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ECON503: Lecture Notes

Macroeconomic Theory II
by Jorge Rojas
This document has been written using L
A
T
E
X based on the Lectures of Professor
Oksana Leukhina. I assume full responsibility for any mistakes or typos. I promise,
I have minimized them.
1
Contents
1 Market Structures, Welfare Theorems. 2
1.1 Arrow-Debreu Competitive Equilibrium. . . . . . . . . . . . . . . . . . . 2
1.2 First Welfare Theorem. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.3 Sequential Market Structure. . . . . . . . . . . . . . . . . . . . . . . . . . 5
2 Neoclassical Growth Model 9
2.1 SETUP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.2 (SP) Sequential Problem Formulation. . . . . . . . . . . . . . . . . . . . 9
2.2.1 Direct approach (Lagrange) . . . . . . . . . . . . . . . . . . . . . 10
2.3 Functional Equation (Recursive approach) . . . . . . . . . . . . . . . . . 12
3 Topology 14
3.1 Contraction Mapping Theorem . . . . . . . . . . . . . . . . . . . . . . . 18
4 NGM REVISITED 20
4.1 SETUP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
4.1.1 Features of the Model . . . . . . . . . . . . . . . . . . . . . . . . 20
4.1.2 Households . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
4.1.3 Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
4.2 Competitive Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
4.3 Solving for the Equilibrium Path . . . . . . . . . . . . . . . . . . . . . . 22
4.4 Solving NGM using the Sequential Approach . . . . . . . . . . . . . . . . 25
4.5 Calibration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
1
Without Equality in Opportunities, Freedom is the privilege of a few, and Oppression the reality of
everyone else.
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
1 Market Structures, Welfare Theorems.
We will use a simple dynamic exchange economy with two agents to define a equilibrium
concept, in other order to discuss different market structures and the First Welfare
Theorem.
Assumptions:
1. Time is discrete t = 0, 1, 2, . . .
2. two individuals that live forever. There are no other identities.
3. Preferences defined over allocations c
i
= {c
i
t
}

t=0
, i = 1, 2
u(c
i
) =

t=0
β
t
ln(c
i
t
) ; β ∈ (0, 1)
This is a pure exchange economy. For example:
e
1
t
=
_
2 if t is even
0 otherwise
and e
2
t
=
_
0 if t is even
2 otherwise
Commodities here are consumption goods at t = 0, 1, 2, . . . .
Information: all public, full enforcement.
{p
t
} denote prices of these commodities.
Market structure: trading takes place at a central market place in period 0. We further
assume that agents take prices as given.
No more trading takes place after this only one meeting, after that only delivery is carried
out. Another crucial assumption is that the market always clears.
1.1 Arrow-Debreu Competitive Equilibrium.
Definition 1. A Competitive Arrow-Debreu equilibrium is given by {ˆ p
t
}

t=0
and
(ˆ c
1
, ˆ c
2
) such that:
1. Given {ˆ p
t
}

t=0
, {ˆ c
i
t
}
i=1,2
solves:
Max
{c
t
}

t=0

β
t
ln c
i
t
s.t.

ˆ p
t
c
i
t

ˆ p
t
e
i
t
c
i
t
≥ 0 ∀t
2. Prices have to be such that market is clear (also called feasibility constraint).
c
1
t
+ c
2
t
= e
1
t
+ e
2
t
∀t ← there is no storage, otherwise ≤
In this model, we can actually find equation prices and allocations analytically. Setting
up the Lagrangian:
L =

β
t
ln c
i
t
−λ
i
_

ˆ p
t
c
i
t

ˆ p
t
e
i
t
_
University of Washington Page 2
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
The FOC’s are given by:
β
t
c
i
t
= λ
i
ˆ p
t
β
t+1
c
i
t+1
= λ
i
ˆ p
t+1
combining them, we get:
c
i
t+1
c
i
t
= β
ˆ p
t
ˆ p
t+1
⇒ βˆ p
t
ˆ c
i
t
= ˆ p
t+1
ˆ c
i
t+1
(1)
Notice that equation (1) establishes the solution, so hats are needed for mathematical
formality.
We know sum equation (1) across individuals i = 1, 2:
βˆ p
t
(ˆ c
1
t
+ ˆ c
2
t
) = ˆ p
t+1
(ˆ c
1
t+1
+ ˆ c
2
t+1
)
For our example, we have that ˆ c
1
t
+ˆ c
2
t
= ˆ c
1
t+1
+ˆ c
2
t+1
= 2 since markets always clear. Thus,
⇒ β =
ˆ p
t+1
ˆ p
t
(2)
Normalizing p
0
= 1 in (2), we get that ˆ p
1
= β and by recursive iteration:
ˆ p
t
= β
t
(3)
Using equation (1) into (3), we get that:
ˆ c
i
t
= ˆ c
i
t+1
= ˆ c
i
0
∀i = 1, 2
Now, we may use the budget constraint to achieve specific values for our optimal con-
sumption. For agent 1 we have:
ˆ c
1
0

t=0
β
t
= 2 + 0 + 2β
2
+ 0 + 2β
4
+ . . .
ˆ c
1
0
1
1 −β
= 2

t=0
β
2t
= 2

t=0

2
)
t
= 2
1
1 −β
2
⇒ ˆ c
1
0
=
2
1 + β
> 1
For agent 2, on the other hand, we will have that:
ˆ c
2
0
= 2 −
2
1 + β
< 1
Agent type 1 gets to eat more than half of the aggregate endowment in each period.
Why? Because the value of his endowment is larger since agent 1 receives 2 units of the
good in period zero, while agent 2 receives nothing in period zero. As we can see, if you
get higher endowment at the beginning, it will have a net benefit for the rest of the “life”.
So, we should tax the bequest from parents to children to build a better society (Jorge’s
comment), otherwise, inequality will keep going on, regardless of talent.
University of Washington Page 3
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
Definition 2. An allocation {c
1
t
, c
2
t
} is feasible if c
i
t
≥ 0 ∀t, i and c
1
t
+ c
2
t
≤ e
1
t
+ e
2
t
Definition 3. An allocation {c
1
t
, c
2
t
} is Pareto Optimal if:
1. it is feasible
2. there is no other feasible allocation {˜ c
1
t
, ˜ c
2
t
} such that:
i. u(˜ c
i
t
) ≥ u(c
i
t
) for both i, and
ii. u(˜ c
i
t
) > u(c
i
t
) for at least one agent i.
Example 1. c
1
t
= 0 and c
2
t
= 2 ∀t
This allocation is efficient, since any change makes agent 2 worse off, given local non
satiation in the utility function and “selfishness” of the agents.
Example 2. Autarky economy (no trade, closed economy)
c
1
t
2 0 2 ...
c
2
t
0 2 0 ...
any feasible allocation without zero is better, because given the log utility of the agents,
we have that for ln(0)→ −∞. Therefore, this allocation is not Pareto Efficient.
Proposition 1. An allocation is Pareto Optimal if and only if (iff) it solves the Planner’s
problem for some α.
Max
{c
t
}

t=0
α

β
t
ln c
1
t
+ (1 −α)

β
t
ln c
2
t
; α ∈ [0, 1]
s.t. c
1
t
+ c
2
t
= e
1
t
+ e
2
t
∀t
c
i
t
≥ 0 ∀t, i
Prove it as an exercise.
1.2 First Welfare Theorem.
Theorem 1. A competitive equilibrium is Pareto Efficient. In other words, let {ˆ c
1
t
, ˆ c
2
t
}
be the C.E. allocation, then it is also Pareto optimal.
Proof. By contradiction.
Suppose is not, i.e., ∃{˜ c
1
t
, ˜ c
2
t
} such that it is feasible, and
i. u(˜ c
i
) ≥ u(ˆ c
i
) ∀i, and
ii. u(˜ c
i
) > u(ˆ c
i
) for at least one i.
Without loss of generality, suppose u(˜ c
1
) ≥ u(ˆ c
1
).
Step 1.
It must be the case that {˜ c
1
t
} was not affordable for 1 at C.E. prices, or else she would
have chosen it. Hence,

t=0
ˆ p
t
˜ c
1
t
>

t=0
p
t
e
1
t
Step 2.
We show that it must be the case that this {˜ c
2
t
} allocation was either not affordable or
University of Washington Page 4
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
exactly as affordable as {ˆ c
2
t
} for agent 2 as equilibrium prices.
Suppose not, i.e., (it means that ˜ c
2
t
was strictly affordable)

