L1 & L2 Economic Growth

Question 1

How much has population increased since 1750?

Answer 1

10 times.

Question 2

How many people live in extreme poverty nowadays?

Answer 2

More than 1 billion.

Question 3

Human activity is threatening the Earth and causing its physical change.

True / False

Answer 3

True.

Question 4

Which is the role of economic growth in sustainability?

Answer 4

It is the cause of sustainability problems but it can also be the solution.
It is key to eradicate poverty aswell.

Question 5

What is the Gross Domestic Product? (GDP)

Answer 5

The market value of total production of goods and services within a country in a given year.

Question 6

Which are the three corrections needed for GDP?

Answer 6

1. GDP per capita (divide by population)
2. Real or adjusted GDP vs. nominal (correct for inflation - changes in prices)
3. Purchasing power parity (PPP) - correct for international differences in price levels.

Question 7

If a Big Mac costs 3.75€ in the Netherlands na d 5.51$ in the US, calculate the PPP exchange rate (dollar/euro) and the market exchange rate.

Answer 7

PPP exchange rate = 5.51 / 3.75 = 1.47 dollar/euro

Market exchange rate = (5.51 - 3.75) / 1.47 = 1.20 dollar/euro

Question 8

Is GDP a perfect indicator of true wellbeing within a country?

Answer 8

It is a rough and imperfect indicator of wellbeing, life satisfaction and happiness; but it is highly correlated with broader measures so it can be a useful summary of wellbeing at the end.

Question 9

When did population start to grow in a constant and fast way? Why?

Answer 9

At the end of the 18th century (1750) becuase of the Industrial Revolution (Watt’s improved steam engine).

Question 10

Has any other important change occured since the Industrial Revolution?

Answer 10

Yes, the Gross World Product (GWP) also increased substantially.

Question 11

What is the current world’s population?

Answer 11

7.8 billion.

Question 12

What does the sustained increase of population (since the Industrial Revolution) involve?

Answer 12

• Positive effect on prosperity

- Negative effect on the Earth and our wellbeing (large-scale economic activity is changing is threatening the Earth)

Question 13

What is sustainable development?

Answer 13

Development that meets the needs of the present generation without compromising the ability of future generations to meet their own needs.

Question 14

Which are the stylized facts of economic growth?

Answer 14

1. Large variation in GDP/capita across countries
2. Large variation of growth rates across countries
3. Mutable relative positions of countries in the world distribution* of GDP/capita (a country can move from being “poor” to being “rich”, and vice versa)
4. Growth rates are not generally constant over time
5. In industrial economies (a) GDP/capita grows at constant rates, (b) capital and labor income shares show no trend, and (c) real interest rate show no trend *

Question 15

World relative income distribution

Answer 15

Represented by a graph with:
X-axis: GDP per capita (relative to US)
Y-axis: share of world population

Diagonal straight line = total equality (50% of the population have 50% of per capita income)

Question 16

Explain the stylized fact 5 of economic growth.

Answer 16

In the US over the last century (example of industrial economy)…

a) the average growth rate of GDP/capital has been positive and constant over time
b) shares of income devoted to capital (rK/Y) and labor (wL/Y) show no trend
c) the real rate of return to capital (r) show no trend
d) the average growth rate of real wages (w) = average growth rate of GDP/capita

Question 17

Which is the theory exists to prove the stylized fact 5 about economic growth?

Answer 17

The Solow Model - It attempts to explain long-run economic growth by looking at capital accumulation, labor / population growth, and increases in productivity (technological progress).

• Simplified representation of reality to see how economy behaves: only one output is produced in our economy - the GDP.

Question 18

Which is the “Cobb-Douglas” production function and which are its components?

Answer 18

Y = F(K, L) = K^α * L^(1−α)

K = capital
L = labor
α = output elasticity of capital (fixed num. between 0 and 1)

Question 19

How are the returns to scale of the “Cobb-Douglas” production function?

Answer 19

Constant returns to scale: if you increase / double K or L, Y will also increase proportionally / double.

Question 20

Rewrite the production function in terms of output per worker.

Answer 20

Output per worker (y) = Y/L
Capital per worker (k) = K/L
Labor is supressed from the formula (L/L)

y = k^α

Question 21

Explain the decreasing returns to scale of the output per worker production function.

Answer 21

If you increase capital, output per worker will also increase because more machinery makes workers more productive.
But each time you increase more capital, the output per worker function will become flatter. That’s because at some point, additional machinery does not make any change in output and productivity (e.g., 10 workers & 100 computers).

Question 22

What is the definition of capital goods?

