Consumption and Savings: Dynasties and OLG: Prof. Dr. Thomas Steger Advanced Macroeconomics I - Lecture - SS 17

Prof. Dr.
Thomas Steger Institut für Theoretische Volkswirtschaftslehre
Advanced Macroeconomics I | Lecture | SS 17 Makroökonomik
1. Consumption and Savings: Dynasties and OLG
(April 25, 2017)
 The Ramsey Model
 Introduction
 Households
 Firms
 Market equilibrium and national income
 Economic dynamics in macroeconomic equilibrium
 The social planner‘s solution
 Technological progress
 Summary
 The Diamond Model
 Basic assumptions
 Household behavior
 Dynamics of the economy
 Dynamic inefficiency
1. Consumption and Savings: Dynasties and OLG (Ramsey) Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
Introduction: Why thinking about “economic growth”? (1)
 Questions related to economic growth are of primary importance for welfare and

have first-order policy implications:
 Why are some countries poor while others are rich?
 What are the major growth engines that drive economic growth?
 Is economic growth sustainable given that some inputs are non-renewable (crude oil)?
 How does capital accumulation and technical change affect the distribution of income?
 How does migration affect well-being of domestic residents?
 To think about these questions, we need analytical devices (concepts, models,

theories) to structure our thinking.
 Ramsey model is one of the prototype models in dynamic macroeconomics.
2
Makroökonomik
 Why are there poor and rich countries?

 Richest countries in 1988 were about 30 times richer than the poorest countries. (Parente and Prescott, 2000)
 Why do some economies experience rapid growth, while some other stagnate at the same time?
 Niger (NER) versus South Korea (KOR)
 Manipulating an economy’s (long run) growth rate seems to have massive welfare consequences.

 If per capita income grows at a growth rate of 1 % it takes about 70 years until per capita income is doubled.
 If per capita income grows at a growth rate of 2 % it takes about 35 years until per capita income is doubled.
 Lucas (1987, 2003) argued that complete removal of consumption volatility (→ business cycle

phenomenon) implies welfare gain of about 0.1% to 1% permanent consumption increase.
 Distinguish intertemporal elasticity of substitution and relative risk aversion (→ recursive utility functions).
 What about heterogeneity?
 Follow up studies: substantially larger welfare gains of 10% to 30% (see Lucas, 2003, p. 7).
 Potential welfare gain due to optimal growth policies appears substantial.

 Capital subsidization and R&D subsidies (Grossmann et al., 2014).
 Welfare gain equivalent to permanent doubling of per capita consumption.
3
Makroökonomik
25000 g=0.1
Real GDP per capita
g=0.02
20000
South Korea Niger

15000
g=0.01
10000
5000
0
1950 1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004
The consequences for human welfare involved in  How long does it take until is twice its initial value?
questions like these are simply staggering: Once one
starts thinking about them, it's hard to think about  Solve 2 for to get ln 2 / .
anything else. Robert Lucas (1988)
back
4
Makroökonomik
 Mass one of HH
Households: setup  HH size: L
 Every HH-member supplies 1 unit of labor
 Mass one of identical and infinitely lived HH (dynasties)
 Let denote, say, income of HH ∈ 0, … , 1 . Aggregate income reads
 “large number" of HH (mass one of HH) is compatible with perfectly competitive markets
 "overall number of HH equals one ": quantities per HH coincide with aggregate quantities!
 Each HH comprises members, every member is endowed with one unit of time

per period, which are inelastically supplied to the labor market.
 HH’s (financial) wealth is lent to firms.

wage rate
interest rate
 Aggregate income (= HH income): ∈ 0, ∞ time index
 Typical HH is assumed to maximize welfare
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Makroökonomik
Households: instantaneous utility (1)

 Instantaneous utility function exhibits constant intertemporal elasticity of substitution (CIES)
 Utility function is compatible with steady state growth (→ Keynes-Ramsey rule).

