Macroeconomics Toolbox:

concepts, techniques, applications

Thomas Steger

Leipzig University, Institute for Theoretical Economics j Macroeconomics

Script is preliminary and permanently under construction.

Comments and suggestions are very welcome: [email protected]

May 4, 2017

Contents
1 Introduction 3

2 Dynamic Optimization 8
2.1 Method of Lagrange Multipliers . . . . . . . . . . . . . . . . . . . . . . 8
2.1.1 Simple example . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
2.1.2 Standard dynamic problem . . . . . . . . . . . . . . . . . . . . . 9
2.1.3 Application: Investment under capital adjustment costs . . . . . 11
2.2 Dynamic Programming . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.2.1 Simple example . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.2.2 More general treatment . . . . . . . . . . . . . . . . . . . . . . . 18
2.3 Control Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2.3.1 Method of Lagrange Multipliers - static problems . . . . . . . . 21
2.3.2 Maximum Principle . . . . . . . . . . . . . . . . . . . . . . . . . 23

0
 2.4 Application (1): Education à la Lucas . . . . . . . . . . . . . . . . . . . 27
2.5 Application (2): TVC in the Ramsey model . . . . . . . . . . . . . . . 29
2.6 Digression: No-Ponzi-game condition . . . . . . . . . . . . . . . . . . . 31

3 Dynamic systems 33
3.1 Di¤erential equations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
3.1.1 First-order, linear di¤erential equations (constant coe¢ cient and
term) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
3.1.2 Second-order, linear di¤erential equations (constant coe¢ cient
and term) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
3.1.3 Two-dimensional, linear di¤erential equation system . . . . . . . 38
3.2 Di¤erence equations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
3.2.1 First-order, linear di¤erence equation (constant coe¢ cient and
term) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
3.2.2 Second-order, linear di¤erence equation (constant coe¢ cient and
term) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
3.2.3 Two-dimensional system of linear di¤erence equations . . . . . . 45
3.3 Linearization techniques . . . . . . . . . . . . . . . . . . . . . . . . . . 46
3.3.1 First-order Taylor series approximation . . . . . . . . . . . . . . 46
3.3.2 Proportional deviations from steady state . . . . . . . . . . . . 48
3.3.3 Application 1: Solow model - speed of convergence . . . . . . . 49
3.3.4 Application 2: PDV of wage income . . . . . . . . . . . . . . . . 50
3.3.5 Application 3: Ramsey model - determining c(0) . . . . . . . . . 51
3.3.6 Application 4: Solow model - internal rate of return . . . . . . . 52
3.4 Miscellaneous . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
3.4.1 First-order, linear di¤erential equations - variable coe¢ cients and
variable term . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
3.4.2 Application 1: Wealth in a small open economy . . . . . . . . . 56
3.4.3 Application 2: Asset prices . . . . . . . . . . . . . . . . . . . . . 57
3.4.4 Normalization of variables . . . . . . . . . . . . . . . . . . . . . 60

1
4 Production and Technology 62
4.1 Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
4.2 General technology (non-parametric) . . . . . . . . . . . . . . . . . . . 63
4.2.1 Homogenous functions . . . . . . . . . . . . . . . . . . . . . . . 63
4.2.2 Euler’s theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
4.2.3 Intensive form and competitive factor prices . . . . . . . . . . . 64
4.2.4 Elasticity of substitution . . . . . . . . . . . . . . . . . . . . . . 65
4.3 Parametric technology: Cobb-Douglas . . . . . . . . . . . . . . . . . . . 66
4.3.1 Properties and implications . . . . . . . . . . . . . . . . . . . . 67
4.4 Parametric technology: CES . . . . . . . . . . . . . . . . . . . . . . . . 69
4.4.1 Properties and implications . . . . . . . . . . . . . . . . . . . . 70
4.4.2 Complementarity: clari…cation on terminology . . . . . . . . . . 73
4.4.3 Application: competitive CES sector . . . . . . . . . . . . . . . 74
4.5 Two methodological issues . . . . . . . . . . . . . . . . . . . . . . . . . 76

5 Utility and Welfare 78

5.1 CIES / CRRA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
5.2 Other utility functions . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
5.3 Welfare - discrete vs. continuous time . . . . . . . . . . . . . . . . . . . 79
5.4 Intertemporal elasticity of substitution . . . . . . . . . . . . . . . . . . 81
5.5 Welfare in the steady state . . . . . . . . . . . . . . . . . . . . . . . . . 83
5.6 Consumption-equivalent change in welfare . . . . . . . . . . . . . . . . 84
5.7 Welfare gain of TFP growth: simplest case . . . . . . . . . . . . . . . 87

6 Appendix: Notes on the literature 88

6.1 Dynamic optimization . . . . . . . . . . . . . . . . . . . . . . . . . . 88
6.2 Dynamic systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
6.3 Numerical solution: simulation of transitional dynamics . . . . 89
6.4 Stochastic growth . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90

2
1 Introduction
The Macroeconomics Toolbox accompanies the course Advanced Macroeconomics at
Leipzig University. It provides a concise summary of those concepts and techniques
that are required to study topics such as: (i) Consumption and Savings: Dynasties and
OLG, (ii) Endogenous Growth, (iii) Investment under Capital Adjustment Costs, (iv)
Real Business Cycles, (v) Price Rigidities: New Keynesians, (vi) Budget De…cits and
Fiscal Policy, (vii) Money and the Financial Sector.
This introduction reviews some important methodological concepts. To start with,
consider a set of well-known methodological statements regarding the use of (economic)
theory.

"The art of successful theorizing is to make the inevitable simplifying assumptions in

such a way that the …nal results are not very sensitive." Robert Solow (1956, p. 65)

Everything should be made as simple as possible, but no simpler. Albert Einstein

(1934)

A map on the scale of one to one would be useless. Joan Robinson (Robinson, 1962,
p. 33).

We prefer simpler theories to more complex ones because their empirical content is
greater, and because they are better testable. In other words, a simple theory applies
to more cases than a more complex one, and is thus more easily falsi…able. Karl Popper
(1992)

Simplifying assumptions. The quotations above all make the following point: If
(economic) theory should be instructive, we need to make use of simplifying assump-
tions. Simplifying assumptions reduce the complexity of the real world and allow us
to learn something about, say, the basic mechanisms which give rise to empirically
observed correlations.

3
 Figure 1: Simplifying assumptions

It is important to distinguish between those simplifying assumptions that are critical

with respect to the major implications of the model under study and those that are
not critical. As economic theorizing proceeds, critical simplifying assumptions should
be relaxed to overcome a state of oversimpli…cation.

Parsimonious modelling. Starting from speci…c research questions, we employ

parsimonious models throughout. For instance, the employed utility functions do usu-
ally not contain all the arguments that have been shown to impact on individual happi-
ness in empirical studies, like individual consumption, leisure time, number of friends,
quality of environment, consumption relative to average consumption of the reference
group. Utility functions in standard macroeconomic models either capture consump-
c1
tion (c) only - such as u(c) = 1
- in the growth context or leisure (l) in addition to
c1
consumption - such as u(c) = 1
+ b ln(1 l) - in the business cycle context. If, for
instance, the research question focuses on economic growth and environmental dam-
age, then environmental quality should be captured in addition to consumption (e.g.
Acemoglu et al., 2012).

Representative agent paradigm. Real world economies are populated by house-

holds and …rms which di¤er along several dimensions. For instance, households may

4
di¤er with respect to preferences and incomes. Firms may di¤er with respect to produc-
tion technologies. Building macroeconomic models which capture these heterogeneities
becomes complicated, if not impossible. Fortunately, there is a modeling trick to avoid
these complications.
To illustrate, let us focus on goods demand. Assume that there are, say, 100 con-
sumers (indexed by i 2 f1; :::; 100g) who may di¤er with respect to income (yi ). Ag-
gregate goods demand then results from the aggregation over individual goods demand
P100
schedules denoted as xi (p; yi ), i.e. i=1 xi (p; yi ). However, the same goods demand

function may result from the optimization problem of 100 identical households, i.e.
100 x(p; y), where x(p; y) is the demanded quantity of good x at price p and income
y. If this is the case and if we are interested in aggregated outcomes, then we can
obviously simplify the analysis by assuming that the model economy is populated by a
large number (100 in the example above) of identical households, which is labelled the
representative household (cf. Mas-Colell, Whinston and Green, 1995, Chapter 4D).
The following quote (Acemoglu, 2009, pp. 149/150) may be further instructive:

An economy admits a representative household when the preferences (demand) side

of the economy can be represented as if there were a single household making the ag-
gregate consumption and saving decision subject to a budget constraint. The major
convenience of the representative household assumption is that rather than modeling
the preference side of the economy as resulting from equilibrium interactions of many
heterogenous households, it allows us to model it as a solution to a single maximization
problem. Note that this description is purely positive - it asks the question of whether
the aggregate behavior can be represented as if it were generated by a single household.
A stronger notion, the normative representative household, would also allow us to use
the representative household’s utility function for welfare comparisons.

It is clear that all phenomena which are essentially based on interpersonal hetero-
geneity (e.g. distributional aspects) cannot be analyzed within this framework. The
representative agent model is used instead to analyze central macroeconomic phenom-
ena such as intertemporal consumption decisions, capital accumulation, and growth.

5
 Heterogeneous agent economy. Caselli and Ventura (2000) consider the follow-
ing Ramsey model (stated below in the form of the dynamic optimization problem of
households):

Z 1 1
cj (t) + j g(t) 1 t
max e dt (1)
fcj (t)g 0 1
s.t. a_ j (t) = r(t)aj (t) + w(t)hj (t) cj (t); aj (0) = given,

where cj (t) denotes consumption of agent j at time t, aj (t) …nancial wealth of agent
j, hj (t) the amount of human capital of agent j, r(t) the real interest rate, w(t) the
wage rate per unit of human capital, j an agent speci…c taste parameter, g(t) a public
good, and ; > 0 constant preference parameters, respectively. Caselli and Ventura
(2000, p. 912) state that

This economy admits a representative consumer, in the usual sense that the sum of
all consumers behave exactly as if the economy contained a single consumer with the
average asset holdings, skills, and taste parameters.

Mass one of identical agents. Often we employ the simplifying assumption that
the economy is populated by a "large number" of representative agents (households,
…rms or consumer-producer households). As an example, consider an economy with N
identical …nal output …rms. Every …rm is indexed by i 2 f1; :::; N g. The …rm index i
represents a discrete variable (i 2 N). Let xi denote output of …rm i. Total output is
P
then given by X = N i=1 xi . Since all …rms are completely identical, it is plausible to

assume that, in equilibrium, every …rm produces the same amount, i.e. xi = x for all
i 2 f1; :::; N g. Total output may then be expressed as X = N x.
A widely employed ’modeling trick’ is as follows. Assume that …rms are indexed
by i 2 [0; ::; 1]. The …rm index i now represents a continuous variable (i 2 R+ ). This
assumption is often expressed by phrases like "there is mass one of identical …rms"
or "there is a continuum of length one of identical …rms". Let x(i) denote output of
R1
…rm i. Total output is then given by X = i=0 x(i)di . Since all …rms are alike, we

6
can assume that x(i) = x for all i 2 [0; ::; 1]. Aggregate output is then given by X =
R1
i=0
x(i)di = 1x. Hence, individual quantities coincide with aggregate quantities.

Walrasian equilibrium. Consider an endowment economy which comprises m

agents and n goods. Every agent j 2 f1; :::; mg is endowed with the amount eji of
good i 2 f1; :::; ng and can purchase any of the n goods. The demand of agent j for
good i is denoted as dji (p1 ; :::; pn ). Overall expenditures of every agent must satisfy
Pn j Pn j
i=1 p i di (p 1 ; :::; p n ) i=1 pi ei . From elementary microeconomics it is known that

demand functions are homogeneous of degree zero, i.e. dji ( p1 ; :::; pn ) = dji (p1 ; :::; pn )
for all 0.
A Walrasian equilibrium (general equilibrium) is de…ned as a price vector (p1 ; :::; pn )
that satis…es the following set of n market clearing equations

X
m X
m
dji (p1 ; :::; pn ) = eji 8 i 2 f1; :::; ng: (2)
j=1 j=1

There are n unknowns (p1 ; :::; pn ) and n equations. The system does not, however,
exhibit a unique solution. It is easily shown that if a solution exists, then there is
a multiplicity of solutions. Assume that (~
p1 ; :::; p~n ) satis…es the system of equations
given by (2). By the property of homogeneity of degree zero, one can multiply this
price vector by any positive constant ( p~1 ; :::; p~n ) such that real goods demand dji (:)
doesn’t change. Hence the price vector ( p~1 ; :::; p~n ) does equally satisfy the above
stated set of market clearing conditions.
Notice that this implies that the n prices (p1 ; :::; pn ) are indetermined, but all ratios
1
of any two prices are determined. For instance, if one sets = pn
, one receives a
solution vector of relative prices ( ppn1 ; :::; 1). One usually states that only the set of
relative prices is determined in general equilibrium. To determine the set of absolute
prices, we can set one of the n prices equal to a constant. Let’s choose pn = 1. Then all
prices are denominated in terms of the numeraire good, which is good n if we choose
pn = 1. In the real world the numeraire good is called ’money’(McKenzie, 2008).

7
2 Dynamic Optimization
Dynamic optimization plays a prominent role in macroeconomic theory. Examples
comprise the determination of an optimal consumption plan (Ramsey model, Diamond
model, Auerbach-Kotliko¤ model) and the determination of an optimal investment
plan (neoclassical …rm under capital adjustment costs). There are three standard ap-
proaches to solve dynamic optimization problems: (i) method of Lagrange multipliers,
(ii) dynamic programming and (iii) maximum principle.

2.1 Method of Lagrange Multipliers

2.1.1 Simple example

Consider the problem of maximizing an intertemporal objective function extending

over three periods (t = 0; 1; 2)

X
2
0 1 2
max u(c0 ) + u(c1 ) + u(c2 ) (3)
fc0 ;c1 ;c2 ;s0 ;s1 g
t=0
s.t. w0 = s0 + c0 (4)

w1 + (1 + r)s0 = s1 + c1 (5)

(1 + r)s1 = c2 (6)

where ct denotes consumption at period t 2 f0; 1; 2g, st savings, wt the wage rate,
0 < < 1 the discount factor, and r the constant interest rate. The problem is to
maximize the objective function (3) with respect to c0 , c1 , c2 , s0 , s1 subject to the
constraints (4), (5), (6). We focus on interior solutions. This problem can be solved
by the method of Lagrange multipliers. The corresponding (present-value) Lagrangian
function reads

0 1 2
L : = u(c0 ) + u(c1 ) + u(c2 )

+ 0 [w0 s0 c0 ] + 1 [w1 + (1 + r)s0 s1 c1 ] + 2 [(1 + r)s1 c2 ] ,

8
where ( 0 , 1, 2) denote present-value shadow prices. Di¤erentiating L w.r.t. the
unknowns yields

@L 0 0
= u (c0 ) 0 =0
@c0
@L 1 0
= u (c1 ) 1 =0
@c1
@L 2 0
= u (c2 ) 2 =0
@c2
@L
= 0 + 1 (1 + r) = 0
@s0
@L
= 1 + 2 (1 + r) = 0
@s1

This set of FOCs, together with (4), (5), (6), determines c0 , c1 , c2 , s0 , s1 , 0, 1,

and 2. Hence, there are 8 unknowns and 8 equations. Solving the set of equations
yields the optimal time path of consumption fc0 ; c1 ; c2 g and savings decisions fs0 ; s1 g.
Notice that the last static constraint (6) requires that entire wealth in the last period
is to be consumed.

2.1.2 Standard dynamic problem

Consider now the following stochastic optimization problem1

" #
X
1
t
maxE0 u(ct ) (7)
fct g
t=0
s.t. xt+1 = f (xt ; ct ) + "t+1 with x0 = given (8)
t
1
xt 0 or lim xt 0 (9)
t!1 1+r

where E0 denotes the expected value given the information at time 0 and "t an i.i.d.
random variable with E("t ) = 0 and V ("t ) = ". Notice that either the constraint
xt 0 (economy without credit market) or the No-Ponzi-Game Condition (NPGC)
1 t
limt!1 1+r
xt 0 (economy with credit market) are assumed to hold.
At t = 0 the agent decides on c0 , taking x0 as given. The unknowns at this stage
1
This section closely follows Chow (1997, Chapter 2) and Heer and Mauß
ner (2009, Chapter 1.3.2).

