Growth Model PDF

Koen Vermeylen
The Stochastic Growth Model
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The Stochastic Growth Model
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The Stochastic Growth Model Contents
Contents
1. Introduction 5
2. The stochastic growth model 6
3. The steady state 9
4. Linearization around the balanced growth path 10
5. Solution of the linearized model 11
6. Impulse response functions 15
7. Conclusions 20
Appendix A 22
A1. The maximization problem of the representative firm 22
A2. The maximization problem of the representative household 22
Appendix B 24
Appendix C 26
C1. The linearized production function 26
C2. The linearized law of motion of the capital stock 27
C3. The linearized first-order condotion for the firm’s labor demand 28
C4. The linearized first-order condotion for the firm’s capital demand 28
C5. The linearized Euler equation of the representative household 30
C6. The linearized equillibrium condition in the goods market 32
References 34
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Koen Vermeylen
The Stochastic Growth Model Introduction
1. Introduction
1 Introduction
This article presents the stochastic growth model. The stochastic growth model
is a stochastic version of the neoclassical growth model with microfoundations,1
and provides the backbone of a lot of macroeconomic models that are used in
modern macroeconomic research. The most popular way to solve the stochastic
growth model, is to linearize the model around a steady state,2 and to solve the
linearized model with the method of undetermined coefficients. This solution
method is due to Campbell (1994).
The set-up of the stochastic growth model is given in the next section. Section 3
solves for the steady state, around which the model is linearized in section 4. The
linearized model is then solved in section 5. Section 6 shows how the economy
responds to stochastic shocks. Some concluding remarks are given in section 7.
2 The stochastic growth model
The representative firm Assume that the production side of the economy
is represented by a representative firm, which produces output according to a
Cobb-Douglas production function:
Yt = Ktα (At Lt )1−α with 0 < α < 1 (1)
Y is aggregate output, K is the aggregate capital stock, L is aggregate labor

supply and A is a technology parameter. The subscript t denotes the time period.
The aggregate capital stock depends on aggregate investment I and the depreci-
ation rate δ:
Kt+1 = (1 − δ)Kt + It with 0 ≤ δ ≤ 1 (2)

solves for the steady state, around which the model is linearized in section 4. The
linearized model is then solved in section 5. Section 6 shows how the economy
responds to stochastic shocks. Some concluding remarks are given in section 7.
The Stochastic Growth Model The stochastic growth model
2.
2 The stochastic
The stochastic growth
growth modelmodel
The representative firm Assume that the production side of the economy
is represented by a representative firm, which produces output according to a
Cobb-Douglas production function:
Yt = Ktα (At Lt )1−α with 0 < α < 1 (1)
Y is aggregate output, K is the aggregate capital stock, L is aggregate labor

supply and A is a technology parameter. The subscript t denotes the time period.
The aggregate capital stock depends on aggregate investment I and the depreci-
ation rate δ:
Kt+1 = (1 − δ)Kt + It with 0 ≤ δ ≤ 1 (2)
The productivity parameter A follows a1stochastic path with trend growth g and
an AR(1) stochastic component:
ln At = ln A∗t + Ât
Ât = φA Ât−1 + εA,t with |φA | < 1 (3)
A∗t = A∗t−1 (1 + g)
The stochastic shock εA,t is i.i.d. with mean zero.
The goods market always clears, such that the firm always sells its total pro-
duction. Taking current and future factor prices as given, the firm hires labor
and invests in its capital stock to maximize its current value. This leads to the
following first-order-conditions:3
Yt
(1 − α) = wt (4)
Lt

1 Yt+1 1−δ
1 = Et α + Et (5)
1 + rt+1 Kt+1 1 + rt+1
According to equation (4), the firm hires labor until the marginal product of
labor is equal to its marginal cost (which is the real wage w). Equation (5) shows
that the firm’s investment demand at time t is such that the marginal cost of
investment, 1, is equal to the expected discounted marginal product of capital at
time t + 1 plus the expected discounted value of the extra capital stock which is
left after depreciation at time t + 1.
The government The government consumes every period t an amount Gt ,

which follows a stochastic path with trend growth g and an AR(1) stochastic
component:
ln Gt = ln G∗t + Ĝt
Ĝt = φG Ĝt−1 + εG,t with |φG | < 1 (6)
G∗t = G∗t−1 (1 + g)
The stochastic shock εG,t is i.i.d. with mean zero. 6 εA and εG are uncorrelated
at all leads and lags. The government finances its consumption by issuing public
debt, subject to a transversality condition,4 and by raising lump-sum taxes.5 The
timing of taxation is irrelevant because of Ricardian Equivalence.6
The government The government consumes every period t an amount Gt ,
which follows a stochastic path with trend growth g and an AR(1) stochastic
component:
ln Gt = ln G∗t + Ĝt
Ĝt = φG Ĝt−1 + εG,t with |φG | < 1 (6)
G∗t = G∗t−1 (1 + g)
The stochastic shock εG,t is i.i.d. with mean zero. εA and εG are uncorrelated
at all leads and lags. The government finances its consumption by issuing public
debt, subject to a transversality condition,4 and by raising lump-sum taxes.5 The
timing of taxation is irrelevant because of Ricardian Equivalence.6
360°
thinking .
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thinking . 360°
thinking .
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7
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The representative household There is one representative household, who

derives utility from her current and future consumption:
∞ s−t
1
Ut = Et ln Cs with ρ > 0 (7)
s=t
1+ρ
The parameter ρ is called the subjective discount rate.
Every period s, the household starts off with her assets Xs and receives interest
payments Xs rs . She also supplies L units of labor to the representative firm, and
therefore receives labor income ws L. Tax payments are lump-sum and amount to
Ts . She then decides how much she consumes, and how much assets she will hold
in her portfolio until period s + 1. This leads to her dynamic budget constraint:
Xs+1 = Xs (1 + rs ) + ws L − Ts − Cs (8)
We need to make sure that the household does not incur ever increasing debts,
which she will never be able to pay back anymore. Under plausible assumptions,
this implies that over an infinitely long horizon the present discounted value of
the household’s assets must be zero:
s
1
lim Et Xs+1 = 0 (9)
s→∞
s =t
1 + rs
This equation is called the transversality condition.
The household then takes Xt and the current and expected values of r, w, and T
as given, and chooses her consumption path to maximize her utility (7) subject
to her dynamic budget constraint (8) and the transversality condition (9). This
leads to the following Euler equation:7

1 1 + rs+1 1
= Es (10)
Cs 1 + ρ Cs+1
Equilibrium Every period, the factor markets and the goods market clear. For
the labor market, we already implicitly assumed this by using the same notation
(L) for the representative household’s labor supply and the representative firm’s
labor demand. Equilibrium in the goods market requires that
Yt = Ct + It + Gt (11)
Equilibrium in the capital market follows then from Walras’ law.

