Topic 2

ES50101/ES50104
1. Neoclassical Growth Models

Topic 2)
Consumption and Savings:
Diamond versus Ramsey
Nikos Kokonas1
University of Bath
Department of Economics
Semester 1
2020-21
1
I would like to thank Andreas Schaefer for sharing his slides with me
Contents
Topic 2) Consumption and Savings: Diamond versus Ramsey
1. Introduction
2. The Diamond Overlapping Generations (OLG) model
3. The Ramsey model
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1. Introduction
Literature
D. Acemoglu (2009). Introduction to Modern Economic Growth,

MIT.
D. Romer (2012). Advanced Macroeconomics, McGraw Hill.
R. Solow (2000). Growth Theory and Exposition, Oxford
University Press.
Remark:
Solow does not contain the first two sections of the lecture. Again you
should read what you like most. Acemoglu is again very detailed.
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1. Introduction
• The question we try to solve here and in the next topic has far
reaching implications for many applications
• What are agents motives to save?
• The standard answer is forward-looking behavior
• Are agents (just) concerned about their own life cycle?
→ How altruistic are they?
• If they are altruistic do they only care about their direct

descendants or do they care about generations not even born
yet?
• This questions are fundamentally interlinked with the

endogeneity of savings
• and serve to apply a growth theory to empirical regularities

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1. Introduction
• in support of the Solow model

• from a methodological point of view it is quite simple
• based on neoclassical production theory
• extended by exogenous technological progress it replicates
empirical regularities of the growth process
• shortcomings of the Solow model

• too many dimensions (variables) are exogenous
• the Solow model does not identify sources of technological
progress
• savings which drive investments and thus capital
accumulation are exogenous
→ even the sources of the prime engine (capital accumulation)
of economic growth are exogenous
→ the Solow model lacks of a sound micro-foundation regarding its
central arguments (savings/consumption decisions,
technological progress)
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1. Introduction
• endogenous savings/consumption decisions or endogenous

technological progress are complicating the models
but the understanding of this decisions in crucial, if we want to

suggest growth promoting policies
• growth promoting policies are aimed at the incentives to save

and invest
• therefore it is important to implement these features into our

models
• in this section, we begin with the implementation of savings

decisions into the neoclassical growth model
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1. Introduction
• savings decisions of households (and investment decisions of
firms) are forward looking
• they are inherently dynamic and not static
→ If you are looking ahead, you are the master of the day
(Goethe, "Wer vorsieht ist der Herr des Tages")
• the literature suggests two views
(1) overlapping generations (OLG) models with life-cycle savings
(Diamond)
(2) optimal savings decision maximizing the welfare of a dynasty
(Ramsey)
• the fundamental difference between the two
• the degree of altruism of agents with respect to the impact of their
decisions on the welfare of future generations
• OLG models [(1)] consider rather selfish agents which care only
about their own life cycle
• dynastic frameworks [(2)] maximize the welfare of a dynasty from
time 0...∞
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1. Introduction
• the application of both concepts depends on the research
question
• sustainability of pension funds and social security systems is
usually analyzed with OLG models
• insights regarding sustainable development depend obviously on
how altruistic agents are
• life cycle models are more appropriate for modeling of
intergenerational interactions like educational investments of
parents into their kids
• the Ramsey setup is the workhorse model in the endogenous
growth literature because of its demographic simplicity
• we proceed as follows
• Microeconomic foundations of savings
• Diamond model
• Ramsey model
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2. Microeconomic Foundations of Savings
• the micro-economic foundation of savings decisions requires a
utility function and a budget constraint
• trick: consumption today (c1 ) and consumption tomorrow (c2 )
are considered as different goods
• utility function
u = u(c1 , c2 ) (1)
• budget constraint
(a) consumption in period 2
c2 = w2 + (w1 − c1 )(1 + r ) (2)
r: interest rate
w1 , w2 : income in period 1,2
→ w1 − c1 > (<)0 implies savings (debts)