9
are c0 and x1 . The associated Lagrangian function reads2
(1 )
X X
1
t t
L := E0 u(ct ) t [xt+1 f (xt ; ct ) "t+1 ]
t=0 t=0

Let us now write the relevant parts of the Lagrangian to read

0 1 0 1
L = E0 u(c0 ) + u(c1 ) 0 [x1 f (x0 ; c0 ) "1 ] 1 [x2 f (x1 ; c1 ) "2 ] + :::

@L @L
The FOCs @c0
= 0 and @x1
= 0 read as follows

@L @f (x0 ; c0 )
= E0 fu0 (c0 ) + 0 g=0
@c0 @c0

@L 0 1 @f (x1 ; c1 )
= E0 f 0 + 1 g=0
@x1 @x1
At t = 1 the agent decides on c1 , taking x1 as given. The unknowns at this stage
are c1 and x2 . The Lagrangian function for this problem is given by

X
1 X
1
t 1 t 1
L := E1 f u(ct ) t [xt+1 f (xt ; ct ) "t+1 ]g
t=1 t=1

Let us write the relevant parts of the Lagrangian to read

0 1 0 1
L = E1 f u(c1 ) + u(c2 ) 1 [x2 f (x1 ; c1 ) "2 ] 2 [x3 f (x2 ; c2 ) "3 ] + :::g

@L @L
The FOCs @c1
= 0 and @x2
= 0 read as follows

@L @f (x1 ; c1 )
= E1 fu0 (c1 ) + 1 g=0
@c1 @c1
2
The de…nition of L di¤ers from Chow (1997, Chapter 2), where it reads (the above is, however,
in line with our RBC examples in lecture notes):
(1 1
)
X X
t t+1
L := E0 u(ct ) t+1 [xt+1 f (xt ; ct ) "t+1 ]
t=0 t=0

This does not make a di¤erence! It merely means a relabeling of shadow prices (number of shadow
prices remains the same, de…nition of shadow prices changes).

10
 @L 1 @f (x2 ; c2 )
= E1 f 1 + 2 g=0
@x2 @x2
In general at period t, the FOCs may be expressed as follows

@f (xt ; ct )
Et fu0 (ct ) + t g=0 (10)
@ct

t @f (xt+1 ; ct+1 )
Et f t + t+1 g=0 (11)
@xt+1
In addition, the dynamic constraint xt+1 = f (xt ; ct ) + "t+1 and the transversality
t
condition (TVC) limt!1 Et ( t xt ) = 0 belong to the set of FOCs. Notice that this
solution strategy does not amount to choose {c0 ; c1 ; c2 ; :::} all at once in an open loop
policy, rather ct is chosen sequentially given the information xt at time t an a closed-
loop policy. Because xt is in the information set when ct is to be determined, the
expectations in (10) and (11) are Et and not E0 .

2.1.3 Application: Investment under capital adjustment costs

Setup Consider a …rm that produces a homogenous …nal output good Yt under perfect
competition. The output technology reads

Yt = A (Kt ) (Lt )1

where Kt is the amount of capital at time t 2 f0; 1; :::g, Lt the amount of labor,
and A > 0, 0 < < 1. The …rm’s planning horizon is in…nity. Expanding the stock of
capital is subject to investment costs (capital adjustment costs). Installing the amount
of It additional capital goods (gross investment) requires

It
ICt = It 1 + (12)
Kt

with 0 and 1 units of …nal output. Notice that the usual assumption is =0

11
(standard Ramsey model). Let

CFt = Yt wt Lt ICt (13)

denote the …rm’s cash ‡ow (or the capitalist’s / entrepreneur’s residual income). We
assume that the …rm maximizes the PDV of cash ‡ow, i.e.

X
1
1
t
max CFt (14)
fIt ;Lt g
t=0
1+r
s.t. Kt+1 = It + (1 )Kt ; (12) ; (13); K0 = given

where wt denotes the wage rate, r the …xed interest rate, and 0 the capital
depreciation rate.

Assignment: Determine the …rm’s investment demand (i.e. the demand for …nal
output devoted to capital investment).

Remark: The investment demand results from the solution of the above stated
dynamic optimization problem and will be a function It = It (qt ), where qt denotes the
shadow price of installed capital goods.

Solution The Lagrangian function and the associated …rst order conditions read
8 h i 9
X
1
1
t < A (Kt ) (Lt )1 wt Lt It 1 + It =
Kt
L=
t=0
1+r : +qt [It + (1 ) Kt Kt+1 ] ;

@L
= (1 )A (Kt ) (Lt ) wt = 0
@Lt

12
 1
@L It It 1
= 1+ It + qt = 0
@It Kt Kt Kt
It It
) 1 + qt = 0
Kt Kt
It
) 1 ( + 1) + qt = 0
Kt
1
qt 1
) It = Kt
( + 1)

@L
From @Kt+1
= 0 one gets

" #
+1
1 1 It+1
qt + A (Kt+1 ) (Lt+1 )1 + + qt+1 (1 ) = 0 (15)
1+r Kt+1

Reasoning for above stated qt+1 = f (qt ) (see also the lecture notes on RBC theory)

0
1 I0
L = A (K0 ) (L0 )1 w0 L0 I0 1 + + q0 (I0 + (1 ) K0 K1 )
1+r K0
1
1 I1
+ A (K1 ) (L1 )1 w1 L1 I1 1 + + q1 (I1 + (1 ) K1 K2 )
1+r K1
+:::

" #
1
@L 1 1 I1 I1
= q0 + A (K1 ) (L1 )1 I1 + q1 (1 ) =0
@K1 1+r K1 (K1 )2
" #
+1
1 1 I1
) q0 + A (K1 ) (L1 )1 + + q1 (1 ) =0
1+r K1

1
qt 1 Kt+1
Steady state From Kt+1 = ( +1)
Kt + (1 ) Kt and Kt
= 1 (steady state)
one gets the steady state value of qt to read

1
qt 1
1= + (1 ) ) q~ = ( + 1) + 1
( + 1)

1
qt 1
Notice that this implies that, by using It = ( +1)
Kt and q~ = ( + 1) + 1,

13
 I
the investment ratio K
in the steady state is

1
SS
I q~ 1
= =
K ( + 1)

Interesting observations: (i) In steady state q = 1 if = 0 and larger than one for
> 0. (ii) Steady state q does not depend on r and A. (iii) As investment technology
becomes more e¢ cient, i.e. falls, the long run value of installed capital declines.
These observations should be discussed.

Dynamic responses The following graph shows the dynamic responses of K, q and
I following a TFP shock of 10 percent, i.e. 0 = 0:1. It is assumed that TFP follows
At+1 = (At ) e t with t white noise. The case = 1 is distinguished from = 0:95.

Figure 2: The dynamic response of a permanent TFP shock

Implications In continuous time the solution for q(t) looks as follows3

Z 1
@Y @IC r( t)
q(t) = e d
t @K @K
3
This results from solving the continuous time analogue of (15) together with an appropriate
boundary condition.

14
 The total value of a …rm (shareholder value) is
Z 1
I r( t)
Vt = Y wL I 1+ e d
t K

If every unit of capital is securitized by one share, the share price is

qA K = V

The variable qA is called average q. The variable q(t) is called marginal q. It shows
by how much the value of a …rm increases when capital increases by one unit, i.e.

@V
q(t) =
@K

On the relation between qA and q see Hayashi (1982).

Merits of the capital-adjustment-cost model

1. It produces a self-contained investment demand schedule. (Think about invest-

ment in the standard neoclassical setup.) Investment turns out to be a function
of a forward-looking variable that captures expectations.

2. It allows us to think about capital mobility in an open economy. (Think about

capital mobility in the standard neoclassical setup.)

3. It allows us to think about the value of a …rm in a perfectly neoclassical setup.

(Think about the value of a …rm in the standard neoclassical setup.)

Extensions / assignments

1. Policy. The …rm’s cash ‡ow may be stated as follows

CFt = Yt wt Lt ICt [Yt wt Lt (1 + sK )ICt ]

= (1 ) [Yt wt Lt (1 s~K ) ICt ]

15
 where 0 < < 1 denotes a corporate income tax rate, 0 < sK < 1 an investment
sK
subsidy (design of …scal incentive: tax allowances), and s~K := 1
may be
labelled the behaviorally relevant subsidy rate.

2. TFP shocks. Assume that TFP At follows an AR(1) according to

At+1 = (At ) e t

where 0 < < 1 and "t white noise. (Figure 2 already captures this case.)

2.2 Dynamic Programming

We consider a deterministic dynamic problems. The solution procedure can be easily

adapted to solve stochastic dynamic problems.

2.2.1 Simple example

Consider an individual living for T > 0 periods. Intertemporal utility is given by4

X
T
t
U (c0 ; :::; cT ) = u(ct )
t=0

A consumer with wealth at time t 2 R of at and consumption of ct has wealth at

time t + 1 of
at+1 = (at ct )Rt

where Rt is the (probably stochastic) gross rate of return. The optimal consumption
plan {c0 ; c1 ; :::; cT } can be determined by backward induction.
At T 1 the individual has wealth aT 1 and the maximum utility may be described
as follows
VT 1 (aT 1 ) = maxfu(cT 1) + u((aT 1 c )R )g (16)
cT 1 | {zT 1 T }1
cT =aT

4
This example is taken from Varian (1992, Chapter 19.3).

16
The value function VT 1 (aT 1 ) shows an indirect utility, i.e. the maximum attainable
utility given wealth aT 1. The FOC for the problem on the RHS is

u0 (cT 1) = u0 ((aT 1 cT 1 )RT 1 )RT 1 =) cT 1 = cT 1 (aT 1 )

Substituting cT 1 = cT 1 (aT 1 ) back into (16) gives VT 1 = VT 1 (aT 1 ). Figure 2

illustrates the decision problem at the last but one period.

Figure 3: Optimal consumption at T 1

At T 2 we have aT 1 = (aT 2 cT 2 )RT 2 . Hence the consumer’s maximization

problem at T 2 may be expressed as

VT 2 (aT 2 ) = maxfu(cT 2) + VT 1 ((aT 2 c )R )g (17)

cT 2 | {zT 2 T }2
aT 1

This is just like (16) but with "second-period" utility replaced by indirect utility
VT 1 (aT 1 ); this equation is often referred to as the Bellman equation. The FOC
for the problem on the RHS is

u0 (cT 2) = VT0 1 ((aT 2 cT 2 )RT 2 )RT 2 =) cT 2 = cT 2 (aT 2 )

Substituting cT 2 = cT 2 (aT 2 ) back into (17) gives VT 2 = VT 2 (aT 2 ). Hence,

the entire sequence Vt = Vt (at ) for all t 2 f0; :::; T g can be traced out. Once we have

17
Vt = Vt (at ), optimal ct follows from the …rst-order conditions u0 (ct ) = EVt+1
0
(at+1 )Rt .
Finally, the time path at for all t 2 f0; :::; T g results from at+1 = (at ct )Rt with a0
given.
As an illustration, consider an agent living for 11 periods who is endowed with
initial wealth a0 = 1. The subsequent …gure displays the time paths for wealth (at )
and consumption (ct ) assuming di¤erent constellations with regard to R and .

Figure 4: Time path of wealth (at ) and consumption (ct )

2.2.2 More general treatment

P1 t
Setup. Life-time utility of the in…nitely-lived agent is Ut = =t u(c ), where
0< < 1.5 The agent wishes to choose c for all 2 ft; t + 1; :::; 1g such that Ut is
maximized, noting the dynamic budget constraint xt+1 = f (xt ; ct ), i.e.

max Ut s.t. xt+1 = f (xt ; ct ) (18)

fc g

The state variable xt cannot be controlled directly but is under indirect control
by choosing ct . An optimal program is a sequence fct ; ct+1 ; :::g that solves the above
stated problem. The value of an optimal program is denoted by

V (xt ) = max Ut s.t. xt+1 = f (xt ; ct )

fc g

5
This section closely follows Wälde (2010, Chapter 3.3).

18
 The value function V (xt ) shows the maximum level of life-time utility Ut given the
amount of the state variable xt .
Step #1: Bellman equation and FOCs. Since the objective function Ut is ad-
ditively separable, it may be written as Ut = u(ct ) + Ut+1 and hence the maximization
problem may be stated as

V (xt ) = maxfu(ct ) + V (xt+1 )g (19)

ct

s.t. xt+1 = f (xt ; ct ). Equ. (19) is known as the Bellman equation. In this equation,
the problem with potentially in…nitely many control variables was broken down into
many problems with one control variable. Notice that, compared to Ut = u(ct )+ Ut+1 ,
Ut+1 is replaced by V (xt+1 ). We assume that the optimal program for tomorrow is
solved and we worry about the maximization problem for today only.
The FOC for the problem on the RHS of (19), noting xt+1 = f (xt ; ct ), is

u0 (ct ) + V 0 (xt+1 )fc = 0 (20)

Increasing consumption ct has bene…ts and costs. The bene…t consist in higher
utility today, which is re‡ected by marginal utility u0 (ct ). The cost comes from lower
overall utility - the value function V (:) - tomorrow. The reduction in overall utility
amounts to the change in xt+1 , i.e. the derivative fc , times the marginal value of xt+1 ,
i.e. V 0 (xt+1 ). As the cost arises only tomorrow, this is discounted at rate .
Equ. (20), together with xt+1 = f (xt ; ct ), implicitly de…nes ct = ct (xt ). As we know
very little about the properties of V (:) at this stage, however, we need to go through
two further steps to eliminate V (:) from this FOC and obtain a condition that uses
only functions of which properties like signs of …rst and second derivatives are known.
Step #2: Evolution of costate variable. At …rst we set up the maximized
Bellman equation. This is obtained by replacing the control variable in the Bellman
equation by the optimal level of the control variable according to the FOC ct = ct (xt ),

19
which gives
V (xt ) = u(ct (xt )) + V [f (xt ; ct (xt ))]
| {z }
xt+1

The derivative w.r.t. xt yields

dct (xt ) dct (xt )

V 0 (xt ) = u0 (ct (xt )) + V 0 [f (xt ; ct (xt ))] fxt + fc
dxt dxt

Inserting the FOC u0 (ct ) = V 0 (xt+1 )fc gives

dct (xt ) dct (xt )

V 0 (xt ) = V 0 (xt+1 )fc + V 0 [f (xt ; ct (xt ))] fxt + fc
dxt dxt

V 0 (xt ) = V 0 (xt+1 )fxt (21)

This equation is a di¤erence equation in the costate variable, the derivative of the
value function w.r.t. the state variable, i.e. V 0 (xt ). The costate variable is also called
the shadow price of the state variable xt . It says how much an additional unit of the
state variable (e.g. wealth) is valued: As V (xt ) gives the value of optimal behavior
between t and the end of the planning horizon, V 0 (xt ) says by how much this value
changes when xt is changed marginally. Hence, equ. (21) describes how the shadow
price of the state variable changes over time when the agent behaves optimally.
u0 (ct 1 )
Step #3: Euler equation. Noting the FOC (20) one may write V 0 (xt ) = fc
u0 (ct )
and V 0 (xt+1 ) = fc
. Inserting into equ. (21) gives

u0 (ct 1 ) u0 (ct ) u0 (ct 1 )

= fxt =) = fxt (22)
fc fc u0 (ct )

This is the Euler equation. It represents a di¤erence equation in marginal utility,

which can be readily transformed into a di¤erence equation in ct . If, for instance, the
c1t 1 ct 1 1
utility function is u(ct ) = 1
one gets ct
= ( fxt ) . The dynamic evolution is
then determined by (22) together with xt+1 = f (xt ; ct ). Boundary conditions typically
are x0 = given and c1 = c~ with c~ the steady state value of ct .

20
2.3 Control Theory

2.3.1 Method of Lagrange Multipliers - static problems

As a preparation for the heuristic proof of the maximum principle, we repeat the
method of Lagrange multipliers.6 Consider the following constrained maximization
problem (equality constraint)

max F (x1 ; x2 ) subject to g(x1 ; x2 ) = b.

x1 ;x2

We assume that a local maximum exists at x = (x1 ; x2 ) and derive the conditions
that describe this solution. Totally di¤erentiating the constraint g(x1 ; x2 ) = b gives

@g @g
dg = dx1 + dx2 = 0,
@x1 @x2

which can be rearranged to yield (it is assumed that @g=@x2 6= 0)

dx2 @g=@x1
= .
dx1 @g=@x2

dh @g=@x1
This relation implies an equation of the form x2 = h(x1 ) with dx1
= @g=@x2
. Using
x2 = h(x1 ) one can now state the above constrained optimization problem in two
variables as an unconstrained optimization problem in one variable

max F (x1 ; h(x1 )).

x1

A FOC for a local maximum is

@F @F dh
+ = 0.
@x1 @x2 dx1
6
This section follows Intriligator (1971, Chapter 3.2)

21
 dh @g=@x1
Substituting dx1
by @g=@x2
gives

@F @F=@x2 @g
= 0. (23)
@x1 @g=@x2 @x1

Moreover, also the following relation holds true7

@F @F=@x2 @g
= 0. (24)
@x2 @g=@x2 @x2

@F=@x2
De…ning = @g=@x2
the FOC may be expressed as

@F @g
=0 8 i 2 f1; 2g. (25)
@xi @xi

Eliminating by taking ratios one obtains

@F=@x1 @g=@x1
= . (26)
@F=@x2 @g=@x2
This is the usual FOC for the initial constrained problem with two variables (the slope
of the contour of the objective function must equal the slope of the constraint).
Now, the set of necessary conditions (25) plus the original constraint g(x1 ; x2 ) = b
can be obtained as the conditions for a stationary point of the function

L = F (x1 ; x2 ) [b g(x1 ; x2 )] .

