Outline

1 Introduction
EC4302: Macroeconomic Analysis III
Ramsey-Cass-Koopmans Growth Model
2 Environment of the model

Dr. FENG Ying 3 Behavior of households and firms

4 The dynamics of the economy

5 Balanced growth path and comparative statics

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Recap the Solow model Two micro-founded frameworks

• How much should a nation save?

• An aggregate production combine capital (K ), labor (L) and
knowledge (A) to produce output (Y ) • Microfoundations ) Explicitly model the optimizing behavior of
agents ) the saving rate is endogenous
• The evolution of the inputs are given exogenously; saving rate is a
constant and no optimization involved • This week: a growth model from Ramsey (1928), Cass(1965),
Koopmans (1965)
• Takeaway: the Solow model implies that di↵erences in capital
accumulation can not account for the large di↵erences in income - Conceptually the simplest

• An obvious question: Do the conclusions of the Solow model hinge on • Next week: the overlapping-generations model by Diamond (1965)
its assumption of the fixed saving rate? To investigate this,
we look at Ramsey model, - Continual entry of new households into the economy
which endogenizes s.
You will see the result is same as Solow.
So the answer to this qn is no.
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 The Ramsey model Outline

1 Introduction
• Competitive firms

- rent capital and hire labor to produce and sell output 2 Environment of the model

• Infinitely lived households

3 Behavior of households and firms
- supply labor, hold capital (and rent to firms), consume, and save
4 The dynamics of the economy
• The model avoids all market imperfections, all issues raised by
heterogeneous households, and links among generations
5 Balanced growth path and comparative statics

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Technology Firms

• Production function is F (K , AL), where F (·) satistifies the same three • A large number of firms which maximize profits
assumptions as in Solowensures concave production function
- Free access to the same production function F (K , AL)
• Initial levels K (0), A(0), L(0) > 0 are taken as given
- Hire workers and rent capital in competitive factor markets
• A grows at rate g , and L grows at rate n () common factor prices)
• Capital accumulation: - F (·) has constant returns to scale
• ) The aggregate output of a large number of firms that collectively
K̇ (t) = Y (t) ⇣(t) K (t) (1)
employ quantities of capital and labor of K and L is the same as the
- ⇣ - total consumption (C - consumption per person; c - consumption output that a single produces using those amounts of capital and
per unit of e↵ective labor) labor, i.e. Y (t) = F (K (t), A(t)L(t)).
- This lecture: Assume depreciation = 0 and K (t) 0, 8t • Homework, Problem 4: prove the result above formally.

no need to assume that the firms are the same size. Only need firms
to have CRS production function.
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 Households Utility
• The household’s utility function
Z +1
• A large number, H, of identical households who maximize the lifetime ⇢t L(t)
U= e u C (t) dt
utility; size of each household grows at rate n 0 H

- Each household member supplies 1 unit of labor at every point in time - ⇢: rate of time preference
• The instantaneous utility function:
- Rent whatever capital it owns to firms
• Initial capital holdings of K (0)/Hinitial capital holdings for each C (t)1 ✓
u(C (t)) = , ✓ > 0, ⇢ n (1 ✓)g > 0
household 1 ✓
• The household divides its income between consumption and saving
Cu 00 (C )
- Known as constant relative risk aversion CRRA = u 0 (C ) =✓
- Income = labor income + rent from capital + profits from firms
• ✓ determines the household’s willingness (1/✓) to shift consumption
between di↵erent periods
If marginal utility is 1, v willing to shift consumption across periods.
- E.g., = C (t) if ✓ = 0 and = ln(C (t)) if ✓ = 1
if theta = 1, then u' = 1/c(t), the higher the consumption, the smaller the
marginal utility --> Less willing to shift consumption across periods, which
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determines eqm interest rate. We didn't have firm behavior in Solow model cuz there were no firms making capital
and labor decisions. But now we do.
Outline less responsive
If theta is bigger, less willing to shift consumption, households Firm’s behavior
to changes in interest rate changes. r = MPK
• Real interest rate at time t with = 0:
1 Introduction
@F (K , AL) AL@F (K /AL, 1) @F (K /AL, 1)
r (t) = = = = f 0 (k(t))
@K AL@(K /AL) @(K /AL)
2 Environment of the model
w = MPL • Real wage per person at time t:

@F (K , AL) A@ [ALf (k)] h K i

3 Behavior of households and firms W (t) = = = A f (k) + ALf 0 (k) 2 2
@L @AL A L
0
= A[f (k) kf (k)]
4 The dynamics of the economy
• Wage per unit of e↵ective labor w (t) = W (t)/A = f (k) kf 0 (k)
5 Balanced growth path and comparative statics
• Homework, Problem 5: Show that because firms pay marginal
products and CRS, firms earn zero profits.