The Stochastic Growth Model The steady state
3. The steady state

3 The steady state
Let us now derive the model’s balanced growth path (or steady state); variables
evaluated on the balanced growth path are denoted by a ∗ .
To derive the balanced growth path, we assume that by sheer luck εA,t = Ât =
εG,t = Ĝt = 0, ∀t. The model then becomes a standard neoclassical growth
model, for which the solution is given by:8
α
α 1−α
Yt∗ = A∗t L (12)
r +δ
∗
1
α 1−α
Kt∗ = A∗t L (13)
r +δ
∗
1
α 1−α
It∗ = (g + δ) ∗ A∗t L (14)
r +δ
α
α α 1−α
Ct∗ = 1 − (g + δ) ∗ A∗t L − G∗t (15)
r +δ r +δ
∗
α
α 1−α
wt∗ = (1 − α) ∗ A∗t (16)
r +δ
r∗ = (1 + ρ)(1 + g) − 1 (17)
4 Linearization around the balanced growth path
Let us now linearize the model presented in section 2 around the balanced growth
path derived in section 3. Loglinear deviations from the balanced growth path
are denoted by aˆ(so that X̂ = ln X − ln X ∗ ).
Below are the loglinearized versions of the production function (1), the law of
motion of the capital stock (2), the first-order conditions (4) and (5), the Euler
equation (10) and the equilibrium condition (11):9
Ŷt = αK̂t + (1 − α)Ât (18)

1−δ g+δˆ
K̂t+1 = K̂t + It (19)
1+g 1+g
Ŷt = ŵt (20)

Et
rt+1 − r ∗
1+r ∗
=
1+r ∗
AXA Global
r∗ + δ
Et (Ŷt+1 ) − Et (K̂t+1 )

(21)
Graduate Program
Find out more and apply
9
α
α 1−α
wt∗ = (1 − α) A∗t (16)
r +δ
∗
r∗ = (1 + ρ)(1 + g) − 1 (17)
The Stochastic Growth Model Linearization around the balanced growth path
4.
4 Linearization around
Linearization around the balanced
the balanced growth path
growth path
Let us now linearize the model presented in section 2 around the balanced growth
path derived in section 3. Loglinear deviations from the balanced growth path
are denoted by aˆ(so that X̂ = ln X − ln X ∗ ).
Below are the loglinearized versions of the production function (1), the law of
motion of the capital stock (2), the first-order conditions (4) and (5), the Euler
equation (10) and the equilibrium condition (11):9
Ŷt = αK̂t + (1 − α)Ât (18)

1−δ g+δˆ
K̂t+1 = K̂t + It (19)
1+g 1+g
Ŷt = ŵt (20)

rt+1 − r ∗ r∗ + δ
Et = Et (Ŷ t+1 ) − Et (K̂t+1 ) (21)
1 + r∗ 1 + r∗

rt+1 − r ∗
Ĉt = Et Ĉt+1 − Et (22)
1 + r∗
Ct∗ It ˆ G∗t
∗
Ŷt = Ĉt + It + ∗ Ĝt (23)
Yt∗ Yt∗ Yt
The loglinearized laws of motion of A and G are given by equations (3) and (6):
Ât+1 = φA Ât + εA,t+1 (24)

Ĝt+1 = φG Ĝt + εG,t+1 (25)
5 Solution of the linearized model
I now solve the linearized model, which is described by equations (18) until (25).
First note that K̂t , Ât and Ĝt are known in the beginning of period t: K̂t depends
on past investment decisions, and Ât and Ĝt are determined by current and past
values of respectively εA and εG (which are exogenous). K̂t , Ât and Ĝt are
therefore called period t’s state variables. The values of the other variables in
period t are endogenous, however: investment and consumption are chosen by
the representative firm and the representative household in such a way that they
maximize their profits and utility (Iˆt and Ĉt are therefore called period t’s control
variables); the values of the interest rate and the wage are such that they clear
the capital and the labor market.
Solving the model requires that we express period t’s endogenous variables as
functions of period t’s state variables. The solution of Ĉt , for instance, therefore
looks as follows:
Ĉt = ϕCK K̂t + ϕCA Ât + ϕCG Ĝt (26)

10
The challenge now is to determine the ϕ-coefficients.
First substitute equation (26) in the Euler equation (22):
Ât+1 = φA Ât + εA,t+1 (24)
Ĝt+1 = φG Ĝt + εG,t+1 (25)
The Stochastic Growth Model Solution of the linearized model
5 Solution of the linearized model

5. Solution of the linearized model
I now solve the linearized model, which is described by equations (18) until (25).
First note that K̂t , Ât and Ĝt are known in the beginning of period t: K̂t depends
on past investment decisions, and Ât and Ĝt are determined by current and past
values of respectively εA and εG (which are exogenous). K̂t , Ât and Ĝt are
therefore called period t’s state variables. The values of the other variables in
period t are endogenous, however: investment and consumption are chosen by
the representative firm and the representative household in such a way that they
maximize their profits and utility (Iˆt and Ĉt are therefore called period t’s control
variables); the values of the interest rate and the wage are such that they clear
the capital and the labor market.
Solving the model requires that we express period t’s endogenous variables as
functions of period t’s state variables. The solution of Ĉt , for instance, therefore
looks as follows:
Ĉt = ϕCK K̂t + ϕCA Ât + ϕCG Ĝt (26)
The challenge now is to determine the ϕ-coefficients.
First substitute equation (26) in the Euler equation (22):
ϕCK K̂t + ϕCA Ât + ϕCG Ĝt

rt+1 − r ∗
= Et ϕCK K̂t+1 + ϕCA Ât+1 + ϕCG Ĝt+1 − Et (27)
1 + r∗
Now eliminate Et [(rt+1 − r ∗ )/(1+ r ∗ )] with equation (21), and use equations (18),
(24) and (25) to eliminate Ŷt+1 , Ât+1 and Ĝt+1 in the resulting expression. This
11

leads to a relation between period t’s state variables, the ϕ-coefficients and K̂t+1 :

r∗ + δ r∗ + δ
= ϕCK + (1 − α) K̂t+1 + ϕCA − (1 − α) φA Ât + ϕCG φG Ĝt
1 + r∗ 1 + r∗
(28)
We now derive a second relation between period t’s state variables, the ϕ-coefficients
and K̂t+1 : rewrite the law of motion (19) by eliminating Iˆt with equation (23);
eliminate Ŷt and Ĉt in the resulting equation with the production function (18)
and expression (26); note that I ∗ = K ∗ (g + δ); and note that (1 − δ)/(1 + g) +
(αYt∗ )/(Kt∗ (1 + g)) = (1 + r ∗ )/(1 + g). This yields:

1 + r∗ C∗
K̂t+1 = − ∗ ϕCK K̂t
1+g K (1 + g)

(1 − α)Y ∗ C∗ G∗ C∗
+ − ϕCA Ât − + ϕCG Ĝt
K ∗ (1 + g) K ∗ (1 + g) K ∗ (1 + g) K ∗ (1 + g)
(29)
Substituting equation (29) in equation (28) to eliminate K̂t+1 yields:

r∗ + δ 1 + r∗ C∗
= ϕCK + (1 − α) − ∗ ϕCK K̂t
1 + r∗ 1+g K (1 + g)

r ∗ + δ (1 − α)Y ∗ C∗
+ ϕCK + (1 − α) − ϕCA Ât
1 + r ∗ K ∗ (1 + g) K ∗ (1 + g)

r∗ + δ G∗ C∗
− ϕCK + (1 − α) + ϕCG Ĝt
1 + r ∗ K ∗ (1 + g) K ∗ (1 + g)

r∗ + δ
+ ϕCA − (1 − α) φA Ât − ϕCG φG Ĝt (30)
1 + r∗
As this equation must hold for all values of K̂t , Ât and Ĝt , we find the following
system of three equations and three unknowns:

r∗ + δ 1 + r∗ C∗
ϕCK = ϕCK + (1 − α) − ϕCK (31)
1 + r∗ 1+g K ∗ (1 + g)

r ∗ + δ (1 − α)Y ∗ C∗
ϕCA = ϕCK + (1 − α) − ϕCA
1 + r ∗ K ∗ (1 + g) K ∗ (1 + g)

r∗ + δ
+ ϕCA − (1 − α) φA (32)
1 + r∗

r∗ + δ G∗ C∗
ϕCG = − ϕCK + (1 − α) + ϕCG − ϕCG φG
1 + r ∗ K ∗ (1 + g) K ∗ (1 + g)
(33)
12

