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Economics 251 Intermediate Macroeconomics

Problem Set Assignment 2

Due Tuesday, March 2, 11pm US EDT

Assignments to be handwritten then scanned into a single pdf (except for approved disabilities), which

is to be sent and the teaching assistant, with a subject line of E251 Problem Set 2. There is a 10-point

penalty for an incorrectly named file. You are responsible for naming your pdf file as follows:

E251_PS2_yourlastname_yourfirstname. For example, if your name were Janine Smith, your pdf file

should be named: E251_PS2_Smith_Janine.

1) (40 points) Solow Growth Model Diagram Problems

a. (20 points) Using the Solow Growth Model diagram that incorporates population

growth,

i. Illustrate what happens to the steady state capital-to-labor ratio when the rate of

population growth decreases from n1 to n2 (5 points). What happens to steady-state per

capita output? (3 points) Does this result, in general, help or hurt the ability of the Solow

growth model to account for differences in incomes of poorer versus richer countries and

why (5 points)?

ii. In a separate diagram, illustrate and state what happens to the maximum consumption

per capita under the golden rule when the rate of population growth decreases from n1 to

n2 (5 points). Does this result, in general, help or hurt the ability of the Solow growth model

to account for differences in living standards of poorer versus richer countries and why (2

points)?

b. (10 points) Using the Solow Growth Model diagram that incorporates population

growth,

i. Illustrate what happens to the steady state capital-to-labor ratio when the level of

technology falls from A1 to A2 (4 points). What happens to steady-state per capita output?

(3 points) Does this result, in general, help or hurt the ability of the Solow growth model

to account for differences in incomes of poorer versus richer countries and why (3 points)?

c. (10 points) Growth economists have estimated that the capital-labor ratio in the U.S. is

below the level implied by the golden rule. Describe three strategies for raising long-run

consumption per capita in the U.S. (a strategy focuses on altering a major variable or factor

that determines long-run output) and for each strategy (make sure that they differ), briefly

mention the reason why it could conceivably work using the workings of the Solow Growth

Model. 3 points for each and 1 point for being correct on all of problem (1c).

Economics 251 Intermediate Macroeconomics

2) (40 points) Fiscal Policy/Loanable Funds Question

Consider the following change in fiscal policy for an economy that was initially operating at its

potential level of output. Suppose that the U.S. federal government notably cut personal and

business taxes and did not change spending, which together greatly increased its current deficit to-GDP ratio from 0 to 4 percent. Despite a very modest, direct positive effect on business

investment, the actions notably increased the budget deficit relative to GDP while having virtually

no effect on private saving. Assume for the sake of this question that these policies are

implemented and are sustained for many years in a closed-economy environment.

a. (30 points) How would this affect the market for loanable funds in the United States?

Your answer should cover

i. …the supply curve for loanable funds,

ii. …the demand curve for those funds, and

iii. …the equilibrium real interest rate.

I am interested only in direction of movement, so calculations are not required. For

each of these variables, your choices include

…no change (applicable in principle to any of the three),

…a shift right or left (applicable in principle to demand and supply curves),

…movement up or down an unchanged supply or demand curve,

…an increase or decrease (applicable in principle to the real interest rate), or

…not enough information to tell (applicable in principle to any of the three).

Briefly explain your reasoning for each, including what information is missing if you

choose the last option. (10 points apiece for a correct answer for each of the three items

requested, including 7 points for the correct direction plus a correct chart and 3 points

for the reasoning). Is this

b. (2 points) Does this policy crowd out or crowd in private investment?

c. (8 points) Instead, now use the Solow Growth Model. What would the fiscal policy

action in 2a likely do (on net) to steady state U.S. output in the long-run and why:

i. …no change (applicable in principle to any of the three),

ii. …induce an increase

iii. …induce a decrease.

Briefly explain your reasoning for the answer. (4 points for the correct direction and

4 points for the reasoning)

3. Solow Model Growth Accounting Problems. (20 points).

For all parts of (3) assume that the Solow model holds for a perfectly competitive economy

with a Cobb-Douglas production function Y = AF(K,L) = AKα

L

1-α

in which both factors of

production are fully employed and 0 < α < 1.

3a) (13 points total) A researcher analyzes economic growth using the Cobb-Douglas

production function Y = AF(K,L) = AKα

L

1-α

, where α = .2. Suppose the output of an economy

has grown by 50% over the past 30 years. It is found that capital stock and labor force have

grown by 40% and 20%, respectively.

i) (2 points) Write down the growth accounting equation.

ii) (9 points) What are the contributions to economic growth from growth in capital,

growth in labor force, and growth in productivity?

iii) (2 points) If GDP had grown by 40 percent, what would change in your answer to

problem (3aii)

3b) (7 points total) A researcher analyzes economic growth using the Cobb-Douglas

production function Y = AF(K,L) = AKα

L

1-α

, where α = .4. Suppose the output of an economy

has grown by 50% over the past 30 years. It is found that capital stock and labor force have

grown by 50% and 20%, respectively.

i) (6 points) What are the contributions to economic growth from growth in capital,

growth in labor force, and growth in productivity?

ii) (1 point) If GDP had grown by 60 percent, what would change in your answer to

problem (3bi)

Economics 251 Intermediate Macroeconomics

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