 The "‐1" in the numerator implies lim ln . Alternative formulation reads
→
 Elasticity of marginal utility w.r.t. C
 Last equality results from: ’ and ’’

 is measure for concavity of utility function 6
Makroökonomik
Households: instantaneous utility (2)
 If 0, marginal utility does not change with consumption;

graphically: is a straight line.
 Consumer is indifferent between different consumption profiles; apart
from, of course, discounting (captured by the term ).
 Willingness to substitute consumption intertemporally is infinite.
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Makroökonomik
Households: dynamic problem (1)
 Household solves dynamic optimization problem
financial wealth
consumption
time preference rate
real interest rate
 One control variable, , and one state variable,

 Consumption enters twice: explain!
 On No‐Ponzi‐Game condition (NPGC) see Macroeconomics Toolbox
 Flow budget constraint plus NPGC may be stated in integrated form
8
Makroökonomik
Households: dynamic problem - Maximum Principle

 Consider the following dynamic problem (Intrilligator, 1971)
. , . , . continuously differentiable functions
n-dimensional vector of state variables
r-dimensional vector of control variables ⋛ ,

piecewise continuous function of
 The (present value) Hamiltonian function and associated first‐order conditions
n-dimensional vector of costate variables
 / , ∗, ∗, plus boundary conditions ₀ / ₀ and / are called canonical equations.

 System of 2 differential equations with initial and boundary conditions. 9
Makroökonomik
Households: dynamic problem (2)

 To solve (P1) we set up the (current-value) Hamiltonian function
 Necessary conditions
 Transversality condition (TVC), states that

present (as of 0) value of wealth at
terminal time must approach zero.
 Easily understood by considering
problem with finite time horizon ; TVC
then reads: 0.
 Keynes‐Ramsey rule of optimal consumption - exercise: employ (3) and (4)
Economic interpretation!
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Makroökonomik
Households: Keynes-Ramsey rule

 Economic intuition
 0 whenever .
 Interest rate : premium HH receives if it reduces today by 1 unit and increases tomorrow by 1 unit.
 Time preference rate : premium HH demands to be marginally indifferent between today and tomorrow.
 If it seems rational to postpone consumption into the future.
 is higher, c.p., the higher . High gives strong incentives to postpone into the future by sacrificing today,
invest into assets, such that a higher level of tomorrow can be financed. ( : opportunity cost of consumption)
 is lower, c.p., the higher . High captures strong impatience such that HH wishes to consume rather today than
tomorrow.
 is higher, all else equal, the smaller . Small implies that ´ falls only slightly as increases. HH exhibits a high
willingness to substitute consumption intertemporally. Hence, unfolds strong incentives to substitute
consumption intertemporally. (Increasing has a strong impact on if is small.)
 Steady state implies that ≔ remains constant. Hence, in the long run.
 Macroeconomic equilibrium
 KRR demonstrates that plays prominent role in determining an economy’s growth rate. As ´ , anything
that affects the impacts on economy’s growth rate. (Education, infrastructure investments, property rights…)
 If ´ 0 and ´´ 0, diminishes as capital is being accumulated such that, sooner or later, .
Ongoing economic growth is possible only if remains above (due to technical change, education,…).
 Notice that, from the perspective of economic theory, maximization of growth rate cannot represent a sensible
objective for economic policy. Statements like “the growth rate should be increased” must be based on some kind of
market failure. 11
Makroökonomik
Firms (1): setup
 Mass one of identical firms producing a homogenous final output good that can be
used for consumption or investment.
 Final output is chosen as numeraire, i.e. its price is set equal to unity ( 1).
 Output technology of the typical firm is Cobb-Douglas
 Firms maximize profits in perfectly competitive

environment, implying that they hire and rent such that
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Makroökonomik
Firms (2): cross-sectional and time series evidence for α
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Market equilibrium and national income (1)
 Definition: general equilibrium
 General (market) equilibrium for this economy consists of time paths for
quantities , , , and prices , such that
 Final good producers maximize profits at each ∈ 0, ∞
 HH maximize welfare , i.e. solve (P1)
 Capital market clears, i.e. at each ∈ 0, ∞
One of these 3 market clearing
 Labor market clears, i.e. at each ∈ 0, ∞ conditions is redundant.
 Goods market clears, i.e. at each ∈ 0, ∞
 National accounting -
 Income of typical HH equals national income - recall if ∀.
 National income equals aggregate production net of depreciation
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Makroökonomik
Market equilibrium and national income (2)
produced input
 Two interpretations
 Robinson‐Crusoe economy: Consumer-
producer household accumulates output
not consumed and thereby builds up a stock
production of physical capital. Stock of capital is used to
produce output.
primary input use
 Market economy
 HH supply “loanable funds” to capital
market (measured in terms of ). Firms
demand loanable funds to finance
purchase of investment goods and thereby
produced (capital market equilibrium)
input build up capital stock.
 Alternatively, HH accumulate capital and
rent capital to firms.
firms / production
(origin)
households (distribution) households
(primary input) (use)
15
Makroökonomik
Economic dynamics: reduced-form system

