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Notes for Macroeconomics I

QEM (UAB)
Hugo Rodrguez Mendizbal
Course 20016-2017

ii

Contents
1 Introduction: Objectives of the Course

2 The Growth Model


2.1 Evidence on growth . . . . . . . . . . . . . . .
2.2 Solows Model . . . . . . . . . . . . . . . . . . .
2.2.1 Transitional Dynamics . . . . . . . . . .
2.2.2 Comparative statics . . . . . . . . . . .
2.2.3 Adding exogenous technological change
2.2.4 The golden rule . . . . . . . . . . . . . .
2.2.5 Decentralized market allocations . . . .
2.2.6 The Solow model and the data . . . . .
2.2.7 Endogenous growth . . . . . . . . . . .

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3 Consumption
23
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.2 The intertemporal utility function . . . . . . . . . . . . . . . . . 24
3.2.1 Consumption smoothing . . . . . . . . . . . . . . . . . . . 25
3.2.2 Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . . 25
3.3 The Fisher Model . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
3.3.1 Elasticity of intertemporal substitution and the coecient
of relative risk aversion . . . . . . . . . . . . . . . . . . . 30
3.3.2 Variations . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
3.4 Ricardian Equivalence . . . . . . . . . . . . . . . . . . . . . . . . 35
3.5 The Permanent Income Hypothesis . . . . . . . . . . . . . . . . . 37
3.5.1 Example: Quadratic utility with constant interest rate . . 39
3.5.2 Empirical Application: Understanding Estimated Consumption Functions . . . . . . . . . . . . . . . . . . . . . 43
4 The
4.1
4.2
4.3
4.4
4.5

Ramsey Model
Introduction . . . . . . . .
Solution of the model . .
The steady state . . . . .
Dynamics . . . . . . . . .
The balanced growth path

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iv

CONTENTS
4.6
4.7

4.8
4.9
5 The
5.1
5.2
5.3

5.4

Eects of a fall in the discount rate . . . . . .


Decentralized market allocations . . . . . . .
4.7.1 Households . . . . . . . . . . . . . . .
4.7.2 Firms . . . . . . . . . . . . . . . . . .
4.7.3 Market clearing . . . . . . . . . . . . .
4.7.4 General equilibrium: Definition . . . .
4.7.5 General equilibrium: Characterization
Exogenous growth . . . . . . . . . . . . . . .
Endogenous growth I: the AK model . . . . .
Overlapping Generations Model
Introduction . . . . . . . . . . . . . . . .
Motives for saving . . . . . . . . . . . .
The model framework . . . . . . . . . .
5.3.1 The savings of the young . . . .
5.3.2 Production . . . . . . . . . . . .
5.3.3 The dynamic equilibrium path of
The social planners problem . . . . . .

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economy
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6 The Overlapping Generations Model with Money


71
6.1 The model framework . . . . . . . . . . . . . . . . . . . . . . . . 71

Chapter 1

Introduction: Objectives of
the Course
Macroeconomics is used to get answers to two very general questions: (i)
how does an economy work? and (ii) is there anything we can do to improve
the way it works?
The first step in understanding how an economy works is to look at the
behavior of certain key aggregate variables. When we look at actual economies
we observe that these variables evolve jointly in a very specific way. In particular,
there are two features that all aggregate variables share: (i) they grow and
(ii) they all have fluctuations. So understanding how an economy works is
understanding why economic variables move together as well as why their comovements should present such pattern of behavior.
[FIGURES 1 & 2: GRAPH OF US GDP AND COMPONENTS
HERE]
[FIGURES 3 & 4: GRAPH OF US GROWTH RATES FOR GDP
AND COMPONENTS HERE]
Modern Macroeconomics build up explanations about the functioning of
actual economies aggregating the decisions of individual agents. However,
these decisions have two important features that condition the way we analyze
them: (i) they are taken in a general equilibrium framework, that is, a system
where prices and quantities are determined jointly and, (ii) they are dynamic
in nature, that is, current decisions depend not only on past decisions but also
on future ones.
This course is an introduction to all these issues. It is not an extensive survey
of possible topics in Macroeconomics. Its purpose is to familiarize the student
with the language and tools used not only to answer these questions but also, and
most importantly, to formulate other related questions in a proper way. So, one
important part of the course is technical and is directed to mastering the tools.
1

CHAPTER 1. INTRODUCTION: OBJECTIVES OF THE COURSE

Given what has been said above, these tools have to do with understanding
equilibrium in dynamic systems. There is also another part with applications
that will be used as examples of how these tools are used in particular problems.

Chapter 2

The Growth Model


2.1

Evidence on growth

The ability of a nation to improve the living standards of its citizens depends
crucially on its capacity to generate long-run growth. For many countries in the
world, this is the normal state by which they are able to maintain positive rates
of growth for a long period of time. The next figure shows the US real GDP
per capita for the period 1947(I)-2015(II). Data is taken from the Maddison
database (include link). GDP is measured in year 2009 dollars. We observe
how with the exception of few years (Great Depression, wars,...) real GDP per
capita has consistently increased over the years.
[FIGURE 5: GRAPH OF US REAL GDP PER CAPITA
(MADDISON)]
This figure takes us to our first question:
1. How can a country grow over a long period of time? What
determines the long-run growth rate of real GDP per capita?
In particular, growth has been accelerating over the years for the US economy. From 1800 until 1850, the US economy grew at about 0.7% annually.
Between 1850 and 1913 (right before WWI), the growth rate was 1.64%. This
rate increased after WWII to be 1.90%. Moreover, the following figure shows
the growth experience is shared by other economies. It includes data on real
GDP per capita of other economies like UK, Germany, Japan and Spain.
[FIGURE 6: GRAPH OF US, UK, GERMANY, JAPAN, AND
SPAIN REAL GDP PER CAPITA (MADDISON)]

CHAPTER 2. THE GROWTH MODEL

When comparing data for dierent countries it seems as if dierences among


them are increasing. The spreading of this distribution is in part due to the
increases in average incomes. To see this, imagine country and country ,
both growing at the same rate but starting from dierent levels of income
with initially richer than . Then, it must be the case that
= (1 + )1 = (1 + ) 0
while
= (1 + )1 = (1 + ) 0
so that
= (1 + ) (0 0 )
with 0 0 0. It is clear then that the dierence between the two GDPs
per capita will grow over time. However, if we take logs (denote log of a variable
by the corresponding lower case letter)
ln( ) = ln(1 + ) + ln(1 ) = ln(1 + ) + 0
while
ln( ) = ln(1 + ) + 0
so
= 0 0
which is constant. Also notice that if a variable grows at a constant rate, its
natural logarithm behaves as a linear function of time (this is why dierences
in logs are parallel to each other and their dierences constant).
[FIGURE 7: GRAPH OF LOG OF US REAL GDP PER CAPITA
(MADDISON)]
[FIGURE 8: GRAPH OF LOG OF US, UK, GERMANY, JAPAN,
AND SPAIN REAL GDP PER CAPITA (MADDISON)].
Again, this figure takes us to our second question:
2. How can countries with low level of GDP per person catch up
with the high levels enjoyed by the United States or the G7?
The answer is only by maintaining higher growth rates sustained for long
periods of time. In fact, small dierences in growth rates over long periods of
time can make huge dierences in final outcome. US per-capita GDP grew by a
factor 20 from 1800 to 2010. In 1990 prices, it was $1296 in 1800 and $30491
in 2010. This means that its average growth rate was 1.5%. If US had grown
with 1%, its GDP would be only $10473 in 2010 (i.e., 1/3 of the actual one,
similar to Uruguay). If US had grown with 2% its GDP would be $82911 in
2010 (i.e., 2.7 times the actual one).

2.1. EVIDENCE ON GROWTH

At a growth rate of 1%, it will take 70 years to double our income. At


a growth rate of 3%, income will be doubled in 23 years. Some East Asian
countries grew by 6% over 1960-1990; this is a factor of 6 within just one
generation!!! To see this, take (0) as the initial GDP and compute the number
of years to double it growing at the rate , that is to get ( ) = 2 (0). Then,
( ) = 2 (0) = (1 + ) (0)
taking logs
ln(2) = ln(1 + )
So,

06931
ln(2)
=

Once we appreciate the importance of sustained growth, the question is


natural:
3. What can we do to make growth faster? Or, equivalently: What
are the factors that explain dierences in economic growth, and
how can we control these factors?
In order to prescribe policies that will promote growth, we need to understand what are the determinants of economic growth, as well as what are the
eects of economic growth on social welfare. Thats exactly where Growth Theory is all about.
In 1960 there were many countries that had much lower standards of living
than the United States. This fact reflects the high cross-country dispersion in
the level of income. In 1960, the richest country then was Switzerland, with
$18557; the United States was second, with $15105, and the poorest country
was Equatorial Guinea with $288. In 2011, the richest country was Norway,
with $63546 per person. The United States came sixth, with $42250. The G7
and most of the OECD countries ranked in the top 25 positions, together with
Singapore, Hong Kong, Taiwan, and South Korea. Most African countries, on
the other hand, fell in the bottom 25 of the distribution. El Salvador was the
poorest country, with only $248 per personthat is, less than 1% of the income
in Norway!.
[FIGURE 9: GRAPH OF DISTRIBUTION OF REAL GDP PER
CAPITA IN S&H DATASET FOR 1960 AND 2011]
The next figure shows the distribution of (the log of) GDP per capita in 1960
and 2011 across 107 countries in the Summers and Heston dataset. The distribution has moved to the right but still the left tail is on the same place as before.
Nevertheless, there were some important movements during this 40-year period.
Mexico, Israel, or South Africa were in the top of the distribution in 1960, but

CHAPTER 2. THE GROWTH MODEL

none made it to the top in 2011. On the other hand, China, Equatorial Guinea,
Botswana, or Romania grew fast enough to escape the bottom of the distribution. These large movements in the distribution of income reflects sustained
dierences in the rate of economic growth.
The next figure shows the distribution of the growth rates the countries
experienced between 1960 and 2011.
[FIGURE 10: GRAPH OF DISTRIBUTION OF GROWTH
RATES IN S&H DATASET]
Just as there is a great dispersion in income levels, there is a great dispersion
in growth rates. The unweighted mean growth rate was 2.26% per annum; that
is, the world on average was three times as rich in 2011 as it was in 1960. The
United States did slightly better than the mean (2.79%). Spain much better
(5.38%). The fastest growing country was Equatorial Guinea, with a annual
rate as high as 8.75% (incidentally, Equatorial Guinea was the poorest country
in the sample in 1960) which accumulates to a factor of 86 over the 51-year
period. The slowest growing country was Democratic Republic of Congo, with
a negative rate at -2.20%; Congos residents show their income shrinking to 1/3
between 1960 and 2011.
Also, the next figure shows an example of how persistent the dierences in
growth rates were across countries.
[FIGURE 11: GRAPH OF GDP PER CAPITA OF SEVERAL
COUNTRIES IN S&H DATASET]
Most East Asian countries (Taiwan, Singapore, South Korea, Hong Kong, Thailand, China, and Japan), together with Bostwana (an outlier for sub-Saharan
Africa as is Equatorial Guinea or Gabon), Cyprus, Romania, and Mauritius,
had the most stellar growth performances; they were the growth miracles of
our times. Some OECD countries (Ireland, Portugal, Spain, Greece, and Norway) also made it to the top 25 of the growth-rates chart. On the other hand,
17 out of the bottom 20 were sub-Saharan African countries.
[TABLES WITH GROWTH MIRACLES AND DISASTERS]
The next figure graphs a countrys GDP per capita in 2011 (normalized by
the US level) against the same countrys GDP per capita in 1960. Clearly, most
countries did not experience a dramatic change in their relative position in the
world income distribution. Therefore, although there are important movements
in the world income distribution, income and productivity dierences tend to
be very persistent. This also means that poor countries on average do not grow
faster than rich countries.

2.2. SOLOWS MODEL

[FIGURE 12: GRAPH OF GDP PER CAPITA OF SEVERAL


COUNTRIES IN 1960 VS. 2011]
Later on we will see why this could be the case.

2.2

Solows Model

Solows model highlights the eects of saving, technological advance and population expansion in this process. Despite its simplicity, the Solow growth model
is a dynamic general equilibrium model (though many key features of dynamic
general equilibrium models, such as preferences and dynamic optimization are
missing in this model). For example, the model is not behavioral in the sense
that tells us how agents make decisions optimally. It does, however, gives us an
idea about how a dynamic system evolves over time. Heuristically, the idea
behind this dynamic is that capital in some period will determine output, ,
which will determine savings, . Savings are used to finance investment in capital, , which is the source behind increases in capital in the following period,
+1 , which will determine output, etc. So, it seems that capital accumulation
is one of the sources of growth. Solows model is designed to understand this
process.
Additionally, despite its simplicity this model yields vital insights and intuition. As we will see below, many of the results can be preserved in models
with more fully specified microfoundations. One fairly robust prediction of this
closed-economy models is that steady-state output per worker can dier across
countries because of dierences in nontechnological factors such as savings rates
and population growth.1
The Solow model is described by the following assumptions:
On the supply side, there is constant return to scale technology summarized by the production function
= ( )

(2.1)

This production function satisfies certain properties. It has constant returns to scale, that is, for all 0,
( ) = ( )
which is another way to say that this function is homogeneous of degree
1. Applying Eulers theorem, if a function is homogeneous of degree
then, it must be the case that
( ) =
1 This

( )
( )
+

section is taken from Obstfeld and Rogo [16], chapter 7, and Sala-i-Martin [19].

CHAPTER 2. THE GROWTH MODEL


or, in our case = 1 so that
( ) =

( )
( )
+

is also strictly increasing,


( )

( )
( )
0 ( )
0

strictly concave,
2 ( )
2 ( )

(
)

2
2
( ) ( ) [ ( )]2 0

( )

and satisfies the Inada conditions (explain intuition)


( 0) = 0 (0 ) = 0
lim ( ) =

lim ( ) =

lim ( ) = 0

lim ( ) = 0

Also, define per capita output as

( )
=
=
=

1 = ( 1) = ()

From the properties on , the properties of are:


(0) = (0 1) = 0
0 () = ( ) 0
lim 0 () =

lim 0 () = 0

00 () 0
By the way, if is homogeneous of degree 1, its partial derivatives (marginal products) are homogeneous of degree 0, that is, for all 0,
( ) = ( )
Taking
( ) = ( )

2.2. SOLOWS MODEL

This means that marginal products only depend on the capital/labor ratio
or capital per capita, i.e.

