Step-by-step solution file
Intermediate Macro problem set. Please help with the entire
Intermediate Macro problem set. Please help with the entire document. Thank you so much!
ECON-UA 12 ? Intermediate Macroeconomics
Professor: Jaroslav Borovi?cka
TA: Jonathan Payne
Fall 2016 Problem Set 2
Due on October 7, in your recitation
Please read the instructions on problem sets in the syllabus carefully. 1 True or false? For each of the following statements, decide whether it is true or false, and explain your
answer in at most two sentences using the material you learned in the course.
No points will be given without an appropriate explanation!
Question 1.1 The arbitrage equation can only hold in an economy in which returns are
not taxed. Question 1.2 Imagine an economy with two investors. Investor 1 can only invest into a
savings account while investor two can only invest into capital, and the two investors cannot
trade with each other. Then the arbitrage equation equalizing the returns on the savings
account and the return on capital still holds. Question 1.3 The user cost of capital also reflects changes in the price of capital. Question 1.4 The price-dividend ratio is high when the dividend growth rate is high
because prices and dividends have to grow at the same rate. Question 1.5 When we look at empirical evidence, we can observe that poor countries
catch up but only when we focus on countries that follow sensible economic policies. Question 1.6 A plausible model of capital depreciation for a factory is one where one
machine depreciates (is destroyed) every year, regardless how big the factory is. Question 1.7 There are two steady states in the Solow growth model but one of them is
more of a mathematical curiosity than of any economic relevance.
1 Question 1.8 When the productivity parameter A increases in the Solow growth model,
the increase in output in the new steady state (relative to the old steady state) will be
larger than the increase in output caused by the same increase in A in the static model of
production from Chapter 4. Question 1.9 The Solow growth model documents that capital accumulation alone can
generate long-run growth. Question 1.10 In the article ?The Myth of Asia?s Miracle?, Paul Krugman argues that
growth in some East Asian economies bears remarkable similarities to that of the communist
Soviet Union, and that this fast growth must necessarily slow down. 2 The Gordon growth formula Recall the Gordon growth formula for the price-dividend ratio ps /d.
Question 2.1 Show by taking the appropriate derivatives that the price dividend ratio
is a decreasing function of the interest rate R and an increasing function of the dividend
growth rate gd . Question 2.2 Recall the graph for the price-earnings ratio from lecture slides (the Robert
Shiller data) and assume that earnings are equal to dividends. Further assume that the real
interest rate is constant at 7%.
If the Gordon growth formulas is correct, what would the dividend growth rate have to
be to explain the highest peak in the P/E ratio data that occurred around 2000?
Similarly, what would the dividend growth rate have to be to explain the deepest through
the the P/E data that occurred in early 1920s? Question 2.3 Are the numbers you obtained plausible? What else could justify the
fluctuations in the P/E ratio? 3 Comparative statics in the Solow growth model In this exercise, we want to assess the contribution of capital accumulation to our understanding of differences in output per capita across countries. We will distinguish between 2 the results obtained from the static model of production and from the Solow growth model.
Question 3.1 Start with the Cobb Douglas production function
Y = AK ? L1?? . (1) We want to compute what is the change in output after a parameter (like the TFP A)
changes. We will proceed exactly in the same way as when we computed annual growth
rates. Denote Yold the amount of capital before the change, and Ynew the amount of capital
after the change in a parameter. Then we can define
= 1 + gY
where gY is the growth rate of output from before until after the change. Substitute in
for Ynew /Yold from equation (1) and do the same for variables A, K, L. By using the
logarithmic approximation, derive the same formula for gY as the one that we were using
to compute annual growth rates (gY will be a function of gA , gK , gL and the parameter ?). Question 3.2 We will now do the same with the steady state relationship in the Solow
growth model. Take the formula for the steady-state capital-output ratio K ? /Y ? (it is a
function of s and ?), and substitute in for Y ? from the Cobb-Douglas production function.
Express K ? as a function of A, s, ?, L and ? only.
Once you are done, take again the production function and substitute in for K ? using
the formula that you just obtained to get an expression for Y ? as a function of A, s, ?, L
and ? only.
Hint: What you should ultimately get is
Y ? = A 1??
but make sure you provide all the intermediate steps in your answer. Question 3.3 Take the expression for output as a function of parameters. We now want
to express the cumulative growth rate of output between the old and the new steady state
when one of the parameters ?, s, A, L, changes (treat ? as constant). In order to do so,
define again the cumulative growth rate of output from the old to the new steady state as
? = 1 + gY
Yold and correspondingly the growth rates of ?, s, A, L; for instance
= 1 + gS .
Remember that gY is not an annual growth rate of output ? it is the total percentage
change in output between the old and the new steady state. Similarly, gS is the percentage
change in the saving rate parameter.
3 Now find the growth rate of output gY as a function of gA , gS , g? and gL .
Hint: The coefficient on gS that you should obtain is 1??
Important: It is important to understand what growth rate are we computing here.
This is not an annual growth rate, it is the cumulative growth rate that expresses the
percentage change in the steady state level of output after one of the variables of interest
(?, s, A, L) changes by a given percentage. It may therefore be more appropriate to call gY a
?percentage change? rather than the growth rate but given the similarities with our previous
computations, we will stick to the term growth rate, with the implicit understanding of
what is going on.
