Faculty of Economic and Management Sciences

Department of Economics

Subject: EKN214 (Macroeconomics)

Date: 14 July 2021

Time Open: 08:00

Time Close: 11:20

Total Marks: 100 marks

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This online exam will close at 11:20 on 14 July 2021. You must submit a
single PDF document with your answers via ClickUP. As with the semester
tests, you are welcome to handwrite some or all of your answers and scan
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 UNIVERSITY OF PRETORIA
FACULTY OF ECONOMIC AND MANAGEMENT SCIENCES
DEPARTMENT OF ECONOMICS

ECONOMICS 214 EXAMINATION JULY 2021

Examiner: Prof HR Bohlmann Time: 150 Minutes

ANSWER ALL QUESTIONS CLEARLY AND CONCISELY

ONLINE SUBMISSION WINDOW CLOSES 11:20

1. Key characteristics of the standard Cobb-Douglas production function include i)

that adding a unit of capital (K) will always increase total output (Y), but ii) that
each such marginal increase of K will increase Y by less and less. Algebraically
derive these two conditions for the specific case where capital and labour each
contribute half of total output. Also use a diagram to clearly illustrate these two
conditions. (Hint: Start by doing the required algebraic derivations, noting the
specific income shares, and then link those answers to a well-labelled graph in
which the two characteristics of the Cobb-Douglas function are highlighted.)
(15)

2. Strong institutions that promote private property rights, the rule of law,
separation of powers, competition, independence of key institutions and freedom
of the press are generally considered by economists as the most important
drivers of long-term growth and overall welfare in a country via its impact of total
factor productivity. In light of the recent state capture revelations and spate of
violence and protest action in South Africa in the last week, discuss how you
believe these events have and may continue to impact economic growth in South
Africa. Make reference to i) how and which institutions were tested in these
events, ii) how these events, taking into consideration the strength of the relevant
institutions, translated into the poor past and projected macroeconomic
outcomes in South Africa, and iii) what you propose should be done, based on
your general knowledge of economic growth and growth models, to help improve
South Africa’s macroeconomic growth outlook. (Hint: Do not simply start by
writing everything you know about institutions and economic growth models.
Carefully structure your answer according to the suggested guideline, keeping
your answer as concise as possible throughout.) (30)

3. Briefly define what the Golden Rule level of saving is within the context of the
Solow growth model. Diagrammatically show where the Golden Rule level of
capital lies and write down the relevant algebraic conditions to support your
answer. (Hint: Remember, while output per capita in the Solow model will always
move towards a steady state position through transition dynamics, it will not
automatically tend to the Golden Rule position and may require policy intervention
to do so.) (15)
4. From the Romer growth model, briefly discuss in your own words, the non-rivalry
characteristic of ideas and how it proves that persistent endogenous economic
growth is possible (as opposed to the standard Solow model in which persistent
endogenous growth is not possible). Write down key equations from the Romer
model that support your answer and demonstrate the increasing returns to scale
characteristic of ideas. (Hint: After discussing the nature and role of ideas, write
down and link it only to the specific equations that capture its effect in the model.
It will be a good idea to also show the solution to the Romer model and highlight
the role of ideas in making persistent growth possible.) (15)

5. Define the following labour market concepts: (10)

5.1 Natural rate of unemployment

5.2 Expanded definition rate of unemployment
5.3 Structural unemployment
5.4 Skill-biased technical change
5.5 Creative destruction

6. Using the quantity theory of money, i) if real GDP growth is 5% and the rate of
inflation is 3%, what needs to happen to the nominal money supply for the
equation to hold, and ii) why does the theory suggest that is it a bad idea to
continuously print more money in order to stimulate the economy? (10)

7. From Chapter 9 onwards in the prescribed Jones textbook, we focus more on the
short run and expenditure side of the economy. Briefly describe the three
premises on which the short-run model developed in subsequent chapters is
based. (5)

[100]
ANSWER GUIDE

1. The first order derivative of the Cobb-Douglas production function – which is

positive – shows that output (Y) will always increase for any given increase in
capital (K). That is, the marginal product of capital is always positive.

For 0 ≤ α ≤ 1 … and in this specific case α = 0.5

Y = Af(K, L)
Y = K0.5L0.5
∂Y/∂K = 0.5K(-0.5)L(0.5)
∂Y/∂K = 0.5K(-0.5)/L(-0.5)
∂Y/∂K = 0.5[K/L](-0.5) > 0

The second order derivative of the Cobb-Douglas production function – which is

negative – shows that output (Y) will increase at a decreasing rate for any given
continued increase in capital. That is, the function exhibits a diminishing marginal
product of capital.

Following from the first order derivative…

∂Y/∂K = 0.5K(-0.5)L(0.5)
∂2Y/∂K2 = 0.5(-0.5)K-1.5L0.5

If 0 ≤ α ≤ 1 then α(α-1) < 0 and

∂2Y/∂K2 = α(α-1)Kα-1-1L1-α < 0

Both these conditions are illustrated below for the case of capital, with the curve
flattening along the x-axis (diminishing MPK), but never turning down (Y still
increases for any marginal increase in K, despite the diminishing rate).
2. Various institutions were tested during the state capture project. Perhaps most
prominently, was the independence of certain institutions such as the NPA, SARS
and the operation of many SOEs such as Eskom and Transnet. Given the nature
of these events, you could argue that the rule of law and separation of powers
were also compromised.

