Advanced Macroeconomics

The Ramsey Model

Marcin Kolasa
Warsaw School of Economics

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

1 / 30

Introduction

Authors: Frank Ramsey (1928), David Cass (1965) and Tjalling

Koopmans (1965)
Basically the Solow model with endogenous savings - explicit
consumer optimization
Probably the most important model in contemporaneous
macroeconomics, workhorse for many areas, including business cycle
theories

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

2 / 30

Basic setup

Closed economy
No government
One homogeneous final good
Price of the final good normalized to 1 in each period (all variables
expressed in real terms)
Two types of agents in the economy:
Firms
Households

Firms and households identical: one can focus on a representative

firm and a representative household, aggregation straightforward

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

3 / 30

Firms
Final output produced by competitive firms
Neoclassical production function with Harrod neutral technological
progress
Yt = F (Kt , At Lt )
(1)
Capital and labour inputs rented from households
Technology is available for free and grows at a constant rate g > 0:
At+1 = (1 + g )At
Maximization problem of firms:
max{F (Kt , At Lt ) Wt Lt RK ,t Kt }

Lt ,Kt

Firms maximize their profits, taking factor prices as given

(competitive factor markets)
First order conditions:
F
F
Wt =
RK ,t =
= f 0 (kt )
Lt
Kt
Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

(2)
4 / 30

Households I
Own production factors (capital and labour), so earn income on
renting them to firms
Labour supplied inelastically, grows at a constant rate n > 0:
Lt+1 = (1 + n)Lt
Capital is accumulated from investment It and subject to depreciation:
Kt+1 = (1 )Kt + It

(3)

Total income of households can be split between consumption or

savings (equal to investment):
Wt Lt + RK ,t Kt = Ct + St = Ct + It

(4)

Make optimal consumption-savings decisions

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

5 / 30

Households II
Households maximize the lifetime utility of their members (present
and future):

X
U0 =
t u(Ct )Lt
(5)
t=0

where:
Ct = CLtt - consumption per capita
- discount factor (0 < < 1)
u(Ct ) - instantaneous utility from consumption:
u(Ct ) =

1
Ct
1

(6)

where:
>0
If = 1 then u(Ct ) = ln Ct

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

6 / 30

Households III
Remarks:
Literally: household members live forever
Justification: intergenerational transfers, people care about utility of
their offspring
Discounting: households are impatient

Remarks on the utility function:

u(Ct ) is a constant relative risk aversion function (CRRA):

Ct u 00 (Ct )
=
u 0 (Ct )

u(Ct ) is a constant intertemporal elasticity of substitution function:

 

ln CC1
1
 0 2  =

u (C1 )

ln
u 0 (C2 )

CRRA form essential for balanced growth (steady state)

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

7 / 30

Households IV
Households optimization problem: maximize (5) subject to the
models constraints:
Capital law of motion (capital is the only asset held by households),
incorporating income definition and savings-investment equality (4)
Transversality condition:
!
t
Y
1
lim Kt+1
0
(7)
t
1 + rs
s=1
where: rt = RK ,t = f 0 (kt ) is the market rate of return on
capital (real interest rate)

Interpretation of the transversality condition:

Analog of a terminal condition in a finite horizon
Non-negativity constraint on the terminal (net present) value of assets
held by households (capital)
No-Ponzi game condition: proper lifetime budget constraint on
households

Optimization by households implies (7) holds with equality

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

8 / 30

General equilibrium
Market clearing conditions:
Output produced by firms must be equal to households total spending
(on consumption and investment):
Yt = Ct + It

(8)

Labour supplied by households must be equal to labour input

demanded by firms
Capital supplied by households must be equal to capital input
demanded by firms

Definition of competitive equilibrium

A sequence of {Kt , Yt , Ct , It , Wt , RK ,t }
t=0 for a given sequence of
{Lt , At }
and
an
initial
capital
stock
K0 , such that (i) the representative
t=0
household maximizes its utility taking the time path of factor prices
{Wt , RK ,t }
t=0 as given; (ii) firms maximize profits taking the time path of
factor prices as given; (iii) factor prices are such that all markets clear.
Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

9 / 30

Households optimization problem

Lifetime utility rewritten:

U0

X
1
t Ct
=

Lt =
1
t=0

= L0

t=0

1
Ct
t
1

(9)

where:
= (1 + n)

(1 + g )1 (1 + n) < 1

the last inequality is assumed and ensures that utility is bounded

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

10 / 30

Households optimization problem II

Capital accumulation rewritten in per capita terms (using (4)):
t+1 = 1 Kt + 1 (Wt + RK ,t Kt Ct )
K
1+n
1+n

(10)

Capital accumulation rewritten in intensive form (using (4) and

t
defining wt = W
At ):
kt+1 =

1
1
kt +
(wt + RK ,t kt ct ) (11)
(1 + g )(1 + n)
(1 + g )(1 + n)

Transversality condition rewritten in intensive form:

!
t
Y
(1 + n)(1 + g )
lim kt+1
0
t
1 + rs

(12)

s=1

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

11 / 30

Lagrange function and FOCs

Lagrange function (normalizing L0 ):

LL =

t=0


!
t1
t + Wt + RK ,t K
t C
t
C
(1 )K
+ t
t+1
(1 + n)K
1

First order conditions (FOCs):

LL
t = t
= 0 = C
t
C
LL
t+1 (1 + RK ,t+1 )) = (1 + n)t
= 0 =
t+1
K

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

(13)

(14)

12 / 30

Euler equation I
Equations (13) and (14) imply:
t+1
C
t
C

RK ,t+1 + 1
=
(1 + n)

(15)

Using the definition of and rewriting in intensive form:



ct+1
ct


=

RK ,t+1 + 1
(1 + g )

(16)

For consumption per capita, using also the definition of the interest
rate rt :
! 

t+1
C
ct+1 At+1
=
= (1 + rt+1 )
(17)
t
ct At
C
Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

13 / 30

Euler equation II

Interpretation of the Euler equation (17):

t+1 > C
t 1 + rt+1 > 1
For > 0: C
Interpretation: For (per capita) consumption to grow the (market)
interest rate must exceed households rate of time preference
Interpretation: It is optimal for households to postpone consumption
(i.e. save in the current period and consume more in the next period)
iff the related utility loss is more than offset by the rate of return on
savings

Role of :
The higher the less responsive consumption to changes in the interest
rate
In other words: The higher the stronger the consumption smoothing
motive (the lower intertemporal substitution)

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

14 / 30

Equilibrium dynamics in intensive form - summary

The equilibrium dynamics of the model at any time t can be
characterized by 3 equations: (16), (11) and (12). They are (after
some rewriting and using (4) and (8) in intensive form):


ct+1
ct


=

f 0 (kt+1 ) + 1
(1 + g )

1
1
f (kt ) ct
kt+1
=
+
kt
(1 + g )(1 + n) (1 + g )(1 + n)
kt
!
t
Y
(1 + n)(1 + g )
lim kt+1
=0
t
f 0 (kt+1 ) + 1

(18)

(19)
(20)

s=1

At t = 0 capital is fixed. For given initial k0 and c0 , equations (18)

and (19) describe the future evolution of these variables: kt and ct .
The transversality condition (20) pins down the initial level of
consumption c0 .
Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

15 / 30

Steady state equilibrium I

In the steady state equilibrium kt and ct must be constant.

Using (18) and (19), the long-run solution to the Ramsey model:
f 0 (k ) =

(1 + g )
1+

c = f (k ) (n + g + + ng )k

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

(21)
(22)

16 / 30

Steady state equilibrium II

Plotting (21) and (22) in the (k, c) space:
ct

ct+1=ct

c*
kt+1=kt

k* kG
Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

kt
17 / 30

Modified golden rule I

How do we know that k < kG ?
From (22):
f 0 (kG ) = n + g + + ng
The transversality condition (20) written in the steady-state:
lim k

(1 + n)(1 + g )
f 0 (k ) + 1

t
=0

This implies:
f 0 (k ) > n + g + + ng
Since f 00 (k) < 0 for any k > 0
f 0 (k ) > f 0 (kG ) = k < kG

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

(23)

18 / 30

Modified golden rule II

Equivalently, we can show that the steady-state savings rate s falls

short of the savings rate consistent with the golden rule:
From (22), the steady-state savings rate is:
s = 1

c
k
= (n + g + + ng )

f (k )
f (k )

Using (23):
s < f 0 (k )

k
= (k )
f (k )

Intuitive explanation: households are impatient ( < 1) and smooth

consumption ( > 0, relevant if g > 0).

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

19 / 30

The role of the discount factor

Higher implies more patient consumers

From (21): if goes up, f 0 (k ) goes down, which means that k
goes up
The ct+1 = ct locus on the (k, c) chart shifts right
Steady-state consumption goes up
Intuition: if households are more patient, they save more, which
brings them closer to the standard golden rule

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

20 / 30

Phase diagram
From (18): k k = c 0
From (19): c f (k) (n + g + + ng )k = k 0
ct

ct+1=ct

c*
kt+1=kt

k*
Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

kt
21 / 30

Saddle path (stable arm)

Transversality condition (20) pins down the inital level of c0 for any
initial k0 , so that the system converges to the steady-state:
ct+1=ct

ct

c*
kt+1=kt
c0
k0
Marcin Kolasa (WSE)

k*
Ad. Macro - Ramsey model

kt
22 / 30

Uniqueness of equilibrium
How do we know that the saddle path is a unique equilibrium?
If the initial level of consumption were below c0 :
capital would eventually reach its maximal level k > kG
this implies:
< f 0 (kG ) = n + g + + ng
f 0 (k)
which violates the transversality condition (20) since:

t
(1 + n)(1 + g )
lim k
=
+1
t
f 0 (k)
informally (but more intuitively): at the end of their planning horizon,
households would hold very valuable assets, which cannot be optimal