( ) =
1 =
1 = 0 ()

Using
( ) = ( ) + ( )
( )

= ( )
+ ( )

or
() = 0 () ( )
or
( ) = () 0 ()
Finally, labor force is growing exogenously at the rate
+1 = (1 + )
On the demand side, the economy is closed and there is no government.
Private saving is assumed to be a fixed fraction of current income
(equal to output here), regardless of interest rates, expectations of future
productivity shifts, and so on. Thus,
= = ( )

(2.2)

Because domestic savings must equal domestic investment in a closed economy, capital accumulation is given by
+1 = = ( )

(2.3)

Given that is growing over time it is easier to look at the dynamics if we


concentrate on the capital per capita
=

Using (2.3) and dividing by we obtain


( )
+1
=

(2.4)

Noting that
+1 +1
+1
=
= (1 + ) +1

+1
we can write (2.4) as
+1 =

1
[ ( ) ( + ) ]
1+

(2.5)

10

CHAPTER 2. THE GROWTH MODEL

where () gives us the per capita production function. Equation (2.5) is the
central equation of the Solow model. The first term in the brackets on the righthand side gives gross saving per worker in period . The second term reflects
the downward pull on caused by depreciation and growth in the labor force.
Both terms are multiplied by 1(1 + ) because any net investment in period
must be spread over a larger number of workers in period + 1.
[GRAPH OF SOLOW MODEL HERE]
Another way of writing (2.5) is
+1 =

1
( ) +

1+
1+

Graphically we see that the output curve () is strictly concave because the
production function is strictly concave in capital. The saving curve () is
also concave because is proportional to output. The vertical distance between
the two curves gives consumption per worker. The linear ray ( + ) gives the
savings needed to maintain any given level of capital per worker. The vertical
distance between the saving curve and this schedule is proportional (by a factor
of 1 + ) to the net increase in capital per capita, +1 . When the capital
stock is high, () ( + ) , and savings are inadequate. Thus the capital
per worker is falling (+1 0). The opposite occur when the capital stock
is low. Therefore, over time, the economy must converge to the steady-state
level where
( ) = ( + )
When the economy reaches this long-run equilibrium, is constant as are all
per capita variables. Thus , and must be growing at the gross rate 1 + .
[LOOK AT OTHER STEADY STATE (0)]

2.2.1

Transitional Dynamics

The above expressions characterized the (unique) steady state of the economy
with positive values for our variables of interest. Naturally, we are interested
to know whether the economy will converge to the steady state if it starts away
from it. Another way to ask the same question is whether the economy will
eventually return to the steady state after an exogenous shock perturbs the
economy and moves away from the steady state.
We can easily see that for any given initial 0 (0 ), this economy converges asymptotically to the steady state. The transition is monotonic. The
growth rate is positive and decreases over time towards zero if 0 ; it
is negative and increases over time towards zero if 0 . To prove this
statement define the function
()

1
() +

1+
1+

2.2. SOLOWS MODEL

11

so that
+1 = ( )
and
= ( )
By the properties of ,
0 ()

1
0 () +
0
1+
1+

and

00 () 0
1+
so that is strictly increasing and strictly concave. Moreover,
00 ()

(0) = 0 0 (0) =

() = 0

0 () =

1
1
1+

By definition of , () = if and only if = . It follows that ()


for all and () for all . Then it must be the case that
+1 whenever and the sequence { }
=0 is strictly increasing
if 0 . A symmetric argument proves that part whenever 0 .
Analyze the stability of each steady state.
[GRAPH OF (2.5) HERE]

2.2.2

Comparative statics

We can use the figure above to consider how various parameters aect the economys steady state capital stock (and, therefore, the rest of per capita variables).
First, consider the eect of a decline in the saving rate to 0 as illustrated in
the following figure:
[GRAPH OF CHANGING SAVING RATE HERE]
In the long-run, the capital per worker ratio declines and, therefore, so does
per capita income. However, once the economy adjusts to its new lower level of
capital, it resumes its former rate of growth (i.e. 0 in per capita terms). The
fact that changes in saving rates have only temporary eects on growth is one
of the most powerful and universal predictions of the Solow model. A country
willing to invest more of its output can enjoy a temporary growth spur, but this
strategy cannot raise growth indefinitely. Eventually, diminishing returns to
capital set in. The Solow model does not predict that technologically identical
closed economies necessarily converge absolutely to the same per capita output
levels. It only predicts absolute convergence conditional on the saving rate and
population growth, as well as technology. Talk about the transition.

12

CHAPTER 2. THE GROWTH MODEL

Another implication of the model is that a rise in a countrys population


growth rate will lower steady-state per capita output. A rise in causes the
( + ) schedule to rotate upward, leading to a lower value of . Given the
economys fixed saving rate, higher population growth dilutes capital resources.
The message from these exercises, of course, is that countries with faster growing populations and lower saving rates will be poorer than countries with low
population growth and high saving rates.
[GRAPH OF CHANGING POPULATION GROWTH RATE
HERE]
[GO BACK TO GRAPHS OF DATA]
Use these graphs to show how the model can be adapted to predict dierences
in relative incomes per capita.

2.2.3

Adding exogenous technological change

One sharp result from the Solow model is that output per capita does not grow
at the steady state. One way of incorporating long-run growth in the model is
by adding technological change in the form of labor augmenting productivity
growth. This means specifying a production function of the form
= ( ) = ( )1
where is the labor-augmenting technological shift parameter, so that may
be thought of as the supply of eciency units of labor. For the case of the
Cobb-Douglas it does not matter whether we specify technological change as
labor-augmenting or as total factor productivity,
= ( ) = 1

since in this case = 1 . Assume this factor grows at an exogenous rate


, that is,
+1 = (1 + )
Now, use again (2.3) but divide this time by instead of to obtain
( )
+1 b
=
b


where b
denotes capital per eciency units of labor
Noting that

b
=

+1 +1 +1
+1
=
= (1 + ) (1 + ) b
+1 = (1 + ) b
+1

+1 +1

(2.6)

2.2. SOLOWS MODEL

13

we can write (2.6) as


b
+1 b
=

i
1 h b

( + ) b
1+

(2.7)

where (b
) gives us the per eciency units production function. Equation (2.7)
is identical to (2.5) except that variables are expressed in per eciency units
of labor. The variable b
also reaches a steady state level in the long run. This
steady state level implies capital per eciency units of labor approaches the
level for which

b
+1 b
= 0 = b
= ( + ) b

which means the per capita variables will be growing at the gross rate 1 +
and aggregate variables at the gross rate 1 + = (1 + ) (1 + ). The rest of
predictions about levels is the same as in the Solow model.
We see that the economy does not converge to a situation where variables
in per capita terms are constant but to a situation where the growth rates of
per capita variables are constant and equal. This is what is called a balanced
growth path. Notice, the model without technological change also converges
to a particular balanced growth path (one where the growth rates of per capita
variables is zero).
Although variables per eciency units of labor help us solve the model, we
are still interested in the evolution of per capita variables ( ) or aggregate
variables ( ). However, once we have the evolution of variables per eciency
units of labor, finding out the behavior of other variables is straight forward as
=
or

2.2.4

The golden rule

b
=

= b

Once we have capital at the steady state, we can compute the rest of variables
of interest at the steady state:
- output
b = (b
)

- consumption
- investment

b
= (1 ) (b
)
b = (b
)

If we look at consumption, we can see the savings rate has an ambiguous


eect. This is because the larger the savings rate the smaller the fraction of
output going to consumption but output is larger because capital is larger. In
fact, consumption per eciency unit at the steady state (and, therefore, the

14

CHAPTER 2. THE GROWTH MODEL

level of consumption at the balanced growth path) is cero for both = 0 and
= 1.
How does consumption at the steady state change with the savings rate? To
answer this question is better to express consumption as a function of capital
only. For that notice that at the steady state
(b
) = ( + ) b

so that consumption at the steady state can be written as


) (b
) = (b
) ( + ) b

b
= (b

The nonlinear relation between consumption and the savings rate translate into
a nonlinear relation between consumption and capital. If we dierentiate with
respect to b
and equate to 0 we see that the level of capital that makes
consumption at the steady state maximum is b
= b
where b
satisfies
0 (b
) = ( + )

Thus, the savings rate that maximizes consumption at the steady state is that
which produces b
.
For the Cobb-Douglas production function we have

But at the steady state

1
b

= +

b = ( + ) b

which implies that the savings rate maximizing consumption at the steady state
is
=
This savings rate is called golden rule.
PROBLEM SET: Look at moving the savings rate to the golden rule when
and when .

2.2.5

Decentralized market allocations

In the previous sections, we characterized the centralized allocation dictated by


a social planner. There was no market to allocate resources. The social planner
put together the sources of income (supply side) with its uses (demand side).
We now characterize the competitive market allocation. For that, we solve the
model without technical change. The model with technical change will go on a
PROBLEM SET.

2.2. SOLOWS MODEL

15

Households
Assume households are dynasties, living an infinite amount of time. There is a
continuum of these dynasties and we index each household by [0 1], having
normalized 0 = 1. The number of persons in every household grow at constant
rate 0. Therefore, the size of the population in period is = (1 + )
and the number of persons in each household in period is also .
We write lower case letter to denote the per capita value of a variable in
the household while the corresponding capital letter refers to the household-wide
variable. Thus, refers to per capita capital while refers to the aggregate
capital of the household so that
=
As there is always a measure 1 of households, these magnitudes correspond also
to economy-wide variables.
Each person in a household is endowed with one unit of labor in every
period, which he supplies inelastically in a competitive labor market for the
contemporaneous wage . Household is also endowed with initial capital 0 .
Capital in household accumulates according to
+1 = (1 ) +
or, in per capita terms
(1 + )+1 = (1 ) +
or

(2.8)
1+
1+
Households rent the capital they own to firms in a competitive market for a
(gross) rental rate .
The household uses its income to finance either consumption or investment
in new capital:
+ =
+1 =

Total per-head income for household in period is simply (with constant returns
to scale there will be no profits)
= +

(2.9)

Combining, we can write the budget constraint of household in period as


+ = +

(2.10)

Finally, the consumption and investment behavior of household is a simplistic


linear rule. They save fraction and consume the rest:
= (1 )
and
=

(2.11)

16

CHAPTER 2. THE GROWTH MODEL

Firms
There is an arbitrary number of firms in period , indexed by [0 ].
Firms employ labor and rent capital in competitive labor and capital markets,
have access to the same neoclassical technology, and produce a homogeneous
good that they sell competitively to the households in the economy.
Let and
denote the amount of capital and labor that firm [0 ]
employs in period . Then, the profits of that firm in period are given by

= ( )

The firms seek to maximize profits. The FOCs for an interior solution require
(
)
=

and
(
)
=

Remember that the marginal products are homogenous of degree zero; that
is, they depend only on the capital-labor ratio. In particular, the two conditions
above imply
0
= (
) = ( )

and

0
= (
) = ( ) ( )

That is, the FOCs pin down the capital-labor ratio for each firm (
),
but not the size of the firm (
). Moreover, all firms use the same capital-labor
ratio.
Furthermore, these two conditions also imply
+ = ( )
It follows that

+
= ( + ) = ( ) = ( )

and therefore

= [ ( ) ] = 0

That is, when the firms optimality conditions are satisfied, the maximal profits
that any firm makes are exactly zero, and these profits are attained for any firm
size as long as the capital-labor ratio is optimal.

2.2. SOLOWS MODEL

17

Market clearing
The capital market clears if and only if
Z
Z
Z 1

= =
=
(1 + )
0

where is the aggregate capital stock in the economy.


The labor market, on the other hand, clears if and only if
Z
Z 1

=
(1 + )

General equilibrium: Definition


The definition of a general equilibrium is more meaningful when households optimize their behavior (maximize utility) rather than being automata (mechanically save a constant fraction of income). Nonetheless, it is always important
to have clear in mind what is the definition of equilibrium in any model. For
the decentralized version of the Solow model, we let:
Definition 1 An equilibrium of the economy is an allocation {( , , )[01] ,

( ,
)[0 ] }=0 , and a price path { , }=0 , such that

(i) Given { , }=0 , the path { , , }=0 is consistent with the behavior
of household , for every ,
(ii) ( ,
) maximizes firm profits, for every and ,
(iii) the capital and labor markets clear in every period.
General equilibrium: Characterization
For any initial positions 0 , with [0 1], an equilibrium exists. The allocation
of production across firms is indeterminate, but the equilibrium is unique with
regard to aggregates and household allocations. The capital-labor ratio in the
economy is given by { }
=0 such that, for all 0,
+1 =

1
( ) +

1+
1+

with
0 =
Equilibrium growth is
=

+1
1
( )
=
( + )

1+

Finally, equilibrium prices are given by


= 0 ( )

(2.12)

18

CHAPTER 2. THE GROWTH MODEL

and
= ( ) 0 ( )

(2.13)

To prove these statements we will first characterize the equilibrium, assuming


it exists. First, we have seen how all firms use the same capital/labor ratio
= . We thus infer that equilibrium prices are given by
= 0 ( ) = ( 1)
and
= ( ) 0 ( ) = ( 1)

Note that = 00 ( ) = ( 1) 0 and = 00 ( ) =


( 1) 0. That is, the interest rate is a decreasing function of the capitallabor ratio and the wage rate is an increasing function of the capital-labor
ratio. The first properties reflects diminishing returns, the second reflects the
complementarity of capital and labor.
Adding up the budget constraints of the households, we get
+ = +
where
=

Equivalently, in per-capita terms,

+ = +
But we have seen that
+ = ( )
We conclude that the household budgets imply
+ = ( )
which is simply the resource constraint of the economy.
Adding up the individual capital accumulation rules, we get the capital accumulation rule for the aggregate of the economy. In per-capita terms,

+1 =
+

1+
1+
Adding up (2.17) across households, we similarly infer
= = ( )
Combining, we conclude
+1 =

1
( ) +

1+
1+

(2.14)

2.2. SOLOWS MODEL

19

which is exactly the same as in the centralized allocation.


