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Dynamic Macroeconomics based on NK system

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Murphy-Shleifer-Vishny; Krugman

Mausumi Das

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 1 / 71

History vis-a-vis Expectations in the Process of

Development:

dierences in the growth trajectories of dierent countries to various

historical factors.

History shows up either in terms of an initial condition (e.g., initial

capotal stock, initial distribution of wealth) or in terms of an

institutional set up that the eceonomy has inherited (e.g., nature of

the nancial or political institutions).

There is however a third strand of the litearture which focuses on the

role of expectations in determining the development trajectory of an

economy.

It has been observed that countries with similar history sometimes

follow divergent growth paths. This latter strand of the literature

attempts to explain these cases.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 2 / 71

Role of Expectations in the Process of Development:

coordination failure models which result in multiple (Nash) equilibria.

The basic idea here is that even with a given history, an economy may

face multiple possible growth trajectories due to existence of strategic

complementarity among the choice variable of agents.

Among the many possible equilibrium trajectories, which one will be

chosen depends crucially on agents expectations - what one believes

about others choice of action.

Even with favouarble historical conditions, an economy mail fail to

take o simply because agents in this economy failed to coordinate on

their actions.

Such cases highlight a special role of the government in terms of

coordinating the actions of various agents to generate an outcome

that is pareto e cient.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 3 / 71

Role of Expectations in the Process of Development:

(Contd.)

as a coordination game:

Murphy, Shleifer, Vishny: Industrialization and the Big Push (Journal

of Political Economy, 1989)

Krugman: History Versus Expectations (Quaterly Journal of

Economics, 1991)

The Murphy-Shleifer-Vishny paper explores a static model of

coordination failure.

The Krugman paper starts with a static model and then extends it to

a dynamic framework which allows us to precisely charaterise the role

of history vis-a-vis expectations.

We shall strat with the Murphy-Shleifer-Vishny model.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 4 / 71

Role of Expectations in the Process of Industrilization:

Murphy-Shleifer-Vishny

Suppose the economy has access to two types of technologies: an IRS

modern technology and a CRS cottage technology.

The rst technology is more productive - but it also entails a xed

cost. Thus a rm will adopt this technology only if there is su cient

demand.

The level of aggregate demand on the other hand depends on the

actions of other rms:

if all rms adopt the modern technology together then that generates

income which in turn creates demand for each of the products to make

the adoption of the modern technolgy viable;

if no other rms adopt the modern technology, then there is no

incentive for a single rm to adopt the technology alone - since the

resulting demand will not be su cient to cover the xed cost.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 5 / 71

Murphy-Shleifer-Vishny: (Contd)

generates possibilities of mutiple equilibria and the consequent role of

self-fullling (rational) expectations:

If each rm expects that others will adopt the modern technology, then

it adopts the modern technology too - hence the economy embarks on

the path of industriazation

If each rm expects that others will not adopt the modern technology,

then it does not adopt the modern technology either - hence the

economy remains stuck wit home production.

However, Murphy-Shleifer-Vishny shows that presence of such

strategic complementarities (in this case working through demand) is

necessary but not su cient to generate multiple equilibria.

In fact they construct two similar models - one of which exhibits

multiple, the other does not.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 6 / 71

Murphy-Shleifer-Vishny: Model I

The economy consists of a continuum of population of measure 1,

represented by the unit interval [0, 1] .

All agents/households in this economy are identical; so we can talk in

terms of a representative agent. (Note that since total population has

a measure of unity, average and aggregate values in this economy

would be identical).

There exists a variety of nal goods, represented by the continuum

[0, 1] , such that each variety is represented by an index q 2 [0, 1] .

The representative agents preference over all these varieties of nal

goods is dened by a Dixit-Stiglitz Love for Varietyutility function:

Z1

U= log xq dq

0

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 7 / 71

Murphy-Shleifer-Vishny: Model I (Contd.)

Notice that this Love for Varietyutility function has similal features

as the Love for Varityproduction funvtion that we have seen bafore.

U 1 2 U 1

In particular, for any variety q, = > 0; = < 0.

xq xq xq2

(xq )2

Morever, as xq ! 0, x U

q

! .

These two features will ensure that as long as the varieties are

associated with nite prices, the agent will consume all the varieties.

