# UCB What Is Meant by The Replacement Effect Economics Questions

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ECN 136  Spring 2021  Midterm One
Economics 136
Midterm #1
Spring 2021
Dr. Emanuel A. Frenkel
Instructions:
This exam has seven (7) questions.
Up to 57 points possible. Overall grading and class performance ranking will be
curved.
ECN 136  Spring 2021  Midterm One
(1) 10 points
Solow Model Question – Take a production function of the form Y = K1/2 * L1/2.
With a savings rate of 0.3 (30%) and a depreciation rate of 0.1 (10%), calculate the value
of income per worker (Y/L) (little y*), and capital per worker (K/L) (little k*) at the
+steady state associated with these values for the rate of saving and the rate of
depreciation? Just by looking at this production function how can you tell it is CRS
(constant returns to scale)?
(Hint: the values of little “n” and “g” are zero in this problem.)
(2) 4 points
In lecture we saw that growth in the macro-economy comes from the growth of business
enterprise and much growth in business comes from R&D. R&D lowers cost structures,
increases economic welfare, and results in large amounts of output and consumption.
When business interacts in the world of R&D, there are two Effects that result in R&D 
the Replacement Effect, and the Efficiency Effect.
What is meant by the Replacement Effect?
What is meant by the Efficiency effect?
(3) 5 points
It would seem that a higher Steady State level of Y/L (y*) and K/L (k*) is a good thing.
We know that a high level of s leads to a higher Steady State. Show with diagrams
why a rate of saving of, say, 80 or 90 percent may not be so good as far as the people in
the economy are concerned.
(4) 5 points
How would you distinguish overall change in technology in the macro-economy from the
technical change embodied in a rise in worker effectiveness? If worker effectiveness
gives rise to sustained increases in the economys standard of living, even in the Steady
State, can the overall level of technology impact the result as well?
(5) 10 points
What is The Golden Rule?
Why is the term Golden Rule applied to the Golden Rule Steady State of y* and k*?
ECN 136  Spring 2021  Midterm One
(6) 15 points
You live in an economy that has no change in worker efficiency (effectiveness), but has a
labor force that is growing at the rate of 6 percent annually. The existing stock of capital
in the economy wears out at a rate of 12 percent per year. You are already in a Steady
State but not the “Golden Rule” Steady State. Your goal is to try to get to the Golden
Rule Steady State level of capital per worker.
a. You first measure the marginal productivity of capital (MPK) in the economy and find
that you must decrease investment to reach the Golden Rule Steady State. What does this
tell you about the rate of saving s in the economy? What does this tell you about the
level of the MPK? Hint: Think of the MPK as the “rate of return on capital”.
b. What happens to the MPK as you decrease investment? Why?
c. What is the value of MPK that you are aiming for as you strive to reach the Golden
d. In a few words, describe what happens to consumption per worker, as you move from
NOW: if suddenly the rate of growth of worker efficiency was 2.6% annually, what MPK
would be your goal to get to the Golden Rule Steady State? (Rates of capital depreciation
and labor force growth remain the same as before.)
(7) 8 points
Now, in the Solow Model STEADY STATE of ANY ECONOMY that has positive
annual rates of capital depreciation (12.7%), labor force growth (2.6%), and rise in
worker effectiveness (3.3%), what is the annual rate of growth of:
a. real GDP (Y)
b. real GDP per worker (Y/L)
c. real GDP per effective worker (Y/(L*E))?
Explain how and/or why you arrived at your answers. Dont just put numbers down.

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production function

Efficiency Effect