EC004-OLG Model PPT - Part 1

Output Dynamics with Heterogenous Agents:
Impact of Income/Wealth Inequality in Solow, R-C-K and OLG
Mausumi Das
Lecture 12, EC004, DSE
April 9, 2024
Das (Lecture 12, EC004, DSE) Heterogenous Agents: Solow to R-C-K to OLG April 9, 2024 1 / 19
Samuelson-Diamond Overlapping Generations Model
In the last lecture I introduced the Samuelson-Diamond OLG

framework as an alternative to the R-C-K framework.
In this framework, agents optimize over a …nite time horizon.
Each agent now lives exactly for T periods. For convenience, we shall
assume that T = 2.
Moreover, all agents in this model are sel…sh - they care only
about their own consumption and utility, and not about their
childrens’wealth/consumption/utility.
We shall see that the …nite time horizon along with non-altruistic
parents will generate results which are diametrically opposite of the
results that we got in the R-C-K model.
OLG Model: General Set Up
Each agent lives exactly for two periods.

We shall denote these two periods of an agent’s life time by ‘youth’
and ‘old-age’respectively.
An agent is born with the endowment of one unit of labour time.
Since parents are sel…sh, there is no bequest/wealth received from
parents.
The agent works only in the …rst period of his life (when young) and
is retired in the second period (when old).
Thus he has to make provisions for his old-age consumption from his
…rst period income itself (through positive savings).
The agent optimally decides about his consumption pro…le by
maximizing his life-time utility (to be speci…ed later).
Heterogeneity in OLG Model: Workers vs Capital Owners
Note that there is an ‘in-built’heterogeneity in the OLG model.

In any time period, of the total population
one section (those currently young) provides only labour in the
production process;
the other section (those currently old) provides only capital - from their
savings undertaken in the previous period.
Thus in every period the workers and the capital owners are two
seperate sets of people.
This is in sharp contrast with the R-C-K model where every
household provides labour and also owns some (not necessarily equal)
amount of capital.
OLG Model: Workers vs Capital Owners (Contd.)
The class di¤erence is a bit convoluted in the OLG framework

because the same person who is a worker when young becomes a
capitalist (capital owner) when old.
So any class con‡ict or distributive con‡ict related to ownership of
factors of production e¤ectively becomes a con‡ict between two
generations: young and old.
But there is at least a recognition that the interests of the

workers/young generation may not be match the interest of the
capitalists/old generation!
We would like to examine how this class/intergenrational con‡ict
plays up in terms of per capita dynamics and in the role of
redistributive policies in that context.
OLG Model: Production Side Story
The production side story in the OLG model is again identical to that
of Solow.
Thus the economy starts with a given stock of capital (Kt ) and a
given stock of labour force (Nt ) at time t.
Notice that since people do not work during their oldage, the current
labour force consist only of the current youth.
We also assume that all …rms have access to an identical production
technology - which satis…es all standard neoclassical properties.
The …rm-speci…c production functions can be aggregated to generate
an aggregate production function such that :
Yt = F (Kt , Nt ).
At every point of time the market clearing wage rate and the rental
rate of capital are given by:
Kt
wt = f (kt ) kt f 0 (kt ); rt = f 0 (kt ) where kt .
Nt
OLG Model: Household Side Story
There are H households or dynasties in the economy. In every
household, at any point of time t, there are two cohorts of agents -
those who are born in period t (‘generation t’- who are currently
young) and those who were born in the previous period (‘generation
t 1’- who are currently old): hence the name ‘overlapping
generations’.
Thus at any point of time t, total population consists of two
successive generations of people:
Lt = Nt + Nt 1.
(Notice that although total population is Lt , total labour force

(working population) at time t in only Nt .)
We shall assume that population in successive generations grows at a
constant rate n :
Nt +1 = (1 + n )Nt .
Hence total population in the economy (Lt ) also grows at the same
constant rate n.
Life Cycle of a Representative Member of Generation t:
All agents within a generation are identical. So we can talk in terms

