Sharif University of Technology

Graduate School of Management and Economics

44710 - Macroeconomics I

Problem Set 5
Due Date: 28th of Farvardin 1402

1 Reading

1.1 Textbook
• * Romer: Ch 2.1-2.7
• ** Kurlat: Ch 9.1-9.3
• CSV: Ch 3
• Nili: Ch 7

2 Papers (each question at least 300 words)

2.1 Acemoglu, Daron. 2010. "Theory, General Equilibrium, and Political Economy in
Development Economics." Journal of Economic Perspectives, 24 (3): 17-32.
(a) What is external validity and why it is important?
(b) What is the role of general equilibrium when thinking about development?
(c) What is the main conclusion of the paper?

2.2 (Optional) Smale, S. (1976) “Dynamics in general equilibrium theory” American

Economic Review, 66 (2): 288-294
What is the main question of the paper and its conclusion?

3 Exercises

3.1 Discrete Social Planner Problem

Consider the social planner problem for the Ramsey economy. Assume for simplicity that there is
no technological growth. Assume that population grows at rate n and capital depreciates at rate δ.
Thus, the planner’s objective function can be stated as
∞

max ∑ 𝛽 𝑡 𝑢(𝑐𝑡 )𝐿𝑡

𝑐(𝑡)
𝑡=0
Subject to the budget constraint:

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 𝑌𝑡 = 𝐶𝑡 + 𝐼𝑡 , 𝑌𝑡 = 𝐾𝑡𝛼 𝐿1−𝛼
𝑡 , 0<𝛼<1
𝐾𝑡+1 = 𝐼𝑡 + (1 − 𝛿)𝐾𝑡
𝐿𝑡+1 = (1 + 𝑛)𝐿𝑡 , 𝐿0 > 0, 𝑛 > 0
(a) Write the problem in per capita variables. What are the control and state variables in the
planner’s problem? What is the difference between control and state variables?
(b) State the Lagrangian and derive the first-order conditions with respect to consumption 𝑐𝑡
and physical capital 𝑘𝑡+1 per capita.
(c) Derive the Euler equation and the transversality conditions.
𝑐𝑡1−𝜎
(d) Assume 𝑢(𝑐𝑡 ) = , characterize the steady state for this economy.
1−𝜎
(e) Draw the phase diagram and show the model’s dynamics.
(You may find ∆𝑐𝑡 = 0 𝑎𝑛𝑑 ∆𝑘𝑡 = 0)
(f) Explain, given k(0), how convergence to steady state comes about?
(g) Assume that the economy is in a steady state and there is an unexpected permanent increase
in the rate of depreciation δ. What is the best response to this change? Does consumption
initially increase or decrease?

3.2 Discrete Decentralized Problem

Consider the household problem:
∞

max ∑ 𝛽 𝑡 𝑢(𝑐𝑡 )𝐿𝑡

𝑐(𝑡)
𝑡=0
subject to 𝐶𝑡 + 𝐼𝑡 = 𝑤𝑡 𝐿𝑡 + 𝑟𝑡𝑘 𝐾𝑡
𝐾𝑡+1 = 𝐼𝑡 + (1 − 𝛿)𝐾𝑡

Hosueholds are the owners of the capital and they work for the firm. The firm’s
problem is to solve.
max 𝜋𝑡 = 𝐾𝑡𝛼 𝐿1−𝛼
𝑡 − 𝑟𝑡𝑘 𝐾𝑡 − 𝑤𝑡 𝐿𝑡

(a) What is the NPG (“No Ponzi Games”-condition)?

(b) Write the Euler condition and the transversality conditions.
(c) Solve for the SS if 𝑢(𝑐𝑡 ) = ln (𝑐𝑡 ).
(d) How does the SS change by changing 𝛿, 𝛽, and 𝛼? Explain.
(e) How does utility function in problem 3.1 convert to our utility function? Compare your
results with previous problem.

3.3 Government and Taxes

Consider a Ramsey model where population grows at the rate n, and physical capital depreciates
at the rate 𝛿. Suppose that capital income is taxed at the constant rate 𝜏. This implies that the

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representative household faces the real after tax interest income (1 − 𝜏)𝑟 . Assume further that the
government return the tax revenue to the household through lump-sum transfers.
(a) Write the Hamiltonian for the optimization problem and apply the maximum Principle.
(b) Find the household’s Euler equation.
(c) Construct the phase diagram of the model dynamics.
(d) Assume that initially the economy is in steady-state with no capital taxation. How does the
economy react to the unexpected introduction the tax? How does capital and consumption
instantaneously respond to the introduction of the tax, and how does the new steady state
compare to the situation without taxation?
y∗ −c∗
(e) Show that the saving rate on the balanced growth path, s∗ = is decreasing in 𝜏.
y∗
(f) How would your answers to the questions (a)-(d) change if the government purchased
goods, 𝐺(𝑡), with the tax proceeds instead of making lump-sum transfers? Assume that
𝑐(𝑡)1−𝜎
𝑢(𝑐(𝑡), 𝐺(𝑡)) = + ℎ𝐺(𝑡)
1−𝜎
(g) Answer question (d) again assuming that the introduction of the capital income tax is
announced some time before it is implemented (and as before the tax revenue will be
rebated lump sum).