Finally, existence and uniqueness is now trivial. (2.14) maps any (0 )
to a unique +1 (0 ). Similarly, (2.12) and (2.13) map any (0 ) to
unique (0 ). Therefore, given any initial
0 =

R 0
0

there exist unique paths { }


=0 and { , }=0 . Given { , }=0 the alloca


tion { , , }=0 for any household is then uniquely determined by (4.8),
(2.9), and (2.11). Finally, any allocation ( ,
)[0 ] of production across
firms in period is consistent with equilibrium as long as =
.
As a corollary, we can see that the aggregate and per-capita allocations in
the competitive market economy coincide with those in the planner economy.
We can thus immediately translate the steady state and the transitional dynamics of the centralized plan to the steady state and the transitional dynamics of
the decentralized market allocations.
Remark: This example is just a prelude to the first and second welfare
theorems, which we will have once we replace the rule-of-thumb behavior
of the households with optimizing behavior given a preference ordering over
dierent consumption paths: in the neoclassical growth model, Pareto ecient
and competitive equilibrium allocations coincide.

2.2.6

The Solow model and the data

Growth accounting
Now we can use Solow model or extensions to interpret both economic growth
over time and cross-country output dierences. It implies decomposing the
growth rate of real GDP among its components. To understand this, think of a
production function
() = [() () ()]
where () is output, () is the technology level, () is labor and () is
the stock of capital all in period . Here, we are taking time to be continuous.
Taking logs,
ln[ ()] = ln[ (() () ())]
and taking derivatives with respect to time
()
() () () () () ()
=
+
+

()
()
()
()
Using () = () and defining growth rates of a variable () as
()
= ()
()

20

CHAPTER 2. THE GROWTH MODEL

and the elasticity of output with respect to () as


()

()()
()

yields
() = () + () () + () ()
In this expression () is the contribution of technology to output growth. Notice
we have data on growth rates and can measure elasticities. Therefore, this
expression can be used to measure technological contribution to growth, i.e.
() = () () () () ()
That is called Solows residual or total factor productivity (TFP). If we specialize this function to be of the Cobb-Douglas form we have
=
But then,
() = ; () = ; () = ()
Thus, the parameters and are the output elasticities of labor and capital,
respectively which are constant in the Cobb-Douglas production function. Additionally, we know that this coecients are equal to the labor and capital share
in total income.

=
; =

This is another thing you will have to show in problem set 2. Finally, with
constant returns to scale we have that = 1 . So, TFP becomes
() = () () (1 ) ()
The following tables show data on growth decompositions for three sets of
countries: Europe and US with Australia, Latin-American countries and Southeast Asian countries.
Growth regressions
We could produce artificial data for the Solow growth model. For that assume
three countries, called , and . All countries have the same savings rate,
= 02, the same capital elasticity of output, = 13, the same depreciation
rate, = 008, the same population growth rate, = 001, the same growth
rate of technology, = 003, the same initial level of technology, 0 = 1, but
dier in their initial level of capital per capita. Country starts with 0 = 2
capital units per worker, country starts with 0 = 1 while country starts
with 0 = 04. The point here is to produce series for capital, consumption,
investment and output per capita.

2.2. SOLOWS MODEL

21

To do that, first we have to compute the steady state level these countries
will be converging to. For a Cobb-Douglas production function, (b
) becomes

(b
) = b

so that steady state capital per eciency units is computed from

= ( + )b

where = (1 + )(1 + ) 1. Then the steady state level of capital per eciency
units is

1(1)

b
=

We observe all countries share the same capital per eciency units at the
steady state. Then compute the initial level of capital per eciency unit of
labor for each country, i.e.
0
b
0 =
0

which dier from country to country because each starts with a dierent level
of capital per capita. From then, we could compute the evolution of capital per
eciency unit applying the formula
b
+1 b
=

i
1 h b

( + ) b
1+

We observe all countries converge to the same level of capital (and therefore,
output and consumption) per eciency unit. Finally, we could compute the
paths of the variables per capita and its growth rates.
We see that there must be an inverse relation between initial levels of income
and average growth rates over a prolonged period of time. In other words, if we
ran the regression
(20111960 ) = + (1960 )
the estimated coecient should be significantly negative. However, if we look
at the data, this coecient is basically zero. On the other hand, consider the
regression
(20111960 ) = + (1960 ) + 1960
where 1960 is a set of country-specific controls, such as levels of education,
fiscal and monetary policies, market competition, etc. Then, the estimated
coecient turns to be around -2% per annum. Therefore, poor countries tend
to catch up with the rich countries with a group of countries that share similar
characteristics. This is what we call conditional convergence.

22

2.2.7

CHAPTER 2. THE GROWTH MODEL

Endogenous growth

We can generate sustained growth in a dierent manner. If we go back to


equation (2.3) and specialize it with a general Cobb-Douglas production function
+1 =

(2.15)

and now divide by , we get


+1 =

i
1 h +1
( + )

1+

Computing growth rates of per capita capital


i
+1
1 h 1 +1
=
( + )

=

1+

(2.16)

(2.17)

In the case we considered above, we had constant returns to scale so + = 1


and

+1
1

=
=

(
+
)
(2.18)

1 + 1
so the growth rate of the economy converge to zero. However, assume that there
are constant returns to capital, so = 1. Then, we have
i
+1
1 h
=
(2.19)
( + )
=

1+

We see that the growth rate does not have to converge to zero. In particular,
we do not need growing population. Imagine that = 0 and normalize the
population level to 1. Then we have
=

+1
=

(2.20)

If the savings rate of this economy is high enough, the economy is continuously
growing in per capita terms. Furthermore, changes in the saving rate not only
aect levels of variables but also the growth rate. This implies there is no
transition. We always are in a balanced growth path.
Summarizing, we can generate a positive growth rate without assuming exogenous productivity growth if we allow for constant returns to the inputs
that can be accumulated. Because the growth rate is determined within the
model, i.e. it depends on other parameters, these models are often called endogenous growth models. Notice, the simplest case is the one with the
technology
=
with constant. We will see later that a wide varieties of models that present
endogenous growth have technologies that can be written in this way. For this
reason, these models are also called AK models. Also, notice that introducing
another, non-reproducible factor will make the production function to present
increasing returns to scale. We will see that this can make us run into
problems and how we can work them out.

Chapter 3

Consumption
3.1

Introduction

As noted above, one of the shortcomings of the Solow model is that the savings
rate was constant. This is problematic as how much agents save is a decision
and, logically, this decision may change when agents face dierent environments
(among them changes in income itself). Thus, we would like to extend the
Solow model to allow for an endogenous determination of the savings rate. To
understand how much households save, we should realize that saving and consumption are two sides of the same coin. We then will concentrate on isolating
the analysis of this decision and then plug it into a growth model.
Some 80 years ago, Keynes hypothesized that people consumed according to
the following consumption function:
= 0 + 1 ( )
where 0 and 1 are coecients to be estimated, is consumption at ,
is income and are taxes so that is disposable income. Explicitly,
consumption in period is a function of disposable income in period only.
Here 1 represents the marginal propensity to consume. Keynes mentioned
0 0 and 0 1 1. There are two problems with this formulation:
Theoretical: Future income does not enter at all into someones decision
to consume. Imagine that you know (with certainty) that youll receive
$1,000,000 exactly one year from today. It seems reasonable to think
that you consume more today in anticipation of that increase in future
income. However the Keynesian function above does not allow for this
eect. One of the issues in modern consumption theory is to build models
that explicitly takes into account future income.
Empirical: The Keynesian consumption function implies that the savings
23

24

CHAPTER 3. CONSUMPTION
rate is aected by the income level
=

0
=1
=1
1


which shows that savings rates should rise with income. In the crosssection, this seems to work. Bill Gates saves a higher proportion of his
income than you do, for example. But over time, this doesnt seem to
hold for countries or even necessarily for people. In Keynes defense, the
data didnt exist at the time he was writing that could have showed him
his function didnt work.
So, we want to construct a better model of savings and consumption in which
agents optimize their decisions. That is, we want an economic model of savings
in which someone is maximizing their utility subject to a budget constraint.
The budget constraint will involve the trade-o of consumption and savings, as
opposed to the trade-o of good X and good Y. Utility will also need to involve
consumption and savings. We will look at these two objects (the utility function
and the budget constraint one at a time)

3.2

The intertemporal utility function

Assume an agent that lives for 0 periods (notice we may allow ). We


can think of this agent as deriving welfare from consumption over his lifetime.
We summarize this welfare through a (utility) function
(0 1 1 )
The standard form this utility takes is that of time separability by which
(0 1 1 ) =

1
X

( )

=0

In this expression 0 1 is the discount factor. Also, the period-specific


utility () satisfies certain properties, namely, it is increasing 0 () 0, and
concave 00 () 0. We also impose
lim 0 () = ; lim 0 () = 0

so as to avoid corner solutions. The discount factor reflects the idea that for an
agent at any time , future consumption is not as valuable as current consumption. This introduces the notion of impatience.
Another way of looking at additive separability is that the marginal rate of
substitution between two periods is assumed to be independent of any other
period, or

0 ( )
+1 =
=
+1
0 (+1 )

3.2. THE INTERTEMPORAL UTILITY FUNCTION

25

is independent of the marginal utility from any other period besides and + 1.
This makes the life of the dynamic optimizing much easier. However, we can
think of situations where this assumption does not hold (habit formation).
On the other hand, the concavity of the period-specific utility function ()
produces two results: the first is consumption smoothing and the second is risk
aversion. To isolate these two eects we for the moment assume there is no
discounting so that = 1.

3.2.1

Consumption smoothing

To talk about consumption smoothing, we need to think about how people


allocate their consumption across periods. Lets say you have $300 and two
periods to spend it in. Your utility function is therefore
(0 1 ) = (0 ) + (1 )
Assume prices in period 0 and 1 are the same. What is the optimal way to
split up the $300? Given the additive nature, the answer is to smooth it, or
consume $150 in each period. To see this, consider what the marginal utility
of consumption would look like in each period if you didnt smooth it. Lets
say you consume 1 = 200 and 2 = 100. Then the marginal utilities, given the
properties we described above, relate like this
0 (200) 0 (100)
or the marginal utility of first period consumption is lower than second period
consumption. So you could move a dollar from period 0 to period 1 and have a
net gain in utility. You could keep doing this until marginal utility was equalized
across periods, which only happens when consumption is 150 in each period.
This shouldnt be too surprising. The price of consumption in each period is
identical, so our intermediate microeconomist training tells us that the ratio
of marginal utilities must equal the price ratio. In other words, the marginal
utilities must be identical, and that can only happen when consumption is 150
in each period.
So one primary consequence of additive separability and the concavity of the
utility function is that people want to smooth consumption over time.

3.2.2

Risk Aversion

Now lets start over and consider utility only within one period, but there is
uncertainly about what consumption might be. Suppose that I have a 50%
chance of having $100 to consume and a 50% chance of having $200 to consume.
How do I calculate my expected utility? There are two ways you could consider
doing this. One, you could take the utility of the expected level of consumption
which would look like this
= (05 100 + 05 200)

26

CHAPTER 3. CONSUMPTION

and in this case you would be completely wrong.


The second method of computing expected utility is the right way and deserves its own definition.
Definition 2 (Von Neumann Mortgenstern (VNM)) The Von Neumann
Mortgenstern (VNM) method of computing utility takes the expected utility of
consumption, written as

X
=
( )
=1

where is the probability of situation occurring (out of a possible outcomes)


and ( ) is the utility of consumption in situation i.
To make sense, we have to have as well that

= 1

=1

Note that VNM utility is very similar to the simple additively separable utility
function from the previous definition. They are both linear combinations of
felicities.
In our example, the correct VNM specification for utility is
= 05 (100) + 05 (200)
How do we know the VNM utility is the right way to think about utility when
there are dierent possible states of the world? Here is a simple demonstration:
Suppose that you can have either $150 with certainty, or a lottery where you
have a chance of getting either $100 or $200, each with a probability of .5.
Which would you prefer? Almost everyone would say they prefer the certain
allocation. The fact that uncertainty lowers your utility is called risk aversion.
But notice that if we chose the first technique for adding up utility across states
of the world, we would say that you should be indierent.
Notice that risk aversion is a direct implication of the utility function being
curved. By the fact that the function is concave (has a negative second
derivative), Jensens inequality tells us that
05 (100) + 05 (200) (05 100 + 05 200)
or in general that the expected utility of consumption is lower than the utility
of expected consumption
[()] [()]
If the utility function were a straight line then the utility of $150 with certainty
would be the same as the utility of a lottery with equal chances of getting $100
and $200. A person who indeed gets equal utility from these two situations is
called risk neutral.