of a representative agent belonging to ‘generation t’.
The agent is born at the beginning of period t with an endowment of
one unit of labour.
Recall that all agents in this model are sel…sh - they care only about
their own consumption/utility and not about their childrens’utility.
Hence they do not leave any bequest.
No bequest implies that the young agent has only labour endowment
and no capital endowment.
The young agent in period t supplies his labour inelastically to the
labour market in period t to earn a wage income wt .
Out of this wage income, the agent consumes a part and saves the
rest - which becomes his capital stock in the next period and allows
him to earn an interest/rental income in the next period.
Representative Agent’s Utility Function:
1 denote the …rst period consumption of an agent of generation
Let ct,t
2
t which takes place in calender time t; and let ct,t +1 denote the
second period consumption of an agent of generation t which takes
place in calender time t + 1.
The young agent in period t optimally decides on his current
1 ) and current savings (s ) (or equivalently, his
consumption (ct,t t
1 ) and future consumption (c 2
current consumption (ct,t t,t +1 )) so as to
maximise his lifetime utility:
1 2 1 2
U (ct,t , ct,t +1 ) u (ct,t ) + βu (ct,t +1 ); 0 < β < 1, (1)
where u 0 > 0; u 00 < 0; lim u 0 (c ) = ∞.

c !0
β is the standard discount factor which tells us that agents prefer
current consumption more than future consumption (rate of time
preference). (Note that here the degree of intergenerational altruism
is zero!)
Representative Agent’s Budget Constraints:
The …rst period budget constraint of the agent:
1
ct,t + st = wt .
The second period budget constraint of the agent:
2 e
ct,t +1 = (1 + rt +1 δ ) st .
Combining, we get the life-time budget constraint of the agent as:

2
ct,t
1 +1
ct,t + = wt . (2)
(1 + rte+1 δ)
The atomistic agent decides on his optimal consumption in the two
periods by maximising (1) subject to (2), treating the market wage
rate and market interest rate as exogenous.
However, as before, we shall assume that agents have perfect
foresight/rational expectations such that rte+1 = rt +1 for all t.
Representative Agent’s Optimal Consumption & Savings:
From the FOC of the optimization exercise:
u 0 (ct,t
1 )
2
= β(1 + rt +1 δ ). (3)
u 0 (ct,t +1 )
From the FOC and the life-time budget constraint, we can derive the
optimal solutions as:
1
ct,t = ψ(wt , rt +1 );
2
ct,t +1 = η (wt , rt +1 ).
Corresponding optimal savings function:
st = wt ψ(wt , rt +1 ) φ(wt , rt +1 ).
We shall now analyse these optimal consumption and savings

functions to predict the dynamic path of per capita capita stock and
per capita consumption in the economy.
Representative Agent’s Optimal Consumption & Savings
(Contd.):
Before we proceed further, it is useful to note the signs of the partial
derivatives sw and sr under the generic utility function.
Notice that
∂φ(wt , rt +1 ) ∂ψ(wt , rt +1 ) ∂c 1
sw =1 =1 .
∂wt ∂wt ∂wt
From the life-time budget constraint of the agent:
∂c 1 1 ∂c 2
+ = 1.
∂wt (1 + rt +1 δ) ∂wt
Under the assumption that both c 1 and c 2 are normal goods, a unit
increase in the wage rate wt ceteris paribus must increase both c 1
∂c 1 ∂c 1 ∂c 2
and c 2 . This implies that 0 < < 1 (since both ∂w t
and ∂w t
are
∂wt
positive).
This in turn implies that 0 < sw < 1.
(Contd.):
The sign of sr however is ambiguous.

Notice that
∂φ(wt , rt +1 ) ∂ψ(wt , rt +1 ) ∂ct1
sr = = .
∂rt +1 ∂rt +1 ∂rt +1
So the sign of sr depends on how …rst period consumption responds

to a unit change in rt +1 .
1
Recall however that is the relative price of ct2+1 in terms
1 + rt +1 δ
of ct1 .
Thus a unit increase in rt +1 ceteris paribus reduces the relative price
of future consumption in terms of current consumption.
(Contd.):
Any such price change will be associated with two e¤ects:
a substitution e¤ect () consumption should move in favour of the
relatively cheaper good);
an income e¤ect () the budget set of the consumer expands, which
increases consumption of both goods)
Thus due to an increase in rt +1 ceteris paribus
ct1 should decrease due to the substitution e¤ect, while
ct1 should increase due to the income e¤ect of a price change.
∂ct1
The sign of depends on which e¤ect dominates.
∂rt +1
This in turn implies that
∂ct1
S 0 , sr R 0
∂rt +1
according as, substitution e¤ect R income e¤ect.
(Contd.):
Notice that sr < 0 implies that savings responds negatively to a

change in the future rate of interest: a rise in the (expected) rate of
interest leades to lower savings.
Apriori we have no reason to rule out this case, even though it is
counter-intutive. It depends on the characteristics of the utility
function.
However, henceforth we shall assume that the utility function of the
agents is such that the substitution e¤ect of a price change is at least
as strong as the corresponding income e¤ect, so that
sr = 0 (Assumption 1)
Aggregate Consumption & Savings:
Let us now turn our attention to the aggregate economy.