Now note that equation (31) is quadratic in ϕCK :
Q0 + Q1 ϕCK + Q2 ϕ2CK = 0 (34)

∗ +δ r ∗ +δ Ct∗ r ∗ −g Ct∗
where Q0 = −(1 − α) r1+g , Q1 = (1 − α) 1+r ∗ K ∗ (1+g) − 1+g and Q2 = ∗
Kt (1+g)
t
This quadratic equation has two solutions:

−Q1 ± Q21 − 4Q0 Q2
ϕCK1,2 = (35)
2Q2
It turns out that one of these two solutions yields a stable dynamic system, while
the other one yields an unstable dynamic system. This can be recognized as
follows.
Recall that there are three state variables in this economy: K, A and G. A
and G may undergo shocks that pull them away from their steady states, but
as |φA | and |φG | are less than one, equations (3) and (6) imply that they are
always expected to converge back to their steady state values. Let us now look
at the expected time path for K, which is described by equation (29). If K is not
at its steady state value (i.e. if K̂ �= 0), K is expected to converge back to its
steady state value if the absolute value of the coefficient of K̂t in equation (29),
1+r ∗ C∗ 1+r ∗ C∗
1+g − K ∗ (1+g) ϕCK , is less than one; if | 1+g − K ∗ (1+g) ϕCK | > 1, K̂ is expected to
increase - which means that K is expected to run away along an explosive path,
ever further away from its steady state.
1+r ∗ ∗
Let us therefore evaluate the coefficient 1+g − K ∗C(1+g) ϕCK , which we call ϕKK .

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retain the solution for ϕKK that is between 0 and 1; which means that of the two
solutions for ϕCK (given in equation (35)), we need to retain the largest one:

−Q1 + Q21 − 4Q0 Q2
ϕCK = (36)
2Q2
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at its steady state value (i.e. if K̂ �= 0), K is expected to converge back to its
steady state value if the absolute value of the coefficient of K̂t in equation (29),
1+r ∗ C∗ 1+r ∗ C∗
1+g − K ∗ (1+g) ϕCK , is less than one; if | 1+g − K ∗ (1+g) ϕCK | > 1, K̂ is expected to
The Stochastic
increase Growth
- which means
Model that K is expected to run away along an explosiveSolution
path, of the linearized model
ever further away from its steady state.
1+r ∗ ∗
Let us therefore evaluate the coefficient 1+g − K ∗C(1+g) ϕCK , which we call ϕKK .

K ∗ (1+g) ∗
Rewriting yields ϕCK = t C ∗ 1+g − ϕKK . Substituting in the quadratic
1+r
t
equation (34) leads to a quadratic equation in ϕKK . Denote this quadratic equa-
2
tion as f (ϕKK ) = 0, and note that f (0) > 0, f (1) < 0 and ∂f∂(ϕ
2ϕ
KK )
KK
> 0. This
implies that the quadratic equation f (ϕKK ) = 0 has one solution between 0 and
1, and another solution which is greater than 1. To ensure stable dynamics,10 we
retain the solution for ϕKK that is between 0 and 1; which means that of the two
solutions for ϕCK (given in equation (35)), we need to retain the largest one:

−Q1 + Q21 − 4Q0 Q2
ϕCK = (36)
2Q2
Substituting in equations (32) and (33) yields then the solutions for ϕCA and
ϕCG :
∗
∗ ∗
ϕCK + (1 − α) 1+r
r +δ
∗ (1 − α) K ∗ (1+g) − (1 − α) 1+r ∗ φA
Y r +δ
ϕCA = ∗
(37)
C∗
1 + ϕCK + (1 − α) 1+r
r +δ
∗ K ∗ (1+g) − φA
∗

G∗
ϕCK + (1 − α) 1+r
r +δ
∗ K ∗ (1+g)
ϕCG = − ∗
(38)
C∗
1 + ϕCK + (1 − α) 1+r
r +δ
∗ K ∗ (1+g) − φG
We now have found all the ϕ-coefficients of equation (26), so we can compute
Ĉt from period t’s state variables K̂t , Ât and Ĝt . Once we know Ĉt , the other
endogenous variables can easily be found from equations (18), (19), (20), (21)
and (23). The values of the state variables in period t + 1 can be computed from
equation (29), and equations (3) and (6) (moved one period forward).
6 Impulse response functions
We now calibrate the model by assigning appropriate values to α, δ, ρ, A∗t , G∗t ,

φA , φG , g and L. Let us assume, for instance, that every period corresponds
to a quarter, and let us choose parameter values that mimic the U.S. economy:
α = 1/3, δ = 2.5%, φA = 0.5, φG = 0.5, and g = 0.5%; A∗t and L are normalized
to 1; G∗t is chosen such that G∗t /Yt∗ = 20%; and ρ is chosen such that r ∗ = 1.5%.11
It is then straightforward to compute the balanced growth path: Yt∗ = 2.9,

Kt∗ = 24.1, It∗ = 0.7, Ct∗ = 1.6 and wt∗ = 1.9 (while r ∗ = 1.5% per construction).
Y ∗ , K ∗ , I ∗ , C ∗ and w∗ all grow at rate 0.5% per quarter, while r ∗ remains
constant over time. Note that this parameterization yields an annual capital-
output-ratio of about 2, while C and I are about 55% and 25% of Y , respectively
- which seem reasonable numbers. Once we have computed the steady state, we
can use equations (36), (37) and (38) to compute the ϕ-coefficients. We are then
ready to trace out the economy’s reaction to shocks in A and G.
Consider first the effect of a technology shock in quarter 1. Suppose the economy
is initially moving along its balanced growth path 14 (such that K̂s = Âs = Ĝs = 0
∀s < 1), when in quarter 1 it is suddenly hit by a technology shock εA,1 = 1.
From equation (3) follows then that Â1 = 1 as well, while equations (29) and
(6) imply that K̂1 = Ĝ1 = 0. Given these values for quarter 1’s state variables
ˆ
endogenous variables can easily be found from equations (18), (19), (20), (21)
and (23). The values of the state variables in period t + 1 can be computed from
equation (29), and equations (3) and (6) (moved one period forward).
The Stochastic Growth Model Impulse response functions
6.
6 Impulse response
Impulse response functions
functions
We now calibrate the model by assigning appropriate values to α, δ, ρ, A∗t , G∗t ,

φA , φG , g and L. Let us assume, for instance, that every period corresponds
to a quarter, and let us choose parameter values that mimic the U.S. economy:
α = 1/3, δ = 2.5%, φA = 0.5, φG = 0.5, and g = 0.5%; A∗t and L are normalized
to 1; G∗t is chosen such that G∗t /Yt∗ = 20%; and ρ is chosen such that r ∗ = 1.5%.11
It is then straightforward to compute the balanced growth path: Yt∗ = 2.9,