3.2. THE INTERTEMPORAL UTILITY FUNCTION

27

What are the consequences of risk aversion? Clearly this is the motivation
for things like insurance. The property of risk aversion means that you will
actually pay to remove uncertainly about your consumption (which is what you
do when you buy insurance). Similarly, this is why in financial theory we say
that people trade o risk and return: to accept more risk, an investor has to be
promised a higher expected return.
Risk aversion is a result of the properties of the utility function and the
use of the VNM utility. As said above, VNM utility is functionally identical to
additive separability. That is, in VNM utility, the marginal rate of substitution
between consumption in two states of the world ( and + 1, for example) is
independent of any other state. This is true even though utility is weighted
by the probabilities . So ultimately, risk aversion is identical to consumption
smoothing. They are the same property! To see how this all fits together, lets
look at a specific functional form for utility that will be very useful throughout
the course.
Example: The CRRA utility function.
This utility form is called constant relative risk aversion and has the mathematical form of
1 1
() =
1
with 0. You may notice that if 1, then utility is actually always
negative, but it becomes less negative as consumption rises. People often get
confused by this. If = 0 then the function is just linear. Finally, if = 1 then
the function reduces to
() = ()
To see this, clearly,
1 1
0
=
1 1
0
To solve this indeterminacy, apply LHopitals rule
lim

1 1
ln()
= lim
= ln()
1 1
1
1
Now, define the Coecient of Relative Risk Aversion as
lim

00 ()
0 ()

This is just the elasticity of marginal utility with respect to consumption. The
larger this coecient is, the more rapidly marginal utility declines as consumption increases, or the utility curve "curves" more. The larger this curve, the
more a person wants to smooth consumption and the more theyd pay to get
rid of uncertainty. It is easy to verify that this is constant for the CRRA utility
function (that is why it got its name)

00 ()
1
=
=
0
()

28

CHAPTER 3. CONSUMPTION

You can see how this works by looking at a simple lottery example. Given
that utility is CRRA, what amount are you willing to pay to avoid the following
lottery: $100 with probability 1/2 and $200 with probability 1/2?
We need to solve the equation for the value of

1
1001 1
1
2001 1
1 1
=
+
1
2
1
2
1
which gives us
=

1001
2001
+
2
2

1(1)

so that the actual value of depends on the size of . If you calculate this out
for several values, this is what you get

1
2
3
4
5
6

141.40
133.30
126.50
121.20
117.10
114.20

and you can see that the amount youd take with certainty () decreases with
, or the more risk averse you are. Empirical attempts to measure seem to
find the value of around 3, but there is a lot of disagreement on this. Some of
the financial puzzles (like the high equity premium) seem to be explained only
by unreasonably high values of . In theoretical work, we will use the = 1, or
log consumption, a lot, even though this is probably not reasonable.
We can also do an exercise to show how the willingness to pay to avoid risk
depends on the size of the risk. Suppose that we take the above example and
now multiply the size of consumption in the two states of the world by some
amount . We can again solve for the amount that a person is willing to pay to
avoid that risk:

1 1
1
(100)1 1
1
(200)1 1
=
+
1
2
1
2
1
or

1001
2001
=
+
2
2

1(1)

In other words, the amount that you are willing to pay to avoid uncertainty
relative to certainty depends only on the risk relative to the certain outcome. If
you are willing to pay $10 to avoid uncertainty of $50 relative to a base of $150,
then you are willing to pay $10,000 to avoid uncertainty of $50,000 relative to
a base of $150,000. That is why this formulation of the utility function is called
Constant Relative Risk Aversion (CRRA).

3.3. THE FISHER MODEL

3.3

29

The Fisher Model

Now we can start thinking about the optimal mix of savings and consumption.
Well do this in a simple two period framework now, and then later look at
how this generalizes to give us the core models of macroeconomics. The model
involves the following facts. There are two periods of life. People earn income
in both periods of 0 and 1 . They have no assets when they enter the world,
and they leave nothing behind when they die (that is, they consume all that
they earn). Theyll consume some amount 0 and some amount 1 such that
0 = 0 + 1
and
1 = 1 + (1 + )1
where is the interest rate. Notice 1 0 means the agent is saving while 1 0
means the agent is borrowing. The rate is the same for saving and borrowing.
Preferences are
(0 1 = (0 ) + (1 )
To solve this model we can combine the two budget constraints by substituting for 0 so that
0 +

1
1
= 0 +
0
1+
1+

This is what is called an intertemporal budget constraint. It says the present


discounted value of consumption cannot exceed the present discounted value of
income. Forming the Lagrangian

1
(0 ) + (1 ) 0 +
0
1+
and taking first order conditions with respect to 0 , 1 , and yields
0 (0 ) =
0 (1 ) =
and
0 +

1+

1
1
= 0 +
0
1+
1+

Substituting the first FOC into the second we get


0 (0 ) = (1 + )0 (1 )
This is the Euler equation, the optimality condition involving an intertemporal
choice. Note that 0 (0 ) is the value of consuming a marginal unit of income
in period 0. On the other hand, (1 + )0 (1 ) is the value of using a marginal

30

CHAPTER 3. CONSUMPTION

unit of income to increase savings in period 0, and consuming the accumulated


proceeds in period 1. Along the optimal path, this equality must hold. Thus,
0 1
0 1
0 = 1

(1 + ) 1
(1 + ) 1
(1 + ) = 1

There are several lessons from this expression. First, notice discounting
works towards reducing consumption in the future while the interest rate works
towards increasing it. Thus, depending which one is larger, consumption will
be increasing, decreasing or constant. This is called intertemporal substitution.
High interest rates implies that the relative price of 1 has fallen because fewer
units of forgone 0 are required to obtain a unit of 1 . The problem is that
associated with the change in the interest rate there is also an income eect
which is opposite to the intertemporal substitution eect if savings are positive.
Notice the degree of intertemporal substitution (or consumption smoothing)
depends on preferences together with the price.
PROBLEM SET: Do eects of changes in interest rate on savings with
CRRA utility function. (see macro1.pdf pg 4-7)
Also, from this model we see that the timing of consumption is independent
of the timing of income () along the optimal path under certainty (0 and 1
are not in the euler equation), that is, consumption is invariant to changes in
income as long as
1
0 +
1+
remains constant. This is dierent from Keynes. Any relation between current
consumption and current income depends on what happens to future income.

3.3.1

Elasticity of intertemporal substitution and the coecient of relative risk aversion

Consider a two-period consumption problem like the one above. Consider also,
a particular indierence curve,
(0 ) + (1 ) =
(plot it). At a given point, (0 1 ) on the curve, the marginal rate of substitution
of period-1 consumption for period-0 consumption, call it , is given by

1
=

0 =

that is, at the point (0 1 ) is the absolute value of the slope of the
tangent to the indierence curve at that point. Under the normal assumption
of strictly convex preferences, is rising along the curve when 0 decreases

3.3. THE FISHER MODEL

31

(and thereby 1 increases). Conversely, we can let be the independent


variable and consider the corresponding point on the indierence curve, and
thereby the ratio 1 0 , as a function of . If we raise along the
indierence curve, the corresponding value of the ratio 1 0 will also rise.
The elasticity of intertemporal substitution in consumption at a given point
is defined as the elasticity of the ratio 1 0 with respect to the marginal rate
of substitution of 1 for 0 when we move along the indierence curve through
the point (0 1 ). The elasticity of intertemporal substitution in consumption
is then defined as
(1 0 )
1 0
(1 0 )
=

1 0

where the approximation is valid for a small increase, in .
A more concrete understanding is obtained when we take into account that
in the consumers optimal plan, equals the ratio of the discounted prices
of 0 and 1 , that is, the ratio 1(1(1 + )) given in the budget constraint.
Indeed,from the optimality condition we have
=

0 (0 )
= 1 +
0 (1 )

We then have

(1 0 )
1 0
(1 0 )
=

1 0

Thus, the elasticity of intertemporal substitution can be interpreted as the approximate percentage increase in the consumption ratio, 1 0 , triggered by a
one percentage increase in the inverse price ratio, holding the utility level unchanged.12
Given () we let () be the coecient of relative risk aversion (which in
general will depend on ), i.e.,
=
It can be shown that
=

00 ()
0 ()

1 + 0

1 (0 ) + 0 (1 )

We see that if () belongs to the CRRA class, i.e., (0 ) = (1 ) = then


= 1. In this case (as well as whenever 0 = 1 ) the coecient of relative risk
aversion and the elasticity of intertemporal substitution are inversely related to
each other.
To show the previous expression, start from the optimality condition and
the expression for the indierence curve
0 (0 ) = 0 (1 )

32

CHAPTER 3. CONSUMPTION
(0 ) + (1 ) =

Let = 1 0 . Then the first-order condition and the equation describing the
considered indierence curve constitute a system of two equations in 0 and
0 (0 ) = 0 (0 )
(0 ) + (0 ) =
For a fixed utility level = these equations define 0 and as implicit
functions of , 0 = () and = (),
0 [()] = 0 [()()]
[()] + [()()] =
We can calculate the total derivative with respect to in both equations and
get
00 (0 )0 () = 0 (0 ) + 00 (0 )0 0 () + 00 (0 )0 ()
0 (0 )0 () + 0 (0 ) [0 ()0 + 0 ()] = 0
From the indierence curve
0 () =

0 (0 )0 ()0

0 (0 ) + 0 (0 )

But from the optimality condition


0 (0 ) = 0 (1 )
so that 0 () is
0 () =

0 (0 )0 ()0
0 ()0
=
0
0
(1 ) + (0 )
+

or also
0 () =

0 (0 )0 ()0
=
0 (0 )
0
(0 ) +

0 (0 )0 ()0

0 (0 )

Then substitute this expressions in the derivative of the optimality condition

0 ()0
(0 )0 ()0
= 0 (0 )+00 (0 )0 0 ()00 (0 )

00 (0 )
0
+
(0 )
+
divide by 0 (0 )

()0
00 (0 )0 0 () 00 (0 ) 0 ()0
00 (0 )
=1+

0
+
(0 )
0 (0 )
0 (0 ) +

3.3. THE FISHER MODEL


and operating

00
(0 )

Then,

or

33

0 ()0
0 (0 )

00 (0 )0 0 ()

= 1+
1
0 (0 )
+

00 (0 )0 0 ()

= 1+

0 (0 )
+

00 (0 )0 00 (0 )0
+
0 () = +
0 (0 )
0 (0 )

00 (0 )0 00 (0 )0 0 ()

+
=+
0 (0 )
0 (0 )

and using the definition of the coecient of relative risk aversion


[(0 ) + (1 )]
But
0 () =
so
=
and
=

0 ()
= +

(1 0 )

0 ()

+ (1 0 )

(1 0 )(0 ) + (1 )

from which we get


=

3.3.2

1 + 0

1 (0 ) + 0 (1 )

Variations

So far weve assumed that the consumer can borrow and save at the identical
interest rate. What if there are dierential interest rates so that or
the real interest rate to borrow exceeds that of savings? Then the budget set
is kinked and there are three possible optima. The indierence curve could
be tangent to one of the arms, so that the dierential doesnt matter. Or the
solution could be to consume at the kink point. The interesting thing about
this is that if either interest rate changes, consumption and savings may not
change at all, meaning that savings are invariant to interest rates.
Another possibility is that the consumer is liquidity constrained, and cannot
borrow but can only save (something like being a college student). Now the
budget set has a vertical section below the endowment point, and the individual
cannot set 0 0 . Does this constraint bind? Only if the person would have
borrowed in the first place. If so, then theyll consume at the kink point again,

34

CHAPTER 3. CONSUMPTION

and any increase in their 0 will translate one for one into increases in 0 , giving
something like a Keynesian relationship.
To see this, consider a model where households are rational and forward
looking but credit markets are imperfect and consumers cannot borrow. Thus
we have a new constraint:
1 0 0 0
Set up the Lagrangian:

1
(0 ) + (1 ) 0 +
0 (0 0 )
1+
where is the shadow value of relaxing the borrowing constraint, holding 0
constant (the other constraint). This is equivalent to saying that is the shadow
value of reducing 1 by (1 + ) units and increasing 0 by 1 unit. The FOCs are
0 (0 ) = +
0 (1 ) =

1+

together with the complementary Slackness (on the inequality constraint):


(0 0 ) = 0
So either the constraint binds (0 = 0 ) or the shadow price is 0. The Euler
equation reads now:
0 (0 ) = (1 + )0 (1 ) +
Now, if the borrowing constraint binds, it is possible for 0 (0 ) to be too high
due to 0 being too low. Although the agent would like to transfer consumption from period 1 to 0 he will not able to do it because of the borrowing
constraint.
In this simple example, the closed form solution is as follows: Let 0 be the
optimal 0 without the borrowing constraint, that is, the solution to the system
0 (0 ) = (1 + )0 (1 )
0 +

1
1
= 0 +
0
1+
1+

Then define 2 groups:


Group 1: If 0 0 , then the optimal 0 under the borrowing constraint
is 0 , = 0, and this constraint does not bind.
Group 2: If 0 0 , then the optimal 0 under the borrowing constraint
is 0 , 0, and this constraint binds.

3.4. RICARDIAN EQUIVALENCE

35

So for people in Group 1, the Euler equation holds with = 0 and is


uncorrelated with . In Group 2, the euler equation holds with 0 so is
correlated with because 0 = 0 and 1 = 1 , which is like the Keynesian case
with marginal propensity to consume equal 1. Thus, the aggregate marginal
propensity to consume will be between 0 and 1.
Group 1 people tend to be people with a relatively high 0 1 so they are
likely to be unconstrained. These could be people with high initial wealth
endowments or declining income paths. In Group 2, we have the poor graduate
students with a lot to gain in the future but are completely constrained today.
So 0 1 is relatively low and face binding borrowing constraints.