Recall that in every period the total output is distributed as wage
income and interest income:
Yt = wt Nt + rt Kt . (4)
The entire wage income goes to the current young generation. Each
of them saves a part of the wage income (st ) and consume the rest.
Thus,
1
wt Nt = ct,t Nt + st Nt .
On the other hand, the entire interest income goes to the current old
generation. Each of them consume not only the interest earnings but
the left over capital stock as well. (Why?)
Thus,
ct2 1,t Nt 1 = rt Kt + (1 δ)Kt .
Aggregate Savings:
Since the older generation at time t consume not only their rental
income, but also consume their left over capital stock, it implies that
the entire capital stock available for production tomorrow must come
from the savings of the young generation today.
In other words, the path of capital accumulation for the economy will
be obtained by aggregating the savings (st ) over the entire population
of young generation today (Nt ).
Thus
Kt +1 = st Nt . (5)
Since we know that labour force (i.e., young generation in every
successive period) is growing at the rate n, i.e., Nt +1 = (1 + n )Nt ,
we can derive the dynamic equation for the capital-labour ratio for
this OLG economy (kt ) as:
Kt +1 st φ(wt , rt +1 )
kt +1 = = . (6)
Nt +1 (1 + n ) (1 + n )
Dynamics of Capital-Labour Ratio:
Also, from the production side of the story, we already know that
wt = f (kt ) kt f 0 (kt );
rt + 1 = f 0 (kt +1 ).
Thus we can write (5) as:
φ(wt (kt ), rt +1 (kt +1 ))

kt +1 = Φ(kt , kt +1 ). (7)
(1 + n )
Equation (7) is the basic dynamic equation of the OLG model, which
implicitly de…nes kt +1 as a function of kt . Given k0 , we should be able
to trace the evolution of the capital-labour ratio over time.
Remark: Notice that kt +1 here denotes the capital-labour ratio
tomorrow, NOT the per capita capital stock! (The latter will now be
de…ned as KLtt++11 K t +1
N t +N t +1 ).
Existence of a Unique Perfect Foresight Path:
Let us take a closer look at dynamic equation (7).
Notice that it is an ‘implicit’di¤erence equation with kt +1 entering
on both sides.
In fact this implicit nature of the equation arises precisely due to
assumption of perfect foresight:
For any given kt , the LHS denotes the kt +1 that will acutally emerge
in the economy, while the rt +1 (kt +1 ) in the RHS captures the kt +1
that people expect to hold in the next period.
Perfect foresight will hold if and only if the LHS exactly matches the
RHS to generate a unique solution for kt +1 .
(Note that this complication would NOT arise if we have, say, static
expectation such that rte+1 = rt for all t.)
This then raises the following question: given a kt , how can we ensure
that we neceassrily get a unique kt +1 that satisfy the dynamic
equation (7) derived under perfect foresight?
We take up this issue in the next class.

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Output Dynamics with Heterogenous Agents:

Impact of Income/Wealth Inequality in Solow, R-C-K and OLG

Lecture 12, EC004, DSE

In the last lecture I introduced the Samuelson-Diamond OLG

Each agent lives exactly for two periods.

Note that there is an ‘in-built’heterogeneity in the OLG model.

The class di¤erence is a bit convoluted in the OLG framework

But there is at least a recognition that the interests of the

(Notice that although total population is Lt , total labour force

All agents within a generation are identical. So we can talk in terms

where u 0 > 0; u 00 < 0; lim u 0 (c ) = ∞.

Combining, we get the life-time budget constraint of the agent as:

We shall now analyse these optimal consumption and savings

The sign of sr however is ambiguous.

So the sign of sr depends on how …rst period consumption responds

Notice that sr < 0 implies that savings responds negatively to a

Let us now turn our attention to the aggregate economy.

Thus we can write (5) as:

φ(wt (kt ), rt +1 (kt +1 ))

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