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Pierre Cahuc
Winter 2012-2013
1 http://sites.google.com/site/eco553x/
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Introduction
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Introduction
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Introduction
I Outline
1. Saving behavior
2. The competitive equilibrium
I Then, next lecture:
1. The optimality of growth
2. Public debt
3. Distortionary taxation
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1. Saving behavior
I We proceed in 2 steps
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1. Saving behavior
1.1. 2 period model
I period t = 0, 1
I ct consumption in period t
I Preferences
U (c0 , c1 ) = u (c0 ) + βu (c1 )
I u ( ) is the instantaneous utility function or the ‘felicity
function’, u 0 (c ) > 0, u 00 (c ) 0
I β 2 (0, 1) is the discount factor, or
1
β=
1+ρ
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1. Saving behavior
1.1. 2 period model
c0 + s = w0
c1 = ( 1 + r ) s + w1
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1. Saving behavior
1.1. 2 period model
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1. Saving behavior
1.1. 2 period model
subject to
c1 w1
c0 + = w0 + =W
1+r 1+r
I Or:
max u (c0 ) + βu ((1 + r )(W c0 ))
c0
u 0 ( c0 ) = β ( 1 + r ) u 0 ( c1 )
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1. Saving behavior
1.1. 2 period model
1+r 0
u 0 ( c0 ) = u ( c1 )
1+ρ
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1. Saving behavior
1.1. 2 period model
ct (ρ, r , W ), t = 0, 1.
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1. Saving behavior
1.1. 2 period model
I Risk neutrality: σ = 0
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1. Saving behavior
1.1. 2 period model
I With a CRRA utility function, the Keynes-Ramsey rule yields
1
c0 1+r σ
= , when σ > 0
c1 1+ρ
I An increase in r :
I more costly to borrow, higher returns of lending
I future consumption increases relative to present consumption
I This e¤ect is larger if the coe¢ cient of relative risk aversion,
σ, is smaller
I 1/σ is the intertemporal elasticity of substitution:
d(c0 /c1 )/(c0 /c1 ) d log(c0 /c1 ) 1
= =
d(1 + r ) / (1 + r ) d log(1 + r ) σ
I Interpretation: one percent increase in the gross returns of
savings induces a 1/σ percent decrease in the ratio c0 /c1
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1. Saving behavior
1.1. 2 period model
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1. Saving behavior
1.1. 2 period model
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1. Saving behavior
1.2. In…nite horizon model in continuous time
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1. Saving behavior
1.2. In…nite horizon model in continuous time
a 1 = w0 ( 1 + r ) + w1 c0 ( 1 + r ) c1 (1)
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1. Saving behavior
1.2. In…nite horizon model in continuous time
2 See Appendix A.
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1. Saving behavior
1.2. In…nite horizon model in continuous time
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1. Saving behavior
1.2. In…nite horizon model in continuous time
a(t + dt ) a (t )
= r (t )a (t ) + w (t ) c (t )
dt
I Since, by de…nition the derivative with respect to time of a(t )
is
a(t + dt ) a(t )
ȧ(t ) = lim
dt !0 dt
we get
ȧ(t ) = r (t )a(t ) + w (t ) c (t ) (3)
I ȧ(t ) is the instantaneous saving at time t
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1. Saving behavior
1.2. In…nite horizon model in continuous time
subject to
ȧ(t ) = r (t )a(t ) + w (t ) c (t )
Z t
lim a(t ) exp r (x )dx =0
t !∞ 0
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1. Saving behavior
1.2. In…nite horizon model in continuous time
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1. Saving behavior
1.2. In…nite horizon model in continuous time
∂H (t )
= u 0 (c (t ))e ρt µ(t ) = 0 (4)
∂c (t )
∂H (t )
= r (t )µ(t ) = µ̇(t ) (5)
∂a(t )
lim a(t )µ(t ) = 0 (6)
t !∞
I Eq. (4) shows that the costate variable µ(t ) is equal to the
