Macroeconomics and Economic Policy

Gregory de Walque

Chapter 11: exercises

11.1 .
(a) True in the simplied framework of the Solow model where
- the economy is assumed to be closed (no foreign saving)
- the government budget is supposed to be in equilibrium (G =
T)
such that the only possible source of investment is the private
saving. Therefore It = St = sYt .
(b) False. A higher investment (=saving) rate will temporarily increase the growth rate of output. This eect is however limited
in time and the economy will converge towards a new long run
equilibrium with a higher output per worker but a zero growth
rate.
(c) True. If capital never depreciated, then an increase in capital stock
will always have a higher return in terms of GDP than the depreciation of capital (equal to zero by assumption), even in the
presence of decreasing returns in capital. Such an economy would
never reach its long run equilibrium and would be growing forever.
(d) False. The higher the saving rate, the higher the GDP per worker.
However, this is dierent from consumption per worker. In particular with s = 1, we have that consumption is nil since Ct =
(1 s) Yt . There exists a particular saving rate sGR , named
the Golden Rule saving rate, such that consumption per worker is
maximized.
(e) False for two reasons.
i. Shifting from a pay-as-you-go (PAYG) pension system to a
fully funded (FF) one cannot increase consumption in the
short run since the pensioners will initially not receive their
pension benet anymore (as workers will now save through
banks instead of paying a pension to the elderly in expectation of the same treatment by the next generation when they
will be old). Therefore aggregate consumption will be initially
decreased.
1

ii. In the long run, it is not obvious that shifting from a PAYG
pension system to a FF pension system would increase consumption. This can only be the case if s < sGR . If s > sGR ,
the economy is already saving too much and shifting towards
a FF system will make it even worse.
(f) This is actually the viewpoint defended since a long time by Martin Feldstein (Harvard University) and some followers. However,
the computation of the ideal (I mean the Golden Rule) saving
rate is not trivial. It depends on several parameters ( , the exact
functional form of the production function, and as seen in chapter 12, of gN and gA ). Feldsteins computation for the US indeed
advocates for an increase of the saving rate which can be engineered through a fully funded pension system. However, since the
pension system is now mainly pay-as-you-go, switching from one
system to the other cannot be done at once since it will make
surfer strongly the actual generation, which will have to pay for
the pension of their parents (pay-as-you-go pension system) and
at the same time save in nancial assets for their own pension.
This process must therefore be spread over several generations.
The transition does not need to be done through tax breaks for
savings. This is one possibility (which is used at very little scale
in Belgium) but not the only one. It could also be done through a
gradual (very slow) reduction of the pension benets paid under
the PAYG regime and the accumulation of the excess into a trust
fund. Note however that PAYG and FF pension system have both
their own dangers:
- in a PAYG pension system, if the population stop to grow,
or even start to decrease, the burden of the pension of the
elderly on the shoulders of the population in age to work gets
heavier and this can become unsustainable
- in a FF system, the saving are placed in some fund through the
nancial system. In the case of a major nancial disruption
as we observed in 2008 and since then, the nancial assets
serving to save may disappear partially or totally. There is
thus an intrinsic risk associated with this form of pension
system, which is due to the nature of the nancial assets.
Diversication of the portfolio surely helps but is of little help
in the presence of a systemic crisis.
(g) True. Education is a particular form of investment, an investment
in human capital. Education does not only help the educated per2

son to get a better productivity and then a higher wage, but this
person furthermore helps to improve the global production level,
with positive externalities for the society as a whole. It is the very
nature of positive externalities to be insu ciently nanced by the
private sector. Therefore a subsidy is fully justied, as long as it is
lower than the derived advantage given by the positive externality
producing good (here education).
11.2 It is clear from this chapter that in the long run there is no paradox
of saving. Indeed, we have seen that a higher saving rate will always
yield to a higher GDP per worker in the long run. Indeed, a higher
saving rate means more capital per worker which is a production factor
allowing to produce more.
11.3 We agree that the long run growth rate of the economy is independent of
the saving rate. Indeed, the Solow model establishes that in the long run
the economy converges towards an equilibrium growth path such that
gY = gN + gA . This growth path is totally independent of the saving
rate. However, we must disagree with the statement that one shouldnt
worry about the saving rate. Even though the long run growth rate of
the economy is independent of s, the level of the GDP/per worker in
the long run is directly related to the saving rate, and this is even more
true for the consumption per worker, since the choice of the saving rate
can help maximize the aggregate consumption per worker.
11.4 Shifting from a PAYG pension system towards a FF pension system will
increase the saving rate s since young workers will now save through
bank accounts (and banks will then invest this money) instead of giving it directly to the elder people who use it for their consumption.
However, this increase in s does not aect the long run growth rate of
output per worker since the latter is independent of s in the long run.
However, it will decrease the long run output per worker, as this one is
always growing in s (and is maximized for s = 1). However the answer
is much more complicated in what concerns the long run level of consumption per worker: it actually depend of the position of the initial
saving rate with respect to the Golden Rule saving rate. If sinit < sGR ,
then shifting from a PAYG pension system to a FF pension system will
increase s above sinit and bring it closer to sGR , such that consumption
per worker will increase. If sinit > sGR , then shifting from a PAYG
pension system to a FF pension system will increase s above sinit and
bring it even further from sGR , such that consumption per worker will
decrease.
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11.5 In the long run,

