Additional - Problem set

paolonicola.barbieri@unibo.it

Consumption and Utility Functions

Compute the coecients of absolute risk aversion and relative risk aversion for the CARA, 1 U (c) = exp(c) >0 CRRA 1 U (c) = c 1 and quadratic utility b U (c) = c c2 2 Do these ARAs and RRas increases or decreases with initial wealth? How these results compare in the three cases?

Durable vs. Non-durable Goods

Solve the following problem considering ct , dt as the control variables (where ct is consumption of non-durables and dt is consumption of durable goods) and bt , st as the state variables (where bt stands for bonds and st for stock of durable goods). is the depreciation rate of durables. The goal is to obtain the marginal rate of inter-temporal substitution between durables and non-durables max
t=0

{ct ,dt }

t u( c t , st )

st+1 = (1 )st + dt+1 b0 , s0 given

bt+1 = bt R y ct dt

Durable vs. Perishable Goods

t=0

Solve max t u ( c t , dt )

{ct ,dt }

s.to mt+1 = (mt ct xt )R + yt+1 dt+1 = (1 )dt + xt+1 dt = (1 )dt1 + xt m0 , d0 given

What is dt ? [HINT: xt is period t expenditure on dt and is the depreciation rate]

Consumption and Labor Choice

t=0

Consider the following problem max t u(ct , lt )

{ct ,lt }

ct + it = f (kt1 , lt ) k t = k t 1 + i t k0 , given

(a) Describe the problem in words. What are the variables dened above? (b) Write the Bellman equation, using ct and lt and control and kt1 as state? How many policy functions you will have? How many Euler equations? Why? (c) Find the Euler equations. [HINT: Since maximizing for ct or kt is the same, use the latter variable to maximize the Bellman equation so that the computation is easier] (d) Repeat step (c) with
c1 (1 lt )1 t + 1 1 1 f (kt1 , lt ) = Akt1 lt

u(ct , lt ) =

Value Function and Policy Function

Sometimes the value function has a form that can be inferred from the objective function of the problem and from the law of motion of the state variable. Consider max t u( c t )
ct t=0

(a) Try to guess and verify a value function for the following case u(c) = ln c xt+1 = xt ct

(b) Write the corresponding policy function.

Living Three Periods

u(c) = ac + bc2

Consider a consumer that lives three periods of life, with utility function

Suppose the consumer begins life with assets A1 and in period 2 and 3 she faces uncertain income of the form P rob(ylow ) = p ylow yi = i = 2, 3 yhigh P rob(yhigh ) = 1 p Call A2 = (A1 c1 ) + y2 cash on hand in period 2 and A3 = (A2 c2 ) + y3 cash on hand in period 3 and assume that the consumer performs her optimization for each period only after learning her income for that period, so that in period 2 she knows period 2 value of A2 . (a) What is in period 3 utility as a function of period 3 cash on hand, A3 (i.e. V3 (A3 ))? (b) Solve for consumption in period 2 as a function of period 2 cash on hand, A2 . Call this optimal consumption c (A2 ). What happens to uncertainty? How is this related to the functional form specied for the utility? What is the value function V2 (A2 )?

A Sweet Problem

Consider a cake of initial size x0 , with the size at time t being xt . In each period you consume a part c1 of the cake, so that xt+1 = xt ct 3 max
ct T t=0

t ln ct

(a) Solve by backward induction, exploring the fact that is a viable way to obtain a value function. [HINT: start with V (xT ) = 0 since at the last period there is no cake left. Then write V (xT 1 ) and maximize it. Then you can verify that V (xT 1 ) = ln xT 1 . Iterate backward until you nd a regularity in the value function] (b) Verify whether the guess V (xt ) = A ln xt + B is a good guess for the value function. (c) Writhe down the value and the policy function once you have computed A and B . (d) Write down the Euler equation for this problem and compare it with the policy function.

