UNIVERSITY OF EAST ANGLIA
School of Economics
Main Series PG Examination 2015-16
ECONOMIC THEORY 2
ECO-M038
Time allowed: 2 hours
Answer BOTH questions in Section A and ONE question in Section B.
Section A carries a weight of 60% of the paper. Section B carries a weight of
40% of the paper.
Notes are not permitted in this examination.
Do not turn over until you are told to do so by the Invigilator.
ECO-M038
Module Contact: Dr. Simone Valente, ECO
Copyright of the University of East Anglia
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SECTION A (Answer BOTH questions in this section)
1
Consider the Solow model without technological progress. Capital per
capita 𝑘(𝑡) obeys the accumulation law
𝑘̇(𝑡) = 𝑠 ∙ 𝑘(𝑡)𝛼 − (𝛿 + 𝑛) ∙ 𝑘(𝑡)
where 𝑠 ∈ (0,1) is the saving rate, 𝛼 ∈ (0,1) is the capital share in production,  ∈
(0,1) is the rate of physical capital depreciation, 𝑛 is the rate of population
growth. Answer the following questions either graphically or by means of a clear
mathematical expression, and describe the economic intuition for all your
answers.
(i) What is the effect of an increase in the population growth rate 𝑛 on the
long-run level of income per capita?
(ii) What is the effect of an increase in 𝑠 on the long-run level of income per
capita?
(iii) Consider two economies, called "1" and "2", identical in every respect (i.e.,
technology, population and all parameters are the same) except for the
initial endowment of capital: at time zero, country 1 has a lower capital
stock than country 2. According to the model, which country exhibits faster
growth in income per capita during the transition?
2
A representative consumer maximizes individual present-value utility
subject to the wealth constraint
𝑎̇ (𝑡) = [𝑟(𝑡)𝑎(𝑡) + 𝑤(𝑡)] ∙ (1 − 𝜏) − 𝑐(𝑡)
where 𝑎(𝑡) is the stock of individual wealth, 𝑟(𝑡) is the market interest rate, 𝑤(𝑡)
is labour income, 𝑐(𝑡) is consumption, and 𝜏 is the constant tax rate on personal
income. Answer the following questions:
(i)
Assuming the logarithmic utility function 𝑢(𝑐(𝑡)) = ln 𝑐(𝑡) and denoting
the utility discount rate by 𝜌 > 0, the solution to this problem yields the
utility-maximizing rule for consumption growth:
𝑐̇ (𝑡)
= 𝑟(𝑡) ∙ (1 − 𝜏) − 𝜌
𝑐(𝑡)
Discuss the economic intuition for this result, explaining the effects of
the interest rate, of the discount rate and of the income tax on the
consumption growth rate.
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(ii)
Suppose that fiscal authorities implement a tax reform: the proportional
tax on income is replaced with a lump-sum tax on households. The
proportional tax on income 𝜏 disappears and each individual pays,
instead, a lump sum tax denoted by T. Write the individual wealth
constraint taking into account this modification. Does the utilitymaximizing rule for consumption growth change after the tax reform?
What is the underlying intuition?
TURN OVER
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SECTION B (Answer ONE question from this section)
3
Describe the traditional methodology of growth accounting: how is Total
Factor Productivity Growth (TFPG) estimated? Can growth accounting analysis
suggest what are the fundamental causes of growth? Discuss the pros and cons
of adopting this empirical methodology.
4
Describe the Mincerian approach for modeling aggregate externalities
from human capital and for testing the size of these spillovers empirically. What
are the main conclusions of this strand of empirical literature? Mention some of
the drawbacks of the Mincerian approach.
5
Suppose that financial development and increased competition within the
financial sector reduce marginal transaction costs for borrowers. Explain how this
phenomenon can potentially increase the level of aggregate output, and discuss
under what conditions the same mechanism may even raise the economy’s
growth rate in the long run.
END OF PAPER
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