ECON 502: Macroeconomic Theory I

METU, Fall 2018

Assignment 2
Due: 24.10.2018

1. Consider the following cost minimization problem

min wL + rP K subject to F (K, L) = X̄.
Assume that production function is in the form of :

X = A[αLσ + (1 − α)K σ ]1/σ whereα ∈ (0, 1) and − ∞ < σ < 1

. Let w and rP denote the unit prices for L and K respectively.

a) Derive the factor demands as functions of price of inputs and the given
level of output.
b) Derive the total cost function for the technology given above.
c) Show that given production function exhibits constant returns to scale
(CRS) property.
d) Suppose that f (.) is the production function, and let Y be the produc-
tion set of this technology. Prove that Y satisfies CRS if and only if f (.) is
homogeneous of degree 1.
(Definition : A function f : Rn → R is homogeneous of degree k if f (tx) =
tk f (x) )
e) Show that for any production technology that exhibits constant returns to
scale property (CRS), the cost function may be written as:

C(w, X) = XC(w, 1) where w is the vector of input prices

f) Prove the following:

∂T C(w, rP, X̄)

L(w, rP, X̄) =
∂w

2. For the cost minimization problem stated above and using the definition of
u = X/K:
a) Write down u as a function of r. Comment on the properties of the function
you derived.

1
 b) Express the relationship between real wage rate, w, and r. Comment on
the properties of the relationship.
c) Express L/K as a function of u. Comment on the properties of the function
you derived.

3. We have studied in class the effects of a rise in government spending (as

represented by γ) under the structuralist model and neoclassical model and
with different closures. Now consider and increase in the saving rate s.
Study the effects of an increase in s in both models under two closures:
(i)output-closure and (ii) the supply-driven closure. Explain.

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ECON 502: Macroeconomic Theory I
METU, Fall 2018

Assignment 2
Sketch of Solutions by T.A. Burcu Ozgun

This sheet does not provide you with step-by-step solutions to the questions. My aim
here is to provide you with the basic steps that you were expected to follow, to show
some of the possible approaches to the problem in hand and to give you an idea
about how the grading will be done. Keep in mind that there may be different ways
to solve some of these exercises. As soon as your approach/solution is correct, you
get the full credit i.e., your solutions need not to be identical to mine.

1. Consider the following cost minimization problem

min wL + rP K subject to F (K, L) = X̄.
Assume that production function is in the form of :

X = A[αLσ + (1 − α)K σ ]1/σ whereα ∈ (0, 1) and − ∞ < σ < 1

. Let w and rP denote the unit prices for L and K respectively.

a) Here you were expected to solve the cost minimization problem and find
the corresponding factor demands.
Due to properties of the objective function and the constraints, one can see
that solution will be interior. Hence, we can set up the Lagrangian as follows:

L = wL + rP K + λ(X̄ − [αLσ + (1 − α)K σ ]1/σ )

F.O.C.:
∂L 1
= w − λA [αLσ + (1 − α)K σ ](1/σ)−1 (σαLσ−1 ) = 0
∂L σ
∂L 1
= rP − λA [αLσ + (1 − α)K σ ](1/σ)−1 (σ(1 − α)K σ−1 ) = 0
∂K σ
∂L
= X̄ − A [αLσ + (1 − α)K σ ]1/σ = 0
∂λ
w αLσ−1
=
rP (1 − α)K σ−1
 w −1/(σ−1)  rP 1/(σ−1)
K= L
α 1−α

1
Plug this in the production function
" !σ #1/σ
 w −1/(σ−1)  rP 1/(σ−1)
X̄ = A αLσ + (1 − α) L
α 1−α

Solve for L∗ :
w 1/(σ−1)


∗ X̄ α
L =  1/σ
A w σ/(σ−1)

rP σ/(σ−1)


α α
+ (1 − α) 1−α

K ∗ can be obtained either by using the symmetry of the problem or by sub-

stituting the solution for L∗ into production function:
 1/(σ−1)
rP
X̄ (1−α)
K∗ =  1/σ
A σ/(σ−1) rP σ/(σ−1)
α wα



+ (1 − α) 1−α

b) Total cost function

T C(w, rP, X̄) = wL∗ (w, rP, X̄) + rP K ∗ (w, rP, X̄)

Plugging in the expressions for L∗ and K ∗ and rearranging yields:

 1/(σ−1)
w 1/(σ−1) rP


X̄ w α
+ rP (1−α)
T C(w, rP, X̄) =  σ/(σ−1) 1/σ
A w σ/(σ−1)


rP
α α + (1 − α) (1−α)

c) The function exhibits constant returns to scale if the following holds. When
capital and labor are multiplied by a positive constant, λ, the amount of
output is also multiplied by λ.

F (λK, λL) = A[α(λL)σ + (1 − α)(λK)σ ]1/σ

Rearranging yields

F (λK, λL) = Aλ[αLσ + (1 − α)K σ ]1/σ = λF (K, L)

d) Here we will consider a single-output case for the sake of simplicity, without
loss of generality.
First prove that if Y satisfies constant returns to scale, then f is homogeneous
of degree 1.
L−1
Take a z ∈ R+ such that (−z, f (z)) ∈ Y where z is a vector of inputs only.
Take a α > 0. Constant returns to scale implies that if y ∈ Y then for any

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α > 0, αy ∈ Y by definition. Then we can say that the point (−αz, αf (z)) ∈
Y . From this, we can deduce that if the point above is in Y, it must have a
vertical coordinate (αf (z)) lower or equal than the maximum amount that is
possible to produce given those inputs (f (αz)) i.e.; αf (z) ≤ f (αz).
If we repeat the same analysis with the chosen constant 1/α, we end up with
inequality αf (αz) ≤ f (z).
Combining αf (z) ≤ f (αz) an αf (αz) ≤ f (z) we get the result that αf (z) =
f (αz).
Second, prove that if f is homogeneous of degree 1, then Y exhibits constant
returns to scale.
Take a production plan (−z, q) ∈ Y . It must be q ≤ f (z) when feasible. This
implies qα ≤ αf (z). If f is homogenous of degree 1, then we have αf (z) =
f (αz). Hence αq ≤ f (αz). Then take another point which is in Y by definition
of production function: (−αz, f (αz)) ∈ Y . Since (−αz, f (αz)) ∈ Y and qα ≤
αf (z), we get (−αz, αq) ∈ Y , i.e.; constant returns to scale.
Here is a diagram to help you visualize:

