Ramsey Ccass Koopman

Macroeconomics 1
Ramsey-Cass-Koopman Model
Sargam Gupta
IGIDR
Fall Semester, 2023
Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 1 / 56

Ramsey-Cass-Koopman Model I
Basic features of the model
Reference: Barro and Salai-Martin (Chapter-2 + Appendix A.3), Daron

Acemoglu (Chapter-8), David Romer (Chapter-2).
Different from Solow model: Households optimizing for consumption
and savings are endogenized
Important basic growth model: Foundation of modern workhorse
models used in macroeconomics
Also known as Ramsey growth model as the orginal mathematical
problem was formulated and solved by Ramsey (1928) and later the
work was extended by Cass (1965) and Koopmans (1965)
Infinite-horizon problem of utility maximization in continuous time
with certainty
Large number of agents with identical households and identical firms
Closed economy model; Single and unique good; No money and No
prices
Ramsey-Cass-Koopman Model II
(a) Frank P. Ramsey (b) David Cass (c) Tjalling C.

(1903-1930) (1937-2008) Koopmans
(1910-1985)

Dynamic Optimization
Decision today influences the outcome tomorrow

Optimization problem: Discrete time vs Continuous time/ Stochastic
vs Deterministic
Stochastic Models (Models with expectations) − > Dynamic
Programming. Example:
Bellman Equation (Discrete time case)
Hamilton-Jacobi-Bellman equation (Continuous time case)
Deterministic Models in continuous time − > Optimal Control Theory

Optimal control theory
Optimal Control Theory deals with finding an optimal control for a

dynamical system over a period of time such that an payoff function
is optimized
Lev S. Pontryagin, Vladimir G. Boltyanskii, and Revaz V. Gamkrelidze
(1956): Maximum principle of optimal control
In a typical OC problem, an agent chooses a time path {ct }t=∞
t=0 of n
t=∞
”control variables” and a time path {kt }t=0 of m ”state variables”

Controlled dynamic problem I
A typical controlled dynamic problem

We call a function α : [0, ∞) → A a control. For each control, we consider
the ordinary differential equation (ODE)
˙ = f (x(t), α(t)) for t > 0
x(t)
x(0) = x0
The trajectory x(·) is the corresponding response of the system.

Controlled dynamic problem II
Optimal control
Our main objective here is to find a control α∗ (.), which maximizes the a
payoff function
Z T
P[α(.)] = r (x(t), α(t))dt + g (x(T ))
0
where x(·) solves ordinary differential equation (ODE) for the control α(.).
Here r : R n × A → R and g : R n → R are given, and where r is the
running payoff and g is the terminal payoff. The terminal time T > 0 is
given as well.

Dynamic problem with control of consumption I
Optimal control problem of consumption

The agent chooses or controls a number of variables, called control
variables, so as to maximize an objective function subject to some
constraints. These constraints are dynamic in that they describe the
evolution of the state of the economy, as represented by a set of state
variables, over time. The problem here is given by:
Z T
max = V (k0 , 0) = v [k(t), c(t), t]dt
ct ,kt 0

Dynamic problem with control of consumption II
subject to constraint
˙ = g [k(t), c(t), t]dt
1 k(t)
2 k(0) = k0 > 0
3 k(T )e −¯r (T )T ≥ 0 No-Ponzi Condition
where V (0) is the value of the objective/ payoff function as seen from the
initial moment 0, r¯(t) is an average discount rate that applies between
dates 0 and t, and T is the terminal planning date, which could be finite
or infinite. The expression for k̇(t) is called the transition equation or
equation of motion. Examples of the felicity function v (.) are utility
functions of consumers, profit functions of firms or objective functions of
governments.

No-Ponzi condition
Forbid your agent from

running Ponzi-schemes,
i.e. acquiring infinite
debt that is never
repaid. Got identified
with Charles Ponzi who
ran a fraudulent scheme
of money making
in 1920s costing his
investors $ 20 million.
Figure: Charles Ponzi (con-artist)

Heuristic derivation for Maximum Principle I
1 Writing Lagrangian Function using Kuhn-Tucker Theorem:

Z T Z T
L= v [k(t), c(t), t]dt + ˙
µ(t)[g [k(t), c(t), t)] − k(t)]dt
|0 {z } |0 {z }
Objective function Dynamic constraint
+ υ.k(T )e −¯r (T )T
| {z }
Static constraint
where µ(t) is the dynamic Lagrangian multiplier or co-state variable or shadow price of
capital
2 ˙ = 0 for all periods. Thus:
Since g (.) − k(t)
Z T
˙
µ(t)[g [k(t), c(t), t)] − k(t)]dt =0
0
It follows that the “sum” of all of the constraints equals 0