Closing the Mine

Your mining license will expire in three years and will not be renewed. The 2 /x where q is price is xed to a dollar a tons. The cost of extraction is qt t t the rate of extraction and xt is the stock of ore. Ignoring the discounting for simplicity (i.e. = 1), dene (a) The problem you are facing each period? (b) Set up the Bellman equation and solve it by Backward Induction

Consumption with Habits Formation

Consider a representative agent whose goal is to maximize the following inter-temporal utility function E0
t=0

t u(ct , lt )

where ct is consumption at time t and lt is labor supplied at time t. The dynamic budget constraint is at+1 = (1 + r)(at + wt lt ct + It ) where r is exogenous and constant over time, wt is the wage rate and It is transfer income. Assume that the household knows wt and lt at time t, but not at time t 1 (i.e. they stochastic and exogenous). Assume that a0 is given and that aT +1 = 0. The per period utility function has the following form B u(ct , lt ) = ln ct lt 4

where B > 0 (so the household gets disutility form working) and > 1. (a) Show that > 1 insures that the marginal disutility of work is increasing in lt . Does this assumption makes sense? (b) Derive the following three conditions for optima behavior of the households: A FOC relating todays labor supply to todays wage and todays consumption. A Euler equation relating todays consumption to expectations and involving tomorrows consumption. A Euler equation relating todays labor supply to todays wage rate and expectations involving tomorrows labor supply and wage. (c) Suppose the agent receives an unexpected increase in transfer income It at time t. Suppose this shock is expected to be permanent. Assuming the wage in unaected, how will current labor supply be aected? What if the shock is expected to be transitory? (d) Now suppose that there is no uncertainty in the model. Suppose we observe that peoples wage rise steadily over their lifetime, but labor supply is roughly constant over their life cycle. What does this tell us about the magnitude of ?

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Consumption and Habit Formation

t=0

Consider a consumer with the following lifetime utility function E0 t w ( c t c t 1 )

where w is a well-behaved concave function. Each periods utility depends on eective consumption (c ) where eective consumption equals this periods consumption minus a fraction of last periods consumption. c = c t ct 1 THis formulation captures the idea of habit formation, if we spend more today, we get habituated to higher consumption and require more consumption in the future to give us a given level of satisfaction. The household is born in period one and he is given initial habit stock c1 which plays no role in the problem. Assume that the household receives uncertain labor income yt every period and that there is only one risk less asset with constant return (1 + r). 5

The household is born with initial wealth A0 and dynamic budget constant for nical wealth A is standard at+1 = (1 + r)(at + yt ct ) (a) Identify one control variable and two endogenous state variables, and write down the period t Bellmans equation for this problem. (b) Derive the Euler equation linking w (c ) at t to the time t expectation of w (c ) at t + 1 and t + 2. (c) It turns out that the Solution for (b) is
w (c t ) = (1 + r )Et w (ct+1 )

Assume that w is quadratic in c and that (1 + r) = 1. Show that the Euler equation implies that Et ct+1 = ct

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Consumption Versus Expenditure Over the Life Cycle

Suppose there is an agent who lies for T periods in an environment with no uncertainty, and who maximizes the following discounted utility function
T t=0

t [u(ct ) + d(lt )]

where c is consumption and l is leisure. Assume that both u and d are increasing and concave. In standard applications, consumption is typically measured using expenditure (xt ) on some group of goods and services. However, in reality, consumption requires both expenditure and time spent in home production, and households have some ability to substitute between the two. For instance, I can either buy pre-prepared food at the grocery store, or I can buy raw ingredients at the grocery store and make the food myself from scratch. The latter option takes more time, but costs less in terms of expenditure. As another example, I can buy the same basket of goods (the same ct ) for a lower price and therefore a lower expenditure if I am willing to spend more time shopping for bargains, going to dierent stores and buying at the lowest price. Assume that consumption is related to expenditure and time inputs as follows: c t = f ( x t , st )

where st represents time spent in home production. Assume that f is increasing and concave in both its inputs. Assume that the household can borrow or lend at a risk-free rate r, so that the dynamic budget constraint is at+1 = (1 + r)(at + wt ht xt ) where at is nancial wealth at period t; wt is a given wage rate; ht is hours spent working, which are freely chosen each period by households. The wage will in general be time varying; for instance, wages might rise early in the life cycle then fall as individuals age. However, there is no uncertainty, so assume that at time zero households know the entire path of wt . Assume that households have to satisfy the solvency constraint aT +1 = 0. Households have an endowment of one unit of time each period, which they spend on leisure, working for wages, and in home production. Thus, leisure time satises l t = 1 ht + s t (a) Write down the Bellman equation for this problem. Derive the FOCs, the envelope condition and an Euler equation. (b) Show that f (xt , st ) is an increasing function of wt , that is, as wage rise, people substitute expenditure for time in the production of consumption. Provide an intuition.
1 1 (c) Now assume that u(c) = log(c), f (xt , st ) = x s1 , d ( l t ) = 1 t lt and that (1 + r) = 1. Show that expenditure will be constant over the life cycle.

