Econ 504, Spring 2021 Name:

FlNAL EXAMINATION
(150 Minutes)

1. (35 points) Consider an one good representative agent economy with human
capital. The utility of the representative agent which is given by u(ct , lt ), where ct is
consumption of the good at time t and lt is time spent on leisure. Each agent is endowed
with one unit of time in each period, which can be spent in either working or spending
in education for accumulating human capital. In other words, lt + et = 1, where et is the
amount of time spent in education and lt is time spent for leisurely activities. There are
two kinds of capital: physical Kt and human capital St . Human capital acccumulation at
individual level is given by;

st+1 = zt ψ(et ) + st
where ψ is human capital production function and zt is the ’mood’ shock that effects the
productivity in human capital production. Assume that z follows a finite state Markov
process and denote the probability that z 0 occurs conditional on z as Γzz0 . Also note that
human capital does not depreciate, whereas the depreciation rate for the physical capital
is δ. The market sturcture is complete and the market for state contingent assets exist,
i.e. there exists assets that can be bought today and delivers only in state z 0 next period
yz0 at price qz0 .
The production technology of the representative firm is given by F (kt , st ) = ktα st1−α ,
i.e. the second argument in the production function is the aggregate human capital ac-
cumulated in the economy. The production technology is standard Cobb-Douglas CRTS,
satisfy the usual conditions and the initial stocks of physical and human capital are given
as K0 and S0 .
Households acumulate physical and human capital to rent it to firms and get the
usual gross interest rate Rt and wage wt .
a. (13 points) Setup the recursive problem of the household completely. Be specific,
state the set of individual and aggregate state variables as well as thechoice variables, write
down the objective function and the set of constraints faced by the household carefully.
Define the recursive competitive equilibrium of this economy.
b. (17 points) Derive the optimality conditions that characterize equilibrium of this
economy. Start with eliminating the constraints of the household by successive substi-
tution as much as you can. Take the relevant FOCs and envelope conditions to end up
with the set of equations that characterize the household problem. Write down aggregate
consistency conditions and substitute them into the equations you found above.
c. (5 points) Briefly (without any derivation) discuss the no-arbitrage condition in
this economy between the rates of return on alternative assets.

2. (35 points) There are two economies, A and B with each with infenetely many
identical households. Since there are infinite identical households in each economy they
are all price takers. Measure of the agents in A and B are the equal.
Preferences are standard time seperable, strictly concave that satisfy all the desirable
properties we like.
∞
β t u(ct )
X
(1)
t=0
 The only difference between economy A and B is the production technology which
is available to firms in each economy. Country A have firms with access to technology of
type A, and country B has firms with access to technology of type B where i ∈ {A, B}
can be expressed as:
y = z i f (k) (2)
Assume that the final goods produced are identical for both technologies and capital
depreciates fully (δ = 1) for both. Let z = (z A , z B ) and assume that z follows a finite
state Markov process of order 1, and denote the probability that z 0 occurs conditional on
z as Γzz0 .
a. (15 pts) First assume that there is no trade between two islands. Write down
the recursive problem of one type with complete markets (with state continget claims lz0 ).
Make sure to list the individual and aggregate state variables properly and expected law
of motion for the aggregate states for the household. Define recursive equilibrium of this
economy (do not derive anything).
b. (20 pts) Now assume that both capital and goods are perfectly mobile across
islands without any cost, that is households can rent their capital to firms in any country
depending on the rate of return they get.
Write down the recursive problem of one type with complete markets (with state
contingent claims lz0 ). Make sure to list the individual and aggregate state variables
properly and expected law of motion for the aggregate states for the household. Define
recursive equilibrium of this combined economy (do not derive anything).

3. (30 points) Think of an Lucas tree economy we covered with two trees, M-tree
gives dM dividends and the B-tree gives dB dividends. Tree fruits are the only endowment
source. The fruits are perishable. Fruit delivery follows a Markov process of order 1. Let
d = {dM , dB }, and let Γd,d0 be the transition probability of the fruit dividends. The
agent has the usual standard preferences and tree shares can be traded in an competitive
market.
a. (13 pts) Write down the recursive problem of the household, making sure
to list the choice and state variables carefully. Define equilibria recursively knowing that
the tree prices only depend on the current dividends.
b. (10 pts) State a formula for the prices of shares of both trees.
c. (7 pts) Write a formula for an option to buy tomorrow either a M-tree
share or a B-tree share but not both, at exercise price q.