EC 502: Midterm Exam for Spring 2016 SOLUTIONS

Exam Instructions

• There are 100 points in total on this exam. You have exactly 1 hour and 20 minutes to
complete the exam. Budget your time accordingly.

• You may not use any outside written material (e.g. notes) or any electronic device during
this exam.

• You must show your work, i.e. you will not receive full credit for simply writing the correct
answer without any justification.

• Before writing anything, record your name and BU ID number below!

NAME:
BU ID:

1. True/False/Uncertain (30 points total)

Please indicate whether the statement in each part is true, false, or uncertain given the
information provided. You must briefly justify your answer, i.e. you will not receive full credit
for simply stating the answer without an explanation.
P γ
N ρ ρ
(a) (8 points) Let Y = i=1 αi Xibe a production function with N inputs X1 ,..., XN
where αi > 0 for all i. Assume that ρ < 1 and γ > 0. If N
P
i=1 αi = 1, then Y exhibits
constant returns to scale.
Let λ > 0 be given, and then note that if Y = F (X1 , ..., XN ), then

N
! γρ N
! γρ
αi Xiρ
X X
F (λX1 , ..., λXN ) = αi (λXi )ρ = λγ = λγ F (X1 , ..., XN ).
i=1 i=1

In general, we may have λγ > λ, λγ < λ, or λγ = λ depending on the value of γ.

So, with the information provided, it is UNCERTAIN whether the production function
exhibits constant returns to scale.
(b) (7 points) Let Y = K α (AL)1−α be an aggregate neoclassical production function, with
0 < α < 1. Y is GDP , K is the capital stock, A is technology, and L is labor input. A
labor share of around 23 in the US data is consistent with the value α = 23 .
With firm profit maximization it must be the case that the first-order condition
∂Y Y
= (1 − α) = W
∂L L
holds, so that
WL
1−α= .
Y
2
In other words, 1 − α is the labor share. So 1 − α = 3 in the US data implies α = 13 .
The statement is therefore FALSE.

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(c) (8 points) Assume that time is continuous and that output Y (t) depends upon technol-
ogy A(t) and labor L(t) according to the production function Y (t) = A(t)σ L(t), where
Ȧ(t)
σ > 0. Technology A(t) and labor L(t) grow at constant rates, with A(t) = g and
L̇(t)
= n. The growth rate of output Y (t) is given by σg + n.
L(t)
The assumed laws of motion for A(t) and L(t) imply that

A(t) = A(0)egt , L(t) = L(0)ent .

Therefore, we have that

σ
Y (t) = A(t)σ L(t) = A(0)egt L(0)ent = A(0)σ L(0)e(σg+n)t .

We conclude that Y (t) grows at the rate σg + n. The statement is therefore TRUE.

(d) (7 points) The utility function U (C) = −e−ρC with ρ > 0 exhibits diminishing marginal
utility of consumption.
We have that
U 0 (C) = ρe−ρC
U 00 (C) = −ρ2 e−ρC < 0
Therefore, by definition, this utility function exhibits diminishing marginal utility of con-
sumption with U 00 (C) < 0. The statement is therefore TRUE.

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2. Solow Model (35 points total)
Time is continuous, and output Y (t) is given by the neoclassical production function Y (t) =
F (K(t), A(t)L(t)), where K(t) is capital, A(t) is technology, and L(t) is labor. F exhibits
constant returns to scale. The exogenous laws of motion for technology and labor are
Ȧ(t) L̇(t)
A(t) = g and L(t) = n. Investment is a constant fraction of output with I(t) = sY (t), and
the law of motion for capital is given by K̇(t) = I(t) − δK(t). To fix terminology, g > 0 is
the technology growth rate, n > 0 is the population growth rate, 0 < s < 1 is the savings
K(t) Y (t)
rate, and 0 < δ < 1 is the capital depreciation rate. Let k(t) = A(t)L(t) and y(t) = A(t)L(t)
be capital and output per efficiency unit of labor, respectively. Let y(t) = f (k(t)) be the
intensive form of the production function. Note that the law of motion for k(t) is given by
k̇(t) = sf (k(t)) − (n + g + δ)k(t),
a result which you may take as given.
(a) (6 points) The term sf (k(t)) in the law of motion for k(t) is realized investment per
efficiency unit of labor. The term (n + g + δ)k(t) is known as break even investment.
Draw a figure which plots both realized investment per efficiency unit of labor and break
even investment as a function of k(t). On the horizontal axis, mark the steady state
level k ∗ such that k̇(t) = 0 whenever k(t) = k ∗ .
The figure will look something like

(b) In the long run, the level of capital per efficiency unit of labor approaches the steady
state level, i.e. k(t) → k ∗ . Similarly, if y ∗ = f (k ∗ ), then output per efficiency unit of
labor approaches y ∗ , i.e. y(t) → y ∗ . For each of the sub-questions (i)-(iv) in this part,
justify your answer using expressions involving only parameters from the following list:
A(0), L(0), g, n, k ∗ , and y ∗ .
i. (3 points) What is the long run growth rate of K(t)?
In the long run,
K(t) = k(t)A(t)L(t) → k ∗ A(t)L(t),
but the laws of motion for A(t) and L(t) imply that A(t) = A(0)egt and L(t) =
L(0)ent . Therefore,
K(t) → k ∗ A(0)L(0)e(g+n)t ,
so K(t) grows at rate g + n in the long run.