Heuristic derivation for Maximum Principle II
RT RT RT ˙
3 L= 0 v [k(t), c(t), t]dt + 0 µ(t)g [k(t), c(t), t)]dt − 0 µ(t)k(t)dt + υ.k(T )e −¯r (T )T
Aside
d
µ(t)k(t) ˙
= µ(t)k(t) ˙
+ k(t)µ(t)
dt
Z T d
Z T Z T
µ(t)k(t)dt = ˙
µ(t)k(t)dt + ˙
k(t)µ(t)dt
0 dt 0 0
Z T Z T
k(T )µ(T ) − k(0)µ(0) = ˙
µ(t)k(t)dt + ˙
k(t)µ(t)dt
0 0
such that, Z T Z T
˙
µ(t)k(t)dt = [k(T )µ(T ) − k(0)µ(0)] − ˙
k(t)µ(t)dt
0 0

Heuristic derivation for Maximum Principle III
4 Thus the Lagrangian can be re-written as,

Z T Z T
L= [v (k(t), c(t), t) + µ(t)g [k(t), c(t), t)] dt + ˙
k(t)µ(t)dt
0 | {z } 0
Hamiltonian function
−k(T )µ(T ) + k(0)µ(0) + υ.k(T )e −¯r (T )T

5 Hamiltonian Function
H(k, c, t, µ) ≡ v (k, c, t) + µg (k, c, t)

6 Re-writing Lagrangian function:
Z T
L= ˙
[H(k(t), c(t), t) + µ(t)k(t)]dt + k(T )[υ.e −¯r (T )T − µ(T )] + k(0)µ(0)
0

Heuristic derivation for Maximum Principle IV
7 Perturbing the paths of c(t) by an arbitrary perturbation function

gives us the following necessary conditions for interior optimal
solutions (See Appendix A.3.3 in Barro and Sala-i-Martin):
∂H(.)
∂c(t) =0
∂H(.) ˙
= −µ(t)
∂k(t)
µ(T ) = υ.e −¯r (T )T where µ(T ) is the shadow price (price of the capital
stock in the last period) The complementary-slackness condition
requires
υ.k(T ).e −¯r (T )T = 0
with υ ≥ 0 which implies µ(T )k(T ) = 0. This boundary condition is
called Transversality Condition.

Pontryagin’s Maximum principle
Maximum Principle
Widely regarded as a milestone in optimal control theory, the significance
of the maximum principle lies in the fact that maximizing the Hamiltonian
is much easier than the original infinite-dimensional control problem; rather
than maximizing over a function space, the problem is converted to a
pointwise optimization. These necessary conditions become sufficient when
the objective function is concave and constraints generate a convex set.
For formal proof of maximum see Pontryagin et al. (1962). For sufficiency
conditions see Mangasarian (1966) and Arrow and Kurz (1970).

Infinite Horizon
When agent is infinitely lived in continuous time
Z ∞
max V (0) = v [k(t), c(t), t]dt
c(t) 0
subject to constraint
1 ˙ = g (k(t), c(t), t)
k(t)
2 k(t) = k(0) > 0
¯
3 limt→∞ [k(t)e −r (t)t ] ≥ 0
Optimality Conditions for infinite horizon case

δ(H)
δ(c) = 0
δ(H)
δ(k) = −µ̇
limt→∞ [µ(t)k(t)] = 0 (Transversality Condition)
Summary steps to solve optimal control problem
1 Identifying: Control and state variables, Payoff function, ODE and

other boundary conditions/ constraints
2 Write the Hamiltonian function (Present Value or Current Value)
3 First order sufficient conditions for Present Value Hamiltonian:
δH(.)
(i) δc(t) = 0
(ii) δH(.) ˙
δk(t) = −µ(t)
(iii) µ(T )k(T ) = 0 (Transversality condition)
4 Solve for equilibrium for optimal control and states.
where µ(T ) is the shadow price (price of the capital stock in the last
period)

Concept of Discounting
Definition
Discounting is the process of converting a value received in a future time
period to an equivalent value today.
Consider a utility function U(ct ). Present value of lifetime utility ( stream

of current and future utility flows) in discrete time:
U(c1 ) U(c2 )
V (0) = U(c0 ) + + + ....... + ∞
(1 + ρ) (1 + ρ)2
In continuous time: Z ∞
V (0) = e −ρt U(ct )dt
0
where ρ is the rate of time preference or the discount factor. Higher the ρ,
more is the present consumption valued. ρ=0 is the case of altruism.