(b) equivalently
w2 c2
w1 + = c1 + (3)
1+r 1+r
| {z } | {z }
present value of income present value of expenditures
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Graphical illustration of a two-period model (1)
2: Die reale Makroökonomik
c2 income is w1 and w2
suppose household can neither borrow nor save
M
w2
M is the only feasible point on the

budget constraint
‐(1+r)
c1
0 w1
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c2
Only by accident, M would constitute
a utility maximum
M
w2
ICM
‐(1+r)
c1
0 w1
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c2
More likely event ...
which is not a utility maximum
M
w2
ICR1
‐(1+r)
c1
0 w1
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c2
utility maximum requires transition
from M to R
M
w2
ICR2
ICR1
‐(1+r)
c1
0 w1
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Teil 2: Die reale Makroökonomik
c2
(i): period 1 debts ܿଵ െ ‫ݓ‬ଵ
M
w2
(i)
ICR2
ICR1
‐(1+r)
c1
0 w1 c1
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c2
(i): period 1 debts
M (ii): period 2 repayment of first period

w2
debts plus accrued interests
(ii) 1
c2 R
(i)
ICR2
ICR1
‐(1+r)
c1
0 w1 c1
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c2
(i): period 1 debts
M (ii): period 2 repayment of first period

w2
debts plus accrued interests
(ii) 1
c2 R 1
Move from M to R is welfare

(i) improving!
ICR2
ICR1
‐(1+r)
c1
0 w1 c1
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c2
(i): period 1 savings
(ii): period 2 consumption equals

savings plus accrued interests plus
income
A point M to the c2 R 1
right of R would
imply savings in (ii)
Move from M to R is welfare
period 1 and a w2 improving!
consumption level M
ICR2
above in period 2 (i) ICR1
‐(1+r)
c1
0 c1 w1
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3. The Diamond OLG Model
• individuals at different stages of their life-cycles interact on
markets
• simplest form of an OLG model is sufficient for many applications
[Allais (1947), Samuelson (1958), and Diamond (1965)]
• individuals live for two periods; one period amounts to around 30
years
• at any point in time, the economy is composed of two cohorts
(=generations): young and old
• first period of life
• individuals work and supply one unit of labor earning a real
wage of wt
• individuals consume and save part of their income for
second-period consumption.
• old agents retire and consume their savings plus accrued
interests.
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Graphical illustration of a two-period OLG model
1 2 3 4 5
time
young
1
generation/cohort
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1 2 3 4 5
time
young old
1
generation/cohort
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1 2 3 4 5
time
young old
1
young old
2
young old
3
young old
4
generation/cohort
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1 2 3 4 5
time
young old
1
young and old
young old individuals interact
2 on markets
young old
3
young old
4
generation/cohort
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• so far we illustrated the intertemporal decision of households to
save
• and the demographic structure of a two period OLG model
• we now turn to the general equilibrium structure
• remember that again I = S
• in contrast to the previous chapter we consider discrete time, i.e.
t = 1, 2, 3, .., ∞
• the change in the capital stock from one period to another is
positive, if aggregate investment exceed aggregate capital
depreciation
∆Kt+1 = Kt+1 − Kt = It − δKt = St − δKt (4)
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firms produce ,
old agents own and young agents supply labor

receive capital incomes and
recieve labor incomes
period period
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firms produce ,
young agents save part of

their labor income

old agents consume their young agents consume

capital incomes part of their income
period period
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firms produce ,
aggregate savings = aggregate investments
young agents save part of

their labor income

old agents consume their young agents consume

capital incomes part of their income
period period
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firms produce , firms produce ,
young agents save part of young agents save part of

their labor income their labor income
old agents own and young agents supply labor old agents own and young agents supply labor
receive capital incomes and receive capital incomes and
recieve labor incomes recieve labor incomes
old agents consume their young agents consume old agents consume their young agents consume
capital incomes part of their income capital incomes part of their income
period period
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• lifetime utility: individuals derive utility out of first and
second-period consumption c1t and c2t+1
1
U(c1t , c2t+1 ) = u(c1t ) + u(c2t+1 ) (5)
1+θ
• θ > 0 captures a notion of pure time preference and β = 1+θ 1

