Problem Set

Problem Set
1. A Static Competitive Economy (20 Points)
Consider a static economy with a large number of identical households and firms. The product
market and factor markets are competitive. For a representative household, preferences are
given by a neoclassical utility function, u (c, l ) , where c is consumption and l is leisure.

Each consumer is endowed with l unit of time endowment, which can be allocated between
work and leisure. For a representative firm, technology is given by a neoclassical production
function, y  zn , to produce output y , where n  l  l is the labor input, and z is a
parameter called total factor productivity (TFP). There are two markets trading for:
consumption, and work/leisure, respectively. In a competitive equilibrium, what we can
determine is all relative prices, so we treat consumption good as the numeraire. The price of
output can arbitrarily be set to one without loss of generality; the price of work/leisure in units
of consumption is w .
(a) Consider a static utility maximization problem:
max u (c, l ) ,
{c , l }

subject to: c  w(l  l ) .

c and l denote the purchase on consumption and leisure, respectively; l is the time
endowment, w is the real wage rate.
Derive the condition as to u (c, l ) under which:

(i) the labor supply curve is upward sloping and backward bending;
(ii) consumption and leisure are substitutes and compliments; and
(iii)
(b) Try to define and solve for the competitive equilibrium of this economy, and then give a
graphical representation about the equivalence between the competitive equilibrium and
Pareto optimality. Show that why a positive productivity shock might generate a decrease or
an increase in employment, provided that leisure is a normal good.
(Hint: Since the First and Second Welfare Theorems apply in this economy, as a result,
resources allocation can be derived by solving a social planner’s problem, and then derive the
relative prices which are consistent with the optimal allocation. Calculate the comparative
statics, dl dz , to determine the effects of an increase in TFP on employment, since

n  l  l .)
(c) We introduce a government sector into our simple static model in the following manner.
The government makes purchases of consumption good, and finances these purchases through

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lump-sum taxes on the representative consumer. We assume here that the government
destroys the goods it purchases. Let g be the quantity of government purchases (per person),

which is treated as being exogenous, and let  be the lump-sum taxes (per person) imposed.
The government budget must balance, i.e.,
g  .

What are the effects of an increase in g on c , y , and l , if both leisure and consumption

are normal goods?

2. The Ramsey Model (20 Points)

Consider the following discrete-time, social planner’s problem for the basic Ramsey model
economy with aggregate output Yt , aggregate capital stock at the beginning of period- t K t

and labor force N t , where the growth rate of labor force n is normalized to be zero. The

aggregate production function is Yt  K t  Nt1 , with 0    1 . Output can be either

consumed or devoted to capital accumulation,

Assume that the aggregate capital accumulation equation becomes to be:
K t 1  Kt  I t1 ,

with   [0,1) , where I t denotes the aggregate investment expenditure. When   0 , this

capital production becomes to be the case in our simple model with full depreciation, i.e.,
K t 1  I t . We rule out the possibility that K t 1  K t for any t  0 when   1 . With no

government purchases, the resource constraint is:

Yt  Ct  I t .

Define the per capita variables as follows: the per capita capital stock (at the beginning of
period- t ) is defined as kt  K t N t , the per capita output is defined as yt  Yt N t , the per

capita investment is defined as it  I t N t , and the per capita consumption is defined as

ct  Ct N t . The per-period utility function is u (ct )  ln ct , and the planner discount future

utility flows with the discount factor given by 0    1 .

(a) Write down the (current value) Lagrangian for the social planner’s problem (if you are
familiar with the method of dynamic programming, you are recommended to write down the
Bellman equation for this problem), using two constraints with two multipliers. Denote the
multiplier on the resource constraint as t , and the one on the capital accumulation equation

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 Problem Set

as t qt . Derive the first order conditions associated with this problem, and try to give an

intuitive interpretation about qt .

(b) Using “guess and verify”, try to solve the model and find the solutions for kt 1 , ct , yt ,

and it . By this, we can show that the Solow model can be seen as a special case of our model

economy.
(Hint: The saving rate, s , is a constant given parameter in the Solow model. Therefore, you
should show the result that the saving rate is indeed a constant in our Ramsey economy. You
can make a tentative guess that ct  (1  s ) yt , solve for the unknown s , and thus verify that

the initial guess is a solution to the model.)

(c)
(d) Show the result that regardless of the value of the initial capital stock, k0 , eventually

kT 1 converges to its steady state level when T   .

(Hint: You are required to show that lim ln kT 1  ln k , and thus lim kT 1  k .)
T  T 

(e) For some un-modeled reasons, assume that the per capita production function can be
written as:
yt  zm kt   za ,

where zm and za are the multiplicative and additive technology shocks, respectively. Now,

the aggregate capital accumulation equation is standard with K t 1  I t  (1   ) K t , where the

rate of capital depreciation is  .