 Dynamic system
 Evolution of economy in macroeconomic equilibrium is governed by
Explain, where this

system comes from!
 Boundary conditions: 0 0 and ∞ (2nd boundary conditions substitutes TVC).
 Steady state
 Unique (nontrivial) steady state
Explain the derivation
of the steady state!
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Makroökonomik
Economic dynamics: phase diagram

 Unique interior steady state:
point A.
Trajectories violate “c(t) must be a continuous function of t”.  Steady state is conditionally
(Jumps in consumption precluded.)
stable (saddle-point stable).
 Equilibrium growth path
(dynamic general
A equilibrium) is unique.
Trajectories violate the TVC.
(Overaccumulation of , i.e. dynamic inefficiency, precluded.)
Saddle Path (equilibrium growth path – EGP)
 Phase diagram illustrates uniqueness of equilibrium growth path (EGP).

 Given 0 0, there is unique choice for such that economy evolves along unique EGP towards unique steady state.
 See associated excel file “Ramsey_discrete.xls”.
17
Makroökonomik
Social planner‘s solution (1)
 Social planner maximizes welfare of representative HH by solving (time index suppressed)
 Robinson Crusoe solves same problem.

 Resource constraint:
 Associated (current-value) Hamiltonian function together with FOCS ( -equation suppressed)
 From these FOCs one gets
 Dynamic evolution of the socially controlled economy is determined by (10), (11) and 0 0 and ∞ .
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Makroökonomik
Social planner‘s solution (2)

 Important implication
 Decentralized equilibrium coincides with social planner's solution, implying that
market equilibrium represents the (unique) first‐best solution.
 Result is driven by the fact that the economy under study is perfectly neoclassical.
 First theorem of welfare economics states that any competitive equilibrium is Pareto-
efficient, provided that the economy fulfills
i. individuals behave rational
ii. perfect competition
iii. prices are flexible
iv. perfect information
v. no technological externalities
vi. complete set of markets
 Moreover,…
 There are technical details that have not been discussed (sufficiency conditions,
stability of the steady state, …).
 Some of these aspects will be considered in the course “Quantitative Dynamic
Macroeconomics”.
19
Makroökonomik
Technological progress: output technology and dynamic system
 Output technology
 Technological progress is exogenous and labor augmenting.

 One plausible possibility to capture technical progress (→ R&D-based growth).
 Following same steps as before leads to dynamic system (boundary conditions

omitted)
20
Makroökonomik
Technological progress: steady state growth rate
 Steady state (definition): A state of the economy such that the growth rates of endogenous
variables remain constant.
 To determine steady state growth rate, consider the growth rates of and
 . requires .
 We can express in growth rates (remember .)
 . implies . Hence, . requires . Summarizing, we get
 Calculate the steady state growth

provided that ?
21
Makroökonomik
Technological progress: normalized variables
 Dynamic system under study displays unbounded growth.

 For technical reasons, we transform this dynamic system into a system that converges
towards a stationary solution. This is done by performing a normalization of variables.
 Assume that variable grows in the long run at rate g, i.e. lim .
→
 Normalized variable is then given by ≔ / .

 Notice that, by construction, lim const.
→
 For the model under study, the following normalization can be employed
 From these definitions it follows ̂ and .
 Dynamic system in normalized variables reads (exercise!)
22
Makroökonomik
Technological progress: stationary solution
 Stationary solution for (normalized) capital
 „Tilde“ above a variable

denotes steady state value.
 Stationary solution for (normalized) consumption
23
Makroökonomik
Technological progress: steady state saving rate

 Steady state saving rate (1)
 Steady state saving rate (2)
0.015, 0.05,
0.03, 1.5,
0.3 gives
0.19 0.05 !
 Compare to golden rule of saving according to Phelps . Provided that 1 (log utility)
24
Makroökonomik
Summary
 Long‐run growth rate is completely determined by exogenous technical

progress.
 Public policy cannot influence long-run growth (policy ineffectiveness).
 However, there is possibility to control the level of the balanced growth

path (BGP)! This is equivalent to saying that policy can affect the growth rate
along the transition path.
 Neither high level of BGP nor high steady state growth rate are ultimate goals.
 From a theoretical perspective, we have to focus on welfare as the ultimate goal of
public policy.
 Decentralized and centralized solutions coincide: first theorem of welfare economics
applies.
 In a neoclassical world, there is simply no need for public policy to intervene!
25
1. Consumption and Savings: Dynasties and OLG (Diamond) Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
Assumptions: demographics
 Turnover in population: new individuals are continually born, old individuals are continually dying.
 Time is discrete, i.e. the variables are defined for ∈ 0, 1, … , ∞ .
 Each individual lives for two periods: "youth" and "retirement”. Population grows at rate 0.
∈ 1,2, … indexes cohorts (suppressed below)

