Econ 506 Macroeconomic Theory II

Bilkent University
Spring 2019

Homework I
Refet S. Gürkaynak
Due April 1, 2019 to Eser Erten, except the computational part, which is due
April 15.

1. Write a short essay (not more than a page) on the progression of models
in your reading list up to and including the papers under the Price Stickiness
and New Keynesian Models heading (excluding time inconsistency, which we
have also covered). How do these papers relate to each other?

2.An exercise in writing and solving the basic RBC model. Use your class
notes to help you. In a complete markets environment with stochastic technol-
ogy growth, the representative consumer maximizes utility given by
(1 )
X
t
E0 u(Ct ; Ht ) ; (1)
t=0

where u(Ct ; Ht ; ) = ln Ct v(Ht ) with v 0 > 0 and v”> 0: Complete markets

allows us to write an intertemporal budget constraint using the pricing kernel
R0;t :
1
X 1
X
E0 fR0;t Ct g E0 fR0;t wt Ht g + a0 ; (2)
t=0 t=0

where a0 is the initial asset value.

(a) Find the …rst order conditions of the consumer’s optimization problem.
Interpret your …ndings.
(b) De…ne ht = Ht =Kt , labor per unit of capital. Let the production function
be
Yt
= f (zt ht ); (3)
Kt
with zt the stochastic technology and f increasing and concave. Denote t as
the per unit of capital pro…t and solve the …rm’s optimization problem. Make
inferences about the labor market using the FOC of the consumer’s and …rm’s
problems.
(c) Write down the market clearing and investment demand equations, dis-
cuss these.
(d) Assume technology follows a random walk,

zt = zt 1 + ut ; (4)

1
with ut an iid standard normal variable. Denote the growth rate of z with
z : Normalize the relevant variables of the model so that they admit balanced
growth paths. (Use the notation in class to do so.)
(e) Write down the market clearing and optimal investment equations using
the transformed variables. Provide log-linear approximations to these equations
around the steady state to simulate dynamic responses to technology shocks.
(f) The two log-linear equations you have derived form a dynamic system

Et ^ t+1 ^t 0
=M + ^ zt+1 : (5)
Kt+1 Kt 1

When you write the system in this form, what are the elements of matrix M
(this won’t be pretty)? Use the fact that
1
+ (1 )= z

at steady state to simplify some. Show that M has one eigenvalue inside the
unit circle and one outside it. To do so remember that

y > 0; > 0; k< yk 1; and k 0

(you can show these if you want), and characterize (you need not explicitly
solve, only characterize) the roots of the characteristic equation of M . Then
show that if the left eigenvector associated with the explosive eigenvalue is [1; e],
then e is positive and an eigenvector associated with the stable root is [ e; 1].
(g) Find the unique bounded solution. What are the impulse response func-
^ ^ , C^ and Y^ to an innovation in z ? Y^ , for example, is unobservable
tions of K,
but Y is observable. What does the model imply for the impulse-response func-
tion of Y , the growth rate of output?

3. Use Chris Sims’ GENSYS (not DYNARE ) when needed to answer this
question. Provide your annotated code as part of your answer.
Take the model you have solved in question (2). Assume that the utility
function is
u(Ct; Ht) = ln Ct + ln(H Ht)
where H represents the time endowment (can be normalized to 1) of the repre-
sentative agent.
(a) Given the two expectational di¤erence equations that you …nd, what
parameter values do you need to calibrate to simulate the mode? Using the
calibrated values given below (from King and Rebelo, 1998), calibrate the re-
maining parameters needed based on your steady-state relationships. [You’ll
need to use basic relationships you had established while solving the model,

2
such as = r + . See King and Rebelo, 1998 for more details.]
r = 0:01625
z = 1:004
z
= 0:007
= 0:66
= 0:025
= h = hw = 4

(b) Show that the model has a unique bounded solution under this calibra-
tion.
(c) Draw the impulse response functions of output, capital, hours, consump-
tion and investment with respect to a technology shock.
(d) If the standard deviation of the technology shock is as given above,
what is the standard deviation of output growth rate? Are the standard devi-
ations of consumption and investment growth rates more or less than that of
output growth? Are consumption and hours growth rates procyclical or counter-
cyclical?

4. Derive the optimal investment demand equation we wrote in class using

dynamic programming. To do so, de…ne Vt as the value of the …rm at the
beginning of the period and t as the cash ‡ow for that period, ie,

t = F (Kt ; zt Ht ) wt Ht It :
Thus,
Vt = Et fRt;t+1 ( t + Vt+1 )g :
Solve this equation forward (and assume away bubbles in the value of the …rm)
to …nd the fundamental value of the …rm in terms of the cash ‡ow. Then
maximize Vt (Kt ) subject to the law of motion of capital and show that the
resulting optimality condition is the same as the one used in class. (Remember
that we are assuming a CRTS production function and competitive markets.)