<1
is referred to as the discount factor of future consumption
• moreover, u(·) is subject to usual concavity assumptions:
u 0 (·) > 0; u 00 (·) < 0
• agents work only in their first period of life and supply one unit of
time
→ wage income wt equals the present value of consumption
expenditures
c2t+1
wt = c1t + (6)
1 + rt+1
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• savings (s1t ) equal the present value of future consumption, i.e.
c2t+1
s1t = 1+r t+1
• solving (6) for c1t and substituting for c1t in (5) yields a modified
utility function (you can also use Lagrange)
c2t+1 1
Ū = u(wt − )+ u(c2t+1 ), (7)
1 + rt+1 1+θ
• from ∂ Ū
∂c2t+1 = 0 we obtain
1 + rt+1 0
u 0 (c1t ) = u (c2t+1 ) (8)
1+θ
→ Euler equation
→ economic interpretation???
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• Euler equation
1 + rt+1 0
u 0 (c1t ) = u (c2t+1 ) (9)
| {z } 1 + θ | {z }
marg. utility in 1 marg. utility in 2
• the Euler equation is an arbitrage condition equilibrating

marginal utility of consumption intertemporally
• and therefore steering the consumption (savings) profile of an
individual over time
• assume (c.p.) an increase in θ, i.e. future consumption has a
lower weight in the utility function
• the RHS of the Euler equation is smaller than the left-hand side
• the LHS needs to shrink in order to restore the Euler equation
• c1t must increase which implies a lower marginal utility in period 1
[u 0 (c1t ) ↓ as c1t ↑ ]
• at the same time c2t+1 ↓ which implies u 0 (c2t+1 ) ↑
→ an increase in θ leads to a stronger preference for c1t and thus
lower savings
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• Euler equation
1 + rt+1 0
u 0 (c1t ) = u (c2t+1 ) (10)
| {z } 1 + θ | {z }
→ slope of an indifference curve in optimum:

u 0 (c1t )
1
u 0 (c )
= (1 + rt+1 )
1+θ 2t+1
1+rt+1
• if 1+θ = 1 → u 0 (c1t ) = u 0 (c2t+1 ) which implies c1t = c2t+1
• 1 + rt+1 expresses the discount factor of the market (c1t versus
c2t+1 )
• 1 + θ expresses the psychological discount factor of an
individual (c1t versus c2t+1 )
• if 1+rt+1
1+θ > 1 the compensation for forgone current consumption
by the market is higher than the individual compensation, such
that the willingness to save increases
1+rt+1
• if 1+θ < 1 the willingness to save shrinks
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• the savings decision (s1t ) of a household is obtained from the
Euler equation and the budget constraint
• in this general form, an analytical solution for s1t does not exist
• moreover, the reaction of s1t in response to a change in rt+1 is

ambiguous
• rt+1 ↑ increases the price of c1t relative to c2t+1 → c1t ↓ and
c2t+1 ↑ → intertemporal substitution effect
• rt+1 ↑ second period income increases which raises the
desire to increase also first-period consumption c2t+1 , c1t ↑
→ intertemporal income effect
⇒ the net effect of income and substitution effects is
ambiguous! If the substitution effect is sufficiently strong,
s1t is increasing in rt+1
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Canonical form of the OLG model
• as the general form of the model is analytically difficult to handle,

we specify functions as follows
• life time utility of a member of generation t
U = log c1t + β log c2t+1 , β ∈ (0, 1) (11)
• budget constraint
wt = c1t + s1t (12)

c2t+1
s1t = (13)
1 + rt+1
• population evolves according to
Lt+1 = (1 + n)Lt (14)
• final output
Yt = Ktα L1−α
t , α ∈ (0, 1) (15)
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Optimal decisions of households (1)
• as the Euler equation reads as