Notation and proof itself might differ. As long as you provide the full proof
(with both ⇒ and ⇐ parts so to say), you get full credit.
e) Let C(w, 1) be cost of producing one unit of output at input prices w and
l be the conditional input demand. Then,

C(w, 1) ≡ wl(w, 1)

By CRS,
f (X ∗ li (w, 1)) ≡ X ∗ 1
This implies:
X ∗ = f (l(w, X ∗ )) = f (X ∗ l(w, 1))
So we have
l(w, X ∗ ) = X ∗ l(w, 1)
C(w, X ∗ ) = wl(w, X ∗ ) = wX ∗ l(w, 1) = X ∗ wl(w, 1) = X ∗ C(w, 1)

f) Here you were expected to provide a general proof of Shephard’s Lemma.

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 Write down a general cost minimization problem where l is the conditional
input demand:
min C(w, X̄) = wl − λ(f (l) − X̄)
F.O.C:
∂f (l)
wi − λ∗ =0
∂li
f (k)∗ − X̄ = 0
∂C(w, X̄) X ∂lj∗  
∗ ∗ ∂f (l) ∂λ
f (l∗ − X̄) = li∗


= li + wj − λ −
∂wi ∂wi ∂lj ∂wi
Here i am skipping the parts between as most of you did it correctly. You will
apply the above procedure to the given case in the question with two inputs.
Then you will end up with:

∂T C(W, rP, X̄)

= L(W, rP, X̄)
∂W

2. Using the definition of u = X/K:

a) Recall that
 1/(σ−1)
rP
X̄ (1−α)
K∗ = 1/σ
A

w σ/(σ−1) rP σ/(σ−1)



α α
+ (1 − α) 1−α

Hence,

w σ/(σ−1)

rP

σ/(σ−1) 1/σ
α α
+ (1 − α) 1−α
u=A  1/(σ−1)
rP
(1−α)

You were also expected to comment on the properties of this function (e.g.
taking derivatives and explaining the relationships)
I am aware of the fact that differentiating some of these functions is not an
easy task and can take too much time. As long as you try to provide a complete
answer and are on the right path, you will get full credit
b)

W α Lσ−1
=r
P 1 − α K σ−1
You were also expected to comment on the properties of this negative rela-
tionship between W and r.
c) By using the expressions for L∗ and K ∗ that we derived in question 1, we
can write

4
 w 1/(σ−1)


L∗ α
=
K∗ rP 1/(σ−1)


1−α

Take wα term out of this expression and plug the expression you find in te
equation of u that we derived in part a.
By rearranging, you will end up with:
1/σ
(u/A)σ − (1 − α)

L
=
K α
You were also expected to comment on the properties of the relationship
between u and L/K.

3. In this part you were expected to assess the effects of an increase in the saving
rate under the structuralist model and neoclassical model.
Explained in detail at class, hence I will not repeat it here.
I had a quick look at your papers. I noticed a very broad range of different
answers here. But most of you did well by using the equations and diagrams
as we did in class. Since there are many different variables and four different
cases to comment on, most of you could not provide a complete answer. I will
be generous in grading this part. As long as you understand the main idea in
different model setups and closures, you will get full-credit.

To upload the solutions before you start preparing for the upcoming mid-term ex-
amination I typed the document quite fast, so if you notice any typo please let me
know via e-mail.

5
ECON 502: Macroeconomic Theory I
METU, Fall 2018

Assignment 3
Due: 31.10.2018

1. Review the cakeeating.m document that we have worked on.

a) Rerun the script for three different discount factors and explain the chang-
ing dynamics.
b) Notice that we divided K into 100 grids. Increase this number to 1000
and rerun the script by using run and time option in the editor. Report the
corresponding durations for the two and comment. Why is computation time
important?

2. Consider the cake-eating problem that we discussed in class. Now assume that
the utility takes CRRA form, so the problem becomes:

T
X ct1−σ
max β t−1
t=1
(1 − σ)
subject to

Wt+1 = Wt − ct

W1 ≥ 0, given

a) Carry out analytically two iterations of the value function iteration algo-
rithm.
b) Find the optimal
 consumption path as a function of cake size by guess and

W 1−σ
verify approach V (W ) = A 1−σ
c) Plot optimal consumption path as a function of cake size in MATLAB (You
can do this by modifying the script that we have worked on earlier).

1
ECON 502: Macroeconomic Theory I
METU, Fall 2018

Assignment 3
Sketch of Solutions by T.A. Burcu Ozgun

In this assignment you were free to choose your own discount factors and other
parameters when necessary. As long as your report is consistent with your script
output and you explain the dynamics well, you will get full credit.
1. About the cakeeating.m script that we have worked on.
a) In this part, you were expected to run the script for three different dis-
count factors and explain the relationship between how much the consumer
values future consumption compared to today’s consumption and the realized
consumption behavior as a function of current cake size.
b) In this part you were expected to increase the grid size, report the com-
putation time and comment on it. Cake-eating problem is the simplest form
of dynamic programming problems whereas in economic modeling we usu-
ally deal with more complicated models with a large number of equations,
unknowns and parameters. In this example, increasing the grid size leads to
more accurate results but it considerably increases the computation time. In
a broader model, computation time can be a serious challenge as it may be
days, weeks or sometimes even more. Hence there is always this trade-off when
solving models numerically.

