Contracts in Macroeconomics

Contracts in Macroeconomics
Ali Shourideh
April 3, 2012
1 Contracts and Mechanism Design

1.1 Introduction
• Economics is about allocation of resources and gain from trade: contracts are es-
sential
• Contracts?
– Competitive equilibrium; linear contracts

– households paying taxes; social contract
– Electoral college system for voting
• Standard approach in macro: Arrow-Debreu competitive markets
– ignores incentive problems:

∗ Poeple know a lot
∗ They can commit to terms
• This course: we relax those assumptions to some extent.
• Main focus: private information and limited commitment
• Main tool: mechanism design
• Applications:
– Optimal Taxation
– Financial Contracting
1
1.2 Example
• Consider an economy with two homogenous goods: apples, c a , and bananas, cb
• There are two agents:
– Each can be of two types: θ = θ H > θ L ; Pr(θ H ) = π.

– θ is taste for apple; Preferences
θu(c a ) + u(cb )
– Shocks are i.i.d across households.

– Joint distribution of shocks: µ(θ1 , θ2 ) = Pr(θ1 ) Pr(θ2 )
• everyone has the same endowment of apples and oranges, ea , eb
• Allocations:
cia (θi , θ−i ), cib (θi , θ−i )
• Feasibility:
c1a (θ1 , θ2 ) + c2a (θ1 , θ2 ) = 2ea
c1b (θ1 , θ2 ) + c2b (θ1 , θ2 ) = 2eb
• Social Planner, Mechanism Designer, Arbitrator, Principal: allocate resources across

these two types efficiently
Objective - utilitarian:
U1 + U2
Could have other objectives as well
• Suppose everybody knows everything: planner and households
• Efficient to equate everyone’s marginal utility of the same good:
θ1 u0 (c1a (θ1 , θ2 ) = θ2 u0 (c2a (θ1 , θ2 ))
u0 (c1b (θ1 , θ2 ) = u0 (c2b (θ1 , θ2 ))
• Consumption of bananas is equated; whoever has a higher taste for apples should
consume more.
• Competitive equilibrium?
• Now suppose θi is privately known only by i.
• How do agents and the planner communicate?
2
• Assume for now they announce their type to the planner and he/she gives them
allocations
• Would they truthfully announce? No. θ L always wants to lie.
• Mechanism design: how do we design games between agents to achieve "efficiency"
1.3 Mechanism
• Need to figure out what is the best way to communicate
• Revelation principle: just focus on direct mechanisms
• Let’s generalize:
– N agents; K consumption goods: c = (c1 , c2 , · · · , cK )

– Agents types, determine their prefs: U i (c) = u(c; θi )
– θ = (θ1 , · · · , θ N ) ∈ Θ has some joint distribution µ(θ )
– Aggregate endowments: e = (e1 , · · · , eK );
– Feasibility as always
N
∑ cij = e j
i =1
set of feasible allocations C = {(c1 , · · · , c N ); ci = (c1i , c2i , · · · , ciK ), {cij }: feasible}
• What is a mechanism: ( M, g)
– M: messaging space
– g: allocation rule
• Agent i send signal mi (can only communicate with the planner); m = (m1 , · · · , m N ) ∈
M
• allocation rule: g : M → C ; g(m) = ( g1 (m), · · · , g N (m))
• Direct mechanism: M = Θ, g(m) = c(θ )
• Each mechanism induces a game with asymmetric information
• Outcome induced by a mechanism: the Bayesian Nash Equilibrium of the game

strategy profile:
m∗ (θ ) = m1∗ (θ1 ), · · · , m∗N (θ N )
such that
3
h i h i
E u gi mi∗ (θi ), m−
∗
i
( θ −i ) , θ i | θ i ≥ E u g i
m̂ i
, m −i
∗ ( θ −i ) , θi |θi ∀m̂i , i
• Most common outcome concept; could also consider dominant strategy equilib-
rium
• A mechanism designer wants to find the best mechanism; complicated problem
1.4 Revelation Principle

Theorem 1. An allocation that is an outcome of an arbitrary mechanism can be outcome of a
direct mechanism where all agents reveal their types truthfully.
Proof. Consider a mechanism ( M, g) and an outcome m∗ , it must satisfy

h i h i
∗
i
( θ −i ) , θ i | θ i ≥ E u g i
m̂ i
, m −i
∗ ( θ −i ) , θi |θi ∀m̂i , i
In particular
h i h i
∗
i
( θ −i ) , θ i | θ i ≥ E u g i
m i
(
∗ i θ̂ ) , m −i
∗ ( θ −i ) , θi |θi , ∀θ̂i , i
New mechanism
M = Θ, c(θ ) = g(m∗ (θ ))
Truth-telling is ‘an’ equilibrium.
• Incentive compatible allocations, c = (c1 , · · · , c N ),

h i h i
i i
E u c (θi θ−i )) , θi |θi ≥ E u c θ̂i , θ−i ) , θi |θi , ∀θ̂i , i
• There could be other equilibria.
• Implementation theory: how do we ensure that it is the unique equilibrium? might

cover it at the end.
• Most applied work; people usually don’t announce their ’types’; decentralization
with real world contracts – will see an example soon.
• Mechanism designer’s problem

h i
max ∑ λi E u(ci (θ ), θi )
i
4
subject to
∑ cij (θ ) = e j , ∀θ ∈ Θ, j = 1, · · · , K
i
h i h i
E u ci mi∗ (θi ), m−
∗
i
( θ −i ) , θ i | θ i ≥ E u c i
m i
(
∗ i θ̂ ) , m −i
∗ ( θ −i ) , θi |θi , ∀θ̂i , i
Continuum of agents
• Suppose there is a continuum of agents and shocks are i.i.d. across agents: no
aggregate shocks
• Θ = θ1 < · · · < θ N , Pr(θi ) = π (θi ).
• Symmetric allocations: allocations only depend on individual types

c(θi ) = (c1 (θi ), c2 (θi ), · · · , cK (θi ))
• feasible allocations:
∑ π ( θi ) c j ( θi ) = e j
i
• incentive compatible allocations:
u(c(θ ), θ ) ≥ u(c(θ̂ ), θ )
• Mechanism design problem:
max ∑ λ(θi )u(c(θi ), θi )

i
subject to Feasbility and incentive compatibility
• Go through a two type simple example
2 First Application - Mirrlees

• If you want to read about this stuff take a look at Salanie’s book on Economics of
Taxation; chapter 4, also Mirrlees(1971), Diamond(1998), and Saez(2001)
• Last week: two types example; marginal tax rate zero at the top, positive at the
bottom
• How general?
5
• Here continuous types; Recall problem
Z
y (θ )
max u (c (θ )) − v dH (θ )
θ
subject to
Z Z
c (θ ) dF (θ ) + G ≤ y (θ ) dF (θ )

u (c (θ )) − v (y (θ ) /θ ) ≥ u c θ̂ − v y θ̂ /θ
• Remember H (θ ) cumulative welfare weight; H (θ ) ≥ F (θ ) with derivative h (θ ).

what is the interpretation of h (θ )?
• Notice: the constraint set can be rewritten as a maximization problem

u (c (θ )) − v (y (θ ) /θ ) = max u c θ̂ − v y θ̂ /θ
θ̂
• One way to simplify the constraint: replace it with its first and second order con-
ditions!!
FOC:
0
0
1 0 0
u c θ̂ c θ̂ − y θ̂ v y θ̂ /θ =0
θ θ̂ =θ
or
1
u0 (c (θ )) c0 (θ ) − y0 (θ ) v0 (y (θ ) /θ ) = 0
θ
SOC: After cumbersome algebra:
y0 (θ ) ≥ 0
One way to see this:

u (c (θ )) − v (y (θ ) /θ ) ≥ u c θ̂ − v y θ̂ /θ

u c θ̂ − v y θ̂ /θ̂ ≥ u (c (θ )) − v y (θ ) /θ̂
Suppse θ > θ̂. Add them up, c’s cancel and:

v y (θ ) /θ̂ − v (y (θ ) /θ ) ≥ v y θ̂ /θ̂ − v y θ̂ /θ
What does this inequality look like

h 1/θ̂, y (θ ) − h (1/θ, y (θ )) ≥ h 1/θ̂, y θ̂ − h 1/θ, y θ̂
where h ( x, y) = v ( xy) and hence h x = yv0 ( xy).
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• Can write this as
Z 1/θ̂ Z 1/θ̂
h x ( x, y (θ )) dx ≥ h x x, y θ̂ dx
1/θ 1/θ
or
Z 1/θ̂ Z 1/θ̂
0
v0 xy θ̂

y (θ ) v ( xy (θ )) dx ≥ y θ̂ dx
1/θ 1/θ

Now because v is convex, it must be that y ( θ ) ≥ y θ̂ . To see this, suppose not,
y (θ ) < y θ̂ .Then
v0 ( xy (θ )) < v0 xy θ̂

and this clearly violates the above inequality.
• So relaxed problem
Z
y (θ )
max u (c (θ )) − v dH (θ )
θ
subject to
Z Z
c (θ ) dF (θ ) + G ≤ y (θ ) dF (θ )
1
u0 (c (θ )) c0 (θ ) − y0 (θ ) v0 (y (θ ) /θ ) = 0
θ
y0 (θ ) ≥ 0
• We call the second constraint local incentive compatibility. You can show that when
local IC holds and y0 (θ ) ≥ 0, then IC holds. For proof see Fudenberg and Tirole,
chapter 7.
• Now this problem is still ugly. A trick a la Mirrlees: this FOC is equivalent to an
Envelop condition. How? Let
U (θ ) = u (c (θ )) − v (y (θ ) /θ )
Then
U (θ ) = max u c θ̂ − v y θ̂ /θ
θ̂
7
• Envelope:
∂
U 0 (θ ) =

u c θ̂ − v y θ̂ /θ θ̂ =θ
∂θ

y θ̂ 0
= v y θ̂ /θ
θ2
θ̂ =θ
y (θ ) 0
= v (y (θ ) /θ )
θ2
Rewrite the problem with this
Z
max U (θ ) dH (θ )
subject to

y (θ )
u (c (θ )) − v = U (θ )
θ
Z Z
c (θ ) dF (θ ) + G ≤ y (θ ) dF (θ )
y (θ ) 0
U 0 (θ ) = v (y (θ ) /θ )
θ2
y0 (θ ) ≥ 0
• Common technique in Mechanism Design problem: Let’s for now ignore the last
constraint. Later we have to check if it is satisfied. If violated, it means that the
original allocation has bunching of types; people have the same allocations. There
is a procedure called ironing; see Myerson’s ’Optimal Auction Design’.
• Looks like a standard Hamiltonian. We can use the standard techniques. If you
wanna learn more about calculus of variation, look at Luenberger, ’Optimization
by Vector Space Methods’. Let me quickly go over it; we can write the Lagrangian

y (θ )
Z Z
L = U (θ ) h (θ ) dθ + γ (θ ) u (c (θ )) − v − U (θ ) dθ
θ
Z Z
+λ y (θ ) f (θ ) dθ − c (θ ) f (θ ) dθ − G

y (θ ) 0
Z
0
+ µ (θ ) U (θ ) − 2 v (y (θ ) /θ ) dθ
θ
If U 0 wasn’t there, we could simply take ‘derivative’!! So let’s try and get rid of it!!
We can use integration by part to do just that
8
Z θ̄ Z
0
µ(θ )U (θ )dθ = µ (θ ) dU (θ )
θ
Z
µ0 (θ ) U (θ ) dθ

= µ θ̄ U θ̄ − µ (θ ) U (θ ) −
• Now, we can take FOCs, i.e., do a calculus of variations argument
h − γ − µ0 = 0
γu0 (c) − λ f = 0

1 0 y 1 0 y y 00 y
−γ v + λf − µ 2v + 3v = 0
θ θ θ θ θ θ

µ θ̄ = µ (θ ) = 0
Let’s do some algebra

Z θ̄
µ = (γ − h) dθ̂
θ
Z θ̄
1
= λ f − h dθ̂
θ u0 (c)
• Then
Z θ̄
λf 1 0 y 1 0 y y 00 y 1
λf − 0 v = 2v + 3v λ f − h dθ̂
u (c) θ θ θ θ θ θ θ u0 (c)
divide by 1θ v0 (y/θ ),
"Z θ̄ #
y/θv00 (y/θ )

dF θ̂ 1−H

1 1 1 1
− = 1+ −
1/θv0 (y/θ ) u0 (c) v0 (y/θ ) θ u0 c θ̂ 1−F λ (1 − F )

θf
"Z θ̄ #
y/θv00 (y/θ )

1−F dF θ̂ 1−H

1 1 1
− = 1+ −
u0 (c) (1 − τ (θ )) u0 (c) v0 (y/θ ) θ u0 c θ̂ 1−F λ (1 − F )

θf
" #
y/θv00 (y/θ )
Z θ̄ 0
(1 − H ) u 0 ( c )

1−F u (c (θ )) dF θ̂

τ
= 1+ −
1−τ v0 (y/θ ) θ u0 c θ̂ 1−F λ (1 − F )

