Econ 5021 (Fall 2015): Practice Question 2

Suggested Solution
The Chinese University of Hong Kong
Remarks: Please hand in Practice Question 2 in class on November 30. No late assignment will be accepted.
I. Basic Concept:
1. See the notes.
II (Econ Students Optimization)
(a) The optimization problem is
max

c1 ;c2 ;s;m0

= c1 +

s:t: c1
c2 + m0

1
c2
1+

s + ln (m0 )

= m
= wh0 = w (1 + (m) s ) h

Substitute the constraint into the optimization problem to obtain

max0 U = m +
s;m

1
1+

m0 ]

[w (1 + (m) s ) h

s + ln (m0 )

The problem becomes an unconstrained optimization problem in s and m0 . The rst-order conditions
with respect to s and m0 are
1+

wh (m) s

1
1+

=
=

;
m0 :

(1)
(2)

(b) From (1) s can be solved as

s =
and m0 can be solved from (2) as

wh (m)
(1 + )

m0 =

1
1

(1 + ) :

That is, the intergenerational transfer is the same across all generations, m0 = m = m . The optimal
consumption bundle is thus (c1 ; c2 ) = ( (1 + ) ; w (1 + (m ) s ) h m ), the optimal study time is
h
i 1
(m) 1
s = wh
, and the optimal intergenerational transfer is m = (1 + ).
(1+ )

(c) If we set w xed and measure the economic growth rate as income growth rate, then the economic
growth rate in this economy equals to the human capital growth rate
h0
= 1 + (m ) s ;
h

which is increasing in ( ) and s. One can interpret the disutility cost from studying as working
attitude. It can be observed that s is decreasing in , which means that if the workers in a country
have better working attitude (lower ), the country will have higher s and thus higher growth rate.
With higher altruism, is higher and m is higher. With higher m, it may be possible that m mC ,
(m) = H , and results in a higher s. This indicates that with more altruistic workers who are more
willing to do transfers to their children, the economy may experience higher economic growth.

III. (A tale of two countries)

(a) With log utility, the saving functions in country A and country B are:

s wtA

s wtB

wtA
2
wtB
2

Firm maximization implies that

wtA

(1

) 2 ktA

wtB

(1

) ktB

, RtA = 2 ktA
, RtB =

ktB

Hence, the rich country A and the poor country Bs capital evolves according to
A
kt+1

B
kt+1

) ktA
) B
kt

(1
(1
2

(b) In the steady state, the capital per capita in country A and B
k~A

k~B

(1

)1

Hence, the per capita income in the steady state are

y~A = 2 (1

)1

y~B =

That is, y~A > y~B . Note that the only dierence between the rich and poor country is total factor
productivity. Therefore, the model predicts that the more productive country will have a higher per
capita income in steady state when the economies are isolated. The steady state interest rates and
wage rates are
w
~tA
w
~tB

=
=

2 (1

)1

(1

)
2

, RtA =

1
1

, RtB =

2
1

That is, real wage in steady state is higher in the country with higher total factor productivity, while
the rate of return on capital in steady state in the two countries are the same.
(c,d) When the capital can move costlessly across national borders, interest rates in every period are equalized, that is
RtA
2 ktA

RtB

ktB

) ktA = 2 1

ktB

When there is perfect capital mobility, the world saving equals the world capital stock in every period:
A
B
kt+1
+ kt+1
= (1

) ktA
2

1
2

ktB

That is
21

B
B
kt+1
+ kt+1

1 + 21

B
kt+1

(1

) 21

(1

) 21

1 + 21

ktB

ktB

1
2

1
2
1
2

ktB
ktB

ktB

and hence we have the same capital laws of motion we had before when the two countries are isolated:
A
kt+1

B
kt+1

(1
(1
2

) ktA
) B
kt

That is, if the two countries are already at the steady state before the capital market is open, nothing
will change when capital mobility is allowed: agents are indierent between investing in their own
country or in the foreign country. If one country is in the steady state while the other is not, capital
will ow from the country with lower marginal return on capital (the country in the steady state) to
the one with higher marginal return on capital (the country not in the steady state and with capital
level under the steady state level) when capital is allowed to move across borders. The interest rate
dierentials vanish as the capital market opens, while the per capita income gap persists.
IV. (Perpetual youth model) This question is essentially the same as the RCK model except the eective
time discount rate is higher. Thus, the required return on capital is higher in the steady state.