Once such important institutions are compromised, it directly affects business

and investor confidence, and places huge strain on the fiscus to maintain the
required level of spending on legitimate growth and development projects. This
raises the cost of doing business and reduces total factor productivity, ultimately
leading to the poor investment, GDP growth and labour market outcomes
witnessed in recent years.

Society must impress on our local and national political leaders the importance of
upholding and strengthening our institutions and punish them at the ballot box if
they fail to do so. Holding poorly performing officials to account is central to the
democratic experiment and proper functioning of the economy, and suitable
checks and balances must be introduced and implemented in this regard. A
strong message must be sent that our constitutional democracy is supreme and
the institutions that underpin and promote its functioning are respected. Where
legitimate discussion on a set of rules or institutions is warranted, this should be
done is an orderly, structured and inclusive way, as was the largely case with the
discussion of the expropriation bill (even though its selected application was
already allowed for in the constitution, but perhaps not explicitly enough).

3. The golden rule steady state or savings rate can be considered the “best” steady
state achievable within the Solow framework. It requires a specific level of capital
per worker, and by implication, a specific rate of saving, that produces the highest
level of consumption possible in the steady state for a given production function
and rate of depreciation. In order to reach this specific level of steady-state capital
(k*gold) policymakers will likely be required to adjust or manipulate the rate of
saving (s) as the economy will not have a tendency to automatically move towards
to golden rule steady state.

To find k*gold which is defined as the steady value level of capital per worker that
maximises consumption, we express c* in terms of k*.

c* = y* - i*
= f(k*) – i*
= f(k*) – δk* … in the steady state i* = δk* because Δk = 0 at that point

From there, we can graph f(k*) and δk*, and look for the point where the gap
between them is biggest. The gap, which represents consumption and is
expressed as c* = f(k*) – δk*, will be biggest where the slope of the production
function f(k*) equals the slope of the depreciation line δk*. The slope of the
production function is determined by the MPK and the slope of the depreciation
line by the constant rate of depreciation δ.
 In more technical or algebraic terms, the problem is to find the value of k* that
maximises c* = f(k*) – δk*, which we can easily do by taking the first derivative of
the expression and setting it equal to zero.

This will yield f’(k*) – δ = 0, where f’(k*) = MPK = slope of the production function
and δ = slope of the steady-state investment and depreciation lines.

steady state
output and
depreciation δk *

f(k * )

steady-state
capital per
worker, k *

4. Ideas are nonrivalrous, which is in contrast to physical objects that are obviously
rivalrous in nature. The use of an idea by one person, does not inherently reduce
the amount of that idea available to another person, hence its nonrivalry. This also
leads to ideas having increasing returns to scale, as opposed to physical objects
(capital and labour) in the Solow model that is characterised by their decreasing
returns to scale. In the Solow model, the diminishing returns to capital per worker
is what ultimately yields the steady-state condition in which no growth occurs.
With increasing returns to ideas in the Romer model, permanent growth can be
achieved. The solution to the Romer model yields a balanced growth path
determined by the rate at which ideas grow, which can be expressed as

>>>
5.1 Natural rate of unemployment is the medium to long-run measure of the
unemployment rate that would prevail if the economy were producing at its
potential level. It may include unemployment that results from institutional and
structural features of the labour market, such as hiring and firing costs, as well
as frictional unemployment.

5.2 Expanded rate of unemployment includes discouraged work-seekers on top of

strictly defined unemployed persons within the working age population.

5.3 Structural unemployment is the part of unemployment associated with the

institutional features of an economy and labour market, including hiring and firing
costs and other regulations impacting compensation.

5.4 Skill-biased technical change is a change in the technology of production that

favour skilled or highly educated labour, in the sense that the wage of such a
worker rises by more than other lesser skilled or educated persons.

5.5 Creative destruction or job destruction describes the natural dismantling of

established processes in order to make way for improved methods of production.
This happens when firms go out of business because their products or production
methods are no longer in demand or desirable, and are replaced by new firms with
improved methods.

6. The quantity theory of money can be written as

M*V = P*Y
gm + gv = gp + gy

The theory suggests that, given a constant velocity of money (v=0), money
supply growth in excess of real GDP growth (m>y) will lead to inflation (p).

When real GDP growth is 5% and inflation is 3%, growth in the nominal money
supply must have been 8%, given a constant velocity of money, to satisfy the
equation.

The classical dichotomy suggests that changes in nominal variables, like the
money supply, only have nominal effects on the economy, in particular, they do
not affect real variables such as GDP in the long run. The theory therefore implies
that simply printing more money will only translate in higher inflation in the long
run, and in extreme cases, hyperinflation.

7. The economy is constantly being hit by shocks;

Monetary and fiscal policy can affect output;
There is a dynamic trade-off between output and inflation.