θf
Also
So called Mirrlees-Diamond-Saez formula. Can be useful and misleading – A func-
tion of a bunch of endogenous stuff!
9
Loosely speaking, it says that marginal tax rates are a function of labor supply
elasticity, tail of the distribution and how redistributive the objective is. Let’s go
through them and see why
– The first term 1θ−fF is the tail of the productivity distribution. If the produc-
tivity distribution looks like a lognormal distribution or bounded above this
term converges to zero; taxes should be zero at the top. If productivity distri-
bution looks like a Pareto distribution at the top – has a fat tail, then this term
is positive.
– The second term looks a lot like an elasticity. In fact it is one plus the Frisch
elasticity of labor supply. So the more elastic is labor supply, the lower the
taxes.
– The last term is a complicated term. Somehow it measures how unequal is
consumption allocated as well as how redistribitive is the planner’s motive.
Suppose that H (θ ) goes up and nothing else changes, then it implies that the
tax rates should go up; a planner that would like to do more redistribution
would like to increase taxes.
• What happens to the top tax rate if the distribution of θ is unbounded. Suppose
that H converges to 1 really fast!!!, then
τ 1−F
lim = lim lim (1 + 1/ε)
1−τ θf
• Before providing some numbers. An exactly solved case. suppose that u (c) = c.
Then:
G (θ ) − F (θ )

τ (θ ) 1
= 1+
1 − τ (θ ) ε θ f (θ )
a function of fundamentals. Can perform comparative statics.
• We can calculate taxes at the top from micro data. What’s the shape of the income
distribution. Can approximate it with Pareto. See Saez’s pictures.
Suppose that
1 − F = Cθ −a
Then
f = aCθ −a−1
So
1−F 1
=
θf a
• Micro estimates of labor supply elasticity: .2-.5. Need to know a.
10
• From data we know the pareto tail for income ( dont really see θ). a from income
distribution is not the same as a above. But we know current taxes and can back
out θ from that
intratemporal Euler equation
(1 − τauctual ) θ = ψl 1/ε
Hence roughly at the top ε

1 − τauctual

y= θ ε +1
ψ
If aincome , then aθ can be calculated from
1 − τauctual ε ε+1 1 − τauctual ε ε+1

1 − Pr θ ≤ θ̂ = 1 − Pr θ ≤ θ̂
ψ ψ
1 − τauctual −εaincome −(ε+1)aincome

= C θ̂
ψ
So aθ = (1 + ε) aincome .So
τ 1 1+ε
=
1−τ (1 + ε) aincome ε
1
=
εaincome
• Then 1−τ τ should be between 2.5 and 1. So τ should be somewhere between .5 and
.71. Very high numbers!!!
• With income effect, the numbers would be higher. Now let’s look at Saez’s num-
bers.
• What is wrong with this
– Conceptual level: infinitely skilled people!!! However, in many practical cases,

zero-tax-at-the-top is local. How do we know the only reason people are
unequal is because of skills?
– suppose we take this model to be stand in for what happens in the world.
Then elasticity of labor supply has to be way higher: human capital accumu-
lation, career concerns, extensive margin, etc.
– Hopefully, when we get to dynamics, we can talk about these things. There is
not a lot that has been done. and there is a lot more to be done!
11
3 Second Application - Diamond and Dybvig
• A dynamic model but we can analyze the problem using our tools.
• What is the role of banks?
• Maturity transformation:
– People need to eat everyday, i.e., they are hit by liquidity shocks
– Production takes time, i.e., physical capital is illiquid.
– Need contracts that insure people against liquidity shocks
– One way to do this is through banks
• Let’s try to formalize this
• Time: t = 0, 1, 2; Continuum of households, eat at t = 1, 2:
(1 − θ )u(c1 ) + θu(c1 + c2 )
• θ ∈ {0, 1}:types realized at t = 1. π = Pr(θ = 0).
• Utility function
cu00 (c)
− >1
u0 (c)
• Technology:
– Short term investment: can invest at t = 0, 1 will give a return of 1 at t +

1.(liquid asset)
– Long term investment: invest at t = 0, returns R rate of return at t = 2.(illiquid

asset); if liquidated at t = 1, pays back its original investment
R>1
• Households: endowed with e unit at t = 0.
12
• Allocations: ct (θ ), t = 1, 2, x:investment in liquid asset,y: investment in illiquid
asset
• Feasibility:
x+y = e
πc1 (0) + (1 − π )c1 (1) = x
πc2 (0) + (1 − π )c2 (1) = Ry
or

1 1
π c1 (0) + c2 (0) + (1 − π ) c1 (1) + c2 (1) ≤ 1
R R
• Incentive constraint:
u(c1 (0)) ≥ u(c1 (1))
u(c1 (1) + c2 (1)) ≥ u(c1 (0) + c2 (0))
• Mechanism Design Problem:

max U
subject to feasibility, incentive compatibility.
• Properties of optimal allocations:
c2 (0) = c1 (1) = 0
0
u (c1 (0)) = Ru0 (c2 (1))
• Since risk aversion is higher than 1, 1 < c1 (0) < c2 (1) < R. There is some
insurance going on. Boring mechanism design problem!!! i.e., incentive constraints
are non-binding. What happens if we have other types?
3.1 Competitive Equilibrium

• Suppose that households can only trade the long and short asset; budget constraint
at date 0.
x i + yi = 1
• If they happen to become impatient, they can sell their claims to long asset to the
patient guys in exchange for claims to the short asset.
c1 (0) = xi + Pyi
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Then the consumption of patient guys is

c2 (1) = xi /P + yi R
• Definition of competitive equilibrium: xi , yi i∈[0,1] such that xi , yi solves

max πu (c1 (0)) + (1 − π ) u (c2 (1))

x,y
subject to
x+y = 1
c1 (0) = x + Py
R
c2 (1) = (y + x/P) R = ( x + Py)
P
• Market clearing:
Z Z
at t = 1, π c1i (0) di = xi di
Z Z
at t = 0, (1 − π ) c2i (1) = R yi di
• In equilibrium P = 1. Why?
– If P > 1, then the solution to the above problem requires x = 0. violates

market clearing!
– If P < 1, then the solution to the above problem requires y = 0. violates
market clearing!
• with P = 1, c1 (0) = 1, c2 (1) = R. Inefficient. Reason: market incompleteness;

no insurance against θ. they want to trade contingent claim on θ. But θ is pri-
vate information, so they can potentially misreport(Will see later that competitive
markets with private information are not necessarily inefficient; see Prescott and
Townsend(1982))
3.2 Bank Run

• Let’s try some other contracts
• Suppose there is a liquidation technology. We can decide whether to liquidate the

long asset at t = 1 and get return 1.
14
• Banks offer a deposit contract, deposit your money at t = 0; if withdraw at t = 1,
then return is r1 if the fraction of people withdrawing is less then 1/r1 . If this
fraction is higher, then return is zero.

r1 f j ≤ 1/r1
V1 f j , r1 =
0 f j > 1/r1
V2 ( f , r1 ) = max { R (1 − f r1 ) / (1 − f ) , 0}
• A game between patient and impatient guys. Now, what happens in the equilib-
rium of this game: two equilibria
• No Run: impatient guys are boring. if patient guys think other patient guys will
not run
R (1 − πr1 )

No Run : u
1−π
Run : u (r1 )
He wont run as long as

R (1 − πr1 )
r1 ≤
1−π
Set r1 = c1 (0). Done.
• Run equilibrium: if patient guys think other patient guys will run:
No Run : u (0)
Run : 1/r1 u (r1 ) + (1 − 1/r1 ) u (0)
If r1 > 1, there is an equilibrium with Bank Runs!
• Suspension of convertability can potentially solve this
• If we add aggregate shocks to π, then still a problem
• Summary: Deposit contracts could lead to "fragility"!!!! Diamond and Dybvig: We

need deposit insurance; but do we?
• Suppose we just ask them and dont care about sequential service. Also suppose
that the number of households is finite, I; Number of patient guys: stochastic
• Planner’s problem
max ∑ Pr (ω ) [α (ω ) u (c1 (0, ω )) + (1 − α (ω )) u (c2 (1, ω ))]
15
subject to
1
( I − α (ω )) c1 (0, ω ) + α (ω ) c2 (1, ω ) = I
R
where ω = (θ1 , · · · , θ I ).
• FOCs
u0 (c1 (0, ω )) = Ru0 (c2 (1, ω ))
Can represent the state of the world by α: c1 (0, α), c2 (1, α).
• Suppose that u (c) = c1−σ / (1 − σ ) with σ > 1
c1 (0, α)−σ = Rc2 (1, α)−σ

1
c2 (1, α) = R σ c1 (0, α)
I
c1 (0, α) =
α + R1/σ−1 ( I − α)
I
=
α + R1/σ−1 ( I − α)
IR1/σ
c2 (1, α) =
α 1 − R1/σ + IR1/σ−1

Since R > 1, c2 (1, α) > c1 (0, α). Also c1 (0, α) > c1 (0, α − 1).
• Doesn’t this mean that truth-telling is a dominant strategy? No Bank Runs!!!!
• Green-Lin(2003, JET)(gerenalized by Andolfatto, Nosal, Wallace(2007, JET)) show

that this argument also works with sequential service but it’s a bit more compli-
cated:
– Intuition: The last patient trader does not want to lie(Given the remaining
resources with the bank, the planner always gives more to the patient guy).
Using a backward induction argument the second to last trader doesn’t want
to lie either. Nobody wants to lie! No Bank Run.
• Ennis and Kiester(2009, JET): if you allow for correlated types the truthfull revela-
tion game might have other equilibria.
• Nosal(2011); Cavalcanti and Monteiro(2011): there are indirect mechanisms that

have unique equilibrium and implement the efficient outcome.
• Bank Runs??!!
• DD: Bank run one issue that can be a result of maturity mismatch.
16
3.3 Non-Exclusive Contracts and The Role of Banks: Jacklin/Farhi-
Golosov-Tsyvinski
• Another issue pointed by Jacklin elaborated by Farhi, Golosov, and Tsyvinski: The
above analysis assumes exclusivity; households cannot contract with each other
and with other banks. Can potentially undo the insurance provided by the inter-
mediaries.
• To see this consider the following alternative private market arrangement:
– There is a lot of banks; all of them are large, i.e., can service the whole market.
– They offer contracts at t = 0 and commit to them
– Households choose the contract with highest utility
– Before talking about non-exclusivity, let’s focus on exclusive contracts: As-
sume that banks can control how much people consume.
– Equilibrium is given by {ct (θ )} , Ū, where Ū is the value of equilibrium con-
tract to households and ct (θ ) solves the following maximization problem by
the intermediary(they take Ū as given)
1
max d1 + d2
R
subject to
x+y = 1
d1 + πc1 (0) + (1 − π ) c1 (1) = x
d2 + πc2 (0) + (1 − π ) c2 (1) = Ry
u (c1 (0)) ≥ u (c1 (1))
u (c1 (1) + c2 (1)) ≥ u (c1 (0) + c2 (0))
πu (c1 (0)) + (1 − π ) u (c1 (1) + c2 (1)) ≥ Ū
and markets clear.
• Let’s focus on the truth-telling equilibrium so do not have to deal with bank runs.
• Now, we want to show that the equilibrium outcome is efficient: when contracts
are exclusive competitive markets are providing the efficient amount of insurance
that a planner offers.
• Obviously profits in equilibrium have to be zero. If positive, some other interme-

diary can come in offer a little more generous contract, make positive profits and
service the whole market.
17
• To show this first notice that as usual c2 (0) = c1 (1) = 0. Then the IC’s can be
written as
u (c1 (0)) ≥ u (0)

u (c2 (1)) ≥ u (c1 (0))
If we didn’t have the incentive constraints in there, we could use concavity proper-
ties to rewrite the bank’s problem as its dual and then bank’s problem would coin-
cide with planner’s problem. So how do we deal with incentive constraints(potentially
they can make the problem non-covex because a concave function is appearing on
the RHS of the IC’s). One way to deal with this in this environment is to rename
stuff: Let
û1 (0) = u (c1 (0))

û2 (1) = u (c2 (1))
Then, the bank’s problem can be written as
1
max 1 − πC (û1 (0)) − (1 − π ) C (û2 (1))
R
subject to
û1 (0) ≥ u (0)

û1 (2) ≥ û1 (1)
π û1 (0) + (1 − π ) û2 (1) ≥ Ū
where C (u) is the inverse of the utility function u (c). Now the constraint set
is linear and the objective is strictly concave – C is strictly convex and −C (u) is
strictly concave.
• So we can write down the dual of the above problem and use the fact that profits
in equilibrium are zero
Ū = max π û1 (0) + (1 − π ) û2 (1)
subject to
û1 (0) ≥ u (0)