The conditions for a stationary point (i.e. a point where the gradient is zero) are
given by
@L @F @g
= = 0 8 i 2 f1; 2g
@xi @xi @xi
@L
=b g(x1 ; x2 ) = 0
@
The function L(:) is the Lagrangian function and the variable is known as La-
7 @F @F=@x1 @g @F=@x1 @F=@x2
By symmetry @x 2 @g=@x1 @x2 = 0. In addition, (23) can be expressed as @g=@x1 = @g=@x2 .
Substituting this into the preceding equation gives (24).

22
grange multiplier. Finally, it should be noted that the variable measures the sensi-
tivity of the optimal value of objective function F = F (x1 ; x2 ) to variations in the
@F
constant b, i.e. = @b
(proof: Intriligator, 1971, pp. 36-37).

2.3.2 Maximum Principle

Consider the following dynamic problem8

ZT
max J = I(x; u; t)dt + F (xT ; T )
fu(t)g
t0
s.t. x_ = f (x; u; t)

x(t0 ) = x0 ; x(T ) = xT ; u(t) 2 U (27)

where I(:), F (:), and f (:) are continuously di¤erentiable functions, x is an n-

dimensional vector of state variables and u an r-dimensional vector of control variables
(n R r). The control trajectory u(t) 8 t 2 [t0 ; T ] may be restricted to belong to a given
control set U and it must be a piecewise continuous function of time.
Let H(x; u; ;t) := I(x; u; t) + f (x; u; t) denote the (present-value) Hamiltonian
function, where (t) represents an n-dimensional (row) vector of costate variables. The
set of FOCs may then be stated as follows9

@H
=0 8 t 2 [t0 ; T ] (28)
@u

_ = @H
8 t 2 [t0 ; T ] (29)
@x
@F
(T ) = (30)
@xT
@H
plus x_ = f (x ; u ; t). @u
denotes a vector of partial derivatives of the Hamiltonian
w.r.t. u. The set of FOCs (28) describes, at each point in time t 2 [t0 ; T ], r equations.
8
This section follows Intriligator (1971, Chapter 14). More textbook treatments can be found
in Barro and Sala-i-Martin (2005), Gandolfo (1996, Chapter 22.1), Silberberg (1990, Chapter 18.2),
Feichtinger and Hartl (1986, Chapter 2), Chiang (1999, Chapter 7), Chiang and Wainwright (2005,
Chapter 20).
9
To simplify, it is assumed that the control trajectory u(t) is unconstrained.

23
The set of FOCs (29) and x_ = f (x ; u ; t) plus boundary conditions - x(t0 ) = x0
@F
and (T ) = @xT
- are called canonical equations. These constitute a system of 2n
di¤erential equations with n initial and n boundary conditions.10

Heuristic proof. Notice at …rst that the Maximum Principle can be considered an
extension of the Method of Lagrange Multipliers to dynamic problems. The expression
to be maximized is the objective functional, as stated in problem (27),

ZT
J= I(x; u; t)dt + F (xT ; T )
t0

and the constraints are the n di¤erential equations

f (x; u; t) x_ = 0 8 t 2 [t0 ; T ] :

Recall that the Method of Lagrange Multipliers requires to set up the Lagrangian
function and then to determine the saddle point (maximizing w.r.t. choice variables
and minimizing w.r.t. the Lagrange multipliers) of this function.
Step #1. De…ne the Lagrangian function

ZT ZT
L = I(x; u; t)dt + F (xT ; T ) + [f (x; u; t) _ dt ,
x] (31)
t0 t0
| {z } | {z }
objective function
Lagrange multipliers times constraints

(= mass T t0 constraints)

ZT
= fI(x; u; t) + [f (x; u; t) _ dt + F (xT ; T )
x]g (32)
t0

where (t) = ( 1 (t); 2 (t); :::; n (t)) are called costate variables and represent the dy-
10
In some cases, e.g. the Ramsey model, the control variable(s) u can be eliminated from the
canonical system by employing @H
@u = 0. If this is impossible, the system under study constitutes a
di¤erential-algebraic system.

24
namic equivalent of Lagrange multipliers. Since the constraints and the costate vari-
ables are de…ned over time, the inner product (2nd term on the RHS of (31)) is properly
treated under the integral sign.
For future uses we reformulate the Lagrangian (32) as follows

ZT ZT
L= fI(x; u; t) + f (x; u; t)g dt _ + F (xT ; T )
xdt
t0 t0

RT RT
Noting _ = xjTt0
xdt _ xdt11 one may express the preceding equation as
t0 t0

2 3
ZT ZT
L = fI(x; u; t) + f (x; u; t)g dt 4 xjTt _ xdt5 + F (xT ; T )
0

t0 t0
ZT n o
= I(x; u; t) + f (x; u; t) + _ x dt [ (T )x(T ) (t0 )x(t0 )] + F (xT ; T(33)
):
t0
ZT n o
= H(x; u; ;t) + _ x dt [ (T )x(T ) (t0 )x(t0 )] + F (xT ; T ) , (34)
t0

where H(x; u; ;t) := I(x; u; t) + f (x; u; t) is called Hamiltonian function.

By analogy to the static case, a saddle point of the Lagrangian would yield the so-
lution. Here, however, the saddle point is in the space of functions, where (u (t); (t))
represent a saddle point if

L [u(t); (t)] L [u (t); (t)] L [u (t); (t)] .

Step #2. Consider the necessary conditions for a saddle point of (32). A change in
the costate variable trajectory from (t) to (t)+ (t), where (t) is any continuous
11
Rb Rb 0
Recall integration by parts: a f (x)g 0 (x)dx = f (x)g(x)jba a
f (x)g(x)dx. Form the total deriv-
ative of f (x)g(x) to get df (x)g(x) = f 0 (x)g(x)dx + f (x)g 0 (x)dx. Next form the (de…nite) integral
Rb Rb
between a and b, which gives: f (x)g(x)jba = a f 0 (x)g(x)dx + a f (x)g 0 (x)dx.

25
function of time, would change L(:) to

ZT
L= [f (x ; u ; t) x_ ] dt
t0

Hence, one set of necessary FOC, resulting from L = 0, reads as follows

x_ = f (x ; u ; t) (35)

Obtaining the equations of motions for x as one set of FOCs is completely analogous
to obtaining the constraints in the static problem.
Step #3. Now consider the e¤ect of a change in the control trajectory from u(t)
to u(t) + u(t), associated by a corresponding change in the state trajectory from x(t)
to x(t) + x(t). Considering (34) this yields

ZT
@H @H _ @F
L= u+ + x dt + (T ) xT (36)
@u @x @xT
t0

For a maximum it is necessary that L = 0 implying that (28), (29) and (30) must
hold. FOCs (28) state that the Hamiltonian is maximized by choice of controls at each
point in time (conditions for an interior solution). Notice also that FOCs (35) can also
be expressed in terms of the Hamiltonian

@H
x_ = 8 t 2 [t0 ; T ] : (37)
@

Comments

1. Su¢ ciency conditions. Provided that either the Hamiltonian is jointly concave
in the control and the state variable (Mangasarian su¢ ciency conditions) or that
the maximized Hamiltonian is concave in the state variable (Arrow su¢ ciency
conditions), the necessary conditions are also su¢ cient; see Kamien and Schwartz
(1981, part II section 3 and section 15).

26
 2. Costate variables. The costate variables have the following interpretation:
@J
@x(t0 )
= (t0 ). The (initial) costate variables give the change in the optimal
value of the objective functional due to changes in the corresponding initial state
variables. This is analogous to the interpretation of the static Langrange multi-
pliers.

3. Hamiltonian function. The (current-value) Hamiltonian, in the context of the

Ramsey model, can be viewed as net national product in utility terms (Solow,
2000, p. 127). It may be expressed as H = u(C) + I(C), where I(C) denotes
net investment. The shadow price has dimension "utility per unit of numeraire
good". One obvious FOC then reads @H
@C
= 0. The costate equation _ + @K
@H
=
represents a no-arbitrage condition (Solow, 2000, p. 160). The LHS shows the
(marginal) bene…t from devoting one unit of output to capital accumulation. This
@H
comprises an increase in "income in utility terms" @K
, accounting for a change
in the value of capital _ . The RHS gives the opportunity costs of devoting one
unit of output to investment rather than consumption. Notice that _ = @H
@K
R 1 @H t
(plus appropriate boundary condition) implies (0) = 0 @K e dt.

2.4 Application (1): Education à la Lucas

Setup. Consider an in…nitely lived agent who is endowed with one unit of time each
period and can accumulate human capital by devoting time 0 u 1 to education.
Let h denote the level of human capital and w the wage rate per unit of human capital
and period of time. Income net of education costs (forgone wages) is (1 u)wh. The
agent is assumed to maximize welfare
Z 1
c1 1 t
max e dt (38)
fug 0 1
s.t. c = (1 u)wh (39)

h_ = Au h h h; h(0) = given (40)

Optimal solution. The (current-value) Hamiltonian and the associated FOCs

27
read as
[(1 u)wh]1 1
H= + Au h hh
1
@H 1
= [(1 u)wh] ( wh) + Au h =0
@u

_ = @H 1
+ = [(1 u)wh] (1 u)w Au h h +
@h
Steady state. Employ the _ -equation to get

^= w 1
[(1 u)wh] (1 u) Au h h

w Au 1 h 1
Noting = [(1 u)wh]
gives

^ = Au 1 h 1 1
[(1 u)wh] (1 u) Au h h
[(1 u)wh]
1 1
= (1 u) Au h Au h 1 h .

Setting ^ = 0 yields and noting Au h 1

= h
^ = 0) yields
(from h

1 1
(1 u) Au
| {zh } h }1 +
|Au {z h =0
= h =u = h

1 u
h h + h =0
u
h
u~ = (41)
h + ( 1) h

The steady state h-level is

1

~= A~
u 1
h .
h

28
2.5 Application (2): TVC in the Ramsey model
@Y
Let the production technology be denoted by Y = F (K) = AK L1 and let YK := @K
.
The reduced-form dynamic system for the Ramsey model may then be expressed as:

C_ 1
= (YK )
C
K_ = Y K C

K(0) = K0 > 0
t
lim e (t)K(t) = 0 (TVC)
t!1

Fig. 5: Ramsey model - phase diagram

The phase diagram, shown in Fig. 5, illustrates that there are three steady states
(de…ned by K_ = C_ = 0):
n o
steady state 1: K~ 1 = 0; C~1 = 0

1
1
steady state 2: ~2 =
K A
L; C~2 = F K
~2 ~2
K
+

n 1
o
steady state 3: K~3 = A 1
L; C~3 = 0 .

~ 2 . Steady
Figure 5 displays also three trajectories, starting at some 0 < K0 < K
state 1 is unstable, steady state 2 is saddle-path stable, while steady state 3 is condi-

29
tionally stable, but economically not relevant. The reason for this irrelevance of steady
state 3 is that it violates the transversality condition (TVC), as will be shown in the
following. By making use of the FOC, =C , the TVC can be rewritten as

t K(t)
lim e = 0: (42)
t!1 C(t)

The TVC holds if, and only if, the expression under consideration has asymptotically
a negative growth rate, i.e.

h i
lim ^
+ K(t) ^
C(t) = ^
+ lim K(t) ^ < 0:
lim C(t) (43)
t!1 t!1 t!1

^
Therefore, we need to determine limt!1 K(t) ^
and limt!1 C(t), assuming that the
^
dynamic system converges to steady state 3. Consider limt!1 K(t) at …rst

^ = lim Y (t)
lim K
K(t)
lim
C(t)
= 0: (44)
t!1 t!1 K(t) t!1 K(t)

Notice that limt!1 Y (t) K(t)

K(t)
= 0 because C = Y K and limt!1 C(t) = C~3 = 0
C(t)
implies limt!1 [Y (t) K(t)] = 0. The second term, limt!1 K(t)
, vanishes also simply
because limt!1 C(t) = C~3 = 0. Turning to limt!1 C(t)
^ we have

^ = lim 1
lim C(t) (YK ) : (45)
t!1 t!1

With the help of (44) and (45) we can rewrite the TVC (43) to read

0> ^
+ lim K(t) ^
lim C(t) (46)
t!1 t!1
1
0> lim (YK ) (47)
t!1

0> lim [YK ]+ (48)

t!1

0> lim [YK ]: (49)

t!1

30
It can be easily shown that steady state 3 does indeed violate limt!1 [YK ] > 0. To
see this, notice that the K_ = 0 locus is given by C = Y K such that

@C 1
= YK = AK L1 (50)
@K
1
Evaluating @C ~3 =
at K = K A 1
L gives
@K

1
! 1
@C A 1
= A L L1 (51)
@K ~3
K=K
1
A 1
= A (52)

= (53)

= ( 1) < 0 (54)

Taken together, the TVC, assuming that the economy converges to steady state 3,
implies limt!1 [YK ] > 0 . However, steady state 3 lies, by construction, on the
K_ = 0 locus implying that @C
@K
= YK < 0. This contradiction means that steady
state 3 violates the TVC and hence is economically irrelevant.

2.6 Digression: No-Ponzi-game condition

Charles Ponzi became known 1920s as a swindler in for his money making scheme. He promised clients huge pro…ts

by buying discounted postal reply coupons in other countries and redeeming them at face value in the US as a form of

arbitrage. In reality, Ponzi was paying early investors using the investments of later investors. This type of scheme is

31
now known as a "Ponzi scheme". (Wikipedia, June 3rd 2013)

Consider an agent who lives for a …nite time period and has access to the capital
market. Let a(t) denote …nancial wealth at time t (time may be continuous or discrete).
The No-Ponzi-Game condition (NPGC) then reads as follows

a(T ) 0;

i.e. a(T ) < 0 is excluded. The economic signi…cance is as follows. The No-Ponzi-Game
condition (NPGC) represents an equilibrium constraint that is imposed on every agent.
Everyone must repay his/her debt, i.e. leave the scene without debt at terminal point
in time. In case of an in…nitely lived agent, the NPGC reads as follows (time is
continuous):
rt
lim a(t)e 0;
t!1

rt
i.e. limt!1 a(t)e < 0 is excluded.
Current-value debt under Ponzi game. To see the economic signi…cance,
assume that Mr. Ponzi (and his dynasty) wishes to increase consumption today by
x (with x being measured in monetary units). Consumption expenditures are being
…nanced by borrowing money. Debt repayment as well as interest payments are being
…nanced by increasing indebtedness further. Debt then evolves according to

t 0 1 2 ...
current value debt x x(1 + r) x(1 + r)2 ...

dt = x(1 + r)t if t 2 Z

d(t) = xert if t 2 R

Asymptotic present-value debt under Ponzi game. If Mr. Ponzi increases

consumption by xe, …nanced by employing his innovative …nancing scheme, the as-

32
ymptotic level of present value debt reads

xert e
lim |{z} rt
= x > 0:
t!1
d(t)

Noting d(t) = a(t) this implies that the NPGC is violated

rt rt
lim d(t)e >0 () lim a(t)e < 0:
t!1 t!1

3 Dynamic systems

3.1 Di¤erential equations

Two points should be noticed at …rst:

1. Di¤erential equations (DE) are functional equations. That is, the solution of a
DE y(t)
_ = f [y(t)] with y(0) = y0 is itself a function of time, i.e. y = g(t; y0 ),
that satis…es the law of motion y(t)
_ = f [y(t)] at any point in time.

2. If the DE under study satis…es the Lipschitz condition, then there exists a unique
solution.12 This implies that if a solution can be found, we know that this solution
is the unique solution.

