Macroeconomic Analysis

ECON 6022
Fall 2022

November 08, 2022

INSTRUCTIONS:

The exam lasts for 120 minutes. The maximal number of points to be attained for this exam is 100
points.

Please write your NAME and University NUMBER on the cover of the answer book that you use.

Please write in an intelligible way, and write all your answers in the answer book.

1 True or False [16 Points]

Consider the following statements,indicate whether you agree or disagree with the following statements. In
each case, provide a brief explanation for your answer.

1. GDP per worker and capital per worker are positively correlated across countries. That is because
higher capital per worker causes higher GDP per worker.

2. The Solow model predicts that poor countries should grow faster than rich countries.

Solution You will get the points as long as the explanation is correct.

1. False. The high level of GDP per worker is not ”caused” by the high level of capital per worker. Think
about the Solow model, in the Solow model, both the level of steady state capital per worker and
GDP per worker is determined by parameters in the model(s,n,A). It’s fire to say that higher GDP per
worker is caused by higer TFP level.

2. False. This statement is only valid when the poor countries and the rich countries share the same
parameter values(have same technology, same saving rate...). If this is the case, since poor countries
will grow faster since it is more far away to the steady state.

2 The Solow Model [35 Points]

Consider a Solow model where the production function is Y = AK ↵ N 1 ↵
, where A is productivity, K and
N are capital and the labor in this economy, and ↵ is output elasticity of capital. A constant fraction s of

1
output is invested (or saved). And the depreciation rate for capital is , the population growth rate is n,
A
and the growth rate of TFP is constant, g > 0. Specifically, = g.
A
K
1. (8 points) Define the capital per e↵ective labor as k̄ = . Show that
1
A1 ↵ · N
g
k̄ = s · k̄ ↵ ( +n+ ) · k̄
1 ↵

2. (7 points) Calculate the steady state capital per e↵ective worker, k̄ ⇤ , output per e↵ective worker level,
ȳ ⇤ and consumption per e↵ective worker c̄⇤ .
Y
3. (6 points) Define output per worker as y = , solve the steady state level of output per worker y ⇤ .
N
⇤
4. (7 points) Derive the golden rule steady state capital per e↵ective worker k̄G and the steady state
level of consumption per e↵ective worker level c̄⇤G .

5. (7 points) Suppose the saving rate unexpectedly increases from s to s0 in Period t⇤ . Before the shock,
the economy is at the steady state. Analyze the dynamics of the convergence to the new steady state
with the Solow Diagram.

Solution
K
1. k̄ = 1 . Then
A1 ↵ N

k̄ K 1 A N
=
k̄ K 1 ↵ A N
sY K 1
= g n
K 1 ↵
1 ✓ ◆
sA 1 ↵ N y 1
= 1 + g + n
A1 ↵ N 1 ↵
✓ k̄ ◆
1
) k̄ = sk̄ ↵ + g + n k̄.
1 ↵

2. When k = 0. Then
! 1 1↵
⇤ s
k̄ = g
+ 1 ↵ +n
! 1 ↵↵
⇤ ⇤ ↵ s
ȳ = k̄ = g
+ 1 ↵ +n
! 1 ↵↵
⇤ ⇤ s
c̄ = (1 s) ȳ = (1 s) g .
+ 1 ↵ +n

1
3. For y = A 1 ↵ ȳ follows
! 1 ↵↵
1 1 s
y⇤ = A 1 ↵ ȳ ⇤ = A 1 ↵
g .
+ 1 ↵ +n

2
 4. There holds c̄⇤ = (1 s) ȳ ⇤ . Hence, in the steady state
✓ ◆
⇤ 1
sk̄ = + g + n k̄ ⇤
1 ↵
✓ ◆
⇤ ⇤ ↵ ⇤ ↵ 1
c̄ = (1 s) k̄ = k̄ + g + n k̄ ⇤ .
1 ↵