1 + rt+1 0
u 0 (c1t ) = u (c2t+1 ) (16)
| {z } 1 + θ | {z }
• we obtain for our case
c2t+1 = β(1 + rt+1 )c1t . (17)
• combining the Euler equation with the budget constraint yields

1
c1t = wt , (18)
1+β
c2t+1 β
s1t = = wt (19)
1 + rt+1 1+β
→ s1t is increasing in the weight of second period consumption (β)

and wage incomes (wt )
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Optimal decisions of households (2)

period period
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Profit maximizing decisions of firms (1)
• firms are identical and the representative firm’s profits read as
π = Ktα L1−α
t − wt Lt − (rt + δ)Kt (20)
• perfect competition on goods and factor markets → (factor)

prices are given
• firms maximizes profits
∂π
• ∂Kt = 0 implies
αktα−1 = rt + δ (21)
Kt
with kt = Lt .
• common assumption in two-period OLG models: δ = 1 →
1 + rt+1 = αktα−1
∂π
• ∂Lt = 0 implies
(1 − α)ktα = wt (22)
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Profit maximizing decisions of firms (2)

period period
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Capital accumulation (1)
• goods market equilibrium: It = St

• aggregate investments increase the aggregate capital stock if
Kt+1 − Kt = It − δKt > 0 (23)
• as we imposed δ = 1
Kt+1 = It = St = s1t Lt (24)
• s1t follows from the households’ optimzation problem

β
Kt+1 = wt Lt (25)
1+β
• wt equals the marginal product of labor

β
Kt+1 = (1 − α)ktα Lt (26)
1+β
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Capital accumulation (2)

period period
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Capital intensity (1)
• we only need to take account for population growth

• dividing (26) by Lt yields
Kt+1 β
= (1 − α)ktα (27)
Lt 1+β
Kt+1 Lt+1 β
= (1 − α)ktα (28)
Lt+1 L 1+β
| {zt }
1+n
(29)
• such that we obtain the difference equation governing the

evolution of kt as
β(1 − α)
kt+1 = kα (30)
(1 + β)(1 + n) t
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• From
β(1 − α)
kt+1 = kα (31)
(1 + β)(1 + n) t
(32)
• we can immediatly solve for the stationary solution (steady state)

• in steady state kt+1 = kt = k∗ = const. such that
β(1 − α)
k∗ = kα (33)
(1 + β)(1 + n) ∗
h β(1 − α) i 1−α 1
⇒ k∗ = (34)
(1 + β)(1 + n)
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Graphical solution of
β(1 − α)
kt+1 = kα (35)
(1 + β)(1 + n) t
(36)
• kt+1 = 0 if kt = 0, i.e. kt+1 starts in the origin

• kt+1 is increasing and concave in kt because 0 < α < 1
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Steady state of kt+1 (1)
݇௧ାଵ
݇௧ାଵ
݇௧
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steady state: ∗
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Steady state of kt+1 (2): stability
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Increase in savings (β ↑)
∗ ∗
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Increase in population growth (n ↑)
∗ ∗
37 / 54
Remarks and further applications (1)
• apparently the dynamic characteristics of the Diamond model

correspond to those of the Solow model
• so what did we gain?
• the Diamond model is compatible with empirically observed
life-cycle savings patterns
→ in their first part of the life cycle agents start to accumulate
wealth, the accumulation rate peaks and declines, such that
agents begin to dissave towards the end of their life cycle
• OLG models with many periods (Auerback and Kotlikoff,
1987) are used to simulate the sustainability of social
security systems in view of demographic change and the
impact of fiscal policies on savings, labor supply, etc.
• these models require numerical solution methods
• the Diamond model has paved an avenue for many applications
→
38 / 54
• the Diamond model is most appropriate to analyze interactions