3.1.1 First-order, linear di¤erential equations (constant coe¢ cient and

term)

A …rst-order di¤erential equation may be written as13

y_ + ay = b, (55)
12
Existence and uniqueness for initial value problems (Intriligator, 1971, p. 469): Consider y_ =
f (y; t) with y(0) = y0 . If f (y; t) is continuos in the region under consideration and satis…es the
Lipschitz condition that for any two values y1 and y2 there exists a …nite positive constant k such
that jf (y1 ; t) f (y2 ; t)j kjy1 y2 j, then there exists a unique solution y(t). Intuitively, a Lipschitz
continuous function is limited in how fast it can change: there exists a de…nite real number such
that, for every pair of points on the graph of this function, the absolute value of the slope of the line
connecting them is not greater than this real number.
13
This section closely follows Chiang and Wainwright (2005, Chapters 15/16)

33
 dy
where t 2 R denotes the independent variable (often the time index) and y_ := dt
.
This is a …rst-order DE since only the …rst derivative of y with respect to t occurs.
Moreover, it is linear since both y_ and y appear only in …rst degree and there is no
such term yy.
_
Homogenous case. Assuming b = 0 8 t we have y_ + ay = 0. A solution is readily
1 dy
found by rewriting y dt
= a and integrating both sides w.r.t. t to get

Z Z
1 dy
dt = adt:
y dt

Next we form the inde…nite integral on both sides (notice that the chain rule implies
1 dy d ln y
y dt
= dt
)

Z
d ln y
LHS: dt = ln y + c1
dt
Z
RHS: adt = at + c2

=) ln y = at + c with c := c2 c1

Finally, taking the antilog on both sides and de…ning A := ec leads to

at
y(t) = Ae (general solution)

at
y(t) = y0 e (de…nite solution),

where the de…nite solution results from the determination of the arbitrary constant A
by exploiting a border condition like y(0) = y0 .
Non-homogenous case. Assuming b 6= 0 8 t in (55) we have y_ + ay = b. The
solution consists of the sum of the complementary function yc and the particular inte-
gral yp . The complementary function yc is the general solution of the homogenous DE
(containing arbitrary constants), whereas the particular integral yp is simply any par-
ticular solution of the non-homogenous equation (containing no arbitrary constants).

34
From above we know that
at
yc = Ae

As regards yp , we can try the simplest possible solution, i.e. y = k. The DE then
becomes ay = b (since y_ = 0) such that yp = b=a (assuming a 6= 0).
The general solution of the non-homogenous equation then is

b at
y = yc + yp = + Ae :
a

The de…nite solution is found by exploiting a border condition, y(0) = y0 , to pin down
b
the arbitrary constant of integration A: y = y0 a
e at
+ ab .

3.1.2 Second-order, linear di¤erential equations (constant coe¢ cient and

term)

Consider the second-order, linear di¤erential equation

y• + a1 y_ + a2 y = b;

where a1 , a2 and b are constants. Recall that y = yc + yp .

Particular solution yp . Let’s try the simplest solution y = k implying (provided
a2 6= 0)
b
y= :
a2
Complementary solution yc . This is the general solution of y• + a1 y_ + a2 y = 0.
Based on experience with …rst-order DE we try y = Aert implying that

y_ = Arert and y• = Ar2 ert .

35
Hence, the homogenous equation may be expressed as

r2 Aert + a1 rAert + a2 Aert = 0

r2 + a1 r + a2 Aert = 0

r 2 + a1 r + a2 = 0 (if A 6= 0)

The solution of this characteristic equation is

q
a1 (a1 )2 4a2
r1;2 =
2

As there are two solutions for r, there are two solutions which satisfy the homogenous
DE, namely
y1 = A1 er1 t and y2 = A2 er2 t .

The solution of a second-order DE must contain two (arbitrary) constants of in-

tegration. These are to be determined by initial conditions. (Stated di¤erently, it
requires two boundary conditions to solve a second-order DE.) Hence, one must indeed
combine both solutions (y1 and y2 ) to set up the general solution of the homogenous
DE.
q
Case 1: distinct real roots. Provided that (a1 ) > 4a2 the square root (a1 )2
2
4a2
is a real number and r1 and r2 take real distinct values. In this case, we can write

yc = A1 er1 t + A2 er2 t (r1 6= r2 )

Case 2: repeated real roots. Provided that (a1 )2 = 4a2 we have repeated real
a1
roots r1 = r2 = 2
(= r). Forming yc = A1 ert + A2 ert = A3 ert does not work (recall:
it requires two arbitrary constants to receive a unique solution). Hence, we try another
solution satisfying y•+a1 y_ +a2 y = 0 which is linearly independent of A3 ert . A candidate

36
is y = A4 tert implying (product rule)

y_ = (rt + 1) A4 ert and y• = r2 t + 2r A4 ert .

Substituting these into y• + a1 y_ + a2 y = 0 gives

r2 t + 2r A4 ert + a1 (rt + 1) A4 ert + a2 tA4 ert = 0

r2 t + 2r + a1 (rt + 1) + a2 t A4 ert = 0

Notice that r = a1
2
and (a1 )2 = 4a2 implies (r2 t + 2r) + a1 (rt + 1) + a2 t = 0
such that y = A4 tert does indeed qualify as a solution. Therefore, the complementary
function reads
yc = A3 ert + A4 tert :

Case 3: complex roots. Provided that (a1 )2 < 4a2 we receive

r1;2 = h vi;

p
a1 4a2 (a1 )2 14
where h = 2
and v = 2
. With the help of Euler’s formula one can
transform any imaginary exponential function into an equivalent linear combination of
sine and cosine functions: eh iv
= eh (cos vt i sin vt).15 The solution yc = A1 e(h+vi)t +
A2 e(h vi)t
= eht [A1 eivt + A2 e ivt
] can now be expressed as

yc = eht [A1 (cos vt + i sin vt) + A2 (cos vt i sin vt)]

= eht [(A1 + A2 ) cos vt + (A1 A2 ) i sin vt]

= eht [A5 cos vt + A6 sin vt] ;

where A5 := A1 + A2 and A6 := (A1 A2 ) i.16

q q
14 2 2p
Notice that (a1 ) 4a2 = 4a2 (a1 ) 1.
15
For a concise proof of Euler’s formula see Gandolfo (1996, p. 196/197).
16
As A1 A2 results from arbitrary constant, it can take an imaginary as well as a real value. If
A1 A2 is imaginary, A6 is a real number and vice versa (Chiang and Wainwright, 2005, p. 523).

37
 Stability, in general, requires that the real part of every characteristic root is nega-
tive. (This is the concept of unconditional stability, below we will discuss the concept
of conditional stability.)

3.1.3 Two-dimensional, linear di¤erential equation system

Consider the following two-dimensional dynamic system17

y_ 1 = a11 y1 + a12 y2 (56)

y_ 2 = a21 y1 + a22 y2 (57)

The system of two linear DE can easily be transformed into a 2nd order DE. Dif-
ferentiating (56) w.r.t. t and substituting y_ 2 according to (57) and y2 according to (56)
yields

a22
y•1 = a11 y_ 1 + a12 y_ 2 = a11 y_ 1 + a12 a21 y1 + (y_ 1 a11 y1 )
a12
= (a11 + a22 ) y_ 1 (a11 a22 a12 a21 ) y1 (58)

y•1 (a11 + a22 ) y_ 1 + (a11 a22 a12 a21 ) y1 = 0 (59)

Equation (59) represents a second-order di¤erential equation in y1 . Recall that

we solved y• + a1 y_ + a2 y = 0 above. The associated characteristic roots were given
p 2
a1 (a1 ) 4a2
by r
0 1;2 = 1 2 . Here we consider y•1 tr (A) y_ 1 + det(A)y1 = 0 with A =
a11 a12
@ A being the coe¢ cient matrix of the underlying di¤erential equation system
a21 a22
and tr (A) = a11 +a22 and det(A) = a11 a22 a12 a21 . The associated characteristic roots
now read q
tr (A) [tr (A)]2 4 det(A)
r1;2 = :
2
Suppose that the roots of the characteristic equation of (59) are real and distinct
17
This section closely follows Chiang and Wainwright (2005, chapter 16).

38
(case 1 above) such that the solution may be expressed as

y1 = A1 er1 t + A2 er2 t (60)

y_ 1 a11
The solution y2 is readily obtained by solving (56) for y2 , i.e. y2 = a12
y.
a12 1

Employing (60) gives

y_ 1 a11
y2 = y1 (61)
a12 a12
1 a11
= A1 r1 er1 t + A2 r2 er2 t A1 er1 t + A2 er2 t (62)
a12 a12
r1 r1 t r2 r2 t a11 a11
= A1 e + A2 e A1 er1 t A2 er2 t (63)
a12 a12 a12 a12
r1 a11 r 2 a11
= A1 er1 t + A2 er2 t (64)
a12 a12

If the roots are real and equal (case 2 above), then the solutions reads

y1 = A3 ert + A4 tert (65)

(r a11 ) A3 + A4 r a11
y2 = + A4 t ert (66)
a12 a12
Provided that the roots are complex conjugate r1;2 = h vi (case 3 above), the
solution is given by
y1 = eht [A5 cos vt + A6 sin vt]
(h a11 ) A5 + vA6 (h a11 ) A6 vA5
y2 = eht cos vt + sin vt (67)
a12 a12

39
 Figure 6: Phase diagramms. Left panel: stable focus; right panel: saddle point.

3.2 Di¤erence equations

The time index t can now take only integer values, i.e. t 2 Z.18 As t = 1 the
di¤erence quotient y= t can be stated simply as y.

3.2.1 First-order, linear di¤erence equation (constant coe¢ cient and term)

A …rst-order di¤erence equation is one that contains the …rst di¤erence yt := yt+1 yt .
A …rst-order di¤erence of yt is transformable into a sum of terms involving a one-
period time lag and we de…ne a …rst-order di¤erence equation as one that contains a
one-period lag in the dependent variable. Consider a linear, homogenous, …rst-order
di¤erence equations with constant coe¢ cients (m; n 6= 0)

myt+1 nyt = 0. (68)

n
Iterative method. Equation (68) may be expressed as yt+1 = y.
m t
Provided that
y0 is given, the solution can be developed by iteratively applying the preceding rule to
18
This section closely follows Chiang and Wainwright (2005, Chapters 17,18)

40
get

n
y1 = y0
m
n n 2
y2 = y1 = y0
m m
n n 3
y3 = y2 = y0
m m
:::
n t
yt = y0
m

The solution of a linear, homogenous, …rst-order di¤erence equation is thus of the

following shape
yt = Abt .

General method. Consider the following non-homogenous di¤erence equation

yt+1 + ayt = c; (69)

where a and c are constants. The general solution comprises the particular solution yp
- any solution of the complete non-homogenous equation (69) - and the complemen-
tary solution yc - the general solution of yt+1 + ayt = 0. The yp part represents the
intertemporal equilibrium, while yc gives the deviation from this stationary solution.
Consider yc …rst. As a solution for yt+1 + ayt = 0 we try yt = Abt (with A; b 6= 0).
This implies yt+1 = Abt+1 such that yt+1 + ayt = 0 becomes

Abt+1 + aAbt = 0 =) Abt (b + a) = 0 =) b= a

Hence, for the initial trial solution yt = Abt to work we must set b = a implying
yt = A ( a)t .
Next we turn to yp , which is any solution to the complete equation. As a trial
solution we chose the simplest example, i.e. yt = k (implying yt+1 = k). Hence we

41
have
c
k + ak = c =) k=
1+a
Since this particular k value satis…es (69), the particular integral can be written as

c
yp = ; a 6= 1
1+a

c
If it happens that a = 1, the particular solution yp = 1+a
is not de…ned. In this
case, one should try a solution of the form yt = kt, which gives

c
k(t + 1) + akt = c =) k= =c
t + 1 + at

and hence
yp = ct

In summary, the general solution of (69) is given by (assuming that a 6= 1)

c
yt = yc + yp = A ( a)t +
1+a

To eliminate A (an arbitrary constant) we assume that y0 is given, which yields

c c
y0 = A + =) A = y0
1+a 1+a

and the de…nite solution to (69) then reads (a 6= 1)

c c
yt = y0 ( a)t +
1+a 1+a

Dynamic stability. Consider the general solution of the form yt = Abt + yp .

The stability of yp obviously depends on the value of b. If jbj < 1 (jbj > 1), then
the equilibrium yp is stable (unstable). In addition, provided that b > 0 (b < 0), the
solution is monotonic (exhibits oscillations).

42
3.2.2 Second-order, linear di¤erence equation (constant coe¢ cient and
term)

A second-order di¤erence equation is one that contains the second di¤erence

2
yt = ( yt ) = (yt+1 yt )

= (yt+2 yt 1 ) (yt+1 yt )

= yt+2 2yt 1 + yt

Thus a second-order di¤erence of yt is transformable into a sum of terms involving

a two-period time lag. Let us de…ne a second-order di¤erence equation as one that
contains a two-period lag in the variable and consider the solution to linear, non-
homogenous, second-order di¤erence equations with constant coe¢ cients, like

yt+2 + a1 yt+1 + a2 yt = c: (70)

Particular solution. We try a solution of the form yt = k. Plugging this into (70)
c
gives k + a1 k + a2 k = c or k = 1+a1 +a2
. Assuming a1 + a2 6= 1 yields

c
yp = .
1 + a1 + a2

If, on the other hand, a1 + a2 = 1, then the trial solution should be yt = kt such
c
that k(t + 2) + a1 k(t + 1) + a2 kt = c or k = a1 +2
. In this case one obtains "a moving
equilibrium"
c
yp = t.
a1 + 2
Complementary solution. This is the solution to

yt+2 + a1 yt+1 + a2 yt = 0: (71)

Motivated by experience with …rst-order di¤erence equations we try a solution yt =

43
Abt . The preceding equation then becomes

Abt+2 + a1 Abt+1 + a2 Abt = 0 =) Abt b2 + a1 b + a2 = 0. (72)

Assuming that Abt 6= 0 the preceding equation implies b2 +a1 b+a2 = 0. This quadratic
equation in b has two roots
p
a1 a21 4a2
b1;2 = :
2

Both b1 and b2 should appear in the solution yc , because the general solution to
(71) must indeed consist of two linearly independent parts. Three cases must be dis-
tinguished:

1. When a21 > 4a2 , the square root is a real number and b1 and b2 are real and
distinct. The terms bt1 and bt2 are linearly independent and yc can be written as
yc = A1 bt1 + A2 bt2 .

2. When a21 = 4a2 , the square root vanishes and the characteristic roots are repeated
a1
b1 = b2 = 2
. In this case, we have yc = A3 bt + A4 tbt .

3. When a21 < 4a2 , the characteristic roots are conjugate complex: b1;2 = h vi
p
4a2 a21
with h = 2a1 v = 2
. In this case, we get yc = A1 bt1 + A2 bt2 = A1 (h + vi)t +
A2 (h vi)t . Using De Moivre’s theorem, the solution can be transformed into a
p
trigonometric form to read yc = Rt (A5 cos t + A6 sin t) with R = a2 (assumed
positive), A5 = A1 + A2 , and A6 = (A1 A2 ) i.19

The general solution of (70) is again yt = yp + yc .

Dynamic stability. The time path yt converges to a (stationary or moving)
intertemporal equilibrium (yp ) if and only if the absolute value of every root is less
than 1.
19
The parameter is determined by cos = h=R and sin = v=R. (cf. Chiang and Wainwright,
2005, p. 572).

44
3.2.3 Two-dimensional system of linear di¤erence equations

Consider a two-dimensional system of …rst-order di¤erence equations as given by

xt+1 = a11 xt + a12 yt

yt+1 = a21 xt + a22 yt

The system of two linear di¤erence equations can easily be transformed into a 2nd
order di¤erence equation (cf. to two-dimensional di¤erential equation system). To
sketch the procedure notice that the above system can be transformed into a second-
order di¤erence equation

xt+2 (a11 + a22 ) xt+1 + (a11 a22 a21 a12 ) xt = 0: (73)

0 1
a11 a12
In terms of tr(A) and det(A) with A = @ A, the preceding di¤erence equation
a21 a22
can be rewritten
xt+2 tr(A)xt+1 + det(A)xt = 0.
p
tr(A) [tr(A)]2 4 det(A)
The associated characteristic roots now read b1;2 = 2
. The gen-
eral solution of (73) is
xt = A1 (b1 )t + A2 (b2 )t (74)

where A1 and A2 are arbitrary constants of integration. Substituting (74) into yt =

1 a11
x
a12 t+1
x
a12 t
yields

1 a11
yt = A1 (b1 )t+1 + A2 (b2 )t+1 A1 (b1 )t + A2 (b2 )t : (75)
a12 a12

45
Using (b1 )t+1 = b1 (b1 )t and (b2 )t+1 = b2 (b2 )t we get

1 a11
yt = A1 b1 (b1 )t + A2 b2 (b2 )t A1 (b1 )t + A2 (b2 )t (76)
a12 a12
A1 b1 (b1 )t A2 b2 (b2 )t a11 A1 (b1 )t a11 A2 (b2 )t
= + (77)
a12 a12 a12 a12
b1 a11 b2 a11
= A1 (b1 )t + A2 (b2 )t : (78)
a12 a12

The subsequent …gure displays solutions of a two dimensional di¤erence equation

system in (x, y) plane.