û1 (2) ≥ û1 (1)
1
1 − πC (û1 (0)) − (1 − π ) C (û2 (1)) ≥ 0
R
Now you can see that this coincides with the planning proble before. So the equi-
librium must be efficient. This is a proof similar to the one used by Prescott and
18
Townsend(1984, Econometrica). They show that if contracts are signed before any
uncertainty is realized and people have access to lotteries (This is a trick to convex-
ify the constraint set – in the above proof, we didn’t really need it given the special
structure of this problem), then Competitive Equilibrium is constrained efficient.
• Now let’s try to see what happens if we have non-exclusive contracts
Alternative2 Competitive Market:
• Let’s assume that household’s have access to trading market where they can trade
with each other but the intermediaries cannot see what they do in those markets,
i.e., hidden trading markets. There is an interest rate R̂ in this market. So if they
face a contract {ct (θ )} from an intermediary, this is the maximization problem
they solve
max (1 − θ ) u ( x1 ) + θu ( x2 )
θ̂,s,xt
subject to

x1 + s = c1 θ̂

x2 = R̂s + c2 θ̂
As it can be seen, they can decide to announce their type to the bank, take the
allocations from the bank, and trade in the hidden trade market. Call the value
associated with the above V {ct (θ )} , θ, R̂ . We also call the optimal choice of
reporting by θ̂ {ct (θ )} , R̂, θ and consumption by xt {ct (θ )} , R̂, θ .
• Major assumption: there is full commitment in the ‘Hidden Trade’ Market.
• Equilibrium Definition: equilibrium is described by { xt (θ ) , ct (θ )} , Ū, R̂ such that
– The intermediary solves the following problem
1
max d0 + d1
R
such that
x+y = 1
d1 + πc1 (0) + (1 − π ) c1 (1) = x
d2 + πc2 (0) + (1 − π ) c2 (1) = Ry

θ = θ̂ {ct (θ )} , R̂, θ

πV {ct (θ )} , R̂, 0 + (1 − π ) V {ct (θ )} , R̂, 1 ≥ Ū
19
– Hidden Trade Market has to clear:

πxt {ct (θ )} , R̂, 0 + (1 − π ) xt {ct (θ )} , R̂, 1 ≤

πct θ̂ {ct (θ )} , R̂, 0 + (1 − π ) ct θ̂ {ct (θ )} , R̂, 1
• First Result: IC implies that
1 1
c1 (0) + c2 (0) = c1 (1) + c2 (1)
R̂ R̂
Note that since consumers can do smoothing on their own in the hidden trad-
ing market, all they care about is the present value of consumption bundles of-
fered(where PV is calculted using hidden trade market prices, R̂). So they always
choose the bundle with the highest present value. IC means that the present values
have to be equal.
• Now, given the fact that banks make zero profits in equilibrium and a similar du-
ality result as before, competitive equilibrium is a solution to the following maxi-
mization problem

max πV {ct (θ )} , R̂, 0 + (1 − π ) V {ct (θ )} , R̂, 1
subject to
1 1
c1 (0) + c2 (0) = c1 (1) + c2 (1)
R̂ R̂
1 1
π c1 (0) + c2 (0) + (1 − π ) c1 (1) + c2 (1) ≤ 1
R R
• Second Result: R̂ = R. Suppose that R̂ < R, then clearly in the solution to the
above problem c1 (0) = c1 (1) = 0.Why? because if not you can decrease
c1 (0) by ε,
and increase c2 (0) by πR + (1 − π ) R̂ ε and c2 (1) by πε R − R̂ . This causes the
present values to increase equally(hence V increases for both types) and feasibility
to be satisfied. In other words, it is optimal for the intermediary to invest in the
long asset only. However, this cannot be an equilibrium because, when c1 (0) =
c1 (1) = 0, impatient types cannot consume anything given market clearing in the
hidden trading market. Similarly we can show that R < R̂ cannot be an equilibrium
either.
• When R = R̂, the equilibrium outcome is clearly c1 (0) = 1, c2 (1) = R.
• Notice that this outcome is identical to the competitive equilibrium we discussed

above. However, there market incompleteness was exogenous – we assumed some
assets do not exist, while here market incompleteness is endogenous – Fundamen-
tal frictions result in market incompleteness.
20
• So is the above allocation constraint efficient? Clearly it is not efficient with respect
to the original planning problem. But we have to define what constrainted efficient
means with hidden trade.
Alternative2 Constrained Efficient Allocation.
• We will assume that a planner is subject to the same hidden trading constraint –
people can trade in the hidden trade market behind planner’s back. However, by
choosing allocations, the planner can affect the interest rate in the hidden trade
market indirectly. So, here is the planning problem
max πU (c1 (0) , c2 (0) , 0) + (1 − π ) U (c1 (1) , c2 (1) , 1)

ct (θ )
subject to

1 1
π c1 (0) + c2 (0) + (1 − π ) c1 (1) + c2 (1) ≤ 1
R R

U (c1 (θ ) , c2 (θ ) ; θ ) ≥ V {ct (θ )} , R̂, θ
R̂ = Eqilibiurm Int. Rate in HT Mkt
• First note that similar to before, we must have

1 1
c2 ( θ ) = c1 θ 0 + c2 θ 0

c1 ( θ ) +
R̂ R̂
If not, the allocation would not be incentive compatible. Call the above present
value I. Define, the following

V̂ I, R̂, θ = max U ( x1 , x2 ; θ )
subject to
1
x1 +
x2 = I
R̂

Call the policy functions x1 I, R̂, θ , x2 I, R̂, θ . Then it is easy to show that the
planner’s problem is equivalent to

max π V̂ I, R̂, 0 + (1 − π ) V̂ I, R̂, 1
I, R̂
subject to

1 1
π x1 I, R̂, 0 + x2 I, R̂, 0 + (1 − π ) x1 I, R̂, 1 + x2 I, R̂, 1 ≤1
R R
21
• Note that if there exists I and R̂ such that
= c1∗ (0) , x2 I, R̂, 0 = 0

x1 I, R̂, 0
I, R̂, 1 = c2∗ (1) , x1 I, R̂, 1 = 0

x2
where c1∗ (0) and c2∗ (1) is the solution to the original planning problem, then this
must be optimal because the above problem is obtained from adding extra con-
straints on the original planning problem.
c2∗ (1)
• Obviously I = c1∗ (0) and R̂ = c1∗ (0)
. To see that this is the case, we just have to show
that R̂ > 1, which is clear from the properties of the allocation described above.
Moreover, we can see that R̂ < R. This is because risk aversion is bigger than 1.
u0 ( I ) = Ru0 R̂I

log u0 R̂I − log u0 ( I ) + log R = 0

Note that
d u00 ( x )
log u0 ( x ) = 0
dx u (x)
So
R̂I u00 ( x )
Z
log u0 R̂I − log u0 ( I ) =

dx
I u0 ( x )
Since risk aversion is bigger than 1,
u00 ( x ) x
− >1
u0 ( x )
Hence,
u00 ( x ) 1
< −
u0 ( x ) x
So, we must have
log u0 R̂I − log u0 ( I ) = − log R

Z R̂I
1
< − dx = log I − log R̂I = − log R̂
I x
Hence, 1 < R̂ < R. So the planner would achieve the original efficient allocation.
• Note: this is not in general true. The Alternative2 Constrained Efficient Allocation
does not usually coincide with the Constrained Efficient Allocation.
• Why this inefficiency: As the above proof shows, the planner essentially affects
22
the interest rate in the hidden trading market. This interest rate affect agents’
incentives to lie. In particular, loweing interest rate R̂ benefits impatient agents
since it increases their income.
• So how can we implement this desired outcome? FGT show that a simple policy
when the government can see banks’ portfolios – or the banking sector’s protfolio
as a whole; there is no difference.
• Now consider a lower bound imposed by the government on banks’ investment

in the liquid/short asset and suppose this bound is given by πI ∗ where I ∗ is the
solution to the above planning problem. It is clear from before that this would
achieve the constrained efficient allocation. When R̂ < R, the banks want to invest
everything in the long asset. The liquidity floor prevents that from happening.
4 Dynamic Mechanism Design

• Let’s go back to our original example with taste shocks.
• Prefs:
θu (c a ) + u (cb )
As we saw in the previous example, we can just call consumption across at each
time a different good, i.e., we can call consumption in the first period apples and
consumption in the second period bananas.
• What is different? Information usually arrives gradually.
• Let’s try to formulate this(Based on Atkeson-Lucas, 1992). Consider a taste shock

economy with preferences of the form
T
∑ βt θt u (ct )
t =0
where θt ∈ Θ is a Markov Process of order 1 with transition transition probabilities

πt (θt+1 |θt ). Later we restrict attention to i.i.d. T ∈ N∪ {∞}.
• Continuum of households; All endowed with e unit of the consumption good in

each period.
• Allocations: ct θ t . Feasbility

Z
ct θ t dµ θ t ≤ e

Θt
23
• Optimal risk sharing with full info
βt θt u0 (ct ) = λt
for all t. λt : multiplier on feasibility at t.
• Now suppose θt is private information; Since there is commitment in this envi-

ronment, revelation principle applies and we can focus on direct mechanisms. An
allocation is incentive compatible, if
T Z T Z
∑β t t t
∑β t
θt u ct σt θ t dµt θ t

θt u ct θ dµt θ ≥
t =0 Θt t =0 Θt
For any measurable function σt : Θt → Θt according to measure µt .
• Planning problem
T Z
max ∑ βt θt u ct θ t dµt θ t

t =0 Θt
subject to
Z
ct θ t dµt θ t = e

Θt
T Z T Z
∑ βt θt u ct θ t dµt θ t ∑ βt θt u ct σt θ t dµt θ t , ∀σt

≥
t =0 Θt t =0 Θt
θ −1 : given
• Complicated set of incentive constraints; Need to simplify
• One-shot deviation principle: Suppose that β < 1 and u is bounded or T < ∞. Then
an allocation is incentive compatible if and only if it satisfies one-shot incentive
t

compatibility: σt θ = θt except for a unique period t̂ and for a positive measure
of histories θ̂ t . With discrete processes,
∃!θ t σt θ t 6= θt

• with finite T, a backward induction argument works.
• With T = ∞, do not have to worry about deviations far away in time. same idea
works. See Fudenberg and Tirole, Section 5.
• This simplifies the set of incentive constraints. How do we write them down?
24
Define the following utility value:

vT θ T = θT u cT θ T
Z
t
= θt u ct θ + β vt+1 θ t , θt+1 π (dθt+1 |θt )
t

vt θ
One-shot deviation: lie today and tell the truth from then on.
Value of telling the truth from now on:
Z
t
vt+1 θ t , θt+1 π (dθt+1 |θt )

θt u ct θ +β
Value of lying today and telling the truth from tomorrow on:
Z
θt u ct θ t−1 , θ̂t + β vt+1 θ t−1 , θ̂t , θt+1 π (dθt+1 |θt )
One-shot incentive compatibility:

Z
t
+ β vt+1 θ t , θt+1 π (dθt+1 |θt ) ≥

θt u ct θ
Z
t −1
θt u ct θ , θ̂t + β vt+1 θ t−1 , θ̂t , θt+1 π (dθt+1 |θt )
• Planning problem Z
∗
w = max v0 (θ0 ) π (dθ0 |θ−1 )
subject to
Z
θt u ct θ t vt+1 θ t , θt+1 π (dθt+1 |θt ) = vt θ t

+β
Z
ct θ t dµt θ t = e

Θt Z
θt u ct θ t + β vt+1 θ t , θt+1 π (dθt+1 |θt ) ≥

Z
θt u ct θ t−1 , θ̂t + β vt+1 θ t−1 , θ̂t , θt+1 π (dθt+1 |θt )
• Would like to rewrite it recursively. For dynamic problems, very practical and
useful to deal with the dual. How do we know it is equivalent. For now, let’s just
assume!! Most problem have no way of knowing, in this case we do!!
• Lagrange multipliers on feasibility must exist, call them λt .
25
• Then the above is equivalent to
T Z
max ∑ λt e − t t

ct θ dµt θ
t =0 Θt
subject to
Z
t
vt+1 θ t , θt+1 π (dθt+1 |θt ) = vt θ t

θt u ct θ +β
Z
v0 (θ0 ) π (dθ0 |θ−1 ) ≥ w̄
Z
t
+ β vt+1 θ t , θt+1 π (dθt+1 |θt ) ≥

θt u ct θ
Z
t −1 t −1
θt u ct θ , θ̂t + β vt+1 θ , θ̂t , θt+1 π (dθt+1 |θt )
• Notice assumption: No names; treating people fully symmetrically; what would

happen if people had names?
• Suppose that |Θ| = N. State variable: θt−1 , vt θ t−2 , θt−1 , θt π dθt |θ̂t−1 = wt θt−1 , θ̂t−1 :
R
the value a true type of θ̂t−1 gets if pretends to be θt−1 at t − 1. N + 1 state variables

Pt θ− , w (θ− ) , w θ− , θ̂− θ̂− 6=θ− =
Z
λ t +1 0
0
max e − c (θ ) + Pt+1 θ, w (θ ) , w θ, θ̂ π (dθ |θ− )
Θ λt
subject to
Z
θu (c (θ )) + βw0 (θ ) π (dθ |θ− ) = w (θ− )

Z
θu (c (θ )) + βw0 (θ ) π dθ |θ̂− = w θ− , θ̂−

θu (c (θ )) + βw0 (θ ) ≥ θu c θ̂ + βw0 θ, θ̂

w θ, θ̂ : feasible
• Period 0 problem
Z
λ1 0
0
max e − c (θ ) + P1 θ, w (θ ) , w θ, θ̂ π (dθ |θ−1 )
w(θ̂−1 ) Θ λ0
26
subject to
Z
θ0 u (c (θ0 )) + βw0 (θ0 ) π (dθ0 |θ−1 )

w̄ =
Z
θ0 u (c (θ0 )) + βw0 (θ0 ) π dθ0 |θ̂−1

w θ̂−1 =

w θ̂−1 : feasible

• How do we find the set of feasible w θ, θ̂ ’s; A procedure similar to Abreu, Pearce
and Stachetti (To read more see Fernandes and Phelan, JET, 2000). The general
problem with persistence is very complicated. Later we will see a special case(θt is
a random walk) that we can actually solve by hand!
4.1 I.I.D. Shocks

