The Diamond Model

Presented to: Dr. Zahid Pervaiz

Presented by: Sidra Naeem
Topics in Macro Economics Theory
 Diamond overlapping-generations model
Assumptions:
Individuals lives for two periods, so we are assuming two groups in
economy, one is young and the the other is old irrespective of Ramsey
model (fix number of infinitely living household).
Each individual lives for two periods. Lt Individuals are born at time t
and die at time t + 1.
Time is discrete.
Population growth rate is exogenous and taken as Lt= (1+n)lt-1
Individuals can only work in the first period (when he is young), supply
one unit of labor and divide his labor income between first period
consumption and saving.
In second period he will consume saved income with interest rate on it.
 Consumption per worker in first and second periods is c1t and c2t
respectively.
Utility of any individual born in t is ut and depends on consumption c1t
and c2t. We are assuming constant relative risk aversion utility.
1 1
C1t 1 C 2t 1
Ut
1 1 1

There are many firms has production function Yt F (kt , AtLt ) constant
return to scale and satisfies inada conditions.
A grows exogenously at the rate At 1 g At 1
 There is no depreciation. Markets are competitive, firms earn zero profits, labor and
capital are earning according to their marginal productivity.
Real rate of interest is MPK rt f ( kt )
And MPL wt f ( kt ) ktf ( kt )

There is some initial capital stock K 0which is owned equally by all old individuals.
In period 0 capital owned by old and labor supplied by young are combined to produce
output. The old will consume both capital income and their existing wealth they then die
and exist the model. Young will divide his labor income wtAt between consumption and
saving. They carry their saving forward in next period thus capital stock in period t+1 is
equal to number of young individuals Lt at time t times each of these individuals savings
( wtAt c1t )
Kt 1 Lt ( wtAt c1t )
This capital is combined by the labor supplied by the next generation and the process
continue.
 Household behavior
Second period consumption of an individual born at t is
C 2t 1 (1 rt 1)( wtAt Ct )
Dividing both sides by 1+r and bringing C1t over to the left hand side yields
budget constraint
1
C1t C 2t 1 Atwt
1 rt 1
This condition states that present value of life time consumption equals the
present value of life time labor income.
The individuals maximizes the utility subject to budget constraint. We will
consider two ways to solving this maximization problem.
First is the derivation of Euler equation. Specifically, imagine the individual
deceasing C1t by a small amount c then it will increase the saving and earn the
C 2t 1
capital income in future and will rise the consumption in second period
by (1 rt 1)C in future.
 This change does not affect the present value of life time consumption
stream and individual will optimize the utility by equating the cost and
benefit of consumption pattern.

The marginal contribution of C1t of life time utility is c1t and marginal
contribution of c2t is 1 c 2t 1

To optimize the utility equalize the cost and benefit

1
C 1t .C C 2 t 1 (1 rt 1).C
1

Canceling the C and multiplying both sides by C 2t 1gives us

1
C 2t 1 1 rt 1

C 1t 1

This expression is analogous to Euler equation in the Ramsey model.

 Future consumption have positive relation with rate of interest and negative
relation with discount rate.
Consumption will increase or decrease it depends on whether real rate of
interest is greater or less than the discount rate.
again determines how much individuals consumption varies in responses
to differences in interest rate and discount rate.
The second way to solve the maximization problem is to set up lagrangian:
1 1
C 1t 1 C 2t 1 1
Atwt C 1t C 2t 1

1 1 1 1 r t 1

Substituting Foc for C1t and C2t+1 and rearranging the equations gives us
C1t as
 C 1t Atwt
1 s rt 1

This equation implies that young individuals saving increasing in r if and only
if 1 r is increasing in r.
1

A rise in r has both income and substitution effect.

Thus s is increasing if is less than 1 (substituting effect) , and decreasing if
is greater than 1 (income effect).

If 1 the two effects balance and saving is independent of r.

 The dynamics of the economy
Equation of motion K

Capital stock in period t+1 is amount saved by young individuals in period t

thus,

Kt 1 s rt 1 LtAtwt

Multiplying by Lt means aggregate of whole economy.

Saving rate depend on r in period t+1 and labor income w in period t
Dividing both sides by Lt+1At+1 and then substitute for rt+1 and wt to
obtain
f kt ktf kt
1
kt 1 s f kt 1
1 n 1 g
 Evolution of k
Kt+1 is implicit function of kt (because kt+1 appears on both sides of the
equation) it therefore determine how k evolve over time given its initial
value.
We want to know whether there is an equilibrium value of k and whether k
converges to such value?
To answer these questions, we need to describe how kt+1 depend on kt.
For this purpose we take logarithmic utility and cobb-Douglas production
function.
 Logarithmic utility and Cobb-Dauglos production
When 1 the fraction of labor income saved is 2 1 and when production is
Cobb-Douglos f k k and w 1 k the future capital stock becomes

1 .kt
kt 1
2 1 g 1 n
Hence proved kt 1 f kt . When kt+1 intersect the 45 degree line, it is the
point where kt 1 f kt and this is unique equilibrium level of k which is
denoted by k and it is the balance growth path. Wherever k starts it
converges to k .
Properties of balance growth path, once it has converged to balance growth
path, are same as Solow and Ramesy model. Saving rate is constant,
output per worker is growing at rate g, the capital ratio is constant and so
on.