Figure 7: Phase diagramms. Left panel: stable focus; right panel: saddle point.

3.3 Linearization techniques

3.3.1 First-order Taylor series approximation

Consider the following two-dimensional, non-linear di¤erential equation system

y_ 1 = f (y1 ; y2 ) (79)

y_ 2 = g (y1 ; y2 ) ; (80)

where f (:) and g (:) are at least twice continuously di¤erentiable functions. The system
is assumed to posses a steady state (~
y1 ,~
y2 ) de…ned by f (~
y1 ; y~2 ) = 0 and g (~
y1 ; y~2 ) = 0.

46
Applying a …rst-order Taylor series approximation gives

@f (y1 ; y2 ) @f (y1 ; y2 )
y_ 1 = f (y1 ; y2 )jy1 =~y1 + (y1 y~1 ) + (y2 y~2 ) (81)
y2 =~
y2 @y1 y1 =~
y1 @y2 y1 =~
y1
y2 =~
y2 y2 =~
y2

@g (y1 ; y2 ) @g (y1 ; y2 )
y_ 2 = g (y1 ; y2 )jy1 =~y1 + (y1 y~1 ) + (y2 y~2 ) :
y2 =~
y2 @y1 y1 =~
y1 @y2 y1 =~
y1
y2 =~
y2 y2 =~
y2

@f (~
y1 ;~
y2 ) @f (y1 ;y2 )
Simplifying the notation by writing @y1
instead of @y1 y1 =~
y1
, noting that
y2 =~
y2

the …rst terms on the RHS equal zero and using y_ 1 = (y1 y~1 ) and y_ 2 = (y2 y~2 ) one
receives
@f (~
y1 ; y~2 ) @f (~
y1 ; y~2 )
(y1 y~1 ) = (y1 y~1 ) + (y2 y~2 ) (82)
@y1 @y2
@g (~
y1 ; y~2 ) @g (~
y1 ; y~2 )
(y2 y~2 ) = (y1 y~1 ) + (y2 y~2 ) : (83)
@y1 @y2
This is a system of linear and homogenous di¤erential equations in the variables
y1 y~1 and y2 y~2 . The coe¢0cient matrix is given
1 by the Jacobian matrix of the
@f (~
y1 ;~
y2 ) @f (~
y1 ;~
y2 )
original non-linear system J = @ @y1 @y2 A. The solution to such a system
@g(~y1 ;~
y2 ) @g(~y1 ;~
y2 )
@y1 @y2
may be expressed as (cf. to Section 3.1.3)

y1 y~1 = B1 v11 er1 t + B2 v12 er2 t

y2 y~2 = B1 v21 er1 t + B2 v22 er2 t ;

where B1 and B2 are "arbitrary constants of integration" (determined by initial con-

ditions), r1 and r2 the eigenvalues resulting from jI Jrj = 0, where J denotes the
Jacobian matrix of the di¤erential equation system and I the identity matrix, and
v11 v12
v21
, v22
are the eigenvectors associated with eigenvalues r1 and r2 (eigenvector v
associated with eigenvalue r is determined by Jv = rv).

47
3.3.2 Proportional deviations from steady state

Consider a non-linear function y = f (x; z) with f (:) at least once continuously di¤eren-
tiable. It may be useful to transform this non-linear function into a relation y^ = g(^
x; z^)
y y~
with g(:) being a linear function and y^ = y~
etc. denote proportional deviations from
the steady state denoted y~, x~ and z~. Linearizing f (x; z) by means of a …rst-order Taylor
approximation around the steady state gives

@f (x; z) @f (x; z)
f (x; z) = f (~
x; z~) + (x x~) + (z z~)
@x x=~
x @z x=~
x
z=~
z z=~
z
@f (x; z) @f (x; z)
= f (~
x; z~) + x~ x^ + z~ z^
@x x=~
x @z x=~
x
z=~
z z=~
z

Applying the same procedure to the LHS yields

y = y~ + 1(y y~)

= y~ + y^ y~

@f (x;z) @f (~
x;~
z)
Simplifying the notation by writing @x x=~
x
= @x
, noting that y~ = f (~
x; z~)
z=~
z
and setting the LHS equal to the RHS again, we obtain

@f (~
x; z~) @f (~
x; z~)
y~ + y^ y~ = f (~
x; z~) + x~ x^ + z~ z^
@x @z

@f (~
x; z~) x~ @f (~
x; z~) z~
y^ = x^ + z^:
@x y~ @z y~
Example 1. Consider y = ax z . Applying the above sketched procedure gives20

1 1
y^y~ = a x~ z~ x~ x^ + a x~ z~ z~ z^
20
Alternatively, one can divide y = ax y by y~ = a x
~ y~ to get

y x z
=
y~ x
~ z~
ln y ln y~ = (ln x ln x
~) + (ln z ln z~)
y^ = x^ + z^:

48
 y^ = x^ + z^:

Example 2. Consider y = ax + bz . Applying the above sketched procedure gives

1 1
y^y~ = a x~ (x x~) + b z~ (z z~)
1 1
= a x~ x~ x^ + b z~ z~ z^

x~ z~
y^ = a x^ + b z^:
y~ y~

3.3.3 Application 1: Solow model - speed of convergence

The speed at which an economy converges to its steady state can be measured by the
rate of convergence (ROC). The ROC of any variable x(t) is de…ned by21

x(t)
_
x (t) := :
x(t) x~

If x > 0 ( x < 0), variable x converges to (diverges from) the steady state x~.
Consider a potentially non-linear di¤erential equation, x(t)
_ = f [x(t)], which is assumed
to possess a stationary equilibrium de…ned by f (~
x) = 0. Linearization of f (x) by means
of a …rst-order Taylor approximation around x~ gives

x(t)
_ x) + f 0 (x)jx=~x (x
= f (~ x~) .

Hence, noting that f (~

x) = 0, x(t) converges (locally) against x~ at the following rate

x(t)
_
x := = f 0 (x)jx=~x :
x(t) x~

To determine the ROC for the Solow model recall that

1
s 1
k_ = sk ( + n + g)k and k~ = :
+n+g
21
The implicit assumption is that the economy under study converges in a monotonic fashion,
otherwise the speed of convergence doesn’t make much sense.

49
Linearizing around k~ gives

h i
k_ = sk~ 1
( + n + g) k k~
" 1 #
s 1
= s ( + n + g) k k~
+n+g

= ( 1) ( + n + g) k k~ :

k_
Hence, the (local) speed of convergence is given by k := k k ~ = (1 ) ( +n+g).

3.3.4 Application 2: PDV of wage income

Consider the application in Section 2.4 (education à la Lucas). Assume the agents starts
~ To determine the agent’s (human) wealth (cf. consumption and
with some h0 < h.
permanent consumption hypothesis) the PDV value of wage income, we can linearize
R1
_
the h-equation around the steady state and then apply the formula 0 xe bt dt = xb .
1
1
First-order approximating h_ = Au h ~ ~
h h around h, noting h =
A~
u
h
, yields

h_ = A~ ~
u h 1
h h ~
h
h ~
= A~
u h h h
A~
u
= ( 1) h h ~1
h

Noting h_ = h ~ one receives

h

h ~ =(
h 1) h h ~
h with h(0) = h0

~ + h0
h=h ~ e(
h 1) ht

Wage income at each instant of time is w(1 u~)h. The PDV value of wage income

50
therefore reads
Z 1 Z 1 h i
w(1 u~)he rt
dt = w(1 u~) h~ + h0 ~ e(
h 1) ht
e rt
dt
0 0
Z 1
= w(1 ~
u~)he rt
+ w(1 u~) h0 ~ e[(
h 1) h r]t
dt
0

~ w(1 u~) h0 ~
h
w(1 u~)h
= +
r (1 ) h +r

3.3.5 Application 3: Ramsey model - determining c(0)

The reduced form of the Ramsey model may be written as

1
c( k )
c_ =

k_ = k k c

k(0) = k0 ; c(1) = c~:

Linearizing the above dynamic system by means of a …rst-order Taylor approxima-

tion around the steady state (~ ~ gives
c, k)

(c c~) = a11 (c c~) + a12 k k~

k k~ = a21 (c c~) + a22 k k~ ;

~ 1 ~ 2
where a11 = k
, a12 = c ( 1)k
, a21 = 1 and a22 = k~ 1
: The solution
may be expressed as

c c~ = B1 v11 er1 t + B2 v12 er2 t

k k~ = B1 v21 er1 t + B2 v22 er2 t ;

where B1 and B2 are "arbitrary constants of integration" (determined by bound-

ary conditions), r1 and r2 the eigenvalues resulting from jI Jrj = 0 with J =

51
0 1
~
k 1 c ( ~
1)k 2

@ A, v11
and v12
are the eigenvectors associated with r1
v21 v22
1 k~ 1

and r2 . It can be shown that one eigenvalue is positive, while the other one is negative,
say r1 > 0 (unstable root) and r2 < 0 (stable root). To determine the two "arbi-
trary constants of integration" B1 and B2 , let us consider the solution to the linearized
system evaluated at t = 0 (notice that e0 = 1)

c(0) = B1 v11 + B2 v12 + c~

~
k(0) = B1 v21 + B2 v22 + k:

Remember that B1 is associated with the unstable root (r1 > 0) and B2 is associated
with the stable root (r2 < 0). The impact of the unstable eigenvalue on the dynamic
evolution can only be eliminated by setting c(0) such that B1 ! Technically this means
we set B1 = 0 and solve the above system for c(0) and B2 .

3.3.6 Application 4: Solow model - internal rate of return

Let the instantaneous net bene…t of a project be denoted by N (t).22 Assume that N (t)
converges at constant rate , i.e. we can write

t
N (t) = N1 + (N0 N1 ) e :

The net present value (NPV) of a project that generates an in…nite ‡ow N (t) may
then be expressed as
Z 1
t rt
NPV = N1 + (N0 N1 ) e e dt
0
Z 1
rt t rt
= N1 e + (N0 N1 ) e e dt
0
N1 N1 N0
= ;
r +r
22
I thank Sjak Smulders for pointing my attention to this application.

52
where r denotes the discount rate. The internal rate of return is de…ned by N P V = 0
such that
N1 N1 N0 N1
=0 ) r= .
r +r N0
Recall the Solow model, described by

t
y = y~1 + (~
y0 y~1 ) e
s1 1
with = (1 ) ; y~1 =

s0
Assume, the economy is initially in a steady state y~0 = 1
. The government
may ask for the rate of return of an investment program that aims at increasing the
gross investment rate. More speci…cally, what is the rate of return of a permanent
increase in the gross saving rate from s0 to s1 ? To answer this question, consider the
associated net bene…t

bene…t costs
z }| { z}|{
N (t) = y y~0 s0 s^y

= (1 s0 s^) y y~0

s1 s0
where s^ := s0
. The initial net bene…t, obtained by setting y = y~0 , is given
by N0 = s0 s^y~0 (initial investment costs). The …nal net bene…t, obtained by setting
y~1 y~0
y = y~1 , reads N1 = (1 s0 s^) y~1 y~0 . Let y^ = y~0
, then the rate of return may be
expressed as

y~1 y~0 s0 s^y~1

r =
s0 s^y~0
y^ s0 s^ (1 + y^)
=
s0 s^
y^
= (1 + y^) .
s0 s^

53
3.4 Miscellaneous

3.4.1 First-order, linear di¤erential equations - variable coe¢ cients and

variable term

1 dy
Homogenous case. Consider y_ + u(t)y = 0, which may be expressed as y dt
= u(t).
Integrating both sides gives
Z Z
1 dy d ln y
LHS: dt = dt = ln y + c
y dt dt
Z Z
RHS: u(t)dt = u(t)dt

Z
=) ln y = c u(t)dt
R R
=) y = e ce u(t)dt
= Ae u(t)dt

Digression: non-homogenous DE with constant coe¢ cient. Consider the

1 a1 23
following DE a0 y_ + a1 y = g(t) with a0 6= 0 or y_ + by = a0
g(t) with b = a0
. As a trial
solution we use
bt
y(t) = A(t)e (84)

which implies
_
y_ = A(t)e bt
A(t)be bt

1
Plugging the RHS into y_ + by = a0
g(t) yields

_ bt 1
A(t)e A(t)be bt + bA(t)e bt = g(t)
| {z } | {z } a0
y_ y

_ bt 1 _ = 1 g(t)ebt
A(t)e = g(t) =) A(t)
a0 a0
23
We follow Gandolfo (1997, Chapter 12.2.6), who applies the method of variation of parameters.

54
Integrating both sides gives
Z
1
A(t) = g(t)ebt dt + B
a0

where B is an arbitrary constant of integration. Replacing A(t) in (84) according to

the RHS of the preceding equation yields
Z
1
y(t) = g(t)ebt dt + B e bt
(85)
a0

Non-homogenous case (variable coe¢ cient). Consider y_ + u(t)y = w(t). We

employ the same procedure as before. The trial solution implies

R R R
y = A(t)e u(t)dt
=) _
y_ = A(t)e u(t)dt
u(t)A(t)e u(t)dt

Plugging the RHS into y_ + u(t)y = w(t) gives

R R R
_
A(t)e u(t)dt
u(t)A(t)e u(t)dt
+ u(t)A(t)e u(t)dt
= w(t)
| {z } | {z }
y_ y

R R
_
A(t)e u(t)dt
= w(t) =) _ = w(t)e
A(t) u(t)dt

Integrating both sides gives

Z R
u(t)dt
A(t) = w(t)e dt + B

R
u(t)dt
and plugging the RHS into the trial solution y = A(t)e gives (see also Chiang,
1984, pp. 487/488) Z R R
u(t)dt u(t)dt
y= w(t)e dt + B e

where B is an arbitrary constant. Notice that this solution, again, consists of two
additive components.

55
3.4.2 Application 1: Wealth in a small open economy

Consider the open economy Ramsey model and assume that r = . The dynamics of
per capita wealth a(t) is governed by a(t)
_ (r n)a(t) = w c(t) with w and r constant
r
and c(t) may be expressed as c(t) = c(0)e( )t . The solution a(t) can be inferred from
the solution of …rst-order, linear di¤erential equations with variable coe¢ cients and
variable term
Z R R
u(t)dt u(t)dt
y(t)
_ + u(t)y(t) = w(t) has solution
! y(t) = w(t)e dt + B e

Z R R
(r n)dt (r n)dt
a(t)
_ (r n)a(t) = w c(t) has solution
! a(t) = (w c(t)) e dt + A1 e :
(86)
R r
Noting e (r n)dt
=e (r n)t
for r and n constant and c = c(0)e( )t one gets
Z Z
r
a(t) = we (r n)t
dt c(0)e( )t e (r n)t
dt + A1 e(r n)t

r (1 )r + n R
Rewrite (r n) = and use xeat dt = a1 xeat + c to get

w 1 r
a(t) = e (r n)t + A1 c(0)e( )t e (r n)t + A2 A3 e(r n)t
(r n) b
w 1 r
= e (r n)t c(0)e( )t e (r n)t + B e(r n)t (87)
r n b

(1 )r + n
where b := < 0. This equation contains two unknowns, namely B :=
A 1 + A2 A3 and c(0). To determine these two unknowns we exploit two boundary
(r n)t
conditions, namely a(0) = a0 and lim a(t)e = 0 (resulting from NPGC together
t!1
r
with TVC). The latter, assuming r n > 0 and (r n) < 0, gives

(r n)t
lim a(t)e =B=0
t!1

56
 Turning to c(0), notice that B = 0 together with a(0) = a0 implies

w 1
a0 = c(0) (88)
r n b

w
c(0) = b a0 + (89)
r n
Remark #1: Notice that the PDV of consumption may be expressed as
Z 1
r 1 1 1
c(0)e( )t e
1 1
(r n)t
dt = c(0)e b 1 c(0)e b 0 = c(0)
0 b b b

R1 r
Hence (88) requires that 0
c(0)e( )t e (r n)t
dt = a0 + w
r n
, i.e. the PDV of con-
sumption must equal total wealth.
Remark #2: Equ. (87) together with B = 0 and (89) gives

c(0)
z }| {
w w
1 ( r )t
a(t) = + b a0 + e
r n r n b
w r w
= a0 + e( )t
r n r n

This is the solution stated in Barro and Sala-i-Martin (1995, p. 99).