ˆ p
t
˜ c
2
t
<

ˆ p
t
e
2
t
(4)
define δ to be the difference (δ > 0).
Define ˇ c
2
t
=
_
˜ c
2
t
for t = 1, 2, . . .
˜ c
2
0
+ δ for t = 0
By “eating” ˇ c
2
t
, agent 2 would have done better than with {˜ c
2
t
} because u(˜ c
2
) ≥ u(ˆ c
2
),
but u(ˇ c
2
) > u(˜ c
2
) ⇒⇐ (stands for contradiction).
Hence,

ˆ p
t
˜ c
2
t

ˆ p
t
e
2
t
(5)
Step 3.
Suming equations (4) and (5),

ˆ p
t
(˜ c
1
t
+ ˜ c
2
t
) >

ˆ p
t
(e
1
t
+ e
2
t
)
and using the fact that (˜ c
1
t
+ ˜ c
2
t
) ≤ (e
1
t
+ e
2
t
), we get:

ˆ p
t
(e
1
t
+ e
2
t
) ≥

ˆ p
t
(˜ c
1
t
+ ˜ c
2
t
) >

ˆ p
t
(e
1
t
+ e
2
t
)
Transitivity of the inequality gives us the contradiction ⇒⇐. Thus, we have proven the
FWT.
1.3 Sequential Market Structure.
AD: agents meet once at t = 0 and traded claims on future consumption goods.
e.g. In our economy, after trade is completed agent 1 holds claims on 2/(1 +β) of agent
2’s “apples” (our consumption good) in every odd periods. To get those, agent 1 traded
a promise to deliver 2β/(1 + β) apples to agent 2 in all even periods.
A much better approximation to reality is a Sequential Market (SM) structure, where
agents trade each period. It turns out that if Arrow securities (bonds) can also be traded,
then equivalent allocations and prices are achieved in both market structures.
An Arrow security is a claim traded at time t to deliver 1 apple at t +1. Notice that this
is a deterministic environment. Let q
t
be the price of 1 bond at time t. Spend q
t
apples
at time t, to receive 1 apple at time (t + 1).
Definition 4.
1 + r
t
=
1
q
t
Let a
i
t+1
denote the number of Arrow securities (bonds) purchased in period t. Im-
portant: bonds are traded after apple deliveries have been made.
The budget constraint is given by:
c
i
t
+ q
t
a
i
t+1
= e
i
t
+ a
i
t
∀t
q
t
is the price of 1 bond at time t. So, equivalently we may write:
c
i
t
+
a
i
t+1
(1 + r
t+1
)
= e
i
t
+ a
i
t
∀t
University of Washington Page 5
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
Note that a
i
t+1
< 0 means that agent i is borrowing against tomorrow’s income.
a
i
t+1
< 0 ⇔ i holds negative bonds (you are borrowing and you have to pay back).
⇔ you get q
t
a
i
t+1
extra apples today in exchange for a promise to deliver a
i
t+1
apples to
the other agent. Assume that a
i
0
∀i.
Definition 5. A competitive SM equilibrium is allocations {˜ c
i
t
, ˜ a
i
t+1
}

t=0
∀i, and interest
rates {˜ r
t+1
}

t=0
such that:
1. For each i, given {˜ r
t+1
}

t=0
, {˜ c
i
t
, ˜ a
i
t+1
}

t=0
solves:
Max

β
t
ln c
i
t
s.t. c
i
t
+
a
i
t+1
1 + ˜ r
t+1
≤ e
i
t
+ a
i
t
∀t
a
i
0
= 0 ∀i
c
i
t
≥ 0 ∀t
a
i
t+1
≥ −
¯
A
i
← (
¯
A
i
is a “big” number).
The last constraint is necessary for existence, although it will not be binding in the
equilibrium.
2. Feasibility:

i
˜ c
i
t
=

i
e
i
t
∀t Goods Market clearing
Asset market clearing:

i
a
i
t
= 0 ∀t
P
Proposition 2. Suppose {˜ c
i
t
, ˜ a
i
t+1
}

t=0
∧{˜ r
t+1
}

t=0
form a SME. Then ∃ an AD equilibrium
{ˆ c
i
t
}

t=0
∧ {ˆ p
t
}

t=0
such that ˆ c
i
t
= ˜ c
i
t
∀t, i
Suppose allocations {ˆ c
i
t
}

t=0
∧ {ˆ p
t
}

t=0
form an AD equilibrium such that
ˆ p
t+1
ˆ p
t
< 1.
Then ∃(
¯
A
i
)
i=1,2
and a SME {˜ c
i
t
, ˜ a
i
t+1
}

t=0
∧ {˜ r
t+1
}

t=0
such that ˜ c
i
t
= ˆ c
i
t
∀t, i
Notice that the equivalence only holds if the No Ponzi constraints do not bind, and
˜ r
t+1
> 0 ∀t. Although, this last condition is for simplicity, but is not crucial for the
result.
Proof. By definitions.
Step 1: We want to show that SME allocations {˜ c
i
t
} satisfy the AD budget constraint
when AD prices are related to the SM interest rates as follows:
Set ˆ p
0
= 1 and let ˆ p
t+1
=
ˆ p
t
1+˜ r
t+1
∀t. Thus, ˜ q
t
=
ˆ p
t+1
ˆ p
t
by definition is the price of apples
at time (t + 1) in terms of apples at time t.
We know that SM budget constraints hold:
[BC
0
] : ˜ c
i
0
+
˜ a
i
1
1 + ˜ r
1
= e
i
0
+ 0
[BC
1
] : ˜ c
i
1
+
˜ a
i
2
1 + ˜ r
2
= e
i
1
+ ˜ a
i
1
From [BC
1
] ⇒ ˜ a
i
1
= ˜ c
i
1
+
˜ a
i
2
1+˜ r
2
−e
i
1
and this into [BC
0
], we get:
˜ c
i
0
+
˜ c
i
1
(1 + ˜ r
1
)
+
˜ a
i
2
(1 + ˜ r
1
)(1 + ˜ r
2
)
= e
i
0
+
e
i
1
(1 + ˜ r
1
)
University of Washington Page 6
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
by recursive iteration, we get:
T

t=0
˜ c
i
t
Π
t
j=1
+
˜ a
i
T+1
Π
T+1
j=1
(1 + ˜ r
t
)
=
T

t=0
e
i
t
Π
t
j=1
(1 + ˜ r
j
)
(6)
We define Π
0
j=1
(1 + ˜ r
j
) = 1. We also have that:
Π
t
j=1
(1 + ˜ r
j
) =
ˆ p
0

ˆ p
1
×

ˆ p
1

ˆ p
2
×· · · ×
¨
¨
¨
ˆ p
t−1
ˆ p
t
=
ˆ p
0
ˆ p
t
=
1
ˆ p
t
(7)
recall that 1 + r
t
=
p
t−1
p
t
. Using (7) into (6), we get:
T

t=0
ˆ p
t
˜ c
i
t
+
˜ a
i
T+1
Π
T+1
j=1
(1 + ˜ r
t
)
=
T

t=0
ˆ p
t
e
i
t
(8)
taking limit when T → ∞, equation (8) becomes:

t=0
ˆ p
t
˜ c
i
t
+ lim
T→∞
˜ a
i
T+1
Π
T+1
j=1
(1 + ˜ r
t
)
=

t=0
ˆ p
t
e
i
t
(9)
We know that a
i
t+1
≥ −
¯
A
i
for all t, and in particular for T. Then:
0 ≥ lim
T→∞
˜ a
i
T+1
Π
T+1
j=1
(1 + ˜ r
j
)
≥ lim
T→∞

¯
A
i
Π
T+1
j=1
(1 + ˜ r
j
)
= 0 since r
t
> 0 ∀t
Hence:
lim
T→∞
˜ a
i
T+1
Π
T+1
j=1
(1 + ˜ r
j
)
= 0
Therefore,

t=0
ˆ p
t
˜ c
i
t
=

t=0
ˆ p
t
e
i
t
(10)
Step 2: Now, suppose {ˆ c
i
t
, ˆ p
t
} comprise the AD competitive equilibrium. We want to
show that {ˆ c
i
t
} satisfies every SM budget constraint if we define {˜ r
t+1
} and {˜ a
i
t+1
} as
follows:
1 + ˜ r
t+1
=
ˆ p
t
ˆ p
t+1
˜ a
i
t+1
=