2. The cake-eating problem with CRRA utility function:

T
X ct1−σ
max β t−1
t=1
(1 − σ)
subject to

Wt+1 = Wt − ct

W1 ≥ 0, given

a) In this part you were expected to carry out analytically two iterations of
the value function iteration algorithm.
Bellman equation:
(W − W 0 )1−σ
V (W ) = max + βV (W 0 )
1−σ

1
Start with V0 = 0
W 1−σ
V1 (W ) =
1−σ
(W − W 0 )1−σ W 01−σ
V2 (W ) = max +β
1−σ 1−σ
F.O.C w.r.t W 0
−(W − W 0 )−σ + β(W 0 )−σ = 0
1
W0 = W
1 + β −1/σ
Plug this into the Bellman Equation:
 1−σ  1−σ
1 − 1+β1−1/σ W 1−σ + β 1+β1−1/σ W 1−σ
V2 (W ) =
1−σ
b) In this part you were asked to find the optimal consumption path as a
function of cake size by guess and verify approach
Guess is given as
W 1−σ
V (W ) = A
1−σ
Substitute the Bellman Equation
W 1−σ (W − W 0 )1−σ A(W 0 )1−σ
 
A = max +β
1−σ 1−σ 1−σ
From the F.O.C:
W
W0 =
1 + (βA)−1/σ
Plug this into the Bellman equation:
W 1−σ W 1−σ
W 1−σ (W − 1+(βA) −1/σ ) A( 1+(βA)−1/σ )
A = +β
1−σ 1−σ 1−σ
Rearranging this, you will find
 σ
1
A=
1 − β 1/σ
By using the first order condition, optimal consumption is:
W
C∗ = W −
1 + (βA)−1/σ
Substitute the value of A to find the optimal consumption as a function of
cake size:
C ∗ = W 1 − β 1/σ

c) In this part you were expected to plot optimal consumption path as a

function of cake size in MATLAB. You could do this simply by changing the
functional form in the script that we have worked on earlier.

2
ECON 502: Macroeconomic Theory I
METU, Fall 2018

Assignment 4
Due: 14.11.2018, 17:00

1. Assume that there exists Neoclassical production function to work the dynam-
ics of the Solow model. Show that the steady state of the Solow model de-
scribed by the Fundamental equation (difference equation) is globally asymp-
totically stable. Moreover, show that if k0 < k ∗ , then the sequence f 0 (kt ) is a
decreasing and f (kt ) − kt f 0 (kt ) is an increasing sequence. [Hint: See Proposi-
tions 2.5 and 2.6 in Acemoglu (2009).]

2. Characterize the dynamic equilibrium of the Solow/AK model where s, δ are

csts.. there is no population growth and the production function takes the
form:
F (Kt , Lt ) = AKt + BLt

3. Consider the optimal growth problem we have analyzed in class:

∞
X
max β t u(Ct )
t=0

s.t.
Ct + Kt+1 ≤ f (Kt )
0 ≤ Ct
0 ≤ Kt+1
K0 > 0
Here let u(C) = lnC and f (K) = K α with 0 < α < 1.

(a) Write down and explain the Functional Equation (FE, Bellman Equa-
tion) that defines the value function v(k) for this problem.
(b) Start with the zero function, i.e. v 0 (K) = 0 ∀K. Iterate over the function
v in the FE to find that v 1 (K) = αlnK and v 2 (K) = α(1 + α)lnK + A1
where A1 is a constant. Show that the policy function g(K) under these
iterations will converge to g(K) = αβK α .
(c) Instead of the procedure in part b), guess and verify that v(K) = a +
blnK. Find a and b.

1
ECON 502: Macroeconomic Theory I
METU, Fall 2018

Assignment 4
Sketch of Solutions by T.A. Burcu Ozgun

1. In the first part of the question you were expected to show that the steady
state of the Solow model is globally asymptotically stable.
Note first that in both parts of the question, we assume that assumptions
of continuity, differentiability, positive and diminishing marginal products,
constant returns to scale hold, as well as the Inada conditions.
Recall the fundamental equation

kt+1 = sf (kt ) + (1 − δ)kt

g(kt ) = kt+1
Notice that g 0 (kt ) exists and is strictly positive for all k.
At steady state,
k ∗ = g(k ∗ )
For any strictly concave differentiable function, we have

f (k) > f (0) + kf 0 (k) = kf 0 (k)

This implies
δ = sf (k ∗ )/k ∗ > sf 0 (k ∗ )
g 0 (k ∗ ) = sf 0 (k ∗ ) + 1 − δ < 1
Hence,
0 < g 0 (k ∗ ) < 1
This establishes local asymptotic stability.
Now move on to the proof of global stability:
Z k∗
∗ ∗
kt+1 − k = g(kt ) − g(k ) = − g 0 (k)dk < 0
kt

since g 0 (k) > 0 for all k.

kt+1 − kt f (kt ) f (k ∗ )
=s −δ >s ∗ −δ =0
kt kt k

1
 Hence, kt ∞
t=0 must monotonically converge to k
∗

In the second part of the question, you were expected to show that if k0 < k,
then the sequence f 0 (kt ) is a decreasing and f (kt ) − kt f 0 (kt ) is an increasing
sequence.

∂f 0 (kt )
= f 00 (kt ) < 0
∂kt
For all k < k ∗ given the assumptions at the beginning of the question hold.
This establishes that f 0 (kt ) is a decreasing sequence in k.

∂f (kt ) − kt f 0 (kt )
= f 0 (kt ) − f 0 (kt ) − kt f 00 (kt ) = −kt f 00 (kt )
∂kt
Given the assumptions at the beginning of the question hold, f (kt ) − kt f 0 (kt )
is an increasing sequence in k for all k < k ∗ .