3.4.3 Application 2: Asset prices

Capital market equilibrium and implied asset prices. Consider a world with
two assets: Land yields a rent of vZ and has price pZ . The second asset (bond issued
by the government or …rms) yields a real rate of return of r and its price is normalized
to one. In equilibrium arbitrage opportunities vanish such that

p_Z + vZ = rpZ .

It can be shown that the di¤erential equation p_Z (t) r(t)pZ (t) = vZ (t) has the

57
following forward-looking solution

Z1
R( ) R( )
pZ (t) = vZ ( ) e d + lim pZ ( ) e :
|!1 {z }
|=t {z } bubble
fundamental price

R
with R( ) := t
r(s)ds.24 Notice that vZ ( ) walks along the time axes ( ) starting at
R( )
= t, running until = 1. At each point in time , vZ ( ) is weighted by e ,
where the cumulative discount rate R( ) is the sum of all instantaneous interest rates
r(s) between s = t (the starting date) and s = (the terminal date). Notice that
is the terminal date for the calculation of R( ) and, at the same time, denotes the
current point in time w.r.t. vZ ( ). Remarks:

1. The fundamentally warranted price, assuming rational expectations, is pZ (t) =

Z1
vZ ( )e R( ) d . Thus validity of the capital market no arbitrage condition does
=t
not, in itself, rule out the existence of asset price bubbles. The terminal condition
R( )
lim !1 pZ ( ) e = 0 must additionally be imposed.

vZ
2. Assume that vZ and r are constant. Then, as long as r > 0, we have pZ = r
.
As r falls, pZ rises. And limr!0 pZ = 1. Summers (2014) has stressed that
r declined over time. Notice also that pZ = vrZ does not hold for negative r:
Z1
pZ (t) = vZ e r( t) d = 1r vZ e r1 1
v e r0 = 1 for r < 0.25
r Z
=t

The math. Consider an economy with two assets: an asset that yields a payo¤ each
period and a bond paying an interest rate. Let ( ) denote the payo¤ at time 2 [t; T ]
and let r(s) denote the interest rate at time s 2 [t; T ]. The present value of the payo¤
R 1 r(s)ds
in period = 1, from the perspective of period t, then is ( 1 )e t , where
R 1 r(s)ds
e t represents the cumulative discount factor between t and 1; in case where
Z R R
24
Recall that y(t)
_ + u(t)y(t) = w(t)has solution
! y(t) = w(t)e u(t)dt dt + B e u(t)dt .
25
Reminder : r~ = ( s 1) in Solow model without population growth and technical change. That
is, dynamic ine¢ ciency s > implies r~ < 0.

58
 r( t)
r(s) = r, the discount factor simpli…es to e 1
. The fundamentally warranted price
of an asset, at time t, that entitles the holder to a stream of earnings ( ) 8 2 [t; T ]
is then given by Z T R
r(s)ds
v(t) = ( )e t d . (90)
t

We now di¤erentiate this equation w.r.t. time to receive the no-arbitrage condition in
the capital market26

=0
zZ }| {
t
RT r(s)ds @t Z T R
r(s)ds
r(s)ds @T @ ( )e t
v_ = (T )e t (t)e t + d
@t
|{z} @t
|{z} t @t
=0 =1

The integrand of the last expression on the RHS can be expressed as27
R
r(s)ds R R
Z
@ ( )e t @ r(s)ds r(s)ds @
= ( ) e t = ( )e t r(s)ds
@t @t @t t

To evaluate the last expression on the RHS we apply the Leibniz rule again
0 1
Z Z
@ B @ @t @r(s) C
r(s)ds = @r( ) r(t) + dsA = r(t)
@t t @t
|{z} @t
|{z} t | @t
{z }
=0 =1 =0

Putting everything together gives

Z T R
r(s)ds
v_ = r(t) ( )e t d (t)
t
= r(t)v(t) (t) (91)

This is the well-known capital market no-arbitrage condition (sometimes called

"Fisher equation"), which must hold at each instant of time under capital market
equilibrium (absence of pro…t opportunities). Buying one unit of the asset at price v(t)
26 d
R v(x) R v(x)
Recall the Leipniz rule: dx u(x)
f (x; z)dz = f (x; v(x))v 0 (x) f (x; u(x))u0 (x) + u(x)
fx (x; z)dz
(Sydsaeter et al., 2005, p. 60).
27 @ f (t)
Notice that @t e = ef (t) f 0 (t):

59
under consideration (say a "share") provides a gain of (t) + v_ (instantaneous pro…t
plus change in asset price). This must equal the reward that can be earned by investing
the amount v(t) into bonds which pays r(t)v(t).
Remark. Di¤erentiating equ. (90) w.r.t. time yields the no-arbitrage condi-
tion (91). However, solving equ. (91), which represents a …rst-order, linear, non-
homogenous DE with variable coe¢ cient, yields equ. (90) provided that the so-called
transversality condition holds (Brunnermeier, Bubbles, New Palgrave of Economics,
2008, p. 4)28
R
r(s)ds
lim v( )e t = 0:
!1

3.4.4 Normalization of variables

Basic concepts. The dynamic systems under consideration typically exhibit perma-
nent growth. For several reasons, the variables are transformed so that the dynamic
system possesses a stationary point (most important reason: stability analysis). A
widely employed technique is scale adjustment (or normalization of variables). Assume
R
28
(CHECK) Multiplying both sides of v_ r( )v( ) = ( ) by e t r(s)ds and integrate forward
to get
Z1 R Z1 R
r(s)ds
e t [v_ r( )v( )] d = e t r(s)ds ( )d (92)
t t

h R i1 Z1 R
r(s)ds r(s)ds
e t v( ) = e t ( )d (93)
t
t

The integration on the LHS can be understood by noting that (Leibniz rule of di¤erentiation)
R
@ h R
r(s)ds
i @e t
r(s)ds R
r(s)ds
e t v( ) = v( ) + e t v(
_ )
@ @ R R
r(s)ds r(s)ds
= r( )e t v( ) + e t v(
_ )

Hence, we have
R
Z1 R
r(s)ds r(s)ds
lim e t v( ) v(t) = e t ( )d (94)
!1
t
R
r(s)ds
If the so-called TVC holds lim !1 e t v( ) = 0 one gets
Z1 R
r(s)ds
v(t) = e t ( )d (95)
t

60
that X(t) grows in the long run at rate g, i.e.

_
X(t)
lim = g:
t!1 X(t)

Scale adjustment requires to de…ne a new variable according to

X(t)
x(t) :=
egt

such that x(t) approaches a constant asymptotically

lim x(t) = x~:

t!1

where x~ denotes a constant. With these concepts at hand the steady state growth path
(SSGP) can be expressed as follows

~
X(t) = x~egt

which shows that x~ represents the level of the SSGP (possibly a¤ected by market
distortions, public policy etc.). The equilibrium growth path (EGP) can now be written
as
X(t) = x(t) egt
|{z} :
|{z}
transitional dynamics component steady state growth component

This demonstrates that the EGP X(t) is obviously composed of two components: (i)
a transitional dynamics component x(t) and (ii) a steady state growth component egt .
Dynamic system in normalized variables. Consider the following dynamic
system (boundary conditions suppressed)

_
X(t) = F (X; Y )

Y_ (t) = G(X; Y )

_
X(t) Y (t)
with limt!1 X(t)
= gX and limt!1 Y (t)
= gY . Assuming that the original dy-

61
namic system ful…lls some not very restrictive requirements (especially linear semi-
homogeneity), there exists an associated (and autonomous) dynamic system in scale-
X Y
adjusted variables x := egX t
and y := egY t
of the following shape (Trimborn, 2006,
Section 2.3)

x_ = F (x; y) x gX

y_ = G(x; y) y gY

Examples: Solow and Ramsey....

4 Production and Technology

4.1 Motivation

In textbooks or in research papers one often …nds statements like the following:

1. The output technology Y = F (K; L) exhibits CRS in K (capital) and L (labor).

Y K
Let y = f (k) denote the intensive technology with y := L
and k := L
. The
competitive interest rate (r) and the competitive wage rate (w) may then be
expressed as follows:
r = f 0 (k)

w = f (k) f 0 (k)k

2. The output technology is assumed to be of the Cobb-Douglas form Y = K L1 .

Competitive factor prices are the given by

Y
r=
K

Y
w = (1 )
L

3. Consider a one-sector economy with …nal output technology Y = K L1 under

62
 autarky. Assume that capital market integration induces an increase in the inter-
est rate r by 1 percent (e.g., from 3 percent to 3.03 percent). Labor is immobile.
As a consequence, GDP (Y ) decreases by 1
percent.

The following pages provide the required concepts and techniques to make sure that
statement like these are fully understood.

4.2 General technology (non-parametric)

4.2.1 Homogenous functions

We often assume that the representative …rm has access to a production technology of
the form
Y = F (K; L)

where Y denotes …nal output (value added), K 0 physical capital, and L 0 the
amount of labor. It is most satisfactory to think of both outputs and inputs as ‡ows:
quantities per unit of time. The K appearing in the production function should be
seen as the number of machine hours per year and L should be interpreted as the ‡ow
of labor services per period of time (K and L can also be interpreted as the stock of
capital and labor). The function F : R2+ ! R+ is twice continuously di¤erentiable
("C 2 ") with FK > 0, FKK < 0, FL > 0, FLL < 0, and FKL = FLK > 0, where
@F (:)
FX := @X
. Moreover, the function F (K; L) is homogenous of degree 2 R+ , i.e.

Y = F ( K; L) with 2 R+

If > 1, the function F (K; L) exhibits increasing returns to scale (IRS)

If = 1, the function F (K; L) exhibits constant returns to scale (CRS)

If < 1, the function F (K; L) exhibits decreasing returns to scale (DRS)

63
4.2.2 Euler’s theorem

Suppose F (K; L) is homogenous of degree . Then

FK K + FL L = F (K; L)

Proof : Di¤erentiate the equation F ( K; L) = F (K; L) w.r.t. to get

@F (:) @ K @F (:) @ L 1
+ = F (K; L)
@( K) | @{z } @( L) @
| {z }
outer derivativeinner derivative

@F (:) @F (:) 1
K+ L= F (K; L)
@( K) @( L)
Setting = 1 yields
FK K + FL L = F (K; L)

4.2.3 Intensive form and competitive factor prices

Assuming that Y = F (K; L) is linearly homogenous, i.e. exhibits CRS, and de…ning
Y K
y := L
(output per unit of labor) and k := L
(capital per unit of labor), the technology
F (K; L) may be expressed in intensive form to read

Y K
= F ( ; 1) =) y = f (k)
L L

The marginal product of capital may then be expressed as FK (:) = f 0 (k). Proof :
Y F (:)
From L
= L
= f (k) we have

F (:) = f (k)L

1
FK (:) = f 0 (k) L = f 0 (k)
| {z } L
|{z}
outer derivative
inner derivative

The marginal product of labor may be expressed as FL (:) = f (k) f 0 (k)k. Proof :

64
 From Y = FK (:)K + FL (:)L (Euler’s theorem) we have

y = FK (:)k + FL (:)

FL (:) = y FK (:)k = f (k) f 0 (k)k

Competitive factor prices may be stated as follows

r| {z
+} = f 0 (k)
user cost of capital

w = f (k) f 0 (k)k

4.2.4 Elasticity of substitution

The elasticity of substitution (EoS) between K and L is de…ned as29

L L L
d( K )= K d ln( K )
" := = 0
d( FFKL )= FFKL d ln( FFKL )

L
The EoS indicates by how much (in percentage terms) the ratio K
changes, if the
dL FK
slope of an isoquant is changed (recall: dY = FK dK + FL dL = 0 implies dK
= FL
,
dL
where dK
denotes the MRS). The EoS is a dimensionless measure of the substitutability
between the factors under consideration. The economic importance of this concept
r FK
becomes clearer by recalling that, under cost minimization, w
= FL
. In most economic
applications it is assumed that the EoS is constant.
r L
Notice that " 0: an increase in w
induces an increase in K
. When the relative
price of capital ( wr ) increases, capital intensity K
L
declines (i.e. L
K
rises).30
The EoS may look like a fairly abstract concept. However, it can readily be reasoned
that the value of the EoS may have important economic implications. Two examples
illustrate this point. First, the EoS between man-made capital and natural resources
dx d ln x
29
Notice that d ln x = x . This results from dx = x1 .
30 d( K K
L )= L
Sometimes the EoS is de…ned as follows: " := F F 0 (e.g. Silberberg, 1990, p. 287).
d( FK )= FK
L L

65
 Figure 1: Figure 7: Substitution of input factors

is decisive for the feasibility of sustained economic growth under limited supply of a
natural resource. Second, the value of the EoS between K and L is decisive for the
impact of an increase in K on the competitive wage rate.

4.3 Parametric technology: Cobb-Douglas

A standard Cobb-Douglas technology reads

Y = AK L1

where Y denotes …nal output (value added), A > 0 total factor productivity, K 0
physical capital, L 0 the amount of labor, and 0 1. At a more general
level, a Cobb-Douglas technology is of the following form Y = i Xi. Notice that the
i

P
Cobb-Douglas representation leads to a log-linear form, i.e. ln Y = i i ln Xi.

66
4.3.1 Properties and implications

1. The above Cobb-Douglas technology exhibits constant returns to scale (CRS)

A( K) ( L)1 = Y

2. Competitive factor prices may be expressed as follows

1 Y
r + = AK L1 =
K

Y
w = (1 )AK L = (1 )
L

3. Alternatively, using the intensive production function one my write

1
r + = Ak

w = (1 )Ak

4. The partial elasticity of output w.r.t. capital is given by . It shows by how

much, in percentage terms, Y changes if K is, say, increased by 1 percent

dY =Y dY K Y K
Y;K := = = =
dK=K dK Y KY

5. The EoS is constant and equal to one

L L L
d( K )= K d ln( K )
" := = =1
d( FFKL )= FFKL d ln( YYKL )

Proof

1 1
Solve Y = AK L1 for L to yield L = Y 1 A1 K1 (the isoquant with
production level Y ).
1 1
@L 1
The slope is given by @K
= 1
Y 1 A1 K1 .

67
 Replacing Y by AK L1 gives

@L L L 1 @L
= ) =
@K 1 K K @K

@L YK
Notice that @K
= YL
(from dY = 0) and hence we have

L 1 YK
=
K YL

Taking the natural logarithm on both sides and forming the derivative w.r.t.
YK
YL
yields
L
d ln( K )
" := =1
d ln( YYKL )

6. Euler’s Theorem (with = 1) holds

Y Y
K + (1 ) L=Y
K L

7. The proportional rate of change in Y may be expressed as

dY dK dL
= + (1 ) (96)
Y K L

Y
Proof : Form the total derivative, dY = K
dK + (1 ) YL dL, and then divide
both sides by Y .

Remark: Alternatively, one could think of Y , K and L as being time dependent by

writing Y (t) = K(t) L(t)1 . Form the natural logarithm on both sides using the fact
d ln Y dY 1
that dt
= dt Y
etc. also leads to the decomposition shown in (96).
8. The equilibrium goods price may be expressed as follows

p = B (r + ) w1

68
 1 (1 )
with B := A (1 ) . Proof. From the …rst-order conditions for a pro…t
maximum one obtains the factor demand schedules to read

Y p Y
r+ =p ) K=
K r+

Y p(1 )Y
w = p(1 ) ) L=
L w
Inserting into the production technology gives

1
p Y p(1 )Y
Y =A
r+ w

Eliminating Y and solving for p yields

1
1 1
Y =A (p Y ) (p(1 )Y )1
r+ w

1 (1 )
p=A (1 ) (r + ) w1

4.4 Parametric technology: CES

A more general production function is the CES (constant elasticity of substitution)

function
1
Y = [aL + (1 a)K ] (97)

1
where 0 < a < 1, 1< 1 and 6= 0. The EoS is given by " = 1
. Three
cases should be distinguished:

For ! 1 one gets " ! 1 (linear isoquants, perfect substitutability)

For ! 1 one gets " ! 0 (rectangular isoquants, no substitutability)

For ! 0 one gets " ! 1 (convex isoquants, Cobb-Douglas case)

Moreover, provided that 0 < " < 1 ( 1 < < 0) there is weak substitutability. For
1 < " < 1 (0 < < 1) there is strong substitutability. Notice that Y = aL +(1 a)K

69
 1
does also represent a CES function with " = 1
(yet this version does not exhibit
CRS).

