EC400, 2020. Dynamic Optimization and Ordinary Differential Equations.

1. (50 marks) Given a0 > 0 and h0 > 0, a consumer maximize at time zero the following objective
function,
X∞
E0 β t εt ln(ct /hγt )
t=0

subject to the following constraints,

at+1 + ct ≤ Rt at , at+1 , ct ≥ 0, for all t ≥ 0.

where 0 < β < 1, 0 < γ < 1 , ht denotes the consumption habit of the consumer at period t. The
habit stock for the next period is increasing in consumption this period,

ht+1 = x(ct , ht ), for all t ≥ 0.

where x is a positive function that is increasing in both arguments, ct and ht . In questions (a), (c),
(d), (e), (f), and (g), assume that Rt = R and εt = 1.
(a) (5 marks) Write down the Lagrangian if we solve period-0 the consumption and saving problem
using the direct approach. (You can assume that constraints at+1 , ct ≥ 0 are not binding.)
(b) (6 marks) Write down the principle of optimality. According to the principle of optimality, which
of the following statements is(are) correct?
i. Given the state variables at period t, we can solve for the optimal consumption and saving
decision at period t;
ii. Given the state variables at period t, we can solve for the optimal consumption and saving
decision at period t + 1;
iii. Given the state variables at period t, we can solve for the optimal consumption and saving
decision at period t − 1.
(c) (5 marks) What is/are the state variable(s) for the optimization problem from period t onwards?
(d) (4 marks) Write down the Bellman equation.
(e) (4 marks) In questions (e) and (f), assume that x(c, h) = c. Derive the first order condition(s) of
the Bellman equation.
(f) (12 marks) Apply the envelope theorem and solve for the Euler equation (the differential equation
about the path of consumptions over time).
(g) (6 marks) Given the initial conditions at period 0 and the policy function for consumption, write
down the path of the state variables and consumptions over time.
(h) (8 marks)Assume now that εt+1 is a random variable that follows distribution function G(εt+1 |εt )
and Rt+1 is a random variable that follows distribution function F (Rt+1 |Rt ). Write down the
state variable(s) of the Bellman equation. Write down the Bellman equation.

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2. (50 marks) A consumer chooses her consumption flow c(t) to maximize
ˆ ∞ h i
e−ρt 1 − e−γc(t) dt
0

subject to
α
ȧ(t) = A [a(t)] − c(t)
where ρ, γ, y > 0 and 1 ≥ α > 0.

(a) (8 marks) Write down the state variable and the control variable. Denote the co-state variable
for the state variable to be λ(t). Write down the present value Hamiltonian, denoted H(t).
(b) (12 marks) Write down the first order conditions and derive the Euler equation.
(c) (5 marks) When α = 1 and ρ = Aα, suppose that saving converges to a finite positive value as t
goes to infinity, show that a(t) = a(0), and c(t) = Aa(0).
(d) (15 marks) For 0 < α < 1, what are the steady state values of ct and at ? Derive that the system
of linear first order differential equations that approximates the nonlinear dynamic system near
the steady state. Show that the system has a saddle path and the steady state is a saddle point
using the eigenvalues of the coefficient matrix of the approximated linear dynamic system.
(e) (10 marks) For 0 < α < 1, use the phase-diagram of the nonlinear dynamic system to show that
the steady state equilibrium is a saddle-point. Explain how you draw it.