Question 3 [20 marks]
An economy can be described by the production function,
๐ = ๐น(๐พ, ๐ฟ) = ๐พ ๐ผ๐ฟ 1โ๐ผ
(a) Show that this production function exhibits constant returns to scale?
(b) What is the per-worker production function?
(c) Assuming a version of the Solow growth model with population growth but no technological progress, find expressions for the steady-state capital-output ratio, capital stock per worker, output per worker, and consumption per worker, as a function of the saving rate (๐ ), the depreciation rate (๐ฟ), and the population growth rate (๐). (You may assume the condition that capital per worker evolves according to โ๐ = ๐ ๐(๐) โ (๐ + ๐ฟ)๐.)
Now consider a specific economy described by the production function,
๐ = ๐น(๐พ, ๐ฟ) = ๐พ 0.6๐ฟ 0.4
The economy has no technological progress and has a depreciation rate of 5% per year. The economy starts in a steady state with growth in output (๐) of 5% per year. Further, the economy exhibits a capital-output ratio of 2 in this steady state.
(d) What is the saving rate for this economy? [4 marks]
(e) Suppose that the saving rate changes such that the economy transitions to the Golden-Rule steady state. What is the capital-output ratio at the Golden-Rule steady state? What is the new saving rate? [6 marks]
(f) Draw a diagram with time, ๐ก, on the horizontal axis, and consumption on the vertical axis to show how consumption per worker increases and/or decreases as the economy transitions from the starting steady state to the Golden-Rule steady state. Was this economy initially in a dynamically efficient or dynamically inefficient steady state? Explain your answer.|