Also, if the same price is charged for all the varieties then the agent

will spread his income equally over all the varieties and consume equal

amount of each.

In general, if the agent has income y , then the optimization problem

of the representative agent is given by:

Z1 Z1

Max. log xq dq subject to pq xq dq = y .

0 0

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 8 / 71

Model I: Production Side Story

(simplication).

Each nal good sector - producing a particular variety q has access

to two types of technologies:

(i) A modern, highly productive, IRS mass-production technology -

which entails a xed set up cost of F units of labour. Once this set

up cost has been incurred, every additional unit of labour emplyed in

this sector generates units of nal output of variety q, where > 1.

(Why is the modern technology IRS?)

(ii) A traditional, less productive, CRS cottage technology - which

does not ential any xed cost. Every unit of labour employed in this

sector generates 1 unit of nal output of variety q.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 9 / 71

Model I: Market Structure

sets its own price (given the demand) so as maximise prot.

However houselds hold ownership shares of these rms so that a part

of the monopoly prot is distributed to the households in the form of

dividends.

The cottage technologies can either be operated by competitive rms

of can be produced at home using own labour.

We shall assume the latter.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 10 / 71

Model I: Wages & Prices

When a variety is produced at home using the cottage technology, a

unit of the nal commdity is produced by a unit of labour. Thus

implicit wage rate in the cottage sector (in tems of the nal

commodity) is equal to 1.

Let us take labour as the numaraire: w = 1.

Then implicit price of each variety under cottage production is also

eqaul to unity: pq = 1.

The monopolist rm in each sector on the other hand sets its price by

looking at the demand.

Notice that given the utlity function of the agent, the demand for any

variety q is derived from the following equation:

1

= pq for all q

xq

1

) pq xq = for all q

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 11 / 71

Model I: Wages & Prices (Contd.)

Plugging this in the budget equation of the agent:

Z1

1 1

dq = y ) = y

0

pq xq = y

demand for each variety is also represented by the same equation:

y

xq = (1)

pq

Notice that the price elasticity of demand of each variety is unity; so a

monopolist would like to charge an arbitrarily high price level (close to

innity) (Why?)

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 12 / 71

Model I: Wages & Prices (Contd.)

However because of the presence of the cottage sector, it cannot

charge anything other than a price equal to 1. (Otherwise nobody will

buy from the monopolist.)

On the other hand, the monopolist being a price-taker in the factor

(labour) market will pay the same cottage wage rate of w = 1.

This implies that irrespective of whether a variety is produced by a

monopolist using the modern technology, or under cottage

production, the corresponding wage rate and the prices would be the

same, given by:

w = 1;

pq = 1 for all q.

However, since the cottage sector is less productive, the level of

income would dier in the two cases. The higher is the proportion of

varieties that are produced by the monopolists, the higher would be

the aggregate output.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 13 / 71

Model I: Demand-Prot Interlinkage

But there is an additional constraint as well: given that the

monopolist has to incur a xed cost, will he always operate?

The answer is: No.

Given the xed cost, a monopolist will operate if and only if the total

revenue is enough not only to cover the variable cost, but also the

xed cost.

To put it dierently, a monopolist would operate if and only if his net

prot is non-negative.

His prot depends on the level of demand - which in turn depends on

the level of income of the households.

Recall that xq denotes the consumption of each variety by a

household. Since the measure of total households is unity, xq also

denotes the aggregate consumption demand for variety q.

Accordingly, prot of a monopolist operating in sector q is given by:

1

q = xq xq F

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 14 / 71

Model I: Demand-Prot Interlinkage (Contd.)

Now from the solution of the householdsoptimization exercise

(equation (1)) we know that for each variety q 2 [0, 1]:

xq = y (since pq = 1)

Simplifying, we get the following relationship between y and q :

1

q = 1 y F

1

= ay F where a < 1. (2)

A monopolist would operate if and only if

F

q = 0 ) y =

.

a

Thus for a monopolist to operate in any sector, the corresponding

demand (y ) has to be su ciently high. (Recall that if the monopolist

in any sector abstains from production then the correspoding demand

is served by the cottage sector.)

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 15 / 71

Model I: Prot-Demand Interlinkage

working though the distributed prots.

