Module 3, 2022 Valery Charnavoki

Computational Macroeconomics

Problem Set 3 Deadline: March 6th, 2022

Problem: Aiyagari model with endogenous labour

Part 1. Individual household’s policy function (2 points)
Let labor efficiency s evolves according to Markov chain with two states {u = 0.1, e = 1}
and transition matrix:
 
0.5 0.5
Π=
0.1 0.9
If the realization of the process at t is s̄i , then at time t the household receives labor
income ws̄i lt , where lt is labour supply.
We constrain holdings of a single asset to a grid A = [amin , a1 , a2 , . . . , amax ]. For given
values of (w, r) and given initial values (a0 , s0 ) the household chooses {at+1 , ct , lt }∞t=0 to
maximize:
∞ γ 1−γ 1−σ
t [ct (1 − lt ) ]
X
E0 β (1)
t=0
1−σ
subject to
ct + at+1 = (1 + r)at + wst lt
(2)
at+1 ∈ A
where β = 0.96, σ = 1.5, γ = 0.7, amin = 0 and amax = 3.
1. Write Bellman equation for this problem.
2. Write MATLAB function computing for any values of (w, r) policy functions
a0 = g a (a, s; r, w), c = g c (a, s; r, w) and l = g l (a, s; r, w) using value function
iteration (VFI) algorithm.

Part 2. Invariant distributions of Markov chains (3 points)

Define the unconditional distribution of (at , st ) pairs, λt (a, s) = P (at = a, st = s). The
exogenous Markov chain Π on s and the optimal policy function a0 = g a (a, s; w, r)
induce a law of motion for the distribution λt , namely,
XX
λt+1 (a0 , s0 ) = λt (a, s)Π(s, s0 )I(a0 , s, a) (3)
a s

where we define the indicator function I(a0 , s, a) = 1 if a0 = g a (a, s; w, r), and 0

otherwise.
1. Write MATLAB function constructing for any values of (w, r) Markov chain for
the joint evolution of (a, s) and compute its invariant distribution.
2. For any given values of (w, r) plot conditional invariant distributions of a for s = u
and s = e.

1
Part 3. Stationary equilibrium of Aiyagari model (5 points)
The aggregate production function determines the rental rates on capital r + δ and labor
w from the marginal conditions
   α
K K
w = (1 − α)
L L
   α−1 (4)
K K
r =α −δ
L L

where α = 0.3 is capital income share, K is aggregate capital, L is aggregate labour and
δ = 0.1 is depreciation rate.
Write MATLAB program computing stationary equilibrium of Aiyagari model with
endogenous labour, i.e. aggregate capital K, aggregate labour L, real interest rate r and
real wage w, policy functions of households a0 = g a (a, s), l = g l (a, s) and invariant
distribution λ(a, s), such that:
X
K = g a (a, s)λ(a, s)
a,s
X
L = sg l (a, s)λ(a, s)
a,s

1. For fixed value of K

L
= k = kj with j = 0, compute (w, r) from equation (4), then
solve the household’s optimum problem. Use the optimal policy gja (a, s) to deduce
an associated stationary distribution λj (a, s).

2. Compute the average values of capital and labour associated with λj (a, s), namely,
X
Kj∗ = gja (a, s)λj (a, s)
a,s
X
L∗j = sgjl (a, s)λj (a, s)
a,s

3. For a fixed relaxation parameter ξ ∈ (0, 1), compute a new estimate of k from

Kj∗
kj+1 = ξkj + (1 − ξ) (5)
L∗j

4. Iterate on this scheme to convergence.