Derivation and Log-linearization of Chari, Kehoe,

and McGrattan (2007)s Closed Economy Model

Chi-hong Chen

Chari, V. V., Patrick J. Kehoe, and Ellen R. McGrattan (2007), Business cycle accounting,
Econometrica, 75 (3), pp. 781-836.

The benchmark prototype economy

The benchmark prototype economy that we employ in our accounting procedure
is a stochastic model.

The economy has four exogenous stochastic variables: the e ciency wedge zt,
1
the labor wedge 1
lt, the investment wedge 1+ xt , and the government
consumption wedge gt.

ct : per capita consumption

lt : per capita labor

kt : per capita capital stock

xt : per capita investment

wt : wage rate

rt : rental rate on capital

Nt : population

Tt : per capita lump-sum transfers

yt : per capita output

Zt : productivity Zt = zt (1 + )t

: discount factor

: depreciation rate of capital

1+

: the rate of labor-augmenting technical process

1 + n : the population growth rate

The representative consumer maximize expected utility subject to the budget

constraint and the capital accumulation law:

Et

1
X

t U (c ; l ) N
t t
t

t=0

ct + (1 + xt) xt = (1

(1 + n) kt+1 = (1

lt) wtlt

+ rtkt + Tt

) k t + xt

Solution of consumersmaximization problem:

max

fct;lt;kt+1 g

ct + (1 + xt) [(1 + n) kt+1

The Lagrangian:

Et

1
X

t U (c ; l ) N
t t
t

t=0

(1

) kt] = (1

lt) wtlt

+ rtkt + Tt

L =

1
X

t=0
1
X

t=0

t U (c ; l ) N
t t
t

tfw l (1
t t

+
lt) + rtkt

+ Tt

(1 + xt) [(1 + n) kt+1

ct

@L
= tUctNt
@ct

@L
= tUltNt + t t (1
@lt

=0

lt) wt

=0

(1

) k t ]g

@L
=
@kt+1

t (1 + xt) (1 +

t+1
E
)+
t
t+1 [rt+1 + (1 + xt+1 ) (1
n

)] = 0

UctNt = t

Ult
=
Uct

t (1 + xt) (1 +

n)

(1

(A1)

lt) wt

= Et t+1 [rt+1 + (1

) (1 + xt+1)]

UctNt (1 + xt) (1 + n) = EtUct+1Nt+1 [rt+1 + (1

Uct (1 + xt) = EtUct+1 frt+1 + (1

The production function is:

F ( k t ; Z t lt )

) (1 + xt+1)]

) (1 + xt+1)g

(A2)

The representative rm maximizes prots:

F ( k t ; Z t lt )

w t lt

r t kt

Solution of rmsmaximization problem

max

fkt;ltg

F ( k t ; Z t lt )

w t lt

r t kt

@ t
= Fkt (kt; Ztlt)
@kt

rt = 0

@ t
= ZtFlt (kt; Ztlt)
@lt

wt = 0

Fkt (kt; Ztlt) = rt

(A3)

ZtFlt (kt; Ztlt) = wt

(A4)

Substitute (A4) into (A1) and rearrange

Ult
=
Uct

(1

lt) wt

Ult
= (1
Uct

(1

lt) ZtFlt (kt; Ztlt)

lt) ZtFlt (kt; Ztlt)

Substitute (A3) into (A2) and rearrange

Uct (1 + xt) = EtUct+1 [rt+1 + (1

) (1 + xt+1)]

Uct (1 + xt) = EtUct+1 Fkt+1 (kt+1; Zt+1lt+1) + (1

The government maintains a balanced budget every period:

gt + Tt = ltwtlt + xtxt

) (1 + xt+1)

Substituting the government budget constraint and prot function into consumer
budget constraint to get the resource constraint:

ct + (1 + xt) xt = wtlt (1

ct + xt + xtxt = wtlt

+ ltwtlt + xtxt

gt

+ rtkt + ltwtlt + xtxt

gt

lt) + rtkt

ltwtlt

ct + xt + gt = wtlt + rtkt

ct + xt + gt = yt

The equilibrium conditions of the benchmark prototype economy are:

ct + xt + gt = yt

(1)

y t = F ( k t ; Z t lt )

(2)

Ult
= (1
Uct

(3)

lt) ZtFlt (kt; Ztlt)

Uct (1 + xt) = EtUct+1 Fkt+1 (kt+1; Zt+1lt+1) + (1

) (1 + xt+1)

(4)

The method assumes that frictions associated with specic economic environment manifest themselves as distortions in the rst-order condition and resource
constraints in the prototype model.