Let us assume that households are the shareholders of the

monopolists rms, which gives them access to the prots earned by

the monopolist rms.

Since a part of the prot income goes back to the households in the

form of dividends, the householdsincome consists of the total wage

bill plus the share of prot that is distributed.

Let be the share of prot that is distributed back to the households.

Then aggregate household income (which is also the income of the

representative household) is the given by:

y = W +

creates the potential of multiple equilibria here.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 16 / 71

Model I: Prot-Demand Interlinkage & Keynesian Demand

Shortage

may arise here if (and only if) < 1.

This is because aggregate production under full employment would be

given by

Y W +

On the other hand, aggregate consumption demand (for all varieties

taken together and across all households) will be given by:

0 1

Z1 Z1

C = @ y dq A dh = y = W +

0 0

demand leading to Keynesian unemplyement.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 17 / 71

Model I: Prot-Demand Interlinkage & Keynesian Demand

Shortage (Contd.)

In a dynamic model with capital, this aggregate demand problem

could be taken care of by assuming that the retained prots of rms

are automatically invested.

This would ensure that aggregate demand is always equal to

aggregate supply:

C + I = W + + (1 ) = W + = Y

But in the absence of investment, (1 ) will constitute a leakage

that would lead to perpetual demand shortage.

To avoid this problem, we assume that = 1, i.e., the entire prot

income is distributed back to the households in the form of dividends.

This once again ensures that there is no aggregate demand shortage;

whatever is produced is always demanded:

C = y = W + = Y

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 18 / 71

Model I: Prot-Demand Interlinkage (Contd.)

Let each agent be endowed with L units of labour, which he supplies

inelastically to the market.

Recall that each unit of labour earns a wage rate of w = 1,

irrespcetive of whether it is employed in cottage production of

modern production.

Then

W = L.

Also let n proportion of the sectors be operated by the respective

monopolist producers. (The exact value of n will evetually be

determined endogeneously within the model).

Then

= n q

Putting these together, we get another relationship between y and

q :

y = L + n q (3)

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 19 / 71

Model I: Prot as a function of no. of modern sectors in

operation

(the proportion of sectors which are mordernised):

y = L + n (ay F)

L nF

) y (n ) = (A)

1 na

Corresponding prot of each of the monopolist in operation:

q = ay (n) F

L nF

) q (n ) = a F

1 na

aL F

) q (n ) = (B)

1 na

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 20 / 71

Model I: Prot as a function of no. of modern sectors in

operation (Contd.)

Equation (B) above shows that the prot of each potential

monopolist in operation depends on the proportion of modern rms

which are under operation.

Notice however that the denominator of the RHS is always positive.

Thus the nature of the relationship depends crucially on the

numerator.

In particular:

d q (n )

1 when aL F > 0, > 0;

dn

d q (n )

2 when aL F < 0, < 0.

dn

Thus there is an externality from one modern rm to another: as the

proportion of modernised rms goes up, the prot of each modernised

rm is aected.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 21 / 71

Model I: No. of Modern Sectors in Operation in

Equilibrium

Recall that a monopolist will operate as long as he earns a

non-negative prot.

Now there are two cases here:

In Case 1, aL F > 0.

d q (n )

We already know that in this case, > 0.

dn

aL F

Moreover, q (0) = aL F > 0 and q (1) = > 0.

1 a

Thus a monopolist will always be willing operate, quite independent of

what value n takes.

Therefore in equilibrium, n = 1.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 22 / 71

Model I: No. of Modern Sectors in Operation in

Equilibrium (Contd.)

In Case 2, aL F < 0.

d q (n )

We already know that in this case, < 0.

dn

aL F

Moreover, q (0) = aL F < 0 and q (1) = < 0.

1 a

Thus a monopolist will stay away from operating, quite independent of

what value n takes.

Therefore in equilibrium, n = 0.

Note that multiple equilibria would have been realized in Case 1 if we

aL F

had q (0) = aL F < 0 while q (1) = > 0. But obviously

1 a

that cannot happen here.

Also note that multiple equilibria can neven happen in Case 2, even

aL F

when q (0) = aL F > 0 and q (1) = < 0. (Why?)

