ECON 20210 - Problem Set 4 Solutions

1. It depends. If we consider all changes in income as permanent, then the graph is

coherent with the PIH/life-cycle theories. Otherwise, the graph would contradict their
predictions. It is highly likely that for such a long period of time, some income shocks
were temporary (e.g., some terms of trade shocks), so we should be inclined to present
the graph more as a contradiction of the theories than as a proof of their validity.

2. First of all, budget constraint of the family is:

Ct + At+1 ≤ yt + (1 + r)At

Dividing by Lt and defining xt ≡ Xt /Lt and ỹt ≡ yt /Lt we have:

ct + at+1 (1 + n) ≤ ỹt + (1 + r)at

Then the family solves:

 −αc
+ βV (a0 )

V (a) = max
0
−e
c,a

s.t. c + a0 (1 + n) = y + (1 + r)a

FOC w.r.t. c:
αe−αc − λ = 0
FOC w.r.t. a0 :
βV 0 (a0 ) − λ(1 + n) = 0
EC:
V 0 (a) = αe−αc (1 + r)
Combining FOCs and EC:

β(1 + r) −αc0 β(1 + r) 0

e = e−αc ⇐⇒ = eα(c −c)
1+n 1+n
Applying logs and re-arranging terms:
 
0 1 β(1 + r)
c = log +c
α 1+n

Given a c0 , the solution to this difference equation is:

 
1 β(1 + r)
ct = c0 + log t
α 1+n

Then:

• If β(1 + r) > 1 + n, ct+1 > ct ∀t

• If β(1 + r) = 1 + n, ct+1 = ct = c ∀t

1
 • If β(1 + r) < 1 + n, ct+1 < ct ∀t
This means that the real return on the family’s savings are diluted by the growth in
the size of the family, so in order to be induced to save the family demands a higher
return from the market.
3. The answers are as follows:
(a) Stochastic Euler equation in this case will be given by:
Ct−γ = β(1 + r)Et Ct+1
 −γ 

(b) Applying logs to our stochastic Euler equation:

−γ log(Ct ) = log(β(1 + r)) + log(Et e−γ log Ct+1 )
 

Note that −γ log Ct+1 ∼ N (−γEt [log(Ct+1 )] , γ 2 σ 2 ). Then:

γ 2 σ2
−γ log(Ct ) = log(β(1 + r)) + log(e−γEt [log(Ct+1 )]+ 2 )
or:
γ 2σ2
−γ log(Ct ) = log(β(1 + r)) − γEt [log(Ct+1 )] +
2
In a more convenient form:
1 γσ 2
Et [log(Ct+1 )] = log(Ct ) + log(β(1 + r)) +
γ 2
(c) We can re-write the last expression of the previous question as:
log(Ct+1 ) = a + log(Ct ) + ut+1
1 γσ 2
where a = γ
log(β(1 + r)) + 2
and Et [ut+1 ] = 0.
(d) Expected consumption growth is given by:
1 γσ 2
Et [log(Ct+1 ) − log(Ct )] = log(β(1 + r)) +
γ 2
Then:
∂Et [log(Ct+1 ) − log(Ct )] 1 β
= >0
∂r γ β(1 + r)
So increases in the interest rate should cause an increase in expected consump-
tion growth. This is because consumption today gets more expensive relative to
consumption tomorrow. On the other hand:
∂Et [log(Ct+1 ) − log(Ct )] γ
2
= >0
∂σ 2
So increases in the variance of the log of consumption the next period, which in
turn are increases in the variance of consumption levels the next period create an
increase in the expected growth of consumption. This is because the agent is risk
averse, so it prefers to save more money to reduce the risk in its consumption the
next period. The higher its risk aversion, which is measured by the parameter γ,
the bigger the response in the expected growth of consumption.

2
4. The answers are as follows:

(a) In this case, if the government forces all citizens to save a fraction of their incomes
and individuals have full access to the financial market, then the savings of agents
will not change. This is because agents know that at the time of retirement they
will have more money (due to their retirement savings), so the optimal thing to
do for them is either to adjust down their voluntary savings or increase their debt
now in the same magnitude of the retirement savings.
(b) In this case, as the government forces all citizens to save a fraction of their incomes,
all individuals but the young people will behave like in (a), i.e. they will not
increase their savings. However, young people will not be able to acquire debt
backed with their higher retirement savings, which means that they will save more
today than what the PIH/life-cycle theories predict. Summing all the individuals
of the economy we get that private savings go up, no one increases its savings but
the young people.
(c) In this case, as parents worry about their offspring’s welfare and as their offspring
cannot borrow as much as they want, parents will serve of financial market to
them. Parents will get indebted to smooth their own consumption and will acquire
even more debt to pass that additional money to their offspring, who will use it
to smooth their consumption. Therefore, private savings in the economy do not
change.
(d) In this case, people will be desincentivized to save as much as they would do
relative to a case where the government does not guarantee a minimum income
during retirement. This is due to the positive wealth effect that government
transfers have on consumption each period. Therefore, the imposition of higher
savings by the government will indeed increase private savings relative to the case
with no imposition. The reason is that the rule will make people to have some
income when they retire, so they will not have the wealth effect of the case without
rule.