These distortions are called wedges.

The economy with four wedges exactly reproduces the data on output, labor,
investment, and government consumption.

In explicit functional form

We substitute the utility function and production function into the equilibrium
conditions.

The equilibrium conditions of the prototype economy are:

ct + xt + gt = yt

(1)

y t = F ( k t ; Z t lt )

(2)

Ult
= (1
Uct

(3)

lt) ZtFlt (kt; Ztlt)

Uct (1 + xt) = EtUct+1 Fkt+1 (kt+1; zt+1lt+1) + (1

) (1 + xt+1)

(4)

Production function and utility function are:

F (k; zl) = k (zl)1

u (c; l) = log c +

log (1

l)

Equilibrium conditions in explicit form:

ct + xt + gt = yt

(1.a)

yt = kt (Ztlt)1

ct
1 lt

= (1

1
1 h
(1 + xt) = Et
(kt+1)
ct
ct+1

vet =

vt
(1+ )t

lt) Zt (1

(2.a)

) kt (Ztlt)

(Zt+1lt+1)

+ (1

(3.a)

) (1 + xt+1)

(4.a)

We assume that gt uctuates around a trend of (1 + )t

Equilibrium conditions in detrended per-capita form:

(1.b)

c~t + x
~t + g~t = y~t

1
~
~
y~t = kt Ztlt

cet
1 lt

= (1

e
lt) Zt (1

(2.b)

e
e
)k
t Ztlt

(3.b)

(1 + xt) (1 + )

1
1
= Et
c~t
c~t+1

e
k
t+1

Zet+1lt+1

+ (1

) (1 + xt+1)
(4.b)

e ,l.
e t, yet, k
Endogenous variables are: cet, x
t t

We need the capital accumulation law to close the model.

(1 + n) kt+1 = (1

) k t + xt

(5)

~t+1 = (1
(1 + n) (1 + ) k

~t + x
)k
~t

(5.b)

Steady state of the prototype model

Variables without time index are steady state values.

(1 + x) (1 + ) =

e
k

e
Zl

+ (1

) (1 + x)

(1 + x) (1 + )

"

1
Ze 1
e
k

(1

) (1 + x) =

(1 + x) (1 + )

1
Ze 1

"

(1

(1 + x) (1 + )

We obtain the steady-state of kl .

e
k
#

1
e
Zl

) (1 + x) =

e
k

(1

#)

) (1 + x)

1
1

(ss1)

~ = (1
(1 + n) (1 + ) k

[(1 + n) (1 + )

~
y~ = k

~ 1
Zl

~1
=Z

~+x
~
)k

~=x
)] k
~

(1

e
k

c~ + x
~ + g~ = y~

e=Z
~1
k

e
k

c~ = y~

x
~

e
k

~1
g~ = Z

ce =

ce

(1

= (1

l)

(1

Use (ss2) and (ss3) to solve l:

[(1 + n) (1 + )

e
l ) Z (1

e1
l) Z

(1

e
)k

(1

~
k
l
)]
l

g~ (ss2)

e
Zl

e
k

(ss3)

~1
Z

e
k

l)

[(1 + n) (1 + )

~
k
)]
l

!)

e
k

l [(1 + n) (1 + )

~1
Z

(1

e
k

e1
Z
)
l

(1

e
k

~
(1
k
l g~ =
)]
l

(1

(1
e1
Z
)
l

e1
l) Z

(1

g~

e
k

e
k

~1
Z

= g~ +

(1

[(1 + n) (1 + )
e1
l) Z

e
k

(1

~
k
)]
l

The above equation solves the steady-state value of l.