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Stochastic Growth and Labor Supply

t=0

Consider an economy with one household, with preferences given by E0 t ln(ct Blt )

where ct is consumption, lt is hours worker and B > 0 so that working causes disutility. The household owns capital kt and uses it along with labor in order to produce output Y in each period, according to the following stochastic production function:
1 Yt = F (t , kt , lt ) = t kt lt

[0, 1]

where is known at time t but uncertain in t 1. Capital is predetermined and is accumulated according to
1 kt+1 = G(kt , lt ) = kt lt

[0, 1]

where It is investment, which turns to obey It = Yt ct Each period, the household inherits its predetermined capital stock kt and observes the value of (i.e. productivity parameter). Then the household chooses optimal labor supply, output, consumption and investment. There are no capital assets other than capital. (a) Write the Bellman equation for this problem. The solution will be more convenient if you see l and I as the two control variables and eliminate Y and c from the problem. (b) Use the optimality condition for l to solve for the optimal decision rule for labor supply. Write down the implied decision for Y , showing that B this optimum will be constant, equal to (1 ) (c) Show that the inter-temporal behavior satises the following Euler equation u (ct ) = Et [Rt+1 u (ct+1 )

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Consumption with Assets and Human Capital

Consider the following problem. A household maximize expected discounted utility where c is consumption and 0 < > 1 E0
t=0

t u( c t )

subjected to the following constraints at+1 = R(at + yt ct et ) y t = w t h t ht+1 = (1 )ht + et The rst is a dynamic budget constraint, where a is nancial wealth; c is consumption; y is labor income; R is the gross return on the single nancial asset, which is risk free; and e is spending on human capital accumulation (education spending). The second shows that labor income depends on an exogenous wage (w), which in general is a stochastic random variable (meaning that wt+1 is a random variable from the point of view of period t); and on a households stock of human capital h. is strictly between zero and one. While the last one shows the accumulation equation for human capital. Human capital in period t + 1 depends on human capital last period (subject to a depreciation rate of , which is between zero and one), and on last periods education spending. Note that human capital at t + 1 is non-stochastic (non-random) from the point of view of period t. 8

(a) Identify the state and control variables and write down the Bellman equation. (b) Derive the FOC and the envelope condition for solving the Bellman equation. (c) Show that we can write the marginal value of human capital at time t as R ht u ( c t ) where we can interpret Rht as the return to human capital in period t. Derive an expression for this term and show that it will be stochastic if and only if w is stochastic. (d) Derive two inter-temporal Euler equations characterizing optimal consumption and investment. One Euler equation should embed the optimal tradeo between consumption and investment in the nancial asset and should include R. The other Euler equation should embed the optimal tradeo between consumption and investment in human capital and should include Rht+1 .

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Consumption, Unemployment and Search

Assume that household preferences and the dynamic budget constraints are given by E0
t=0

t [u(ct ) C (st )]

at+1 = (1 + r)(at + yt ct ) where u(.) is an increasing and concave utility from consumption, C (.) is the utility cost of searching for a job and all the usual assumption holds for the budget constraint. In any period, household can either be unemployed or employed. Employed households receive yt = w where w is the wage which is timeinvariant. Unemployed households receive a time-invariant unemployment benet yt = b < w. Unemployed households can spend eort to search a job. Assume that an unemployed household at time t can choose the probability st that they nd a job that starts in period t + 1. Thus if you are unemployed at time t, your yt = b no matter what st you choose. However, if you nd a job in period t then y = w starting from period t+1. Search eort is costly to the household. The utility cost of seating is given by C (st ), which is an increasing and convex function: C > 0, C > 0. To insure an interior solution for s, we

