EC004 OutputDynamics - Microfoundation 2022 Lecture2

Output Dynamics with Microfoundations
From Solow-Swan to Ramsey-Cass-Koopmans & OLG
Mausumi Das
Lecture 2, EC004, DSE
17 May, 2022
Das (Lecture 2, EC004, DSE) Solow to RCK & OLG 17 May, 2022 1 / 17
Addressing ‘Dynamic Ine¢ ciency’in Solow Model:
In the last class we have noted that

The steady state in the Solow model might be ‘dynamically ine¢ cient’
because people may oversave.
If one allows the households to choose their savings ratio optimally,
then this ine¢ cinency is likely disappear.
But this latter possibility is simply not there in the Solow model,
because the savings rate is assumed to be exogenous.
The basic Solow growth model has subsequently been extended,

allowing the households to choose their consumption/savings
behaviour optimally.
In these models therefore the savings rate is determined endogenously.
Extensions of Solow Model: Optimizing Households
There are two di¤erent frameworks of optimizing households:
(1) The Ramsey-Cass-Koopmans In…nite Horizon Framework
(henceforth, R-C-K);
(2) The Samuelson-Diamond Overlapping Generations Framework
(henceforth, OLG).
The …rst framework was developed by Frank Ramsey in 1928 in the
context of a centralized (planned) economy, and was subsequently
applied to a perfectly competitive decentralized (market) economy by
David Cass and Tjalling Koopmans independently in 1965.
The second framework was developed by Paul Samulson in 1948 in
the context of an exchange economy, and was subsequently extended
for a production economy by Peter Diamond in 1965.
In both frameworks, the production side story is exactly identical to
Solow; but now the households choose their consumption and savings
decisions optimally.
Extensions of Solow: Optimizing Households (Contd.)
The main di¤erence between the two frameworks arises from the time
horizon speci…ed for the households’optimization exercise:
In the R-C-K framework, the utility function of an agent is de…ned over
in…nite horizon;
In the OLG framework, the utility function of an agent is de…ned over
…nite horizon.
As we shall see later, this apparently trivial di¤erence gives rise to

non-trivial di¤erences in the conclusions derived from the two models.
Optimizing Households: The R-C-K Model
We start with the Ramsey-Cass-Koopmans Ini…nite Horizon

Framework.
The R-C-K model is considered Neoclassical - because it retains all
the assumptions of the Neoclassical (Solow) production function
(namely diminishing returns to a single factor, CRS and Inada
conditions.)
As in Solow, the economy starts with a given stock of capital (Kt )
and a given level of population (Lt ) at time t.
These factors are supplied inelastically to the market in every period.
This implies that households do not care for leisure.
Population grows at a constant rate n.
Capital stocks grows over time due to the savings/investment
undertaken by the households - which is now determined optimally.
The R-C-K Model: Household Side Story
The household side story in the R-C-K model is embedded in a

Dynamic General Equilibrium (DGE) approach which has become
the main workhorse of modern macroeconomics (including modern
business cycle analyses).
This approach is ‘dynamic’because agents make choices over
variables that relate to both present and future.
This approach is ‘equilibrium’because the macroeconomic outcome
for the entire economy is derived from aggregation of individuals’
equilibrium (optimal) behaviour.
This approach is ‘general equilibrium’because it simultaneously
takes into account the optimal behaviour of diiferent types of agents
(…rms and households) in di¤erent markets and ensures that all
markets clear.
Main Tenets of the DGE Approach:
The DGE approach postulates that
Households are rational and make economic decisions on the basis of
an explicit ego-centric optimization exercise subject to their
constraints and subject to their information set. They optimize not
only over their current choice variables but also the choices that would
be realized in future.
Households have rational expectations: thus their ex ante optimal
future choices would ex post turn out to be less than optimal if and
only if their information set is incomplete and/or there are some
random elements in the economy which cannot be anticipated perfectly.
Households are atomistic is the sense that they treat the market
factors as exogenous in their optimization exercise. The optimal
choices of all agents are then mediated through the markets to produce
an equilibrium outcome for the macroeconomy (which, by construction,
is also consistent with the optimal choice of each agent).
Is the assumption of "rational" agents endowed with "rational
expectations" realistic? No!! But it provides a good benchmark!
DGE Approach: (Contd.)
There are some DGE models which incorporate non-neoclassical