It follows:

e=
k

e
k

(1

e1
l) Z

e
k

! )

ce =

(1

l)

(1

e1
l) Z

~1
y~ = Z

(1

e
k

x
~ = [(1 + n) (1 + )

e
k

(1

~
)] k

Log-linearization
We log-linearize the equilibrium conditions around the steady state.

cbt = log cet

log ce

b t = log x
et
x

e
log x

ybt = log yet

log ye

b = log k
e
k
t
t

e
log k

lbt = log let

gbt = log get

log le
log ge

Zbt = log Zet

b lt =

lt

b xt =

xt

log Ze
l

Equilibrium conditions in detrended per-capita form:

(1.b)

c~t + x
~t + g~t = y~t

1
~
~
y~t = kt Ztlt

cet
1 lt

(1 + xt) (1 + )

= (1

1
1
= Et
c~t
c~t+1

e
e
)k
t Ztlt

e
lt) Zt (1
e
k
t+1

(2.b)

Zet+1lt+1

(3.b)

+ (1

) (1 + xt+1)
(4.b)

~t+1 = (1
(1 + n) (1 + ) k

~t + x
)k
~t

Equation (1.b)

c~t + x
~t + g~t = y~t

c~ec^t + x
~ex^t + g~eg^t = y~eybt

(5.b)

e (1 + x
ce (1 + c^t) + x
^t) + ge (1 + g^t) = ye (1 + y^t)
ex
cec^t + x
^t + geg^t = yey^t
e
ce
x
ge
c^t + x
^t + g^t = y^t
e
e
y
y
ye

Equation (2.b)

(1.c)

~t Z
~tlt 1
y~t = k

y~ey^t

y~ey^t

^t
k
~
= ke

~
= k

1
~
Zl

^
ey^t = e kt+(1

^t ^
Z
~
Ze lelt

^
e kt+(1

^t+(1
)Z

^t+(1
)Z

)^
lt

)^
lt

^t + (1
1 + y^t = 1 + k

^t + (1
y^t = k

)^
lt

^t + (1
)Z

^t + (1
)Z

)^
lt

Equation (3.b)

cet
1 lt

= (1

e
lt) Zt (1

e
e
)k
t Ztlt

(2.c)

e
lt) Zt (1

cet = (1
ce = (1

(1

ceec^t = (1

^lt

e
l ) Z (1

1
t) (1

l)

e Zt
l ) Ze (1

e
e
)k
t Ztlt
e
)k

1 e
Z (1
e
c
^t
e k
) ke

(1

e
Zl

lt )

(1

e
)k

l)

e
Zl
^

e Zt lelt
Ze

lelt

ceec^t

= (1

ec^t = (1

e
l ) Z (1

^lt

^lt

l)

ec^t =

(1
1 + c^t =
(1

"

(1
(1

1 e
Z (1
ce

e (Zl)
)k
e
)k

e
Zl

^lt
^
l)
e kt+(1
l)
t) (1

^lt
l)
^t + (1
1+ k
l)
t) (1

^t+(1
k
e

^
lt

^t
)Z

^
e kt+(1

^t
)Z

^
lt

lelt

^t
)Z

^t
)Z

^
lt

^
lt

^
lelt

lelt

l 1+^
lt

(1

t) (1

l) (1 + c^t) = (1

^lt

l)

^t + (1
1+ k

^t
)Z

^
lt

l^
lt

(1

t) (1

l) (1 + c^t) = (1

^lt

= (1

^lt

= (1

l)

= [(1
= (1

= (1
(1

^
^t
^t
)Z
lt l
lk
^t + l^
lt l^
lt
) lZ
i
^t + (1
^
^t
l) 1 + k
)Z
lt
l^
lt

^t + (1
l) 1 + k

^t + (1
l) 1 + k
^t + (1
l) 1 + k

l ) (1

l ) l lt

^t + (1
1+ k
(1

^lt] (1

l ) (1

^
^t
)Z
lt 1 l l^
lt
1
^
^
^
) Zt
lt l
l kt
^t C
^t + l^
A
) lZ
lt l^
lt l^
lt k
^t + l^
lt ^
lt
l^
lt (1
)Z

(1

l)

l)

^lt (1

^t + (1
1+ k
0
^t + (1
1+ k

B
l) @

^lt

^lt (1

l)

^t
)Z

^
lt

(1

^
lt + ^ltl^
lt
^
^t
)Z
lt

^t
)Z

l ) l lt

(1

l ) (1

l) (1 + c^t) = (1

(1

^t + (1
(1 + c^t) = 1 + k

^t + (1
c^t = k

^t + (1
c^t = k

^t + (1
l) 1 + k

l ) (1

^
lt
"