2. Here you were expected to characterize the dynamic equilibrium of the growth
model whose production function is given as:

F (Kt , Lt ) = AKt + BLt

To characterize the dynamic equilibrium let’s first derive the fundamental
equation for the given case.
St = Yt − Ct
Given that households save a constant fraction s ∈ (0, 1) of their income;

St = sYt

Ct = (1 − s)Yt
Ct + It = Yt
Hence the fundamental law of motion

Kt+1 = sYt + (1 − δ)Kt

Plug in the functional form of Yt

Kt+1 = s(AKt + BLt ) + (1 − δ)Kt

In per capita terms:

kt+1 = sAkt + sB + (1 − δ)kt

Here it would be nice to discuss the properties of this equation for different
cases regarding the constants of the model. But writing the fundamental law
of motion correctly is enough for the full credit for this question.

2
 3. Optimal growth problem with u(C) = log C and f (K) = K α
a) Bellman Equation

V (K) = max{log(K α − K 0 ) + βV (K 0 )}

b) Value function iteration and finding the policy function

V1 (K) = max{log(K α − K 0 ) + βV0 (K 0 )}

Start with V0 (K 0 ) = 0, and notice that maximum occurs at K 0 = 0

V1 (K) = log(K α )K)

Continuing to iterate

V2 (K) = max{log(K α − K 0 ) + βV1 (K 0 )}

V2 (K) = max{log(K α − K 0 ) + βα log(K 0 )}

F.O.C.:
−1 αβ
0
+ 0 =0
Kα −K K
αβK α
K0 =
1 + αβ
Plugging this in and rearranging,

V2 (K) = log(K)α(1 + αβ) + constants

Continuing to iterate, you will find

0 αβ(1 + αβ)K α
K = (1)
1 + αβ + α2 β 2

Notice the pattern in the equation of K 0 and write the general formula for
iteration j: Pj−1 i
0 i=1 (αβ)
K = Kα
1 + j−1
P i
i=1 (αβ)
As j → ∞ we have K 0 = g(K) = αβK α

c) In this part, you were expected to use guess and verify approach.

V (K) = a + b log(K)

Substituting the guess, the functional equation becomes:

a + b log(K) = max{log(K α − K 0 ) + β(a + b log(K 0 ))}

3
F.O.C.:
bβK α
K0 =
1 + bβ
Plug this into the functional equation:

a + b log(K) = α log(K) − log(1 + bβ) + βa + βb log(βb) − βb log(1 + βb) + βbα log(K)

Equating the coefficients:

α
b=
1 − αβ
bβ log(bβ) − log(1 + bβ)(1 + bβ)
a=
1−β

4
 Middle East Technical University
Department of Economics
ECON 502-Macroeconomic Theory I
Fall 2018-2019

MIDTERM II, 12th Dec. 2018

Ebru Voyvoda

1. Consider the following model of growth. Output production at the firm level is given by:

Yi (t) = Ki (t)α (B(t)Li (t))1−α

with i denoting the index of firm i. From each firm i’s point of view B(t) is given. Hence,
aggregate production function for this economy can take the form:

Y (t) = K(t)α (B(t)L(t))1−α

We are considering a decentralized economy where wage rate is denoted by w(t) and profit
rate by r(t). Suppose that depreciation rate of the capital stock, δ = 0.

On the demand side, we consider an infinitely-living representative household which

maximizes lifetime utility. The discount rate is given by ρ, A(t) denotes the accumulated
asset stock of the household at time t. Assume that per-period utility function, u(Ct ) = lnCt .

(a) (4p) Assume that productivity level at time t takes the form: B(t) = BY (t)γ B > 0, 0 <
γ ≤ 1. Can you give an economic interpretation of this assumption about productivity?
Explain shortly.

ANSWER: The (labor-augmenting) productivity level is an increasing function of

aggregate output Y (t) for each firm. hence, aggregate output works as a (positive)
externality to output production of each firm (and at the aggregate) since the firm does
not take any action to choose the level of productivity. This phenomenon serves as the
”learning by doing”’ effect in the literature.

1
(b) (8p) Derive the equilibrium factor prices, w(t) and r(t) under the assumption for the
dynamics of B(t).

ANSWER: Since Y (t) = K(t)α (B(t)L(t))1−α , and each factor is paid its marginal
product, we have:

Y (t) = K(t)α (B(t)L(t))1−α

Y (t) = K(t)α (BY (t)γ L(t))1−α

Y (t)1−γ(1−α) = K(t)α L(t)1−α

α 1−α
Y (t) = K(t) 1−γ(1−α) L(t) 1−γ(1−α)

and,
∂Y (t)
r(t) =
∂K(t)
∂Y (t)
w(t) =
∂L(t)

from above. [Find the two expressions]

(c) (4p) Suppose that the model described leads to endogenous growth. What should be the
assumption on γ to ensure that the model is generating endogenous growth dynamics?
Explain.

ANSWER: For model to describe endogenous growth, the returns to capital (M PK )

should be bdd. away from zero (or should escape the diminishing returns, WHY?).
Here,
∂Y (t)
r(t) =
∂K(t)
α α 1−α
= K(t) 1−γ(1−α) −1 (BL(t)) 1−γ(1−α)
1 − γ(1 − α)
α ∂Y (t)
Hence, 1−γ(1−α) − 1 = 0 implies ∂K(t) = cst. Therefore γ = 1.

(d) (6p) Write down the problem faced by the representative consumer.

ANSWER: Write the maximization problem. Note here that the decentralized model
implies the budget constraint:

at+1 − at = rt at + wt − ct

Note that the problem you have written down above leads to the following Euler
equation:
(1 + r)
[1/Ct ] = [1/Ct+1 ]
(1 + ρ)

2
(e) (8p) Suppose that γ satisfies the property to achieve endogenous growth under the model
specification. Derive the Balanced Growth Path (BGP) growth rate of the economy.

ANSWER: Since γ is found to be equal to 1 for endogenous growth, from the FOC
above,
ct+1 (1 + rt )
=
ct (1 + ρ)
1−α
1−α 1+(BL) α
Here, rt = (BL) α . Substituting, g = 1+ρ .