Neo-classical growth model I
In the standard economic problem with households doing optimization, the

pay-off function, v [k(t), c(t), t] is given by the utility function:
Z ∞
V (0) = e −ρt U(ct )dt
0
where, ρ is the rate of time preference. For now we assume it as only a

function of consumption and not leisure. Following are the constraints:
˙ = g (k(t), c(t), t)
1 k(t)
2 k(t) = k(0) > 0

¯
3 limt→∞ [k(t)e −r (t)t ] ≥ 0

Neo-classical growth model II
Present Value Hamiltonian Function
H = e −ρt U(ct ) + µ(t)g (k(t), c(t), t)
where present value of shadow price, µ(t) = e −ρt λ(t)

Re-writing:
H = e −ρt U(ct ) + e −ρt λ(t)g (k(t), c(t), t)
H = e −ρt [U(ct ) + λ(t)g (k(t), c(t), t)]

Assume
H = e −ρt Ĥ
Ĥ = U(ct ) + λ(t)g (k(t), c(t), t) is the Current Value Hamiltonian
(CVH) and λ(t) is the current value of shadow price.

Optimal conditions for Current Value Hamiltonian
Exercise
Show that for the Current Value Hamiltonian, first order conditions are
modified as following: (Ĥ) = U(ct ) + λ(t)g (k(t), c(t), t)
δ Ĥ
1
δc =0
2 δ Ĥ ˙
= ρλ(t) − λ(t)
δk
3 λ(T )e −ρT k(T ) = 0 (finite time), or

limt→∞ [λ(t)e −ρt k(t)] = 0 (infinite time)

Ramsey Growth Model I
Key features of the representative household:

1 Endogenizing savings here
2 Infinite horizon in continuous time
3 Representative household: N households in continuum [0, 1], with
identical households having instantaneous utility function U(ct ).
Assumption 1
U(c) strictly increasing in c, concave, twice continuously differentiable,
0
U (.) > 0 and U ” (.) < 0
Assumption 2
0 0
Inada Conditions limc→0 U (c) = ∞ and limc→∞ U (c) = 0

Ramsey Growth Model II
4 L(0) = 1 and Lt = e nt where n is the rate of growth of household’s
population. This modifies the present value of lifetime utility function
at a household level to the following:
Z ∞
V (0) = e −(ρ−n)t U(c(t))dt
0
where c(t) = CL(t)

(t)
is consumption per capita at t and ρ is subjective
discount rate, and (ρ − n) is the effective discount rate.
Assumption
ρ > n ensures the discounted utility is finite as the utility is valued less
further you move to future in time.
5 Assume no technological progress.
6 All members of the HH supply labour inelastically and receive wages.
Ramsey Growth Model III
7 Households also accumulate assets and earn interest rates. A(t) are
the asset holdings by all the members in a household.
˙ = r (t)A(t) + w (t)L(T ) − c(t)L(t)

A(t)
where,
r (t) is the return to the households on assets
r (t)A(t) = Savings
w (t)L(t) = Labour Earning
c(t)L(t) = Total Spending

Ramsey Growth Model IV
8 Per-capita assets, a(t) would thus be:
A(t) ˙
a(t) ˙
A(t) ˙
L(t) ˙
A(t)
a(t) = =⇒ = − = −n
L(t) a(t) A(t) L(t) A(t)
and,
˙ = r (t)a(t) + w (t) − c(t) − na(t)
a(t)
˙ = (r (t) − n)a(t) + w (t) − c(t)
→ a(t)

Firms
Note that the firm side problem exactly the same as Solow model with
production function satisfying both the Assumptions
Firms are producing output Yt using Lt and Kt
Y (t) = F (K (t), L(t), A(t))
”Technology is labour augmenting” but rate of technology growth is

assumed 0.
Y (t)
y (t) = L(t) = f (k(t), A(t)) = f (k(t)) since A = 1
Gross Return rate from Capital: R(t) = FK = f 0 (k(t))
Wage rate: W (t) = FL = f (k(t)) − k(t)f 0 (k(t))
Market Clearing: (Household Savings)a(t) = k(t) (Firms Investment)
and return to the household r (t) = R(t) − δ, where δ is depreciation
and R(t) is gross return to firms.