1 a

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 23 / 71

Model I: Limitations

Thus we see even when there are prot interlikages bewteen rms

working through demand externalities, that may not be su cient to

generate multiple equilibria.

Depending on the parametric conditions, we get two dierent

equilibrium values of n. But the equilibrium value is unique.

Each monpolist rm will decide either to operate or not operate -

quite independent of what others are doing.

Thus there is no role of expecations here. Neither is there any scope

for coordination-driven multiple equilibria.

This is because here the demand externality works only through the

prot channel: if prot is positive to begin with, that creates more

demand and therefore even higher prot - eventually leading to

n = 1. On the other hand, if prot is negative to begin with, that

creates less demand and therefore even lesser prot - eventually

leading to n = 0.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 24 / 71

Model I: Limitations (Contd.)

This tells us that for the multiple equilibria story to operate we need

an additional channel of demand externality that works independent

of the prot channel.

Murphy-Shleifer-Vishny builds a second model, where this additional

channel is provided by a demand externality that works through the

wages.

For this purpose the rst model is modied to incorporate a wage

premium for the modern sector workers.

We now discuss the details of the second model.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 25 / 71

Model II: Introducing Factory Wage Premium

Let us assume that working in factories under modern production has

certain disutilities associated with it (due to displacement cost,

impersonal non-family environment etc.).

The utility function of the representative agent is now given as follow:

8

>

> R1

>

< log xq dq if he works in cottage sector;

U= 0

>

> R1

>

: log xq dq V if he works in modern sector.

0

As before, under cottage production:

w = 1;

pq = 1 for all q.

Under modern production, once again pq = 1 (for the same reason as

before). However, the wage rate in the moden sector can no longer

be the same as that of the cottage sector. The modern sector must

oer a wage premium to compensate for the associated disutility.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 26 / 71

Model II: Factory Wage Premium

Let w denote the wage rate in the modern sector. What is its value in

equilibrium?

Notice that at this wage rate, an agent should be indierent between

working in the cottage sector and working in the modern sector.

Now the indirect utility of any agent who is working in cottage

production and earning a wage income of L in given by:

Z1

Uc = = log L.

log Ldq

0

On the other hand, the indirect utility of any agent who is working in

modern production and earning a wage income of w L in given by:

Z1

Uc =

log w Ldq V = log w L V.

0

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 27 / 71

Model II: Factory Wage Premium (Contd.)

sector vis-a-vis the cottage sector i:

log w L V = log L

) log w L log L = V

) log (w ) = V

) w = expV > 1

w = 1 + v

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 28 / 71

Model II: Demand-Prot Interlinkage

Once again the demand for any variety q is given by the aggregate

household income y . (Notice however that now income across agents

may dier depending on which sector they are working in, although

their utilities would be the same).

Let Y denote the aggegate demand for any variety q coming from all

the households.

The prot of a monopolist operating in sector q is given by:

1

q = Y (1 + v ) Y +F

(1 + v )

= 1 Y (1 + v )F (4)

We shall assume the the modern sector is productive enough so that

> 1 + v.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 29 / 71

Model II: Prot-Demand Interlinkage

Once again the aggregate income is the given by the sum of the wage

bills and the distributed prot :

Y = Wc + Wm +

Let n proportion of the sectors be operated by the respective

monopolist producers.

Then

1

Wm = n ( 1 + v ) Y +F

1

Wc = L n Y +F

while

= n q .

Thus

1 1

Y = n (1 + v ) Y + F + L n Y +F + n q . (5)

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 30 / 71

Model II: Prot as a function of no. of modern sectors in

operation

(the proportion of sectors which are mordernised):

L nF

Y (n ) = (A0 )

1

1 n

(1 +v )

[L nF ]

q (n ) = (1 + v )F (B0 )

1

1 n

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 31 / 71

Model II: Existence of Multiple Equilibria:

d q (n ) 1

whenever aL F > 0, > 0 (where a ).

dn

Thus as before, there exists a positive externality from one rm to

another working through the demand channel (under suitable

parameter restrictions).

Does that generate multiple equilibria in the current scenario? The

answer is yes and no.

It still does not gaurantee the existence of multiple equilibria for all

possible cases.