∈ , indexes generations
t=0 t=1 t=2 t=3 ∈ 0,1,2, … indexes periods
Total population in
j=1
j=2
j=3
Workforce in
 Each individual supplies one unit of labor when young and divides resulting labor income between

current consumption and savings.
 In 2nd period of life, individuals consume savings and interest payments.
 Life‐time utility of an individual born at
26
Makroökonomik
 Setup HH side:
Assumptions: firms  Mass L of young agents
 Every agent supplies 1 unit of labor inelastically
 Production is based on a CRS technology with exogenous technological progress
 : / and ≔ / .
 state of technology evolves according to 1 with 0.
 Product and factor markets are perfectly competitive.

 and ′ , where is real wage rate per unit of effective labor
 Firms, in equilibrium, earn zero profits (→ Euler’s Theorem and CRS technology).
 Capital stock owned by the old and labor supplied by the young are combined in production.

 Aggregate capital stock in period : ,
 , : savings by the young generation at period 1
 1: labor income
 : wage rate per effective labor and 1 is amount of effective labor at level of individuals.
27
Makroökonomik
Household behavior (1)
 Problem of an individual born at period t
 Associated Lagrangian function together with necessary FOCs
28
Makroökonomik
 Dividing FOC2 by FOC1 yields
 Euler equation (analogue to the Keynes‐Ramsey rule)

 Consumption increases whenever .
 Curvature of household's utility function (given by ) determines how much
consumption varies in response to “ ”.
 Notice that log-linearization yields ≅ / !
 Euler equation together with budget constraint describes the behavior of the
household. Implied consumption function (see next slide)
29
Makroökonomik
Household behavior (2a)

 Multiplying both sides of Euler equation by ,
 Substituting , into budget constraint and solving for ,
 Savings rate
 First‐period consumption
30
Makroökonomik

 How does the savings rate vary with
the interest rate?
 Substitution effect. As increases,
0.1
the opportunity costs of go up.
Hence, is depressed and the
savings rate increases: ↑→ 1 ↓→ ↑
 Income effect. As increases, capital
income (2nd period of life) increases.
σ=1
Everything else the same,
increases (2nd period income is
completely consumed). Due to
σ=2 consumption smoothing, (out of
labor income) goes up, meaning that
the savings rate falls: ↑→ 1
1 ↑→ 2 ↑ → 1 ↑→ ↓
 Log utility: For 1 both effects

cancel each other such that
.
31
Makroökonomik
Household behavior (3a)
/
 is increasing in if and only if 1 is increasing in
 This can be seen more clearly as follows
 Three cases
32
Makroökonomik
Market equilibrium and national income

 Setup HH side (brief):
 Mass of young agents
 Definition: general equilibrium  Every agent supplies 1 unit of labor inelastically
 A general (market) equilibrium for this economy consists of time paths for the
quantities , , and the prices , such that
 Final good producers maximize profits at each ∈ 0, ∞ .
 Households maximize life-time utility, i.e. solve problem (P2).
 Capital market clears, i.e. at each ∈ 0, ∞ .
 Labor market clears, i.e. at each ∈ 0, ∞ . One of these 3
market clearing
conditions is
 Goods market clears, i.e. at each ∈ 0, ∞ . redundant.
 National accounting ‐ (with )
 National income (=total income of all households) equals aggregate output .
 Noting 1 , and ≔ / gives
33
Makroökonomik
Economic dynamics (1)

 Aggregate capital in period
 depends on current wage income and expected interest rate in 1
 Noting 1 and 1 gives

 Recall: ′ and
′
 First‐order difference equation (together with ) describes evolution of economy.

 Steady state must satisfy
 =const. implies 1 1 .
 Steady state: . and .

34
Makroökonomik
Economic dynamics (2)
 Special case: Logarithmic utility and
Cobb‐Douglas technology.
 For 1, we get . Moreover,
under Cobb-Douglas and
1 .
 Any parameter change that raises
savings rate shifts balanced growth
path upward but leaves the long-run
growth rate unaffected.
45°
35
Makroökonomik
Dynamic inefficiency (1)
 Decentralized equilibrium not necessarily Pareto‐optimal (as in Ramsey model)!
 To illustrate, assume , 1, 0 and focus on steady state
 Golden rule capital stock, noting 0, is characterized by: .
 ′ above can be either larger or smaller than !