Kt∗ = 24.1, It∗ = 0.7, Ct∗ = 1.6 and wt∗ = 1.9 (while r ∗ = 1.5% per construction).
Y ∗ , K ∗ , I ∗ , C ∗ and w∗ all grow at rate 0.5% per quarter, while r ∗ remains
constant over time. Note that this parameterization yields an annual capital-
output-ratio of about 2, while C and I are about 55% and 25% of Y , respectively
- which seem reasonable numbers. Once we have computed the steady state, we
can use equations (36), (37) and (38) to compute the ϕ-coefficients. We are then
ready to trace out the economy’s reaction to shocks in A and G.
Consider first the effect of a technology shock in quarter 1. Suppose the economy
is initially moving along its balanced growth path (such that K̂s = Âs = Ĝs = 0
∀s < 1), when in quarter 1 it is suddenly hit by a technology shock εA,1 = 1.
From equation (3) follows then that Â1 = 1 as well, while equations (29) and
(6) imply that K̂1 = Ĝ1 = 0. Given these values for quarter 1’s state variables
and given the ϕ-coefficients, Ĉ1 can be computed from equation (26); the other
endogenous variables in quarter 1 follow from equations (18), (19), (20), (21)
and (23). Quarter 2’s state variables can then be computed from equations (28),
(3) and (6) - which leads to the values for quarter 2’s endogenous variables,
and quarter 3’s state variables. In this way, we can trace out the effect of the
technology shock into the infinite future.
15

Figure 1: Effect of a 1% shock in A ...
in % ... on K̂ in % ... on Ŷ
0.15 0.8
0.6
0.10
0.4
0.05
0.2
0 0
0 4 8 12 16 20 24 28 32 36 40 0 4 8 12 16 20 24 28 32 36 40
quarter quarter
in % ... on Ĉ in % ... on Iˆ
0.15 3
0.10 2
1
0.05
0
0
0 4 8 12 16 20 24 28 32 36 40 0 4 8 12 16 20 24 28 32 36 40
quarter quarter
in % ... on ŵ in % ... on E(r) − r ∗

0.8 1.5
0.6 1.0
0.4 0.5
0.2 0
0 −0.5
0 4 8 12 16 20 24 28 32 36 40 0 4 8 12 16 20 24 28 32 36 40
quarter quarter
16

Figure 2: Effect of a 1% shock in G ...
in % ... on K̂ in % ... on Ŷ
0 0
−0.01 −0.005
−0.02
−0.010
−0.03
−0.04 −0.015
0 4 8 12 16 20 24 28 32 36 40 0 4 8 12 16 20 24 28 32 36 40
quarter quarter
in % ... on Ĉ in % ... on Iˆ
0 0
−0.01 −0.2
−0.02 −0.4
−0.03 −0.6
−0.04 −0.8
0 4 8 12 16 20 24 28 32 36 40 0 4 8 12 16 20 24 28 32 36 40
quarter quarter
in % ... on ŵ in % ... on E(r) − r ∗

0 0.12
−0.005 0.08
−0.010 0.04
−0.015 0
0 4 8 12 16 20 24 28 32 36 40 0 4 8 12 16 20 24 28 32 36 40
quarter quarter
17

Figure 1 shows how the economy reacts during the first 40 quarters. Note that
Y jumps up in quarter 1, together with the technology shock. As a result, the
representative household increases her consumption, but as she wants to smooth
her consumption over time, C increases less than Y . Investment I therefore
initially increases more than Y . As I increases, the capital stock K gradually
increases as well after period 1. The expected rate of return, E(r), is at first higher
than on the balanced growth path (thanks to the technology shock). However,
as the technology shock dies out while the capital stock builds up, the expected
interest rate rapidly falls and even becomes negative after a few quarters. The real
wage w follows the time path of Y . Note that all variables eventually converge
back to their steady state values.
Consider now the effect of a shock in government expenditures in quarter 1.

Assume again that the economy is on a balanced growth path in quarter 0. In
quarter 1, however, the economy is hit by a shock in government expenditures
εG,1 = 1. From equation (3) follows then that Â1 = 1 as well, while equations
(29) and (6) imply that K̂1 = Ĝ1 = 0. Once we know the state variables in
quarter 1, we can compute the endogenous variables in quarter 1 and the state
variables for quarter 2 in the same way as in the case of a technology shock -
which leads to the values for quarter 2’s endogenous variables and quarter 3’s
state variables, and so on until the infinite future.
Figure 2 shows the economy’s reaction to a shock in government expenditures

during the first 40 quarters. As G increases, E(r) increases as well such that C
and I fall (to make sure that C +I +G remains equal to Y , which does not change
in quarter 1 as K̂1 = 0). As I falls, the capital stock K gradually decreases after
period 1, such that Y starts decreasing after period 1 as well. In the meantime,
however, the shock in G is dying out, so after a while E(r) decreases again. As a
result, C and I recover - and as I recovers, K and Y recover also. Note that the
93%
real wage w again follows the time path of Y . Eventually, all variables converge
OF MIM STUDENTS ARE
WORKING IN THEIR SECTOR 3 MONTHS
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7 Conclusions
This note presented the stochastic MASTER IN MANAGEMENT

growth model, and solved the model by first
linearizing it around a steady state and by then solving the linearized model with
• STUDY IN THE CENTER OF MADRID AND TAKE ADVANTAGE OF THE UNIQUE OPPORTUNITIES
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the method of CAPITAL
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Language: ENGLISH / SPANISH
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Even though the stochastic growth model itself might bear little
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(29) and (6) imply that K̂1 = Ĝ1 = 0. Once we know the state variables in
quarter 1, we can compute the endogenous variables in quarter 1 and the state
variables for quarter 2 in the same way as in the case of a technology shock -
which
The leadsGrowth
Stochastic to theModel
values for quarter 2’s endogenous variables and quarter Impulse
3’s response functions
state variables, and so on until the infinite future.
Figure 2 shows the economy’s reaction to a shock in government expenditures

during the first 40 quarters. As G increases, E(r) increases as well such that C
and I fall (to make sure that C +I +G remains equal to Y , which does not change
in quarter 1 as K̂1 = 0). As I falls, the capital stock K gradually decreases after
period 1, such that Y starts decreasing after period 1 as well. In the meantime,
however, the shock in G is dying out, so after a while E(r) decreases again. As a
7 Conclusions
This note presented the stochastic growth model, and solved the model by first
the method of undetermined coefficients.
Even though the stochastic growth model itself might bear little resemblance to
19