3.4

Ricardian Equivalence

Consider a two period Fisher world, but now you have to pay taxes in each
period (the government collects this money and throws it in the ocean, so there
is no aect of government spending here). Your budget constraint is now
0 +

1
1 0
= 0 0 +

1+
1+

From before, we know that this will have no eect on the optimal consumption
path, and that we should still have
0 (0 ) = (1 + )0 (1 )
which shows that the size of your income and their distribution doesnt aect
your optimal path.
What happens if we introduce a change in the tax collection scheme? We
will say that taxes change as follows
0 =
1 = (1 + )
or that the present value of taxes collected is unchanged. If was positive, then
taxes are being cut today, and raised in the future. Plug this into the budget
constraint and you get
0 +

1
1 0 + (1 + )
= 0 0 +

1+
1+

and if you do the algebra you see that cancel out completely and youre left
with the same exact budget constraint as before. What happens to first period
savings? Well, the Euler equation is identical, and the budget constraint is
identical to before the change in taxes, so your consumption must be completely
unchanged by this change in taxes. Then
1 = 0 0 0

36

CHAPTER 3. CONSUMPTION

Since 0 is fixed, any decrease in taxes must raise savings by the same amount.
People do not choose to consume any of their tax break. Does this increase
in savings have any eect on the capital stock? No. Because to finance the
tax cut, the government has to issue bonds, on which it will pay an interest
rate of . So from an individuals perspective, these bonds are wealth, in that
they provide a way of earning on their savings. But from the aggregate
perspective they are not wealth, because they are just government liabilities
which have to be paid back by the economy later. So the upshot is that if
taxes go down today, that should have no eect on consumption because people
are far-sighted enough to understand that theyll need to pay higher taxes in
the future. Ricardian equivalence is about the timing of taxes - it does not
say that government spending will have no eect on consumption. So if the
government raises spending, this will lower your absolute consumption levels as
they take more money out of the system. But it wont matter to you whether
this new spending is financed by direct taxes or by bonds. The optimal path of
consumption will remain the same, only the level will change.
There a host of objections to Ricardian equivalence:
1. Dierent interest rates for government borrowing and individual saving/
borrowing
2. If people are liquidity constrained in the first period, then government
borrowing (taxes going down) will raise their consumption
3. If people are myopic it doesnt work. Probably true, but how exactly do
you model myopia?
4. If people will be dead before they have to pay back the taxes, then the
tax decrease will allow them to increase their consumption. Later generations will pay the extra taxes and consume less. This has raised a lot of
debate and runs into a whole long-winded debate about intergenerational
relations. Before touching on that, note that most of the present value
of a tax cut will be paid back by people alive today, so RE should hold
pretty close to absolutely. The intergenerational argument in defense of
RE is that we see people giving bequests when they die, so they must
care about their childrens consumption. The tax decrease is like taking
money away from their children and giving it to them, so theyll just leave
that as a bequest for their children and consumption wont change in the
current period. A lot of people attack this reasoning. Parents may not
get utility from their children consumption but from the actual giving
of a bequest, and then the bequest is kind of like consumption for the
parent and when taxes fall theyll increase both their bequest and their
income. Alternately, you could argue that most bequests are accidental,
not intentional, because people die before they expect to.
A last thought about RE. If people were completely myopic and never expected to pay back their tax cut, what would happen? If they followed our usual

3.5. THE PERMANENT INCOME HYPOTHESIS

37

model of consumption smoothing, they would still only raise their consumption
by a little, spreading the tax decrease out over their whole lives (remember that
the timing of your income doesnt matter). So RE would be very close to true.
Compare that to Keynesian consumption, where people would consume almost
the whole tax cut immediately.

3.5

The Permanent Income Hypothesis

We can generalize the two-period model to an economy with periods (notice


again may go to ). For that, the corresponding time separable utility
function would be

1
X
( )
(0 1 1 ) =
=0

We also would like to include uncertainty. For that, we assume the future is
random and not known at time 0 when decisions are made. The agent would
like to maximize his expected utility function
#
" 1
X

0
( )
=0

One of the items to be specified is the probability structure from which this
expectation can be written. This is one of the central items in Economics.
The reason is that the distributions with respect these expectations are taken
are endogenous as they (may) depend on choices and prices (which themselves
depend on the aggregation of choices). For now we leave it as it is and then
look at it again when we solve the model.
For example, assume each period there exists a discrete random variable
with distribution ( ). Assume this variable is i.i.d. and can take any of
values. That is, tells us the probability takes any of its possible values.
Think of as whether I am employed or unemployed. Consumption in period
0 is a known variable but what consumption in period 1 would depend upon?
It will depend on the realization of 1 . Thus, possibly it will take dierent
values, each corresponding to the optimal decision for each possible value of 1 .
Now, what would 2 depend upon? Clearly, it will depend on the realization of
1 as well as the realization of 2 . This means it will take 2 possible values. In
general, will depend upon the whole history of realizations of from 0 until
and will take any of possible values. Thus, if we denote by the history
of up to period , consumption will be a function of that history = ( )
and the expectation will be with respect to the probability distributions of these
histories
#
" 1
X

( )
0
=0

[Note that the superscripts on are powers while the one in represent histories.
Bad notation]. The question now is to work out the probability distribution of

38

CHAPTER 3. CONSUMPTION

the histories. In the i.i.d. case this is easy as it is simply the product of the
period probability distributions. So, if is the probability distribution of it
will equal
( ) = (0 ) (1 ) ( )
The structure of the model is the same as the two-period case. The agent
starts period 0 with accumulated assets 0 which are given (in the two-period
example we assumed it to be zero). The rate of return on savings (or cost of
borrowing if negative) is 1+ . Thus, the agent faces the sequence of constraints
0 given
+1 = ( + )(1 + +1 )
= 0 if is finite
" 1
#
Y
1
= 0 if is infinite.
lim

1 +
=0
Here is (random) income at . The last expression is the no-Ponzi game
restriction. Notice there is no need for
lim = 0

for this condition to be satisfied. All it says is that debt cannot grow faster than
the interest rates so that the present discounted value ends up being zero.
What does the household choose at time 0? Under certainty: the entire sequence, { }=0 should be completely decided and hence we have non-stochastic
consumptions. Under uncertainty, this is neither feasible or optimal. Instead,
at time 0, the household chooses 0 , and a decision rule mapping all possible
future realizations of state variables into future choice variables {( )}=0 .
To solve for the optimal choice we can provide a similar argument than in
the two-period model. Imagine you have solved the model which means you
know how much to consume for each possible history of the exogenous shocks
(income). Now put yourself on the shoes of this agent at time . By the time
it reaches that period, the agent will know the realization of (and +1 if the
interest rate is stochastic). So he will know in which branch of the probability
tree he is moving. Then he will ask himself whether to consume an additional
unit or not. Consuming one unit at that time contributes to the utility function
with 0 ( ). However, saving that unit produces (1 + +1 ) units more at + 1.
Consuming those units imply, in period- utility (1 + +1 )0 (+1 ). However,
what will be the marginal utility at + 1 is not known at time . It will depend
on the realization of the exogenous shock at that period. Thus, for the initial
decision to be optimal, the known marginal cost of saving the unit [0 ( )] must
equal the expected marginal utility from saving it, (1 + +1 ) [0 (+1 )], or
0 ( ) = (1 + +1 ) [0 (+1 )]

3.5. THE PERMANENT INCOME HYPOTHESIS

39

Notice this is still not a closed form decision rule for consumption. Can we find
decision rules? Unfortunately, we can only find analytical solutions for very few
special cases. For a broad class of problems we can approximate the solution
numerically.

3.5.1

Example: Quadratic utility with constant interest


rate

Define utility:

() = 2 0
2
Also assume 1 + = 1 + = 1 for all 0 [below we will see there are good
reasons to assume this]. Notice
0 () = 1

so the Euler equation becomes


1 = (1 + ) [1 +1 ]
or
= [+1 ]
This is to say that consumption should follow a martingale [EXPAND]. Then
by the law of iterative expectations:
= [+1 ] = [+1 [+2 ]] = [+2 ] =
So,
= [+ ] for 0
This is called expected consumption smoothing. Consume today as if we believe we can consume the same amount for the rest of our lives.
But this is still not a decision rule. To get a decision rule, we need to derive
an intertemporal budget constraint from our dynamic budget constraint and
our solvency condition. The constraint for periods 0 and 1 are
1 = (0 + 0 0 )(1 + )
2 = (1 + 1 1 )(1 + ) = (1 1 )(1 + ) + (0 + 0 0 )(1 + )2
Then, for period 2
3 = (2 +2 2 )(1+) = (2 2 )(1+)+(1 +1 1 )(1+)2 +(0 +0 0 )(1+)3
Following this patter, for period 1

= 0 (1 + ) +

1
X
=0

(1 + ) ( )

40

CHAPTER 3. CONSUMPTION

Divide by (1 + ) and rearrange

1
X
=0

= 0 +

(1 + )
(1 + )
(1 + )
=0

However, = 0 for finite while


"
#
Y
1

lim
=0
= lim

1
+

(1
+
)

=0
if is infinite so the intertemporal budget constraint becomes

1
X
=0

= 0 +

(1 + )
(1
+
)
=0

Note, this is the realized intertemporal budget constraint that must hold
ex-post on all sample paths. Note that the RHS of the intertemporal budget
constraint is a random variable at time 0, but we know the intertemporal budget
constraint will also hold in expectation ex-ante:
" 1
#
" 1
#
X
X

0
= 0 + 0
= 0 + 0
(1 + )
(1 + )
=0
=0
So now combine the expected intertemporal budget constraint with the
quadratic utility euler equation to find a closed form solution. From Euler:
0 = 0 [ ] for all
So expected intertemporal budget constraint becomes:
0

1
X
=0

or

1
= 0 + 0
(1 + )

0 + 0
0 = P 1

=0 (1 + )

In the infinite horizon case, we can simplify even more. Note:

X
=0

1
1
1+
=
=
(1 + )
1 (1(1 + ))

And the equation for 0 becomes:

(0 + 0 )
0 =
1+

3.5. THE PERMANENT INCOME HYPOTHESIS


At any time period :
=

1+

Here
=

"
X
=0

41

( + )

+
(1 + )

And this is a closed form decision rule. It says that the agent should consume
in each period as an annuity payment on total lifetime expected wealth as of
time .
Now consider the change in consumption from period 1 to period ,
= 1
To compute this use
= (1 + )(1 + 1 1 )
in the expression above
=

1+

( + ) = (1 + 1 1 ) +

1+

=0

(+ )

(1 + )

On the other hand, lag the solution for consumption one period
(1 + )1

= 1 + 1 = 1 +

X
1 (1+ )
=0

= 1 + 1 +

(1 + )

X
1 (1+ )
=1

(1 + )

= 1 + 1 +

1+

Subtracting this from the previous equation

= 1 =
=

1+

1+

=0

(+ ) 1 (+ )
(1 + )

[ 1 ( )]

The term (+ ) 1 (+ ) represents the news about income in period


+ arriving at period . What this expression is saying is that the changes in
consumption are proportional to the news about the present discounted value
of income. Moving 1 to the right of this expression we see that current
consumption equals past consumption plus the revision from time 1 to time
in predictions for income at time , time + 1, time + 2, etc. Note that
lagged income (e.g. 1 , 2 ) does not appear in this expression. That is,
consumption during time 1 is all one needs to know about all events in the

=0

1 (+ )

(1 + )

42

CHAPTER 3. CONSUMPTION

past (time 1 and earlier) to determine what current consumption ( ) will


be.
This also means that consumption only changes when the consumer anticipates that the change in income is going to stay in the future. The marginal
propensity to consume will depend upon the consumers expectation about the
persistence of the shock. To see this specialize in the case of AR(1) process for
income, that is, assume
= 1 +
where 0 1 and is a white noise process with standard deviation .
There are two limiting cases:
= 0. Then = and output is a purely transitory white noise process
= 1. Then output is a random walk and all shocks are permanent.
With this,
"
X
=
=0

+
(1 + )

1+
1+

X
=0


1
=
=

(1 + )
1
+

1
=0
1+

Then

1+
=
( + ) =
+

1+
1+
1+
1+

=
+

1+
1+

Also,

[ 1 ( )] =
[ 1 ( )]
1+
1+

=
[1 + 1 ]
1+

=

1+
=

So for this case of quadratic utility, = , (1 + ) = 1, and as an AR(1)


process, we have the following:
1. Consumption changes are orthogonal to the predictable part of income
changes.
2. Consumption changes should be positively related to the innovation in
income and this relationship is stronger, the higher is . Thus:

3.5. THE PERMANENT INCOME HYPOTHESIS

43

high: Income shocks persistent and consumption response is large.


For example, for the random walk case, = 1,
=
low: Income shocks transitory and consumption response is small.
For example, for the white noise case, = 0,

1+
Hall (1978) tested this assumption using aggregate data. That is, he tested
whether 1 has any predictive power for once 1 is already included as
a regressor. He found no predicted power for 1 . This was interpreted as
evidence in favor of the permanent income hypothesis.

3.5.2

Empirical Application: Understanding Estimated Consumption Functions

The traditional Keynesian consumption function posits that consumption is determined by current disposable income. Keynes (1936) argued that the amount
of aggregate consumption mainly depends on the amount of aggregate income,
and that this relationship is a fairly stable function. He claimed further that
it is also obvious that a higher absolute level of income . . . will lead, as a
rule, to a greater proportion of income being saved (Keynes, 1936, pp. 9697;
emphasis in original).
The importance of the consumption function to Keyness analysis of fluctuations led many researchers to estimate the relationship between consumption
and current income. Contrary to Keyness claims, these studies did not demonstrate a consistent, stable relationship. Across households at a point in time, the
relationship is indeed of the type that Keynes postulated; an example of such
a relationship is shown in Panel (a) of Figure 8.1. But within a country over
time, aggregate consumption is essentially proportional to aggregate income;
that is, one sees a relationship like that in Panel (b) of the figure. Further, the
cross-section consumption function diers across groups. For example, the slope
of the estimated consumption function is similar for whites and blacks, but the
intercept is higher for whites. This is shown in Panel (c) of the figure.
As Friedman (1957) demonstrates, the permanent-income hypothesis provides a straightforward explanation of all of these findings. Suppose consumption is in fact determined by permanent income: = . Current income
equals the sum of permanent and transitory income:
= +
And since transitory income reflects departures of current income from permanent income, in most samples it has a mean near zero and is roughly uncorrelated
with permanent income.

44

CHAPTER 3. CONSUMPTION
Now consider a regression of consumption on current income:
= + +

In a univariate regression, the estimated coecient on the right-hand-side variable is the ratio of the covariance of the right-hand-side and left-hand side
variables to the variance of the right-hand-side variable. In this case, this implies

( )
b = ( ) = ( + ) =

( )
( + )
( ) + ( )

Here the second line uses the facts that current income equals the sum of permanent and transitory income and that consumption equals permanent income,
and the last line uses the assumption that permanent and temporary income
are uncorrelated. In addition, the estimated constant equals the mean of the
left-hand-side variable minus the estimated slope coecient times the mean of
the right-hand-side variable. Thus,
= () b( ) = b = ( b)

(3.1)

where the last line uses the assumption that the mean of transitory income is
zero.
Thus the permanent-income hypothesis predicts that the key determinant
of the slope of an estimated consumption function, b, is the relative variation in
permanent and transitory income. Intuitively, an increase in current income is
associated with an increase in consumption only to the extent that it reflects an
increase in permanent income. When the variation in permanent income is much
greater than the variation in transitory income, almost all dierences in current
income reflect dierences in permanent income; thus consumption rises nearly
one-for-one with current income. But when the variation in permanent income
is small relative to the variation in transitory income, little of the variation in
current income comes from variation in permanent income, and so consumption
rises little with current income.
This analysis can be used to understand the estimated consumption functions in Figure 8.1. Across households, much of the variation in income reflects
such factors as unemployment and the fact that households are at dierent
points in their life cycles. As a result, the estimated slope coecient is substantially less than 1, and the estimated intercept is positive. Over time, in
contrast, almost all the variation in aggregate income reflects long-run growth
(that is, permanent increases in the economys resources). Thus the estimated
slope coecient is close to 1, and the estimated intercept is close to zero.
Now consider the dierences between blacks and whites. The relative variances of permanent and transitory income are similar in the two groups, and
so the estimates of b are similar. But blacks average incomes are lower than
whites; as a result, the estimate of a for blacks is lower than the estimate for
whites (see (3.1)).