(1
1

(1

l)

1
(1

l)

^
lt

^t
)Z

^t
)Z

^t
)Z

^lt (1

l ) l lt

l)

l^
lt

^
lt

^t
)Z

l ^
lt

l)

l^
lt

(1
1

(1

l)

^lt

1
(1

l)

^lt

l)

^lt

(3.c)

Equation (4.b)

1
1
(1 + xt) (1 + ) = Et
c~t
c~t+1

(1 + x) (1 + )

1
=
c~

(1 + x) (1 + ) =

e
k

1
c~

t+1

e
k
e
k

1
e
Zt+1lt+1

e
Zl

e
Zl

+ (1

+ (1

+ (1

) (1 + xt+1)

) (1 + x)

) (1 + x)

y~
+ (1
~
k

(1 + x) (1 + ) =

(1 + x) (1 + )

y~
+ (1
~
k

1 c^t
1 c^t+1
= Et e
(1 + ^xt + x) (1 + ) e
c~
c~

(1 + ^xt + x) (1 + ) e c^t = Ete c^t+1

"

) (1 + x)

) (1 + x)

y~ey^t+1

~ k^t+1
ke

+ (1

) (1 + ^xt+1 + x)

y~ y^t+1 k^t+1
e
+ (1
~
k

) (1 + ^xt+1 + x)

Ignore Et for a moment

(1 + ^xt + x) (1 +

) ec^t+1 c^t

ye y^t+1 k^t+1
e
+ (1
e
k

(1 + ^xt + x) (1 + ) (1 + c^t+1

(1 + ^xt + x) (1 + c^t+1

c^t)

c^t) =

(1 + )

2
4
2

=4

+ (1

+ (1

) (1 + ^xt+1 + x)

ye
^t+1
e (1 + y
k

^t+1)
k
5
) (1 + ^xt+1 + x)

ye
^t+1
e (1 + y
k

^t+1)
k
5
) (1 + ^xt+1 + x)

LHS

(1 + ^xt + x) (1 + c^t+1
= [1 + (^
ct+1
= (1 + x)
+ (^
ct+1
= (1 + x)

c^t)

(1 + )

c^t)] [(1 + x) + ^xt]

(1 + )
c^t) ^xt

(1 + )

+ ^xt

(1 + )

(1 + )

+ (^
ct+1

c^t) (1 + x)

(1 + )

(1 + )
+ ^xt

(1 + )

+ (^
ct+1

c^t) (1 + x)

(1 + )

RHS

LHS=RHS

ye

^t+1) + (1
(1
+
y
^
k
) (1 + ^xt+1 + x)
t+1
e
k
ye
ye
^t+1 + (1
) (1 + x) + (1
+
y
^
k
t+1
e
e
k
k

) ^xt+1

(1 + x)
=

^xt

(1 + )

ye

e
k

+(^
ct+1

(1 + )
ye

e
k

y^t+1

+ ^xt

^t+1
k

c^t) (1 + x)

Add back expectation

(1 + )

+ (^
ct+1

+ (1

(1 + )

c^t) (1 + x)

) (1 + x) + (1

ye

y^t+1
e
k

(1 + )
) ^xt+1

^t+1 + (1
k

) ^xt+1

^xt

(1 + )

+Et (^
ct+1

^xt

(1 + )

= Et

Equation (5.b)

ye

c^t) (1 + x)

+ (1 + x)

y^t+1
e
k

(1 + )

(1 + )

^t+1 + (1
k

ye

= Et

y^t+1
e
k

Etc^t+1

(1 + x)

) ^xt+1

~t+1 = (1
(1 + n) (1 + ) k

~t + x
)k
~t

^t+1 + (1
k

(1 + )

c^t

) ^xt+1

(4.c)
(5)

~ kt+1 = (1
(1 + n) (1 + ) ke

~ 1+k
^t+1 = (1
(1 + n) (1 + ) k

~ kt + x
~ex^t
) ke

~ 1+k
^t + x
)k
~ (1 + x
^t )

~k
^t+1 = (1
(1 + n) (1 + ) k

~k
^t + x
)k
~x
^t

^t+1 = (1
(1 + n) (1 + ) k

x
~
^
) kt + x
^t
~
k

(5.c)