PS IV 1. Interpret equations 1 through 4. (1) Utility is a forward-looking variable with a constant marginal utility with respect to consumption.

(2) Equation of motion that describes growth in the individuals assets. (r-n) is the rate of effective asset interest, since there is a dilution effect due to population growth. w*l is income at time t. This is different than in the original Ramsey model because people now choose the amount they work. So, overall, this equation is saying that growth in assets = added assets at time t due to interest- dilution + wage income at time t consumption. Note that this equation suppresses the time t for convenience of notation, but it holds for any t. (3) Equation that says initial assets are greater than or equal to 0. That is, we do not start out in debt. (4) PDV of assets must be greater than 0 as t tends to infinity. This says that one cannot end the planning period in debt. This rules out chain-letter schemes. It is a no ponzi game condition.

2. Derive the FOC for the maximization of (1) s.t. (2), (3), and (4).

3. Derive and interpret an expression that relates current consumption to current work effort.

So, consumption is increasing in wages holding amount worked constant and decreasing in amount worked holding wages constant. This makes sense since if one has a higher wage, they can consume more, holding constant amount worked. Also, if one works more and wages are equal, one can certainly consume more. Consumption and leisure (1-l) are compliments. 4. Derive and interpret the Euler equation that relates growth rates of consumption and work effort to the interest rate. We rewrite the Hamiltonion in a more general form, now calling it J and calling our shadow value nu.

This equation can be simplified if the utility function takes the form specified in the problem:

Therefore, the relation between r and rho determines whether households choose a pattern of per capita consumption that rises over time, stays constant, or falls over time. The function is separable in c and l, so that the cross partial of utility with respect to c and l is 0, meaning that labor-leisure choice does not play a role in consumption. Note that the interest rate is endogenous in this model. This is essentially saying that the optimal time profile of consumption depends on the gap between the interest rate and the rate of time preference. If r> rho postpone consumption until later and adopt an upwardsloping time profile of consumption. 5. Derive and interpret the consumption and work effort functions.

And for l(0) we can use our expression relating consumption and work effort from problem 3. Plugging in, we get:

Interpretation of work effort function: Work effort is a fraction of your time which depends negatively on your initial assets and present discounted value of future earnings and depends positively on your wage today. This makes sense because people should work more when making a higher wage today and work less when their future earnings are more (because they prefer to shift their working to the future). They should work less if they have more initial assets because they dont need to work as much to consume what they want. Interpretation of consumption function: consumption today depends on your time preference adjusted for population, and on your initial assets and present discounted value of earning potential over your life ( ). This makes sense because people would consume more if they knew they could make more in the future. Likewise, they would consume less if they knew they would make less in the future. Further, initial assets provide them with additional consumption. 6. Discuss the effects of an increase in the average future interest rate on aggregate consumption and aggregate labor supply. An increase in average interest rates for a given wealth has no effect if we hold the work effort function constant, since does not depend on the interest rate. But, we see that interest rate will have an effect through its changing . Higher interest rates decrease as we can see because the interest rate enters the expression for discounting future wages from labor. Thus, since we assumed we know that c(0) will decrease when the interest rate increases. The logic is that higher interest rates increase the cost of current consumption relative to future consumption; this is the intertemporal substitution effect that motivates households to shift consumption from the present to the future. An increase in interest rates also affects l(0) through its negative effect on . Since l(0) depends negatively on because of the signs of and , we know that l(0) will increase when interest rates rise. This makes sense because if the interest rates rise, households want to consume less and work more to save money because they earn higher returns on their money. 7. Under the assumption that the economy is closed, derive the economy-wide resource constraint.

Notice first that because two forms of assets, capital and loans, are assumed to be perfect substitutes as stores of value they must pay the same real rate of return. Since capital stocks depreciate at a constant rate the net rate of return to a household that owns a unit of capital is R- , where R = fk. Recall that households also receive the interest rate r on funds lent to other households. Since capital and loans are perfect substitutes as stores of value, we must have r = R- . Also we will use below the fact that in a full market equilibrium, w = mpl corresponding to the value of capital that satisfies fk = r+ .

8. Together with the two boundary conditions, the Euler equation, and the economys resource constraint, define the economys general equilibrium. Discuss the dynamic behavior of this equilibrium. Show that for any initial condition there exists a unique trajectory that satisfies the FOC. The time paths of and are determined by the transversality condition, resource constraint, and equation of motion for . The steady state values for and are determined by setting and equal to zero. The =0 locus in the graph below shows pairs of ( , ) that satisfy =0, and the =0 locus shows pairs of ( , ) that satisfy =0. For =0 these are combinations for which net investment is zero. The =0 locus represents combinations for which the r = .

