EC744 Lecture Note 4 Deterministic DP with Unbounded Returns

Prof. Jianjun Miao

Unbounded Returns without the Boundedness Condition Theorem: Let X, , F, and satisfy Assumptions 1-2. Suppose there is a b b b b function v : X R such that (i) T v v, (ii) limn nv (xn) 0, all b x0 X, all x (x0) , (iii) u (x) v (x0) , all x0 X, all x (x0) . b If the function v dened by v (x) = lim T nv (x) is a xed point of T , then v = v . Proof: Step 1. Show v is well dened and v v . Step 2. Show v v .
b b Find an upper bound v for v and then apply the operator T to v , iterating down to a xed point, which is v .

Example 1. Log Cob-Douglas Growth Model max

X t ln (kt kt+1)

t=0

Note that ln kt ln kt1 t ln k0. Thus,

t=0 X t ln (kt kt+1) t=0 X t ln (kt ) t=0 X

s.t. 0 kt+1 kt

()t ln (k0)

=
ln k b Take v (k) = 1 . Then:

ln k0 . 1

It converges to v (k) =

b T nv (k) =

1 n 1

"

ln (1 ) + ln () + ln (k) 1 1
!

1 ln (1 ) + ln () + ln k. 1 1 1

Example 2: Investment with Quadratic Adjustment Cost 1 2 1 t akt bkt c (kt+1 kt)2 . max 2 2 t=0
a2 , k b (k) = Take v 2b(1) X

R.

It can be shown that n , n , and n .

nc , 0 = 0, n + c nc n+1 = a + , 0 = 0, n + c 1 (n)2 a2 n+1 = n + , = . 2 n + c 0 2b (1 ) n+1 = b +

nv (k) = k 1 k2 + , T b n n n

Homogeneous Functions: Alvarez and Stokey (1998, JET) Power (log) utility U (c) = c / with 1, and linearly homogeneous constraints

Endogenous growth models Consumption/savings/portfolio choice problem Investment with CRTS

 X Rl is a convex cone. H (X, ) linear space of functions f : X R that are HOD , bounded in the sup norm ||f || = sup
||x||=1,xX

|f (x)| ,

and continuous, except at the origin if < 0. Dene (f + a) (x) = f (x) + a ||x||

Assumption 1 (0 < 1) a. : X X is nonempty, compact-valued, and continuous, and the graph of , A, is a cone: i.e., (0) = {0} and y (x) = y (x) , all > 0, all x X. b. > 0, and there exists > 0 with < 1, such that ||y|| ||x|| , all (x, y) A. c. F : A R is continuous and HOD , and for some B > 0, F (x, y) B (||x|| + ||y||) .

Theorem: Let (, X, , , F ) satisfy Assumption 1. Then: a. v H (X, ) ; b. v satises Bellman equation; c. x (x0) attains the supremum in SP for initial state x0 i
(x) = F x, x x v t t t+1 + v t+1

Proof: Use Theorem of the Maximum. Show

t

lim t |v (xt)| = 0.

T f (x) = sup F (x, y) + f (y)

y(x)

Weighted Contraction Mapping Theorem (Boyd) Let X be a cone, excluding the origin if < 0. Let J (X, ) be a space of functions that are HOD and bounded in the sup norm on the unit circle. Let T : J (X, ) J (X, ) be an operator satisfying a. (monotonicity) f ,g J (X, ) and f g implies T f T g b. (discounting) there exists (0, 1) such that T (f + a) T f + a, all f J (X, ) , a 0. Then T is a contraction of modulus .

Proof: The case of = 1 is in the book. For any f H (X, ) , f (x) = ||x|| f (x/ ||x||) . Thus, f (x) = g (x) + f (x) g (x) = g (x) + ||x|| [f (x/ ||x||) g (x/ ||x||)] g (x) + ||x|| ||f g|| .

By denition, f g + ||f g|| . Monotonicity and discounting imply that T f T (g + ||f g||) T g + ||f g|| .

Theorem. Given the above assumptions, v is the unique xed point of T in H (X, ) . The optimal policy correspondence is nonempty, compact-valued, u.h.c., and HOD one. Proof: Step 1. H (X, ) is Banach space and T : H (X, ) H (X, ) . Step 2. Verify T is a contraction with modulus using the Weighted Contraction Mapping Theorem. T (f + a) (x) = sup F (x, y) + (f + a) (y) = sup F (x, y) + f (y) + a kyk = T f (x) + a kxk sup F (x, y) + f (y) + a kxk

Thus, T (f + a) T f + a

The case with 0. Return function may not be continuous. Theorem of the Maximum cannot be used. When < 0, T is not a contraction. Additional assumptions are needed.

Example 3: Investment with Constant Returns to Scale = 1 Assume that output z = F (k, y) , F1 > 0, F2 < 0. Also F exhibits constant returns to scale and is strictly quasi-concave. Also limy(1+)k Fy (k, y) = . Consider v (k0) = subject to (1 ) kt kt+1 (1 + ) kt, k0 given. DP v (k) =
(1)ky(1+)k {kt+1}t=0 t=0

max

t {pF (kt, kt+1) q (kt+1 (1 ) kt)}

max

pF (k, y) q (y (1 ) k) + v (y)

Step 1. To verify Assumption 1(a,b), we need (1 + ) 1. Step 2. To verify Assumption 1c, dene f (k, y) = pF (k, y)q (y (1 ) k) . Then f is HOD1. |f (k, y)| pkF (1, 1 ) + q (1 ) k + qy. Let B = max {pF (1, 1 ) + q (1 ) , q} . Then |f (, y)| B (|k| + |y|) . Step 3. Apply Theorem 4.13.

Step 4. Conjecture v (k) = Ak and y = dk. Then Ak = max {pF (1, d) q (d (1 )) + Ad} k.
d

So d = arg maxd pF (1, d) q (d (1 )) + Ad. Thus, pF2 (1, d) q + A = 0, pF (1, d) q (d (1 )) . A= 1 d Step 5. We need to assume (1 + ) < 1 so that the boundedness condition holds:
t

lim tv (kt) = lim A tkt lim A ((1 + ) )t k0 = 0

Homework: p.109 Exercise 5.6, 5.16