τ=1
ˆ p
t+τ
(ˆ c
i
t+τ
−e
i
t+τ
)
ˆ p
t+1
← excess demand!
so, a
i
t+1
is the value of the excess demand in terms of (t + 1) apples. Thus,
˜ a
i
t+1
= ˆ c
i
t+1
−e
i
t+1
+
ˆ c
i
t+2
−e
i
t+2
(1 + ˜ r
t+2
)
+
ˆ c
i
t+3
−e
i
t+3
(1 + ˜ r
t+2
)(1 + ˜ r
t+3
)
+ . . .
˜ a
i
t
= ˆ c
i
t
−e
i
t
+
ˆ c
i
t+1
−e
i
t+1
(1 + ˜ r
t+1
)
+
ˆ c
i
t+2
−e
i
t+2
(1 + ˜ r
t+1
)(1 + ˜ r
t+2
)
+ . . .
dividing period (t + 1) by (1 + ˜ r
t+1
) and subtracting it to ˜ a
i
t
, we get:
˜ a
i
t

˜ a
i
t+1
(1 + ˜ r
t+1
)
= ˆ c
i
t
−e
i
t
University of Washington Page 7
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
This shows what we wanted.
By assumption r
t
> 0, then
ˆ p
t+1
ˆ p
t
≤ ξ < 1. Hence,
˜ a
i
t+1
> −

τ=1
ˆ p
t+τ
e
i
t+τ
ˆ p
t+1
> −

τ=1
ξ
τ−1
e
i
t+τ
. ¸¸ .
¯
A
i
Thus, ˜ a
i
t+1
≥ −
¯
A
i
.
Step 3: Consider a SM equilibrium allocation {˜ c
i
t
, ˜ a
i
t+1
} and {˜ r
i
t+1
} such that ˜ r
t+1
> 0 ∀t
and ˜ a
i
t+1
> −
¯
A
i
. We show that {ˆ c
i
t
} = {˜ c
i
t
} constitute an AD equilibrium allocation for
the earlier definition for {ˆ p
t
}. {ˆ c
i
t
} satisfies market clearing and also maximizes utility
subject to the AD constraint. If not, i.e., if there were another allocation chosen under
AD markets, we know that it would also satisfy SM budget constraints, so it should have
been chosen under SM too.
quot erat demonstrandum
University of Washington Page 8
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
2 Neoclassical Growth Model
2.1 SETUP
1. Time is discrete t = 0, 1, 2, . . .
2. Commodities
i. labour services h
t
ii. capital services k
t
iii. final output y
t
3. Technology: y
t
= F(k
t
, h
t
)
i. F(·) continuous differentiable,
ii. strictly increasing in both arguments,
iii. strictly concave,
iv. homogenous of degree 1,
v. Inada Conditions
a. F(0, h) = F(k, 0) = 0
b. lim
k→0
F
k
(k,
¯
h) = ∞, lim
k→∞
F
k
(k,
¯
h) = 0
c. lim
h→0
F
h
(
¯
k, h) = ∞, lim
h→∞
F
h
(
¯
k, h) = 0
4. Market clearing: y
t
= c
t
+ i
t
5. Law of Motion for capital: k
t+1
= (1 −δ)k
t
+ i
t
; δ ∈ [0, 1]
6. Households: a large number of infinitely lived households preferences can be repre-
sented by a time-separable utility function.
u({c
t
}

t=0
) =

t=0
β
t
u(c
t
) (11)
7. Endowments
i. t = 0 each household has
¯
k
0
units of capital
ii. t = 0, 1, 2, . . . each household has 1 unit of labour
2.2 (SP) Sequential Problem Formulation.
W(k
0
) = Max
{c
t
,k
t+1
,h
t
}

t=0

β
t
u(c
t
)
s.t. c
t
+ k
t+1
−(1 −δ)k
t
. ¸¸ .
i
t
= F(k
t
, h
t
)
c
t
, k
t+1
≥ 0, 0 ≤ h
t
≤ 1
k
0

¯
k
0
given (but we know that k
0
=
¯
k
0
)
University of Washington Page 9
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
Notice that i
t
can be negative k
t+1
< (1 −δ)k
t
(we may disinvest).
W(k
0
): total lifetime utility of the representative household if the Planner chooses
{c
t
, k
t+1
, h
t
}

t=0
to solve the above.
From the utility function we get that h
t
= 1 since the agent does not care about leisure
in this model. We also have that k
0
=
¯
k
0
.
There is no cost of adjustment, so we may define:
f(k) = F(k, 1) + (1 −δ)k (12)
Therefore, we can restate the problem as:
Max
{k
t+1
}

t=0

t=0
β
t
u(f(k
t
) −k
t+1
)
0 ≤ k
t+1
≤ f(k
t
) ← from law of motion for k
k
0
given
This problem is stationary, i.e., time-invariant. Theorem 6.11 in Acemoglu establishes
existence and uniqueness of the solution. Theorem 6.12 in Acemoglu establishes that
FOC’s and TVC are necessary and sufficient to characterize the optimal plan {k

t+1
}

t=0
.
2.2.1 Direct approach (Lagrange)
We may “tackle” this problem using the Lagrange approach:
L =

t=0
β
t
u(f(k
t
) −k
t+1
)
L = u(f(k
0
) −k
1
) + βu(f(k
1
) −k
2
) + β
2
u(f(k
2
) −k
3
) + . . .
FOC’s:
[k
t+1
] : 0 = −β
t
u

(f(k
t
) −k
t+1
) + β
t+1
u

(f(k
t+1
) −k
t+2
)f

(k
t+1
)
rearranging this equation, we get:
⇒ β
t
u

(f(k
t
) −k
t+1
) = β
t+1
u

(f(k
t+1
) −k
t+2
)f

(k
t+1
) (13)
Equation (13) is the so-called Euler equation or intertemporal choice equation.
The Transversality condition (TVC) in Sequential Markets ensures No-Ponzi Game Schemes.
lim
t→∞
β
t
u

(f(k
t
) −k
t+1
)f

(k
t
)k
t
= 0
This condition is equivalent to:
lim
t→∞
λ
t
k
t+1
= 0
Example 3. Solve the above problem using the following functions:
1. u(c) = ln c
2. F(k, 1) = k
α
University of Washington Page 10
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
3. δ = 1
Using the Euler equation and defining the auxiliary variable z
t
=
k
t+1
k
α
t
, we analyse different
cases and we obtain the policy rule k
t+1
= αβk
α
t
. Then,
W(k
0
) =
1
1 −β
_
αβ
1 −αβ
ln (αβ) + ln (1 −αβ)
_
+
α
1 −αβ
ln k
0
NOTE: If there is a steady-state, then we do NOT need the TVC.
Theorem 2. If a sequence {
ˆ
k
t+1
}

t=0
satisfies the Euler Conditions and the Transversality
Conditions, then it solves the related planning problem.
Proof. We have the following functional equation for the Social Planner’s problem:
V (k(0)) = Max
{k(t+1)}

t=0

t=0
U(k(t), k(t + 1)) (14)
subject to:
k(t + 1) ∈ G(k(t)) ∀t ≥ 0
k(0) is given
We define:
Φ(k(t)) = {{k(s)}

s=t
: k(s + 1) ∈ G(k(s)) for s = t, t + 1, . . . }
In other words, Φ(k(t)) is the set of feasible choices of vectors starting from k(t).
This is one way proof (⇒). So, we want to show that if the conditions are satisfied by a
given sequence, then this sequence solves the social planner’s problem.
Consider an arbitrary k(0), and let us define the sequence
ˆ
k ≡ (k(0),
ˆ
k(1), . . . ) ∈ Φ(k(0))
as a feasible nonnegative sequence satisfying the Euler equations (15) and TVC (16).
∂U(k(t),
ˆ
k(t + 1))
∂y
+ β
∂U(
ˆ
k(t + 1),
ˆ
k(t + 2))
∂x
= 0 (15)
and
lim
t→∞
β
t
∂U(
ˆ
k(t),
ˆ
k(t + 1))
∂x
·
ˆ
k(t) = 0 (16)
where x stands for the first argument and y for the second argument of the utility function.
We will show that
ˆ
k yields higher value than any other k ∈ Φ(k(0)). For any k ∈ Φ(k(0)),
define:

k
≡ lim
T→∞
inf
T

t=0
β
t
[U(
ˆ
k(t),
ˆ
k(t + 1)) −U(k(t), k(t + 1))] (17)
Notice the subtle detail that the limit is actually limit inf, since there is no guarantee
that for an arbitrary k ∈ Φ(k(0)), the limit will exist.
We assume that the utility function is well-behaved. That is, U is continuous, concave
and differentiable. Since U is concave, a Taylor expansion of order 1 around (k(t), k(t+1))
tells that:
U(y) = U(x) + DU(x)
T
(y −x) + o(||y −x||
2
)
University of Washington Page 11
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
where DU(x) is the Jacobian of U(x).We also know that U(x) > 0∀x ∈ R
2
and
o(||y −x||
2
) is also positive. Thus, we get:

k
≥ lim
T→∞
inf
T

t=0
β
t
[D
x
U(
ˆ
k(t),
ˆ
k(t+1))·(
ˆ
k(t)−k(t))+D
y
U(
ˆ
k(t),
ˆ
k(t+1))·(
ˆ
k(t+1)−k(t+1))]
(18)
for any k ∈ Φ(k(0)),where D
x
=

