Macroeconomics I

Problem Set 7
Marti Mestieri
UPF and BSE
March 2023

This problem set consists on characterizing a BGP equilibrium in an economy similar to the
one in Ngai-Pissarides-07.

Set-up

The economy consists of three different sectors: agriculture, manufacturing, and services, in-
dexed by i = {a, m, s}. Output yit of each sector can be used for final consumption cit . Only
output from manufacturing, ymt , can be used for final investment xmt . An infinitely-lived rep-
resentative households rents capital kt and labor (normalized to one) to firms and chooses how
much of each good to buy for consumption and investment satisfying the standard budget con-
straint:
X
wt + rt kt = pit cit + pmt xmt (1)
i={a,m,s}

where pit is the price of output of sector i at time t, wt is the wage rate, and rt is the rental rate
of capital. Capital accumulates with the standard law of motion

kt+1 = (1 − δ) kt + xt (2)

where 0 < δ < 1 is a constant depreciation rate, and xt = xmt . The period utility function u(ct )
is defined over a consumption basket ct ≡ C(cat , cmt , cst ) that aggregates goods from the three
sectors. We will use a standard CRRA utility function,

ct1−σ − 1
u(ct ) = (3)
1−σ
and specify standard (potentially) non-homothetic CES aggregators for consumption:
 1
ρ

(θic )1−ρ cρi 

X
C(ca , cm , cs ) =  (4)
i∈{a,m,s}

with ρ < 1, 0 < θic < 1 and c

P
i∈{a,m,s} θi = 1 for i = a, m, s.
 Macroeconomics I, Problem Set

There is a representative firm in each sector i combining capital kit and labor lit to produce
the amount yit of the good i. The production functions are Cobb-Douglas with equal capital
shares and different technology levels Bit :

α
yit = kit (Bit lit )1−α

1 Problem Set

1. Write down the Lagrangian that represents the HH’s dynamic problem and find the first
order conditions (FOC)

2. Use the FOC for each good i (together with the tricks from the notes) to get an expression
for the FOC of the consumption good ct of the form:

c−σ
t = λt pct (5)

where pct is the implicit price of the consumption basket defined as:
  ρ−1
ρ
X ρ
pct ≡  θic pit
ρ−1  (6)
i=a,m,s

3. Use equation 5 together with the FOC for xt and kt+1 to solve for the Euler equation.
Provide the intuition

4. Use the FOC with respect to each of the goods i to provide and expression for:

pit cit
(7)
pjt cjt
What are the drives of structural transformation in this economy? What is the main
parameter that determines the extent of structural transformation?

5. Solve for the firms’ problem. Find the implied FOC

6. Characterize relative prices as a function of relative productivities

7. Provide an expression for the interest rate of the economy in terms of the relative price of
manufacturing m, its TFP, and the aggregate stock of capital. HINT (Use the fact that
the capital-labor ratio is the same across sectors)

8. Define a competitive equilibrium

2
 Macroeconomics I, Problem Set

9. Define a BGP in terms of the evolution of the interest rate of the economy that you solved
for in (7). How should the aggregate stock of capital kt evolve?

10. Assume that pmt = pxt = 1 ∀t. Define the productivity with which consumption goods
are produced as:

1
Bct = (8)
pct

11. Use this definition together with the assumption you made in (10) to re-write the Euler
equation

12. Consider the following resource constraint:

1−α α
kt+1 = (1 − δ)kt + Bmt kt − pct ct (9)

This equation, together with the Euler equation, represents the dynamic system of the
kt ct
economy. Re-write this system in terms of k̂t = Bmt and ĉt = Bct

13. Find the conditions (in terms of values of parameters) under which there is BGP