If the initial level of consumption were above c0 :

capital would eventually reach 0 but consumption would stay positive,
which is clearly not feasible

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

23 / 30

Speed of convergence
Compared to the Solow model, the speed of convergence in the
Ramsey model depends additionally on the behaviour of the savings
rate along the transition path
For very small time intervals, the following implications hold (see
Barro and Sala-i-Martin, 2004, ch. 2.6.4):
1

< s = st s depends positively on kt k

= s = st = s
> s = st s depends negatively on kt k

Intuition (suppose the economy starts from k0 < k , so c0 < c ):

if households care much about consumption smoothing ( is high),
they wll try to shift consumption from the future to the present
if households care little about consumption smoothing ( is low), they
will try to postpone consumption to reach steady-state sooner

For standard parameter values 1 > s , so the Ramsey model predicts

relatively fast pace of convergence
Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

24 / 30

The budget constraint of the government

In the Ramsey model Ricardian equivalence holds:
Government plans sustainable - initial debt plus net present value of
expenditures equals net present value of revenues
Households live forever
Hence: financing expenditures with lump-sum taxes equivalent to
financing expenditures with debt

Then, without loss in generality, the government is assumed to run a

balanced budget each period:
Gt = Vt +w Wt Lt +k (RK ,t ) Kt +c Ct +i It +f (Yt Wt Lt Kt )
(24)
where:
Gt - government purchases (exogenous)
w , k , c , i , f - proportional tax rates on wage income, capital
income, consumption, investment and firms taxable profits,
respectively (all exogenous)
Vt - lump-sum taxes (net of lump-sum transfers) from households,
adjusted so that the balanced budget constraint (24) holds
Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

25 / 30

Modified firms problem

Maximization problem of firms:
max{F (Kt , At Lt ) Wt Lt RK ,t Kt f (F (Kt , At Lt ) Wt Lt Kt )}

Lt ,Kt

First order conditions (using definition rt = RK ,t ):

Wt =

F
Lt

rt
F
+ =
= f 0 (kt )
1 f
Kt

Firms are competitive so earn zero profits:

Yt = Wt Lt + RK ,t Kt + f (Yt Wt Lt Kt )

(25)

Market clearing on the product market:

Yt = Ct + It + Gt
Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

(26)
26 / 30

Modified households problem

We assume that government actions do not affect utility directly, so
households lifetime utility is still given by (5)
Households budget constraint (4) becomes:
Wt Lt +RK ,t Kt w Wt Lt k (RK ,t ) Kt Vt = (1+c )Ct +(1+i )It
(27)
Note that, by (25), households factor income is no longer equal to
output
Modified transversality condition:
lim

Marcin Kolasa (WSE)

Kt+1

t
Y
s=1

1
1 + (1 k )rs

Ad. Macro - Ramsey model

!
0

(28)

27 / 30

Modified households optimization problem

Lifetime utility (identical to (9)):
U0 = L0

X
t=0

1
C
t t
1

(29)

Capital accumulation (substituting for investment from (27)):

t+1 =
K

1
1
Kt +
1+g
(1 + g )(1 + i )


t + k K
t
(1 w )Wt + (1 k )RK ,t K
t V
t
(1 + c )C

(30)

Transversality condition:
lim

Marcin Kolasa (WSE)

t+1
K

t
Y
s=1

1+n
1 + (1 k )rs

Ad. Macro - Ramsey model

!
0

(31)

28 / 30

Equilibrium dynamics
The equilibrium dynamics of the model at any time t is given by the
following equations:
Euler equation (maximizing (29), subject to (30) and using firms
FOC):


ct+1
ct


=

1 + i (1 ) + (1 k )(1 f )(f 0 (kt+1 ) )

(1 + g ) (1 + i )

(32)

Capital accumulation equation (30) (merged with government budget

constraint (24) and firms zero profit condition (25), with gt = AGt Lt t ):
kt+1
1
1
f (kt ) ct gt
=
+
kt
(1 + g )(1 + n) (1 + g )(1 + n)
kt

(33)

Transversality condition (31):

lim

Marcin Kolasa (WSE)

t
Y
(1 + n)(1 + g )
kt+1
f 0 (kt+1 ) + 1
s=1
Ad. Macro - Ramsey model

!
=0

(34)

29 / 30

Main implications of the Ramsey model

As in the Solow model, long-run growth (of output per capita)
possible only with technological progress (exogenous in both models)
We should observe conditional, but not necessarily unconditional,
convergence (in line with the data)
Compared to the Solow model:
Explicit optimality criterion - households utility
If there is no distortionary taxation (i.e. if there is no government or all
taxes are lump-sum), allocations are Pareto optimal: decentralized
equilibrium coincides with allocations dictated by a benevolent social
planer (markets are competitive and complete, so the first welfare
theorem applies)
Savings rate endogenous and in the long-run always lower than implied
by the golden rule
Speed of convergence higher than in the Solow model (for standard
parameter values)

Marcin Kolasa (WSE)

Ad. Macro - Ramsey model

30 / 30