The Stochastic Growth Model Conclusions
7 Conclusions
7. Conclusions
This note presented the stochastic growth model, and solved the model by first
the method of undetermined coefficients.
Even though the stochastic growth model itself might bear little resemblance to
the real world, it has proven to be a useful framework that can easily be extended
to account for a wide range of macroeconomic issues that are potentially impor-
tant. Kydland and Prescott (1982) introduced labor/leisure-substitution in the
stochastic growth model, which gave rise to the so-called real-business-cycle liter-
ature. Greenwood and Huffman (1991) and Baxter and King (1993) replaced the
lump-sum taxation by distortionary taxation, to study how taxes affect the be-
havior of firms and households. In the beginning of the 1990s, researchers started
introducing money and nominal rigidities in the model, which gave rise to New
Keynesian stochastic dynamic general equilibrium models that are now widely
used to study monetary policy - see Goodfriend and King (1997) for an overview.
Vermeylen (2006) shows how the representative household can be replaced by a
large number of households to study the effect of job insecurity on consumption
and saving in a general equilibrium setting.
1
Microfoundations means that the objectives of the economic agents are formulated ex-
plicitly, and that their behavior is derived by assuming that they always try to achieve
their objectives as well as they can.
2
A steady state is a condition in which a number of key variables are not changing. In the
stochastic growth model, these key variables are for instance the growth rate of aggregate
production, the interest rate and the capital-output-ratio.
3
See appendix A for derivations.
4
This means that the present discounted value of public debt in the distant future should
be equal to zero, such that public debt cannot keep on rising at a rate that is higher
than the interest rate. This guarantees that public debt is always equal to the present
discounted value of the government’s future primary surpluses.
5
Lump-sum taxes do not affect the first-order conditions of the firms and the households,
and therefore do not affect their behavior either.
6
Ricardian equivalence is the phenomenon that - given certain assumptions - it turns out
to be irrelevant whether the government finances its expenditures by issuing public debt
or by raising taxes. The reason for this is that given the time path of government expen-
ditures, every increase in public debt must sooner or later be matched by an increase in
taxes, such that the present discounted value of the taxes which a representative house-
hold has to pay is not affected by the way how the government finances its expenditures -
which implies that her current wealth and her consumption path are not affected either.
7
See appendix A for the derivation.
8
See appendix B for the derivation.
9
See appendix C for the derivations.
10
The solution with unstable dynamics not only does not make sense from an economic
point of view, it also violates the transversality conditions.
11
Note that these values imply that the annual depreciation rate, the annual growth rate
and the annual interest rate are about 10%, 2% and 6%, respectively.
20
used to study monetary policy - see Goodfriend and King (1997) for an overview.
Vermeylen (2006) shows how the representative household can be replaced by a
large number of households to study the effect of job insecurity on consumption
The Stochastic Growth Model Conclusions
and saving in a general equilibrium setting.
1
Microfoundations means that the objectives of the economic agents are formulated ex-
plicitly, and that their behavior is derived by assuming that they always try to achieve
their objectives as well as they can.
2
A steady state is a condition in which a number of key variables are not changing. In the
stochastic growth model, these key variables are for instance the growth rate of aggregate
production, the interest rate and the capital-output-ratio.
3
See appendix A for derivations.
4
This means that the present discounted value of public debt in the distant future should
be equal to zero, such that public debt cannot keep on rising at a rate that is higher
than the interest rate. This guarantees that public debt is always equal to the present
discounted value of the government’s future primary surpluses.
5
Lump-sum taxes do not affect the first-order conditions of the firms and the households,
and therefore do not affect their behavior either.
6
Ricardian equivalence is the phenomenon that - given certain assumptions - it turns out
to be irrelevant whether the government finances its expenditures by issuing public debt
or by raising taxes. The reason for this is that given the time path of government expen-
ditures, every increase in public debt must sooner or later be matched by an increase in
taxes, such that the present discounted value of the taxes which a representative house-
hold has to pay is not affected by the way how the government finances its expenditures -
which implies that her current wealth and her consumption path are not affected either.
7
See appendix A for the derivation.
8
See appendix B for the derivation.
9
See appendix C for the derivations.
10
The solution with unstable dynamics not only does not make sense from an economic
point of view, it also violates the transversality conditions.
11
Note that these values imply that the annual depreciation rate, the annual growth rate
and the annual interest rate are about 10%, 2% and 6%, respectively.
21

The Stochastic Growth Model Appendix A
Appendix A
Appendix A
Appendix A
A1. The maximization problem of the representative firm
A1. The maximization problem of the representative firm
The
A1.maximization problem of the
The maximization firm can be
problem of rewritten as:
the representative firm

1
Vt (Kt ) = max Yt − wt Lt − It + Et Vt+1 (Kt+1 ) (A.1)
{Lt ,It } 1 + rt+1
The maximization problem of the firm can be rewritten as:

s.t. Yt = Ktα (At Lt )1−α 1
Vt (Kt ) = max Yt − wt Lt − It + Et Vt+1 (Kt+1 ) (A.1)
t ,It }= (1 − δ)Kt + It
Kt+1
{L 1 + rt+1
The first-order conditions
s.t. Ytfor=L Kttα, (A
respectively It , are:
t Lt )
1−α
Kt+1 = (1(1 −− α)Kδ)K

α 1−α −α
t+
t A t It Lt − wt = 0 (A.2)

The first-order conditions 1 It ,(K
∂Vt+1 t+1 )
−1for+E Ltt , respectively are: = 0 (A.3)
1 + rt+1 ∂K t+1
(1 − α)Kt At Lt − wt = 0
α 1−α −α
(A.2)
In addition, the envelope theorem implies that
1 ∂Vt+1 (Kt+1 )
∂Vt (Kt ) −1 + Et 1 = (K0t+1 )
∂Vt+1 (A.3)
= αKt (At Lt ) t+1
α−1 1 +
1−α r + Et ∂K t+1 (1 − δ) (A.4)
∂K 1 + rt+1 ∂Kt+1
In addition, tthe envelope theorem implies that
Substituting the production function in (A.2) gives equation (4):
∂Vt (Kt ) 1 ∂Vt+1 (Kt+1 )
= αKtα−1 (At Lt )1−α + Y Ett (1 − δ) (A.4)
∂Kt (1 − α) 1=+ rwt+1 t
∂Kt+1
Lt
Substituting the production function in (A.2) gives equation (4):
Substituting (A.3) in (A.4) yields:
Yt
∂Vt (Kt ) (1 − α)α−1 L
= wt
= αKt t (At Lt )1−α + (1 − δ)
∂Kt
Moving one period forward, and substituting again in (A.3) gives:
∂Vt (Kt ) = αK α−1 (A L )1−α + (1 − δ)
∂K1 α−1 t
t t
−1 + Et t αKt+1 (At+1 Lt+1 )1−α + (1 − δ) = 0
1 + rt+1
Moving one period forward, and substituting again in (A.3) gives:
Substituting the production
function in the equation above and reshuffling leads to equa-
1
tion (5): −1 + Et αKt+1 (At+1 Lt+1 )
α−1 1−α
+ (1 − δ) = 0
1 + rt+1
1 Yt+1 1−δ
1 = function
Substituting the production Et in the α equation +E above
t and reshuffling leads to equa-
1 + rt+1 Kt+1 1 + rt+1
tion (5):

1 Yt+1 1−δ
1 = Et α + Et
A2. The maximization problem 1 + rt+1 K 1 + rt+1
oft+1the representative household
The maximization problem of the household can be rewritten as:

A2. The
The maximization
maximization problem ofof
the representative household
A2. problem
the representative
household
1
Ut (Xt ) = max ln Ct + Et [Ut+1 (Xt+1 )] (A.5)
{Ct } 1+ρ
The maximization problem of the household can be rewritten as:

s.t. Xt+1 = Xt (1 + r1t ) + wt L − Tt − Ct
Ut (Xt ) = max ln Ct + Et [Ut+1 (Xt+1 )] (A.5)
{Ct } 1+ρ
s.t. Xt+1 = Xt (1 + rt ) + wt L − Tt − Ct
22

The Stochastic Growth Model Appendix A
The first-order condition for Ct is:

1 1 ∂Ut+1 (Xt+1 )
− Et = 0 (A.6)
Ct 1+ρ ∂Xt+1
In addition, the envelope theorem implies that

∂Ut (Xt ) 1 ∂Ut+1 (Xt+1 )
= Et (1 + rt ) (A.7)
∂Xt 1+ρ ∂Xt+1
∂Ut (Xt ) 1
= (1 + rt )
∂Xt Ct
Moving one period forward, and substituting again in (A.6) gives the Euler equation
(10):

1 1 + rt+1 1
− Et = 0
Ct 1 + ρ Ct+1
Appendix B
If C grows at rate g, the Euler equation (10) implies that
1 + r∗ ∗
Cs∗ (1 + g) = C
1+ρ s
Rearranging gives then the gross real rate of return 1 + r∗ :
Excellent Economics and Business programmes at:
1 + r∗ = (1 + g)(1 + ρ)
which immediately leads to equation (17).
Subsituting in the firm’s first-order condition (5) gives:

∗
Yt+1
α ∗ = r∗ + δ
Kt+1
Using the production function (1) to eliminate Y yields:

∗α−1
“The perfect start
αKt+1 (At+1 L)1−α = r ∗
+δ
Rearranging gives then the value of Kt+1

∗
:
of a successful,

α
1−α
1
international career.”
∗
Kt+1 = At+1 L
r∗ + δ
which is equivalent to equation (13).