3.4 (Optional) Using the phase diagram to analyze the impact of an anticipated change
Consider the policy described in Problem 3.3, but suppose that instead of announcing and
implementing the tax at time 0, the government announces at time 0 that at some later time, time
t1 , investment income will begin to be taxed at rate 𝜏.
(a) Draw the phase diagram showing the dynamics of c and k after time 𝑡1 .
(b) Can 𝑐 change discontinuously at time 𝑡1 ? Why or why not ?
(c) Draw the phase diagram showing the dynamics of 𝑐 and 𝑘 before 𝑡1 .
(d) In light of your answers to parts (a), (b), and (c), How does 𝑐 change at time 0?
(e) Summarize your results by sketching the paths of c and k as functions of time.
Now we want to use the phase diagram to analyze the impact of unanticipated and anticipated
temporary changes.
(f) At time 0, the government announces that it will tax investment income at rate 𝜏 from
time 0 until some later date 𝑇; thereafter investment income will again be untaxed.
(g) At time 0, the government announces that from time 𝑡 to some later time 𝑡 + 𝑇 , it will
tax investment income at rate 𝜏; before 𝑡 and after 𝑡 + 𝑇 , investment income will not be
taxed.

3.5 Growth, saving, and 𝑟 – 𝑔 (question 2.6 of Romer, 5th ed.)

Piketty (2014) argues that a fall in the growth rate of the economy is likely to lead to an increase
in the difference between the real interest rate and the growth rate. This problem asks you to
investigate this issue in the context of the Ramsey Cass Koopmans model. Specifically, consider

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a Ramsey Cass Koopmans economy that is on its balanced growth path, and suppose there is a
permanent fall in 𝑔.
(a) How, if at all, does this affect the 𝑘̇ = 0 curve?
(b) How, if at all, does this affect the 𝑐̇ = 0 curve?
(c) At the time of the change, does 𝑐 rise, fall, or stay the same, or is it not possible to tell?
(d) At the time of the change, does 𝑟 − 𝑔 rise, fall, or stay the same, or is it not possible to
tell ?
(e) In the long run, does 𝑟 − 𝑔 rise, fall, or stay the same, or is it not possible to tell?
(f) Find an expression for the impact of a marginal change in 𝑔 on the fraction of output that
is saved on the balanced growth path. Can one tell whether this expression is positive or
negative?
(g) For the case where the production function is Cobb Douglas, 𝑓 (𝑘) = 𝑘 𝛼 , rewrite your
answer to part (f) in terms of 𝜌, 𝑛, 𝑔, 𝜃, and 𝛼.
(Hint: Use the fact that 𝑓 ′(𝑘 ∗) = 𝜌 + 𝜃𝑔.)
(h) Can the increase in the distance between the interest rate and the growth rate of technology
indicate an increase in inequality in societies? Why or why not? Summarize the literature's
answer to this question.

3.6 A comparison of the Solow model and the Ramsey growth model
Consider a closed economy without exogenous technology and population growth, where firms
produce a generic good 𝑌𝑡 with the production function
𝑌𝑡 = 𝐹(𝐾𝑡 , 𝐿) = 𝐾𝑡𝛼 𝐿1−𝛼 , 0 < 𝛼 < 1,
Where 𝐾𝑡 is aggregate capital and 𝐿 is the number of workers in the economy. The law of motion
for aggregate capital is given by
𝐾𝑡+1 = (1 − 𝛿)𝐾𝑡 + 𝐼𝑡 , 𝐾0 > 0,
Where it denotes aggregate investment, and 0 < 𝛿 < 1 the depreciation rate. For simplicity, let
aggregate labor supply (population) be equal to one, 𝐿 = 1, such that consumption per worker, 𝑐𝑡 ,
is the same as aggregate consumption, 𝐶𝑡 = 𝑐𝑡 = 𝑐𝑡 𝐿. Now consider two different models. The
Solow model where agents have constant saving rate, s, such that
𝐼𝑡 = 𝑠𝑌𝑡 .
And the Ramsey growth model where household utility is maximized
∑∞ 𝑡
𝑡=0 𝛽 𝑢(𝐶𝑡 ),
such that aggregate investment (saving) is endogenous
𝐼𝑡 = 𝑌𝑡 − 𝐶𝑡 .
In both models markets are competitive, thus input factors 𝐾𝑡 and 𝐿 are paid their marginal
products.
(a) Compute the wage in Solow model in a steady state.
(hint: compute the aggregate steady state capital stock first.)

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(b) Taking into account the functional form of output, 𝑌𝑡 , and investment, 𝐼𝑡 , and that 𝐿 = 1,
write up the Lagrangian of household maximization problem and derive the following
optimality conditions of Ramsey growth model:
(i) The model’s Euler equation
(ii) The resource constraint.
(c) Compute the wage in Ramsey model in a steady state.
(hint: compute the aggregate steady state capital stock first.)
(d) Does the wage in the Solow model depend on the saving rate 𝑠 in a steady state? Is the
wage increasing or decreasing in 𝑠 or independent from 𝑠. Why?
(e) Does the wage in the Ramsey model depend on the discount factor 𝛽 in a steady state? Is
the wage increasing or decreasing in 𝛽 or independent from 𝛽. Why?
(f) Compute the saving rate 𝑠̅ which gives the same steady state capital stock in the Solow
model as in the Ramsey growth model. Is this saving rate, 𝑠̅, increasing or decreasing in
𝛽?
(g) Compute the saving rate 𝑠̂ which gives the same wage in the Solow model as in the
Ramsey growth model. Is this saving rate, 𝑠̂ , increasing or decreasing in 𝛽?