1. 2.

Answers to Textbook Problems

The three sources of economic growth are capital growth, labor growth, and productivity growth. The growth accounting approach is derived from the production function. A decline in productivity growth is the primary reason for the slowdown in output growth in the United States since 1973. Productivity growth may have declined because of deterioration in the legal and human environment, reduced rates of technological innovation, and the effects of high oil prices. To some extent the apparent decline in productivity may be due to measurement difficulties. The rise in productivity growth in the 1990s occurred because of the revolution in information and communications technologies (ICT). Not only were there improvements in ICT, but also government regulations did not rein in the growth of productivity in the United States, as they did in other countries, such as those in Europe. In addition, intangible investment (research and development, reorganization of firms, and worker training) allowed the ICT improvements to boost productivity. A steady state is a situation in which the economys output per worker, consumption per worker, and capital stock per worker are constant. If there is no productivity growth, then output per worker, consumption per worker, and capital per worker will all be constant in the long run. This represents a steady state for the economy. The statement is false. Increases in the capital-labor ratio increase consumption per worker in the steady state only up to a point. If the capital-labor ratio is too high, then consumption per worker may decline due to diminishing marginal returns to capital, and the need to divert much of output to maintaining the capital-labor ratio. (a) An increase in the saving rate increases long-run living standards, as higher saving allows for more investment and a larger capital stock. (b) An increase in the population growth rate reduces long-run living standards, as more output must be used to equip the larger number of new workers with capital, leaving less output available to increase consumption or capital per worker. (c) A one-time increase in productivity increases living standards directly, by increasing output, and indirectly, since by raising incomes it also raises saving and the capital stock. Endogenous growth theory suggests that the main sources of productivity growth are accumulation of human capital (the knowledge, skills, and training of individuals) and technological innovation (research and development, as well as learning by doing). The production function in an endogenous growth model does not exhibit diminishing marginal productivity of capital. This differs from the production function in the Solow model, which has diminishing marginal productivity of capital. Government policies to promote economic growth include policies to raise the saving rate and policies to increase productivity. One way to increase the saving rate is to increase the real return to saving by providing a tax break, as Individual Retirement Accounts did in the United States. Unfortunately, the response of saving to increases in the real rate of return is small. Another way to increase the saving rate is to reduce the government budget deficit. However, the theory of Ricardian equivalence suggests that this will not do much to increase national saving. Note that an increase in the saving rate will increase the steady-state capital-labor ratio, but will not increase the long-run rate of economic growth. One way that government policy can increase productivity is by spending more on the economys infrastructure, which has been neglected over the past two decades in the United States. Another
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Review Questions

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possibility is to support the creation of human capital by spending more on education and training programs, and reducing barriers to entrepreneurial activity. The issue is whether the government should intervene in the market to do these things, or whether the free market by itself provides an efficient outcome. A one-time increase in productivity will increase the steady-state capital-labor ratio but will not increase the long-run rate of economic growth. To increase the long-run rate of economic growth, the growth rate of productivity must be permanently increased. Endogenous growth theory modifies these conclusions to some extent. A rise in the saving rate leads to a higher long-run rate of economic growth in endogenous growth models.

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Numerical Problems
1. Hare: $5000 (1.03)70 = $39,589 Tortoise: $5000 (1.01)70 = $10,034

2. 20 Years Ago Y K N 1000 2500 500 Today 1300 3250 575 Percent Change 30% 30% 15%

(a) A/A = Y/Y aK K/K aN N/N = 30% (0.3 30%) 0.7 15% = 30% 9% 10.5% = 10.5% Capital growth contributed 9% (aK K/K ), labor growth contributed 10.5% (aN N/N ), productivity growth was 10.5%. (b) A/A = 30% (0.5 30%) (0.5 15%) = 30% 15% 7.5% = 7.5% Capital growth contributed 15% (aK K/K), labor growth contributed 7.5% (aN N/N), productivity growth was 7.5%. 3. (a) Year 1 2 3 4 K 200 250 250 300 N 1000 1000 1250 1200 Y 617 660 771 792 K/N 0.20 0.25 0.20 0.25 Y/N 0.617 0.660 0.617 0.660

This production function can be written in per-worker form since Y/N = K.3N.7/N = K.3/N.3 = (K/N).3. Note that K/N is the same in years 1 and 3, and so is Y/N. Also, K/N is the same in years 2 and 4, and so is Y/N. (b) Year 1 2 3 4 K 200 250 250 300 N 1000 1000 1250 1200 Y 1231 1316 1574 1609 K/N 0.20 0.25 0.20 0.25 Y/N 1.231 1.316 1.259 1.341