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23
Moving one period forward, and substituting again in (A.6) gives the Euler equation
(10):

1 1 + rt+1 1
− Et = 0
The Stochastic Growth Model Ct 1 + ρ Ct+1 Appendix B
Appendix
Appendix BB
If C grows at rate g, the Euler equation (10) implies that
1 + r∗ ∗
Cs∗ (1 + g) = C
1+ρ s
Rearranging gives then the gross real rate of return 1 + r∗ :
1 + r∗ = (1 + g)(1 + ρ)
which immediately leads to equation (17).
Subsituting in the firm’s first-order condition (5) gives:

∗
Yt+1
α ∗ = r∗ + δ
Kt+1
Using the production function (1) to eliminate Y yields:

∗α−1
αKt+1 (At+1 L)1−α = r∗ + δ
Rearranging gives then the value of Kt+1

∗
:
1−α
1
α
∗
Kt+1 = At+1 L
r +δ
∗
which is equivalent to equation (13).
24

The Stochastic Growth Model Appendix B
Substituting in the production function (1) gives then equation (12):

1−α
α
α
Yt =
∗
At L
r∗ + δ
Substituting (12) in the first-order condition (4) gives equation (16):
1−α
α
α
wt = (1 − α)
∗
At
r∗ + δ
Substituting (13) in the law of motion (2) yields:
1−α
1 1−α
1
α α
A t+1 L = (1 − δ) At L + It∗
r∗ + δ r∗ + δ
such that It∗ is given by:
1−α
1 1−α
1
α α
It∗ = At+1 L − (1 − δ) At L
r∗ + δ r∗ + δ
1−α
1
α
= [(1 + g) − (1 − δ)] At L
r∗ + δ
1−α
1
α
= (g + δ) ∗ At L
r +δ
...which is equation (14).
Consumption C ∗ can then be computed from the equilibrium condition in the goods
market:
Ct∗ = Yt∗ − It∗ − G∗t
1−α
α 1−α
1
α α
= At L − (g + δ) At L − G∗t
r∗ + δ r∗ + δ
1−α
α
g+δ α
= 1−α ∗ At L − G∗t
r +δ r∗ + δ
Now recall that on the balanced growth path, A and G grow at the rate of technological
progress g. The equation above then implies that C ∗ also grows at the rate g, such that
our initial educated guess turns out to be correct.
Appendix C
C1. The linearized production function
The production function is given by equation (1):

Yt = Ktα (At Lt )1−α
25

Now recall that on the balanced growth path, A and G grow at the rate of technological
progress g. The equation above then implies that C ∗ also grows at the rate g, such that
our initial educated guess turns out to be correct.
The Stochastic Growth Model Appendix C
Appendix C
Appendix C
C1.
C1. The
The linearized productionfunction
linearized production function
The production function is given by equation (1):

Yt = Ktα (At Lt )1−α
Taking logarithms of both sides of this equation, and subtracting from both sides their
values on the balanced growth path (taking into account that L̂t = 0), immediately yields
the linearized version of the production function:
ln Yt = α ln Kt + (1 − α) ln At + (1 − α) ln Lt
ln Yt − ln Yt∗ = α(ln Kt − ln Kt∗ ) + (1 − α)(ln At − ln A∗t ) + (1 − α)(ln Lt − ln L∗t )
Ŷt = αK̂t + (1 − α)Ât
C2. The linearized law of motion of the capital stock
The law of motion of the capital stock is given by equation (2):
Kt+1 = (1 − δ)Kt + It
values on the balanced growth path, yields:
American online
ln Kt+1 − ln Kt+1
∗
= ln {(1 − δ)Kt + It } − ln Kt+1
∗
Now take a first-order Taylor-approximation of the right-hand-side around ln Kt = ln Kt∗

LIGS University
and ln It = ln It∗ :
ln Kt+1 − ln Kt+1 = ϕ1 (ln Kt − ln Kt ) + ϕ2 (ln It − ln It )

∗ ∗ ∗
is currently enrolling in the
K̂t+1 = ϕ1 K̂t + ϕ2 Iˆt (C.1)
Interactive Online BBA, MBA, MSc,
where DBA and PhD programs:
∗
∂ ln {(1 − δ)Kt + It }
ϕ1 =
∂ ln Kt
▶▶ enroll by September 30th,2014 and
∂ ln {(1 − δ)Kt + It }
∗
▶▶ save up to 16% onϕthe 2 =
tuition! ∂ ln It
ϕ▶▶ pay in 10 installments / 2 years
1 and ϕ2 can be worked out as follows:
▶▶ Interactive

∂ ln {(1Online
− δ)Kt education
+ It } ∂Kt
∗
ϕ1 =
▶▶ visitwww.ligsuniversity.com
∂Kt

∂ ln Kt to
∗
find 1−δ
= out more! Kt
(1 − δ)Kt + It
∗
1−δ
Note:
= LIGS University
Kt+1
Kt is not accredited by any
nationally recognized accrediting agency listed
by the 1−δ
= US Secretary oft Education.
...as K grows at rate g on the balanced growth path
More info
1 +here.
g
∗
∂ ln {(1 − δ)Kt + It } ∂It
ϕ2 =
∂It ∂ ln It
26
ln Yt − ln Yt∗ = α(ln Kt − ln Kt∗ ) + (1 − α)(ln At − ln A∗t ) + (1 − α)(ln Lt − ln L∗t )
Ŷt = αK̂t + (1 − α)Ât

C2.
C2. The
The linearized lawofofmotion
linearized law motionof of
thethe capital
capital stock
stock
The law of motion of the capital stock is given by equation (2):
Kt+1 = (1 − δ)Kt + It
ln Kt+1 − ln Kt+1
∗
= ln {(1 − δ)Kt + It } − ln Kt+1
∗
Now take a first-order Taylor-approximation of the right-hand-side around ln Kt = ln Kt∗

and ln It = ln It∗ :
ln Kt+1 − ln Kt+1
∗
= ϕ1 (ln Kt − ln Kt∗ ) + ϕ2 (ln It − ln It∗ )
K̂t+1 = ϕ1 K̂t + ϕ2 Iˆt (C.1)
where
∗
∂ ln {(1 − δ)Kt + It }
ϕ1 =
∂ ln Kt
∗
∂ ln {(1 − δ)Kt + It }
ϕ2 =
∂ ln It
ϕ1 and ϕ2 can be worked out as follows:
∗
∂ ln {(1 − δ)Kt + It } ∂Kt
ϕ1 =
∂Kt ∂ ln Kt
∗
1−δ
= Kt
(1 − δ)Kt + It
∗
1−δ
= Kt
Kt+1
1−δ
= ...as Kt grows at rate g on the balanced growth path
1+g
∗
∂ ln {(1 − δ)Kt + It } ∂It
ϕ2 =
∂It ∂ ln It
∗
1
= It
(1 − δ)Kt + It
∗
1
= It
Kt+1
g+δ
= ...as It∗ /Kt∗ = g + δ and Kt grows at rate g on the balanced growth path
1+g
Substituting in equation (C.1) gives then the linearized law of motion for K:
1−δ g+δˆ
K̂t+1 = K̂t + It
1+g 1+g
C3. The linearized first-order condition for the firm’s labor de-
mand
The first-order condition for the firm’s labor demand27