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 Household’s budget constraint No-Ponzi-game condition
• Rearranging terms in the BC yields
Initial wealth
Z z }| { Z Z +1
+1
L(t) K (0) +1
L(t) K (0) L(t)
e R(t) C (t) dt  + e R(t)
W (t) dt (2) + e R(t) [W (t) C (t)] dt 0
H H H H t=0 H
| t=0 {z } | t=0 {z } h K (0) Z s L(t) i
PV of lifetime consumption PV of lifetime labor income lim + e R(t) [W (t) C (t)] dt 0 (3)
s!1 H t=0 H
R
• R(t) = ⌧t=0 r (⌧ )d⌧ such that 1 unit of output invested at time 0 • Note the household’s wealth at time s is
yields e R(t) units of the good at time t Z s
K (s) R(s) K (0) L(t)
• ) No-Ponzi-game condition: Present Value of the household’s asset =e + e R(s) R(t) [W (t) C (t)] dt (4)
H H t=0 H
holdings cannot be negative in the limit
• Therefore, the budget constraint of eq. (3) can be simply written as

R(s) K (s)
lim e 0 (5)
s!1 H
- Application of the condition: i) ii) on the eq. path
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Household’s problem in intensive form Budget Constraint in intensive form

• Household’s instantaneous utility function
• Consider the budget constraint eq. (2):
C (t)1 ✓ A(t)1 ✓ c(t)1 ✓ [A(0)e gt ]1 ✓ c(t)1 ✓
= = Z 1 Z 1
1 ✓ 1 ✓ 1 ✓ R(t) A(t)L(t) A(0)L(0) A(t)L(t)
e c(t) dt  k(0) + e R(t) w (t) dt
c(t)1 ✓ t=0 H H t=0 H
= A(0)1 ✓ e (1 ✓)gt Z 1 Z 1
1 ✓ e R(t)
c(t)e (n+g )t
dt  k(0) + e R(t) w (t)e (n+g )t dt
• Household’s objective function t=0 t=0
Z 1 Z 1
C (t)1 ✓ L(t) R(t)
U= e ⇢t dt ) k(0) + e w (t) c(t) e (n+g )t dt 0
t=0 1 ✓ H t=0
Z 1 h c(t)1 ✓ i L(0)e nt
= e ⇢t A(0)1 ✓ e (1 ✓)gt dt
t=0 1 ✓ H
Z 1 • Because K (s) is proportional to k(s)e (n+g )s , we can rewrite eq. (5) as
1 ✓ L(0) c(t)1 ✓ Intensive form of BC
= A(0) e ⇢+(1 ✓)g +n t dt
H t=0 1 ✓
intensive form of Z 1 lim e R(s) e (n+g )s k(s) 0 (6)
lifetime utility c(t)1 ✓ s!1
⌘B e t dt
t=0 1 ✓
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 Household behavior Consumption per worker
• Setup the Lagrangian: So far we have found the optimal consumption for each worker.
Z 1 1 ✓ h Z 1 i
t c(t) R(t) (n+g )t
L=B e dt + k(0)+ e w (t) c(t) e dt
t=0 1 ✓ t=0
C (t) = A(t)c(t)
• First order condition @L/@c(t) = 0: Ċ (t) Ȧ(t) ċ(t)
t ✓ R(t) (n+g )t
) = +
Be c(t) = e e C (t) A(t) c(t)
) lnB t ✓lnc(t) = ln R(t) + (n + g )t r (t) ⇢ ✓g
=g+
Z t ✓
= ln r (⌧ )d⌧ + (n + g )t r (t) ⇢
⌧ =0 = (8)
✓
ċ(t)
) = r (t) + (n + g ) “Leibniz integral rule”
✓
c(t) • The smaller is ✓
ċ(t) r (t) n g - the larger are the changes in consumption in response to r (t) ⇢
) =
c(t) ✓ The higher the interest rate, r, the higher the consumption growth rate.
r (t) ⇢ ✓g The more impatient the consumer, the higher the row, the lower the consumption
= “Euler equation” (7) growth rate.
✓ 17 / 40 18 / 40
tells us how much consumption is required to maximize utility.
Another way to find the Euler eqn is using economic insights
Intuitions of Equation (7) Outline
• If a household is behaving optimally, the utility cost of reducing
current consumption by c at some date t = marginal benefit of
using the resulting greater wealth to increase consumption at time 1 Introduction
t+ t
- Household marginal utility in period t: Be t c(t) ✓
2 Environment of the model
- Increase in consumption at t + t: e [r (t) g n] t c
- Household’s marginal utility in period t + t:
Be (t+ t) c(t + t) ✓ , with c(t + t) = c(t)e [ċ(t)/c(t)] t 3 Behavior of households and firms

t (t+ t)
) Be c(t) ✓
c = Be [c(t)e [ċ(t)/c(t)] t
] ✓ [r (t) g n] t
e c 4 The dynamics of the economy
ċ(t)
0= t ✓ t + [r (t) g n] t
c(t) 5 Balanced growth path and comparative statics
ċ(t) r (t) n g
= (7)
c(t) ✓
same as Euler Eqn in (7)
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 Dynamics of c Dynamics of c in (k, c) space