present value of the marginal utility of consumption c (t )
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1. Saving behavior
1.2. In…nite horizon model in continuous time
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1. Saving behavior
1.2. In…nite horizon model in continuous time
I The derivative with respect to time of condition (4),
∂H (t )
= u 0 (c (t ))e ρt
µ (t ) = 0
∂c (t )
yields
µ̇(t ) = e ρt
u 00 (c (t ))ċ (t ) ρu 0 (c (t ))
I Substituting into condition (5) gives the Euler equation, or
the Keynes-Ramsey rule
ċ (t ) u 0 (c (t ))
= [r (t ) ρ]
c (t ) u 00 (c (t ))c (t )
I Or, using the de…nition of the Arrow-Pratt coe¢ cient of
relative risk aversion,
u 00 (c (t ))c (t )
σ(c (t )) =
u 0 (c (t ))
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1. Saving behavior
1.2. In…nite horizon model in continuous time
I We get
ċ (t ) 1
= [r (t ) ρ]
c (t ) σ(c (t ))
where 1/σ(c (t )) is the intertemporal elasticity of substitution
I Interpretation: increase in future consumption relative to
present consumption when the interest rate is increased
I The increase is larger when the intertemporal elasticity of
substitution is larger
I The Keynes Ramsey rules in discrete time and in continuous
time are in fact identical (Appendix C)
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1. Saving behavior
1.2. In…nite horizon model in continuous time
ċ (t ) 1
= [r (t ) ρ]
c (t ) σ(c (t ))
ȧ(t ) = r (t )a(t ) + w (t ) c (t )
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2. The competitive equilibrium
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2. The competitive equilibrium
2.1. De…nition of equilibrium
I Model with labor and an output, produced, consumed,
invested
I Output is the numeraire
I There are many in…nite live identical households, continuum,
size = 1
I Their welfare function is given by
Z ∞
ρt
u (c (t ))e dt
0
I There are many identical …rms, with the same constant return
to scale technology
F (K (t ), L(t )),
f (k ) = F (k, 1), k = K /L
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2. The competitive equilibrium
2.1. De…nition of equilibrium
k (0) = k0 > 0
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2. The competitive equilibrium
2.2. Behavior of households
subject to
ȧ(t ) = r (t )a(t ) + w (t ) c (t ),
Z t
lim a(t ) exp r (x )dx =0
t !∞ 0
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2. The competitive equilibrium
2.2. Behavior of households
ċ (t ) 1
= [r (t ) ρ] (7)
c (t ) σ(c (t ))
ȧ(t ) = r (t )a(t ) + w (t ) c (t )
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2. The competitive equilibrium
2.3. Behavior of …rms
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2. The competitive equilibrium
2.3. Behavior of …rms
f 0 (k (t )) = r (t ) + δ (8)
0
f (k (t )) k (t )f (k (t )) = w (t ) (9)
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2. The competitive equilibrium
2.4. Characterization of equilibrium
I There are 2 factor markets: labor market, capital market
I Labor market equilibrium:
a (t ) = k (t )
k̇ (t ) = r (t )k (t ) + w (t ) c (t )
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2. The competitive equilibrium
2.4. Characterization of equilibrium
k̇ (t ) = f (k (t )) δk (t ) c (t )
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2. The competitive equilibrium
2.4. Characterization of equilibrium
I Using eq. (8) and (7), we …nd that an equilibrium path
fc (t ), k (t ), t 0g satis…es
ċ (t ) 1
= [f 0 (k (t )) δ ρ] (10)
c (t ) σ(c (t ))
k̇ (t ) = f (k (t )) δk (t ) c (t ) (11)
r = ρ (14)
0
f (k ) = ρ + δ (15)
c = f (k ) δk
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2. The competitive equilibrium
2.5. Steady state equilibrium
I Eq. (15) is the modi…ed golden rule: the level of capital does
not maximize steady stated consumption, as with the golden
rule, because future consumption is discounted at rate ρ
I The steady state level of capital decreases with the discount
rate ρ
I The steady steady state saving rate δk /f (k ) decreases with
ρ
I Is this solution socially e¢ cient ??