is given by equation (4):
Download Yt
(1 − α)free eBooks
= wat bookboon.com
t
Lt
Substituting in equation (C.1) gives =
K̂t+1 then the linearized
K̂t + law
Iˆt of motion for K:
1+g 1+g
1−δ g+δˆ
...which is equation (19). K̂t+1 = K̂t + It
1+g 1+g
The Stochastic
...which Growth Model
is equation (19). Appendix C
C3. The linearized first-order condotion for the firm’s labor demand
mand
mand
The first-order condition for the firm’s labor demand is given by equation (4):
The first-order condition for the firm’s Yt demand is given by equation (4):
(1 − labor
α) = wt
Lt
Yt
Taking logarithms of both sides of(1this − α) = and
equation,
Lt
wt subtracting from both sides their
Taking logarithms
the linearized of both
version of thissides of this condition:
first-order equation, and subtracting from both sides their
ln (1first-order
the linearized version of this − α) + lncondition:
Yt − ln Lt = ln wt
(ln Yt − ln Yt ) − (ln Lt − ln L∗ ) = ln wt − ln wt∗
∗
ln (1 − α) + ln Yt − ln Lt = ln wt
Ŷt = ŵt
(ln Yt − ln Yt∗ ) − (ln Lt − ln L∗ ) = ln wt − ln wt∗
...which is equation (20). Ŷt = ŵt

C4. The linearized first-order condition for the firms’ capital de-
mand
C4. The linearized first-order condition for the firms’ capital de-
C4. The linearized first-order condotion for the firm’s capital demand
mand
The first-order condition for the firm’s capital demand is given by equation (5):
1 for
The first-order condition Et [Z
= the t+1 ] capital demand is given by equation (5):
firm’s (C.2)
Yt+1
with Zt+1 = 1+r1t+1 α K + 1+r
1−δ
(C.3)
1 = Et [Zt+1 ] t+1 t+1 (C.2)
Yt+1
Now take a first-order Taylor-approximation
with Zt+1 = 1+r1t+1of αthe right-hand-side
Kt+1 + 1+r
1−δ
t+1
of equation (C.3)
around ln Yt+1 = ln Yt+1 , ln Kt+1 = ln Kt+1 and rt+1 = r :
∗ ∗ ∗
Now take a first-order Taylor-approximation of the right-hand-side of equation (C.3)

around = =1ln+Yϕt+1
ln Yt+1
Zt+1 ∗1 (ln Yt+1 − ln Y ∗ )
, ln Kt+1 = lnt+1 ∗ + ϕ2 (ln Kt+1 −∗ln K ∗ ) + ϕ3 (rt+1 − r∗ )
Kt+1 and rt+1 = r : t+1
= 1 + ϕ Ŷt+1 + ϕ2 K̂t+1∗+ ϕ3 (rt+1 − r∗ ) (C.4)
Zt+1 = 1 + ϕ11 (ln Yt+1 − ln Yt+1 ) + ϕ2 (ln Kt+1 − ln Kt+1∗
) + ϕ3 (rt+1 − r∗ )
= 1 + ϕ1 Ŷt+1 + ϕ2 K̂t+1 + ϕ3 (rt+1 − r∗ ) (C.4)
28

where
 � Yt+1
� ∗
∂ 1+r1t+1 α K + 1−δ
1+rt+1
ϕ1 =  t+1

∂ ln Yt+1
 � � ∗
∂ 1
α Yt+1 + 1−δ
ϕ2 =  1+rt+1 Kt+1 1+rt+1


∂ ln Kt+1
 � Yt+1
� ∗
∂ 1+r1t+1 α K + 1−δ
1+rt+1
ϕ3 =  t+1

∂rt+1
ϕ1 , ϕ2 and ϕ3 can be worked out as follows:

 � Yt+1
� ∗
∂ 1+r1t+1 α K + 1−δ
1+rt+1 ∂Yt+1 
ϕ1 = 
t+1
∂Yt+1 ∂ ln Yt+1
� �∗
1 1
= α Yt+1
1 + rt+1 Kt+1
r∗ + δ
= ...using the fact that αYt+1 ∗
= (r∗ + δ)Kt+1
∗
1 + r∗
 � Yt+1
� ∗
∂ 1+r1t+1 α K + 1−δ
1+rt+1 ∂Kt+1 
ϕ2 = 
t+1
∂Kt+1 ∂ ln Kt+1
� �∗
1 Yt+1
= − α 2 Kt+1
1 + rt+1 Kt+1
r∗ + δ
= − ...using the fact that αYt+1 ∗
= (r∗ + δ)Kt+1
∗
1 + r∗
� � ��∗
1 Yt+1
ϕ3 = − α + 1 − δ
(1 + rt+1 )2 Kt+1
1
= − (C.5)
1 + r∗
Substituting in equation (C.4) gives then:
r∗ + δ r∗ + δ rt+1 − r∗
Zt+1 = 1+ Ŷt+1 − K̂t+1 −
1+r ∗ 1+r ∗ 1 + r∗
Substituting in equation (C.2) and rearranging, gives then equation (21):
� �
rt+1 − r∗ r∗ + δ � �
Et = E t (Ŷt+1 ) − Et (K̂ t+1 )
1 + r∗ 1 + r∗
29

C5. The linearized Euler equation of the representative household

C5. The linearized Euler equation of the representative household
The Euler equation of the representative household is given by equation (10), which is
equivalent to:
1 = Et [Zt+1 ] (C.6)
1+rt+1 Ct
with Zt+1 = 1+ρ Ct+1 (C.7)
Now take a first-order Taylor-approximation of the right-hand-side of equation (C.7)

around ln Ct+1 = ln Ct+1
∗
, ln Ct = ln Ct∗ and rt+1 = r∗ :
Zt+1 = 1 + ϕ1 (ln Ct+1 − ln Ct+1
∗
) + ϕ2 (ln Ct − ln Ct∗ ) + ϕ3 (rt+1 − r∗ )
= 1 + ϕ1 Ĉt+1 + ϕ2 Ĉt + ϕ3 (rt+1 − r∗ ) (C.8)
where
 � 1+r � ∗
t+1 Ct
∂ 1+ρ Ct+1
ϕ1 =  
∂ ln Ct+1
 � 1+r � ∗
t+1 Ct
∂ 1+ρ Ct+1
ϕ2 =  
∂ ln Ct
 � 1+r � ∗
t+1 Ct
∂ 1+ρ Ct+1
ϕ3 =  
∂rt+1

 � 1+r � ∗
t+1 Ct
∂ 1+ρ Ct+1 ∂C t+1 
ϕ1 = 
∂Ct+1 ∂ ln Ct+1
� �∗
1 + rt+1 Ct
= − 2 Ct+1
1 + ρ Ct+1
= −1
 � 1+r � ∗
t+1 Ct
∂ 1+ρ Ct+1 ∂Ct 
ϕ2 = 
∂Ct ∂ ln Ct
� �∗
1 + rt+1 1
= Ct
1 + ρ Ct+1
= 1
� �∗
1 Ct
ϕ3 =
1 + ρ Ct+1
� 1+rt+1 Ct
�∗
1+ρ Ct+1
=
1 + rt+1
30

