ECON 20210 - Problem Set 1 Solutions

1. T : S → S is a contraction if for β ∈ (0, 1):

|T x − T y|
≤β≤1
|x − y|
∴ T has to be a function with slope uniformly less than 1 in absolute value.

Morevoer, we know that:

|T x − T y| ≤ β|x − y|
Then, take an arbitrary ε > 0 and any 0 < δ < ε. This will imply that ∀x, y ∈ S with
|x − y| < δ, the following will hold:

|T x − T y| ≤ β|x − y| < δ < ε

Hence, T is uniformly continuous.

2. Let C 0 (X) ⊂ C(X) be the set of bounded, continuous, weakly concave functions on X.
Let f ∈ C 0 (X) and that for x0 6= x1 , θ ∈ (0, 1), xθ ≡ θx0 + (1 − θ)x1 . Let yi ∈ Γ(xi )
attain (T f )(xi ), for i = 0, 1. Then, as Γ is convex, yθ = θy0 + (1 − θ)y1 ∈ Γ(xθ ). It
follows that:

(T f )(xθ ) ≥ F (xθ , yθ ) + βf (yθ )

≥ θ [F (x0 , y0 ) + βf (y0 )] + (1 − θ) [F (x1 , y1 ) + βf (y1 )]
= θ(T f )(x0 ) + (1 − θ)(T f )(x1 )

Since x0 and x1 were arbitraryb, it follows that T f is concave, and since f was arbitrary,
that T [C 0 (X)] ⊆ C 0 (X)
3. Answers for each subitem are:
(a) Let us define g(k) ≡ f (k) + (1 − δ)k. Then the Bellman equation is:

v(k) = max
0
{u(g(k) − k 0 ) + βv(k 0 )}
k

The controls are k 0 and c, the state is k.

(b) Let us define T v(k) = maxk0 {u(g(k) − k 0 ) + βv(k 0 )}. First we have to verify that
T is a contraction. Blackwell’s sufficient conditions:
i. Monotonicity: for f ≥ v:

T v(k) = max
0
max
0
{u(g(k) − k 0 ) + βv(k 0 )}
k k
= u(g(k) − h(k)) + βv(h(k))
≤ u(g(k) − h(k)) + βf (h(k))
≤ max
0
{u(g(k) − k 0 ) + βf (k 0 )}
k
= T f (k)

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 ii. Discounting: for a > 0:

T (v + a)(k) = max
0
{u(g(k) − k 0 ) + β(v(k) + a)}
k
= max
0
{u(g(k) − k 0 ) + βv(k)} + βa
k
= T v(k) + βa

Hence, T is a contraction. Therefore, by the corollary of the CMT, it suffices

to show that T f is increasing if f is increasing. Let k ≤ k̃:

T f (k) = max
0
{u(g(k) − k 0 ) + βf (k)}
k
= u(g(k) − h(k)) + βf (h(k))
≤ u(g(k̃) − h(k̃)) + βf (h(k̃))
n o
0 0
≤ max
0
u(g(k̃) − k ) + βf (k )
k

= T f (k̃)

(c) Apply result of 2.

(d) FOC:
−uc (c) + βV 0 (k 0 ) = 0
Envelope condition:
V 0 (k) = g 0 (k)uc (c)
Combining FOC and EC, we get Euler Equation:

uc (c) = βg 0 (k 0 )uc (c0 )

(e) Here a graph plotting u0 (g(k) − k 0 ) versus βV 0 (k 0 ) makes the trick. Let k̃ > k,
then:

4. Answers for each subitem are:

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(a) Bellman equation is:

V (x) = max
0
{u(x(1 + r) + w − x0 ) + βV (x0 )}
x

(b) FOC:
uc (c) = βV 0 (x)
Envelope condition:
V 0 (x) = (1 + r)uc (c)
Combining these two equations:

uc (c) = β(1 + r)uc (c0 )

As β(1 + r) = 1, uc (c) = uc (c0 ), then c = c0 = c̄ constant. It is possible to show

that if we iterate on the budget constraint we will obtain:
∞ ∞
xT X ct X 1
lim + = x 0 + w
T →∞ (1 + r)T +1 (1 + r)t+1 (1 + r)t+1
t=0 t=0

xT
As we have imposed a no-Ponzi schemes condition lim T +1 = 0. Therefore:
T →∞ (1+r)

∞ ∞
c̄ X 1 w X 1
0+ t
= x 0 +
1 + r t=0 (1 + r) 1 + r t=0 (1 + r)t
c̄ 1 + r w 1+r
= x0 +
1+r r 1+r r
c̄ w
= x0 +
r r
c̄ = rx0 + w

