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Topic 1: Introduction To Intertemporal Optimization: Yulei Luo
Topic 1: Introduction To Intertemporal Optimization: Yulei Luo
Yulei Luo
SEF of HKU
September 6, 2013
subject to
x (t + 1) x (t ) = f (c (t ) , x (t ) , t ) , (2)
x0 = x (0) , x (T + 1) 0 , (3)
for any t 0.
∂L
= rx0 (ct +1 , xt +1 , t + 1) + λt +1 fx0 (ct +1 , xt +1 , t + 1)
∂xt +1
+λt +1 λt = 0,
for t = 0, ,T 1.
at + 1 = ( 1 + r ) a t ct . (8)
subject to
∂L
The FOC for ct is ∂ct = 0:
λ T +1 0, aT +1 0, aT +1 λT +1 = 0, (15)
which means that either the asset holdings (a) must be exhausted on
the terminal date, or the shadow price of capital (λt ) must be 0 on
the terminal date. Since u 0 > 0, the marginal value of capital (λ)
cannot be 0 and thus the capital stock should optimally be exhausted
by the terminal date T + 1, i.e., aT +1 = 0.
a1 = Ra0 c0 ,
a2 = Ra1 c1 ,
aT +1 = RaT cT .
aT + 1 c c1
T
+ TT + + + c0 = Ra0 =)
R R R
T
ct
∑ Rt = Ra0 , (20)
t =0
R t +1 β t
ct = a0 (22)
1+β+ + βT
where t = 0, , T . Given ct , it is straightforward to determine the
time path of at :
R t +1 β t
at +1 = Rat ct = Rat a0 , (23)
1+β+ + βT
where t = 0, , T and aT +1 = 0.
Luo, Y. (SEF of HKU) ECON6012: Macro Theory September 6, 2013 15 / 56
(conti.) Consider an important special case, βR = 1. In this case,
(18) implies that c0 = c1 = = cT ,
1
c0 1 + + = Ra0 =)
RT
R 1
ct = a
(T +1 ) 0
. (24)
1 R
where t = 0, ,T.
Next, the optimal path of at can be derived by solving the following
di¤erence equation:
r
at +1 = Rat ct = Rat a
(T +1 ) 0
=)
1 R
1 1
at = 1 (T +1 )
a0 R t + a ,
(T +1 ) 0
(25)
1 R 1 R
where we have used the fact that aT +1 = 0. That is, we may write
the Lagrangian as follows
!
T T
ct
L = ∑ β u (ct ) + λ Ra0 ∑ t ,
t
t =0 t =0 R
1
β t u 0 ( ct ) = λ , where t = 0, ,T. (26)
Rt
Since λ is a constant, the above FOCs implies that the Euler
equations are
t =0 t =0 R
Suppose that the utility function is log, u (ct ) = log ct . (31) implies
that ct = ( βR )t c0 , 8t 1. Substituting them into the (30a) gives
!
∞ ∞
( βR )t
∑ R t c0 = Ra0 =) ∑ βt c0 = Ra0 =)
t =0 t =0
c0 = R ( 1 β ) a0 , (33)
ct = ( βR )t c0 = ( βR )t R (1 β ) a0 , 8 t 1. (34)
at +1 = Rat ( βR )t R (1 β ) a0 .
u 0 ( ct ) βJ 0 (Rat ct ) = 0. (38)
γ γ R
ct = βA (Rat ct ) , or ct = at . (44)
1 + ( βA)1/γ
a1 γ c (a )1 γ (Ra c (a))1 γ
A = + βA , (45)
1 γ 1 γ 1 γ
1
A = γ, (46)
1/γ 1 1/γ
β β R 1
ct = ( βR )1/γ β 1/γ
R1 1/γ
1 at , (47)
subject to e
x = g (x, c ) with x given, starting from any bounded and
continuous initial V0 .
3 There is a unique and time-invariant optimal policy of the form
c = h (x ), where h is chosen to maximize the right side of (51).
4 The limiting value function V is di¤erentiable.
There are three main types of solution methods for solving DP.
1 Guess and verify. It involves guessing and verifying a solution V to
the Bellman equation.
2 Value function iteration. It proceeds by constructing a sequence of
value functions and associated policy functions. The sequence is
created by iterating on the following equation, starting from V0 = 0,
and continuing until Vj has converged:
subject to e
x = g (x, c ) with x given.
3 Policy function iteration (or Howard’s improvement algorithm).
First, consider an initial guess for the value function V0 (x ). (It does
not matter very much and we usually guess it is 0.)