Consider the following experiment. At date- t0 , the God suddenly announced that at some

future date t1  t0 , a permanent increase in zm is to be credibly realized. That is to say, the

announcement is unexpected by the households, but all of the consumers know the fact that
starting from date- t1 , zm is to be permanently higher than before. Use phase diagram to

show the effects of this type of TFP change on the economy.

(Hint: The difference from the textbook example is that (what) the locus/loci now does/do not
change immediately. It remains the same for t  t1 and shifts/shift (to what direction) only

for t  t1 . Therefore, the dynamics of c and k will be dictated by the “old” loci

corresponding to a lower level of zm for t  t1 , and by the “new” ones corresponding to a

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 Problem Set

permanently higher level of zm for t  t1 .)

3. The Basic Ramsey Model—Revisited (20 Points)

In our lecture notes, we do not pay much attention to the transversality condition (TVC). Now,
we will give a deeper discussion on TVC using the following example.
Consider a model in which a representative agent has the following objective function:

Ct1  1
max
{Ct , Kt 1 ,bt 1 }
t 0
t
t 0 1
,   0,

and faces the budget constraints at each time period t  0,1, 2,...,  :

Ct  K t 1  bt 1  rK ,t Kt  rt 1bt   t ,

K t 1  0 ,

bt 1  0 ,

with K 0 and b0 given. Household holds real bonds, bt , issued by the government, which

pay gross real interest rate, rt 1 . Household earns rental rate, rK ,t , on her capital holding, K t ,

and pays lump sum (real) taxes,  t , to the government. Notice that, we keep the time

convention that K t 1 and bt 1 denote the capital and bond holding at the beginning of

period- t  1 , and rt 1 is the interest rate known at time- t  1 which pays out in time- t .

Suppose that there is no real resource used by the government, the government budget
constraint can be written as:
bt 1   t  rt 1bt .

(Hint: Since taxes are lump sum, (good and factors) prices are flexible in competitive good
and factors markets, there are a large number of representative agents, and there are no
distortions in this model economy, we are in a world of Ricardian equivalence. Therefore,
taxes and debt or variations in interest rate and tax policy have no effect, in equilibrium, on
the time path of real allocation.)
(a) Suppose that rK ,t  rK  1 is constant and fiscal policy fixes rt  r  rK and  t    0 .

Show that there is an equilibrium in which t  K t 1 Ct   is constant, and find the value

of  as a function of rK and  . In this case, debt can also be a constant.

(b) Write down the transversality conditions with respect to b and K for this model, and

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 Problem Set

verify that they hold for our proposed constant-  solution.

(c) Show that solutions to the FOCs other than the fixed-  solution violate the

transversality conditions.
(Hint: To make an easy life, you are allowed to just verify the TVC w.r.t. K .)

4. The OLG Model (20 Points)

Consider an economy with two-period lived overlapping generations of agents. Time is
discrete and runs from t  0 to infinity. Agents live for two periods. There is a constant
measure one of individuals in each generation (i.e., there is no population growth and the
number of population for each generation is normalized to be one). Young agents born in
period- t have identical preferences over consumption streams of a single non-storable good.
Lifetime utility can be represented by:
u (c1,t )   u (c2,t 1 ) , 0    1 ,

where u (c)  ln c is the per-period utility function, and c1,t denotes per capita consumption

of an agent born in period- t when she is young, c2,t 1 denotes per capita consumption of an

agent born in period- t when she is old in period- t  1 . For any generation- t , each young
agent has one unit of labor endowment at period- t and supplies it in-elastically at the real
wage rate wt . The labor endowment is zero when she is old, thus each young agent has to

save by holding physical capital kt 1 —which depreciates fully after used in production—at

the gross return of rt 1 . Assume that initial capital stock K 0 is hold by the initial old. In

addition, there is a representative competitive firm rents capital and hires labor in competitive
capital and labor markets to produce output.
(a) Assume that the (aggregate) production function is given by:
bK t N t
Yt  F ( K t , N t )  , with a  0 and b  0 ,
K t  aN t

where K t denotes the amount of capital at the beginning of period- t , and N t is the amount

of labor employed.
The per-capita production function can be written as:
bkt N t
yt  Yt N t  ,
kt  a

where kt  K t N t , which can be simplified further as:

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 Problem Set

bkt
yt  f (kt )  ,
kt  a

with the assumption that N t will be normalized to be one for all t  0 .