As this applies for any initial x:

c(x) = rx + w

Replacing this policy function in the budget constraint:

x0 = x(1 + r) + w − w − rx ⇒ g(x) = x

Finally:
∞
X
V (x) = β t u(c̄)
t=0
∞
X
= u(c̄) βt
t=0
1 u(w + rx)
= u(c̄) =
1−β 1−β

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5. The answers associated with each subitem are:
(a) The Bellman equation is:

v(k) = max
0
{ln(Ak α − k 0 ) + βv(k 0 )}
k

FOC:
1
− + βV 0 (k 0 ) = 0
Ak α − k0
(b) Given our guess:
1 F
0
=β 0
Ak α
−k k
⇐⇒ k = βF Ak − βF k 0
0 α

⇐⇒ k 0 (1 + βF ) = βF Ak α
βF Ak α
⇐⇒ k 0 = h(k) =
1 + βF
Then:
βF Ak α βF Ak α
    
α
E + F ln(k) = ln Ak − + β E + F ln
1 + βF 1 + βF
α α
   
Ak βF Ak
E + F ln(k) = ln + βE + βF ln
1 + βF 1 + βF
   
A βF A
(1 − β)E + F ln(k) = ln + α ln(k) + βF ln + βF α ln(k)
1 + βF 1 + βF
Two equations for two unknowns:
   
A βF A
0 = (1 − β)E − ln − βF ln (1)
1 + βF 1 + βF
0 = α + βF α − F (2)

From (2):
α
F =
1 − αβ
After replacing in (1) we get:
 
1 αβ
E= ln((1 − αβ)A) + ln(αβA)
1−β 1 − αβ
Therefore, policy function looks like:

h(k) = αβAk α

and value function:

 
1 αβ α ln(k)
v(k) = ln((1 − αβ)A) + ln(αβA) +
1−β 1 − αβ 1 − αβ

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6. The answers for each subitem are
(a) Current-value Hamiltonian:
Ĥ = u(c) + µ(g(x) − c)
Optimality conditions:
0 = u0 (c) − µ (3)
ρµ − µ̇ = µg 0 (x) (4)
ẋ = g(x) − c (5)
x(0) = 0 (6)
0 = lim [exp(−ρt)µẋ] (7)
t→∞

From (3):
u0 (c) = µ ⇒ u00 (c)ċ = µ̇
Replacing in (4):
ρu0 (c) − u00 (c)ċ = u0 (c)g 0 (x)
⇐⇒ u00 (c)ċ = u0 (c) [ρ − g 0 (x)]
u0 (c)
ċ = 00 [ρ − g 0 (x)]
u (c)
ċ u0 (c)
= 00 [ρ − g 0 (x)]
c cu (c)
ċ u0 (c)
= − 00 [g 0 (x) − ρ]
c cu (c)
ċ 1
= [g 0 (x) − ρ]
c θ
00
Where θ = − cuu0 (c)
(c)
is the inverse of the inter-temporal elasticity of substitution.
(b) Given θ
i. If g 0 (x) > ρ, consumption grows over time
ii. If g 0 (x) = ρ, consumption is constant over time
iii. If g 0 (x) < ρ, consumption decreases over time
Speed of change is related to the value of 1/θ. If θ → ∞, i.e. inter-temporal
elasticity of substitution tends to zero, then consumption will not change at all,
no matter the relation between g 0 (x) and ρ. On the other hand, if θ → 0, inter-
temporal elasticity of substitution will tend to infinity, i.e. any minor deviation
from g 0 (x) = ρ will prompt swift and instantaneous adjustments in consumption
patterns by the consumer.

We can solve the differential equation defined by the Euler equation and get:
Z t 0 
g (x(s)) − ρ
c(t) = c0 exp ds
0 θ(c(s))

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7. The answers for each subitem are:

(a) The current-value Hamiltonian is:

Ĥ = u(y) − µy

(b) The optimality conditions are:

u0 (y) − µ = 0 (8)
ρµ − µ̇ = 0 (9)
ẋ = −y (10)
x(0) = x0 (11)
0 = lim [exp(−ρt)µẋ] (12)
t→∞

From (8):
u0 (y) = µ
which means that the marginal utility of consumption has to be equal to the cost
of making the resource constraint tighter. From (9):

µ̇ = ρµ

which means that if µ is higher, it will grow faster. In other words, as the resource
constraint is more binding, it gets more binding over time, which reflects the
depletion of the resource. We can solve this differential equation and obtain:

µ = µ0 exp(ρt)

Then:
y = (u0 )−1 [µ0 exp(ρt)]
Because of discounting, there is preference for early consumption, whereas delayed
consumption has no return (no production or interest payments on the stock),
hence, the amount of resource consumed is monotonically decreasing over time.
Nevertheless, the entire resource is not consumed immediately, since there is also
a preference for smooth consumption arising from the fact that u(·) is strictly
concave.