Suggested Solution to Problem Set 1.

Econ 202B, 2019

1 Heterogeneous beliefs
1. Take log of the aggregate endowment:
t
X t
X
t
log yt (s ) = log y(s0 ) + log g(sk ) = log g(sk ).
k=1 k=1

Every period s is drawn independently from distribution {π0 (s)}s∈S , therefore log g(s1 ),
log g(s2 ), · · · are iid. By the strong law of large number,
Pt
log yt (st ) log g(sk ) a.s.
= k=1 −→ E [log g(s)] > 0.
t t
Thus limt→∞ yt (st ) = ∞, π0 −almost surely.

2. The derivatives of utility u0j (c) = c−γj and u00i (c) = −γj c−γj −1 ,

cu00 (c)
RRAj = − = γj .
u0 (c)

3. In a deterministic economy, households of type j’s problem:

max{cjt }∞
t=0
β t u(cjt )
1
s.t. cjt + bt+1 = yjt + bt , ∀t.
Rt
The interest rate is γj
u0 (cjt )

1 cjt+1
Rt = 0
= .
βu (cjt+1 ) β cjt
Plug the expression of interest rate into EIS:
d log (cjt+1 /cjt ) d log (cjt+1 /cjt ) 1
EISj = = = .
d log Rt γj d log (cjt+1 /cjt ) γj
That is, EIS is the inverse of RRA.

4. Households of type j’s problem:

X
β t πjt (st )u cjt (st )
 
max
cj
t≥0,st ∈S t
X
q0t (st ) cjt (st ) − yjt (st ) = 0.


s.t.
t≥0,st ∈S t

1
 The Lagrangian
X
β t πjt (st )u cjt (st ) + µj q0t (st ) yjt (st ) − cjt (st ) .
  

L=
t≥0,st ∈S t

Take FOC w.r.t. cjt (st ):

β t πjt (st )cjt (st )−γj = µj q0t (st ), ∀j, t, st .

Take the ratio of the FOC of agent 2 over the FOC of agent 1:
π2t (st )c2t (st )−γ2 µ2
t t −γ
= .
π1t (s )c1t (s ) 1 µ1
Transform consumption into consumption shares:
π2t (st )ĉ2t (st )−γ2 t γ1 −γ2 µ2
t t −γ
y t (s ) = .
π1t (s )ĉ1t (s ) 1 µ1
Solve for ĉ2t (st ) as a function of ĉ1t (st ):
  γ1  t
 γ1
t µ1 2  t γ2 −1 π2t (s )
 γ1 2 γ1
ĉ2t (s ) = yt (s ) t
ĉ1t (st ) γ2 .
µ2 π1t (s )
The market clearing condition:
1   t
 γ1
t t µ1 γ2 
t t γ2 −1 π2t (s )
 γ1 2 γ
t γ21
ĉ1t (s ) + ĉ2t (s ) = ĉ1t (s ) + yt (s ) ĉ 1t (s ) = 1.
µ2 π1t (st )
h i γ1
Therefore ρ = µµ12 2 exists and is a positive constant such that consumption share
solves 1
 γγ1 −1 π2t (st ) γ2

γ
t t t γ12

ĉ1t (s ) + ρ yt (s ) 2 ĉ 1t (s ) = 1. (1)
π1t (st )
π2t (st )
5. (This answers questions 5 and 6.) When π1 (s) = π2 (s), ∀s ∈ S, we have π1t (st )
= 1.
Equation (1) can be simplified to
 γ1 −1 γ1
ĉ1t (st ) + ρ yt (st ) γ2 ĉ1t (st ) γ2 = 1.


From part 1, we have shown that limt→∞ yt (st ) = ∞, π0 −almost surely. When γ1 > γ2 ,
we would have limt→∞ ĉ1t (st ) = 0, π0 −almost surely.

Interpretation: the households with higher risk aversion γj would have lower EIS.
They are less willing to substitute inter-temporally, so they frontload consumption.
This result does not rely on there being uncertainty in the model. The same result
would hold even if the aggregate endowment is deterministically growing.

2
7. When γ1 = γ2 , equation (1) can be simplified to
 γ1
π2t (st )

2
ĉ1t (st ) + ρ ĉ1t (st ) = 1.
π1t (st )
π2t (st )
(a) Take log of π1t (st )
:
t
π2t (st )
   
X π2 (sk )
log = log .
π1t (st ) k=1
π1 (sk )
t
For limt→∞ ĉ1t (st ) = 0, π0 −almost surely, we would need to have limt→∞ ππ1t2t (s )
(st )
=
   
π2 (s1 ) π2 (s2 )
∞, π0 −almost surely. Since log π1 (s1 ) , log π1 (s2 ) , · · · are iid, by the strong
law of large number,
 t
 Pt  
log ππ1t
2t (s )
(st ) k=1 log
π2 (sk )
π1 (sk ) a.s.
 
π2 (s)

= −→ E log .
t t π1 (s)
h  i
π2 (s) π2t (st )
When E log π1 (s)
> 0, limt→∞ π1t (st )
= ∞, π0 −almost surely.
        
π2 (s) π0 (s) π0 (s)
E log = E log − E log > 0.
π1 (s) π1 (s) π2 (s)
It means that household 1’s belief is further away from the truth than household
2. Their consumption share decreases to zero over time as their belief played
against them.

(b) Households of type 1 believe that their asymptotic consumption share is 1. They
believe that the true distribution π0 = π1 , which implies that limt→∞ ĉ1t (st ) =
1, π1 -almost surely.

(c) Even when households have different beliefs about the distribution, it might still
be that   
π2 (s)
E log = 0.
π1 (s)
 
π2t (st )
The log of the ratio of subjective probabilities, log , follows a random π1t (st )
 
walk, where the increment log ππ12 (s)
(s)
is a mean zero random variable, drawn
iid each time. The ratio of subjective probabilities will fluctuate indefinitely
between zero and infinity. This implies that the consumption share will fluctuate
indefinitely between zero and one.

3
8. Reorganize equation (1):
 γ1
γ −γ π2t (st )

2 γ1
ĉ1t (st ) + ρ yt (st ) 1 2 ĉ1t (st ) γ2 = 1.

π1t (st )
γ1 −γ2 π2t (st )
Take log of [yt (st )] π1t (st )
:
 t
 X t  
t γ1 −γ2 π2t (s ) π2 (sk )
 
log yt (s ) = (γ1 − γ2 ) log g(sk ) + .
π1t (st ) k=1
π1 (sk )

γ1 −γ2 π2t (st )

The conditions to ensure limt→∞ [yt (st )] π1t (st )
= ∞, π0 −almost surely is
  
π2 (s)
(γ1 − γ2 ) E [log g(s)] + E log > 0.
π1 (s)