5. Given the assumptions, we have β(1 + r) = 1. Thus:

(a) We need to satisfy:

dEt + dEt+1 + dEt+2 = 0 (1)

2
(1 − δ) dEt + (1 − δ)dEt+1 + dEt+2 = 0 (2)

Subtracting (2) from (1) we get:

δ(2 − δ)dEt + δdEt+1 = 0 ⇒ dEt+1 = (δ − 2)dEt

Replacing this in (1):

dEt + (δ − 2)dEt + dEt+2 = 0 ⇒ dEt+2 = (1 − δ)dEt

3
(b) Given dEt , dCt = dEt and dCt+1 = (1 − δ)dCt + dEt+1 . Then:

dCt = dEt
dCt+1 = −dEt

Expected utility at time t is:

" ∞ 
#
2

X Ct+s
Ut = Et α1 Ct+s − α2
s=t
2

If we totally differentiate expected utility we get:

"∞ #
X
dUt = Et (α1 dCt+s − α2 Ct+s dCt+s )
s=t

We know that dCt = dEt , dCt+1 = −dEt , and that only Ct and Ct+1 change.
Then:

dUt = α1 dEt − α2 Ct dEt + Et [−α1 dEt + α2 Ct+1 dEt ]

= α1 dEt − α2 Ct dEt − α1 dEt + α2 Et [Ct+1 ]dEt
= α2 (Et [Ct+1 ] − Ct ) dEt

(c) The condition is that Ct = Et [Ct+1 ], i.e. Ct has to follow a random walk.
(d) If we write:

Et − Et−1 = Ct − (1 − δ)Ct−1 − Ct−1 + (1 − δ)Ct−2

= Ct − Ct−1 − (1 − δ)(Ct−1 − Ct−2 )

Apply expectations conditional on information at time t − 1:

Et−1 [Et ] − Et−1 = Et−1 [Ct ] − Ct−1 − (1 − δ)(Ct−1 − Ct−2 )

= Et−1 [Ct ] − Ct−1 − (Ct−1 − Ct−2 ) + δ(Ct−1 − Ct−2 )

and given that Et [Ct+1 ] = Ct ⇒ Et [dCt+1 ] = dCt , we have:

Et−1 [Et ] − Et−1 = δ(Ct−1 − Ct−2 )

Hence, Et is not a random walk in general. The reason is that a previous higher in-
crease in consumption had to be sustained with more purchases of durables, which
are still good to partially provide consumption services in the future. Therefore,
we are expected to increase our purchases of durables just in the depreciated part
of that past increase in consumption if we want to keep our consumption path
stable.

However, if δ = 0, goods eternally provide services, so there is no need for sys-

tematic adjustments in our purchases of durables. Then, changes in Et can only
be unexpected, so we can say that Et follows a random walk.

4
6. The answers are as follows:

(a) The problem of the consumer is:

(∞ )
X Ct
max E0
{Ct ,St+1 }∞
t=0
t=0
(1 + r)t
s.t. Ct + Pt St ≤ Pt St−1 + Dt St−1 + Yt
St ≥ 0

where St is amount of stocks purchased and Yt is an exogenous and deterministic

endowment of income. In recursive form:
 
1 0
V (S) = max0 C + E [V (S )|P ]
C,S 1+r
s.t. C + P S 0 ≤ P S + DS + Y
S0 ≥ 0

FOC w.r.t. C:
1−λ=0
FOC w.r.t. S 0 (assuming interior solution):
1
E[V 0 (S 0 )|P ] − λP = 0
1+r
EC:
V 0 (S) = P + D
Combining these three equations:

P 0 + D0
 
P =E |P
1+r

Or:  
Pt+1 + Dt+1
Pt = Et
1+r

5
 (b) We have:
   
1 Pt+2 + Dt+2 Dt+1
Pt = Et Et+1 +
1+r 1+r 1+r
 
Pt+2 + Dt+2 Dt+1
= Et +
(1 + r)2 1+r
   
1 Pt+3 + Dt+3 Dt+2 Dt+1
= Et Et+2 + +
(1 + r)2 1+r (1 + r)2 1 + r
 
Pt+3 Dt+3 Dt+2 Dt+1
= Et + + +
(1 + r)3 (1 + r)3 (1 + r)2 1 + r
..
.
  X ∞
Pt+s Et [Dt+s ]
= lim Et s
+
s→∞ (1 + r) s=1
(1 + r)s
∞
X Et [Dt+s ]
=
s=1
(1 + r)s