can assume that C (0) = 0, C (0) = 0 and that C approaches in the limit as s approaches 1. For simplicity assume that jobs last forever, once a household is employed it will stay so and earn w forever. Therefore employed households never have to search, and they will have C (s) = C (0) = 0 each period. For employed households, we can simplify preferences by omitting the C (s) from the utility function. (a) Clearly, one state variable of the household is whether or not it is employed or unemployed. Identify the minimum set of additional state and control variables necessary to characterize this problem. (b) Write down the Bellman equation dening Vut and Vet the value function of a household that i unemployed or employed at the period t. Write the dow as explicit functions of all other state variables besides whether the household is employed or unemployed. Also, write these equations so that uncertainty is accounted for explicitly; in other words, dont use Et to capture expectations, but write out any expected values explicitly in terms of underlying future outcomes and their conditional probabilities. [HINT: Vet+1 should appear somewhere in Vut ]. (c) Write down the FOCs and the envelope conditions for both the Bellman equation. Derive a Euler equation linking cet and cet+1 and another one linking cut , ctt+1 , cet+1 and st . (d) Using the results form (c), prove the following result: for an unemployed agent optimal search eort st is a decreasing function of nancial wealth, at . In establish this result, you may use the following (without having to derive them): (I) given at , cet > cut t; (II) for any agent, optimal nancial wealth next period at+1 is increasing in nancial wealth this period i.s. at+1 / at > 0 (e) Using you results from (c) prove the following result: for an agent that is unemployed in period t and t + 1, consumption is decreasing over time cut > cut+1 . In establish this result, you may use the result (I) and (2) from part (d), and you may also assume for simplicity that there is no discounting involved i.e. (1 + r) = 1. (f) Derive a closed form solution for the optimal level of cet , also assuming (1 + r) = 1.

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Habits Persistence
t=0

Consider the problem of choosing a consumption sequence ct to maximize max

ct

t (ln ct + ln ct1 )

0 < < 1,

>0

s.to ct + kt+1 Akt

A > 0, 0 < < 1 k0 given ct1 given

Here ct is consumption at t and kt is capital stock at the beginning of period t. The current utility function is ln ct + ln ct1 , designed to represent habit persistence in consumption. (a) Formulate the Bellman equation for this problem, deriving FOC, Envelope condition and the Euler equation (b) Prove that the solution of Bellmans equation is of the kind V (k, c1 ) = E + F ln k + G ln c1 and that the optimal policy is of the form ln kt+1 = I + H ln kt where E, F, F, H and I are constant, which you should express in terms of the parameters A, , and .

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Precautionary Savings
T 1
t=0

Assume that the consumer maximizes max E 1 Ct e

yt = yt 1 + t

at+1 = at + yt ct

t N (0. 2 )

(a) Assume that labor income follows a random walk, with normally distributed innovations. Verify that the optimal consumption veries ct+1 = ct + 11 2 + t 2

and that the level of consumption is given by ct = 1 (T t 1) 2 a t + yt T 1 4

2, [HINT: if x is normally distributed with mean E [x] and variance x 2 then E [ex ] = eE [x]+e /2 . Then use the i.b.c. and solve for the level of consumption. The equation satises the i.b.c. for any sequence of realization of labor income.]

(b) How would the result change if the discount rate and the interest rate were not zero?

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Optimal Control with non-time separable utility

V (wt ) = max{c + ( Et V (wt+1 )) ]
ct

Consider the following non-time separable preferences function (Weil):

where < 1, < 1 and [0, 1] and Et denotes expectation as of the current period. The households dynamic budget constraint is given by wt+1 = Rt+1 (wt ct ) where Rt+1 is a stochastic gross return on households assets, realised next period and unknown as of the current period. Assume that Rt+1 is an iid random variable with mean R. Note that there is no labor or transfer income in tho model. Solve for the value function and optimal decision rule, using the guess and verify method. Specically, rst guess that the value function takes the form V (wt ) = Aw A>0 (a) Use this guess to solve the RHS of the Bellman equation. Show that the optimal consumption is a linear function of current wealth. Letting denotes the optimal marginal propensity to consumer out of wealth, write as a function of A and model parameters. Prove that [0, 1]. For given A analyse how changes in the mean interest rate R aect - for what parameter values is the interest elasticity of current saving positive, zero or negative? (b) Using your solution to part (a), verify that your guess is correct and write down an expression for A in terms of and model parameters. HINT: In principle you can solve the two equations in two unknowns to express A and in terms of the models underlying parameters, but you do not need to do this 12

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The Life-Cycle and Durable Goods

