MSc in Economics for Development

Macroeconomics for Development

Week 6 Class

Sam Wills
Department of Economics, University of Oxford
[email protected]
Consultation hours: Friday, 2-3pm, Weeks 1,3-8 (MT)
15 November 2011

Macro for Development Class 6 1

References:

• Romer, D., 2001, Advanced Macroeconomics, McGraw-Hill Higher

Education
– Chapter 2, especially 2.3, 2.6, 2.7
– Focus on phase diagrams rather than log-linearisation

• Heijdra, B. J., Van der Ploeg, F., 2002, Foundations of Modern

Macroeconomics, OUP, Ch 14.5
– Alternative treatment

• Macro Class 2:
– Phase Diagrams and Dynamic Systems

Macro for Development Class 6 2

Overview: the Ramsey model

• The Ramsey model’s key characteristic is an endogenous savings rate

• It can be summarised in 2 dynamic equations and represented in a phase
diagram
• The dynamics of c are derived from optimising household behaviour, and
those of k are defined
• The phase diagram can be constructed using the stationary locii of c and k
• At the steady state the economy is on the balanced growth path, though
consumption is not maximised in perpetuity
• Away from the steady state, consumption is chosen to move to the stable
saddle path
• If we start at the steady state, then we can analyse the dynamics associated
with shocks to the economy
1. Fall in the discount rate
2. Permanent increase in Government spending
3. Temporary increase in Government spending

Macro for Development Class 6 3

FROM CLASS 2: “The Solow-Swan model was discussed in the
lecture. There have been a wide range of extensions to it.”
Solow-Swan Limitation Extension

• Endogenise savings/consumption (Ramsey, 1928): This Class

• Using technological change (Lucas, 1988)
1. Constant savings rate • Using capital accumulation (Jones and Manuelli, 1990)

• Include human capital:

2. Omitted factors esp.
• As schooling (Mankiw, Romer, Weil)
human capital (“Lucas
• As knowledge (Romer, 1986)
Paradox”, Lucas, AER,
• Y=AK model (Romer, 1986)
1990)
• As skill (Lucas, 1988)
• As learning by doing (Young, 1999) Class 2
•Endogenise technical change:
• Using R&D (Romer, 1990)
3. Exogenous technical
• Using Schumpeterian competition (Grossman and Helpman, 1991)
change
• Using both R&D and Schumpeterian competition (Aghion and Howitt, 1992)

4. Aggregation • Develop non-aggregate theory (Solow, 2005)

production function
assumes optimal
resource allocation
across economy
Macro for Development Class 2 4
Summary of the Ramsey-Cass-Koopmans model

The Ramsey model’s key characteristic is an endogenous savings rate

• Endogenous savings rate
• Perfectly competitive firms rent capital and employ labour owned by households (GE)
•No market imperfections
•Households are infinitely lived
The Ramsey Model can be summarised in two
...which can be illustrated in a phase diagram
dynamic equations

Dynamics of Consumption (c) c  0

c
c ( t ) f ' ( k ( t ))     g
ρ discount rate
 θ 1/IES
c (t ) 
g tech. growth
• Derived from maximising
consumer (choice variable)
Dynamics of Capital (k)

k ( t )  f ( k ( t ))  c ( t )  ( n  g ) k ( t )

•Defined as the difference between actual k  0

investment and break-even investment (state
variable) k
Macro for Development Class 6 5
To derive the dynamics of consumption we consider how
households optimally choose their level of c
Household behaviour is summarised by maximising the Lagrangian
max utility subject to budget constraint (lifetime wages > consump.)

see Romer
maxc eqn 2.16
B adjustment for units of effective labour θ 1/IES (intertemporal elasticity of substitution)
B = A(0)1 – θL(0)/H g technology growth
β discount factor: R(t) real interest rate between time 0 and t
β = ρ – n – (1 – θ)g > 0 w wages per unit effective labour
ρ discount rate c consumption per unit effective labour
n population growth k(0) initial capital
This gives the first-order conditions

Rearranging (i), taking logs (ii) and differentiating (iii) gives the equation of motion for consumption (the Euler Eqn)

i)

ii)
Euler Equation
iii)
Macro for Development Class 6 6
The phase diagram can be constructed with reference to the
stationary locii for c and k

Stationary locus for c Phase diagram for c and k

c  0
c
c ( t ) f ' ( k ( t ))     g
 c  0
c (t )  c
c  0 c  0
0

k
E
Stationary locus for k

c
k  0
k  0
k ( t )  f ( k ( t ))  c ( t )  ( n  g ) k ( t )
0 k

k  0
k  0

Macro for Development Class 6 7

At the steady state the economy is on the balanced growth path,
though consumption is not maximised in perpetuity

