Practice Problems: Overlapping Generations

Prof. Lutz Hendricks. July 28, 2011

Government bonds in an OLG model

t

Demographics: At each date Nt = (1 + n) households are born. Preferences are given by

o (1 ) ln(cy t ) + ln(ct+1 )

Endowments: Young persons are endowed with one unit of time which they use for work. Technology: The resource constraint is standard: C + K (1 )K = F (K, L) = K L1 Government: The government starts with bonds B0 and issues enough bonds in each period to repay the outstanding ones: Bt+1 = Rt Bt Markets: Households work at wage rate wt when young. They rent savings (capital) to the rm at rental price rt+1 with an implied interest rate Rt+1 . The households budget constraints are given by st co t+1 Rt+1 Questions: = = = w t cy t Rt+1 st rt+1 + 1

(a) Solve the household problem for a saving function.

(b) Derive the FOCs for the rm. (c) Dene a competitive equilibrium. Make sure the number of variables equals the number of independent equations.
(d) Derive the law of motion for the capital stock (bt+1 + kt+1 )(1 + n) = (1 )kt , where b = B / L.

(e) Derive the steady state capital stock for b = 0. Why does it not depend on ? (f) Derive the steady state capital stock for b > 0.

(g) Can you show that the capital stock is lower in the steady state with positive debt (crowding out)? Answer: Government bonds (a) The household solves max(1 ) ln(w s) + ln(R s). (b) Firms: This is standard:

The FOC is c /c = R /(1 ). Therefore s = (w s) /(1 ) and thus s = w. r w where k = K/L.

o (c) A CE is a list of sequences (cy t , ct , st , Kt , Lt , bt , wt , rt ) that satisfy

= =

f ( k ) = k 1 f (k ) f (k )k = (1 )k

 the saving function and the 2 household budget constraints the 2 rm FOCs capital market clearing: st = (1 + n)(bt+1 + kt+1 )
o goods market clearing: Nt cy t + Nt1 ct + Kt+1 = F (Kt , Lt ) + (1 )Kt .

government budget constraint (d) Law of motion: This follows directly from the capital market clearing condition together with the equilibrium levels of w and the saving function. (e) Steady state with b = 0: From the law of motion: k 1 = (1 )/(1 + n) It does not depend on because of log utility: households save a constant fraction of earnings. (f) Steady state with b > 0. Now we need to satisfy the law of motion for b : b (1 + n) = Rb. In steady state: R = 1 + n. The steady state capital stock therefore satises k 1 = n or k 1 = /(n + ) Note that the steady state satises the Golden Rule. There is some concern that this steady state may not be stable. Imagine that R > 1 + n. Then b rises (b > b). This may reduce the capital stocks and drive up R even further, etc. (g) Crowding out: Note that from the law of motion derived in (d): (1 ) (1 ) 1 b= k k =k k 1 1+n 1+n Therefore b > 0 requires which is exactly what was to be shown. (1 )/(1 + n) > /(n + )

Labor income taxes

Consider a two-period OLG economy with production. Demographics: Each period N = 1 young households are born. They live for 2 periods. Endowments: Young households work 1 unit of time. Preferences: Technology:
o ln(cy t ) + ln(ct+1 ) 1 Y t = Kt Lt

There is no depreciation. The resource constraint is therefore

o Y t + Kt = c y t + ct + Kt+1

Markets: Standard. There are no bonds.

Questions: (a) Derive the optimal level of savings of the household as a function of w. Briey, why do savings not depend on r ? (b) Derive the FOCs for the rm. (c) Dene a competitive equilibrium. Be sure to clearly state the market clearing conditions and to ensure that the number of independent equations equals the number of endogenous variables. (d) Write down a dierence equation for the equilibrium capital-labor ratio, (kt = Kt /Lt ). Sketch a graph of this relationship. (e) The government now imposes a time-invariant tax on labor income of the young so that after-tax earnings are (1 )wt . The revenues are thrown into the ocean. By how much does this tax lower the savings of the young for given w? Briey, what is the intuition for this result? (f) How does the tax aect the relationship graphed in (d)? What happens to the steady state capital-labor ratio? Sketch a graph.

2.1

Answer. Labor income taxes

(a) With an eye on part (d), we set up the household problem with the wage tax. The budget constraints are cy t = (1 )wt st+1 and The Euler equation is co t+1 = (1 + rt+1 )st+1
y co t+1 = Rt+1 ct

where R = 1 + r. Substituting using the budget constraints yields Rt+1 st = Rt+1 [(1 )wt st ] The savings function is therefore It is independent of R because of log utility: income and substitution eects cancel. (b) This is the standard answer: and (c) Market clearing requires Capital rental:
kt+1 = st+1 = (1 )(1 )kt /(1 + )

st = (1 )wt /(1 + )

r = k 1 w = (1 )k

Labor rental: Lt = 1 Goods: Same as feasibility.

