve would shift to the right (JCS). When
there is only a single large union for all the workers in the economy, it realizes that the
higher wages will be across the board. Consequently, demand for labor will shrink
everywhere. Hence it is less inclined to push for as high a wage as a decentralized
union, the JC curve shifts to the right as well to JCL, but not as much as that when there
are many small unions.

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