(f) (5p) Is the decentralized solution Pareto Optimal? Explain why/why not.

ANSWER: No, the externality causes a lower output (lower investment to K) than
optimum. WHY?

3
 Middle East Technical University
Department of Economics
ECON 502-Macroeconomic Theory I
Fall 2017-2018

Midterm II, 25th Dec. 2017

Ebru Voyvoda

1. Consumption Theory (25p)

Consider a household with the following quadratic utility:

α 2
u(ct ) = ct − ct α ≥ 0
2

Household has an optimization problem with horizon T , finite, of maximizing discounted

1
sum of utilities. Let the discount factor β = 1. Also assume 1+r = β. The life-time budget
constraint of the household as of time 0 then will be as follows:
T T
X yt X ct
a0 + E0 = E0
t=0
(1 + r)t t=0
(1 + r)t

where yt is the labor income of the household at time t. The labor income in period t is the
source of uncertainty in the model and is only revealed in period t. The Euler equation of
this model is given by:

u0 (ct ) = β(1 + r)Et [u0 (ct+1 )], ∀t ≤ T − 1

(a) (5p) Find the exact form of the Euler equation, under the given setup of the model
above. Give an economic interpretation of the Euler equation you have derived.

(b) (5p) Show that:

T
!
1 X
c0 = a0 + E0 [yt ]
T +1 t=0

and
T
!
1 X
c1 = a1 + E1 [yt ]
T t=1

(c) (10p) Now suppose that in period 0, the government makes and announcement that all
the households in the economy will be provided with a subsidy S from t = 1 until T .
Derive the consumptions in period 0 and period 1.

(d) (5p) How would you explain the differences between the consumptions in part b) and
part c)? Comment briefly.

1
2. RBC Theory and Application (33p)

Consider a RBC model with the following setup:

∞
X
β t [ln(ct ) − θln(1 − lt )]


maxct ,lt
t=0

subject to

ct + it = yt (1)

kt+1 = it + (1 − δ)kt (2)

yt = ezt ktα lt1−α (3)

ct ≥ 0, lt ∈ [0, 1], k0 > 0, given (4)

(5)

There is no population growth in the model.

(a) (5p) Describe the problem above and the constraint in words. Explain why the problem
is a social planner’s problem.

(b) (10p) Derive the FOC(s) of the planner’s problem above. Give the economic intuition
of each of the FOC(s) that you have derived.

(c) (5p) Assume now that zt = 1 ∀t, i.e. there is no technology growth. Derive the steady
state relationships from the FOC’s you have found in part b).

(d) (9p) Can you suggest method(s) to calibrate the parameters (α, β, δ) for this model?
Clearly explain the method(s) you follow.

(e) (4p) Assume that the households in this economy suddenly experience a patience shock,
i.e. they become much more impatient with β rising to 0.99. All other parameters
remain unchanged. How would the ss values of c, y, i, k change. Comment of the effects
of impatience shock on the ss of this economy.

2
3. Investment (42p)

Consider a firm supplying in a certain sector with the production technology:

yt = Ktα L1−α
t 0<α<1

with Kt and Lt capital and labor inputs at time t. Suppose that the real wage rate w in this
economy is given to the firm exogenously and is constant. There is also firm-level demand
given by y d .

[You may think that y d = p− Y /n, a downward sloping industry-level demand function with
 price elasticity and n large number of firms in the industry. Assume industry-level demand
Y is constant and p is fixed for simplicity.]

The increase in capital stock of the firm is given by:

K̇t = It + (1 − δ)Kt 0 < δ < 1; K0 > 0

There is capital adjustment cost given by the following properties:

C(0) = C 0 (0) = 0; C 00 (I) > 0

Finally assume that the firm’s revenue flow at time t is given by:

Rt = py d − wLt − It − C(It )

(a) (2p) To satisfy demand, what level of labor does the firm need? Write down the firm’s
demand for labor Lt as a function of (Kt , y d ).

(b) (4p) Suppose, as of time zero, and subject to the constraint of the dynamics of capital
stock, the firm maximizes the following:
Z ∞
V0 = e−rt [py d − wLt (Kt , y d ) − It − C(It )]dt
t=0

Here r is the constant (real) interest rate.

Write down the full decision problem of the firm (the objective and the constraints).
Explain briefly the decision problem of the firm.

(c) (8p) Defining the corresponding variable q, write down the necessary FOC(s). Note
that you can write down the Hamiltonian of the above problem as:

H(Kt , It , qt , t) = e−rt [py d − wLt (Kt , y d ) − It − C(It )] + qt (It − δKt )

3
(d) (3p) Note that you can write down the necessary transversality condition as:

limt→∞ e−rt Kt qt

Interpret this condition.

(e) (3p) Show that the optimal investment level of the firm, It can be written as an implicit
function of qt . Call this function M .

(f) (6p) Show that the FOC’s you have derived leads to the following two equations
governing the dynamics of the decision of the firm:

K̇t = M (qt ) − δKt

with M (1) = 0, M 0 (qt ) > 0.

 −1
 1−α
α Kt
q̇t = (r + δ)qt − w
1−α yd
(g) (8p) Construct a Phase Diagram for (K, q) dynamics. For a given level of K0 , comment
of how the movement of (Kt , qt ) pair along the optimal path.

(h) (4p) Assume initially that the firm is operating under the conditions of the steady state.
Then, unexpectedly, the interest rate r increases to a new constant level r(new) > r(old).
Suppose this increase is expected to be permanent. Show on a phase diagram the new
and the old ss’s, what happens at the time of the shock and what happens through time
during the transition. Comment on your graph.

(i) (4p) Can you also comment on what would happen, at the same time of the shock to
interest rate, there is also a permanent decrease in demand y d , i.e. y d (new) > y d (old).
You have to think about the combined impact of both the shock to r and to y d , instantly
and through time.