Second, one can then calculate an updated value function V1 (x )
using:
V1 (x ) = max fr (x, c ) + βV0 (g (x, c ))g , (58)
c
over the domain of x. Repeated this step until the sequence of the
approximate value functions converges to V (x ). Note that in the
repeated calculations of the value function, one is also calculating
repeated approximations to the policy function, c = h (x ).
Luo, Y. (SEF of HKU) ECON6012: Macro Theory September 6, 2013 35 / 56
Finite-horizon Dynamic Programming
The basic idea of …nite-horizon DP is to solve the optimization
problem period by period – starting from the terminal period, taking
the previous periods’solutions as given, and then working back
sequentially to the …rst period.
Having optimized the terminal period (T ), this solution is substituted
into the period T 1 problem and then period T 1 is optimized.
Substituting these previous solutions, the solutions for T 2, T 3,
, 0 are obtained in sequence in the same way.
Suppose that the problem is to maximize:
U (xt ) = r (xt , ct ) + βV (xt +1 ) , (60)
for t = 0, , T , subject to
xt +1 = f (xt , ct ) , (61)
with x0 given and xT +1 = x. Note that here we assume that the
value function, V (xt +1 ), is time invariant and later we can see that it
is correct.
Luo, Y. (SEF of HKU) ECON6012: Macro Theory September 6, 2013 36 / 56
Consider the problem for period T . First, we maximize
The FOC is
∂r (xT , cT ) ∂V (f (xT , cT ))
+β = 0,
∂cT ∂cT
which means that the solution for cT has the form:
cT = gT (xT ) . (63)
∂r (xt , ct ) ∂V (f (xt , ct ))
+β = 0, (67)
∂ct ∂ct
and optimal control:
ct = gt (xt ) . (68)
U ( aT 1) = u ( cT 1) + βV (aT )
= u ( cT 1) + β [ln (RaT ) + βV (0)] (71)
x (t + 1) x (t ) = f (c (t ) , x (t ) , t ) , (77)
x (t + ∆t ) x (t ) = f (c (t ) , x (t ) , t ) ∆t (78)
x (t + ∆t ) x (t )
xt0 = lim = f (c (t ) , x (t ) , t ) (79)
∆t !0 ∆t
as ∆t ! 0,
T /∆t Z T
lim ∑
∆t !0 i =0
r (c (i ∆t ) , x (i ∆t ) , i ∆t ) ∆t =
0
r (c (t ) , x (t ) , t ) dt
(81)
Hence, the continuous-time version of the dynamic optimization
problem can be written as
Z T
max r (c (t ) , x (t ) , t ) dt,
c (t ) 0
dx (t )
s.t. xt0 = = f (c (t ) , x (t ) , t ) ,
dt
x0 = x (0) , and x (T ) 0.
Luo, Y. (SEF of HKU) ECON6012: Macro Theory September 6, 2013 44 / 56
Solving the Model
where we use the fact that the rule of integration by parts implies
Z T Z T
λt xt0 dt = λt0 xt dt + λ0 x0 λ T xT (83)
0 0
Now we can regard the integral as the sum and take …rst derivatives
w.r.t. ct and xt :
0
(ii) xt = f (ct , xt , t ) for all t (The state transition equation)
(iii) Hx + λt0 = 0 rx (ct , xt , t ) + λt fx (ct , xt , t ) + λt0 = 0 for all t (The
costate (λt ) equation)
(iv) xT 0, λT 0, xT λT = 0 (The transversality condition, or the
complementary-slackness condition)
Luo, Y. (SEF of HKU) ECON6012: Macro Theory September 6, 2013 46 / 56
Continuous-time Version of the Consumption-Saving Model
subject to
at0 = rat ct , (89)
where ρ is called the discount rate, r is the instantaneous interest
rate, given a0 , and aT 0 (preventing the consumer from dying with
debts).
Here we assume that the utility function u (ct ) satis…es the usual
conditions (just like those discussed in the discrete-time case) and
ct > 0.
λt0
= r, (94)
λt
which can be easily solved for λt :
λt = λ0 exp ( rt ) . (95)
1 γ
ct 1
Suppose that u (ct ) = 1 γ . Then combining (91) with (95) gives
γ
ct = c0 γ exp ((ρ r ) t) . (96)
Since
dct u 0 ( ct ) ct
ct0 , = 00 (ρ r) = (r ρ) ,
dt u ( ct ) γ
we have
ct
at00 = rat0 + (ρ r )
γ
1
= rat0 + (ρ r ) rat at0
γ
1 1
= r (ρ r ) at0 + r (ρ r ) at , (97)
γ γ
u (ct ) exp ( ρt ) dt
∆t
Z ∞
= exp ( ρ∆t ) u (ct ) exp ( ρ (t ∆t )) d (t ∆t )
0
, exp ( ρ∆t ) J (a∆t ) . (107)