3.5. THE PERMANENT INCOME HYPOTHESIS

45

To see the intuition for this result, consider a member of each group whose
income equals the average income among whites. Since there are many more
blacks with permanent incomes below this level than there are with permanent
incomes above it, the blacks permanent income is much more likely to be less
than his or her current income than more. As a result, blacks with this current
income have on average lower permanent income; thus on average they consume
less than their income. For the white, in contrast, his or her permanent income
is about as likely to be more than current income as it is to be less; as a result,
whites with this current income on average have the same permanent income,
and thus on average they consume their income. In sum, the permanent-income
hypothesis attributes the dierent consumption patterns of blacks and whites
to the dierent average incomes of the two groups, and not to any dierences
in tastes or culture.

46

CHAPTER 3. CONSUMPTION

Chapter 4

The Ramsey Model


4.1

Introduction

From a theoretical perspective, the most unattractive feature of the Solow model
is that the saving function, the models only behavioral equation, is ad hoc. The
model does not say why it could be desirable for an economy to save always the
same fraction of income independently of the level of income in that period or
expectations about future income. Basically, what we need is a model that gives
us, not only the dynamics of capital and output, but also a way to determine
optimally this saving rate.1
From now on we are going to abstract from population changes so all the
models have a per capita interpretation. Think on an agent who wants to
determine optimally how much it saves. Specializing the model even more to
have time-separable utility functions we can write it as
max

{ +1 }
=0

( )

=0

where 0 1 is a discount factor, subject to the constraint that initial


capital (0 ) is given, that consumption ( ) and gross investment ( ) should
exhaust output [ ( )] every period
+ = ( )
that captal evolves as
+1 = + (1 )
and that consumption and capital cannot be negative
0
1 This

section is taking from Stokey, Lucas and Prescott [22], chapter 2.

47

48

CHAPTER 4. THE RAMSEY MODEL

Substituting for from the capital evolution equation into the resource constraint gives
+ +1 (1 ) = ( )
(4.1)
So, the problem of the agent is how to accumulate capital to maximize the
present value of utility derived from the stream of consumption given its initial
capital level. This is the basic form of what is called the Ramsey model.
Notice equation (4.1) is the same equation as in the Solow model. The dierence
with that model is that we have substitutes the fixed saving rate assumption
for an objective function the agent has to maximize. Also notice there are no
markets in this problem. We can interpret it as the problem an individual
would solve if he is isolated or the one solved by a planner in an economy where
everyone is identical and the planner treats everyone the same. We just solve
for the optimal allocations.
In the problem above, we assume 0 1 to be the discount factor.
Also, the period-specific utility () satisfies certain properties, namely, it is
increasing 0 () 0, and concave 00 () 0. We also impose
lim 0 () = ; lim 0 () = 0

so as to avoid corner solutions. The discount factor reflects the idea that for an
agent at any time , future consumption is not as valuable as current consumption. This introduces the notion of impatience. Furthermore, the per capita
production implies (0) = 0, it is increasing 0 () 0, and concave 00 () 0
with
lim 0 () = ; lim 0 () = 0
0

4.2

Solution of the model

To solve the problem write the corresponding lagrangean


max

{ +1 }
=0
0 g i v e n

L=

max

{ +1 }
=0
0 g i v e n

X
=0

[ ( ) ( + +1 ( ) (1 ) )]

In this lagrangean the lagrange multiplier has the interpretation of the marginal increase in the objective function, from the point of view of time if the
constraint at time is relaxed and the agent has available one extra unit of good.
From the point of view of time 0 the marginal gain is . Notice the solution to
this model is a sequence of allocations and lagrange multiplier { +1 }
=0 .
To get the first order conditions (FOC) take derivatives with respect a general period . Developing the summation sign and concentrating on the periods
around period the lagrangean would look like
L = + 1 [ (1 ) 1 (1 + (1 ) (1 )1 )]
+ [ ( ) ( + +1 ( ) (1 ) )]
+ +1 [ (+1 ) +1 (+1 + +2 (+1 ) (1 )+1 )] +

4.2. SOLUTION OF THE MODEL

49

Then take first order conditions with respect to ,


[0 ( ) ] = 0
+1 ,

+ +1 +1 [1 + 0 (+1 ) ] = 0

and ,
+ +1 ( ) (1 ) = 0
Substituting for and rearranging produces the two equations
0 ( ) = 0 (+1 ) [1 + 0 (+1 ) ]

(4.2)

+ +1 = ( ) + (1 )

(4.3)

and
Notice the lagrange multiplier is equal to the marginal utility of consumption
at time . This makes sense. The value the agent attaches to an extra unit of
consumption in period is the change in utility associated with its consumption.
Equations (4.2) and (4.3) summarize the necessary and sucient conditions
for the sequence of allocations { +1 }
=0 to be optimal. Equation (4.3) imposes that an optimal allocation should exhaust output. It cannot use more
resources than the ones available and it will not be optimal to use less because
agents always value consumption. Equation (4.2) says that for an allocation
to be optimal, the revenues associated with changing it should compensate its
costs. Assume we have already decided on an allocation and want to verify it
is optimal. For that, we think how our objective function would change if we
decided on a dierent allocation. For example, we could decide to transfer consumption from (any) period to the future (period + 1) by consuming less on
period , accumulate capital, and then produce more and consume the proceeds
on + 1. This modification of the allocation has costs on period , as it reduces
consumption, and therefore utility, on that period, but generates more consumption on period + 1 therefore boosting utility there. The costs are measured by
0 ( ) (that is, the last increase in utility associated with the last unit consumed
that now is saved). The revenues are measured by 0 (+1 ) [1 + 0 (+1 ) ].
That is, the agent will have available 1 + 0 (+1 ) more goods (the unit
saved, plus the extra output produced by the additinal unit of capital minus the
depreciated part of the extra unit of capital. If consumed, each of these units
will improve utility by 0 (+1 ) when consumed at time + 1 so in total utility
is increasing at time + 1 by 0 (+1 ) [1 + 0 (+1 ) ]. To put it in utility at
time , as costs are measured, the agent should multiply these revenues by .
Thus, if costs are smaller than revenues (so that the left hand side of (4.2) is
smaller than the right hand side) transfering goods from period to period + 1
increases utility and therefore the initial allocation was not optimal (it did not
maximize utility. Conversely, if costs were larger than revenues (so that the left
hand side of (4.2) is larger than the right hand side) doing so will reduce utility
as costs overcome revenues. Does it mean the initial allocation was optimal?

50

CHAPTER 4. THE RAMSEY MODEL

The answer is no as doing the reverse transaction, that is, transferring resources
from period + 1 to period would improve utility. The agent can do that
by reducing capital by one unit at and consuming it. This way what before
was a cost, 0 ( ), now becomes revenue in terms of more utility at . On the
other hand the cost of reducing capital is reducing goods available at + 1 by
[1+ 0 (+1 )] which in terms of utility at is worth 0 (+1 ) [1+ 0 (+1 )].
If the left hand side was smaller than the right hand side increasing consumption
at at the expense of consumption at + 1 is utility increasing and, again, the
initial allocation ws not optimal. The only way an allocation can be optimal is
if expression (4.2) is satisfied with equality. Notice these costs and revenues are
measured in utility at . To put it in utility at time 0 we should multiply both
sides by but this will not add much to the analysis.

4.3

The steady state

One question at this point is to see whether in the Ramsey model there exists
a situation in which per capita variables are constant as in the Solow model
without technical change. In such a condition = +1 = and = +1 =
for all 0. From condition (4.2) we see that such situation would imply
that
1
0 ( ) + (1 ) =

That is, the stationary value of capital only depends on preferences through the
discount factor but not though the utility function. It also depends on technology through the depreciation rate and the marginal productivity of capital but
not on the specific form of the utility function.
In our model, consumption per capita in the stationary situation is equal to
= ( ) ( ) = ( )
and the saving rate is
=

( ) (1 )
( )

Therefore, in the stationary situation the savings rate is constant as the


rest of per capita variables. We also observe that the stationary situation is
independent of the initial level of capital 0 . These are similar conclusions as
the ones obtained by the Solow model.
There are two issues that we have to address. One is whether we will converge
to the stationary situation as in the Solow model if we start at an initial capital
level dierent than . The second issue is the eects on the economy of changes
in the parameters of the model. We have shown that we will converge to the
stationary point. Below is the intuition why that must be so.

4.4. DYNAMICS

4.4

51

Dynamics

To study the dynamics of the model, i.e. how the economy evolves if we are
not at the stationary point, we can summarize the optimality conditions of the
model
0 ( ) = 0 (+1 ) [1 + 0 (+1 ) ]
(4.4)
+ +1 = ( ) + (1 )

(4.5)

plus the nonnegativity conditions


0.
We can transform equations (4.4) and (4.5) to give us a system that determines
the evolution of and as a function of the levels of these two variables. For
example, if we take (4.5) we have
+1 +1 = ( )

(4.6)

From (4.4) we obtain


0 ( )
= [1 + 0 (+1 ) ]
0 (+1 )
It is simpler to specialize the model to the CRRA case,
1 1
if 6= 1
1
() =
ln () if = 1
With the CRRA
0 () =
so, the FOC becomes
0 ( )
=
0 (+1 )
and

+1

+1
1
= [ (1 + 0 (+1 ) )]

(4.7)

We can plot expressions (4.6) and (4.7) in the (, ) plane. In that plane,
the vertical +1 = 1 schedule (or equivalently, the = 0 schedule) is the
combinations of and such that consumption is constant. The value of capital
where this is the case is ,
1 + 0 ( ) =

1
.

On the other hand, the hump-shaped = 0 schedule is the locus of points


such that there is no tendency for to rise or fall. It is given by
( ) = 0

52

CHAPTER 4. THE RAMSEY MODEL

Figure 4.1:

We can plot these two schedules in a phase diagram In this diagram we observe
the following information. Take the locus = 0. What this line is telling are
the implications for +1 of choosing consumption , given a particular level
of . For a given level of the amount of available goods, ( ) + (1 ) ,
is given. If the agent consumes = ( ) , then capital next period,
+1 , will equal this periods capital, . That is the consumption level on the
locus = 0. This means that if consumption is lower than that level, capital
next period will be larger than capital this period, 0 and capital will be
increasing. This is denoted by the horizontal arrows pointing to the right below
the locus. If conumption is larger than that level, capital next period will be
smaller than capital this period, 0 and capital will be decreasing. This is
denoted by the horizontal arrows pointing to the left above the locus.
On the other hand, consumption at and + 1 should satisfy the Euler
equation (4.7) too. That equation determines the consumption profile that the
agent would like to have. If the retorns to capital are high it would be optimal to
postpone consumption and make consumption at + 1 larger than consumption
at . This will happen if capital is scarce and its marginal productivity large and
denoted in the phase diagram by vertical arrows pointing up on the left part.
On the other hand, high levels of capital are associated with low returns and
the agent will find it optimal to advance consumption and making consumption
at larger than consumption at + 1. This is denoted in the phase diagram by
vertical arrows pointing down on the right part. In between, if capital is ,
the agent would prefer constant consumption profiles. this is the locus = 0.

4.4. DYNAMICS

53

Figure 4.2:

The phase diagram shows how and must evolve over time to satisfy households intertemporal optimization condition (Euler equation) and the equation
relating the change in capital to the level of capital and consumption (resource
constraint) given initial values for and . The initial value of is given but we
have to choose the initial value for . How is that value determined? Figure 4.2
shows this point when we start with an initial capital level 0 lower than .
We see that depending on the initial value of the trajectory of the economy will
be dierent. We also see that there is one trajectory that makes us approach
the stationary point. Call the initial consumption that allows us to do this, 0 .
All trajectories shown in figure 4.2 satisfy equations (4.6) and (4.7). But we
have to choose the trajectory that maximizes utility. Which one is it?
If the economy starts with a consumption level larger than 0 , we observe it
will end up in trajectories with capital decreasing and consumption increasing.
On the other hand, paths that start with a level of consumption too low will
follow paths with consumption decreasing and capital increasing. Finally, if the
economy begins with consumption 0 , converges to and converges to .
The function giving the initial as a function of is known as the saddle path.
It turns out that the optimal consumption/investment plan is the one described
by the saddle-path trajectory. Inspection of figure 4.2 suggests that either if
consumption is too low or too high, consumption eventually becomes zero and
remains so forever. It is clear that such paths cannot be optimal, leaving us
with only the saddle path.

