LECTURE 2-3

Note: these notes are produced for didactical use. They contain no original
contribution from the author and should not be quoted
Growth with consumer optimization
Main shortcomings of Solow model
no explanation of sustained growth (long run growth is driven by ex-
ogenous t.p.)
no way to investigate how incentives aect the behavior of the economy
(exogenous saving rate)
Growth models with consumer optimization
the path of consumption and savings is determined by optimizing house-
holds and rms that interact on competitive markets
+ Ramsey-Cass-Koopmans (RCK): innitely lived agents maximize their
dynastic utility subject to intertemporal budget constraint
+ Overlapping Generations Model (OLG): nitely lived individuals max-
imize their lifetime utility (incomplete altruism)
basic dynamic general equilibrium macroeconomic models applied in
many dierent contexts
introduce in simple framework analysis of consumer behavior (no un-
certainty)
The neoclassical growth model
Ramsey-Cass-Koopmans
dynamic general equilibrium macroeconomic model
the description of a general equilibrium macroeconomic model includes:
+ a description of households (hh)
+ a description of technology for production and saving
+ a description of the institutional set up (market structure, ownership
structure)
Market economy
hh own capital, provide capital and labor services to rms, consume
goods, and accumulate assets (save)
rms produce output hiring labor and capital services from hh
hh maximize utility and rms maximize prots
all markets are competitive
one-sector closed economy where one unit of output can be used indif-
ferently to generate one unit of hh consumption or one unit of capital
Representative innitely-lived agents
all hh are identical; the mass of hh is normalized to one
hh are innitely-lived (nitely lived agents are connected through a
operative intergenerational transfers based on altruism); adult members
of the hh make decisions taking into account the welfare and prospects
of their future descendants
hh size grows at exogenous rate a. Normalizing to one the initial size
of the hh 1(0), we have 1(t) = c
at
Preferences and household behavior
hh maximizes the intertemporal utility function
l =
_
o
0
&[c(t)] c
at
c
jt
ot
where &[c(t)] is the instantaneous utility function p.c. from consump-
tion p.c. c(t); utility p.c. is added up over all family members alive at
time t through c
at
; j is the subjective discount factor
assume &
t
0 and &
tt
< 0 (consumption smoothing); Inada conditions
hold;
assume j a implying that l is bounded if c is constant over time
(j 0 implies parental selshness)
each hh holds assets in the form of capital or loans which are perfect
substitutes as stores of value and pay the same real rate of return v(t)
each adult supplies inelastically one unit of labor services per unit of
time which is paid &(t)
the hh assets accumulation equation in p.c. terms is:

o(t) = [&(t) + v(t)o(t)] c(t) ao(t)

where o = 1; this equation is derived from oot = v+&1C
where C is hh consumption and 1 is hh size
credit markets impose the No Ponzi Game Condition (NPGC)
lim
to
_
o(t) exp
_

_
t
0
[v() a] o
__
0
interpretation: hh cannot borrow indenitely and roll over debt forever,
that is debt p.c. cannot grow as fast as v(t) a or higher
hh problem is to maximize the intertemporal utility function s.t. the
dynamic budget constraint for asset accumulation and the NPGC given
the stock of initial assets o(0); perfect competition implies that hh
takes v(t) and &(t) as given
Production technology and rms behavior
the production function 1(1, 1, T) takes the form
Y (t) = 1[1(t), 1(t), T(t)] = 1[1(t), T(t) 1(t)]
where T(t) is the level of technology which grows at constant rate
a 0; normalizing to one the initial level of technology, we have
T(t) = c
at
neoclassical production function: CRS to 1 and 1, diminishing returns
to each input, and Inada conditions are satised; technological progress
is labor augmenting (K/Y constant at s.s.)
the representative rm maximizes the ow of prots at any point in
time (no adjustment costs of installing capital), given by:
(t) = 1[1(t), 1(t), T(t)] [v(t) + c]1(t) &(t)1
where the price of the nal good is normalized to one and c is the
(constant) depreciation rate of capital; the price of 1 in terms of C is
also at unity (reversible investment or irreversible investment with non
binding non-negativity constraint on aggregate gross investment)
1(t) = v(t) +c is the rental price of capital: as capital depreciates at
rate c the net rate of return on one unit of capital is 1(t) c which
must equal the return on loans v(t);
perfect competition: rms take v(t) and &(t) as given
Solution of the model
solve the hh problem and derive an optimal consumption path
solve the rm problem and derive prot maximization conditions
combine the behavior of rms and hh to analyze the structure of a
competitive equilibrium
Firms
demand for capital services and labor are derived from the prot maxi-
mization conditions equating the marginal product of each input to its
price
it is convenient to express quantities per unit of eective labor, as these
will be constant at steady state
by CRS we have j = 1(1