Optimal control problem: Ramsey growth Model
R∞
Objective function: maxct ,at V (0) = 0 e −(ρ−n)t U(ct )dt (I)
Constraints
1 a(0) > 0 (II)
2 ˙ = (r (t) − n)a(t) + w (t) − c(t) (III)
a(t)
3 No-ponzi game condition
Z t
lim [a(t)exp[− [r (v ) − n]dv ] ≥ 0 (IV)
t→∞ 0
¯ = 1 t
R
Note that r (t) t 0
r (v )dv

Equilibrium
Definition of equilibrium
A competitive equilibrium of the Ramsey economy consists of paths
[c(t), k(t), w (t), R(t)]∞
t=0 such that the representative household
maximizes (I ) subject to initial capital-labour ratio k(0), (II ), (III )and(IV ).
A steady state is just one point of equilibrium path.

Present Value Hamiltonian Function
1 General Hamiltonian function:
H(k, c, t, µ) ≡ v (k, c, t) + µg (k, c, t)
2 PVH for the model:
H = e −(ρ−n)t U(c(t)) + µ(t)[w (t) + (r (t) − n)a(t) − c(t)]
where,
e −(ρ−n)t U(c(t)) is the objective function
µ(t) is the present value of shadow price
w (t) + (r (t) − n)a(t) − c(t) is the asset accumulation condition

First order conditions I
For the following PVH:
Ht = e −(ρ−n)t U(c(t)) + µ(t)[w (t) + (r (t) − n)a(t) − c(t)]
the sufficient conditions for optimal equilibrium path are as follows:

1 δH
δc = 0 =⇒ U 0 (c(t))e −(ρ−n)t − µ(t) = 0 (I)
2 δH ˙ =⇒ (r (t) − n)µ(t) = −µ(t)

= −µ(t) ˙ (II)
δa
3 Transversality Condition: limt→∞ [µ(t)a(t)] = 0 (III)

First order conditions II
From (I),
U 0 (c)e −(ρ−n)t = µ
Differentiating wrt time:

δµ(t) 0
˙ = δU (c(t)) e −(ρ−n)t + [−(ρ − n)]U 0 (c(t))e −(ρ−n)t
= µ(t)
δt δt
˙ = e −(ρ−n)t [ δU 0 (c) − (ρ − n)U 0 (c)]

=⇒ µ(t) (IV)
δt
˙
Now, from II, (r (t) − n)µ(t) = −µ(t)
Using II and IV, we get

δU 0 (c(t))
e −(ρ−n)t [ − (ρ − n)U 0 (c(t))] = −(r (t) − n)U 0 (c(t))e −(ρ−n)t
δt
Simplifying further:
δU 0 (c(t))
− (ρ − n − r + n)U 0 (c(t)) = 0
δt
δU 0 (c(t))
=⇒ = (ρ − r )U 0 (c(t))
δt
δU 0 (c(t))/δt
=⇒ r (t) = ρ − ( )
U 0 (c(t))
U”(c(t)).δc(t)/δt
=⇒ r (t) = ρ − ( )
U 0 (c(t))
Euler’s Equation :
U”(c(t))c(t) ċ(t)
r (t) = ρ − [ ]
U 0 (c(t)) c(t)
ċ
Smoothing of Consumption: c = 0, then r = ρ
Assume CRRA type utility function:
c (1−θ) − 1
U(c) =
(1 − θ)
U”(c).c
=⇒ [− ]=θ
U 0 (c)
where,
U 0 (c) = c −θ
U”(c) = −θc −θ−1
U”(c).c −θc (−θ−1) .c
− =⇒ −[ ]=θ
U 0 (c) c −θ

θ = Elasticity of Marginal Utility of Consumption
1
θ = Inverse of Intertemporal Elasticity of Substitution = σ
Euler’s Condition: r = ρ + θ ċc
Transition Equation for Consumption: cċ = 1θ [r − ρ]

Time period 1 and 2
−1
d[U 0 [c(t1 )]/U 0 [c(t2 )]]

c(t1 )/c(t2 )
σ= 0 0
.
−U [c(t1 )]/U [c(t2 )] d[c(t1 )]/c(t2 )]
t2 → t1 =⇒ Instantaneous Elasticity i.e.
U 0 (c)

σ= −
c.U”(c)

Transition Equation for Consumption (for CRRA Utility function):
ċ
c = 1θ [r − ρ]
c˙t 1
Now, ct = θ(ct ) [r (t) − ρ]
c˙t
Now, ct = 1θ [r (t) − ρ]: 1st Transition Equation

