Homework 1 Advanced Macroeconomics. Part II.

E.Arbatli, D.Veselov
November 2023

1 OLG model
This is a model about aging and capital deepening. Imagine an OLG economy
with two generations: young and old. The young work and earn labor income.
The old do not work. The young can invest in capital and sell it in old age (for
retirement). The life-time utility of a generation born at time t is
1 β
Ut = (C y )1−σ + (C o )1−σ .
1−σ t (1 − σ) t+1

where Cty and Ct+1

o
are young and old age consumptions. Agents face the
following budget constraint when young

Cty = wt l − kt+1 − τt

where wt is the real wage, l is the fixed labor endowment and kt+1 is the capital
saving of the young which can be used for production in the next period. Finally,
τt is tax. Budget constraint of the old is
o k
Ct+1 = Rt+1 kt+1
k
where Rt+1 is the gross return on capital. Assume that capital fully depreciates.
Denote number of young and old people at time t as Nty and Nto . Size of young
population grows at a gross rate 1 + gt . Then the ratio of old versus young
population at time t is
y
o
At = Nt+1 /Nt+1 = Nty /Nt+1
y
= 1/(1 + gt )

We call At the aging parameter which is inversely related to population growth

rate. Firms are perfectly competitive with access to a CRS Cobb-Douglas
production function Yt = Ktα L1−α
t . Assume that there is full employment:
Lt = Nty l. In each period market equilibrium requires that demand and supply
of capital are equated. Define
d d y
k̃t+1 ≡ log(Kt+1 /Nt+1 )
k k
R̃t+1 ≡ logRt+1

1
 d
where k̃t+1 is capital demand per worker in logarithm. Denote the logged supply
s s s
of capital per worker as k̃t+1 = log(Kt+1 /Nt+1 ). Similarly denote log transfor-
mation of any other variable x by x̃. There is a government with balanced
budget: Gt = Tt where Gt is government spending and Tt tax collected at time
t. Let Gt = ΩYt so government spending is an exogenously given Ω fraction of
output.
d d
1. Solve the model to obtain k̃t+1 and k̃t+1 as functions of model parameters
k k
(R̃t , R̃t+1 , Ãt , l and others).

2. Solve for steady-state equilibrium quantities R̃ and k̃. How does aging,
i.e. an increase in Ãt , effect k̃ and R̃ (Hint: in this point you can assume
that σ = 1 for simplicity)?

3. How does aging affect output per worker?

4. Under what conditions does aging lead to an increase in output per capita?