 For sufficiently small, implying .
 Dynamic inefficiency: reduction of the saving rate could increase !
36
Makroökonomik
Dynamic Inefficiency: Reminder on Solow Model
37
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 Intuition behind dynamic inefficiency
 Agents are forced to finance 2nd period consumption out of wealth ( ).
 They therefore may accumulate too much in the sense that “ ” declines.
 An economy that has permanently too much wastes scarce resources: investment required to
maintain stationary capital-to-output ratio ( ) is larger than capital income ( ):
 Acemoglu (2009, p. 339)

Dynamic inefficiency arises from overaccumulation, which results from the need of the current
generation to save for old age. However, the more they save, the lower is r, and this may
encourage them to save more. The effect of the savings by the current generation on the future is
a pecuniary externality. Had the First Welfare Theorem applied, these pecuniary externalities
would not have led to Pareto suboptimal allocations. But this reasoning need not apply when there
are infinite numbers of commodities and households.
 Abel et al. (1989): USA and 6 other major advanced countries are dynamically efficient
(criterion: with average interest rate)
 Geerolf (2013): Based on updated data all these economies appear to be dynamically
inefficient: “This world savings glut can potentially explain otherwise hard-to-understand
macroeconomic stylized facts (low , cash holdings by firms, financial bubbles…)”
38
Makroökonomik
39
1. Consumption and Savings: Dynasties and OLG Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
The limits to growth debate - comments
 Normative issue: Which growth rate is socially desirable?

 Growth is endogenous: investment (saving), education, R&D!
 More or less investment (saving), education, R&D?
 How large is the socially optimal growth rate ?
 Trick: Identify, quantify and internalize the „major externalities“ (environmental
damages, educational spill overs).
 Moreover: constraints like “max. inequality“, “sustainability“, “stability of
ecological system“ (threshold effects)
 Growth compulsions? Hard to see! (what about ?)
 Politicians usually claim “we need more growth” (→ myopic and opportunistic).
 However: We should not deny benefits of economic growth (Cpricvat, Cpublic)!
40
Consumption and Savings: Dynasties and OLG Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
Notation and abbreviations (1)

Ramsey Model
0<α<1 constant technology parameter X household’s total income
a financial capital (wealth) Y final output
A technology parameter (either TFP or labor δ>0 capital depreciation rate
efficiency) λ shadow price of wealth
C consumption μ shadow price of capital
C:=dC/dt derivative of C w.r.t. time ρ>0 time preference rate
C:=C/C growth rate of consumption σ elasticity of marginal utility w.r.t.
H Hamiltonian function consumption
K physical capital
K steady state value of K
L labor supply (in units of time)
r interest rate
s saving rate
t∈[0,∞] time index
u(C) instantaneous utility function
w wage rate
41
Consumption and Savings: Dynasties and OLG Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
Notation and abbreviations (2)

OLG Model
0<α<1 constant technology parameter Y final output
A technology parameter (either TFP or labor δ>0 capital depreciation rate

efficiency) λ Lagrange multiplier
C consumption ρ>0 time preference rate
H Hamiltonian function σ elasticity of marginal utility w.r.t.
g growth rate of A consumption
K physical capital
kGR golden rule capital stock Abbreviations
CIES constant intertemporal elasticity of
k steady state value of k
substitution
L number of individuals EGP equilibrium growth path
n population growth rate OLG overlapping generations
r interest rate PDV present discounted value
s savings rate TVC transversality condition
t∈{0,∞} time index w.r.t. with respect to
U life time utility
w wage rate
42
Makroökonomik
Supplement: Heuristic proof of maximum principle for Ramsey model (1)
 Consider the following dynamic optimization problem  Model context: real economy a

la Robinson Crusoe.
 Observe that enters twice.
represents a positive
effect, while “– ” represents a
negative effect.
 Such a problem can be solved by applying the maximum principle. This requires to set
up the (current-value) Hamiltonian function (time index is suppressed to simplify
notation)
 Hamiltonian can be viewed as net national product in utility terms (Solow, 2000, p. 127).

 denotes the shadow price of capital, with dimension “utility per unit of output”.
 Notice that term captures an immediate effect, while captures future effects (capital
accumulation increases future income, hence future utility). Since Hamiltonian captures
forward looking aspects it is a forward-looking concept. 43
Makroökonomik
 Solution of (P3) is a time path that maximizes the PDV of utility.
 It can be shown that a time path that maximizes PDV of utility must also
maximize the Hamiltonian at each point in time.
 The Hamiltonian function turns the dynamic problem into a static problem.
 Necessary first-order condition for a time path to maximizes at each point is
 Notice that, at any instant of time, when

is determined is also determined.
 What about , the value of an additional capital good?