• What happens if we have i.i.d θt ’s?
Z
vt θ t−2 , θt−1 , θt π dθt |θ̂t−1

w θt−1 , θ̂t−1 =
Z
= vt θ t−2 , θt−1 , θt π (dθt |θt−1 ) = w (θt−1 )
Number of state variables = 1

Z
λ t +1 0

Pt (w) = e − c (θ ) + Pt+1 w (θ ) dπ (θ )
λt
subject to
Z
θu (c (θ )) + βw0 (θ ) dπ (θ ) = w

θu (c (θ )) + βw0 (θ ) ≥ θu c θ̂
+ βw0 θ̂

Have to find λt ’s together with w0 such that P0 (w0 ) = 0 and that ct θ t dµt θ t =
R
e.
• How do we know that solution to the above problem is unique? IC’s make the
problem potentially non-covex.
• Let’s do a transformation as before:

Z
λ t +1 0

Pt (w) = −C (u (θ )) + Pt+1 w (θ ) dπ (θ )
λt
27
subject to
Z
θu (θ ) + βw0 (θ ) dπ (θ ) = w

θu (θ ) + βw0 (θ ) ≥ θu θ̂ + βw0 θ̂

Constraint set is linear now and the period objective is strictly concave. The usual
method from SLP can be used to show that the value function is (strictly) concave.
• What happens when T = 0?
• What happens when T = 1?
• It turns out for many practical utility functions we have closed form solutions. For
now, let’s assume that qt+1 = λt+t 1 is constant over time, q, and also that T = ∞. It
λ
is fairly easy to generalize the following analysis to the case where qt+1 is changing
over time and finite horizon. Given this, we can drop the subscript t:
Z
−c (θ ) + qP w0 (θ )

P (w) = max dπ (θ )
subject to
Z
θu (c (θ )) + βw0 (θ ) dπ (θ ) = w

θu (c (θ )) + βw0 (θ ) ≥ θu c θ̂ + βw0 θ̂

It is helpful to work with utilities u (θ ) = u (c (θ )) or c (θ ) = C (u (θ )).

Z
−C (u (θ )) + qP w0 (θ )

P (w) = max dπ (θ )
subject to
Z
θu (θ ) + βw0 (θ ) dπ (θ ) = w

θu (θ ) + βw0 (θ ) ≥ θu θ̂ + βw0 θ̂

Now, we can see that the constraint set is linear of degree one in all the variables.
That suggests that the policy functions should be homogenous too, as long as the
objective is homothetic. We can consider three cases:
– u (c) = log c; In this case, C (u) = eu , adding a constant to either u (θ ) or

w0 (θ ) would not violate the incentive constraints. This suggest that the policy
28
functions and value functions are homogeneous too. Guess:
1−β
u (θ, w) = û (θ ) + w
Eθ
w0 (θ, w) = ŵ (θ ) + w
1− β
P (w) = − Ae Eθ w
Problem becomes
1− β
Z h 1− β
i
max e Eθ w −eû(θ ) − qAe Eθ ŵ ( θ ) dπ (θ )
subject to
Z
[θ û (θ ) + βŵ (θ )] dπ (θ ) = 0
θ û (θ ) + βŵ0 (θ ) ≥ θ û θ̂ + βŵ θ̂

Notice that the solution to the above problem is independent of w. So the

objective must take value given by Â ( A). By contraction mapping theorem,
the function Â ( A) must have a unique fixed point and hence the guess is
verified. We can describe the policy functionsin for consumption by
1− β
c (θ, w; q) = eû(θ;q) e Eθ w
Note that q is an endogenous object and need to be determined in order to

fully describe the solution to the original planning problem. Will get to this
soon.
Notice also what the baseline planning problem looks like. It looks a lot like
our original risk sharing problem with apples and bananas. This problem
keeps coming up all the time!
We can also use the above policy functions repeatedly, to see
1− β t −1
ct θ t , w0 ; q = eû(θt ;q) e Eθ [w0 +∑s=0 ŵ(θs ;q)]

1− σ 1
– u (c) = c1−σ , σ 6= 1; In this case, C (u) = ((1 − σ) u) 1−σ . Multiplying the
constraint set by a positive factor doesn’t change anything, so we can make
the following guess
u (θ, w) = û (θ ) · (1 − σ ) w
w0 (θ, w) = ŵ (θ ) · (1 − σ) w
1
P (w) = A [(1 − σ ) w] 1−σ
29
Putting the 1 − σ there makes sure that the factor is positive. To see why it
works, under the above guess the problem becomes
Z h
1 1 1
i
max [(1 − σ ) w] 1−σ − [(1 − σ) û (θ )] 1−σ − qA [(1 − σ) ŵ (θ )] 1−σ dπ (θ )
subject to
1
Z
[θ û (θ ) + βŵ (θ )] dπ (θ ) =
1−σ

θ û (θ ) + βŵ (θ ) ≥ θ û θ̂ + βŵ θ̂
As before, the solution is independent of w. Hence,

1 1
c (θ, w; q) = [(1 − σ) w] 1−σ [(1 − σ) û (θ; q)] 1−σ
and
1 1
t −1 1
t
∏ [(1 − σ) ŵ (θs ; q)] 1−σ

ct θ , w0 ; q = [(1 − σ ) w0 ] 1− σ [(1 − σ) û (θt ; q)] 1− σ
s =0
– u (c) = − ψ1 e−ψc ; In this case C (u) = − ψ1 log (−ψu). Again multiplying the
constraint set by a positive factor does not change anything, so we have the
following guess
u (θ, w) = û (θ ) · (−w)
w0 (θ, w) = ŵ (θ ) · (−w)
1
P (w) = log (−w) + B
(1 − q ) ψ
for some constant B. Given the guess, the problem becomes

Z
1 1
max log [−ψû (θ ) · (−w)] + q log [−ψŵ (θ ) · (−w)] + qB dπ (θ )
ψ ψ (1 − q )
Z
1 1 1
= log (−w) + log [−ψû (θ )] + q log [−ψŵ (θ )] + qB dπ (θ )
ψ (1 − q ) ψ ψ (1 − q )
subject to
Z
[θ û (θ ) + βŵ (θ )] dπ (θ ) = −1

θ û (θ ) + βŵ (θ ) ≥ θ û θ̂ + βŵ θ̂
30
This confirms the guess. So we have
1
c (θ, w; q) = − log (−ψû (θ; q) · (−w))
ψ
and
1 1 1 t −1
ct θ t , w0 ; q = − log (−ψû (θ; q)) − log (−w0 ) − ∑ log (−ŵ (θs ; q))

ψ ψ ψ s =0
A note about the CARA case: Notice that utility function is given by
1 T t −ψct
− ∑ β θt e
ψ t =0
Let ϕt = − ψ1 log θt . Then, the above problem becomes
1 T t −ψ(ct + ϕt )
ψ t∑
− βe
=0
So the taste shock problem above becomes equivalent to an income fluctua-

tion problem with the shock process ϕt . For more on this see Thomas and
Worrall(1990, JET). The income fluctuation problem in general turns out to
be harder to handle than the taste shock model. It is a lot harder to show
concavity; have to make assumptions about the direction that the incentive
constraints bind. Thomas and Worrall are being very careful about this al-
though the paper has some small mistakes. It is a must-read.
• To completely solve the original planning problem, we need to find q and w0 . For
this, we will use feasibility:
Z
ct θ t , w0 ; q dµt θ t = e, ∀t ≥ 0

Θt
Now, let’s what this implies for each case:
– Log case Z
ct θ t , w0 ; q dµt θ t = e

Θt
or
1− β
Z
e û(θt ;q)
e Eθ [w0 +∑ts−=10 ŵ(θs ;q)] dµt θ t = e
Θt
Since θt ’s are independent, we can rewrite the above integral as

1− β
Z 1− β
Z
e Eθ w0 Πts−
=0
1
e Eθ ŵ ( θ;q ) dπ (θ ) eû(θ;q) dπ (θ ) = e
31
This will come down to the followig equations(why?)
Z 1− β
e Eθ ŵ ( θ;q ) dπ (θ ) = 1
e
P ( w0 ) + = 0
1−q
These two equations pin down q and w0 .

– CRRA case: Z

Θt
or
Z
1 1
t −1 1
∏ [(1 − σ) ŵ (θs ; q)] 1−σ dµt θt = e

[(1 − σ) w0 ] 1−σ [(1 − σ) û (θt ; q)] 1−σ
Θt s =0
Similarly, we have
Z
1
[(1 − σ) ŵ (θ; q)] 1−σ dπ (θ ) = 1
e
P ( w0 ) + = 0
1−q
– CARA case: Z

Θt
or
" #
1 1 1 t −1
Z
− log (−ψû (θ; q)) − log (−w0 ) − ∑ log (−ŵ (θs ; q)) dµt θ t = e

Θt ψ ψ ψ s =0
Hence,
Z
log (−ŵ (θ; q)) dπ (θ ) = 0
e
P ( w0 ) + = 0
1−q
For more general formulations, it is possible to write the above but wouldn’t be
able to bring them down to single equations.
Question: What happens when the problem is non-stationary, i.e, when T < ∞ or
when qt ’s are not constant.
• Now, we have fully characterized the solution to original planning problem. One
way to think about the model: what is the amount of optimal inequality? How
much inequality in consumption and wealth should societies tolerate given hetero-
32
geneity in taste or income? Let’s see what the model implies about optimal amount
of inequality in consumption:
• Let’s focus on the log case:

1− β
ct (θt ) = eû(θt ;q) e Eθ [w0 +∑ts−=10 ŵ(θs ;q)]
where w0 and q are given by the above equations. or

" #
t −1
1−β
log ct (θt ) = û (θt ; q) + w0 + ∑ ŵ (θs ; q)
E [θ ] s =0
log ct − log û (θt ; q) is a random walk with drift:
1−β
E [ŵ (θs ; q)]
E [θ ]
What is the sign of the drift? We know that

Z 1− β
e Eθ ŵ ( θ;q ) dπ (θ ) = 1
Take logs Z 1− β
log e Eθ ŵ ( θ;q ) dπ (θ ) = 0
By Jensen’s inequality and since log is concave,
E [log X ] < log E [ X ]
when X is non-constant almost surely. So

Z h 1− β
i Z 1− β
log e Eθ ŵ ( θ;q ) dπ (θ ) < log e Eθ ŵ ( θ;q ) dπ (θ ) = 0
or
1−β
Z
ŵ (θ; q) dπ (θ ) < 0
Eθ
Hence the drift is negative. So consumption is a random walk with a negative drift.
So the variance of consumption converges to infinity and consumption converges
to 0 almost surely (can show this for other cases too). Immiseration. Disappointing
theory of optimal inequality!! This property is very robust in dynamic contracting
models– general preferences, finite horizon(increasing variance) or even shock pro-
cess (how persistent it is, we will see an example for this soon)
• Alternative theories to address this issue: can we modify the model to think about
optimal inequality? (if we have time, we’ll talk about them)
33
– Unequal discounting: Interpret each period as a generation; The planner puts
more weight on future generations than households: Phelan(2006, Restud),
Farhi and Werning(2007, JPE)
– Lack of Commitment: Planner cannot committ to future contracts; it realizes
that inequality is really high; will reneg. Can be shown to be equivalent to a
version of the above; Sleet and Yeltekin(RED, 2006)
– Fertility: Generational interpretation; planner can use both number of children
and promised utility to provide incentives; will use fertility more heavily and
hence there is a stationary distribution; Hosseini, Jones, and Shourideh(2010)
4.2 Persistent Shocks

• What happens with persistence? As we saw, the problem with persistence is im-
possible to solve because the state space becomes too large. Why? because we
need to know the deviation values for households, when they lie. But when there
is persistence, the household know the distribution of future payoffs but the plan-
ner does not. Easiest way to deal with this was to just stick those deviation values
into the state space. But then the problem becomes impossible to solve.
• Another way of doing this is to see that truth-telling values are related to each other
through the future stream of consumption so may be we can use some properties
of the shock process to relate these two values to each other. It turns out that there
is a special case where we can do this,the case where θt is a geometric random walk
log θt+1 = log θt + log ε t+1
Now, just think about a two period example. Moreover, assume that we represent
1

the allocations in terms of innovation shocks: ε t , c0 (ε 0 ) , c1 ε
The future utility of telling the truth, type ε 0
Z
w (ε 0 ) = θ−1 ε 0 ε 1 u (c1 (ε 0 , ε 1 )) dG (ε 1 )
The future utility of lying, ε 0 pretenfing to be ε̂ 0

Z
w (ε̂ 0 , ε 0 ) = θ−1 ε 0 ε 1 u (c1 (ε̂ 0 , ε 1 )) dG (ε 1 )
The future utility of telling the truth type ε̂ 0