1, 1) = )(

I), and we can write:

cYc1 = c[)(

I)

1]c1 = )
t
(

I) = v (t) + c
cYc1 = c[)(

I)

1]c1 = [)(

I)

I)
t
(

I)] c
at
= &(t)
Household
the hh must solve a dynamic optimization problem in continuous time
dynamic optimization problems involve choosing the path of a (set of)
control variable [here the control variable is c(t)] to maximize an objec-
tive function [here the intertemporal utility function] which is dened as
the integral of instantaneous felicity functions [here [&(c(t)]c
at
c
jt
],
subject to a (set of) dynamic constraint expressed in the form of tran-
sition equation that relates the control variable to the evolution of
the state of the economy, i.e. of a (set of) state variable [here the
state variable is o(t) and the transition equation is &(t) +v(t)o(t)
c(t) ao(t)], and given an initial condition and a terminal condition
for the state variable (here the terminal planning date is innite and
the terminal condition is the NPGC)
to solve this kind of dynamic optimization problems in continuous time
the mathematical tool is the Maximum Principle of Optimal Control
dene the (PV) Hamiltonian 1 (o, c, i, t) as
1 = &[c(t)] c
(aj)t
+ i(t) [&(t) + v(t)o(t) c(t) ao(t)]
where i(t) is the costate variable and can be interpreted as the shadow
value (price) of an extra unit of assets at time t in units of utility at
time 0
interpretation of 1: in each instant in time the agent consumes c(t)
and owns a stock of assets o(t); the choice of c(t) aects utility directly
(rst term in 1); the choice of c(t) also aects the change in the stock
of assets through the transition equation; the value of this change is
the second term in 1; thus for a given i the Hamiltonian captures the
total contribution to utility from the choice of c(t)
necessary (and sucient under our assumptions on preferences) condi-
tions for a maximum of l are given by:
1
c
= c1cc = 0
1
o
= c1co =

i
1
i
= c1ci =

o
lim
to
[i(t) o(t)] = 0
the last equation is called the transversality condition (TVC)
interpretation: the value of assets must be asymptotically zero other-
wise something valuable would be left over and utility would increase
by increasing consumption in nite time; as o(t) typically grows indef-
initely over time in growth models, TVC requires that i (t) goes to
zero at faster rate
The rst two conditions imply:
&
t
[c (t)] c
(aj)t
= i (t)
i(t) [v(t) a] =

i (t)
take logs of the rst equation and dierentiate w.r.t. time; rewrite the
second equation as

ii = [v(t) a] and substitute in rst equation
to obtain the so called Euler Equation (EE)
The EE determines the slope of the optimal consumption path:
v(t) = j +

c(t)
c(t)
_

&
tt
[c (t)]c(t)
&
t
[c (t)]
_
the LHS is the return to saving, i.e. the opportunity cost of consump-
tion
the RHS is the return to consumption: hh value consumption today as
future utility is discounted at rate j; moreover, if consumption is grow-
ing, hh tend to increase current consumption to smooth consumption
over time, the more so the higher the magnitude of the elasticity of
marginal utility [term in square brackets]
the elasticity of marginal utility determines the premium of v(t) over j
required by the hh to tolerate a given

c(t)c(t)
the intertemporal elasticity of substitution between c (c) and c(t) is
dened as the inverse of the proportionate change in the magnitude of
the slope of an indierence curve in response to a proportionate change
in the ratio c (c) c (t), that is:
o (t, c) =
&
t
(c(t))&
t
(c(c))
c (t) c(c)]

o[c (t) c(c)]
o[&
t
(c(t))&
t
(c(c)]
for c t, we get the instantaneous elasticity of substitution:
o (t, c) o (t) =
&
t
[c(t)]
&
tt
[c (t)]c(t)
which is the inverse of the magnitude of the elasticity of marginal utility;
rearranging terms in the EE we get:

c(t)
c(t)
= o (t) [v(t) j]
integrating the dierential equation for i(t) w.r.t. time we get
i(t) = i (0) exp
_