- output per person will be positively aected by the right to exclude saving from the tax base. Indeed, this will act as an incentive
to save more since, beside the usual benet from saving it furthermore drive a "scal dividend" by allowing to pay less taxes.
- if, for a constant population more women enter the labor market
and thus the labor force, this will have an impact on the level
of output which will increase since the labor force is augmented.
However, output per worker will not be modied in the long run
since this higher output will be produced by a higher number of
workers. But the question relates to output per person which will
be denitely increased since the population is now made of a larger
number of person participating to the production of market goods
and services while less persons stay away from the production
sector (note that women staying home produce lots of goods and
services but these are not computed into the GDP).
11.6

p p
Y = 0:5 K N
(a) Then output per worker is equal to
p p
Y
0:5 K N
=
N
rN
K
= 0:5
N
and in steady state, we can easily compute the capital stock per
worker
Kt+1
N

Kt
N

Yt
Kt
= 0 8t
N
N
Yt
Kt
, s =
N rN
Kt
Kt
, s 0:5
=
N
N
r
s
Kt
, 0:5 =
N
Kt
s 2
,
= 0:5
N
= s

and therefore the steady state output per worker is

r
Y
K
= 0:5
N
rN
s 2
0:5
= 0:5
= 0:25

(b) The steady state output per worker has been derived in (a) above.
Consumption per worker can be computed by using the following
identities
Y = C +I
I = sY ) C = (1

s)Y

Therefore
C
N

= (1
= 0:25

Y
N
s(1

s)

s)

(c) (d) and (e). Using the answers in (a) and (b) above, we can easily
enter the formulas into an xls spreadsheet and obtain the folC
Y
(s) and N
(s) for
= 0:05 and
lowing graphs for the series N
s = 0; 0:01; 0:02; :::1.

As predicted by the theory of the Solow model, we observe that

the long run (steady state) level of output per worker is maximized
for s = 1, while the long run (steady state) level of consumption
C
is maxiper worker is minimized for s = f0; 1g. Steady state N
mized for s = 0:5. The reason why consumption per worker is not
maximized when income per worker is maximized is that what is
saved and invested cannot be consumed. There is thus a trade-o
between saving (which allows to produce more) and consuming.
We could have found the saving rate that maximizes consumption per worker (i.e. the golden rule saving rate sGR ) through the
following computation:
@C=N
@s

=
= 0:25
= 0:25

and

C
N

s(1 s)

@ 0:25

@C=N
@s

is maximized when
@C=N
@s

(1

@s
s)

(1

0:25

2s)

is equal to zero, i.e. if

= 0:25

(1

2s)

=0

, s = 0:5
11.7 We assume the following production function
= K N1
1
=
3

Y
with

(a) We can prove that this production function displays constant return to scale. Indeed, if we multiply both K and N by some constant x, then output will be multiplied by x as well:
(xK) (xN )1

=
=
=
=

x K x1 N 1
x +1 K N 1
xK N 1
xY

(b) This production function displays decreasing returns to capital.

Indeed, the larger capital is, the less an increase in the capital
6

stock by one unit will increase total output. In mathematics,

@ (K N 1 )
@K
= K 1N 1
1
N
=
K

@Y
@K

and you directly observe that if K = 0, then

@Y
K ! 1, then @K
= 0.

@Y
@K

= 1, while if

(c) The same can be said about labour. This production function
displays decreasing returns to labour. Indeed, the larger labour
is, the less an increase in the number of workers by one unit will
increase total output. In mathematics,
@Y
@N

@ (K N 1 )
@N
= (1
) K N
K
= (1
)
N
=

and you directly observe that if N = 0, then

@Y
N ! 1, then @N
= 0.