So the price of a stock is just the expected present discounted value of future
dividends.
7. The answers are as follows:
(a) We can write the generic problem of the consumer as:
"∞ #
X
max ∞ U0 = E0 β t log(Ct )
{Ct ,Tt+1 }t=0
t=0
s.t. Ct + Pt Tt+1 = Tt (Pt + yt )
where yt is fruit per tree. The recursive formulation is then:
V (T ) = max
0
{log(T (P + y) − P T 0 ) + βE [V (T 0 )|y]}
T

The FOC associated with this problem is:

P
− + βE [V 0 (T 0 )|y] = 0
C
The EC:
P +y
V 0 (T ) =
C
Combining them:  0
P + y0 1

1
= βE |y
C P C0
If we assume that that initial number of trees is just 1 per person, then we have
y = Y . So:  0
P +Y0 1

1
= βE |Y
C P C0

6
 Now, going to the question. The situation proposed is exactly one in which
consumers are optimizing their holdings of trees, so they are satisfying the just
written Euler equation with equality. In this sense, we can safely assume that any
infinitesimal re-adjustment of the consumer will not have any first-order effect on
utility and this equation will still be satisfied with equality. Then, the condition
we are looking for in sequential formulation is:
 
1 Pt+1 + Yt+1 1
= βEt
Ct Pt Ct+1

If Ct = Yt , then we can solve for Pt from the expression from above and obtain:
 
Yt
Pt = βEt (Pt+1 + Yt+1 )
Ct+1

(b) Rewriting the price equation:

   
Pt Pt+1 Pt Pt+1
= βEt + 1 ⇐⇒ = βEt +β
Yt Yt+1 Yt Yt+1

Then:
  
Pt Pt+1
= βEt βEt+1 +β +β
Yt Yt+1
 
2 Pt+2
= β Et + β2 + β
Yt+2
 
3 Pt+3
= β Et + β3 + β2 + β
Yt+3
..
.
  ∞
T Pt+T X
= lim β Et +β β s−t
T →∞ Yt+T s=t
β
=
1−β
Then:
β
Pt = Yt
1−β
(c) We are imposing people to not trade trees. Therefore, people must be happy with
the tree they have. This means that consumption moves one-to-one with respect
to output or that asset prices will adjust in order to guarantee this. The price
that makes people not to desire to increase or decrease their capital holdings is
the one just derived. An increase in future dividends that would induce people
to save has to leave this price intact in order to discourage people from reacting.
Then, the price of an asset can only be a function of current dividends.

7
 (d) Not necessarily. If we plug our solution for the asset price in the Euler equation:
" β #
1 Y + Yt+1 1
1−β t+1
= βEt β
Ct Y
1−β t
Ct+1
 
1 Yt+1 1
= Et
Ct Yt Ct+1
Et [Ct+1 ] Et [Yt+1 ]
=
Ct Yt
i.e., consumption has a systematic behavior. Expected change in this variable
has to be equal to the expected change in the dividend of the asset. If the latter
follows a random-walk, then consumption will follow a random-walk, but outside
of this special case consumption will have a stable behavior.

9. The answers are as follows:

(a) If Ḣ = 0, we know that I(pH )/H = δ. Therefore, if we have a higher H, in order

to satisfy the condition for Ḣ = 0, we need a higher pH . Then the Ḣ = 0 locus
will be positively sloped. On the other hand, we have that p˙H = rpH − R(H). So,
if p˙H = 0, then R(H)/pH = r, where r is constant. Thus if we have a higher H,
which means lower rent, we need a lower pH to satisfy the condition. Then the
p˙H locus will be negatively sloped.
(b) If pH is higher than the pH that satisfies Ḣ = 0 at each possible level of H, then
Ḣ > 0. The converse is true when pH is lower. If H is higher than the H that
satisfies p˙H = 0 at each possible level of pH , p˙H > 0. The converse is true when
H is lower. The resulting graph is:

8
 Figure 1: Phase Diagram

(c) If r permanently increases, it is necessary an increase in the steady-state ratio

R(H ∗ )/pH . This is achieved by lowering both H and pH . Hence, all dynamics
of the system have to be consistent with this long-run equilibrium. From the
equation p˙H = rpH − R(H) we can get that:
Z ∞
pH (t) = e−r(s−t) R(H(s))ds
t

Therefore, a permanent increase in r has an immediate impact on pH , making

it fall sharply. Housing, on the other hand, evolves according to the reaction of
investment, which even though it also falls strongly, will not have an immediate
impact on the stock of housing which will be gradually reduced via poor invest-
ment and depreciation. The gradual reduction in the stock of housing will also
gradually drive up rents, which will tend to weakly recover the value of the price
of houses over time. As we need to converge to a lower value of houses in steady-
state, the fall of the price of houses at the impact of the shock has to be towards