Answer 22

Physical objects that extend our ability or do work for us (machines, buildings, infrastructure, transport vehicles, computers…)

Question 23

Explain the capital accumulation equation.

Answer 23

K· = sY − δK

Savings (S) = sY -> households save a constant fraction (s) of their income (Y)
δ = capital depreciation (constant fraction of K)

• In a closed economy: Investments = Savings

Change in capital stock (K·) depends positively on savings and negatively on depreciation.

Question 24

Explain the economy functioning according to the Solow Model using: Y, C, I, L, and K.

Answer 24

A fraction of income (Y) goes for consumption (C), so it leaves the economy; and another fraction goes for savings / investment (I = sY).
These savings / investment goes to stock capital (K) of the economy, minus depreciation (δK).
The amount of capital left after substracting depreciation and the labor (L) go into companies as inputs.

Question 25

Rewrite the capital accumulation equation in per-worker terms.

Answer 25

k· = sy - (δ + n)k

sy (savings per worker): increase k·
δk (depreciation per worker): reduces k·
nk (population growth): reduces k·

Question 26

Which are the endogenous and the exogenous variables in the Solow Model? And the parameters?

Answer 26

• Endogenous: K, L, Y, C, I, S, w, r
• Exogenous: n, s, K0, L0
• Parameters: α, δ

Question 27

How do we solve the model?

Answer 27

Obtaining the values of the endogenous variables for a given exogenous variables and parameters.

Question 28

What is the Steady State Level in the Solow Model?

Answer 28

At the steady state level (economy in the long-run), k· = 0 (constant) because investment = depreciation & population growth.

Over time, the economy converges to its steady state (k*). Capital per worker increases or decreases over time until k· = 0 and sy = (n+δ)k.

Question 29

How do you calculate the steady state (k*)?

Answer 29

k* = [s / (δ + n)] ^ [1 / (1 - α)]
y* = [s / (δ + n)] ^ [α / (1 - α)]

Question 30

How do you calculate the steady state (k*)?

Answer 30

k* = [s / (δ + n)] ^ [1 / (1 - α)]
y* = [s / (δ + n)] ^ [α / (1 - α)]

Question 31

What can you interpret from these two formulas of the steady state?

Answer 31

1) Countries with a higher savings rate (s)…
- Accumulate more capital per worker (k)
- Are more productive in the long run
- Have a higher per capita income (y) in the long run

2) Countries with faster population growth…
- Have less savings to increase k (because they need most part of these savings to equip newborn people with capital)
- Are less productive in the long run
- Have lower per capita income (y) in the long run

Question 32

How is the correlation between GDP/capita and investment rate (or savings)?

Answer 32

Positive: Increase in savings/investment = increase in k (intersection or steady state moves to the right)

Question 33

How is the correlation between GDP/capita and population growth?

Answer 33

Negative: increase in population growth = decrease in k (intersection or steady state moves to the left)

Question 34

Explain the growth in the Solow Model according to a country’s steady state level.

Answer 34

If k is below the steady state level…

• Countries grow rapidly (positive growth) because actual savings are higher than required investment
• But over time capital goods/worker increase until this growth lowers to 0.

If k is above the steady state level…

• Countries have a negative growth because actual savings are lower than required investment
• But over time, capital goods/worker decrease until growth converges to 0.

Question 35

Which is the formula for the growth rate of income per worker (y)?

Answer 35

y· / y = α (k· / k)

• Growth rate of y is proportional to growth rate of k.

Question 36

Which are the factor demand equations (marginal products & optimal equilibrium)?

Answer 36

Real wage (w) =  (1 − α)k^α - marginal product of L
Interest rate (r) = αk^(α−1) - marginal product of K

Optimal equilibrium of w = it defines the amount of L
Optimal equilibrium of r = it defines the amount of K

Question 37

Explain the diminishing marginal returns to labor and capital.

Answer 37

• w depends negatively on L (higher wages = less workers)

- r depends negatively on K (higher interest rates = less capital)

Question 38

Rewrite the factor demand equations in terms of factor income shares.

Answer 38

wL/Y = 1 - α

rK/Y = α

Question 39

Which of this actual data does the Solow Model predict?

a) Growth of per capita income and wages is sustained over time
b) Income shares are constat
c) Interest rate is constant in the long run
d) Real wage grows proportionally to per capita income growth

Answer 39

a) No - the Solow Model predicts that income growth stops in the long run (steady state)
b) Yes - rK/Y = α, wL/Y = 1 − α (so they depend on a constant parameter)
c) Yes - r = αk^(α−1)
d) No - the Solow Model states that real wage is constant over time
w = (1 − α)k^α