In what follows assume that the capital share is equal to 13 , as we have usually assumed.
Question 3.4 If the TFP parameter increases by 10%, how does total output change in
the model of production and in the Solow growth model? Why is there a difference? Question 3.5 If population increases by 3%, how does the total output in the economy
change in the model of production and in the Solow growth model? Why (or why not) is
there a difference? Question 3.6 So far, we computed changes in total output. We will now focus on the
growth rates of output per capita.
Compute the growth rate of output per capita, YL , in the model of production and in
the Solow growth model.
Hint: Notice that you do not need to derive everything from scratch, just slightly
reorganize the results for gY . Question 3.7 What happens to the level of output per capita when population increases
by 10% in the model of production? What happens to the steady state level of output per
capita when population increases by 10% in the Solow growth model?
Provide an economic explanation for the results. Why do you observe an negative sign
in your answer for the model of production? And why not in the Solow growth model? 4 Experiments in the Solow growth model In the questions in this section, we will use the Solow growth model, described by equations
Yt = AKt? L1??
?Kt+1 = sYt ? ?Kt
with a given initial value K0 .
Question 4.1 What are empirically plausible values for ?, s and ??
4 (3) Question 4.2 Sketch the Solow diagram (with the stock of capital on the horizontal axis),
including curves for output, depreciation and saving. Provide appropriate notation for
axes and the curves. Depict the steady state value for capital, K ? . Question 4.3 Into a separate graph, plot the net investment curve as a function of
the stock of capital. Clearly depict the steady state level of capital in this graph. 4.1 Experiment 1: Productivity increase Question 4.4 Use a new Solow diagram to capture the following experiment. The economy
starts in a steady state (with steady state level of capital K ? ). Then at time t0 the TFP
parameter A increases.
Plot the depreciation, investment, and output functions before and after the change
in A, clearly denoting each curve. Also clearly denote the old steady state K ? and the new
steady state K ?? . Question 4.5 In two separate graphs (underneath each other), plot the time trajectories
of the following quantities for the experiment described in the preceding question:
In each of the graphs, clearly depict the time t0 , and the original and new steady states
of each of the quantities. Question 4.6 Set up the problem of a profit-maximizing firm. The firm uses production
function (3) to produce output, pays each worker a competitive wage wt and rents each
unit of capital at a competitive rental rate rt . Take the first-order condition with respect
to capital to derive the relationship between the marginal product of capital and the rental
rate. Question 4.7 What is the steady-state level of the rental rate r ? ? How does it depend on
the productivity parameter A?
Hint: The following expression for the steady-state level of capital will be useful:
? K = sA
? 5 1
1?? L. All you have to do is to use this expression to substitute out capital in the first-order
condition for the capital choice. Question 4.8 Plot the time trajectory for the rental rate r. Clearly depict the time t0 ,
and the original and new steady state for the rental rate. Is the new steady-state rental
rate r ?? lower or higher than the original steady-state rental rate r ? ? Question 4.9 The expenditure approach to GDP calculates GDP by adding up components that are determined by how income is used (what is it spent on). On the other
hand, the income approach to GDP calculates GDP by adding up components that are
determined by how income is distributed (who earns it).
When we studied the model of production and the Solow growth model, we have seen
equations that capture each of these approaches. So for each of the two approaches, write
down the particular equation and write in one sentence what this equation represents.
Hint: One of these equations was related to the zero-profit result of a firm with Cobb?
Douglas technology, while the other was a resource constraint. 4.2 Experiment 2: Decline in saving rate Question 4.10 Assume that the economy starts in a steady state with capital K ? . Imagine
that at time t0 the saving rate in the economy declines to zero.
What will be the new steady state level of capital K ?? ? What will be the new steady
state level of wages w?? ? Provide an economic justification of your answers.
Hint: The wage is equal to the marginal product of labor, which you can compute from
the production function. 5 Reading: Nobel Prize in Economics Sciences 2013 This problem is based on the article ?Trendspotting in asset markets?.
Question 5.1 The efficient market hypothesis postulates that asset prices should reflect
all currently available information. As a result, it is near to impossible to predict in which
direction should the stock market move, say, in the next week. Why is that?
Hint: Imagine that we would know with a reasonable degree of certainty that the stock
market will crash next week. What should happen then? Question 5.2 Even though the stock market movements are near to impossible to predict
over short time intervals, there are empirical regularities in asset price data that allow us
to predict stock market movements over longer horizons, say over the business cycle. 6 What is the standard risk-based (rational) explanation for these movements? Provide a
verbal interpretation and illustrate this using the Gordon growth formula.
Hint: We argued that risk adjustments may change over the business cycle. Why? How
is this captured by the Gordon growth formula? What is the consequence of changes in
these risk adjustments for the behavior of the price-dividend ratio over the business cycle? Question 5.3 The behavioral finance literature would argue that while risk adjustments
may contribute somewhat to asset price fluctuations, there are other, more important factors
at play. Explain at least some of these factors that may generate movements in asset prices. References 7
This question was answered on: Feb 21, 2020
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