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ii. (3 points) What is the long run growth rate of Y (t)?
In the long run,

Y (t) = y(t)A(t)L(t) → y ∗ A(t)L(t) = y ∗ A(0)L(0)e(g+n)t

Therefore, Y (t) grows at rate g + n in the long run.

iii. (3 points) What is the long run growth rate of K(t) + Y (t)?
In the long run,

K(t)+Y (t) = (k(t)+y(t))A(t)L(t) → (k ∗ +y ∗ )A(t)L(t) = (k ∗ +y ∗ )A(0)L(0)e(g+n)t

Therefore, K(t) + Y (t) grows at rate g + n in the long run.

K(t)+Y (t)
iv. (3 points) What is the long run growth rate of L(t) ?
In the long run,

K(t) + Y (t)
= (k(t) + y(t))A(t) → (k ∗ + y ∗ )A(t) = (k ∗ + y ∗ )A(0)egt
L(t)
K(t)+Y (t)
Therefore, L(t) grows at rate g in the long run.

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(c) Assume that the production function takes a Cobb-Douglas form Y (t) = K(t)α (A(t)L(t))1−α ,
where 0 < α < 1. Note that this implies the intensive form of the production function
y(t) = f (k(t)) = k(t)α .
i. (6 points) Derive a formula for the steady state level of capital per efficiency unit
of labor k ∗ using only parameters from the list α, s, δ, n, and g.
The steady state level of k(t) is implicitly defined by the equation k̇(t) = 0, which
in the case of Cobb-Douglas production with f (k) = k α implies

0 = sk ∗ α − (n + g + δ)k ∗

sk ∗ α = (n + g + δ)k ∗
s
k ∗ 1−α =
n+g+δ
  1
∗ s 1−α
k =
n+g+δ
This final formula only involves the desired parameters.
ii. (5 points) Derive a formula for the steady state level of output per efficiency unit of
labor y ∗ using only parameters from the list α, s, δ, n, and g.
It must be the case, by definition, that y ∗ = f (k ∗ ), but in the Cobb-Douglas case
with f (k) = k α we have
  α
∗ ∗α s 1−α
y =k =
n+g+δ

since we previously showed that

  1
∗ s 1−α
k = .
n+g+δ

This formula for y ∗ only involves the desired parameters.

iii. (6 points) If the population growth rate n increases, does the long run level of
output per worker YL(t)
(t)
increase, decrease, or stay the same?
Note that if the population growth rate n increases, then y ∗ decreases, since an
s
increase in n increases the expression in the denominator of the fraction n+g+δ
α ∗ s
and since the exponent 1−α > 0 implies that y is increasing in the fraction n+g+δ .
But note that in the long run,

Y (t)
= y(t)A(t) → y ∗ A(t).
L(t)
Y (t)
Therefore, since y ∗ decreases, the level of output per worker L(t) decreases in the
long run.

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3. Utility Maximization (35 points total)

(a) A household which lives for two periods faces income levels Y1 and Y2 in periods 1
and 2 respectively. These income levels are known with certainty. The household can
save the amount S in period 1 and receive the return 1 + r on its savings, also known
with certainty, in period 2. The household derives utility U (C) from consumption in
each period, and the household discounts period 2 at rate β. The household solves
the utility maximization problem

max U (C1 ) + βU (C2 )

C1 ,C2

s.t. C1 + S = Y1 , C2 = Y2 + (1 + r)S
i. (4 points) Derive the Euler equation governing the optimal savings choice S. Ex-
plain, in words, the intuition behind the Euler equation.
By substituting the budget constraints into the household utility functions we can
obtain the equivalent utility maximization problem

max U (Y1 − S) + βU (Y2 + (1 + r)S).

S

The first-order condition of this problem with respect to S is given by

0 = −U 0 (Y1 − S) + β(1 + r)U 0 (Y2 + (1 + r)S)

which can be simplified to the Euler equation

U 0 (C1 ) = β(1 + r)U 0 (C2 ).

The Euler equation for optimal savings behavior implies that the household sets
the marginal cost of savings, equal to the marginal utility of lost consumption in pe-
riod 1 on the left hand side, equal to the marginal benefit of savings. The marginal
benefit of savings is given by the discounted marginal utility of consumption to-
morrow, adjusted by the return on savings. This marginal benefit is exactly the
right hand side of the Euler equation.

ii. (3 points) Derive the lifetime present value budget constraint of the household. For
Y2
convenience in notation, let H = Y1 + 1+r be the value of human wealth, and note
that your answer will involve H.
Using the given expression, we have

Y2 C2 − (1 + r)S
H = Y1 + = (C1 + S) +
1+r 1+r
by substitution of the two budget constraints. By canceling out the terms involving
S we can write
C2 Y2
C1 + = Y1 + = H,
1+r 1+r
which is the lifetime present value budget constraint discussed in class.