54

4.5

CHAPTER 4. THE RAMSEY MODEL

The balanced growth path

The behavior of the economy once it has reached the stationary point is identical
to that of the Solow model on the balanced growth path. Capital, output and
consumption per capita are constant and so is the savings rate. Thus, the
central implications of the Solow model concerning the driving forces of economic
growth do not hinge on its assumption of a constant saving rate. Even when
saving is endogenous, we reach the same conclusion due to the diminishing
returns to the accumulation of capital.
The only notable dierence between the balanced growth paths of the Solow
and Ramsey models is that unlike the Solow model, in the Ramsey model it
is not possible to have a balanced growth path with a capital stock
above the golden rule (i.e. that level of capital that maximizes consumption)
defined by
0 ( ) =
In the Solow model a suciently high saving rate causes the economy to reach
a balanced growth path with the property that there are feasible alternatives
that involve higher consumption at every moment. In the Ramsey model, in
contrast, saving is derived from the behavior of households whose utility depends
on their consumption. As a result, it cannot be an equilibrium for the economy
to follow a path where higher consumption can be attained in every period; if
the economy where on such a path, households would reduce their saving and
take advantage of this opportunity. This is why the saddle path is above the
peak of the = 0 schedule with approaching the steady state.
Additionally, another fact of the Ramsey model is that the steady-state
capital level is less than the golden rule level. This means that the economy does not converge to the balanced growth path that yields the maximum
sustainable level of . The intuition is as follows. Imagine that the initial capital
level is . One possible initial consumption level is in Figure 1, right on
the = 0 schedule. This level of consumption is feasible and the economy
can stay there forever. However, the saddle path is telling us that choice of
consumption is not optimal. Agents prefer consume more today, decrease the
capital stock and reach a stationary point where consumption is smaller. The
reason is discounting. What the golden rule says is that if we value the future
the same as the present we would like to maintain as high a consumption always
as we can. However, that decision is not optimal if we are impatient. If that
is the case we are better of increasing current consumption and reducing future
consumption.

4.6

Eects of a fall in the discount rate

Consider a Ramsey economy that is on its balanced growth path, and suppose
that there is an increase in the time preference parameter. Since is the
parameter governing households preferences between current and future con-

4.7. DECENTRALIZED MARKET ALLOCATIONS

55

sumption, this change is the closest analogue in this model to a rise in the saving
rate in the Solow model.
Since the evolution of is determined by technology rather than preferences,
enters the = 0 schedule but not the = 0 schedule. An increase in
moves this line to the right. At the time of the change, the value of is given
by the history of the economy and it cannot change. In particular, at the time
of the change has been assumed to be on the old balanced growth path. In
contrast can jump at the time of the shock. It is clear that jumps down so
that the economy is on the new saddle path. Thereafter, and rise gradually
to their new balanced growth path with larger output, capital and consumption.
Thus the eects of an increase in are similar to the eects of a
rise in the saving rate in the Solow model with a capital stock below
the golden-rule level. In both cases, rises gradually to a new higher level,
and in both initially falls but then rises to a level above the one it started at.
Thus, just as with a permanent rise in the savings rate in the Solow model, the
permanent fall in the discount rate produces temporary increases in the growth
rate of per capita output and capital. The only dierence between the two
experiments is that, in the case of an increase in , in general the fraction of
output that is saved is not constant during the adjustment process.

4.7

Decentralized market allocations

In the previous sections, we characterized the centralized allocation dictated by


a social planner. There was no market to allocate resources. The social planner
put together the sources of income (supply side) with its uses (demand side).
We now characterize the competitive market allocation. For that, we solve the
model without technical change or population growth.

4.7.1

Households

Assume households are dynasties, living an infinite amount of time. There is a


continuum of these dynasties and we index each household by [0 1], having
normalized 0 = 1. The number of persons in every household is constant over
time so we can normalize population to be equal to 1 and write the model in
per capita variables.
We write lower case letter to denote the per capita value of a variable in
the household while the corresponding capital letter refers to the economy-wide
variable. Thus, refers to per capita capital while refers to the aggregate
capital of the household.
Each person in a household is endowed with one unit of labor in every
period, which he supplies inelastically in a competitive labor market for the
contemporaneous wage . Household (agent) is also endowed with initial
capital 0 . Capital for agent accumulates according to
+1 = (1 ) +

(4.8)

56

CHAPTER 4. THE RAMSEY MODEL

Households rent the capital they own to firms in a competitive market for a
(gross) rental rate .
The household uses its income to finance either consumption ( ) or investment in new capital ( ). Total income for household in period is simply (with
constant returns to scale there will be no profits) the sum of the wage ( ) and
the revenue from renting capital at the price ( ). Then, it must be the
case that
+ = +
(4.9)
Knowing the whole secuence of prices { , }
=0 , households chose their
sequence of consumption and capital, { , +1 }
=0 , to maximize utility

( )

=0

subject to the budget constraint

+ +1 = + + (1 )
To solve the problem write the corresponding lagrangean
max

{ +1 }
=0
0 g i v e n

L=

max

{ +1 }
=0
0 g i v e n

X
=0

[ ( ) ( + +1 (1 ) )]

In this lagrangean the lagrange multiplier has the interpretation of the marginal increase in the objective function, from the point of view of time if the
constraint at time is relaxed and the agent has available one extra unit of good.
From the point of view of time 0 the marginal gain is . Notice the solution to
this model is a sequence of allocations and lagrange multiplier { +1 }
=0 .
To get the first order conditions (FOC) take derivatives with respect a general period . Developing the summation sign and concentrating on the periods
around period the lagrangean would look like
L = + 1 [ (1 ) 1 (1 + 1 1 1 (1 )1 )]
+ [ ( ) ( + +1 (1 ) )]
+ +1 [ (+1 ) +1 (+1 + +2 +1 +1 +1 (1 )+1 )] +
Then take first order conditions with respect to ,
[0 ( ) ] = 0
+1 ,
and ,

+ +1 +1 [1 + +1 ] = 0
+ +1 (1 ) = 0

Substituting for and rearranging produces the two equations


0 ( ) = 0 (+1 ) [1 + +1 ]

(4.10)

+ +1 = + + (1 )

(4.11)

and

4.7. DECENTRALIZED MARKET ALLOCATIONS

4.7.2

57

Firms

There is an arbitrary number of firms in period , indexed by [0 ].


Firms employ labor and rent capital in competitive labor and capital markets,
have access to the same neoclassical technology, and produce a homogeneous
good that they sell competitively to the households in the economy.
Let and
denote the amount of capital and labor that firm [0 ]
employs in period . Then, the profits of that firm in period are given by

= ( )

The firms seek to maximize profits. The FOCs for an interior solution require
(
)
=

and
(
)
=

Remember that the marginal products are homogenous of degree zero; that
is, they depend only on the capital-labor ratio. In particular, the two conditions
above imply
0
= (
) = ( )

and

0
= (
) = ( ) ( )

That is, the FOCs pin down the capital-labor ratio for each firm (
),
but not the size of the firm (
). Moreover, all firms use the same capital-labor
ratio.
Furthermore, these two conditions also imply
+ = ( )
It follows that

+
= ( + ) = ( ) = ( )

and therefore

= [ ( ) ] = 0

That is, when the firms optimality conditions are satisfied, the maximal profits
that any firm makes are exactly zero, and these profits are attained for any firm
size as long as the capital-labor ratio is optimal.

58

4.7.3

CHAPTER 4. THE RAMSEY MODEL

Market clearing

The capital market clears if and only if


Z

= =

where is the aggregate capital stock in the economy.


The labor market, on the other hand, clears if and only if
Z

= = 1

4.7.4

General equilibrium: Definition

The definition of a general equilibrium in the Ramsey model is as follows:


Definition 3 An equilibrium of the decentralized economy is an allocation {( ,

, )[01] , ( ,
)[0 ] }=0 , and a price path { , }=0 , such that

(i) Given { , }=0 , the path { , , }=0 is optimal from the point
of view of household , for every , that is, maximizes their objective function
subject to their constraints
(ii) ( ,
) maximizes firm profits, for every and ,
(iii) the capital and labor markets clear in every period.

4.7.5

General equilibrium: Characterization

Imposing that markets clear, capital per capita per each household, , all
[0 1], must equal the capital per capita of every firm, =
, all
[0 ]. Denoting this capital per capita as and substituting prices in
optimality conditions for households we reach the equations
0 ( ) = 0 (+1 ) [1 + 0 (+1 ) ]
+ +1 = ( ) + (1 )
which coincide with those of the planners problem. Once we have this allocation, equilibrium prices will be
= 0 ( )
and
= ( ) 0 ( )
As a corollary, we can see that the aggregate and per-capita allocations in
the competitive market economy coincide with those in the planner economy.
We can thus immediately translate the steady state and the transitional dynamics of the centralized plan to the steady state and the transitional dynamics of
the decentralized market allocations.

4.8. EXOGENOUS GROWTH

4.8

59

Exogenous growth

As in Solows model, the simplest way to ensure steady-state consumption


growth is to postulate exogenous labor-augmenting technological change. So,
assume that the aggregate production function is of the form
= ( )
where denotes the eciency of labor and evolves exogenously as
+1 = (1 + )
Assuming constant returns to scale we see that

=
= b
1 = b

b =

Then, dividing by in the optimality conditions and defining hat variables


as variables per eciency units, we have

= b
b

b
(1 + ) b
+1 b

or

+1 b
=
b
+1 b

On the other hand,

i
1 h b

b
( + ) b
1+

i1
1 h
b
+1
=
+1 )

1 + 0 (b
b

1+

(4.12)

(4.13)

(if the function is homogeneous of degree one, the derivative is homogeneous of


degree 0). With these conditions, the conjecture is then that variables in eciency units converge to a stationary situation where they are constant. Besides
the constant 1(1 + ), conditions are identical as before, so they reproduce a
similar phase diagram in hat variables. This means generating a saddle path
in these variables. This also means that per capita consumption, capital and
output will all grow at the same rate 1 + along the balanced growth path. In
that situation, we have that

(1 + )
+ 1
= 0 b

While the steady state consumption growth rate is exogenously given by 1 + ,


the endogenous steady state ratio b
is such that the implied rate of return on
capital induces the agents to choose a consumption growth rate of 1 + . As can
be seen, a higher degree of patience (a larger ), a higher willingness intertemporaly to substitute (a lower ), and a more durable capital stock (a lower )
each yield a higher ratio b
, and therefore more output (and consumption) at
a point in time; but the growth rate remains fixed at the rate of exogenous
labor-augmenting technological change.

60

4.9

CHAPTER 4. THE RAMSEY MODEL

Endogenous growth I: the AK model

The neoclassical growth model provides important insights about growth, but
it also has some serious limitations. First, the Ramsey model in its simplest
form, is not able to generate long run growth but also is arguable limited in
its ability to explain the magnitude and persistence of the real income gaps
between poor and rich countries. To see this, we can look at some numbers. For
example income dierences between US and India is 10 to 1. This means that
there must be a dierence in per capita capital levels of 101 to 1. To see this,
assume both India and US have the same technology level. Then

= ( )1 = 10
( )1 = 10

Then, defining capital per capita and eliminating technology we get

= =
= 10

So, the ratio of the two capital must be

= 101

If = 13 (which is roughly the estimations for most economies) capital per


capita in the US has to be around 1000 times that of India. We observe dierences of around 20 to 30 times, not 1000.
An additional problem with the neoclassical model has to do with returns
to capital. With competitive markets, we know that the return on capital
investment must be close to the marginal productivity of capital. With a CobbDouglas production function this is
= 1 = (1)
So, with = 13, having 10 times more output implies that returns in India
must be of the order of 100 times those in the US. We know this cannot be
the case, otherwise we would observe an enormous capital inflow into India.
Dierences in the tax code, risk, imperfections in the credit market would not
be enough to stop the capital inflows.
The model tells us that, because decreasing returns to the accumulation
of capital, in the long run technological progress is the central factor driving
changes in per capita income. But it says nothing about the factors that
drive technological progress itself. For example, we cannot answer questions
of whether government subsidies to research and development could raise a
countrys growth rate because we have no idea what is it behind our index .
In the 1990s, a new growth theory evolved that extends neoclassical growth
theory to incorporate market driven innovation and that allows for endogenously
driven growth. In order to review these models it is useful first to see how an

4.9. ENDOGENOUS GROWTH I: THE AK MODEL

61

economy can sustain indefinite growth in per capita income even in the absence
of exogenous technological change. So, instead of postulating an exogenous
technical change that compensates these diminishing returns, we start by eliminating the assumption of diminishing returns all together. So, assume that the
production function is of the form
= ( ) = ,
where is a parameter. Then, we have, assuming no technological change,
+1 +1 = + (1 )
So, dividing by we obtain

+1
=+1

On the other hand,


+1
= [ ( + 1 )]1

In the balanced growth path, all variables grow at the same rate so
+1
+1
=
= 1 +

which implies that


1 + = [ ( + 1 )]1
and

We observe that there is no transitional dynamics in this model. All variables


grow at the same rate from day 0. As before, we see that a higher degree of
patience (a larger ), a higher willingness intertemporaly to substitute (a lower
), and a more durable capital stock (a lower ) each yields a higher growth rate
. Also, the larger the technological level of the economy the larger growth is.
So, anything that changes permanently the saving rate has permanent eects
on the growth rate of the economy.
On the other hand, there is no convergence here. Suppose that countries
have the same parameters (, , , ) but for some reason, they dier in their
initial capital stock 0 . Since they will all grow at the same constant rate , the
poor country will always be poorer in levels.

62

CHAPTER 4. THE RAMSEY MODEL

Chapter 5

The Overlapping
Generations Model
5.1

Introduction

What are the main shortcomings of the Ramsey model that have lead to the
development of the OLG model? The first criticism is that individuals apparently do not live forever, so that a model with finitely lived agents is needed.
We could provide the infinitely lived agent model an interpretation in which
individuals lived only for a finite number of periods, but, by having an altruistic
bequest motive, act so as to maximize the utility of the entire dynasty, which
in eect makes the planning horizon of the agent infinite. So infinite lives in
itself are not as unsatisfactory as it may seem. But if people live forever, they
dont undergo a life cycle with low-income youth, high income middle ages and
retirement where labor income drops to zero. In the infinitely lived agent model
every period is like the next (which makes it so useful since this stationarity
renders dynamic programming techniques easily applicable). So in order to analyze issues like social security, the eect of taxes on retirement decisions, the
distributive eects of taxes vs. government deficits, the eects of life-cycle saving on capital accumulation one needs a model in which agents experience a life
cycle and in which people of dierent ages live at the same time in the economy.
This is why the OLG model is a very useful tool for applied policy analysis.
Because of its interesting (some say, pathological) theoretical properties, it is
also an area of intense study among economic theorists.
In this chapter we introduce the overlapping generations developed by the
American economist Peter A. Diamond. The model extends the original contributions of Allais (1947) and Samuelson (1957) by including physical capital.
Among the strengths of the model are:
The life-cycle aspect of human behavior is taken into account. Although
the economy is infinitely-lived, the individual agents have finite time horizons. During lifetime ones educational level, working capacity, income,
63

64

CHAPTER 5. THE OVERLAPPING GENERATIONS MODEL


and needs change and this is reflected in the individual labor supply and
saving behavior. The aggregate implications of the life-cycle behavior of
individual agents at dierent stages in their life is at the centre of the
OLG approach.
The model takes elementary forms of heterogeneity into account (young
versus old, currently alive versus unborn whose preferences are not reflected in current market transactions). Questions relating to the distribution of income and wealth across generations can be studied. For example, how does the investment in capital and environmental protection by
current generations aect the conditions for succeeding generations?