4. Show that in the RBC model studied in class (and you have solved above),
the equilibrium allocation of resources is optimal. That is, the decentralized
1
equilibrium paths Ct ; Ht ; Kt t=0 solve the planner’s problem subject to the
feasibility problem
(1 )
X
t
max E0 u(Ct ; Ht ) ; (6)
t=0
Ht
s:t:Ct + [Kt+1 (1 )Kt ] K t zt ; (7)
Kt
given the exogenous process fztng and the initial
o1 capital stock. To do so, as-
sume that an alternative path C~t ; H
~ t; K
~t is also feasible but provides a
t=0

3
 n o1
higher expected utility for the representative household. The plan C~t ; H
~t
t=0
should not be a¤ordable by the representative household at equilibrium prices
(otherwise it would have been chosen). Thus, it must be that
X1 n o X 1 n o
E0 R0;t C~t > ~ t + a0 :
E0 R0;t wt H (8)
t=0 t=0

First argue that a0 = K0 [ 0 + (1 )] by using the budget constraint in period

zero. Then show that (8) leads to a contradiction.

5. Assume an economy in which the representative agent maximizes

1
X
E0 (1 + r) t u(Ct )
t=0

where the period utility is given by

u(Ct ) = Ct Ct2 ; > 0:
Further assume that C’s support is limited to the range where u0 > 0. The
production function is
Yt = rKt + "t
and capital does not depreciate. The production shock follows an autoregressive
process
"t = "t 1 + t ; j j < 1; t is mean zero iid.:
(a) Write down the rule of motion of capital (trivial) and solve the consumer’s
optimization problem for the Euler equation linking Ct to Et Ct+1 .
(b) The optimal consumption is a linear function of the capital stock and
the production shock (and you happen to see this from the setup of the model).
Ct = + Kt + "t : Given this, express Kt+1 as a function of the current capital
stock Kt and the production shock "t .
(c) The Euler equation in (a) should be satis…ed for all Kt and "t . What
restriction does this imply for , , and ?
(d) What are the paths of Yt , Kt and Ct after a one time shock to "t ?

6. Explain the RBC model to an undergraduate economics student (who

has taken intermediate macroeconomics). Make sure to put it in its proper
place in the recent history of economic thought and to mention its successes
and weaknesses.

7. Consider a competitive equilibrium business cycle model in which the

representative household seeks to maximize
(1 " !#)
X Ht1+
t
E ln Ct ;
t=0
1+

4
where Ct is consumption in period t and Ht is hours worked. 0 < < 1 and
> 0.
Let there be a single, non-durable consumption good, which is either con-
sumed by households or by the government. The good is produced by using
labor and capital, where capital is perfectly durable and in a …xed supply of
one per household. (Thus there is no depreciation, investment spending or pro-
duction of capital goods.) The production technology allows the production
of
h1
yt = t
1
units of the consumption good per unit of capital, if h units of labor are employed
per unit of capital. Importantly, the production function is constant over time,
there are no technology shocks.
The capital stock is owned by the households in equal quantities, who col-
lect the competitive stock return to capital in addition to their wage income.
All markets are perfectly competitive and …nancial markets are frictionless and
complete so that–among other things–each household faces a single intertem-
poral budget constraint. Government purchases of the good in period t are
Gt , a quantity that may vary over time, and for simplicity assume that the
government maintains a balanced budget each period.
(Hint: Remember that in this representative household model per unit of
capital values and aggregate values do not have to di¤er. You may …x aggregate
K = 1 so that the two are the same. This makes no di¤erence in how you solve
the model. Also remember that market clearing in this economy will require
ct + gt = yt , in per unit of capital terms.)
a. Derive a set of equilibrium conditions which su¢ ce to determine the
equilibrium levels of output Yt , hours worked Ht , real wage wt and consumption
Ct in a given period t. (Express hours, output and consumption in per capita
terms.) You need not give a closed form solution but show the set of equations
that would be solved to obtain the answers. [Hint: Notice that this is a simple
RBC model in which time time variation stems from government spending rather
than from technology.]
b. Using the equations from part (a) compute the e¤ect of a temporary
increase in the level of government purchases on output. That is, consider an
initial case in which Gt = G in each period and Y be the associated steady
state level of output. Then assume that a change in policy makes Gt higher by
a small quantity in period t, without changing the expected level of govern-
ment purchases in any subsequent date. Compute the government purchases
multiplier dY =dG in the case of a small increase in government purchases, as
a function of the model parameters , , , and sG = YG : [Hint: You may
want to use a log-linear approximation to the market clearing condition. The
approximation will be valid around a small enough neighborhood of the stady
state as the shock being considered is small.] What is the sign of the multiplier?
Is it greater than or less than one in absolute value? Interpret.
c. Brie‡y discuss how your conclusions about the size of the output e¤ect of
an increase in government spending should depend, if at all, upon (i) whether

5
the increase is expected to be temporary or permanent, (ii) whether the increase
is unexpected in date t or announced in advance. [In part (b) you were asked
to assume that the increase is temporary and unexpected.]
d. Discuss the qualitative e¤ects of the temporary increase in government
purchases on hours worked, the average product of labor, the total factor pro-
ductivity (measured by the Solow residual), the real wage and aggregate private
consumption spending, according to the model.
Now consider the stationary ‡uctuations in each of those variables that the
model would predict, in the case of i:i:d: variations in the level of government
purchases. Which variables would be predicted to move procyclically, and which
counter cyclically? To what extent do these qualitative predictions match the
properties of the actual business cycles? (The Stock and Watson handbook
paper in your reading list is a good source to check for US business cycle styl-
ized facts.) Does this model seem promising as a hypothesis about the general
character of business cycles?

8. Answer questions 2, 4, and 6 from chapter 2 of Gali.