Solve for the steady state equilibrium, and derive the condition for local stability of this model
economy.
Now, assume that the (aggregate) production function is given by:
Yt  F ( K t , N t )  K t  N t1 , with 0    1 ,

where K t denotes the amount of capital at the beginning of period- t , and N t is the amount

of labor employed.
The per-capita production function can be written as:
yt  Yt N t  f (kt )  kt  ,

where kt  K t N t .

Profit maximization implies that:

rt  f ( kt )   kt  1 ,

wt  f ( kt )  f (kt ) kt  (1   )kt  .

(b)
(c) Let k  be the level of capital that maximizes the per-period net output yt  kt in steady

state. Show that if r  1 , then k  k  , and hence a planner would be able to make all agents
better off by reducing the capital stock in all periods.
(Hint: Let the steady state value of capital be reduced by a little bit, say  . Thus the total
resources available for consumption is a function of  , say G ( ) . Take the derivative of

G ( ) and let   0 .).

Suppose now that for any period- t the agents are allowed to trade a useless, non-reproducible
asset at the price pt . We call this asset “money”. The amount of money supply is fixed and

normalized to be one.
(d) Argue that if pt  0 , the agent must be indifferent between holding capital and holding

asset. Derive the associated arbitrage condition.

(Hint: Consider the case of interior optimality.)
 1 
(e) Show that if  1 holds, there exists a steady state equilibrium with
1 

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 Problem Set

pt  pt 1  p  0 .

(Hint: Guess that there exists a steady state equilibrium with positive price of the asset. Make
a check the conditions for this equilibrium will be exactly satisfied.)

5. An Extension to the Basic Ramsey Model (20 Points)

Consider an infinitely-lived representative household in an exogenous growth model economy.
The life time utility is given by:

Ct1
t
t 0 1
, with   0 , and 0    1 .

We assume that the household owns the economy’s stock of capital. Each period, the
household supplies its one unit of labor endowment in-elastically to the competitive labor
market, receiving the wage rate of wt . In addition, she rents her capital holding at the

beginning of period- t , K t , to the competitive capital market, receiving the rental rate of rK ,t .

She uses the wage income, capital renting income, and the profits rebated back by firms to
purchase consumption, Ct , and investment goods, I t . The capital stock evolves over time

according to the following accumulation equation:

K t 1  (1   ) K t  I t , 0    1 .

The initial level of capital, K 0 , is given.

A competitive final good firm produces final output using intermediate goods xi ,t (for

i  [0, At ] ), and labor N t as inputs by the following linear homogenous production function:
At
Yt  N t1  xi ,t  di , 0    1 ,
0

where At can be interpreted as the varieties of the intermediate goods. Final good firm takes

At , the wage rate, wt , and the price of the intermediate inputs, Pi ,t (for i  [0, At ] ), as given.

The i -th intermediate input, xi ,t , is produced by a monopolist indexed by i using the

technology:
xi ,t  K i ,t ,

where K i ,t is the physical capital employed by monopolist- i —taking the rental rate, rK ,t , as

given—in the competitive market for renting capital. Entry into the production of the i -th
intermediate input is forbidden.

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 Problem Set

The allocation of capital across intermediate goods must satisfy the following constraint:
At
K t   K i ,t di ,
0

where K t is the aggregate stock of capital. The aggregate resource constraint is:

Yt  Ct  I t  Ct  K t 1  (1   ) K t .

Finally, the number of varieties of goods evolves exogenously over time as follows:
At 1  At (1  g A ) , g A  0 ,

where A0 is given.

(a)
(b) Show the result that for possible combinations of A0 and K 0 , there exists balanced

growth equilibrium such that output, consumption, and the capital stock all grow at the same
rate for t  0,1, 2,... .

(Hint: Conjecture that the balanced growth path involves Ct 1 Ct  K t 1 K t  Yt 1 Yt  1  g A ,

for t  0,1, 2,... , i.e., along the BGP, (aggregate) consumption, output, and capital stocks all

grow at the same and constant growth rate of technology, which is exogenously given by
g A .)

(c) Consider the efficient allocations solved by a social planner who maximizes the
representative household’s life-time utility, subject to the resource constraint as follows:
Ct  K t 1  (1   ) K t  At1 K t  .

Show that along the BGP, the efficient allocations are characterized by the same growth rate
as the equilibrium allocations in (b), but the levels in the efficient allocations are higher than
those in the equilibrium allocations.
(Hint: In an efficient allocation, for any given period- t , we have: K i  K j , for any

i, j  [0, At ] . Thus the resource constraint on capital implies that:

At
K t   K i ,t di  K i ,t  Kt At .
0

Then, output is:

Yt  N t1 ( K t At ) At  N t1 K t At1 ,

which is increasing in the range of inputs A .)