UNIVERSITY OF CAPE COAST

COLLEGE OF HUMANITIES AND LEGAL STUDIES

SCHOOL OF ECONOMICS
DEPARTMENT OF ECONOMIC STUDIES
ECO422: ADVANCED MACROECONOMICS ASSIGNMENT

(1) Assume an individual faces an instantaneous quadratic utility function, u(ct ) = (ct − α2 c2t ) so that
u′ (ct ) > 0. Continue to assume, for simplicity reasons, that both the interest rate and the discount
rate are zero. In particular, suppose there is uncertainty about the individual’s labour income (yt′ s)
each period (future income). The individual maximizes expected lifetime utility
E[U ] = Et [ Tt=1 (ct − α2 c2t )], α > 0
P

subject to the lifetime budget constraint:

PT PT
t=1 ct = A0 + t=1 yt .

(a) Using the random walk hypothesis, will uncertainty about future income affect consumption?
(b) Show whether or not this uncertainty about future income will affect expected lifetime utility?
(c) Will the result in (b) change if u(ct ) = ln(1 − αct )?
(d) The random-walk hypothesis argues that change in consumption is unpredictable. Discuss this
with the necessary derivations.
(e) Using the instantaneous utility above, also show that the utility function exhibits increasing
relative risk aversion (IRRA), and which individuals is it consistent with in the economy as
wealth increases?

(2) Consider an economy populated by agents where the household optimisation problem is:
∞
X ct1−θ
max βt( )
ct ,kt+1 1−θ
t=0
subject to

kt+1 = At ktα − ct
where yt = At ktα is output. The technology shock, At , follows the AR process, ln At = ρA ln At−1 + εt ; εt is a
serially uncorrelated, i.i.d, and normally distributed shock with mean zero and standard deviation σA ; ρA is
the autocorrelation coefficient.
(a) Solve for equilibrium output, consumption and capital. Now using the assumptions that ct = γAt ktα and
θ = 1, pin down the equilibrium values and trace how a one standard deviation of negative Covid-19 like
(technology) shock will impact on these real variables. How do your impulse response functions (IRF) behave?
(b) How will this result look like if ρA = 0.90, α = 1/3? How will you describe the shape of your IRF?
(c) Now assume that ρA = 0 and consider the effect of a one time (temporary) negative technology shock.
Assume that the share of capital, α = 1/3. Let y0 be the output at time t − 1. Suppose that at time T
a negative technology shock is realised and let εT = 1. Suppose that the shock is entirely temporary, i.e.
εt = 0 ∀t > T . What would be the response of output, capital and consumption?
(3) Consider a Cobb Douglas production function AF (K, L) = AK α L1−α , 0 < α < 1; all variables in time
t. The firm maximises the present value of all future cash flows subject to the constraint: K̇t = It −δKt
(a) Show that it satisfies the key neoclassical assumptions.
(b) Set up the Hamiltonian using the “present value shadow price”. Find the first order conditions
and solve the model for Kas a function of r, L, A and δ.
(c) Set up the Hamiltonian using the “current value shadow price”. Find the first order conditions
and solve the model for Kas a function of r, L, A and δ. Compare the results to (b).
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(d) Find equations representing the dynamics of K and q and show their graphs at the steady state.
(e) Consider an unexpected and permanent increase in A. How do capital and investment behave
over time?
(f) Consider an unexpected and permanent increase in r. How do capital and investment behave
over time?
(g) Consider an unexpected and permanent increase in δ. How do capital and investment behave
over time?
(h) Imagine that at time 0, we learn that A will increase at some future time T . How do capital and
investment behave over time?