∂x
and D
y
=

∂y
.
Since
ˆ
k(0) = k(0), D
x
U(
ˆ
k(0),
ˆ
k(1)) · (
ˆ
k(0) −k(0)) = 0, we can rewrite the inequality as:

k
≥ lim
T→∞
inf
T

t=0
β
t
[D
y
U(
ˆ
k(t),
ˆ
k(t + 1)) + βD
x
U(
ˆ
k(t + 1),
ˆ
k(t + 2))] · (
ˆ
k(t + 1) −k(t + 1))
− lim
T→∞
inf β
T+1
D
x
U(
ˆ
k(T + 1),
ˆ
k(T + 2)) ·
ˆ
k(T + 1)
+ lim
T→∞
inf β
T+1
D
x
U(
ˆ
k(T + 1),
ˆ
k(T + 2)) · k(T + 1)
Recall that liminf(−y
n
+ x
n
) ≥ −limsup y
n
+ liminf x
n
.

k
≥ lim
T→∞
inf
T

t=0
β
t
[D
y
U(
ˆ
k(t),
ˆ
k(t + 1)) + βD
x
U(
ˆ
k(t + 1),
ˆ
k(t + 2))] · (
ˆ
k(t + 1) −k(t + 1))
− lim
T→∞
sup β
T+1
D
x
U(
ˆ
k(T + 1),
ˆ
k(T + 2)) ·
ˆ
k(T + 1)
+ lim
T→∞
inf β
T+1
D
x
U(
ˆ
k(T + 1),
ˆ
k(T + 2)) · k(T + 1)
We know that k satisfies equations (15) and (16). Thus, the terms in the first line
from above are equal to zero because of the Euler equations. The same is true for
the second line because of transversality condition. For the last line, we know that
D
x
U(
ˆ
k(T + 1),
ˆ
k(T + 2)) > 0 since U is increasing in both arguments by assumption. In
addition, we know that k > 0 since we cannot have negative capital. Therefore, we get:

k
≥ lim
T→∞
inf β
T
D
x
U(
ˆ
k(T + 1),
ˆ
k(T + 2)) · k(T + 1) ≥ 0 (19)
Hence, ∆
k
≥ 0. This means that {
ˆ
k
t+1
}

t=0
yields higher value than any other feasible
sequence in Φ(k(0)), and is therefore optimal.
2.3 Functional Equation (Recursive approach)
The recursive formulation, also known as the “Bellman Equation” consists in writing
the problem in the form:
v(k) = Max
0≤k

≤f(k)
{u(f(k) −k

) + βv(k

)} (20)
where:
(a) k: state variable
(b) k

: control variable
(c) v(k): value function
University of Washington Page 12
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
The solution is the function v

(k) and the corresponding optimal policy function is
k

= g(k). Thus,
v

(k) = u(f(k) −g(k)) + βv

(g(k))
In general, we will find conditions under which:
v(k)
.¸¸.
sol. to FE
= W(k)
. ¸¸ .
sol. to SP
and the optimal policy function g(k) from the FE corresponds to the optimal plan
{k

t+1
}
. ¸¸ .
SP
.
Example 4. We have the functions u(c) = ln c and f(k) = k
α
. So, we get:
v(k) = Max
0≤k

≤k
α
{ln(k
α
−k

) + βv(k

)} (21)
We conjecture that the solution has the form v(k) = A + Bln k. Thus,
A + Bln k = Max
0≤k

≤k
α
{ln(k
α
−k

) + β(A + Bln k

)}
FOC’s:

1
k
α
−k

+
βB
k

= 0 ⇒ k

=
βBk
α
1 + βB
= g(k)
at the optimal:
A + Blnk = ln
_
k
α

βBk
α
1 + βB
_
+ β
_
A + Bln
_
βBk
α
1 + βB
__
= ln
_
k
α
1 + βB
_
+ Aβ + βBln
_
βBk
α
1 + βB
_
= (1 + βB)ln(k
α
) −ln(1 + βB) + βA + βBln
_
βB
1 + βB
_
= α(1 + βB)ln(k) −ln(1 + βB) + βA + βBln
_
βB
1 + βB
_
equating the terms with the variable capital k:
⇒ B = α(1 + βB) ⇒ B =
α
1 −αβ
Therefore,
g(k) =
βBk
α
1 + βB
⇒ g(k) = αβk
α
and it holds!!!
In a similar fashion we obtain A.
A =
1
1 −β
_
αβ
1 −αβ
ln(αβ) + ln(1 −αβ)
_
So,
v(k) =
1
1 −β
_
αβ
1 −αβ
ln(αβ) + ln(1 −αβ)
_
+
α
1 −αβ
ln(k)
University of Washington Page 13
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
3 Topology
In macroeconomics, we study functional equations(equations that give functions as a
result, instead of numbers) of the form:
v(x) = Max
y∈Γ(x)
{F(x, y) + βv(y)} (22)
In the case of the Neoclassical Growth Models we have that:
x = k
y = k

F(x, y) = u(f(k) −k

)
Γ(x) = {k

∈ R|0 ≤ k ≤ f(k)}
Definition 6. A function operator is a mapping that takes functions as an input and
returns out a function as an output.
Definition 7. (S, d) is a metric space with norm d(f, g) with f, g ∈ S, if the following
conditions are satisfied:
(i) d(f, g) ≥ 0
(ii) d(f, g) = 0 ⇔ f = g
(iii) d(f, g) = d(g, f)
(iv) d(f, h) ≤ d(f, g) + d(g, h)
Example 5. S = R, d : R×R →R, and d(x, y) = |x−y|. Then (S, d) is a metric space.
Example 6. S =

= {x = {x
t
}

t=0
|x
t
∈ R, ∀t sup
t
|x
t
| < ∞} space of all infinite
sequences of real finite values.
We define the norm d :

×

→ R as d(x, y) = sup
0≤t≤∞
|x
t
− y
t
|. So, (S, d) is a
metric space.
Example 7. S = C(X) = {f|f : X → R, f is continuous and bounded, X ⊆ R
L
} and
we define the norm d : C(X) × C(X) → R as d(f, g) = sup
x∈X
|f(x) − g(x)|. Later, we
will show that (S, d) is indeed a metric space. (This follows directly from the properties
for the supremum operator).
Definition 8. Cauchy Sequence.
A sequence {x
n
}

n=0
with x
n
∈ S is Cauchy if:
∀ > 0, ∃N

∈ N such that d(x
n
, x
m
) < ∀n, m ≥ N

Definition 9. We say that (S, d) is a complete metric space if every Cauchy sequence
{f
n
}

n=0
with f
n
∈ S ∀n converges to some f ∈ S.
Definition 10. Convergence of a sequence.
∀{f
n
}

n=0
∃f ∈ C(X) such that ∀ > 0 ∃N

satisfying d(f
n
, f) < ∀n ≥ N

Example 8. Consider the set S = C(X) to be the set of all continuous bounded functions
defined on a subset of R
L
. Let the metric d : C(X) ×C(X) →R be the supnorm metric.
Prove that (S, d) is a complete metric space.
University of Washington Page 14
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
Solution:
We want to prove that (S, d) is a complete metric space. Therefore, we can prove this
claim in two stages:
(1) we prove that (S, d) is a metric space,
(2) we prove that every Cauchy sequence {f
n
}

n=0
with f
n
∈ S ∀n converges to some
f ∈ S.
First part:
To prove that (S, d) is a metric space, we need to show that for the set S = C(X) and the
metric d(f, g) = sup
x∈X
|f(x) −g(x)| the following conditions are satisfied ∀f, g, h ∈ S:
(i) d(f, g) ≥ 0
(ii) d(f, g) = 0 ⇔ f = g
(iii) d(f, g) = d(g, f)
(iv) d(f, h) ≤ d(f, g) + d(g, h)
We know that f ∈ S, where S is the set of all continuous bounded functions in a subset
of R
L
, we can see that sup
x∈X
|f(x)| < ∞. Thus,
(i) sup
x∈X
|f(x) −g(x)| < sup
x∈X
|f(x)| +sup
x∈X
|g(x)| by property of the supremum.
Moreover, the functions are bounded. This implies that sup
x∈X
|f(x)−g(x)| < λ
1