Household’s constraint and asset accumulation equation:
˙ = (r (t) − n)a(t) + w (t) − c(t)
a(t)
˙ = f (k(t)) − c(t) − (n + δ)k(t)
k(t)
˙ = r (t)a(t) − na(t) + w (t) − c(t)

Now, a(t)
r (t) = Rt − δ = f 0 (k(t)) − δ
Also, y (t) = f (k(t)) = f 0 (kt )kt + wt
˙ = f 0 (k(t))a(t) − δa(t) − na(t) + w (t) − c(t)

a(t)
From Solow Model,

˙ = f (k(t)) − c(t) − (n + δ)k(t) : 2nd Transition Equation
k(t)

Optimizing Conditions for Ramsey Model:
c˙t
1
ct = 1θ [r (t) − ρ] : 1st Transition Equation
k˙t f (k(t)) c(t)
2
kt = k(t) − k(t) − (n + δ) : 2nd Transition Equation
3 Initial Condition, k(0) > 0, c(0) > 0
4 Transversality Condition

Phase Diagram I (From class)

Phase Diagram II (From class)

Phase Diagram III (From class)

Phase Diagram IV (From class)

Phase Diagram V (From class)

Phase Diagram VI (From class)

Phase Diagram VII (From class)

Phase Diagram VIII (From class)

Phase Diagram IX (From class)

Phase Diagram X (From class)

Phase Diagram XI (From class)

Phase Diagram- Ramsey model I (From class)

Phase Diagram- Ramsey model II (From class)

Phase Diagram- Ramsey model III (From class)

Phase Diagram- Ramsey model IV (From class)

Phase Diagram- Ramsey model V (From class)

Phase Diagram- Ramsey model VI (From class)

Phase Diagram- Ramsey model VII (From class)

Ramsey Ccass Koopman

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Macroeconomics 1

Fall Semester, 2023

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 1 / 56

Reference: Barro and Salai-Martin (Chapter-2 + Appendix A.3), Daron

(a) Frank P. Ramsey (b) David Cass (c) Tjalling C.

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 3 / 56

Decision today influences the outcome tomorrow

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 4 / 56

Optimal Control Theory deals with finding an optimal control for a

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 5 / 56

A typical controlled dynamic problem

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 6 / 56

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 7 / 56

Optimal control problem of consumption

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 8 / 56

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 9 / 56

Forbid your agent from

Figure: Charles Ponzi (con-artist)

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 10 / 56

1 Writing Lagrangian Function using Kuhn-Tucker Theorem:

It follows that the “sum” of all of the constraints equals 0

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 11 / 56

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 12 / 56

4 Thus the Lagrangian can be re-written as,

−k(T )µ(T ) + k(0)µ(0) + υ.k(T )e −¯r (T )T

H(k, c, t, µ) ≡ v (k, c, t) + µg (k, c, t)

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 13 / 56

7 Perturbing the paths of c(t) by an arbitrary perturbation function

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 14 / 56

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 15 / 56

Optimality Conditions for infinite horizon case

1 Identifying: Control and state variables, Payoff function, ODE and

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 17 / 56

Consider a utility function U(ct ). Present value of lifetime utility ( stream

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 18 / 56

In the standard economic problem with households doing optimization, the

where, ρ is the rate of time preference. For now we assume it as only a

2 k(t) = k(0) > 0

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 19 / 56

Present Value Hamiltonian Function

H = e −ρt U(ct ) + µ(t)g (k(t), c(t), t)

where present value of shadow price, µ(t) = e −ρt λ(t)

H = e −ρt U(ct ) + e −ρt λ(t)g (k(t), c(t), t)

H = e −ρt [U(ct ) + λ(t)g (k(t), c(t), t)]

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 20 / 56

3 λ(T )e −ρT k(T ) = 0 (finite time), or

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 21 / 56

Key features of the representative household:

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 22 / 56

where c(t) = CL(t)

˙ = r (t)A(t) + w (t)L(T ) − c(t)L(t)

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 24 / 56

8 Per-capita assets, a(t) would thus be:

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 25 / 56

Y (t) = F (K (t), L(t), A(t))

”Technology is labour augmenting” but rate of technology growth is

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 26 / 56

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 27 / 56

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 28 / 56

1 General Hamiltonian function:

H(k, c, t, µ) ≡ v (k, c, t) + µg (k, c, t)

2 PVH for the model:

H = e −(ρ−n)t U(c(t)) + µ(t)[w (t) + (r (t) − n)a(t) − c(t)]

Sargam Gupta (IGIDR) Macroeconomics 1 Fall Semester, 2023 29 / 56