• Each household takes the real interest rate r (t) as given

• In equilibrium, r (t) = f 0 (k(t))
• Therefore, dynamics of c is determined by
This is from the Euler Eqn (7)
ċ(t) f 0 (k(t)) ⇢ ✓g
= (9)
c(t) ✓

- ċ = 0 when f 0 (k) = ⇢ + ✓g ; denote k ⇤ as this level of k level of k for c does not

consumption decreases
- ċ < 0 when f 0 (k) < ⇢ + ✓g , i.e., k > k ⇤ change.
0
- ċ > 0 when f (k) > ⇢ + ✓g , i.e., k < k ⇤

consumption increases

If k is high, then MPK is low, so interest rate is low, which means capital accumulation slows down. Hence consumption will fall.
If k is low, then MPK is high, so interest rate is high, which means capital accumulation speeds up. Hence consumption will rise.
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Dynamics of k in intensive form Dynamics of k

• The dynamics of the capital stock is given by K̇ (t) = Y (t) C (t)L(t)
K (t)
• Active Learning Exercise: Recall that k(t) = A(t)L(t) , derive the • Need to find the locus k̇ = 0 in the k c plane
expression of k(t) as the following:
• k̇ = 0 ) c(t) = f (k(t)) (n + g )k(t)
k̇(t) = f (k(t)) c(t) (n + g )k(t) (10) | {z } | {z }
actual output break-even investment

• Solution: similar to the derivation in the Solow model. - c on locus k̇ = 0 is maximized when f 0 (k) = (n + g ) derived from FOC wrt k

- Denote kGR as this level of k, such that f 0 (kGR ) = (n + g )

- c is increasing when k < kGR , and decreasing when k > kGR

• k̇(t) < 0 when c exceeds the level that yields the locus k̇ = 0

k̇(t) > 0 when c is less than the level that yields the locus k̇ = 0
At k_GR, consumption is maximized. So if k < k_GR, c should still be increasing. If k > k_GR, c should be
decreasing.

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 Combine cdot = 0 and kdot = 0.
Dynamics of k in (k, c) space The phase diagram
Because f 0 (k ⇤ )
= ⇢ + ✓g and f 0 (k
GR ) = (n + g ), with the assumption of
⇢ n (1 ✓)g > 0, we have f (k ⇤ ) > f 0 (kGR ), that is, k ⇤ < kGR .
0

Point E is the steady state the economy converges to.

consume too much capital, so k should fall

consume too little capital, so k should rise.

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At D, k will eventually exceed k_GR.
f'(kGR) = n+ g result of Ramsey Model
Since k > kGR, f'(k) < n + g
Equilibrium Since r = f'(k), f'(k) < n + g Saddle Path
Are all the possible paths in slide 26 part of the eqm?
No. Because they do not satisfy all the conditions an eqm requires. • For any possible level of k, there is a unique initial level of c that is
The conditions are as follows.
consistent with i) households’ intertemporal optimization, ii) the
• An equilibrium of the Ramsey model is a pair of functions c(t), k(t) dynamics of capital stock, iii) households’ budget constraints, and iv)
satisfying: the requirement that k not be negative.
PHASE DIAGRAM IS THE KEY OF
Euler Eqn RAMSEY MODEL.
ċ(t) f 0 (k(t)) ⇢ ✓g
= (9) ALSO NEED TO KNOW HOW THE ECONOMY
c(t) ✓ CHANGES IF THERE IS SOME SHOCK
capital dynamics eqn (NEXT SLIDE)
k̇(t) = f (k(t)) c(t) (n + g )k(t) (10)
R(s) (n+g )s
lim e e k(s) 0 (6)
s!1
intensive form of no-ponzi game condition.
(in the limit of time, net assets cannot be infinity. It must converge
k(0) = k0 , k(t) 0 to a positive finite number)

on A,B,C, k eventually
goes negative. So they cannot
be eqm.
at any point in time, capital cannot be negative.
the negative term -R(s) is not enough to compensate for (n+g)s as s-> infty. So overall will tend to infty. Therefore, this means net wealth will tend to infty. Which doesn't
make sense. --> D cannot be an eqm. 27 / 40 28 / 40
 Welfare Outline

• Does the equilibrium of the economy represents a desirable outcome,

i.e, the solutions of a social planner’s problem? 1 Introduction
- The planner wants to maximizes the representative households’
utility, thus having the same optimization for c(t) 2 Environment of the model
- The planner faces the same technology as firms, thus obeying the
evolution of k(t) 3 Behavior of households and firms

• ) Yes.
4 The dynamics of the economy
• First welfare theorem from microeconomics: if markets are
competitive and complete and there are no externalities (and if the
5 Balanced growth path and comparative statics
number of agents are finite), then the decentralized equilibrium is
Pareto efficient.