between generations
• and the evolution of economic inequality over time if agents are
endowed with different amounts of wealth or education
• two examples
1) denote by bt+1 the level of bequests a households wishes
to transfer to his child and lifetime utility by
h i
ut = log c1t + β log c2t+1 + θ log(bt+1 + b̄) , b̄ > 0; β, θ ∈ (0, 1)
→ richer agents transfer a higher amount of wealth to their

kids.
→ if this framework is enriched by human capital investment
and poor agents have no access to the capital market→
inequality adversely affects human capital investments and
the prospects of growth (Galor and Zeira, 1993)
39 / 54
2) consider a household that derives pleasure out of the level of

human capital of his child
h i
ut = log c2t + γ log(h1t+1 ) + β log c3t+1 , b̄ > 0; β, γ ∈ (0, 1)
1−τ
h1t+1 = (ē + et )η · h2t
τ
· h̄2t ē > 0; η, τ ∈ (0, 1)
et : level of education chosen by the parents

h2t : parental level of human capital
h̄2t : teachers’ level of human capital
τ: measures the intergenerational persistence of human capital
η: child’s marginal productivity in education
→ better educated parents chose more human capital for their

children
→ the intergenerational persistence in educational inequality can
be dampened by public schooling (de la Croix and Doepke
2003,2004; Glomm and Ravikumar, 1990)
40 / 54
From selfish to altruistic agents (1)
• the Diamond model is a theoretical benchmark in which

generations do care only about themselves
• in the two examples we have seen that the degree of selfishness
can be reduced by implementing payoff relevant variables of
other individuals into the utility function
• like the amount of wealth
• like the level of children’s education or income
• the relative or absolute distance in incomes to capture
inequality aversion
→ impure altruism
• pure altruism means that individuals derive utility out of the
utility level of other persons
• translated to our framework: an agent derives utility out of his
own life cycle consumption and his descendant’s level of utility
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From selfish to altruistic agents (2)
• the modified utility function then writes

U0 = u(c1,0 ) + βu(c2,1 ) + γU1 , γ ∈ (0, 1) (37)
where
U1 = u(c1,1 ) + βu(c2,2 ) + γU2 , (38)
U2 = u(c1,2 ) + βu(c2,3 ) + γU3 (39)
and so on, with γ representing a discount factor of future
generations’ utility.
• omitting second period consumption c2,t+1 , we obtain therefore
∞
X
V0 = γ t u(ct ) (40)
t=0
⇒ if an individual is altruistic towards her direct descendant she

behaves implicitly as if she seeks to maximize the welfare V0 of
the entire dynasty from now to infinity
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4. The Ramsey Model
• the second work horse in the literature dealing with
intertemporal utility maximization is the Ramsey model (Ramsey,
1928; Cass, 1965; Koopmans, 1965)
• this framework makes use of altruistic agents
• since we will apply this framework in the next topic in continuous
time, we transform V0 to continuous time, such that dynastic
welfare writes
Z ∞
V (t) = e−ρt u(c(t))dt, (41)
0
where ρ > 0 is the time preference rate and

Z ∞
V (t) = e(n−ρ)t u(c(t))dt, (42)
0
in case that the population grows at a rate n
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4. The Ramsey Model
Graphical illustration of the equilibrium
households consume ,
hold assets and
accumulate assets by
savings
aggregate amount of supply one unit of

assets equals the labor each
capital stock
firms
,
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4. The Ramsey Model
• the representative household maximizes
Z ∞
V (t) = e−ρt u(c(t))dt, (43)
0
subject to a dynamic budget constraint
ȧ = w(t) + r (t) · a(t) − c(t). (44)
intuition: by consuming today (c(t) ↑) the household reduces

savings, thus ȧ and therefore future incomes and consumption
possibilities
• the economic rationality behind this program is the same as

before
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4. The Ramsey Model
• specifying u(c(t))
(
c(t)1−σ −1
u(c(t)) = 1−σ , if σ 6= 1 (45)
ln c(t), if σ = 1
u(c(t)) is a CIES utility function (constant intertemporal elasticity
of substitution)
• σ measures the elasticity of marginal utility, i.e. the willingness to
shift consumption from the present into the future
• σ is a measure for the curvature of the utility function
• you don’t need to know the solution method for the exam. I will
provide a mathematical appendix for those who are interested
• the maximization of V (t) subject to ȧ yields the famous
Keynes-Ramsey rule
ċ 1
= (r − ρ) (46)
c σ
→ economic intuition?
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4. The Ramsey Model
Economic intuition
• the growth rate of consumption ( ċc ) is positive, whenever r > ρ