2
= λ
where λ ∈ R
+
∪ {0}, so we will have that sup
x∈X
|f(x) − g(x)| ∈ [0, λ], and therefore,
d(f, g) ≥ 0.
(ii) Two ways demonstration. Let us start with (⇐).
If f = g, then sup
x∈X
|f(x) −g(x)| = sup
x∈X
|f(x) −f(x)| = sup
x∈X
|0| = 0.
Now, the other implication (⇒). If sup
x∈X
|f(x) − g(x)| = 0 means that the maximum
distance between the two functions is zero, i.e., the two functions must be the same.
Suppose is not, then |f(x) − g(x)| = 0 for at least one x ∈ X. This is a contradiction.
We establish the desired result.
(iii) sup
x∈X
|f(x)−g(x)| = sup
x∈X
| −(f(x)−g(x))| by property of the absolute value.
Then, sup
x∈X
|f(x) −g(x)| = sup
x∈X
|g(x) −f(x)|. Hence, d(f, g) = d(g, f).
(iv) From the properties for the absolute value, we know that |a + b| ≤ |a| + |b|,
and for the properties from the supremum we have a similar triangle inequality given by
sup
x∈X
{f(x) + g(x)} ≤ sup
x∈X
{f(x)} + sup
x∈X
{g(x)}. So,
d(f, h) = sup
x∈X
|f(x) −h(x)|
= sup
x∈X
|(f(x) −g(x)) + (g(x) −h(x))| ← we add a zero
≤ sup
x∈X
|f(x) −g(x)| + sup
x∈X
|g(x) −h(x)| ←triangle inequality
= d(f, g) + d(g, h)
Hence, d(f, h) ≤ d(f, g) + d(g, h). We have shown the first part.
University of Washington Page 15
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
Second part:
We need to prove that:
∀{f
n
}

n=0
∃f ∈ C(X) such that ∀ > 0 ∃N

satisfying d(f
n
, f) < ∀n ≥ N

(23)
We will proceed as it is usual in this kind of problems, i.e., we will apply the definitions
to look for convergency rather than attempting a proof by contradiction.
By assumption {f
n
(x)}

n=0
is a Cauchy sequence, therefore, ∀ > 0, ∃A

such that
sup
x∈X
|f
n
(x) − f
m
(x)| < for all n, m > A

. Now, recall that {f
n
(x)}

n=0
is a sequence
of functions. Therefore, if we fixed x at a particular value in X, say, ¯ x, the sequence
of functions becomes a sequence of numbers given by {f
n
(¯ x)}

n=0
. So, the sequence of
numbers is a Cauchy sequence in R. We know that R is a complete metric space, and
therefore, {f
n
(¯ x)}

n=0
→ f(¯ x). By definition A.9 in Acemoglu (page 881), we can say
that {f
n
(¯ x)}

n=0
converges to the pointwise limit f(¯ x). Applying the same concept for the
whole domain, X, we can claim that the sequence of functions {f
n
(x)}

n=0
will converge
to the pointwise limit function f(x).
To prove convergency we will proceed by definition. We know that {f
n
(x)}

n=0
is
Cauchy and we want to prove that goes to f(x). So, we need to prove there exists N

such that d(f
n
, f) < for all n ≥ N

. Fixing x at ¯ x ∈ X and using the fact that the
sequence is Cauchy, hence d(f
n
, f
m
) < δ, let us say, δ =

2
for all m ≥ n ≥ N

. We have
as follows:
|f
n
(¯ x) −f(¯ x)| = |f
n
(¯ x) −f
m
(¯ x) + f
m
(¯ x) −f(¯ x)| ← add zero
≤ |f
n
(¯ x) −f
m
(¯ x)| +|f
m
(¯ x) −f(¯ x)| ← triangle inequality


2
+|f
m
(¯ x) −f(¯ x)| ← |f
n
(¯ x) −f
m
(¯ x)| <

2
by Cauchy sequence in R
once again we apply the fact that {f
n
(¯ x)}

n=0
→ f(¯ x), therefore, |f
m
(¯ x) −f(¯ x)| < δ =

2
for some m ≥ N

(¯ x). Thus, |f
n
(¯ x) −f(¯ x)| < and the fact that ¯ x is arbitrary. This will
hold for all x ∈ X. Therefore, |f
n
(¯ x) −f(¯ x)| < for all n ≥ N

, implying that under the
norm for this metric space we will have:
sup
x∈X
|f
n
(x) −f(x)| = d(f
n
, f) ≤ ⇒ {f
n
}

n=0
→ f
Once we have proven that this function f(x) is in C(X), we will be done. So, we need
to prove that f(x) is bounded and continuous. First, we prove that f is bounded, i.e.,
sup
x∈X
|f(x)| < ∞.
sup
x∈X
|f(x)| = sup
x∈X
|f(x) −f
n
(x) + f
n
(x)| ← add zero
≤ sup
x∈X
|f(x) −f
n
(x)| + sup
x∈X
|f
n
(x)| ← triangle inequality
we know that sup
x∈X
|f
n
(x)| < α since f
n
is bounded, and we also know that the sequence
converges to f(x), whence sup
x∈X
|f(x) − f
n
(x)| = sup
x∈X
|f
n
(x) − f(x)| < where is
a finite number.
sup
x∈X
|f(x)| < + α = δ
Thus, sup
x∈X
|f(x)| < δ. This shows that f(x) is indeed bounded.
University of Washington Page 16
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
To show continuity we apply the definition for a continuous function. We say that a
function f(x) is continuous if and only if:
∀ > 0, ∀x ∈ X ∃δ(, x) > 0 such that ||x −y|| < δ ⇒ |f(x) −f(y)| < ∀x, y ∈ X
We proceed in a similar fashion as before. Assume that there is a n large enough such
that d(f
n
, f) <

3
. We also know that the sequence of functions f
n
(x) is continuous. So,
we choose a δ > 0 such that ||x −y|| < δ is compatible with |f
n
(x) −f
n
(y)| <

3
. Then,
|f(x) −f(y)| = |f(x) −f
n
(x) + f
n
(x) −f
n
(y) + f
n
(y) −f(y)| ← add zero
≤ |f(x) −f
n
(x)| +|f
n
(x) −f
n
(y)| +|f
n
(y) −f(y)| ← triangle inequality
<