However, it is easy to construct examples (with specic parameter

values) which would generate multiple equilibria in the current

scenario.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 32 / 71

Model II: Existence of Multiple Equilibria - An Example

two conditions are met :

(1 + v )

L < (1 + v )F

and

[ (1 + v )] [L F ] > (1 + v )F

(Construct such an example. Note that in addition, you have two

more conditions, namely, aL F > 0 and > 1 + v )

It is easy to verify that for this specic example,

d q (n )

> 0; q (0) < 0; q (1) > 0.

dn

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 33 / 71

Model II: Existence of Multiple Equilibria - An Example

(Contd.)

In terms of diagram:

n = 1.(Notice that n is not a nash equilibrium.)

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 34 / 71

Model II: Existence of Multiple Equilibria - An Example

(Contd.)

Apriori we cannot say. Depends on agentsexpectations.

Notice that n = 1 is a betterequilibrium than n = 0 in the sense

that the aggregate income is higher in the former. But the agents

may not reach this equilibrium on their own.

Moreover, two economies which are exactly identical otherwise (in

terms of history and institutions) may end up with completely

dierent economic outcomes simply because agentsexpectations

diered in the two cases.

The existence of multiple equilibria where one equilibrium is better

than the other justies any kind of governement intervention that

nudges an economy from the bad equilibrium to the good equilibrium.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 35 / 71

Limitation of the Murphy-Shleifer-Vishny Framework:

which can explain the observed divergence in economic outcomes in

apparently similar countries, its biggest drawback is that it is a static

model. There is no dynamics here. Hence it cannot explain growth.

More importantly, being static, it also cannot explain the relative

importance of history vis-a-vis expectations in the development

process.

Notice that history can be captured in the model by the amount of

total labour available: L

Let us allow for population growth at a constant exogenous rate so

the the economy starts with a given labour force of L at the initial

point of time, but it grows over time.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 36 / 71

Limitation of the Murphy-Shleifer-Vishny Framework:

(Contd.)

Let us take our earlier example with multiple equilibria, but now allow

L to increase over time.

It is easy to verify that as L increases, the prot line shifts up and

eventully it moves entirely above the horizontal axis. From that point

onwards, expectations ceases to play any role and we are back to a

world where history dominates.

However Murphy-Shleifer-Vishny do not explore the possible

interaction between history and expectations.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 37 / 71

From Murphy-Shleifer-Vishny to Krugman:

Krugman also develops a static model of multiple equilibria which is

very similar to M-S-V.

But Krugman subsequently brings in a dynamic mechanism to

chracterise the dynamic paths of the economy.

In the process he precisely identies the relative role of history

vis-a-vis expectations.

We now turn to the Krugman model.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 38 / 71

Krugman: A Short Run (Static) Model of Multiple

Equilibria

There are two nal goods (C and X ) that are produced using a single

factor (labour, L):

C , a good produced with constant returns;

X , a good whose production is subject to an externality resulting in

increasing returns (which is internal to the industry, but external to the

rms).Assume that the larger is the labour force engaged in X

production (LX ), the higher is labour productivity in that sector:

The economy is able to sell both C and X at xed prices on world

markets. Normalize these world prices to unity.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 39 / 71

Technology

one unit of labour produces one unit of C : YC = LC

the value of that unit is one.

) Real wage rate in the C sector is unity.

In the X sector productivity depends on industry employment:

YX = (LX )LX

Since the economies of scale are external, each rm treats labour

productivity as constant.

) Perceived marginal product = average product.

) Real wage rate in the X sector is equal to the average product:

w = ( LX ) . (2)

LC + LX = L

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 40 / 71

Existence of Multiple Equilibria

Assumption: (0) < 1, and (L ) > 1.

Existence of Multiple Equilibria:

1. EC : Nobody is employed in X (LX = 0)

2. EX : Everyone is employed in the X sector (LX = L)

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 41 / 71

Expectation or History? Speed of Adjustment Matters

Depends on workersexpectations.

Notice that history will come back to play a crucial role if labour

adjustment across sectors is gradual and not instantaneous.

How?

Suppose the economy starts with a given initial allocation of labour

between the two sectors (LX (0) given).