4
 Middle East Technical University
Department of Economics
ECON 502-Macroeconomic Theory I
Fall 2018-2019

MIDTERM II, 12th Dec. 2018

Ebru Voyvoda

1. Consider a household with an optimization problem with horizon T , finite, of maximizing

discounted sum of utilities. Let the discount factor 1/(1 + ρ). Assume that the household
has the following flow-budget constraint:

At+1 = (1 + r)(At + Yt − Ct )

where At is the value of household assets, Yt is disposable labor income, and Ct is consumption
expenditures. The labor income in period t is the source of uncertainty in the model and is
only revealed to the consumer in period t.

With the flow-budget constraint above, the life-time budget constraint of the household as
of time 0 then will be as follows:
T T
X Yt X Ct
A0 + E 0 = E0
t=0
(1 + r)t t=0
(1 + r)t

(a) (5p) With u(Ct ) indicating the per-period utility function, show that the Euler equation
takes the form:
(1 + r)
u0 (Ct ) = Et [u0 (Ct+1 )], ∀t ≤ T − 1
(1 + ρ)
(b) (4p) Suppose the utility function above takes the quadratic one with:
α 2
u(Ct ) = Ct − Ct α ≥ 0
2
Suppose, r = ρ = 0. Find the exact form of the Euler equation, under the given utility
function. Give an economic interpretation of the Euler equation you have derived.

(c) (12p) Show that in this case:

T
!
1 X
C0 = A0 + E0 [Yt ]
T +1 t=0
and
T
!
1 X
C1 = A1 + E1 [Yt ]
T t=1

(d) (8p) Assume now that at t = 0 the household expects no payment of taxes/subsidies.
Suppose also that at time t = 1 the government levies an income tax, T on the household,
totally coming at a surprise. From time t = 2 on no taxes are levied. What would be
the consumptions at time t = 0 and 1 under this new condition? Derive C0 and C1 .

1
(e) (6p) How would you explain the differences between the consumptions in part b) and
part c)? Comment briefly.

2
2. Consider the following model of growth. Output production at the firm level is given by:

Yi (t) = Ki (t)α (B(t)Li (t))1−α

with i denoting the index of firm i. From each firm i’s point of view B(t) is given. Hence,
aggregate production function for this economy can take the form:

Y (t) = K(t)α (B(t)L(t))1−α

We are considering a decentralized economy where wage rate is denoted by w(t) and profit
rate by r(t). Suppose that depreciation rate of the capital stock, δ = 0.

On the demand side, we consider an infinitely-living representative household which

maximizes lifetime utility. The discount rate is given by ρ, A(t) denotes the accumulated
asset stock of the household at time t. Assume that per-period utility function, u(Ct ) = lnCt .

(a) (4p) Assume that productivity level at time t takes the form: B(t) = BY (t)γ B > 0, 0 <
γ ≤ 1. Can you give an economic interpretation of this assumption about productivity?
Explain shortly.

(b) (8p) Derive the equilibrium factor prices, w(t) and r(t) under the assumption for the
dynamics of B(t).

(c) (4p) Suppose that the model described leads to endogenous growth. What should be the
assumption on γ to ensure that the model is generating endogenous growth dynamics?
Explain.

(d) (6p) Write down the problem faced by the representative consumer.

Note that the problem you have written down above leads to the following Euler
equation:
(1 + r)
[1/Ct ] = [1/Ct+1 ]
(1 + ρ)
(e) (8p) Suppose that γ satisfies the property to achieve endogenous growth under the model
specification. Derive the Balanced Growth Path (BGP) growth rate of the economy.

(f) (5p) Is the decentralized solution Pareto Optimal? Explain why/why not.

3
3. Consider a two-period decentralized OLG model where an individual born in period t has
the following utility function:

1
Ut = ln c1,t + ln c2,t+1
1+ρ

Competitive firms produce according to the CES production technology; wt denoting wager
rate and rt denoting profit rate at time t.

Yt = F (Kt , Lt ) = [Ktα + Lα
t]
1/α
0<α<1

(a) (6p) Write down the life-time budget constraint of a representative consumer.

(b) (8p) Derive the saving function for this consumer.

(c) (6p) How does capital per labor evolve over time for this economy? Derive the
fundamental equation for this OLG model. Comment on the dynamics of capital stock
per labor.

4. (10p) Consider the Uzawa-Lucas framework. Suppose that initially the economy is at its BGP.
Now, compare two shocks (i) a natural disaster, which destroys only physical capital,(ii) an
epidemic, which destroys only human capital. Do we expect a difference in how the growth
rate of consumption changes following the shocks in (i) and (ii)? Explain.

4
 Middle East Technical University
Department of Economics
ECON 502-Macroeconomic Theory I
Fall 2017-2018

MIDTERM, 23rd Nov. 2017

Ebru Voyvoda

Short Questions
1. (15p, 5p each) We have overviewed in class how the two main schools of thought, the Classical
school and the Keynesian school consider the (short-run) fluctuations in a macroeconomic
environment.

(a) What do you think is the ONE major difference between these two schools of thought
in understanding the changes in output (in the short-run)?

(b) What is the difference between a demand shock and a supply shock? Can you give two
examples each?

(c) What is an endogenous variable vs. an exogenous variable? Explain.

2. In the last decade the income gap between developed economies and emerging economies has
been reduced.

(a) (5p) Would this be in line with the forecasts of the AK model? Explain briefly.

(b) (5p) Would this be in line with the forecasts of the basic Solow model? Explain briefly.

3. Consider an OLG model of 2-periods with (exogenous) wage income w > 0 is given to the
working young. There is no labor income in the second period of the lives of individuals. The
(exogenous) interest rate on savings is r. The representative agent of generation t maximizes:

U (c1t , c2t+1 ) = ln(c1t ) + βln(c2,t+1 ) 0<β<1

There is a government trying to decide on a compulsory pension system where each agent
shall contribute with a lump-sum amount of τ when young with the return of a pension of
P = (1 + r̃)τ when old. Now suppose the government is much well informed (about the
financial markets) than the agents in the economy s.t. r̃ > r.

