Dear ECN 101, The homework below covers the subject of economic growth and takes material from

the lectures and from the textbook chapters #7 and #8. These problems will test your basic understanding of the Solow Growth Model elements, in particular the Golden Rule steady state level of Consumption. The questions also are geared to reflect the types of problems that might appear on an exam. Please regard this homework as a PRACTICE EXAM. Take your time with these, and if you have any questions, PLEASE SEE our TAs or myself. Like I said, work slowly and carefully, and you will understand the material! REMEMBER, REPETITION IS A SOURCE OF SKILL! (1) Serenity Economics question: In lecture we saw that the key to sustained increases in the macro-economic standard of living (Y/L) is individual worker effectiveness, that is, a rise in worker productivity. Using Serenity Economics Chapters #3 and #5 as a guide, choose five things that workers can do to help the economy grow. (2) If we take a macroeconomic production function of the form Y = f( K, L ), how can we restate the function in order to break out the four principle sources of growth of real income. (Use the theory of the neo-classical distribution of income to do this) This is kind of a REPEAT QUESTION, but it helps to really understand the growth process. Remember, firms in the economy aim to maximize profits. (3) Think about and answer the following: (a) How can government policy raise the rate of saving in an economy? (b) What institutions need to be present to encourage savings in a society? (4) In the full Solow Growth Model, assume that the depreciation of the capital stock, and n (growth of the labor force) are greater than zero. The growth rate of worker efficiency, g, is zero. What are the alternatives to changing the rate of saving in order to reach a higher K/L ratio at the STEADY STATE equilibrium? How would you go about promoting these changes? (5) In words, how would you distinguish overall change in technology from the technical change embodied in a rise in worker effectiveness? (6) Serenity Economics question: Given your answer to (5) above, how would you describe your increase in worker effectiveness when you were alone on the island (Chapter#2) relative to any increase you might want to achieve today in Davis? What might be different about these two changes in your effectiveness that has to do with the overall level of Technology? (The Big A)

(7) You are the boss of an economy that has worker efficiency rising at a 1 percent annual rate. The labor force is growing by 4 percent annually. The depreciation rate of your capital stock per worker is 10 percent. Also your economy is operating at a savings rate whose associated capital/labor ratio steady state is ABOVE the GOLDEN RULE steady state. Your challenge (should you choose to accept it) is to get to the golden rule steady state, which is the steady state that gives maximum consumption to each worker in the economy (maximum C/L* or maximum c*). What do you propose to do and how might you go about it? What happens to consumption per worker as you go from where you begin to the Golden Rule steady state? What happens to the MPK as you approach the Golden Rule Steady State? What value of MPK are you aiming for? Hint: think of MPK as the "return on capital" in this instance. (8) You are the boss of an economy that has no rise in worker efficiency and whose labor force is not growing. The depreciation rate of your capital stock per worker is 10 percent. Also your economy is operating at a savings rate whose associated capital/labor ratio steady state is below the golden rule steady state. Your challenge is to get to the golden rule steady state, which is the steady state that gives maximum consumption to each worker in the economy. What do you propose to do and how might you go about it? What happens to consumption per worker as you go from where you begin to the Golden Rule steady state? What happens to the MPK as you approach the Golden Rule Steady State? What value of MPK are you aiming for? Hint: think of MPK as the "return on capital" in this instance. (9) You live in an economy that has no change in worker efficiency, but has a labor force that is growing at the rate of 5 percent annually. The existing stock of capital in the economy wears out at a rate of 10 percent per year. You are already in a Steady State but not the "Golden Rule" Steady State. Your goal is to try to get to the Golden Rule Steady State level of capital per worker. a. You first measure the marginal productivity of capital (MPK) in the economy and find that you must increase investment to reach the Golden Rule Steady State. What does this

tell you about the level of the MPK? Hint: Think of the MPK as the "rate of return on capital". b. What happens to the MPK as you increase investment? c. What is the value of MPK that you are aiming for as you strive to reach the Golden Rule Steady State? d. In a few words, describe what happens to consumption per worker, as you move from the initial Steady State to the Golden Rule Steady State. (10) Now, in the Solow Model STEADY STATE of ANY ECONOMY that has positive rates of capital depreciation, labor force growth and rise in worker effectiveness, what is the rate of growth of: a. real GDP (Y) b. real GDP per worker (Y/L) c. real GDP per effective worker (Y/L*E)? (11) NOW: take a production function of the form Y = K1/3 * L2/3. (the 1/3 and the 2/3 are exponents of K and L.) With a savings rate of 0.3 (30%) and a depreciation rate of 0.1 (10%), can you calculate the value of income per worker (Y/L) (little y), and capital per worker (K/L) (little k) at the steady state associated with these values for the rate of saving and the rate of depreciation? Just by looking at this production function how can you tell it is CRS (constant returns to scale)? (Hint: the values of little "n" and "g" are zero in this problem.) (12) Now do the same calculations as in (11) with the production function as Y = K1/2 * L1/2. (This should be easier). (13) Serenity Economics question: With one or two sentences each, please indicate three ways the quality of "human capital" and be increased in an economy. How would you think that your overall attitude toward the economy and its possibilities might affect the attempts to increase the quality of human capital? (14) We have discussed how increasing the rate of domestic saving will raise the steady state level of capital and income per worker in the Solow Model. Yet, the rate of saving can

be excessive. In the context of the Solow Model of Economic Growth, what does "saving can be excessive" mean? (15) Serenity Economics question: We have discussed the relationship between saving and investment many times. Now, take yourself back to the island in chapter #2. When you were alone, you were a closed economy. You tried to increase your standard of living, by saving. Was this saving (taking time not to consume) investment? What forms did this investment take? Do you see the equality here between S and I? (16) Can you now see from all we have discussed that for any economy to sustain economic growth, and a rising standard of living of the individuals who live in it, we need: a good system of education supported by a stable and trustworthy political and social environment? Our theory is clear. People will not invest in themselves unless they have a positive mental attitude toward the community and the environment in which they live. Take away or retard the development of these things, and you limit the possibilities for growth. Seen from this point of view, it is less of a mystery why the United States controls some 25% of global GDP! (17) Please remember to CAREFULLY READ Chapters #7 and #8, but also remember that part of the next midterm will reflect some of the problems in this homework, so there should be no surprises.