Figure 8: Weak and strong substitutes

4.4.1 Properties and implications

1
1. The EoS is given by " = 1
. Proof :

1
1 1 a
Solving (97) w.r.t. L gives L = a
Y a
K (the isoquant with pro-
duction level Y ).

The slope of this isoquant is

1
1
@L 1 1 1 a 1 a 1
= Y K ( 1) K
@K a a a

Replacing Y according to Y = aL + (1 a)K gives

1
1
@L 1 1 a 1 a 1 a 1
= L + K K ( 1) K
@K a a a

1
@L 1
11 a 1 1 1 a 1 L 1 a
= (L ) K = L K =
@K a a K a
1 1
L L a @L
Solving for K
yields K
= 1 a
1
@K
1
.

70
 @L YK
Noting @K
= YL
leads to

1
L YK 1
=c
K YL

1
a
with c := 1 a
1
.

Now take the natural logarithm on both sides and form the derivative of
L YK
ln K
w.r.t. ln YL
to get

L
L 1 YK d ln( K ) 1
ln( ) = ln(c) + ln( ) ) "= =
K 1 YL d ln( YYKL ) 1

2. There is a well-known special case for = 0. Taking the natural logarithm on

both sides gives
1
ln Y = ln[aL + (1 a)K ] (98)

ln[aL +(1 a)K ] 0

Regarding the RHS we have = 0
for = 0. Applying L’Hopital’s
0
dv x
rule, lim fg(x)
(x)
= lim fg0 (x)
(x)
, gives (recalling dx
= v x ln v)
x!b x!b

ln[aL + (1 a)K ] aL ln L + (1 a)K ln K

lim = lim = a ln L + (1 a) ln K
!0 !0 aL + (1 a)K

Hence, for ! 0, we have ln Y = a ln L + (1 a) ln K or Y = La K 1 a .

3. The above stated CES technology is linearly homogeneous, i.e. [a( L) + (1

1
a)( K) ] = Y with = 1.

1 1 1
[a( L) +(1 a)( K) ] = [a L +(1 a) K ] = [aL +(1 a)K ] = Y

4. Euler’s theorem (with = 1) holds: YK K + YL L = Y . Proof : The MPC and

MPL read

Y
1 z }| { 1 1
Y
YK = [aL + (1 a)K ] 1 (1 a) K 1 = (1 a) (99)
| {z }| inner derivative
{z } K
outer derivative

71
 Y
1 z }| { 1 1
Y
YL = [aL + (1 a)K ] 1 a | L
1
{z } = a (100)
| {z }inner derivative L
outer derivative

where the last equalities use Y = aL + (1 a)K . Hence

1 1
Y Y
YK K + YL L = (1 a) K +a L
K L
= (1 a)Y 1 K + aY 1
L

= Y1 Y =Y

5. Consider now the following CES technology

h 1 1
i 1
Y =A K + (1 )L (101)

where A > 0, 0 < < 1 and 0. Let r + denote the user cost of capital and
w the wage rate. The equilibrium goods price p is then given by a CES index of
factor prices according to

1
p=A 1
(r + )1 + (1 ) w1 1

Proof. Take the partial derivative of (101) to get

@Y h 1 1
i 1
1 1 1
1
= A K + (1 )L K
@K 1

( 1) 1 1 1 1
Notice 1
1= 1
= 1
and 1= = . Hence, we get

@Y h 1 1
i 1
1 1
=A K + (1 )L K
@K

Moreover
h 1 1
i 1
1 1 1
K + (1 )L =Y A

72
Therefore 1
@Y 1 1 1 1 Y
= AY A K =A
@K K
Similarly
1
@Y 1 1 1 1 Y
= AY A (1 )L =A (1 )
@L L
First-order conditions read as follows
1 1
!
1 Y pA 1
r + = pA =) K= Y =A p Y
K r+ r+

1 1
!
1 Y pA (1 ) 1 (1 )
w = pA (1 ) =) L= Y =A p Y
L w w

The indirect production technology may be expressed as

" 1 1 # 1
1 1 (1 )
Y =A A p Y + (1 ) A p Y
r+ w

Eliminating Y and solving for p gives the goods price in competitive equilibrium

" 1 1 # 1
(1 ) 1
Y = A + (1 ) A p Y
r+ w
" 1 1 # 1
(1 )
p = A + (1 )
r+ w
" #11
1 1
1 r+ w
p = A + (1 )
(1 )
1
= A 1
(r + )1 + (1 ) w1 1

4.4.2 Complementarity: clari…cation on terminology

Often one reads statements like "due to complementarity between K and L a higher
stock of K increases the marginal product of L". There are in fact (at least) two uses
of the phrase "complementarity".

73
 (1) Complementarity applies (only) under a Leontief technology Y = minfK; Lg
(strict complementarity).31
(2) Complementarity applies if one input factor’s marginal product depends posi-
tively on the level of other input factor(s). Hence, complementarity requires that the
underlying technology is not additively separable.

Example 1
Y = aK + bL; a; b > 0

Properties: no complementarity (implying additive separability), perfect substitutabil-

a
ity (reducing K by 1 unit requires to increase L by b
units to keep Y = const).

Example 2
Y = aK + bL ; 0< <1

Properties: no complementarity (implying additive separability), imperfect substi-

tutability.

Example 3
1
Y = (aK + bL ) ; < 1; 6= 0

Properties: complementarity (implying non-additive separability), imperfect substi-

tutability.

4.4.3 Application: competitive CES sector

Consider a sector composed of a continuum of length one of identical …rms, which have
access to the following CES technology

Z N
1

X= x(i) di ;
0

31
Starting from an e¢ cient ratio of input factors, Y = minfK; Lg implies that an increase in one
input factor increases the marginal product of the other input factor from zero to a positive constant.

74
where x(i) denotes the amount of intermediate good of type i 2 [0; :::; N ], N the
’number’of intermediate goods, and 0 < < 1. Pro…t of the typical X-…rm is
Z N
= PX
|{z} p(i)x(i)di
0
sales revenue | {z }
production costs

where P denotes the price of good X and p(i) the price of intermediate good i, respec-
tively. The demand schedule for any xi , i.e. arg max , is given by
xi

1
1
p(i) 1 x(i)
x(i) = X () p(i) = P
P X

The ideal price index of intermediate goods prices, which allows us to write P X =
RN
0
p(i)x(i)di, is obtained as follows. Substituting x(i) by the RHS of the demand
schedule yields
Z N
1
p(i) 1
PX = p(i) di X
0 P
Solving for P gives
Z N
1
P = p(i) 1 di P 1
0
Z N
1

= p(i) 1 di
0

The price index times a quantity index, P X, equals total expenditures for intermedi-
RN
ates goods 0 p(i)x(i)di. Notice that P represents an ideal price index of intermediate
goods prices and represents the price of good X. See also the remarks in index numbers
at the end of this section.
RN
It can easily be checked that P satis…es P X = 0
p(i)x(i)di. At …rst, notice that
an equilibrium must be characterized by a symmetric allocation of x(i) (an asymmetric

75
x(i)-allocation cannot be e¢ cient and the …rst theorem of welfare applies) and hence

Z N
1
x(i)=x8i 1
X= x(i) di =) X = N x(i)
0

Now assume, for the time being, that the price index P is given by

Z N
1

P = p(i) 1 di
0

1
1 1
Under symmetry this implies P = N p(i). Hence, one may write (notice: + =
1)
1 1
PX = N p(i)N x(i) = N p(i)x(i)

which implies that the equilibrium condition = 0 does indeed hold true.

4.5 Two methodological issues

Dimensions. Consider a microeconomic production process (just one type of output,

one type of labor and one type of capital) described by Y = AK L . Output Y may
be measured in units of widgets per time period, capital K in units of machine hours
per time period, and labor L in units of labor hours per time period. The parameters
and are pure (i.e. dimensionless) number. To guarantee that the dimension of the
LHS equals the dimension of the RHS A must have dimension

widgets per time period

(machine hours per time period) (labor hours per time period)

"...the purpose of any function’s parameters...is to help describe the relationship be-
tween the function’s dependent variable and its independent variables, including their
dimension units. Therefore, a function’s parameter dimensions (and values) simply are
whatever they need to be (including roots and powers) to describe the relationship
fully and accurately— including that the left and right side dimensions must match.
Variables must have (understandable) dimensions. Parameters may or may not have

76
dimensions... In the Cobb-Douglas production function, parameter A has dimensions
that force the function’s left and right side dimensions to match. More generally, pa-
rameter A has dimensions that the function needs to describe its assumed relationship
between output and input variables..." (Folsom and Gonzalez, Quarterly Journal of
Austrian Economics, 2005)
Heterogeneous capital. Under what conditions can a consistent meaning be
given to the quantity of capital? Suppose we have a production function which relates
the output of a single commodity to inputs of labor (assumed homogenous) and the
services of several kinds of capital goods. When if ever can the various capital inputs
be summed up in a single index-…gure, so that the production function can be "col-
lapsed" to give output as a function of inputs of labor and "capital-in-general"? This
is sometimes possible, but only in a very narrow class of cases.
Formally, suppose we have a production function Q = F (L; C1 ; C2 ) where Q is a
single output, L is labor, and C1 and C2 are inputs of the services of two distinct kinds
of capital equipment. The question is: when can we write, identically

Q = F (L; C1 ; C2 ) = H(L; K) with K := (C1 ; C2 )

That is to say, when can we collapse the production function from one having three
variables to one having only two? If this can be done, we would seem to have a right to
call K an index of the quantity of capital. For the purposes of production any pattern
of inputs C1 , and C2 are equivalent so long as they yield the same value of the index
K.
Two examples: (i) Consider the Cobb-Douglas production function Q = Lu C1v C2w .
v w
It is obviously collapsible since we can rewrite it Q = Lu K v+w with K := C1v+w C2v+w .
2
(ii) Consider the production function Q = (L0:5 + C10:5 + C20:5 ) . It can then be col-
2 2
lapsed into Q = (L0:5 + K 0:5 ) with K := (C10:5 + C20:5 ) . (Solow, RES, 1955-56)
Index numbers. The index number problem may be stated as follows. Suppose we
have price data p := (p1 ; : : : ; pN ) and quantity data q := (q1 ; : : : ; qN ) on N commodities.

77
The index number problem is to …nd numbers P and numbers Q such that

X
N
P Q = pq = p n qn
n=1

P is the price index and Q is the corresponding quantity index. P is supposed to

be representative of all of the prices pn , n = 1; : : : ; N in some sense, while Q is to be
similarly representative of the quantities qn , n = 1; : : : ; N . In what precise sense P and
Q represent the individual prices and quantities is not immediately evident, and it is
this ambiguity that leads to di¤erent approaches to index number theory. Note that we
require that the product of the price and quantity indexes P Q equals the expenditures
on the N commodities, pq. Thus if the P are determined, then the Q may be implicitly
determined using the above equation, or vice versa. (Diewert, 2008, p. 190)

5 Utility and Welfare

Modelling utility has implications for the implied behavior of households. It may
also a¤ect the normative model implications. We therefore review some fundamental
aspects of modelling utility and welfare in dynamic macroeconomics.

5.1 CIES / CRRA

In dynamic macroeconomics we often assume that the (instantaneous) utility function

is of the following shape
c1 1
u(c) = (102)
1
where c 0 denotes consumption and > 0. The following aspects should be noticed

The elasticity of marginal utility w.r.t. consumption (a measure for the curvature
of the utility function) is

du0 (c)=u0 (c) du0 (c) c u00 (c) c

u0 (c);c := = = = <0
dc=c dc u0 (c) u0 (c)

78
 The last equality uses u0 (c) = c and u00 (c) = c 1
.

u00 (c) c
The Arrow-Pratt measure of relative risk aversion reads u0 (c)
. Hence, the CIES
utility function exhibits a constant, i.e. independent of the level of consumption,
degree of relative risk aversion.

1 c1
The term " 1 " is motivated as follows. The function 1
is not de…ned for
= 1. In contrast (102) is de…ned for = 1 (it boils down to an expression of
the form 00 , which can be evaluated by applying L’Hopital’s rule) and given by
d(c1 1)
1 c1
u(c) = ln c. Proof : lim c 1 1
= lim d
d(1 ) = lim 1
ln c
= ln c.32
!1 !1 d !1

The primary reason for the frequent use of the CIES utility function lies in the
fact that this utility function is compatible with steady state growth (cf. the
Keynes-Ramsey rule).

5.2 Other utility functions

1 c
The CARA (or exponential) utility function reads u(c) = e with > 0.
u00 (c)
It implies a constant absolute risk aversion, i.e. u0 (c)
= . The IES is given
u0 (c) 1
by u00 (c)c
= c
. Obviously, the IES vanishes as c approaches in…nity. Proof : see
below.

A utility function that accounts for subsistence consumption needs is as follows:

(c c)1 1
u(c) = 1
, where c 0 and > 0. Only to the extent that consumption
exceeds the minimum level of consumption c, welfare is created. It can be shown
c c1
that, in this case, IES = c
. Notice that lim c c c 1 = 1 .
c!1

5.3 Welfare - discrete vs. continuous time

Intertemporal welfare is measured by the present discounted value of an utility stream

over a given period
X
T
1
t
U= u(ct )
t=0
1+
da x d(c1 1) dc1
32
Recall: dx = a x
ln a; also notice: d = d = c dcd = c( c ln c) = c1 ln c.

79
where 0 is the discount rate and t 2 f0; :::; T g is the discrete time index. If the
time index is continuous, i.e. t 2 [0; :::; T ], intertemporal welfare reads as follows
Z T
t
U= e u[c(t)]dt
t=0

The relation between these two formulations can be seen as follows. Consider the
case where an amount of Ae is being invested into an asset that pays a (nominal)
interest rate of r per period of length 1. Assuming that the interest is compounded
once a period, the value of this asset after t periods is
0 1t

V = A @1 + r
|{z}
A
interest rate for period of length 1

If the interest is compounded m times per period, assuming that the payo¤ is
reinvested immediately, the value of this asset after t years reads33
0 1mt
B r C
B C
V = A B1 + C
@ m
|{z} A
1
interest rate for subperiod of length m

In case of continuous interest compounding, i.e. m ! 1, one gets34

r mt
V = lim A 1 + = Aert
m!1 m

The economic interpretation of e accordingly reads as follows: an asset that pays a

nominal interest of 100 percent per period (i.e. r = 1), assuming continuous interest
compounding and immediate reinvestment of the payo¤s, yields a total payo¤ of e '
2:718 after one period. Hence, the e¤ective interest rate is about 1:718.
33
In case of interest compounding twice a period and assuming that the payo¤ is reinvested immedi-
ately one gets V = A(1+ 2r )(1+ 2r ) = A(1+ 2r )2 after one period. Assuming interest compounding three
times a period and immediate reinvestment of payo¤s one gets V = A(1 + 3r )(1 + 3r )(1 + 3r ) = A(1 + 3r )3
after one period.
34 1 m
Notice the following de…nition of Euler’s number: e = limm!1 1 + m .

80
 If m is …nite, then t is discrete. For instance, assuming m = 2, one gets t 2
f1=2; 1; :::g, while for m = 4, we have t 2 f1=4; 2=4; 3=4; 1; :::g. If, on the other hand,
m ! 1, then t becomes continuous (i.e. t 2 Q+ ).
The case of discounting is, of course, closely related to the cases considered above.
t
The present value of a payment of V taking place in t periods is A = V (1 + r) (with
rt
interest compounding once a period) and A = V e (with instantaneous interest
compounding).

5.4 Intertemporal elasticity of substitution

Why should we care about the intertemporal elasticity of substitution (IES)? Answer:
The IES is one important determinant which a¤ects the growth rate of consumption
according to the KRR: c^ = 1 (r ) where 1
is the IES, as will be shown below.
CIES preferences. The present value of an in…nite utility stream is given by
R1
U = t=0 u[c(t)]e t dt where 0 is the discount rate per period of length dt. Assume
that instantaneous utility is of the CIES type such that
Z 1
c(t)1 1 t
U= e dt (103)
t=0 1

The (intertemporal) elasticity of substitution between consumption at two points

in time, t = i and t = j (with i 6= j), is given by

c(i) c(i) c(i)

d( c(j) )= c(j) d ln( c(j) )
IES := Uc(j) U
= Uc(j)
0
d Uc(i)
= Uc(j)
c(i)
d ln Uc(i)

c(i)
The IES indicates by how much (in percentage terms) the ratio c(j)
changes, if the
slope of an indi¤erence curve is changed (recall: dU [c(i); c(j)] = Uc(i) dc(i)+Uc(j) dc(j) =
dc(i) Uc(j) dc(i)
0 implies dc(j)
= Uc(i)
, where dc(j)
denotes the MRS). The IES is a dimensionless
measure of the substitutability between the consumption in period i and consumption
in period j.