(a) (5p) How will the pension system change the lifetime (intertemporal) budget constraint
of the individuals? Show and comment.

(b) (5p) Will the change you have documented in part a have an effect on the optimal
consumption path of the individuals? Show and comment.

1
 Longer Questions

4. Consider the standard Ramsey growth model. There is a single representative agent. Time
begins in period t and lasts forever. The initial capital stock, Kt is given, and total factor
productivity, At , is exogenous and constant in each period. There is no exogenous growth
of population and labor is supplied inelastically, and can be normalized to one each period
(e.g. Lt+j = 1). Lifetime utility of the representative agent as of time t is:

∞
X
Ut = Et β j u(Ct+j )
j=0

The aggregate resource constraint of the economy is:

Kt+j+1 = At+j F (Kt+j , Lt+j ) − Ct+j + (1 − δ)Kt+j

The function F (Kt+j , Lt+j ) is increasing and concave in both arguments, and homogenous
of degree 1.

(a) (6p) State the choice variable(s) of this problem. Find the first order conditions for a
maximum of the social planner’s problem.

(b) (3p) Now, suppose instead of social planner’s problem, we consider a decentralized
version of the economy. In particular, the household supplies capital and labor to a
representative firm at market prices Rt and wt , respectively. Both the household and
the firm take these prices as given. The household accumulates capital and rents it to
the firm. The firm faces a static problem and want to maximize profit, where per-period
profit is given by:

Πt+j = At+j F (Kt+j , Lt+j ) − Rt+j Kt+j − wt+j Lt+j

Find the FOC’s for a maximum of the firm’s problem.

(c) (5p) The household owns the capital stock. It receives income from labor, from
renting capital, and distributed profit (household takes this as given). The households
either consumes or saves her income. Total savings define total investment, hence the
accumulation of capital in this economy. The lifetime utility is as given above.

Write down the representative household’s budget constraint. Explain.

(d) (6p) Find the FOC’s associated with the household’s maximization problem.

(e) (5p) Argue that the resulting allocations from the competitive equilibrium will be
identical to the allocations from the planner’s solution.

2
5. Consider an OLG model with no population growth and with consumers that maximize:

ln(c1t ) + ln(c2t+1 )

where the initial old are endowed with k0 units of physical capital and b0 units of government
debt (just to keep the economy going). Agents work when young (supply their labor
inelastically) for the wage rate of wt and the interest rate (return on capital) is given to
be rt . The output is produced by capital and labor each period in accordance with the
technology:

yt = Akt + lt

Hence the resource constraint of the economy (goods market equilibrium) at time t be:

c1t + c2t + kt+1 + gt = yt

with gt denoting government consumption at time t.

The government each period taxes labor income (at a rate τt ), issues bonds bt , uses the
revenues to pay for government consumption and interest payments of debt outstanding each
period:

bt + τt wt lt = gt + (1 + rt−1 )bt−1

(a) (5p) Write down the utility maximization problem of the representative household of
generation t.

(b) (5p) Derive the household’s consumption and saving functions.

(c) (5p) How would you define (the elements of) competitive equilibrium for this economy?
Explain each condition. (You may assume gt and τt as given and government debt
balances the government budget each period).

(d) (5p) Solve for the steady state dynamics of the physical capital and the government
debt in this economy. Comment.

3
6. Consider the following model of optimal growth:
∞
X
max β t U (Ct )
t=0

subject to

Kt+1 = (1 + α)(Kt − Ct )

with 0 < β < 1, α > 0 and U (Ct ) = ln(Ct ). There is no population growth, Lt = L̄ ∀t.

(a) (5p) Write down the Bellman equation for the problem defined above.

(b) (8p) Show that value function of the form V (K) = A + Eln(K) satisfies the Bellman
equation.

(c) (7p) Derive the values of A and E as functions of α and β.

4
ECON 502: Macroeconomic Theory I
METU, Fall 2018

Problem Set 1
This problem set is for self-study, for the upcoming midterm exam. Solutions will not
be provided. Questions are straightforward, i.e., there are no tricks. Hence, following the
lecture notes, you should be able to solve them all. If you still can’t, you can visit either
Prof. Ebru Voyvoda or T.A. Burcu Ozgun for your questions during their office hours.

1. Consider the exogenous growth model in which production function is given as

Yt = AKtα Lt1−α

where Lt+1 = (1 + n)Lt and α ∈ (0, 1).

(a) Find the dynamical system (describing the evolution of kt over time) under
the assumption that the saving rate is s ∈ (0, 1) and the depreciation rate is
δ ∈ (0, 1].
(b) What is the growth rate of kt ≡ (kt+1 − kt )/kt
(c) Find the steady state level of the stock of capital per worker k, income per
worker y and consumption per capita c.
(d) Find the Golden Rule value of k.
(e) What saving rate is needed to yield the Golden Rule?
(f) Find the elasticity of y with respect to s (in steady-state).

2. In the basic Solow model:

(a) How does the growth rate depend on how far a country’s economy is from the
steady state?
(b) How does the growth of GDP per capita respond to an increase in the savings
rate?

3. In the Uzawa-Lucas model set-up, how the growth rate of consumption changes
following a natural disaster, which only destroys physical capital, compared with
an epidemic, which only destroys human capital?

1
4. Consider a standard two period OLG model. Firms rent capital and labor so as to
maximize period profits. The production function is F (K, L) = K α L1−α . Capital
does not depreciate. At time t, (1 + n)t households are born. They supply one unit
of labor inelastically when young. Preferences are ln(cyt ) + β ln(cot+1 ). The budget
constraints are wt = cyt + st and cot+1 = (1 + rt+1 )st

(a) Solve the household’s problem, given prices.

(b) Find the steady state capital-labor ratio.
(c) Is the steady state unique and stable?
(d) Discuss the effects of a one-time increase in the size of the young generation.