_
t
0
[v() a] o
_
observing that i (0) = &
t
[c(0)] which is positive as c (0) is nite (as
long as l is nite) and substituting in the TVC, this can be rewritten
as:
lim
to
_
o(t) exp
_

_
t
0
[v() a] o
__
= 0
implying that the NPGC must hold as equality; it is suboptimal for the
hh to accumulate positive assets at rate v(t) or higher as utility would
increase if these assets were instead consumed in nite time (local non
satiation assumption)
hh would like to borrow at rate v(t) or higher but they are unable to
do so as nobody is is willing to lend at this rate; thus in equilibrium
the credit market would impose the NPGC
The consumption function
assume &(c) =
_
c
10
1
_
(1 0) where 0 0 (CRRA); the elas-
ticity of marginal utility is constant and equal to 0 and the elasticity
of intertemporal substitution is o = 10; as 0 1, &(c) log c
[asymptotically constant elasticity of intertemporal substitution is nec-
essary to have constant growth rate of consumption per capita and
BGP; see below]
use the dynamic budget constraint and the NPGC (with equality) to
derive the intertemporal budget constraint of the hh (IBC):
_
o
0
c(t)c
[v(t)a]t
ot = o(0)+
_
o
0
&(t)c
[v(t)a]t
ot = o(0)+ &(0)
where v(t) = (1t)
_
t
0
v()o is the average interest rate between 0
and t, and &(0) is the present value of wage income (human wealth)
integrating the equation for consumption growth, we get:
c(t) = c(0)c
o[v(t)j]t
and substituting into the IBC:
c(0) = j(0) [o(0) + &(0)]
where 1j(0) =
_
o
0
c
[v(t)(10)0j0+a]t
the net eect of an increase in v(t) on j(0) depends on whether the
income eect (o < 1) or the substitution eect dominates (o 1);
for o = 1 the two eect cancel out and j(0) = j a
these eects of v(t) carry over on c(0) holding &(0) constant; notice
that &(0) decreases with v(t), reinforcing the substitution eect
Equilibrium
in a closed economy, domestic production equals domestic demand
(investment plus consumption)
capital is owned by residents, implying o = I
using the dynamic budget constraint, and prot maximization condi-
tions for & and v, the economys resource constraint in eective terms
can be written as:

I(t) = )(

I(t)) c(t) (a + a + c)

I(t)
substitute the condition for prot maximization into the EE, and use
the denition c = C

1 to write:

c
=

c(t)
c(t)
a = (10)
_
)
t
(

I(t)) c j 0a
_
using o = I and the denition of

I, the TVC can be rewritten as:
lim
to
_

I(t) exp
_

_
t
0
_
)
t
(

I()) c a a
_
o
__
= 0
the two dierential equations in c(t) and

I(t), together with the TVC
and the initial condition

I(0) 0, dene the behavior of

I and c
over time implied by utility and prot maximization and equilibrium
conditions
using j(t) = )(

I(t)) we can determine the behavior of j(t)

recalling the denitions of c,

I, and j we can then determine the
optimal paths of c, I, and j
Steady state
BGP: situation where variables grow at constant (possibly zero) rate
+ if (
c
)
+
is constant, the EE (with constant intertemporal elasticity
of substitution) implies

I(t) =

I
+
or equivalently (

I
)
+
= 0
+ rewrite the resource constraint as:
c (t)

I(t) = )(

I(t))

I(t) (a + a + c)

I
at BGP (

I
)
+
= 0 and

I(t) =

I
+
, implying that c (t)

I(t) must
also be constant, or equivalently (
c
)
+
= (

I
)
+
+ (

I
)
+
= 0 implies (
j
)
+
= 0
at BGP (
c
)
+
= (

I
)
+
= (
j
)
+
= 0
the s.s. value of capital per eective labor

I
+
is dened by
)
t
(

I
+
) = c + j + 0a
which is called the modied golden rule; notice that, dierently from
the Solow model,

I
+
does not depend on the population growth rate
a
the s.s. value of consumption per eective labor is:
c
+
= )(

I
+
) (a + a + c)

I
+
the s.s. value of the saving rate is dened by:
c
+
=
)(

I
+
) c
+
)(

I
+
)
=
(a + a + c)