production structures - with nominal rigidities and market
imperfections (e.g., the New Keynesian Business Cycle models).
There are other DGE models which incorporate stochastic elements in
the production function (e.g., the Real Business Cycle models).
However the R-C-K model constitutes a special case of the DGE
framework which has the following features:
A perfectly competitive market structure: no rigidities;
A completely deterministic set up: no stochastic elements;
An in…nite horizon optimization framework for the households.
Let us now examine the consumption-savings choices of a household
over in…nite horizon in a perfect market and deterministic set up.
Household’s Choice Problem under In…nite Horizon:
Assume that the economy is populated by H households indexed by

h = 1, 2, ...., H. The households have identical preferences,
although they may di¤er in terms of their asset holdings.
To simplify the analysis, we shall only focus on the
consumption-savings choice of the household and ignore the
labour-leisure choice (for the time being).
At any point of time a household is endowed with one unit of labour -
which it supplies inelastically to the market.
We shall also ignore prices and the concomitant role of money and
focus only on the ‘real’variables.
Let ath denote the asset stock of the household h at the beginning of
period t.
We shall assume that positive savings by a household in any period are
invested in various forms of assets (all assets have the same return),
which augments the household’s asset stock in the next period.
Household’s Choice Problem: In…nite Horizon (Contd.)
We now have to formulate the budget constraint of the household for
every time period t = 0, 1, 2, .........∞.
Recall that at the beginning of any time period t, a household starts
with its given labour endowment (1 unit) and a certain amount of
asset stock ath (carried forward from the past).
The household then o¤ers its labour in the production process to earn
some wage income towards the end of the period.
The stock of assets held at the beginning of the period (ath ) also
generates certain net interest income during the period, denoted by
rt ath .
Thus the ‡ow income of the household at time t is given by
yth = wt + rt ath .
Moreover, assuming that asset stocks (in particular, physical capital)
get depreciated at a constant rate δ during the producation process,
after production has taken place, the household would still be in
possesion of the depreciated value of its asset stock (1 δ)ath .
Household’s Problem: In…nite Horizon & No Borrowing
The household now has to decide how much it wants to consume and
how much to save.
Let us assume that the household is not allowed to borrow.
Then the consumption of the household is likely to be limited by its
‡ow income yth = wt + rt ath .
But in this one good world, the household also has the option of
eating up its existing asset stocks (which constitutes negative
savings).
Thus under no berrowing, the maximum consumption possible in time
period t is: yth + (1 δ)ath .
This de…nes the feasible consumption set available to the household
at every point of time t as follows:
cth 5 yth + (1 δ)ath for all t = 0, 1, .....∞
(Contd.)
The ‡ow income of the household is distributed between consumption
and savings. Thus, by de…nition:
sth yth cth
All savings are invested is buying various new assets, which means the
asset stock of the household at the beginning of next period (period
t + 1) will be
ath+1 = sth + (1 δ)ath
Note that if the household decides to eat up its existing asset stocks
(over and above its ‡ow income) then that will constitute negative
savings and would lower the asset base of the household over time.
Putting all these information together, we write the period by period
budget constraint of the household as
ath+1 = yth cth + (1 δ)ath for all t = 0, 1, .....∞
(Contd.)
In the absence of intra-household borrowing, the representative

household h’s problem would given by:
∞
∞
Max. ∞ ∑ βt u cth ; u 0 > 0; u 00 < 0; 0 < β < 1 (1)
fcth gt =0 ,fath+1 gt =0 t =0
subject to
(i) cth 5 wt + rt ath + (1 δ)ath for all t = 0;

(ii) ath+1 = wt + rt ath cth + (1 δ)ath ; ath = 0 for all t = 0;
where a0h is historically given.