Labour moves over time to the sector that oers higher wage through

the following dynamic adjustment process: L X = f (w 1); f (0) = 0;

f 0 > 0.

Note that LX in Figure 1 now represents a steady state - but it is an

unstable one.

If the initial employment in X sector is greater than LX , i.e.,

LX (0) > LX , then the economy in the long run moves to EX .

If the initial employment in X sector is smaller than LX , i.e.,

LX (0) < LX , then the economy in the long run moves to EC .

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 42 / 71

Crucial Question: Why Labour Adjusts Gradually?

If there is no cost of moving labour across sectors, then adjustments

should be instantaneous.

In that case there is no reason why the initial allocation of labor

should matter.

Thus, in the absence of some cost of shifting labour, we would be

back to the multiple equilibria story: either equilibrium can be

obtained as a self-fullling prophecy, irrespective of the initial

position.

To make the initial position matter, or to justify why the labour

adjustment process is gradual, it is then necessary to introduce some

cost of adjustment in shifting labour between sectors.

But if there is cost of adjusting labour and it happens gradually over

time, then when we should look at not just the current wage

dierential, but in fact the entire future stream of benets coming

from such labour adjustments. In other words, we should have a fully

developed dynamic optimization model.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 43 / 71

A Dynamic Model: Interaction Bewteen History &

Expectation

innitely lived agents who are identical in every respect - so we can

talk in terms of a representative agent.

At each point of time, the representative agent has a xed

endowment of labour, L, which he allocates between the two sectors:

X and M. Initial allocation (LX (0)) is given.

Cost of moving labour across sectors depends on how much labour is

being moved in or out of sector X :

1 2

F (L X ) = LX ,

2

L X

) The marginal cost of labour re-allocation: F 0 (L X ) = .

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 44 / 71

AgentsDynamic Optimization Problem:

upfront, before the labour movement has actually taken place.

Consider a household which starts with a historically given initial

distribution of labour across the two sectors, given by LX (0) and

L LX (0) respectively.

It it wants to shift its labour from one sector to the other by a

magnitude L X (equivalent of 4LX in continuous time) then it has to

incur a cost of F (L X ) in the current period itself. This will result in a

new allocation of labour in the next period.

Hence for any given LX (t ), the net income available for consumption,

after incurring the labour re-allocation cost, is given by:

1 2

Y t = wt LX (t ) + (L LX (t )) LX . (3)

2

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 45 / 71

AgentsDynamic Optimization Problem: (Contd.)

value of his life time utility, where instantaneous utility is linear in

consumption, Z

t

U= Ct e dt. (4)

0

Then the dynamic optimization problem of the household would be to

maximise (4) subject to (3).

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 46 / 71

AgentsDynamic Optimization Problem: (Contd.)

lend freely in the world market at a given world interest rate r .

Since the agent is allowed to borrow/lend at the given interest rate r ,

his ow budget constraint in every period is given by:

dB

= Ct Y t + rBt ,

dt

where Bt denotes the existing stock of (un-repaid) loans.

Now there are two state variables: LX (t ) and B (t )

Note that with a linear utility function, and facing a given world rate

of interest, an agent will have non-zero consumption in every period if

and only if r = . Otherwise he will always frontload all his

consumption at the initial point (if > r ); or will concentrate all his

consumption at the end point (if < r ). So we shall assume from

now on that r .

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 47 / 71

No Ponzi Game Condition:

Obviously, the moment we allow for borrowing, the possibility of

Ponzi-nancing arises.

We rule that out by imposing the following No-Ponzi-Game (NPG)

Condition:

rt

lim Bt e = 0.

t !

Note that the ow budget constraint can be easily converted into the

following life-time budget constraint (multiplying both sides by exp rt

and intergrating over 0 to ):

dB

e rt

rBt e rt

= Ct e rt

Y t e rt

dt

d (Be rt

)

) = Ct e rt

Y t e rt

Z dt Z Z

) d Be rt

= Ct e rt

dt Y t e rt

dt

0 0 0

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 48 / 71

No Ponzi Game Condition (contd.):

In other words,

Z Z

lim Bt e rt

B0 = Ct e rt

dt Y t e rt

dt.

t ! 0 0

Using the NPG Condition and assuming that the agent does not start

with any inherited debt (i.e., B0 = 0), the life-time budget constraint

implies, Z Z

rt

Ct e dt = Y t e rt dt.

