Macro II – Part A

Exercise Set - Week 1

Academic Year 2021/2022
Version: 100222

Exercise 1.1
Consider an infinite horizon economy with firms active in every interval (t, t + 1) and a
representative consumer with initial capital k0 . The consumer has time separable prefer-
ences, instantaneous utility u(c) = log(c), and discount factor β. Each firm in (t, t + 1) has
α
production function f (kt+1 ) = Akt+1 , α ∈ (0, 1), and can transform the consumption good
into capital one-to-one and and across time: kt+1 = ii (so that capital depreciates fully in
one period). (see also Section 3.1.2 of [LS])

a) Write down the sequential equilibrium formulation when in each date t the firm can sell
t
as many units of the bond as its output. Name qt+1 the date-t price of the bond with
maturity in t + 1.

b) Write down the maximization problem to be solved to find the Pareto optimal allocation.

c) Derive the Euler Equation that the Pareto optimal allocation needs to satisfy.

d) Verify that both kt+1 = Aktα and kt+1 = Aαβktα are possible solutions of the Euler
Equation found above.

e) Only kt+1 = Aαβktα satisfies the transversality condition. Characterize the related
consumption and investment behaviour and find their limit for t → ∞.

Exercise 1.2
Consider the same economy as in Exercise 1.1

a) Find the value function V (k) and the policy function h(k) associated to the Pareto
problem using the iteration method with V0 (x) = 0.

b) Find the value function V (k) and the policy function h(k) associated to the Pareto
problem using the Howard algorithm starting from h0 (k) = ZAk α , Z > 0.

c) Find the value function V (k) and the policy function h(k) associated to the Pareto
problem using the guess-and-verify method with V (k) = E + F log k.

d) Use the policy function found and the feasibility constraint to derive the law of motion
of capital, consumption, investment, interest rates.
Exercise 1.3
Consider the same economy as in Exercise 1.1 but assume now that for each (t − 1, t)
the production function is f (kt , θt ) = Aθt ktα with θt = θ1 with probability π 1 and with
θt = θ2 > θ1 with probability π 2 > π 1 . (see also Ex. 3.1 in Chapter 3 of [LS])
a) Find the value function V (k, θ) and the policy function h(k, θ) associated to the Pareto
problem using the Howard algorithm starting from h0 (k, θ) = (1 − Z)Ak α θ, Z > 0.

b) Use the policy function found and the feasibility constraint to derive the law of motion
of capital, consumption, investment, interest rates.

c) Under which assumptions can the same allocation be achieved in a competitive sequen-
tial equilibrium. Try to write down the consumer’s problem and the firm’s problem in
such a set-up.

Exercise 1.4
Consider an infinite horizon economy with two consumers i = 1, 2 with time separable
preferences, discount
factor β, instantaneous utility u(c) = log c. Assume that agent 1 has
endowment δ ∈ 0, 21 when t = 0, 2, . . . and 1 − δ otherwise, while agent 2 has endowment
1 − δ when t = 0, 2, . . . and δ otherwise.
a) Write the agent maximization problem assuming that she can trade consumption good
for all t in t = 0 (time-0 trading, name qt0 the price in 0 of consumption good in t and
normalize q00 = 1)

b) Show that there exists a competitive equilibrium of the economy in a) with prices
qt0 = β t for all t = 1, 2, . . . and allocations

1 − δ + δβ δ + (1 − δ)β
c1t = and c2t = t = 1, 2, . . .
1+β 1+β

c) The same allocation can be achieved in a sequential competitive equilibrium where

in each period t consumers can trade a bond with maturity one period at the price
t
qt+1 = β and the debt limit is mild enough. Find the bond position that supports this
equilibrium.

d) What happens to equilibrium allocations and interest rates of the economy in c) when
agents cannot go short in the bond (zero debt limit)?

Exercise 1.5
Consider an infinite horizon bond economy with constant gross interest rate R and a
consumer with time separable preferences, discount factor β, and instantaneous utility
u(c) = cγ , with γ ∈ (0, 1). Assume that the agent has no endowment of the consumption
good, yt = 0 for every t, but starts with an initial amount a0 > 0 of bonds. Assume also
that she cannot go short on bonds, at >= 0 for every t.
a) Write the agent maximization problem assuming that she can trade the bond in each t.

b) Find the value function and policy function associated to the agent maximization as-
suming that the value function has the form V (a) = Aaγ .

c) Find the value function and policy function associated to the agent maximization as-
suming that the policy function has the form h(a) = Ba.

d) Use the policy function found and the budget constraint to derive the law of motion of
consumption and bond position.

Ex. 1.6
Consider an infinite horizon bond economy with random gross interest rates {Rt }. In
particular, for all t ≥ 0 the interest rate between date t and date t + 1, Rt , is known at date
t, and it is equal to Rmin > 1 with probability π and to Rmax > Rmin otherwise. Moreover,
subsequent realizations of the interest rate are independent. In the initial date t = 0
a consumer starts with and positive consumption a0 > 0. Assuming that the consumer
wants to maximize his discounted stream of expected utility with instantaneous utility
u(c) = log(c) and with a discount rate β < 1/Rmax :

a) Find the agent policy rule, that is, how much the agent decides to consume at each
date conditional on his bond demand a and on the interest rate R. (hint: assume that
c = h(a, R) = A(R)a);

b) Find the law of motion of agent’s demand for bonds and compute its limit for t → ∞;

c) Characterize the agent optimal consumption path (is it lumpy or smooth?) and his
value function.

d) Would the agent be better off or worse off by investing in a bond economy with constant
interest rate equal to R̄ = πRmin + (1 − π)Rmax ?