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This production function cant be written in per-worker form since Y/N = K.3N.8/N = K.3/N.2. Note that K/N is the same in years 1 and 3, but Y/N is not the same in these years. The same is true for years 2 and 4. 4. To answer this problem, an approximate solution can be found by finding the ratio GDP (2008)/GDP (1950), taking the natural logarithm of that ratio and dividing by 58. This is the answer given in the table below. Real GDP Per Capita 1950 2008 Australia Canada France Germany Japan Sweden United Kingdom United States 7,412 7,291 5,186 3,881 1,921 6,769 6,939 9,561 25,301 25,267 22,223 20,801 22,816 24,409 23,742 31,178 Growth Rate 2.1% 2.1% 2.5% 2.9% 4.3% 2.2% 2.1% 2.0%

Ratio 3.41 3.47 4.29 5.36 11.88 3.61 3.42 3.26

Germany and Japan had the highest growth rates because damage from World War II caused capital per worker to be lower than its steady-state level, and thus output per worker was temporarily low. 5. (a) sf(k) = (n + d )k 0.3 3k.5 = (0.05 + 0.1)k 0.9k.5 = 0.15k 0.9/0.15 = k/k.5 6 = k.5 k = 62 = 36 y = 3k.5 = 3 6 = 18 c = y (n + d )k = 18 (0.15 36) = 12.6 (b) sf(k) = (n + d )k 0.4 3k.5 = (0.05 + 0.1)k 1.2k.5 = 0.15k 1.2/0.15 = k/k.5 8 = k.5 k = 82 = 64 y = 3k.5 = 3 8 = 24 c = y (n + d )k = 24 (0.15 64) = 14.4 (c) sf(k) = (n + d )k 0.3 3k.5 = (0.08 + 0.1)k 0.9k.5 = 0.18k 0.9/0.18 = k/k.5 5 = k.5
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k = 52 = 25 y = 3k.5 = 3 5 = 15 c = y (n + d )k = 15 (0.18 25) = 10.5 (d) sf(k) = (n + d )k 0.3 4k.5 = (0.05 + 0.1)k 1.2k.5 = 0.15k 1.2/0.15 = k/k.5 8 = k.5 k = 82 = 64 y = 4k.5 = 4 8 = 32 c = y (n + d )k = 32 (0.15 64) = 22.4 6. (a) In steady state, sf(k) = (n + d )k 0.1 6k.5 = (0.01 + 0.14)k 0.6k.5 = 0.15k 0.6/0.15 = k/k.5 4 = k.5 k = 42 = 16 = capital per worker y = 6k.5 = 6 4 = 24 = output per worker c = .9 y = .9 24 = 21.6 = consumption per worker (n + d )k = 0.15 16 = 2.4 = investment per worker (b) To get y = 2 24 = 48, since y = 6k.5, then 48 = 6k.5, so k.5 = 8, so k = 64. The capital-labor ratio would need to increase from 16 to 64. To get k = 64, since sf(k) = (n + d )k, s 48 = 0.15 64, so s = 0.2. Saving per worker would need to double. First, derive saving per worker as sy = y c g = [1 0.5(1 t) t] 8k.5 = 0.5(1 t)8k.5 = 4 (1 t)k.5 (a) When t = 0, sy = 4 (1 0)k.5 = 4k.5 = national saving per worker Investment per worker = (n + d )k = 0.1k In steady state, sy = (n + d)k, so 4k.5 = 0.1k, or 40k.5 = k, so 1600k = k2, so k = 1600. Since k = 1600, y = 8 1600.5 = 320, c = 0.5(1 0)320 = 160, and (n + d)k = 0.1 1600 = 160 = investment per worker. (b) When t = 0.5, sy = 4 (1 0.5)k.5 = 2k.5 = national saving per worker Investment per worker = (n + d )k = .1k In steady state, sy = (n + d)k, so 2k.5 = 0.1k, or 20k.5 = k, so 400k = k2, so k = 400. Since k = 400, y = 8 400.5 = 160, c = 0.5(1 0.5)160 = 40, and (n + d)k = 0.1 400 = 40 = investment per worker, g = ty = 0.5 160 = 80.

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Analytical Problems
1. (a) The destruction of some of a countrys capital stock in a war would have no effect on the steady state, because there has been no change in s, f, n, or d. Instead, k is reduced temporarily, but equilibrium forces eventually drive k to the same steady-state value as before. (b) Immigration raises n from n1 to n2 in Figure 6.3. The rise in n lowers steady-state k, leading to a lower steady-state consumption per worker.

Figure 6.3 (c) The rise in energy prices reduces the productivity of capital per worker. This causes sf(k) to shift down from sf 1(k) to sf 2(k) in Figure 6.4. The result is a decline in steady-state k. Steady-state consumption per worker falls for two reasons: (1) Each unit of capital has a lower productivity, and (2) steady-state k is reduced.

Figure 6.4 (d) A temporary rise in s has no effect on the steady-state equilibrium. (e) The increase in the size of the labor force does not affect the growth rate of the labor force, so there is no impact on the steady-state capital-labor ratio or on consumption per worker. However, because a larger fraction of the population is working, consumption per person increases.