0 0

This implies that even when we allow for borrowing, as long as the

NPG

R condition satised, choosing a consumption path that maximises

C e rt dt is equivalent to choosing a net income path that

t

0 R

maximises 0 Y t e rt dt. (The maximized values would be the same).

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 49 / 71

AgentsOptimization Problem Re-written:

as

Z

Maximize Y t e rt

dt.

fY t g 0

q

L X = 2 w LX + (L LX ) Y t , (i)

terms) the suplus income that would arise after allowing for

consumption, and the entire term on the RHS then tells us how much

labour can actually be moved with this suplus income, given the cost

function.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 50 / 71

AgentsOptimization Problem Re-written (contd.):

Z

Maximize Y t e rt

dt

fY t g 0

subject to q

L X = 2 wt LX + (L LX ) Y t .

Control variable: Y t

State variable: LX

LX (0) given

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 51 / 71

First Order Conditions:

q

H = Y t + qt 2 wt LX + (L LX ) Y t

unit of labor in the X rather than the C sector.

The rst-order conditions are:

H

= 0, (i)

Y t

H

= rqt q,

(ii)

LX

q

L X = 2 wt LX + (L LX ) Y t , (iii)

rt

lim qt e LX (t ) = 0. (iv)

t !

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 52 / 71

Simplifying the FONCs:

(i) implies

qt

1 p = 0.

2 [wt LX + (L LX ) Yt ]

L X = qt . (5)

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 53 / 71

Simplifying the FONCs: (Contd.)

(ii) implies

qt [wt 1]

rqt q = p

2 [wt LX + (L LX ) Yt ]

Using (iii) and (5)], we get

q = rqt wt + 1.

H

Notice that In calculating , atomistic agents do not internalize the

LX

increasing returns to scale present in X production and therefore they

take wt as exogeneously given.

However, under the assumption of perfect foresight, their guesses are

always correct so that w = (LX ) .

Using this information in the above equation, we get:

q = rq (LX ) + 1. (6)

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 54 / 71

Dynamic Equations & their interpretations:

Equations (5) and (6) are the two dynamic equations that are

generated from the FONCs. These along with the initial condition

and the TVC will determine the optimal trajectories for the economy.

Equation (5) can be re-written as :

L X

= qt

where,

the LHS denotes that marginal cost of moving one unt of labour from

L

C to X ( X ), and

the RHS represents the marginal benet (valuation at the margin, or

shadow price) of such a movement (qt ).

Equation (5) says that along an optimal trajectory, the marginal cost

must be equal to the corresponding marginal benet.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 55 / 71

Interpretations (contd.):

( 1) + q

r=

q

where,

the LHS denotes that international rate of return (r ), and

the RHS is the domestice rate of return of shifting labour from sector

C to sector X (plus the associated capital gains)

Equation (6) says that along an optimal trajectory, the two rates of

return must be equal.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 56 / 71

Phase Diagram:

L X = qt ;

q = rqt (LX ) + 1,

where LX (0) is given. Moreover, the optimal trajectory has to satisfy the

Transversility condition:

limt ! qt e rt LX (t ) = 0.

In drawing the phase diagram in the (LX , q ) plane, notice that

L X = 0 ).q = 0.

Thus in the phase diagram the L X = 0 locus co-incides with the

horizontal axis.

Whenever q is positive (i.e., in the postive quadrant), LX is rising.

Whenever q is negative (i.e., in the negative quadrant), LX is falling.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 57 / 71

Phase Diagram (Contd.):

1

On the other hand, q = 0 ) q = [ (LX ) 1] .

r

Thus in the phase plane, the q = 0 locus is represented by an

1

upward-sloping line, which takes negative value [ (0) 1] when

r

1

LX = 0, and takes a positive value [ (L )

1] .when LX = L.

r

For any given LX , higher value of q means higher q;hence

At all points above the q = 0 line , q is rising.

At all points below the q = 0 line , q is falling.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 58 / 71

Phase Diagram (Contd.):

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 59 / 71

Characterization of Steady States:

unstable steady state.

There are, two other quasi-steady-states in this model: one

illustrated by EC ; the other illustrated by EX .