• interest rate r is the premium a household receives if it reduces c
by one unit today and increases c tomorrow
• time preference rate ρ is the premium a household demands to
be marginally indifferent between c today and tomorrow
→ for r > ρ it seems rational to postpone consumption into the future
• ċ
c is (c.p.) higher, the higher r . High r gives strong incentives to
postpone c into the future by sacrificing c today, invest into
assets, such that a higher level of c tomorrow can be financed.
(r : opportunity cost of consumption)
• High ρ captures strong impatience such that HH wishes to
consume rather today than tomorrow.
• ċ
c is higher, the lower σ. Low σ implies low curvature of the utility
function, i.e. elast. of marginal utility is low, such that the
household is willing to sacrifice more today and consume at a
higher level tomorrow. r > ρ unfolds a stronger effect
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4. The Ramsey Model
Implications
• apparently r plays a prominent role in determining the growth

rate
• in equilibrium r = f 0 (k ) − δ, such that any policy that affects f 0 (k )

will promote growth
• education
• infrastructure and public services
• property rights
• if the production function is neoclassical, i.e. f 0 (k ) > 0 and

f 00 (k ) < 0, the marginal productivity of capital will shrink if k is
increasing → consumption growth will cease whenever
f 0 (k ) − δ = ρ
• it should be noticed that the maximization of the growth rate is

not a reasonable target of economic policy (why?)
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4. The Ramsey Model
Dynamic system
the dynamics of the economy is now described by a

two-dimensional system of differential equations
1. dynamic equation for consumption

c c
ċ = (r − ρ) = (f 0 (k ) − δ − ρ) (47)
σ σ
2. dynamic equation for the capital intensity which is the same
as in the Solow model
k̇ = f (k ) − c − δk , (48)
note that we assumed here simplifying matters that

x = n = 0.
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4. The Ramsey Model
Steady state (1)
an intuitive "proof" of the existence of a steady state

• assume the production function is neoclassical → f 0 (k ) > 0
and f 00 (k ) < 0
• we know that
c 0
ċ = (f (k ) − δ − ρ) (49)
σ
⇒ ċ = 0 if f 0 (k ∗ ) = δ + ρ
⇒ ċ > 0 if k < k ∗ because f 0 (k ) > δ + ρ
⇒ ċ < 0 if k > k ∗ because f 0 (k ) < δ + ρ
• under diminishing marginal returns to capital
• capital accumulation implies a declining marginal product of
capital (f 0 (k ) ↓)
• the growth rate of consumption shrinks
• and approaches zero if f 0 (k ∗ ) = δ + ρ
• ongoing consumption growth is again impossible
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4. The Ramsey Model
Steady state (2)
steady state: variables grow at constant rates
• this means in our case that c and k should grow at constant
rates
• accumulation (deaccumulation) k̇ > 0 (k̇ < 0) implies declining
(increasing) consumption growth
• the only possibility that c and k grow at constant rates is
ċ = k̇ = 0 (50)
implying that they don’t grow at all

• this is again a neoclassical steady state with zero growth in the
long-run
• steady state solution
ċ = 0→ f 0 (k ∗ ) = δ + ρ ⇒ k ∗ (51)
∗ ∗ ∗
k̇ = 0→ c = f (k ) − δk (52)
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4. The Ramsey Model
Some remarks (1)
• endogenizing savings decisions does not affect the long-run

growth performence
→ as long as the production function is subject to diminishing
returns to capital there is no steady state growth (the growth rate
converges to zero in the long-run)
• this is not surprising as the production side corresponds still to
the Solow model
• the achievement: microeconomic foundation of savings
decisions
• the growth rate of an economy is the result of households’
decisions
⇒ if there are no further imperfections/externalities the objective to
maximize growth is meaningless because a Ramsey household
behaves optimally
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4. The Ramsey Model
Some remarks (2)
• difference to Keynesian view:

• Keynes considered underemployment equilibrium
→ prices are fix and adjustments take place via quantities
→ increase in aggregate demand f.e. government
expenditures
• neoclassical theory assumes full employment
• prices are flexible
• savings build up future production and consumption
possibilities
• massive underemployment and constant prices are
inappropriate assumptions for a (long-run) trend analysis
• underemployment equilibria are rather short-run
phenomenons
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4. The Ramsey Model
Some remarks (3)
• the Ramsey model attaches a predominant role to r in

determining the growth rate
• as in equilibrium r = f 0 (k ) − δ, any policy that affects f 0 (k )
through A (education, infrastructure and public services,
property rights) will promote growth
• if the production function looks like
y =A·k (53)
the growth rate of consumption reads
ċ 1
= (A − δ − ρ), (54)
c σ
ċ
with c > 0 for all times, if A > δ + ρ
• policies that affect the level of A induce higher growth rates
• if Arich > Apoor it follows that richer countries grow faster
⇒ DIVERGENCE!!
54 / 54

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ES50101/ES50104

1. Neoclassical Growth Models

2. The Diamond Overlapping Generations (OLG) model

3. The Ramsey model

D. Acemoglu (2009). Introduction to Modern Economic Growth,

• What are agents motives to save?

• The standard answer is forward-looking behavior

• Are agents (just) concerned about their own life cycle?

→ How altruistic are they?

• If they are altruistic do they only care about their direct

• This questions are fundamentally interlinked with the

• and serve to apply a growth theory to empirical regularities

• in support of the Solow model

• shortcomings of the Solow model

• endogenous savings/consumption decisions or endogenous

but the understanding of this decisions in crucial, if we want to

• growth promoting policies are aimed at the incentives to save

• therefore it is important to implement these features into our

• in this section, we begin with the implementation of savings

→ w1 − c1 > (<)0 implies savings (debts)

M is the only feasible point on the

(i): period 1 debts ܿଵ െ ‫ݓ‬ଵ

(i): period 1 debts

M (ii): period 2 repayment of first period

(i): period 1 debts

M (ii): period 2 repayment of first period

Move from M to R is welfare

(i): period 1 savings

(ii): period 2 consumption equals

∆Kt+1 = Kt+1 − Kt = It − δKt = St − δKt (4)

old agents own and young agents supply labor

young agents save part of

old agents own and young agents supply labor

old agents consume their young agents consume

aggregate savings = aggregate investments

young agents save part of

old agents own and young agents supply labor

old agents consume their young agents consume

firms produce , firms produce ,

aggregate savings = aggregate investments

young agents save part of young agents save part of

• θ > 0 captures a notion of pure time preference and β = 1+θ 1

• the Euler equation is an arbitrage condition equilibrating

→ slope of an indifference curve in optimum:

• moreover, the reaction of s1t in response to a change in rt+1 is

• as the general form of the model is analytically difficult to handle,

U = log c1t + β log c2t+1 , β ∈ (0, 1) (11)

wt = c1t + s1t (12)

Lt+1 = (1 + n)Lt (14)

• as the Euler equation reads as

• we obtain for our case

c2t+1 = β(1 + rt+1 )c1t . (17)

• combining the Euler equation with the budget constraint yields

→ s1t is increasing in the weight of second period consumption (β)

firms produce , firms produce ,

aggregate savings = aggregate investments

young agents save part of young agents save part of

• firms are identical and the representative firm’s profits read as

• perfect competition on goods and factor markets → (factor)

firms produce , firms produce ,

aggregate savings = aggregate investments

young agents save part of young agents save part of