5. Consider the canonical Diamond OLG model where an individual born in period t
has the following utility function
1
Ut = log c1,t + log c2, t + 1
1+ρ
where ρ < −1 and the budget constraints are

c1,t + st = wt

c2,t+1 = (1 + rt+1 )st

Competitive firms produce according to the Cobb-Douglas production

Yt = F (Kt , Lt ) = Ktα L1t − α

(a) Show that individual utility maximization implies

1
st = wt
2+ρ

(b) Show that capital per unit of labor evolves according to

1 1
kt+1 = (1 − α)ktα
1+n2+ρ

(c) Show that it cannot be ruled out that the steady state is dynamically ineffi-
cient.
(d) Assume that in period t0 a fully funded pension system is introduced according
to which a fraction, τ ∈ (0, 1), of wage income is collected from each young
individual. The contribution is invested in physical capital, thereby earning a
rate of return equal to the interest rate, and the contribution including interest
is paid as a pension when the individual get old. Analyze and explain how this
will affect consumption, savings and capital accumulation in the economy.

2
6. Consider the canonical Diamond OLG model. Assume that utility is logarithmic
and production is Cobb-Douglas; f (k) = Ak α , α ∈ (0, 1). Show how the following
changes in parameters affect the capital accumulation schedule kt+1 (kt ).
(a) An increase in the rate of population growth, n.
(b) A fall in A.
(c) An increase in the share of capital in production, α.
7. Consider the following production function.
(
K2
6Kt − Ltt Kt /Lt ≤ 2
Yt = F (Kt , Lt ) =
2Kt + 4Lt Kt /Lt > 2

(a) Show that this production function is characterized by constant returns to

scale.
(b) Calculate the share of labor income as a function of kt .
(c) Find the dynamical system for the Solow model under the assumption that
the saving rate s = 1/3. Show that there exists a unique, globally stable,
non-trivial steady state.
(d) Find the dynamical system of the OLG model (where individuals work intheir
first life period and retire in the second). Assume utility is a function of only
second period consumption (that is, individuals save their entire first period
income). Is the non-trivial steady state unique and globally stable?
(e) Why do the two models generate results that are qualitatively different?

8. Assume that a household has the following budget constraint

At+1 = (1 + r)(At + Yt − Ct )
where At is the value of household assets, Yt is disposable labor income, and Ct is
consumption expenditures.
(a) Derive the inter-temporal budget constraint:
∞ ∞
X Et Ct+k X Et Yt+k
k
= At +
k=0
(1 + r) k=0
(1 + r)k

(b) State the assumptions required to derive the random walk hypothesis that
expected changes in consumption should be unpredictable, i.e., that Ct =
Et Ct+1 and sketch out how this result is derived.
(c) Show that the random walk hypothesis implies that current consumption de-
pends on current assets and on current and expected future labor income.
(d) Now suppose that consumers expect disposable labor income to grow at rate
g forever (where g < r). Maintaining the random walk assumption, what does
this imply for the relationship between consumption, labor income and assets?

3
 9. Does a consumer with preferences u(c) = c − αc2 save more as her future income
becomes more uncertain?

10. Consider the following infinite horizon economy in discrete time that admits a
representative household with preferences at time t = 0 as:
∞
C(t)1−θ − 1
X  
t
U (0) = β
t=0
1−θ

where C(t) is consumption, and β ∈ (0, 1). Total population is equal to L and there
is no population growth and labor is supplied inelastically. The production side of
the economy consists of a continuum 1 of firms, each with production function:

Yi (t) = F (Ki (t), A(t)Li (t))

where Li (t) is employment of firm i at time t, Ki (t) is capital used by firm

R 1 i at time
t and A(t) is a common technology term. Market clearing implies that 0 Ki (t)di =
R1
K(t), where K(t) is the total capital stock at time t, and 0 Li (t)di = L(t). Assume
that capital fully depreciates, so that the resource constraint of the economy is:
Z 1
K(t + 1) = Yi (t)di − C(t)
0

Assume also that labor-augmenting productivity at time t, A(t), is given by:

A(t) = K(t) (1)

(a) Explain Equation (1) and why it implies an externality.

(b) Define a competitive equilibrium (where all agents are price takers) for this
model economy.
(c) Show that there exists a unique balanced growth path competitive equilibrium,
where the economy grows (or shrinks) at a constant rate every period. Provide
a condition on F , β and θ such that this growth rate is positive.

4
 C.3. Consider the following two-sector economy with two types of firms producing in-
vestment and consumption goods using the following technologies:

α 1−α
Ct = Kc,t Lc,t
α 1−α
It = γKi,t Li,t

where Kt = Kc,t + Ki,t and Lt = Lc,t + Li,t are capital and labor services and γ is the
productivity parameter in investment good sector, and the aggregate law of motion for the
total in the economy is;
Kt+1 = (1 − δ)Kt + It

where, δ is the depreciation rate of capital, equal in both sectors. Infinitely living households
maximize the following lifetime utility;
∞
X
β t u(ct )
t=0

Households own the capital and rent it to firms. Let wc,t , wi,t and Rc,t Ri,t be the wage
rate and gross rental rate for capital in respective sectors. Let the consumption good be the
numeraire in each period and q be the relative price of investment good.
a. (7 points) Formulate the problem of maximizing the representative consumer’s utility
subject to budget constraint as a well defined recursive problem. What are the individual and
aggregate state variables? (Hint: Note that capital and labor is perfectly mobile between the
two sectors). Write down the problem of the representative firm in investment good sector,
and the optimality conditions that characterize the solution to their problem.
b. (5 points) Define the RCE of this economy, be precise.
c. (8 points) Write down the first order condition, envelope condition for the representa-
tive household, derive the Euler equation.
d. (5 points) Solve for the steady state of this economy (i.e. impose steady state condition
on all relevant variables x0 = x) and find the equilibrium price of investment good, q ∗ .

11