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Advanced Macroeconomics I: Problem Set 1

Martı́n Gallardo
January 23, 2019

Question 1
i) We consider the following production function, that takes the form of a Cobb-
Douglas function.
1 1
Y = K 2 (AL) 2
To prove that this function presents Constant Returns to Scale (CRTS), we will
try to see if the following holds:

λY = λF (K, AL) = F (λK, λAL)


1 1 1 1 1 1
λF (K, AL) = (λK) 2 (λAL) 2 = λ 2 K 2 λ 2 (AL) 2
1 1
= λ K 2 (AL) 2 = λF (K, AL)
| {z }
F (K,AL)

So, given that λ has an exponent equal to one, we can say that this function in
fact presents constant returns to scale.

ii) We begin by obtaining the Marginal Product of Capital (MPK). In order to


do so, we derive the given production function with respect to K.

∂F (K, AL) 1 1 1
= M P K = K − 2 (AL) 2 > 0
∂K 2
Once obtained the MPK, whe derive it, again, with respect to K.

∂M P K ∂ 2 F (K, AL) 1 3 1
= = − K − 2 (AL) 2 < 0
∂K ∂K 2 4
Therefore, given that the derivative of the MPK with respect to K is negative
(provided that K, A, L > 0), we can say that MPK is decreasing in capital K.

iii) Proceeding in the same way that the previous point, we will obtain the
Marginal Product of Labour (MPL) by deriving the production function with
respect to L.
∂F (K, AL) 1 1 1 1
= M P L = K 2 A 2 (L)− 2 > 0
∂L 2

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And then continue by deriving the MPL with respect to L again.

∂M P L ∂ 2 F (K, AL) 1 1 1 3
= 2
= − K 2 A 2 (L)− 2 < 0
∂L ∂L 4
Then again, since the derivative of MPL with respect to labour is negative, we
can say that the marginal product of labour is decreasing in L

iv) We begin our demonstration by defining output per worker y and capital
per worker k as follows.
Y K
y= k=
L L
Then we take the CRTS property demonstrated in the first point, and introduce
λ = L1
1 Y 1 1 1 K 1 AL 1 1 1
Y = = y = K 2 (AL) 2 = ( ) 2 ( )2 = k2 A2
L L L L L
1 1
y = f (k, A) = k 2 A 2
Thus, we’ve obtained that the output per worker y as a function of capital per
worker k and technology A.

Question 2
i) Here we will take Marginal Product of Capital (MPK) and then derive with
respect to labour L-
1 1 1
M P K = K − 2 (AL) 2
2
∂M P K 1 A 1
= ( )2 > 0
∂L 4 KL
So we see that the Marginal Product of Labour increases as Labour increases.

ii)First we define capital per efficiency worker k̃ and output per efficiency worker
ỹ as follows.
Y K
ỹ = k̃ =
AL AL
1
Then again, we use the CRTS property and take λ = AL .

1 Y 1 1 1 K 1 AL 1 1 1
Y = = ỹ = K 2 (AL) 2 = ( )2 ( ) 2 = k̃ 2 1 2
AL AL AL AL AL
1
ỹ = f (k̃) = k̃ 2
Thus we can express output per efficiency worker ỹ solely as a function of capital
per efficiency worker k̃.

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iii) We take the MPK obtained before, presented conveniently.

1 AL 1 1 K −1
MPK = ( )2 = ( ) 2
2 K 2 AL
1 −1
MPK = (k̃) 2
2
So here we see that we can take the MPK as a function of capital per efficiency
worker k̃ alone.

Question 3
i) We take the marginal product of capital (MPK) expressed as we did en in
the section 2)iii), id. est., as a function of capital per efficiency worker. Then,
we derive with respect to k̃.
1 −1
MPK = (k̃) 2
2
∂M P K 1 3
= − (k̃)− 4 < 0
∂ k̃ 4
Now, given that the derivative is negative, we shall say that the marginal prod-
uct of capital is decreasing in capital per efficiency worker k̃.

ii) We begin by taking the marginal product of labour obtained earlier, and
rearrange some terms.
1
1 1 1 1 1 KA 1 A 2 1 K 1
M P L = K 2 A 2 (L)− 2 = ( )2 1 = ( )2 A
2 2 L A 2 2 AL
1 1
M P L = f (k̃, A) = (k̃) 2 A
2
So we arrived to an expression of the marginal product of labour as a function
of capital per efficiency worker k̃ and technology A.

iii) We will take the expression of marginal product of labour found in the
previous point and then derive with respect to capital per efficiency worker k̃.
1 1
MPL = (k̃) 2 A
2
∂M P L 1 1
= (k̃)− 2 A > 0
∂ k̃ 4
Thus, given that the derivative is positive, we can say that the marginal product
of labour MPL increases as capital per efficiency worker k̃ increases.

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Question 4
A) We take the growth rate of capital as determined by the differential equation
k̇ = −7 + 2k(t) . Taking k̇ = 0 to find the point where capital doesn’t grow
nor shrink, we arrive to k = 72 as the Steady State. If we plot the equation
we can see that if the initial capital is below the steady state, the growth rate
will be negative, id. est., the capital will dicrease (will travel west). But if the
starting capital is above the equilibrium point, the capital will grow infinitely
(travel east); whereas if the starting point is exactly k = 72 it will stay at that
level forever. Therefore, we shall say that the equilibrium point is unstable.