Consider a consumption-saving problem in which a household values both non-durable good and a durable good. Preferences are represented by max E0
t=1

t [u(ct ) + w(kt )]

where [0, 1] is a discount factor, E0 refers to expectations at time 0, ct is non-durable consumption, kt is the stock of durable good and u(ct ) and w(kt ) are concave ow utility functions. The stock of the durable good evolves according to Kt = (1 )kt + dt where dt represented the purchase of the durable good at time t and represents a depreciation rate. The households assets evolve according to at+1 = (1 + r)(at + yt ct pdt ) where at represents the households wealth at the start of period t, yt represents labor income received in period t, which follows a stationary dirt-order Markov stochastic process, r is the net rate of interest of risk-less saving and p is the constant price of durable good in term of non-durables (i.e. nondurables are the numeraire good, whose price is set to one for convenience). Note that there is only one risk-less asset in the economy. Assume to complete the problem that households have an initial stock of durables (d0 ) and an initial level of nancial wealth (a0 ) and that there is a No-Ponzi Game condition limiting borrowing. (a) Identify the state and control variables, and identify which states are exogenous and which are endogenous. Write down the Bellman equation for this household. (b) Take the rst order and even lope conditions for the Bellman equation and show that the standard expectational Euler equation relating the marginal utility of non-durable consumption (u (ct )) in periods t and t + 1 holds in this economy. Show that a similar Euler equation holds for the marginal utility of durable consumption (w (kt )) in t and t + 1. Also, show that along the optimum path there is a linear relationship between the current marginal utilities of nondurable and durable consumption. That is, show that w (kt ) = Au (ct ) Where A is a function of the model parameters to derive.

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(c) Now suppose that the utility function for durable is quadratic, so that w(kt ) = bkt f 2 k 2 t

where b > 0 and f > 0. Also assume (1 + r) = 1. Using the results from part (b), show that the stock of durables follows a martingale, that is kt+1 = kt + t+1 where t+1 is an innovation term satisfying Et t+1 = 0. Also show that spending on durables follows a moving average function, that is dt+1 = dt + t+1 + at where t+1 and t are the same innovation process in the martingale process, in period t + 1 and t, respectively; while a is a function of the model parameter. (d) Explain intuitively why changes in durables spending are partly predictable even though changes in the stock of durables are unforecastable. [Hint: think about what should happen to the stock of durables and durables spending on impact and in subsequent periods if at some time T there is an unexpected boost to current and future expected income].

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Health Care Spending

Households choose a streams of health care and other good consumption to maximise lifetime utility, given by:
T t=1

u(ht ) + v (ct )]

Consumers live for T periods. There is no uncertainty and no time disc outing (i.e. = 1), ht and ct refer to consumption of health care and a composite other good, respectively. The households budget constraints are given by at+1 = at ct pt ht

aT +1 = 0; at > 0 given Household nancial assets at the beginning of period t are given by at . There is no labor income, and there is only one asset, which is risk-free and which yield a gross return of one (i.e. (1 + r) = 1). pt is the relative prove of 14

health care, while the price of other goods is normalised to one. The second equation imposes the terminal and initial conditions. Assume that utility is isoelastic and that the utility function for health care and other consumption are identical: u( x) = v ( x) = 1 x , < < 1

(a) Derive a closed form solutions for initial c1 and h1 in terms of initial nancial sates, the path of health care prices and model parameters. (b) Now suppose that in period 1, the household learns that health care will be less expensive in period 2; in other words, p2 falls, holding p1 and other future prices xed. Characterize the sign of the response of initial health care spending as a function of . Over what range of will initial health care spending rise in anticipation of the future decline in prices? Over what range will initial spending fall, or be unchanged? Provide an intuitive explanation for this dependence Modify the problem to allow current consumption of health care to depend on both current and lagged health care spending. This captures the idea that going to the doctor today could yield health benets in the future as well as today. Spicically, household preferences are still described as before, however health care consumption now depends on current and lagged spending as follows:
ht = [ s t + s t 1 ] ,
1

< < 1

where st refers to spending on health care in period t, reects the degree of substitutability or complementarity between spending in dierent periods. The households dynamic budget constraint is modied as follows at+1 = at ct pt st Utility is now assumed to be in log form u(x) = v (x) = ln(x) which is the same as before but for = 0. All the other assumptions still hold. (c) Identify state and control variables and write down the Bellman Equa problem. tion for the householdOs prob(d) Take the rst order and envelope conditions for the householdOs lem. Derive the Euler Equation characterizing ct and show that ct is constant. Find an expression relating health care spending in periods t 1, t and t +1 to the price of health care in period t, and the constant level of c. 15

(e) Again, suppose that the household learns in period 1 that health care will be less expensive in period 2; p2 falls while p1 is held xed. Assuming that s0 = 0 and that s2 will rise when p2 falls, characterize the sign of the change in health care spending s1 as a function of - for what range of will health care spending increase in period 1? For what range of will spending decrease or be unchanged?

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