Next week, we will see that if number of agents is infinite, then decentralized eqm is inefficient.
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Let's now talk abt some dynamics of the Ramsey model

Ramsey Model has same implications as Solow Model. Steady-state Modified Golden-rule capital stock
• Now it becomes clear that kGR = n + g maximizes c on the k̇ = 0
• A pair (k, c) such that k̇ = 0 and ċ = 0 locus

ċ = 0 ) f 0 (k) = ⇢ + ✓g • Di↵erence from the Solow model:

k̇ = 0 ) f (k) (n + g )k = c - In Solow, s is exogenous and nothing guarantees whether k ⇤ is

below, above or at the GR level
• Once the economy converges to Point E on Slide 26, its behavior is - In Ramsey, if k(0) kGR , households would consumption a lot and
identical to that of the Solow economy on the BGP: k gradually approaches k ⇤ Even if we start at a place where k > kGR, the agent will consume
a lot to max lifetime utility such that k eventually approaches k* < kGR.
In steady state,- c, k, y
y c
are constant, and the saving rate y is also constant • Because households value present consumption more than future
c and k are constant.
so y is also constant
• Takeaway: the central implications of the Solow model concerning the consumption, the benefits of eventual permanent increase in
driving forces of economic growth does not hinge on its assumption of consumption is bounded.
a constant saving rate. • The modified golden-rule capital stock k ⇤ < kGR is the optimal level
We started the lecture thinking maybe Solow model predictions are constrained cuz savings rate is constant, so
it doesn't respond to the level of capital or output you have. of k for the economy to converge to.
But after solving the agent's optimization problem, we find that even though we endogenize savings, and thus choose
how much capital to hold, the savings rate is still also going to be a constant. As long as savings rate is a constant, we will
have same implications as Solow model.
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 Comparative statics
E↵ects of a fall in the discount rate Graph of a fall in the discount rate
EXAMINABLE
If rho decreases, f'(k*) falls --> k* increases.
So cdot = 0 line shifts right
• Suppose that ⇢ decreases (agents become more patient)
- A close analogue to a rise in the savings rate in the Solow model
• The change is unexpected ) At some date households suddenly this kind of qn will be tested in
exam
discover they now discount utility at a lower rate
• In the phase diagram, only the c locus is a↵ected
) an increase in k ⇤
• Note that k is a predetermined variable (it cannot change
discontinuously)
• In contrast, c can jump to a new value at any time

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More on comparative statics Adding Government to the Model

• Government buys at rate G (t) per unit of e↵ective labor per time
- Assumes that G (t) does not a↵ect utility from private consumption
and future output
- Government purchases are financed by lump-sum taxes
• The steady-state capital stock decreases with ⇢ and g
• The evolution of capital eq. (10) becomes
For any level of k, if G increases, c must fall.
• If g > 0, k ⇤ decreases with ✓; if g = 0, k ⇤ is not a↵ected by ✓. k̇(t) = f (k(t)) c(t) G (t) (n + g )k(t)

- A higher value of G shifts the k̇(t) = 0 locus down

• By assumption, households’ preferences and optimization conditions
are una↵ected
• Households’ budget constraint implies the same expression, eq. (6),
as before for the limiting behavior of k

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 E↵ects of an increase in G E↵ects of a permanent increase in G

• A unanticipated, permanent increase in G

- Suppose the economy is on a BGP with G (t) = GL , and there is an You will jump from E to E'
unexpected, permanent increase in G to GH meaning c will change but not k,
because you cannot change k overnight.
k is the result of capital accumulation over time.
- Consumption immediately jumps to the new saddle path; otherwise,
the eq. conditions will not be satisfied
• An unanticipated, temporary increase in G

- Suppose the economy is on a BGP with G (t) = GL , and there is an

increase in G to GH at time t0 and returns to GL at time t1

For the slopes of how c or k change, the general rule is that the change
slows down as you approach the steady-state!
The further away from steady-state, the faster the change.
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E↵ects of a temporary increase in G E↵ects of a temporary increase in G

What happens to interest rate, r?
on r (t)
r is a function of f'(k)=rho+theta*g

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