81
 Figure 9: Intertemporal consumption substitution

i
The IES can be evaluated as follows. First, notice that Uc(i) = e c(i) and
j
Uc(j) = e c(j) such that

Uc(j) j
c(j) e c(i) (j i)
= i
= e
Uc(i) c(i) e c(j)

c(i)
Taking the natural logarithm and forming the derivative w.r.t. ln c(j)
yields

Uc(j)
Uc(j) c(i) d ln Uc(i)
ln = ln (j i) =) =
Uc(i) c(j) d ln c(i)
c(j)

It follows immediately that

c(i)
d ln( c(j) ) 1
IES = Uc(j)
=
d ln Uc(i)

Notice that this result holds for any two c(i) and c(j).
CARA preferences. The IES between any two consumption points t = i and

82
t = j is 2 3
U 1 U
d Uc(j) c(j)
Uc(i)
IES := 4 5
c(i)
c(i) c(i)
:
d c(j) c(j)

The ratio between the marginal utilities at t = i and t = j reads

Uc(j) (j i) (c(j) c(i)) (j i) c(j)(1

c(i)
)
=e e =e e c(j) :
Uc(i)

Uc(j) c(i)
Forming the derivative of Uc(i)
w.r.t. c(j)
yields

U
d Uc(j)
c(i) (j i) (c(j) c(i))
c(i)
= c(j)e e :
d c(j)

Putting everything together gives

(j i) (c(j) c(i))
(j i) (c(j) c(i)) 1 e e
IES = c(j)e e c(i)
c(j)
(j i) (c(j) c(i))
1 e e c(j) 1
= (j i) e (c(j) c(i))
= :
c(j)e c(i) c(i)

5.5 Welfare in the steady state

If consumption is constant at level c~, intertemporal welfare U may be expressed as

Z 1
c~1 1 t c~1 1
U= e dt = (104)
0 1 (1 )

R1 h i h i
t 1 1 1 0
The last equality uses 0
u(~
c)e dt = F (1) F (0) = u(~
c) e u(~
c) e =
u(~
c) t
, where F (t) is the antiderivative (inde…nite integral) of f (t) = u(~
c)e .
If consumption grows at a constant (geometric) rate of growth, i.e. c = c~egt , one
gets
Z 1 Z 1
cegt )1
(~ 1 t c~1 1
U = e dt = e((1 )g )t
e t
dt
0 1 0 1 1
c~1 1
=
(1 )((1 )g ) (1 )

83
It is usually assumed that (1 )g < 0. Otherwise intertemporal welfare would not
be bounded from above implying that usual dynamic optimization techniques cannot
be applied.
Notice that in the case of log utility, u(c) = ln(c), life-time utility in the stationary
steady state (c = c~) would be given by
Z 1
t ln(~
c)
U= ln(~
c)e dt = : (105)
0

If the steady state growth rate of consumption is positive, then life-time utility
reads as follows Z 1
ln(c0 ) + g
U= ln(c0 eg t )e t
dt = 2
: (106)
0

Remark:

Z 1 Z 1
gt t t
U = ln(c0 e )e dt = [ln(c0 ) + gt] e dt (107)
0 0
Z 1 Z 1
t t ln(~
c) g ln(c0 ) + g
= ln(c0 )e dt + gte dt = + 2
= 2
: (108)
0 0

5.6 Consumption-equivalent change in welfare

Assume we know the change in intertemporal welfare U in response to some policy

intervention. To assess the quantitative importance of this welfare change, one can
calculate the consumption-equivalent change in intertemporal welfare, i.e. the perma-
c
nent, percentage variation in consumption c0
which is equivalent to the given change
in intertemporal welfare U.
To illustrate, consider the following example. Imagine a Ramsey economy with
capital externalities. Assume the economy is in a steady state initially. The resulting
time path of consumption is denoted as cB (t) (’consumption in baseline scenario’).
Assume further that the government implements a capital subsidy. This policy leads to
a transition to the new steady state. The implied time path of consumption is denoted
R1 1
as cA (t) (’consumption in alternative scenario’). Evaluating UB = 0 (cB (t))
1
1
e t dt

84
 R1 (cA (t))1 1 t
and UA = 0 1
e dt enables one to calculate U = UA UB , i.e. the
absolute change in life-time utility resulting from the policy measure under study.
Since this information is not very instructive, one usually transforms U into the
c
associated c0
, i.e. the (hypothetical) permanent, percentage variation in consumption
which is equivalent to U . In Figure 4, cH (t) shows the hypothetical, time-invariant
cH (t) cB (t)
level of consumption which leads to the life-time utility UA such that cB (t)
gives
the (hypothetical) permanent, percentage variation in consumption which is equivalent
to U.

Figure 10: Time path of consumption in baseline scenario, CB (t), consumption in

alternative scenario, CA (t), and hypothetical consumption, CH (t).

c
The permanent, percentage variation in consumption c0
which is equivalent to the
given change in intertemporal welfare U can be computed as follows. We proceed in
two steps.
First, we calculate the hypothetical, time-invariant level of consumption, denoted
as cH , which delivers the life-time utility UA . This results from (recall (1 )g < ):
Z 1
(cH egt )1 1 t (cH )1 1
UA = e dt =
0 1 (1 ) [(1 )g ] (1 )

85
 Solving this equation for cH gives

1
( (1 )g) 1
cH = UA (1 )( (1 )g) + >0

In case g = 0 (i.e. the steady state growth rate is zero) the preceding result simpli…es
to read:35
1
cH = [UA (1 ) + 1] 1 >0

Second, given cH and cB , one immediately determine

c cH cB
=
c0 cB

c
One can also determine c0
directly, which is conceptually a bit more complicated.
The starting point here is the following equation:

Z 1 1 Z 1 1
((c0 + c)egt ) 1 t (c0 egt ) 1 t
U= e dt e dt
0 1 0 1
| {z } | {z }
welfare under alternative scenario (policy change) welfare under baseline scenario (no policy change)
(109)
The change in intertemporal welfare U is represented to result from a one-time
permanent shift in consumption by c. In other words, c indicates the hypothetical
permanent increase in consumption (the BGP is shifted upwards by c) which is
equivalent to U ! Notice that the unknown in (109) is c.

Z 1 1 Z 1
((c0 + c)egt ) t 1 t
U = e dt e dt
0 1 0 1
Z 1 1 Z 1
(c0 egt ) t 1
e dt + e t dt
0 1 0 1
35 c1H 1
By noting equ. (104) this result can also be determined directly from UA = (1 ) .

86
 Z Z
((c0 + c))1
1 1
c01
U = e(g(1 ) )t
dt e(g(1 ) )t
dt
0 1 0 1
((c0 + c))1 1 c10 1
=
1 (g(1 ) ) 1 (g(1 ) )
!
1 1
((c0 + c)) c0 1
=
1 1 (g(1 ) )

Solving for c=c0 gives

1
c (c10 + U( 1)(g(1 ) )) 1
= 1
c0 c0
c
c0
gives the permanent, proportional (per time period) increase of consumption
which is equivalent to U . See the study on changes of the R&D subsidy based on the
Jones (1995) model and the …le ’optimal_capital_subsidization.nb’.

5.7 Welfare gain of TFP growth: simplest case

Consider a small open Ramsey economy with r = . The constant level of consumption,
c~, reads36
w
c~ = a0 + ;
r
Life-time utility is then given by
Z 1
c1 1 t c~1 1
e dt = .
0 1 (1 )

Assume that the wage w increases once and for all according to A 1. The
36
See section 3.4.2 with r = and n = 0.

87
associated welfare gain may then be expressed by calculating that satis…es
0 11
0 11 c~(alternative)
c~(baseline) z }| {
z }| { B Aw C
B w C B C
B a0 + C 1 B a0 + C 1
@ r A @ r A

=
(1 ) (1 )

w Aw
a0 + = a0 +
r r
Aw
a0 + Awr
1+ a0 r
= =
a0 + wr 1+ w
a0 r

We are interested in (a0 ). Notice that lima0 !0 (a0 ) = A and lima0 !1 (a0 ) = 1.
Hence, this setup implies that the welfare gain of a once and for all increase in TFP
is independent of and declines with a0 . However, this setup may be too simple to
gain deeper insights. The assumed constancy of r and the implied constancy of c may
appear too restrictive.

6 Appendix: Notes on the literature

6.1 Dynamic optimization

Chiang, A. C. (1999), Elements of Dynamic Optimization, McGraw Hill, New York.

Dockner, E. J. et al., Di¤erential Games in Economics and Management Science,
2000, Cambridge University Press, Cambridge.
Feichtinger, Gustav and Richard F. Hartl (1986), Optimale Kontrolle ökonomis-
cher Prozesse, Anwendung des Maximumprinzips in den Wirtschaftswissenschaften, de
Gruyter, Berlin.
Kamien, Morton I. and Nancy L. Schwartz (1981), Dynamic Optimization, The
Calculus of Variations and Optimal Control in Economics and Management, North-
Holland, New York.
Silberberg, Eugene (1990), The Structure of Economics: A Mathematical Analysis,

88
Mc Graw-Hill, New York. (the respective chapter contains a nice summary on control
theory)
Intriligator, Michael D. (1971), Mathematical Optimization and Economic Theory,
Prentice-Hall, Inc., Englewood Cli¤s, N.J. ("despite its age" an excellent book on
optimisation methods)
Seierstad, Atle and K. Sydsaeter (1987) Optimal Control Theory with Economic
Applications, North Holland.

6.2 Dynamic systems

Chiang, A. C., Fundamental Methods of Mathematical Economics, McGraw-Hill, 1984,

PART 5.
Galor, Oded, Discrete Dynamical Systems, Springer, 2007.
Gandolfo, Giancarlo (1996), Economic Dynamics, Springer-Verlag, Berlin, Heidel-
berg, New York.
Lorenz, Hans-Walter (1989), Nonlinear Dynamical Economics and Chaotic Motion,
Lecture Notes in Economics and Mathematical Systems, Springer-Verlag, Berlin.
Tu, Pierre N.V. (1994), Dynamical Systems, An Introduction with Applications in
Economics and Biology, Springer-Verlag, Berlin.

6.3 Numerical solution: simulation of transitional dynamics

Abell, M. L. and J. P. Braselton, Di¤erential Equations with Mathematica, 1997,

Academic Press, San Diego.
Brunner, M. and H. Strulik, Solution of perfect foresight saddlepoint problems: a
simple method and applications, Journal of Economic Dynamics and Control, 2002,
26, 737-753.
Judd, K., Numerical Methods in Economics, MIT Press, Cambridge (Massachusetts),
1999.
Shone, R., Economic Dynamics, Cambridge University Press, Cambridge UK, 2002.

89
6.4 Stochastic growth

Dixit A. K. and R. S. Pindyck, Investment under Uncertainty, Princeton University

Press, Princeton, New Jersey.
Mikosch, T., Elementary Stochastic Calculus with Finance in View, World Scien-
ti…c, Singapore, 1998.
Turnovsky, Stephen J., Methods of Macroeconomic Dynamics, MIT Press, Cam-
bridge Mass, Part V, 1996.
Jitka Dupacova, Jan Hurt, Josef Stepan, Stochastic Modeling in Economics and
Finance (Applied Optimization, 75), Kluwer Academic Publishers; 2002.
Kamien, Morton I. and Nancy L. Schwartz (1981), Dynamic Optimization, The
Calculus of Variations and Optimal Control in Economics and Management, North-
Holland, New York. Section 22
Waelde, Klaus, Applied Intertemporal Optimization, 2014 (http://www.waelde.com/aio.html)

References
[1] Acemoglu Daron (2009), Introduction to Modern Economic Growth, Princeton
University Press, Princeton, London.

[2] Acemoglu, Daron, Philippe Aghion, Leonardo Bursztyn, and David Hemous. 2012.
"The Environment and Directed Technical Change.", American Economic Review,
102(1): 131-66.

[3] Barro, Robert J. and Xavier Sala-i-Martin (2005), Economic Growth, 2nd Edition,
The MIT Press, Cambridge, London.

[4] Blanchard, Oliver Jean and Fischer, Stanley (1989), Lectures on Macroeconomics,
The MIT press, Cambrdige, Oxfordshire.

[5] Caselli,Francesco and Jaume Ventura, (2000), "A Representative Consumer The-
ory of Distribution", The American Economic Review, Vol. 90, No. 4, pp. 909-926.

90
 [6] Chiang, A. C. (1999), Elements of Dynamic Optimization, McGraw Hill, New
York.

[7] Chiang, Alpha C. and Kevin Wainwright (2005), Fundamental Methods of Math-
ematical Economics, McGraw Hill, New York.

[8] Chow, Gregory C. (1997), Dynamic Economics: Optimization by the Lagrange

Method, Oxford University Press.

[9] Diewert, W.E., Index Numbers, in: Durlauf, Steven N. and Lawrence E. Blume
(eds.), The New Palgrave Dictionary of Economics, Second Edition, Volume 4,
Palgrave Macmillan, 2008, pp. 190-214.

[10] Einstein, Albert (1934), "On the Method of Theoretical Physics", Philsophy of
Science, Vol. 1, No. 2, pp. 163-169.

[11] Feichtinger, Gustav and Richard F. Hartl (1986), Optimale Kontrolle ökonomis-
cher Prozesse, Anwendung des Maximumprinzips in den Wirtschaftswis-
senschaften, de Gruyter, Berlin.

[12] Folsom, Roger N, and Rodolfo A. Gonzalez (2005), "Dimensions and Economics:
Some Answers", The Quarterly Journal of Austrian Economics, Vol 8. No.4, pp
45-65.

[13] Gandolfo, Giancarlo (1996), Economic Dynamics, Springer-Verlag, Berlin, Heidel-

berg, New York.

[14] Heer, Burkhard and Mauß

ner, Alfred (2009), Dynamic General Equilibrium Mod-
eling, 2nd Edition, Springer-Verlag, 2nd Edition, Berlin, Heidelberg.

[15] Intriligator, Michael D. (1971), Mathematical Optimization and Economic Theory,

Prentice-Hall, Inc., Englewood Cli¤s, N.J.

[16] Jones, Charles I. (1995), "R & D-Based Models of Economic Growth", The Journal
of Political Economy, Vol. 103 Issue 4, pp. 759-784.

91
[17] Kamien, Morton I. and Nancy L. Schwartz (1981), Dynamic Optimization, The
Calculus of Variations and Optimal Control in Economics and Management,
North-Holland, New York.

[18] Mas-Colell, Andreu, Whinston, Michael D. And Jerry R. Green (1995), Microeco-
nomic Theory, Oxford University Press, New York.

[19] McKenzie, Lionel W., General Equilibrium, in: Durlauf, Steven N. and Lawrence
E. Blume (eds.), The New Palgrave Dictionary of Economics, Second Edition,
Volume 3, Palgrave Macmillan, 2008, pp. 586-604.

[20] Popper, Karl, 1992, The Logic of Scienti…c Discovery, pp. 121-132.

[21] Robinson, J. (1962), Essays in the Theory of Economic Growth, London: Macmil-
lan.

[22] Silberberg, Eugene (1990), The Structure of Economics: A Mathematical Analysis,

Mc Graw-Hill, New York.

[23] Solow, Robert M. 1955–1956. “The Production Function and the Theory of Cap-
ital.”Review of Economic Studies 23 (2): 101–108.

[24] Solow, Robert (1956), "A contribution to the Theory of Economic Growth", The
Quarterly Journal of Economics, Vol. 70, No. 1 , pp. 65-94.

[25] Solow, Robert (2000), Growth Theory: An Exposition, 2nd Edition, Oxford Uni-
versity Press, New York.

[26] Summers, Lawrence H., 2014, “Re‡ections on the ‘New Secular Stagnation Hy-
pothesis”’. In Secular Stagnation: Facts, Causes and Cures, ed. by Coen Teulings
and Richard Baldwin, A VoxEU.org Book.

[27] Sydsæter, Knut, Arne Strøm and Peter Berck, Economists’Mathematical Manual,
Springer Verlag, 2005.

[28] Varian, Hal, Microeconomic Analysis, W. W. Norton & Company, 1992.

92
[29] Waelde, Klaus, Applied Intertemporal Optimization, 2014
(http://www.waelde.com/aio.html)

[30] "Charles Ponzi" http://en.wikipedia.org/wiki/Charles_ponzi, accessed June 3rd,

2013.

93