Macroeconomics III

Tutorial 4

Rajat Agarwal 13-612-650

University of St. Gallen
April 22, 2015

Contents
1 Base Economy and initial starting point

2 Alternative 1

3 Alternative 2

4 Alternative 3

List of Figures
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16

Diagram
Diagram
Diagram
Diagram
Diagram
Diagram
Diagram
Diagram
Diagram
Diagram
Diagram
Diagram
Diagram
Diagram
Diagram
Diagram

0:
0:
1:
2:
3:
4:
0:
1:
2:
3:
4:
0:
1:
2:
3:
4:

Phase diagram base economy

Phase diagram alternative 1
ln(yt ) alternative 1 . . . . .
ln(ct ) alternative 1 . . . . .
gt alternative 1 . . . . . . . .
Kt
and HYtt alternative 1 . . .
Yt
Phase diagram alternative 2
ln(yt ) alternative 2 . . . . .
ln(ct ) alternative 2 . . . . .
gt alternative 2 . . . . . . . .
Kt
and HYtt alternative 2 . . .
Yt
Phase diagram alternative 3
ln(yt ) alternative 3 . . . . .
ln(ct ) alternative 3 . . . . .
gt alternative 3 . . . . . . . .
Kt
and HYtt alternative 3 . . .
Yt

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.

1
3
3
4
4
5
6
7
7
8
8
10
10
11
11
12

The computations have all been done in MATLAB. In the attached exercise4.m file you can
change the the parameters and run the simulation. Since the computations of all alternatives
are the same and only the parameters change, I created a function simulateEconomy.m which
gets called from exercise4.m and runs with the parameters provided in that file. Please refer
to this .m file to see how the computations are performed. Please make sure that both .m
files are in the same directory while running exercise4.m.

Base Economy and initial starting point

The base scenario is defned by the economy being, in all periods from 0 to 200, in the
positive steady state of the Solow model with human capital, at parameter values = = 13 ,
sK = 0.12, sH = 0.2, = 0.055, n = 0, g = 0.02, A0 = 1.
The steady state values for such an economy are:
= 11.3778 y = 4.2667.
k = 6.8267 h
The following phase diagram illustrates this steady state and depicts how randomly
chosen points eventually converge to this steady state during the 200 periods.

20
Phase k
Phase h

18

16

14

12

10

Figure 1: Diagram 0: Phase diagram base economy

Alternative 1

In this scenario sK , the fraction of income for physical capital investment, changes from 0.12
to 0.24. The steady state values for this alternative economy are:
= 22.7556 y = 8.5333.
k = 27.3067 h
We can see that this change in sK results in stretching of the
kt = 0 =

1
t (n + g + + ng)kt )
(sK kt h
(1 + n)(1 + g)

t =
P hasek = h

(n + g + + ng)kt1
sH

! 1

phase curve to right (shifting it down) because

P hasek
<0
sK
and leaving the
t = 0 =
h

1
t (n + g + + ng)h
t)
(sH kt h
(1 + n)(1 + g)

t =
P haseh = h

sH kt
n + h + + ng

1
! 1

phase curve unaffected since

P haseh
=0
sK
The initial sK implies more accumulation of physical capital, but as soon as the increased
stock of physical capital begins to generate increases in output (via the production function),
more human capital will also be accumulated because of the constant rate of investment in
, y compared to the base
human capital, sH . This shifts the steady state to a higher k , h
scenario.
This transition is shown in figure 2 as a green dotted line.
Also while in tutorial 3 it took 13 periods for yt to reach its half way value to its new steady
state, in this alternative model (with human capital) the half way is reached in approximately
period 40 (41 with periods starting at 1), i.e. 30 periods after the exogenous shock of sK .
This fits with the refined Solow model, where the inclusuion of human capital, Ht , which is
accumulated similarly to physical capital, raises the overall elasticity of capital to output,
+ , and thereby delays the convergence to the steady state.

40
Phase k - Base
Phase h - Base
Phase k - Alternative
Phase h - Alternative
Transition

35

30

25

20

15

10

10

15

20

25

30

35

Figure 2: Diagram 0: Phase diagram alternative 1

7
Base
Alternative
Transtition

20

40

60

80

100

120

140

160

Figure 3: Diagram 1: ln(yt ) alternative 1

3

180

200

6
Base
Transtition
Alternative

5.5

4.5

3.5

2.5

1.5

20

40

60

80

100

120

140

160

180

200

Figure 4: Diagram 2: ln(ct ) alternative 1

0.045
Base
Transtition
Alternative

0.04

0.035

0.03

0.025

0.02

0.015

20

40

60

80

100

120

140

Figure 5: Diagram 3: gt alternative 1

160

180

200

K/Y Base
K/Y Transtition
K/Y Alternative
H/Y Base
H/Y Transtition
H/Y Alternative

3.2

2.8

2.6

2.4

2.2

1.8

1.6

1.4

20

40

60

80

Figure 6: Diagram 4:

100

Kt
Yt

and

120

Ht
Yt

140

160

180

200

alternative 1

Alternative 2

In alternative 2 sH increases from 0.2 to 0.25 while all other factors remain constant. The
steady state values for this alternative economy are:
= 17.7778 y = 5.3333.
k = 8.5333 h
Using the explanation from section 1 we can conclude that the h phase curve is shiftet
upwards since
P haseh
>0
sH
and the k phase curve is unaffected since
P hasek
=0
sH
The transition from the steady state of the base economy to the steady state of alternative
2 is given in figure 7 by the green dotted line.
Concerning the consumption sacrifice, comparing figure 4 and figure 9 shows that after
the exogenous shocks consumption initially decreases below the level of where it would be if
the shock didnt take place. This is because ct decreases after the exogenous shock because
the fraction of income for consumption (1 sH sK ) decreases. Analyzing ct by using
5

numerical methods it can be found out that in alternative 1 the counsumption sacrifice is 11
periods and in alternative 2 it is 16 periods. i.e. after the exogenous shock it takes 11 and
16 periods respectively till the economys consumption reaches a level at which it would be
if that exogenous shock did not happen (where the red line is above the blue line again).
From a development perspective, this may suggest that countries would be reluctant in
raising their savings rate, especially if they value present consumption more than future
consumption. This could be an explanation for the disputes between Germany and Greece,
which does not want to raise its savings rate because it will suffer less present consumption.
Germany howerver insists that Greece raises its savings beause it argues that the long-term
effects outweigh the short term consumption sacrifice (which can also be seen in figure 4 and
9).

30
Phase k - Base
Phase h - Base
Phase k - Alternative
Phase h - Alternative
Transition

25

20

15

10

10

Figure 7: Diagram 0: Phase diagram alternative 2

12

6
Base
Alternative
Transtition

5.5

4.5

3.5

2.5

1.5

20

40

60

80

100

120

140

160

180

200

Figure 8: Diagram 1: ln(yt ) alternative 2

5.5
Base
Transtition
Alternative

4.5

3.5

2.5

1.5

20

40

60

80

100

120

140

160

Figure 9: Diagram 2: ln(ct ) alternative 2

7

180

200

0.027
Base
Transtition
Alternative

0.026

0.025

0.024

0.023

0.022

0.021

0.02

0.019

20

40

60

80

100

120

140

160

180

200

Figure 10: Diagram 3: gt alternative 2

3.4
K/Y Base
K/Y Transtition
K/Y Alternative
H/Y Base
H/Y Transtition
H/Y Alternative

3.2

2.8

2.6

2.4

2.2

1.8

1.6

1.4

20

40

60

80

Figure 11: Diagram 4:

100

Kt
Yt

120

and

Ht
Yt

140

160

alternative 2

180

200

Alternative 3

In this alternative sH decreases from 0.2 to 0.15 and sK increases from 0.12 to 0.24 while all
other factors remain constant. The steady state values for this alternative economy are:
= 12.8 y = 6.4.
k = 20.48 h
Since

P haseh
>0
sH
P haseh
=0
sK

and

P hasek
<0
sK
P hasek
=0
sH
and sH < 0 and sK > 0 the h phase line shifts down while the k phase line shifts right.
t decreases due to sH and kt increases due to sK . However after several periods
At first h
the effect from sK outweighs the effect from sH and the change in physical capital accumulated is greater than the change in human capital. This translates via the production
t rising again. This explains the
function into a higher income, yt , which then leads to h
t first decreases and then starts increasing again while kt
transition path in figure 12 where h
rises continuously.
Considering all the alternatives analyzed in this tutorial, we can conclude that the economy always seem to react to parameter changes with a growth jump. We can even conclude
that this must be so all the time. The reason is that initially the economy is in steady state
and therefore grows at the rate of technological advance, g. If the parameters are changed,
then a new steady state exists which is only reached by the grwoth rate changing from g
to another growth rate. This change in growth rate is the jump and is there in all cases
because otherwise the new steady state would not be feasable. After that new steady state
is reached, the growth rate is back at g since then the economy is back in a steady state.
What can change is however the direction of the jump. If for instance sH and sK are
both < 0 then the direction of the jump would be negative.

25
Phase k - Base
Phase h - Base
Phase k - Alternative
Phase h - Alternative
Transition

20

15

10

10

15

20

25

30

Figure 12: Diagram 0: Phase diagram alternative 3

6
Base
Alternative
Transtition

5.5

4.5

3.5

2.5

1.5

20

40

60

80

100

120

140

160

Figure 13: Diagram 1: ln(yt ) alternative 3

10

180

200

5.5
Base
Transtition
Alternative

4.5

3.5

2.5

1.5

20

40

60

80

100

120

140

160

180

200

Figure 14: Diagram 2: ln(ct ) alternative 3

0.04
Base
Transtition
Alternative

0.035

0.03

0.025

0.02

20

40

60

80

100

120

140

Figure 15: Diagram 3: gt alternative 3

11

160

180

200

3.4
K/Y Base
K/Y Transtition
K/Y Alternative
H/Y Base
H/Y Transtition
H/Y Alternative

3.2

2.8

2.6

2.4

2.2

1.8

1.6

1.4

20

40

60

80

100

Figure 16: Diagram 4:

Kt
Yt

12

120

and

Ht
Yt

140

160

alternative 3

180

200