The atomistic household also treats wt and rt as exogenous.
Household’s Utility Function: Some Explanations
Households’utility function as de…ned here is special and requires

some explanation.
Expanding the terms, we can write the utility function as follows:
u (c0 ) + βu (c1 ) + β2 u (c2 ) + β3 u (c3 ) + ......
There are three alternative explanation, each associated with a

di¤erent interpretaion of the intertemporal discount factor β:
(1) Agents live forever:
Then the above utility function de…nes the discounted values of his
‘life-time’utlity.
By this de…nition, β is to be interpreted as the agents’innate
preference for present vis-a-vis future (or their rate of time
preference).
Household’s Utility Function: Some Explanations (Contd.)
Notice that in this formulation, the agent discounts future utilities at

each successive time periods by the same factor β:
Sitting at time 0, when the agent is comparing between utilities today
and tomorrow (i.e. between period 0 and period 1) the relative
weightage given to today’s utility vis-a-vis tomorrow’s utility is 1β .
Similarly, when he is comparing between utilities tomorrow and
day-after-tomorrow (i.e. between period 1 and period 2) the relative
weightage given to tomorrow’s utility vis-a-vis day-after-tomorrow’s
utility is again 1β .
This speci…c formulation is called "constant rate of time
preference", where the discount factor between any two consecutive
time periods t and t + 1 does not depend on calendar time: the
discount rate is time-invarying.
It is also called "exponential discounting".
There are alternative "behavioural" speci…cations of agent’s utility
function where the relative weightage given to today’s utility vis-a-vis
tomorrow’s utility is di¤erent from the relative weightage given to
tomorrow’s utility vis-a-vis day-after-tomorrow’s utility.
For example, consider the following utility function:
u (c0 ) + β δu (c1 ) + δ2 u (c2 ) + δ3 u (c3 ) + ......
Notice that in this formulation, the rate at which the agent discounts
future utilities at each successive time periods does not remain the
same. In particular,
Sitting at time 0, when the agent is comparing between utilities today
and tomorrow, the relative weightage given to today’s utility vis-a-vis
tomorrow’s utility is βδ1 .
On the other hand, when he is comparing between utilities tomorrow

and day-after-tomorrow, the relative weightage given to tomorrow’s
utility vis-a-vis day-after-tomorrow’s utility 1δ .
This alternative "behavioural" speci…cation is called

"quasi-hyperbolic discounting".
In this speci…cation the discount rate is not time-invarying - it
depends on the calender time.
This implies that if I ask you to make a decision today and ask you to
make the same decision at some future date in the calendar, your
optimal choice would di¤er.
This is called the "time inconsistency" problem.
For the rest of the lectures, we shall stick to the standard

"exponential discounting" speci…cation, where such "time
inconsistency" problem does not arise.

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Output Dynamics with Microfoundations

From Solow-Swan to Ramsey-Cass-Koopmans & OLG

Lecture 2, EC004, DSE

In the last class we have noted that

The basic Solow growth model has subsequently been extended,

As we shall see later, this apparently trivial di¤erence gives rise to

We start with the Ramsey-Cass-Koopmans Ini…nite Horizon

The household side story in the R-C-K model is embedded in a

There are some DGE models which incorporate non-neoclassical

Assume that the economy is populated by H households indexed by

cth 5 yth + (1 δ)ath for all t = 0, 1, .....∞

In the absence of intra-household borrowing, the representative

(i) cth 5 wt + rt ath + (1 δ)ath for all t = 0;

where a0h is historically given.

Households’utility function as de…ned here is special and requires

u (c0 ) + βu (c1 ) + β2 u (c2 ) + β3 u (c3 ) + ......

There are three alternative explanation, each associated with a

(1) Agents live forever:

Notice that in this formulation, the agent discounts future utilities at

On the other hand, when he is comparing between utilities tomorrow

This alternative "behavioural" speci…cation is called

For the rest of the lectures, we shall stick to the standard

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