3
+

3
+

3
← by above paragraph
Hence, |f(x) −f(y)| < . This shows that f(x) is continuous.
Therefore, we have proven the second part. This concludes the proof.
Example 9. This is an example of a metric space that is not complete.
S = {f|f : [1, 2] →R, f is continuous and strictly decreasing}
d(f, g) = sup
x∈[1,2]
|f(x) −g(x)|
We just need to provide one Cauchy sequence that does not converge in this space, and
we are done. The sequence f
n
(x) =
1
nx
belongs to the space, however, as n → ∞ f
n
(x) →
0 and 0 is a continuous function, but is not strictly decreasing. Thus, our sequence
converges to an element outside our space, i.e., it does not converge in S.
Let (S, d) be a metric space. T : S → S an operator. We say that T is a Contraction Mapping
if ∃ a number β ∈ (0, 1) such that:
d(T
X
, T
Y
) ≤ βd(X, Y ) ∀X, Y ∈ S
β is called the modulus of a contraction mapping.
Example 10. S = [a, b] ⊆ R and d(X, Y ) = |X−Y | and T
X
= βX for β ∈ (0, 1). Then,
d(T
X
, T
Y
) = |T
X
−T
Y
| = |βX −βY | = β|X −Y | ≤ β|X −Y | ⇒ T(X) is a contraction!
Simple and awesome ¨
Theorem 3. BLACKWELL (Sufficient conditions) Theorem
Let X ⊆ R
L
and B(X) be the space of bounded functions f : X → R with d being the
sup-norm. Let T : B(X) → B(X) such that:
(1) Monotonicity: If f, g ∈ B(X) such that f(x) > g(x) ∀x ∈ X, then
(Tf)(x) ≥ (Tg)(x) ∀x ∈ X
(2) Discounting: Let the function f + a for all f ∈ B(X) and a ∈ R
+
be defined by
(f + a)(x) = f(x) + a.
∃β ∈ (0, 1), ∀f ∈ B(X), a ≥ 0 ∧ x ∈ X ⇒ [T(f + a)](x) ≤ [Tf](x) + βa
University of Washington Page 17
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
Then T is a contraction mapping with modulus β.
Proof. We want to show that (w.t.s.) d(T
f
, T
g
) ≤ βd(f, g) ∀f, g ∈ B(X). Fix an arbitrary
x ∈ X. Then f(x) −g(x) ≤ sup
y∈X
|f(y) −g(y)|. So, f(x) ≤ g(x) + d(f, g). Then,
(Tf)(x) ≤
.¸¸.
by monot.
(Tg + d(f, g))(x) ≤
.¸¸.
by disctg
(Tg)(x) + βd(f, g)
⇒ (Tf)(x) ≤ (Tg)(x) + βd(f, g)
⇒ (Tf)(x) −(Tg)(x) ≤ βd(f, g) / sup
x∈X
(·)
sup
x∈X
|(Tf)(x) −(Tg)(x)| ≤ βd(f, g)
⇒ d(Tf, Tg) ≤ βd(f, g)
This completes the proof.
3.1 Contraction Mapping Theorem
Theorem 4. Contraction Mapping Theorem
Let (S, d) be a complete metric space. Suppose that T : S → S is a contraction mapping.
Then:
(a) T has exactly one fixed-point v

∈ S (existence and uniqueness)
(b) For any v
0
∈ S and any n ∈ N we have that d(T
n
(v
0
), v

) ≤ β
n
d(v
0
, v

), i.e., {v
n
}

n=0
converges to v

at a geometric rate.
Computational approach to FE in NGM.
1. Pick an arbitrary function v
0
(k), say v
0
(k) = 0∀k, after defining a grid for k
2. update your function until convergence.
v
1
(k) = Max
0≤k

≤f(k)
{u(f(k) −k

) + βv
0
(k

)}
until Max
k
|v
n+1
(k) −v
n
(k)| <
Example 11. This may be an exam question.
Prove that the Blackwell sufficient conditions theorem applies to the operator in the NGM
defined as:
Tv(k) = Max
k

∈Γ(k)
{u(f(k) −k

) + βv(k

)}
Proof. W.t.s. the operator:
Tv(k) = Max
k

∈Γ(k)
{u(f(k) −k

) + βv(k

)}
satisfies the 3 conditions.
1) T : B(X) → B(X). Take an arbitrary element v(k) ∈ B(X). v(k) is bounded. Since
we assume that u is bounded, we have that Tv is also bounded.
University of Washington Page 18
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
2) Monotonicity. Suppose v ≤ w (i.e. v(k) ≤ w(k) ∀k ∈ R
+
). We want to show that
Tv ≤ Tw. Let g
v
(k) be an optimal policy corresponding to v. Then for all k ∈ (0, ∞):
Tv(k) = u(f(k) −g
v
(k)) + βv(g
v
(k))
Tv(k) ≤ u(f(k) −g
v
(k)) + βw(g
v
(k)) ≤ Max
k

∈Γ(k)
{u(f(k) −k

) + βw(k

)} = Tw(k)
This implies that Tv(k) ≤ Tw(k). Thus, we have proven monotonicity.
3) Now, we proceed to prove discounting.
T(v + a)(k) = Max
0≤k

≤f(k)
{u(f(k) −k

) + β(v(k

) + a)}
= Max
0≤k

≤f(k)
{u(f(k) −k

) + βv(k

)} + βa
= Tv(k) + βa
so it holds with equality and that is enough since we ask for ≤.
This completes the proof.
Lemma 1. Let (S, d) be a metric space and T : S → S be a contraction mapping. Then
T is continuous.
Proof. Take an arbitrary s
0
∈ S and an arbitrary small > 0. We want to show that
∃δ(s
0
, ) such that whenever d(s, s
0
) < δ(, s
0
) we also have d(Ts, Ts
0
) < . Just choose
δ = . Then:
d(Ts, Ts
0
) ≤
.¸¸.
by T contract.
βd(s, s
0
) < βδ(, s
0
) = β <
This shows the definition for continuity of a function, and hence T is continuous.
Now, we will proceed to prove that Contraction Mapping Theorem (Theorem 4).
Proof. This is an sketch of the proof.
Choose a candidate for a fixed-point.
v

= lim
n→∞
v
n
First, show that this limit is well-defined and it is in S. Do this by showing that v
n
is
a Cauchy sequence and completeness of the metric space (this establishes existence and
uniqueness of the limit).
To show that this limit is indeed a fixed-point, we want to show that: Tv

= v

.
Tv

= T( lim
n→∞
v
n
) =
.¸¸.
by cont.of T
lim
n→∞
Tv
n
= lim
n→∞
v
n+1
= v

University of Washington Page 19
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
4 NGM REVISITED
4.1 SETUP
4.1.1 Features of the Model
a. Includes leisure-labour trade-off, technological progress, and population growth
b. Time is discrete t = 0, 1, 2, . . .
c. One representative household
d. N
t
: the number of identical members in the HH at t (or population size)
e. Population dynamics N
t+1
= N
t
(1 + n) where n > 0 is known parameter
f. Initial population size N
0
g. Each HH member is given 1 unit of time, trade-off between leisure (1 −h
t
) and work
h
t
h. Market wage is w
t
i. Each household is given k
0
units of capital in the initial period
j. HH’s rent their capital to the firm at r
t
k. Upper case variables → aggregate variables,
lower case variables → per-capita variables.
4.1.2 Households
The HH’s are described by:
a. Preference: infinite sequence of consumption, leisure and HH’s size
b. Utility function:


t=0
β
t
N
t
U(c
t
, 1 −h
t
), where β ∈ (0, 1)
c. Assumption: β(1 + n) < 1
d. U(c
t
, 1 − h
t
): increasing in each argument, strictly concave, Inada conditions hold.
These guarantee the existence and uniqueness of a solution
e. Taking the sequence {p
t
, w
t
, r
t
}

t=0
and initial capital endowment per member (k
0
) as
given, the representative HH solves:
Max
{c
t
,k
t+1
,h
t
}

t=0

t=0
β
t
N
t
U(c
t
, 1 −h
t
)
s.t.

t=0
p
t
[c
t
+ (1 + n)k
t+1
] =

t=0
p
t
[w
t
h
t
+ (r
t
+ 1 −δ)k
t
]
c
t
, k
t
> 0, 0 < h
t
< 1∀t
University of Washington Page 20
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
4.1.3 Firms
Firms are described by:
a. One representative firm
b. Behaviour is competitive
c. Production function F(K
t
, H
t
, t)
d. F(K
t
, H
t
, t) satisfies:
(i) homogeneous of degree 1 in K
t
, H
t
(ii) F(0, H, t) = F(K, 0, t) = 0
(iii) increasing in K
t
, H
t
(iv) strictly concave in K
t
, H
t
(v) Inada conditions hold
e. The representative firm seeks to maximise profits taking r
t
and w
t
as given.
Max
{K
t
,H
t
}
F(K
t
, H
t
, t) −r
t
K
t
−w
t
H
t
4.2 Competitive Equilibrium
The Competitive Equilibrium (C.E.) is given by the sequences {c

t
, h
S∗
t
, k
S∗
t+1
, N

t+1
, K
D∗
t
, H
D∗
t
}

t=0
and {r

t
, w

t
}

t=0
such that:
i. Given {r
t
, w
t
}

t=0
, the sequence {c

t
, h
S∗
t
, k
S∗
t+1
}

t=0
solves the HH’s problem
ii. Given {r
t
, w
t
}

t=0
, the sequence {K
D∗
t
, H
D∗
t
}

t=0
solves the firm problem
iii. All markets clear for each t
- labor: h
S∗
t
N

t
= H
D∗
t
- capital: k
S∗
t
N

t
= K
D∗
t
- goods: c

t
N

t
+ K
S∗
t+1
−(1 −δ)K
S∗
t
= F(K
D∗
t
, H
D∗
t
, t)
iv. Population: N

t+1
= N

t
(1 + n)
To solve the HH’s problem we combine the direct approach (i.e. we write the La-
grangian) with the AD formulation:
L =

