# ECON202midterm1_s07_answerkey - ECON 202 SPRING 2007 MID...

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ECON 202, SPRING 2007 Malhar Nabar March 1, 2007 MID TERM I - ANSWER KEY Instructions. The maximum score is 75. Please answer all FOUR questions. Show all your work. Simply writing down an answer (even if it happens to be the correct one) without an adequate demonstration of how you arrived at your answer will not get you full credit. Partial credit will be awarded for incorrect answers where adequate reasoning is demonstrated. You may use a scienti°c calculator. GOOD LUCK! 1. (Twenty Points) Evaluation of Solow Model with no population growth and no technological progress Consider the following picture which shows data on predicted steady state ratios of income (output) per capita relative to the US for a large set of countries plotted against the actual ratios of income (output) per capita relative to the US in 2000 . The predicted ratios are calculated under the assumption that the physical capital investment rate is the only source of di/erence across countries. Countries are assumed to have identical per worker productions, y = k ° . a. ( Eight points ) What does this picture tell us about the ability of the basic Solow Model to explain di/erences in income per capita across countries? 1

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As the picture demonstrates, the predicted per capita income ratios based only on investment rates y i y US = ° s i s US ± ° 1 ° ° are much higher for most countries than the actual per capita income ratios (most of the points lie below and to the right of the 45 degree line, indicating that the x-coordinates are larger than the y-coordinates for those points). This suggests that the Solow Model in its most basic form °over- predicts±the per capita income ratio for most countries relative to the US. We can infer that there must be elements other than just di/erences in investment rates that contribute to income di/erences between countries. Because of di/erences in these omitted elements, the actual income ratio (gap relative to the US) appears to be very di/erent compared to the predicted income ratio. The Model as it is set-up in this basic example therefore does not do an adequate job of explaining the gap in income per capita between several countries and the US. b. ( Twelve points ) Provide three additional elements (other than investment in physical capital) that could help explain di/erences in income per capita across countries. Please be sure to explain clearly how each element you mention would a/ect income per capita. Three additional elements are: di/erences in human capital, di/erences in technology, and dif- ferences in dependency burdens. Human capital is a complement to physical capital, and it also directly in²uences the quality of labor services provided (more educated and healthier workers are likely to be more productive in the workforce than less educated and unhealthy workers). If countries
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