Econ 609 Spring 2017 UH Manoa

Midterm Exam
March 16, 2017

The exam lasts for 75 minutes. This is a closed-book closed-notes exam. Please clearly
de…ne all the notations used in your solutions and make additional assumptions when necessary.

1. (65%) Consider the following problem with two agents having identical preferences:
1
X
t
max ln cit
cit
t=0
s.t. kt+1 = akt c1t c2t
i = 1; 2, k0 given.

(a) Solve the planner’s problem when he treats both individuals the same:

i. (15%) Derive Euler equations and TVC;

Solution: Because the planner treats both individuals identically, we can set c1t = c2t = ct .
Hence, the optimization problem becomes
1
X
t
max ln ct
ct
t=0
s.t. kt+1 = akt 2ct
k0 given.

We can write down the Bellman equation

V (kt ) = max fln ct + V (kt+1 )g

s.t. kt+1 = akt 2ct

FOC is
1
= 2 V 0 (kt+1 ) .
ct
Envelope condition is
a
V 0 (kt ) = .
2ct
Therefore, we arrive at the Euler equation
1 a
= .
ct ct+1

One can see that if a < 1, then ct ! 0, kt ! 0, as t ! 0. Hence, we can assume that a > 1.
The transversality condition is
t
kt+1
lim = 0.
t!1 ct

1
 ii. (10%) Derive policy functions for capital and consumption, i.e., kt+1 = g(kt ) and ct = c(kt ),
and specify g( ) and c( ). Hint: you can use the guess and verify method.
Solution: We use the guess and verify approach. From the Euler equation, we see that
ct+1 = a ct . Then, we guess that kt+1 = a kt . We need to verify that it satis…es and budget
constraint and the Euler equation.
akt+1 kt+2 a2 kt a kt+1
ct+1 = =
2 2
a (akt kt+1 )
= = a ct .
2
We also need to check the TVC.
t
kt+1 2 t (a kt ) t 2
lim = lim = lim = 0.
t!1 ct t!1 kt (a a ) t!1 1
The guess indeed works and ct = a(1 )kt =2. Note that we have not proved these are the
unique policy functions that satisfy the Euler equation and the TVC.

(b) (30%) Solve for the competitive equilibrium when capital is jointly owned by two individuals. Set
up the problem carefully, but do not need to provide a formal de…nition. Look for a symmetric
equilibrium with linear policy functions, where cit = kt and …nd . Hint: note that cit depends
only on kt and is the same for both individuals.
Solution: The individual optimization problem for i can be written as

V (kt ) = max fln cit + V (kt+1 )g

s.t. kt+1 = akt cit kt .

Notice that we consider joint ownership of capital. We treat kt as the state variable for both
individuals. Because agent 1 and 2 jointly own capital, if agent 1 does not consume anything in
period t, agent 2 can consume all the output in that period, and vice versa. If you set up this
problem with private ownership of capital, the state variable would be the distribution of capital
stock between the two agents at the beginning of period t. Interest rate on kt does not depend
on the distribution of capital ownership, because the production technology is CRTS.
FOC is
1
= V 0 (kt+1 ) .
cit
Envelope condition is
a
V 0 (kt ) = .
cit
Hence, we have the following Euler equation.
1 (a )
=
cit ci;t+1
The transversality condition is
t
kt+1
lim
= 0.
cit t!0

Again, we look at the Euler equation and guess kt+1 = (a )kt . We can check that the Euler
equation is satis…ed.
2
ci;t+1 = (a ) kt+1 kt+2 = (a ) kt (a ) kt+1
= (a ) [(a ) kt kt+1 ] = (a ) cit

2
 We then verify the TVC:
t t
kt+1 [ (a ) kt ]
lim = lim
t!1 cit t!1 (a ) kt (a ) kt
t
= lim = 0.
t!1 1

Therefore, our guess is veri…ed and we have cit = (a )(1 )kt . We notice that cit is indeed a
linear function of kt . A symmetric equilibrium with linear policy functions indeed exists. Finally,
we need to solve for by = (a )(1 ) and

a (1 )
= .
2
The policy functions are

a (1 )
cit = kt ,
2
a
kt+1 = kt .
2

(c) (10%) Compare the planner’s solution with the competitive equilibrium and discuss.
Solution: In the competitive equilibrium, the two agents consume a greater proportion of the
output in the current period. Hence, they save a smaller proportion than in the planner’s solution.
In the long run, there will be lower capital stock in the competitive equilibrium, and thus lower
consumption as well. The social planner’s problem gives both agents higher utility than the
competitive equilibrium allocation. The reason for this is that, when agent 1 is making a decision
about how much to consume and how much to save for the next period, he takes into account
that if he saves one extra unit of output, he will derive extra utility from consumption in the
future. However, he does not take into account that agent 2 will also derive extra utility from the
additional saving. Therefore, by ignoring the positive externality of his saving behavior, he saves
less than he should if he would have taken the externality into account.

2. (35%) The social planner faces the following problem

1
X
t
max u (ct )
t=0
s.t. f (kt ) = ct + it
kt+1 = kt (1 ) + it
2 (0; 1) , 2 (0; 1) , k0 given

(a) (5%) De…ne value function V (k) and rewrite the planner’s problem in the recursive form. Use
substitution to eliminate all the budget constraints.
Solution: The value function is

V (k) = max fu [f (k) + (1 )k k 0 ] + V (k 0 )g ,

0 k0 k

where k = f (k) + (1 )k.

3
(b) (15%) Outline the steps you will take to prove that the value function V (k) is concave and specify
the assumptions you need to make.
Solution: Assume k 0 2 K = [0; k] and K is a non-empty, compact, connected, and convex set;
u( ) is continuous, bounded, and concave; f ( ) is continuous and concave in k. Then, by the
Theorem of the Maximum, there exists a solution to the maximization problem and the optimal
value function exists, is bounded and continuous in k.
The value function V can be viewed as the …xed point of the mapping T : C ! C, where C is the
set of concave, continuous, bounded, and real-valued functions on K. Then, we can show that
the mapping T is a contraction mapping by either directly applying the de…nition of contraction
mapping or checking the Blackwell’s su¢ cient conditions.
Finally, since the metric space de…ned by C with the sup norm is complete, we can use the
Contraction Mapping Theorem to show that T has a unique …xed point in C. Therefore, there
exists a unique V 2 C satisfying the Bellman equation and V is concave in k.

(c) (10%) Outline the steps you will take to prove that V (k) is strictly concave and specify the
assumptions needed.
Solution: We can show that V is strictly concave in two steps. We need one more assumption
that u is strictly concave in c. First, we show that because V is concave and u is strictly concave,
T maps concave functions into strictly concave functions. Second, since T V = V , V must be
strictly concave as well.

(d) (5%) Could the above arguments be used to prove that V (k) is di¤erentiable? Why?
Solution: The above argument cannot be used to prove that V is di¤erentiable, because the
metric space de…ned by the set of di¤erentiable functions with sup norm is not complete. Hence,
we cannot use the contraction mapping argument to show that V is di¤erentiable.