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2.

(a) Solow model The rise in capital depreciation shifts up the (n + d )k line from (n + d1)k to (n + d2)k, as shown in Figure 6.5. The equilibrium steady-state capital-labor ratio declines. With a lower capital-labor ratio, output per worker is lower, so consumption per worker is lower (using the assumption that the capital-labor ratio is not so high that an increase in k will reduce consumption per worker). There is no effect on the long-run growth rate of the total capital stock, because in the long run the capital stock must grow at the same rate (n) as the labor force grows, so that the capital-labor ratio is constant.

Figure 6.5 (b) Endogenous growth model In an endogenous growth model, the growth rate of output is Y/Y = sA d, so the rise in the deprecia-tion rate reduces the economys growth rate. Similarly, the growth rate of capital equals K/K = sA d, which also declines when the depreciation rate rises. Since consumption is a constant fraction of output, its growth rate declines as well. So the increase in the depreciation rate reduces the long-run growth rate of the capital stock, as well as long-run capital, output, and consumption per worker. 3. (a) With a balanced budget T/N = g. National saving is S = s(Y T) = sN[(Y/N) (T/N)] = sN( y g). Setting saving equal to investment gives S = I, sN(y g) = (n + d )K, s(y g) = (n + d )k, s[f(k) g] = (n + d )k. This equilibrium point k* is shown in Figure 6.6.

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Figure 6.6 (b) If the government permanently increases purchases per worker, the s[ f(k) g] curve shifts down from s[ f (k) g1] to s[ f (k) g2] in Figure 6.7. In steady-state equilibrium, the capital-labor ratio is lower. Output per worker, capital per worker, and consumption per worker are lower in the steady state. The optimal level of government purchases is not zeroit depends on the benefits of the government purchases as well as on the costs of these purchases.

Figure 6.7 4. St = sYt hKt = Nt(syt hkt). Setting St = It yields Nt(syt hkt) = (n + d )Kt. Dividing through by Nt and eliminating time subscripts for steady-state variables gives sy hk = (n + d )k. Rearranging and using the expression y = f(k) gives sf(k) = (n + d + h)k. The steady-state value of capital per worker, k*, is given by the intersection of the (n + d + h)k line with the sf(k) curve, as shown in Figure 6.8. Output per worker is f(k*). Since Ct = Yt St, c = y (sy hk) = (1 s)f(k*) + hk*. This expression gives consumption per worker.

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Figure 6.8 A change in the steady-state value of h increases the slope of the (n + d + h)k line, as shown in Figure 6.9. This reduces the steady-state value of per-worker capital (k*), per-worker output [since y* = f(k*)], and per-worker consumption [since c* = (1 s)y* + hk* and both y* and k* decline].

Figure 6.9 5. The initial level of the capital-labor ratio is irrelevant for the steady state. Two economies that are identical except for their initial capital-labor ratios will have exactly the same steady state. Since the two economies must have the same growth rate at the steady state, and since the economy with the higher current capital-labor ratio has higher current output per worker, then the country with the lower current capital-labor ratio must grow faster.

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The answer holds true regardless of which country is in a steady state. If the country with a higher initial capital-labor ratio is in a steady state at capital-labor ratio k*, then the other countrys capitallabor ratio will rise until it too equals k*. So the country with the lower capital-labor ratio grows faster than the one with the higher capital-labor ratio. If the country with the lower initial capital-labor ratio is in a steady state at capital-labor ratio k*, then the other countrys capital-labor ratio is too high and it will decline until it equals k*. So the country with the higher capital-labor ratio must grow more slowly than the country with the lower capitallabor ratio. If the two countries are allowed to trade with each other, then their convergence to the same capital-labor ratio and output per worker will occur even faster. 6. The growth accounting equation is Y/Y = A/A + (aK K/K ) + (aN N/N ). We are just increasing the amount of capital and labor, and there is no change in productivity, so A/A = 0. If the production function can be written in per-worker terms, then total output must increase in the same proportion as the percentage increase in capital and labor, so K/K = N/N = Y/Y = X. Plugging this into the growth accounting equation, Y/Y = A/A + (aK K/K ) + (aN N/N ), X = 0 + aKX + aNX, X = (aK + aN)X, aK + aN = 1. 7. Assume there are a constant number of workers, N, so that Ny = Y and Nk = K. Since y = Akah1a and h = Bk, then y = Ak a(Bk)1a = (AB1a)k. Then Y = Ny = (AB1a)K = XK, where X equals AB1a. This puts the production function in notation used in the chapter. Investment is K + dK = sY = national saving. Dividing through both sides of that expression by K and using the production function gives K/K + d = sXK/K = sX, so K/K = sX d, which is the longrun growth rate of physical capital. Since output and human capital are proportional to physical capital, they will all grow at that same rate.

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