Instructor: Dr.
Divya Tuteja
Indian Institute of Foreign Trade
M.A. Economics: Winter Semester 2024-25
Advanced Topics in Macroeconomic Theory Problem Set 3
1. Consider the following modified version of the Solow model where output is
produced by identical firms using a CRS technology:
𝑌𝑌𝑡𝑡 = (𝐾𝐾𝑡𝑡 )𝛼𝛼 (𝐴𝐴𝑁𝑁𝑡𝑡 )1−𝛼𝛼 ; 0 < 𝛼𝛼 < 1.
Each firm takes the labour productivity factor (A) as given which grows at the rate
𝐴𝐴̇
𝑚𝑚 i.e. 𝐴𝐴 = 𝑚𝑚 and maximizes profit so as to equate the marginal product of labour
and capital to the market wage rate and market interest rate respectively. The
entire output is distributed to the households in the form of wage income (wL)
and interest income (rK). Suppose further that the wage-earners consume their
entire income and save nothing; while the interest-earners save their entire
income and consume nothing. The aggregate savings so generated are
automatically invested in physical capital formation which augments next period’s
physical capital over time (with no depreciation of capital). Labour force grows at
a constant exogenous rate n.
(i) Derive the dynamic equation for 𝑘𝑘𝑡𝑡 .
(ii) Plot the corresponding phase diagram and show that there exists a non-
trivial steady state which is stable.
(iii) Verify that the non-trivial steady state is always dynamically efficient.
2. Consider a Solow type economy where technology at time 𝑡𝑡 is given by the
following production function:
𝑌𝑌𝑡𝑡 = 𝐾𝐾𝑡𝑡𝛼𝛼 𝑁𝑁𝑡𝑡1−𝛼𝛼 + 𝐴𝐴𝐾𝐾𝑡𝑡 ; 0 < 𝛼𝛼 < 1, 𝑤𝑤ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝐴𝐴 𝑖𝑖𝑖𝑖 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐.
Population in the economy grows at a constant rate 𝑛𝑛. There is no depreciation of
the existing capital stock.
(i) Derive the dynamic equation for the capital-labour ratio for this economy.
(ii) Derive the parametric conditions under which this economy will exhibit
perpetual growth of income per unit labour.
(iii) What is the corresponding rate of growth of per capita income and
aggregate income?
3. Consider a standard two-period overlapping generations model where all the
agents have identical preferences. Each young agent is endowed with one unit of
labour and no capital or bequests. Suppose that the representative agent has the
1
Advanced Topics in Macroeconomic Theory Problem Set 3
Instructor: Dr. Divya Tuteja
Indian Institute of Foreign Trade
1−𝜎𝜎 1−𝜎𝜎
�𝑐𝑐𝑡𝑡1 � �𝑐𝑐𝑡𝑡2 �
following lifetime utility function: 𝑈𝑈(𝑐𝑐𝑡𝑡1 , 𝑐𝑐𝑡𝑡2 ) = + ; 𝜎𝜎 ≠ 1. Technology
1−𝜎𝜎 1−𝜎𝜎
𝛼𝛼 1−𝛼𝛼
is given by the production function: 𝑌𝑌𝑡𝑡 = 𝐴𝐴𝐾𝐾𝑡𝑡 𝐿𝐿𝑡𝑡 ; 0 < 𝛼𝛼
< 1. Population in
successive generations grows at the constant rate 𝑛𝑛 and there is no depreciation
of capital stock.
(i) Derive the dynamic equation for 𝑘𝑘𝑡𝑡 in this economy.
(ii) Derive a parametric restriction for 𝜎𝜎 which will ensure existence of a
unique perfect foresight path for 𝐾𝐾/𝐿𝐿 ratio in this case.
(iii) Assuming that the above parametric restriction is satisfied, derive the
equation which identifies the steady state value of 𝐾𝐾/𝐿𝐿 for this economy.
Using this equation, show that a unique non-trivial steady state exists.
𝑑𝑑𝑑𝑑𝑡𝑡+1
(iv) Calculate 0 < � < 1 and comment on the local stability property of
𝑑𝑑𝑘𝑘𝑡𝑡 𝑘𝑘∗
the non-trivial steady state.
4. Show that in the OLG framework, the golden rule value of capital labour ratio not
only maximizes the steady state value of ‘average’ (or per capita) consumption,
but it also maximizes the steady state value of life-time utility of any agent.
5. Consider a standard two-period overlapping generations model where all the
agents have identical preferences. Each young agent is endowed with one unit of
labour and no capital endowment or bequests. A representative agent belonging
to generation t works only in the first period of his life. Out of his first period wage
income, he consumes a part (𝑐𝑐𝑡𝑡1 ) and saves (and invests) the rest (𝑠𝑠𝑡𝑡 ). His savings
in period t gets converted into capital stock in period t+1 one-to-one, which
generates some (expected) interest income in period t+1. The agent consumes his
entire (expected) interest earnings in period t+1, along with the capital stock.
Suppose the representative agent of generation t has the following life-time utility
function:
2 ) 2
𝑢𝑢(𝑐𝑐𝑡𝑡1 , 𝑐𝑐𝑡𝑡+1 = 𝑙𝑙𝑙𝑙𝑙𝑙𝑐𝑐𝑡𝑡1 + 𝑙𝑙𝑙𝑙𝑙𝑙𝑐𝑐𝑡𝑡+1 .
Aggregate production function in the economy is Cobb-Douglas:
𝑌𝑌𝑡𝑡 = (𝐾𝐾𝑡𝑡 )𝛼𝛼 (𝐴𝐴𝑡𝑡 𝑁𝑁𝑡𝑡 )1−𝛼𝛼 ; 0 < 𝛼𝛼 < 1.
Population in the successive generation grows at a constant rate n and there is no
depreciation of capital stock.
(a) Assume that agents have ‘static expectation’ about the future interest rates, i.e.,
𝑒𝑒
𝑟𝑟𝑡𝑡+1 = 𝑟𝑟𝑡𝑡 .
(i) Derive the aggregate savings in this economy at any period t.
(ii) Derive the dynamic equation for the capital-labour ratio and draw the
corresponding phase diagram. On the basis of the phase diagram, argue
that there exists a unique non-trivial steady state 𝑘𝑘 ∗ , which is stable.
(iii) Calculate the precise value of 𝑘𝑘 ∗ in terms of the parameters.
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Advanced Topics in Macroeconomic Theory Problem Set 3
Instructor: Dr. Divya Tuteja
Indian Institute of Foreign Trade
(b) Now assume the agents have ‘perfect foresight’ about future interest rates, i.e.,
𝑒𝑒
𝑟𝑟𝑡𝑡+1 = 𝑟𝑟𝑡𝑡+1 .
(i) Derive the aggregate savings in this economy at any period t.
(ii) Derive the dynamic equation for the capital-labour ratio and draw the
corresponding phase diagram. On the basis of the phase diagram, argue
that there exists a unique non-trivial steady state 𝑘𝑘 ∗ , which is stable.
(iii) Calculate the precise value of 𝑘𝑘 ∗ in terms of the parameters.
(iv) Compare the steady state value of 𝑘𝑘 ∗ derived in case (a) vis-à-vis case
(b). Which one is higher and why?
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Advanced Topics in Macroeconomic Theory Problem Set 3