Both satisfy the transversality condition (Verify)

Thus

any trajectory that takes the economy to one of these two points would

stay there.

These two are the possible long run equlibria of the model - which

satisfy the optimality criteria.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 60 / 71

Optimal Trajectories:

trajectories for the economy? Two possibilities:

(a) The trajectories approach EC or EX monotonically.

Happens when the characteristic roots associated with the unstable

steady state (q = 0; LX = LX ) are both real and positive.

(b) The trajectories approach EC or EX in a cyclical fashion.

Happens when the characteristic roots associated with the unstable

steady state (q = 0; LX = LX ) are both complex with positive real

parts.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 61 / 71

Characterization of the Optimal Trajectory: Case (a)

If LX (0) > LX , then the economy would gradually move to EX ;

If LX (0) < LX , then the economy would gradually converge to EC .

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 62 / 71

Characterization of the Optimal Trajectory: Case (b)

LX (an overlap of the two trajectories) from which either of EC or EX

can be reached.

Within the overlap, history is no longer decisive; expectations

play a role: For the same value of LX (0);there exist multiple optimal

trajectories within the overlap

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 63 / 71

Precise Role of Expectation in Case (b)

Recall that qt is a jump variable: its value is not historically given. In

fact solving the dierental eqaution

q = rqt ( LX ) + 1

and using the steady state condition that in the long run limt ! qt !

some constant q,

one can show that at any point of time t,

Z

qt = ( 1) e r d .

t

R

Thus, the intial choice of q is given by: q0 = 0 ( 1) e r d .

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 64 / 71

Precise Role of Expectation in Case (b) (contd.)

one expects to prevail today, tomorrow and all points of time in

future.

For example, if you expect everyone else will stay in the C sector

forever so that your expected (LX ) 1 value is negative, then you

would choose a q0 < 0.

On the other hand if you expect everyone else will stay in the X sector

so that your expected (LX ) 1 value is positive, then you would

choose a q0 > 0.

Moreover, midway along any trajectory you could suddenly change

your expectation, and start moving along a dierent trajectory, which

will again be self-fullling (since all other agents will also behave

symmetrically).

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 65 / 71

Parameters Determining the Existence of an Overlap:

If there is no overlap, then history is always decisive in this model.

If there is an overlap, then

history determines the outcomes if LX lies outside the overlap, but

expectations decide the outcome if LX lies inside.

Overlap exists if and only if the characteristic roots associated with

the unstable steady state are complex.

Recall that the dynamic system is reprented by:

q = rq (LX ) + 1

LX = q

Linearizing the system around the unstable steady state

(q = 0; LX = LX ):

q = rq (LX LX )

LX = q

where = 0 (LX ): a constant.

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 66 / 71

Parameters Determining the Existence of an Overlap

(contd.):

r

A=

0

Characteristic roots:

p

r r2 4

1 ; 2 = .

2

Roots are real and positive if r 2 = 4

Roots are complex (with postive real parts) if r 2 < 4

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 67 / 71

Parameters Determining the Existence of an Overlap

(contd.):

r 2 < 4 or not.

r : the interest/discount rate

: represents the degree of the externalities

: measures the degree of responsiveness of cost to labour relocation

(higher implies lower cost responsiveness which in turn implies that

labour can be relocated very fast without much increment in cost)

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 68 / 71

Parameters Determining the Existence of an Overlap

(contd.):

dominate expectations.

r is su ciently large ) the future icome is heavily discounted,

) individuals will not care much about future gains to be generated by

adjusting labour across sectors in a coordinated manner (based on

beliefs about others peoples action).

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 69 / 71

Parameters Determining the Existence of an Overlap

(contd.):

small ) degree of externality is relatively small.

) there is not enough future gain in by adjusting labour across sectors in

a coordinated manner (based on beliefs about others peoples action).

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 70 / 71

Parameters Determining the Existence of an Overlap

(contd.):

small ) cost increases very fast in response to labour relocation,

) it is not protable enough to majorly relocate labour in coordination

with other agents (based on beliefs about others peoples action).

Das (Lecture Notes, DSE) Dynamic Macro Oct 20-Nov 10; 2016 71 / 71

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