a) We can calculate Private and Public savings as well as investment as a share of GDP using (1):

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1 Q1 (8 marks) a) We can calculate Private and Public savings as well as investment as a share of GDP using (1): Public saving = (Gross saving, corporate + Gross saving, private)/gdp Investment = Investment/GDP Government spending= Saving, Government /GDP ( 2 for the correct graph ) Private Saving as Share of GDP Government Saving as Share of GDP National Saving as a Share of GDP Investment as Share of GDP Current Account as a Share of GDP -0.1 b) Investment as Share of GDP Investment as Share of GDP

2 Consider the above graph of Investment. The behaviour of Investment is certainly varied over time. While Investment has increased in recent years, ultimately what I am looking for is recognition that over the long term the share of investment in GDP in Canada has fallen. (1 mark) Is this a cause for concern? There is no right or wrong answer. Lower levels of investment today means more resources available for consumption today but less productive capacity in the future (and hence potentially lower levels of consumption in the future). Ideally, the answer should recognize this trade-off and discuss it. Generally looking for any well thought out discussion. (1 mark) Possible policies: tax incentives for investment; tax incentives to increase savings (and so provide more resources for investment); increased government investment. Generally looking for any well thought out discussion (1 mark) c) The current account (or trade balance) is plotted in the figure in part (a). You can plot it on that graph or separately here. The Current Account as a share of GDP is constructed as S/Y - I/Y. (1 mark for the TB graph if you put it in as part of the graph in (a), that is fine) In an open economy, aggregate output has the following components: [ Y = C + I + G + NX ] where NX = {Exports} - {Imports}. Since S = Y - C - G, the above can be re-written as [ S - I = NX] (the latter is all that is required for the question). When investment exceeds savings in the economy, the funds (or resources) are obtained from overseas, by borrowing. (0.5) In the last few years, the Current Account has increased considerably. In terms of the two underlying variables, it seems to be driven primarily by the increase in National Savings. (Just look for discussion relating the behaviour of TB to the behaviour of S and I.) (0.5 mark)

3 Q2.(a) (8 marks) i. National saving is the amount of output that is not purchased for current consumption by households or the government: (1.5 mark total for getting S, I and NX right) S= Y C G = 5,000 ( (5,000 1,000)) 1,000 = 750. Investment depends negatively on the interest rate, which equals the world rate r* of 5. Thus, I = 1, = 750. Net exports equals the difference between saving and investment. Thus, NX = S I = = 0. (0.5 mark for getting Having solved for net exports, we can now find the exchange rate that clears the foreign-exchange market: NX = = = 1. ii. Doing the same analysis with the new value of government spending we find: (1.5 mark total for getting S, I and NX right) S= Y C G = 5,000 ( (5,000 1,000)) 1,250 = 500 I = 1, = 750 NX = S I = = 250 (0.5 mark for getting NX = = = 1.5. (1 mark for explanation) The increase in government spending reduces national saving, but with an unchanged world real interest rate, investment remains the same. Therefore, domestic investment now exceeds domestic saving, so some of this investment must be financed by borrowing from abroad. This capital inflow is accomplished by reducing net exports, which requires that the currency appreciate.

4 iii. Repeating the same steps with the new interest rate, (1.5 mark total for getting S, I and NX right) S= Y C G = 5,000 ( (5,000 1,000)) 1,000 = 750 I = 1, = 500 NX = S I = = 250 (0.5 mark for getting NX = = = 0.5. (1 mark for explanation) Saving is unchanged from part (a), but the higher world interest rate lowers investment. This capital outflow is accomplished by running a trade surplus, which requires that the currency depreciate. Q2(b) - 4 marks 2 for discussion and 2 for the graph. Governor Bernanke s statement is consistent with the models in the chapter. Suppose we consider the United States as a small open economy, for example. The increase in the global supply of saving pushes the global interest rate down, which encourages U.S. investment. If we assume that this is primarily non-u.s. saving, then for the United States, the saving curve doesn t shift but we get a movement along the investment curve from point A to point B in Figure 5 7. The interest rate falls, and the trade deficit rises (S-I falls).

5 Q3 (10 marks) a. The profit-maximizing condition is that the firm hire labour until the marginal product of labour equals the real wage, MPL=.W/P 1 mark for stating MPL=W/P or solving MPL To solve for Labour demand, set MPL equal to the real wage and solve for L. 2 marks for getting the right solution for L b. We assume that the 1,000 units of capital and the 1,000 units of labour are supplied. In this case we know that all 1,000 units of each will be used in equilibrium, so we can substitute them into the above labour demand function and solve for W/P. 1 mark for getting the correct W/P In equilibrium, employment will be 1,000, and multiplying this by 2/3 we find that the workers earn 667 units of output. The total output is given by the production function: 2 mark for the correct L (1000), income earned by labour (677) and Y (1000) c. The congressionally mandated wage of 1 unit of output is above the equilibrium wage of 2/3 units of output. 1 mark d. Firms will use their labour demand function to decide how many workers to hire at the given real wage of 1 and capital stock of 1,000: 296 workers will be hired for a total compensation of 296 units of output. Y = marks for getting solving for L (1 mark) and writing the correct Y (444) and amount earned by labourers (296) correct (2 marks).

6 Q4 (10 Marks) a. The production function is Y = K^0.3*L^0.7. To derive the per-worker production function f(k), divide both sides of the production function by the labour force L: Rearrange to obtain: Because y = Y/L and k = K/L, this becomes: 1 mark for this correct answer and derivation. b. Recall that The steady-state value of capital per worker k* is defined as the value of k at which capital per worker is constant, so Δk = 0. It follows that in steady state 0 = sf(k) δk, or, equivalently, For the production function in this problem, it follows that: Rearranging: 2 marks for this answer 1 for each of the derivation and the solution. Substituting this equation for steady-state capital per worker into the per-worker production function from part (a) gives: 1 mark for this answer.

7 Consumption is the amount of output that is not invested. Since investment in the steady state equals δk*, it follows that 1 mark for this answer. c) 3 marks for the following table filled in correctly. (2 marks for k*, y* and c*, and one mark for MPK-δk*) S=1 maximizesd output; s=0.3 maximizes consumption. 1 mark d. To find the marginal product of capital, differentiate the per-worker production function with respect to capital per worker (k): 1 mark for the correct MPK. To find the marginal product of capital net of depreciation, use the equation above to calculate the marginal product of capital and then subtract depreciation, which is 10 percent of the value of the steady-state level of capital per worker. These values appear in the table above. Note that when consumption per worker is maximized, the value of the marginal product of capital net of depreciation is zero.

8 Q5 (10 marks) a. The per worker production function is 1 mark for the correct production function. b. In the steady state, Δk = sf(k) (δ + n + g)k = 0. Hence,, or, after rearranging: 2 marks for the correct k*. Note: you can also solve for k* for each country here and by subbing in values for S, n, g and δ Plugging into the per-worker production function from part (a) gives: 2 mark for the correct y* Thus, the ratio of steady-state income per worker in Richland to Poorland is: 2 marks for this correct answer. c. If alpha equals 1/3, then Richland should be 4 1/2, or two times, richer than Poorland. 1 mark d. If, then it must be the case that, which in turn requires that equals 2/3. 2 marks

9 Hence, If the Cobb-Douglas production function puts 2/3 of the weight on capital and only 1/3 on labor, then we can explain a 16-fold difference in levels of income per worker. One way to justify this might be to think about capital more broadly to include human capital which must also be accumulated through investment, much in the way one accumulates physical capital. 1 mark for this justification.