Z
w (ε̂ 0 ) = θ−1 ε̂ 0 ε 1 u (c1 (ε̂ 0 , ε 1 )) dG (ε 1 )
34
It is easy to see that
ε0
w (ε̂ 0 , ε 0 ) = w (ε̂ 0 )
ε̂ 0
and hence the incentive constraint is given by
ε0
θ−1 ε 0 u (c0 (ε 0 )) + βw (ε 0 ) ≥ θ−1 ε 0 u (c0 (ε̂ 0 )) + β w (ε̂ 0 )
ε̂ 0
Notice that in the above two period example, if we let persistence to be ρ < 1, or
log θt+1 = ρ log θt + ε t+1
then ρ
ε0
w (ε̂ 0 , ε 0 ) = w (ε̂ 0 )
ε̂ 0
and the incentive constraint can be written as
ρ
ρ ρ ε0
θ−1 ε 0 u (c0 (ε 0 )) + βw (ε 0 ) ≥ θ−1 ε 0 u (c0 (ε̂ 0 )) + β w (ε̂ 0 ) (1)
ε̂ 0
• In case that ρ = 1, it is easy to extend the above analysis to a multi-period envi-

ronment. The reason is that promised utility and threat keeping utility are given
by
T Z Z
w ε t −1
, ε̂ t = ∑ β s − t −1
··· θ−1 ε 0 · · · ε t−1 ε̂ t ε t+1 · · · ε s u cs εt−1 , ε̂ t , ε t+1 , · · · , ε s dG (ε t+1 ) · · ·
s = t +1
T Z Z
t
∑ s − t −1
θ−1 ε 0 · · · ε t−1 ε t ε t+1 · · · ε s u cs εt−1 , ε̂ t , ε t+1 , · · · , ε s dG (ε t+1 ) · · ·

ŵ ε ; ε̂ t = β ···
s = t +1
t
ε t t −1
w ε ; ε̂ t = w ε , ε̂ t
ε̂ t
• Note that the above formulation with persistence ρ < 1 does not work any more.
This is because
T Z Z
ρ s +1 ρ s ρ s − t +1 ρ s − t ρ s − t −1

w ε t −1
, ε̂ t = ∑ β s − t −1
··· θ−1 ε 0 · · · ε t−1 ε̂ t ε t +1 · · · ε s u cs εt−1 , ε̂ t , ε t+1 , · · · , ε s dG (ε
s = t +1
T Z Z
ρ s +1 ρ s ρ s − t +1 ρ s − t ρ s − t −1

t
∑ s − t −1 t −1

ŵ ε ; ε̂ t = β ··· θ −1 ε 0 · · · ε t −1 ε t ε t +1 · · · ε s u cs ε , ε̂ t , ε t+1 , · · · , ε s dG (ε
s = t +1
35
• Now, let’s see what happens in the infinite horizon case – now only a two dimen-
sional state variable θ− and w.
Z
−C (u (θ )) + qP w0 (θ ) , θ

P (w, θ− ) = max dF (θ |θ− )
subject to
Z
θu (θ ) + βw0 (θ ) dF (θ |θ− ) = w

θ
θu (θ ) + βw0 (θ ) ≥ θu θ̂ + β w0 θ̂

θ̂

w
• Further characterization: conjecture P (w, θ− ) = P̂ θ− . Why?
w
Let v = θ− . We can rewrite the problem as

Z 1
0 θ
max −C (u (θ )) + q P̂ v (θ ) g dθ
θ− θ−
subject to

Z
0
1 θ
θu (θ ) + βθv (θ ) g dθ = θ− v
θ− θ−
θu (θ ) + βθv0 (θ ) ≥ θu θ̂ + βθv0 θ̂

or Z
−C (û (ε)) + q P̂ v̂0 (ε)

max g (ε) dε
subject to
Z
θ− εû (ε) + βεv̂0 (ε) g (ε) dε = θ− v

û (ε) + βv̂0 (ε) ≥ û (ε) + βv̂0 (ε)
Notice that the incentive constraint implies that û (ε) + βv̂0 (ε) is constant. So we
can combine promise promise keeping and IC’s and rewrite them as
v
û (ε) + βv̂0 (ε) =
E [ε]
Now, look at the above problem, This problem is independent of θ− . So by contrac-

tion mapping theorem, the solution to the above function equation only depends
on v. So we can rewrite the recursive problem by
Z
−C (û (ε)) + q P̂ v̂0 (ε)

P̂ (v) = max g (ε) dε
36
subject to
v
û (ε) + βv̂0 (ε) =
E [ε]
It is clear that in the solution to the above problem
û (ε) = û ε0

v̂0 (ε) = v̂0 ε0

No INSURANCE.
If the steady state of the above problem is given by v∗ and q is such that û (ε, v∗ ) = e,
then
ct θ t

= e
t
= θt v∗

wt θ
• Why? loose intuition: in this problem the planner uses differences in marginal rate
of substitution to provide incentives. With geometric random walk, the marginal
rate of substituition is the same across all types. No incentive for risk sharing can
be provided.
• This can be more clear by looking at the incentive constraint (1). Suppose that
−ρ
θ−1 = 1 and let v = ε 0 w (ε 0 ). Given this the incentive constraint becomes
ρ ρ
ε 0 u0 (ε 0 ) + βε 0 v (ε 0 ) ≥ ε 0 u0 (ε̂ 0 ) + βε 0 v (ε̂ 0 )
Now think about the trade-off between current utility, u0 , and future ’utility’, v (ε 0 ).
The slope of the indifference curve for a person of type ε 0 is given by
ρ −1
− βε 0
When ρ = 1, the slope of these indifference curves are all equal. Hence the planner
cannot exploit these differences to provide incentives. So the planner must treat all
agents similarly. The lower ρ, the higher it is the difference between these slopes.
Hence, for lower ρ’s, it is easier to provide incentives for truth telling and easier to
separate types.
• In the income shock interpretation of this model – with CARA, constant consump-
tion means autarky. So the variance of consumption still goes off to infinity in
the long run – geometric random walk. See Williams(2011, Econometrica) for a
continuous time version of this; Hopefully we will discuss continuous time soon.
37
5 Application: Optimal Unemployment Insurance
• We have learned the basic way to deal with dynamic contracting/mechanism de-
sign problems. The first application of those methods, we will consider is optimal
unemployment insurance.
• The main idea is that unemplyment insurance is desirable – it ensures worker

against income shocks, but it provides perverse incentives for people to look for
jobs.
• Questions: How should we design optimal unemployment insurance policy to bal-

ance insurance and incentives? How should benefits depend on the unemployment
spell? What should be the replacement ratio? etc.
• How do we model this tention? job seeking effort: private information with effort
being costly
• If provide full insurance against unemployment, nobody would ever look for a job.
• Can think of this as a dynamic contracting problem – Based on Hopenhayn and

Nicolini (1997, JPE).
• Basic environment: one agent and one unemployment insurance agency.(Can also
think of a continuum; doesn’t really make a difference in the way we write down
the contracting problem)
• Agent’s preference:
∞
∑ βt [u (ct ) − at ]
t =0
• Probability of finding a job: p ( at ):concave
• Job: a permanent wage w.(no firing); Employment: an absorbing state
• History ht = (s0 , · · · , st−1 ) where s j is 0 if unemployed at j and 1 otherwise.
• Contracts: ct (ht ), at (ht ). πt (ht ; at ) distribution of histories at t
• Unemployment agency’s problem wants to maximize household utility

∞ Z
max ∑ β t
[u (ct (ht )) − (1 − st (ht )) at (ht )] dπ (ht ; at )
t =0
• Total resources available to the insurance agency C:

∞ Z
∑β t
[ct (ht ) − wst (ht )] dπ (ht ; at ) = C
t =0
38
• Full information
ct ( ht ) = c
consumption is constant. a∗ solves
∞
βu0 (c) w

a = arg max ∑ β (1 − p ( a))
∗ t t
−a
a
t =0 1−β
• Private Information: revelation principle still applies; the planner suggest an action
to the agent; that action has to be optimal, i.e.,
∞ Z
∑ βt [u (ct (ht )) − (1 − st (ht )) at (ht )] dπ (ht ; at ) ≥
t =0
∞ Z
∑β t
[u (ct (ht )) − (1 − st (ht )) ât (ht )] dπ (ht ; ât )
t =0
for any other action profile ât (ht ).
• As before, we can focus on one-shot deviations. They only matter after histories
for which the worker has been unemployed. We can also define promise utility
ve ( ht ) , vu ( ht )
where ve (ht ) is the promised utility of a person who finds a job at the begining of
t + 1; vu (ht ) is the promised utility for a person who does not find a job; one-shot
IC is given by
− at (ht ) + β [ p ( at (ht )) ve (ht ) + (1 − p ( at (ht ))) vu (ht )] ≥

− â + β [ p ( â) ve (ht ) + (1 − p ( â)) vu (ht )]
• We are also gonna look at the dual as usual; so the unemployment insurance
agency minimizes the cost of insuring the agent subject to providing a least level
of utility.
• We are gonna jump right into the recursive formulation: Suppose Pu (v) and Pe (v)
are two value functions associated with employment and unemployment, then we
have
Pu (v) = min c + β [ p ( a) Pe (ve ) + (1 − p ( a)) Pu (vu )]
subject to
u (c) − a + β [ p ( a) ve + (1 − p ( a)) vu ] = v
− a + β [ p ( a) ve + (1 − p ( a)) vu ] ≥ − â + β [ p ( â) ve + (1 − p ( â)) vu ]
39
• As long as ve > vu , − â + β [ p ( â) ve + (1 − p ( â)) vu ] is a concave function. We can
replace by its first order condition
1 = βp0 ( a) (ve − vu )
•
Pu (v) = min c + β [ p ( a) Pe (ve ) + (1 − p ( a)) Pu (vu )]
subject to
u (c) − a + β [ p ( a) ve + (1 − p ( a)) vu ] = v
βp0 ( a) (ve − vu ) = 1
• Solving for Pe (v) is really easy; when people get a job their consumption is con-
stant. Also they do not have to look for jobs:
Pe (v) = min c − w + βPe v0

subject to
u (c) + βv0 = v
By Euler equation c has to be constant. Hence
u (c)
=v
1−β
and therefore
−w + u−1 ((1 − β) v)
Pe (v) =
1−β
• Now, let’s turn to the unemployed state’s problem. In general proving convex-
ity of the value function is almost impossible in dynamic contracting problems.
This is because of the non-convexity that incentive constraints introduce. So what
Hopenhayn and Nicolini do is to assume that the value function is convex and
differnetiable. Hence, we will be able to take first order conditions. They are given
by – let’s call consumption cu :
1 − λu0 (cu ) = 0
βp ( a) Pe0 (ve ) − λβp ( a) − ηβp0 ( a) = 0
β (1 − p ( a)) Pe0 (vu ) − λβ [1 − p ( a)] + ηβp0 ( a) = 0
βp0 ( a) [ Pe (ve ) − Pu (vu )] − λ −1 + βp0 ( a) [ve − vu ] − ηβp00 ( a) [ve − vu ] = 0

and an envelope condition

1
Pu0 (v ) =
u0 (cu )
40
We can rewrite the above
1 p0 ( a)
Pe0 (ve ) = + η
u0 (cu ) p ( a)
1 p0 ( a)
Pu0 (vu ) = − η
u0 (cu ) 1 − p ( a)
p0 ( a) [ Pe (ve ) − Pu (vu )] = η p00 ( a) [ve − vu ]
• Inverse Euler Equation.

Combingin the above with the envelope condition, we have the following
Pu0 (v) = p ( a) Pe0 (ve ) + (1 − p ( a)) Pu0 (vu )
We can think about the above equation as an Euler Equation for the UI agency.
Consider an increase in v by ε. As a result, the UI agency can increase cu by ε or
can increase ve and vu by εβ−1 . Note that the latter, does not affect the incentive
constraint. The beneft of the former change to the insurance agency is given by
1
ε = Pu0 (v ) ε
u0 (cu )
while the benefit of the latter perturbation is given by
β p ( a) Pe0 (ve ) + (1 − p ( a)) Pu0 (vu ) β−1 ε

At the optimal allocation, the UI agency should be indifferent between these two
perturbations, so we get the original equation. Notice that if we use Envelop con-
ditions, the above equation implies that
1 1
= Et
u0 (c t) u0 (c t +1 )
This is the so-called Inverse Euler Equation. It turns out that it is a very general
property of consumption in dynamic contracting problems, as long as the source
of private information, here cost of effort, is separable from consumption – think
about the above perturbation; what part of the argument fails if utility function
was of the form u (c, a)?
It also has a strong implication, that these agents should be saving constrained
when they are in the unemployed state. Why? This is because of Jensen’s inequality
1 1 1
= Et ≥
u0 (c t) u0 (c t +1 ) Et u0 (c t +1 )
41
and hence
u0 (ct ) ≤ Et u0 (ct+1 )
Note that the above inequality is strict in the unemployment state since future
consumption is not degenerate. So if the agent had access to saving technology
with return β−1 , he would like to save in order to decrease future promsied utility.
The reason is that in this model, saving tightens future incentive constraints. An
unemployed agent would rather save a little bit and put in less effort, lower than
what the UI agency would like him/her to do. This is because of concavity of
utlity function. If the agent increases his saving, his utility in the unemployed
state increases more than his utility in the employed state since utility function is
concave and therefore he has a lower incentive to exert effort.
• Decreasing Benefits.
Consider a decentralization in which UI agency doesn’t let the agents save. In this
decntralization, unemployment benefit is simply cu (v) when the state is unem-
ployed is at state v. Moreover, the agent pays unemployment taxes once he gets a
job. The tax level is given by w − ce (v) at state v. Given the strucutre of the model
we can define three objects:
1. vut : the promised utility for an agent who has been unemployed since t = 0
and is unemployed at the beginning of t.
2. vet+1 : the promised utility for an agent who has been unemployed since t = 0
and finds a job at the beginning of t + 1.
3. cut : the consumption of a person who is unemployed at t.
Now, whether benefits are decreasing or increasing depends on whether cut is a

decreasing or increasing sequence. Now consider the above FOCs. We have
1 p0 ( a) 1
Pu0 vut+1 =

