Advanced Macroeconomics

Problem Set 4
Numerical simulation of the neoclassical model with public spending
and endogenous labor
This problem will guide you through a numerical simulation of the Neoclassical
Model. You can use the excel le from class as a guideline.
Preferences are given by
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P
U=

t=0

The production function is

F (k; l) = Ak l1

ln ct

4=3
2lt

, with A = 4 and

, with

= 0:75:

= 1=3. Depreciation is

= 1:

Public spending is g = 2: The government uses lump sum taxes to nance its
expenditures.
(a) Determine the dynamics for consumption, labor, and capital in the rst best
solution for this economy. Note: you can replace all the paramenter values except g
and A since we will have shocks to those paramenters later in the exercise.
(b) Solve for lt as a function of ct and kt . Plug this expression into the Euler
equation and the resource constraint to get the dynamics of the economy in terms of
consumption and capital only.
(c) Find the c = 0 and k = 0 lines and plot them in a graph. What is the steady
state of the economy?
(d) Now let us plot the dynamics of the economy. To do this, consider an initial
value of k0 = 0:5k . Make a guess for the initial value of c0 . Use the equations
you found in part (b) to determine the evolution of the economy. Adjust your initial
guess for c0 using the goalseek tool, so that the economy converges to its steady state.
Repeat these steps for an initial value of k0 = 1:5k .
(e) Suppose the economy is in its steady state when it is hit by a shock that
permanently decreases public spending to g = 1. Plot the new steady state and the
behavior of the economy after this shock. What is happening to labor?
(f ) Suppose the economy is in its steady state when it is hit by a shock that
permanently increases productivity to A = 5. Plot the new steady state and the
behavior of the economy after this shock. Draw the impulse responses for this shock.
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