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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

(β

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

+λ

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,

University of Washington Page 26

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

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