t=0
β
t
N
t
U(c
t
, 1 −h
t
) −λ

t=0
p
t
[c
t
+ k
t+1
(1 + n) −w
t
h
t
−(r
t
+ 1 −δ)k
t
]
The FOC’s are given by:
∂L
∂c
t
⇒ β
t
U
1
(c
t
, 1 −h
t
)N
t
= λp
t
∂L
∂h
t
⇒ −β
t
U
2
(c
t
, 1 −h
t
)N
t
= −λp
t
w
t
∂L
∂k
t+1
⇒ λp
t
(1 + n) = λp
t+1
(r
t+1
+ 1 −δ)
University of Washington Page 21
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
After some algebraic manipulation, we get:
[H1]: U
2
(c
t
, 1 −h
t
) = −w
t
U
1
(c
t
, 1 −h
t
)
[H2]: U
1
(c
t
, 1 −h
t
) = βU
1
(c
t+1
, 1 −h
t+1
)(r
t+1
+ 1 −δ)
Now, we solve the firm’s problem:
Max
{K
t
,H
t
}
F(K
t
, H
t
, t) −r
t
K
t
−w
t
H
t
FOC’s:
[F1]: r
t
= F
1
(K
t
, H
t
, t) = F
1
(k
t
, h
t
, t) ← HOD 1(Euler’s theorem)
[F2]: w
t
= F
2
(K
t
, H
t
, t) = F
2
(k
t
, h
t
, t)
From the Goods market clearing condition in aggregated terms:
C
t
+ K
t+1
= F(K
t
, H
t
, t) + (1 −δ)K
t
⇒ [M]: c
t
+ k
t+1
(1 + n) = F(k
t
, h
t
, t) + (1 −δ)k
t
Finally, Transversality condition is:
[TVC]: lim
t→∞
β
t
U
1
(c
t
, 1 −h
t
)(r
t
+ 1 −δ)N
t−1
λ
k
t
= 0
From theorem (2) in section (2.2.1), we know that if we find a “candidate” a path
that satisfies conditions [H1], [H2], [F1], [F2], [M], and [TVC], then we have found a C.E.
path.
4.3 Solving for the Equilibrium Path
Let us assume the following functional forms:
U(c
t
, 1 −h
t
) = ln(c
t
) + ηln(1 −h
t
)
F(k
t
, h
t
, t) = Ak
α
t
((1 + g)
t
h
t
)
1−α
Substituting them into the system of equations that defines the equilibrium, we get:
[H1]:
η
1 −h
t
=
w
t
c
t
[H2]:
1
c
t
=
β
c
t+1
(r
t+1
+ 1 −δ)
[F1]: r
t
= Aα(1 + g)
t(1−α)
_
h
t
k
t
_
1−α
[F2]: w
t
= A(1 −α)(1 + g)
t(1−α)
_
k
t
h
t
_
α
[M]: c
t
+ k
t+1
(1 + n) = Ak
α
t
((1 + g)
t
h
t
)
1−α
+ (1 −δ)k
t
We conjecture that the equations solution exhibit balanced growth path behaviour in the
long run, i.e., all variables grow at constant rates, although not necessarily the same.
Let these long run growth rates of c, h, k, r, w, and y be denoted by 1 + γ
c
, 1 + γ
h
, 1 +
γ
k
, 1 + γ
r
, 1 + γ
w
, and 1 + γ
y
.
University of Washington Page 22
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
Proposition 3. It must be the case that:
1 + γ
c
= 1 + γ
k
= 1 + γ
w
= 1 + γ
y
= 1 + g and γ
r
= γ
h
= 0
To prove this proposition we just need to work with the set of equations [H1]-[M], and
find the relationships for
x
t+1
x
t
that is the growth rate of the variable x
t
.
Let us define the variables:
ˆ c
t
=
c
t
(1 + g)
t
,
ˆ
k
t
=
k
t
(1 + g)
t
, ˆ w
t
=
w
t
(1 + g)
t
,
ˆ
h
t
= h
t
, ˆ r
t
= r
t
So, we get:
[
ˆ
H1] :
η
1 −
ˆ
h
t
=
ˆ w
t$
$
$
$$
(1 + g)
t
ˆ c
t$
$
$
$$
(1 + g)
t
=
ˆ w
t
ˆ c
t
[
ˆ
H2] :
ˆ c
t+1
(1 + g)
£
t+1
βˆ c
t$
$
$
$$
(1 + g)
t
=
ˆ c
t+1
(1 + g)
βˆ c
t
= ˆ r
t+1
+ 1 −δ
[
ˆ
F1] : ˆ r
t
= Aα
_
ˆ
h
t
ˆ
k
t
_
1−α
[
ˆ
F2] : ˆ w
t
= A(1 −α)
_
ˆ
k
t
ˆ
h
t
_
α
[
ˆ
M] : ˆ c
t
+
ˆ
k
t
(1 + g)(1 + n) = A
ˆ
k
α
t
ˆ
h
1−α
t
+ (1 −δ)
ˆ
k
t
Proposition 4.
ˆ
k
t
cannot grow unboundedly.
Proof. By contradiction.
Suppose
ˆ
k
t
→ ∞. We know from the utility function that
ˆ
h
t
< 1, so by [
ˆ
F1] we have that
ˆ r
t
→ 0 as
ˆ
k
t
→ ∞. From [
ˆ
H2], we have that:
ˆ c
t+1
ˆ c
t

t→∞
(1 −δ)β
1 + g
< 1
taking [
ˆ
M] and dividing it by
ˆ
k
t
(1 + g)(1 + n), we get:
$
$
$
$
$
$
$
$
$$X
0
ˆ c
t
(1 + g)(1 + n)
ˆ
k
t
+
ˆ
k
t+1
ˆ
k
t
=
$
$
$
$
$
$
$
$
$
$
$
$
$$X
0
A
(1 + g)(1 + n)
_
ˆ
h
t
ˆ
k
t
_
1−α
+
(1 −δ)
(1 + g)(1 + n)
Therefore,
ˆ
k
t+1
ˆ
k
t
< 1
This implies that
ˆ
k
t
is decreasing through time, so
ˆ
k
t
cannot go to ∞, and hence
ˆ
k
t
cannot
grow unboundedly.
Notice that not growing unboundedly is not the same as converging to a Steady State
(SS).
We can find the analytical solution for our economy by solving the system [
ˆ
H1]-[
ˆ
M] in
terms of ˆ c
ss
, ˆ w
ss
, ˆ r
ss
,
ˆ
k
ss
,
ˆ
h
ss
.
University of Washington Page 23
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
Proposition 5. Characterizing the equilibrium.
1) ∃ a unique equilibrium for this model (matter of faith, we won’t prove it)
2) FOC’s and TVC are sufficient conditions for being an equilibrium. We proved it in
theorem (2) section (2.2.1)
Notice that our variables will not exhibit “jumps” because of consumption smoothing.
Lemma 2. If k
0
=
ˆ
k
ss
, then k
t
= k
BGP
t
= (1 + g)
t
ˆ
k
ss
Lemma 3. If k
0
=
ˆ
k
ss
, then k
t
→ k
BGP
t
Figure 1: Converging to the BGP.
Figure (1) shows that there are different transition paths to the BGP for different
initial conditions. However, every transition path converges to the BGP.
Figure 2: Gross Domestic Product for the US between 1890 and 2010.
University of Washington Page 24
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
Assumption 1. From figure (2), we can see that for the post-war data (i.e. ignoring
1940-1950) the slope of log-GDP is quite stable. Thus, in order to identify the param-
eters of the model, we assume that the post-war data can be well-represented by BGP
equilibrium.
We usually have parameters given to us. We can solve for empirical moments along
the BGP.
k
BGP
t
y
BGP
t
=
ˆ
k
ss$
$
$
$$
(1 + g)
t
A(k
BGP
t
)
α
(
$
$
$
$$
(1 + g)
t
h
BGP
t
))
1−α
k
BGP
t
y
BGP
t
=
1
A
_
ˆ
k
ss
ˆ
h
ss
_
1−α
Similarly, we get:
x
BGP
t
y
BGP
t
=
1
A
[(1 + n)(1 + g) −(1 −δ)]
_
ˆ
k
ss
ˆ
h
ss
_
1−α
We solve for the other moments as in homework 2, question 4.
4.4 Solving NGM using the Sequential Approach
Consider the Neoclassical Growth Model with technical change, but no utility from leisure.
Time is discrete t = 0, 1, 2, . . . Population dynamics is given by N
t+1
= N
t
(1 + n), N
0
is
known. Each household member is endowed with 1 unit of productive time that can use
to earn the market wage w
t
per unit of time. The representative household’s preferences
are described by