1
=
1 + r∗
Substituting in equation (C.8) gives then:
rt+1 − r∗
Zt+1 = 1 − Ĉt+1 + Ĉt +
1 + r∗

rt+1 − r∗
Ĉt = Et Ĉt+1 − Et
1 + r∗
C6. The linearized equilibrium condition in the goods market
The equilibrium condition in the goods market is given by equation (11):
Yt = Ct + It + Gt
ln Yt − ln Yt∗ = ln (Ct + It + Gt ) − ln Yt∗
Now take a first-order Taylor-approximation of the right-hand-side around ln Ct = ln Ct∗ ,

ln It = ln It∗ and ln Gt = ln G∗t :
ln Yt − ln Yt∗ = ϕ1 (ln Ct − ln Ct∗ ) + ϕ2 (ln It − ln It∗ ) + ϕ3 (ln Gt − ln G∗t )

Ŷt = ϕ1 Ĉt + ϕ2 Iˆt + ϕ3 Ĝt (C.9)
where
∗
∂ ln {Ct + It + Gt }
ϕ1 =
∂ ln Ct
∗
ϕ2 =
∂ ln It
∗
ϕ3 =
∂ ln Gt

∗
∂ ln {Ct + It + Gt } ∂Ct
ϕ1 =
∂Ct ∂ ln Ct
∗
1
= Ct
Ct + It + Gt
Ct∗
=
Yt∗
31

rt+1 − r∗
Ĉt = Et Ĉt+1 − Et
The Stochastic Growth Model 1 + r∗ Appendix C
C6.
C6. The
The linearized equillibrium
linearized equilibrium condition
condition in the
in the goods
goods market
market
The equilibrium condition in the goods market is given by equation (11):
Yt = Ct + It + Gt
ln Yt − ln Yt∗ = ln (Ct + It + Gt ) − ln Yt∗
Now take a first-order Taylor-approximation of the right-hand-side around ln Ct = ln Ct∗ ,

ln It = ln It∗ and ln Gt = ln G∗t :
ln Yt − ln Yt∗ = ϕ1 (ln Ct − ln Ct∗ ) + ϕ2 (ln It − ln It∗ ) + ϕ3 (ln Gt − ln G∗t )

Ŷt = ϕ1 Ĉt + ϕ2 Iˆt + ϕ3 Ĝt (C.9)
where
∗
ϕ1 =
∂ ln Ct
∗
ϕ2 =
∂ ln It
∗
ϕ3 =
∂ ln Gt

∗
∂ ln {Ct + It + Gt } ∂Ct
ϕ1 =
∂Ct ∂ ln Ct
∗
1
= Ct
Ct + It + Gt
Ct∗
=
Yt∗
32

∗
∂ ln {Ct + It + Gt } ∂It
ϕ2 =
∂It ∂ ln It
∗
1
= It
Ct + It + Gt
It∗
=
Yt∗
∗
∂ ln {Ct + It + Gt } ∂Gt
ϕ3 =
∂Gt ∂ ln Gt
∗
1
= Gt
Ct + It + Gt
G∗t
=
Yt∗
Substituting in equation (C.9) gives then the linearized equilibrium condition in the
goods market:
Ct∗ It∗ ˆ G∗t
Ŷt = Ĉt + It + Ĝt
Yt∗ Yt∗ Yt∗
33
The Stochastic Growth Model References
References
References
Baxter, Marianne, and Robert G. King (1993), ”Fiscal Policy in General Equilibrium”,
American Economic Review 83 (June), 315-334.
Campbell, John Y. (1994), ”Inspecting the Mechanism: An Analytical Approach to the

Stochastic Growth Model”, Journal of Monetary Economics 33 (June), 463-506.
Goodfriend, Marvin and Robert G. King (1997), ”The New Neoclassical Synthesis and
the Role of Monetary Policy”, in Bernanke, Ben S., and Julio J. Rotemberg, eds., NBER
Macroeconomics Annual 1997, The MIT Press, pp. 231-83.
Greenwood, Jeremy, and Gregory W. Huffman (1991), ”Tax Analysis in a Real-Business-

Cycle Model: On Measuring Harberger Triangles and Okun Gaps”, Journal of Monetary
Economics 27 (April), 167-190.
Kydland, Finn E., and Edward C. Prescott (1982), ”Time to Build and Aggregate Fluc-
tuations”, Econometrica 50 (Nov.), 1345-1370.
Vermeylen, Koen (2006), ”Heterogeneous Agents and Uninsurable Idiosyncratic Employ-

ment Shocks in a Linearized Dynamic General Equilibrium Model”, Journal of Money,
Credit, and Banking 38, 3 (April), 837-846.
34

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Koen Vermeylen

The Stochastic Growth Model

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The Stochastic Growth Model Introduction

2 The stochastic growth model

Yt = Ktα (At Lt )1−α with 0 < α < 1 (1)

Y is aggregate output, K is the aggregate capital stock, L is aggregate labor

Kt+1 = (1 − δ)Kt + It with 0 ≤ δ ≤ 1 (2)

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Yt = Ktα (At Lt )1−α with 0 < α < 1 (1)

Y is aggregate output, K is the aggregate capital stock, L is aggregate labor

Kt+1 = (1 − δ)Kt + It with 0 ≤ δ ≤ 1 (2)

The stochastic shock εA,t is i.i.d. with mean zero.

The government The government consumes every period t an amount Gt ,

© Deloitte & Touche LLP and affiliated entities.

© Deloitte & Touche LLP and affiliated entities.

© Deloitte & Touche LLP and affiliated entities.

The representative household There is one representative household, who

The parameter ρ is called the subjective discount rate.

This equation is called the transversality condition.

Equilibrium in the capital market follows then from Walras’ law.

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3. The steady state

4 Linearization around the balanced growth path

Ŷt = αK̂t + (1 − α)Ât (18)

Ŷt = αK̂t + (1 − α)Ât (18)

Ât+1 = φA Ât + εA,t+1 (24)

5 Solution of the linearized model

Ĉt = ϕCK K̂t + ϕCA Ât + ϕCG Ĝt (26)

5 Solution of the linearized model

Ĉt = ϕCK K̂t + ϕCA Ât + ϕCG Ĝt (26)

The challenge now is to determine the ϕ-coeﬃcients.

First substitute equation (26) in the Euler equation (22):

ϕCK K̂t + ϕCA Ât + ϕCG Ĝt

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ϕCK K̂t + ϕCA Ât + ϕCG Ĝt

Substituting equation (29) in equation (28) to eliminate K̂t+1 yields:

ϕCK K̂t + ϕCA Ât + ϕCG Ĝt

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Now note that equation (31) is quadratic in ϕCK :

Q0 + Q1 ϕCK + Q2 ϕ2CK = 0 (34)

This quadratic equation has two solutions:

1, and another solution which is greater than 1. To ensure stable dynamics,10 we

advising and the N

6 Impulse response functions

We now calibrate the model by assigning appropriate values to α, δ, ρ, A∗t , G∗t ,

It is then straightforward to compute the balanced growth path: Yt∗ = 2.9,

We now calibrate the model by assigning appropriate values to α, δ, ρ, A∗t , G∗t ,

It is then straightforward to compute the balanced growth path: Yt∗ = 2.9,

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Figure 1: Eﬀect of a 1% shock in A ...

in % ... on ŵ in % ... on E(r) − r ∗

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Figure 2: Eﬀect of a 1% shock in G ...

in % ... on ŵ in % ... on E(r) − r ∗

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Consider now the eﬀect of a shock in government expenditures in quarter 1.

Figure 2 shows the economy’s reaction to a shock in government expenditures

This note presented the stochastic MASTER IN MANAGEMENT

5 Specializations #10 WORLDWIDE 55 Nationalities

www.ie.edu/master-management mim.admissions@ie.edu Follow us on IE MIM Experience

Figure 2 shows the economy’s reaction to a shock in government expenditures