0 u − η = 0 u
u (ct ) 1 − p ( a) u c t +1
So whether cut is bigger or smaller than cut+1 is determined by the sign of η.
Lemma 2. η > 0.
Proof.
Suppose not. Then
Pu0 (vu ) ≥ Pu0 (v ) ≥ Pe0 (ve )
together with convexity of the value function and local incentive compatibility im-
plies that
v ≤ vu < ve
42
Note that cu ≥ ce = u−1 ((1 − β) ve ) since η ≤ 0. Now, we can write
v − ve = [u (cu ) − u (ce )] − a + β [1 − p ( a)] (vu − ve )
or
v − ve + β (ve − vu ) = [u (cu ) − u (ce )] − a + βp ( a) (ve − vu )

v − vu + ( β − 1) (ve − vu ) = [u (cu ) − u (ce )] − a + βp ( a) (ve − vu )
Note that the RHS of the above is positive since cu ≥ ce and that a is incentive
compatible. However, the left hand side is negative since v ≤ vu < ve and β < 1.
A contradiction. Q.E.D.
Since η > 0, then
1 p0 ( a) 1
0 u − η = 0 u
u (ct ) 1 − p ( a) u c t +1
implies that
1 1
> 0 u ⇒ cut > cut+1
u0 (cut ) u c t +1
Moreover, by assumption, Pu is convex and therefore
vut > vut+1
• Dependence of Taxes on Duration

The unemployment tax is w − ce (vet ) for an agent that found a job at t. It is very nat-
ural that vet changes with t – taxes are history dependent; they depend on duration.
How do they depend on the duration?
p00 ( a) p( a)(1− p( a))
Proposition 3. Suppose either of the following conditions hold: i. − is
βp0 ( a)3
p00 ( a)
increasing in a, ii. − is increasing in a, then taxes paid by workers increase with
p 0 ( a )2
unemployment duration, i.e., vet > vet+1 .
Proof.
We have
1
p0 ( a) [ Pe (ve ) − Pu (vu )] = η p00 ( a)
βp0 ( a)
and
p ( a) (1 − p ( a))
η = Pe0 (ve ) − Pu0 (vu )

p0 ( a)
hence
p00 ( a) p ( a) (1 − p ( a))
Pe (ve ) − Pu (vu ) = Pe0 (ve ) − Pu0 (vu )

βp0 ( a)3
43
Now suppose to the contrary that vet+1 > vet , then since vut+1 < vut . This together
with IC and concavity of p ( a) implies that at+1 > at . Under assumption i.,
p00 ( at+1 ) p ( at+1 ) (1 − p ( at+1 )) p00 ( at ) p ( at ) (1 − p ( at ))

− >−
βp0 ( at+1 )3 βp0 ( at )3
Moreover,
Pe0 vet+1 > Pe0 (vet ) > Pu0 (vet ) ≥ Pu0 vut+1

due to convexity of Pe and Pu . Therefore,
p00 ( at+1 ) p ( at+1 ) (1 − p ( at+1 )) p00 ( at ) p ( at ) (1 − p ( at )) e0 e

Pe0 vet+1 − Pu0 vut+1 > −

− P (vt ) −
βp0 ( at+1 )3 βp0 ( at )3
or
Pe vet+1 − Pu vut+1 < Pe (vet ) − Pu (vut )

However, this is in contradiction with the fact that Pe and Pu are both increasing.
When assumption ii. holds, the argument is similar.
• Intuitively, absent incentive constraints and due to insurance reasons, the planner
would like to equate vut and vet . So a decrease in vut should be accompanied by a
decrease in vet . However, the planner might want to make sure that agents exert
the efficient level of effort. So provided that the effect of keeping ve and vu close is
not so strong on incentives, then it is efficient to have vut be decreasing over time.
5.1 The Role of Saving

• Above, we assumed that the UI agency controls agents consumption. Furthermore,
we showed that the agents were in general saving constrained, i.e., they would like
to save on their own if they have the opportunity to do so. A natural question is
what happens when we let them do so? Here we try to formulate this.
• We make the following change in the environment. Assume that the timing of the
events in each period is as follows: upon entering date t the households consume,
ct , they then look for jobs by exerting effert, and will realize whether they find a
job or not, with probability pt . We assume that the utility function in each period
is given by
u ( c t , (1 − s t −1 ) p t −1 )
Notice that we have assumed that utility is a direct function of job finding rate as
opposed to effort.
• Suppose that in addition to effort, saving by agents is also hidden. A contract in
44
this case is consisted of
{ct (ht ) , τt (ht ) , pt (ht ) , bt (ht )}
where τt (ht ) is the transfer to the agent, bt is a suggested level of saving by the
planner with b0 = 0 and ct is defined by the following budget constraint
ct (ht ) + bt (ht ) = τt (ht ) + wst (ht ) + β−1 bt−1 (ht−1 )
• In this case, the allocation is said to be incentive compatible if it is the solution to

the following maximization problem
∞
max ∑ β ∑π
ĉt (ht ), p̂t (ht ),b̂t (ht ) t=0
t
ht ; p̂ t −1
[u (ĉt (ht ) , (1 − st−1 ) p̂t−1 (ht ))]
ht
subject to
ĉt (ht ) + b̂t (ht ) = τt (ht ) + wst (ht ) + β−1 b̂t−1 (ht−1 )
together with an appropriate borrowing limit that is low enough so that it is never
binding.
• So the UI agency now would like to minimize the cost of providing an allocation
subject to incentive compatibility and an appropriate promise keeping. The UI
agency also has access to the same borrowing and lending rate β−1 .
• First observation: without loss of generality, we can assume that in any incentive
compatible allocation, bt (ht ) = 0. Intuitively, as long as agents don’t want to
deviate, the UI agency can save for them. More technically, one can start from an
allocation with bt (ht ) 6= 0 and define transfers as
τ̃ (ht ) = τ (ht ) + β−1 bt−1 (ht−1 ) − bt (ht )
It can be shown that the contract {c (ht ) , τ̃ (ht ) , pt (ht ) , 0} is incentive compatible.
• Incentive constraint is very complicated now. One way to simplify, as always, is to
focus on the first order conditions. What are they? The first order condition with
respect to at is given by
u (cet (ht ) , pt−1 (ht−1 )) + βvet (ht ) − u (cut (ht ) , pt−1 (ht−1 )) − βvut (ht )
+ pu p (cet (ht ) , pt−1 (ht )) + (1 − p) u p (cet (ht ) , pt−1 (ht−1 )) = 0
when ht = ( 0, · · · , 0 ),similar to before. Additionally, there is first order condition

| {z }
t+1 times
with respect to bt :
uc (ct (ht ) , pt−1 (ht−1 )) = E [uc (ct+1 , (1 − st ) pt ) |ht ]
45
An Euler equation, c.f., Inverse Euler Equation.
In order for this relaxed version of incentive compatibility to be equivalent to the
original definition, the objective in the original must be concave. Nothing guar-
antees that this is the case. In fact, here I show you a two period example where
the two constraints are not equivalent – for more detailed discussion see Kocher-
lakota(2004, Review of Economic Dynamics).
• Consider the following two period environment: preferences are given by
u ( c1 ) + u ( c2 ) − v ( p1 )
where p1 determines the distribution of income at t = 2:

E with probability p
y=
U with probability 1 − p
Suppose the optimal value of p is given. Then the partially planning problem is
given by
min c1 + pc E + (1 − p) cU
c1 ,c E ,cU
subject to
u (c1 ) + pu (c E ) + (1 − p) u (cU ) − v ( p) ≥ w
(0, p) ∈ arg max u (c1 − s) + p̂u (c E + s) + (1 − p̂) u (cU + s) − v ( p̂) (2)
s, p̂
The ralxed version of the problem is given by
min c1 + pc E + (1 − p) cU
c1 ,c E ,cU
subject to
u (c1 ) + pu (c E ) + (1 − p) u (cU ) − v ( p) ≥ w
u0 (c1 ) = pu0 (c E ) + (1 − p) u0 (cU )
v 0 ( p ) = u ( c E ) − u ( cU )
The three constraints pin down the level of consumption. For the allocation to be
incentive compatible, this has to be the solution to the maximization problem (2).
For this to happen, the Hessian matrix associated with that problem should be
negative semi-definite at that point. This hessian matrix is given by
p
− 1c−2 p
" #
− c12 − c2E
1
cE − 1
cU
1 U
1
cE − 1
cU −v00 ( p)
46
When v00 ( p) is small – very little curvature in the cost function, it is possible that
the determinant of this matrix is negative so there are potential second order gains
from deviations.
• Next we consider some cases where we have closed form solutions and we can
check whether the first order approach is valid.
• Let’s switch to the original problem. How can we rewrite the problem recursively
to incorporate the Euler equation? Werning(2000) shows that if we keep track of
uc = λ in addition to v, then we can rewrite the problem recursively. The only
thing we have to worry about is that not all pairs of (v, λ) are attainable. In order
to ensure this, he proposes a procedure similar to Abreu, Pearce, and Stachetti with
set operators and the fixed point of that operator leads to two sets, ∆u and ∆e such
that
∆s = {(v, λ) | (v, λ) is attainable by some contract}
I will side step this issue here since we will work with cases in which we can
characterize these sets analytically.
• The recursive representation of the problem is given by:

When employed at the end of the last period
Pe (v, λ) = min c − w + βPe v0 , λ0

c,v0 ,λ0
subject to
u (c, 0) + βv0 ≥ v
λ = uc (c, 0)
v0 , λ0 ∈ ∆e

When unemployed at the end of the last period:
Pu (v, λ) = min p [ce − w + βPe (ve , λe )] + (1 − p) [cu + βPu (vu , λu )]

p,ce ,cu ,λe ,ve ,λu ,vu
subject to
p [u (ce , p) + βve ] + (1 − p) [u (cu , p) + βvu ] ≥ v

puc (ce , p) + (1 − p) uc (cu , p) = λ
{u (ce , p) + βve − u (cu , p) − βvu }
pu p (ce , p) + (1 − p) u p (cu , p) = 0
(vs , λs ) ∈ ∆s , s = e, u
47
• Let’s assume that the utility function satisfies the following
1
u (c, p) = − e−ψ(c−α( p))
ψ
where v ( p) is a convex function.
• The first step is to characterize ∆s . Given the above utility function, we have
uc (c, p) = −ψu (c, p)
Now, from the Euler equation
uct = Et uc,t+1 = Et uc,s
and therefore
ut = Et ut+1 = Et us , s > t
Therefore
∞
u t −1
v = Et−1 ∑ βs us =
s=t 1−β
1 uc,t−1 1
= − =− λ
ψ1−β ψ (1 − β )
When we assume that households can only save the above equalities become and
inequality. In the optimal contract, however, one can show that these inequalities
bind, so we ignore them here.
The above equality not only characterizes the sets ∆s , it also means that we can
drop λ as state variable.
• So the recursive problem becomes:
Pe (v) = min c − w + βPe v0

subject to
u (c, 0) + βv0 = v
uc (c, 0) = −ψ (1 − β) v
Pu (v) = min p [ce − w + βPe (ve )] + (1 − p) [cu + βPu (vu )]
48
subject to
p [u (ce , p) + βve ] + (1 − p) [u (cu , p) + βvu ] = v

puc (ce , p) + (1 − p) uc (cu , p) = −ψ (1 − β) v
{u (ce , p) + βve − u (cu , p) − βvu }
pu p (ce , p) + (1 − p) u p (cu , p) = 0
Note that
u p (c, p) = −ψα0 ( p) e−ψ[c−α( p)] = ψα0 ( p) u (c, p)

uc (c, p) = ψe−ψ[c−α( p)] = −ψu (c, p)
So we can rewrite the above problem as
Pu (v) = min p [ce − w + βPe (ve )] + (1 − p) [cu + βPu (vu )] (3)
subject to
p [u (ce , p) + βve ] + (1 − p) [u (cu , p) + βvu ] = v

pu (ce , p) + (1 − p) u (cu , p) = (1 − β) v
{u (ce , p) + βve − u (cu , p) − βvu }
+ψα0 ( p) [ pu (ce , p) + (1 − p) u (cu , p)] = 0
Similar to the taste shock cases studied before, the constraint set is linear in terms
of u (c, p)’s and v’s. So we conjecture the following
1
ce (v) = ĉe − log (−v)
ψ
1
cu (v) = ĉu − log (−v)
ψ
e e
v (v) = v̂ · (−v)
vu (v) = v̂u · (−v)
p (v) = p̂
and
1
Pu (v) = Au − log (−v)
ψ (1 − β )
1
Pe (v) = Ae − log (−v)
ψ (1 − β )
Not gonna go through the algebra. Can check again that vu (v) < v.
49
• Are there simple policies that can implement the above optimal allocation? Let’s
try a simple policy: constant unemployment benefit b̂, constant tax τ̂. Now think
about a household’s problem
V u ( a) = max p [u (ce , p) + βV e ( ae )] + (1 − p) [u (cu , p) + βV u ( au )] (4)