t=0
β
t
N
t
logc
t
. Each household member is also endowed with k
0
units
of capital. Every period, household members rent their capital to the firm at the rate r
t
.
Capital depreciates at rate δ. There is a competitive production sector, with technology
given by F(K
t
, H
t
, t) = K
θ
t
((1 + g)
t
H
t
)
1−θ
, where K and H stand for capital and labour
inputs.
(a) Define the competitive equilibrium in this economy, clearly stating the representative
household’s and firm’s maximization problems and market clearing conditions.
(b) Derive conditions that fully characterize the competitive equilibrium. Derive bal-
anced growth rates of c
t
, w
t
, k
t
, y
t
, and r
t
.
Solution part (a).
The representative firm takes the sequences for the interest rate and the wage, {r
t
, w
t
}

t=0
,
as given. The firm’s problem is to maximise profits subject to its technology. This is
written as follows:
Max
{Y
t
,K
t
,H
t
}

t=0

t=0
Y
t
−r
t
K
t
−w
t
H
t
s.t.
Y
t
= F(K
t
, H
t
, t) = K
θ
t
((1 + g)
t
H
t
)
1−θ
∀t ≥ 0
Y
t
, K
t
, H
t
≥ 0
Plugging the technology into the objective function, we get the equivalent maximisation
problem:
Max
{K
t
,H
t
}

t=0
Π =

t=0
K
θ
t
((1 + g)
t
H
t
)
1−θ
−r
t
K
t
−w
t
H
t
(24)
University of Washington Page 25
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
We assume that there are interior solutions, so we can ignore the non-negativity cons-
traints.
The representative household takes as given the sequences for the interest rate {r
t
}

t=0
and the wage {w
t
}

t=0
, as well as the endowed capital k
0
. The household wants to maximise
his/her lifetime utility subject to the budget constraint given by:
c
t
+ i
t
= w
t
+ r
t
k
t
and
i
t
= k
t+1
−(1 −δ)k
t
⇒ c
t
+ k
t+1
−(1 −δ)k
t
= w
t
+ r
t
k
t
c
t
+ k
t+1
= w
t
+ r
t
k
t
+ (1 −δ)k
t
c
t
+ k
t+1
= w
t
+ (r
t
+ 1 −δ)k
t
So, for the whole economy this is translated into:
c
t
N
t
+ k
t+1
N
t+1
= w
t
h
t
N
t
+ (r
t
+ 1 −δ)k
t
N
t
Therefore, the maximisation problem that the representative household solves is given
by:
Max
{c
t
,k
t+1
,h
t
}

t=0

t=0
β
t
N
t
logc
t
s.t.
c
t
+ (1 + n)k
t+1
= w
t
h
t
+ (r
t
+ 1 −δ)k
t
∀t
c
t
, k
t
≥ 0, 0 ≤ h
t
≤ 1 ∀t
There are some facts, that are worthwhile mentioning. First, there is no leisure in the
utility function. Hence, h
t
= 1 for all t. The other fact is that the utility function satisfies
the Inada conditions, so the non-negativity constraint for consumption will not be
binding. Finally, k
t
at time 0 is given by k
0
, and capital cannot be negative. Although,
we allow for “disinvestment”. Thus, we can rewrite the problem for the household as:
Max
{c
t
,k
t+1
}

t=0

t=0
β
t
N
t
logc
t
(25)
s.t.
c
t
+ (1 + n)k
t+1
= w
t
+ (r
t
+ 1 −δ)k
t
∀t
c
t
, k
t+1
> 0, ∀t
k
0
given
So, the maximization problems for the firm and the household are given by (24) and (25),
respectively.
The competitive equilibrium, in general, is given by the sequences:
{ˆ c
t
,
ˆ
k
S
t+1
,
ˆ
h
S
t
,
ˆ
N
t+1
,
ˆ
K
D
t
,
ˆ
H
D
t
, ˆ r
t
, ˆ w
t
}

t=0
where D is for demand and S is for supply, such that:
(i) given {r
t
, w
t
}

t=0
, the sequences {ˆ c
t
,
ˆ
k
S
t+1
,
ˆ
h
S
t
}

t=0
solve the household problem ∀t,
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ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
(ii) given {r
t
, w
t
}

t=0
, the sequences {
ˆ
K
D
t
,
ˆ
H
D
t
}

t=0
solve the firm’s problem ∀t,
(iii) Population dynamics is given by
ˆ
N
t+1
=
ˆ
N
t
(1 + n).
(iv) all markets clear ∀t:
Labor market:
ˆ
h
S
t
ˆ
N
t
=
ˆ
H
D
t
Capital market:
ˆ
k
S
t
ˆ
N
t
=
ˆ
K
D
t
Goods market: ˆ c
t
ˆ
N
t
+
ˆ
K
S
t+1
= F(
ˆ
K
D
t
,
ˆ
H
D
t
, t) + (1 −δ)
ˆ
K
S
t
ˆ c
t
ˆ
N
t
+
ˆ
K
S
t+1
−(1 −δ)
ˆ
K
S
t
= F(
ˆ
K
D
t
,
ˆ
H
D
t
, t)
ˆ c
t
ˆ
N
t
+
ˆ
I
S
t
= F(
ˆ
K
D
t
,
ˆ
H
D
t
, t)
The last equation above states that the total output of the economy is equal to the
total consumption by the households plus the total investment from the households
in the economy.
Solution part (b).
Let us start with the representative firm. The FOC’s for this problem are given by:
∂Π
∂K
t
= θ((1 + g)
t
H
t
)
1−θ
K
θ−1
t
−r
t
= 0
⇒ θ
_
(1 + g)
t
H
t
K
t
_
1−θ
−r
t
= 0
⇒ r
t
= θ
_
(1 + g)
t
_
H
t
K
t
__
1−θ
⇒ r
t
= θ
_
(1 + g)
t
_
1
k
t
__
1−θ
⇒ r
t
= θ(1 + g)
t(1−θ)
k
θ−1
t
∂Π
∂H
t
= (1 −θ)(1 + g)
t
K
θ
t
((1 + g)
t
H
t
)
−θ
−w
t
= 0
⇒ (1 −θ)(1 + g)
t
_
K
t
H
t
_
θ
(1 + g)
−θt
−w
t
= 0
⇒ w
t
= (1 −θ)(1 + g)
t(1−θ)
k
θ
t
For the household we will have three FOC’s (c
t
, k
t+1
, h
t
). Let us first write the
Lagrangian:
L =

t=0
β
t
N
t
logc
t
−λ
t
(w
t
+ (r
t
+ 1 −δ)k
t
−c
t
−(1 + n)k
t+1
)
Thus,
∂L
∂c
t
: β
t
N
t
c
t
−λ
t
= 0
⇒ λ
t
=
β
t
N
t
c
t
∂L
∂k
t
: −λ
t
(r
t
+ 1 −δ) + λ
t−1
(1 + n) = 0
⇒ λ
t
(r
t
+ 1 −δ) = λ
t−1
(1 + n)
University of Washington Page 27
ECON503: Lecture Notes
Macroeconomic Theory II
by Jorge Rojas
Combining these two equations, we get that:
β
t
N
t
c
t
(r
t
+ 1 −δ) =
β
t−1
N
t−1
c
t−1
(1 + n) / ·
1
N
t−1
β
$
$
$
$
(1 + n)
$
$
$
$
(1 + n)
(r
t
+ 1 −δ) =
c
t
c
t−1
Therefore, the condition is:
c
t
c
t−1
= β (r
t
+ 1 −δ)
We already know that h
t
= 1, since there is no utility from leisure. The other conditions
are identical to [H1] to [M] in section (4.3) with the appropriate conversions.
4.5 Calibration
We define an economy by choosing specific functional forms and assigning values to the
parameters of the model. Then, we solve for the Balanced Growth Path (BGP). If we set
the model correctly, then the data counterparts should approach the BGP good enough.
In order to properly define the economy, we go in reverse: Start with the feature of
the data we want to match, then select the parameter values that would give us those
“features”.
University of Washington Page 28