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2. The competitive equilibrium
2.6. Transitional dynamics
k̇ (t ) = f (k (t )) δk (t ) c (t )
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2. The competitive equilibrium
2.6. Transitional dynamics
ċ (t ) 1
= [f 0 (k (t )) δ ρ]
c (t ) σ(c (t ))
implies that 8
< ċ (t ) > 0 if k (t ) < k
ċ (t ) = 0 if k (t ) = k (16)
:
ċ (t ) < 0 if k (t ) > k
I These properties are displayed in the next …gure
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2. The competitive equilibrium
2.6. Transitional dynamics
k* k
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2. The competitive equilibrium
2.6. Transitional dynamics
I Eq. (11),
k̇ (t ) = f (k (t )) δk (t ) c (t )
implies that
8
< k̇ (t ) > 0 if c (t ) < f (k (t )) δk (t )
k̇ (t ) = 0 if c (t ) = f (k (t )) δk (t ) (17)
:
k̇ (t ) < 0 if c (t ) > f (k (t )) δk (t )
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2. The competitive equilibrium
2.6. Transitional dynamics
kgold k
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2. The competitive equilibrium
2.6. Transitional dynamics
c*
k* k
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2. The competitive equilibrium
2.6. Transitional dynamics
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2. The competitive equilibrium
2.6. Transitional dynamics
c*
k* kgold k
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2. The competitive equilibrium
2.6. Transitional dynamics
du 0 (c (t ))/dt
=ρ r (t ) = ρ f 0 (k (t )) + δ > ρ
u 0 (c (t ))
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2. The competitive equilibrium
2.6. Transitional dynamics
K α (AL)1 α
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2. The competitive equilibrium
2.6. Transitional dynamics
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2. The competitive equilibrium
2.6. Transitional dynamics
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2. The competitive equilibrium
2.6. Transitional dynamics
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2. The competitive equilibrium
2.6. Transitional dynamics
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Concluding comments
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APPENDIX
A. The intertemporal budget constraint and the no-Ponzi game condition
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APPENDIX
A. The intertemporal budget constraint and the no-Ponzi game condition
a (T ) =
value of the assets at date T
Z T Z T
w (t ) exp r (x )dx dt
0 t
Value of the sum of incomes at date T
Z T Z T
c (t ) exp r (x )dx dt
0 t
Value of the sum of consumptions at date T
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APPENDIX
A. The intertemporal budget constraint and the no-Ponzi game condition
I Using the
h no-Ponzi game
Rt
condition,
i
limt !∞ a(t ) exp 0
r ( x ) dx = 0 we get eq (18).
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APPENDIX
B. Transversality condition and no-Ponzi game condition
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APPENDIX
B. Transversality condition and no-Ponzi game condition
∂H (t )
I The necessary condition = r (t ) µ (t ) = µ̇(t ) implies
∂a (t )
Z t
µ(t ) = µ(0) exp r (x )dx
0
∂H (t )
I The necessary condition ∂c (t )
= u 0 (c (t ))e ρt µ (t ) = 0
yieds Z t
µ(t ) = u 0 (c (0)) exp r (x )dx
0
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APPENDIX
B. Transversality condition and no-Ponzi game condition
I Substituting
Z t
µ(t ) = u 0 (c (0)) exp r (x )dx
0
yields
Z t
0
lim a(t )u (c (0)) exp r (x )dx =0
t !∞ 0
1+r 0
u 0 ( c0 ) = u ( c1 )
1+ρ
I In continuous time, the Keynes-Ramsey is
ċ (t ) u 0 (c (t ))
= [r (t ) ρ]
c (t ) u 00 (c (t ))c (t )
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APPENDIX
C. Keynes-Ramsey rule in discrete time and in continuous time
u 0 (c (t + dt )) u 0 (c (t ))
u 00 (c (t )) =
c (t + dt ) c (t )
or
u 0 (c (t )) = u 0 (c (t + dt )) [c (t + dt ) c (t )] u 00 (c (t ))
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APPENDIX
C. Keynes-Ramsey rule in discrete time and in continuous time
we get
[c (t + dt ) c (t )]
u 00 (c (t )) = u 0 (c (t + dt ))(r ρ)
dt
which yields
ċ (t ) u 0 (c (t ))
= [r (t ) ρ]
c (t ) u 00 (c (t ))c (t )
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