p
subject to
ce + ae ≤ w − τ̂ + β−1 a
cu + au ≤ b̂ + β−1 a
together with
V e ( a) = max u (c, 0) + βV e a0

subject to
c + a0 ≤ w − τ̂ + β−1 a
• We can show that there exists τ̂ and b̂ so that the solution to the above problem
coincides with the optimal allocations. To do so note that the functional forms for
the above value functions is given by
−1
V u ( a) = − Âu e−ψ( β −1) a
−1
V e ( a) = − Âe e−ψ( β −1) a
Compare this with
1
Pu (v) = Au − log (−v)
ψ (1 − β )
1
Pe (v) = Ae − log (−v)
ψ (1 − β )
or
u u (v)
v = − e ψ (1− β ) A e − ψ (1− β ) P
e e (v)
v = − e ψ (1− β ) A e − ψ (1− β ) P
u e
Now, if we set τ̂ and b̂ so that eψ(1− β) A = Âu and eψ(1− β) A = Âe , then Pu (v) and
Pe (v) are associated with β−1 a. Moreover, it can be checked that the solution for p
in (4) is identical to the solution in (3). Moreover, since the margin between c and
v0 in (3) is undistorted – the same as in (4), one can show that the solution to the
planner’s problem coincides with the solution to the agent’s problem given v0 , a0
is chosen so that Pu (v0 ) = β−1 a0 – we assume that the ange starts unemployed.
• To illustrate how the model changes with search explicitly modeled, we setup the
50
model with McCall search – Shimer and Werning (2008, AER): agents draw a wage
from a distribution F (w); decide whether to accept or reject the offer; The value of
the offer is private information. The model is very similar to the above.
– A contract is a sequence of {w̄t , bt , τt } where bt is the transfer to the unem-

ployed who’s been unemployed for t periods, τt is the tax paid by the unem-
ployed who find a job at t and w̄t is a suggestion of a reservation wage to the
unemployed at date t.
– Consider an agent who comes into period t unemployed and draws wage, if
he accepts the job, his utility will be
u (w − τt )
1−β
and if he doesn’t, his utility will be
u (bt ) + βvt+1
where vt+1 is the ex-ante utility of an unemployed agent at t + 1. For the agent
to follow the recommended reservation wage, we must have
u (w̄t − τt )
= u (bt ) + βvt+1
1−β
where
Z ∞
u (w − τt )
vt = (1 − F (w̄t )) (u (bt ) + βvt+1 ) + dF (w)
w̄t 1−β
6 Application: Optimal Dynamic Taxation

• In this part, we use the techniques that we have seen so far to think about optimal
taxes in dynamic settings. To do so we first have to think about what restrictions
we want to put on tax function. In the static setting, this was easy. The government
could only see income and there were no markets for insurance against income
shocks in advance. Given this, a government’s problem becomes
Z
V ( T; θ ) dG (θ )
subject to
Z
TdF (θ ) = g
V ( T; θ ) = max u (y − T (y) , y; θ )
y
51
Now, we need to turn this into a mechanism design problem. To do so, consider
a tax function and the allocation that is implied by it, i.e., c (θ; T ) = y (θ; T ) −
T (y (θ; T )) so that u (c (θ; T ) , y (θ; T ) ; θ ) = V ( T; θ ). This allocation has to be in-
centive compatible because
u (y (θ; T ) − T (y (θ; T )) , y (θ; T ) ; θ ) ≥ u (y − T (y) , y; θ )

≥ u y θ̂; T − T y θ̂; T , y θ̂; T ; θ
Moreover, consider an incentive compatible

mechanism c (θ ) , y (θ ). Note that,
by
incentive compatbility, if y (θ ) = y θ̂ (= y), then we must have c (θ ) = c θ̂ , since

u (c (θ ) , y; θ ) ≥ u c θ̂ , y; θ

u c θ̂ , y; θ̂ ≥ u c (θ ) , y; θ̂
This means that a function T (y) must exist such that c (θ ) = y (θ ) − T (y (θ )). What
we have proved is the Taxation Principle.
In dynamic environments this becomes a bit trickier. It is very plausible to as-
sume that there are some insurance markets to insure households against some
of the productivity shocks they receive; health insurance for instance. This means
that when we right down the problem of an agent, we should take into account
what type of insurance markets are available to the household. Unfortunately, our
underlying friction – private information – does not pin down the limits of govern-
ment and markets. So for now, we assume that markets are incomplete and that
the only tool available to households for insurance is self-insurance a la Aiyagari.
More instead of writing the problem as a problem of finding best taxes, we start
directly from the mechanism design problem and then derive the properties of the
tax functions that can implement efficient allocation.
• The setup is as follows – based on Golosov, Kocherlakota, Tsyvinski: time: t =

0, 1, · · · , T with T ∈ N∪ {∞}
• A continuum of households subject to productivity shocks: θt . Most general

stochastic process for θt : There exists some distribution π θ T overall possible
histories.
• Preferences:
T
yt
∑β t
u (ct ) − v
θt
t =0
• Allocations:

T
ct θ : ΘT → R

yt θ T : ΘT → R
52
such that ct θ T and yt θ T are both measurable with respect to θ t – they cannot

depend on information that has not arrived at period t.
• Feasible allocations
Z Z
ct θ dπ θ + Kt+1 − (1 − δ) Kt = F Kt , yt θ dπ θ T
T T T
• Incentive compatibility:
( " !#)
T yt θ T
E0 ∑ βt u ct θ T −v ≥
t =0 θt
( " !#)
T yt σ θ T
E0 ∑ βt u ct σ θ T −v
θt
, ∀σ : Θ T → Θ T
t =0
• Mechanism Design Problem is to maximize agent’s ex-ante utility subject to incen-

tive compatibility and feasibility.
Inverse Euler Equation
• A key property that we have come across before is the Inverse Euler Equation. Any
solution of the mechanism design problem should satisfy
1 1 1
= Et 0
u0 (c T
t ( θ )) β [1 − δ + FK,t+1 ] u (ct+1 (θ T ))
• The idea behind this equation is that this is an Euler equation for the insurance
agency. Consider an insurance agency who wants to decide between whether to
deliver utility(from consumption) in period t and history θ t or to deliver utility in
period t + 1 for all histories θ t+1 following θ t . At the margin this insurance agency
should be indifferent to deliver utility at t vs. t + 1. To see what this implies,
consider a small decrease in utility at history θ t by ε and a small increase in utility
from consumption at t + 1 in all states θ t+1 following θ t , i.e.,

u ĉt θ T = u ct θ T − ε

u ĉt+1 θ T = u c t +1 θ T + β −1 ε
Note that this perturbation leaves incentive compatibility unchanged. At θ t the

expected utility of the households, when telling the truth and when lying has not
changed. Moreover, at t + 1, since utility of the households with the common
history θ t has gone up uniformly, neither of them has an additional incentive to lie.
53
Now, the benefit of the above perturbation at t is given by
ε
u0 (c T
t ( θ ))
while the cost of it at t + 1 is given by
1 ε
Et 0
β u (ct+1 (θ T ))
To make the benefit in terms of period t goods, we have to discount them by the
gross interest rate given by 1 − δ + FK,t+1 and hence we have the above equation.
• Using Jensen’s inequality, we have that

u0 ct θ T ≤ β [1 − δ + FK,t+1 ] Et u0 ct+1 θ T
with equality only if there is no variation in ct+1 θ T , or the household should be

saving constrained. Later we will interpret this as a tax on capital.
• To see more intuitively why the above equation holds, we consider the following
simple example:
• 2-periods, θ0 = θ̄ and θ1 ∈ {θ L < θ H } with π H = Pr (θ1 = θ H ) = 1 − π L .
• F (K, Y ) = RK + Y and δ = 1.
• So the mechanism design problem can be written as

y
y1i
max u (c0 ) − v
0
+ ∑ πi u (c1i ) − v
θ̄ θi
subject to
1 1
c0 +
R i∑ πi c1i ≤ y0 + ∑ πi y1i
R i

y1L y1H
u (c1L ) − v ≤ u (c1H ) − v
θH θH
n o
Now take the solution to the above problem c0 , y0 , {c1i , y1i }i= H,L . There are two
key properties that will provide intuition for us. First, c1H > c1L . Second, the IC
constraint binds with equality.
• Now consider increasing the household’s risk-free saving at date 0 by ε > 0. In

addition to the usual cost and benefit of this saving – absent private information
this leads to the usual Euler Euqation, this saving has an effect on the incentives for
54
truth-telling in the future. The RHS of the IC constraint is increased by u0 (c1H ) Rε
and its LHS is increased by u0 (c1L ) Rε. Now since c1H > c1L and u is concave, the
RHS is increased by less than the LHS. Hence saving decreases the incentive for
truth-telling in the future. Hence, in addition to decreasing consumption today,
saving tightens future incentive constraints and therefore it has an additional cost.
Hence, on the margin
u0 (c0 ) + Incentive Cost of saving = RE0 u0 (c1 )
This implies that the household should be saving constrained.

• An important assumption for this result is the separability of consumption and
leisure. To see how different specifications determine whether the household
should be saving constrained or borrowing constrained, consider the following
alteration to
the example above: preferences in the second period are given by
y
U c1 − v θ1 . Under this, the incentive constraint becomes

y1L y1H
U c1L − v ≤ U c1H − v
θH θH
Since this incentive constraint binds in the second period, the solution to the mech-
anism design problem must satisfy

y1L y1H
c1L − v = c1H − v
θH θH
Now consider increasing saving by ε and increasing c1L and c1H by Rε. As it can
be seen from above, this perturbation changes the RHS and LHS of the above IC
by the same amount. Hence, the incentive cost of saving in this model is zero and
therefore Euler Equation must hold
u0 (c0 ) = RE0 U 0 (c1 − v (y1 /θ1 ))
• As the above analysis suggests, whether the houehold should be saving constrained
or borrowing constrained, depends on how marginal utility when telling the truth
is compared to marginal utility when lying for binding incentive constraint. In the
separable case, marginal utility when the telling the truth is lower than when lying
hence saving tightens the incentive constraints in the future. In Shourideh(2011),
I develop a model with capital income risk where truth-telling marginal utility is
higher than lying marginal utility and hence sometimes it is optimal to subsidize
saving.
Implementation
• So far we have focused on the mechanism design problem. Here we try to see, first
through the lens of the above example, how to implement the solution to the above
55
mechanism design problem. As mentioned before, we assume that the only asset
available to the households is a risk free bond. Now consider the above two period
example and suppose that there are no taxes in the first period and taxes in the
second period are a function of labor income and asset/capital income. Given this
market structure, the household budget constraint are given by
c0 + b1 ≤ y0
c1 ≤ y1 + (1 + r1 ) b1 − T (y1 , r1 b1 )
Household’s problem is given by

y
max u (c0 ) − v
0
+ ∑ πi [u (c1i ) − v (y1i /θi )]
θ̄ i
subject to
c0 + b1 ≤ y0
c1i ≤ y1i + (1 + r1 ) b1 − T (y1i , r1 b1 )
where r1 = R − 1 is the equilibrium interest rate.
• The goal is to find a tax function T (·, ·) so that the solution to the above problem
coincides with the solution to the mechanism design problem c0∗ , y0∗ , c1i ∗ , y ∗ , b ∗ (=
1i 1
y0∗ − c0∗ ).
• Let’s start from a simple tax function T (y1 , r1 b1 ) = T y (y1 ) + τk r1 b1 . Given the
allocation, the candidate for τk is given by
1 u0 (c0∗ )
τk∗ = 1 + −
r1 rE0 u0 c1∗

Therefore, T y (y) can be constructed from the budget constraint:

∗ ∗ ∗
T y (y1i ) = y1i − c1i + (1 + r1 (1 − τk∗ )) b1∗
For other values of y, we construct T y (y) as in the static case;
• Obviously, the solution of the mechanism design problem is feasible. However, it

turns out that for this specific tax function, there is a deviation that delivers more
56
utility. Consider the following allocation:
c0 = y0∗ − ε
b1 = b1∗ + ε
∗
y1i = y1L
∗ ∗
c1i = y1i − T y (y1i ) + (1 + r1 (1 − τk∗ )) (b1∗ + ε)
∗
= c1L + (1 + r1 (1 − τk∗ )) ε
The utility from the constrained efficient allocation is given by
u (c0 ) − v y0 /θ̄ + ∑ πi [u (c1L

∗ ∗

) − v (y1L /θi )]
i
where we have used the fact that incentive constraint binds.