In several respects the conclusions we get from OLG models are dierent than
those from representative agent models (RA models for short). The underlying
reason is that in an RA model, many aggregate quantities are just a multiple
of the actions of the representative household. In OLG models this is not so;
the aggregate quantities are the outcome of the interplay of agents at dierent
stages in their life; further, the turnover in the population plays a crucial role.
The OLG approach lays bare the possibility of coordination failure on a grand
scale.

5.2

Motives for saving

Before going to the specifics of Diamonds model, let us briefly consider what
may motivate people to save:
1. The life-cycle motive for saving. Typically, individual income has a
hump-shaped lifetime pattern; by saving and dissaving the individual attempts to obtain the desired smoothing of consumption across lifetime.
This is the essence of the life-cycle saving hypothesis put forward by Nobel laureate Franco Modigliani (1918-2003) and associates in the 1950s.2
This hypothesis states that consumers plan their saving and dissaving in
accordance with anticipated variations in income and needs over lifetime.
Because needs vary less over lifetime than income, the time profile of
saving tends to be hump-shaped with some dissaving early in life (while
studying etc.), positive saving during the years of peak earnings and then
dissaving after retirement where people live o the accumulated wealth.
2. The precautionary motive for saving. Income as well as needs may
vary due to uncertainty (sudden unemployment, illness, or other kinds
of bad luck). By saving, the individual can obtain a buer against such
unwelcome events.
3. Saving enables the purchase of durable consumption goods and owner
occupied housing as well as repayment of debt.
4. Saving may be motivated by the desire to leave bequests to heirs.

5.3. THE MODEL FRAMEWORK

65

5. Saving may simply be motivated by the fact that financial wealth may
lead to social prestige or economic and political power.
Diamonds OLG model aims at simplicity and concentrates on motive (a).
In fact, only a part of motive (a) is considered, namely the saving for retirement. Owing to the models assumption that people live for two periods only, as
young and as old, there is no room for considering education and dissaving
in the early years of life. The young work full-time while the old have retired
and live by their savings. The Diamond model also abstracts from a possible
bequest motive as well as non-economic motives for saving. Uncertainty is absent in the model. Numerous extensions of the framework, however, have taken
up issues relating to the motives (b) - (e).

5.3

The model framework

The flow of time is divided into successive periods of equal length, taken as
the time unit. Given the two-period lifetime of (adult) individuals, the period
length is understood to be around, say, 30 years. The time structure of the
model is illustrated in the following figure. In every period two generations
are alive and interact with each other as indicated by the arrows. The young
supply labor to the firms and these use capital goods owned and rented out by
the old. The young save for retirement, thereby osetting the dissaving of the
old and possibly bringing about positive net investment in the economy. Further
assumptions are:
1. The number of young people in period , denoted changes over time
according to = (1 + )1 , where is a constant, 1. As is
common in economic models, indivisibility problems are ignored and so
is just considered a positive real number.
2. Only young people work. Each young supplies one unit of labor inelastically. They receive the wage rate . So the division of available time
between work and leisure is considered as exogenous.
3. Output is homogeneous and can be used for consumption as well as investment in physical capital. Physical capital is the only asset in the economy;
it is owned by the households and rented out to the firms. Physical capital depreciates at the rate . Money (means of payment) is ignored (as of
now).
4. The economy is closed.
5. Firms technology has constant returns to scale.
6. There are three markets, a market for output, a market for labor services,
and a market for capital services. Perfect competition rules in all markets.

66

CHAPTER 5. THE OVERLAPPING GENERATIONS MODEL

The model ignores recurrent stochastic influences on the system in which the
agents act. When a decision is made, its consequences are known. The agents
are assumed to have rational expectations or, with a better name, model
consistent expectations. That is, forecasts made by the agents coincide with
the forecasts that can be calculated from the model. And since there are no
stochastic elements in the model, these forecasts are equivalent with perfect
foresight. So the seventh assumption is:
7. Agents have perfect foresight.
The households place their savings directly in new capital goods which constitute the non-consumed part of aggregate output. The households rent their
stock of capital goods out to the firms. Let the homogeneous output good be
the numeraire and let denote the rental rate for capital in period ; that is,
is the real price a firm has to pay at the end of period for the right to use
one unit of someone elses physical capital through period . Now one question
here is to compute the return of owners of capital if the rental rate is . For an
agent who supplies units of capital, he receives . Then he must cover for
the depreciation of capital equal to . Thus, the return to his savings placed
as capital are

=
=
(5.1)

5.3.1

The savings of the young

The decision problem of the young in period , given and +1 is: Theyll
consume some amount 1 and some amount 2+1 such that
1 + =
and
2+1 = (1 + +1 )
Notice the young are the only agents saving in each period so no need to more
subscripts to define that variable. Also, because agents do not have income in
the second period and the Inada conditions, +1 0 always. The agent chooses
1 , 2+1 and to maximize utility
(1 ) + (2+1 )
subject to the intertemporal budget constraint (obtained from combining the
two budget constraints by substituting for so that
1 +

2+1
=
1 + +1

Forming the Lagrangian

2+1
(1 ) + (2+1 ) 1 +

1 + +1

5.3. THE MODEL FRAMEWORK

67

and taking first order conditions with respect to 1 , 2+1 , and yields
0 (1 ) =
0 (2+1 ) =
and
1 +

1 + +1

2+1
=
1 + +1

Substituting the first FOC into the second we get


0 (1 ) = (1 + +1 )0 (2+1 )
which has the same interpretation as in the two-period consumption problem
seen before.

5.3.2

Production

The specification of technology and production conditions follows the simple


competitive one-sector setup already discussed in the Solow or Ramsey models.
Although the Diamond model is a long-run model, we shall in this chapter for
simplicity ignore technical change.
The representative firm
There is a representative firm with a neoclassical production function and constant returns to scale (CRS). Omitting the time argument t, we have
= ( ) = ( 1) = ()
where is output (GDP) per period, is capital input, is labor input,
and is the capital intensity. Finally, the derived function, () is
called the production function on intensive form. Capital installation and other
adjustment costs are ignored. Hence the profit function is
= ( )
The firm maximizes

under perfect competition. This gives two FOCs


( ) = 0 () =

(5.2)

( ) = () 0 () =

(5.3)

and
Expression (5.2) determines the desired capital intensity. Owing to CRS, however, at this stage the separate factor inputs, and are indeterminate; only
their ratio, is determinate. We will now see how the equilibrium conditions
for the factor markets select the factor prices and the level of factor inputs
consistent with equilibrium.

68

CHAPTER 5. THE OVERLAPPING GENERATIONS MODEL

Clearing in the factor markets


Let the aggregate demand for capital services and labor services be denoted
and , respectively. Clearing in factor markets in period implies
=

(5.4)

= = (1 + )1 = (1 + ) 0

(5.5)

where is the aggregate supply of capital services and the aggregate supply
of labor services.
The aggregate input demands, and , are linked through the desired
capital intensity, and in equilibrium it must be the case that

= =

by (5.4) and (5.5). Therefore, in (5.2) and (5.3) can be identified with the ratio
of the stock supplies, = which is a predetermined variable. Interpreted
this way, (5.2) and (5.3) determine the equilibrium factor prices and in each
period. In view of (5.1), = , and so we end up with
= 0 ( ) ( )

where

0 ( ) = 00 ( ) 0

and
= ( ) 0 ( ) ( )

where

0 ( ) = 00 ( ) 0

Finally, there is the output market. In equilibrium supply, , must equal


demand which has two components, consumption and investment. There are
two types of agents on the demand side, the young and the old. So, aggregate
consumption at period is
= 1 + 2 1
Saving is in this model an act of acquiring capital goods and is therefore directly
an act of capital investment. So the net investment by the young equals their
net saving, . The old in period disinvest by consuming not only their
interest income but also the financial wealth with which they entered period .
The claim is that this financial wealth, must equal the aggregate capital stock
at the beginning of period : . Indeed, there is no bequest motive and so
the old in any period consume all they have and leave nothing as bequests. It
follows that the young in any period enter the period with no financial wealth.
So any financial wealth existing at the beginning of a period must belong to
the old in that period and be the result of their saving as young in the previous
period. As equals the aggregate financial wealth in our closed economy at
the beginning of period then follows that
1 1 =

(5.6)

5.4. THE SOCIAL PLANNERS PROBLEM

69

Aggregate gross investment is


= +1 (1 )
Using the expression above for we have
= (1 )
Then clearing in the goods market implies
= ( ) = + = 1 + 2 1 + (1 )

5.3.3

The dynamic equilibrium path of the economy

Definition 4 An equilibrium is a sequence of {1 , 2+1 , , , }


=0 satisfying:
(1) given prices the sequences {1 , 2+1 , }
=0 are optimal form the agents
point of view,
(2) markets clear.
To characterize such a path, we forward (5.5) one period and rearrange so
as to get
+1 =
Since
+1 = +1 +1 = +1 (1 + )
this can be written
+1 =

( +1 )
[( ) (+1 )])
=
=

1+
1+
1+

(5.7)

Equation (5.7) is a first-order dierence equation, known as the fundamental


dierence equation or the law of motion of the Diamond model.
To be able to further characterize equilibrium paths we construct a transition diagram in the ( , +1 ) plane. The transition curve is defined as the set
of points, ( , +1 ) satisfying (5.7). The following figure shows a possible, but
not necessary configuration of this curve. A complicating circumstance is that
the equation (5.7) has +1 on both sides. Sometimes we are able to solve the
equation explicitly for +1 as a function of but sometimes we can do so only
implicitly. What is even worse is that there are cases where +1 is not unique
for given . We will proceed step by step.

5.4

The social planners problem

70

CHAPTER 5. THE OVERLAPPING GENERATIONS MODEL

Chapter 6

The Overlapping
Generations Model with
Money
6.1

The model framework

The flow of time is divided into successive periods of equal length, taken as the
time unit. Every period individuals are born and live for 2 periods. Agents
in their first period of life are called "young" while they are called "old" in
their second period of life. The number of agents grow at the rate so that
= (1 + )1 . At time = 0 there are 1 = 1 old agents born at period
= 1. All agents are endowed with income 1 when young and 2 when old
with 1 2 . These goods are not storable and the economy is closed. Each
generation born at 0 decide on their consumption when young, 1 , and
when old, 2+1 , to maximize
(1 ) + (2+1 )
where 0 1 is the discount rate. Members of the initial old generation
choose consumption when old, 20 , to maximize
(20 )
Furthermore, the inital old are endowed with units of unbacked fiat money.
We can easily see that if = 0, the only possible equilibrium is autarky.
Since we assumed that individuals are identical there cannot be trade within
the same generation. Trade between generations is also not possible, because
we assume that a generation only lives for two periods. Trade between young
and old in period cannot be completed because the old do not exist anymore
in period + 1.
71

72CHAPTER 6. THE OVERLAPPING GENERATIONS MODEL WITH MONEY


If 0, we could solve the problem of each generation. This problem is
to choose consumption {1 , 2+1 } and money demand, , to maximize
(1 ) + (2+1 )
subject to the budget constraints
1 + 1
and
+1 2+1 + +1 2
where is the nominal price level at . Substituting for we arrive to the
inntertemporal budget constraint
1 +

+1
+1
2+1 = 1 +
2

Setting up the Lagrangean

+1
+1
2+1 1
2
(1 ) + (2+1 ) 1 +

and taking FOCs with respect to 1 , 2+1 , and yields the Euler equation
0 (1 ) =

0
(2+1 )
+1

and the budget constraint


1 +

+1
+1
2+1 = 1 +
2

Notice the inverse of the inflation rate ( +1 ) acts as the interest rate in
the Euler equation. This is because the inverse of the inflation rate is the real
return on money.
Assuming logarithmic utility function () = ln() the Euler equation becomes

1
1
=

1
+1 2+1
Substituting for 2+1 in the budget constraint produces

1
+1
2
1 =
1 +
1+

This means that the demand for money equals

1
+1

=
2
1

1+
1+

6.1. THE MODEL FRAMEWORK

73

For the economy to have an equilibrium with valued money, the money market
should clear, that is, = , for all . This means that prices should satisfy
the following condition

1
+1
=
2
1

1+
1+

or
=

1+

+
+1
1
1

Does this expression have any solution?. One possibility is to think that,
as aggregate money, , and aggregate output per capita, 1 + 2 (1 + ), are
constant, prices should also be constant. In fact, there is a constant level for
the price, call it , that satisfy this equation. This price level is

1+

=
2

1 1
1
For this price level to be positive we need 1 2 , which we assumed at the
beginnig. Notice for money to be demanded we need young agents to have
an incentive to save. Thus, we need income when young to be larger than
income when old. When prices are constant, the inflation rate is 0 and the real
return on money is 1. With this return and logarithmic utility, the condition
to endure agents save (that is, the intertemporal marginal rate of substitution
being smaller than the return on assets) is
11
1
2
from which we derive 1 2 .
However, the model accepts another solution in which prices are changing.
It is easy to check that
=

1+

+
2
1 1
1

1
2

is also a solution to the price equation above with 0 (so that prices never
go to negative territory). Because 1 2 this solution calls for inflation and
prices converging to , that is, to the situation when money has no value.
Because this is reached when , any generation within a finate period
still accepts money as a store of value. Notice that dierent values for
0 just aect the price level but not the inflation rate.

74CHAPTER 6. THE OVERLAPPING GENERATIONS MODEL WITH MONEY

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