14.

06 Midterm 2005 - Solutions

Note: Most questions ask for an explantion. In many cases, you lost points because the explanation was missing or
incomplete.

Question 1
(a) The resource constraint is

k(t) = k(t) c(t) k(t)

To derive the Euler equation, solve the social planners’s maximization problem
t
H=e log c(t) + (t)[k(t) c(t) k(t)]
The FOCs are
t 1
Hc = e c(t) (t) = 0
1
Hk = (t)[( )k(t) ]= (t)

Now use the FOC for consumption to …nd (t) and (t)

t 1
(t) = e c(t)

t 1 t 1 c(t)
(t) = e c(t) e c(t)
c(t)

Plugging these into the FOC for capital gives the Euler equation

c(t) 1
=( )k(t)
c(t)

The Phase diagram is a usual, where the c = 0 locus and the k = 0 locus are given by
1
1 +
c = 0 <=> k =
+
k = 0 <=> c(t) = k(t) k(t)

(b) Assume that k > 1 for simplicity. Then, as decreases, the c = 0 locus shifts to the right and the k = 0 locus shifts
up. Lowering increases the returns to capital, which leads to more capital accumulation and shifts out the c = 0 locus.
Also, lowering increases production for any level of k, which causes the to k = 0 (the resource constraint) to shift up.

(c) It is uncertain wether c increases or decreases initially. If the wealth e¤ect dominates, c increases. If the substitution
e¤ect dominates, c decreases. Which of these e¤ects dominates depends on the EIS. However, we know that c has to jump
onto the new saddle path (if the new saddle path goes through the old stead state, then c doesn’t have to jump at all). From
then on, c follows the new saddle path and both c and k smoothly converge to the new steady state.

1
 (d) We know that the Euler equation for the household is like the one for the social planner, just with the interest rate
in the place of the marginal product of capital

c(t)
= r(t)
c(t)
To …nd the interest rate, we solve the …rm’s maximization problem, where the …rms don’t take into account the externality

maxQk(t) r(t)k(t)
k(t)

The FOC is
1 1
r(t) = Qk(t) = k
Thus we get

c(t) 1
= k
c(t)

First note that the k = 0 locus is not di¤erent in the decentralized equilibrium since the overall amount of resources for
a given k does not change. However, the incentives for accumulating capital change since the private return to capital is
higher. From the Euler equation, we can derive that the steady state k is now higher, which means that the c = 0 locus is
further to the right.

(e) The social planner’s allocation is e¢ cient, but the decentralized allocation is not. Households overinvest in capital
since they don’t internalize the externality. The private return to capital is higher than the social return. To restore e¢ ciency,
we could impose a distortive/proportional tax on capital income. This would give the following Euler condition

c(t) 1
= [(1 ) k(t) ]
c(t)
The tax that sets (1 ) =( ) is = .

(f) The answer is the same as for part (b), except that the c = 0 locus does not shift quite as much.

Question 2
(a) False. The neoclassical model can explain a big fraction of income di¤erentials if we include human capital in the
model (see Mankiw, Romer, Weil). However, it does not explain all of the variation. Moreover, although the model can
explain conditional convergence, it predicts that all countries grow at the same rate once they are in steady state (unless
technology growth varies across countries, which is not explained by the model).

(b) False. In the Ramsey model, output per capita grows at the rate of technological progress in the long-run (in steady
state). Hence, in Ramsey the long-run growth rate does not depend on the EIS. However, in the AK model, the growth rate
is always 1 [A ], where 1 is the EIS.

(c) False. The immediate impact on consumption and labor supply is uncertain since it depends on whether the wealth or
the substitution dominates, which in turn depends on the EIS. The increase in productivity causes the wage and the interest
rate to increase, which implies that household income increases. The wealth e¤ect leads households to consume more and to
work less since they are richer. The higher wage makes leisure more expensive and gives an incentive to households to work
more. The higher interest rate makes consumption today more expensive (in terms of consumption tomorrow), which leads
to a decrease in consumption.

(b) False. When …nancial markets are incomplete, agents can not diversify all the risk they face. Since they are risk
averse, they don’t like investing in undiversi…ed risky projects, which lowers savings and growth.