I
+
)(

I
+
)
the saving rate is determined by incentives to physical capital accumu-
lation: higher j and 0 imply lower saving rate
let

I
jc|o
denote the value of capital per eective labor that maximizes
consumption per eective labor, that is

I
jc|o
satises:
)
t
(

I
jc|o
) = (a + a + c)

I
jc|o


I
+
if and only if j a a(1 0)
j a a(1 0) must holds to ensure bounded utility at BGP; this
condition is also required to satisfy the TVC
inecient oversaving, that is

I
jc|o
<

I
+
, cannot occur in the optimiz-
ing framework
it is not optimal to sacrice more current consumption to reach maxi-
mum consumption at s.s. as consumers are
impatient (the eective discount rate with consumption growth is j +
0a)
Transitional dynamics
uniqueness and global stability of the s.s. can be established by means
of a phase diagram
construction of the phase diagram in the (

I, c) plane:
+ draw the locus (CC) where

c = 0; by the EE, this is a vertical line
at

I
+
; to the left (right) of (CC), we have

c 0 (< 0)
+ draw the locus (KK) where

I = 0; this is an inverse-U shaped curve

that reaches a maximum at

I
jc|o
and touches the a-axis at the origin
and at

I
++


I
jc|o
; above (below) the KK locus, we have

I < 0
( 0)
steady states: the two loci intersect at (

I
+
, c
+
); there are two more
s.s., one at the origin (which we ignore) and one at (

I
++
, 0)
by observing the arrows for motion of

I, c, we know that (

I
+
, c
+
) is
saddle-path stable
it can be shown that (

I
+
, c
+
) is actually globally stable: given the initial
value of capital per eective labor, only the choice of consumption
that puts the system on the saddle path is consistent with equilibrium
behavior
consider, for example, an initial value

I
0
<

I
+
; let c
0
be the level of
consumption per eective labor that puts the economy on the saddle
path, given

I
0
; then, the economy converges to (

I
+
, c
+
); this path
satises all equilibrium conditions
consider c
t
0
< c
0
; capital is accumulated fast and consumption grows
slowly; once we cross the

c = 0 locus, consumption per eective labor
starts to decline and capital per eective labor continues to grow; the
economy converges to (

I
++
, 0); notice that )
t
(

I
++
) c < a + a, as

I
++


I
jc|o
, implying that this path violates the TVC; on this path hh
are oversaving: utility would increase if consumption were increased at
earlier dates
consider c
t
0
c
0
and below the

I = 0 locus; capital is accumulated

slowly and consumption grows rapidly; once we cross the

I = 0 locus,
capital per eective labor starts to decline and consumption continues
to grow; capital and production per eective labor fall to zero in nite
time; c should jump to zero at this point, but this would violate the
EE
the level of consumption jumps to set the economy on the saddle path,
given the initial condition; this is important to keep in mind when one
investigates the eects of variations in parameters
Optimal growth
consider the problem of a central planner seeking to maximize the utility
of the representative hh subject to the economys resource constraint
and I (0) 0
it can be shown that the growth path chosen by the social planner is
the same we obtained in the decentralized equilibrium
the competitive equilibrium is a Pareto optimum and the optimal growth
path can be decentralized as competitive equilibrium
Main results
s.s. growth of consumption, capital and output per capita are given
exogenously and equal the rate of technical progress a; they do not de-
pend on preferences parameters or on policies and institutions aecting
the incentive to accumulate physical capital
the s.s. value (path) of capital per eective labor (capital per capita)
and output per eective labor (output per capita) depend on prefer-
ences parameters 0 and j (related, for example, to cultural or geo-
graphic factors)
the s.s. value (path) of capital per eective labor (capital per capita)
and output per eective labor (output per capita) depend on institu-
tions and policies aecting the incentive to accumulate physical capital
(e.g. tax on returns to capital)
e.g. assume that returns to capital income net of depreciation are taxed
at rate t and revenues are rebated lump-sum
the EE becomes:

c(t)
c(t)
= (10)[(1 t) ()
t
(

I(t)) c) j 0a]
the s.s. capital per eective labor is dened by:
)
t
(

I
+
) c =
j + 0a
1 t
where

I
+
is decreasing with t
as j
+
= )(

I
+
) and j
+
(t) = )(

I
+
) c
at
, steady state output per capita
is lower at all times compared to the zero tax case