@Y
@N

= 1, while if

(d) Dividing the production function by N we can transform it into

a relationship between capital per worker and output per worker,
thanks to the property observed above in (a) of constant return
to scale:
Y

= K
Y
,
N
Y
,
N
Y
,
N

N1
K N1
=
N
=K N
=

K
N

(e) In steady state, there is no more capital accumulation per worker

such that
Kt+1
N

Kt
N

Y
K
=0
N
N
Y
K
, s =
N
N
K
K
, s
=
N
N
= s

K
N
s

K
=
N

1
1

(f) From what we computed in (d) and (e) above, we can derive the
steady state output per worker as
Y
N

K
N
s 1

=
=

(g) If = 1=3, = 0:08 and s = 0:32, we can then easily compute

that the steady state output per worker is
Y
N

=
=

0:32
0:08

1=3

= 4 1=3
= 41=2
= 2
(h) If s drops now from s = 0:32 to s = 0:16, the steady state output
per worker would drop from 2 to
Y
N

=
=

0:16
0:08
1=3

= 2 1=3
= 21=2
= 1:41
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which means that halving the saving rate reduces output per
worker but by less than a factor 2.
11.8 We continue with the production function
= K N1
1
=
3

Y
with
but now state that

= s = 0:1:

(a) From 11.7(e) above, the steady state capital per worker can be
computed as
K
N

= 1
(b) And it follows that the steady state output per worker will be
equal to unity accordingly since
Y
=
N

K
N

=1

Y
=N
= 1 and that
(c) If the economy is at its steady state such that K
N
suddenly the depreciation rate increases from = 0:1 to 0 = 0:2,
the economy will move away from its initial long run equilibrium
and converge slowly towards a new one. This new steady state will
be reached when

K
N

0
1

= 0:5 2=3
= 0:53=2
= 0:35
and
Y
N

= 0:50:5
= 0:71
Without surprise, as increases to 0 , the steady state capital
stock per worker decreases as well as the steady state output per
worker.
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(d) Lets say that in period t = 0 the economy is at its initial steady
Y
= N
= 1. Then jumps from 0:1 to 0 = 0:2. In order
state K
N
to asses the dynamic path of the economy, we have to use the
equation of capital accumulation
Kt+1 Kt
Yt
0 Kt
=s
N
N
N
N
We then compute
K1 K0
Y0
0 K0
= s
N
N
N
N
Y0
K1
0 K0
= s + (1
)
,
N
N
N
K1
,
= 0:1 1 + 0:8 1
N
K1
= 0:9
,
N
1=3
Y1
K1
= 0:91=3 = 0:97
and
=
N
N
The next period we have
K 2 K1
Y1
0 K1
= s
N
N
N
N
Y1
K2
0 K1
= s + (1
)
,
N
N
N
K2
,
= 0:1 0:97 + 0:8 0:9
N
K2
,
= 0:82
N
1=3
Y2
K2
and
=
= 0:821=3 = 0:94
N
N
and in period t = 3, we get
K3 K2
Y2
0 K2
= s
N
N
N
N
K3
Y2
0 K2
,
= s + (1
)
N
N
N
K3
,
= 0:1 0:94 + 0:8 0:82
N
K3
,
= 0:75
N
1=3
Y3
K3
and
=
= 0:751=3 = 0:91
N
N
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11.9 Let us now use the production function

p p
Y = K N
which, you will verify, is actually identical to the production function
= K N1
1
=
2

Y
with

(a) With such a production function, one can easily nd the steady
state capital per worker as well as the steady state output per
worker. The procedure is the same as the one applied in 11.7(e)
above. The rst step requires to nd the level of capital per worker
such that capital accumulation is nil. From the capital accumulation equation we get
Kt+1 = (1
)Kt + s Yt
Kt
Kt+1
= (1
)
+s
,
N
N
Kt+1 Kt
Yt
,
=s
N
N
N

Yt
N
Kt
N

and
Kt+1
N

=
,
,
,
,
,
,

Kt
K
=
N
N
K
Y
=
s
N
N
Y
K
s
=
N
p pN
K N
K
=
s
N
p N
K
K
s p =
N
N
r
s
K
=
N
K
s 2
=
N

and therefore the steady state output per worker is

r
Y
K
s
=
=
N
N
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(b) If s = 18% and

state

while

= 8%, then we easily compute that in steady

s
0:18
Y
= =
= 2:25
N
0:08
K
s
=
N

= 2:252 = 5:06

(c) If the private saving rate remains equal to 18% but that the public
(or government) saving rate jumps from 0 to 6%, the national
saving rate becomes 18% + 6% = 24%. This increase in s has
the eect of increasing gradually the capital stock per worker up
to a new long run equilibrium. The new steady state that will
be reached in the end of the convergence process can easily be
computed as
snew
0:24
Ynew
=
=
=3
N
0:08
snew 2
Knew
=
= 32 = 9
N
We clearly observe that the capital stock per worker has considerably increased thanks to this increased saving rate, yielding to
a higher output per worker as well.

12