A competitive equilibrium is a sequence

o (cy t , ct+1 , kt , Lt , st , wt , rt )

that satises (i ) the households budget constraints (2 eqn) and FOCs (2 eqn); (ii ) the rms FOCs (2 eqn); market clearing (2 eqn). We have 8 equations (per period) and 7 unknowns, which works out given Walras law. (d) The dierence equation is the capital market clearing condition above, which is simply a positive constant times the production function. This is strictly concave and goes through the origin. The slope at zero is innite. There is exactly one intersection with the 45-degree line (steady state). (e) The tax reduces savings of the young, but less than one-for-one. The household spreads the pain across the two periods (see the savings function). (f) The tax shifts the kt+1 line down and therefore reduces the steady state capital stock.

An Economy with Land

Consider a two-period OLG model in which production requires land and labor. Agents hold land as their savings and rent it to rms for production. The total amount of land is xed at M units per young household. The cohort size is constant and normalized to one. Each household supplies one unit of labor when young. 1. Write down the households budget constraints. Note that the household sells his land holdings at price qt+1 when old. Denote the purchase price of land by qt and its rental price by rt+1 . 2. Derive the households FOCs and Euler equation. Utility is
o u( c y t ) + u(ct+1 )

3. Derive the equilibrium wage and rental rate from the rms problem. The production function has constant returns in land and labor: F (M, L) 4. Dene a competitive equilibrium. 5. Derive an implicit solution for q in steady state.

3.1

Answer: An Economy With Land

Life is much easier when solving this model, if you distinguish household m from rm m from aggregate M . Otherwise you have to be very careful with market clearing conditions. (a) The budget constraints are wt = cy t + qt mt and co t+1 = (qt+1 + rt+1 )mt (b) The household problem is therefore max u (wt qt mt ) + u ((qt+1 + rt+1 )mt ) The Euler equation is
o u ( c y t )qt = u (ct+1 )(qt+1 + rt+1 )

Rt+1 = (qt+1 + rt+1 )/qt 4

The Euler equation can then be written as

o u ( c y t ) = u (ct+1 )Rt+1

which looks just like the equation from a model with bonds or capital. It implicitly denes a savings function giving mt as a function of prices (after substituting for consumption). The solution to the household problem is thus a triple
o (cy t , ct+1 , mt )

that satises the 2 budget constraints and the Euler equation. (c) The FOCs for the rms are as usual: rt+1 = f (mt ) and wt = f (mt ) f (mt )mt (d) There are four markets: goods, land (rental and purchase), and labor. Goods market clearing requires
o cy t + ct = f (M )

Land rental and labor market clearing are implicit in the notation. The market for land clears if savings equal supply of land or m = M . A CE is then a sequence of prices (w, q, r) and quantities (cy , co , m, L) that satisfy the households Euler equation and budget constraints (3 equations), the rms FOCs (2 equations), and the 3 market clearing conditions. We thus have 8 equations and 7 unknowns. Convince yourself that the two household budget constraints imply the goods market clearing condition; so we are ne. (e) In equilibrium, the Euler equation becomes qt u (wt qt M ) = u ((qt+1 + rt+1 )M ) (qt+1 + rt+1 ) With log utility this can be solved in closed form: q/[w qM ] = /M Therefore, w/q M = M/ qM = w (M ) 1+ (1)

Fully-Funded Social Security

Fully-funded social security authority taxes households when young, invests the tax revenues, and pays benets to the old out of the capital income accumulated on their own contributions. (a) Explain why fully-funded social security does not aect the steady state capital stock, if public and private savings earn the same rate of return. (b) How would this result change if the public rate of return was lower than the private one?

4.1

Answer: Fully-funded Social Security

(a) Households only care about the present value of future tax payments when deciding how much to consume. If the government earns the same rate of return as does the private sector, fully-funded social security does not alter this present value. Thus, consumption does not change and households reduce private savings by exactly the tax revenue. Therefore, total saving (public + private) remains unchanged. (b) If the public rate of return is lower than the private one, the present value of lifetime resources available to the household declines. Given a rate of return, consumption at all ages is reduced. Therefore, private savings falls by less than the tax revenue and the capital stock increases. An easy way to see this is to note that such a policy is equivalent to a combination of case (a) plus a tax on the old.