The steady state is at the The steady state levels of consumption and capital do not
intersection of the stationary locii maximise consumption in perpetuity
• On the k stationary locus, c is highest when f’(k)=n+g, known
c  0 as the “golden rule” level of capital k=kgr
c
• The steady state level of capital is below this, k*<kgr, as:
• f’(k*)=ρ+θ g
• f’(kgr) = n+g
and
E’ • β = ρ – n – (1 – θ)g > 0
E
•This prevents lifetime utility from diverging as the
contribution of technology growth to utility
outweighs the reduction in utility due to
preferences (ρ)and population growth (n)
k  0 • Intuitively:
• E<E’ because consumers discount the future and so
k* kgr k prefer to consume some more now, reducing future k.
• E (not >) E’ as could consume more now and in future
c ( t )  0 : f ' ( k ( t ))     g
k ( t )  0 : c(t)  f ( k ( t ))  ( n  g ) k ( t ) • At the steady state E the savings rate is constant and C grows
at rate n+g (as in Solow model). Technology still drives growth.
Macro for Development Class 6 8
Away from the steady state, consumption is chosen to move to
the stable saddle path

For a given level of capital, consumption Formally this is done by applying budget constraints to
is chosen to lie on the stable saddle path the path of consumption
• Given an initial value of capital k(0), the corresponding
initial value of c must be chosen
c  0
c
•All options (A, B, C,D) satisfy at each point in time
c ( t ) f ' ( k ( t ))     g

c (t ) 
k ( t )  f ( k ( t ))  c ( t )  ( n  g ) k ( t )

•However, the consumer is also subject to the budget

E
constraint:

B expressed as “no Ponzi game”  R(s) (n g )s

lim e e k (s)  0
transversality condition: s 

C k  0 • Above C: consuming capital which eventually becomes

D
negative
k(0) k • Below C: k(s) rises and R(s) falls causing the
transversality condition to diverge to infinity
Macro for Development Class 6 9
If we start at the steady state, then we can analyse the dynamics
associated with shocks to the economy
c  0
c

1. Fall in the E E’

discount rate
k  0

k*OLD k*NEW k

c  0
c

a. Permanent increase E
’

k  0

2. Increase in k

government c
c  0

spending E

B A
b. Temporary increase E’

k  0

k
Macro for Development Class 6 10
Shocks to the economy:
1. Fall in the discount rate

Before the shock the economy After the shock consumption jumps immediately on
is at the original steady state to the new saddle path

c  0 c  0
c c c
cE’
cE
t
E E’
E

k
kE’
k  0 k  0
kE
k*OLD k k*OLD k*NEW k t

c ( t ) f ' ( k ( t ))     g
 • Consumers care more about future consumption, so
c (t ) 
save more in the present
k ( t )  f ( k ( t ))  c ( t )  ( n  g ) k ( t )

Macro for Development Class 6 11

Shocks to the economy:
2a. Permanent increase in government spending

Before the shock the economy After the shock consumption jumps immediately to
is at the original steady state the new level of equilibrium consumption

c  0 c  0
c c c
E E
cE
t
cE’

E’
k
k  0 k  0
kE
k k t

c ( t ) f ' ( k ( t ))     g
adding
 gov’t • Government consumption reduces the amount
c (t ) 
available to consumers if maintaining the same level of
k ( t )  f ( k ( t ))  c ( t )  G ( t )  ( n  g ) k ( t ) capital

Macro for Development Class 6 12

Shocks to the economy:
2b. Temporary increase in government spending
A temporary increase in government spending induces dynamics both The fall in private c is smoothed by
during and after the shock consuming capital

c  0
c Whilst G is temporarily higher

E • Increase in government spending shifts

the stationary k locus down for the duration
A of the shock c
•Consumption adjusts immediately, but not
E’ all the way to the temporary equilibrium E’
(as there is perfect foresight on when the cE
t
k  0
shock ends) cE’
•Capital starts to be consumed...
k
c  0
c When G returns to original levels k

E •The consumer has consumed with perfect kE

foresight the exact amount of capital t
B A needed to be on the saddle path when G
falls again
E’ •As the economy is on the stable saddle
path it returns to the initial equilibrium
k  0

k
Macro for Development Class 6 13
Summary: the Ramsey model

• The Ramsey model’s key characteristic is an endogenous savings rate

• It can be summarised in 2 dynamic equations and represented in a phase
diagram
• The dynamics of c are derived from optimising household behaviour, and
those of k are defined
• The phase diagram can be constructed using the stationary locii of c and k
• At the steady state the economy is on the balanced growth path, though
consumption is not maximised in perpetuity
• Away from the steady state, consumption is chosen to move to the stable
saddle path
• If we start at the steady state, then we can analyse the dynamics associated
with shocks to the economy
1. Fall in the discount rate
2. Permanent increase in Government spending
3. Temporary increase in Government spending

Macro for Development Class 6 14