B) Doing the same procedure as in the previous point, we analyze the differential
equation k̇ = −3 + 2k(t) . We find the equilibrium point by defining k̇ = 0,
and we obtain that this point is k = 32 . Then we can see that if k is smaller
than this point, the derivative becomes positive and therefore it will tend to
grow towards the equilibrium point. But if the starting capital is bigger than
the equilibrium point, the derivative becomes negativa, making the capital in
period t smaller and smaller, until the equilibrium point. Therefore, we can say
that the equilibrum point is stable, in the sense that it will converge to it no
matter what the initial state is.

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Question 5
A) Taking a Cobb-Douglas production function, the firm maximizes benefit
choosing the demand of Labour and Capital, which takes the following form.

max AK α L1−α − wL − RK
Lt ,Kt

In order to find the quantities that maximize the benefit, we proceed to derive
and equal to zero, with respect to both choice variables.
∂π
= (1 − α)AK α L−α − w = 0
∂Lt

w = (1 − α)AK α L−α = M P L
Found the equilibrium wage, we look for the equilibrium interest rate.
∂π
= αAK α−1 L1−α − R = 0
∂Kt

R = αAK α−1 L1−α = M P K


Thus we arrived to the conclusion that, in equilibrium, the wage w is equal to
marginal product of labour, as interest rate R is equal to marginal product of
capital.

B) In order to discover how wage and interest rate react to a change in L,


we derive both equilibrium values found. First we try wage.
∂w
= −αAK α L−α−1 < 0
∂L
Given that we assume 0 < α < 1, we can see that the derivative of the wage is
negative with respect to labour L. In other words, we can say that the more

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workers there are, the smaller the wage will be, in a sense that the wage is
determined by the marginal product of labour, which is decreasing in labour L.
Now we turn to interest rate R.
∂R
= α(1 − α)AK α−1 L−α > 0
∂L
In the same way that with wage, the interest rate is determined here by the
marginal product of capital, which is increasing in labour L. The more work-
ers we have, the more productive the capital will be, so the interest rate will rise.

C) We proceed to derive first the equilibrium wage w with respect to tech-


nology A
∂w
= (1 − α)K α L−α > 0
∂A
We can see that wage depends positively on technology A, so that we can say
that if technology decreases, so will wage. Again we can relate it to a decrease
in marginal product of labour, which will be lower in the case that technology
decreases. For interest rate R we have:
∂R
= αK α−1 L1−α > 0
∂A
As with wage, the interest rate depends positively to changes in technology A.
This means that if technology decreases, the same will happen to wage. Given
that the interst rate is determined by the marginal product of capital, we can see
that a decrease in technology will lower the MPK, and thus lower the interest
rate.

Question 6
A) In class we arrived to an expression of growth rate of capital per efficiency
worker that takes the following form:
˙
k˜t = sf (k˜t ) − k˜t (σ + n + a)
| {z } | {z }
actual savings break-even
and investment investment

In the diagram we can observe that an increase in the rate of deppreciation σ


will shift the break-even investment line up (to the dashed line). This will result
in a new, lower, balanced grow path of the capital per efficiency worker, which
0 1
we can observe from the point k̃BGP to the point k̃BGP .

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k̃t (σ + n + a)

. . sf (k̃t )

k˜t
1 0
k̃BGP k̃BGP

We can also see that, with the rate of depretiation increasing and the break even
investment curve shifting upwards, the right side of the equation would become
bigger, making the growth rate of capital per efficiency worker negative, and
thus making the k̃BGP tend towards the new point
˙
k˜t (σ + n + a) > sf (k˜t ) =⇒ k˜t < 0

B) In an inverse way that the previous point, a decrease in the rate of techno-
logical progress a wil shift the break-even investment line downwards, making
the new balanced grow path capital per efficiency worker higher than before.

k̃t (σ + n + a)

. . sf (k̃t )

k˜t
0 1
k̃BGP k̃BGP

In terms of the growth path of k̃t , we can observe that the new dashed line is
below the savings line, so the equation presented before must be positive, thus
moving the capital per efficiency worker to it’s new higher state.
˙
k˜t (σ + n + a) < sf (k˜t ) =⇒ k˜t > 0

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Question 7
A) Similarly than the previous points, an increase in the population growth
n, will move the break-even investment line up, so that the new k̃B GP is at a
lower point.

k̃t (σ + n + a)

. . sf (k̃t )

k˜t
1 0
k̃BGP k̃BGP

Again, if we take a look at the equation for the growth path of capital per
efficiency worker, we will see that with the new higher population growth n,
the right side of the equation must be higher, so that the growth path must be
negative, moving the capital per efficiency worker downwards.
˙
k˜t (σ + n + a) > sf (k˜t ) =⇒ k˜t < 0

B) If the coefficient α of the Cobb-Douglas production function were to decrease,


then the saving-investment line would go down, forcing a new lower balanced
grow path capital per efficiency worker. We can see in the diagram as the blue
line moving towards the dashed blue line.

k̃t (σ + n + a)
.
. sf (k̃t )

k˜t
1 0
k̃BGP k̃BGP

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And in terms of the grow path, we would have a decrease in the first term of the
˙
equation, making ˜kt negative, what would mean that the capital per efficiency
0
worker would decrease until it reaches it’s new equilibrium at k̃BGP .

˙
k˜t (σ + n + a) > sf (k˜t ) =⇒ k˜t < 0