 Contribution of an additional unit of to , , is ≔ / .
 The value (fundamental price) of capital then equals the PDV of
44
Makroökonomik
 Differentiating w.r.t. me gives (→ Leibniz rule)
 In summary, set of necessary first‐order conditions are (plus -equation)
 There are, moreover, two boundary conditions  2nd boundary condition, transversality

condition (TVC), states that present (as of
0) value of capital at terminal time
must approach zero.
 Easily understood by considering
problem with finite time horizon ; TVC
then reads: 0. 45
Makroökonomik
Supplement: TVC at upper boundary steady state: 0, 0

 Transversality condition requires (together with steady state assumption)
Upper boundary steady state: growth rates
 Upper boundary steady state ( -locus hits the horizontal axis that represents another branch of -locus)
 TVC is violated!
 Steady state is dynamical inefficient in a radical sense: 0 and there exists another 0 46

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Prof. Dr.

Thomas Steger Institut für Theoretische Volkswirtschaftslehre

Advanced Macroeconomics I | Lecture | SS 17 Makroökonomik

Introduction: Why thinking about “economic growth”? (1)

 Questions related to economic growth are of primary importance for welfare and

 How does migration affect well-being of domestic residents?

 To think about these questions, we need analytical devices (concepts, models,

 Ramsey model is one of the prototype models in dynamic macroeconomics.

Introduction: Why thinking about “economic growth”? (2)

 Why are there poor and rich countries?

 Manipulating an economy’s (long run) growth rate seems to have massive welfare consequences.

 Lucas (1987, 2003) argued that complete removal of consumption volatility (→ business cycle

 Potential welfare gain due to optimal growth policies appears substantial.

Introduction: Why thinking about “economic growth”? (3)

South Korea Niger

 Each HH comprises members, every member is endowed with one unit of time

 HH’s (financial) wealth is lent to firms.

 Aggregate income (= HH income): ∈ 0, ∞ time index

 Typical HH is assumed to maximize welfare

Households: instantaneous utility (1)

 Utility function is compatible with steady state growth (→ Keynes-Ramsey rule).

 Last equality results from: ’ and ’’

Households: instantaneous utility (2)

 If 0, marginal utility does not change with consumption;

Households: dynamic problem (1)

 Household solves dynamic optimization problem

 One control variable, , and one state variable,

Households: dynamic problem - Maximum Principle

. , . , . continuously differentiable functions

n-dimensional vector of state variables

r-dimensional vector of control variables ⋛ ,

 The (present value) Hamiltonian function and associated first‐order conditions

n-dimensional vector of costate variables

 / , ∗, ∗, plus boundary conditions ₀ / ₀ and / are called canonical equations.

Households: dynamic problem (2)

 Transversality condition (TVC), states that

 Keynes‐Ramsey rule of optimal consumption - exercise: employ (3) and (4)

Households: Keynes-Ramsey rule

Firms (1): setup

 Output technology of the typical firm is Cobb-Douglas

 Firms maximize profits in perfectly competitive

Firms (2): cross-sectional and time series evidence for α

Market equilibrium and national income (1)

 Goods market clears, i.e. at each ∈ 0, ∞

Market equilibrium and national income (2)

Economic dynamics: reduced-form system

Explain, where this

 Boundary conditions: 0 0 and ∞ (2nd boundary conditions substitutes TVC).

Economic dynamics: phase diagram

 Phase diagram illustrates uniqueness of equilibrium growth path (EGP).

Social planner‘s solution (1)

 Social planner maximizes welfare of representative HH by solving (time index suppressed)

 Robinson Crusoe solves same problem.

 Associated (current-value) Hamiltonian function together with FOCS ( -equation suppressed)

 From these FOCs one gets

Social planner‘s solution (2)

Technological progress: output technology and dynamic system

 Technological progress is exogenous and labor augmenting.

 Following same steps as before leads to dynamic system (boundary conditions

Technological progress: steady state growth rate

 We can express in growth rates (remember .)

 . implies . Hence, . requires . Summarizing, we get

 Calculate the steady state growth