The =0 locus slopes down. Why? If we note that r = means that r = MPK . So if this = 0 , we have a constant ratio of capital to labor. Hence, w and Y/K are constant along this line, meaning that C/(1-L) is also constant. => it is linear and downward sloping. For points above the =0 locus, consumption is too high and labor supply is too low and the K/L ratio is too high. i.e. r< . Opposite for points below the =0locus. For points below the =0 line, consumption is too low, and net investment too high and for points above, consumption is too high and net investment too low. The model exhibits saddle-path stability. To see that there is a unique trajectory that satisfies the FOC, postulate that k(0)< *. Then, notice that if is greater than , for example , we violate the FOC and transversality condition (we are not solvent). If we start greater than the optimal, then we diverge downwards and eventually meet C=0, at which there is an infinite penalty on consumption, so we cannot choose this path. Along the transition, and increase towards their steady state values, * and *) a *. The key to the determination of * is diminishing returns to capital, which make monotonically decreasing function of *. Moreover, the Inada conditions )= and )= ensure that the golden rule holds at a unique positive value of *.

9. Suppose now that the government taxes wages so that people receive labor income (1- )wl. Discuss the dynamic effects on consumption, capital accumulation, and labor supply of: Below, we assume throughout that we start at the steady state. First, a derivation:

We see from our calculations that because

at the steady state, if

(which means the tax is

merely a transfer), then this tax does not change our steady state levels of consumption and capital. So, from here on, we look at what happens if the government wastes something or provides some necessary service that agents dont get utility from (this is questionable of course, but otherwise the tax does not change our steady state levels of k and c). a) An unexpected announcement at time t0 of a permanent increase in the tax rate from to implemented at t0. If a policy change is unexpected, then the system dynamics change immediately when the change happens, i.e. the phase diagram (hence the corresponding saddle path) changes. Suppose that the agent still stays in the old steady state, she would end up with disaster (i.e. end up at a point that would lead to an extreme in consumption; either more consumption than can afford over lifetime or negative consumption) under the new system dynamics. To avoid this, the only thing she can do at this time is to jump (via adjusting the control variables) onto the new saddle path which leads her to the new steady state. The economy immediately jumps to the new saddle path. What is this new saddle path? This depends on how elastic our labor supply is. If very elastic, then we will work much less, thus forcing consumption down. If inelastic, we would work more and consume more. We have two effects: Substitution effect: lower wage leads people to work less. This depends on elasticity of labor wrt wage. Income effect: As people feel poorer, they want to consume less and work more. In the images below, we illustrate the two cases, with the after shock loci in red and the old in purple. Case 1: the general case. Labor elastic. Income effect stronger (This is the more realistic case, so we discuss it more!)

Households immediately adjust consumption downward and labor supply upward because of the higher taxes => total output of economy increases. Also, households save more because for the period after the shock. Also, K/L ratio falls so that interest rates rise and thus . So what we see is that after the jump, both and rise until the equilibrium is reached. Loci will change as we saw in our derivations (just set and see that the equation is not the same because of the term. The other locus will change because the marginal product of labor changes as labor changes, so the wage will change. In this case, G increases => consumption is crowded out; the capital stock rises. This is because the household feels poorer because the tax is permanent => the expected value of future wages goes down and thus, as we saw in the interest rate case, consumption goes down and labor supplied (l) goes up. This drop in consumption makes k increase to restore the constant K/L ratio. In the long run, output is crowded in by additional government consumption, more so the more elastic labor supply is. 1 to 1 crowding out if labor supply perfectly elastic. (More permanent the shock, stronger the income effect. People realize that their income over the rest of their life has changed so they are more likely to consume less and work more.) Case 2: Labor inelastic; we have substitution effect. This is the case that probably would not happen (since we have an infinite planning horizon so labor likely to be elastic and substitution effect likely to be minimal.) Mathematically possible but not in the real world.

In this case, we increase consumption now and work less in the future. This is very unrealistic. Heres what happens to consumption and capital in the two cases, both with 0 being t0.

b) An unexpected announcement at time t0 of a permanent increase in the tax rate from to implemented at t1>t0. In this case, similar to above but individuals would want to work more now and less in the future. We use the rational expectations hypothesis to understand this part of the problem set. Agents are atomistic and they know the model, so they make correct predictions and are penalized for deviating from these predictions. Further, arbitrage opportunities are rare. Agents know that the tax rate will increase at time t1, so they know that at that point and thereafter they will want to work less. Therefore, they immediately adjust consumption and labor now in expectation of future changes in tax. Case 1:

Case 2: Could also be the case where consumption rises, if the labor supply is relatively inelastic in the short run. This is realistic, but probably wouldnt generally be the case.

And below I illustrate the trajectories of effective consumption and capital:

Now, what happens to labor? Labor simply adjusts to bring effective consumption and capital to their steady states quicker, no matter what those are. This is clear from the fact that

and

So, when is too low, increases and increases to bring to its steady state level; same for When is too high, decreases and decreases to bring to its steady state level; same for l is always giving us a feedback effect such that we get to our steady state faster. This makes economic sense because now economic agents have one more thing they can adjust so that they can optimize better. This is one more degree of freedom they can use to bring their consumption and capital accumulation to the optimal level.