9
 a value that is lower than its long-run value, i.e. the price of houses overshoots.
Graphically:

Figure 2: Permanent Shock

(d) The shock is the same in the long run, so long run equilibrium is identical with
respect to (c). Similarly, by making use of the equation for pH (t) we highlighted in
(c) we know that at the time of the news the price of houses has to fall. However,
as this is a permanent increase that is not realized until later, the adjustment in
the price is smaller than in (c). The fall in the price though will create a fall in
the investment rate too (also smaller than in (c)). Therefore, in the transition to
the arrival of the shock, housing will already be falling. As housing falls, rents
will increase. The increase in rents and the proximity of the interest rate hike
are two opposite forces that help prices to gradually fall in the transition. At
the moment of the arrival of the news, there should not be discrete jumps in the
price of houses, as news have already been incorporated into them. For this same
reason, housing should gradually converge to the new steady-state. Rents should

10
 gradually increase to their new level, and investment should gradually converge
to a lower level. There is no overshooting. Graphically:

Figure 3: Permanent Shock in the Future

10. The answers are as follows:

(a) In this case the firm will solve the following problem:
Z ∞ (  2 )
α i
max e−rt Ak α − i − −δ
i(t),t≥0 0 2 k
s.t. k̇ = i − δk
k0 given

The current value Hamiltonian will be:

 2
α α i
Ĥ = Ak − i − − δ + q(i − δk)
2 k

11
 The main optimality conditions of the Hamiltonian are:
 
α i
0 = −1 − −δ +q (3)
k k
 
A i i
rq − q̇ = α 1−α + α 2 − δ − δq (4)
k k k
k̇ = i − δk (5)

plus the initial and transversality conditions.

Using equation (4) and making q̇ = 0 we get:
  
1 A i i
q= α 1−α + α 2 −δ (6)
r+δ k k k

which is the q̇ = 0 locus. We can check it is negatively sloped:

i2
   
∂q 1 A i i
=− (1 − α)α 2−α + 2α 3 −δ +α 4 <0
∂k r+δ k k k k

In steady-state i∗ /k ∗ = δ. This means, by equation (3), that q ∗ = 1. Replacing

this result and i∗ /k ∗ = δ in equation (6), we get:
 1
 1−α
∗αA
k =
r+δ

(b) From (3) we can write:

i (q − 1)k
= +δ
k α
Replacing this in (4) and (5) we obtain:

αA (q − 1)2 k
q̇ = (r + δ)q − − − (q − 1)α (7)
k 1−α α
(q − 1)k 2
k̇ = (8)
α
and we have a system of two equations in two variables. We are looking for the
saddle-path, which is a function q = h(k) that can be reasonably approximated
as:
q = q ∗ + h0 (k ∗ )(k − k ∗ ) = 1 + h0 (k ∗ )(k − k ∗ )
So we need to find h0 (k ∗ ) in order to get the slope. Given the phase diagram seen
in class, we know that the slope of this saddle-path has to be negative.
Taking h0 (k ∗ ) as dq/dk at the steady-state, we can write the following:

dq dq/dt
h0 (k ∗ ) = =
dk dk/dt

12
However, we know that the numerator and the denominator of the right most ex-
pression are both zero when we are at the steady-state, which is problematic as it
makes the expression indeterminate. To overcome this problem we use L’Hopital
rule:

q̇ dq̇/dk
=
k̇ dk̇/k
The numerator of this expression is:

2(q − 1)kh0 (q − 1)2

 
dq̇ A
= (r + δ)h0 + (1 − α)α 2−α − +
dk k α α

Evaluating at the steady-state:

dq̇ A
= (r + δ)h0 + (1 − α)α ∗ 2−α
dk (k )

The denominator is:

dk̇ k2 2k
= h0 + (q − 1)
dk α α
At the steady-state:
dk̇ (k ∗ )2
= h0
dk α
Then we have:
0 ∗
(r + δ)h0 (k ∗ ) + (1 − α)α (k∗A
)2−α
h (k ) = ∗ 2
h0 (k ∗ ) (kα)
This defines a quadratic equation on h0 (k ∗ ):

(k ∗ )2 0 ∗ 2 A
(h (k )) − (r + δ)h0 (k ∗ ) − (1 − α)α ∗ 2−α = 0
α (k )

We need the negative root as we know that h0 (k ∗ ) has to be negative. Then:

" p #
r + δ − (r + δ)2 + 4(1 − α)A(k ∗ )α
h0 (k ∗ ) = α
2(k ∗ )2

which is the slope of the saddle-path.

13