The first order condition with respect to k̄ ⇤ is

↵ 1 1
↵ k̄ ⇤ = + g+n
1 ↵
! 1 1↵
⇤ ↵
k̄G = 1 .
+ 1 ↵g +n

Therefore, we have
! 1 ↵↵
⇤ ↵ ↵
c̄⇤G = (1 s) k̄ = (1 s) 1 .
d+ 1 ↵g +n

5. The following figure shows the change from s to s0 .

After the shock, k̄ will first enjoy a quick growth, as k̄ increases, the growth rate will go down, and
0
⇤
finally reach the new steady state k̄

3 Consumption and Saving [29 Points]

Suppose an agent lives for two periods without initial wealth. The agent earns labor income in each period.
The agent’s net asset position at the end of period t is at , and consumption in each period ct , where t = 1, 2.
The agent faces the following sequence of budget constraints during her life:

c 1 + a 1 = y1
c2 = y2 + (1 + r)a1 (1)
(2)

3
where yt is the labor income in period t, r is the interest rate. The agent maximizes his life-time utility:

U = u(c1 ) + u(c2 )

where u(c) = ln(c).

1. (10 points) Derive the Euler equation and solve for the optimal conumption level c1 and c2 .

2. (9 points) From now on, we further assume that = 1. Suppose there’s a government and the agent
need to pay a lump-sum tax T in the first period. How does this a↵ect current consumption, future
consumption, and current saving?

3. (10 points) What if the agent need to pay tax T in both period 1 and 2 (in each period, agent need
to pay a lump-sum tax T). Solve for the optimal c1 and c2 .

Solution

1. The agent’s problem is:

M axc1 ,c2 ln(c1 ) + ln(c2 )

subject to
c2 y2
c1 + = y1 +
1+r 1+r
Thus the Euler equation is:
1 1
= (1 + r)
c1 c2
Take the Euler equation to the budget constraint:

1 y2
c1 = (y1 + )
1+ 1+r
(1 + r) y2
c2 = (y1 + )
1+ 1+r

2. This shock will only change the budget constraint and will not change the inter-temporal preference.
The new budget constraint is:
c2 y2
c1 + T + = y1 +
1+r 1+r
And the new solution is:
1 y2
c1 = (y1 + T)
2 1+r
1+r y2
c2 = (y1 + T)
2 1+r
The current saving s1 is:
1 y2
s 1 = y1 T c1 = (y1 T)
2 1+r
3. In this case, the budget constraint is:

2+r c2 y2
c1 + T+ = y1 +
1+r 1+r 1+r

4
 And the optimal consumption is:

1 y2 2+r
c1 = (y1 + T)
2 1+r 1+r

1+r y2 2+r
c2 = (y1 + T)
2 1+r 1+r

4 Precautionary Savings [20 Points]

In a two period model, suppose the agent’s lifetime utility function is U (c1 , c2 ) = u(c1 ) + E[u(c̃2 )], where
u(·) takes the logarithmic form u(c) = ln(c). The market interest rate is constant r = 0. The initial wealth
endowment is zero. The agent’s incomes are y1 and ỹ2 in Period 1 and 2, respectively. Assume that ỹ2 is
uncertain in Period 2, which can be y2 h and y2 l with equal probability. Specifically, y2 h = y2 + 0 and
l
y2 = y 2 0, where > 0. Suppose that y1 = 2, E(ỹ2 ) = 1 and = 1. Please calculate the precautionary
savings in this case. Solution
1
Since the utility function takes the logarithmic form,u0 (c) = c The Euler equation gives:

1 1 1
⇤⇤ = 0.5 + 0.5
c1 c˜h
2 c˜h 2
1 1
= 0.5 + 0.5
4 c⇤⇤
1 2 c⇤⇤
1

Solve for c⇤⇤

1 we get:
c⇤⇤
1 ⇡ 1.22

Since here we assume r = 0 and = 1. Obviously, withour uncertainty:

c⇤1 = 0.5 ⇤ (2 + 1) = 1.5

Thus the precautionary saving is 1.5 1.22 = 0.28

—– end of paper —–