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 1−γ
iii. (8 points) Assume that U (C) = C1−γ where γ > 0. Solve for consumption C1 and
C2 in periods 1 and 2 as a function of H, r, β, and γ.
Given this utility function, we have U 0 (C) = C −γ , so that the Euler equation can
be rewritten
C1−γ = β(1 + r)C2−γ
C2γ = β(1 + r)C1γ
1
C2 = (β(1 + r)) γ C1 .
But then substituting into the lifetime present value budget constraint we have
1 1 !−1
(β(1 + r)) γ C1 (β(1 + r)) γ
C1 + = H → C1 = 1 + H,
1+r 1+r

which implies by the final formula for C2 that

1 !−1
1 1 (β(1 + r)) γ
C2 = (β(1 + r)) C1 = (β(1 + r))
γ γ 1+ H.
1+r

This final formula only involves the constants H, r, β, and γ, as desired.

(b) A household which lives for two periods faces income levels Y1 and Y2 in periods 1 and
2 respectively. The income level Y1 is known with certainty, but the income Y2 in period
2 is uncertain and varies according to

 Ȳ2 − ∆, with probability 1/3
Y2 = Ȳ2 , with probability 1/3 ,
Ȳ2 + ∆, with probability 1/3


where Ȳ2 > ∆ > 0. The household can save the amount S in period 1 and receive the
return 1 + r on its savings, known with certainty, in period 2. The household derives
utility U (C) from consumption in each period, and the household discounts period 2 at
rate β. The household solves the expected utility maximization problem

max U (C1 ) + βEU (C2 )

C1 ,C2

s.t. C1 + S = Y1 , C2 = Y2 + (1 + r)S
i. (5 points) Given a savings choice S, derive the mean value of period-2 consump-
tion E(C2 ).
We have that given a savings level S, the period 2 budget constraint implies that
the consumption level C2 is a random variable satisfying

 Ȳ2 − ∆ + (1 + r)S, with probability 1/3
C2 = Ȳ2 + (1 + r)S, with probability 1/3 ,
Ȳ2 + ∆ + (1 + r)S, with probability 1/3


which implies by definition that the mean level EC2 is given by

1
1
1

EC2 = Ȳ2 − ∆ + (1 + r)S + Ȳ2 + (1 + r)S + Ȳ2 + ∆ + (1 + r)S = Ȳ2 +(1+r)S
3 3 3

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ii. (5 points) Derive the Euler equation governing the optimal savings choice S. Ex-
plain, in words, the intuition behind the Euler equation.
As in the case with certainty, we can rewrite the household utility maximization
problem by substituting the budget constraints into the utility functions to obtain
max U (Y1 − S) + βEU (Y2 + (1 + r)S)
S
 
1 1 1
max U (Y1 −S)+β U (Ȳ2 − ∆ + (1 + r)S) + U (Ȳ2 + (1 + r)S) + U (Ȳ2 + ∆ + (1 + r)S)
S 3 3 3
The first order condition for this problem with respect to S is given by
 1+r 0 
3 U (Ȳ2 − ∆ + (1 + r)S)
0 = −U 0 (Y1 − S) + β  + 1+r 0
3 U (Ȳ2 + (1 + r)S)

1+r 0
+ 3 U (Ȳ2 + ∆ + (1 + r)S)
which can be simplified to read
U 0 (C1 ) = β(1 + r)EU 0 (C2 ).
This final equation is the standard Euler equation. The Euler equation for optimal
savings behavior implies that the household sets the marginal cost of savings,
equal to the marginal utility of lost consumption in period 1 on the left hand side,
equal to the expected marginal benefit of savings. The expected marginal benefit
of savings is given by the discounted expected marginal utility of consumption
tomorrow, adjusted by the return on savings. This expected marginal benefit is
exactly the right hand side of the Euler equation.
1−γ
iii. (10 points) Assume that U (C) = C1−γ where γ > 0, and also assume that β = 1+r 1
.
Is consumption C1 in period 1 less than, greater than, or equal to the mean value
E(C2 ) of consumption in period 2? Explain the intuition behind your answer. Hint:
A function f (X) is convex if f 00 (X) > 0.
This utility function implies that
U 0 (C) = C −γ , U 00 (C) = −γC −γ−1 , U 000 (C) = γ(γ + 1)C −γ−2 > 0.
Note that this final inequality implies that marginal utility is convex. Now, the Euler
equation can be written
C1−γ = β(1 + r)EC2−γ
which implies since β(1 + r) = 1 that
C1−γ = EC2−γ
C1−γ > (EC2 )−γ .
The final inequality follows from Jensen’s Inequality and the convexity of marginal
utility. But then, since C −γ is decreasing in C, we have that
C1 < EC2 .
Consumption in the first period is less than the expected value of consumption
in the second period. Intuitively, the risk of the bad income realization Ȳ2 − ∆ in
period 2 causes the household to engage in “precautionary savings” in period 1.
The result is higher savings and lower consumption in the first period, driving C1
below the mean value of C2 .

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