The utility from the above plan is given by
u (c0 − ε) − v y0 /θ̄ + ∑ πi [u (c1L

∗
+ ε (1 + r (1 − τk∗ ))) − v (y1L
∗

/θi )]
i
The change in utility is approximately equal to
−u0 (c0 ) ε + ∑ πi u0 (c1L

∗
) (1 + r (1 − τk∗ )) ε
i
> −u (c0 ) ε + ∑ πi u0 (c1i
0 ∗
) (1 + r (1 − τk∗ )) ε = 0
i
The idea behind this deviation is that when facing a linear tax function on saving,
the household finds it optimal to save a bit more than what she is supposed to and
work less.
• One way to resolve this issue is to allow for non-linear asset/capital income tax.
For example, suppose that the capital tax function has a kink at r1 b1∗ . That is
T (y1 , r1 b1 ) = T y (y1 ) + T b (r1 b1 )
with
b0 1 u0 (c0∗ )
lim T (r1 b1 ) = 1 + − 0 ∗
b1 &b1∗ r ru c1L
1 u0 (c0∗ )
lim∗ T b0 (r1 b1 ) = 1 + − ∗
r rEu0 c1L

b1 %b1
Then clearly the above double deivation doesn’t not deliver higher utility. However,
there might be some other deviations that deliver a higher level of utility. To find
the tax function T b (r1 b1 ) we do as follows:
57
Consider the following maximization problem
V ( x ) = max ∑ πi [u (c1i ) − v (y1i /θ1i )]

y1i ,c1i
i
subject to
c1i = y1i − T y (y1i ) + x
Now, define the function T b (r1 b1 ):

u (y0 − b1 ) − v y0 /θ̄ + V (1 + r1 )b1 − T b (b1 r1 ) = u∗

where u∗ is the utility level from the solution to the mechanism design problem.
This is the lowest asset tax function that can implement the optimal allocation.
See Werning(2011, ‘Nonlinear Capital Taxation’) for a proof of differentiability of
T b (r1 b1 ) when the distribution of shocks is continuous as well as its extension of
multiple periods.
• There are other implementations. In particular implementations where the capi-

tal/asset income taxes are risky a la Kocherlakota(2005) and Albanesi and Sleet(2006),
i.e., the tax function is non-separable between labor and capital income.
i.i.d. Shocks
• Here we study optimal capital and labor income taxes in a dynamic setting with
i.i.d. shocks. As before, the problem can be written in recursive form using promise
utility w as state variable. The mechanism design problem as before is given by
Z
c (θ ) − y (θ ) + qt+1 Pt+1 w0 (θ )

Pt (w) = min dF (θ )
subject to
Z
u (c (θ )) + h (y (θ ) , θ ) + βw0 (θ ) dF (θ ) = w

u (c (θ )) + h (y (θ ) , θ ) + βw0 (θ ) ≥ u c θ̂ + h y θ̂ , θ + βw0 θ̂

The above formulation is more general than before. In particular, it allows us to

study cases where the shock is a taste shock to the value of leisure:
h (y, θ ) = θ ĥ (1 − y)
• Before trying to characterize the solution to the above problem, we first try and see
if we can show the convexity of the value function. Obviously at its current form
the constraint set of the above problem is not concave – concave functions showing
up on the RHS of the IC. This mean that the usual techniques from SLP cannot
58
be applied. However, there is a transformation of variables that might make the
constraint set convex. Consider the following variables
υ (θ ) = u (c (θ ))
η (θ ) = h (y (θ ) , θ )
Note that the period objective is given by
C (υ (θ )) − Y (η (θ ) , θ )
where
u (C (υ)) = υ
h (Y (η, θ ) , θ ) = η
• Under this transformation, the constrain set can be written as

Z
υ (θ ) + η (θ ) + βw0 (θ ) dF (θ ) = w

υ (θ ) + η (θ ) + βw0 (θ ) ≥ υ θ̂ + h Y η θ̂ , θ̂ , θ + βw0 θ̂

For this constraint
set to be convex, we must have that h Y η θ̂ , θ̂ , θ is a convex
function of η θ̂ . In general it is hard to come up with conditions on h (·, ·) so that
this function is convex. There are some cases, however, that the above function
becomes linear in η θ̂ . These are cases where h (y, θ ) = ĥ (y) g (θ ) where ĥ (y) is
concave and decreasing. Under this assumption

−1 η
Y (η, θ ) = ĥ
g (θ )
and hence
! !
η θ̂
= h ĥ−1

h Y η θ̂ , θ̂ , θ ,θ
g θ̂
!!
η θ̂
= ĥ ĥ−1 g (θ )
g θ̂

η θ̂
= g (θ )
g θ̂
There are two examples that satisfy the above criterion:
59
– Productivity shocks + constant Frisch Elasticity specification
1 y 1+ γ
h (y, θ ) = −
1+γ θ
– Taste shock to the value of leisure
h (y, θ ) = θh (1 − y)
Here y can be interpted as hours worked which is observable.
• Another way of ensuring that the constraint set is convex is to assume that only
downward constraints bind and that hh11 is a decreasing function of θ – can be
1
interpreted as decreasing absolute risk aversion with respect to θ.
• Example: Here we focus on an example where we have closed form solutions and
see how taxes evolve over time and in the cross section. Assume that preferences
have the following form
1
log c + log (1 − y)
θ
These preferences imply that optimal static distortions are independent of how
much wealth is brought in by the household, i.e., MRS between c and l is the same
when telling the truth and when lying.
• The recursive formulation is given by

Z
c (θ ) − y (θ ) + qt+1 Pt+1 w0 (θ )

Pt (w) = min dF (θ )
subject to
Z
U (θ ) dF (θ ) = w
log c (θ ) + θ −1 log (1 − y (θ )) + βw0 (θ ) = U (θ )

log c (θ ) + θ −1 log (1 − y (θ )) + βw0 (θ ) ≥ log c θ̂ + θ −1 log 1 − y θ̂ + βw0 θ̂

If we let υ (θ ) = log c (θ ) and η (θ ) = log (1 − y (θ )), then we can rewrite this

problem as
Z h i
Pt (w) = min eυ(θ ) + eη (θ ) − 1 + qt+1 Pt+1 w0 (θ ) dF (θ )
60
subject to
Z
U (θ ) dF (θ ) = w
υ (θ ) + θ −1 η (θ ) + βw0 (θ ) = U (θ )
U 0 ( θ ) = − θ −2 η ( θ )
Starting from last period, t = T , we can guess that

w
υT (θ, w) = υ̂T (θ ) +
1 + Eθ −1
w
ηT (θ, w) = η̂T (θ ) + −1
w
Z 1h+ Eθ i
υ̂T (θ ) η̂T (θ )
PT (w) = e 1 + E [ 1/θ ] e +e dF (θ ) − 1
w
= A T e 1+E[1/θ ] − 1
where {η̂T (θ )} and {υ̂T (θ )} are the solution to the planning problem
Z h i
min eυ(θ ) + eη (θ ) dF (θ )
{υ(θ ),η (θ )}
subject to
Z
[υ (θ ) + θη (θ )] dF (θ ) = 0
υ 0 ( θ ) + θ −1 η 0 ( θ ) = 0
Note that given this solution, labor wedge is given by
h0 (1 − y (θ ))
1 − τl,T (θ ) =
θu0 (c (θ ))
1
= eυ̂T (θ )−η̂T (θ )
θ
and hence is independent of history so far.
• At T − 1, the recursive formulation of the problem is given by

Z w0 (θ )

υ(θ ) η (θ )
PT −1 (w) = min e +e − 1 + qT AT e 1+ E[1/θ ] −1 dF (θ )
61
subject to
Z
U (θ ) dF (θ ) = w
υ (θ ) + θ −1 η (θ ) + βw0 (θ ) = U (θ )
U 0 ( θ ) = − θ −2 η ( θ )
Note that since consumption is separable from labor supply, th margin between c
and w0 is undistorted, i.e.,
1 w0 (θ )
e υ ( θ ) = β −1 q T A T e 1+E[1/θ ]
1 + E [1/θ ]
Hence, the objective can be written as

Z h i
υ(θ ) η (θ )
PT −1 (w) = min e (1 + β (1 + E [1/θ ])) + e dF (θ ) − 1 − q T
subject to
Z
U (θ ) dF (θ ) = w
υ (θ ) + θ −1 η (θ ) + βw0 (θ ) = U (θ )
U 0 ( θ ) = − θ −2 η ( θ )
Policy functions:
w
υT −1 (w, θ ) = υ̂T −1 (θ ) +
(1 + β) (1 + E [1/θ ])
w
ηT −1 (w, θ ) = η̂T −1 (θ ) +
(1 + β) (1 + E [1/θ ])
w
wT −1 (w, θ ) = ŵT −1 (θ ) +
1+β
w
PT −1 (w) = A T −1 e (1+β)(1+E[1/θ ])
where {υ̂T −1 (θ ) , η̂T −1 (θ )} solves the following problem

Z h i
A T −1 = min eυ(θ ) (1 + β (1 + E [1/θ ])) + eη (θ ) dF (θ )
subject to
Z h i h i
υ (θ ) (1 + β (1 + E [1/θ ])) + θ −1 η (θ ) dF (θ ) = β (1 + E [1/θ ]) log β−1 q T A T / (1 + E [1/θ ])
υ0 (θ ) (1 + β (1 + E [1/θ ])) + θ −1 η 0 (θ ) = 0
62
• In general, we can show that
w
υt (w, θ ) = υ̂t (θ ) +
αt
w
ηt (w, θ ) = η̂t (θ ) +
αt
0
wt (w, θ ) = αt+1 υt (w, θ ) − ψt
w
Pt (w) = At e αt
where ψt is some constant, αt = 1 + β + · · · + β T −t (1 + E [1/θ ]), and {υ̂t (θ ) , η̂t (θ )}

is the solution to the following program

Z h i
At = min (1 + βαt+1 ) eυ(θ ) + eη (θ ) dF (θ )
subject to
Z h i
(1 + βαt+1 ) υ (θ ) + θ −1 η (θ ) dF (θ ) = βψt
(1 + βαt+1 ) υ0 (θ ) + θ −1 η 0 (θ ) = 0
From this, we can see that the labor wedge
h0 1 − lt θ t

t

1 − τl,t θ =
θt u0 (ct (θ t ))
ct θ t

1 υ̂t (θt )−η̂t (θt )
= = e
θt (1 − lt (θ t )) θt
Hence, labor wedges are indpendent of history. However, they depend on t. More-
over, taxes should increase over life cycle.
• What about capital taxes
63

Contracts in Macroeconomics

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Contracts in Macroeconomics

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Contracts in Macroeconomics

1 Contracts and Mechanism Design

– Competitive equilibrium; linear contracts

• Standard approach in macro: Arrow-Debreu competitive markets

– ignores incentive problems:

• This course: we relax those assumptions to some extent.

• Main focus: private information and limited commitment

• Main tool: mechanism design

• There are two agents:

– Each can be of two types: θ = θ H > θ L ; Pr(θ H ) = π.

– Shocks are i.i.d across households.

• everyone has the same endowment of apples and oranges, ea , eb

• Social Planner, Mechanism Designer, Arbitrator, Principal: allocate resources across

• Suppose everybody knows everything: planner and households

• Efficient to equate everyone’s marginal utility of the same good:

θ1 u0 (c1a (θ1 , θ2 ) = θ2 u0 (c2a (θ1 , θ2 ))

u0 (c1b (θ1 , θ2 ) = u0 (c2b (θ1 , θ2 ))

• Now suppose θi is privately known only by i.

• How do agents and the planner communicate?

• Would they truthfully announce? No. θ L always wants to lie.

• Mechanism design: how do we design games between agents to achieve "efficiency"

• Revelation principle: just focus on direct mechanisms

– N agents; K consumption goods: c = (c1 , c2 , · · · , cK )

set of feasible allocations C = {(c1 , · · · , c N ); ci = (c1i , c2i , · · · , ciK ), {cij }: feasible}

• allocation rule: g : M → C ; g(m) = ( g1 (m), · · · , g N (m))

• Direct mechanism: M = Θ, g(m) = c(θ )

• Each mechanism induces a game with asymmetric information

• Outcome induced by a mechanism: the Bayesian Nash Equilibrium of the game

• A mechanism designer wants to find the best mechanism; complicated problem

1.4 Revelation Principle

Proof. Consider a mechanism ( M, g) and an outcome m∗ , it must satisfy

• Incentive compatible allocations, c = (c1 , · · · , c N ),

• There could be other equilibria.

• Implementation theory: how do we ensure that it is the unique equilibrium? might

• Mechanism designer’s problem

• Θ = θ1 < · · · < θ N , Pr(θi ) = π (θi ).

• Symmetric allocations: allocations only depend on individual types

• incentive compatible allocations:

• Mechanism design problem:

max ∑ λ(θi )u(c(θi ), θi )

subject to Feasbility and incentive compatibility

• Go through a two type simple example

2 First Application - Mirrlees

• Remember H (θ ) cumulative welfare weight; H (θ ) ≥ F (θ ) with derivative h (θ ).

• Notice: the constraint set can be rewritten as a maximization problem

One way to see this:

Suppse θ > θ̂. Add them up, c’s cancel and:

What does this inequality look like

where h ( x, y) = v ( xy) and hence h x = yv0 ( xy).

and this clearly violates the above inequality.

• Now, we can take FOCs, i.e., do a calculus of variations argument

Let’s do some algebra

a function of fundamentals. Can perform comparative statics.

• Micro estimates of labor supply elasticity: .2-.5. Need to know a.

Hence roughly at the top ε

1 − τauctual ε ε+1 1 − τauctual ε ε+1

• What is wrong with this

– Conceptual level: infinitely skilled people!!! However, in many practical cases,

• What is the role of banks?

– Production takes time, i.e., physical capital is illiquid.

– Need contracts that insure people against liquidity shocks

– One way to do this is through banks

• Let’s try to formalize this

Hence roughly at the top ε